On April 22, the SEC announced a settled enforcement action against a registered adviser for failing to perform all phases of its advertised due diligence prior to recommending to clients that they invest in certain hedge funds that were later determined to be a fraud. More specifically, the SEC alleged that the Hennessee Group did not perform several key elements of its advertised due diligence process with respect to recommending Bayou funds to its clients and failed to adequately respond to red flags regarding conflicting information received about Bayou’s auditors. This case may foreshadow SEC efforts to bring enforcement actions against those advisers who invested client assets with Bernard Madoff. See In the Matter of Hennessee Group LLC, Advisers Act Release No. 2871 (Apr. 22, 2009).
According to the SEC settlement order, Hennessee Group is a hedge fund consultant and investment adviser that recommends hedge funds to its clients and monitors the investments on their behalf. As part of its client solicitation efforts, Hennessee Group made multiple representations regarding the quality and rigor of its due diligence process for evaluating hedge funds. The representations included a description of a “Five Level Due Diligence Process,” which noted, among other steps, that Hennessee Group conducted (1) a portfolio/trading analysis of a fund’s investment portfolio and (2) a verification of a fund’s relationship with its independent auditor.
The SEC settlement order also stated that when Hennessee Group conducted its initial review of the Bayou management company and its funds, Bayou refused to provide Hennessee Group with prime brokerage reports that Hennessee Group requested. Hennessee Group apparently did not insist on receiving the reports in order to conduct a portfolio/trading analysis. Rather, it determined that the analysis was irrelevant because Bayou’s strategy was to day trade and represented that it held securities positions for brief periods of time and converted the positions to cash prior to each day’s market close. As a result, Hennessee Group did not obtain or evaluate any quantitative information about the Bayou funds’ portfolio characteristics, investment and trading strategies, or risk management discipline. Rather, Hennessee Group relied on Bayou’s uncorroborated representations and purported rates of return that Bayou provided during the initial phase of due diligence.
The SEC settlement order also noted that Hennessee Group never told clients that it had not conducted a portfolio/trading analysis of the Bayou funds and thereby left clients with a misleading impression that it had satisfied its portfolio/trading analysis. The SEC concluded that by not conducting the entire due diligence process it had advertised (and failing to disclose to clients that its evaluation of the Bayou funds deviated from the prior representations), Hennessee Group rendered its prior representations materially misleading and breached its fiduciary duties owed to clients.
The SEC settlement order further alleged that Hennessee Group told many of its clients that as part of its review of a fund’s audited financial statements, Hennessee Group verified the funds’ relationship with its purported independent auditor and that the audit firm had actually conducted the audit. The order stated that Hennessee’s auditor verification procedure, however, consisted only of confirming that a fund’s financial statements contained an unqualified audit opinion letter. In addition, the order stated that Hennessee Group took no steps during the initial due diligence process to contact either the purported auditor (which was a bogus accounting firm devised by one of Bayou’s principals) or an actual auditing firm that Bayou indicated it had retained to conduct future audits. The order also noted that neither the purported auditor nor the proposed auditor were used by any of the other approximately 150 hedge funds that Hennessee Group monitored on behalf of its clients.
The SEC settlement order continued by stating that Hennessee Group failed to investigate and reconcile certain contradictory information about Bayou that Hennessee Group had a duty to investigate based on its representations to clients that it would conduct on-going monitoring of client investments. This contradictory information involved a series of conflicting claims by Bayou about its auditor’s identity. The order noted that Hennessee Group did not attempt to investigate the inconsistent information, including whether the new auditor had been retained to conduct audits, and failed to contact prior auditors to verify the past relationships and obtain their perspectives on why Bayou had terminated them. The order also noted that Hennessee Group accepted “without the requisite skepticism or searching inquiry Bayou’s claims that it had changed outside auditors several times.”
Finally, the SEC settlement order stated that Hennessee Group also failed to investigate a rumor that one of Bayou’s principals had a connection to the Bayou funds’ auditor and therefore had a potential conflict of interest. The rumor was received in the form of an email from a client of Hennessee Group who had invested in Bayou. The order noted that Hennessee Group contacted Bayou about the rumor and received an explanation, but that the explanation was inconsistent with prior information provided by Bayou. The order further noted that Hennessee Group made no effort to verify the assertions made by Bayou, even though Hennessee Group had information in its files directly contradicting the Bayou explanation.
The SEC settlement order concluded that Hennessee (and its principal) owed fiduciary duties to their clients not to misrepresent the services they were providing and to discloses all material deviations from the representations they made. The order further stated that Hennessee Group and its principal breached their fiduciary duties in violation of Section 206(2) of the Advisers Act by failing to (1) conduct two of the five elements of their advertised due diligence process and (2) adequately respond to information suggesting that the identity of Bayou’s outside auditor was in doubt and the possibility of a potential conflict of interests between one of Bayou’s principals and the purported outside auditor of Bayou.
As part of the settlement, Hennessee Group and its principal agreed to disgorgement and penalties of $814,644.12; cease and desist from committing or causing further violations; adopt polices and procedures to ensure adequate disclosures in the future; and provide copies of the SEC’s order to all current and prospective clients for a period of two years.
The SEC enforcement action suggests some important steps that advisers should consider taking, particularly those advisers that invest client assets in third-party hedge funds.
- Review representations to clients and due diligence materials. Advisers should consider reviewing representations made in solicitation/marketing materials regarding their degree of due diligence and on-going monitoring of fund investments. Advisers also should consider reviewing due diligence files and other “audit trail” materials that demonstrate the steps taken to review potential investments for clients and ensure that the files both tie with what the adviser represented it would do in its solicitation/marketing materials and provide evidence of appropriate skepticism and follow-through. The SEC examination staff may begin looking closely at these materials in future examinations.
- Insist on underlying documentation. Advisers should insist on obtaining appropriate corroborating documentation when conducting due diligence. As the enforcement case noted, a primary concern involved the Hennessee Group’s willingness to waive its usual insistence on receiving documentation from Bayou’s prime broker that would otherwise have been used to conduct the portfolio/trading analysis that Hennessee represented to clients.
- Speak with service providers. Advisers should speak with service providers, such as auditors, to confirm directly their engagement by the applicable funds, particularly where an adviser has made such representations. Advisers should pay particular attention to potential red flags that may be suggested by a fund’s use of auditors that are unfamiliar or not active in hedge fund space. Advisers also should document their undertakings in this area.
- Follow up on red flags. Advisers should follow up on potential red flags, such as the use of unfamiliar auditors, inconsistent statements of material matters by hedge funds and their advisers, refusals by funds and their advisers to provide reasonably requested information, potential conflicts of interests between funds and their auditors, and significant matters brought to the adviser’s attention by clients and other legitimate sources. Advisers also should document any steps taken to follow up on red flags.
- Periodically review due diligence files. Advisers should periodically review their due diligence files for potential discrepancies, particularly when encountering red flags.