SEC Continues Crackdown on Overvaluations of Hedge Fund Assets

As we have previously discussed here, the Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers overvalue illiquid assets so as to generate higher management fees. Most recently, on October 25, 2010, the SEC charged hedge fund manager Stephen M. Hicks and his investment advisory businesses with defrauding investors in funds managed by Southridge Capital Management LLC and Southridge Advisors LLC by overvaluing the largest position held by the funds.

According to the SEC’s complaint, the largest holding of the Southridge funds was an investment in Fonix Corporation, which was valued at $30 million. The Southridge funds had acquired Fonix securities in exchange for securities of two telecommunications companies owned by the Southridge funds - LecStar Telecom, Inc. and LecStar DataNet, Inc. (collectively, “LecStar”). Southridge and Hicks valued the Fonix securities at their cost of acquisition, which they determined to be equal to the appraised value of the LecStar securities at the time of the exchange. The SEC alleges that the defendants knew or should have known that this appraisal did not reflect the “real” acquisition cost of the Fonix securities because it was based on erroneous information indicating that LecStar was profitable and assumed that an earlier transaction in LecStar securities had been negotiated at arm’s length when in fact it was a transaction between affiliates.

Even if Southridge and Hicks had properly calculated the acquisition cost of the Fonix securities, they would not have been permitted to use this as the basis of a valuation. The offering materials for the Southridge funds indicated that such investments would be valued based on a valuation provided by a clearing broker or independent pricing service rather than acquisition cost.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.