SEC Complaint Reads Like a List of Things Not to Do

SEC complaints usually contain great stories about what you should not to do. A recent case involving PEF Advisors caught my eye. The SEC claimed that hedge fund managers Paul Mannion, and Andrew Reckles, and their investment advisory company PEF Advisors misappropriated investor cash and securities by using the “side pockets” in 2005.

When used properly, a side pocket is a mechanism that a hedge fund uses to separate illiquid investments from the liquid investments. If a fund investor redeems their investment in a hedge fund with a side pocket, the investor cannot redeem the pro-rata portion of their investment allocated to the side pocket. That portion of the redemption is delayed until the asset is liquidated or is released from the side pocket. It’s a way to protect all of the investors when the fund has a big chunk of illiquid assets. A wave of redemptions would force the sale of liquid assets, leaving those who did not redeem with the illiquid assets.

Side pockets can be abused by putting liquid investments aside to limit the damage from redemptions. That is one of the many claims by the SEC against PEF.

Stavroula Lambrakopoulos, a lawyer who represents the defendants, said her clients “strongly deny the allegations in the complaint.” Whether they are true or not, the complaint lays out a list of things you should not do.

  • Do not sell securities from your personal account while having the fund invest in that security.
  • Do not violate your valuation policy.
  • Do not overvalue assets that you know are worthless.
  • Do not dramatically overvalue assets to increase your management fee.
  • Do not exercise the fund’s warrants in your personal account.
  • Do not borrow from the fund to make personal investments.
  • Do not trade on material non-public information when you have agreed to keep the information confidential.
  • Do not sign agreement stating that you do “not hold a short position, directly or indirectly, in” a stock when you shorted the shares the prior week.

The SEC brought claims under 10(b) of the Exchange Act, 206 (1) of the Advisers Act, and 206 (2) of the Advisers Act. There were lots of bad acts in the complaint, but the press release emphasized the side pocket problems.

Back in April, the SEC Enforcement Division’s new asset management unit announced that they were looking at ‘side pocket’ arrangements. This is the first case I’ve seen focused on this issue. I expect we will see some more soon.