In a case that may signal regulators are casting a broader net for errant RIAs, the Securities and Exchange Commission has settled charges with a New York-based hedge-fund advisor who it says failed to do promised due diligence before putting clients into hedge funds later found to be fraudulent.

On Wednesday the SEC charged Hennessee Group LLC and its principal Charles J. Gradante with securities law violations for failing to perform their advertised review and analysis before recommending that their clients invest in the Bayou hedge funds that were later discovered to be a fraud. Hennessee Group, one of the early pioneers of the "fund of funds" hedge fund concept, agreed to settle the charges by paying $814,644 in penalties.

Hennessee had approximately $519 million in assets under management, and more than 75% of its clients were high-net-worth individuals, according to the most recent ADV form it filed with the SEC in February 2008. In 2005, Hennessee Group had approximately 100 clients and $1.35 billion in client assets under management, the SEC says. The firm says in its ADV that it provided investment advice and published newsletters, but did not do financial planning. Gradante, a 63-year-old New York City resident, founded the firm in 1997.

In a settled administrative proceeding, the SEC issued an order finding that Hennessee Group and Gradante did not perform key elements of the due diligence that they had represented they would conduct prior to recommending investments in the Bayou hedge funds. The SEC also found that they failed to conduct a reasonable investigation into red flags concerning Bayou. Hennessee Group and Gradante routinely represented to clients and prospective clients that they would not recommend investments in hedge funds that did not satisfy all phases of their due diligence evaluation.

"Forewarned is forearmed-investment advisors must make good on their promises or face the consequences of vigorous SEC enforcement action," said Robert Khuzami, director of the SEC's Division of Enforcement.

The advice that clients receive from hedge fund consultants is especially critical because hedge funds are neither regulated nor transparent, commented Antonia Chion, associate director of the SEC's Division of Enforcement.

According to the SEC order, approximately 40 clients invested $56 million in the Bayou hedge funds from February 2003 through August 2005 after the Hennessee Group recommended those investments. Hennessee Group and its principals held themselves out as "Pioneers in Hedge Fund Consulting" with years of experience helping clients achieve "higher investment returns with lower risk" by recommending "a customized portfolio of hedge funds, properly diversified and managed."

The SEC charged the managers of the Bayou hedge funds with fraud in 2005. Bayou Fund LLC was a Stamford, Conn. hedge fund formed in 1996 that was directed, managed and controlled by Bayou Management LLC. Samuel Israel III, 49, was the owner and managing member of Bayou Management from the time of its inception in 1996 until it ceased operation as a hedge fund in late 2005.

Instead of analyzing Bayou's results and processes through a review of Bayou's historical trading methods to determine whether the fund was, in fact, successfully executing its purported day-trading strategy, Hennessee Group and Gradante decided not to perform any analysis after Bayou refused to produce its trading data, the SEC says. They relied entirely on Bayou's uncorroborated representations about its strategy and its purported rates of return, the SEC adds.

The administrative order also found that despite conflicting reports from Bayou about the identity of their independent auditor, Hennessee Group and Gradante failed to verify Bayou's relationship with its auditor. In fact, the accounting firm that purportedly conducted Bayou's annual audit was a non-existent entity fabricated by one of Bayou's principals, who was identified in publicly available state accountancy board records as the registered agent for the bogus accounting firm. Hennessee Group and Gradante also failed to respond to red flags concerning Bayou that came to their attention while they were monitoring Bayou on behalf of their clients, the SEC says. In particular, they failed to inquire or investigate when Bayou provided contradictory responses regarding the identity of its auditor or to adequately inquire about a rumor that one of Bayou's principals was affiliated with Bayou's purported outside auditing firm.

The SEC order finds that Hennessee Group and Gradante violated Section 206(2) of the Advisers Act. The order requires Hennessee Group and Gradante to pay $814,644.12 in disgorgement and penalties, and to cease and desist from committing or causing further violations. The parties also are required to adopt policies to ensure adequate disclosures in the future and to provide copies of the SEC's order to all current and prospective clients for a period of two years.

Hennessee Group and Gradante consented to the entry of the SEC's administrative order without admitting or denying the findings.

Bayou Fund LLC was a Stamford, Conn. hedge fund formed in 1996 that was directed, managed and controlled by Bayou Management LLC. Samuel Israel III, 49, was the owner and managing member of Bayou Management from the time of its inception in 1996 until it ceased operation as a hedge fund in late 2005.