CFTC Hits Fund With $10 Million Charge

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Misleading statements, supervision failures cost commodity pool operator, CEO more than $10 million

The Commodity Futures Trading Commission (CFTC) issued an order simultaneously filing and settling charges against Catalyst Capital Advisors LLC, of Huntington, NY, and its CEO, Jerry Szilagyi. Catalyst and one of its portfolio managers Edward Walczak of Madison, WI, were charged with making materially misleading statements and for failing to implement an adequate supervisory system to prevent such misstatements.  Separately, the CFTC charged Walczak with fraud in a complaint filed in the U.S. District Court for the Western District of Wisconsin.

The order requires Catalyst, a registered commodity pool operator, to pay a $1.3 million civil monetary penalty and $8,908,481 in disgorgement (including pre-judgment interest).  The order also requires Szilagyi to pay a $300,000 civil monetary penalty. 

“We are committed to protecting investors,” says CFTC Director of Enforcement James McDonald, including those who invest in our markets through mutual funds. When companies or individuals make misleading statements about the risks of investing in their products—statements that go to the heart of any investment decision—they will be held accountable.”   

Parent responsible for the actions of the child

The CFTC order finds that Catalyst was liable for the misstatements of the fund’s portfolio manager regarding his management of the Fund’s risk, as well as Catalyst’s misrepresentations that stop-loss measures were in place to limit losses, when in fact no such measures existed. Further, Catalyst represented that a dedicated risk manager monitored the fund’s risk metrics daily, but the risk manager did not actually do so.  Moreover, Catalyst failed to implement or maintain adequate procedures to ensure that those acting on its behalf did not make misrepresentations to investors or investment advisors.  

In its complaint against Walczak, the CFTC alleges that, from at least November 2014 to February 2017, the portfolio manager, as the face of the fund, led investors or investment advisors to believe that the fund was a safer investment than it actually was. Among other things, Walczak falsely told investment advisors that he took specific steps to prevent the fund from losing more than eight percent of its value. However, the complaint also alleges that Walczak routinely failed to hedge in the manner he said he did, ultimately resulting in at least $500,000,000 of investor losses.

Risk averted up to a point

The Fund’s strategy—Walczak’s strategy—relied heavily on selling call options on S&P Futures contracts. While selling a call option is an inherently risky trade because the potential losses are unlimited. Walczak, repeatedly assured investors or investment advisors (who had discretionary authority over client accounts) that he used sophisticated options portfolio software to manage risk. He used a software program called OptionVue to stress test the portfolio daily against 5% and 10% increases in the price of the underlying S&P Futures. He told investors that if and when any one of the stress tests indicated that the Fund would lose more than 8% of its value, he traded to eliminate that risk before it could materialize.

However, in reality, Walczak never acted to neutralize risks. Often, he was lucky that the market did not rise so dramatically as to cause risk of loss to materialize. On July, 2016, for example—a day when OptionVue or similar software would have shown that an approximately 2% rise in the S&P Futures market would result in an approximately 14% loss to the Fund—Walczak’s assistant portfolio manager wrote to him: “We got lucky today with a down market.”

But in February 2017, however, Walczak’s luck ran out. On February 1, 2017, the Fund was short over 49,000 call options on S&P Futures contracts expiring in less than three weeks. It was short another 25,000 call options on S&P Futures contracts expiring at the end of the month. Because the underlying S&P Futures price, at the time, was above or close to the strike price of these options, this was a particularly high-risk position—it stood to decline significantly in value if the market were to continue to rise just a few percentage points. Indeed, internal company documents predicted that the Fund, as a whole, would lose 3.3% for every 1% increase in the S&P. In other words, the company’s own analysis projected that the Fund would decline approximately 10% if the market were to rise just 3%.

Walczak had told investors that in this situation, he would “jump in” to neutralize the risk of the Fund losing more than 8%. Yet, from February 1, 2017, through February 8, 2017, he did not execute a single trade on behalf of the Fund. And the magnitude of risk only increased over that period. Indeed, by February 8, the company’s internal analysis projected that the Fund would lose 4.7% for every 1% increase in the S&P. But, rather than reduce risk—as he told investors he would—Walczak chose to gamble that the market would decline.

However, the market did not decline and the risk that Walczak chose to ignore materialized. The market rose approximately 3% and during that same period, the Fund’s share price plunged almost 18%, which translated into at least $500,000,000 in investor losses.

“We trusted you!”

Advisors and investors fumed. One noted that Walczak “chose to gamble with mine and my clients’ money.” Another lamented, “We trusted you and believed you when you said…that you had risk management protocols in place… [A]ll these statements were simply inaccurate and I have a hard time believing you didn’t know that at the time.”

In addition to the CFTC action, the Securities and Exchange Commission (SEC) issued an order filing and settling similar charges against Catalyst and Szilagyi,and filed a complaint against Walczak in federal court.  Per the terms of the CFTC and SEC orders, each agency will give credit for monetary sanctions paid by Catalyst and/or Szilagyi to the other, and a Fair Fund will be established for the benefit of affected investors.

 In its continuing civil litigation against Walczak, the CFTC seeks, among other relief, disgorgement of benefits from violations of the CEA and CFTC regulations, restitution, civil monetary penalties, registration bans, and permanent injunctions against future violations of the federal commodities laws, as charged.

 And, where was compliance?

Nowhere to be found. And, that’s where Patrina could have helped. For more than 25 years, Patrina has been helping uniquely committed compliance professionals like you to stay on the “straight and narrow” efficiently and cost-effectively. So, let’s talk. Call 212-233-1155 to ask about Patrina’s cost-effective designated third-party services, our comprehensive 8-module compliance solution, and compliant data capture& file storage, and records archiving specifically designed for the financial services community. Be smart. Be covered. Let’s talk.  

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