On August 8, 2013, the Second Circuit vacated the SEC’s $38 million fine against hedge fund Pentagon Capital Management PLC, holding that the Supreme Court’s decision in Gabelli v. SEC required the case to be remanded for recalculation of the civil penalty. This case is one of several SEC enforcement actions affected by the Gabelli ruling since the Court issued its decision less than six months ago. The Second Circuit’s decision highlights the limiting effect Gabelli will have on civil remedies available to the SEC for securities law violations that occurred more than five years before the agency initiated its enforcement action.
In Gabelli, the Court held that the five-year statute of limitations for filing civil enforcement actions seeking penalties for fraud begins to run from the date of the alleged violation, not when the SEC discovers, or reasonably should have discovered, the violation. Citing Gabelli, the Second Circuit in SEC v. Pentagram Capital Management PLC found that any profits Pentagon earned more than five years before the SEC filed its suit could not be included in the penalty. The parties agreed that remand on the issue was required.
The SEC alleged that Pentagon and its owner, Lewis Chester, committed securities fraud under Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 by engaging in late trading of mutual funds. Late trading involves placing and executing orders as if they occurred at or before the time the mutual fund price was determined. Such trading allows the purchaser to profit from information released after the mutual fund price is fixed each day, but before it can be adjusted the following day. The SEC alleged that Pentagon engaged in late trading through its broker dealer, Trautman Wasserman & Co., from February 2001 through September 2003.
Following a bench trial in March 2012, a New York federal judge found Pentagon and Chester liable for late trading and ordered, jointly and severally, $38 million in disgorgement and $38 million in civil penalties. The Second Circuit found that civil penalties could not be imposed on a joint and several basis, but upheld the lower court’s liability finding and disgorgement order. The panel rejected Pentagon and Chester’s argument that their trades did not involve fraud or deceit under federal securities laws and instead held that “deceitful intent is inherent in the act of late trading.”
The Second Circuit also rejected defendants’ argument that, as investment advisers, they could not be held primarily liable for fraud because they did not directly communicate with the mutual funds. Citing the Supreme Court’s 2011 decision in Janus Capital Group, Inc. v. First Derivative Traders, the panel held that even though the brokers may have been responsible for the acts of communication, Pentagon and Chester were liable because they had ultimate control over the content of the communication and the decision to late trade.