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News October 17, 2005 Issue

Yet Another Hedge Fund Valuation Case — This Time, Involving Side Pockets

The SEC last week settled a case against Joseph Daniel, a former hedge fund managing general partner, for allegedly inflating the values of the fundís private placement investments and failing to de-value them in the face of subsequently lower offering prices and negative business events.

According to the SECís complaint, the private placement memoranda of the Critical Infrastructure Fund and a related offshore fund stated that the funds would, from time to time, invest in non-marketable or illiquid investments, termed "Special Situation Investments." The PPMs stated that the general partner would determine, at the time of investment, whether to classify an investment as a Special Situation Investment. Investments so designated would be held in a separate sub-account, where they would be valued at cost, "subject to the General Partnerís discretion to estimate the fair value." The SECís complaint noted that "investors could not withdraw assets in sub-accounts until the occurrence of a Ďrecognition eventí such as a sale or exchange."

But the side pockets remained empty. The SEC alleged that Daniel "did not understand that it was necessary for him to make a designation" of investments to go in the side-pockets. As a result, none of the fundís private placements were designated as Special Situation Investments, and no sub-accounts were created.

Which left everything outside the side pockets. And per the PPM, investments not held in the side pockets were to be valued at fair market value. The SEC alleged, however, that Daniel either valued the private investments at cost, or at a "higher Ďfair valueí." When private companies made new offerings at higher prices, said the SEC, Daniel raised the value of the fundís holdings. When the private companies experienced financial difficulties or made offerings at lower prices, said the SEC, he did not correspondingly write down the value of the fundís holdings. In one instance, Daniel allegedly held valuations steady in the face of a pending bankruptcy.

As a result, claimed the SEC, account statements and performance information provided by the fund were inaccurate, inflated management fees were assessed, and redeeming shareholders benefited at the expense of remaining shareholders.

Daniel left his employer in February 2002, after falling ill. Although the SEC brought a host of fraud charges against him, the agency did not order disgorgement or impose a civil penalty, citing Danielís inability to pay and other information.

Meanwhile, the funds are currently in the process of being wound down by vFinance, Inc., the company that acquired the fundsí general partners in August 2001. In its most recent annual report, vFinance disclosed that the SEC was conducting a non-public (at the time) investigation of the domestic fund and the two fundsí general partners (but apparently not the offshore fund itself).

Purrington Moody partner David Moody noted that the SECís case seemed to imply that had the private placement investments been properly side pocketed, they could have been held at cost ó at least until negative events indicated that a write-down was necessary. Moody explained that typically, PPMs state that assets placed in a side pocket are held at cost, but are subject to fair valuation ó downwards. "It always goes down, it never goes up," he said. For example, if a fund invests in a company at $100,000, and six months later there is a subsequent offering that indicates that a higher valuation of $200,000 might be warranted, the fund still has to carry it at $100,000. "The side pocket investment is held at cost until there is a realization event, like a sale to a third party or an IPO, at which time the investment is treated like the rest of the portfolio," he explained.