SEC Takes Action Against Two Sigma for Failing to Fix Vulnerabilities in Investment Models

The Securities and Exchange Commission (SEC) is taking a tough stand against Two Sigma Investments LP and Two Sigma Advisers LP, two major New York-based investment advisers, for neglecting to fix known vulnerabilities in their investment models, resulting in potential harm to clients. The SEC’s order also highlights a disturbing breach of whistleblower protections that puts a dark cloud over the firm’s reputation.

Here’s the timeline: Back in March 2019, employees at Two Sigma identified significant weaknesses in some of their key investment models. These issues were far from trivial—potentially affecting their clients’ returns in a big way. Yet, despite knowing about the vulnerabilities, Two Sigma didn’t take action to fix them for more than four years. Not until August 2023 did the firm finally begin addressing these problems. In the meantime, the firm continued to make critical investment decisions based on models that were, in some cases, flawed and out of date.

What's worse, the firm’s inaction wasn't just about missed opportunities to fix problems. It also involved a lack of internal controls. Two Sigma failed to supervise one of its employees, who made unauthorized changes to multiple models—actions that led to investment decisions that were, simply put, not in the best interests of their clients.

In response to the SEC’s investigation, Two Sigma repaid a substantial $165 million to affected funds and accounts. The firm took this step voluntarily to make right by its clients—but the SEC isn’t stopping there. The firm has also agreed to pay $90 million in civil penalties to settle the charges and close the case.

Sanjay Wadhwa, Acting Director of the SEC’s Division of Enforcement, pointed out that this case serves as a wake-up call. "When vulnerabilities are identified that could significantly impact client returns, there’s no room for hesitation. An investment firm can’t sit on its hands for years," Wadhwa said. "The law requires advisers to take action—proactively and reactively—to mitigate these risks."

In addition to the investment model issues, the SEC also found that Two Sigma was messing with more than just its models—it was also messing with the firm’s own employees. Specifically, the firm violated the SEC’s whistleblower protection rule by forcing departing employees to sign separation agreements that falsely stated they hadn’t filed complaints with any government agency. In practice, this made it harder for potential whistleblowers to come forward with concerns and discouraged them from reporting violations to the SEC.

Two Sigma is now facing charges under the Investment Advisers Act of 1940 for fraud and failure to comply with essential operational rules. On top of that, the firm’s actions ran afoul of the Securities Exchange Act of 1934, which protects individuals’ rights to communicate freely with the SEC about potential legal violations.

While Two Sigma has neither admitted nor denied the SEC’s findings, the firm has agreed to a cease-and-desist order, which includes a formal censure and a $90 million penalty. The penalty is split between the two entities—$45 million for Two Sigma Investments and $45 million for Two Sigma Advisers.

This case serves as a reminder that, in today’s world, financial firms can’t afford to neglect the integrity of their investment models. In an era where technology and models drive investment decisions, those responsible for clients’ money have a duty to ensure everything is in order—especially when the stakes are so high.

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