While criticisms abound as to who, or which regulatory entity, or set of laws and oversight, is to blame for the credit crisis, the Securities and Exchange Commission is quietly flexing new muscle of its own on the mutual fund trading scandal front.

In what is being viewed as a landmark case in the continuing pursuit of mutual fund late traders a full 4-1/2 years after the fund scandal was first uncovered, the SEC is moving beyond the borders of scandal fatigue in the U.S.

On April 3, the U.S.'s top securities regulator filed a lawsuit in the U.S. District Court, Southern District of New York against Pentagon Capital Management, a U.K.-based hedge fund manager, and its Chief Executive Officer Lewis Chester, 38. This is one of those rare times when the SEC isn't merely cooperating on a fraud case with an overseas regulator but actually suing an entity abroad.

From June 1999 through September 2003, the SEC charges, Pentagon and its top executive "orchestrated a scheme to defraud mutual funds in the United States" by engaging in deceptive market-timing practices and after-hours trading of fund shares.

Pentagon allegedly bought, sold or exchanged various U.S. mutual funds after the 4 p.m. daily trade cutoff, through an elaborate and deliberate scheme to squeeze out extra profits and leverage the time lag between European and U.S. market closings. All told, the SEC noted, the illegal and flagrant disregard of trading rules and deadlines netted the hedge fund firm $62 million in ill-gotten gains.

This case sends a clear message, said an SEC official. "If a hedge fund comes to the U.S. and defrauds U.S. investors, it may find itself a defendant in a Commission action," said Kay Lackey, SEC Assistant Regional Director, New York.

Lackey declined to comment as to whether other non-U.S. hedge funds are under investigation for similar illegal practices or could face the SEC's litigation wrath. But experts predict that it's highly likely other non-U.S. investment managers that engaged in illegal mutual fund trading will also be sued by the SEC.

In a lawsuit filed Thursday in U.S. District Court in Manhattan, the SEC is accusing another U.K.-based hedge fund, Headstart Advisors Ltd. and its investment advisor Najy Nasser, of orchestrating a scheme to defraud mutual funds and their shareholders by using late trading and deceptive market timing.

"The SEC is not going to get out of the business of prosecuting market-timers and late-traders," predicted George Simon, Chicago-based partner in the securities litigation, enforcement and regulatory practice of the law firm Foley & Lardner. Beyond the illegality of late trading, mutual funds hate market timing because it reduces fund returns, he said.

"With such a big constituency hammering at the SEC [to pursue timers], they won't stop," Simon added.

According to the SEC's complaint, in the late 1990s, Pentagon executives traveled to the U.S. on several occasions for the purposes of opening up accounts at a multitude of brokerage firms for the express purpose of executing late trades. E-mails among Pentagon executives reveal the intent and plan to execute late trades, according to the SEC's lawsuit.

Nine broker/dealers were referred to but not directly named in the SEC's complaint. Nonetheless, names were thinly veiled. Many, if not all, of these brokerage firms have already faced their own SEC lawsuits and/or sanctions for their involvement in the mutual fund scandal that initially broke in September 2003, at which time Pentagon ceased its late-trading activities, the SEC charges.

Pentagon traded through multiple broker/dealers, used multiple accounts and employed multiple brokerage registered rep identification numbers, all in an attempt to conceal the ongoing activity, the SEC claims. When mutual fund companies balked at the frequency of trading, Pentagon simply opened up new accounts to sidestep fund rules.

Pentagon Capital Management is regulated in the U.K. by the Financial Services Authority (FSA), the equivalent of the SEC, as both an investment advisor and asset manager.

"We refute the charges, and we will be defending them as vigorously as one can," said a London-based spokesman for Pentagon.

What is surprising is that in 2003, the FSA did an investigation into these charges and determined there was no wrongdoing to follow up on, the spokesman noted. In addition, Pentagon had commenced its own independent audit performed by a third-party firm, which concluded that there was no wrongdoing, he added.

"I don't believe that is accurate," said a source close to the Pentagon Capital SEC investigation, who spoke on condition of anonymity, commenting on the statement that the FSA had given the firm a clean bill of regulatory compliance health.

Despite assertions that it did nothing wrong, Pentagon recently closed all of its 17 hedge funds with a collective $2.2 billion under management and is now in the process of returning assets to investors in an orderly fashion, the spokesman said.

That decision was made last month, as the firm was concerned that its hedge fund investors might run for the exits once they heard of the SEC's allegations, the spokesman added, noting that the firm is absolutely not closing down. Management wants to dedicate all of its time to its defense, he said.

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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