SEC Fines Northern Trust for Not Stopping Criminal Hedge Fund Manager

The US Securities and Exchange Commission’s recent US$152,553 fine against mega hedge fund administrator Northern Trust provides a clear sign the regulatory agency will continue to hold a service provider accountable for any wrongdoing committed by its client if the SEC thinks it could have prevented the bad apple’s actions.

The New York headquartered L-R Managers, the SEC suggests, could never have violated the Investment Advisers Act of 1940 which governs the conduct of investment advisers by defrauding investors in its master fund LR Global Frontier Master Fund and two feeder funds– the onshore LR Global Frontier Fund LP and offshore LR Global Frontier Fund Ltd — without Northern Trust’s poor decisions. Those bad judgments ultimately led to inflated net asset valuations and performance results. As the fund administrator, Northern Trust was responsible for calculating monthly NAVs, preparing monthly financial statements for the funds, and producing periodic reporting of account balances. Calculating an NAV is a multi-step process involving trade capture, security valuation, reconciliation of cash and positions with the prime broker and other brokers, expense capture, and holding current authorized signatory lists of investors. A mistake in one or more of those tasks could result in striking the wrong NAV and Northern Trust by the SEC’s account of events failed in at least security valuation and expense capture.

The Chicago-headquartered Northern Trust isn’t the first hedge fund administrator to be whammied by the SEC for being a bad gatekeeper, but it appears to be the largest so far. In 2016 Apex Fund Services, an independent fund administrator was fined $352,449 of which US$185,000 was for disgorgement for helping two fund manager clients — ClearPath Wealth Management and EquityStar Capital Management — violated the Investment Company Act of 1940 by producing incorrect financial and investor statements. In 2015 the SEC fined ALPS Fund Services US$45,000 for not discovering that Andrew Boynton, a trustee of three closed-end funds it serviced, had a conflict of interest; ALPS Fund Services is now owned by SS&C Technologies. Deloitte Consulting was also hit with a fine of more than US$1 million for not allowing its own procedures for preventing conflicts of interest. Boynton was paid by Deloitte for the intellectual property rights to a brainstorming methodology and received consulting fees while serving as trustee. In 2013 Gemini Fund Services paid a US$50,000 fine for causing Northern Lights Fund Trust and Northern Lights Variable Trust to violate the recordkeeping and reporting rules of the Investment Company Act of 1940.

Northern Trust could have avoided the SEC’s penalty and reputational embarrassment if it hadn’t taken on L-R Managers as a client in the first place. It had plenty of warning signs L-R Managers would be nothing but trouble during the onboarding process before January 2016. Once its services started, Northern Trust kept plunging deeper into the fund manager’s corrupt hole and it wasn’t until May of 2017 that Northern Trust started to think twice about its client and its own poor decisions. Northern Trust came clean to the SEC three months later. By then, L-R Managers had declared bankruptcy and Northern Trust’s two indirect wholly-owned subsidiaries– Northern Trust Hedge Fund Services and Northern Trust Global Fund Services Cayman Limited– which were fined by the SEC had dropped L-R Managers as a client. The meager US$15,076 Northern Trust earned in fees that it must now forfeit by paying back the SEC as part of its larger fine certainly wasn’t worth the grief. Northern Trust also served as the custodian for the LR Global Frontier funds but was never paid for that service, says the SEC (In January 2020, the SEC took separate action against the CEO of L-R Partners, Donald LaGuardia Sr).

In its settlement with Northern Trust, the SEC details just what went wrong from the start of the fund administrator’s relationship with the client. During the due diligence process between August and December 2015, Northern Trust failed to catch that an investor had sued LaGuardia and L-R Managers in August for alleged fraud. (It could not be verified whether the investor had won or lost the lawsuit by the time Northern Trust accepted L-R Managers as a client). When Northern Trust spoke with L-R Managers’ previous fund administrator — never named by the SEC– it learned that the prospective client had cash flow issues, and transferred money from the Frontier Funds to the manager calling the transfer a “promissory note” — which meant that it was supposed to be paid back. What’s more payments from the funds that should have been booked as expenses were booked as receivables due from the manager — which meant that they were considered assets. As if those two discoveries weren’t enough to dissuade Northern Trust from accepting L-R Managers as a client, another was one of its significant holdings was an illiquid asset related to L-R Managers.

In its documentation of the settlement with Northern Trust, the SEC never specifies whether the former fund administrator dropped L-R Managers as a client or was dropped by the fund manager but the fact that L-R Managers needed a new fund administrator was meaningful enough for some compliance experts to question Northern Trust’s decision. “We recommend heightened due diligence to make sure you [fund administrators] don’t get stuck with a miscreant,” writes Todd Cipperman, managing principal of Cipperman Compliance Services, a Wayne, Pennsylvania-headquartered regulatory compliance consulting company focused on investment management firms in a recent blog. “It’s always a red flag when the sales team brings a client who has just fired a qualified competitor for murky reasons.” It could not be determined whether Northern Trust’s fees were lower or higher than the previous administrator’s.

It is unclear why an experienced large hedge fund administrator such as Northern Trust, servicing over S$1 trillion in alternative fund assets, would take on a client with a questionable track record. One can only presume that whoever was in charge of Northern Trust’s hedge fund administration business at the time either wasn’t told about the problematic signs or decided to overlook them not thinking they were material. Hindsight is always 20-20. Unfortunately, once Northern Trust took on its new client, it became unknowingly entangled in the fund manager’s wrongdoing by following its instructions. From January 2016 until March 2017 the funds’ advisers withdrew US$211,000 from the funds on “letters of authorization” without explaining what the money was being used for. Northern Trust was told to add US$211,000 to a large receivable that already existed as “due from” L-R Managers on the accounting records from the prior fund’s administrator. By the SEC’s account when an employee from Northern Trust asked about the money that was transferred out of the funds to L-R Managers, he was told that it was part of a larger receivable due from the manager. Apparently, Northern Trust didn’t question that explanation sufficiently by the SEC’s standards and enabled the theft of funds under the guise of the funds being a receivable or asset. Northern Trust then booked the promissory note at face value for the purpose of calculating the NAV and investment return.

