Enforcement News: Hedge Fund Manager Charged With Making False and Misleading Statements Resulting in Over $39 Million in Investor DamagesPrint Article
- Posted on: May 31 2022
By: Jeffrey M. Haber
Trust. Trust is an important part of investing. Studies show that trust has a significant impact on investor decision making, such as investing with a hedge fund manager. As one commentator observed, “Clients entrust their capital to advisers to invest, often at the advisers’ discretion … That requires an immense amount of trust. And when properly earned and thoughtfully applied, that trust pays off. It sets in motion successful ideas that benefit both the investor and society at large, creating greater social wealth and well-being. Trust is the glue that binds the financial system together and is essential if the investment industry is to benefit society.”1
Since trust is so important, how does a hedge fund manager build trust with existing and prospective investors? The answer is not so easy. Investors consider many factors in deciding whether to invest their money with a hedge fund. Clearly, performance is an important factor. But other factors also play an important role, such as brand identity, the qualifications of the hedge fund manager, disciplinary history within the securities industry and the way in which the hedge fund manager safeguards the fund’s assets.
In Future State of the Investment Profession, the CFA Institute developed a trust equation in which the authors tried to outline some of the factors investors and prospective investors consider when determining whether the hedge fund manager is trustworthy. The study showed that hedge fund managers establish trust through credibility (i.e., credentials, track record and brand) and professionalism (i.e., competency and values). When one or more of the foregoing factors is missing investors may be harmed.
Today, we examine SEC v. Middlebrooks, an enforcement action brought by the Securities and Exchange Commission (“SEC” or “Commission”) to redress the harm done to fund investors by defendants’ alleged scheme to defraud.
According to the SEC, from at least mid-2017 through the present (the “Relevant Period”), defendant Andrew M. Middlebrooks, through the EIA All Weather Alpha Fund I Partners, LLC (“EIA”), a purported long/short equity hedge fund, solicited and raised approximately $39 million from over 100 investors for a private fund that he managed.
Defendants allegedly made numerous false and misleading statements to fund investors and prospective investors, in which they misstated the fund’s performance and claimed that its financials were audited by an independent accounting firm when they were not. Defendants allegedly represented to investors and prospective investors that the fund was extremely successful, with cumulative returns of more than 2,500% from the fund’s inception through January 2022. In reality, alleged the SEC, the fund suffered catastrophic trading losses of approximately $27 million.
Additionally, said the SEC, defendants falsely represented that the fund had an auditor and would provide audited financial statements to investors. In reality, claimed the SEC, no audit was ever performed and, in early 2022, defendants fabricated financial statements and an audit report, which they provided to existing and prospective fund investors.
Further, the SEC alleged that defendants made over $9 million in Ponzi-like payments to conceal the fund’s poor performance. Specifically, the SEC said that defendants met redemption requests using other investors’ funds, paying not only the original amount invested despite the dismal trading losses, but also the phony returns defendants had claimed.
According to the SEC, Middlebrooks also misappropriated investor money, by, among other things, transferring at least $470,000 to his wife’s business, making over $750,000 in transfers to his personal bank account, and using $64,000 of investor money to pay for jewelry.
To halt the alleged ongoing fraud, the SEC sought and obtained emergency relief from the U.S. District Court in the Eastern District of Michigan, including a temporary restraining order against EIA and Middlebrooks and an asset freeze against defendants and the named relief defendants.
“As we allege in the complaint, Middlebrooks lured investors by touting extraordinary performance returns and then concealed the truth of his fraud, including by fabricating documents provided to investors,” said C. Dabney O’Riordan, Co-Chief of the Asset Management Unit.
By its compliant, the SEC charged EIA and Middlebrooks with violating the antifraud provisions of the federal securities laws and further charged Middlebrooks with aiding and abetting EIA’s violations of the Investment Advisers Act of 1940. The SEC seeks injunctions, disgorgement of ill-gotten gains with prejudgment interest, and financial penalties against EIA and Middlebrooks.
A copy of the SEC’s complaint can be found here.
A copy of the SEC’s press release announcing the enforcement action can be found here.
A hedge fund pools investors’ money and invests the money in securities in an effort to make a positive return. Hedge funds typically have more flexible investment strategies than, for example, mutual funds. Many hedge funds seek to profit in all kinds of markets by using leverage (i.e., borrowing to increase investment exposure as well as risk), short-selling and other speculative investment practices that are not often used by mutual funds.
