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WAYNE M. CARLIN (WC-2114) UNITED STATES DISTRICT COURT
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Securities and Exchange Commission, Plaintiff, v. EDWARD J. STRAFACI, Defendant. |
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03 Civ _____________ COMPLAINT |
Plaintiff Securities and Exchange Commission for its Complaint against defendant Edward J. Strafaci, alleges as follows:
1. This action involves violations of certain antifraud provisions of the federal securities laws in connection with the valuation of four hedge funds. From at least 1998 until January 2002, Edward J. Strafaci, the funds' portfolio manager, knowingly and recklessly overstated the value of convertible bonds and preferred stock held by the funds, resulting in the dissemination of materially false and misleading fund valuations and performance figures to investors and prospective investors, and the filing of false reports with the Commission. Contrary to representations in the funds' offering materials, Strafaci valued the funds' convertible securities at prices materially in excess of, and not reasonably related to, marketprices or the fair value of such securities. As a result of his fraudulent conduct, Strafaci violated, or aided and abetted the violation of, several antifraud provisions of the federal securities laws. Strafaci also caused certain books and records and reports to be inaccurate, and failed to maintain certain records. As a result, he aided and abetted the violation of certain record-keeping and reporting provisions applicable to investment advisers and broker-dealers registered with the Commission.
2. By the conduct alleged herein, Strafaci, directly or indirectly, has engaged and may be continuing to engage in transactions, acts, practices, and courses of business which constitute violations of Section 17(a) of the Securities Act of 1933 ("Securities Act") [15 U.S.C. § 77q(a)], and Sections 10(b) and 17(a) of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. §§ 78j(b) and 78q(a)] and Rules 10b-5 [17 C.F.R. § 240.10b-5], 17a-3(a)(2) [17 C.F.R. § 240.17a-3(a)(2)], 17a-3(a)(11) [17 C.F.R. § 240.17a-3(a)(11)], 17a-4(b) [17 C.F.R. § 240.17a-4(b)], 17a-5(a) [17 C.F.R. § 240.17a-5(a)], and 17a-5(d) [17 C.F.R. § 240.17a-5(d)] thereunder; and Sections 204, 206(1), and 206(2) of the Investment Advisers Act of 1940 [15 U.S.C. §§ 80b-4, 80b-6(1), and 80b-6(2)], and Rules 204-2(a)(16) [17 C.F.R. § 275.204-2(a)(16)] and 204-2(e)(3) [17 C.F.R. § 275.204-2(e)(3)] thereunder.
3. Strafaci, unless restrained and enjoined by this Court, will continue to engage in the transactions, acts, practices and courses of business described herein, and in transactions, acts, practices, and courses of business of a similar type and object.
4. The Commission brings this action pursuant to the authority conferred upon it by Sections 20(b) and 20(d) of the Securities Act, 15 U.S.C. §§ 77t(b) and 77t(d); Section 21(d) ofthe Exchange Act, 15 U.S.C. § 78u(d); and Sections 209(d) and 209(e) of the Investment Advisers Act, 15 U.S.C. §§ 80b-9(d) and 80b-9(e).
5. This Court has subject matter jurisdiction over this action pursuant to Sections 20(b) and 22(a) of the Securities Act, 15 U.S.C. §§ 77t(b) and 77v(a); Sections 21(d) and 27 of the Exchange Act, 15 U.S.C. §§ 78d(e) and 78aa; and Sections 209(d) and 214 of the Investment Advisers Act, 15 U.S.C. §§ 80b-9(e) and 80b-14.
