Paradigm Capital Management encountered a whistleblower and handled it poorly. The hedge fund had been conducting principal trades in violation of Section 206(3) of the Investment Advisers Act. Paradigm’s head trader reported the violations to the Securities and Exchange Commission.
It’s tricky to deal with a hedge fund making principal trades with an affiliated broker-dealer. The principal trade requires consent of the client under SEC Rule 206(3)-2. With a hedge fund, it’s not the investors who are the client. It’s the fund that is the client.
That makes it tricky to structure the consent. Most hedge funds are privately-owned so there is no board of directors to act on behalf of the fund. That was true with Paradigm where Candace King Weir owned 73% of the advisory firm and 73% of the broker-dealer.
Paradigm tried to do the right thing and established a conflicts committee. It consisted of the CCO and CFO of Paradigm. The problem was that the CFO reported to Weir, so the CFO’s presence did not alleviate the conflict.
Paradigm was ordered to pay a penalty of $1.7 million as an “approximation of certain administrative fees the Fund paid in connection with the principal transactions….” The order does not go into detail about the investors in the fund were hurt by the principal trades.
The order spends its most time discussing the whistleblower aspects of the case.
It was Paradigm’s head trader who made a whistleblower submission to the SEC in March 2012. That’s about seven months after the new whistleblower rule went into effect, making the trader eligible for up to 30% of the penalty.
The head trader continued doing his job until the middle of July. At that point he told the firm that he reported a possible securities law violation to the SEC.
The next day Paradigm pulled him off the trading desk and relieved him of his day-to-day responsibilities. The firm sent him off-site to prepare a report on all the facts that supported his claims. Eventually, he ended up working at home.
Paradigm was looking for a “gotcha” moment to fire the whistleblower. That came when he sent a confidential document to Paradigm’s CCO. The firm accused the whistleblower of removing confidential documents in violation of firm policy and the confidentiality agreement he signed when he joined the firm. He eventually resigned because of the adverse treatment.
Paradigm had a compliance failure. Principal trades are bad for investment advisers and tricky for hedge funds. But I would guess that it was the firm’s treatment of the whistleblower that resulted in such a harsh penalty.
Sources:
- Order In the Matter of Paradigm Capital and Candace King Weir
- First SEC Case Under New Authority to Bring Anti-Retaliation Enforcement Actions
- SEC Charges Hedge Fund Firm with Retaliating Against Whistleblower in Corporate Crime Reporter
- S.E.C. Fines Hedge Fund in Demotion of Whistle-Blowing Employee by Alexandra Stevenson in NYTimes.com’s Dealbook
- Paradigm Settles With SEC in Whistleblower Case by Rachel Louise Ensign in the Wall Street Journal
- A Weekend of Whistleblowing