Chicago-area hedge fund adviser SBB Research Group and its top two executives have been charged by the SEC with allegedly conducting a multi-year fraud that inflated fund values and overcharged investors approximately $1.4 million in fees.
According to the SEC’s complaint, SBB CEO Samuel Barnett founded the company in 2010 while still in college. He raised millions of dollars from friends and family, which he invested almost exclusively in structured notes. SBB managed at least six private investment funds with approximately $407 million in assets raised from 64 investors. The SEC said that although the fraud involved the use a complex mathematical formula, the alleged scheme was simple at its core.
“Barnett, Aven, and SBB intentionally rigged SBB’s valuation model to inflate the recorded value of the funds’ securities and make the funds’ performance look much better than it actually was,” said the SEC in its legal complaint. “Using those manipulated values, defendants reported inflated net asset values (NAVs) to investors and created a false track record for the funds which defendants marketed to prospective investors.”
The SEC alleges that Barnett and COO and Chief Compliance Officer Matthew Aven promised prospective investors that they would use “fair value” as required by Generally Accepted Accounting Principles (GAAP) when recording investments.
“In reality, Barnett, Aven, and SBB had no intention of complying with GAAP or determining an exit price,” said the complaint. “Although Barnett and Aven had never worked for a hedge fund or created a valuation model, they thought that they knew better than the rest of the market. Starting in 2011, Barnett, Aven, and SBB rejected over 50 years of standard valuation principles, ignored expert advice, and created a home-brewed valuation model that radically departed from the norm.”
The SEC said that some inputs in SBB’s model “acted like a financial steroid – artificially pumping up note values.” Other inputs acted like a masking agent that smoothed artificial gains by spreading them over the notes’ multi-year term. According to the SEC, none of the firm’s model’s so-called innovations reflected the assumptions of market participants or were validated by published academic research.
“Instead, the model was designed to get results that dovetailed with the defendants’ subjective ‘intuition’ regarding how the notes should be valued,” said the complaint. And the allegedly rigged model worked as intended, said the SEC, as it consistently inflated note values, which resulted in inflated fund performances that were included in financial statements provided to investors.
“Conveniently, their ‘intuition’ led to consistently higher note values than those yielded by more traditional models,” said the SEC.
The regulator added that when it first uncovered the model’s deficiencies in 2014 that Barnett, Aven, and SBB “could have come clean.” Instead, the SEC said they tried – and failed – to find experts who would validate SBB’s model, concealed the model’s deficiencies from investors, and deceived an auditor to maintain the facade of GAAP compliance.
Even when Barnett, Aven, and SBB eventually agreed to remediate, the SEC alleges they hid the SEC’s findings from their auditor and paid a secret credit into investor accounts without disclosing they had been overcharged. They also failed to disclose to investors materially reduced fund values after SBB hired a third party to revalue the notes. It also alleges SBB used two sets of books – one for its current investors that used a flawed homemade model, and a separate set for prospective investors that used a more standard approach applied by a third-party consultant.