SEC Charges Hedge Fund Adviser with Conducting Conflicted Transactions and Retaliating against Whistleblower (with Lofchie Comment)

The SEC charged hedge fund advisory firm Paradigm Capital Management ("Paradigm") and its owner with first engaging in prohibited principal transactions, and then retaliating against the employee who reported the trading activity to the SEC. The SEC also charged the firm's owner with causing the prohibited transactions.

According to the SEC order, Paradigm's owner conducted transactions between Paradigm and a broker-dealer that the owner also owned while trading on behalf of a hedge fund client. Despite the transactions' posing conflicts between the interests of the adviser and the client, Paradigm failed to provide effective written disclosure and did not obtain its consent, as required prior to the completion of each principal transaction.

The SEC order also found that, after Paradigm's head trader reported the potential misconduct to the SEC, the firm engaged in a series of retaliatory actions that ultimately resulted in the head trader's resignation. This is the first time the SEC has filed a case under its new authority, adopted in 2011, to bring anti-retaliation enforcement actions.

Lofchie Comment:Based on the facts as described in the SEC Order, this enforcement action makes for an interesting story. The person charged with the violation seems to have been well intentioned (even if acting in violation of the rules). The whistleblower seems, at worst, to have been gaming the system and, at best, to have engaged in strategic conduct that would have made his continued employment so awkward as to be untenable.The basic violation is as follows: one individual (the "Owner") owned a broker-dealer and an investment adviser to a hedge fund. The Owner caused the hedge fund to sell securities positions to the broker-dealer, which transactions required the informed consent of the hedge fund. In order to provide such consent, the Owner established a committee of two individuals to review the transactions. Partly because both individuals reported to the Owner, and partly because one of the committee members also acted as CFO of the broker-dealer, the SEC found that the committee was itself conflicted; thus, adequate informed consent was not given (furthermore, the consent procedures were not disclosed to the hedge fund investors). Had the transactions been made at prices that disadvantaged the hedge fund and benefited the Owner of the broker-dealer, there would be nothing interesting to say about the matter. In fact, according to the SEC Order, (i) the transactions were made at fair prices, (ii) the hedge fund apparently benefited materially from tax aspects of the trade and (iii) the broker-dealer took on material financial risk to provide this benefit to the hedge fund. In short, the Owner seems to have arranged these trades to benefit her advisory clients and did so at her own risk. In this regard, the SEC Order seems to criticize the conflicts committee for permitting trades that had a "negative impact on [the broker-dealer's] net capital." That is, the improper conduct seems to have been intended to benefit the advisory client.As for the whistleblower,during the period of the relevant transactions, he had been the head trader of the fund. According to the SEC Order, the whistleblower went to the SEC secretly at the end of March 2012 to report the violative conduct. Although the Order is silent in this regard, the SEC's determination necessarily presumes that the whistleblower had not informed the Owner previously of the whistleblower's belief that she was engaged in improper conduct. In July, the whistleblower then informed the Owner of having made a secret report to the SEC previously. Not surprisingly, the relationship between the Owner and the whistleblower deteriorated; it is hard to see how a good relationship could have been maintained in a small office. In summary, one may view the outcome of this case in different ways. On the "positive" side, one may see the story as that of a righteous whistleblower who risked, and eventually lost, his job in reporting illegal conduct. On the "negative" side, one may see the story as that of an individual who failed to raise concerns internally, but instead went to the government in hopes of earning a reward, and then strategically outed himself as a whistleblower with the goal of either making himself impossible to fire or negotiating a severance payment. In either case, the lesson is this: firms that discover a whistleblower, or to which a whistleblower discloses himself, must be exceedingly careful in the treatment of that individual, regardless of how strained the relationship with them might be.

See: SEC Order; SEC Press Release. See also: Cabinet Whistleblower Page (available to Cabinet subscribers only).