SEC Turns Up Heat On Hedge Funds

August 10, 2007

On July 31, 2007, SEC Chairman Christopher Cox announced the creation of a new hedge fund task force within the Enforcement Division as the Commission's latest effort to "enhance its efforts to combat hedge fund insider trading." Although no other details were disclosed with respect to the new unit's formation, the creation of a task force dedicated to scrutinizing hedge funds suggests a greater need for fund managers to stay abreast of the latest SEC staff interpretations that may affect business practices.

Rule 10b-5

Hedge funds should consider the potential application of Rule 10b-5, one of the cornerstones of the SEC's enforcement program, to certain hedge fund business practices. Rule 10b-5 makes it unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility or any national securities exchange: (1) to employ any device, scheme, or artifice to defraud, (2) to make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made, in the light of circumstances under which they were made, not misleading, or (3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Big Boys

The Enforcement Division of the SEC may seek to apply Rule 10b-5 to activities generally referred to as "big boy" practices. Pleadings in a recent lawsuit filed by R2 Investments ("R2") against Solomon Smith Barney ("SSB") may indicate how "big boy" practices may come under Rule 10b-5 scrutiny. According to pleadings in the litigation, SSB engaged in negotiations with World Access, Inc. with respect to the terms of a tender offer. Through these negotiations, SSB allegedly learned material, non-public information about World Access. Afterwards, SSB sold its position to Jefferies Group under a "big boy" letter. Jefferies later sold the notes to Fimat Group, without a "big boy" letter, which in turn sold them to R2 without a "big boy" letter. Two days after the sale by SSB, World Access made public the material, non-public information available to SSB, causing a significant decline in the value of R2's investment. R2 filed suit against SSB alleging that the "big boy" letter did not inoculate SSB from 10b-5 liability. Although the matter is still pending, SSB's efforts to dismiss the 10b-5 allegations have failed.

Material, Non-Public Information

Barclays Bank recently paid over $10 million to settle an SEC Enforcement Action alleging trading violations under Rule 10b-5. This enforcement action suggests that hedge funds should be mindful of their trading activities when possibly in possession of material, non-public information. According to the SEC complaint in this matter, Barclays obtained material, non-public information through its membership to creditors committees of various issuers. Notwithstanding the confidentiality agreements Barclays signed, the SEC alleged that over an 18 month period, Barclays unlawfully traded in the securities of the various issuers.

"In Connection With"

In 2005, the SEC alleged Rule 10b-5 violations against Van D. Greenfield and Blue River Capital LLC in connection with WorldCom's chapter 11 bankruptcy cases. According to the SEC's administrative order imposing sanctions, Greenfield (Blue River Capital's manager and compliance officer) caused Blue River Capital to enter into simultaneous backdated purchases and short sales of WorldCom unsecured notes. In order to gain appointment to WorldCom's official unsecured creditors' committee, Greenfield never disclosed to the U.S. Trustee the existence of the short sale order, or that the trades had not yet settled. After being appointed to the committee, Greenfield cancelled the short sale and associated purchase of the notes. Even though the purchase and short sale did not directly involve any party other than the trade counterparties, the SEC alleged that by failing to disclose its true ownership position in unsecured notes to obtain membership on WorldCom's creditors' committee, Greenfield and Blue River Capital violated Rule 10b-5 by making indirect misrepresentations to all WorldCom constituencies in connection with the purchase and sale of securities.

Take Aways

The formation of a hedge fund task force indicates that the SEC staff may scrutinize certain hedge fund business practices, and may increase the likelihood of regulatory action in the hedge fund arena. The actions against SSB, Barclays and Blue Water Capital are just a few examples of Rule 10b-5's application to certain trading activities. In the past year, the SEC has brought numerous enforcement actions against hedge funds alleging violations of 10b-5. Given the sweeping reach of Rule 10b-5, it would be wise for hedge fund managers and other market participants to discuss their current strategies with counsel before the SEC strikes.