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News May 21, 2018 Issue

Hedge Fund Adviser Execs May Face Personal Fines if They Ignore Red Flags

A chief financial officer at a hedge fund advisory firm on May 8 settled SEC charges that he failed to act on red flags involving asset mismarking and insider trading. The firm ended up paying more than $10 million, and the CFO agreed to separately pay a $100,000 fine. The lesson: Advisory firm executives need to be on the lookout for signs of fraud, and act on them when they find them.

What happened, according to the SEC, was that two portfolio managers of New York City-based Visium Asset Management, a SEC-registered hedge fund adviser with more than $7.8 billion in assets under management, inflated the value of securities held by its funds. This caused the funds to falsely inflate their returns, overstate their aggregate net asset value, and pay approximately $3.15 million in excess fees to Visium, the agency said.

As for the insider trading allegations, the SEC charged that certain Visium portfolio managers traded in the securities of pharmaceutical companies in advance of two generic drug approvals by the Food and Drug Administration. "The trades were based on confidential information received from a former FDA official working as a paid consultant to Visium," the agency said.

In addition, according to the SEC’s separate settlement order with Visium, "trades were also made in the securities of home healthcare providers in advance of a proposed cut to certain Medicare reimbursement rates by the Centers for Medicare and Medicaid Services (CMS)," this time based on confidential information obtained from a former CMS employee now working as a Visium paid consultant.

"The SEC will always be interested in fraudulent mismarking by entities and their employees, particularly in a manner that allows for millions of dollars in ‘fraudulent’ fees," said Mayer Brown partner Richard Rosenfeld.

Two Visium funds were involved in these settlements. One was the Visium Credit Master Fund, which the adviser launched in May 2009 for investing primarily in high risk and at times thinly traded corporate debt instruments issued by health care companies. According to the settlement order, the Credit Fund, over its life, raised approximately $600 million in investor capital. "From May 2009 to June 2013, the fund reported positive returns in 44 of 50 months," the SEC said, noting that at its peak, in March 2012, it had more than $471 million in net assets. However, in 2013, following a string of redemption requests, Visium closed the fund and began liquidating its assets.

The other fund, the Visium Balanced Master Fund, was involved, along with the Credit Fund, in the insider trading scheme (see below), according to the settlement order.

A question of supervision

Where was Visium management while these activities were going on? According to the agency, the advisory firm’s CFO, Steven Ku, "failed reasonably to supervise two portfolio managers, Christopher Plaford and Stefan Lumiere, by failing to respond appropriately to red flags that should have alerted Ku to their misconduct." The red flags cited by the SEC included the frequency with which the portfolio managers used price overrides and the fact that the overrides almost always resulted in higher valuations for the Credit Fund.

Despite these and other red flags named in Ku’s settlement order, "Ku failed to take appropriate action to determine whether an employee under his supervision was engaged in unlawful conduct and failed to take reasonable steps to prevent violations of the federal securities laws," the agency said. "On several occasions, Ku asked Plaford about the valuations, but each time Ku simply accepted as true Plaford’s false representations that the override quotations were reliable because they were obtained from broker-dealers who made markets in the particular distressed securities. Ku failed to take appropriate steps to verify the reliability or independence of the brokers or quotes Plaford and Lumiere used to support Visium’s price overrides for the securities at issue."

"Advisory firms must create a culture of zero tolerance when it comes to unlawful conduct, and supervisors at those firms must take reasonable measures necessary to detect and prevent securities law-related violations by their personnel," said SEC New York Regional Office director Marc Berger.

Behind supervisory liability

"This is yet another example of the SEC pursuing supervisory liability claims based on the alleged misconduct of certain rogue employees," said Paul Hastings partner John Nowak. "With the apparent benefit of 20/20 hindsight, the agency examined the policies and practices of the adviser in the context of the perceived misconduct by the rogue employees and identified alleged inconsistencies between the adviser’s internal practices and its own policies."

"This case should act as a reminder to compliance counsel and fund personnel to periodically review written procedures and disclosures to ensure that the practices of the adviser are in conformity with written policies and procedures, and to update and amend written policies and procedures as the business activities of the adviser change," he said.

"Defending an SEC investigation is trickier if a firm fails to comply with its own procedures," said Bell Nunnally partner Robert Long. "Accordingly, a firm’s procedures need to be tailored, but realistic so they can be followed."

"Advisers should also be aware that the SEC will be an armchair quarterback when it finds ‘red flags,’" he said. "That’s a luxury that firm officers and compliance personnel don’t have. They need to be vigilant."

