Hedge Fund Caught Using Soft Dollars To Pay Twice For Fake Research

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Earlier this month, the SEC charged a Minneapolis-based hedge fund with running a scam that diverted more than $1.0 million in “fake research” fees and expenses to illegally pay for staff salaries, country club dues, boarding school tuition and a Lexus.

Charging Investors Twice for Fake Research

A few weeks ago, the Securities and Exchange Commission charged that between 2008 and 2013, Minneapolis-based hedge fund Archer Advisors LLC, owner Steven R. Markusen, and employee Jay C. Cope bilked investors out of more than $1.0 million in phony research expenses and fees as the hedge fund’s deteriorating performance led to shrinking fund income.

According to the SEC’s complaint, Markusen and Cope’s scam actually charged fund investors twice for fake investment research expenses.  First, Markusen billed the funds directly for what he claimed were Archer’s out-of-pocket research expenses.

Markusen caused investors to repay Archer almost $500,000 in fake research expenses.  Of this total, Markusen directed the funds to reimburse Archer $100,000 for Cope’s salary payments by falsely characterizing them as “’research” expenses. The SEC alleges that Markusen spent these proceeds on personal luxury items like boarding school tuition, country club dues, and a Lexus.

However, this was not enough for Markusen and Cope.  Purportedly, Markusen also generated fake research invoices to direct Archer’s brokers to pay Cope’s $10,000 per month salary out of soft dollars for “research” he allegedly did as an independent consultant.  However, Cope did little or no research for Archer.  He was an Archer insider and officer whose main duties were helping Markusen find new investors and placing trades.  In total, Archer directed it’s brokers to pay Cope $450,000 in illicit “soft dollar” payments directly out of client assets rather than out of fee income earned from managing investor assets.  Cope paid Markusen a $1,000 monthly kickback from these soft dollar payments.

The SEC explained its charge against Markusen and Cope, “Soft dollars were supposed to be used to buy third-party investment research that benefited the funds.  Cope conducted no third-party research as an Archer officer whose main duties were placing trades and helping Markusen find new investors.”

In order to generate sufficient soft dollar commissions to pay for Cope’s salary, the SEC contends that Markusen and Cope began to aggressively trade their fund, prompting commissions paid to the funds to jump more than 600% from approximately $5,200 in March 2013 to almost $36,000 in April 2013.

Portfolio Pumping Scheme

The SEC’s complaint also charges Markusen and Cope with conducting a separate scheme to manipulate the stock price of the funds’ largest holding in order to inflate the monthly returns reported to investors and conceal the true extent of the funds’ mounting investment losses.

According to the SEC, Markusen and Cope manipulated the price of the thinly-traded stock of CyberOptics Corp. (CYBE), which comprised over 75% of the funds’ portfolios.  Markusen and Cope, knowing that Archer was CYBE’s largest shareholder, used this position to materially impact the closing price of CYBE on the last trading day of the month.

Marusen and Cope accomplished this by placing multiple buy orders for CYBE seconds before the market closed on the last trading day of the month to artificially pump up the market value of CYBE, and therefore the overall value of the funds’ portfolios.  Those valuations were used to calculate the funds’ monthly returns that Archer reported to investors, and were used to calculate Archer’s monthly management fee.  The SEC alleges that this illicit “painting the tape” happened in at least 28 months between 2010 and 2013.

“Markusen and his firm had an obligation to manage investor money in the hedge funds fairly and honestly.  Instead, he and Cope exploited their control of the funds to engage in long-running schemes to misappropriate fund assets and artificially pump up the value of the poorly-performing funds,” says Robert J. Burson, associate director of the SEC’s Chicago Regional Office.

Integrity’s Take

Obviously, the SEC charges against hedge fund Archer Advisors, Steven Markusen, and Jay Cope, if true is an egregious example of a criminal scheme to enrich themselves at the expense of investors in the funds.  However, this case is also an unfortunate illustration of why “soft dollars” has gotten such a bad name among regulators, politicians, and journalists.  The rampant misuse of client assets in this case provides opponents of “soft dollars” an easy illustration of why they believe the use of client commissions to pay for investment research should be banned in order to protect investors from this type of illicit behavior.   It is truly sad how a few bad apples can spoil the whole bunch.

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