Karen Analysis (Part 1)

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Note from Tim. The following is kindly contributed by Buccaneer. I am not sure what preamble is required with respect to what I assume is an ongoing legal case, except to say that the words below are obviously a matter of opinion and none of these are offered as fact or conclusive findings: On Karen Bruton the Supertrader (KST) topic here’s my analysis about her case. (Links to SEC PDFs are here and here).

According to the SEC’s complaint filed in federal court in Atlanta:
The two private hedge funds managed by Hope Advisers and Bruton – named Hope Investments LLC and HDB Investments LLC – have more than $175 million in net asset value.

Hope Advisers receives its only compensation for managing the funds in the form of an incentive fee, calculated as a share of the profits (10 or 20 percent) earned in the funds’ accounts each month.

Hope Advisers and Bruton engaged in a continuous pattern of trading to inflate their compensation from the funds. They not only delayed realization of trading losses but also intentionally sized certain trades so the funds realized a profit every month.

The scheme has enabled Hope Advisers to avoid realization of more than $50 million in losses in the hedge funds while earning millions of dollars in fees to which they were not entitled. Without the fraudulent trades, Hope Advisers would have received almost no incentive fees from at least October 2014 through the present.

The SEC’s complaint charges Hope Advisers and Bruton with violating or aiding and abetting violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 as well as Sections 206(1), (2) and (4) of the Investment Advisers Act of 1940, and Rule 206(4)-8. The SEC’s complaint seeks disgorgement of ill-gotten gains plus interest and penalties as well as permanent injunction.

The complaint also names Bruton’s charity called Just Hope Foundation as a relief defendant for the purposes of returning money it received out of the fees to which the firm was not entitled. The complaint does not allege that the Just Hope Foundation participated in the wrongdoing.

After reading all the docs and reactions (good and bad) and hear Sosnoff about KST, here are my 2 cents on KST’s case. She filed with the SEC but was hedging with futures and forgot to file with the CFTC. She was already fined for $100K by the SEC for not marking to market. She probably found this “calendar” accounting solution to still obtain a similar result in terms of fee charged per month while at the same time complying with the M2M rule.

The goal from a manager perspective is clear here. Since she charges only on profits (performance fee) she needs to show positive gains at the end of every month (btw I am pretty sure that charging only on realized is not fully legal) in order to have a positive cash flow for her firm and pay bills. The real question is: if it’s bona fide, why not charge a management fee and avoid all these accounting schemes? Not as profitable for her on a monthly basis, but definitely more understandable for investors and cheaper for the fund (3.6% a year is a lot anyway if that’s what it cost).

What makes me think the most is the issue about the redemption clause by which investors that redeem funds invested are not passed the losses. This makes it look like a sort of pyramid Ponzi scheme as the last one who stays inherits the losses theoretically pertaining to others.

When Karen started the fund, her lawyer gave her different ways of accounting for the profit and loss. The first one is the NAV which accounts for both realized and realized p/l and is done monthly. This is a typical method for actively traded funds with liquid/easy to value investments (equities, options, futures etc).

However, there is a downside to this method. What happens at end of year for tax accounting is that the taxable income is based only on realized p/l (unless you elect a mark to market approach for taxes which is a complete mess tax-wise). So it can create some “unclean” accounting because at the end of the year, the taxable profit will not equal the actual profit to the investor. Karen, being a CPA, did not like this so she chose the 2nd method.

The method Karen chose is the realized gain/loss accounting. This is actually very common in hedge fund also, but more so with those that invest in illiquid investments. For example, many VC funds do this because their investments in companies do not really generate a true profit until they sell the investment (IPO or acquisition). And it would not make sense for investors to pay tax year after year on some phantom gains without actually receiving any money. So the method Karen chose was not wrong or illegal in any way. It was just not really the most common or appropriate method for a liquid market based fund (because there is no reason to not use the NAV based p/l in her case).

It is important to remember that under normal circumstances, regardless of whether a fund uses the NAV method of the realized p/l method, the end result to the investor should be the same. Especially in her case, trading options with less than 60 DTE, any unrealized losses would normally soon become realized as those positions are closed and/or expire.

So at the outset, and for many years, this did not present any real problems. In fact, as you can see by the 2013 CFTC complaint, they audited Karen and made her show the unrealized p/l on her statements yet did not pursue any other enforcement action. In that consent order it specifically said that it was fine for her to use that method, but she also needed to let her investors know what the carried unrealized p/l is to comply with full disclosure of performance. That is very telling as of course if the method she was using was illegal or flat out wrong, she would have been shut down at that audit.

Be sure to tune in tomorrow for the exciting conclusion of the Adventures of Karen!