The US Securities and Exchange Commission (SEC or the Commission) has announced a $2.2 million settlement in the Commission’s first whistleblower anti-retaliation case.1 As part of the settlement order, the SEC charged Paradigm Capital Management, Inc., a registered investment adviser, and Candace King Weir, the firm’s founder, president, and chief investment officer (collectively, “Paradigm”), with violations of the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 for engaging in prohibited principal transactions with advisory clients and subsequently retaliating against an employee who reported the transactions to the SEC; Paradigm settled the matter without admitting or denying the charges.
In announcing the settlement, Andrew Ceresney, director of the Enforcement Division, emphasized the SEC’s commitment to protecting whistleblowers from retaliation: “Those who might consider punishing whistleblowers should realize that such retaliation in any form, is unacceptable.” In addition, Sean McKessy, chief of the Office of the Whistleblower, pledged to continue to enforce anti-retaliation rules: “We will continue to exercise our anti-retaliation authority in these and other types of situations where a whistleblower is wrongfully targeted for doing the right thing and reporting a possible securities law violation.”2
Dodd-Frank Act Whistleblower Provisions
Section 922 of the Dodd-Frank Act created a new whistleblower program at the SEC that (i) provides for awards to individuals who inform the SEC of violations of the federal securities laws, (ii) prohibits employers from retaliating against whistleblowers and (iii) grants whistleblowers a private cause of action for employer retaliation against them.
The SEC implemented Section 922 through a 2011 rulemaking that created the Securities Whistleblower Incentives and Protection Program.3 In adopting the implementing regulations, the SEC broadly read the anti-retaliation provisions of Section 922 to permit their enforcement not only by a private party, but also in an action brought by the Commission. Although private parties have filed lawsuits to enforce the anti-retaliation provisions of Section 922, the Paradigm case is the first instance of the SEC bringing its own enforcement action.
Paradigm’s Principal Transactions
Paradigm’s prohibited principal transactions involved trades on behalf of a hedge fund client with a proprietary trading account maintained by a Paradigm-affiliated broker-dealer without disclosure of the arrangement to, or consent from, the hedge fund client. The trades were part of a strategy to reduce the hedge fund’s tax liability, and Paradigm used the affiliated broker-dealer prop trading account when Paradigm believed that it might want to repurchase the security for the hedge fund. The trades took place at the prevailing market price, with no additional markup or commission charged by the affiliated broker-dealer. Beginning in 2009, Paradigm engaged in at least 83 of these principal transactions, selling 47 securities positions to the affiliated broker-dealer’s proprietary trading account and repurchasing 36 of the securities over the course of three years.
Because Paradigm and the broker-dealer were under common control, each trade was subject to the restrictions on principal trades in Section 206(3) of the Investment Advisers Act of 1940. Under Section 206(3), an investment adviser that seeks to engage in a principal transaction must provide written disclosure to, and receive consent from, the client before completion of the trade.4 The disclosure and consent requirements must be satisfied on a transaction-by-transaction basis. In this case, because the hedge fund had no board of directors and the hedge fund’s general partner was under common control with Paradigm, Paradigm established an internal Conflicts Committee to review and approve each principal transaction on behalf of the hedge fund in lieu of seeking consent from investors on a transaction-by-transaction basis.
Conflicted Conflicts Committee
According to the SEC, however, the Conflicts Committee itself was conflicted. The two-person Committee consisted of Paradigm’s Chief Compliance Office (CCO) and Chief Financial Officer (CFO), both of whom reported to Weir in some capacity: the CFO reported directly to Weir, while the CCO reported to Paradigm’s board of directors, of which Weir was a member. Moreover, the SEC noted that Paradigm’s CFO also served as the affiliated broker-dealer’s CFO, which gave him a second conflict of interest with respect to transactions between Paradigm and the affiliated broker-dealer. Specifically, the CFO had the obligation to monitor the affiliated broker-dealer’s net capital requirements, which were negatively impacted each time the broker-dealer purchased, at Paradigm’s instruction, securities from the hedge fund. Accordingly, the SEC alleged that this obligation to the affiliated broker-dealer was in conflict with his obligation as a member of the Conflicts Committee to act in the best interests of the hedge fund.
Paradigm also charged the client an administrative fee for compliance-related expenses that included the Conflict Committee’s administration of the principal transactions and failed to disclose the Conflict Committee’s own conflicts on Paradigm’s Form ADV Part 2A.
On March 28, 2012, Paradigm’s head trader made a whistleblower submission to the SEC that disclosed the prohibited principal transactions. Three-and-a-half months later, the whistleblower notified Paradigm that he had reported a potential securities violation to the SEC; Paradigm subsequently removed him from the trading desk, temporarily relieving him of his trading and supervisory responsibilities. Paradigm then instructed him to investigate the conduct that he had reported to the SEC from an off-site location and to prepare a report detailing the alleged violations. During this time, the whistleblower was denied access to certain trading and account systems at the firm, including his company email account.
After the whistleblower completed his report, Paradigm asked him not to return to work and began to negotiate a termination of his employment. However, the two sides failed to agree on severance terms, and the whistleblower requested to be reinstated to his previous position as head trader.
Paradigm denied the whistleblower’s request and assigned him additional compliance-related tasks. Specifically, he was required to analyze 1,900 pages of the firm’s trading activity to identify other potential wrongdoing. The firm refused to provide the whistleblower access to its trading system and required that he review hard-copy documentation of trades. In addition, Paradigm assigned the whistleblower the task of consolidating and revising the firm’s trading procedure manuals into one comprehensive document.
Finally, despite having previously granted the whistleblower permission to use a personal email account for company business, Paradigm reprimanded the whistleblower for sending confidential documents from his personal email account about the compliance investigation to the firm’s CCO. Paradigm accused the whistleblower of violating his confidentiality agreement with the firm and firm policies. The whistleblower resigned on August 17, one month after revealing himself as a whistleblower.
From these actions, the SEC concluded that “Paradigm had no legitimate reason for removing the Whistleblower from his position as head trader, tasking him with investigating the very conduct that he had reported to the Commission, changing his job function from head trader to a full-time compliance assistant, stripping him of his supervisory responsibilities, and otherwise marginalizing him” and that Paradigm’s actions constituted adverse employment actions against the whistleblower.
As part of the settlement agreement, Paradigm agreed to the disgorgement of $1.7 million to hedge fund investors for administrative fees paid in connection with the principal transactions and the payment of an additional $481,771 for prejudgment interest and a civil money penalty.5 In addition, Paradigm was required to cease and desist from illegal principal transactions and to retain an independent compliance consultant to review its policies and procedures related to prohibited principal transactions.
The settlement does not attribute any portion of the civil money penalty to the anti-retaliation violation, but Andrew Ceresney, director of the Enforcement Division, stated that the whistleblower could potentially receive a portion of the amount the agency recovered as a bounty.
Endnotes:1 Paradigm Capital Management, Exch. Act Rel. No. 72,393 (June 16, 2014), available at http://www.sec.gov/litigation/admin/2014/34-72393.pdf.
2 SEC, SEC Charges Hedge Fund Adviser With Conducting Conflicted Transactions and Retaliating Against Whistleblower (June 16, 2014), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542096307#.U6hQnPldUW0
3 17 C.F.R. § 240.21F-2(b).
4 15 U.S.C. § 80b-6.
5 Notably, the SEC did not allege that Paradigm failed to act in the best interests of the hedge fund or that investors in the hedge fund lost money as a result of Paradigm’s conflicted transactions.
6 The firm wishes to thank Micah D. Stein, a summer associate in the firm’s Washington DC office, who contributed to the drafting of this legal update.