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Regulation

SEC is said to probe if banks helped hedge funds inflate returns

Wall Street banks are known to fiercely compete for hedge fund clients because of the lucrative trading profits they provide.

The U.S. Securities and Exchange Commission is now investigating whether some banks crossed the line to win business by offering hedge funds bogus price quotes on hard-to-value bonds, said two people familiar with the matter. The SEC's concern: As a reward for helping hedge funds make money — by submitting quotes at requested levels — banks got trades steered their way.

As part of its probes, the regulator is reviewing at least a dozen banks and brokerage firms to determine whether they provided inflated prices on debt securities that funds used to pump up the value of their investments, said the people who asked not to be named because the inquiries aren't public.

J.P. Morgan Chase and Citigroup are among the banks being looked at, said one of the people who added that the SEC is also scrutinizing other large firms and several smaller ones. The investigations, which won't necessarily lead to any allegations of wrongdoing, focus on valuations of mortgage securities and other thinly traded bonds where swings of just a few cents can have a big impact on hedge fund returns, the people said.

"It doesn't take much to manipulate a bond price," said Charles Geisst, a finance professor at Manhattan College in New York who has written books on the history of Wall Street. "It's sort of an alternate reality. No one really knows the price of a bond until it's traded."

Spokesmen for the SEC, J.P. Morgan and Citigroup declined to comment.

The probes show the SEC isn't letting up in its multiyear push to try to uncover illicit conduct in one of Wall Street's most opaque markets. Bonds tied to home loans and other debt can go months without trading. That lack of transparency prompts investors to value bonds by relying on estimates from brokers and other third parties, a system the SEC believes is ripe for abuse.

Hedge fund firms typically task internal committees with valuing thinly traded bonds, a process that prevents conflicted portfolio managers from assigning favorable prices to their own investments.

Still, portfolio managers can push back if they feel prices don't reflect the current market. In such instances, they sometimes tap brokers at banks for additional, higher estimates.

The portfolio manager might argue that the higher valuation is more accurate because it comes from an actual market participant. If the hedge fund's valuation committee accepts the broker quote in pricing a bond, it might make the difference between a good month or a bad one for money managers depending on the size of the position in their portfolio.

Portfolio managers at hedge funds have significant clout with brokers because they are sought-after customers. Hedge funds engage in frequent buying and selling, they amplify their bets with borrowed money and they are big buyers of derivatives. Banks receive millions in fees from such services.

The SEC's suspicion that brokers sometimes provide sham prices isn't just theoretical. In June 2016, the agency accused two portfolio managers at Visium Asset Management of soliciting phony quotes from friendly brokers over an 18-month period to justify inflated valuations on distressed debt holdings.

Due to the scheme, Christopher Plaford and Stefan Lumiere were able to post a 0.68% gain in 2011 for the credit hedge fund they ran at Visium, instead of a roughly 4% loss, the SEC said. Mr. Plaford has pleaded guilty to related criminal charges brought by federal prosecutors, while a judge sentenced Mr. Lumiere to 18 months in prison in June for his role in inflating some of the firm's bond investments.

The SEC is also looking at Keri Findley, a former partner at Dan Loeb's Third Point hedge fund firm, people familiar with the matter have said. The regulator is probing whether Ms. Findley, who left Third Point in February, caused mortgage bonds in her portfolio to be undervalued, the people said.

While it's unclear how she might have benefited from her investments being worth less, it's possible that undervaluing a position for much of the year could make it easier for a portfolio manager to then mark up the investment to match market prices at year-end when firms calculate fees and bonuses.

A spokesman for Ms. Findley has declined to comment. Third Point has said it has a rigorous process for pricing securities and that it is cooperating with the SEC.

Technological advancements have assisted the regulator. In recent years, it has been using computer algorithms to spot bond trades that occur at prices that are suspicious because they don't reflect recent transactions. SEC officials say the algorithms have helped them to identify billions of dollars of problematic trades.