As a hedge fund lawyer one of my most important jobs is to help keep the client out of any trouble and to help the manager deal with any potential issues before they become issues.

Below is a classic example of an investment manager who did not adequately describe his investment program (and the risks). One of the more important parts of the hedge fund start up process is to create an investment program which accurately describes the trading which the fund will engage in. While many offering documents include very broad language allowing a manager to make changes to the investment program, gross or wholesale changes should be communicated to the investor (potentially with the right to redeem the interests, depending on the hedge fund’s terms and structure). The highlighted language below emphasizes the point that descriptions of a hedge fund’s investment program should be accurate, as well as the point that hedge fund managers should never lie or intentionally mislead their clients.

The full release can be found here.

Release:

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20713 / September 11, 2008
SEC v. Mark D. Lay and MDL Capital Management, Inc., Civil Action No. 08-CV-1269 (DSC) (W.D. Pa.)
SEC Charges Mark D. Lay and MDL Capital Management, Inc. With Defrauding Ohio Bureau of Workers’ Compensation

The Securities and Exchange Commission announced that today it filed securities fraud charges in the United States District Court for the Western District of Pennsylvania against Mark D. Lay of Aliquippa, Pennsylvania, and MDL Capital Management, Inc. (“MDL Capital”), an investment adviser registered with the Commission and located in Pittsburgh, Pennsylvania. Lay was the Chairman, CEO and Chief Investment Strategist of MDL Capital and part-owner of MDL Capital. Without admitting or denying the allegations of the Complaint, Lay and MDL Capital have consented to the entry of a final judgment permanently enjoining them from engaging in the violations set forth below, and ordering other relief

The Commission’s Complaint alleges that, between February 2004 and November 2004, Lay and MDL Capital defrauded their advisory client, the Ohio Bureau of Workers’ Compensation, in connection with the Bureau’s investment of public money in the MDL Active Duration Fund, Ltd., a hedge fund affiliated with and managed by Lay and MDL Capital. The Bureau transferred approximately $200 million from its advisory account managed by MDL Capital and Lay to the hedge fund pursuant to an agreement that those assets would be conservatively leveraged.

The Complaint further alleges that MDL Capital and Lay exposed Bureau funds to unauthorized and undisclosed risk by substantially exceeding a 150% leverage guideline, at one point using leverage of over 21,000% in the hedge fund. As a result, the Bureau incurred losses of approximately $160 million. During the course of the fraud, Lay repeatedly lied to and misled the Bureau as to the reasons for and amount of the losses as well as the excessive leverage Lay was using.

In October 2007, based on these same facts, Lay was convicted in the Northern District of Ohio of criminal mail fraud, wire fraud and investment adviser fraud. Lay is currently serving a 12 year prison sentence.

The Complaint alleges that Lay and MDL Capital violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. Subject to the Court’s approval, the final judgment imposes permanent injunctions against MDL Capital and Lay and orders them to pay $1,544,195 in disgorgement and prejudgment interest, but waives payment of these amounts, and does not impose civil penalties, based on the defendants’ sworn statements of financial condition.