Failing To Conduct Due Diligence — An Investment Adviser Is Sanctioned
In what may be a harbinger of things to come, the Commission filed a settled administrative proceeding against an investment advisor and its principal. Respondents were charged with failing to adequately analyze, in accord with their representations, investments recommended to clients in the Bayou hedge funds. That fund later turned out to be a massive fraud. In the Matter of Hennessee Group LLC and Charles J. Gradante, Adm. Proc. File No. 3-13454 (April 22, 2009). This action may be significant in view of dozens of market crisis investigations under way and scandals like Madoff were feeder funds frequently funneled investor cash into a Ponzi scheme with little due diligence according to some.
Hennessee Group LLC is a registered investment adviser which acts as a hedge fund consultant. Mr. Gradante served from 1997 to the present as the president, CEO chief investment officer and managing principal of the Group which he co-founded with his spouse. Essentially, the Group recommends hedge funds for client investment and monitors those investments. Hennessee Group routinely represented to clients and prospective clients that it would not recommend investments in hedge funds that did not satisfy all phases of its due diligence program.
From 2002 through 2005, the Group promoted a due diligence process for selecting hedge funds for investments which it called the Five Level Due Diligence Process. This process included: 1) a request for information about the fund and data on historical returns; 2) a face-to-face interview with the fund manger on key investment topics which includes ascertaining the identity of the outside auditors; 3) a detailed review and analysis of the fund’s investment portfolio based on a review of prime brokerage reports; 4) interviewing key personnel at the office of the fund; and 5) a reference and background check on the fund’s manager. Mr. Gradante chaired the investment committee. After a client investment, the Group monitored it.
Here, the Group did not conduct the due diligence evaluation of Bayou in a manner that is consistent with its representations to clients. Specifically, Hennessee Group did not conduct a portfolio/trading analysis on the Bayou Funds. In fact, Respondents did not review its prime brokerage records. The Group also failed to verify Bayou’s relationship with its auditors or resolve conflicts over the identity of the outside auditors. The Group also accepted without question Bayou’s statement that it had changed outside auditors several times — the explanations offered were not questioned. Likewise, the Group did not adequately investigate information it received suggesting that “the head of back office for Bayou is also a principal in the firm that does the annual audit … .” Overall, Respondents failed, according to the Order for Proceedings, to conduct due diligence in accord with its representations to the public.
To resolve the matter, Respondents agreed to adopt polices and procedures to ensure proper disclosure of its evaluating and monitoring processes and furnish all clients with a copy of the Order for Proceedings. The Respondents also consented to the entry of a censure and an order requiring the payment of over $549,000 in disgorgement along with prejudgment interest and to pay a civil penalty of $100,000.
Previously, Bayou fund and its principal, Samuel Israel, were the subject of civil and criminal charges. SEC v. Israel, Civil Action No. 05-CIV-8376 (S.D.N.Y. Filed Sept. 29, 2005) concluded with the entry by consent of permanent injunctions prohibiting future violations of the antifraud provisions of the Securities Act, Exchange Act and Investment Advisers Act. See Release 19692. The criminal inquiry concluded when Mr. Israel pled guilty to a three-count information which alleged conspiracy to commit investment adviser fraud and mail fraud, investment adviser fraud and mail fraud. Mr. Israel was sentenced to a term of 240 months and, in addition, certain forfeiture orders were entered. U.S. v. Israel, 1:05-cr-01039 (S.D.N.Y. Filed Sept.29, 2005).