The key aspect of registration under the Investment Advisers Act is managing conflicts of interest. The financial services industry is full of conflicts. Investment advisers owe a higher level of duty to their clients than broker-dealers. In the case of fund managers, they owe the duty to their funds. One particular concern is a transaction between an investment adviser’s funds.
The SEC recently issued a cease-and-desist order that highlights a fund manager that handled the conflict poorly. I’m assuming the facts in the SEC’s order is true, although Martin Currie neither admits nor denies the allegations in the complaint.
The main focus of SEC’s complaint is that Martin Currie used one fund to rescue another fund. That’s good for investors in one fund and bad for investors in the other fund.
Hedge Fund Investment
The problems began in June 2007 when Martin Currie caused its Hedge Fund to purchase a large quantity of illiquid bonds in a Chinese company: Jackin International Holding. That deviated from the Hedge Fund’s normal equities-trading strategy. Martin Currie realized the investment would cause the Hedge Fund to breach its self-imposed 5% limit on investments in unlisted securities. To cure that problem, Martin Currie obtained approval from the Hedge Fund’s board of directors to modify the 5% limit. However, Martin Currie may have failed to present all material issues and risks for the board’s consideration. After the deal closed, the high-yield Jackin bonds were improperly characterized as cash in the firm’s risk management system. Because of this misclassification, the liquidity and credit risks from the Hedge Fund’s exposure to Jackin were not appreciated at Martin Currie headquarters until after the Hedge Fund had purchased even more Jackin bonds. It’s not clear from the order whether the misclassification was intentional or accidental.
2008 Financial Crisis
Then the 2008 financial crisis rears up and causes a liquidity crunch in the Hedge Fund as investors redeem their interests. As more liquid assets were sold off to generate cash for redemption, those illiquid Jackin bonds became an increasingly larger part of the portfolio.
Martin Currie also acted as the adviser to a closed end fund: the China Fund. It just so happened that the China Fund was working with a group investors to buy one of Jackin’s subsidiaries: Ugent Holdings. Coincidentally, the sale of Ugent would allow Jackin to repay the bonds held by the Hedge Fund.
Board Approval of the Transaction
The group at the China Fund decided they needed approval of the fund’s board to proceed with transaction. However, the SEC accuses Martin Currie of failing to properly disclose the conflict of interest when it sought the board approval. Board approval does not clear the conflict if the board did not know about the conflict. It’s even worse if the board approval is based on “incomplete and misleading representations.”
On top of the faulty approval, Martin Currie used some dubious pricing and rationale for the China Fund’s investment. Ugent and Jackin’s financial situation had detoriated as a result of the 2008 financial crisis and its earnings and profits had fallen sharply. But Martin Currie used eight month old financial data and due diligence. They pushed ahead without assessing whether the Ugent investment was good for the China Fund. (It certainly was good for the Hedge Fund.)
At the next regular meeting of the China Fund’s board, the Ugent investment was once again presented. Once again the description of the transaction failed to mention that the sales proceeds would ultimately end up in the hands of the Hedge Fund. The Hedge Fund’s bond investment was cashed out at par, solving its liquidity crisis. Now the China Fund was holding $22 million of illiquid convertible bonds of dubious value.
Board approval could have cured the conflict. Without disclosing the conflict, the board approval fails. I would have to assume the board would not have approved the transaction if it knew about the conflict.
To compound the problem, Martin Currie failed to follow its procedures for valuation of the shiny, new bonds. The China Fund had adopted FAS 157 and was supposed to value its holding at “fair value.” For non-traded, direct investments like these bonds, the China Fund’s policies called for a valuation at cost, unless there was a material change in value.
Martin Currie failed to point out to the valuation group that Jackin/Ugent was having serious financial problems. Jackin’s auditor issued a going concern warning and Martin Currie failed to inform the valuation group. On top of that the Hedge Fund was selling its remaining interests in Jackin.
Within 19 months of the investment, the China Fund wrote down the investment by 50%. A month later, it wrote it all the way down to $0.
Pointing the Finger of Blame
Although I used the name Martin Currie liberally above, the investment advice was coming from different units of the company and separate individuals in the organization. Martin Currie cooperated with the SEC, including refunding losses incurred by the China Fund and refunding management fees. The firm also terminated an unidentified project manager who directed the misrepresentations to the board. I assume that project manager is subject to further investigation, perhaps by the investigators who can subject the project manager to jail time.
Even with the cooperation, Martin Currie was subject to a fine in excess of $8 million. From the press release, it sounds like the problem was discovered as part of an SEC examination and gives credit to an SEC examination conducted by Jason Rosenberg and Lucas Tepper under the supervision of Mavis Kelly.
To some extent, this case in another in a long string of cases where fund managers took in appropriate steps to stay alive during the 2008 financial crisis. There were no safe places to put money. The robust underwriting standards of the 2007 boom collapsed under the weight of a global financial crisis and a stark new reality. Some managers stepped up and did the right thing by investors, hoping they would appreciate the honesty. Others locked down the funds keeping investors from jumping into lifeboats, claiming the boat is just in rough waters and not sinking. Others took dubious actions trying to cover up their failings.
Remember that it was the redemptions from the 2008 financial crisis that finally brought down the Madoff ponzi scheme after years (decades?) of deceit. Even this master swindler could not hide from a global financial crisis.
- SEC Charges Scotland-Based Firm for Improperly Boosting Hedge Fund Client at Expense of U.S. Fund Investors – SEC Press Release
- SEC’s Order Against Martin Currie (.pdf)
Image of Success or Failure is from Todd Ehlers