The Securities and Exchange Commission has accused Sentinel Management, the short-term cash manager for clients such as hedge funds and futures brokers which filed for bankruptcy last week, of misappropriating client assets and seeking to cover its problems by claiming to be a victim of the collapse in value of asset-backed securities.
Northbrook, Illinois-based Sentinel, whose funds had assets valued at USD1.6bn earlier this month, wrote to investors last week saying that it could not meet client redemption requests without selling securities at a deep discount.
The firm wrote: 'Investor fear has overtaken reason and has induced a period in which most securities have simply ceased to trade. We've all read the stories about one hedge fund or another suffering losses related to sub-prime exposure and closing down or being rescued.
'This fear has spilled over into the rest of the credit market and liquidity has dried up all over the street. This liquidity crisis has caused bids to disappear from the market and makes it virtually impossible to properly price securities or to trade them. High-grade securities are trading like junk bonds as panicked investors dump names like General Electric at Tyco-like prices.
'We had previously thought that the market would return to some semblance of order and that our clients would not join in the panic. Unfortunately, this has not been the case. We are concerned that we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients.'
Sentinel said it had contacted the US futures market regulator, the Commodity Futures Trading Commission, to request permission to halt redemptions 'until we can honour them in an orderly fashion', although the CFTC said the suspension of redemptions was a matter for the firm and its investors, not the regulator.
Subsequently Citadel Investment Group, a hedge fund manager that has already acquired distressed credit portfolio assets over the past month from Sowood Capital, bought a reported USD312m in assets from Sentinel at a discount of at least 10 per cent.
The deal bought an angry response from investors including Penson Worldwide, which said the assets had been sold 'at an unfair price', without consultation with creditors and in violation of the contract between them. While Sentinel's clients went to court in a bid to halt the sale, the company filed for bankruptcy.
On Monday the SEC announced that it was bringing fraud charges against Sentinel, arguing that an inspection of the firm's books shortly before the crisis broke had revealed that it had been concealing losses for months and submitting false client account statements to investors.
The action by the US financial regulator sought 'to halt Sentinel's improper commingling, misappropriating and leveraging [of] client securities without client consent in violation of Section 206 of the Investment Adviser Act of 1940'.
The SEC claims: 'For a period of at least several months up to and including the week of August 13, Sentinel's advisory clients suffered undisclosed losses and risks of losses as a result of several unauthorised practices engaged in by Sentinel.
'These include pledging securities owned by clients as collateral in order to obtain a line of credit [from Bank of New York] as high as USD500m for Sentinel, placing at least USD460m of client securities properly belonging in segregated customer accounts in Sentinel's house proprietary account, commingling client assets without the ability to verify ownership of particular securities by particular clients, and providing false client account statements that did not accurately reflect client portfolio holdings or the fact that securities had been encumbered by Sentinel.'
The SEC's order required Sentinel to provide a full accounting of client assets and the firm's assets and liabilities within five days, and to produce immediately brokerage and bank documents in order to begin the process of determining client portfolio holdings and ownership of securities. The complaint also seeks a permanent injunction, disgorgement and civil penalties against Sentinel.
A Chicago bankruptcy judge ruled on Wednesday that Sentinel could distribute to investors the USD312m proceeds of the asset sale to Citadel, but the money currently remains blocked by an order from the National Futures Association.
Although some investors are understood to have recovered their assets from Sentinel prior to its collapse, Paris-based hedge fund manager Capital Fund Management has told investors that its Discus Master Fund may face losses of as much as USD407m.