Charging the Gatekeeper

The SEC charged EIA All Weather Alpha Fund and its investment adviser, Andrew Middlebrooks, for fraud last year. The SEC alleged that Middlebrooks misrepresented the Fund’s performance in order to retain current investors and to induce new investors. The Adviser directed the creation of and approved an inflated NAV for the Fund with false and misleading performance results. The Fund provided investors with statements showing positive returns in the investors’ accounts and purported Fund gains from trading. In reality, the purported gains reflected in the investor statements were false. The Fund had actually lost money.

Normally, you would have expected a fund auditor to pick up on the problem. One of the claims against Middlebrooks and the Fund is that they falsely claimed the Fund had an auditor.

In the past, the SEC has shown its willingness to go after gatekeepers who missed obvious red flags in a fraud, in addition to the fraudster. The obvious target in this case would have been the auditor. The SEC claimed that Middlebrooks fabricated the financial statements and an audit report.

The SEC turned to the fund administrator for culpability. To be honest, I was a bit surprised to hear that there was a fund administrator. Based on the SEC order, it looks like the fund administrator failed to catch the red flags.

The agreement between the Fund and Theorem Fund Services required the fund to appoint an independent auditor to conduct an audit of the fund. At the onboarding in early January 2018, Theorem relied on a representation of the Fund. At year end of 2018, Theorem found out that no auditor had been engaged. That started the process of Theorem ending its services. By then, the damage had been done.

Over the course of 2018 Theorem was responsible for calculating the Fund’s NAV monthly. Theorem did what it was supposed to do and used the trading statements to calculate the NAV. The big failure happened in March 2018 when the fund lost $342,000. Rather than record the loss on the Fund, Middlebrooks decided to treat the loss as a “receivable” from the fund manager. The result would be no reduction of the Fund’s NAV. This treatment of losses as a receivable continued through 2018 and Theorem published investor statements that didn’t show the losses.

As a result of this “weird treatment,” the Fund’s performance for July 2018 since inception was positive 148.39%. The true result was a negative 63.9%.

Obviously the treatment of the loss as a receivable is “weird.” I suppose its possible that a fund could structure a loan from the manager to the fund to cover losses. That would need to be disclosed in the financial statements and creates a whole set of conflicts and compliance issues. Blackstone offered a guaranteed return to an investor in BREIT earlier this year.

Here, there was no disclosure. There was actually no receivable. There was no provision in the fund documents to allow a loan and no note or documentation to evidence the loan resulting in the receivable. Theorem just accepted that the Fund’s word that it was legally liable to reimburse the losses. (They were not.)

In January 2019, the fund switched trading platforms. Theorem at that time required disclosure of the receivable and a plan for its repayment to investors. The Fund did not do so and Theorem terminated the arrangement.

Theorem still provided investor statements with the bogus receivable until the termination was effective 30 days later.

The question I have is “who turned in the Fund and Middlebrooks?” It could have been Theorem. But the charging documents make no mention of Theorem’s cooperation. I think it’s more likely to have been a disgruntled investor.

Sources: