Sec. & Exch. Comm'n v. Pentagon Capital Mgmt. PLC

• Decision Date: 08 August 2013
• Docket Number: Docket No. 12–1680–cv.
• Citation: 725 F.3d 279
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff–Appellee, v. PENTAGON CAPITAL MANAGEMENT PLC, Lewis Chester, Defendants–Appellants, Pentagon Special Purpose Fund, Ltd., Relief Defendant.
• Court: U.S. Court of Appeals — Second Circuit

725 F.3d 279

SECURITIES AND EXCHANGE COMMISSION, Plaintiff–Appellee,

v. PENTAGON CAPITAL MANAGEMENT PLC, Lewis Chester, Defendants–Appellants,Pentagon Special Purpose Fund, Ltd., Relief Defendant.

Docket No. 12–1680–cv.

United States Court of Appeals, Second Circuit.

Argued: April 9, 2013.

Decided: Aug. 8, 2013.

Benjamin L. Schiffrin (Michael A. Conley, John W. Avery, Susan S. McDonald, David Lisitza, on the brief), Securities and Exchange Commission, Washington, DC, for Appellee.

Frank C. Razzano (Ivan B. Knauer, Matthew D. Foster, John C. Snodgrass, on the brief), Pepper Hamilton LLP, Washington, DC, for Defendants–Appellants.

Before: WALKER and CHIN, Circuit Judges, and RESTANI, Judge. ^*

JOHN M. WALKER, JR., Circuit Judge:

Defendants–Appellants Pentagon Capital Management and Lewis Chester appeal from a judgment of the United States District Court for the Southern District of New York (Sweet, Judge ). After a bench trial, the district court found the defendants liable for securities fraud under Section 17(a) of the Securities Act of 1933 (the “Securities Act”), Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Rule 10b–5; ordered disgorgement; and imposed a civil penalty. Each monetary award was imposed jointly and severally in the amount of $38,416,500. We find no error in the district court's determination of liability, the amount of its disgorgement award, and its decision to impose that award jointly and severally. But we reverse the district court's imposition of joint and several liability for the civil penalty, vacate that penalty, and remand for reconsideration of its amount in light of the Supreme Court's decision in Gabelli v. SEC, ––– U.S. ––––, 133 S.Ct. 1216, 185 L.Ed.2d 297 (2013).

BACKGROUND

We assume the parties' familiarity with the background of this case and recite only those facts relevant on appeal. For additional detail, we refer the parties to the district court's thorough opinion. See SEC v. Pentagon Capital Mgmt. PLC, 844 F.Supp.2d 377 (S.D.N.Y.2012). The basis for the district court's imposition of fraud liability was the defendant's practice of late trading in the mutual fund market. Late trading occurs when, after the price of a mutual fund becomes fixed each day, an order is placed and executed as though it occurred at or before the time the price was determined, thereby allowing the purchaser to take advantage of information released after the price becomes fixed but before it can be adjusted the following day.

I. Mutual Funds and Late Trading

Mutual fund shares are priced according to the fund's “net asset value,” or NAV. SEC Rule 22c–1, promulgated under the Investment Company Act of 1940, requires that a mutual fund calculate its NAV at least once per day, Monday through Friday. 17 C.F.R. § 270.22c–1(b)(1) (2013). A mutual fund's NAV is generally calculated “by using the closing prices of portfolio securities on the exchange or market on which the securities principally trade.” Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings, 68 Fed.Reg. 70,402–01, 70,403 (proposed Dec. 17, 2003) (to be codified at 17 C.F.R. pts. 239, 274) (final rule adopted in 69 Fed.Reg. 22,300). However, if the closing price of a security held in a mutual fund's portfolio does not reflect its current market value at the time of the fund's NAV calculation, a mutual fund must calculate its NAV “by using the fair value of that security, as determined in good faith by the fund's board.” Id. This could occur, for example, when some price-affecting event occurs after the closing price is established but before the fund's NAV calculation. If a mutual fund's shares are mispriced, “an investor may take advantage of the disparity between the portfolio securities' last quoted prices and their fair value.” Id.

Rule 22c–1 also requires that mutual funds “sell and redeem their shares at a price based on the NAV next computed after receipt of an order,” a practice called “forward pricing.” Id. (emphasis added); see also17 C.F.R. § 270.22c–1(a). Forward pricing prevents dilution of mutual fund shares by keeping traders from profiting off of a stale share price. Some mutual fund investors, however, engage in late trading, “the practice of placing orders to buy or redeem mutual fund shares after 4 p.m., Eastern time, as of which most funds calculate their [NAV], but receiving the price based on the 4 p.m. NAV,” instead of the next day's NAV, as required by Rule 22c–1. Disclosure, 68 Fed.Reg. at *70,402. In VanCook v. SEC, 653 F.3d 130 (2d Cir.2011), we held that such late trading violated Rule 22c–1.

