January 9, 2009
I. Hedge Fund Enforcement Update
A. Introduction
1. 2008–A Watershed Year in Hedge Fund Enforcement
By virtually any measure, 2008 was a watershed year on the hedge fund enforcement front. Driven by the turmoil that has reshaped our capital and credit markets, enforcement efforts soared to new heights. Regulators and prosecutors redefined their enforcement priorities, commenced an unprecedented number of investigations and enforcement actions, and, according to a senior Securities and Exchange Commission ("SEC" or "Commission") insider, reached out to and cooperated with domestic and foreign agencies in a manner that has not been seen in at least thirty years. Explaining the unusually intense scrutiny that regulators placed upon hedge funds in 2008, Bruce Karpati, who coordinates the SEC’s Hedge Fund Working Group out of the New York Regional Office, suggested that, given the economic climate, "half to two-thirds of hedge funds might go out of business"–and, as the aphorism goes, desperate times may lead hedge funds to take desperate measures.
According to Linda Thomsen, Director of the SEC’s Division of Enforcement, since 2000, the SEC has brought 145 actions involving hedge funds; and since 2003, the number of actions involving hedge funds each year has been in the teens or twenties. In 2008, that trend continued with the filing of twenty-two hedge-fund-related enforcement matters. In addition, the Department of Justice brought five hedge-fund-related criminal actions. While these numbers may seem unexceptional given the unprecedented scrutiny that hedge funds faced, the figures should be considered in light of the fact that 2008 saw: (a) the filing of a significant number of large, complex, or novel cases; (b) the culmination of similarly large, complex, or novel previously filed actions; and (c) the commencement of several broad industry-wide sweep investigations focusing on the activities of hedge funds and other market participants–all of which likely required the deployment of significant regulatory and prosecutorial resources. One need look no further than the highly publicized civil and criminal actions brought against Bernard L. Madoff for allegedly defrauding his advisory clients (hedge funds and others) out of billions of dollars in what might be the largest financial fraud in history. Investor losses from the fraud could reach $50 billion.
Importantly, hedge fund enforcement activities in 2008 were part of a broader wave of general enforcement-related efforts that set new records. For example, in fiscal year 2008, the SEC reportedly brought the highest number of insider trading cases in the agency’s history and a record high number of enforcement actions against market manipulation–including a precedent-setting case against a former hedge fund trader for spreading false rumors. Further, the SEC reportedly completed the highest number of enforcement investigations in any year to date, by far, and initiated the second highest number of enforcement actions in agency history. Adding to these records, SEC Chairman Christopher Cox noted that the Commission devoted more than one-third of the entire agency staff to the enforcement program–a higher percentage of the SEC’s total staff than at any time in the past twenty years–and the internal allocation of funds for enforcement was the highest in agency history.
The level of interaction and cooperation among enforcement agencies similarly rose to new heights. Thomas Biolsi, Associate Regional Director for Examinations at the SEC’s New York Regional Office, recently observed that he has never seen–in thirty years–the type of multi-agency interaction now taking place. Not only are U.S. regulators increasingly working with each other in more sophisticated ways, they are also doing so with their foreign counterparts. According to Chairman Cox, "[t]he Commission’s international work was more significant in FY 2008 than ever before." During that time, the SEC reportedly made more than 550 requests of foreign regulators for assistance with SEC investigations–more than one a day on average, and far higher than any previous year–and cooperated with more than 450 requests from foreign regulators for enforcement assistance. A significant amount of this "international work" likely involved hedge funds. Indeed, Bruce Karpati recently stated that, given the "global nature" of the hedge fund industry and the fact that "such a big component of what hedge funds do is in the overseas markets," the Hedge Fund Working Group is "increasingly working with foreign regulators."
The take-away is clear: hedge funds were under extraordinary regulatory scrutiny in 2008–particularly so once the economic crisis came to dominate the daily news–and that level of scrutiny is expected to continue, if not intensify, in 2009.
Gibson Dunn has been counsel to hedge funds during this time, and we have written extensively on an array of enforcement and regulatory developments affecting hedge funds. This section of the client update provides an overview of hedge fund enforcement activities in 2008 and the priorities that emerged as the year progressed, as well as practical guidance to help hedge funds avoid or limit liability. Much of the information presented in this section is based on our review of cases filed and public sources describing enforcement initiatives and investigations. In addition, we have incorporated salient comments and observations made by senior regulators and prosecutors at a November 24, 2008 Practising Law Institute Conference in New York on Hedge Fund Enforcement and Regulatory Concerns. We follow this section of the client update with an overview of hedge-fund-related regulatory developments and compliance considerations. We discuss actions taken by the SEC and others in response to the economic crisis, and we present best practices and related guidance. At the end of the client update, we provide an addendum containing a compilation of hedge fund enforcement actions and developments in 2008.
2. Hedge Fund Enforcement Priorities
Senior regulators and prosecutors from the SEC, the Financial Industry Regulatory Authority ("FINRA"), the New York Stock Exchange ("NYSE"), and the New York Attorney General’s Office recently identified their top hedge fund enforcement priorities in 2008–all of which are expected to remain priorities in 2009. They are:
- Rumor mongering;
- Insider trading;
- Private investment in public equity ("PIPE") transactions;
- Portfolio pumping;
- Valuation/Risk of investment;
- Allocation; and
- Predatory short selling and illegal short selling in connection with Regulation M.
B. Rumor Mongering
Rumor mongering–the act of knowingly creating, spreading, or using false or misleading information with the intent to manipulate securities prices–became a staple of the hedge fund enforcement vernacular in 2008. Bruce Karpati of the SEC’s Hedge Fund Working Group explained why: "from an enforcement and examination perspective, jittery markets . . . can be taken advantage of" by false rumors, with particularly dangerous effects on our markets. Echoing this sentiment, David Markowitz, Chief of New York Attorney General Andrew Cuomo’s Investor Protection Bureau, indicated that, in light of the financial market turmoil and economic crisis, short selling in conjunction with rumors became a hedge fund enforcement priority. Regulators have recognized that, in this economic climate, rumor mongering can lead to the precipitous collapse of even our most venerable institutions. Accordingly, 2008 saw unprecedented efforts to address this issue.
First, the SEC initiated nationwide enforcement investigations into alleged intentional manipulation of securities prices through rumor mongering and abusive short selling. In connection with these investigations, the SEC reportedly issued subpoenas to more than fifty hedge fund advisers and other participants in the securities markets, seeking various trading and communications data. Supplementing these investigations, the SEC, FINRA, and NYSE launched coordinated examinations of broker-dealers and investment advisers, including unregistered hedge fund managers, aimed at preventing the intentional spreading of false rumors to manipulate securities prices.
Only weeks later, the SEC announced a sweeping expansion of its ongoing investigations, stating that the Commission would require hedge fund managers and other investors with significant trading activity in financial issuers or positions in credit default swaps ("CDS") to disclose those positions under oath pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934 ("Exchange Act"). According to Bruce Karpati, the expansion of the investigation to include CDS should not have come as a surprise. Mr. Karpati noted that it is appropriate to be "very much focused" on this area because false rumors can "affect a company’s credit quality," which in turn can affect trading in CDS. Shortly after its announcement, the SEC issued orders under Section 21(a)(1) to more than two dozen hedge funds and sell-side firms. The SEC’s use of this tool–one that had not been broadly used for several years–represented a significant escalation of its enforcement efforts in this area. Notably, Linda Thomsen recently stated that, while she does not believe the SEC will use this tool "every week," "it’s one more tool," and "it’s something [the SEC] will use in the future."
Enter the New York Attorney General’s Office, which similarly launched a wide-ranging investigation into rumor mongering and short selling on Wall Street. Attorney General Andrew Cuomo has said he will use New York’s Martin Act to prosecute any short sellers engaging in any improper conduct, including the spreading of false rumors. (The Martin Act empowers the Attorney General to investigate fraud in the purchase or sale of securities and to bring civil and criminal charges where appropriate.)
Following the trajectory of the SEC’s investigation, David Markowitz recently stated that a "new focus" of the Attorney General’s investigation is CDS. According to Mr. Markowitz, CDS "contributed greatly to the economic situation we’re facing today," and it is a "ripe area for regulatory action" or "at least inquiry." As such, the office is taking a "very comprehensive," "broad-based look" at CDS. In particular, the Investor Protection Bureau is looking at potential manipulation of the CDS market as a way of manipulating the equity market. And the Attorney General’s Office is not working alone: it has partnered with the U.S. Attorney’s Office in Manhattan–a partnership that signals just how comprehensive this investigation is. Thus far, the Attorney General’s Office has sent subpoenas to multiple hedge funds in a wide range of locales, including New York, Texas, and London, among others.
Significantly, these ongoing investigations appear to be international in scope. Bruce Karpati recently observed that many rumors appear to come from overseas trading desks, and the SEC is increasingly working with foreign regulators to combat rumor mongering. The New York Attorney General’s Office and the U.S. Attorney’s Office in Manhattan may similarly be working with foreign authorities. Indeed, it is believed that Attorney General Cuomo partnered with federal prosecutors in recognition of the fact that a comprehensive investigation of these issues requires substantial coordination with foreign sources–a function that the U.S. Attorney’s Office is particularly well suited to perform.
1. SEC v. Berliner
In April 2008, the SEC filed its first ever (and, to date, only) styled rumor mongering case–SEC v. Berliner–which was brought against a former trader with the Schottenfeld Group, a hedge fund. After the Blackstone Group had entered into an agreement to acquire Alliance Data Systems ("ADS") for $81.75 per share, Paul S. Berliner allegedly disseminated a false rumor that read:
ADS getting pounded–hearing the board is now meeting on a revised proposal from Blackstone to acquire the company at $70/share, down from $81.50. Blackstone is negotiating a lower price due to weakness in World Financial Network–part of ADS’ Credit Services unit, as evidence [sic] by awful master trust data this month from the World Financial Network Holdings off-balance-sheet credit vehicle.
Berliner allegedly spread this false rumor through instant messages to thirty-one traders at hedge funds and brokerage firms. According to the complaint, Berliner profited by short selling ADS stock and covering those sales as the false rumor caused the price of ADS stock to fall.
The SEC brought an action in the U.S. District Court for the Southern District of New York, charging Berliner with securities fraud and market manipulation for intentionally disseminating a false rumor. Without admitting or denying the allegations in the complaint, Berliner agreed to settle the charges, and the court entered a judgment that (among other things) ordered him to disgorge $26,129 and pay a civil penalty of $130,000. The SEC separately barred him from associating with any broker or dealer. Commenting on Berliner, Chairman Cox stated: "The message of this case is simple and direct. The Commission will vigorously investigate and prosecute those who manipulate markets with this witch’s brew of damaging rumors and short sales."
2. Comment
While Chairman Cox has acknowledged that it is difficult to pin down the source of market-moving rumors and to prove that rumors are "knowingly false," these enforcement hurdles apparently have not deterred regulators from aiming their collective sights on rumor mongering. Shedding light on what may trigger a rumor mongering enforcement action by the Hedge Fund Working Group, Bruce Karpati said it "comes down to knowledge" and "falsity of information." That is, did the individual have actual knowledge of the information’s falsity? Or did he or she recklessly disregard the falsity of the information? Linda Thomsen suggested that contrived defenses such as, "it’s true that he or she told me [substance of rumor]," would fall into this "recklessness" category and should not be attempted.
The Berliner case is also instructive. Notably, the rumor in Berliner was highly specific and completely (as opposed to partly) false. If Berliner is the SEC’s model for future rumor mongering cases–and Bruce Karpati has suggested that it is–then a rumor’s degree of specificity and falsity may also be a significant factor in whether the Commission brings an enforcement action.
If a client finds himself or herself under investigation for rumor mongering, and if an assessment of these or other pertinent factors shows that a rumor mongering investigation or case is unfounded, Linda Thomsen and Bruce Karpati stated that a presentation should be given to the SEC. According to Mr. Karpati, a presentation in a rumor mongering matter would be "especially . . . beneficial."
C. Insider Trading
Not only was insider trading by hedge funds an enforcement priority in 2008, but, according to Linda Thomsen, it was an issue on which the Hedge Fund Working Group (and other regulators) put a "particular emphasis." Director Thomsen elaborated: "it is clear that there is a widespread public perception of insider trading by hedge funds ahead of the public announcement of significant corporate transactions. This perception, in and of itself, is harmful to the reputation of our markets for fairness and integrity and therefore warranted further investigation–which has been undertaken by our Hedge Fund Working Group."
Two areas of focus that have emerged in connection with insider trading are CDS and PIPE transactions. Bruce Karpati has said that CDS are "ripe for insider trading" because they can be used to "bet on the future outlook of companies"; accordingly, the Hedge Fund Working Group has recognized CDS as a priority. So, too, has the New York Attorney General’s Office, in partnership with the U.S. Attorney’s Office in Manhattan. It should be noted that, as with the rumor mongering enforcement efforts discussed above, the SEC, the New York Attorney General’s Office, and the U.S. Attorney’s Office appear to be working with foreign regulators to combat insider trading in increasingly vigorous ways. The SEC has also brought insider trading cases in connection with PIPE transactions; however, because regulators have identified PIPE transactions as a standalone priority, we discuss this topic separately below.
Apart from these specific focus areas, regulators and prosecutors have continued to name hedge funds and persons associated with them in more traditional insider trading cases. In 2008, there were a number of significant developments on this front.
1. SEC v. Tom
In May 2008, a Massachusetts federal district court entered final judgments by consent against former hedge fund manager Michael K.C. Tom, former investment adviser Global Time Capital Management, and former hedge fund GTC Growth Fund. As alleged in the complaint, this insider trading case arose out of Citizens Bank’s May 2004 announcement that it was acquiring Charter One Financial. A then-Citizens employee allegedly conveyed certain material, nonpublic information relating to this acquisition to Tom, who purchased numerous Charter One call options for his personal account and for the GTC Growth Fund and tipped his brother about Citizens’ acquisition plan. The final judgment permanently enjoined Tom and Global Time Capital Management from future violations of the federal securities laws. In addition, Tom agreed to pay disgorgement of $543,875.07, plus pre-judgment interest of $107,381.63, and a civil penalty of $150,000. Global Time Capital Management agreed to pay a civil penalty of $39,056.93, and GTC Growth Fund agreed to pay disgorgement of $189,868.39, plus pre-judgment interest of $23,145.67.
2. In the Matter of Rubin Chen
In July 2008, the SEC issued an order barring Rubin Chen, a former vice president and head of relative value hedge fund strategies at ING Investment Management Services in New York, from associating with any investment adviser. The order stemmed from actions taken earlier in the month by the U.S. District Court for the Southern District of New York, which entered a final judgment by consent against Chen and his wife, Jennifer Xujia Wang, permanently enjoining them from future violations of the federal securities laws, ordering them to pay disgorgement and pre-judgment interest totaling $784,829, and assessing a civil penalty of $50,000 each. The SEC’s complaint alleged that they obtained illegal profits of $727,733 by trading on the basis of material, nonpublic information concerning various proposed corporate acquisition transactions. The complaint further alleged that Wang, in her position as a vice president of Morgan Stanley, was privy to material, nonpublic information concerning each of the pending acquisitions, which she unlawfully disclosed to Chen. Chen had pleaded guilty to four felony counts, including one count of conspiracy to commit securities fraud, in September 2007.
3. The Mitchel S. Guttenberg Matter
Several significant developments also occurred in connection with SEC v. Guttenberg–billed as the most significant insider trading case since the late 1980s. Alleging two insider trading schemes involving several hedge funds and over $15 million in illicit profits, the SEC brought this civil enforcement action against fourteen defendants in the so-called Wall Street Insider Trading Ring. As part of the scheme, the SEC alleged that Mitchel S. Guttenberg, an executive director in the equity research department of UBS and one of the key participants in the scheme, illegally passed inside information regarding upcoming UBS research reports to others, including Erik R. Franklin, in exchange for sharing in the illicit profits from their trading on that information. Franklin allegedly used the information to make trades for the two hedge funds that he managed. The SEC also alleged that Randi E. Collotta, an attorney who worked in the global compliance department of Morgan Stanley, passed inside information regarding the upcoming corporate acquisitions of Morgan Stanley’s investment banking clients to Marc R. Jurman, a registered representative, in exchange for sharing in Jurman’s profits from trading on that information. The complaint further alleged that Jurman illegally traded on this inside information and passed the information to several downstream tippees who also traded on it, both for themselves and for hedge funds under their management.
In September 2008, a number of the defendants settled the SEC’s insider trading charges. These defendants were permanently enjoined from violating the federal securities laws and ordered to pay various disgorgement amounts ranging from $4,500 to approximately $2.7 million. Many of them were also barred from associating with any broker, dealer, or investment adviser. With respect to Collotta, the SEC separately issued an order suspending her from appearing or practicing before the Commission as an attorney.
Also, in November 2008, in connection with the parallel criminal case brought by the U.S. Attorney’s Office for the Southern District of New York, Guttenberg was sentenced to six-and-a-half years in prison after pleading guilty to six counts of conspiracy and securities fraud.
4. Efforts by Foreign Regulators to Combat Insider Trading
a. The Steven Harrison Matter
In September 2008, a settlement was reached in what the U.K. Financial Services Authority ("FSA") has called its first ever credit market abuse case. The FSA alleged that Steven Harrison, a former hedge fund manager at Moore Europe Capital Management, was provided with inside information about the refinancing plans of Rhodia, which he illicitly passed onto a colleague with instructions to buy. Under the settlement, Harrison agreed not to act as a fund manager or trader for twelve months and to pay a $92,500 fine. In setting this penalty, the FSA considered several notable factors. The FSA found that Harrison’s conduct was not deliberate, he made no direct personal profit from these activities, and he cooperated with the FSA’s investigation. The FSA also took into account the impact of the twelve-month restriction to which Harrison agreed. Significantly, the FSA sanctioned the former hedge fund manager even though it apparently could not prove that he knew he possessed inside information when trading took place and even though he did not appear to profit from the trades.
b. The Porsche Matter
In October 2008, Germany’s financial regulator, BaFin, announced that it will investigate whether the dramatic price moves seen in Volkswagen’s share price were due to market manipulation in general or insider dealing in particular. As reported in the press, Volkswagen’s share price more than quadrupled after it was revealed that Porsche had built up a much larger stake in Volkswagen than had previously been thought. This reportedly caused hedge funds that believed its price would fall to close out their short positions and scramble to buy up the small amount of free-float shares available. As a result, news reports noted, Volkswagen’s share price surged, briefly making it the world’s largest company by market capitalization. Shortly thereafter, its price fell dramatically, reportedly losing forty-five percent on October 29, 2008. BaFin has not yet identified any targets of its investigation.
5. Comment
In addition to being an enforcement priority, insider trading by hedge funds is a key examination priority. From an examination perspective, the SEC has said it will focus on "the adequacy of policies and procedures, information barriers, and controls to prevent insider trading and leakage of information including the identification of sources of material non-public information, surveillance, physical separation, and written procedures." Thomas Biolsi of the SEC recently emphasized that, in addition to these factors, he and his team will check to see whether a company has a code of ethics, and whether the policies and procedures in place are actually being followed. Clients are encouraged to review carefully their insider trading policies and procedures, paying particular (but not exclusive) attention to these express focus areas.
D. PIPE Transactions
For the past few years, the SEC has focused significant attention on the use of shares acquired in PIPE offerings to cover short sales of the publicly traded stock, and Linda Thomsen has made clear that PIPE transactions will remain a hedge fund enforcement priority going forward.
In a PIPE offering, a public company issues unregistered securities to private investors, including hedge funds. The public company commits to investors that, within a short time following their investment, it will file a registration statement and register the shares that were sold in the PIPE with the SEC. Absent effective SEC registration, investors’ public resales of shares generally must be effected in accordance with Rule 144 under the Securities Act of 1933 ("Securities Act").
When the issuance of restricted shares in a PIPE offering is publicly announced, the price of the PIPE issuer’s publicly traded stock typically declines. Given this dynamic, PIPE investors often attempt to reduce their risk by selling short the PIPE issuer’s publicly traded securities. To cover their short positions, certain investors choose to wait until the SEC declares a PIPE resale registration statement effective and then use their previously restricted PIPE shares to close out their short positions.
The SEC has taken the position that this strategy violates the federal securities laws. Specifically, the SEC has advanced two legal theories in response to this conduct. First, the SEC has claimed that these short sales constitute insider trading violations. This argument is premised on the view that the public announcement of a PIPE offering will cause a decline in the market price of the issuer’s publicly traded stock, thereby permitting the investor to profit wrongfully from confidential, pre-announcement information about the PIPE offering. Second, when investors cover their pre-effective date short positions with the actual shares received in the PIPE, the SEC has claimed that investors have engaged in the sale of unregistered securities in violation of Section 5 of the Securities Act. This contention is based on the view that shares used to cover a short position are deemed to have been sold when the short sale was made (i.e., when they were still unregistered).
1. The Commission’s Section 5 Theory Sees Defeat–For Now
In January 2008, two federal district courts weighed in on the SEC’s legal theories. Both courts ruled that the SEC’s insider trading theory constituted a plausible legal basis upon which the SEC could continue to litigate its case. But the SEC’s Section 5 theory met a different fate, with both courts rejecting and dismissing the theory as legally deficient. In a subsequent action, the SEC advanced only its insider trading theory. Notwithstanding these adverse rulings and the SEC’s recent decision to press only its insider trading theory, the SEC has indicated that it does not plan to abandon its Section 5 theory.
a. SEC v. Lyon
In SEC v. Lyon, the Commission filed an enforcement action in the U.S. District Court for the Southern District of New York against Edwin Buchanan Lyon, a hedge fund manager, and seven hedge funds for short sales involving thirty-five PIPE offerings. The SEC brought insider trading claims, arguing that the defendants were selling short the securities of certain PIPE issuers prior to the public announcement of the PIPE while using nonpublic information they received when being solicited to invest in the PIPE, notwithstanding their agreement to keep such information confidential or refrain from trading prior to the public announcement of the PIPE. The SEC also pressed its Section 5 claim, contending that the defendants caused an unregistered distribution of securities when they covered their short sales with shares purchased in the PIPE offerings.
In a January 2008 opinion, the court declined to dismiss the SEC’s insider trading claims. The court first observed that the complaint appeared to be based on the misappropriation theory of insider trading, which states that a person commits securities fraud "when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information." The court then held that the complaint "alleged facts with the requisite specificity that plausibly support its claim that a confidential relationship arose between defendants and [the] PIPE issuers." The court reasoned that, by selling short the PIPE issuers’ securities, the defendants may have breached this confidential relationship. Thus, the court concluded, the SEC had set forth a plausible claim for insider trading.
But the court rejected as "logical[ly] implausibl[e]" the SEC’s Section 5 theory that delivering the previously restricted PIPE shares to close a short position transforms the short sale into a sale of the unregistered securities. This position, the court observed, is "inaccurate and not reflective of what occurs in the market." The court concluded that "a short sale of a security constitutes a sale of that security" and "[h]ow an investor subsequently chooses to satisfy the corresponding deficit in his trading account does not alter the nature of that sale."
b. SEC v. Berlacher
In SEC v. Berlacher, the SEC filed suit in the U.S. District Court for the Eastern District of Pennsylvania against a hedge fund operator, Robert A. Berlacher, and his group of funds, known as the Lancaster Funds. The allegations in Berlacher materially reflect those in Lyon, and the SEC likewise advanced its insider trading and Section 5 theories. The court in Berlacher, following Lyon‘s reasoning, similarly allowed the SEC’s insider trading claims to proceed but dismissed its Section 5 claim.
c. SEC v. Ladin
In October 2008–following these adverse rulings on the SEC’s Section 5 theory–the Commission filed a settled enforcement action in the U.S. District Court for the District of Columbia, charging Brian D. Ladin, a former analyst for Bonanza Master Fund, a Dallas-based hedge fund, with improper PIPE-related trading. The allegations are similar to those in Lyon and Berlacher, yet the SEC alleged only that Ladin engaged in unlawful insider trading in connection with a 2004 PIPE offering. Ladin agreed to settle the matter, and the court entered a final judgment permanently enjoining him from future violations of the federal securities laws, ordering him to pay $10,895 in disgorgement, along with $2,532 in pre-judgment interest thereon, and assessing a $317,000 civil penalty. Bonanza and its investment adviser consented to the entry of a final judgment ordering them to pay a total of $371,429 in ill-gotten gains.
2. Comment
Including SEC v. Mangan–a 2007 case that fits the mold of Lyon and Berlacher–the SEC’s Section 5 theory has seen defeat in three different federal district courts. Given this adverse case law, Linda Thomsen recently conceded that the SEC’s Section 5 theory is "not doing well in the courts." Director Thomsen quickly added, however, that the Commission’s insider trading theories "still work." Consistent with that assessment, the SEC in Ladin appeared to advance only its insider trading theory. Recently, however, Gibson Dunn learned through its network of relationships that the SEC does not plan to give up on its Section 5 theory, though the SEC did not specify what it intends to do or when it intends to act. The SEC could appeal the dismissal of its Section 5 claim once its insider trading claims are resolved in the ongoing Mangan, Lyon, or Berlacher litigation. The SEC, rather than its staff, could also issue clarification or guidance on this issue. What is clear, however, is that regulators will continue to scrutinize hedge funds’ trading practices in PIPE offerings, and hedge funds therefore should be particularly attentive to the substantial risks that are presented by the conduct at issue in these cases.
3. The Hilary L. Shane Matter–Use of a Deferred Prosecution Agreement
Although the federal litigation involving the SEC’s insider trading and Section 5 theories received much attention in 2008, a less noticed but significant development occurred in August 2008 when the U.S. Attorney’s Office for the Southern District of New York struck a deferred prosecution deal with Hilary L. Shane, a former hedge fund manager, who had been indicted in 2006 on five counts of insider trading in connection with a PIPE transaction. This appears to be the first use of a deferred prosecution agreement in the PIPE context. The criminal case stemmed from a settled SEC civil action against Shane for entering into short sales, both for herself and the hedge fund she managed, while also taking part in a PIPE offering. Among other things, the SEC claimed that Shane engaged in insider trading by entering into short sales ahead of the issuer’s public announcement of the PIPE transaction after agreeing to keep the information confidential. In pertinent part, the 2008 deferred prosecution agreement reads: "after a thorough investigation it has been determined that the interest of the United States and your own interest will best be served by deferring prosecution in this District. Prosecution will be deferred during the term of your good behavior and satisfactory compliance with the terms of this agreement for a period of six months . . . ." Under the terms of the agreement, Shane must (among other things) refrain from associating with an investment adviser and pay a $50,000 fine. If Shane complies, the government is expected to dismiss her 2006 indictment on insider trading charges. Shane, who had pleaded not guilty, had faced up to one hundred years in prison if convicted on all five counts.
E. Portfolio Pumping
According to Bruce Karpati, the Hedge Fund Working Group has focused on attempts by hedge fund personnel to "inflat[e] performance during a desperate situation." In particular, the SEC has brought enforcement actions based on portfolio pumping or "marking the close"–where a hedge fund buys large quantities of thinly traded securities to boost fund asset values at the end of a reporting period. In 2008, portfolio pumping firmly established itself as a priority on the SEC’s hedge fund enforcement agenda based on the view (articulated by Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations) that, "in times of financial strain, people may act in uncharacteristic ways–in order to conceal losses, [or] inflate revenues or profits, to stay in business or just to avoid delivering bad news."
1. SEC v. Lauer
In September 2008, a federal district judge in Florida granted the SEC’s motion for summary judgment against the architect of a massive billion dollar hedge fund fraud involving portfolio pumping. According to the SEC’s complaint, Michael Lauer lied about the performance and net asset value of three hedge funds that he created. As alleged in the complaint, Lauer systematically manipulated the month-end closing prices of certain securities held by the funds to overstate the value of their holdings in virtually worthless companies. For example, in December 2002, at the end of the last trading day of the year, Lauer allegedly placed two orders for Fidelity First stock, which artificially raised the price of the stock to $5.00 a share. Lauer then valued all of the funds’ Fidelity First stock holdings at $5.00 per share. Among other things, the summary judgment order found that Lauer manipulated the prices of several securities and materially overstated the hedge funds’ valuations for a number of years. The court permanently enjoined Lauer from future violations of the federal securities laws but reserved ruling on the SEC’s claim for disgorgement and similar matters. The Commission is seeking disgorgement and penalties totaling more than $50 million.
Earlier, the U.S. Attorney’s Office for the Southern District of Florida indicted Lauer on one count of conspiracy to commit mail, wire, and securities fraud and six counts of wire fraud. If convicted, Lauer reportedly could face a maximum sentence of twenty years and a $250,000 fine for each count of wire fraud, and five years and a $250,000 fine for the conspiracy count.
2. The MedCap Matter
In October 2008, the SEC charged San Francisco investment adviser MedCap Management & Research ("MMR") and its principal, Charles Frederick Toney, Jr., with reporting misleading results to hedge fund investors by engaging in portfolio pumping. Toney, through MMR, is the manager of MedCap Partners ("MedCap"), a hedge fund that reportedly suffered dramatic losses throughout 2006. In an effort to report favorable news to the fund’s investors, Toney–through a separate fund he managed–allegedly placed large orders for a thinly traded stock in which MedCap was heavily invested. According to the administrative complaint, because the stock represented over a third of MedCap’s holdings, the brief boost in its price inflated the reported value of the MedCap fund from approximately $9 million to $38 million. Toney allegedly reported to MedCap’s investors that the fund’s performance was improving without disclosing the reason for this bounce. Without admitting or denying the Commission’s findings, MMR and Toney agreed to cease and desist from violating the federal securities laws. MMR disgorged $70,633.69 and received a Commission censure. Toney was also ordered to pay a $100,000 penalty and was barred from associating with any investment adviser, with the right to reapply after one year.
