Sec. v. Gabelli

• Decision Date: 01 August 2011
• Docket Number: 10–3628–cv(XAP),Docket Nos. 10–3581–cv(L),10–3760–cv(XAP).
• Citation: 653 F.3d 49
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff–Appellant/Cross–Appellee,v.Marc J. GABELLI and Bruce Alpert, Defendants–Appellees/Cross–Appellants.
• Court: U.S. Court of Appeals — Second Circuit

653 F.3d 49

SECURITIES AND EXCHANGE COMMISSION, Plaintiff–Appellant/Cross–Appellee,

v.Marc J. GABELLI and Bruce Alpert, Defendants–Appellees/Cross–Appellants.

Docket Nos. 10–3581–cv(L)

10–3628–cv(XAP)

10–3760–cv(XAP).

United States Court of Appeals, Second Circuit.

Argued: June 2, 2011.Decided: Aug. 1, 2011.

Dominick V. Freda (Jacob H. Stillman, Hope Hall Augustini, on the brief), Securities and Exchange Commission, Washington, D.C., for Plaintiff–Appellant.Lewis J. Liman (Kimberly C. Spiering, Katherine L. Wilson–Milne, David R. Lurie, on the brief), Cleary Gottlieb Steen & Hamilton LLP, New York, NY, for Defendant–Appellee Gabelli.Kathleen N. Massey (Edward A. McDonald, Joshua I. Sherman, on the brief), Dechert LLP, New York, NY, for Defendant–Appellee Alpert.Before: LIVINGSTON and CHIN, Circuit Judges, and RAKOFF, District Judge.^*RAKOFF, District Judge.

Plaintiff-appellant the Securities and Exchange Commission (“SEC”) appeals from a judgment entered August 17, 2010, dismissing the SEC's complaint against Marc J. Gabelli, the portfolio manager of the mutual fund Gabelli Global Growth Fund (“GGGF” or the “Fund”), and Bruce Alpert, the chief operating officer for the Fund's adviser, Gabelli Funds, LLC (“Gabelli Funds” or the “Adviser”). For the following reasons, we REVERSE the District Court's judgment and REMAND for further proceedings consistent with this opinion. ¹

BACKGROUND

Unless otherwise noted, the following facts are taken from the complaint and are presumed to be true. In essence, the SEC's complaint charges defendants with failing to disclose favorable treatment accorded one GGGF investor in preference to other investors: specifically, the fact that Gabelli Funds, investor adviser to GGGF, while prohibiting most GGGF investors from engaging in a form of short-term trading called “market timing,” secretly permitted one investor to market time the Fund in exchange for an investment in a hedge fund managed by Gabelli. Compl. ¶¶ 1, 20–21, 17, 31, 35–38, 42, 44–45.

A. Market Timing

“Market timing” refers, inter alia, to buying and selling mutual fund shares in a manner designed to exploit short-term pricing inefficiencies. See Exemptive Rule Amendments of 2004: The Independent Chair Condition (Apr.2005) (“Staff Report”), available at http:// www. sec. gov/ news/ studies/ indchair. pdf. A mutual fund sells and redeems its shares based on the fund's net asset value (“NAV”) for that day, which is usually calculated at the close of the U.S. markets at 4:00 P.M. Eastern Time. Prior to 4:00 P.M., market timers either buy or redeem a fund's shares if they believe that the fund's last NAV is “stale,” i.e., that it lags behind the current value of a fund's portfolio of securities as priced earlier in the day. The market timers can then reverse the transaction at the start of the next day and make a quick profit with relatively little risk.

Mutual funds like GGGF that invest in overseas securities are especially vulnerable to a kind of market timing known as “time zone arbitrage,” whereby market timers take advantage of the fact that the foreign markets on which such funds' portfolios of securities trade have already closed (thereby setting the closing prices for the underlying securities) before the close of U.S. markets.² Market timers profit from purchasing or redeeming fund shares based on events occurring after foreign market closing prices are established, but before the events have been reflected in the fund's NAV. In order to turn a quick profit, market timers then reverse their positions by either redeeming or purchasing the fund's shares the next day when the events are reflected in the NAV.

Although market timing is not itself illegal, market timing can harm long-term investors in the fund by “rais[ing] transaction costs for a fund, disrupt[ing] the fund's stated portfolio management strategy, requir[ing] a fund to maintain an elevated cash position [to satisfy redemption requests], ... result[ing] in lost opportunity costs and forced liquidations ... unwanted taxable capital gains for fund shareholders and [a reduction of] the fund's long term performance.” Id. at 32–33. See also Janus Capital Grp. Inc. v. First Derivative Traders, ––– U.S. ––––, 131 S.Ct. 2296, 2300, 180 L.Ed.2d 166 (2011) (“Although market timing is legal, it harms other investors in the mutual fund.”).

