The Securities and Exchange Commission brought charges of securities fraud for concealing a significant error in the computer code of the quantitative investment model. I found this case to be interesting because it was not flawed human decisions, but flawed computer decisions. However, we still live in the age where computers do what we tell them to do. So, if the computer is doing something wrong, then a person is behind it.
Barr M. Rosenberg developed complex automated models and an “optimization” process to create and manage client portfolios. Barr Rosenberg Research Center LLC was the registered investment adviser. In April 2007, BRRC put into production a new version of the Risk Model, one component of its quantitative trading program. Two programmers linked the Risk Model to the Optimizer, a second component of the quantitative trading program. However, they made an error in the Optimizer’s computer code.
In June 2009, an employee noticed some unexpected results when comparing the new Risk Model to the existing one that was rolled out in April 2007. Some Risk Model components sent information to the Optimizer in decimals while other components reported information in percentages. That meant the Optimizer had to convert the decimal information to percentages in order to effectively consider all the information. That screwed up the inputs and the outputs resulting in the Optimizer not giving the intended weight to common factor risks.
As with most mistakes that lead to SEC action, the error caused the portfolios to underperform. The error impacted more than 600 client portfolios and caused approximately $217 million in losses. Obviously, this is a bad result.
The problems came, as they usually do, when someone tried to hide the problem. Mr. Rosenberg concealed the error and told his employees not to disclose the error to the investment officers or managers of the firm. That meant the firm was making material misrepresentations and omissions concerning the error to their clients, including:
(i) omitting to disclose the error and its impact on client performance,
(ii) attributing the Model’s underperformance to market volatility rather than the error, and
(iii) misrepresenting the Model’s ability to control risks.
The SEC charged Rosenberg with willful violations of Sections 206(1) and 206(2) of the Investment Advisers Act. Section 206(1) prohibits any investment adviser from, directly or indirectly, “employing any device, scheme, or artifice to defraud any client or prospective client.” Section 206(2) prohibits any investment adviser from engaging in any “transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”
Rosenberg was aware of the problems, but did not disclose the error and directed others not to disclose. As a result, the firm misrepresented that the underperformance was attributable to factors other than the error and inaccurately stated that the model was functioning when in fact it was not. In addition, Rosenberg’s caused a delay in fixing the error leaving it uncorrected for several additional months. Rosenberg caused his clients to continue sustaining losses from an error that could have been promptly fixed.
Rosenberg has to pay the $2.5 million penalty fine and he received the ban from the SEC. He is barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization and prohibits him from serving as an officer, director or employee of a mutual fund.
Lesson learned. If the computer is broken, fix it right away. And don’t lie about it.
- SEC Charges Quant Manager with Fraud
- Administrative Order in the Matter of Barr M. Rosenberg (.pdf – 6 pages)
- Quant Manager Charged With Fraud by Steven Meyerowitz in Financial Fraud Law