6. Edward J. Strafaci, age 45, was at all relevant times an executive vice-president and the Director of Fixed Income Money Management for Lipper & Company, L.P. ("Lipper & Co.") and its affiliates, and the portfolio manager of the four hedge funds — Lipper Convertibles, L.P., formerly known as Lipco Partners, L.P. ("Convertibles"); Lipper Convertibles Series II, L.P. ("Series II"); Lipper Offshore Convertibles, L.P. ("Offshore"); and Lipper Fixed Income Fund, L.P. ("Fixed Income") (together, the four funds are referred to in this Complaint as "the Funds"). At all relevant times, Strafaci was also a registered representative of Lipper & Co., Convertibles, Series II, and Offshore, each of which was registered as a broker-dealer with the Commission and was a member of the National Association of Securities Dealers ("NASD"). Strafaci was also the designated chief compliance officer of Lipper & Co. and the Funds. On January 14, 2002, Strafaci resigned his positions with the Funds and Lipper & Co. and its affiliates. He is now a principal, majority shareholder, and portfolio manager of a hedge fund holding company. Strafaci is a resident of Colts Neck, New Jersey.
7. The Funds are hedge funds,1 that at all relevant times were organized as limited partnerships and managed by one or more of the following entities: Lipper & Co., Lipper Holdings, LLC ("Holdings"), and Jerome Services Corp. LDC ("Jerome") (together, the "Managing Entities"). Three of the four funds, Convertibles, Series II, and Offshore, were registered with the Commission as broker-dealers and were members of the NASD.
8. Convertibles, Series II, and Offshore primarily invested in convertible securities -bonds or preferred stock convertible by the owner into shares of common stock. Fixed Income, a "fund of funds," invested approximately 60% of its capital in Convertibles, and thus indirectly followed the strategy described herein. The Funds generally hedged their long positions in convertible securities by selling short the common stock into which the bond or preferred was convertible. The Funds also employed leverage — borrowed funds — to purchase the convertible securities, which allowed them to hold securities in an amount in excess of the equity contributed to the Funds by the partners. Accordingly, a distinction is drawn herein between"assets" of, or "securities" held by, the funds — representing the total face value owned — and "partners' capital," or the net value of those assets after borrowings.2
9. Collectively, on or about December 31, 2000, the Funds had reported total assets of approximately $4.9 billion, including convertible securities of $2.8 billion. Convertibles, the oldest and largest of the Funds, had reported total assets of approximately $4.2 billion as of that date, including approximately $2.3 billion in convertible securities.
10. Strafaci resigned before the Funds' December 31, 2001 valuations and performance figures were disseminated. When questions arose after his resignation about those valuations and performance figures, Strafaci refused to assist the Managing Entities by explaining how he arrived at the values he ascribed to the convertible securities. In February 2002, after Strafaci's resignation and following an internal review of his pricing, the Managing Entities wrote down the value of Funds, notifying partners that the value of their interests in Convertibles, Series II, Offshore, and Fixed Income were, respectively, approximately 40%, 15%, 8%, and 22% less than the value reported for November 30, 2001. The Funds are currently in liquidation.
11. Each of the Managing Entities was, at various times, the general partner of one or more of the Funds, and collected performance fees based on the fund's performance, and/or management fees based on the amount of assets in the fund. All the Managing Entities areaffiliated and were, at all relevant times, directly or indirectly subject to common control and ownership.
12. Lipper & Co. is a Delaware limited partnership established in 1987 and, at all relevant times, was registered with the Commission as an investment adviser and broker-dealer, and was a member of the NASD. Lipper & Co. was appointed by Offshore's general partner as the investment manager for Offshore and, during the relevant time, received management fees for managing Offshore and Fixed Income, based on the reported value of those funds' assets.
13. Holdings is a Delaware limited liability company and, at all relevant times, was the general partner of Fixed Income, Convertibles, and Series II. At all relevant times, Holdings also managed the portfolio for Convertibles and Series II, received performance fees based on the reported profits of Convertibles and Series II, and received a performance fee based on Fixed Income's profits attributable to its investment in Convertibles.
14. Jerome is a Cayman Islands partnership that, at all relevant times, served as the general partner of Offshore. During the relevant period, Jerome received performance fees based on Offshore's reported net profits.