B. The Parties

Gabelli Funds, an investment adviser within the meaning of Section 2(a)(20) of the Investment Company Act of 1940 and Section 202(a)(11) of the Investment Advisers Act of 1940 (the “Advisers Act”), is the investment adviser to GGGF, an open end investment company, or mutual fund, registered under the Investment Company Act. Compl. ¶¶ 12–13. Marc Gabelli was the portfolio manager for GGGF and its predecessor fund from 1997 to 2004 and also managed several Gabelli-affiliated hedge funds. Id. ¶ 10. From 1988 to 2003, Bruce Alpert was Gabelli Funds' chief operating officer and the person who directed the Adviser's “market timing police,” a group of GGGF employees that monitored trading in the Adviser's mutual funds in order to restrict market timing. Id. ¶¶ 1, 11, 31. Najy N. Nasser was the chief investment adviser to Folkes Asset Management, now called Headstart Advisers Ltd. (“Headstart”). Id. ¶¶ 1, 10.

C. The Alleged Misconduct

The complaint alleges that from 1999 until 2002, Gabelli and Alpert permitted Headstart to engage in time zone arbitrage (which defendants referred to as “scalping”) that took advantage of stale pricing opportunities in GGGF. Id. ¶¶ 17, 36, 42. Initially the amount of such scalping was limited, but on April 7, 2000, Gabelli allegedly agreed to permit Headstart to increase its market timing capacity from $7 million to $20 million, in exchange for a $1 million investment by Headstart in a hedge fund that Gabelli managed. Id. ¶ 21. Headstart's $1 million investment, which constituted approximately four percent of Gabelli's hedge fund's assets, was made the day after Headstart's increase in market timing. Id. ¶ 23.

Between April 2000 and the Spring of 2002, Headstart's increased market timing in GGGF's shares regularly involved between four and fifteen percent of GGGF's assets. Id. ¶ 24. Eventually, however, following instructions from the Fund's parent company, Gabelli and Alpert caused Headstart to reduce its ownership in GGGF and, in August 2002, to cease its market timing activity, whereupon Headstart redeemed its remaining investment in Gabelli's hedge fund. Id. ¶¶ 25–28.

Prior to the cessation, however, and during the same period that Gabelli and Alpert were approving Headstart's market timing in GGGF shares, Alpert and Gabelli banned at least 48 other GGGF accounts from market timing and rejected market timing purchases totaling at least $23 million. Id. ¶ 35. As early as December 2000, Alpert drafted an internal memorandum that explained that since “Market Timers (scalpers) have been using the International and Global Funds in a way that is disruptive to the Fund and the management of the portfolio,” the Adviser was making efforts to “identify each account and restrict them for purchasing the funds.” Id. ¶ 31. For the next two years, “market timing police”—employees instructed by Alpert to monitor market timing activity within Gabelli Funds—reviewed purchases in global funds: if it appeared that the purchase was a market timing trade, the purchase was rejected and sometimes the account was banned from making future purchases. Id. Yet, during the very same period, Alpert instructed the market timing police to ignore Headstart's market timing activity because “it was a Marc Gabelli client relationship,” and assured Nasser that Headstart's accounts would not be blocked. Id. ¶¶ 33, 35.

According to the complaint, Headstart's market timing unfairly favored Headstart over all other GGGF investors. Thus, while Headstart's three accounts that market timed GGGF shares during the relevant period earned rates of return of 185 percent, 160 percent, and 73 percent, respectively, the rate of return for all other GGGF shareholders over the same period was, at best, negative 24.1 percent. Id. ¶¶ 2, 39. Headstart's market timing also caused annual dilution ranging from one to four percent of GGGF's assets. Id.

While Headstart was market timing GGGF, the defendants allegedly did not disclose to GGGF's Board of Directors or to the other GGGF shareholders that Headstart was market timing, that it was being given an advantage accorded no other shareholder, and that there was a conflict of interest created by the agreement with Headstart. As a result, the Board was allegedly misled into believing that the Adviser was taking all necessary steps to reduce or ban market timing activity in general. Id. ¶¶ 36–38. For example, on February 21, 2001, Alpert and Gabelli attended a GGGF Board meeting where they each addressed the Board. Alpert told the Board about the dangers of market timing and the efforts that Gabelli Funds was undertaking to eliminate this practice, but failed to disclose that Headstart was being permitted to market time GGGF. Immediately after Alpert's report, Gabelli reported on operations of GGGF, but also failed to disclose Headstart's market timing. After the meeting, Alpert and Gabelli continued to allow Headstart to engage in market timing trades. Id.

According to the complaint, even after the market timing ceased, the defendants continued to mislead the Board and GGGF investors. In particular, on September 3, 2003—the same day that the New York Attorney General announced he was investigating market timing in mutual funds—Alpert, in an alleged effort to reassure GGGF investors, posted a memorandum (the “Memorandum”) on the website of Gabelli Funds' parent company. Id. ¶¶ 43–44. The Memorandum stated that:

[F]or more than two years, scalpers have been identified and restricted or banned from making further trades. Purchases from accounts with a history of frequent trades...