SEC charges hedge fund of inflating "side pockets"

Date: Wednesday, October 20, 2010
Author: Emily Chasan, Reuters

Securities regulators charged two hedge fund managers at Georgia-based Palisades Master Fund with fraud on Tuesday, claiming they had overvalued illiquid assets placed in a "side pocket" to deceive investors and steal millions of dollars.

Hedge funds typically use "side pockets" to stash illiquid securities and avoid losses until the markets for the securities improve, but the U.S. Securities and Exchange Commission has heightened scrutiny of the practice recently.

In a civil complaint filed in U.S. District Court in Atlanta on Tuesday, the SEC claimed that hedge fund managers Paul Mannion, 48 and Andrew Reckles, 40, and their investment advisory company PEF Advisors misappropriated investor cash and securities by using the side pockets in 2005.

The SEC said that the fund had placed fraudulent values on convertible debt, bridge loans and restricted stock in the side pocket, and misrepresented values to investors.

"Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets," Robert Kaplan, Co-Chief of the SEC's Asset Management Unit said. "Mannion and Reckles deceived investors about the fund's performance and extracted excessive management fees based on the inflated asset values in a side pocket."

The fund managers said in a statement through their lawyer they would "vigorously" defend themselves against the claims.

"We are disappointed that the SEC has chosen to litigate this action more than five years after the events at issue. Our clients strongly deny the allegations in the complaint," Stavroula Lambrakopoulos an attorney at K & L Gates LLP representing Mannion and Reckles said on behalf of her clients.

The suit focuses on the fund's investments in World Health Alternatives Inc, a healthcare staffing company which filed for bankruptcy in 2006.

"No valuation was reliable at that stage so the fund managers, with their investors' consent, did what they should have done -- they segregated the investments into a side pocket," Lambrakopoulos said.

While there is nothing inherently wrong with side pockets, they can lend themselves to abuse because a lot of discretion is left to managers about how they value the assets.

The Palisades side pocket case is the first of its kind for the U.S. investor protection agency, which has taken another look at the practice in the aftermath of the financial crisis. Many hedge funds parked illiquid assets in side pockets in late 2008.

Kaplan said investors can expect to "see additional side pocket cases" in the future.

Kaplan noted that the hedge fund group, which is also led by Bruce Kaparati, is putting a lot of focus on hedge fund valuation issues.

The suit is Securities And Exchange Commission v. Paul Mannion et al, U.S. District Court, Northern District of Georgia, No. 10-3374.