15. The Funds' offering documents set forth the methodology by which each fund's portfolio securities were to be valued. The offering documents for each fund consisted of an offering memorandum and a partnership agreement; in the event of a conflict between the two documents, the terms of the partnership agreement were controlling. The offering documents for each of the funds required the general partner (or, for some periods in the case of Offshore, theinvestment manager) to value the Funds' portfolio securities in a manner that closely reflected the prevailing market prices for the securities.
16. For example, the partnership agreement for the largest of the Funds, Convertibles, stated, in relevant part:
The Market Value of a Position shall be determined as follows:
(a) Securities that are listed on a national securities exchange or quoted on the National Association of Securities Dealers Inc.'s National Market System shall be valued at their last sales price on the principal exchange on which such Securities are listed or quoted.
(b) Securities traded over-the-counter (but which are not traded or quoted as provided in clause (a) above) shall be valued between the last "bid" and "asked" price for such Security as determined by the General Partner in its reasonable discretion.
(c) All other Securities and other property shall be valued by the General Partner in its reasonable discretion.
(d) If the General Partner determines that the valuation of any Securities or other property in accordance with the terms of this Agreement does not fairly represent the value of such Securities or property, the General Partner shall value such Securities or other property in a manner which it reasonably chooses and shall set forth the basis of that valuation in writing in the records of the Partnership.
(e) The foregoing valuation methods may be changed by the General Partner if it determines in good faith that such change is advisable to reflect more accurately market conditions or activities. The basis of any such determination shall be set forth in the records of the Partnership.
17. Convertibles' offering memorandum similarly provided:
18. The convertible securities held by the Funds generally traded in a dealer market, or over-the-counter, as distinguished from on an exchange. Some of the convertible securities held by the Funds were traded on an exchange, but also traded over-the-counter in conjunction with the hedging short position in the issuer's stock.
19. Strafaci, to whom the Managing Entities delegated responsibility for valuing the Funds' portfolio securities, represented to colleagues, senior management, investors, and others that he was pricing the Funds' portfolio securities at or close to the prevailing market price for the security, as reflected in the current "bid" and "ask" prices for the security disseminated by major market makers or recent transactions in the security of substantial size.
20. Under the terms of Convertibles' offering documents, the market value of the Convertibles' portfolio securities, determined as described above, was the basis for thecalculation of the Fund's net profit or loss for a given period, for the value of the Fund, and for the value of each limited partner's capital account. Throughout the relevant period, partners received reports at least monthly of the value of their capital accounts and were permitted to, and did, add to and withdraw from the Funds on a monthly basis. The Series II and Offshore offering documents made representations similar to those contained in Convertibles' offering documents as to how those funds' portfolio securities, and partners' capital accounts, would be valued.
21. Contrary to the representations in the offering documents and Strafaci's own representations, Strafaci did not value many of the Funds' convertible securities at or close to the prevailing market price for the security, as reflected in the current "bid" and "ask" prices for the security disseminated by major market makers or recent transactions in the security of substantial size. Nor did he price the securities at "fair value," setting forth the basis for that valuation in writing.3 Instead, he priced significant portions of the Funds' convertible securities at prices substantially higher than the prevailing market price, or the security's fair value. As a result, throughout the relevant period, the values of the Funds, and of partners' capital, were substantially overstated.
22. For example, analyses have shown that total value of Convertibles' convertible bonds and preferred stock as of December 31, 2000 was overstated by approximately 12-14%;its value as of June 30, 2001 was overstated by approximately 13-15%; and its value as of September 30, 2001 was overstated by approximately 16-19%. Because the Funds' use of leverage magnified the effect of these overstatements, partners' capital was inflated to an even greater degree. These analyses have further shown that the value of Convertibles' partners' capital as of December 31, 2000 was overstated by approximately 49%; this value as of June 30, 2001 was overstated by approximately 44%; and this value as of September 30, 2001 was overstated by approximately 46%.