3. Comment
Given the heightened regulatory concern that portfolio managers may engage in portfolio pumping to boost fund performance or enhance their fees, clients are encouraged to review their written policies and procedures that pertain to conflicts of interest. In particular, those policies that relate to self-dealing conflicts should specifically identify portfolio pumping as a concern and clearly prohibit it. In addition, clients should ensure that they have systems in place to capture and evaluate trading data that could be construed to constitute portfolio pumping.
F. Valuation/Risk of Investment
According to Bruce Karpati, another enforcement priority for the Hedge Fund Working Group is valuation, with a particular focus on how the risk of underlying investments is disclosed to investors. Mr. Karpati indicated that the "trend" is to look for instances where "hedge fund managers l[ie] about value." Linda Thomsen and Mr. Karpati recently suggested that the following matters illustrate the kinds of cases that the SEC is looking to bring in this area.
1. SEC v. Lauer
As discussed above, in September 2008, a Florida federal court granted the SEC’s motion for summary judgment against Michael Lauer. The SEC alleged, among other things, that Lauer lied about the net asset value of three hedge funds that he created and provided unfounded and unrealistic valuation opinions to the auditor of one of the funds. Lauer’s groundless valuations were allegedly designed to attract new investors to invest and induce actual investors to forgo redemptions and continue investing in the funds–with the objective of generating increased management fees. The summary judgment order found that Lauer materially overstated the hedge funds’ valuations for a number of years and failed to provide any basis to substantiate or explain his exorbitant valuations. The order permanently enjoined Lauer from future violations of the federal securities laws. The SEC’s claim for disgorgement and penalties remains pending, as do criminal charges brought earlier in the year by the U.S. Attorney’s Office for the Southern District of Florida.
2. In the Matter of Don Warner Reinhard
In October 2008, the SEC initiated administrative proceedings against Don Warner Reinhard, the sole owner and president of Magnolia Capital Advisors, a registered investment adviser, charging Reinhard with making false and misleading statements and omissions of material fact to investors in connection with the offer and sale of collateralized mortgage obligations. According to the SEC’s complaint, Reinhard misrepresented the investment risk associated with the mortgage obligations that he purchased for his clients and for Magnolia Capital Partners, a hedge fund he controlled. The complaint also alleges that Reinhard provided clients with false quarterly account statements that materially inflated their account valuations. The action is currently pending.
3. Comment
Not only is valuation an enforcement priority, it is also an examination priority. Lori Richards has said this is an "important area," and she and Thomas Biolsi recently made clear that SEC examiners will continue to focus on firms’ valuation controls. Clients should therefore take proactive measures in this area, including (among other things):
- Ensuring that their valuation policies and procedures are well designed and effective;
- Confirming that the individuals involved in valuing products have the requisite seniority and expertise; and
- Verifying that the process used to value products is marked by independence and objectivity.
G. Allocation
Bruce Karpati recently stated that "favoritism in allocations" is an enforcement priority of the Hedge Fund Working Group. With respect to this issue, Mr. Karpati indicated that the SEC is focused on the following questions: "How are investors treated?" "Are hedge fund principals given an advantage over other hedge fund investors?" "Is preferred status given?" Mr. Karpati added that, at bottom, allocation "is a matter of disclosure."
1. SEC v. Dawson
In September 2008, the SEC filed a complaint in the U.S. District Court for the Southern District of New York against James C. Dawson, an investment adviser to a hedge fund, Victoria Investors, and to individual clients. The Commission’s complaint alleges that Dawson cherry-picked profitable trades for his own account, thereby harming his clients and unjustly enriching himself at their expense. Dawson allegedly conducted this scheme by purchasing securities throughout the day in a single account and delaying the allocation of the purchases until later in the day, after he saw whether the securities appreciated in value. According to the complaint, Dawson allocated approximately 400 trades to his personal account, approximately 393 of which were profitable on the first day, for a success rate of approximately ninety-eight percent; in contrast, of the 2,880 trades Dawson allocated to his clients during the same time, only 1,489 were profitable on the first day, for a success rate of approximately fifty-two percent. Dawson allegedly did not tell Victoria Investors or his individual clients about this allocation process. The complaint further alleges that Dawson used his hedge fund clients’ assets to pay for personal expenses without the clients’ knowledge. Among other things, the Commission is seeking disgorgement and an order permanently enjoining Dawson from violations of the federal securities laws.
2. Comment
Although only one allocation case appears to have been brought in 2008, investigations may very well be underway. Equally important, fund allocation is an examination priority. Calling this a "focus area," Lori Richards has indicated that "[e]xaminers are looking for cherry-picking and favoritism in allocations to, for example, relatives, high profile clients, clients with performance-fee accounts, or other clients that the adviser may have an incentive to benefit."
Accordingly, hedge fund advisers are encouraged to review their fund allocation policies and procedures to ensure that the full range of potential conflicts is addressed. Among other things, hedge fund advisers should also confirm that those policies and procedures are designed to ensure–and actually produce–equitable allocation among different funds and managed accounts.
H. Predatory Short Selling and Illegal Short Selling in Connection with Regulation M
Recently, Linda Thomsen of the SEC and David Markowitz of the New York Attorney General’s Office stated that "predatory short selling" and "illegal short selling in connection with Regulation M" are top hedge fund enforcement priorities. In September 2008, the SEC brought two enforcement actions in this area.
1. In the Matter of Moon Capital Management
The SEC initiated administrative proceedings against Moon Capital Management, a registered investment adviser, alleging that it violated Rule 105 of Regulation M when it sold securities short on behalf of one of the hedge funds it advises during the five business days before the pricing of an offering and then covered the short positions with securities purchased in the offering. According to the SEC, this resulted in $88,100 in illicit profits for the hedge fund. The Commission censured Moon Capital, required it to cease and desist from committing or causing any violations of Rule 105 of Regulation M, and directed it to disgorge $88,100 (plus pre-judgment interest of $20,971.67) and pay a $30,000 civil penalty.
2. SEC v. Victoire Finance Capital
The SEC brought administrative proceedings against Victoire Finance Capital, alleging that the hedge fund adviser violated Rule 105 of Regulation M on eighteen occasions by selling securities short within five business days before the pricing of the offering and covering the short sale, in whole or in part, with shares purchased in the offering. The SEC alleged that these violations generated profits of $168,139.50 for Victoire Finance et Gestion, B.V., the offshore hedge fund that Victoire Finance Capital advises. The Commission censured Victoire Finance Capital, required it to cease and desist from committing or causing any violations of Rule 105 of Regulation M, and directed it to disgorge $168,139.50 (plus pre-judgment interest of $47,491.53) and pay a $85,000 civil penalty.
I. A Shift in Focus–Soft Dollars and Late Trading/Market Timing
As the SEC and other regulators grappled with the economic crisis and the enforcement issues flowing from it, previous front-and-center issues affecting money managers became less of a focus. Two such issues were (1) soft dollar practices and (2) late trading/market timing. At the November 24, 2008 Practising Law Institute conference on hedge fund enforcement, neither issue was identified by senior regulators or prosecutors as a top priority going forward. While these issues may have abated somewhat as enforcement priorities, clients should nonetheless remain mindful of them and review their policies and practices to prevent potentially problematic activities.
1. Soft Dollars
Among other things, the term "soft dollars" generally refers to an arrangement by which a discretionary investment manager, including a hedge fund manager, receives brokerage or research services in addition to trade executions from a broker-dealer in exchange for brokerage commissions. Congress established a conditional safe harbor pursuant to Section 28(e) of the Exchange Act, which, in general, protects money managers from charges of breach of fiduciary duty that might be alleged because the manager paid more than the lowest possible commission on a client transaction in order to receive certain brokerage and research services from the executing broker-dealer. A number of issues can arise for hedge fund managers who participate in soft dollar arrangements, including whether adequate disclosure has been made to investors, whether the services received are consistent with such disclosures and whether they are expenses of the manager or the funds, and any quid pro quo or conflicts with the manager’s duty of best execution.
FINRA–Proceedings Against SMH Capital
In January 2008, FINRA announced that it had fined Texas-based SMH Capital $450,000 for inadequate supervisory procedures and systems that allowed improper payments of $325,000 in soft dollars to a hedge fund manager. In pertinent part, FINRA found that SMH sent two improper soft dollar payments to a hedge fund manager, who had submitted facially suspicious invoices requesting one check for $75,000 to an individual for "consulting services" and a second check for just under $250,000 to the manager for "research expense reimbursement"–all without any additional detail or documentary support. In addition to the fine, FINRA ordered SMH to retain an independent consultant to review the firm’s policies and procedures with regard to its hedge fund operations.
2. Late Trading/Market Timing
In previous years, the SEC focused much of its enforcement attention on late trading and market timing by and on behalf of hedge funds. But in 2008, these issues appeared to fade somewhat, particularly as the year progressed and the economic crisis deepened.
a. SEC v. Chronos Asset Management
In January 2008, the SEC issued an order instituting administrative and cease-and-desist proceedings against hedge fund adviser Chronos and its principal Mitchell L. Dong, finding that they engaged in a fraudulent market timing and late trading scheme. The SEC found that they used deceptive means to continue market timing in mutual funds that had previously attempted to detect and restrict Chronos’s trading. The SEC also found that Chronos late traded through two broker-dealers, which routinely allowed Chronos to communicate orders to purchase and sell mutual fund shares after mutual fund companies calculated their daily net asset value. Chronos’s late trading arrangements thus allowed the traders to purchase or sell mutual fund shares at prices set as of the market close with the benefit of after-market information, thereby giving Chronos a competitive advantage. The SEC’s order, among other things, censured Chronos, suspended Dong from associating with an investment adviser or investment company for twelve months, and directed Chronos and Dong to pay disgorgement in the amount of $303,000, plus $73,915.80 in pre-judgment interest, and a civil money penalty in the amount of $1,800,000.
b. In the Matter of Ritchie Capital Management
Following on an investigation by New York Attorney General Andrew Cuomo, the SEC initiated administrative proceedings against a hedge fund, Ritchie Multi-Strategy Global Trading, its investment adviser, Ritchie Capital Management, and the firm’s founder and two employees. In its February 2008 order settling the proceedings, the SEC found that Ritchie Capital engaged in an illegal late trading scheme in which it placed thousands of trades in mutual fund shares after the markets had closed, allowing it to trade in mutual funds at pre-close prices based on post-close information. The Commission ordered the hedge fund and adviser firm to pay approximately $40 million in disgorgement, interest, and penalties.
In a related action, the SEC settled administrative proceedings against Michael Mauriello, the Ritchie Capital employee who was primarily responsible for placing late trades on behalf of the hedge fund adviser.
c. SEC v. Pentagon Capital Management
In April 2008, the SEC filed a civil action in the U.S. District Court for the Southern District of New York against a U.K.-based hedge fund adviser, Pentagon Capital Management ("PCM"), and its chief executive officer, Lewis Chester, for allegedly defrauding U.S. mutual funds through late trading and deceptive market timing. As alleged in the SEC’s complaint, PCM and Chester routinely engaged in late trading of U.S. mutual funds. PCM allegedly placed orders to buy, redeem, or exchange mutual fund shares after the market close while still receiving the current day’s mutual fund price, thereby generating unlawful profits–at the expense of other shareholders in the U.S. mutual funds–from after-market events that were not reflected in the price that was paid for the mutual fund shares. In addition, PCM and Chester also allegedly used deceptive techniques to market time U.S. mutual funds. For example, PCM allegedly used multiple accounts so that, when a U.S. mutual fund detected market timing and attempted to stop it, PCM would simply transfer funds to a different brokerage account of which the U.S. mutual fund was unaware, and market timing the same mutual fund would then resume. This matter is currently pending.
d. SEC v. Headstart Advisers; SEC v. Gabelli and Alpert
In April 2008, the SEC brought a civil action in the U.S. District Court for the Southern District of New York against a U.K.-based hedge fund adviser, Headstart Advisers, and its "Chief Investment Adviser," Najy Nasser, for allegedly defrauding U.S. mutual funds through late trading and deceptive market timing. The allegations are strikingly similar to those in SEC v. Pentagon Capital Management, above. This matter is currently pending.
In a related action, the SEC sued Marc J. Gabelli, the former portfolio manager of the Gabelli Global Growth Fund ("GGGF"), currently known as GAMCO Global Growth Fund, and Bruce Alpert, chief operating officer of GGGF’s adviser, Gabelli Funds, in connection with an undisclosed market timing arrangement with Headstart Advisers. The SEC’s complaint alleges that Gabelli authorized Headstart to place market timing trades in GGGF in exchange for a "sticky asset" investment in a hedge fund that he also managed. This action is currently pending in the U.S. District Court for the Southern District of New York.
The Commission simultaneously instituted and settled administrative and cease-and-desist proceedings against Gabelli Funds, a registered investment adviser. Gabelli Funds was censured, ordered to cease and desist its securities law violations, and ordered to pay $9.7 million in disgorgement, $1.3 million in pre-judgment interest, and a penalty of $5 million, for a total payment of $16 million. Gabelli Funds’ payment will be distributed to shareholders harmed by the market timing activity during the relevant period.
e. SEC v. Gann
In 2005, the SEC filed a civil action against Scott B. Gann, a former vice president and stockbroker with Southwest Securities, in the U.S. District Court for the Northern District of Texas. The complaint alleged that Gann took part in a scheme to defraud hundreds of mutual funds and their shareholders by engaging in deceptive market timing practices on behalf of a hedge fund client, for whom he opened multiple accounts and used multiple registered representative numbers to place trades. Following a recent three-day trial, the court concluded that Gann’s actions were "intentionally geared toward evading detection by the mutual fund managers" and constituted "material misrepresentations made in the course of buying securities." In April 2008, the court permanently enjoined Gann from future violations of the securities laws and ordered him to pay disgorgement and pre-judgment interest of $70,209.35, plus a $50,000 civil penalty. The SEC subsequently issued an order instituting administrative proceedings, resulting in a September 2008 order barring Gann from associating with any broker, dealer, or investment adviser.
f. United States v. Beacon Rock Capital and Gerbasio
In May 2008–in connection with the first U.S. criminal case brought against a hedge fund for deceptive market timing–the U.S. District Court for the Eastern District of Pennsylvania sentenced Beacon Rock Capital, a hedge fund located in Oregon, to three years of probation, and entered an order requiring the hedge fund to forfeit $475,905 and pay a fine of $600,000. In addition, Thomas J. Gerbasio, a former registered representative, was sentenced to one year and one day in prison and two years of supervised release, and was ordered to pay a fine of $7,500. According to the information, Gerbasio provided brokerage services to Beacon Rock in order to assist it in evading and circumventing controls implemented by mutual funds seeking to restrict market timing trading. Gerbasio allegedly engaged in a number of deceptive and fraudulent practices designed to conceal the identity of Beacon Rock and the nature of its trading activity, resulting in more than 26,000 Beacon Rock market timing trades. Both Beacon Rock and Gerbasio pleaded guilty to securities fraud.
g. United States and SEC v. Ficken
In September 2008, Justin F. Ficken of Massachusetts pleaded guilty to one count of conspiracy, three counts of wire fraud, and two counts of securities fraud in a market timing case brought by the U.S. Attorney’s Office in Boston. The indictment charged that Ficken and others at Prudential Securities disguised their own and their hedge fund customers’ identities to execute market timing trades that mutual funds were trying to prohibit. The SEC earlier filed a civil injunctive action against Ficken and others based on similar conduct. As alleged in the SEC’s complaint, Ficken was part of a three-person group of registered representatives, known as the Druffner Group, that defrauded mutual fund companies and the funds’ shareholders by placing thousands of market timing trades worth more than $1 billion for five hedge fund customers. In September 2007, the U.S. District Court for the District of Massachusetts entered a final judgment against Ficken after granting the Commission’s motion for summary judgment (which was recently upheld on appeal). The final judgment enjoined Ficken from future violations of the federal securities laws and ordered him to pay $589,854 in disgorgement and pre-judgment interest.
