Most of the investment fund cases brought by the SEC in
recent months have centered on Ponzi scheme claims. Recent enforcement actions
involving hedge funds, however, suggest that perhaps a new trend is coming.
Consider for example, the SEC's recent action captioned SEC v. Southridge
Capital Management LLC, Civil Action No. 3: 10-cv-1685 (D. Conn. Filed Oct.
25, 2010). The defendants in the case are Southridge Capital, an investment
adviser initiated in 1996, its founder defendant Stephen Hicks and Southridge
Advisors, founded in 2008. The complaint centers on allegations that
misrepresentations were made to investors regarding the liquidity of the funds,
assets were over-valued, management fees were overcharged and fund assets were
improperly used to pay operating expenses.
Initially, three funds advised by Mr. Hicks invested
primarily in PIPEs involving micro-cap issuers. These companies typically have
limited assets. Trading in their shares is limited. By 2004, the funds had
insufficient cash to pay redemption requests.
In late 2003, however, Mr. Hicks began to solicit
investors in the then existing funds as well as others to invest in a new fund
which he promised would be liquid. Despite this representation and later claims
that the new fund was 75% liquid, by year end 2006 over half of the assets were
relatively illiquid PIPE deals or other instruments such as promissory notes.
This situation persisted over the next two years. Again redemption requests
could not be honored.
As the market crisis unfolded in 2008, the over $100
million Southridge Funds had under management diminished to about $70 million. Its
largest single holding was a $30 million investment in Fonix Corporation. That
interest had been obtained in a February 2004 exchange offer. Since the date of
the acquisition, the investment had been significantly overvalued. Management
fees were nevertheless charged as a percentage of the fund assets. This
permitted Southridge and Mr. Hicks to reap hundreds of thousands of dollars in
management fees each year.
The fund was also saddled with about $5 million in legal
expenses. Those fees were actually incurred by the old funds as a result of the
numerous lawsuits filed against Mr. Hicks, Southridge Capital and related
persons in connection with the investments made by those funds. Mr. Hicks
informed investors in the new fund about this charge. Rather than repaying the
money, however, he had the illiquid assets of the old funds transferred to the
The complaint alleges violations of Securities Act
Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), (2)
and (6). The case is in litigation. See also Litig. Rel. 21709 (Oct. 25, 2010).
Southridge Capital is one of what may be a growing number
of cases which focus on the operation of hedge funds rather than Ponzi scheme
allegations. An action brought in late September month involving Valentine
Capital Asset Management (here) centered on allegations regarding a breach of
fiduciary adviser. There, the complaint claimed the defendant solicited clients
in one fund under management to switch to a second without disclosing that the
investors would incur significant additional fees. Similarly SEC v. Mannion
claims that a "side pocket" was improperly used to hold illiquid investments
which were overvalued. That resulted in an inflated NAV used to solicit new
investors and calculate management fees - that is the fund and investors were
overcharged as in Southridge Capital. See also SEC v. Prevost (here) (feeder fund
case). Now that hedge funds are required to register with the Commission, keep
certain records and submit to inspections under Dodd-Frank (here), there may
be more cases like these in the future.
For more cutting edge commentary on
developing securities issues, visit SEC Actions, a
blog by Thomas Gorman.