23. The discrepancy between Strafaci's valuation of the Funds' portfolios and the valuation of the portfolios based on prevailing market prices or fair value varied and generally increased over time. The discrepancy began in the mid-1990s but grew significantly over 1998, and over each of 2000 and 2001.
24. Strafaci's inflated valuations — or "marks" — distorted not only the values but the performance of the Funds. For example, upon information and belief, those inflated marks converted losses over each of 1998 and 2000 into reported gains.
25. Because Series II and Offshore held many, but not all, of the convertible securities held by Convertibles, the values and performance of those funds were also substantially overstated. Because Fixed Income was substantially invested in Convertibles, its values and performance were also substantially overstated.
26. Strafaci knew or recklessly disregarded that the values he assigned to substantial portions of the Funds' convertible securities were substantially higher than market prices and thus that he was not valuing those securities in a manner consistent with the Funds' representations.
27. The Managing Entities delegated their responsibility for valuing the Funds' portfolios to Strafaci, and, throughout the relevant period, he in fact valued each of the convertible securities held by the Funds.
28. In connection with the marking of the portfolio, Strafaci obtained pricing information from a variety of market sources. He obtained, directly and through traders employed by the Managing Entities (the "Lipper traders"), indications of interest from major market makers, and information about actual trades and negotiations for trades. Strafaci was also delegated responsibility for creating and maintaining records necessary to demonstrate the calculation of the Funds' performance and the valuation of the Funds' securities. However, he failed to maintain records reflecting the basis for his valuation of the Funds' convertible securities.
29. Strafaci disregarded crucial information he obtained concerning the market value of some of the Funds' convertible securities: the prices he was able to obtain on recent sales of a portion of the Funds' holdings of a security. During the relevant period, Strafaci's marks were often significantly higher than the price at which he had recently sold the same security.
30. Moreover, Lipper traders told Strafaci, on numerous occasions and with regard to numerous securities, that his mark for the security was substantially higher than what the trader believed the market price for the security to be, based upon indications of interest from major market makers and information about actual trades and negotiations for trades that the trader had observed (and had provided to Strafaci). Strafaci disregarded the views of his traders and rarely, if ever, made any significant change to his marks based on the traders' views.
31. As a result of Strafaci's overstatement of the value of the Funds' securities, the Funds and Managing Entities disseminated false and misleading statements to investors and prospective investors concerning the Funds' value and performance. The Funds' overstated performance and valuations were directly reflected in monthly reports to investors, in the Funds' audited annual financial statements, and in Financial and Operational Combined Uniform Single ("FOCUS") reports filed by Convertibles, Series II, and Offshore. The FOCUS reports contain, among other things, information regarding the broker-dealer's assets and liabilities, and net capital. In addition, marketing and offering materials disseminated to prospective investors contained materially misleading performance information derived from Strafaci's inflated valuations. For example, marketing and offering material provided to all prospective investors contained historical performance information for Convertibles, and offering materials for Series II and Offshore contained historical performance information for Convertibles and for the fund being offered. In addition, because Strafaci failed to value the Funds' convertible securities in accordance with the representations regarding valuation in the offering materials, the offering materials misrepresented the Funds' pricing methodology during the relevant period.
32. Throughout the relevant period, investors made, or added to, investments in the Funds, and made withdrawals from the Funds. Strafaci's overmarking caused these investments and withdrawals to occur at inflated prices.
33. Based on Strafaci's inflated marks, the Managing Entities received tens of millions in performance and management fees to which they were not entitled. For the relevant period, Strafaci received bonuses totaling at least $3.9 million, and salaries totaling at least $600,000. Strafaci's bonuses and salaries were based, in whole or in significant part, on his inflated marks, and the fund valuations and performance figures derived from those marks.
