SEC aberrational performance inquiry using data-driven tools to uncover adviser misconduct

December 2013 | SPECIAL REPORT: INVESTMENT FUNDS

Financier Worldwide Magazine

Under a recently announced initiative, the US Securities and Exchange Commission has been using sophisticated, data-driven analytical tools to monitor performance claims by hedge fund managers and other investment advisers. This initiative, termed the ‘Aberrational Performance Inquiry’ (API), is a joint effort among the staff in the SEC’s Enforcement Division, Office of Compliance, Inspections and Examinations and Division of Risk, Strategy and Financial Innovation.

The SEC uses available data to find and investigate financial advisory firms whose reported results seem “too good to be true”, according to then-SEC Commissioner Elisse B. Walter, speaking at the SEC Historical Society Annual Meeting in June 2013. The Aberrational Performance Inquiry has so far led to seven separate enforcement actions, and the SEC has indicated that it intends to rely on this initiative going forward as a valuable tool to help it ferret out managers who are misstating their firms’ investment performance or committing other misconduct. In fact, the SEC has used results from this initiative to bring questionable behaviour to the attention of regulators in 17 different countries and, according to former SEC Commissioner Mary L. Schapiro, a number of these countries asked for the SEC’s help in developing their own analytics-based approaches, suggesting that the use of risk models and computer-based technology to identify fraud could become a global trend. While the initiative signals an increased SEC focus on fraudulent performance claims, it also raises troubling issues for managers who have honestly outperformed the market. There are, however, several steps an honest manager can take to prepare itself in the event that it is improperly singled out by this SEC initiative.

Launch of the SEC’s Aberrational Performance Inquiry

In late 2011, the SEC announced enforcement actions against three separate advisory firms and six individuals for various misconduct, including the misrepresentation of fund returns. In this announcement, the SEC introduced the initiative that had led to these enforcement actions: the Aberrational Performance Inquiry.

In March 2011, then-director of the SEC Division of Enforcement Robert Khuzami presaged this initiative by telling the House Committee on Financial Services that the SEC was “canvassing all hedge funds for aberrational performance”, and, in particular, was looking for funds that were beating market indexes by 3 percent on a steady basis. The SEC has since stated that it does not set fixed thresholds, but instead tests for both abnormally high returns on an absolute level and also for returns that remain steady when the markets are unstable.

Through the API, the SEC relies on its computer-based system to comb through the investment returns of thousands of funds and identify funds whose returns are unusually high or out of line with the overall market. Once a suspicious fund has been identified, the SEC Enforcement Division’s Asset Management Unit investigates the performance results to determine whether there is a benign explanation for the fund’s extraordinary performance. If it discovers that the performance results were fraudulently reported, it then seeks to determine whether the fraudulent reporting is symptomatic of other types of misconduct, such as misappropriation of fund assets or inflated valuations. Based on the evidence of misconduct it discovers in the course of its investigation, the SEC may then bring an enforcement action against the fund manager or others.

Recent SEC enforcement actions arising from the Aberrational Performance Inquiry

The SEC has conducted at least seven enforcement actions as a result of investigations stemming from the API. These enforcement actions have been based on charges of improper use of fund assets, fraudulent valuations, misrepresenting fund returns, and failure to disclose related party transactions. Most recently, in SEC v. Yorkville Advisors, LLC, the SEC charged a former $1bn hedge fund advisory firm, and two of its executives, with inflating the value of assets under management and exaggerating the reported returns of their hedge funds in order to increase the fees collected from investors and to solicit additional investors for their existing funds and new funds. Yorkville and the two executives were charged with failure to adhere to Yorkville’s stated valuation policies, ignoring negative information about certain funds’ investments during the valuation process, withholding adverse information about fund investments from Yorkville’s auditor and misleading investors about the liquidity of the funds, collateral underlying the investments and Yorkville’s use of a third-party valuation firm.

In 2011, the SEC also brought an enforcement action against two individuals associated with Millennium Global Emerging Credit Fund: the fund’s former portfolio manager and an affiliated broker. In its complaint, the SEC alleged that the portfolio manager schemed with two European-based brokers, including the second defendant, to inflate the fund’s reported monthly returns and net asset values by manipulating its supposedly independent valuation process. To accomplish this scheme, the portfolio manager surreptitiously provided the brokers with 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. In connection with this enforcement action, the US Attorney’s Office for the Southern District of New York arrested the portfolio manager and filed a criminal action against him for securities fraud, wire fraud and conspiracy to commit both securities fraud and wire fraud.

Another API-related enforcement action was brought against New York-based hedge fund firm ThinkStrategy Capital Management and its sole managing director in late 2011. Although the SEC began its investigation based on ThinkStrategy’s suspiciously high returns, it discovered in the course of its investigation that ThinkStrategy was not only materially overstating the performance of one of its funds, but had been inflating the firm’s assets under management, exaggerating the firm’s longevity and performance history and misrepresenting the size and credentials of ThinkStrategy’s management team.

ThinkStrategy’s managing director, according to the SEC, gave investors the false impression that the fund’s returns were consistently positive and minimally volatile. The ThinkStrategy enforcement action illustrates how the API may help the SEC uncover forms of fraud that go beyond simple overstatement of investment returns.

How to prepare for an SEC inquiry about aberrational performance

Although most managers would support the SEC’s efforts to weed out the bad actors who intentionally overstate their performance, the API may be troubling to a manager that has legitimately outperformed the market and, as a result, finds itself at risk of an API investigation. A legitimate manager, however, can take steps in advance to make an API investigation less painful. The best way to prepare for an SEC inquiry about aberrational performance is to have robust compliance procedures and strong internal controls in place prior to any inquiry, so that any questions about performance can be sufficiently explained. In particular, firms should make sure to document valuation procedures and to keep clear records demonstrating the calculation of any performance information given to investors in marketing materials. In addition, compliance officers should investigate investment returns that are consistently stable despite volatility in the market or are abnormally high to ensure that there is a legitimate explanation for the returns and that they are not the result of any fraud or misconduct on the part of, for example, a portfolio manager or auditor.

Conclusion

The SEC is increasingly relying on data-based analytics to uncover manipulation and fraud by investment advisers and managers before a tip is received or a routine SEC examination discovers any misconduct. Use of these tools by the API has already brought some significant instances of adviser misconduct to light, and the SEC has indicated it intends to expand its use of this type of technology to proactively detect other types of fraud. For instance, in July 2013 the SEC announced three enforcement initiatives to combat financial reporting and microcap fraud. Managers who have honestly outperformed the market do not need to lie awake at night in fear of the API, but instead should focus on ensuring they have strong compliance systems and internal controls in place to provide a credible explanation for exceptional returns.

Gregory S. Rowland is a partner and Beth M. Bates is an associate at Davis Polk & Wardwell LLP. Mr Rowland can be contacted on +1 (212) 450 4930 or by email: gregory.rowland@davispolk.com. Ms Bates can be contacted on +1 (212) 450 4062 or by email: beth.bates@davispolk.com.

Gregory S. Rowland and Beth M. Bates

Davis Polk & Wardwell LLP