II. Pentagon Capital Management

Chester formed Pentagon Capital Management (“Pentagon”) in 1998 to facilitate mutual fund trading in the European markets with a market timing strategy. ¹ In 1999, Chester and Pentagon explored the possibility of market timing and late trading in the United States mutual fund market. ² To facilitate its trading in the United States, Pentagon formed Pentagon Special Purpose Fund (“PSPF”), the relief defendant in this case. PSPF was the sole member and manager of three Delaware limited liability companies that were established solely for Pentagon's use in trading mutual funds in the United States. At all times relevant to this case, Pentagon was PSPF's investment advisor and made all of its trading decisions.

In the United States, unlike in Europe, Pentagon was required to trade through a broker. As relevant here, Pentagon primarily used two individual brokers, James Wilson and Scott Christian, first at other brokerage firms, and finally at Trautman, Wasserman & Company (“Trautman”). Pentagon began trading through Trautman on February 15, 2001.

Based on Pentagon's instructions, Wilson and Christian executed Pentagon's trades through Bank of America, Trautman's clearing broker. Notwithstanding that the NAV was normally fixed at 4:00 p.m., Bank of America used a processing system for mutual fund orders that allowed brokers to change an order until 5:15 p.m. or 5:30 p.m. and later, until 6:30 p.m.

The parties do not dispute that Pentagon utilized Bank of America's permissive clearing system to engage in late trading with the assistance of Trautman's brokers. Pentagon opened 67 different accounts with Trautman, each of which could trade separately without a mutual fund knowing they were related. Wilson and Christian registered the accounts with different broker numbers with the effect that if a mutual fund detected late trading or market timing and blocked one account from trading, other accounts could remain active. Pentagon knew that various of its accounts had been expelled from at least thirteen funds, but it continued to trade in those funds using different accounts.

In April 2001, Chester sent an email to Wilson and Christian detailing Pentagon's “After Hours Trading Instructions.” Chester instructed that Wilson and Christian would receive a target figure on the Standard & Poors (“S & P”) future ³ near the close of the markets from a Pentagon employee; then, if the future exceeded or fell below the target, the brokers were to contact Pentagon to ask them what to do. Chester then emailed other executives at Pentagon about the potential for late trading through Trautman:

For this week only, [Trautman] can place or cancel any trades up to 5:00pm (10pm UK time). From next week—[Trautman] to confirm—the time will be 6:30pm (11:30 pm UK time).

The significance of this is great.

For instance, last night, the S & P future shot up at around 9:45pm [UK time]. Even though we hadn't placed any trades before 9pm [UK time], we STILL COULD HAVE PLACED THE TRADE after the bell, which we should have done given the marked rise in the future.

I have been in Jimmy [Wilson's] office. Every day, whether we do a trade or not, they time-stamp our trade sheets before 4pm, and then sit on them until they leave the office, at which point they will process them or not. Hence, the ability to place a buy order after the bell, even if we haven't done so before the bell.

...

This facility is VERY VALUABLE and we should utilize it accordingly.

...

It doesn't matter whether we place trades or not before the bell, we can do so afterwards, up to Trautman's time limits.

Pentagon, 844 F.Supp.2d at 400–01 (alterations omitted).

Thereafter, Christian would create potential trade sheets for Pentagon each day and time-stamp them before 4:00 p.m., notwithstanding that the actual decision to place the order or not would be made after 4:00 p.m. Then, sometime after 4:00 p.m., a Pentagon employee would email Christian the instructions for Pentagon's late trades for that day. The district court found that Pentagon realized profits of “approximately $38,416,500 from the U.S. mutual fund [late] trades they executed through [Trautman]” between February 15, 2001 and September 3, 2003. Id. at 427.

Pentagon tried to conceal its late trading activities. For example, on July 30, 2002, Chester sent an email to a broker that instructed him not to use the words “market timing” (which, viewed broadly, includes late trading) on any correspondence, telling him “ ‘to label what we do ... “dynamic asset allocation,” but never market timing!’ ” Id. at 396. In August 2002, Chester instructed another Pentagon employee to “phone around First Union” to see if late trading was available because “late trading is key,” adding “[I] don't know how you find out about this [late trading] without actually saying it. No doubt you'll work it out!” Id. at 408.

In September 2003, the New York Attorney General announced that it had settled an enforcement action with Canary Capital Partners for violations of the New York State securities laws, including late trading. Shortly thereafter, Chester received a request from an investor for a letter stating that Pentagon had not engaged in late trading or any other illegal activity. Chester provided the letter, stating that Pentagon had “ ‘never...