U.S. Securities and Exchange Commission
Litigation Release No. 21870 / March 1, 2011
Securities and Exchange Commission v. Lawrence R. Goldfarb et al., CV-11-0938-DMR (U.S. District Court for the Northern District of California, filed March 1, 2011)
SEC CHARGES BAY AREA HEDGE FUND MANAGER WITH MISAPPROPRIATING “SIDE POCKETED” ASSETS
The Securities and Exchange Commission today charged a Bay Area hedge fund manager with concealing more than $12 million in investment proceeds that he owed investors in his fund.
The SEC alleges that Lawrence R. Goldfarb of Larkspur, Calif., and his company Baystar Capital Management LLC (BCM) instead diverted the cash to other entities he controlled, ultimately funding a real estate venture and a San Francisco record company. Goldfarb also comingled investor funds in a bank account which he used to pay for unauthorized personal expenses including entertainment and charitable donations.
According to the SEC’s complaint filed in federal district court in San Francisco, Goldfarb and BCM were able to carry out their fraud in part because the investment was maintained in a “side pocket” into which investors in the hedge fund – Baystar Capital II, L.P. – had limited visibility. A side pocket is a type of account that hedge funds use to separate particular investments that are typically illiquid from the remainder of the investments in the fund. Goldfarb’s side pocket investment became profitable in 2006, but he diverted the proceeds for other uses rather than paying the fund’s investors. None of his transactions were authorized by the fund’s partnership agreement or offering documents.
According to the SEC’s complaint, Goldfarb and BCM concealed the fraud for several years by providing investors with false account statements showing no gains had been realized in the side pocket. This falsely indicated that the side pocket investment had not yet distributed any profits to the fund, and investors were unable to determine that they were entitled to distributions. Generally, investors can only withdraw their side pocket investments once the underlying position has been sold or liquidated. This helps ensure fairness by limiting the ability of an early-redeeming investor to withdraw a disproportionate share of the fund’s liquid assets.
The SEC also alleges that Goldfarb also took steps to conceal the side pocket profits from the fund’s third party administrator. For example, he directed money to the bank account of an entity that no longer existed.
Without admitting or denying the SEC’s allegations, Goldfarb and BCM consented to permanent injunctions against violations of Section 206(1), (2) and (4) of the Investment Advisers Act of 1940 and to pay disgorgement of $12,112,416 and prejudgment interest of $1,967,371, which will be distributed to the fund’s investors. Goldfarb also agreed to pay a $130,000 penalty, be barred from associating with any investment adviser or broker (with the right to reapply in five years), and be barred from participating in any offering of penny stock.