The Securities and Exchange Commission (SEC) recently announced that a Manhattan-based investment advisory firm and its Toronto-based hedge fund manager agreed to settle charges that they misled investors about a fund’s investment strategy and historical performance. They will reimburse investors $2.877 million in losses. The manager agreed to pay a $75,000 penalty and is barred from the securities industry.

Key Takeaways

While the investment adviser and the manager appear to have engaged in some egregious behavior, there are some key takeaways for all investment advisers and funds. Failure to adhere to these takeaways may result in investment advisers and funds facing lawsuits, enforcement actions, and significant monetary penalties:

  • A fund’s disclosure about its investment strategy must be accurate, and it must be followed. 

The investment adviser and the manager claimed that the fund followed a “five categories” strategy focusing on 285 varying metrics within the categories of momentum, growth, value, risk, and estimates They also stated that no more than 20 percent of the fund’s assets could be invested in any single security, and that no more than 5 percent of the fund’s assets could be invested in an illiquid security. Deviation from this investment strategy led to poor performance and a further bad decision to misrepresent fund performance.

  • Historical performance must be accurate. 

The manager provided investors with documents that reported purported historical results that were significantly higher than the fund’s actual results. In order to show these misleadingly positive returns, the manager excluded the disastrous returns he actually achieved, replacing them with the hypothetical returns that his model purportedly would have achieved if he had applied it correctly and consistently during the periods reported.

  • Do not engage in conflict of interest transactions without making full disclosure to investors. 

The manager did not disclose to the investors that a significant investment had been made in return for the promoters agreeing to help the adviser and the manager find clients.

Summary

The investment advisory firm and manager acted as advisers to a private investment company or fund. They marketed the fund based on promises to follow a scientific stock selection strategy but, in practice, they repeatedly deviated from that strategy. When an early deviation led to heavy losses, the manager marketed the fund based on a misleading mixture of actual and hypothetical returns. When the investment advisory firm and manager later deviated from the strategy again, by investing most of the fund’s assets in a single penny stock, the manager failed to disclose the investment to the fund’s investors. The manager also failed to disclose that when he made the investment in the penny stock, he had a conflict of interest.

The manager subsequently used unsupported valuations of the penny stock to make the fund appear more successful than it was, thereby inducing additional investments and delaying investor redemption attempts. He also lied to investors about the fund’s liquidity when they began requesting redemptions in 2013. Through these deceptions, the manager delayed the discovery of his fraud and prolonged his ability to earn management and performance fees.