Quantitative hedge fund manger Two Sigma is settling charges that it failed to address weaknesses in its systems, which allowed employees to alter its algorithmic trading models without approval — a weakness that cost certain clients US$165 million after unapproved model changes resulted in underperformance.
On Thursday, the U.S. Securities and Exchange Commission (SEC) said it settled with a pair of affiliated New York-based investment advisers, Two Sigma Investments LP and Two Sigma Advisers LP, for allegedly breaching their fiduciary duties by failing to address the lack of controls around their trading models.
According to the SEC’s order against the firms, in March 2019, a couple of employees flagged weaknesses in the firms’ controls that gave numerous employees access to the models, which allowed them to make changes to their parameters without any review or approval.
The SEC alleged that the firms’ senior management didn’t immediately address the concerns, and between November 2021 and August 2023, one of its employees did make changes to certain models’ parameters without approval.
Those changes altered the models’ performance, resulting in certain funds and accounts underperforming by US$165 million, while other funds and accounts overperformed by US$400 million, the SEC said.
As part of the settlement with regulators, the firms voluntarily repaid US$165 million to the negatively affected funds and accounts. Without admitting or denying the SEC’s findings, they also agreed to pay a combined US$90-million penalty.
The lack of action to address known compliance weaknesses represented a breach of the firms’ fiduciary duties to investors, the SEC alleged.
“As investment advisers rely more heavily on models and advanced technology when investing client assets, the importance of a robust compliance program grows. When an investment adviser identifies material vulnerabilities to its core investment operations that may substantially impact client returns, it must address those vulnerabilities promptly and fully. Doing nothing for years is not the answer,” Sanjay Wadhwa, acting director of the SEC’s enforcement division, said in a release.
“Here, Two Sigma not only failed to respond reasonably to known vulnerabilities to its investment models, but also failed to adopt and implement reasonable policies and procedures governing such models. The federal securities laws require investment advisers like Two Sigma to take steps — both proactively and reactively — to minimize operational risks to protect their clients,” he added.
Additionally, the SEC alleged that the firms violated the agency’s whistleblower protection rule by requiring employees that left the firm to certify that they had not filed any complaints with the government — a requirement that could identify potential whistleblowers and prevent them from receiving post-severance payments, in violation of the SEC’s requirements.