Also, in February 2008, an administrative law judge issued an initial decision barring Ficken from associating with any broker, dealer, or investment adviser. Ficken has appealed that decision to the Commission, and that appeal is pending.
J. Conclusion
At this time, the hedge fund enforcement landscape appears relatively clear. Regulators and prosecutors have been transparent in identifying their priorities. Still, there are questions concerning the specific ways in which regulators will move forward in pursuing them. For example, will regulators bring rumor mongering cases with facts that are less compelling than those in Berliner–perhaps one where the rumor at issue is general or vague? Will the SEC reinvigorate its Section 5 PIPE theory? If so, what specific form will the Commission’s efforts take? Questions abide. In navigating these and similar issues, regulators will need to ensure that the specific enforcement positions they take do not unduly chill appropriate and important hedge fund (and other) activities that constitute a key component to the sound and efficient functioning of our securities markets.
And while regulators’ enforcement priorities seem clear now, those priorities can change suddenly and dramatically. Consider the Bernard L. Madoff scandal. In December 2008, the SEC and the U.S. Attorney’s Office in Manhattan brought concurrent civil and criminal actions against Madoff and his investment firm, charging Madoff with orchestrating a Ponzi scheme through which he defrauded his hedge fund clients and other investors out of billions of dollars. For years, Madoff’s scheme apparently escaped the attention of regulators, including the SEC and FINRA. The SEC has come under fire for not uncovering the Madoff scandal until his sons went to authorities and told them he had confessed to the fraud. Indeed, on January 5, 2009, the House Committee on Financial Services held a hearing to examine how a scheme of this magnitude could have gone undetected for so long, whether the SEC has the resources to police the markets effectively, and what new safeguards may be needed to protect investors.
From an enforcement and examination perspective, the fallout from the Madoff scheme and regulators’ failure to detect it will almost certainly cause the Commission to step up and revamp its examination of investment advisers and oversight of those that are unregistered. Whether, and to what extent, these expected efforts detract from or augment the SEC’s identified enforcement priorities should be a compelling story line in 2009.
II. Regulatory Developments and Compliance Considerations
The significant regulatory developments affecting hedge funds in 2008 were largely actions by the SEC and other authorities in response to the financial markets crisis. Other developments, such as the best practices developed by the Asset Managers’ Committee ("AMC") of the President’s Working Group on Financial Markets ("PWG") and statements on "group" determinations following the CSX Corporation v. The Children’s Investment Fund Management decision, should also be considered when reviewing compliance programs and procedures. Summarized below are:
- The SEC’s rulemakings relating to curbing abusive short selling activities;
- FINRA’s proposed new Rule 2030 relating to the circulation of rumors, which if adopted in its current form would significantly curtail the flow of information between broker-dealers and their customers;
- The SEC’s exemptive orders to facilitate the development of central counterparties ("CCPs") for CDS;
- Potential changes to beneficial ownership and group determinations;
- Proposed disclosure obligations pursuant to Form ADV relating to, among other things, use of commissions by hedge fund managers who are registered investment advisers; and
- The AMC’s suggested best practices for hedge funds.
1. Initial SEC Response to the Evolving Financial Crisis
From July 15, 2008 through October 15, 2008, the SEC issued an unprecedented six emergency orders pursuant to Section 12(k)(2) of the Exchange Act relating to short selling. In July, the SEC issued its first order, which banned short selling in the specified securities of nineteen financial firms absent pre-borrowing or arranging to borrow. See Exchange Act Release No. 58166 (July 15, 2008), available here. In September, the SEC banned short sales in the publicly traded securities of 799 financial firms, and that number increased to nearly 1000 public companies as the SEC delegated responsibility for determining "financial firms" to the primary listing exchanges. See Exchange Act Release No. 58592 (Sept. 18, 2008), available here.
In addition, the SEC adopted two rules of particular significance to hedge funds:
- New interim final temporary Rule 10a-3T and Form SH, which requires certain institutional investment managers to report certain information concerning their short sales of and short positions in Exchange Act Section 13(f) securities (other than options). See Exchange Act Release No. 58785 (Oct. 15, 2008), available here; and
- Previously proposed Exchange Act Rule 10b-21, which is intended to address abusive "naked" short selling. See Exchange Act Release No. 58774 (Oct. 14, 2008), available here.
The SEC also adopted new interim final temporary Rule 204T of Regulation SHO, which imposes hard close-out requirements for fails to deliver on long and short sale transactions, see Exchange Act Release No. 58773 (Oct. 14, 2008), available here, and an amendment to Rule 203 of Regulation SHO to eliminate the options market maker exception from the close-out requirement for failures to deliver resulting from short sales to hedge options positions established before the underlying securities became threshold securities, see Exchange Act Release No. 58572 (Sept. 17, 2008), available here.
2. Reporting Requirements: Interim Final Temporary Rule 10a-3T and Form SH
Interim final temporary Rule 10a-3T requires certain "institutional investment managers" to report on temporary Form SH certain information concerning their short sales of and short positions in Exchange Act Section 13(f) securities (other than options). Rule 10a-3T and Form SH were effective from October 18, 2008 and are effective until August 1, 2009, unless extended. The key elements of the reporting requirements are as follows:
a. Institutional Investment Managers Required to Report
An institutional investment manager who exercises investment discretion with respect to accounts holding Section 13(f) securities is required to file Form SH if: (i) at the end of the most recent calendar quarter it was required to file a Form 13F for the quarter (i.e., the manager exercised investment discretion with respect to accounts holding Section 13(f) securities having an aggregate fair market value on the last trading day of any month of the prior calendar year of at least $100,000,000), and (ii) it effected a short sale in a Section 13(f) security (other than options) during a Sunday to Saturday calendar week.
b. Definitions of "Short Sales" and "Short Positions"
For purposes of Rule 10a-3T, "short sale" has the same meaning as under Rule 200 of Regulation SHO: "any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller." A "short position" for purposes of Form SH is the aggregate gross short sales of an issuer’s Section 13(f) securities (other than options), less purchases to close out a short sale in the securities of the same issuer. Short positions are not net of long positions.
If a manager sells a security that was loaned to another person, and a bona fide recall is initiated within two business days of trade date (T+2), the sale should be treated as "long" for purposes of Form SH. Options and short sales of options are not reported on Form SH, except that the manager will have Form SH short sales if it: (i) exercises a put option and is net short for purposes of Regulation SHO, or (ii) effects a short sale as a result of assignment to it as a call writer, upon exercise.
c. Public Availability of Information
The SEC has stated that it remains sensitive to concerns about additional, imitative short selling and will treat Form SH as nonpublic "to the extent permitted by law." Filers are not required to submit a Freedom of Information Act confidential treatment request, but should instead label their reports as "non-public" pursuant to the Form SH instructions (i.e., in bold, capitalized letters).
d. Exceptions to the Reporting Requirements
An institutional investment manager is not required to report short sales and short positions if: (i) it has not effected any short sales of Section 13(f) securities during the relevant reporting period; or (ii) its short positions or short sales are de minimis. In the first case, this means that even if an institutional investment manager reported for prior periods, it does not need to file a Form SH for any week in which it effected no short sales even if it has short positions.
In the second case, for purposes of Form SH reporting requirements, de minimis means that (i) during the reporting period, the start of day short position, the gross number of securities sold short during the day, and the end of day short position constitute less than 0.25 percent of the class of the issuer’s Section 13(f) securities issued and outstanding, and (ii) the fair market value of the start of day, the gross number of securities sold short during the day, and the end of day short position is less than $10,000,000. The analysis is made on a per column and per day basis, and the manager may report "N/A" for any data element where the exception is available. Managers are no longer able to exclude short positions attributable to short sales effected before September 22, 2008.
e. Required Information; Formatting Requirements
Managers required to file Form SH must report for each 13(f) security and for each calendar day of the reporting period: (i) the gross quantity of shares sold short, (ii) the start of day short position, and (iii) the end of day short position.
Certain information must be submitted in XML tagged data format with additional identification within the data file; i.e., the date, the filer’s Central Index Key, the identity and CUSIP number of the issuer, the short position at the start of the day, the number of securities sold short on that day and the short position at the end of the day. The formatting requirements are intended to facilitate data analysis by the SEC staff. The report must contain a signature block for the person signing on behalf of the manager and additional information about the report type (see below) and managers covered.
Similar to Form 13F, there are three Form SH report types: (i) a Form SH Entries Report, used if all of the information an institutional investment manager is required to report is included in the Form SH filing; (ii) a Form SH Notice, used if all of the information a manager is required to include is reported in another manager’s report; and (iii) a Form SH Combination Report, used if a portion of the manager’s entries is filed in the manager’s report and a portion is reported by another manager. A manager that files a Form SH Combination must identify the other manager whose reports cover a portion of the filing manager’s entries.
g. Timing
Each Form SH is due on the last business day of the calendar week subsequent to a week in which reportable short sales were effected.
h. Request for Comment
Although adopted on a final, albeit interim temporary, basis, Rule 10a-3T and Form SH were published for comments, which were due December 16, 2008. To date, approximately fifty commenters have submitted their views to the SEC. Naturally, the comments vary based on the particular perspectives of those commenting on behalf of persons who are deemed "institutional investment managers" and required to report, and those commenting on behalf of issuers, but key themes are:
- Public Availability of Information. Not surprisingly, comments on behalf of issuers continue to press for public availability of short sale information, at least on a delayed basis. On the other hand, those commenting on behalf of broker-dealers and hedge funds have expressed concern that disclosure of short sale and short position information could, among other things, (i) cause competitive harm, including through front-running and short squeezes, to market participants required to disclose their short positions and possibly their trading strategies; (ii) shift trading to less transparent markets; (iii) confuse investors who will have only partial information and no way to distinguish between short selling effected for hedging purposes and short selling related to a negative view on an issuer’s outlook; and (iv) encourage short selling by those who trade by imitating others’ positions.
- Scope of Covered Securities. Generally, there has been no push to expand the scope of reporting requirements beyond Section 13(f) securities, despite discussion in the press about extending the rule to require reporting of derivatives.
- Harmonization of Various Rules. Several commenters recommended that the SEC attempt to harmonize its new short selling rules with foreign jurisdictions to eliminate the burdens of overlapping and inconsistent disclosure burdens.
- Frequency of Reporting. Comment letters from institutional investment managers have argued that weekly reporting is time-consuming, and quarterly reporting would be less burdensome on investors while still providing the SEC with the information it is seeking.
3. The "Naked" Short Selling Antifraud Rule–Exchange Act Rule 10b-21
Following its proposal in March 2008, see Exchange Act Release No. 57511 (Mar. 17, 2008), available here, the SEC adopted new Rule 10b-21, effective October 17, 2008, to address abusive "naked" short selling. Naked short selling is deemed to occur when a seller of equity securities deceives its broker about its intention or ability to deliver the relevant securities on or before settlement date and fails to deliver securities on or before settlement date.
Rule 10b-21 provides that sellers who knowingly or recklessly misrepresent to their broker that they own the securities being sold "long" or have obtained a locate for securities sold "short" expose themselves to liability for engaging in a "manipulative or deceptive device or contrivance" in violation of Exchange Act Section 10(b). Although the SEC emphasized that, prior to the adoption of Rule 10b-21, it had authority under the Exchange Act over short sellers who are not broker-dealers, and that the rule does not impose any additional liability or requirements, the new rule further evidences the SEC’s direct authority.
Rule 10b-21 poses numerous potential risks for investment managers. For example, a manager’s reckless inaccurate calculations of long and short positions could create liability. Also, recklessly identifying locate brokers to executing brokers (e.g., by programming an execution management system to populate automatically the locate field with the market participant identifier of a prime broker without taking appropriate steps to obtain the required locate from the broker) could expose an investment manager to liability. Rule 10b-21 is not violated, however, by a seller’s good faith reliance on a broker’s "easy to borrow" list to satisfy Regulation SHO’s locate requirements.
Finally, the SEC confirmed that a private right of action exists under Section 10(b) and Rule 10b-5, and that if a plaintiff is able to prove the elements of a Rule 10b-21 violation, an actor in violation of Rule 10b-21 may face private litigation in addition to regulatory sanctions.
C. Controlling and Reporting the Spread of False Rumors
1. Introduction
As described above in Section I.B, "Hedge Fund Enforcement Update–Rumor Mongering," the SEC and Justice Department investigations and examinations of rumor mongering have increased hedge funds’ focus on practices relating to the circulation of false rumors. The dissemination of a false rumor about a security, particularly when accompanied by trading, can result in liability under Section 17(a) of the Securities Act and Sections 9(a)(4) and 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder.
In addition, broker-dealers are subject to self-regulatory organization ("SRO") rules prohibiting the spreading of false and sensational rumors, including National Association of Securities Dealers ("NASD") Rule 6140(e) and NYSE Rule 435(5). On November 18, 2008, FINRA issued Regulatory Notice 08-68 and requested comment on proposed FINRA Rule 2030, which would replace the NASD and NYSE rules as part of its consolidated rulebook initiative. Comments on proposed Rule 2030 were due to FINRA by December 18, 2008, and after processing these comments, FINRA will file its proposed rule with the SEC for approval.
Although proposed Rule 2030 is an SRO rule and directly applicable only to FINRA’s broker-dealer members and their associated persons, it is significant to hedge funds and other industry participants because, as proposed, it requires FINRA members to "promptly report to FINRA any circumstances which reasonably would lead the member to believe that [a prohibited] rumor might have been originated or circulated." The key components of the proposed rule are summarized below.
2. Proposed Rule 2030
a. Scope
Proposed Rule 2030 would prohibit the "originat[ion] or circulat[ion] . . . [of] a rumor concerning any security which the member knows or has reasonable grounds for believing is false or misleading or would improperly influence the market price of such security." (emphasis added). Accordingly, proposed Rule 2030 can be violated when a party circulates an unfounded rumor even if there is no expectation that the rumor would have market impact.
