This is the seventh in a series of articles examining the creation of the Financial Reporting and Audit Task Force along with a Center for Risk and Quantitative Analysis. Today’s article examines new approaches instituted by the Enforcement Division following its reorganization that center on risk analysis, critical metrics and big data.
In 2009 the Division of Enforcement undertook its largest reorganization. As part of that effort specialty groups were created to marshal the resources of the Division in select areas. No specialty group was created to focus on financial statement fraud.
The retooled Division adopted new techniques centered on risk and data analysis to help identify performance outliers as an earlier indicator of possible misconduct. The asset management unit, for example, developed what its former chief called “risk-based investigative approaches through which the Unit can detect and prevent fraudulent conduct. Each initiative utilizes data analysis and appropriate risk criteria to identify individuals or entities that may be engaged in specific types of misconduct.” Remarks of Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit, delivered to the Regulatory Compliance Association, New York, New York (December 18, 2012).
The Aberrational Performance Inquiry is another recent initiative that is risk and data driven. It focuses on suspicious or improbable performance returns by hedge fund advisers. The point is to find abnormal performance returns. See SEC Press Release, 2011-252 (Dec. 1, 2011); see also SEC Press Release 2012-209 (Oct. 17, 2012). Utilizing a big data type approach, and working with the Office of Inspections, performance metrics were developed to utilize in evaluating fund results in an effort to identify possible wrongful conduct at an earlier date.
The risk-based approach and, in particular, the Aberrational Performance Inquiry, has to date spawned several enforcement actions which give some indication of the direction this approach may take. Typically, these cases are based on abnormal results which are “too good to be true.” SEC Press Release 2011-252 (Dec. 1, 2011). The cases brought to date tend to focus on misrepresentations regarding the manner in which the fund operated or on the valuation of assets. Examples include:
- Misrepresentations: SEC v. Balboa, Case No. 11 Civ. 8731 (S.D.N.Y. Filed Dec. 12011) is an action against Michael Balboa, the portfolio manager of now defunct Millennium Global Emerging Credit Fund who resides in England, and Gilles De Charsonville, a representative at a U.K. based broker dealer who resides in Spain. The scheme centered on the overvaluation of key assets in 2008. Specifically, during the first ten months of 2008, Mr. Balboa is alleged to have enlisted two independent brokers, defendant De Charsonville and another U.K. broker, to furnish false mark-to-market quotes for two of the Fund’s securities. Those quotes were furnished to the fund’s independent valuation agent and auditors. As a result of this scheme, the NAV was overstated by about $163 million for a fund with reported assets of $844 million. The incorrect valuation yielded millions of dollars in illegitimate management and performance fees and attracted over $400 million in new investments while deterring redemptions. The complaint alleges violations of Securities Act Section 17(a), Exchange Act Sections 10(b) and 20(e) and Advisers Act Sections 206(1), (2), (4) and 209(f).
- Misrepresentations: SEC v. Kapur, Civil Action No. 11-CIV-8094 (S.D.N.Y. Filed Nov. 10, 2011) is an action against investment adviser ThinkStrategy Capital Management and its principal, Chetan Kapur. ThinkStrategy managed two hedge funds. The complaint alleges that over a period of about seven years the defendants engaged in a deceptive pattern of conduct in which they made a series of misrepresentations about the funds concerning their performance, returns, assets and performance history. The complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Section 206(4).
