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.
Decided: Aug. 8, 2013.
728 F.3d 212
Argued: April 9, 2013.
CONCLUSION
For the foregoing reasons, we AFFIRM the judgment of the District Court.
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
* The Honorable Jane A. Restani, of the United States Court of International Trade, sitting by designation.
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
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.
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“) future3 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 entered into arrangements with any U.S. onshore Mutual Fund in order to trade post-4:00pm EST for same-day NAV,‘” and that all of Pentagon‘s trading arrangements were “in accordance with the relevant rules, regulations, investment prospectus, and/or any other such relevant documentation relating to the investment(s) concerned.‘” Id. at 410.
On April 3, 2008, the SEC brought this enforcement action against Pentagon. The complaint alleged that Pentagon‘s market timing and late trading activities violated
DISCUSSION
On appeal, Pentagon and Chester argue that they cannot be held liable because their actions involved no fraud or deceit and that as investment advisors (as opposed to brokers), they cannot be held primarily liable for securities fraud. They further argue that the district court made various errors related to the monetary awards. Following a bench trial, we review the district court‘s findings of fact for clear error and its legal conclusions de novo. SEC v. Mayhew, 121 F.3d 44, 50 (2d Cir.1997).
I. Primary Liability for Securities Fraud
- to employ any device, scheme, or artifice to defraud, or
- to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
- to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
- To employ any device, scheme, or artifice to defraud,
- To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or
- To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
We have held that to violate
Pentagon and Chester do not deny that they engaged in late trading. The defendants argue, however, that there was no fraud or deceit in their actions. The defendants also argue that an investment advisor—as opposed to a broker—may not be held liable for securities fraud because the advisor is not responsible for communicating the direction to late trade to the clearing broker. We reject both arguments.
First, the defendants’ argument that their lack of fraudulent or deceitful intent bars a finding of liability fails because deceitful intent is inherent in the act of late trading. The late trader places an order after the daily mutual fund price is set, but receives the benefit of additional information that the earlier price does not reflect. For this reason, we have held that late trading violates all three subsections of
Pentagon and Chester engaged in similarly deceitful behavior. They sought out brokers who would engage in late trading. As evidenced by Chester‘s email, they knew that the trade sheets were time-stamped before 4 p.m., even though they had no intention of trading before that time. Finally, they issued a false and deceitful letter of assurance that they were not engaging in late trading, similar to VanCook‘s false assurances to his employer.
The defendants are not identically situated to VanCook, however. VanCook was a broker, directly bound by the language of
We also reject the defendants’ corollary argument that they may not be held liable because they did not communicate directly with the mutual funds. In Janus Capital Group, Inc. v. First Derivative Traders, — U.S. —, 131 S.Ct. 2296, 180 L.Ed.2d 166 (2011), shareholders of Janus Capital Group sued Janus Capital Group and Janus Capital Management for making false statements in mutual fund prospectuses filed by Janus Investment Fund. Because Janus Investment Fund retained ultimate control over the content of the prospectuses, the Supreme Court held that Janus Capital Management could not be liable as a “maker” of the statement under
For purposes of
Rule 10b-5 , the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not “make” a statement in its own right. One who prepares or publishes a statement on behalf of another is not its maker.
Id. at 2302. To illustrate its point, the Supreme Court used the analogy of “the relationship between a speechwriter and a speaker. Even when a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it.” Id. Pentagon and Chester argue that because they never communicated directly with the mutual funds, they cannot be held liable as “makers” of any false statements.
To the extent that late trading requires a “statement” in the form of a transmission to a clearing broker, we find that in this case, Pentagon and Chester were as much “makers” of those statements as were the brokers at Trautman. The brokers may have been responsible for the act of communication, but Pentagon and Chester retained ultimate control over both the
Moreover, we reaffirm our holding in VanCook and find that the defendants’ activities violated all three subsections of
We have considered the remainder of Pentagon‘s arguments and find them to be unpersuasive. The district court‘s determination of liability is affirmed.
II. Monetary Awards
The district court imposed joint and several liability for a disgorgement award and a civil penalty, each in the amount of $38,416,500. The district court first determined that both monetary awards would be imposed jointly and severally because the defendants (including the relief defendant) “collaborated on the mutual fund trading scheme, and [Chester and Pentagon] exercised complete control over PSPF‘s trading.” 844 F.Supp.2d at 425. The district court then determined that a disgorgement award of $38,416,500 was appropriate because it was a reasonable approximation of the profit made through defendants’ late trades with Trautman beginning in February 2001. Turning to the amount of the civil penalty, the district court applied
A. Civil Penalty
We review the district court‘s imposition of the civil penalty for abuse of discretion. See SEC v. Kern, 425 F.3d 143, 153 (2d Cir.2005) (“The tier determines the maximum [civil] penalty, with the actual amount of the penalty left up to the discretion of the district court.“).
In light of the Supreme Court‘s recent decision in Gabelli, 133 S.Ct. 1216, rendered after the district court‘s decision, we must vacate the district court‘s civil penalty award and remand it for reconsideration. In Gabelli, the Supreme Court held that the so-called “discovery rule,” which tolls a statute of limitations for crimes that are difficult to detect, does not apply to toll the five-year statute of limitations for fraud cases in SEC enforcement actions. See id. at 1221-24. Thus, any profit earned through late trading earlier than five years before the SEC instituted its suit against the defendants may not be included as part of the civil penalty. All parties agree that remand on this issue is required.
We also must reverse the district court‘s decision to impose joint and several liability for the amount of the civil penalty as an error of law. See Johnson v. Univ. of Rochester Med. Ctr., 642 F.3d 121, 125 (2d Cir.2011) (“A court abuses its discretion
B. Disgorgement Award
The district court‘s disgorgement award is also reviewed for abuse of discretion. See SEC v. Warde, 151 F.3d 42, 49 (2d Cir.1998).
We find no abuse of discretion in the amount of the disgorgement award, which reflected a “reasonable approximation of profits causally connected to the [late trading] violation.” SEC v. First Jersey Sec., Inc., 101 F.3d 1450, 1475 (2d Cir.1996) (quotation marks omitted).8 It was reasonable for the district court to consider the profit to PSPF as well as Chester and Pentagon in light of the fact that PSPF existed only to enable Pentagon‘s trading in the United States. See SEC v. AbsoluteFuture.com, 393 F.3d 94, 96 (2d Cir.2004) (“It is only logical that the total disgorgement of multiple defendants be determined by the total amount of profit realized by those defendants.“) (per curiam).
We also affirm the district court‘s decision to impose the disgorgement award jointly and severally on all defendants. Unlike the civil penalty, there is no statutory requirement that a disgorgement award be measured as to each individual defendant. The district court found that relief defendant PSPF opened accounts at Pentagon‘s direction and that defendants late-traded on PSPF‘s behalf. Hence, the district court found that defendants and PSPF had “collaborated” on the late trading scheme, and concluded that joint and several liability with respect to disgorgement was warranted. See id. at 97 (in reviewing disgorgement award, holding that “joint and several liability for combined profits on collaborating ... parties” is “appropriate“). We agree with the district court that, in light of their collaboration, Pentagon, Chester, and PSPF should be held liable for the disgorgement award on a joint and several basis. See First Jersey, 101 F.3d at 1475-76 (affirming district court‘s decision to impose joint and several liability of disgorgement award).
CONCLUSION
For the foregoing reasons, the district court‘s rulings are AFFIRMED in part, VACATED in part, and REMANDED in part for further proceedings in accordance with this opinion.