SEC Enforcement Trends:  Hedge Funds
This year and continuing into the future we should see continued efforts to regulate hedge funds through enforcement actions.  Recently the regulatory spotlight has been on hedge funds.  The reason for the increased focus on hedge funds is clear:  they play an increasingly significant role in the capital markets.  As SEC Commissioner Atkins noted in his recent speech at the Ninth Annual Alternative Investment Roundup,  “Hedge funds have been in the regulatory spotlight.  With over $1.2 trillion in worldwide assets, the attention is understandable.”   Remarks on January 29, 2007  
Presently a number of agencies in Washington are studying hedge funds and assessing the need for regulation.  Although the SEC’s efforts to regulate the funds failed, it seems determined to continue if only through enforcement actions.  Last year in Goldstein v. SEC, 451 F. 3d 873 (D.C. Cir. 2006) the D.C. Circuit struck down an SEC rule requiring hedge fund advisers to register.  Although the agency chose not to appeal the ruling, SEC Chairman Cox later told Congress that hedge funds will not go unregulated noting that they “are not, should not be, and will not be unregulated.”   Testimony Concerning the Regulation of Hedge Funds, July 25, 2006 www.sec.gv/news/testimony/ts072506cc.htm.  Subsequently, the agency issued Proposed Rule 206(4)-8 which prohibits investment advisers from making false statements to investors and Proposed Rules 509 and 216 which limit private placements of securities that are exempt from the registration requirements of the securities laws (and, thus, SEC scrutiny) by  requiring accredited investors to have at lest $2.5 million in investments.  Comments on the proposed restrictions on private placements – limiting those who can invest in hedge funds – have been very negative to date. 

Regardless of whether more rules are passed concerning hedge funds, the SEC will no doubt continue to impact their operations with enforcement actions – a kind of regulation  through litigation – because the antifraud provisions of the federal securities laws continue to apply to the funds.  Two of the cases brought last year may suggest future enforcement efforts: 

  • SEC v. Langley Partners, L.P. et al., (D.D.C. March 14, 2006),  involved claims of insider trading and the sale of unregistered securities regarding 23 PIPE offerings.  The action was resolved with a consent decree in which the defendants agreed to the entry of a statutory injunction and the entry of an order requiring the payment of over $13 million in disgorgement, prejudgment interest and penalties by the fund.  Defendant Thorp consented to the payment of a penalty of over $2.3 million.
  • SEC v. Deephaven Capital Management, LLC. et al., (D.D.C. May 2, 2006), involved claims of insider trading relating to 19 PIPE offerings.  The company consented to a statutory injunction and the payment of over $5.5 million in disgorgement, prejudgment interest and penalties.  Defendant Lieberman consented to the payment of a penalty of $110,000.  

The SEC’s efforts in these areas are continuing.  At present a sweep of major Wall Street brokers is underway.  (see blog posting 2/15/07).  The focus of the sweep is to determine if brokerage houses are giving hedge funds advance information about orders of large traders such as mutual funds so that the hedge funds can use the information to trade at other brokerage houses.  If established this would be a very complex form of front running.    
On February 22, 2007, the President’s Working Group on Financial Markets issued its Principles and Guidelines Regarding Private Pools of Capital, which recommended that hedge funds not be further regulated at this time. Public interest in the funds is high however.  In February U.S. Fortress conducted the first IPO by a fund.  The share price opened up 89% on the first day of trading.   This kind of public interest along with the rapidly growing influence of the funds on the markets because of their size virtually ensures more regulation through enforcement actions, such as those cited above, and which may come out of the Wall Street sweep  currently underway.  Accordingly, for the remainder of this year and for the foreseeable future we should expect a series of enforcement efforts like the current sweep and the cases noted above relating to hedge funds.

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Yesterday, the SEC announced that a jury found former CFO, John J. Todd, and the former controller, Robert D. Manza, of Gateway Inc., liable on all charges for violating the antifraud, false statements to accountants, and recordkeeping provisions of the federal securities laws, and for aiding and abetting Gateway’s violations of the reporting and recordkeeping provisions of the securities laws.  In June 2006, Judge Roger Benitez of the U.S. District Court for the Southern District of California found that the SEC failed to provide sufficient evidence to support its allegations of similar conduct against  Gateway’s former CEO, Jeffrey Weitzen.

A key difference in proof offered against Messrs. Todd and Manza and Mr. Weitzen appears to have been a program recorded in documents offered by the SEC.  Throughout the three week trial, the jury heard testimony detailing the fraudulent revenue and earnings manipulation scheme of John Todd and Robert Manza and their concealment of important information about the success of Gateway’s PC business.  The release states that the jury learned of the  scheme of Messrs. Todd and Manza to offer pre-approved financing to individuals whose credit requests had previously been denied and that “[t]his effort continued into the third quarter with even riskier credit candidates and became known within Gateway as the ‘DDS program,’ which stood for ‘deep, deep sh[–],’ according to documents and testimony from company insiders.  

In contrast to Messrs. Todd and Manza and their DDS program reflected in company documents, the court found no evidence linking Mr. Weitzen to the DDS program leaving one to wonder why he was named as a defendant in the first place – particularly when the SEC had a clear case based on the admissions of the  wrong doers.

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