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Hedge Fund Due Diligence Firm Drops Ball, Receives Fine

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In what represents an unbelievable screw-up, professed hedge fund due diligence firm Hennessee Group was charged by the SEC with not performing the due diligence it supposedly provided to hedge fund investors who used their services.  According to the SEC Administrative Order, Henessee did not perform certain key elements of the due diligence process which they advertised to potential clients.  Because of the lack of due diligence, Henessee recommended investing into the fraudulent Bayou hedge fund.

A few of the more interesting parts of the release include the following:

From February 2003 through August 2005, approximately forty clients of Hennessee Group invested a total of over $56 million in the Bayou funds after receiving Hennessee Group’s recommendations. Most of those monies were lost and dissipated by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance in client account statements, periodic newsletters, and year-end financial statements that included a phony audit opinion fabricated by one of Bayou’s principals.

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Hennessee Group and Gradante, in their capacities as investment advisers, owed fiduciary duties to their clients to perform the services that they represented they would provide and to disclose all material departures from the representations that they made to their clients. Despite their representations about their services, with regard to the Bayou Funds and the funds’ management, Hennessee Group and Gradante did not perform two of the five elements of the due diligence evaluation that they had represented to their clients they would undertake. In addition, Hennessee Group and Gradante failed to adequately respond to information that they received that suggested that the identity of Bayou’s outside auditor was in doubt and that there existed a potential conflict of interest between one of Bayou’s principals and its purported outside auditor.

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With regard to Bayou, Hennessee Group, at Gradante’s direction, failed to perform two elements of the due diligence evaluation that Hennessee Group had told its clients and prospective clients that it would do: (1) a portfolio/trading analysis; and (2) a verification of Bayou’s relationship with its purported independent auditor. By not conducting the entire due diligence evaluation that it had advertised, and by failing to disclose to clients that its evaluation of Bayou deviated from its prior representations, Hennessee Group and Gradante rendered the prior representations about the due diligence process materially misleading and breached their fiduciary duties to Hennessee Group’s clients.

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In the fall of 2002, Bayou refused to provide Hennessee Group with the prime brokerage reports that Hennessee Group had requested. However, instead of insisting that Bayou provide the reports as a condition of potentially being recommended, Hennessee Group proceeded to the next phases of due diligence. Gradante decided that a portfolio/trading analysis was irrelevant for a day-trading fund like Bayou, which stated in marketing materials that it held securities positions for brief periods of time and converted positions to cash prior to each day’s market closing.

As a result, Hennessee Group did not obtain or evaluate any quantitative information about Bayou’s portfolio characteristics, investment and trading strategies, or risk management discipline. Instead of confirming Bayou’s results and processes through an analysis of Bayou’s historical trading data to determine whether the fund was, in fact, executing its purported “high-velocity” day-trading strategy and utilizing appropriate risk management techniques, Gradante and Hennessee Group relied entirely on Bayou’s uncorroborated representations and purported rates of return that Bayou had provided during its initial information-gathering phases.

Hennessee Group never told the clients to whom it recommended Bayou that it had not conducted a portfolio/trading analysis on the funds. By failing to disclose this information in connection with its recommendation of Bayou, Hennessee Group left those clients with the misleading impression that it had conducted a portfolio, trading, and risk management evaluation of Bayou and that Bayou had satisfied Hennessee Group’s purported standards. In so doing, Hennessee Group and Gradante breached their fiduciary duties to Hennessee Group’s clients.

I have written a number of posts about proper hedge fund due diligence and am always surprised how haphazardly investments are made into some hedge funds.  Over the past six to eight months I have also been surprised that so many sophisticated and savvy investors would be duped by frauds like Madoff… but I guess if those gatekeepers who are paid to help investors research managers are asleep at the wheel we can’t really expect much more from investors.

Please contact us if you have a question on this issue or if you would like to start a hedge fund.  If you would like more information, please see our articles on starting a hedge fund.  Other related hedge fund law articles include:

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SEC Charges Investment Adviser That Recommended Bayou Hedge Funds to Clients

FOR IMMEDIATE RELEASE
2009-86

Washington, D.C., April 22, 2009 — The Securities and Exchange Commission today charged New York-based investment adviser Hennessee Group LLC and its principal Charles J. Gradante with securities law violations for failing to perform their advertised review and analysis before recommending that their clients invest in the Bayou hedge funds that were later discovered to be a fraud.

In a settled administrative proceeding, the Commission issued an order finding that Hennessee Group and Gradante did not perform key elements of the due diligence that they had represented they would conduct prior to recommending investments in the Bayou hedge funds. The SEC also finds that they failed to conduct a reasonable investigation into red flags concerning Bayou. Hennessee Group and Gradante routinely represented to clients and prospective clients that they would not recommend investments in hedge funds that did not satisfy all phases of their due diligence evaluation.

“Forewarned is forearmed — investment advisers must make good on their promises or face the consequences of vigorous SEC enforcement action,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

“As the Commission found, these investment advisers failed to honor the representations they made to their clients and did not disclose these material departures from their advertised services,” said Antonia Chion, Associate Director of the SEC’s Division of Enforcement. “The advice that clients receive from hedge fund consultants is especially critical when the hedge funds are neither regulated nor transparent.”

According to the Commission’s order, approximately 40 clients invested millions of dollars in the Bayou hedge funds from February 2003 through August 2005 after the Hennessee Group recommended those investments. Most of the money was lost through trading or dissipated by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance in client account statements and year-end financial statements. The SEC charged the managers of the Bayou hedge funds with fraud in 2005.

The Commission’s order finds that Hennessee Group and Gradante failed to conduct the portfolio and trading analysis that it had advertised to clients. Instead of analyzing Bayou’s results and processes through a review of Bayou’s historical trading methods to determine whether the fund was, in fact, successfully executing its purported day-trading strategy, Hennessee Group and Gradante decided not to perform any analysis after Bayou refused to produce its trading data. They relied entirely on Bayou’s uncorroborated representations about its strategy and its purported rates of return.

The Commission’s order also finds that despite conflicting reports from Bayou about the identity of their independent auditor, Hennessee Group and Gradante failed to verify Bayou’s relationship with its auditor. In fact, the accounting firm that purportedly conducted Bayou’s annual audit was a non-existent entity fabricated by one of Bayou’s principals, who was identified in publicly available state accountancy board records as the registered agent for the bogus accounting firm.

According to the Commission’s order, Hennessee Group and Gradante also failed to respond to red flags concerning Bayou that came to their attention while they were monitoring Bayou on behalf of their clients. In particular, they failed to inquire or investigate when Bayou provided contradictory responses regarding the identity of its auditor or to adequately inquire about a rumor that one of Bayou’s principals was affiliated with Bayou’s purported outside auditing firm.

The Commission’s order finds that Hennessee Group and Gradante violated Section 206(2) of the Advisers Act. The order requires Hennessee Group and Gradante to pay $814,644.12 in disgorgement and penalties, and to cease and desist from committing or causing further violations. The parties also are required to adopt policies to ensure adequate disclosures in the future and to provide copies of the Commission’s Order to all current and prospective clients for a period of two years.

Hennessee Group and Gradante consented to the entry of the Commission’s order without admitting or denying the findings.
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For more information, contact:
Antonia Chion
Associate Director, SEC’s Division of Enforcement
(202) 551-4842
Yuri B. Zelinsky
Assistant Director, SEC’s Division of Enforcement
(202) 551-4769