Proposed Rule 2030 would apply to all securities, not just securities reported to the Consolidated Tape.
c. No Safe Harbor for Information Published by Widely Circulated Public Media
FINRA does not propose to include the safe harbor in NYSE Rule 435(5) for unsubstantiated information published by a widely circulated public media even when its source and unsubstantiated nature are disclosed. Whether a media report is considered a rumor under the proposed rule would depend on the degree to which a member may regard the report as substantiated or as likely to be substantiated; however, this uncertainty is of concern to market participants.
Not surprisingly, this proposed change from the existing NYSE rule has drawn considerable criticism. For example, it would seem to eliminate the possibility of a broker being able to point to an article in a mass media publication as a possible explanation for a stock’s price movement or spike in trading volume, even if the broker were to disclaim any knowledge as to the accuracy of the article. At least informally, FINRA has acknowledged the unintended consequences of not allowing references to information contained in widely circulated public media. According to William Jannace, managing director in FINRA’s Member Regulation Group, if information is available in the public market through newspapers or other media, FINRA "probably wouldn’t look to circumscribe that and limit communication." More of Mr. Jannace’s remarks are available here.
d. Reporting
Proposed Rule 2030 would require members promptly to report to FINRA any circumstance that might lead the member to believe that a prohibited rumor might have been originated or circulated. Although many broker-dealers’ procedures currently call for reporting of rumors, the specific requirement in the rule, coupled with the increased regulatory focus, may lead to an increase in the number of rumors reported. Presumably, in circumstances when FINRA does not have jurisdiction over the persons named by the broker-dealer, the information would be relayed by FINRA to the SEC.
3. U.K. Financial Services Authority Approach
The Markets Division of the FSA recently published a Market Watch report, available here, on its findings of the review of the policies for handling rumors of fifty firms, ranging from small funds to large investment banks. While the Market Watch report is specifically disclaimed from being FSA guidance, it does reflect the Markets Division’s views as to good and bad practices for handling rumors and summarizes industry best practices.
In contrast to FINRA’s proposal, the Market Division recognized that legitimate business reasons can exist for disseminating a rumor, such as if a client seeks an explanation for the behavior of a security or the market. Accordingly, the U.K. construct allows broker-dealers to point to news articles, even if unsubstantiated, as a possible explanation for a price change or increased trading volume, provided that (i) the client is also provided, where possible, with the source of the information, (ii) the broker-dealer gives no additional credibility or embellishment to the information, (iii) the broker-dealer makes clear that the information is a rumor, and (iv) the broker-dealer makes clear that the information has not been verified.
4. Compliance Considerations
Among the compliance controls relating to rumors that we have recommended that clients consider, depending on their particular activities and circumstances, are:
- Reviewing existing compliance policies to make sure they clearly prohibit the initiation and circulation of rumors, and require the inclusion of attribution, if appropriate;
- Reminding personnel of the firm’s policies; training them on how to handle the receipt of rumors and other potentially problematic information and encouraging them to notify the appropriate managers on receipt of such information. Bruce Karpati recently commented that personnel should consider phrasing language that potentially could be construed as a rumor as a question (as opposed to a declarative sentence);
- Encouraging personnel to ask supervisors for assistance in handling rumors;
- Considering the use of rumor lists for names that are the subject of rumors, and using such lists as a spot check for any suspicious trading in proprietary, customer, or employee accounts in names on the list;
- Spot checking relevant emails, instant messages, chat rooms, bulletin boards, and other communications for suspicious terms;
- Reviewing lexicons to determine if additional words or terminology should be included;
- Reviewing trading surveillance protocols for inclusion of the securities of issuers who are the subject of rumors to catch potentially manipulative trading;
- Updating compliance policies and supervisory procedures to reflect any changes made; and
- Making and keeping records of how and when any of these steps are taken.
D. Credit Default Swaps
1. Introduction
On November 14, 2008, the PWG announced "a series of initiatives to strengthen oversight and the infrastructure of the over-the-counter ("OTC") derivatives market." The press release is available here.A key component of the PWG‘s initiatives is addressing any regulatory impediments to the development of CDS CCPs, which are viewed as beneficial to reducing the systemic risks associated with counterparty credit exposures in the CDS market.
One challenge has been that each of the Board of Governors of the Federal Reserve System ("Federal Reserve"), the SEC, and the Commodity Futures Trading Commission ("CFTC") have prescribed regulatory responsibilities with respect to CDS. Section 3A of the Exchange Act excludes non-security-based and security-based swap agreements from the definition of "security" in Exchange Act Section 3(a)(10). A "swap agreement" is "any agreement, contract, or transaction between eligible contract participants (as defined in Section 1a(12)(c) of the Commodity Exchange Act . . .) . . . the material terms of which (other than price and quantity) are subject to individual negotiation." 15 U.S.C. § 78c note. Accordingly, the SEC has regulatory authority over CDS that are "non-excluded" products, e.g., products whose terms are standardized to facilitate exchange trading or central clearing and are not individually negotiated.
To address impediments to the development of clearing agencies for CDS in order to increase transparency and reduce systemic risk, on November 14, 2008, the three regulators entered into a Memorandum of Understanding ("MOU") regarding CDS CCPs. The MOU, which is available here, is intended to facilitate the regulatory approval process for CCPs and to promote more consistent regulatory oversight among the three regulators by establishing a framework for consultation and information sharing on issues related to CDS CCPs.
2. SEC’s Temporary Conditional Exemptions for LCH.Clearnet Ltd.
On December 23, 2008, the SEC issued a press release announcing that it had approved, on a seriatim basis, temporary and conditional exemptions allowing LCH.Clearnet Ltd. ("LCH.Clearnet") to operate as a CCP to clear "Cleared Index CDS" (i.e., CDS that (i) are submitted to LCH.Clearnet; (ii) are offered only to, purchased only by, and sold only to eligible contract participants; and (iii) have a reference index in which eighty percent or more of the index’s weighting consists of certain specified entities or securities). See the press release here, and the SEC order here. As a result of these exemptions, LIFFE, the global derivatives business of NYSE Euronext, became the first exchange eligible to offer clearing of CDS contracts. The SEC stated that it developed the temporary exemptions in "close consultation with the [Federal Reserve, the Federal Bank of New York, the CFTC, and the U.K. FSA]" and it is expected that the exemptions will further PWG‘s Policy Objectives for the OTC Derivatives Market. The press release is available here.
The exemptions, which were granted pursuant to Section 36(a) of the Exchange Act until September 25, 2009, consist of:
- A temporary, conditional exemption from the requirement that LCH.Clearnet register as a clearing agency under Exchange Act Section 17A solely to perform the functions of a clearing agency for Cleared Index CDS. Among other things, LCH.Clearnet is required to (i) post on its Web site and provide to the SEC annual audited financial statements, (ii) comply with certain recordkeeping requirements for five years, (iii) supply information about its Cleared Index CDS clearance and settlement services to the SEC, (iv) provide access to the SEC to conduct on-site inspections of its facilities, records, and personnel, subject to coordination with the FSA; (v) provide monthly notice to the SEC of material disciplinary actions, including any denials of services, relating to its Cleared Index CDS clearance and settlement services, (vi) provide the SEC with notice of all changes to its default rules, (vii) provide the SEC with reports relating to its automated systems used in connection with Cleared Index CDS clearance and settlement services, (viii) provide notice to the SEC regarding any suspension of services or inability to operate its facilities for clearance and settlement of Cleared Index CDS; and (ix) make available to the public, on terms that are fair, reasonable, and not discriminatory, all end of day settlement prices and other prices relating to Cleared Index CDS that are established to calculate mark-to-market margin requirements and other pricing or valuation information;
- Broad temporary exemptions from the Exchange Actto encourage market participants to use CCPs to clear CDS transactions, provided that they do not receive or hold funds or securities for the purpose of purchasing, selling, clearing, settling, or holding Cleared Index CDS positions. Generally, this temporary exemption essentially treats Cleared Index CDS as OTC (i.e., excluded) CDS. This exemption does not extend to the antifraud rules, or Sections 5, 6, 12, 13, 14, 15(d), or 16 of the Exchange Act;
- A temporary exemption from broker-dealer registration requirements for certain clearing and non-clearing members of LIFFE Administration and Management ("LIFFE A&M") and LCH.Clearnet without regard to whether they receive or hold funds or securities for the purpose of purchasing, selling, clearing, settling, or holding Cleared Index CDS. Among other things, eligibility for this exemption depends on the LIFFE A&M member complying with the rules of LIFFE A&M and LCH.Clearnet. Notwithstanding the application of "mutual recognition" in this context, the SEC’s proposal to amend Exchange Act Rule 15a-6, which exempts certain foreign broker-dealers from SEC registration is still pending with the SEC. See Exchange Act Release No. 58047 (Jun. 27, 2008), available here;
- A temporary exemption for registered broker-dealers from Exchange Act provisions and rules and regulations thereunder that do not apply to security-based swap agreements. In particular, this means that a broker-dealer will not be exempt from the antifraud provisions of the Exchange Act of Sections 5, 6, 12(a) and (g), 13, 14, 15(b)(4), 15(b)(6), 15(d), 16, and 17A. In addition, the SEC noted that exemptions are not being granted from Exchange Act provisions relating to margin and unlawful extensions of credit, books and records requirements, net capital requirements, the customer protection rule, or quarterly security count requirements; and
- Separate exemptions from the exchange registration requirements of Sections 5 and 6 of the Exchange Act for exchanges that effect or report transactions in non-excluded CDS and are not otherwise subject to these provisions, and for any broker or dealer that effects or reports transactions in non-excluded CDS on such an exempt exchange. See Exchange Act Release No. 59165 (Dec. 21, 2008), available here.
During the temporary exemptions, i.e., until September 25, 2009, the SEC is seeking public comment on what action it should take with respect to the CDS market in the future, including, among other things, whether the exemptions should be extended or allowed to expire, and whether registration with the SEC as a clearing agency should be required.
3. SEC Approval Pending for Other CCP Initiatives
Two other proposals to operate CDS CCPs have cleared regulatory approvals, but are awaiting SEC approval. CMDX, a joint venture company of the CME Group and Citadel Investment Group, has completed regulatory reviews by the CFTC and Federal Reserve Bank of New York; however, SEC review and approval is still pending. The CFTC’s press release is available here. In addition, the New York State Banking Board has approved an initiative by the IntercontinentalExchange, Inc. ("ICE") and The Clearing Corporation, together with nine global investment banks, to create a New York-charted trust company, ICE US Trust LLC, to serve as a central clearing facility for CDS. The press release is available here. Federal approval for ICE to operate a CCP is still pending with the Federal Reserve as well as the SEC.
4. Open Issues
The January 8, 2009 report to Congress by the U.S. General Accountability Office ("GAO") on Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System ("GAO Report on Financial Regulation"), available here, includes recommendations that gaps in federal oversight of CDS and other complex financial products be closed, but does not reference the recent combined regulatory efforts to foster the development of CCPs. Other issues still to be addressed are: the extent to which cross margining will be permitted, if at all; the development of risk management protocols regarding market participants‘ positions, exposures, and collateral requirements and needs; a CCP guaranty fund; additional recordkeeping requirements, including transaction reporting requirements to facilitate creation of audit trails; and information sharing protocols among the Federal Reserve, SEC, and CFTC concerning CCPs‘ financial condition, risk management systems, internal controls, liquidity and financial resources, operations, and governance as well as results and reports of examinations of CCPs.
E. Determination of "Group" Under Section 13(D) of The Exchange Act
On June 11, 2008, Judge Lewis A. Kaplan of the U.S. District Court for the Southern District of New York issued a decision in CSX Corporation v. The Children‘s Investment Fund Management (UK) L.L.P. et al., available here, holding that The Children’s Investment Fund ("TCI") and 3G Capital Partners ("3G"), two large hedge funds, violated Section 13(d) of the Exchange Act. Specifically, Judge Kaplan’s decision stated that TCI should be deemed to beneficially own the shares referenced in its cash-settled equity total return swaps pursuant to the anti-avoidance provisions of Rule 13d-3(b) under the Exchange Act. Accordingly, TCI violated Section 13(d) by not filing a Schedule 13D within ten days of acquiring beneficial ownership of more than five percent of CSX shares. Further, TCI and 3G were found to have formed a group and to have violated Section 13(d) by not making the required filing within ten days of forming the group. Although TCI and 3G were found to have violated Section 13(d), the Court did not enjoin them from voting their shares at the 2008 annual shareholders’ meeting, leaving the question of penalties to the SEC or Department of Justice.
On September 15, 2008, the Second Circuit issued a summary order, available here, affirming Judge Kaplan’s ruling not to enjoin TCI from voting its shares, and CSX subsequently agreed to seat all four of TCI’s slate of nominees to the CSX board. Although the Second Circuit has stated that it will issue an opinion (in addition to the summary order), the expectation is that any guidance or requirement to reflect the reference securities related to equity derivatives will need to come from the SEC.
To date, the SEC’s statements have been limited to a June 4, 2008 amicus letter to the district court signed by Brian Breheny, Deputy Director of the SEC’s Division of Corporation Finance. In his letter, Mr. Breheny wrote that "a person who entered into a swap would be a beneficial owner under Rule 13d-3(b) if it were determined that the person did so with the intent to create the false appearance of non-ownership of a security." The letter is available here.
Beyond this letter, the SEC has indicated that it plans to address the issues raised by the case in 2009. In the meantime, the compliance focus in this area should remain on external communications to avoid at least the inadvertent formation of a group. Judge Kaplan’s statements are a reminder that incriminating communications coupled with parallel behavior, such as directional trading or activist shareholder activities, can create the risk that a shareholder will be deemed to have formed a group with other shareholders.
F. Disclosure–Amendments to Form ADV
1. Introduction
On March 3, 2008, the SEC re-proposed amendments (the "Proposed Amendments") to Part 2 of Form ADV and its related rules under the Investment Advisers Act of 1940. See SEC Release No. IA-2711, available here. The proposed amendments are intended to improve the quality of information that registered investment advisers provide their clients about business practices, conflicts of interest, and the background of the adviser and its personnel.
Currently, Part 2 of Form ADV is a "check-the-box" and "fill-in-the-blank" form that is not required to be filed with the SEC. The Proposed Amendments would replace this form with Part 2B, a narrative disclosure written in plain English in a prospectus-like brochure that would be filed electronically with the SEC’s Investment Adviser Registration Depository and, therefore, publicly available. Proposed Part 2A, the firm brochure, contains nineteen items of disclosure about the adviser firm and its senior management. Part 2A would be augmented by proposed Part 2B, the brochure supplement, which contains six items of disclosure about the firm’s advisory personnel. Part 2B would not need to be filed with the SEC, but copies, including any amendments, would need to be preserved in accordance with applicable recordkeeping requirements.
