Portfolio Pumping

Even before the current financial turmoil, some fund managers attempted various illegal means to hide their poor portfolio performance.

Last week SEC charged San Francisco investment adviser MedCap Management & Research LLC (MMR) and its principal Charles Frederick Toney, Jr. with reporting misleading results to hedge fund investors by engaging in a practice known as "portfolio pumping."

According to SEC's order, MedCap Partners L.P. (MedCap), a hedge fund run by MMR and Toney, was suffering from dramatic losses and facing increasing redemptions from fund investors by Sep 2006. Over the last four days of the month, Toney — through a separate fund that MMR managed — placed numerous buy orders for a thinly-traded over-the-counter stock in which MedCap already was heavily invested. Toney's buying pressure caused the stock price to more than quadruple, from US$0.85 to US$3.72.

Since the stock represented over one-third of MedCap's holdings, the brief boost in its price inflated MedCap's reported value by US$29m, masking what would otherwise have been a 40% quarterly loss for MedCap. Immediately after the quarter ended, Toney reported to MedCap's investors that the fund's investments had begun to "bounce" and that the fund's performance was improving. Toney failed to disclose that this "bounce" was almost entirely the result of his four-day purchasing spree. Following MMR's brief buying activity, both the stock price and MedCap's asset value declined to their previous levels. At the same time, MMR charged fees to the fund based on the inflated quarter-end asset value.

Toney and MMR, without admitting or denying the findings, have agreed to cease and desist from violating the antifraud provisions of the Investment Advisers Act of 1940. MMR also will disgorge the higher management fees it received due to the inflated fund asset value, plus interest — an amount totaling US$70,633.69 — and receive the censure. Toney also has agreed to a bar from association with any investment adviser with the right to reapply after one year, and to pay a US$100,000 penalty.