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).

The DC Circuit And Non-Waiver Agreements

The question of waiver by companies furnishing privileged materials to the SEC or DOJ has been the subject of much debate. Frequently in the center of the debate is materials from the internal investigation. The SEC or DOJ would like the materials in the name of cooperation. The company would like the credit for cooperating, but is concerned about the impact of the privilege waiver.

One solution proposed by the SEC is the non-waiver agreement. In its Enforcement Manual as discussed here, the SEC claims that materials can be produced under an agreement in which the producing corporation and the Commission agree that the production does not constitute a waiver as to third parties. The Manual does acknowledge that this can be viewed as a waiver. In fact, most courts have rejected this theory.

The DC Circuit recently considered the use of a similar arrangement in the context of a grand jury investigation. U.S. v. The Williams Companies, Inc., Case No. 08-5203 (D.C. Cir. April 17, 2009). While the decision holds that production of work product materials does not always result in a waiver, it does not seem to be a solution to the dilemma of producing materials to the SEC or DOJ.

In The Williams Companies, a defendant in a criminal case sought to obtain documents produced to the government by the company in response to a grand jury subpoena. The materials, which included interview notes of attorneys who conducted an internal investigation, were produced under cover of a letter which reserved all privileges. In part, the cover letter stated that the materials “will be afforded Rule 6(e) [grand jury secrecy] protection under the Federal Rules of Criminal Procedure, and to the extent possible you will assist WPC [the company] in preserving the confidentiality of these.” Later, the company entered into a deferred prosecution agreement which stipulated that it would cooperate and not assert privilege as to factual documents from the internal investigation.

Subsequently, a company employee was indicted on charges growing out of the grand jury investigation. That employee sought the production of the materials furnished to the government by the company. While the government opposed production, the district court granted the employee’s request and denied an application for relief by The Williams Company.

The DC Circuit remanded the case to the district court to consider which materials would be produced. The court began by noting that it has previously declined to adopt a selective waiver approach to attorney client material. This however, does not resolve the question as to attorney work product. For those materials, “not all disclosures to third parties waive the protection afforded by the doctrine,” the court held. Rather, disclosure of attorney work product materials results in a waiver only if the production would be inconsistent with the purposes of the doctrine which is the maintenance of secrecy from one’s adversary. Accordingly, waiver of the attorney work product doctrine is measured by a three prong test: “(1) ‘the party claiming the privilege seeks to use it in a way that is not consistent with the purpose of the privilege’; (2) the party had no reasonable basis for believing that the disclosed materials would be kept confidential by the [government]; and (3) waiver of the privilege in these circumstances would not trench on any policy elements now inherent in this privilege,'” quoting In re Subpoenas Duces Tecum, 738 F.2d 1367, 1372 (D.C. Cir. 1984).

Here, the company failed to establish each of the factors. First, the court held that it would be “inconsistent and unfair” to permit the company to select the adversaries to which it would produce materials.

Likewise, the court concluded that the company failed to establish the second prong of the test. While the materials were produced under agreements claiming to preserve privilege, those understandings were limited by the statement that the government would protect the materials “to the extent possible.” Thus, while the company did in fact seek confidentiality, it failed to demonstrate that it could reasonably expect the government to protect the materials from the obligations of the government to produce certain materials in criminal prosecutions.

Finally, as to the third factor, which turns on the public policy interests inherent in the doctrine, the court found that “the assurances it secured were neither sufficiently strong nor sufficiently unqualified to prevent the government’s disclosure of the documents material to preparation of a criminal defense.” The case was remanded to the district court to consider which documents must be produced.

While The Williams Companies concludes that not every production of work product materials constitutes a waiver, it seems clear that production in a government investigation will in fact constitute waiver. Although the court concluded that the company failed to seek a strong enough assurance of confidentiality, this is beside the point here. If producing work product materials to the government to obtain cooperation credit is an “inconsistent and unfair” use of selective waiver, then arguably every such production fails the first prong of the test and results in a waiver.

If the decision is read as limited to a grand jury investigation where the company is a target and thus the government is an “adversary,” it may be possible to meet the first prong of the test. Then however, the third prong cannot be met. Even for a third party witness in a grand jury proceeding or in an SEC investigation where there are no targets, it is not possible to obtain an assurance of confidentiality which would preclude production. As the court held, in a criminal case, the government has obligations to produce certain materials which will override any arrangement with a producing party. The SEC also has obligations to produce materials furnished to it as it informs every witness in Form 1662. Thus, even when the company is a third party witness, producing attorney work product materials to the SEC or DOJ will under The Williams Companies result in a waiver.