To invest, a person must generally be an accredited investor (i.e., the investor has a minimum level of income or assets to invest in hedge funds). Typical investors include institutional investors, such as pension funds and insurance companies, and wealthy (i.e., high net worth) individuals.
Hedge funds are not subject to many of the regulations that protect investors. Depending on the amount of assets in the hedge funds advised by a manager, some hedge fund managers may not be required to register or to file public reports with the SEC. Hedge funds, however, are subject to the same prohibitions against fraud as are other market participants, and their managers owe a fiduciary duty to the funds that they manage.
The SEC has issued an investor bulletin (here) in which investors and potential investors are provided with information concerning the factors to consider when investing with a hedge fund manager. According to the SEC, investors should do, among other things, the following before entrusting money with a hedge fund manager:
- Read the fund’s offering memorandum and related materials. These documents contain information about investing in the fund, including the investment strategies of the fund, whether the fund is based in the United States or abroad, the risks of the investment, fees earned by the hedge fund manager, expenses charged to the hedge fund, and the hedge fund manager’s potential conflicts of interest.
- Understand the fund’s investment strategy. In particular, investors should be sure that they understand the level of risk involved in the fund’s investment strategies and that investment strategies are suitable to their investment objectives, time horizons and risk tolerance.
- Determine if the fund is using leverage or other speculative investment techniques. A hedge fund using leverage will typically invest both the investors’ capital and the borrowed money to make investments in an effort to increase the potential returns of the fund. The use of leverage will magnify both the potential gain and the potential loss from an investment. The use of leverage can turn an otherwise conservative investment into an extremely risky investment. A hedge fund may also invest in derivatives (such as options and futures) and use short-selling (selling a security it does not own) to increase its potential returns, which could likewise increase the potential gain or loss from an investment.
- Evaluate potential conflicts of interest disclosed by hedge fund managers. For example, if the investment adviser recommends that investment in a fund that the adviser manages, there may be a conflict of interest because the adviser may earn higher fees from the investment in the hedge fund than the adviser might earn from other potential investments.
- Understand how a fund’s assets are valued. Hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing illiquid securities. You should understand a fund’s valuation process and know the extent to which a fund’s securities are valued by independent sources. Valuations of fund assets will affect the fees that the manager charges.
- Understand how a fund’s performance is determined. Hedge funds do not need to follow any standard methodology when calculating performance, and they may invest in securities that are relatively illiquid and difficult to value. By contrast, the federal securities laws dictate how mutual funds can advertise their performance by requiring specific ways to calculate current yield, tax equivalent yield, average annual total return and after-tax return, as well as having detailed requirements for the types of disclosure that must accompany any performance data.
- Understand any limitations on the right to redeem shares. Unlike mutual funds where an investor can elect to sell shares on any given day, hedge funds typically limit opportunities to redeem, or cash in, shares (e.g., monthly, quarterly or annually), and often impose a “lock-up” period of one year or more, during which an investor cannot cash in his or her shares. Further, hedge funds may charge a redemption fee before an investor is allowed to cash in his or her shares. Hedge funds may also have authority to suspend redemptions under certain circumstances, including in times of market distress or when their investments are not able to be quickly or easily liquidated.
- Research the backgrounds of hedge fund managers. Investors should be sure that the hedge fund manager is qualified to manage money. In doing so, investors should ascertain whether the fund manager has a disciplinary history within the securities industry.
- Ask about fees and expenses. Fees and expenses affect an investors’ return on investment. Hedge funds typically charge an annual asset management fee of 1 percent to 2 percent of assets as well as a “performance fee” of 20 percent of a hedge fund’s profit. These fees are typically higher than the fees charged by a mutual fund. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return.
- Ask about how a fund’s assets are safe guarded. A hedge fund’s manager generally has authority to access and transfer the fund’s assets. To guard against this, many hedge funds undergo an annual financial audit by an independent auditor that includes verification of the existence of the fund assets. Investors should inquire about where a fund’s assets are held (e.g., whether they are held in custodial accounts at a reputable bank or broker) and whether an independent third party confirms or otherwise verifies the existence of the fund’s assets.
Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.
This article is for informational purposes and is not intended to be and should not be taken as legal advice.
- Robert Stammers, How Can Investment Professionals Build Trust?, CFA Institute (June 22, 2018) (here).