The U.S. District Court for the Southern District of New York (the “Court”) issued an opinion finding in part for the SEC in an enforcement proceeding brought against a U.K.‑based hedge fund adviser and its chief executive officer that also named as a relief defendant the fund through which they were found to have engaged in market timing and late trading of U.S. mutual funds during the period from June 1999 to September 2003. The action was brought under Section 17(a) of the Securities Act of 1933 (the “Securities Act”), and Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Rule 10b-5 thereunder, which, among things, “prohibit the use of fraudulently misleading representations in the purchase or sale of securities.” The Court held that the SEC had established the defendants’ liability for their late trading activities, but failed to establish liability for their market timing activities.
Market Timing. The Court found that the defendants had engaged in frequent trading of U.S. mutual funds by (a) using multiple broker-dealers, accounts and registered representative numbers, (b) trading in small amounts and (c) “cloning” trading accounts, in order to avoid or circumvent the enforcement of fund policies limiting frequent trading activity. The Court held, however, that the SEC had failed to establish that market timing rules prior to September 2003 were sufficiently clear to permit liability. “Defendants’ actions thus took place in an atmosphere of uncertainty. There were no definitions or prohibitions from the [SEC] with respect to market timing, and the [mutual funds’] enforcement of their provisions relating to timing was discretionary, inconsistent, and occasionally conflicted with [agreements in which mutual fund sponsors agreed to provide market timing capacity to certain parties].” The Court acknowledged that the defendants “generally sought to outwit the funds and knew that the funds in at least some instances did not permit market timing;” however, in the absence of definitive SEC guidance and “[w]ithout the clarity of what the funds’ rules were, despite Defendants’ general intent to deceive, the SEC has failed to establish the requisite scienter required by Section 10(b), Rule 10b-5, and Section 17(a(1).” Having made this finding, the Court observed that SEC disclosure requirements for mutual funds adopted in response to the market timing scandals may provide “sufficient clarity . . . so as to establish that market timing of a [mutual fund], in contravention of its now published rules and practices, may violate the federal securities laws.”
Late Trading. In contrast to its view regarding the permissibility of market timing during the relevant time frame, the Court found that late trading, the violation of mutual forward pricing practices (which require that purchase and redemption orders be priced at a fund’s next established net asset value (“NAV”) following receipt of the order by the fund or an appropriate intermediary), clearly is and was, during the relevant period, a violation of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, noting that every other court to have considered the issue had made a similar finding. The Court also held that the defendants “knew that late trading was impermissible and that they were obtaining an advantage over other investors contrary to the mutual funds’ rules and SEC regulation,” and that “the evidence as a whole demonstrates that Defendants were the creators, directors, and chief beneficiaries of the fraudulent scheme, and as such they are primarily liable.”
Injunctive Relief and Disgorgement. The Court granted the SEC’s request for the entry of injunctions against future violations of the antifraud provisions of the securities laws as to the defendant hedge fund adviser and its chief executive officer. The Court found all the defendants jointly and severally liable for disgorgement in the sum of $38,416,500, which represented the approximate amount of the profits realized by the defendants from their late trading activity. The Court also imposed civil penalties of $38,416,500.
SEC v. Pentagon Capital Management, 2012 U.S. Dist. LEXIS 18504 (S.D.N.Y. Feb. 14, 2012).