Improper Soft Dollars to Hedge Funds

FINRA recently fined SMH Capital Inc. US$450,000 for procedural failures to address its prime brokerage and soft dollar services to hedge funds.

FINRA also penalized the two brokers who helped manage SMH's prime brokerage services business while at the same time serving as the managers of a hedge fund that executed trades at SMH. They improperly received compensation from a profit pool derived, in part, from commissions on trading by their fund. This was obviously a conflict of interest, contrary to the fund's private placement memorandum (PPM) and a separate contractual agreement.

SMH commenced its hedge fund services business in July 2000 and eventually established relationships with more than 15 different hedge funds, making the hedge fund business an important part of the firm's overall operations. It provided a platform of services to hedge fund managers including office space and facilities, marketing assistance and capital introduction, with the fund managers paying for such services through commissions earned on trades directed to SMH.

The firm also operated soft dollar accounts for hedge funds that opted not to join SMH's prime brokerage services platform. These accounts collected a portion of the commissions earned when SMH executed trades for each fund. Fund managers could then submit invoices for goods and services. SMH then paid the providers from the balances accumulated in the soft dollar accounts.

FINRA found that SMH sent two improper soft dollar payments totaling $325,000 to a hedge fund manager. The manager had submitted an invoice to SMH requesting that SMH issue one cheque for US$75,000 to an individual for "consulting services" and a second check for just under US$250,000 to the manager for "research expense reimbursement".

The invoice raised several red flags because:

• it requested SMH to pay the hedge fund manager directly for expenses that had purportedly been provided by a third party;
• it did not describe what research had been provided to the manager or who had provided the research; and
• it failed to describe the "consulting services" the individual provided.

The hedge fund manager did not provide SMH with any invoice or backup documentation from the individual consultant or from any research provider to support the invoice.

A hedge fund could become an investment scam if there is no proper control procedure in place.