• SEC Focuses on Efforts by Hedge Fund Managers to Conceal Poor Performance
  • November 2, 2008 | Authors: Caryn Mazin Schechtman; Perrie M. Weiner
  • Law Firms: DLA Piper - New York Office ; DLA Piper - Los Angeles Office
  • The SEC has charged a San Francisco investment adviser, MedCap Management and Research LLC (MMR), and its principal, Charles Toney, Jr., with falsely inflating the price of a thinly-traded portfolio security to enhance fund asset values at the end of a reporting period so that it could avoid reporting a 40 percent loss and stave off a rash of investor redemptions. This practice, which the SEC calls “portfolio pumping,” is alleged by the SEC to violate the antifraud provisions of the Investment Advisers Act of 1940. The charges were filed October 16.

    MedCap Partners L.P. (MedCap), a fund managed by Toney and MMR, was plagued by poor performance and investor redemptions in 2006. According to the SEC, facing mounting losses in the third quarter of the year, Toney and MMR allegedly placed numerous buy orders during the last few days of the quarter in a thinly traded over-the-counter security heavily owned by MedCap through another MMR-controlled fund. The SEC alleges that this purchasing activity caused the portfolio security to quadruple and fraudulently increased MedCap’s value for the third quarter of 2006 by $29 million; both the stock price of the underlying security and MedCap’s value subsequently declined back to their previous levels.

    Without admitting or denying the SEC’s allegations, Toney and MMR agreed to:

    • cease and desist from violating the antifraud provisions of the Investment Advisers Act of 1940;
    • disgorge the additional management fees MMR received as a result of MedCap’s inflated value and interest in the amount of $70,633.69; and
    • receive a Commission censure.

    In addition, Toney consented to a bar from association with an investment adviser, with the right to reapply after one year, and he has agreed to pay a $100,000 penalty.

    It is worth noting that the SEC did not charge Toney or MMR with market manipulation in violation of Section 10(b) of the Securities Exchange Act of 1934. The Second Circuit’s 2007 decision in ATSI Communications, Inc. v. Shaar Fund Ltd. may be why. In ATSI, the Second Circuit held that mere intent to manipulate the market through trading is not sufficient for a market manipulation claim and that there could be no claim for market manipulation absent the injection of false information into the market. The only trade activity allegations against Toney and MMR concerned market purchases at market prices; there was no allegation that any false information has been injected into the market.

    We have received numerous calls and e-mails from hedge fund clients seeking guidance and counseling in the proper valuation of their assets, especially complicated for hedge funds with privately held portfolio companies with illiquid securities that are very difficult to mark to market. There are a variety of acceptable methodologies, but recent adverse market conditions are creating enhanced pressure on hedge funds to increase their valuations by using aggressive methods in order to avoid redemptions due to poor performance.

    This case makes clear that the SEC is not only interested in hedge funds but intends to pursue them when it believes that asset valuations cross the line from the aggressive to the unlawful. We expect to see a growing number of SEC investigations in this area.