Multiple Disclosure Issues Lead to Enforcement Against Hedge Fund Manager
Disclosure is a basic requirement of most SEC regulations. If you want a visit by the SEC, failure to disclose, particularly when it occurs more than once, is one of the best ways to ensure that you get one.
Consider the SECís January 28 settlement with New York-based adviser QED Benchmark Management and its Toronto-based founder and hedge fund manager, Peter Kuperman. A failed algorithmic investment strategy led them to misstate†returns in marketing, and then fail to disclose new investments. These in turn led to what the agency said were improper valuations and difficulty honoring investor redemption requests.
Complicated as that may sound, it comes down to a†basic point: Had the adviser disclosed the failure of the initial investment strategy to investors in the first place, the enforcement action probably wouldnít have been necessary.
QED Management and Kuperman "avoided disclosing heavy trading losses to investors by using a misleading mixture of hypothetical and actual returns when providing the fundís performance history," the SEC said. "After obtaining millions of dollars from investors based on these misrepresentations, [QED Management] and Kuperman deviated from their stated investment strategy and poured most of their fundís assets into a single penny stock. They went on to make misleading and†incomplete disclosures to fund investors about the value and liquidity of this penny stock investment."
"Investment advisers must be completely candid when disclosing two key features that investors rely upon when making investment decisions: investment strategy and historical performance," said SEC New York Regional Office director Andrew Calamari. "This settlement enables investors in the [fund] to receive full monetary relief for losses suffered when they were misled on both fronts."
Breadth of allegations
"If you accept the SECís allegations as true, this case had a little of everything Ė misstatements to investors, use of hypothetical returns, undisclosed conflicts of interest and valuation problems," said Sidley Austin partner Mark Borrelli. "You donít often see managers deviating from a broad investment mandate in a manner that would require investor consent, but in this case, according to the SEC, the manager essentially ignored the investment mandate and pursued a new strategy. That dramatic of a change can only be made with full disclosure and consent."
"All of these issues are important to the SEC," noted Mayer Brown partner Matthew Rossi. "For example, the Office of Compliance Inspections and Examinationís priorities for 2015 included assessing liquidity and valuation policies and practices, and the 2016 exam priorities include examining advisers to funds that have exposure to certain types of illiquid investments and reviewing controls over valuation and liquidity management. The SEC also recently proposed liquidity management rules for mutual funds and exchange-traded funds (ACA Insight, 2/1/16), and the Enforcement Division has brought cases recently concerning performance advertising, investments contrary to strategy, and failure to disclose conflicts of interest."
Expect SEC exam and enforcement staff to take a hard line when they find these violations, he said. "Advisers must be careful to comply with their disclosed investment strategies and concentration limits, especially as they relate to illiquid investments. This case also serves as a warning that a general partner or its principal should not attempt to waive conflicts or consent to deviations from the terms of a limited partnership agreement by themselves when they are also acting under a conflict of interest."
As part of the settlement, Kuperman, who was barred from the securities industry, agreed to pay $2.9 million to a fair fund that would compensate investors, as well as a civil money penalty of $75,000. He and QED were found to have willfully violated Sections 206(1), (2) and (3) of the Advisers Act, as well as Rule 206(4)-8, all of which prohibit fraud. They were also found to have violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and its Rule 10b-5, which also outlaw fraud. The attorney representing both QED Management and Kuperman, when contacted, chose not to comment.
The fund and the algorithm
Kuperman founded QED Management in 2004, according to the agency, adding that the firm has never been registered with the SEC. That same year, he founded the fund in question, QED Benchmark. From approximately 2005 through 2008, according to the agency, Kuperman obtained approximately $1.2 million in capital from a close relative and the relativeís business associates.
QED Management and Kuperman purportedly used an algorithmic strategy that Kuperman referred to as the "five categories" strategy, the SEC said, noting that it focused on "285 varying metrics within the categories of momentum, growth, value, risk and estimates." It used those metrics to select multiple investments that appeared likely to outperform the market.
The fundís offering memorandum and limited partnership agreement said, according to the SECís administrative order, that "no more than 20 percent of the fundís assets could be invested in any single security, and that no more than 5 percent of the fundís assets could be invested in an illiquid security."
