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News August 28, 2017 Issue

Hedge Fund Manager Ordered to Pay $13 Million in Investor Fraud Case

Don’t promise what you can’t deliver, don’t overvalue investments and don’t take from Peter to pay Paul. Those seem to be the main lessons drawn from a federal court’s judgment against a hedge fund manager that the SEC has litigated against for the past seven years.

The U.S. District Court for the District of Connecticut ordered New York and Connecticut-based investment advisers Southridge Capital Management, Southridge Advisors and their owner, Stephen Hicks to pay $7.8 million in disgorgement and prejudgment interest, and Hicks alone to pay a civil money penalty of $5 million, for a total of almost $13 million, the Commission announced August 11.

The SEC filed its original complaint against the advisory firm owner and his firms in October 2010 over charges that they "knowingly or recklessly" engaged in what the complaint described as three fraudulent acts:

  • Promised liquidity, but provided little. The firms raised nearly $80 million from investors between 2004 and 2007 by promising that at least 75 percent of their money would be invested in "unrestricted, free-trading shares," when much of the money was actually placed in relatively illiquid securities, according to the complaint;
  • Overvalued the hedge funds’ largest single investment. The agency said that this allowed Hicks and his firms "to pay or accrue for themselves more than $1.8 million in undeserved management fees;" and
  • Caused two hedge funds to pay bills incurred by three others. This allegedly involved approximately $5 million of legal and administrative expenses. "When the misappropriation came to light, they repaid the two funds with illiquid securities, not cash," the SEC said.

"We are reviewing the judgment and are considering an appeal," said the attorney representing Hicks and the Southridge firms.

Interestingly, the agency’s complaint does not appear to mention any specific executives in the two advisory firms other than Hicks. It simply states that Hicks and his wife owned a controlling interest in both firms. Hicks founded Southridge Capital in 1996. He founded Southridge Advisors in 2008 to replace Southridge Capital as manager for two of its funds, according to the complaint. The agency does not state whether the firms were registered with the SEC as advisers, which indicates that they were not, said Stern Tannenbaum partner Aegis Frumento.

"It seems like it was a one-man show," he said, noting that no other officers, including for compliance, appear to be listed – and that may have been one of the reasons the problems occurred. "If you’ve got any kind of compliance function in the firm, this wouldn’t happen."

"This appears to be a clear case of a hedge fund manager doing various things that not only disadvantaged investors, but also directly contradicted statements made to investors and the funds’ offering documents," said Rogers & Hardin partner Stephen Councill. "Most advisers would not engage in the alleged activity, but the case still serves as a good reminder for advisers to know their offering documents and review them periodically to make sure they are complying with the terms offered to investors."

Raising money . . . and meeting redemptions

According to the SEC’s complaint, Hicks began raising money for a group of his funds in late 2003, telling prospective investors that three quarters of the investments would be in shares that would be, the agency said, "available to be sold."

"One investor even obtained a side letter giving him the right to redeem his entire investment if more than 25 percent of his assets in the [funds] became illiquid," the SEC said. "Hicks also told some investors that the [funds] would invest in short-term transactions that would take only 10 to 15 days, such as equity line of credit deals." He made similar statements, the agency said, on a web site that provided information about hedge funds to the public.

But while Southridge and Hicks did invest assets primarily in liquid investments in 2004 and 2005, "that soon began to change," the SEC said. "At year-end 2006, more than one-third of [one of the fund’s] assets and more than half of Southridge Capital’s assets were invested in relatively illiquid . . . deals (convertible debentures, convertible preferred stock or restricted common stock) or in other instruments such as promissory notes. The same was true for year-end 2007 and year-end 2008."

Despite these developments, Hicks continued to tell investors that more than 75 percent of the funds’ assets would be invested in liquid investments, cash or cash equivalents, according to the complaint, with nearly $80 million raised for the funds between 2004 and 2007.

Then the redemption requests began to come in.

"By year-end 2007, investors in the [funds] had submitted nearly $7 million in redemption requests which defendants were unable to satisfy," the SEC said. "The principal reason is that . . . the bulk of the [funds’] assets were now invested in relatively illiquid . . . deals . . . from a handful of micro-cap issuers, and the ordinary trading volume for those stocks was too small for a profitable liquidation of the funds’ substantial holdings."

A question of valuation

The 2008 financial collapse affected Southridge, just as it affected many others. From 2004 through 2007, according to the SEC’s complaint, the Southridge funds had between $100 million and $125 million in assets under management. After the 2008 financial debacle, however, the value of those assets shrank, to the point that as of February 2009, the funds had less than $70 million in total AUM.

Of those assets held since 2004, the largest single holding was an aggregate investment of $30 million or more in Fonix Corporation, which the complaint describes as "a small Utah-based company whose primary business has been the development of speech recognition software."

But was that valuation accurate? The SEC complaint describes a complicated set of valuations and transactions, including investments by the Southridge funds in Fonix involving preferred stock and secured notes, during which Fonix was having serious financial difficulties.

"Even if defendants could properly have valued the Fonix preferred stock and secured notes at its acquisition cost, they knew or were reckless in not knowing that the $30 million figure was not a real ‘acquisition cost’ because . . . 1) Hicks had effectively been on both sides of [a related] February 2004 transaction, 2) the Southridge funds had not paid cash, and 3) the value of what the Southridge funds did pay . . . was worth much less than $30 million," the agency said.

The $30 million valuation allowed Southridge and Hicks "to collect hundreds of thousands of dollars in management fees every year since 2004," the SEC said. With a standard management fee of at least 1 percent of the funds’ net assets, "the funds paid or accrued management fees totaling at least $300,000 per year on the $30 million in Fonix securities, for a total of more than $1.8 million to date."

Those legal bills

The last thing anyone wants when they are in financial difficulty is legal bills, but that’s what some of the funds received. Between 2005 and 2008, according to the complaint, Southridge and Hicks caused some of the funds to pay approximately $5 million of legal and administrative expenses incurred by other funds. Investors in the funds paying the bills were not told about this while the money was being "misappropriated," the agency said.

In February 2009, the SEC said Hicks sent a letter to the Southridge funds, "admitting that certain legal and administrative expenses had been improperly allocated between the funds." However, rather than repaying the money to the funds in question, Southridge and Hicks simply transferred certain illiquid securities from one set of funds to the other, the agency said.


The court’s judgment was partial, with the SEC’s litigation continuing in regard to the allegations involving valuation and liquidity misrepresentation, the SEC said.

Among the violations alleged in the complaint are that the Southridge firms and Hicks violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and its Rule 10b-5, and Sections 206(1) and (2) of the Advisers Act, all of which prohibit fraud. In addition they were charged with violating Section 206(4) of the Advisers Act and its Rule 206(4)-8, which prohibits making untrue statements of material fact to investors or prospective investors in pooled investment vehicles.