UPDATE 1-Fine against British fund for abusive trades must be cut -U.S. court

* Pentagon Capital accused of late trading in mutual funds

* 2nd Circuit upholds finding of liability

Aug 8 (Reuters) - A British hedge fund firm and its chief executive must give up $38.4 million of profit tied to abusive mutual fund trading, but a civil fine in that amount must be reduced, a federal appeals court said on Thursday.

The decision, by the 2nd U.S. Circuit Court of Appeals, involves Pentagon Capital Management Plc and its chief, Lewis Chester. It is among the last tied to an industrywide probe into market timing and “late trading” in funds, brought to light a decade ago by then-New York Attorney General Eliot Spitzer.

Market timing involves rapid trading in violation of funds’ rules and at ordinary investors’ expense, and is considered improper. Late trading involves the trading of fund shares after the market closes but at old prices, and is considered illegal.

Pentagon and Chester were sued by the U.S. Securities and Exchange Commission in April 2008 for what the regulator said was late trading between roughly June 1999 and September 2003. U.S. District Judge Robert Sweet in Manhattan found them liable in a non-jury trial.

In appealing the judge’s finding, the defendants did not deny engaging in the practice but claimed there was no deceit, and that as investment advisers rather than brokers they could not be held primarily liable for securities fraud.

A three-judge panel of the 2nd Circuit disagreed.

Calling deceitful intent “inherent” in late trading, Circuit Judge John Walker said the defendants sought out brokers to conduct late trading, and knew that trade sheets would be time-stamped before 4 p.m. though they had no intention of trading before then.

The appeals court also said the fine must be recalculated and not take into account profit earned through late trading more than five years before the 2008 SEC lawsuit.

It cited an intervening February ruling by the U.S. Supreme Court, in SEC v Gabelli, that said a five-year period for the regulator to seek civil penalties for fraud begins when the fraud ends, not when it is discovered.

Both sides agreed that the fine needed to be revisited, though the 2nd Circuit said Sweet erred in holding that Pentagon and Chester could each be held fully responsible for it.

“We are obviously pleased by the decision, which upholds the successful result of trial, including the district court’s finding that Chester and Pentagon committed fraud,” said George Canellos, co-director of the SEC enforcement division.

Frank Razzano, a lawyer for Pentagon and Chester, was not immediately available for comment.

Pentagon once oversaw more than $2 billion of assets but began closing its funds shortly before the SEC sued.

Spitzer also served as New York’s governor and is now a candidate to become New York City’s comptroller.

The case is SEC v. Pentagon Capital Management Plc et al, 2nd U.S. Circuit Court of Appeals, No. 12-1680.