The SEC’s Aberrational Performance Inquiry

The SEC’s Aberrational Performance Inquiry resulted in another case this week. The action named as defendants prominent hedge fund manager Yorkville Advisor, LLC and two of its principals Mark Angelo and Edward Schinik. SEC v. Yorkville Advisors, LLC, Civil Action No. 12 CIV 7728 (S.D.N.Y. Filed Oct. 17, 2012). The Aberrational Performance Inquiry is a joint project of the Enforcement Division’s Market Abuse Unit and the Office of Compliance, Inspections and Examinations and the Division of Risk, Strategy and Financial Innovation. It focuses on identifying areas of inquiry by using a series of performance metrics to assess the performance of a hedge fund. The Inquiry has resulted in six earlier cases.

Yorkville is a registered investment adviser founded by Mr. Angelo. Mr. Schinik served as CFO and COO. It managed the YA Global Investments (U.S.) LP fund, the YA Offshore Global Investments, Ltd. fund and the YA Global Investments, LP fund. Generally the investment strategy called for funds to be put into privately negotiated structured equity and debt in public and private companies. It provided alternative financing for microcap and small-cap publicly traded companies. The investments were structured in various forms including convertible securities, standby equity distribution agreements and convertible preferred securities. An important part of the profits achieved came from sale of securities obtained as part of the overall investment.

Yorkville’s ability to understand the valuation of its investments was critical to its strategy and results. The PPM given to investors specified that GAAP would be followed in calculating the net worth of each fund. Yorkville’s internal policies also required it to mark the funds’ investments at fair value. Until the market crisis the adviser used a valuation method it called in pitch maters the “Yorkville Method” which it claimed was GAAP compliant.

As the market crisis unfolded Yorkeville had difficulty liquidating securities it obtained from the investments. In 2008 the adviser altered its branded valuation method, adopting a new approach. While it claimed that the new method was GAAP compliant in fact it was not, according to the complaint. Under the new method most of the convertibles were simply carried at face value rather than at current, fair and accurate valuations as required. No testing was done to validate the values. Indeed, the values of the collateral underlying the convertibles were unknown. As a result Yorkville overvalued a series of investments by at least $50 million as of December 2008 and $47 million as of the end of December 2009. The supporting documentation of the defendants reflected these over valuations, according to the complaint. These over valuations inflated the value of the funds which attracted investors as well as the fees that Yorkville charged.

Misrepresentations were also made to prospective investors to lure them into putting their money in the funds. Those concerned the collateral underlying certain securities obtained as investments, the liquidity of the Funds and their internal procedures.

The complaint alleges violations of each subsection of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisors Act Sections 206(1) and (2) and 204(4). It also alleges control person liability under Exchange Act Section 20(a). The case is in litigation. See also Lit. Rel. No. 22510 (Oct. 17, 2012).