ANOTHER SPLIT DECISION FOR THE SEC

The Commission obtained a partial victory in a late trading and market timing case against Pentagon Capital Management Plc and its Chief Executive Officer, Lewis Chester. SEC v. Pentagon Capital Management Plc., Case No. 1:08-cv-03324 (S.D.N.Y. Filed April 3, 2008). The SEC prevailed after trial on its late trading claim, securing an order enjoining the defendants from future violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and requiring that they pay disgorgement of $38,416,500 plus prejudgment interest and a civil penalty equal to the amount of the disgorgement. The Commission lost on its market timing claim. An analysis of the Court’s rationale on the late trading claim however suggests that the decision may not be sustained on appeal.

The decision

Pentagon Capital is an investment adviser based in London, England. It has furnished investment advisory services to Pentagon Fund, a British Virgin Island entity, and related entities since at least 1999. Mr. Chester, a resident of London, England, has served as CEO since 1999 and as one of two portfolio managers. The Commission’s complaint against the investment adviser and its CEO alleges violations of the antifraud provisions based on claims of market timing and late trading. Those claims centers on trading in the shares of mutual funds from 1999 through September 2003 on the New York Stock Exchange.

Following a seventeen day bench trial the Court rejected the Commission’s market timing claim. Market timing refers generally to buying and selling mutual fund shares in a fashion which takes advantage of short-term pricing inefficiencies. Many mutual funds during this period had policies which restricted short term in and out, market timing transactions. At the same time a number of funds made side deals with certain traders which permitted those policies to be circumvented.

Here the defendants utilized multiple accounts at brokers and restricted their trades to relatively small amounts to avoid detection by mutual funds. This “under the radar” approach was designed to elude detection by funds which policed their policies. Despite these precautions, the Pentagon was kicked out of a number of funds, a result it expected for a certain percentage of its trades.

From 1999 to 2003 Pentagon placed a total of 44,488 mutual fund transactions through thirteen U.S. broker-dealers. The transactions had a value of over $14 billion and were held ffor an average of three days. Approximately 22,448 transactions were purchases totaling about $7.1 billion while 22,038 were sales or redemptions totaling almost $7.2 billion.

Pentagon and Mr. Chester also engaged in late trading through TW&Co. beginning in February 2001 the Court concluded. Mutual funds accept orders up to 4:00 p.m. EST when the New York Stock Exchange closes. Late trading is an extreme form of market timing. By trading after the close of the trading day for the NAV calculated traders can profitably utilize certain informational advantages to profit.

To trade after hours the Pentagon initially sent its orders to the firm prior to 4:00 p.m. EST but was later permitted to cancel them. Initially the firm processed late trades up to about 5:15 or 5:30. Later that deadline was extended to 6:30 p.m. EST. Pentagon and Mr. Chester were aware of the 4 p.m. closing of the New York Stock Exchange and its significance to the mutual funds and the calculation of NAV.

Between February 1, 2001 and September 3, 2003 the Fund placed about 10,052 purchases of open-ended U.S. mutual funds through TW&Co. for a principle investment of about $3.1 billion. The average hold period for these transactions was two days. The Fund made about $38.4 million in profits from trades executed through TW&Co.

In its conclusion of law the Court rejected the SEC’s market timing claims. Market timing alone “is neither illegal nor necessarily fraudulent,” the Court concluded. The SEC has not prohibited the practice. Nevertheless, many mutual funds prohibit market timing. In essence the Commission is enforcing the corporate regulations enacted by various mutual funds by bringing a market timing claim.

Critical to such a claim is the element of deception which is at the core of a Section 17(a) and 10(b) claim. While market timing itself is not illegal, the execution of certain practices in connection with it may be deceptive. In this regard courts have concluded that practices such as breaking down trades, cloning accounts and using multiple accounts and brokers with the intent to deceive a fund into accepting trades may constitute fraud.

In this case the defendants engaged in the kind of practices some courts have found to be deceptive. However, during the time period of this case there was uncertainty regarding market timing. There were no definitions or prohibitions from the responsible agency on the issue. While various mutual funds had policies prohibiting the practice, enforcement was inconsistent. In this case the SEC has not presented evidence to the contrary. Yet “to establish securities fraud in connection with market timing, the SEC must forge a link between a given market timed transaction and a given prospectus or standard utilized by the market timing police of a specific fund.” Here “the lack of clarity by either the funds’ prospectuses or their enforcement policies undermines the SEC’s case . . . “

In contrast, the Court concluded that the defendants engaged in fraudulent late trading. Under SEC Regulation 22c-1, and well known industry practice, mutual funds orders must be placed by the close of the markets at 4 p.m. in order to receive the NAV for that day. Every court which has considered the question has concluded that the practice constitutes a violation of the anti-fraud provision of the securities laws the Court found.

Here the defendants’ submission of late-trade orders “constituted a fraudulent device and an implied misrepresentation in violation of Rule 10b-5 because it suggested that final orders were received before the funds’ 4:00 pm. pricing time . . .” according to the Court. The defendants knew that late trading gave them an impermissible advantage over other investors. In reaching this conclusion the Court relied in part on the fact that the defendants knew of the 4:00 p.m. cut-off and that they were aware of the practice by TW&Co. of falsely stamping timesheets as if their orders were placed prior to the deadline. This is deliberately misleading and false for which defendants are primarily liable the Court concluded.

The Court rejected the argument of Pentagon and Mr. Chester that they could not be primary violators under the Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders., 131 S.Ct. 2296 (2011). That decision was a private damage action which is not applicable to an SEC enforcement action, according to the Court. This conclusion is bolstered by the fact that Janus is based on subsection (b) of the Rule while this action is predicated on scheme liability under subsections (a) and (c). In view of this conclusion the Court found it unnecessary to address the question of aiding and abetting.

Analysis

While the Court authored a lengthy 126 page set of findings of fact and conclusions of law it seems doubtful that its late trading determination will withstand scrutiny if the defendants chose to appeal. The findings as to market timing issues are clear and well grounded. During the time period of this case funds frequently adopted market timing policies and then engaged in side deals which permitted certain traders to time their trades. Utilizing those policies as the predicate for securities fraud given the inconsistencies in their application would be inappropriate. This is particularly true in view of the lack of proof offered by the SEC regarding the practices of the specific funds involved in this case.

At the same time the Court’s conclusion that Janus does not apply in an SEC enforcement action simply ignores the directive of the Supreme Court. Janus is predicated squarely on the language of the Section and Rule. That language applies with equal force in every action based on the statute and the rule. Indeed, the position of the Court here was argued by the SEC staff in a recent administrative proceeding and rejected. In the Matter of John P. Flannery, Adm. Proc. File No. 3-14081 (Initial Decision Dated Oct. 28, 2011).

Likewise, the Court’s conclusion that this case is based on scheme liability rather than a misrepresentation appears to be little more than an attempted end run on Janus. If accepted it would eviscerate the Supreme Court’s holding as the court concluded in rejecting this contention in SEC v. Kelly, Case No. 08-CV 4612 (S.D.N.Y.), a case not cited by the Court here. But see Hawaii Ironworkers Annuity Trust Fund v. Cole, Case No. 3:10CV371 (N.D. Ohio)(holding the opposite). In any event, the Court’s attempt to rely on scheme liability is belied by its own finding that the fraudulent late trading was based on an implied misrepresentation that the orders were timely when the brokers presented them to the funds. In view of the Court’s disregard of Janus and its failure to address the question of aiding and abetting, it seems clear that the Second Circuit will have little choice but to reverse the decision.