SEC's Asset Management Unit Gets Ahead Of The Curve
Bernie Madoff was arrested just over three years ago. The SEC’s side of the Madoff narrative is by now well known. In 2005 Harry Markopolos sent a lengthy memo outlining Madoff’s giant Ponzi scheme, in painful detail, to the SEC’s Boston office. Markopolos’s concerns were then directed to the Commission’s New York office. While members of the exam staff had great concerns about the asset management side of Madoff’s business, ultimately the investigation failed, and billions of dollars were lost. The SEC barely survived the aftermath, and still faces threats to its budget from legislators who cite the Madoff debacle as exhibit A in their case for undermining the agency. The SEC has made some progress in putting Madoff behind it, and its Asset Management Unit took a big step toward doing that earlier this month. On December 1st, the SEC announced a series of cases against hedge funds and their principals for wide-ranging misrepresentations and misuse of fund assets. The cases themselves appear to be strong ones, though perhaps not Earth-shaking. The misconduct includes:
feeding fictitious prices for illiquid securities to a fund’s outside valuation agent and auditor;
misrepresenting a fund’s returns as consistently positive and minimally volatile;
investing a fund’s entire corpus in a single, financially troubled microcap company, and hiding that fact for years;
misrepresenting a fund general partner’s negative regulatory history, compensation in connection with the fund’s investments, and ownership in some of the same companies to which he directed fund investments.
It’s all bad conduct. But to me, the interesting part is how the cases arose. They didn’t come from whistleblowers or auditors walking the cases in the door. They instead came out of an initiative the SEC calls the Aberrational Performance Inquiry. The Commission claims to have used “proprietary risk analytics” to evaluate these hedge funds’ claimed returns, scrutinized them closely, and then conducted investigations to learn the actual facts underlying them.
As the Unit co-chiefs Bruce Karpati and Rob Kaplan put it in the press release (did they say it out loud in unison?), “The extraordinary returns reported by these advisers and portfolio managers were, in most cases, too good to be true.... We are applying analytics across the investment adviser space — beyond performance and beyond hedge funds.” It’s hard to know how sophisticated these proprietary risk analytics really are. But these cases are a significant collective achievement. If the SEC can initiate productive investigations out of data, it will be policing the securities markets in an active way that few would have given it credit for in early 2009. The Enforcement Division has quantitative analytical skill on its staff. It would be wise to unleash it so it can bring more cases like these.