- Misrepresentations: SEC v. Rooney, Case No. 11-cv-8264 (N.D. Ill. Filed Nov. 18, 2011). Patrick Rooney and Solaris Management, LLC are named as defendants in the case. Mr. Rooney is the founder and managing partner of Solaris Management. The firm serves as the general partner and investment adviser of hedge funds Solaris Opportunity Fund, LP (“the Fund”) and Solaris Offshore Fund. The two entities were managed together. The Fund claims to follow a non-directional strategy to trade equity, options and futures. According to the Fund, under this strategy it used long, short and neutral positions to hedge risk, generate income and maintain equity growth over the long term. Between August 2003 and September 2008 investors put nearly $30 million into the Fund. The Fund had 30 investors and reported assets of $16,277,780 as of December 2008. Initially Mr. Rooney caused the Fund to trade in accord with its defined strategy. Beginning in 2005, however, the defendants caused the Fund to begin investing in Positron Corporation, a molecular imaging company whose shares were traded on the NASDAQ OTC Bulletin Board. At the time the company had reported significant losses. Its auditors expressed substantial doubt as to its ability to continue as a going concern. Mr. Rooney joined the board of directors, became Chairman and started drawing a salary in 2004 in connection with financing furnished to Positron from another entity whose board included his father. By 2007 the Fund invested millions of dollars in Positron and held about 60% of the outstanding shares. Fund investors were not told about the investment in Positron until March 2009. At that point a newsletter told investors that Mr. Rooney became Chairman of the company to safeguard the investment of the Fund. This statement was false, according to the complaint. In fact, the investment in Positron benefited that company and Mr. Rooney. In the end, Fund investors were left with a concentrated, undiversified and illiquid position in a cash poor company with a history of losses. The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Sections 10(b) and 13(d)(1) and Advisers Act Sections 206(1), (2) and (4).
Misrepresentations: In the Matter of LeadDog Capital Markets, LLC, Adm. Proc. File No. 3-14623 (Filed Nov. 15, 2011) is a proceeding which names as Respondents the firm, its owner Chris Messalas, and Joseph Laroco, a managing member and counsel to LeadDog. From late 2007 through August 2009 Respondents raised about $2.2 million from 12 investors for investments in LeadDog Capital LP, a hedge fund. Investors were told that the fund would be invested in part in liquid assets. Investors were also told about the securities expertise of the Respondents. These representations were false. In fact, the fund invested in illiquid penny stocks. Many of the firms had received going-concern qualifications from their auditors. Investors were also not told that Mr. Messalas controlled a broker dealer that had been repeatedly fined, censured and ultimately expelled by FINRA. In addition, Respondents concealed significant conflicts and related party transactions from investors and the auditors, according to the Order. The Order alleged violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Section 206(4).
- Valuation: SEC v. Yorkville Advisors, LLC, Civil Action No. 12 CIV 7728 (S.D.N.Y. Filed Oct. 17, 2012). This case names as defendants a registered investment adviser and its CFO and COO. The action focused on the valuation of the assets in the fund during the period of the market crisis. While the private placement memorandum assured investors that the securities in the fund would be fair valued in accord with GAAP, in fact they were not, according to the Commission’s complaint. As the market crisis unfolded, the adviser had increasing difficulty valuing the assets. It switched methods, adopting an untested methodology. That resulted in an over-valuation by about $50 million. The over-valuation aided in attracting new investors to the fund and improperly inflated management fees. The complaint alleges violation of each subsection of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisors Act Sections 206(1) and (2) and 204(4).
- Valuation: In the Matter of KCAP Financial, Inc., Adm. Proc. File No. 3-15109 (Nov. 28 2012) is the first proceeding centered on FAS 157 regarding Fair Value Measurement. The proceeding against the closed ended fund alleged that during late 2008, and continuing until the middle of 2009, the firm did not account for certain market based activity in determining the fair value of its debt securities. It also did not account for certain market based activity for its two largest CLO investments by properly fair valuing them. At the time KCPs filings stated that those CLOs were valued using a discounted cash flow method that incorporated market data. In fact the CLOs were valued at KCAP’s cost. In May 2010 the firm disclosed that it had to restate the fair values for certain securities and the CLOs. It had materially overstated NAV. The internal controls also were not designed to properly value illiquid securities As a result, the Order alleges that the firm violated Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). Also named in the proceeding were the CEO and CFO of the firm who are alleged to have caused the violations.
- See also In the Matter of J. Kenneth Alderman, CPA, Adm. Proc. File No. 3-15137 (Dec. 10, 2012) (proceeding against eight mutual fund directors alleging that the directors failed to cause the funds to adopt and implement reasonable procedures as to valuation); SEC v. Mannion, Civil Action No. 10-cv-3374 (N.D. Ga. Filed October 19, 2010(assets of fund materially overvalued to conceal losses).