RIA Compliance Blog
The SEC recently charged New York-based investment advisers Two Sigma Investments LP and Two Sigma Advisers LP (collectively, “Two Sigma”) with breaching their fiduciary duties for failing to reasonably address known vulnerabilities in their investment models. In its Order, the SEC also found compliance and supervisory failures related to those violations, plus violation of the Commission’s whistleblower protections via Two Sigma’s employee separation agreements.
Two Sigma is a large quantitative-analytics-based hedge fund manager using computer-based algorithmic investment models when managing or advising client investments. The SEC claims that, by March 2019, multiple Two Sigma employees had informed senior management that various Two Sigma personnel could freely change variable inputs of their algorithmic models. These unchecked input modifications would alter the algorithm’s predictions and trades without notifying the firm, its representatives, or its clients. This autonomy of various personnel to rewrite the models’ data could materially impact investment decisions for Two Sigma clients.
Subsequently, between November 2021 and August 2023, a Two Sigma employee (referred to in the SEC Order as “Modeler A”) changed inputs for fourteen live trading models without any supervisory review or approval. Modeler A’s changes caused Two Sigma’s models to make investment decisions for their clients that they otherwise wouldn’t have made. Modeler A’s changes, first detected in August 2023, resulted in certain funds overperforming by $400 million and others underperforming by $165 million.
The SEC found that Two Sigma’s failure to address potential client harms constituted a willful violation of Advisers Act Section 206(2)’s prohibition of an investment adviser’s engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” The Commission also found that Two Sigma violated Advisers Act Section 206(4) and Rule 206(4)-7 thereunder by failing to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisors Act – specifically, their models’ above-described vulnerabilities. Finally, the SEC also found that Two Sigma failed to reasonably supervise Modeler A within the meaning of Advisers Act Section 203(e)(6), relating to reasonable prevention and detection of Modeler A’s federal securities laws violations.
The SEC also found that Two Sigma violated the Commission’s whistleblower protection rules through its employee separation agreements. These agreements required departing employees to state that they hadn’t filed a complaint with any government agency. The SEC found that this requirement could identify whistleblowers and jeopardize their post-separation compensation and benefits, thereby discouraging employees’ cooperation with Commission investigations. The SEC found this to violate Rule 21F-17(a) of the Exchange Act’s bar against impeding an individual from communicating directly with Commission staff about a possible securities violation.
The SEC noted that Two Sigma cooperated with the Commission’s investigation and acted promptly to remedy the violations and harms. Prior to the SEC’s Order, Two Sigma voluntarily repaid approximately $165 million to the negatively impacted client funds and accounts. Two Sigma also advised its clients of its violations and rewrote its written disclosures, policies, and procedures relating to model input security, as well as related internal controls and approval processes. Two Sigma also revised its employee separation agreements and informed nearly three hundred former employees who’d signed the old agreement of their right to communicate directly with the Commission regarding any potential securities law violations.
Without admitting or denying the SEC’s findings, Two Sigma agreed to settle the Commission’s claims by paying $90 million in civil penalties in addition to its already enacted remedies.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including compliance with federal and state laws and rules. Please visit our website for more information.