Demonstrating the SEC's concerns over the abusive misuse of side pockets by hedge fund managers, the SEC filed suit in October 2010 in the U.S. District Court for the Northern District of Georgia (SEC v. Mannion, N.D. Ga., Civil Action No. 10-CV-3374, 10/19/10) against two hedge fund managers and their investment advisory firm for allegedly using a side pocket to overvalue assets.

A side pocket is typically used by a hedge fund manager to separate assets from the rest of the hedge fund assets that may be particularly illiquid investments. Segregating the assets allows the investment manager some flexibility in dealing with the assets and paying off investors from those assets. The SEC suspects that side pockets are often used as a dumping ground to conceal overvalued assets. The main concern by the SEC is that fees collected for the management over those assets are too high based on the inflated values.

In this case, the SEC alleges that the hedge fund managers deposited certain assets in a side pocket and valued them in “a manner that was inconsistent with the fund's policy and contrary to undisclosed internal assessment.” According to the SEC, the valuation of these assets allowed the investment manager to collect inflated fees and stave off investor redemptions. The SEC also alleges that the fund managers stole approximately $1.6 million of securities that belong to the fund and used investors' cash intended for the fund for their own personal use.

Counsel for the defendants expressed disappointment with the SEC for filing the charges some five years after the alleged events took place.

The SEC has asked the court to issue an injunction, ordering disgorgement plus interest and civil penalties.

The use of side pockets and side letters by hedge fund managers is an area of enhanced scrutiny by SEC staff and will likely continue to be a target of SEC examinations and enforcement actions.