By Mikhail Iliev, Who's In My Fund -- Hedge fund managers ought to be calling their attorneys relating to their use of side pockets. The SEC fired its latest salvo against the hedge fund industry on Tuesday, charging two hedge fund managers with fraud over their use of "side pocket" accounts, and federal officials have indicated more prosecutions are likely as they target this little-known financial tool.
In a civil complaint filed in U.S. District Court in Atlanta, the SEC claimed that hedge fund managers Paul Mannion and Andrew Reckles and their investment advisory company PEF Advisors (through both its onshore arm, PEF Advisers LLC, and its offshore arm, PEF Advisors Ltd.) misappropriated investor cash and securities in 2005 from their Georgia-based Palisades Master Fund. The managers were alleged to have reported to investors fraudulent valuations of certain assets and to have misleadingly inflated net asset values, effectively allowing them to take excessive management fees from the fund. This practice was facilitated by the use of a special account, a so-called side pocket, which fund managers usually reserve for very illiquid investments and which an SEC enforcement director has likened to "a dumping ground for hedge fund managers to conceal overvalued assets."
The SEC has become swift and resolute in these matters, as illustrated by the following brief chronology.
It was barely a year ago, on Oct. 16, 2009, that the director of the SEC’s Division of Enforcement, Robert Khuzami, singled out the hedge fund industry as one that would be the focus of increased enforcement scrutiny.
“We at the SEC are committed to pulling back the curtain on hedge fund operations and taking a closer look at their activity,” he said.
On Jan. 13, at a conference in Washington, D.C., the SEC formally announced the creation of various specialized enforcement units to combat financial fraud and other illegal conduct in certain high priority areas. One of the units formed was the Asset Management Unit, a group of roughly 60 SEC enforcement attorneys spread across nine offices. The unit’s co-chiefs Rob Kaplan and Bruce Karpati were tasked with focusing on investment companies, investment advisers, mutual funds, hedge funds and private equity funds.
When the Asset Management Unit met for the first time in April the use of side pockets by hedge fund managers caught its notice. Issues included how funds were assigning fair values to side pocket assets and disclosing information to investors. The unit reportedly targeted hedge fund managers, but it appeared that directors, administrators, and auditors would be under scrutiny as well. Investigations would also likely focus on offshore funds' directors, who help managers govern their funds, including by looking out for fund clients' interests, and questions about whether directors properly discharged their responsibilities related to valuations and investor disclosure of side pockets
And now, some five months later, the first formal complaint has been lodged in court involving the use of side pockets.
So, what is a side pocket? A side pocket is an account set up by a hedge fund to segregate certain assets or investments from the fund’s general portfolio. Side pockets are typically used to hold less liquid securities and their use may well be specifically sanctioned in a hedge fund’s placement documents. Fund managers can use side pockets to isolate assets until market conditions improve and the assets can be sold at prices that better reflect their intrinsic value. Properly used, the practice helps managers limit losses to the fund and protect fund investors in the process.
The practice became an issue during the financial crisis of 2007-2009. At the time, many of the assets held by hedge funds became difficult or impossible to sell for a reasonable price. Investors began trying to redeem stakes in hedge funds in droves. To avoid fire sales, some managers transferred their hard-to-sell or price assets into side pocket accounts. Some investors complained to the SEC about the practice, and thus began the cycle of enforcement leading directly to the PEF case. Of course, a hedge fund need not have used side pockets only during the crisis to attract scrutiny from the SEC. PEF’s side pocket was put in place in September 2005.
It’s not likely side pockets will be going away soon. With funds regaining their footing and clients again reaching for their wallets, managers aren't moving away from side pockets. Many are even inserting new language into their fund documents to make sure they have more flexibility to freeze holdings, according to Montreal-based Castle Hall Alternatives, which assesses investment risks for hedge-fund clients (as reported in the Wall Street Journal in April).
What are the sensitive areas and possible targets for the SEC to pry into? Broadly speaking, the SEC’s Asset Management Unit will likely focus on how fund offering documents authorized and disclosed the use of side pockets, and how managers implemented side pocket arrangements. What assets were put in the side pocket, when, and why? The unit will also likely review how fund management and fund service providers accounted for the side pocket assets, and whether the manager charged fees associated with those assets. Did the manager receive a fee on the value of the securities in the side pocket, and if so, how were those securities valued? Such fees may not be improper per se, but the SEC may focus on whether fund documents provided adequate authority and disclosure to support the charging of fees under the circumstances.
Hedge fund managers ought to be call their attorneys. Expecting further SEC scrutiny, they should reexamine their current side pocket arrangements and evaluate if additional disclosure to investors of those arrangements is advisable. They should also be ready to justify the methodology used to value side pocketed assets, especially if those assets are sold at an appreciably lower price. Fund administrators and fund directors should also review situations in which their funds implemented side pockets and be prepared to justify the associated valuations. Finally, as hedge fund stabilize and bounce back, new funds should carefully consider how to adequately disclose information about side pockets to investors and the rules that will govern their use so as to avoid disputes down the road.
The lawsuit is Securities And Exchange Commission v. Paul Mannion et al, U.S. District Court, Northern District of Georgia, No. 10-3374.
Mikhail Iliev is a contributing editor of Who's In My Fund, a site which groups hedge fund investors by investment, allowing them to communicate directly and discretely with each other in a secure environment and share news and opinion on their investments. Mikhail practiced law for 11 years as an associate at Dewey LeBoeuf, LLP and as Senior Vice President at KBC Financial Products. He has extensive experience in the field of securities law and private investments and has advised clients on financing and offering matters for domestic and offshore funds, mergers and acquisitions and securities regulation. He is also a visiting professor at Segal Graduate School of Business in Vancouver, Canada where he has taught courses on securities regulation and ethics.