SEC Shorting Target was Served by Canadian Broker

by Stockwatch Business Reporter
Canada StockWatch
March 14, 2006

The U.S. Securities and Exchange Commission has settled with three New York hedge funds that nearly had the Holy Grail of hedge fund management -- a shorting recipe with guaranteed profits. The funds allegedly made $7-million as they funnelled two years of naked shorting through a Canadian brokerage. (All figures are in U.S. dollars.)

It seems the shorting was only profitable until the SEC came along. In a simultaneous lawsuit and settlement filed Tuesday, the SEC sued the hedge funds, Langley Partners LP, North Olmsted Partners LP and Quantico Partners LP, and their portfolio manager, Jeffery Thorp.

The SEC says the hedge funds shorted 23 stocks between August, 2000, and March, 2002, and covered with restricted shares bought at a discount in so-called PIPE offerings. (PIPE stands for private investment in public equity.) The PIPE shares were discounted to compensate for trading restrictions, typically a hold period of two to four months.

"[The] strategy was simple: to short sell Langley Partners' entire restricted PIPE allocation as quickly as possible ... then to close out those short positions using the PIPE shares," the SEC says.

For example, the SEC says Langley Partners invested $1.1-million in 100,000 restricted shares of MGI Pharma Inc., a Minneapolis pharmaceutical company, and immediately sold 100,000 shares short for $1,335,500. By doing so, Langley was guaranteed a $235,500 profit.

The SEC says Langley could not short MGI or any of the other companies in a conventional manner because they were too thinly traded. The SEC says the hedge funds repeated this profitable formula with 23 companies, mostly Nasdaq-listed small-caps.

To mask the shorting, the SEC says Mr. Thorp would cover by selling the PIPE shares into the Canadian account in wash trades. "Thorp would call or instant message his Canadian broker to inform him that Langley Partners intended to sell a certain number of its PIPE shares ... at a particular time and price using a particular exchange, and would instruct the broker to enter a buy order," the SEC says.

In some instances the SEC says Mr. Thorp would also cover the short by "closing the box."

"To close the box, Langley Partners simply journaled its PIPE shares from its cash account to its short account," the SEC says.

Unlike prior SEC cases that include Canadian firms, the SEC will not identify the Canadian brokerage. "We are still investigating," says SEC lawyer Daniel Chaudoin. It is believed the brokerage is a Toronto-area firm, but Mr. Chaudoin would not confirm this.

The SEC credits the Investment Dealers Association with helping in the investigation. IDA investigators in Toronto were not available for comment.

$15.8-million in fines

The hedge funds have agreed to pay $13.5-million to settle the allegations, without admitting any wrongdoing. The portfolio manager, Mr. Thorp, has agreed to pay $2.3-million, also without admitting he did anything wrong. The funds' lawyer did not return calls.

Hedge fund shorting made headlines last month when Toronto Stock Exchange listing Biovail Corp. filed a $4.6-billion market manipulation lawsuit against billionaire hedge fund manager Steven Cohen and his SAC Capital funds. In that case, Biovail says SAC Capital carried out co-ordinated attacks on the stock while holding short positions.

That case has yet to go to court, and SAC Capital denies any wrongdoing.

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