SEC And Manhattan DA Investigate Southridge Capital

Date: Thursday, October 8, 2009
Author: Nathan Vardi,

Stephen Hicks' firm specializes in private investments in public equities, known as PIPEs.

Southridge Capital Management, a Ridgefield, Conn., hedge fund firm run by Stephen Hicks that primarily employs an investment strategy known as PIPEs, is under investigation by the Securities and Exchange Commission and Manhattan District Attorney Robert Morgenthau.

The SEC has opened an investigation into Southridge, according to two subpoenas the SEC sent in late July to companies that had received financing from the firm's hedge funds.

In the five-page subpoenas, Vyta Corp. and Hyperdynamics Corp. ( HDY - news - people ), two micro-cap companies that have been fighting Southridge for years in court, were asked by the SEC to produce documents reflecting all transfers of cash between them and the Southridge hedge funds over a four-year period. The companies were also told to provide documents relating to securities they issued to Southridge and communications between the companies and Southridge.

Late last week, the Ridgefield Police Department searched Southridge's offices, executing a search warrant on behalf of Morgenthau. The search was first reported by Bloomberg News.

"Our department assisted the Manhattan district attorney's office," said Ridgefield Police Captain Steven Brown. A Manhattan DA spokesperson declined to comment. An SEC spokesperson neither confirmed nor denied the existence of an investigation.

In an e-mailed statement, Southridge Capital Management says: "We are cooperating fully with authorities and cannot provide any further information at this time."

Hyperdynamics and Vyta, formally known as Nanopierce Technologies, first sued Southridge back in 2001, alleging Southridge manipulated their stocks. In May 2009, Vyta announced it was ceasing its operations. Hyperdynamics is battling to keep its case in state court in Georgia.

"From the nature of the document requests, they are looking into trading patterns with respect to Southridge, and they are looking at what Southridge Capital promised companies with regard to certain financings versus what actually happened," says James "Wes" Christian, an attorney who represents Vyta and Hyperdynamics. Christian says he represents LecStar Telecom, which has also sued Southridge. The suit of another Christian client against Southridge, Internet Law Library, has been tossed out of court.

Hicks' main investment strategy has been to make private investments in public equities, known as PIPEs, in which Hicks invested in thinly traded stocks. In these deals, Hicks would get securities that were convertible into discounted common shares of the companies in which he invested.

Hicks and Southridge Capital were the subject of a 2002 Forbes article (see "Sinking Fund") on death spiral preferred financings that also detailed the work of Mark Valentine, former chairman of Canadian brokerage Thomson Kernaghan. Southridge was a key client of the now defunct Thomson Kernaghan. Valentine pleaded guilty in March 2004 to U.S. federal charges of securities fraud, receiving nine months of house arrest and four years of probation. He was also banned from working as a stockbroker.

Hicks founded Southridge Capital in 1996 and also set up an affiliated brokerage, Southridge Group, which provides investment banking and financial advisory services. Southridge claims its funds have provided $1.3 billion in capital to over 250 issuers worldwide.

Over the last few years, hedge funds have made billions of dollars of investments in penny stocks using PIPE structures, often causing the underlying stocks to plummet. The practices of hedge funds that specialize in penny stock PIPE financings have recently come under renewed scrutiny by regulators and law enforcement agencies.

In July, the SEC subpoenaed documents from NIR Group, the Long Island hedge fund firm run by Corey Ribotsky that specializes in PIPEs, in an investigation focusing on the performance valuations of NIR's family of hedge funds and communications NIR made to investors.

Prosecutors from the U.S. Attorney's office in Brooklyn and investigators from the FBI are looking into whether Ribotsky defrauded investors as the stock market fell last year, The Wall Street Journal has reported. NIR has previously said that it's fully cooperating with the SEC and is eager to provide to it any information or documents that it requests.

The efforts of hedge funds like NIR Group and Laurus Capital Management to turbocharge their returns by focusing on penny stocks and PIPEs have been the subject of several articles in Forbes over the last three years.