SEC Charges Hedge Fund Adviser with Engaging in Prohibited Principal Transactions and Retaliating Against Whistleblower

by Dechert LLP
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The U.S. Securities and Exchange Commission (SEC or Commission) issued a cease and desist order on June 16, 2014 (the Order) against Paradigm Capital Management, Inc. (Paradigm) and its founder, Director, President and Chief Investment Officer, Candace King Weir (Weir).The Order alleged that Weir caused Paradigm’s hedge fund client, PCM Partners L.P. II (Fund), to engage in certain transactions (Transactions) with a proprietary account (Trading Account) at the Fund’s prime broker, C.L. King & Associates, Inc. (C.L. King). Paradigm and C.L. King were allegedly under the common control of Weir. The Order further alleged that, because of Weir’s personal interest in the Transactions and the fact that the committee designated to review and approve the Transactions on behalf of the Fund was conflicted, Paradigm failed to provide the Fund with effective disclosure and failed effectively to obtain the Fund’s consent to the Transactions, as required under the Investment Advisers Act of 1940 (Advisers Act).

In addition, the Order alleged that Paradigm retaliated against a whistleblower who had notified the SEC of the Transactions. According to the SEC, the Order represents the first case filed under the Commission’s new authority to bring enforcement actions against those that retaliate against whistleblowers.2

The Order directed Paradigm and Weir to, among other things, disgorge to certain Fund investors $1,700,000, which represented the approximate amount of administrative fees the Fund paid in connection with the Transactions.3 The Order also directed Paradigm and Weir to pay a $300,000 civil penalty and prejudgment interest.

The Transactions and Alleged Violations of Advisers Act Section 206(3)

Background. According to the Order, Weir owned 73% of Paradigm and had ultimate control of, and decision-making authority for, Paradigm. Further, Weir owned 99% of the entity serving as the Fund’s general partner and approximately 73% of C.L. King.

The Order alleged that, from at least 2009 through 2011, Weir caused the Fund to engage in a trading strategy designed to reduce Fund investors’ tax liability. In part, the strategy involved selling to the Trading Account certain securities that had unrealized losses. The sales were made at prevailing market prices, and the resulting realized trading losses were allegedly used to offset the Fund’s realized gains. The Transactions were executed using C.L. King’s trading systems, and C.L. King did not charge a markup or commission on the Transactions. In some instances, Weir caused the Fund to later repurchase certain of the securities initially sold to the Trading Account.

Section 206(3) of the Advisers Act makes it unlawful for an investment adviser, directly or indirectly, “[a]cting as principal for his own account, knowingly to sell any security to or purchase any security from a client … without disclosing to such client in writing before the completion of the transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.” Because Weir controlled both Paradigm and C.L. King, the Transactions involved an investment adviser, for its own account,4 knowingly purchasing securities from, and (in some instances) selling securities to, a client. Recognizing this issue, Paradigm established a conflicts committee to review and approve each Transaction on behalf of the Fund. However, as described below, the makeup of the committee allegedly resulted in insufficient disclosure and consent for purposes of Section 206(3).

“Conflicted” Conflicts Committee. The Order alleged that, because Weir owned and controlled the Fund’s general partner and shared in the trading profits and losses resulting from the Transactions through her ownership in C.L. King, disclosure directly to Weir would be insufficient and she could not provide effective consent to the Transactions on behalf of the Fund.

According to the Order, the conflicts committee established to review each Transaction on behalf of the Fund consisted of Paradigm’s Chief Compliance Officer, who reported directly to Paradigm’s board of directors (including Weir), and Paradigm’s Chief Financial Officer (CFO), who reported directly to Weir. The CFO also served as C.L. King’s chief financial officer. The Order alleged that the CFO was in a “conflict situation” – and thus, the conflicts committee was itself conflicted – because during the CFO’s evaluation of each Transaction, he was also monitoring the Transaction’s impact on C.L. King’s net capital, in his capacity as C.L. King’s chief financial officer.5

Because both Weir and the conflicts committee were allegedly conflicted, disclosure of the Transactions to either Weir (as a controlling person of the Fund’s general partner) or the conflicts committee was allegedly insufficient for purposes of Section 206(3). Similarly, because of these conflicts, neither Weir nor the conflicts committee allegedly could provide consent on behalf of the Fund that was adequate for purposes of Section 206(3). As a result, according to the SEC, the Transactions were effected without sufficient consent or disclosure and, thus, violated Section 206(3).6

Whistleblower Retaliation

In March 2012, Paradigm’s then-head trader (Whistleblower) voluntarily notified the SEC of the Transactions. Four months later, the Whistleblower notified Weir and another C.L. King officer that he had reported potential securities law violations to the SEC. Shortly thereafter, according to the Order, Paradigm embarked on a series of adverse employment actions against the Whistleblower that ultimately resulted in the Whistleblower resigning from Paradigm.

