The Securities and Exchange Commission has brought a little-noticed case, apparently charging an investment adviser who also controls a hedge fund with bringing certain clients into his fund who were not suited for the risks of hedge funds.
However, the regulator seems to be going through the back door by charging the individual over certain disclosures. This underscores the degree to which the SEC will try to rein in certain practices as it more aggressively brings cases against hedge funds. “This case involves fraud and breach of fiduciary duty,” the SEC says in its order to cease and desist.
The case is surprising to at least one attorney. “When there is a broad-based product or problem, the SEC usually leaves it to FINRA [Financial Industry Regulatory Authority] or the plaintiff bar,” notes Vinny Sama, a litigation partner in the New York office of Winston & Strawn, who concentrates in part on securities and derivatives litigation.
In the case announced last week, the SEC’s Division of Enforcement charged Boulder, Colorado–based investment adviser Neal Greenberg with fraud and breach of fiduciary duty in the marketing and recommendation of his firm’s hedge funds to investors, including many elderly clients.
According to the SEC, Greenberg falsely stated that the Agile hedge funds offered and managed by his two investment advisory firms were suitable for conservative investors who were retired or nearing retirement. “However, the Agile hedge funds used leverage and [were] concentrated in a small number of investments,” the regulator says.
The SEC, however, fails to point out that such practices are not uncommon among hedge funds in general. It does note that the funds suffered substantial losses in September 2008 and ceased redemptions to investors. Of course, so did scores of other hedge funds.
The SEC Division of Enforcement further alleges that the Agile hedge funds improperly collected about $2 million in management and performance fees that were not adequately disclosed to investors.
“Greenberg misrepresented the diversification, risks and fees involved with investing in the Agile hedge funds to conservative investors who were dependent on their investment income for some or all of their living expenses,” says Donald M. Hoerl, director of the SEC’s Denver regional office, in the announcement made by the regulator. “Greenberg’s unsuitable recommendations and misrepresentations deceived his advisory clients into believing their money was safe with him.”
According to the SEC’s order instituting administrative and cease-and-desist proceedings against Greenberg, the Agile hedge funds held about $174 million of capital from more than 100 investors when Greenberg suspended redemptions in September 2008 — a pretty diversified client list for that amount of capital.
Greenberg was CEO of investment advisory firm Tactical Allocation Services, which made investment recommendations to clients, and head portfolio manager of his other investment advisory firm, Agile Group, which managed the Agile hedge funds.
The SEC’s Division of Enforcement alleges that Greenberg falsely stated that the Agile hedge funds offered liquidity, immense diversification and minimal risk. He is also accused of falsely stating that the hedge funds could safely represent an investor’s entire investment portfolio, and that they used leverage in a way that did not significantly increase the funds’ risk profile.
“The risk disclosures in private placement memoranda for the Agile hedge funds for 2007 and 2008 contradicted Greenberg’s false and misleading verbal and written representations to investors,” the SEC goes on to say.
Now I am not in a position to determine whether Greenberg lied to his clients or verbally told them things that differed from what was contained in written documents. I am also not in a position to judge whether the portfolio was properly diversified.
But it seems the SEC is very concerned with the notion that the majority of Greenberg’s advisory clients were generally conservative, older investors who wanted low-risk investments offering significant capital protection.
“The Division of Enforcement alleges that Greenberg failed to ensure that adequate compliance policies and procedures were developed or implemented for determining when it would be suitable for advisory clients to invest in complex hedge fund products, particularly for unsophisticated investors or elderly clients on limited incomes who were risk-averse,” it states. “Greenberg also failed to ensure that adequate supervisory procedures were developed or implemented relating to those determinations.”
As for the fees, the SEC’s order notes that when one Agile hedge fund invested in another Agile hedge fund, investors were assessed performance and management fees on the leveraged portions of their investments. These fees, which totaled approximately $2 million between 2003 and 2006, were not disclosed to investors.
The SEC does not claim that the clients were not accredited investors, so it is true that they were qualified to invest in private partnerships. In fact, many retired people are invested in hedge funds.
It seems to me that among the many funds that blew up in 2008, the regulator found a way to go after one of them due to its client base. But if it is not comfortable having retired and near-retired people investing in hedge funds that use leverage, it should change the definition of “accredited investor.”
The current threshold for qualifying for these investments should not depend solely on one’s income or wealth. Making $800,000 per year or having $2 million in net worth doesn’t suddenly make you savvier as an investor, especially if you built your wealth from totally unrelated ways.
So the SEC should not wimp out. If it doesn’t think retired and near-retired people should invest in hedge funds, then it should spell it out in its definition of “accredited investor,” and set an age limit as well.
Although this also will not make sense in all cases, at least managers and investment advisers will know what the rules are.
The SEC declined to comment for this article.
Stephen Taub , who has covered the hedge fund industry for 30 years, is a contributing editor to Institutional Investor and Absolute Return-Alpha magazines.
