One In Nine Fund Managers Has Regulatory Black Mark, New Forms Show

Date: Thursday, May 31, 2012
Author: Daniel Fisher, Forbes

The hedge-fund industry thrives on secrecy. Clients sign non-disclosure forms to keep investment results secret, hedge funds and private-equity firms compare their performance to themselves instead of the broader stock indexes, and nobody knows how much that performance is skewed upward by “survivor bias” because hedge funds have a habit of shutting down after a bad year instead of continuing on to drag the averages down.

Now a report compiled from new data required by the Securities and Exchange Commission shows another secret the industry would prefer its clients didn’t know about. One in nine advisors to private funds have a “significant adverse regulatory event” ranging from a regulatory violation to a felony conviction in the past 10 years.

This remarkable track record has been compiled by Diligence Review Corp., a New York consulting firm that advises pension funds and other institutional investors on private money managers. It provides a powerful lesson for investors looking to avoid the next Bernie Madoff or Sammy Israel: Take advantage of the new regs to check out that hot hedge fund manager before sending him a check.

Diligence Review obtained the data from the Form ADV all money managers have been required to file with the SEC starting March 30 of this year. The firm downloaded ADVs for some 12,000 managers, then looked at the 4,054 that identified themselves as managing at least one private fund. (This list didn’t include venture capitalists, foreign private advisors, and managers of small funds under $150 million, which are currently exempt from the Form ADV requirement.) Of the 4,054, 466 reported at least one significant adverse regulatory event, an 11.5% rate.

Diligence Review’s Jennifer Cooper tells clients to pull a Form ADV for any money manager they are thinking about hiring, as well as ones they already employ. If there’s a black mark, don’t invest or at the very least get a full explanation, she says. For firms already holding an investor’s money, she advises clients to structure the investment in a manner that reduces risk to the investor (had Madoff’s clients insisted on using custodial banks to hold their investments, his scam wouldn’t have worked); hire independent advisors to check out the advisors; or fire the manager if the danger can’t be eliminated.

“It’s not an automatic don’t-hire, but it’s certainly a red flag — not a yellow flag, but a red flag,” said Cooper, a longtime consultant in the investment management business. “There are some firms that just have a systemwide problem with putting their clients first, and others where a principal has a felony conviction.”

The SEC has made the data available in a spreadsheet format although investors still must create their own database to search it fully.

“Kudos to the SEC for putting a large amount of data out there,” said Cooper, who urged investors to stay on top of these forms as they can change with every new event. And in keeping with the industry’s tradition of offering managers a fresh start whenever they bomb most horribly, even felony convictions are expunged from the record after 10 years. So do a FINRA broker check as well.

Fund managers may dismiss these events as non-events, but the list involves more than mere hand slaps. The lowest-level trigger would be violating the rules of a self-regulatory agency like FINRA, but this must be other than a “minor rule violation.” The list continues up through violations of federal regulations, misdemeanor violations regarding investments or investment-related businesses, up to convictions or no-contest pleadings for felonies.

My own search of the SEC database turned up a selection of black marks against investment firms big and small, including:

Oppenheimer & Co.: Five employees with criminal convictions; numerous state and federal consent orders as recently as 2009.
Credit Suisse Securities: Numerous U.S. and international violations including a $535,000 fine over auction-rate securities.
Amundi Investments: Parent Credit Lyonnaise pled guilty to three felony counts of hiding its control of another bank in 2004.
Dorset Management Corp.: Employee has criminal record for marijuana bust as college freshman.
Scopus Asset Management: Employee has 2004 conviction for computer fraud.