SEC turns to data analysis to draw out offending advisers

Dec 11, 2011 @ 12:01 am

By Liz Skinner

The Securities and Exchange Commission expects to bring an increasing number of enforcement actions against advisers to mutual funds, hedge funds, private-equity funds and other investment advisers in the coming year, thanks, in part, to computer systems programmed to root out lies.

Advanced data analysis is helping the SEC mine public and private advertising, sales, registration and other documents for what its investigators consider warning signs of deception.

State securities regulators are also starting to use analytics.

The majority of cases that the SEC's asset management unit pursues still come from the traditional sources of investor complaints, tips from firm insiders and whistle-blowers, and through its adviser examinations.

However, a greater number of investigations — and now some settled cases — are coming from data mining. And these probes hold the potential of identifying suspicious patterns before investors have been completely hoodwinked, a goal important to securities regulators who still encounter criticism for missing investment adviser Bernard Madoff's giant swindle.

“The whole division is doing a lot more quantitative analysis to identify transactions or practices that have red-flag warning signs that would cause us to take a closer look,” said Robert Khuzami, the SEC's enforcement director. “The technologies can help us identify activities before they have hatched into full-blown frauds.”

In one initiative, the SEC is taking a closer look at the registration documents, or Form ADVs, of high-risk investment advisers. They are looking for documents that raise suspicions that assets under management are being fabricated — or even seemingly less important information such as an educational achievement.

“The theory is, if investment advisers are willing to lie or misrepresent that they graduated Phi Beta Kappa when they didn't, what are these advisers going to be willing to say during a period when the markets are down?” Mr. Khuzami said.

But not everyone agrees this tool will flesh out abuse.

“We are not sure that there is any empirical evidence that these violations are gateway crimes for more serious violations,” said compliance attorney Todd Cipperman.

Adviser Anthony Ogorek said that those with a disproportionate amount in private equity — or other who manage less transparent assets that may not have a daily price — will be the most challenged when it comes to reporting assets accurately.

“I'm not sure the initiative will enhance the veracity of information on these disclosure documents,” he said. “The problem is with people who are doing securities business, who are not registered. How can the SEC identify them?”

A second SEC initiative is focused on analyzing subadviser fees of mutual funds. Investigators analyze databases that track performance to identify funds that show poor results compared with benchmarks, have high fee arrangements and subadvisers, all of which may signal “excessive fee arrangements” that erode investor returns, Mr. Khuzami said.

The SEC last month settled just such a case against Morgan Stanley Investment Management Inc., the registered investment adviser subsidiary of Morgan Stanley. The adviser agreed to pay $3.3 million in fines and returned investor funds for allowing a subadviser to its Malaysia Fund to collect fees for 12 years even though it essentially provided no advice, the SEC said.

The firm didn't admit or deny the allegations in settling the case.

In a third initiative, the SEC is looking similarly at valuation issues related to bond funds. Investigators are highlighting suspicious performance based on annual reports and databases that evaluate funds, said Robert Kaplan, co-chairman of the enforcement division's asset management unit.

In deciding which funds to examine further, investigators look at the regulatory history of the firm and individuals involved, the size of the firm and other factors that he declined to specify.

A fourth SEC program is focused on using risk analytics to evaluate hedge fund returns.

Investigators are looking for performance data inconsistent with the fund's investment strategy or compared with benchmarks. Such outliers are further investigated.

So far, the SEC has brought actions against three firms and six individuals as a result of this initiative, alleging that firms and advisers fraudulently overstated returns or assets, misused fund assets or, in one case, failed to tell investors that the hedge fund was invested in a microcap company for which the adviser served as chairman.

Many hedge funds are still being investigated as a result of the analytic data searches, Mr. Kaplan said.

The quantitative analysis is conducted by a team of economists and other professionals spanning three sections of the enforcement division, one focused on risk, another on examinations and a third on investment management.


The SEC also has hired people with experience from the industries on which they focus. They help the division decide which data to consider, and provide qualitative analysis of the information, Mr. Kaplan said.

For example, Igor Rozenblit joined the SEC last year from Amundi Private Equity Funds. He is helping with the asset management division's “still-developing” fifth initiative, which will target private-equity advisers, Mr. Kaplan said.

Compliance lawyers urge investment advisers to be cautious about every document that they prepare.

Morrie Simkin, a securities compliance attorney with McLaughlin & Stern LLC, said that it is hard to recommend to investment advisers who are doing well that they shouldn't advertise.

“But I tell them to be careful about how they value the securities, especially when they are valuing those based on nonpublicly traded securities for which there is no regular market,” he said. “That's where you run the risk of mistakes or, going beyond that, to where people are trying to enhance their performance.”

Mr. Simkin counsels advisers to make sure that their valuations and performance data are correct and can be reasonably supported with trade records and analyses.

State securities regulators also are increasingly using analytics.

“Particularly with states that have a large investment adviser population, they can't hit them all, so identifying the ones who should rise to the top as far as scrutiny is crucial,” said Colleen Keefe, enforcement manager of the Kentucky Division of Securities and a member of the enforcement section at the North American Securities Administrators Association Inc.

In recent years, the states and the SEC have shared data, she said.

That is likely to be even more common when midsize advisers switch from SEC registration over to the states next year.

“The technologies can help us identify activities before they have hatched into full-blown frauds.”

Robert Khuzami

Enforcement director



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