The SEC settled administrative proceedings against an investment adviser, Paradigm Capital Management, Inc. (the “Adviser”), and Candace King Weir, the Adviser’s principal owner (the “Principal”), over violations of the principal transactions prohibitions of Section 206(3) of the Investment Advisers Act of 1940 (the “Advisers Act”) and retaliatory action taken by the Adviser against its head trader (the “Head Trader”) after learning that he had reported the transactions in question to the SEC.  The press release announcing the settlement noted that “[t]his is the first time the SEC has filed a case under its new authority to bring anti-retaliation enforcement actions.”  (See the May 31, 2011 Financial Services Alert for a detailed description of SEC’s adoption of final rules implementing the Dodd-Frank Act whistleblower provisions.)  This article summarizes the SEC’s findings in the settlement order, which the respondents have neither admitted nor denied.

Background

The Principal is the founder, chief investment officer, and president of, and a portfolio manager for, the Adviser, which manages hedge funds with total assets of approximately $1.7 billion.  The Principal owns 73% of the Adviser and was found by the SEC to exercise ultimate control and authority over the Adviser.  The order focuses on transactions between one of the Adviser’s hedge funds (the “Fund”) with assets of approximately $275 million, and the Fund’s prime broker, a broker-dealer in which the Principal owned a 73% interest (the “Affiliated Broker-Dealer”).

Harvesting Tax Losses for the Fund

From at least 2009 to 2011, the Adviser sought to reduce the Fund’s tax liability by selling securities with unrealized losses in the open market and to a proprietary trading account at the Affiliated Broker-Dealer (the “Trading Account”).  As the Fund’s portfolio manager, the Principal would direct the sale of such a security to the Trading Account if she thought she might like to repurchase the security later for the Fund and if it made execution more efficient.  Sales to the Trading Account were effected on the Affiliated Broker-Dealer’s trading systems without any markup or commission.  Between 2009 and 2011, the Adviser sold 47 securities positions from the Fund to the Trading Account, 36 of which were subsequently repurchased by the Fund.  (The settlement order includes no findings regarding any harm or benefit to the Fund from these transactions.)

Compliance with Section 206(3) Disclosure and Consent Requirements

The SEC found that because the Principal owned a controlling interest in both the Adviser and the Affiliated Broker-Dealer, the Funds’ transactions with the Trading Account (the “Trading Account Transactions”) were subject to the prior disclosure and consent requirements of Section 206(3) of the Advisers Act, and further found that review and approval of the Trading Account Transactions by the conflicts committee established by the Adviser for the purpose of satisfying Section 206(3) (the “Conflicts Committee”) were not effective in meeting those requirements.  The Conflicts Committee consisted of the Adviser’s CFO, who also served as CFO of the Affiliated Broker-Dealer, and the Adviser’s CCO. 

The SEC found that the Conflicts Committee could not provide effective consent because the CFO had an obligation to monitor the Affiliated Broker-Dealer’s compliance with net capital requirements which was in conflict with his obligation as a member of the Conflicts Committee to act in the best interests of the Fund.  In this regard, the SEC cited a situation that arose in early 2012 when the Affiliated Broker-Dealer’s net capital declined in part because the Trading Account had purchased large blocks of securities from the Fund in late 2011.  To improve the Affiliated Broker-Dealer’s net capital position, the CFO suggested that the Affiliated Broker-Dealer begin selling securities worth more than $20 million held in the Trading Account either to the open market or back to the Fund.  He also suggested staggering future sales of securities from the Fund to the Trading Account for the benefit of the Affiliated Broker-Dealer’s net capital.

The SEC also observed that the Principal Owner owned and controlled 99% of the Fund’s general partner (the “General Partner”), and by virtue of her ownership interest in the Affiliated Broker-Dealer shared in the profits and losses resulting from the Trading Account Transactions.  On that basis, the SEC concluded that “any written disclosure to her as the owner of the General Partner was insufficient, and for the same reason she also could not provide effective consent to the principal transactions.”

The SEC found that the Adviser’s Form ADV Part 2A disclosure, which stated that the Conflicts Committee acts on behalf of the Fund when approving principal transactions, was materially misleading because it failed to disclose the conflict of interest to which the Adviser’s CFO was subject as result of also serving as the Affiliated Broker-Dealer’s CFO.

Retaliation Against Whistleblower

The settlement included a determination that the Adviser had impermissibly retaliated against the Head Trader for reporting the Trading Account Transactions to the SEC.   On March 28, 2012, the Head Trader made a voluntary written submission to the SEC that revealed the Trading Account Transactions.  On July 16, 2012, the Head Trader notified the Principal and the Affiliated Broker-Dealer’s Chief Operating Officer that he had reported potential securities law violations to the SEC and identified the general conduct referred to in his submission.  The SEC found that the Adviser subsequently took a series of retaliatory actions against the Head Trader that violated the whistleblower protections adopted under the Dodd-Frank Act.  Among other things, the Head Trader had his job duties changed from head trader to what the SEC characterized as “full-time compliance assistant” analyzing trade data and reviewing trading-related compliance policies, “stripped him of his supervisory responsibilities, and otherwise marginalized him.”  The Head Trader ultimately resigned.

Violations

The SEC found that the Adviser violated (1) Section 206(3) of the Advisers Act, (2) Section 207 of the Advisers Act, which prohibits material misstatement or omissions in any registration application or report filed under the Advisers Act, and (3) Section 21F(h) of the Securities Exchange Act of 1934, pursuant to which an employer may not “discharge, demote, suspend, threaten, harass, 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 in, among other things, providing information to the SEC.  The SEC found that the Principal caused the Adviser to violate Section 206(3) of the Advisers Act.

Sanctions

Among other sanctions, the Adviser and the Principal agreed to pay, jointly and severally, (i) disgorgement of $1,700,000 to compensate certain investors in the Fund between 2009 and 2011; (ii) prejudgment interest of $181,771; and (iii) a civil penalty of $300,000.  The disgorgement amount was designed to approximate certain administrative fees the Fund paid in connection with the principal transactions in question.  The Fund’s fee structure provided that the Adviser charged the Fund for compliance-related expenses, including the Conflicts Committee’s administration of the disclosure and consent requirements of Advisers Act Section 206(3).

The Adviser was also required to retain an independent compliance consultant to, among other things, conduct a comprehensive review of the Adviser’s supervisory and compliance policies and procedures designed to detect and prevent prohibited principal transactions, such as the Adviser’s use of any committees and advisory boards involved in reviewing and approving principal transactions.

In the Matter of Paradigm Capital Management, Inc. and Candace King Weir, SEC Release No. 34 – 72393 (June 16, 2014).