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Feeder Funds Held Subject to Commodity Pool Regulation
New Jersey Law Journal
July 16, 2009
A fund that solicits money from investors for trading in commodity futures is subject to registration and regulation as a commodity pool operator, even if it does no trading itself, the 3rd U.S. Circuit Court of Appeals held Monday in a precedent-setting ruling.
The decision, in Commodity Futures Trading Commission v. Equity Financial Group LLC, 08-1558, could have repercussions in suits against other "feeder funds," including those that funneled investors' money into accounts run by Bernard Madoff in his $50 billion Ponzi scheme.
The three-judge panel based the ruling on the Commodity Exchange Act's definition of a commodity pool operator in 7 U.S.C. 1a(5), which does not explicitly require trading.
"If an entity is engaged in a business in the nature of an investment trust, syndicate, or similar form of enterprise, and it solicits, accepts, or receives funds for the purpose of trading, it is a commodity pool operator," wrote Judge Anthony Scirica, joined by Judges Dolores Sloviter and Thomas Hardiman. "The actual trading of commodity futures is not required."
Scirica added that "the remedial purpose of the statute would be thwarted if the operator of a fund could avoid the regulatory scheme simply by investing in another pool rather than trading." His opinion compared commodity pools to mutual funds, which also spread and diversify risk.
The ruling came in an enforcement action filed by the Commodity Futures Trading Commission against Equity Financial Group, the creator and operator of Shasta Capital Associates, alleging it induced customers to invest $15 million based on false reports of large returns. The money was funneled into Tech Traders, which pooled it with other funds and executed trades.
In monthly and quarterly reports and in Internet postings, Tech Traders claimed double-digit returns for most months between June 2001 and February 2004, when it was actually losing money.
According to the suit, Equity Financial's owner, Vincent Firth, and its lawyer, Robert Shimer, knew at least some reports were false or probably false. Shimer even came up with a verification procedure to conceal their falsity, getting Tech Traders to hire an accountant who prepared the false reports using nonstandard and misleading accounting procedures and then sent those reports to Shasta's accountant, who relied on the bogus numbers in communicating with investors.
Tech traders diverted some of its profits back to Shimer using a West Indies trust account.
Tech Traders settled out before trial. A consent order entered by U.S. District Judge Robert Kugler, in Camden, N.J., on June 28, 2007, required it to pay more than $30 million in sanctions for fraudulently soliciting investors.
The claims against Equity Financial, Firth and Shimer were tried in November 2007 and on Feb. 4, 2008, Kugler found they were liable under 7 U.S.C. 6k and 6m for not registering and they committed fraud under 7 U.S.C. 6b and 6o.
In addition, Shimer was liable under 7 U.S.C. 13c(a) for aiding and abetting Tech Traders' violation of 17 C.F.R. §4.30, which prohibits a commodity trading adviser from soliciting, accepting or receiving client funds for certain purposes. Shimer contended Tech Traders was not a commodity trading adviser to Shasta because Shasta did no trades. The 3rd Circuit disagreed, saying Shasta Capital's choice to invest in the Tech Traders fund rather than trade under its own name was irrelevant to Tech Traders' status under the rule.
Firth and Shimer were also held liable as controlling persons of Equity Financial. On appeal, Scirica pointed out they knew they were required to register. In 2003, after two potential investors told them so, they sought legal advice from the firm of Arnold & Porter, which confirmed it and suggested they fix the problem. They did not follow the advice because they did not want to jeopardize the lucrative arrangement. "The failure to register was not a result of a good faith belief, that Equity Financial did not need to register but because 'the numbers were still there,' numbers that furthered the fraudulent scheme," wrote Scirica.
Kugler's June 4, 2008, judgment, upheld on appeal, ordered Equity, Firth and Shimer to pay investors $4.13 million in restitution. It also required disgorgement of $2.5 million, $1.45 million of it from Shimer, and imposed civil penalties totaling over $5.5 million, $2.9 million of it from Shimer. Kugler also awarded prejudgment interest and enjoined the defendants from involvement in commodities trading.
Stephen Obie, acting director of the commission's Division of Enforcement, says the case shows that Ponzi schemers cannot escape liability by creating multiple entities, some of which do not engage in trading. He sees the 3rd Circuit opinion, the first by any appellate court on the issue, as helpful to securities lawyers as well as commodities lawyers who go after feeder funds for fraudulent activities.
Bill Singer, a securities lawyer with Stark & Stark in New York, says the case could help lay the groundwork for future actions against feeder funds involved in the Madoff scam. It also highlights the need for Congress to update commodities and securities laws to keep pace with changes in the markets during the past decade, he says.
Neither Firth, of Medford, N.J., nor Shimer of Camp Hill, Pa., could be reached for comment.
Shimer has been admitted as a lawyer in Massachusetts since 1973 and has no disciplinary history. Michael Fredrickson, general counsel for the Massachusetts Board of Bar Overseers, says no ethics case is pending against Shimer.
