Laven Partners has published its February 2017 newsletter, where they look back at a notable fund blow-up in 2016, the causes, and whether a sound operational due diligence (“ODD”) process would have raised enough concerns and red flags to deter a potential investor.
The first case considers Visium Asset Management (“Visium”).
Founded in 2005, Visium grew to an $8bn business by 2016 when the US government filed charges against three of the firm’s former traders for instances of insider trading and mismarking bonds.
Taken separately, there appears to have been illegal activity within two separate parts of the business.
The first concerns two traders charged with mismarking underperforming distressed debt securities using ‘sham’ prices requested from friendly brokers on unrecorded phone lines.
The second concerns an equity trader specialised in the healthcare sector who was alleged to have traded on tips from a former Food and Drug Administration (“FDA”) official since 2005.
All-in the mismarking fraud is said to have made the firm up to USD 6 million in extra fees.
The traders in both cases made many millions of dollars via bonuses.
What might an ODD examination have found?
• Part 1: Mismarking of Debt Securities:
1. Valuation overrides: According to reports, the independent administrator’s valuations were overridden 284 times in a one and a half year period in favour of the trader-procured broker quotes.
As part of a sound ODD approach, questions should be asked directly of the administrator specifically with regard to valuation sources. For instance, how many broker quotes are required, how regularly does the manager override valuations, and is any evidence obtained in valuing the portfolio of investments. Separately, the investment advisor should be asked the same questions thereby corroborating or contradicting what the administrator has asserted. A documented valuation policy should also be in place confirming the valuation procedure.
2. ASC 820 classification: Such valuations reportedly caused these illiquid assets to be incorrectly classified as Level II assets for the purposes of US GAAP’s Topic ASC 820 rather than the far less liquid Level III assets.
A review of the three most recent audited financial statements should be conducted. As well as looking for a clean audit opinion, the ODD process would check for significant assets reclassified from Level III to Level II. Separately, a valuation policy should be requested and reviewed, specifically with regards to valuation hierarchy. If there is a valuation committee, what can ODD ascertain from the committee’s meetings and members as to the valuation procedures and any potential conflicts of interest?
3. Use of unrecorded telephone lines and flash drives: The SEC alleges that Visium traders used personal mobile phones to avoid recorded telephone lines and flash drives delivered by couriers to collaborate with brokers on false prices.
A sound ODD process will question the use of unrecorded telephone lines and raise concerns where interaction with brokers is conducted outside of recommended practice. Furthermore, as part of ODD on data protection, information technology policies and procedures will be reviewed to ascertain, for example, whether the firm bans the use of flash drives.
4. Conflicts of interest: The founder and Chief Investment Officer’s (“CIO”) younger brother was made Chief Compliance Officer (“CCO”), then promoted to Chief Administrative Officer (“CAO”). Additionally, the CIO’s brother-in-law was hired as a portfolio manager (and in January 2017, convicted for violating federal securities law for securities and wire fraud as part of the debt securities mismarking).
Employees in senior positions related to one another gives rise to a potential conflict of interest. A sound ODD process should establish reporting lines and segregation of functions, particularly between the business and administrative parts of a firm to ensure the investment side or beneficial owner cannot exert too much influence.
5. Background checks: Background checks should be conducted on all key employees. Although not implicated in any of the charges, a review of the CCO would have likely revealed little compliance experience prior to joining Visium, his brother’s firm.
Background checks should form a key part of any ODD process. Identifying key employees and obtaining a full biography and discussing past experience will provide information as to the suitability of an employee to his or her role. Further checks can be made on formal qualifications and any information can be independently corroborated.
• Part 2: Trading on Insider Information:
1. Use of expert networks: A Visium trader, Sanjay Valvani, was charged with insider trading. It is alleged he hired a consultant, Gordon Johnston, as part of an expert network who had ties to the FDA. Johnston was paid to elicit insider information on pending drug patents from which the fund made millions of dollars.
The use of expert networks is permitted, however, there should be policies and procedures in place to ensure that insider information is contained and is prevented from being traded upon. A sound ODD process would examine any policies and procedures as well as question the CCO to establish the standard of control, particularly at a firm trading in healthcare stocks known for having significant price volatility. Further, recorded phone lines again can be a useful control.
2. Suspicious activity or transactions: According to reports, in one notable trade position, Valvani had purchased a significant stock position in a company that stood to gain substantially from the FDA decision on a generic drug whilst at the same time taking CDS protection against the company that stood to lose market share. The positions made approximately USD 25 million.
It would be expected that an investment advisor involved in trading of liquid stocks would have processes and mechanisms in place to detect suspicious trading patterns or activity. A sound ODD process would look for evidence of an investigation mechanism, ideally automated, that could demonstrate monitoring of live portfolios and transactions. We would expect the compliance team or another party independent of the investment process to have oversight of suspicious transaction monitoring and for there to be clear reporting protocols.
3. General compliance culture: The SEC (vs Sanjay Valvani/Gordon Johnston 2016) claims the following: “Further, Investment Adviser did little to prevent Valvani from violating its written policies against insider trading. No one at Investment Adviser monitored Investment Adviser's or Valvani's relationship with Johnston or, at a minimum, questioned the lawful nature of the information that Valvani had obtained from Johnston. Further, no one at Investment Adviser monitored Valvani's relationship with Pharma Company's executive management. Reporting, or even questioning, the receipt of material non-public information from these executives was left to Valvani.”
A sound ODD process will thoroughly review the compliance manual. It will go further to review the training records to establish the topics covered, attendees and frequency. Furthermore a sound ODD process will verify whether employees are required to make attestations, how frequently and whether records were complete. Finally, the CCO and other members should be questioned on the general culture of compliance at the firm.
By gathering information using the above techniques, it is possible to build a mosaic of the overall operational excellence or otherwise of an investment advisor. Whilst the above due diligence is unlikely to uncover a show-stopper, we believe enough concerns or red flags would be raised to ensure a prospective investor carefully considers a potential investment with such an advisor and at a minimum, requires further deep-dives and discussion with the advisor on the areas of concern.