As part of an initiative to combat hedge fund fraud by identifying abnormal investment performance, the SEC has filed enforcement actions against multiple advisory firms and individuals for various misconduct including improper use of hedge fund assets, fraudulent valuations, and misrepresenting fund returns. Under the Aberrational Performance Inquiry initiative, the SEC uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further scrutiny.
As explained by Robert Khuzami, Director of the Division of Enforcement, the Commission is using risk analytics and unconventional methods to help achieve what the Director called the holy grail of securities law enforcement, which is earlier detection and prevention. This approach, especially in the absence of a tip or complaint, minimizes both the number of victims and the amount of loss while increasing the chance of recovering funs and charging the perpetrators.
In these actions, the SEC alleges that the firms and managers engaged in a wide variety of illegal practices in the management of hedge funds or private pooled investment vehicles, including fraudulent valuation of portfolio holdings, misuse of fund assets, and misrepresentations to investors about critical attributes such as performance, assets, liquidity, investment strategy, valuation procedures, and conflicts of interest.
In one action, the SEC alleged that a hedge fund’s former portfolio manager schemed with two European-based brokers to inflate the fund’s reported monthly returns and net asset value by manipulating its supposedly independent valuation process. According to the SEC complaint, the portfolio manager surreptitiously fed the brokers fictional prices for two of the fund’s illiquid securities holdings for them to pass on to the fund’s outside valuation agent and its auditor. The SEC said that the scheme caused the fund to drastically overvalue these securities holdings, which in turn allowed the fund to report inflated and falsely-positive monthly returns. (SEC v. Balboa, et al, SD NY, Dec. 1, 2011)
In another action, the SEC charged a hedge fund manager and its sole managing director with fraud in connection with two separate hedge funds that they managed, one of which was a fund of hedge funds. The SEC alleged that the fund manager misstated the scope and quality of due diligence checks on certain managers and funds selected for inclusion in the portfolio of the fund of hedge funds.
Specifically, the Commission said that the fund manager told investors that all funds in the portfolio would be selected using a rigorous due diligence process, including having reputable service providers, but instead selected several funds that failed to meet this standard. As a result, claimed the SEC, the fund made investments in hedge funds that were later revealed to be Ponzi schemes or other serious frauds. (SEC v. Kapur, SD NY, 11 Civ. 8094, Nov. 10, 2011)
With regard to the other fund being managed, primarily an equity fund, the SEC said that the fund manager materially overstated the performance of the fund, giving investors the false impression that the fund’s returns were consistently positive and minimally volatile.
The Commission also alleged that the fund management firm engaged in a pattern of deceptive conduct designed to bolster its track record, size, and credentials. In particular, the SEC said that the management firm’s assets were inflated, its longevity and performance was exaggerated, and the firm’s size and the credentials of its management team were misrepresented
Without either admitting or denying the allegations, the fund and the managing director consented to the entry of judgments permanently enjoining them from violating the antifraud provisions of the securities laws, and agreed to pay financial penalties and disgorgement in an amount to be determined by a federal court. In addition, the managing director was barred from the industry.
In yet another enforcement action, the SEC alleged that an investment adviser to a hedge fund made a radical change in the fund’s investment strategy, contrary to the fund’s offering documents and marketing materials, by becoming wholly invested in a financially troubled microcap company. The SEC said that the adviser hid the investments and his relationship with the company, including stock options, from the fund’s investors for over four years. (SEC v. Rooney and Solaris Management, LLC, ND IL, No. 1:11-cv-08264)
Although the adviser finally told fund investors about the investments, noted the SEC, he allegedly falsely told them he became chairman of the company in order to safeguard the fund’s investments. In fact, the SEC said that these investments benefited the company and the adviser, while providing the fund with a concentrated, undiversified, and illiquid position in a cash-poor company with a lengthy track record of losses.