In October 2012 the Securities and Exchange Commission charged hedge fund Yorkville Advisors LLC, its president, and its chief financial officer with fraud.
The SEC alleged the hedge fund advisory firm and its two executives had been “scheming to overvalue assets under management and exaggerate the reported returns of hedge funds they managed in order to hide losses and increase the fees collected from investors.”
The Wall Street Journal report at the time was headlined, “SEC Snares Fund Firm in Data Dragnet.” The New York Times: “S.E.C. Accuses Hedge Fund of Lying About Performance.” MarketWatch went with, “SEC charges hedge fund with exaggerating returns.”
Nearly six years later, the SEC admitted it had no case. The SEC declined to discuss the Yorkville case.
It was too little, too late for Yorkville Advisors president Mark Angelo. “It was in the economic interest of a few people to bring a big case with sensational headlines and then drag it out until they could take advantage of the revolving door to the private sector,” Angelo told MarketWatch in an interview.
The Yorkville case was the seventh brought by the SEC using a “black box” algorithm called Aberrational Performance Inquiry.
The API tool was developed jointly beginning in 2009 by the SEC’s division of enforcement, its office of compliance, inspections and examinations, and its division of risk, strategy and financial innovation. It was designed to make sure they spotted the next Bernie Madoff, that is, an investment fund producing rSEesults that were too good to be anything but the product of fraud.
Bruce Karpati and Robert Kaplan, co-chiefs of the SEC enforcement division’s asset management unit, took a bow in December 2011 in the press release for the first API cases. “The extraordinary returns reported by these advisers and portfolio managers were, in most cases, too good to be true. In other cases, outlier returns were a telltale sign that something else was amiss,” they were quoted.
Karpati, now the chief compliance officer for private equity firm KKR, did not respond to a request for comment. Kaplan, now in private practice at the law firm Debevoise, also did not respond to a request for comment.
Angelo is upset at Karpati’s fortune.
“I had to let 40 people go but the SEC lawyer who called me a fraud, Bruce Karpati? He now works at KKR.”
A federal judge first dismissed substantially all of the case in March after the defendants requested a summary judgment in their favor. They told the judge the SEC had failed to prove its case, failed to show evidence of the alleged wrongdoing and in some case got its facts completely wrong. The judge agreed.
The SEC finally agreed to dismiss all remaining charges against the executives, with prejudice, in May. That means the SEC is permanently barred from ever bringing them again.
It’s not surprising that after missing the totally fake nature of the outstanding performance of Bernie Madoff’s hedge fund, the SEC would feel pressured to ferret out hedge fund frauds before they got too big. But in the SEC attempt to spot bad actors who intentionally overstate or create performance from thin air, the API highlighted money managers legitimately outperforming the market.
In March 2011,Robert Khuzami, then the SEC’s director of enforcement, was still defending the agency from ongoing criticism for its complete miss of the Bernie Madoff fraud, uncovered only by his confession in December 2008. He told a Congressional oversight committee, “It was a horrible tragedy, and one for which we failed in our mission and one for which we are doing many things across the agency to rectify.”
“We are doing things,” said Khuzami, “like canvassing all hedge funds for aberrational performance. Anybody who is beating the market indexes by 3% and doing it on a steady basis, we are going to look for them.”
Cynthia Harrington, a consultant to hedge funds, wrote at the time about the difficult position this approach put hedge funds in. “Under the new SEC initiative, fund owners and advisers find themselves in a strange balancing act between needing to outperform to meet investor expectations but not by too much to stay within the SEC’s performance guardrails,” she wrote.
The first four cases brought by the SEC in December 2011 alleged a variety of typical misdeeds such as fraudulent valuation of portfolio holdings, misuse of fund assets and misrepresentations of performance, type of assets held, degree of liquidity, specific investment strategy, valuation procedures, and key personnel conflicts of interest. The SEC said each was flagged by the outperformance indicator and then investigated.