"The facts cited by the agency staff include information designed to show that Ku should have known about the fraudulent conduct, including Ku receiving reports that showed Visium’s valuations to be significantly higher than the same valuation in a separately managed account," said Rosenfeld. "The action taken against the individual supervisor here shows how serious the SEC regards supervision and its place in the regulatory framework. On the heels of the settlement with Wedbush Securities earlier this year, the Commission is sending a strong reminder to the industry that supervisors must take their responsibilities seriously, or risk significant SEC action."


Visium, as part of the settlement, had to pay disgorgement of more than $4.7 million, plus interest of more than $720,000, the agency said. It also had to pay a civil money penalty of more than $4.7 million, meaning the total settlement costs to the adviser are more than $10 million. Ku, as part of his individual settlement, was ordered to pay a $100,000 civil money penalty and was suspended from the securities industry for one year. An attorney representing Ku said that his client was happy to have resolved the matter. An attorney representing Visium did not respond to a voice message or an email seeking comment.

Plaford and Lumiere were not charged in the May 8 complaint, having been charged, along with a former FDA official, by the SEC in a June 2016 enforcement action (ACA Insight, 6/20/16). Lumiere was barred from the securities industry by the agency earlier this year, based on a final judgment in the SEC’s case, as well as his conviction in a parallel criminal case, the agency said. The SEC’s case against Plaford, meanwhile, has been stayed pending the completion of a parallel criminal case against him, according to the agency.

Mismarking allegations

"From at least July 2011 to December 2012, Plaford and Lumiere repeatedly obtained sham broker quotes to inflate falsely the value of certain securities held by the Credit Fund, the fund’s reported NAV, and its performance," the SEC said. "The sham quotes were used to override available prices from established pricing sources that the Credit Fund’s independent administrator otherwise should have used when striking the fund’s month-end NAV, to price securities held by the fund." They were also used to price securities at month-end at times when the independent administrator did not provide Visium with available prices from established pricing sources, the agency said.

The quotes were allegedly procured from one or more of three friendly outside brokers at three different registered brokerage firms. "To make the sham quotes appear to be legitimate quotes from independent outside brokers, Plaford and Lumiere asked the friendly brokers for the specific prices they wanted with the direction to email or instant message the prices back to them as the brokers’ own quotes," a practice known as "U-turning" the quotes.

On at least 308 occasions, Visium relied on the sham quotes and provided them to the fund’s independent administrator to strike the fund’s month-end NAV, according to the Visium settlement order. "Of the 308 price overrides, 282, or 91.56 percent, resulted in higher valuations for long positions or lower valuations for short positions held by the Credit Fund."

"The mismarking scheme caused the Credit Fund to overstate its month-end NAV routinely, during the relevant period, by approximately 2.4 percent to 7.2 percent, and the fund’s audited and reported NAV for year-end 2011 and 2012, by approximately 5.1 percent and 7.0 percent, respectively," the SEC said. "As a result, some investors bought into the fund at an inflated NAV. Some investors redeemed out of the fund at an inflated NAV, thereby diluting remaining investors’ interests."

The bottom line here was that for 2011 and 2012, Visium received from the Credit Fund more than $2.6 million in ill-gotten performance fees, the agency said. Incentive compensation was paid to the Credit Fund investment team from that money. The fund also allegedly received $533,700 in management fees that it was not entitled to. The total take of ill-gotten fees from the Credit Fund was more than $3.1 million, the SEC said.

Insider trading

Visium involved both the Credit Fund and the Balanced Fund in its insider trading, according to the administrative order.

One of the adviser’s portfolio managers for the Balanced Fund caused the fund to trade in the securities of pharmaceutical companies in advance of generic drug approvals by the FDA’s Office of Generic Drugs (OGD), "based on material, nonpublic information he received from a former OGD official," the SEC said.

Another portfolio manager caused both the Credit and Balanced Funds to trade in the securities of home healthcare providers in advance of a proposed cut to certain Medicare reimbursement rates by CMS, based on material, nonpublic information he received from a former CMS employee, the agency alleged. "The insider trading generated more than $7 million in illicit profits for the Credit and Balanced Funds combined, and nearly $1.6 million in ill-gotten performance and management fees for Visium," the agency said.

It’s not that Visium didn’t have policies and procedures that addressed insider trading, but that the adviser, according to the SEC, "failed to enforce policies and procedures designed to prevent the misuse of material nonpublic information by the firm and the persons associated with it."