Law360, New York (June 2, 2011) -- A Georgia federal judge ruled Wednesday that a fraud case against two hedge fund advisers can go forward, but the U.S. Securities and Exchange Commission must narrow its case against them.

Paul Mannion Jr., Andrews Reckles and their firms, PEF Advisors LLC and PEF Advisors Ltd., were accused in October of defrauding investors and overvaluing the hedge fund they advised by hiding trouble assets in a medical staffing company.

The SEC claims they failed to disclose that the company, World Health Alternatives Inc., had defaulted on a $6 million bridge loan in August 2005. The hedge fund, Palisades Master Fund LP, had a restricted stock position in World Health, and the defendants allegedly overstated the position's value as $1.9 million, when it should have been zero. They also allegedly sold off most of their personal stock in World Health without disclosing the sale.

In a motion to dismiss filed in January, the defendants argued that the SEC's claims were bogus for a number of reasons. U.S. District Judge William S. Duffey Jr. agreed on Wednesday with two of their arguments, which will narrow the case for the SEC, but allowed the claims to stand.

First, the defendants moved to dismiss a claim that they violated the Securities Exchange Act by defrauding investors. Such a claim, they argued, must show that the alleged fraud was perpetrated “in connection with the purchase or sale of any security.” But the hedge fund's investors didn't buy into the fund after receiving the allegedly fraudulent information about its holdings in World Health. They simply left their money in the fund, and the judge agreed that this was not enough to qualify as a security transaction.

But he allowed the claim to stand because one investor who allegedly put $3 million into the fund as a result of allegedly fraudulent information was enough of a connection to a purchase or sale of a security.

The defendants also tried to dismiss two claims based on the Investment Advisers Act, which specifies that it is illegal to defraud a client. The defendants argued that the allegedly defrauded investors were not their clients. A hedge fund adviser's client, they argued, is the hedge fund itself, not its investors.

The judge upheld that notion, but ruled that the SEC's claim that they had defrauded the fund itself could stand.

Other arguments — that the SEC's complaint didn't show intent to deceive or willful negligence, that the alleged misrepresentations were immaterial, and that the SEC failed to show fraud with particularity to each defendant — were denied.

The defendants are represented by Stavroula E. Lambrakopoulos, Stephen J. Crimmins, Richard James Mitchell and Matthew B. Bowman of K&L Gates LLP, and Ross A. Albert of Morris Manning & Martin LLP.

The case is U.S. Securities And Exchange Commission v. Mannion et al., case number 1:10-cv-03374, in the U.S. District Court for the Northern District of Georgia.

--Editing by Anne Urda and John Williams.

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