On December 8, 2020, BlueCrest Capital Management Limited (“BlueCrest”), a UK-based investment adviser, agreed to a $170 million settlement with the Securities and Exchange Commission (“SEC”) to settle charges involving insufficient and misleading disclosures to investors that BlueCrest was also operating a proprietary, internal fund, moving its best traders to such fund and replacing the traders with a volatile and underperforming algorithm.

The SEC alleged that from October 2011 through December 2015, BlueCrest managed one of its proprietary funds, BSMA Limited (“BSMA”), in a way that was detrimental to the investors in another one of BlueCrest’s funds, BlueCrest Capital International (“BCI”). While BCI was BlueCrest’s flagship client hedge fund, BSMA was set up to trade insider capital invested by members of BlueCrest’s executive committee.

During those four years, BlueCrest transferred roughly half of the top-performing live traders from BCI to BSMA. Unbeknownst to the investors, BlueCrest then did not replace those live traders in BCI with additional live traders, but instead reallocated significant capital to its algorithm. The algorithm was designed to replicate the trades executed in BSMA, but often it greatly underperformed the live traders, and the algorithm’s trades were much delayed and volatile.

According to the SEC’s findings, BlueCrest made a slew of related and egregious disclosure failures. Specifically, the SEC alleged that BlueCrest did not properly disclose the existence of BSMA to BCI investors and prospective investors and that BCI traders had been transferred to BSMA while BCI investor capital was allocated to a replicating algorithm. BlueCrest did not disclose the amount of capital allocated to the algorithm or that the algorithm greatly underperformed live traders. BlueCrest also did not disclose any of the risks involved with utilizing such an algorithmic-based strategy.

Further, prior to 2014 BlueCrest did not disclose in due diligence questionnaires and marketing literature that BCI used an algorithm in the first place. After 2014, BlueCrest only disclosed the existence of the algorithm to select investors, and conveyed the misleading impression to those investors that live traders caused losses that were in fact caused by the algorithm. Moreover, in its marketing brochures and literature, BlueCrest did not disclose the existence of BSMA (though it did disclose the existence of other proprietary funds), the movement of traders between the funds, that BCI could only draw upon BSMA traders through the replicating algorithm, or that much of BCI’s allocated capital was represented by an algorithm rather than live traders.

The SEC’s settlement highlights the materiality of use of an algorithm. It is the affirmative obligation of fiduciaries to disclose all material facts to clients and investors. Firms using algorithmic-based trading should consider whether they have an obligation to disclose the use and details of the algorithm in their Form ADV, prospectus and other marketing materials. The SEC also noted referring to an algorithm in disclosures as “quantitative strategies” was insufficient and often misleading because those strategies could also be implemented by live traders, so care should be given to how such strategies are described in firm materials.

Further, while not explicitly describing a duty to update an algorithm or other artificial intelligence- based applications, the SEC did note multiple times that the algorithm was extremely volatile and more often than not underperformed the live traders. Firms utilizing such AI and algorithmic-based trading strategies should consider whether and how they monitor and update such strategies and ensure that proper disclosure is given.