New York, NY – In 2011 it became clear that US federal authorities had started the widespread use of telephone wiretaps to investigate and prosecute insider trading among hedge funds, industry consultants, and expert networks. Now, the SEC has started employing quantitative analysis to identify hedge funds, mutual funds and private equity firms that might be perpetrating fraud based primarily on performance that seems too good to be true.
It is clear that the criticism that the SEC has faced for failing to identify the Bernie Madoff scandal has had a profound effect on the way the government is attacking securities fraud in the hopes that another such case does not slip through the cracks.
In 2009 the SEC started the development of a computerized system called its “aberrational performance initiative” which currently analyzes the monthly performance data on thousands of hedge funds in search of firms whose performance seems out of the ordinary.
This system doesn’t just flag firms’ whose performance is consistently better than other similar type funds. It also identifies funds whose returns remain strangely stable even in the face of severe market volatility. The results of the “aberrational performance initiative” has led the SEC to identify 100 hedge funds which it feels warrants additional investigation.
Based on the initial results of this initiative, the SEC is expanding it to include mutual funds and private equity firms. Consequently, the SEC expects to be analyzing monthly performance data on over 20,000 hedge funds, mutual funds, and private equity firms.
Wall Street Response
Identifying potential fraud cases based on fund performance isn’t popular within the financial services industry, as some investment managers are worried they might get caught up in an investigation simply because their numbers are better than their peers. In fact, some argue that such an initiative might have a chilling effect on investment managers who are legitimately doing a good job for their investors.
However, the SEC argues that it does not rely solely on an analysis of a fund’s performance to bring a case. According to Robert Kaplan, the co-chief of the SEC Enforcement Division’s Asset Management Unit, after the SEC runs its quantitative assessment of hedge fund and mutual fund performance, it does a qualitative evaluation of suspicious looking firms to determine if their performance can be explained or if further investigation is warranted.
So far, the results of this new initiative must seem encouraging for the SEC. In December 2011, the agency announced four civil-fraud lawsuits against various fund managers including ThinkStrategy, LeadDog and Solaris Management LLC based on this analysis.
In the case of ThinkStrategy, the SEC alleges the firm’s founder engaged in deceptive conduct in an effort to raise their “track record, size and credentials.” This included claiming the firm generated returns of 4.6% in 2008 when the average hedge fund fell roughly 19%. The SEC claims that ThinkStrategy’s real return for the year was a loss of 90%.
The SEC alleges that LeadDog Capital Markets’ owners Chris Messalas and Joseph LaRocco induced investors to invest in a hedge fund they controlled through material misrepresentations and omissions about a number of issues, including (i) Messalas’ negative regulatory history; (ii) Compensation received by Messalas and LaRocco in connection with the fund’s investments; and (iii) Messalas’ substantial ownership interest in some of the companies to which he directed fund investments.
Solaris Management operator Patrick Rooney is charged with fraudulently misusing fund assets. According to the SEC’s complaint, Rooney allegedly misused the Solaris Fund’s money by investing over $3.6 million in Positron Corp. through both private transactions and market purchases contrary to the fund’s offering documents and marketing materials. Positron Corp. is a financially troubled microcap company of which Rooney has been Chairman since 2004.
It is clear to us at Integrity Research that the government’s use of wiretaps in investigating and prosecuting insider trading, and the SEC’s recent development of its “aberrational performance initiative” to identify potential fraud at hedge funds, mutual funds and private equity firms marks a significant change in the way regulators intend to fight white collar crime.
In a statement, Robert Khuzami, Director of the SEC’s Division of Enforcement explained this shift by saying, “We’re using risk analytics and unconventional methods to help achieve the holy grail of securities law enforcement — earlier detection and prevention. This approach, especially in the absence of a tip or complaint, minimizes both the number of victims and the amount of loss while increasing the chance of recovering funds and charging the perpetrators.”
In other words, criminals beware.