Things went wrong
Despite these guidelines, in February 2009, "Kuperman deviated from the fundís stated strategy, investing heavily in one industry and a single stock," the SEC said. The fundís administrator, the agency said, provided statements to investors for January, February and March 2009, which showed that the fundís returns,†respectively, were -8.7 percent, -35.48 percent, and -64.03 percent, for a total quarterly return of -78.81 percent.
But were accurate return percentages shared in the fundís marketing? Not according to the SEC. "Beginning in December 2009, Kuperman provided potential investors with documents that reported purported historical results for 2009, and in some cases for the first quarter of 2009, that were significantly higher than the fundís actual results," the agency said. "In order to show these misleadingly positive returns, Kuperman excluded the disastrous returns he actually achieved in the first quarter of 2009, replacing them with the hypothetical†returns that his model purportedly would have achieved if he had applied it correctly and consistently during the quarter."
Kuperman then, according to the SEC, raised approximately $2.2 million, mostly from new investors, from 2010 through 2013, by using the same marketing with what the agency called "fraudulent historical results. Ö There is no evidence that any of them received any additional, corrective material."
In 2010, Kuperman made the acquaintance of two Canadians who were active in the penny stock markets. One of them, as it turns out, had pled guilty to securities fraud and been barred by the SEC from participating in penny stock offerings for his involvement in a penny stock promotion scheme, the agency said.
Nonetheless, in July 2011, Kuperman, on behalf of the fund, purchased $300,000 worth of convertible debentures through these two individuals in Nevada-based Emo Capital, a penny stock company, according to the SEC. Emo was also a Commission-registered shell company with no reported assets of any kind as of April 2011 and had negative cash flow and earnings in the most recent nine months, the SEC said, adding that Kuperman "performed no due diligence on the company before investing the fundís money."
"Kuperman did not disclose to the fundís investors that the investment had been made, nor the fact that, because he and QED Management expected the [two Canadian promoters] to help them find clients in return for the fundís investment, they had a financial conflict of interest," the agency said.
And the EMO investments continued. By late November 2011, according to the administrative order, Emo convertible debentures represented almost 20 percent of the fundís net asset value. After an additional purchase of $400,000 of the fundís money in the illiquid Emo convertible debentures in December 2011, they represented more than 50 percent of the fundís net asset value. The December 2011 purchase was also a violation of the fundís limited partnership agreement, as it involved putting more than 5 percent of the fundís assets in an illiquid security and more than 20 percent of the fundís assets in a single security, liquid or otherwise, the SEC alleged.
Not to stop there, however, the fund in December 2011 also purchased 300,000 shares of Emoís common stock, the agency said, and another 892,913 shares in January 2012. "By the end of that month, the fund held more than 1,192,913 shares of Emoís common stock, at a cost basis of $779,330. These shares represented over 75 percent of the net asset value of the holdings in the fundís brokerage account."
Valuation and pricing
In January 2012, the SEC said, Kuperman instructed the fund administrator to value the shares at $0.75 per share for the end of December, even though Emo traded at $0.64 per share on December 31. Investors were apparently happy with what seemed like a positive performance from the fund, and Kuperman was able to solicit an additional $245,000 from five of its existing investors between January and April 2012, according to the agency.
The SEC administrative order continues to outline further alleged manipulations in the valuations of both the Emo common stock and its convertible debentures. By February 2013, Emo common stock and the illiquid convertible debentures collectively accounted for 100 percent of the fundís net asset value, the agency said.
Then the other shoe dropped. In approximately August 2013, according to the administrative order, the two Canadian promoters reneged on a previous agreement that would have allowed QED Management and Kuperman to use a put option to value the fundís shares at $1.00 per share, which would have allowed the fund to sell its entire Emo holdings at any time at $1.00 per share Ė higher than the market price Ė at any time until December 2013. Instead, the two promoters gave the fund an overvalued asset from their portfolio Ė more illiquid convertible debentures, and paying 6 percent annual interest. The likelihood that the company could pay such an interest rate was "extremely low," the SEC said, noting that Kuperman again performed no due diligence on the new company.
"In reality, the fund had virtually no liquid assets in 2013," the SEC said. "The fund ultimately sold the Emo common stock it had bought on the OTC market at a steep loss and used the proceeds to fund partial†redemptions for some investors. The fund also obtained a new investor, introduced to the fund by the [Canadian promoters], and used the $190,000 investment by this investor to issue partial redemptions to some of the complaining investors."