Hedge Fund Manager Failed to Correctly Calculate Fees, SEC Alleges
The co-owners of a small Provo, Utah-based hedge fund manager have agreed to pay $120,000 each to settle SEC charges that their firm incorrectly assessed performance fees due from their funds, and then failed to disclose the resulting overpayment to fund investors until months after the error had been discovered. However, perhaps in recognition that the firm voluntarily returned the overpaid fees, the SEC did not put the firm out of business.
In a December 1 administrative order, the SEC alleged that Maxwell Investments, along with firm president Gary Maxwell and vice-president Bart Coon, did not comply with disclosures made in the firmís hedge fund private placement memoranda about how, exactly, the fundsí performance fees would be calculated and paid. "Rather than basing its fees on the percentage increase in each Fundís Ďaverage market value,í as stated in the PPMs," claimed the SEC, the firm "calculated its fees based on each Fundís cash flow as projected for a twelve-month period." As a result, the firm overpaid itself, assessing incorrect fees over at least a two-year period, the SEC alleged.
After the error was detected, the two executives paid $931,670 back to the funds to correct the overpayment. The firm then performed a year-end accounting reconciliation to determine the exact amount of fees due, and to correct all discrepancies in the firmís accounting records. As it turned out, the actual overpayment was a little less than what had been repaid ó $839,798. A few months later, the firm disclosed the issue to the fund investors, explaining that the funds already had been reimbursed in an amount more than adequate to account for the discrepancy.
In addition to the fee calculation problems, the SEC alleged that the firm commingled partnership assets by arranging short-term transfers between funds to cover maintenance requirements in certain fundsí trading accounts. Although the transfers were repaid, the SEC alleged that they created a material conflict of interest because the firm, as an adviser to multiple hedge funds, "may have been acting (or had an incentive to act) in its own best interest at the expense of its clients." Neither the inter-fund transfers, nor the conflicts that may have created by the mere availability of such transfers, were disclosed to investors, the SEC alleged.
The SECís order also alleged that:
Maxwell borrowed $30,000 from one of the funds for a personal auto purchase (the amount was repaid ten days later);
the firm did not adequately maintain individual capital accounts for each investor, to track each investorís contributions to the funds and share of fund liabilities, profits, and losses, as had been represented in the fundsí PPMs;
the firm did not maintain adequate books and records, and had "no formal accounting/bookkeeping system in place"; and
the firm made inaccurate disclosures on its ADV.
The SEC alleged a variety of Securities Act, Exchange Act, and Advisers Act fraud violations, as well as violations of the Advisers Act custody and books and records rules. Among other things, the SEC noted that Rule 206(4)-4(a)(1) requires that an adviser disclose all material facts about its financial condition that are reasonably likely to impair the adviserís ability to meet contractual commitments to clients.
In addition to the two $120,000 civil money penalties, Maxwell and Coon agreed to be suspended from associating with any investment adviser for twelve months each. The SEC agreed to allow Maxwell serve his suspension first, with Coonís suspension beginning thirty days after the end of Maxwellís suspension. The firm also agreed to provide a copy of the SECís order to all existing investors in its hedge funds, as well as to all new investors and potential investors for a one-year period.
Ken Israel, district administrator of the SECís Salt Lake District Office, explained that the SEC typically agrees to non-concurrent suspensions "in situations where itís a very small firm and to take out both principals at the same time would basically cause the firm to go under." The SEC, he said, has "done it before," but "itís not done very often."
IM Insight asked Israel what lessons advisers should take away from the case. "I think the big thing on this one" is that an adviser "needs to be careful that their conduct conforms to what they are telling investors," said Israel. Advisers, he said, donít want to end up in a situation where "they said one thing and then did another."
Israel indicated that the length of time during which the incorrect fees were being assessed played a factor in the SECís decision to bring the case. While Maxwell did detect the problem themselves, it was "not until they had been doing it for quite a while." If the firm had promptly detected the problem and taken remedial action "immediately," that "certainly would have factored into our decision as to whether or not to take an action," he said.
The firmís president, Gary Maxwell, said that his firm does "not admit nor deny the SECís allegations," adding that that was pretty much all he could say about the case under the terms of the SECís settlement agreement. However, he did pass along some words of advice for others: "Read the fine print," said Maxwell, referring to an adviserís familiarity with its own disclosures. And, he added, "watch the little details."