On Monday of this week, the SEC charged hedge fund manager Paradigm Capital Management of Albany, New York with making improper principal trades and retaliating against the firm’s head trader who reported the alleged misconduct to the SEC. This was the first anti-retaliation enforcement action the SEC has brought under the Dodd-Frank Whistleblower statute. In anticipation of the proceedings, Paradigm, and its owner Candace King Weir agreed to pay $2.2 million to settle the charges without admitting or denying wrongdoing. It is unclear at this point how much, if any, of this amount will be awarded to the whistleblower.
According to the SEC’s order [link to order here], Paradigm made trades between the hedge fund it manages and the broker-dealer its principal owns. The SEC alleged that these principal transactions violated Section 206(3) of the Investment Advisers Act of 1940, which prohibits an investment adviser from, directly or indirectly acting as a principal for its own account, when selling any security to, or purchasing any security from, a client without disclosing to the client the capacity in which the adviser is operating, and obtaining the client’s prior consent to the transaction. Unbeknownst to Ms. Weir, Paradigm’s head trader reported the allegedly illegal trades to the SEC. When Weir discovered that the trader had reported to the SEC, the trader was demoted from head trader to an assistant in Paradigm’s compliance department.
There are several things that are unusual about this case. First, Paradigm appointed a “conflicts committee” to approve the principal trades on behalf of its client the hedge fund, and Paradigm disclosed in its Form ADV that it would make principal trades if approved by the conflicts committee. Second, the trades were made to benefit the investors in the hedge fund by realizing tax losses to offset tax gains. Nevertheless, the SEC alleged that the approval procedure was insufficient because the conflicts committee was conflicted. Paradigm’s chief financial officer and its chief compliance officer were the two members of the committee, but the CFO was also the CFO of Weir’s broker dealer. The SEC maintained that because the CFO was on both sides of the transaction, Paradigm had not complied with Section 206(3)’s disclosure and consent requirements.
The SEC learned of the principal transactions because Paradigm’s head trader made a voluntary whistleblower submission to the SEC. More than three months later when Paradigm learned of his report to the SEC, Paradigm removed the head trader from the trading desk and told him that because he executed the trades that were reported to the SEC he needed to investigate his actions and prepare a report to the firm’s chief compliance officer. The SEC alleged that these actions, among others, violated the anti-retaliation provisions of Section 21F(h) of the Securities Exchange Act of 1940.
Hedge Fund and Private Equity Fund managers should take note of the SEC’s willingness to bring charges against firms who allegedly retaliate against whistleblowers. The SEC adopted Regulation 21F under the Dodd Frank Act, which provides that individuals who provide information leading to a successful SEC enforcement action resulting in sanctions of greater than $1 million can receive 10% to 30% of the amount collected. While the whistleblower provisions are designed to help the SEC enforce the securities laws, they present challenges to an investment adviser’s internal compliance program because whistleblowers are not required to report violations internally before they report to the SEC.
Nevertheless, there are a number of steps firms can take to incentivize whistleblowers to report violations internally. First, firms should establish effective procedures to allow employees to report violations either directly to the chief compliance officer or to an outside “hot line.” Employees should have the option to report violations anonymously to the hot line, but should be encouraged to report directly to the CCO, which will allow for a more productive response. Most importantly, however, employees should be assured that there will be no retaliation. This can be done through employee training and, if practical, meetings with senior management assuring all employees that the compliance program is taken seriously and that employees are encouraged to report violations either anonymously or directly to the firm’s CCO.