Ponzi Scheme Suit Filed Against Minnesota-based Hedge Fund Managers

Jack Humphrey, Regulatory journalist
November 10, 2011 /

The Securities and Exchange Commission has charged two Minnesota-based hedge fund managers and their firm for facilitating a multi-billion dollar Ponzi scheme operated by Minnesota businessman Thomas Petters.

The SEC’s investigation conducted by Michael Wells, Andrew O’Brien, Donald Ryba, and Peter Chan of the SEC’s Chicago Regional Office, revealed that James Fry of Long Lake, Minn., Michelle Palm of Edina, Minn., and Fry’s firm Arrowhead Capital Management LLC invested more than $600 million in hedge fund assets with Petters while collecting more than $42 million in fees.

According to the SEC, Fry, Palm, and Arrowhead falsely assured investors and potential investors that the flow of their money would be safeguarded by the operation of certain collateral accounts when, in fact, the process did not exist as described. When Petters was unable to make payments on investments held by the funds they managed, Fry, Palm, and Arrowhead concealed Petters’s inability to pay by entering into secret note extensions with Petters.

This is the fourth enforcement action that the SEC has brought against hedge fund managers that collectively fed billions of dollars into the Petters fraud. The SEC previously charged Petters and froze the assets of an Illinois-based hedge fund manager who was a $2 billion feeder to his scheme, charged two Florida-based fund managers who facilitated the scheme, and blocked an attempt by a Connecticut-based hedge fund manager to divert funds from victims of the scheme.

“Fry and Palm presented themselves as protectors of their hedge fund investors when in fact they were facilitators of the Petters Ponzi scheme,” said Merri Jo Gillette, Director of the SEC’s Chicago Regional Office.

“Arrowhead’s promises were filled with lies and deceit, and as a result investors lost more than $600 million dollars while Fry pocketed millions in fees.”

According to the SEC’s complaint filed in the U.S. District Court for the District of Minnesota, Petters promised investors that their money would be used to finance the purchase of vast amounts of consumer electronics by vendors who then re-sold the merchandise to “Big Box” retailers including such well-known chains as Wal-Mart and Costco. In reality, Petters’s “purchase order inventory financing” business was a complete sham and amounted to nothing more than a Ponzi scheme.

The SEC claimed that Petters sold promissory notes to a number of hedge funds, including those managed by Fry, Palm, and Arrowhead. From as early as 1998 to June 2008, Fry, Palm, and Arrowhead funneled money into the Petters Ponzi Scheme by selling interests in the funds managed by Arrowhead to investors throughout the country. The funds, in turn, invested nearly all contributions into the Petters Ponzi Scheme and were holding more than $600 million worth of Petters’s notes when the Ponzi scheme collapsed.

The SEC’s complaint further alleged that Fry, Palm, and Arrowhead falsely assured investors that the inventory financing transactions were structured in such a way that after the retailers received their merchandise from vendors, they would send their payments for the merchandise directly to the funds’ collateral accounts to pay off the notes held by the funds. In reality, money for the repayment of notes held by the funds always came directly from Petters and never came from any retailers.

Fry and Palm did not disclose this material fact to investors in the funds, and instead continued to lie about the operation of the collateral accounts.

According to the SEC’s complaint, Fry, Palm, and Arrowhead hid the fact that Petters was on the verge of defaulting on certain of the notes held by the funds by engaging in a series of secret note extensions with Petters beginning around February 2008.

While holding the Petters notes out as 90-day notes, the funds were holding a group of notes that were so far past due that they were on the verge of their 182-day default date. In order to hide that fact and help Petters avoid default, Fry, Palm, and Arrowhead secretly extended the due dates on these notes without ever informing investors in the funds.

The SEC alleges that Fry, Palm, and Arrowhead distributed pitch books to investors and potential investors that falsely represented that independent accountants were conducting quarterly examinations of the funds’ transaction procedures. In reality, no such examinations were conducted and Fry, Palm, and Arrowhead knew it.

The SEC seeks entry of a court order of permanent injunction against Fry, Palm, and Arrowhead, as well as an order of disgorgement, including prejudgment interest and penalties.

Both Fry and Palm have been charged criminally in connection with the same misconduct. Palm pleaded guilty to one count of securities fraud and one count of making false statements to SEC staff during investigative testimony. Fry pleaded not guilty to multiple counts of securities fraud, wire fraud, and making false statements to SEC staff during investigative testimony.

The SEC’s litigation will be led by Daniel J. Hayes and John E. Birkenheier.

 

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