Abstract:
On March 15, 2010, the Securities and Exchange Commission (“SEC”) received an anonymous complaint, which detailed failures and inappropriate conduct concerning its examination program in 2005 against Westridge Capital Management, Inc. (“Westridge”) and WG Trading Investors, L.P. (“WGTI”), entities controlled by Paul Greenwood and Stephen Walsh for their defunct Ponzi scheme.
In the investigation report published almost 8 months later, the SEC admitted that the agency’s practice had numerous flaws and it should have identified the fraud in 2005. The purpose of this subsection is to understand why the SEC missed those obvious signs, and then, to learn from the problems faced by the SEC’s examiners.
Case Profile:
Numerous Red Flags on Westridge, but No Action:
In April 2005, the SEC’s Los Angeles Regional Office (“LARO”) conducted an investment advisor examination of Westridge. It has been 5 years since the last exam conducted by the same office in 2000. The 2005 examination was led by Mr. David Bergers, Regional Director, and Ms. Rosalind Tyson, Regional Director, supported by 15 other examiners.
The report says, “The examiners who conducted the 2005 Westridge examination acknowledged that Westridge’s investment structure in which Westridge clients became limited partners in the broker-dealer, was a red flag in and of itself, and its complex investment strategy combined with its goal of circumventing Regulation T and unusually high leverage was highly questionable.”
It further says, “the LARO examination team reviewed the report of a previous examination of Westridge conducted in 2000 and identified specific concerns regarding Westridge’s ability to access client assets held by WG Trading, and based upon that review, made a decision that “the examination will focus on custody issues.” However, the actual examination did not conduct a custody analysis and made no effort to scrutinize Westridge’s custody arrangement.”
The LARO also identified some other red flags as following:
Poor compliance culture at Westridge – the examiners concluded Westridge did not consider compliance with the federal securities laws to be a priority. Westridge, a $1.3 billion investment adviser, hired a completely inexperienced compliance officer and purportedly could not afford compliance seminars.
A myriad of inaccuracies in Westridge’s Form ADV – 15 incidents of inaccurate or incomplete information, including failing to disclose that Westridge gave advice on interests in partnerships.
Questionable e-mail retention policy – Westridge deleted all e-mails after a hardcopy was printed and, as a result, the examiners couldn’t review the e-mails.
Despite those critical findings, the 2005 examiners concluded to lower Westridge’s risk rating to “risk group 2 – medium risk” as Westridge’s operations “do not appear to involve a high degree of risk.” What is comical about this decision was that on the same report stated that “there are significant risks associated with the operations of WG Trading.”
An examiner who conducted post-fraud examination confirmed said, “[I]n retrospect that fraud was not that hard to uncover.” And, “all you really had to do was look at the amount of net assets that were on Westridge’s books, compare that with the amount of money that WG Trading was representing that they were managing, and those amounts just didn’t tie out.”
After reading the investigation reports, I identified the following two problems of the LARO examiners:
(1) Silo Mentality and Intra-team Rivalry
The following testimony of a junior examiner describes the LARO team’s silo mentality point very well.
The 2005 LARO examination team, upon concluding their examination, had enough concerns about the operations at WG Trading and they decided to recommend that the Boston Branch Office conduct a broker-dealer examination of WG Trading. However, the investigation revealed that the LARO team failed to make an appropriate referral to its Boston counterpart.
“I’m not totally shocked that there is no evidence that the referral was made to Boston. I think the IA supervisors wanted to placate […] but they weren’t so eager to carry out a recommendation from a BD staff member.”
“[B]etween the BD and IA staff, there [was] not always complete teamwork. There’s a level of competition between the two groups.”
(2) Inability to See a Big Picture
The 2005 LARO examination staff had access to records including Westridge’s records for client investments in WG Trading. WG Trading’s 2003 audited financial statements showed $1.125 billion in partner contributions, representing the funds that Westridge’s investors had purportedly invested in WG Trading. On the other hand, Westridge’s 2003 Form ADV stated that Westridge had $2.9 billion in assets under management. As 80 percent of the $2.9 billion in Westridge’s funds were purportedly invested in WG Trading, or $2.32 billion, the comparison yielded a shortfall of $1.2 billion. However, the 2005 LARO examiners did not think about this comparison as necessary.
What We Should Learn?
The examiners’ problems are not unique. Any hedge fund analyst can be exposed to those problems without acknowledgment. The silo mentality could be a problem at a firm where investment-related due diligence and operational due diligence are completely separated.
It is God’s work to erase all traces of misconduct for any intelligent fraudsters. So, it is our responsibility to conduct our reviews with widely open eyes and an open mindset. We should never underestimate the importance of being diligent.