2. Summary of the Proposed Amendments
a. Part 2A: Brochure
As proposed, Part 2A will require disclosure about the adviser’s services, fees, compensation, disciplinary history, and related conflicts of interest. An adviser would need to respond only to the items applicable to its business. In addition to an increased emphasis on how advisers address conflicts of interest that arise during the course of business, below are some of the major disclosure items that generally would affect registered hedge fund managers:
- Types of services the adviser provides, including specialized services, as well as the methods of analysis, investment strategies, and general and/or specialized areas of risks in its investment approach;
- Total amount of client assets that the adviser manages;
- Adviser compensation for services, including brokerage commissions and custody fees, client referral compensation, or any other compensation attributable to the sale of a security or investment product and the circumstances in which the adviser charges performance fees and manages accounts side-by-side;
- Selection of brokers and determination of reasonableness of commissions and other fees;
- Soft dollar arrangements, including products and services received, and related conflicts of interest;
- All legal or disciplinary events that are material to a client’s assessment of the integrity of the adviser or its management;
- Information about conflicts of interest associated with the use of affiliated portfolio managers; and
- A summary of any material changes since the last brochure update.
b. Part 2B: Brochure Supplement
While Part 2A pertains to the investment adviser and its senior management, Part 2B is intended to provide an adviser’s clients with information about the advisory personnel responsible for servicing their particular accounts. Neither Part 2, nor Part 2B, would be required to be delivered to certain clients receiving only impersonal investment advice. In addition, investment advisers would not be required to provide Part 2B to clients who are qualified purchasers or certain "qualified clients" who also are officers, directors, employees or other persons related to the manager.
If an adviser is required to deliver Part 2B, it is proposed that each advisory client would be required to receive a supplement for each "supervised person" employed by the adviser who either (i) has direct contact with and formulates investment advice for such client, or (ii) has discretionary authority over such client’s investment needs. A "supervised person" is defined as any officer, partner, director, employee, or other person who provides investment advice on the adviser’s behalf and is subject to the control of the adviser.
The supplement for each supervised person contains information regarding:
- His or her education and business experience for the last five years;
- Legal or disciplinary events material to a client’s evaluation of such person’s integrity;
- Other investment-related business activities (non-investment-related activities included only if such activities constitute a "substantial" portion of income or time);
- Any arrangement under which someone other than the client compensates the supervised person for providing advisory services; and
- An explanation of how the person is supervised at the firm and the supervisor’s contact information.
c. Delivery
An adviser would be required to deliver a copy of Part 2A to relevant clients before or at the time it enters into an advisory agreement with them, and annually thereafter within 120 days of the end of its fiscal year. The annual delivery would also include a summary of any material changes since the last brochure–either on the brochure cover or via a separate communication accompanying the brochure. Interim brochures would be delivered only if a material change or disciplinary event occurs. Part 2B would need to be delivered to relevant clients before or at the time the applicable supervised person begins to provide advisory services to the client and would need to be updated only if a material change occurs.
All deliveries may be made electronically by complying with the SEC’s 1996 interpretative guidance on electronic deliveries, available at here.
d. Compliance
If the Proposed Amendments are adopted, beginning six months after their effective date, registered advisers will need to be in compliance by the date of their next annual Form ADV.
3. Most Frequently Raised Comments
Sixty-nine comment letters were filed with the SEC regarding the proposed amendments by the close of the comment period on May 16, 2008. Below are the issues that were most frequently raised:
- Delivery. A number of larger advisers expressed concern over the annual delivery requirement due to the increased costs and labor that would be required, and instead proposed an "access equals delivery" model to meet the requirement. Under such a model, the adviser would (i) post the brochure on the SEC website and its own website, (ii) provide notification of the postings, and (iii) offer to deliver a paper copy of the brochure at a client’s request.
- Supplements. The proposed addition of Part 2B has been met with a fair amount of opposition. Some commenters asserted that the operational and cost burdens of producing the supplements outweigh their additive value because such information is available from FINRA’s free online system, BrokerCheck.
- Soft Dollars. Some commenters expressed concern over the disclosure of broker selection based on soft dollar benefits and argued that consideration of such benefits does not necessarily conflict with an adviser’s fiduciary duty to obtain best execution of client transactions. These commenters requested guidance on how execution should be evaluated in this context.
- Definition of "Material Change." Because an interim brochure and separate summary are required if any "material change" occurs, several commenters requested that the SEC provide a definition of "material change" for uniform disclosure among advisers.
- Definition of "Substantial." Commenters requested that the SEC provide a definition for "substantial" in connection with the requirement that a supervised person’s outside business activities be disclosed if such activities constitute a "substantial" portion of income or time.
The comment period ended on May 16, 2008, and the SEC has taken no further action with respect to the amendments. In an October 28, 2008 letter to the Investment Adviser Association, SEC Chairman Christopher Cox stated that, tentatively, the SEC would consider the final amendments in early December 2008, but he appears to have left this issue to the next Commission.
In response to the growth of hedge funds, and the increased calls for hedge funds to demonstrate appropriate controls in managing their activities, the PWG formed a private sector committee, the AMC, to develop best practices for the hedge fund industry based on the PWG’s earlier "Agreement among PWG and U.S. Agency Principals on Principles and Guidelines regarding Private Pools of Capital." The AMC released its best practices (the "Report") in April 2008. The Report is available here.
The proposed best practices favor increased voluntary action by hedge fund managers rather than greater mandatory regulation. Of course, considering the complexity of the industry, there is no "one size fits all" solution to best practices, risk management, and compliance processes and controls. The overarching principle of the Report, however, is the hope that promotion of industry standards will assist in reducing systemic risk and promote investor protection. To foster this expectation, the AMC contemplates that managers explain to investors how they have implemented the best practices, and if they have not, why not.
The Report calls on hedge funds to adopt comprehensive best practices in all aspects of their business and specifically identifies and addresses five key areas: (i) disclosure, (ii) valuation, (iii) risk management, (iv) trading and business operations, and (v) compliance, conflicts, and business practices–each of which is discussed below.
The authors of the Report believe strong disclosure practices will provide investors with the information needed to determine whether to invest in a fund, better monitor an investment, or redeem an investment. The framework for disclosing information should include:
- Deciding when and what information will be provided to investors;
- Guidelines for disclosure regarding potential conflicts of interest;
- Guidelines relating to disclosure of information to counterparties; and
- Guidelines for the qualifications of investors in the fund (to assist the fund in complying with safe harbors).
Effective disclosure of information to investors can occur in various forms, including (i) a private placement memorandum that can be updated upon material changes or upon new investments, (ii) quarterly annual audited, GAAP-compliant financial statements, and/or (iii) regular investor letters and risk reports. The Report outlines what should be included in each document. For example, an offering memorandum would include descriptions of the fund’s investment philosophy, strategies, products, and risks, while GAAP financial statements would contain estimates of the fund’s performance.
Hedge funds and managers are also encouraged to (i) disclose, to the extent possible, information regarding parallel managed accounts and side letters, (ii) outline their valuation policies (including any non-GAAP measures), and (iii) provide periodic performance information on the value of fund assets and profits at least quarterly. The Report further recommends that managers address the disclosures that will be made to counterparties, such as banks and broker-dealers. Reflecting concerns about the collapse of prime brokers such as Bear Stearns & Co. Inc. and Lehman Brothers Inc., the AMC noted that stable relationships between hedge funds and counterparties will be enhanced if they agree at the outset on what information will be provided to each other.
The AMC recommends that funds maintain documented and consistent valuations of all investment positions while also minimizing potential conflicts that may arise in the valuation process. Where relevant, a framework for valuation might include:
- A governance mechanism, such as a valuation committee, that has the ultimate responsibility for establishing compliance with any valuation policy and for providing consistent oversight;
- The development by the manager of well-documented valuation policies, together with guidelines to evaluate exceptions and to test and review compliance; and
- Sufficiently knowledgeable and independent personnel who are separate from and do not report to the trading or portfolio management personnel and who are responsible for the valuation of the fund’s investment positions and for implementing the policies.
The valuation committee, in addition to establishing compliance, should be tasked with approving the manager’s policies for classification of the fund’s assets (as described below), reviewing the fairness of valuation policies and their consistent application, selecting and supervising third-party service providers who are involved in the valuation process, reviewing any material exceptions made to the policies, and approving final valuations. The AMC further recommended that assets be classified according to Statement of Financial Accounting Standards No. 157 (categorized as Level 1, 2, and 3 investments), and that the percentage of assets in each level, along with the percentage of realized and unrealized profit and loss derived from assets in Levels 2 and 3, be disclosed to investors at least quarterly.
The Report notes that, in addition to providing for the valuation of assets, valuation policies should address conflicts of interest (such as those that can arise when a manager receives an incentive fee or performance allocation). Where appropriate and practical, the AMC recommended the establishment of a system of segregated responsibilities of personnel and the appropriate use of advisers. This can be particularly important in situations where the potential conflict may be more pronounced, such as when pricing information is available only from brokers dealing in certain OTC derivatives. While third-party service providers can be useful in eliminating valuation conflicts, the Report noted that managers should remain involved and not take "undue comfort" from an administrator’s independence.
Finally, the Report outlines suggested procedures for using "side pockets" to segregate illiquid or other difficult to value investments, including determining whether to move an asset in or out of a side pocket, and setting fees and investment restrictions.
The AMC recommends that funds establish and carry out a comprehensive risk management framework that emphasizes the measuring, monitoring, and managing of risk. The framework set out in the Report includes the following elements:
- Identification of portfolio risk by a member of senior management, such as a chief risk officer (including liquidity risk, leverage, market risk, counterparty credit risk, and operational risk);
- Measurement of the principal categories of risk;
- Adoption of policies that establish monitoring and measurement criteria;
- Maintenance of a regular process of risk monitoring appropriate for the fund, including risks that are not quantifiable; and
- Retention of knowledgeable personnel to measure and monitor risk (with very limited outsourcing).
Specific recommendations include: (i) preparing risk reports describing the portfolio’s exposures and distributing those reports to the senior management responsible for the portfolio, and (ii) appointing a member of senior management or establishing a risk committee to supervise risk analysis (including when risk measurement is outsourced) and to take responsibility for the creation of policies covering risk management.
The Report also emphasizes stress-testing of portfolios for market and liquidity risk. In addition, because the failure of a counterparty could have serious implications for a fund’s liquidity and success, the AMC recommends that managers assess the creditworthiness of counterparties and consider taking steps to increase access to liquidity in the event of market stress, along with fully understanding the complex legal relationships at issue with counterparties. Managers are also encouraged to disclose material risk information to investors quarterly (taking into account confidentiality obligations), including qualitative and quantitative analyses.
4. Trading and Business Operations
To the extent that hedge funds have grown into complex organizations, their operations and infrastructure should mirror such growth. Suggested best practices for trading and business operations might include, if appropriate:
- Checks and balances in operations and systems;
- Sufficient infrastructure, automation, and resources;
- Policies and procedures that address segregation of duties and reconciliation;
- Senior management (e.g., a chief operating officer) responsibility for operations, and adequate resources to perform this duty; and
- Continual assessment of effectiveness of operational and internal controls.
The checks and balances policies should address the appropriate management of counterparty relationships; adequate management of cash, margin, and collateral requirements; careful selection of key service providers; adequate infrastructure and operational practices; adequate operation and accounting processes (including appropriate segregation of business operations and portfolio management personnel); and a disaster recovery process.
Regular systems reviews, most likely by the chief operating officer, are another suggested tool for assessing operational risks arising from changes. In the case of counterparties and service providers, managers should review the terms of the agreements with such parties to understand the risks that could affect the parties’ rights and obligations and the service providers and counterparties’ suitability for providing the relevant service.
5. Compliance, Conflicts, and Business Practices
The AMC emphasizes the importance of a continued commitment to the highest standards of integrity and professionalism. The Report therefore outlines a framework to address conflicts of interest and to promote high standards of conduct. This framework should include:
- A written code of ethics containing guidelines that will foster integrity and professionalism;
- A written compliance manual that addresses the various rules and regulations governing the manager’s operations, potential conflicts of interest, and the maintenance and preservation of adequate records;
- A process for handling conflicts, such as a formally constituted conflicts committee, particularly for those conflicts that are not anticipated by the manager’s policies;
- Regular and robust training of personnel regarding the material elements of the compliance program; and
- A compliance function that includes a chief compliance officer, appropriate discipline, and an annual review of the framework that will account for any legislative or regulatory developments, changes in business practices, and employee conduct.
The Report emphasizes that the success of this framework depends upon creating a top down culture of compliance that is grounded in the commitment and active involvement of the senior leaders of the firm and fostered throughout the organization. The Report also identifies potential conflicts relevant to the hedge fund industry to help managers evaluate where conflicts might arise based on their own structure and operations. However, because it is possible some conflicts will not be anticipated, the Report recommends that managers establish a conflicts committee to address issues as they arise.
H. Conclusion
With a new administration, a Congress focused on financial markets reform, and multiple governmental authorities pursuing a variety of investigations and actions that directly or indirectly affect hedge funds, we expect 2009 to be a busy year. The GAO Report on Financial Regulation, available here, recommends, among other things, that regulators address problems in financial markets, particularly potential systemic and counterparty credit risks resulting from hedge funds and other "large and sometimes less-regulated market participants."
In addition, with the new Congress having convened this week, Senator Charles E. Grassley (R-IA) is expected to introduce a bill modeled after S.1402, the Hedge Fund Registration Act that he introduced in May 2007. Sen. Grassley’s new bill is expected to require hedge funds to register with the SEC. The 2007 legislation was referred to the Senate Committee on Banking but was never brought up for consideration. In particular, Sen. Grassley has expressed concern about the increasingly large investments by public pension funds in hedge funds and has stated that transparency of hedge funds is necessary to protect those investments. Sen. Grassley’s press release is available here. In anticipation of the ever increasing likelihood of some form of federal registration or charter, hedge funds may want to begin considering the implications of such action for their business and operations.
A further challenge for hedge funds will be dealing with increased compliance and regulatory scrutiny, often with reduced compliance staff.
Addendum–A Compilation of Hedge Fund Enforcement Actions and Developments in 2008
Rumor Mongering/Market Manipulation
SEC v. Paul S. Berliner (May 2008)
The SEC filed a civil action against Paul S. Berliner, a Wall Street trader previously associated with the Schottenfeld Group, charging him with securities fraud and market manipulation for intentionally disseminating a false rumor concerning The Blackstone Group’s acquisition of ADS. The complaint alleged that on November 29, 2007–approximately six months after Blackstone agreed to acquire ADS at $81.75 per share–Berliner disseminated a false rumor, through instant messages to traders at brokerage firms and hedge funds, that ADS’s board of directors was meeting to consider a revised proposal from Blackstone to acquire ADS at $70 per share, a substantially lower price than the agreed-to $81.75 price. According to the SEC’s complaint, this rumor caused the price of ADS stock to plummet, with Berliner profiting by short selling ADS stock and covering those sales as the stock price fell. Berliner consented to a judgment enjoining him from future violations of the federal securities laws and ordering him to pay over $26,000 in disgorgement and $130,000 in civil penalties.
