Hedge fund fraud cases are important because they give some definition and life to the various investment advisor and hedge fund laws. Much of the advice that hedge fund lawyers give to their clients is based on reasonableness and best guesses on how the securities laws will be implemented in the hedge fund context. For many hedge fund issues there are not clear cut cases which give color to the securities laws. One of my colleagues refers to this as the “square peg – round hole” dilemma by which he means it is hard to apply the archaic securities laws with the current state of the hedge fund and investment management industry.
When the SEC does bring cases, as practitioners we get to see how the SEC views the securities rules and how we should be advising clients. While many of the fraud cases represent completely unbelievable actions by unscrupulous people, there are still lessons which well-intentioned managers can learn from.
Specifically this case gives us an opportunity to examine five separate areas which invesment managers should be aware of:
1. Make sure all statements in the hedge fund offering documents and collateral marketing materials is are accurate.
In this case the hedge fund offering documents contained many material misstatements including materially false and misleading statements in offering materials and newsletters about, among other things, the Funds’ holdings, performances, values and management backgrounds. For example the complaint alledges:
Specifically, both PPMs represented that most investments made by Partners and Offshore would trade on “listed exchanges.” In truth, a majority of those funds’ investments were and are on unlisted exchanges such as the OTCBB or pink sheets. Furthermore, the Partners’ PPM stated that investors would receive yearly audited financials upon request. Partners has not obtained audited financials since the year ended 2000 and repeatedly refused at least one investor’s requests for audited financials for the year ended 2001.
2. Make sure all appropriate disclosure relating to personnel are made.
Hedge fund attorneys will usually spend time with the manager discussing the employees of the management company and their backgrounds. During this time the attorney will ask the manager, among other questions, whether any person who is part of the management company has been involved in any securities related offense. In this case there were two specific items which the manager should have disclosed in the offering documents and other collateral material:
Failed to disclose that a “consultant” to the management company was enjoined, fined and also barred from serving as an officer or director of a public company for five years for his fraudulent conduct involving, among other things, misallocating to himself securities while serving as CFO and later president of a publicly traded company.
Failed to discloase a member of the fund’s board of directors was barred from associating with any broker or dealer for 9 years.
3. Take care when going outside stated valuation policies.
Many hedge fund documents have stated valuation policies but then allow the manager to modify the valuation, in the manager’s discretion, to better reflect the true value of the securities. However, when a manager uses this discretion, the manager should have a basis for the valuation. Such valuation should not be based on an artificially inflated value of the asset. To be safe managers should probably have some internal valuation policies which should be in line with generally accepted valuation standards for such assets. I found the following paragraph from the SEC’s complaint particularly interesting (emphasis added):
II. Bogus Valuations
34. In order to obtain at least year end 2001 audited financials for Offshore, Lancer Management provided Offshore’s auditor with appraisals valuing certain of that fund’s holdings. These appraisals mirrored or closely approximated the values assigned to Offshore’s holdings by Defendants based on the manipulated closing prices at month end. These valuation reports were, however, fatally flawed and did not reflect the true values of Offshore’s holdings under the generally accepted Uniform Standards of Professional Appraisal Practice or American Society of Appraisers Business Valuation Standards. For example, the valuations were improperly based on unreliable market prices of thinly traded securities; unjustified prices of private transactions in thinly traded securities; unfounded, baseless and unrealistic projections; hypotheticals; and/or an averaging of various factors. Indeed, under accepted standards of valuing businesses, certain of the Funds’ holdings were and/or are essentially worthless.
4. Do not engage in market manipulation.
Many of the securities in which this hedge fund invested were traded on the OTCBB. The fund engaged in trading in these securities near valuation periods in order to artificially inflate the price of these very thinly traded securities. Additionally, the complaint alleges many incidents of “marking the close.” This goes without saying but a hedge fund manager should not engage in market manipulation.
5. Always produce accurate portfolio statements. Do not overstate earnings. Always make sure that statements to investors are accurate.
While many of the examples above are so egregious they probably do not need to be listed on a “do not” list, you should make sure you do not engage in any of these activities. Additionally, if you do make some error or mistake (for example, if a valuation turns out to be incorrect or inaccurate), immediately contact your attorney to create a plan to inform investors about the incorrect or inaccurate statements. A mistake can generally be cured, all out fraud cannot.
I have posted a full text version of the SEC’s case, SEC v. Lauer. I have included the statement by the SEC below which can be found here.
SEC Wins Major Hedge Fund Fraud Case Against Michael Lauer, Head of Lancer Management Group
FOR IMMEDIATE RELEASE
Washington, D.C., Sept. 24, 2008—The Securities and Exchange Commission announced that a district court judge today granted its motion for summary judgment against the architect of a massive billion-dollar hedge fund fraud.
Michael Lauer of Greenwich, Conn., was found liable for violating the anti-fraud provisions of the federal securities laws. In a 67-page order, The Honorable Kenneth A. Marra, U.S. District Judge for the Southern District of Florida, found that Lauer’s fraud as head of two Connecticut-based companies – Lancer Management Group and Lancer Management Group II – that managed investors’ money and acted as hedge fund advisers was “egregious, pervasive, premeditated and resulted in the loss of hundreds of millions of dollars in investors’ funds.”
Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “This case highlights the SEC’s ongoing efforts to combat hedge fund fraud and our dedicated work on behalf of investors to ensure that hedge fund managers are held accountable for any unlawful conduct.”
David Nelson, Director of the SEC’s Miami Regional Office, added, “We are particularly gratified at this decision, which resulted from several years of hard work to protect investors, starting when we successfully halted the fraud while it was still ongoing.”
Lauer raised more than $1.1 billion from investors and his fraudulent actions caused investor losses of approximately $500 million. The SEC initially won emergency temporary restraining orders and asset freezes against Lauer and his companies, which were placed under the control of a Court-appointed receiver after the SEC filed its enforcement action in 2003.
During the protracted litigation, the SEC successfully stopped Lauer from diverting or hiding millions of dollars of assets from the Court’s asset freeze.
The summary judgment order found that Lauer:
- Materially overstated the hedge funds’ valuations for the years 1999 to 2002.
- Manipulated the prices of seven securities that were a material portion of the funds’ portfolios from November 1999 through at least April 2003.
- Failed to provide any basis to substantiate or explain the exorbitant valuations of the shell corporations that saturated the funds’ portfolios.
- Hid or lied to investors about the Funds’ actual holdings by providing them with fake portfolio statements.
- Falsely represented the funds’ holdings in newsletters.
The judge’s order entered a permanent injunction against Lauer against future violations of Sections 17(a)(1)-(3) of the Securities Act of 1933 (Securities Act), Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (Exchange Act), and Sections 206(1) and (2) of the Investment Advisers Act of 1940 (Advisers Act). The order reserved ruling on the SEC’s claim for disgorgement with prejudgment interest against Lauer, and on the amount of a financial penalty Lauer must pay. The SEC is seeking a financial penalty and disgorgement of the more than $50 million Lauer received in ill-gotten gains from his fraudulent scheme.