When it came to booking L-R Partners’ expenses, Northern Trust also followed its client’s orders to not deduct some expenses from profits, but to consider them as part of an offsetting reimbursement due from L-R Managers. Northern Trust, says the SEC, never questioned whether L-R Managers could repay the funds. The expense receivable soon grew to US$830,000 resulting in an inflated NAV. Northern Trust’s other puzzling mistake: to include in the funds’ income a hypothetical performance gain or “true-up” reflecting the fund manager’s estimated performance of previous investments of the funds. The fund manager told Northern Trust that these holdings had been liquidated during the migration of the funds from the books of the previous fund administrator to Northern Trust’s books. The funds from the investments had not been reinvested, yet the fund manager wanted to reimburse investors for any gains that would have been received had the investments been retained.

What was an “alleged” gain was made real by Northern Trust’s shoddy accounting practice. Northern Trust never analyzed the basis of the “true-up,” says the SEC, to determine whether it would be appropriate to book the “alleged gain” as assets of the funds. The effect of the performance “true-up” was to add US$347,000 to the funds’ NAV. Last but not least, Northern Trust failed to verify L-R Managers’ valuation of a large illiquid investment in an affliliated private company. Northern Trust took the adviser at its word. The SEC says that Northern Trust did not follow its own procedures for an independent valuation of any hard-to-price assets, but based on a reading of the regulatory agency’s documentation it is unclear whether the terms of the contract with L-R Managers called for a second opinion or independent valuation.

In May 2017 Northern Trust’s relationship with L-P Partners finally came to a climax when the adviser asked it to write down its promissory note. At that point Northern Trust must have realized it had been played for a fool. But why had it taken so long for Northern Trust to wake up and smell the coffee? The SEC claims it was because its hedge fund administration employees were not required to determine whether the monies from L-P Partners’ promissory note, receivables, and “true up” were really collectible before booking them as assets of the funds’ Those assets, which added up to US$2 million in erroneously booked assets, accounted for 73 percent of the value of the funds’ NAVs, says the SEC.

The SEC acknowledges that after it cut ties with L-P Partners and contacted the regulatory agency, Northern Trust strengthened its policies and procedures. The laundry list of improvements included developing a written due diligence protocol for new fund launches and conversions or migration of accounts from former administrators, creating a revised pricing verification protocol, establishing independent monitoring mechanisms to review the accounting treatment of non-investment assets, and implementing extra professional training related to fraud detection. What the SEC’s documentation about its settlement with Northern Trust doesn’t specify who in senior management knew what and when concerning the decision junior employees at Northern Trust’s hedge fund administration unit made to comply with L-R Managers’ requests and flimsy explanations with no further due diligence. Did lower level employees simply not tell senior management about their concerns before accepting the client or as the relationship progressed for over a year. Or did senior management know and decide to take the client at its word? Peter Sanchez has led Northern Trust’s Hedge Fund Services unit since 2011. Northern Trust declined to comment for this article.

The SEC’s documentation also doesn’t explain what Northern Trust should have done other than ask L-R Managers more probing questions or verify its explanations. Compliance directors at several fund administration shops as well as external fund accounting specialists contacted by FinOps Report acknowledged that fund administrators are often caught between a rock and a hard place when it comes to following client requests and explanations. Dumping a client is considered an anathema, only to be done as a last resort. The extent to which a fund manager can override a client’s wishes is also dictated by the terms of their contract. None of the fund administrators, regulatory compliance consultant or fund accounting experts who spoke on condition of anonymity believe Northern Trust was complicit in the client’s wrongdoing; it was simply a matter of poor training and oversight. They all speculate that junior level executives in Northern Trust’s hedge fund administration business never escalated any concerns about L-P Partners’ requests to senior management. Of course, that stance begs the question of whether the executives were savvy enough to recognize the possibility of fraud in the first place. Maybe not.

Northern Trust’s biggest blunder, say rivals and third-party compliance experts who spoke with FinOps Report, was its acceptance of the lack of any independent audit of L-P Managers which could have uncovered wrongdoing. According to the SEC’s account of events, L-R Managers did promise Northern Trust that it would have its books audited when it signed up with Northern Trust, but apparently never followed through on its commitment. There is no indication in the SEC’s documentation of whether Northern Trust insisted on an independent audit during the course of its relationship with L-R Managers for over a year. None of Northern Trust’s rivals would admit to servicing a client without an independent audit which is typically required for large hedge fund managers. With no more than US$3 million in assets under management, L-P Partners was a small fish in Northern Trust’s big pond, hence it might not have attracted as much attention as larger clients. It was not registered with the SEC or any state regulatory agency, says the SEC.

The SEC has never provided any explicit guidance on what fund administrators should or shouldn’t do when confronted with a problematic client. Given that the regulatory agency wants to hold fund administrators accountable for the illegal actions of their clients even if they are not intentionally complicit suggests that fund administrators may have no choice but to end toxic relationships sooner or not accept some clients. At the very least, hedge fund administrators should have policies in place for junior level administration executives to escalate any questionable demands by clients to senior level executives for further approval. L-P Partners’ requests certainly fit into the questionable category particularly since the firm could not prove how payment on the promissory note, receivables or “true-ups” were to be made or was made. Hopefully, Northern Trust won’t make the same mistakes again and neither will any other fund administrator. Winning a bad client or keeping a bad client doesn’t pay.