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The SEC has charged John Hughes, President and Chief Compliance Officer of New Jersey-based hedge fund manager Prophecy Asset Management, for his involvement in a long-term fraud. The case, which involved concealing the losses of hundreds of millions of dollars from investors, highlights the need for oversight at every level of the organization.
In the SEC’s complaint, they alleged that Hughes and his associates lied to investors, auditors and the fund administrator about the funds’ trading practice, risk, performance and liquidity. Hughes gave the impression to his investors that their investments were protected from loss by spreading their capital among many different sub-advisers trading in liquid securities and posted cash collateral to offset any losses. The SEC found that, in reality, the majority of the funds’ capital went to one sub-adviser who suffered massive trading losses. Additionally, Hughes directed the funds to invest in highly illiquid investments which resulted in additional substantial losses to the funds. While this was all going on, the funds collected more than $15 million in fees from investors.
Hughes was able to hide these losses by fabricating documents and entering into fake transactions that would cover up the true financial situation of the fund. Eventually, the house of cards crumbled when Prophecy accumulated losses that amounted to greater than $350 million. At this point, Prophecy was required to indefinitely suspend redemption by investors. For those investors that were promised liquidity in the fund, this must have been a shocking turn of events.
Hughes is now being charged with violations of antifraud provisions of the federal securities laws. These charges seek permanent injunction, disgorgement of ill-gotten gains plus interest, civil penalties and an officer and director bar. Additionally, the US Attorney’s Office for the District of New Jersey announced criminal charges.
It’s always unfortunate when cases like this come out, with investors being completely misled and lied to about the status of their investments – they must have felt as though their investment advisor really did have a crystal ball. Unfortunately, what seems too good to be true often is.
Whenever there is an egregious case of fraud like this, we can’t help but put ourselves in the shoes of the adviser committing the fraud and wonder how they are able to rationalize these actions to themselves, particularly when the alleged illegal activity is happening for years on end. What is particularly glaring in this case is that the CCO appears to be the main culprit. This situation is a great reminder that part of building a strong culture of compliance is to make sure that everyone at the organization has checks and balances, and that employees feel empowered to speak up against inappropriate activity.
This is clearly an particularly grievous offense, but all firms must ensure they have some sort of oversight of their CCO. Often times this can be overlooked, since the CCO is the one responsible for doing the watching, so we recommend having formal oversight for this position in place. It makes sense that most compliance issues will flow through the CCO, but organizations should also make sure they have a channel where issues related to the CCO can be directed.
While we do not expect most organizations will experience issues this extreme, even smaller issues can be difficult to bring up internally when a lower-level person finds their superior doing something unscrupulous. Having an unbiased third-party can help to address those issues before they escalate beyond the point of no return.
How we can help
We can advise you on how to improve the checks and balances at your organization, while offering an avenue for employees to escalate any issues that might arise. Depending on your firm’s situation, we would recommend reviewing either the ongoing support or mock exam services we offer.