Section 21F(h) of the Securities Exchange Act of 1934 (Exchange Act) states that an employer may not “discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower … [i]n providing information to the Commission in accordance with this section."7

Upon learning that the Whistleblower had provided information to the SEC regarding the Transactions, Paradigm allegedly removed the Whistleblower from the trading desk and relieved him of his day-to-day trading and supervisory responsibilities. Paradigm also moved the Whistleblower to a different office building and instructed him to prepare a report concerning his disclosures to the Commission. The Whistleblower was later assigned to identify potential wrongdoing at the firm and, because Paradigm determined not to provide the Whistleblower with electronic access to its trading system, was given hard copies of more than 1900 pages of trading data to review in connection with the assignment. The Whistleblower was also tasked with consolidating multiple trading procedure manuals and proposing revisions to Paradigm’s trading policies and procedures. These and other actions detailed in the Order allegedly constituted adverse employment actions in violation of Exchange Act Section 21F(h).

Considerations for Advisers after Paradigm

In light of this case, investment advisers that engage in principal trades may benefit from reviewing their policies and procedures for compliance with Advisers Act Section 206(3). To the extent any form of board or committee is used as a mechanism of providing disclosure to, or obtaining consent from, clients for principal trades, advisers may wish to consider the composition of such board or committee. In particular, advisers should consider whether the composition of such board or committee is sufficiently independent from the adviser (or its affiliates) to provide the necessary check on self-dealing that Section 206(3)’s requirements are intended to achieve. Investment advisers should also understand that, in Paradigm, the Transactions were apparently undertaken for the benefit of Fund investors (at prevailing market prices) and that the Transactions and the conflicts committee were disclosed. Notwithstanding the apparent lack of intent to defraud Fund investors, the composition of the conflicts committee nonetheless resulted in alleged violations of Section 206(3).

Investment advisers may also benefit from reviewing their policies and procedures concerning whistleblowers. Among other things, such policies and procedures should seek to ensure that the adviser’s response to and management of a whistleblower situation is in accordance with all legal requirements and should sufficiently address the competing concerns and risks presented when a whistleblower has provided information to the Commission.

Footnotes

1

 

2

 

3

 
According to the SEC, Paradigm charged the Fund an administrative fee for, among other things, compliance-related expenses, including expenses associated with the conflicts committee’s review of the Transactions.

4

 
The SEC Staff has stated that an investment adviser’s ownership of a significant interest (e.g., more than 25%) in a pooled investment vehicle may cause cross transactions involving such a pooled investment vehicle to be treated as principal transactions under Section 206(3). Whether such a transaction implicates Section 206(3) depends on the facts and circumstances of the transaction, including the extent of the ownership interest of the adviser and/or its controlling persons or other personnel of the adviser. See Gardner Russo & Gardner, SEC Staff No-Action Letter (pub. avail. June 7, 2006) at n.9 (“The Commission has deemed ownership interests of controlling persons of an investment adviser to be ownership interests of the adviser for purposes of Section 206(3) of the Advisers Act.”)

5

 
The Order did not address whether Paradigm’s Chief Compliance Officer, who reported directly to Paradigm’s board of directors (including Weir), was also in a “conflict situation.”

6

 
Paradigm’s Form ADV Part 2A (Brochure) described the conflicts committee’s role in reviewing and approving the Transactions on behalf of the Fund. However, the Paradigm Brochure failed to disclose that the CFO, as a member of the conflicts committee, also served as C.L. King’s chief financial officer and was responsible for monitoring the Transactions’ impact on C.L. King’s net capital. As a result of this omission, according to the SEC, the Brochure’s disclosure concerning the conflicts committee was deemed materially misleading.

7

 
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) established a whistleblower program that requires the Commission to pay an award to eligible whistleblowers who voluntarily provide the Commission with original information about a violation of the federal securities laws that leads to successful enforcement. For purposes of this provision, a “whistleblower” is “any individual who provides … information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission.” Exchange Act Section 21F(a)(6).

 

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