Insider Trading
SEC v. Mitchel S. Guttenberg et al.; United States v. Jurman et al. (November 2008)
In November 2008, Mitchel S. Guttenberg, former executive director of UBS Securities LLC and one of the key participants in what many call the most significant insider trading case in history, was sentenced to seventy-eight months in prison and ordered to forfeit approximately $15.8 million in fraudulent profits. From 2001 to August 2006, Guttenberg tipped material, nonpublic information to Erik R. Franklin, a hedge fund manager at Bear Stearns, and David M. Tavdy, a trader at Assent LLC and Andover Brokerage LLC, in exchange for a share in the illicit profits that they generated on behalf of their hedge fund clients and brokerage accounts. The inside information was also used by a number of other individuals to trade for their personal accounts and for other entities. Both civil and criminal charges have been settled with respect to Franklin, Tavdy, and the other defendants.
SEC v. Brian D. Ladin et al. (October 2008)
The SEC filed a civil action against Brian D. Ladin, a former analyst for Dallas-based hedge fund Bonanza Master Fund Ltd., charging him with insider trading in connection with a 2004 PIPE offering conducted by Radyne Comstream, Inc. The complaint alleged that Ladin, on the basis of material, nonpublic PIPE information, presented an investment in Radyne to Bonanza, resulting in Bonanza establishing a 100,000 share short position in Radyne stock. According to the complaint, Ladin, in signing the offering’s stock purchase agreement on behalf of Bonanza, represented that Bonanza did not hold a short position in Radyne common stock when he knew, or was reckless in not knowing, that the fund did hold such a position.
Ladin consented to an injunction and an order requiring him to pay approximately $331,000 in disgorgement, interest, and penalties. Bonanza and its investment adviser, Bonanza Capital Ltd., consented to the entry of a final judgment ordering them to pay approximately $370,000 in disgorgement.
FSA–Proceedings Against Steven Harrison (September 2008)
The U.K. FSA brought proceedings against Steven Harrison, a senior portfolio manager at the London unit of American hedge fund Moore Europe Capital Management, alleging that he received inside information that a company in which Harrison’s fund held bonds was about to refinance its debt and used the information to direct the purchase of two million of the company’s senior bonds on the eve of the refinance. The FSA fined Harrison $92,500 and excluded him from employment in the hedge fund market for twelve months.
United States v. Hilary L. Shane (August 2008)
In August 2008, the U.S. Attorney’s Office for the Southern District of New York struck a deferred prosecution deal with Hilary L. Shane, a former hedge fund manager, who had been indicted in 2006 on five counts of insider trading in connection with a PIPE transaction. This appears to be the first use of a deferred prosecution agreement in the PIPE context.
In the Matter of Rubin Chen (July 2008)
In July 2008, the SEC issued an order barring Rubin Chen, a former vice president and head of relative value hedge fund strategies at ING Investment Management Services in New York, from associating with any investment adviser. The order stemmed from actions taken earlier in the month by the federal court in Manhattan, which entered a final judgment by consent against Chen and his wife, Jennifer Xujia Wang, permanently enjoining them from future violations of the federal securities laws and ordering them to pay roughly $885,000 in disgorgement, interest, and penalties. The SEC’s complaint alleged that they obtained illegal profits of $727,733 by trading on the basis of material, nonpublic information concerning various proposed corporate acquisition transactions. The complaint further alleged that Wang, in her position as a vice president of Morgan Stanley, was privy to material, nonpublic information concerning each of the pending acquisitions, which she unlawfully disclosed to Chen. Chen had pleaded guilty to four felony counts, including one count of conspiracy to commit securities fraud, in September 2007.
SEC v. Michael K.C. Tom et al. (May 2008)
In May 2008, the SEC announced that the U.S. District Court for the District of Massachusetts entered final judgments by consent against the remaining defendants in an insider trading case arising out of Rhode Island-based Citizens Bank’s May 4, 2004 announcement that it was acquiring Charter One Financial, Inc., a Cleveland-based bank. The SEC’s complaint alleged that Global Time Capital Management ("GTCM") portfolio manger Michael K.C. Tom, a former Citizens employee who managed the GTC Growth Fund, obtained over $740,000 in illicit profits by purchasing numerous Charter One call options for his personal account and for the hedge fund after receiving material, nonpublic information relating to Citizens acquisition of Charter One from a then-Citizens employee. Both Tom and GTCM consented to judgments enjoining them from future violations of the federal securities laws. Tom was ordered to pay disgorgement, interest, and penalties totaling over $800,000, and GTCM was ordered to pay a penalty of nearly $40,000. The hedge fund was ordered to pay disgorgement and interest of over $210,000 as a relief defendant.
Stock Registration Issues in Connection with PIPE Transactions
SEC v. Edwin B. Lyon et al. (January 2008)
In December 2006, the SEC filed a civil action against Edwin B. Lyon and the collection of onshore and offshore hedge funds that he managed, alleging that he and his funds obtained over $6.5 million in unlawful profits by using PIPE offerings to cover short sales of the same issuer’s stock, thus causing unregistered shares to be distributed in violation of the registration provisions of Section 5 of the Securities Act. The SEC also alleges that the defendants committed insider trading by trading ahead of the various companies’ announcements of PIPE offerings and committed securities fraud by attempting to hide their PIPE trading. In January 2008, the New York district court, echoing the U.S. District Court for the Western District of North Carolina’s decision in SEC v. Mangan, dismissed the SEC’s unregistered distribution claim and its attendant fraud allegations, holding that Lyon did not cause an unregistered distribution of shares simply by covering short sales with shares purchased in the PIPE offerings. The securities fraud and insider trading charges remain pending in the Southern District of New York.
SEC v. Robert A. Berlacher (January 2008)
In late 2007, the SEC filed a civil action against hedge fund adviser Robert A. Berlacher, alleging that he pumped up his hedge funds’ performance–and his own compensation–through illegal trading in at least ten PIPE offerings. According to the SEC’s complaint, Berlacher and his hedge funds employed a variety of techniques to conceal the funds’ trading in unregistered PIPE shares. The SEC also alleged that Berlacher violated the Securities Act’s registration provisions by causing an unregistered distribution of shares in connection with the PIPE transactions, but, as in Lyon, the district court dismissed this claim. The case is currently pending in the Eastern District of Pennsylvania.
Portfolio Pumping/"Marking the Close"
In the Matter of MedCap Management & Research LLC and Charles Frederick Toney, Jr. (October 2008)
The SEC initiated administrative proceedings against a Delaware investment adviser, MedCap Management & Research LLC, and its principal, Charles Frederick Toney, Jr., alleging that the defendants misled hedge fund investors about the fund’s performance by engaging in portfolio pumping. According to the SEC’s order of settlement, in an attempt to save MedCap Partners, one of his hedge funds, Toney placed numerous buy orders for an OTC stock through MedCap Partners Offshore, his other hedge fund, pushing the share price for the stock from $0.85 per share to $3.72 per share and thereby quadrupling the value of the shares already held by MedCap. The brief boost inflated the fund’s reported value by $29 million, masking what would otherwise have been a forty percent quarterly loss. The defendants consented to an order enjoining them from future violations of the securities laws, barring Toney from associating with an investment adviser for one year, and requiring Toney to pay $100,000 in penalties and MedCap Management to pay roughly $70,000 in disgorgement and interest.
SEC v. Michael Lauer; United States v. Lauer (September 2008)
In September 2008, the SEC announced that the U.S. District Court for the Southern District of Florida granted its motion for summary judgment against Michael Lauer, the principal and manager of a group of hedge funds called the Lancer Group. The summary judgment order found that Lauer materially overstated the hedge funds’ valuations from 1999 to 2002, engaged in portfolio pumping to manipulate the prices of seven securities that were held by the Lancer Group funds, issued false portfolio statements to investors, and falsely represented the funds’ holdings in newsletters in an effort to hide the fraudulent scheme. The court permanently enjoined Lauer from violating the federal securities laws but reserved ruling on the SEC’s claim for disgorgement and interest. The Commission is seeking disgorgement and penalties totaling more than $50 million.
In a related criminal proceeding, the U.S. Attorney’s Office for the Southern District of Florida indicted Lauer and four other individuals on charges of conspiracy and mail, wire, and securities fraud in connection with the above-described scheme. Those charges remain pending.
Valuation/Risk of Investment
In the Matter of Don Warner Reinhard (October 2008)
The SEC initiated administrative proceedings against Don Warner Reinhard, the sole owner and president of Magnolia Capital Advisors, a registered investment adviser, charging Reinhard with making false and misleading statements and omissions of material fact to investors in connection with the sale of certain mortgage obligations. According to the SEC’s complaint, Reinhard misrepresented the investment risk associated with mortgage obligations that he purchased for his clients and for Magnolia Capital Partners, a hedge fund that Reinhard controlled. The SEC’s complaint also alleges that Reinhard provided his clients with false quarterly account statements as part of the fraud. The action is currently pending.
SEC v. Michael Lauer; United States v. Lauer (September 2008)
Please see the summary of these parallel cases under the heading "Portfolio Pumping/"Marking the Close," above.
Allocation/"Cherry Picking"
SEC v. James C. Dawson (September 2008)
The SEC filed a civil action against James C. Dawson, the investment adviser to Victoria Investors LP, charging him with "cherry picking" profitable trades for his own account between April 2003 and October 2005. According to the complaint, Dawson orchestrated the scheme by purchasing securities throughout the day in a single account and then delaying the allocation of the shares until later in the day after he had determined whether the securities appreciated in value. The complaint alleges that Dawson achieved a first-day success rate of ninety-eight percent on trades for his own account, while he achieved only a fifty-two percent first-day success rate on trades for his clients’ accounts. The SEC also alleges that Dawson used hedge fund assets to pay for personal expenses. The case remains pending in the Southern District of New York.
Illegal Short Selling in Connection with Regulation M
In the Matter of Moon Capital Management, LP (September 2008)
The SEC initiated administrative proceedings against Moon Capital Management, LP, a registered investment adviser, alleging that it violated Rule 105 of Regulation M when it sold securities short on behalf of one of the hedge funds it advises during the five business days before the pricing of an offering and then covered the short positions with securities purchased in the offering. According to the SEC, this resulted in $88,100 in illicit profits for the hedge fund. Moon Capital consented to a judgment ordering it to pay over $138,000 in disgorgement, interest, and penalties, and to cease and desist from future violations of Regulation M.
SEC v. Victoire Finance Capital, LLC (September 2008)
The SEC brought administrative proceedings against Victoire Finance Capital, LLC, alleging that the hedge fund adviser violated Rule 105 of Regulation M on eighteen occasions by selling securities short within five business days before the pricing of the offering and covering the short sale, in whole or in part, with shares purchased in the offering. The SEC alleged that these violations generated profits of nearly $170,000 for Victoire Finance et Gestion, B.V., the offshore hedge fund that Victoire Finance Capital advises. The hedge fund adviser consented to a cease-and-desist order and agreed to disgorge the $170,000 in profits.
Soft Dollar Practices
FINRA–Proceedings Against SMH Capital, Inc. (January 2008)
FINRA fined SMH Capital, Inc., $450,000 for failing to adopt adequate supervisory procedures and systems designed to address its prime brokerage and soft dollar services to hedge funds. As a result of this oversight, SMH made improper payments of $325,000 in soft dollars to a hedge fund manager.
Late Trading/Market Timing
SEC v. Justin F. Ficken; United States v. Ficken (September 2008)
In September 2008, the SEC announced that Justin Ficken, a former representative at Prudential Securities, pleaded guilty to one count of conspiracy, three counts of wire fraud, and two counts of securities fraud in connection with his role in a scheme to place deceptive market timing trades in mutual funds on behalf of some of Prudential’s hedge fund clients. In the SEC’s earlier civil action arising from the matter, the district court entered an order enjoining Ficken from future violations of the federal securities laws and ordering him to pay nearly $590,000 in disgorgement and interest. In related administrative proceedings, the SEC secured an order barring Ficken from associating with any broker, dealer, or investment adviser. Ficken has appealed that decision to the Commission, and that appeal is pending.
United States v. Beacon Rock Capital and Thomas J. Gerbasio (May 2008)
Following on an earlier civil action, the SEC announced in May that Thomas J. Gerbasio, a broker-dealer, and Beacon Rock Capital, a hedge fund, were sentenced in the first U.S. criminal case brought against a hedge fund for deceptive market timing. The information in the case alleged that, from at least August 2002 until October 2003, Gerbasio defrauded hundreds of mutual funds and their shareholders by engaging in deceptive market timing practices through trades on behalf of Beacon Rock. According to the government’s allegations, Gerbasio structured trades on behalf of Beacon Rock in a number of ways to evade detection by the mutual funds. Gerbasio was sentenced to one year and one day in prison and ordered to pay a fine of $7,500. Beacon Rock was sentenced to two years of probation and ordered to forfeit $475,500 and pay a fine of $600,000.
Earlier, the SEC obtained a permanent injunction against Gerbasio and disgorgement of $540,000, which was decreased to $100,000 due to his financial condition.
SEC v. Headstart Advisers, Ltd.; SEC v. Marc J. Gabelli and Bruce Alpert; In the Matter of Gabelli Funds, Inc. (April 2008)
The SEC filed a civil action against U.K.-based hedge fund adviser Headstart Advisers, Ltd. and its chief investment adviser, Majy N. Nasser, charging the defendants with devising a scheme to defraud U.S. mutual funds and their shareholders through late trading and deceptive market timing on behalf of the adviser’s hedge fund client, Headstart Fund, Ltd. The SEC’s complaint alleges that the defendants split trades on behalf of the hedge fund across multiple accounts to avoid detection and that the hedge fund obtained approximately $198 million in fraudulent profits through this scheme. The SEC seeks an injunction, disgorgement of profits, and civil penalties. The action remains pending in the Southern District of New York.
In a related action, the SEC filed a civil complaint against Marc J. Gabelli, the former portfolio manager of the Gabelli Global Growth Fund, and Bruce Alpert, chief operating officer of the fund’s adviser, Gabelli Funds, LLC, in connection with an undisclosed market timing arrangement with Headstart Advisers. The complaint alleges that, from September 1999 until August 2002, Gabelli permitted Headstart Advisers to place market timing trades in the Gabelli Global Growth Fund while prohibiting other investment advisers from doing so. This action also remains pending in the New York court.
The SEC settled administrative proceedings against Gabelli Funds, LLC, ordering it to cease and desist from securities violations and to pay approximately $16 million in disgorgement, interest, and penalties.
SEC v. Pentagon Capital Management PLC (April 2008)
The SEC filed a civil action against U.K.-based hedge fund adviser Pentagon Capital Management PLC and its chief executive officer, Lewis Chester, alleging that, from June 1999 through September 2003, the defendants routinely engaged in late trading and market timing of U.S. mutual funds on behalf of Pentagon Special Purpose Fund, Ltd., an international business company incorporated in the British Virgin Islands that served as the master fund in a master-feeder fund structure. According to the complaint, the Pentagon fund obtained approximately $62 million in illicit profits through the scheme. The SEC seeks an injunction, disgorgement of profits, and monetary penalties. The action remains pending in the Southern District of New York.
