On January 16, 2025, the SEC announced the settlement of administrative proceedings brought against a hedge fund manager that used algorithmic investment models to provide investment advice to its private fund and separately managed account (SMA) clients. The order alleged that the manger breached its fiduciary duty by failing to exercise reasonable care in addressing known vulnerabilities to certain models. The order also identified alleged failures by the manager to reasonably supervise one of its modelers and alleged violations of Rule 21F-17(a) under the Securities Exchange Act of 1934, also known as the Whistleblower Protection Rule.
According to the order, between March 2019 and October 2023, the manager knew of, but failed to address, significant vulnerabilities to certain of its algorithmic investment models due to lack of access controls. As described in the order, a large number of the manager’s employees had “read and write” access to a database that stored these models, allowing the employees to change model parameters without review or approval, which could materially impact the manager’s investment decisions for its clients. Senior personnel were allegedly made aware of the vulnerabilities as early as March 2019, but did not take reasonable steps to address the vulnerabilities until October 2023, in connection with an examination by the SEC’s Division of Examinations. During the course of the examination, the manager also disclosed to SEC staff and to investors that one of its modelers had made a number of unauthorized changes to the models, which the manager described as “intentional misconduct,” resulting in significant compensation to the modeler and causing certain funds and SMAs advised by the manager to underperform by approximately $165 million and other funds and SMAs to outperform by more than $400 million. The manager voluntarily repaid the adversely impacted funds and SMAs the full amount of the underperformance in December 2023 and January 2024. In addition, the order alleged that the manager separately violated the Whistleblower Protection Rule by entering into separation agreements with departing employees that required the employees to represent that they had not previously filed a complaint against the manager with any governmental agency.
The SEC found that the manager willfully violated (1) Section 206(2) of the Investment Advisers Act of 1940, which makes it unlawful for any adviser to engage in a transaction, practice or course of business that operates as a fraud or deceit upon a current or prospective client; (2) Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which require registered investment advisers to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder; (3) Section 203(e)(6) of the Advisers Act for failing to reasonably supervise its modeler; and (4) the Whistleblower Protection Rule, which prohibits any person from taking any action to impede an individual from communicating directly with the SEC staff about a possible securities law violation.
Without admitting or denying the allegations, the manager agreed to cease and desist from future violations, to be censured and to pay a civil monetary penalty of $90 million. The order acknowledged the cooperation the manager afforded the SEC staff and the remedial actions the manager promptly undertook.
The SEC’s order is available here, and a related press release is available here.
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