The SEC settled administrative proceedings against Structured Portfolio Management, L.L.C., a hedge fund adviser (the “Adviser”), and two of its affiliated advisers, SPM Jr., L.L.C. (“Adviser A”) and SPM IV, L.L.C. (“Adviser B”), (collectively with the Adviser, the “Advisers”) over findings that the Advisers had violated the compliance program requirements of the Investment Advisers Act of 1940 (the “Advisers Act”) by failing to adopt written procedures reasonably designed to (a) detect and prevent improper trade allocations and (b) ensure the accuracy of disclosures in offering documents and marketing materials regarding fund trading and investment strategies. This article summarizes the SEC’s findings in the settlement order (the “Order”), which the respondents have neither admitted nor denied.
Background. The Adviser advises the Structured Servicing Holdings Master Fund, L.P. (the “Fund”). Adviser A, which was registered with the SEC until January 2013, advised the Parmenides Master Fund, L.P. (“Fund A”). During the relevant period, Adviser owned approximately 90% of Adviser A. Adviser B, which was registered with the SEC until April 2009, advised the Aqueous Master Fund, L.P. (“Fund B”). During the relevant period, the Adviser owned approximately 44% of Adviser B.
The Fund and Fund A invested in mortgage-related securities, including collateralized mortgage obligations, mortgage-backed securities (“MBS”), and interest-only bonds. Interest rate risk for the Fund and Fund A was hedged by trading in a variety of liquid securities, including U.S. Treasury securities (“Treasuries”). Separate portfolio managers were responsible for the Fund’s and Fund A’s core mortgage-related securities holdings while a third trader (the “Hedge Trader”) was responsible for hedging interest rate risk for both Funds. The Adviser’s principals subsequently formed Fund B, which sought to provide excess returns by investing in a wide range of financial assets drawn principally from the U.S. residential and commercial mortgage markets, along with Treasuries and other securities. Adviser B was created to manage Fund B, and the Hedge Trader was appointed as the Fund’s portfolio manager and trader. Fund B received seed capital from the Fund and Fund A, which were consistently among Fund B’s largest investors.
Hedge Fund Trader Conflict. The SEC found that the Hedge Trader was subject to a potential conflict of interest with respect to trade allocation when trading the same Treasuries for all three Funds. When trading for the Fund and Fund A, the Hedge Trader’s main responsibility was to hedge interest rate risk. When trading for Fund B, the Hedge Trader’s sole responsibility was to make a profit. The Advisers recognized and disclosed this potential conflict at Fund B’s inception but did not modify or update its written policies and procedures.
Trading Compliance Procedures. The Advisers followed a single set of compliance policies and procedures (the “Compliance Manual”), which was created in consultation with an external consultant. The Compliance Manual stated that Advisers’ traders would seek to allocate trades “in a fair and equitable manner in light of the investment objectives and strategies of [the Advisers’] funds and other factors.” The trade confirmation procedures in the Compliance Manual required a trader executing a trade to complete a trade blotter identifying, among other things: (i) the name of the Fund purchasing or selling the security; (ii) a description of the security traded; (iii) the amount of securities traded; (iv) the price at which the trade was executed; and (v) the counterparty. On a daily basis, a member of the operations staff was required to review and enter the blotter information into the Advisers’ proprietary trade management system. The SEC found that (a) after the creation of Fund B, the Advisers did not institute any additional procedures to confirm that traders identified at the time of trade the Fund for which the securities were traded, and (b) trade blotters were provided to, or collected by, the Advisers’ operations department on a sporadic basis throughout the day without any way of determining when the trader had identified the Fund for which the securities were traded in relation to when the trade was executed.
Trade Allocation Concerns. In August 2006, based on reviews of trading data, concerns were raised internally at the Advisers as to whether Fund B was receiving more favorable prices than the Fund and Fund A when all three were trading the same Treasury security on the same day. As a consequence, the Hedge Trader was allowed to trade only for Fund B for a period of six months. In January 2007, in conjunction with allowing the Hedge Trader to resume trading for all three Funds, the Advisers instructed traders to provide trade blotters to the operations department more frequently throughout the day and assigned a junior compliance officer to ensure that trade blotters were provided in a timely manner, but the Advisers did not amend their written policies and procedures to address the potential for conflicts.
The SEC faulted these remedial measures on several scores:
“[T]he oral instructions regarding the trade blotters were not accompanied by anything in writing and no additional guidance was provided to the traders or to the junior compliance officer. For example, while traders were required to provide blotters to the operations department more frequently, there was no written guidance concerning when the blotter needed to be provided in relation to when the trade was placed. Further, [the Advisers] did not provide the junior compliance officer with any written procedures to ensure that blotters were provided in a timely manner. In November 2008, while the junior compliance officer was on vacation and there was no one assigned to carry out those responsibilities, [the Advisers] raised concerns that traders were not properly allocating their trades by fund at the time of execution.”
Trade allocation concerns were subsequently raised by an independent firm during the Advisers’ annual compliance review in November 2008, and again internally in January 2009 on the basis of a statistical analysis showing that Fund B’s trading performance from September 2007 through January 2009 was aberrational. A subsequent review of trade allocations by outside counsel was inconclusive. In March 2009, Fund B was closed.
The SEC found that while the Advisers’ compliance manual “required traders to identify the fund for which the securities were being traded upon execution, this requirement alone was not sufficient for preventing improper trade allocations,” and that “[d]espite being aware of concerns about improper trade allocations, [the Advisers] failed to adopt and implement written policies and procedures reasonably designed to prevent improper trade allocations.”
Inadequate Procedures for Disclosure Review. The SEC found that as a result of not adopting and implementing compliance policies and procedures reasonably designed to prevent inaccurate investor disclosures, the Advisers did not adequately review Fund B’s offering documents and other investor disclosures on a regular basis to determine whether they were inaccurate. Fund B’s private placement memorandum disclosed that it would invest primarily in MBS, including Fannie Maes and Freddie Macs, but that it also might invest in Treasuries and other liquid securities. From Fund B’s inception in February 2006 until mid‑2007, it traded highly liquid MBS and Treasuries as set forth in its offering documents. Over time, however, Fund B stopped trading MBS and began almost exclusively to day-trade Treasuries from September 2007 through February 2009, Fund B made only two trades that were not in Treasuries.
Violations. The SEC found that the Advisers violated the compliance program requirements of Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder by failing to implement written policies and procedures reasonably designed to prevent (1) improper trade allocations and (2) inaccurate disclosures in offering and marketing materials.
Sanctions and Remedial Measures. In addition to a cease-and-desist order and censure, the Advisers agreed jointly and severally to pay a civil penalty of $300,000. The Adviser also agreed to (a) engage a compliance consultant to make recommendations with respect to its policies and procedures designed to prevent and detect improper trade allocations and inaccurate investor disclosures and (b) send a copy of the Order to its advisory clients and private fund investors within twenty days of the Order’s entry and promptly revise its Form ADV to reflect the Order.