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SEC files late trading charges against UK-based hedge fund manager

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The Securities and Exchange Commission has filed a civil action in the US District Court for the Southern District of New York alleging late trading fraud against London-based hedge fund m

The Securities and Exchange Commission has filed a civil action in the US District Court for the Southern District of New York alleging late trading fraud against London-based hedge fund manager Pentagon Capital Management and its chief executive Lewis Chester.

The US regulator’s legal complaint, SEC v. Pentagon Capital Management PLC, alleges that Pentagon Capital, which has USD2bn in assets, and Chester orchestrated a scheme to defraud US mutual funds and their investors through late trading and deceptive market timing.

The SEC claims that the Pentagon Special Purpose Fund, the master fund in a master-feeder fund structure that has been named as a relief defendant in the case, gained some USD62m in illicit profits through this scheme at the expense of the mutual funds and their shareholders.

The commission’s complaint names as defendants Pentagon Capital, which has provided investment advisory services to the Pentagon Special Purpose Fund and its various feeder funds since 1999, and Chester, who joined Pentagon in 1998 and became chief executive since the following year. Over the intervening period, Chester was one of the fund’s two portfolio managers, and the SEC alleges he directed the market timing and late trading strategies.

Pentagon Special Purpose Fund, an international business company incorporated in the British Virgin Islands, is a relief defendant in the case, defined as a person or entity who has received ill-gotten funds or assets as a result of the illegal acts of other defendants. Its feeder funds included Pentagon Global Opportunity Fund, Pentagon Investment Capital International and Pentagon High Performance Fund.

The SEC describes Pentagon as a ‘key player’ in London’s hedge fund community as the manager of a large number of offshore regulated and unregulated funds in a range of diversified quantitative and alternative investment strategies for high net worth individuals, family offices, pension funds, corporations, charities, trusts and institutional investors.

Through Pentagon Finance products, the firm is also a provider of finance to the hedge fund community, providing a debt alternative to seed financing as well as acting as a senior secured lender to certain hedge fund strategies that are not normally serviced by traditional prime brokers or commercial lenders.

The SEC alleges that between approximately June 1999 and September 2003, Pentagon Capital actively traded US mutual funds through the fund’s accounts at numerous broker-dealers in the US and routinely engaged in late trading of mutual funds.

It claims that the Pentagon Special Purpose Fund placed orders on behalf of the fund to buy, redeem, or exchange mutual fund shares after the 4.00 p.m. Eastern Time market close while still receiving the current day’s mutual fund price.

An illegal practice, this enabled the fund to profit, at the expense of other shareholders in the mutual funds, from market events that occurred after the close but that were not reflected in the price that it paid for the mutual fund shares.

According to the SEC, Pentagon Capital and Chester used deceptive techniques to carry out market timing of mutual funds. The commission says inn its complaint states: ‘PCM [Pentagon Capital] opened numerous accounts for the Pentagon [Special Purpose] Fund at various US broker-dealers, and split Pentagon Fund trades among these multiple accounts to hide the extent of the Pentagon Fund’s trading from mutual fund companies.

‘PCM also used multiple accounts so that when a mutual fund detected market timing and informed the Pentagon Fund to stop, PCM would simply transfer funds to a new brokerage account that the mutual fund was unaware of, and Pentagon Fund would then resume market timing the same mutual fund.

‘Pentagon Fund earned illicit profits of approximately USD62m [while] PCM and Chester obtained ill-gotten gains, including performance and management fees for managing the Pentagon Fund.’

The SEC claims that Pentagon Capital and Chester violated Section 17(a) of the Securities Act of 1933, and violated, or aided and abetted violations of, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5. It is asking for a permanent injunction against the defendants, the disgorgement of the illicit profits with interest, and civil monetary penalties.

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