US SEC sues UK hedge fund over mutual fund trades

Date: Friday, April 4, 2008
Author: Paritosh Bansal, Reuters

U.S. securities regulators sued a London-based hedge fund and its chief executive on Thursday, alleging they schemed to defraud mutual funds and shareholders in the United States.

The U.S. Securities and Exchange Commission said Pentagon Capital Management Plc, which manages $2 billion in assets, and chief executive Lewis Chester orchestrated a scheme to defraud mutual funds through late trading and deceptive market timing, according to a complaint filed in U.S. District Court in Manhattan.

From about June 1999 through September 2003, "PCM actively traded U.S. mutual funds through Pentagon Fund's accounts at numerous broker-dealers in the United States," the SEC said.

The SEC also named Pentagon Special Purpose Fund Ltd as a relief defendant, saying it earned illicit profits of about $62 million, while Pentagon Capital and Chester received fees for managing it.

Frank Razzano, a lawyer for the defendants, said: "We believe that we have substantial legal and factual defenses to the complaint.

"We look forward to proving at a court of law the innocence of the clients," said Razzano, a partner at Dickstein Shapiro LLP.

Chester, 38, a graduate of the University of Oxford and the Harvard Business School, "understood that PCM gained an improper, illegal trading advantage by being able to make trading decisions concerning which U.S. mutual fund shares to buy, redeem or exchange after 4 p.m. ET," according to the SEC complaint.

When two of Chester's U.S. brokers, James A. Wilson, Jr and Scott A. Christian, objected to staying until 6:30 p.m. to complete the trades, he sent them an e-mail:

"We're sending you some leverage money ... Hopefully this should stop your endless pathetic, pittiful (sic) moaning that I've been subjected to for years ... poor souls, working past cookie and milk time ... for once in your lives, you can work like real men and do a proper's day's work. (You really are a bunch of women of the first order)."

Late trading refers to the practice of placing orders in U.S. mutual fund shares after the close of trading at 4 p.m. ET when the value of each fund's holdings, or NAV, is calculated daily. Late trading harms other mutual fund shareholders by diluting the value of their shares and is illegal.

Market timing, which includes frequent trading of shares of the same mutual fund, can harm other mutual fund shareholders because it can dilute the value of their shares. While not illegal per se, it can disrupt the management of a mutual fund's investment portfolio.

Market timing is illegal, for example, if deception is used to induce a mutual fund to accept trades that it otherwise would not under its own market timing policies.

Pentagon Capital said it suspended its funds last month because it expected the SEC to file civil complaints against Chester.

Pentagon, which manages 1.1 billion pounds ($2.21 billion) in assets in 17 funds, said on March 27 that it will close the Pentagon Sterling Multi-Strategy fund, the Pentagon High Performance fund and the Pentagon Investment Capital International fund.

(Additional reporting by Leslie Gevirtz; Editing by Andre Grenon and Dave Zimmerman)