Re-Learning the Lessons of Watergate: The Cover-Up Is Worse Than the Crime


On February 3, 2011, the SEC severely sanctioned two affiliated investment advisers and their parent for failing to promptly correct an error in a quantitative model used to manage client accounts and making misleading statements about the benefits of the quantitative model after the error was detected.1

The Error in the Model

In settling the SEC action, the advisers agreed to pay injured clients almost $217 million, to adopt numerous compliance enhancements, and to pay a fine of $25 million. The advisers developed three computer models which were used together as the exclusive means of selecting investments in managed accounts. One model, the Alpha Model, evaluated public companies based on their earnings and valuations. A second model, the Risk Model, evaluated risks based on numerous factors. A third model, the Optimizer Model, combined the first two models and recommended specific investments based on a benchmark chosen by the client.

In April 2007, a new version of the Risk Model was developed. Due to an inadvertent error in computer coding, which was not detected for over two years, the Risk Model sent information to the Optimizer Model in a form that produced errors in the selection of stocks for investment. This error resulted in stock selections that were inconsistent with selections that would have been made if the model had worked properly.

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