SEC v. Scott B. Gann (April 2008; September 2008)
In 2005, the SEC filed a civil action against Scott B. Gann, a former vice president and stockbroker with Southwest Securities, in the U.S. District Court for the Northern District of Texas. The complaint alleged that Gann took part in a scheme to defraud hundreds of mutual funds and their shareholders by engaging in deceptive market timing practices on behalf of a hedge fund client, for whom he opened multiple accounts and used multiple registered representative numbers to place trades. In April 2008, following a three-day trial, the court permanently enjoined Gann from future violations of the securities laws and ordered him to pay disgorgement and pre-judgment interest of $70,209.35, plus a $50,000 civil penalty. The SEC subsequently issued an order instituting administrative proceedings, resulting in a September 2008 order barring Gann from associating with any broker, dealer, or investment adviser.
In the Matter of Chronos Asset Management, Inc. and Mitchell L. Dong (January 2008)
The SEC brought settled administrative proceedings against Chronos Asset Management, Inc., a hedge fund adviser, and its principal, Mitchell L. Dong. The Commission alleged that, from January 2001 to September 2003, the respondents used deceptive means to continue market timing in mutual funds despite earlier attempts by the mutual funds to restrict such trading. The SEC also alleged that the respondents engaged in late trading from May 2003 to September 2003. As part of the settlement, the SEC ordered Chronos and Dong to cease and desist from future violations of the federal securities laws and to pay disgorgement and interest of over $375,000 and a civil penalty of $1.8 million.
In the Matter of Ritchie Capital Management LLC, Ritchie Multi-Strategy Global Trading, Ltd., A.R. Thane Ritchie, and Warren Louis Demaio; In the Matter of Michael Mauriello (January 2008; February 2008)
Following on an investigation by New York Attorney General Andrew Cuomo, the SEC initiated administrative proceedings against a hedge fund, Ritchie Multi-Strategy Global Trading, Ltd., its investment adviser, Ritchie Capital Management LLC, and the firm’s founder and two employees. In its order settling the proceedings, the SEC found that, between January 2001 and September 2003, Ritchie Capital engaged in an illegal late trading scheme in which it placed thousands of trades in mutual fund shares after the markets had closed, allowing it to trade in mutual funds at pre-close prices based on post-close information. The Commission ordered the hedge fund and adviser firm to pay approximately $40 million in disgorgement, interest, and penalties.
In a related action, the SEC settled administrative proceedings against Michael Mauriello, the Ritchie Capital employee who was primarily responsible for placing late trades on behalf of the hedge fund adviser.
Fraud
SEC v. Bernard L. Madoff; United States v. Madoff (December 2008)
On December 11, 2008, the SEC and the U.S. Attorney’s Office for the Southern District of New York brought concurrent civil and criminal actions against Bernard L. Madoff and his investment firm, Bernard L. Madoff Investment Securities LLC ("BMIS"), charging Madoff with orchestrating a Ponzi scheme through which he defrauded his hedge fund clients out of billions of dollars. According to the charging documents, Madoff admitted to two of his employees that his hedge fund business "was a fraud" and that, for years, he had paid returns to BMIS hedge fund investors out of the principal received from other investors in the funds. He allegedly estimated the losses from the fraud to approach $50 billion. In an emergency measure, the U.S. District Court for the Southern District of New York entered an order freezing all of Madoff’s and BMIS’s assets. The civil and criminal actions remain pending.
Following Madoff’s arrest, investors have raised questions and concerns about the role of hedge funds in the scheme. Investors have alleged that their hedge fund managers handed over billions of dollars to Madoff without giving him much scrutiny, or that fund managers missed red flags that might have put investors on alert that their assets were not safe. For example, commenters have noted that money managers should have been concerned with Madoff’s outside auditor, which reportedly is not a nationally recognized auditing firm specializing in financial service clients but a relatively unknown three-person shop. These commenters have further noted that managers should have been troubled by the lack of transparency of BMIS’s operations, including the investment process that produced consistently high positive returns irrespective of market conditions. Based on these types of allegations, a number of private lawsuits have been filed against hedge funds. Even the SEC has been sued for allegedly missing red flags in what appears to be the first attempt by an investor to recover investment losses from the Commission.
SEC v. Marc S. Dreier; United States v. Dreier (December 2008)
The SEC and Department of Justice filed concurrent civil and criminal actions against Marc S. Dreier, a high profile New York lawyer and founding partner of the Dreier LLP law firm, charging him with defrauding a number of hedge funds and other private investment funds out of nearly $113 million through the sale of bogus promissory notes. According to the complaints in the actions, Dreier created an elaborate scheme to convince investors that the promissory notes were genuine: he allegedly prepared phony financial statements and audit opinion letters in the name of a reputable accounting firm and recruited others to play the parts of representatives of legitimate companies involved in the transactions, even creating dummy email addresses and telephone numbers. The SEC has charged Dreier with multiple civil violations of the federal securities laws, and the Justice Department has charged him with securities and wire fraud. The cases are pending in the Southern District of New York.
SEC v. William H. Eichengreen and David L. Myatt (September 2008)
The SEC brought a civil action against William H. Eichengreen and David L. Myatt, charging them with violating the antifraud provisions of the federal securities laws based on their conduct related to a now-defunct hedge fund, Directors Performance Fund, LLC ("DPF"). According to the complaint, Myatt defrauded DPF by convincing the fund’s investment adviser, Directors Financial Group, Ltd. ("DFG"), through a series of false disclosures to invest $25 million in a fraudulent "prime bank" scheme concocted by Myatt and Richard E. Warren, the purported trader who was to handle DPF’s investments in the bank. The complaint alleges that Eichengreen, DPF’s chief compliance officer, defrauded the fund by falsifying the fund’s financial statements and misrepresenting the fund’s trading strategy and investment performance to investors. The SEC previously settled charges against DFG and its president, Sharon Vaughn, in connection with this matter. The civil action against Myatt and Eichengreen remains pending in the Northern District of Illinois.
In related criminal proceedings, a jury convicted Warren on eleven counts of wire fraud, and Myatt pleaded guilty to obstruction of justice. Myatt has been sentenced to sixteen months in prison.
SEC v. Michael Lauer; United States v. Lauer (September 2008)
Please see the summary of these parallel cases under the heading "Portfolio Pumping/"Marking the Close," above.
SEC v. Ralph R. Cioffi and Matthew M. Tannin; United States v. Cioffi (June 2008)
The SEC charged Ralph R. Cioffi and Matthew M. Tannin, two former Bear Stearns asset management portfolio managers, with fraudulently misleading investors about the financial state of the firm’s two largest hedge funds and about the funds’ exposure to subprime mortgage-backed securities before the collapse of the funds in late 2007. In a related criminal action, the U.S. Attorney’s Office for the Eastern District of New York indicted Cioffi and Tannin on conspiracy and fraud charges. Both the civil and criminal actions remain pending in the Eastern District of New York.
SEC v. Plus Money, Inc. and Matthew La Madrid et al. (May 2008)
The SEC charged a San Diego-based investment adviser, Plus Money, Inc., and its principal, Matthew La Madrid, with orchestrating a $30 million hedge fund fraud. The SEC’s complaint alleges that, beginning in 2004, the defendants raised more than $30 million from investors by telling them that they would engage in a covered call options trading strategy; however, the defendants allegedly abandoned the covered call trading strategy in the fall of 2007 and distributed the monies in the fund’s brokerage accounts to La Madrid and the relief defendants through a series of illicit transfers. The district court has frozen the assets of all defendants. The action remains pending in the Southern District of California.
SEC v. Peter Krieger, Sheldon Krieger, and John Madey (February 2008)
The SEC announced that, on February 6, 2008, the U.S. District Court for the Southern District of Florida entered final judgments against Peter Krieger, Sheldon Krieger, and John Madey in connection with the Commission’s civil action against the defendants. According to the SEC’s complaint, the Kriegers and Madey raised approximately $7.5 million from approximately forty-five investors for the KFSI Equity Fund, L.P., a Florida-based hedge fund, and then diverted roughly half of the fund’s assets to pay for the operation of the brokerage firm that the defendants controlled. The complaint also alleged that the defendants concealed their misappropriation of KFSI’s assets by issuing false account statements. The district court enjoined the defendants from future violations of the federal securities laws and ordered the Kriegers to pay $110,000 each in penalties and Madey to pay over $270,000 in disgorgement and interest.
Misrepresentations of Fund Performance or Investment Strategy
SEC v. Lydia Capital, LLC et al. (September 2008)
In September 2008, the Massachusetts federal district court entered a consent judgment against Evan K. Andersen, one of the principals of Boston-based hedge fund adviser Lydia Capital, in connection with the SEC’s civil action against Andersen, Lydia Capital, and Glenn Manterfield, a U.K. citizen and resident of Sheffield, England. According to the SEC’s complaint, the defendants engaged in a scheme to defraud more than sixty investors who invested approximately $34 million in a hedge fund managed by Lydia Capital by making numerous material misrepresentations regarding the fund’s performance. The SEC previously obtained an order from the Massachusetts court freezing Andersen’s assets and an order from the High Court of Justice in London freezing Manterfield’s assets. As part of the consent judgment, the district court enjoined Andersen from future violations of the federal securities laws and ordered disgorgement and interest totaling over $2.5 million. The case against Lydia Capital and Manterfield remains pending.
SEC v. Daniel N. Jones and Azure Bay Management, LLC; United States v. Jones (September 2008)
The SEC brought a civil action against an investment adviser, Azure Bay Management, LLC, and one of its investment managers, Daniel N. Jones, alleging that the defendants defrauded their hedge fund client, The Addington Fund, by issuing false account statements and reports to investors for nearly two years in an effort to hide the fund’s poor performance. According to the SEC’s complaint, Azure Bay continued to take excessive fees of at least $135,000 based on the fund’s "performance." The Michigan federal court found that the defendants had violated the federal securities laws, issued an injunction, and ordered the defendants to pay nearly $3 million in disgorgement and interest. In a related criminal action, Jones pleaded guilty to one count of wire fraud and was sentenced to twenty-one months in prison.
SEC v. Northshore Asset Management et al. (July 2008)
In July 2008, the U.S. District Court for the Southern District of New York entered a final judgment against Francis J. Saldutti in connection with the Commission’s earlier complaint against Northshore Asset Management, the former investment adviser to a number of hedge funds that became defunct in early 2005. The SEC alleged, among other things, that Saldutti sold his investment adviser firm to the other Northshore defendants–thereby granting them control over the now-defunct hedge funds–without disclosing to his investors material facts about multiple conflicts of interest raised by the sale of the firm. Once in control of the hedge funds, Saldutti’s codefendants allegedly diverted millions of dollars from the hedge funds to their personal use. The court enjoined Saldutti from future violations of the federal securities laws and ordered him to pay over $5 million in disgorgement and interest.
SEC v. James G. Marquez (May 2008)
In a civil action, the SEC charged James G. Marquez, the portfolio manager and principal for the now-defunct Bayou Fund, LLC, with concealing from investors and prospective investors the hedge fund’s mounting trading losses by materially misrepresenting the fund’s performance in account statements, promotional materials, and correspondence. The complaint also alleged that, with Marquez’s knowledge, Bayou Fund created a sham accounting firm to issue annual false audits of the hedge fund. Marquez consented to an order enjoining him from future violations of the securities laws.
In an earlier criminal action, Marquez pleaded guilty to one count of conspiracy. He was sentenced to fifty-one months in prison and was ordered to pay over $6.2 million in restitution.
SEC v. Alexander James Trabulse et al.; In the Matter of Alexander James Trabuls (April 2008)
The SEC charged Alexander James Trabulse, a San Francisco hedge fund manager, with defrauding investors in the fund by dramatically overstating the fund’s profitability and misusing the fund’s assets. The complaint alleged that Trabulse sent account statements to investors in his Fahey Fund that inflated the fund’s returns by as much as 200 percent and that he used investors’ monies to finance personal purchases and shopping sprees for his family. Trabulse entered into a consent judgment with the SEC. The Commission enjoined Trabulse from future violations of the federal securities laws and ordered that he pay $250,001 in disgorgement and penalties. In a related administrative proceeding, the SEC barred Trabulse from associating with any investment adviser for five years.
SEC v. Thompson Consulting et al. (March 2008)
The SEC brought a civil action against a Salt Lake City investment adviser, Thompson Consulting, and three of its principals–Kyle J. Thompson, David C. Condie, and E. Sherman Warner–for making undisclosed subprime and other high risk investments that resulted in near total asset losses for two hedge funds managed by the investment adviser. According to the complaint, Thompson Consulting deviated significantly from its stated investment policy from March through August 2007, writing options on the stock of a subprime lender and making other high risk investments. The complaint also alleges that the defendants transferred money from the hedge funds to individual client accounts to make up for losses. The SEC seeks an injunction, disgorgement of profits, interest, and monetary penalties. The action remains pending in the District of Utah.
SEC v. Justin M. Paperny; United States v. Paperny (January 2008)
The SEC brought a settled enforcement action against Justin M. Paperny, a former UBS broker, in connection with his role in a fraudulent hedge fund offering. The Commission alleged that Paperny raised $14.1 million from forty-two investors on behalf of a hedge fund by falsely representing that the fund had special access to sought-after initial public offerings and that the fund had previously achieved high annual returns. Paperny consented to a permanent injunction.
The SEC’s action followed on the heels of a related criminal action against Paperny in which he pleaded guilty to one count of conspiracy to commit mail fraud, wire fraud, and securities fraud. Paperny was sentenced to eighteen months in prison and ordered to pay over $510,000 in restitution.
SEC v. Coadum Advisors, Inc. (January 2008)
The SEC obtained a permanent injunction, disgorgement, and civil penalties against three hedge funds, their two principals, and two other associated firms for engaging in a fraudulent scheme by which they raised approximately $30 million from at least 150 investors over the course of four securities offerings in early 2006. According to the SEC’s complaint, the defendants falsely told investors that they would receive a return of three to six percent per month when in fact the defendants transferred investments into accounts and funds that either were not yet in operation or did not produce any return on investment. The complaint also alleged that the defendants failed to disclose to investors that they made loans to themselves from investor proceeds, created and distributed false monthly account statements to mask their failure to produce the results promised to investors, and disbursed $5 million to various third parties without investor knowledge or approval.
Improper Transfer of Assets
In the Matter of Thomas C. Palmer and Aeneas Capital Management, L.P. (July 2008)
The SEC brought a settled administrative action against a hedge fund adviser, Aeneas Capital Management, L.P., and its former director of operations, Thomas C. Palmer, for improperly transferring $13.4 million from two hedge funds to a third in order to satisfy the third fund’s margin calls. The SEC found that Palmer had violated the Investment Advisers Act of 1940 through the transfers and that Aeneas Capital had failed reasonably to supervise him. The Commission ordered both respondents to cease and desist from future violations of the Act, suspended Palmer for twelve months from associating with any investment adviser, and fined Aeneas Capital and Palmer $150,000 and $65,000, respectively.
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