An institutional money manager registered as an investment adviser and specializing in quantitative investment strategies (the “Manager”), an affiliated registered investment adviser responsible for developing the code for Manager’s quantitative investment model and the holding company for the two advisers (“Holding Company” and, together with the two advisers, the “Respondents”) agreed to pay over $240 million to settle administrative securities fraud charges brought by the SEC alleging that the Respondents concealed an error in the computer code of the quantitative investment model used for managing the assets of Manager’s clients.
Background. According to the SEC order describing the settlement, the Respondents concealed a material error in the model’s code that disabled one of the key components for managing risk. The error, discovered in June 2009, affected a number of accounts managed by the Manager. Employees of the Respondents who were aware of the error delayed escalating information about the error to senior officers, and did not notify the CEO of the Holding Company until November 2009. In addition, in presentations and other communications to clients and consultants after discovery of the error, the Respondents misrepresented the computer model’s ability to control risk and ascribed underperformance caused in part by the error to market volatility and factors unrelated to the error. The error was fixed between late October and early November 2009. The Respondents did not notify the SEC of the error until March 31, 2010, and first notified clients on April 15, 2010.
Violations. The SEC found that the actions of the Holding Company violated the anti-fraud provisions of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 based on the material misrepresentations and omissions made to investors concerning (i) the model and (ii) the compliance and control procedures of the adviser affiliate that maintained the model (the “Model Affiliate”). The SEC found violations of Section 206(2) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), under which a registered adviser owes a fiduciary duty to its clients, based on (a) the material misrepresentations and omissions giving rise to the Section 17(a)(2) and (a)(3) violations, (b) the Model Affiliate’s failure to conduct a meaningful materiality analysis of the error in the code and (c) the affiliated advisers’ failure to act promptly to correct the error. The SEC also found that the Model Affiliate had violated Rule 206(4)-7 under the Advisers Act by failing to maintain compliance procedures designed to ensure that the model operated as intended and that false and misleading statements/omissions were not made to clients.
Sanctions. As part of the settlement, without admitting or denying the charges brought by the SEC, the Respondents agreed to (1) pay approximately $217 million to 608 client portfolios estimated to have experienced losses as a result of the error, (2) pay a $25 million penalty to the SEC, (3) undertake specified oversight and global compliance measures, and (4) hire an independent compliance consultant with expertise in quantitative investment techniques to make recommendations regarding (a) appropriate disclosures to investors regarding the code, (b) the reporting process relating to the model and (c) how to document and retain changes in the code.