A CFO with a conflict of interest was at the heart of a tax scheme that ultimately led to the Securities and Exchange Commission’s first enforcement action under its new authority to protect whistleblowers against retaliation by employers.
In charges issued yesterday, the SEC alleged that an Albany, N.Y.-based hedge fund advisory firm and its owner illegally failed to report conflicts in its trades and then retaliated against a trader who reported the securities law violations to the SEC. Without admitting or denying the charges, the firm, Paradigm Capital Management, and its owner Candace King Weir, agreed to pay $2.2 million to settle the case.
From at least 2009 to 2011, Paradigm engaged in a trading strategy aimed at reducing the tax liability of the investors in a hedge fund affiliated with the firm, according to the SEC’s cease-and-desist order. As part of that strategy, Weir (who was also a general partner of the hedge fund) told Paradigm’s traders to sell securities that had unrealized losses from the hedge fund to a proprietary trading account at a broker-dealer also owned by Weir. The losses, which were realized when the securities were sold to the brokerage, were used to offset the hedge fund’s realized gains.
Since such deals represent a conflict of interest between the adviser and the client, advisers must disclose that they are on both sides of the trade and must obtain the client’s consent, according to the SEC. “Paradigm failed to provide effective written disclosure to the hedge fund and did not obtain its consent as required prior to the completion of each principal transaction,” the commission charged.
Since Weir had a conflicted role as owner of both the broker-dealer and the hedge fund, “merely providing written disclosure to her as the hedge fund’s general partner and obtaining her consent was insufficient,” according to the SEC. Attempting to satisfy the written disclosure and consent requirements, Paradigm set up a conflicts committee to review and approve each of the trades made on behalf of the hedge fund.
But the conflicts committee, which consisted of Paradigm’s CFO and chief compliance officer, was itself conflicted, the SEC charged, noting that “each essentially reported to Weir.” Further, the finance chief also served as the CFO of the broker-dealer, “which placed him in a conflict,” according to the SEC, which named neither the CFO or the COO.
That’s because there was a negative effect on the broker-dealer’s net capital each time it bought securities from the hedge fund, according to an SEC press release. The finance chief’s obligation to monitor the broker-dealer’s net capital requirement “was in conflict with his obligation to act in the best interests of the hedge fund as a member of the conflicts committee,” it said.
Under the Dodd-Frank Act, the SEC was authorized in 2011 to bring enforcement actions based on employer retaliations against whistleblowers. After Paradigm learned that its head trader had reported possible misconduct to the SEC, “the firm engaged in a series of retaliatory actions that ultimately resulted in the head trader’s resignation,” according to the release.
“Paradigm removed him from his head trader position, tasked him with investigating the very conduct he reported to the SEC, changed his job function from head trader to a full-time compliance assistant, stripped him of his supervisory responsibilities and otherwise marginalized him,” according to the SEC.