by T. GormanPosted on Posted in SECActions

Most of the investment fund cases brought by the SEC in recent months have centered on Ponzi scheme claims. Recent enforcement actions involving hedge funds, however, suggest that perhaps a new trend is coming. Consider for example, the SEC’s recent action captioned SEC v. Southridge Capital Management LLC, Civil Action No. 3: 10-cv-1685 (D. Conn. Filed Oct. 25, 2010). The defendants in the case are Southridge Capital, an investment adviser initiated in 1996, its founder defendant Stephen Hicks and Southridge Advisors, founded in 2008. The complaint centers on allegations that misrepresentations were made to investors regarding the liquidity of the funds, assets were over-valued, management fees were overcharged and fund assets were improperly used to pay operating expenses.

Initially, three funds advised by Mr. Hicks invested primarily in PIPEs involving micro-cap issuers. These companies typically have limited assets. Trading in their shares is limited. By 2004, the funds had insufficient cash to pay redemption requests.

In late 2003, however, Mr. Hicks began to solicit investors in the then existing funds as well as others to invest in a new fund which he promised would be liquid. Despite this representation and later claims that the new fund was 75% liquid, by year end 2006 over half of the assets were relatively illiquid PIPE deals or other instruments such as promissory notes. This situation persisted over the next two years. Again redemption requests could not be honored.

As the market crisis unfolded in 2008, the over $100 million Southridge Funds had under management diminished to about $70 million. Its largest single holding was a $30 million investment in Fonix Corporation. That interest had been obtained in a February 2004 exchange offer. Since the date of the acquisition, the investment had been significantly overvalued. Management fees were nevertheless charged as a percentage of the fund assets. This permitted Southridge and Mr. Hicks to reap hundreds of thousands of dollars in management fees each year.

The fund was also saddled with about $5 million in legal expenses. Those fees were actually incurred by the old funds as a result of the numerous lawsuits filed against Mr. Hicks, Southridge Capital and related persons in connection with the investments made by those funds. Mr. Hicks informed investors in the new fund about this charge. Rather than repaying the money, however, he had the illiquid assets of the old funds transferred to the new fund.

The complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), (2) and (4). The case is in litigation. See also Litig. Rel. 21709 (Oct. 25, 2010).

Southridge Capital is one of what may be a growing number of cases which focus on the operation of hedge funds rather than Ponzi scheme allegations. Another is an action brought in late September involving Valentine Capital Asset Management (here) which centered on allegations regarding a breach of fiduciary duty. There, the complaint claimed the defendant solicited clients in one fund under management to switch to a second without disclosing that the investors would incur significant additional fees. Similarly SEC v. Mannion (here) involved claims that a “side pocket” was improperly used to hold illiquid investments which were overvalued. That resulted in an inflated NAV used to solicit new investors and calculate management fees – that is the fund and investors were overcharged as in Southridge Capital. See also SEC v. Prevost (here) (feeder fund case). Now that hedge funds are required to register with the Commission, keep certain records and submit to inspections under Dodd-Frank (here), there may be more cases like these in the future.

by T. GormanPosted on Posted in SECActions

The Commission settled with the two remaining defendants in SEC v. Winning Kids, Inc., Civil Action No. 10-CV-80186 (S.D. Fla. Filed Jan. 29, 2010) (here). Defendants Victor Selenow and Edward Tamimi were salesmen for Winning Kids, Inc. The action centered on the sale of fraudulent interests in Winning Kids, a children’s book company.

The two salesmen resolved charges against them by consenting to the entry of final judgments which impose permanent injunctions prohibiting future violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b) and 15(A). Mr. Selenow also agreed to the entry of an order requiring him to pay disgorgement of $41,500 along with prejudgment interest and a civil penalty of $50,000. Likewise, Mr. Tamimi agreed to pay $194,250 in disgorgement plus prejudgment interest and a civil penalty of $130,000. See Litig. Rel. 21707 (Oct. 22, 2010). Previously, a default judgment had been entered against a third sales agent, Robert Comiskey.

The complaint was brought against Winning Kids, Inc., its founder and CEO, Christian Hainsworth, and the three former salesmen. According to the SEC, the defendants defrauded investors by selling unregistered securities through a series of private offerings marketed primarily on the radio. Investors were told that the company was operating, expanding nationally and experiencing extraordinary growth. The claims were bolstered by projections furnished to investors showing annual returns of 300%.

In fact, Winning Kids had virtually no revenue from the sale of its books or any other product. There was no basis for the sales projections according to the SEC. Investors also were not told that the salesmen were paid commissions of up to 20%.

The complaint alleged violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b) and 15(a). The company and Ms. Hainsworth settled at the time the complaint was filed (also here). These two settlements conclude the litigation.