SEC Targeting Suspicious Investment Returns

Last week, the SEC announced THREE actions against investment advisers for compliance failures. The Securities and Exchange Commission has turned the dial a little higher and announced FOUR enforcement actions against multiple hedge funds by identifying abnormal investment performance. (Does their dial turn all the way up to 11?)

The SEC launched an initiative to combat hedge fund fraud by identifying abnormal investment performance — the Aberrational Performance Inquiry. Back in March, SEC Enforcement Director Robert Khuzami revealed during congressional testimony that the SEC had launched an initiative that would focus on funds that consistently outperform the market.  Enforcement is now focusing on hedge funds that outperform “market indexes by 3% and [are] doing it on a steady basis.” Khuzami referred to such performance as “aberrational,” and stated that Enforcement is “canvassing all hedge funds” for such “aberrational performance.” The SEC Enforcement Division’s Asset Management Unit uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmarks can form a basis for further scrutiny. This initiative came directly from from the Madoff scandal. If they had focused on Madoff’s consistent and aberrational returns, the SEC may have caught him sooner.

Half a year later, Khuzami is crediting Aberrational Performance Inquiry initiative with these four enforcement actions.

Michael Balboa and Gilles De Charsonville

These two were nabbed for overvaluing the reported returns and net asset value of the Millennium Global Emerging Credit Fund, organized to invest in sovereign and corporate debt instruments from emerging markets. Among the fund assets were Nigerian payment adjusted warrants and Uruguayan value recovery rights.

In October 2008, the hedge fund’s reported assets were $844 million. The SEC’s complaint alleges that Balboa, the fund’s former portfolio manager, schemed with two European-based brokers including Gilles De Charsonville to inflate the fund’s reported monthly returns and net asset value by manipulating its supposedly independent valuation process.

Apparently the SEC found Balboa’s action particularly egregious because the the U.S. Attorney’s Office for the Southern District of New York announced the arrest of Balboa and filing of a criminal action against him.

According to the SEC complaint, from at least January to October 2008, Balboa provided De Charsonville and another broker 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. The scheme caused the fund to  overvalue these holdings by as much as $163 million in August 2008.  That meant falsely-positive monthly returns, millions of dollars more in management fees, another $410 million in new investments, and the avoidance of  about $230 million in redemptions.

The SEC is crediting their new initiative with this enforcement action, but the fund has been in liquidation since October of 2008.

ThinkStrategy Capital Management and Chetan Kapur

The SEC charged ThinkStrategy Capital Management LLC and its sole managing director Chetan Kapur with fraud in connection with two funds. ThinkStrategy Capital Fund was an equities-trading fund that ceased operations in 2007.  TS Multi-Strategy Fund was a fund of hedge funds. At its peak in 2008, ThinkStrategy managed approximately $520 million in assets.

The SEC’s complaint alleges that ThinkStrategy and Kapur engaged in a pattern of deceptive conduct designed to bolster their track record, size, and credentials. They materially overstated the performance of the Capital Fund and gave investors the false impression that the fund’s returns were consistently positive and minimally volatile. ThinkStrategy and Kapur also repeatedly inflated the firm’s assets, exaggerated the firm’s longevity and performance history. In 2008 they reported a 4.6% return when they actually had a -89.9% return. It looks like the trouble started in June of 2006.

They also made claims about the quality of their due diligence checks. Unfortunately, they ended up invested in the Bayou Superfund, Valhalla/Victory Funds and Finvest Primer Fund, each of which was revealed to be engaged in serious fraud.

ThinkStrategy also faked a management team, listing several individuals as principals or directors who had no affiliation with the firm. A few were Kapur’s classmates at Wharton. Kapur himself claimed to have an MBA from Wharton, even though he only had an undergraduate degree. Kapur claimed to have over 15 years of experience as an “investor, money manager, researcher, and system designer”. That means he would have started his career in 1988 at the age of 14.

As with most SEC settlements, these are merely allegations against Kapur and ThinkStrategy which they neither admit or deny.  The funds wound down over a year ago and other investors brought suit. In this case, I’m not sure you can credit the SEC with shutting down a bad fund using this Aberrational Performance Inquiry initiative.

Patrick Rooney and Solaris Management

According to the SEC’s complaint, Rooney and Solaris made a radical change in the fund’s investment strategy, contrary to the fund’s offering documents and marketing materials, by going all in for Positron Corp. In late 2008, Solaris held over 1.1 billion shares of Positron stock and had liquidated all of its non-Positron investments.

That’s certainly a risky binary bet on one company. You don’t usually see concentrated, undiversified, and illiquid position in a cash-poor company with a lengthy track record of losses.

The big problem was that Rooney was also the Chairman of Positron  and received salary and stock options from Positron.  Rooney and Solaris hid the Positron investments and Rooney’s relationship with the company from the fund’s investors for over four years. Although Rooney finally told investors about the Positron investments in a March 2009 newsletter, he allegedly lied by telling them he became Chairman to safeguard the fund’s investments.

It’s hard to see how Solaris would have been outperforming the market by more than 3% and fallen under the watchful eye of the new initiative.

LeadDog Capital Markets, Chris Messalas and Joseph LaRocco

The SEC instituted administrative proceedings against LeadDog Capital Markets LLC and its general partners and owners Chris Messalas and Joseph LaRocco. The charges were for misrepresenting or failing to disclose material information to investors in the LeadDog Capital LP fund.

The Fund was almost entirely invested in illiquid penny-stocks or other micro-cap private companies, each of which had received “going concern” opinions from their auditors, all but one of which had a consistent history of net losses, and most of which they or their affiliates owned or controlled

In addition, LeadDog, Messalas, and LaRocco allegedly misrepresented to, and concealed from, existing and prospective investors the substantial conflicts of interests and related party transactions that characterized the fund’s illiquid investments. For example, to induce one elderly investor to invest $500,000 in the fund, LeadDog, Messalas, and LaRocco represented falsely that at least half of the fund’s assets were liquid and could be marked to market each day, and that the investor could exit the fund at any time. In February 2009, the SEC alleges that 92% of the fund’s non-cash assets were illiquid and could not be marked-to-market on a daily basis.

In October 0f 2009, the fund’s auditors learned about some of the problems, resigned, and issued a retraction letter. Let’s assume that the date the problems were discovered. We could credit the initiative with taking action in this case. It would just be two years before charges were filed.

Assuming the allegations are true, these four cases are good cases for SEC enforcement. The consistent out performance initiative is a good one. However, these four just don’t seem to fit in the right time frame for the new enforcement initiative. Since these fund managers were not registered with the SEC, there is no good database for the SEC to check returns and easily find the outliers. Perhaps once Form PF reports start flowing, the SEC will have a better database to go looking for problems.


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