Court Finds Securities Rules Must Be Clear to Impose Liability

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A federal district judge refused to impose liability on an investment adviser to a hedge fund and its CEO in an SEC enforcement action because the conduct was not clearly identified as being impermissible. The court also ruled that the Supreme Court’s recent holding in Janus Capital Group, Inc., et al, v. First Derivative Traders,1 which limited primary liability to “makers” of misstatements, only applies to private suits alleging material misstatements and not SEC enforcement actions.

On February 14, 2012, Judge Robert Sweet issued an opinion in Securities and Exchange Commission v. Pentagon Capital Management PLC and Lewis Chester, 08 Civ. 3324 (S.D.N.Y), one of the last remaining late trading and market timing cases. The court found that U.K.-based hedge fund investment adviser Pentagon, and its CEO Chester, violated the antifraud provisions of the federal securities laws by engaging in a scheme with one of their broker-dealers, Trautman Wasserman & Co., Inc., to deceive mutual funds by engaging in late trading. 

Late trading is the practice of placing orders to buy or sell mutual fund shares after the mandated 4:00 pm cut-off order time while making it appear to the mutual funds as though the order was placed before the cut-off order time. The court ordered the defendants to disgorge $38.4 million and to pay an additional $38.4 million as a penalty. Significantly however, the court ruled that Pentagon and Chester did not violate the antifraud provisions by engaging in deceptive mutual fund market timing, a trading strategy premised on the rapid buying and selling of mutual fund shares to exploit short-term pricing inefficiencies, because market timing is not per se illegal.

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