SEC Scrutiny of Hedge Fund Managers Up in 2006

If 2005 was the year of "hedge fund activism," 2006 promises to be the year of SEC hedge fund enforcement cases.

According to the public statements of senior managers in the Securities and Exchange Commission’s Division of Enforcement, the agency brought approximately 30 hedge fund enforcement actions in 2005 and is dedicating "substantial resources" to hedge fund fraud investigations in 2006. The agency publishes few hard statistics about its filed enforcement actions, and takes a "no comment" approach to the details of pending investigations, so quantifying the level of regulatory scrutiny is more art that science.

Here’s what is known, (1) The 2005 count of 30 enforcement actions overstates the true number because it lumps together everything from Ponzi schemes masquerading as hedge funds to hyper-technical rule violations by legitimate, well-known hedge fund management firms; and (2) There remain several dozen active fraud investigations in the SEC "pipeline" according to a informal survey of defense counsel.

Recent SEC enforcement activity suggests a particular emphasis on investigations involving PIPE transactions.

Beginning with the government’s high-profile criminal and civil actions against former SG Cowan managing director Guillaume Pollett (April 21, 2005) and the SEC’s civil action against hedge fund manager Hillary Shane (May 18, 2005), short selling in connection with PIPE offerings has been a hot topic at PIPEs conferences and in the trade press. In recent months, the SEC has announced significant new enforcement actions, including cases against hedge fund manager Jeffrey Thorp (March 14, 2006) and Deephaven Capital Management LLC, a unit of Knight Securities (May 2, 2006). Why are we seeing so many of these cases now? Have participants in the PIPEs market suddenly decided, seemingly en masse, to engage in fraudulent behavior? Not likely.

Trends in SEC enforcement activity often have multiple origins. Others, such as the 2003 global research analyst settlement, can have a single trigger (i.e., a headline-grabbing case brought by the New York Attorney General). By all accounts, the current trend in hedge fund PIPEs cases has multiple origins. Some of the cases that are now being brought date back to an early 2000s boom in PIPEs activity, when the market for public secondary offerings was soft and PIPE financings plentiful. A few of the matters grow out of conduct that prosecutors stumbled upon while investigating other activity. Other factors may also explain the trend; for example, some SEC observers believe that the agency is anxious to solidify its oversight of the hedge fund industry in light of Congressional criticism (see accompanying article) and a pending federal lawsuit challenging its new hedge fund manager registration rules.

In each of these four cases mentioned above, the defendants chose to settle with the government at the time of filing rather than to litigate the underlying issues before a judge and jury. Why? Is the government’s evidence so strong and its legal theory so solid that litigation is simply pointless? Not hardly.

Although some in the SEC’s Enforcement Division would no doubt like the hedge fund community to believe that these cases represent well-established law, several of the legal theories advanced in these matters have never been tested in a court of law. Some of the theories, in fact, have been publicly criticized by leading academics, such as Columbia law professor John Coffee, who called one of the SEC’s theories "fundamentally lawless." There is, however, one common element to all of these settled SEC enforcement actions, it’s the benefit gained from a practice that the SEC pioneered some years ago called "never admit, nor deny." In short, settling litigants do not admit liability, so long as they: (1) don’t deny liability and (2) consent to the remedies the SEC demands (e.g. an injunction from future violations, return of illegal profits, payment of interest and monetary penalties). A combination of other factors likely drove these individual settlement decisions on a case by case basis. These include pressure exerted by criminal authorities, leverage held by the SEC because of other, non-disclosed problems and, in the case of the Shane matter, very bad facts.

If public statements by senior SEC officials are to be believed, and there’s no reason to doubt their resolve, more hedge fund cases are just around the corner, including enforcement actions that do not involve PIPE trading. The compliance date for the new hedge fund manager registration rules was February 6, 2006, and SEC examination teams have already completed their on-site inspections of a handful of hedge fund managers around the country. These first-ever inspections are certain to yield compliance issues as newly-registered hedge fund managers attempt to comply with the SEC’s one-size-fits-all set of rules. When SEC exam teams encounter what they perceive to be serious deficiencies, they will refer them to the SEC’s enforcement staff for additional action. In the months (and years) ahead, look for SEC enforcement activity in the following areas: (1) valuation of private securities, (2) marketing statements, particularly statements about past performance, and (3) the use of soft dollars.

Stay tuned . . .

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