The SEC recently denied an appeal from two portfolio managers regarding an ALJ’s finding that they violated the anti-fraud provisions of the securities laws. The portfolio managers managed a closed-end fund with prospectus disclosure stating that the fund would pursue a covered call strategy (which involves taking a long position in a security and writing call options on the same number of shares). However, in 2007, the managers began using two new kinds of derivatives, which would contribute to performance and expose the fund to substantial risk of loss in the event of market turmoil or a sharp decline in stock prices. The naked puts and variance swaps used by the portfolio managers ultimately led to losses in the fund of $45 million.
The fund’s reports mischaracterized the fund as being hedged, when the managers knew that the derivatives positions actually added significant risk to the portfolio. Despite the fact that the risky derivatives positions in the fund had a greater impact on the fund’s returns than its other investments, the fund’s registration statement or annual report never reflected the change. In addition, the managers misled the fund’s board. In response to the board’s questions, the managers stated that the fund’s macro hedging strategy, rather than the index puts and short variance swaps, was causing the fund’s losses. In addition, the managers stated that they intended to take more cash heavy, diversified positions due to the market turmoil – two days before acquiring a new variance swap position. In addition, the managers asserted that the fund was locked into the short put exposure when, in fact, they could have purchased offsetting positions though they would have been expensive.
The fund’s adviser ultimately reimbursed shareholders the $45 million in losses attributable to the undisclosed derivatives positions. The managers were ordered to cease and desist from violations of the securities laws, disgorge ill-gotten gains, and pay a civil penalty of $130,000 each. In addition, the lead manager was permanently barred from the industry because the Commission found that he “had more involvement in designing, executing, and monitoring the Fund’s use of the new types of derivatives.” The Commission also found that because of his greater understanding of the characteristics of the risky derivatives, “he bears comparatively more culpability with respect to the disclosure violations and we therefore permanently bar him.” The Commission barred the other manager as well, but will allow him to apply for reinstatement after two years.
The Commission also rejected the appellants argument that the SEC’s ALJ is unconstitutional.