34. The allegations contained in paragraphs 1 through 33 are repeated and realleged as if fully set forth herein.
35. The Funds' limited partnership interests are securities within the meaning of Section 2(1) of the Securities Act, 15 U.S.C. § 77b(1), and Section 3(a)(10) of the Exchange Act, 15 U.S.C. § 78c(a)(10).
36. From at least 1998 until January 14, 2002, Strafaci, directly and indirectly, by the use of the means or instruments of transportation or communication in, or the means or instrumentalities of, interstate commerce, or by use of the mails, or of any facility of any national securities exchange, in the offer or sale, and in connection with the purchase or sale, of securities: (a) employed devices, schemes, or artifices to defraud; (b) obtained money or property by means of, or otherwise made, untrue statements of material fact or omitted to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; and/or (c) engaged in transactions, acts, practices and courses of business which operated or would have operated as a fraud or deceit upon purchasers of securities and upon other persons.
37. As part and in furtherance of such violative conduct, as more fully described in paragraphs 6 through 33 above, Strafaci, a senior official of the Funds and the Managing Entities, knowingly, recklessly and negligently made, and caused the Funds and the Managing Entities to make, materially misleading statements to investors in the offer or sale, and inconnection with the purchase or sale, of interests in the Funds, concerning the value and performance of the Funds, and the methods by which the Funds' portfolio securities were valued
38. By reason of the foregoing, Strafaci violated Section 17(a) of the Securities Act, and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
39. The allegations contained in paragraphs 1 through 38 are repeated and realleged as if fully set forth herein.
40. Each of the Managing Entities was, during the relevant period, an investment adviser within the meaning of Section 202(a)(11) of the Advisers Act, 15 U.S.C. § 80b-2(a)(11).
41. From at least 1998 until January 14, 2002, the Managing Entities (a) employed devices, schemes or artifices to defraud clients or prospective clients; and (b) engaged in acts, practices or courses of business which operated as a fraud or deceit upon clients and prospective clients.
42. As part and in furtherance of such violative conduct, as more fully described in paragraphs 6 through 33 above, Strafaci knowingly, recklessly and negligently caused the Managing Entities to make materially misleading statements to clients and prospective clients concerning the value and performance of the Funds, and the methods by which the Funds' portfolio securities were valued.
43. By reason of the foregoing, Strafaci aided and abetted the Managing Entities' violations of Sections 206(1) and 206(2) of the Advisers Act.
44. The allegations contained in paragraphs 1 through 43 are repeated and realleged as if fully set forth herein.
45. Section 204 of the Advisers Act and Rules 204-2(a)(16) and 204-2(e)(3) promulgated thereunder require investment advisers to make and keep true, accurate and current books and records relating to their advisory business. Rule 204-2(a)(16) requires an investment adviser to keep all documents necessary to form the basis for, or demonstrate the calculation of, the performance or rate of return of all managed accounts, and Rule 204-2(e)(3) requires that such records specified under Rule 204-2(a)(16) be maintained and preserved for five years.
46. By failing to make and keep the required documents, Strafaci aided and abetted Lipper & Co.'s violations of Section 204 of the Advisers Act and Rules 204-2(a)(16) and 204-2(e)(3).
47. The allegations contained in paragraphs 1 through 46 are repeated and realleged as if fully set forth herein.
48. As registered broker-dealers, Convertibles, Series II, and Offshore (the "broker-dealers") were required to comply with the books-and-records and reporting requirements under Section 17(a) of the Exchange Act.
49. Section 17(a) of the Exchange Act requires a registered broker-dealer to make and keep current certain books and records relating to its brokerage business, and to make certainreports and filings with the Commission. Exchange Act Rules 17a-3(a)(2) and 17a-2(a)(11) requires that a broker-dealer make and keep current a number of books and records, including records that reflect the firm's: (a) assets, liabilities, income, expense, and capital accounts; and (b) aggregate indebtedness and net capital.