The Yorkville investment strategy centered on investing in distressed small-cap and microcap business in exchange for illiquid, hard-to-value securities such as warrants, convertible debt and convertible preferred securities. During the time covered by the case, the majority of its assets under management consisted of privately negotiated, custom securities, so an SEC tool that compared its returns to traditional equity market benchmarks would likely find its results “aberrational.”
According to the SEC’s press release, Angelo and Schinik had “enticed pension funds and other investors to invest in their hedge funds by falsely portraying Yorkville as a firm that managed a highly-collateralized investment portfolio and employed a robust valuation procedure. They misrepresented the safety and liquidity of the investments made by the hedge funds, and charged excessive fees to the funds based on the fraudulently inflated values of the investments.”
The vast majority of SEC cases involving corporations and their subsidiaries are settled at the time of filing. The API cases were no different.
In the book, The Securities Enforcement Manual: Tactics and Strategies, published by the American Bar Association, the authors write that successful negotiation of an SEC enforcement action depends on many factors, including the personalities of the SEC staff members involved. Critics of the SEC say its often aggressive enforcement tactics coerce settlements even when parties are innocent because of the huge expense and substantial ignominy firms face if they choose to fight.
The Yorkville defendants adamantly refuted the SEC’s allegations. Their defense was bolstered, they believed, because at all times the valuation committee had an ex-SEC professional as one of the three members. There were no investor lawsuits and no charges were filed against any of the Yorkville Advisors’ valuation committee members who used to work at the SEC.
Yorkville fought the case.
Yorkville’s attorney Caryn Schectman of DLA Piper told MarketWatch, “When a case goes on for nine years some lawyers get tired. I never got tired for a minute because I believed in the case and I knew all along that my clients had done nothing wrong.”
When U.S. District Judge George Daniels wrote the 79-page decision in March dismissing the case he said he had found “no material evidence of fraud or negligence” to support SEC claims that Yorkville Advisors LLC, Angelo and Schinik had inflated asset values.
The judge was particularly critical of the SEC’s allegations that Yorkville’s president and its CFO had lied and hidden information about the current value of the fifteen investments in question from its auditors. The SEC alleged that the defendants attempted to defraud investors and the auditor by misrepresenting the value of the investments. The judge wrote that the internal and external reviews of the 15 investments “never showed any fraud or deceit.”
“However,” the judge wrote, “the SEC attempts to support its allegations by misinterpreting and mischaracterizing the record.” The SEC, he wrote, never provided any evidence the executives ever instructed anyone to withhold information for the valuation committee or to delay the write-down of any investment.
Schectman told MarketWatch, “If you use an algorithm to identify potential wrongdoing to investigate, you still have to develop a case with credible witnesses and actual evidence. You can’t just blindly follow the lead of a software tool that brings you to a dead-end and then file a complaint anyway.”
Tom Gorman, a lawyer with Dorsey & Whitney and former SEC enforcement attorney who publishes a widely-read securities blog, told MarketWatch the agency seems to have gotten lost in the detail and ignored the actual evidence. “Yorkville is a very ugly loss for the SEC. The API inquiry is supposed to be the beginning of the analysis. For a valuation issue — and particularly here where the securities are difficult to value — the SEC has to evaluate the actual method used in context along with what their disclosure says about valuation and what GAAP says.”
Not only did the SEC lose the case by “misinterpreting and mischaracterizing” the evidence but the judge also ruled the agency’s response to a motion to turn over some evidence was not timely and also inadequate. He awarded the defendants some attorney’s fees and costs of $22,051.
The API tool analyzes data from Form PF, data that advisers to larger hedge funds and certain other private funds must periodically provide to the SEC since October 2011. The SEC asset management division annual report mentioned the API tool every year from 2012 through 2016 when describing how it uses the Form PF data.
Sometime in 2017 the SEC stopped mentioning the API tool by name in speeches, reports and other testimony about its enforcement accomplishments. The asset management division’s 2017 report says instead that Form PF data is used to create “flag reports” for follow-up.
The last time the API tool was mentioned by name in an enforcement action was in April 2017. The case was settled by November 2017 with a bar but no financial penalties.