Regulatory complaints don’t serve as a timely fire detector due to limited resources as against the large universe of managers and strategies, believe experts at Swiss Analytics. In their report titled “Regulatory cases: Accident Analysis of Three Regulatory Complaints,” Swiss Analytics emphasizes that an investment advisor’s registration with a regulator is no substitute for proper, proactive due diligence.

Regulatory complaints and inability to prevent damage

The Swiss Analytics report points out that regulatory complaints can usually only serve as an inspection after the “house has already been burnt to the ground” rather than a timely detector. The report indicates thats regulatory complaints’ inability to timely prevent damage is accentuated by a host of factors. Those include limited specialization and expertise for a detailed understanding of the underlying operations, a lack of verification of information provided by investment managers, and insufficient follow-up on hints

In its report, Swiss Analytics considered three complaints to drive home its point of view.

Regulatory Complaints Are informative, But Often Too Late

The report starts off with a complaint involving Stanford International Bank. ValueWalk covered the case in detail wherein Texas financier R. Allen Stanford was found guilty in a $7 billion Ponzi scheme.

The Swiss Analytics report points out that the SEC complaint alleged there a staggering amount of unsecured personal loans made to Allen Stanford himself, accumulating as high as $1.6 billion, which were never disclosed in the “related party transactions” sections in SIB’s financial reporting. Moreover, the SEC complaint estimated that only approximately 10% of SIB‘s total assets were managed according to the strategy advertised.

The Swiss Analytics report states that factors such as making investments beyond mandate and expertise has facilitated or covered up the fraud. Moreover, it was claimed the CFO and his team essentially reverse-engineered fair values based on predetermined investment returns as dictated by Allen Stanford.

Structures and circumstances facilitated fraud

The Swiss Analytics report next highlights the Westridge Capital Management complaint. The report points out that a 2005 examination of Westridge Capital Management by the SEC Los Angeles Regional Office failed to detect the fraud. In this case, Greenwood and Walsh misappropriated as much as $554 million of investor assets over the course of a decade. Thus, instead of investing the money as promised, Greenwood and Walsh were accused of misappropriating investor funds for their own personal use.

The Swiss Analytics report notes that the unusual structure of a feeder fund being a limited partner in a broker-dealer rendered it more difficult for regulators and investors to get the full picture of the entire fund structure. The report highlights that this unusual structure and insufficient checks and balances facilitated and covered up the fraud in the Westridge Capital Management case.

Lastly, turning its focus on the Absolute Capital Management case, the Swiss Analytics report notes in the fall of 2007, the Absolute funds had between $440 billion and $530 million of “illiquid positions” in their books, the majority of which were thinly traded U.S. microcap stocks acquired and traded by the funds through Hunter World Markets. The report points out that the SEC complaint identified six such microcap companies which were traded in the OTC markets. However, these microcap stocks were allegedly privately acquired by means of reverse mergers with already publicly listed shell companies.

The Swiss Analytics report stated also that the small-cap nature of investments and manager and broker-dealer affiliation have facilitated or covered up the fraud in the Absolute Capital Management case. Moreover, numerous conflicts of interest, such as related party transactions around the IPOs of manager-owned private companies, were also subjected to conflicts of interest.

The Swiss Analytics report concludes that the above three regulatory cases should provide sufficient warning signs to investors. However, the report also emphasizes that in order to access this value in time and not only after “the house has already burnt down,” proactive due diligence has to be implemented.