50. Section 17(a) of the Exchange Act also requires brokerage firms to make and disseminate such reports as the Commission prescribes by rule. Exchange Act Rule 17a-5(a) requires certain broker-dealers, such as the Convertible Funds, to file accurate monthly and quarterly unaudited FOCUS reports with the Commission or a self-regulatory organization. Rule 17(a)-5(d) requires certain broker-dealers, such as the Convertible Funds, to file accurate annual audited financial statements.
51. As discussed more fully in Paragraphs 6 through 33 above, Strafaci inflated the values of the Funds' convertible securities. As a result, the broker-dealers' books and records, FOCUS reports, and audited financial statements were inaccurate.
52. Further, Rule 17a-4(b)(8)(iii) requires certain broker-dealers to preserve the records that contain information that supports the amounts included in FOCUS reports and audited financial statements. Strafaci had been delegated responsibility to preserve these records but failed to do so.
53. By reason of the foregoing, Strafaci aided and abetted violations of Section 17(a) of the Exchange Act and Rules 17a3-(a)(2), 17a-3(a)(11), 17a-5(a), 17a-5(d), and 17a-4(b)(8)(iii) thereunder by Convertibles, Series II, and Offshore.
WHEREFORE, the Commission respectfully requests that the Court
1. Enter a Final Judgment:
(a) enjoining Defendant Strafaci from violating Section 17(a) of the Securities Act, and Sections 10(b) and 17(a) of the Exchange Act and Rules 10b-5, 17a-3(a)(2), 17a-3(a)(11), 17a-4(b)(8), 17a-5(a), and 17a-5(d) thereunder; and Sections 204, 206(1), and 206(2) of the Advisers Act, and Rules 204-2(a)(16) and 204-2(e)(3) thereunder;
(b) ordering that Strafaci disgorge all his ill-gotten gains from the conduct alleged herein;
(c) imposing civil money penalties against Strafaci pursuant to Section 20(d) of the Securities Act [15 U.S.C. § 77t(d)]; Section 21(d) of the Exchange Act [15 U.S.C. § 78u(d)] and Section 209(e) of the Advisers Act [15 U.S.C. § 80b-9(e)]; and
2. Grant such other relief as the Court deems just and proper.
Dated: October _, 2003
New York, New York
Respectfully submitted,
WAYNE M. CARLIN (WC-2114)
Regional Director
___________________
ATTORNEY FOR PLAINTIFF
SECURITIES AND EXCHANGE COMMISSION
Northeast Regional Office
233 Broadway
11th Floor
New York, New York 10279
Of Counsel:
Edwin H. Nordlinger
Mark K. Schonfeld
Leslie Kazon
Eduardo A. Santiago-Acevedo
Kristine Zaleskas
1 The term "hedge fund" generally and in this Complaint refers to an entity that holds a pool of securities and other assets that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act of 1940 [15 U.S.C. §§80a-1 et. seq.]. Typically, a hedge fund is not required to be registered as an investment company, pursuant to Section 3(c)(1) or 3(c)(7) of the Investment Company Act, because its securities are not offered for sale pursuant to a public offering, and are held by no more than 100 investors or are offered for sale exclusively to qualified purchasers.
2 During the relevant period, the Funds employed leverage between two-to-one and four-to-one, meaning that for each $100 in partners' capital, the Funds owned securities valued at between $200 and $400. The Funds' use of leverage magnified the effect on partners' capital of an overvaluation of the assets in the Funds' portfolios; for example, if a Fund's securities were overvalued by five percent, and the Fund was leveraged three to one, the partners' capital would be overstated by 15 percent.
3 The term "fair value" as generally understood in the context of portfolio securities and as used herein, means the amount the owner might reasonably expect to receive for the security upon its current sale, i.e. the amount an arm's length buyer, under the circumstances, would currently pay for the security, not the amount a buyer might pay at some later time, such as when the market ultimately recognizes the security's true value as currently perceived by the portfolio manager.
http://www.sec.gov/litigation/complaints/comp18432.htm
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