/>iAs all of us who practice securities law (or have ever seen an advertisement for Fisher Advisors) have become acutely aware investment advisers are different from broker/dealers. Investment advisers are fiduciaries. While the precise borderlines of the differences can sometimes be a bit complex, it is safe to say that an investment adviser is under a legal obligation to put the interests of the client first, even to the adviser’s detriment. What happens when an adviser fails to do so? Among several possible consequences, if the adviser is registered with the U.S. Securities and Exchange Commission (“SEC”), are the imposition of sanctions both operationally and financially. How much more troubling is it to discover that the adviser, while seeking to ameliorate the negative consequences of its breach of fiduciary duties, engages in an arrangement that only makes matters worse? Well, that is the case now before us.
Catalyst Capital Advisors, LLC, a New York limited liability company (“CCA”) has been a registered with the U.S. Securities and Exchange Commission (“SEC”) as an investment adviser since June 2006. In its most recently filed Form ADV, dated 29 March 2023, CCA reported that it had some $7.1 billion in assets under management. Until February 2020 (considering events in January 2020, an interesting time to relocate), CCA was headquartered in Huntington, Long Island, New York. Its principal place of business is now San Juan, Puerto Rico. CCA is the investment adviser to 18 of the 86 series of the Mutual Fund Series Trust, one of those series is the Catalyst Hedged Futures Fund (“CHFF”). The Mutual Fund Series Trust and all its series, including CHFF, are SEC-registered open-end investment companies, i.e., mutual funds. CHFF had an insurance policy providing coverage (subject to a deductible and a ceiling) for liability arising out claims against CHFF for violations of the securities laws and related fiduciary obligations. CCA did not have comparable insurance.
CCA’s problems began in September 2013 when it combined with a private investment fund, Harbor Assets, LLC, founded and managed by then 56-year-old Edward Walczak of Madison, Wisconsin. Walczak had started Harbor Assets in 2005 and sold shares in Harbor to accredited investors in private transactions. By 2013 Harbor had grown to about $7 million in assets, focusing on investing in stock index futures traded on the Chicago Mercantile Exchange. Under the deal reached between CCA and Walczak in 2013, Walczak was to receive 60% of the net fees received by the resulting CCA operated entity, i.e., CHFF, until CHFF reached $20 million in size, and thereafter, 50%. By the end of 2016 CHFF had grown to almost $4 billion, with Walczak receiving compensation of $24 million just for 2016, and another $8 million for the period from December 2016 through February 2017. Walczak clearly benefitted greatly from CHFF’s growth, primarily attributable to CCA’s nationwide distribution capacities.
In 2013, when CCA became the adviser to CHFF with Walczak as the Senior Portfolio Manager, CHFF registered with the SEC as a mutual fund and sold shares in CHFF with disclosure materials approved by Walczak emphasizing “Risk Management – Hedges are built into every position when it is initiated and stop loss trigger points are used to limit draw downs.” Indeed, those materials stated that CHFF had “metrics [which] are dialed in to limit our drawdown to 8 %;” a position repeatedly confirmed by Walczak in oral presentations to investors. The slide show used to portray CHFF’s risk management cited protective steps taken by CHFF to limit risk, namely:
- Optimized position sizing.
- Trade entry scaling.
- Diversification of time and price exposure.
- Dynamic hedging of option structures; and
- Limiting overall portfolio risk.
Between December 2016 and February 2017 CHFF lost some 20% of its value, some $700 million because of its option trading strategy. In the ensuing investigation by the Complex Financial Instrument Unit of the SEC’s Division of Enforcement, the Commission alleged that there was effectively NO Risk Management at CHFF. According to the SEC, during the period from December 2016 through 2017 CHFF’s Assistant Portfolio Manager repeatedly warned Walczak of the cascading losses in its positions, but the SEC claimed he either refused to take corrective steps or simply ignored her. During the SEC investigation Walczak admitted that he did not regularly review all the daily portfolio risk reports, and most distressing of all, he conceded:
I don’t know… that there is a way to place a hard limit on losses in a hedge fund strategy.
Walczak was sued by the SEC on 27 January 2020 in the Federal Court for the Western District of Wisconsin for securities fraud and for breaching his fiduciary obligations as an investment adviser to CHFF. The SEC sought a permanent injunction against Walczak barring him from engaging in similar violations in the future. It also sought a civil penalty as the Court might determine. Further, the Commission requested the Court to order that Walczak disgorge his ill-gotten gains with prejudgment interest. In a parallel administrative proceeding brought by the U. S. Commodity Futures Trading Commission (“CFTC”) that same day Walczak faced claims brought by the CFTC for abuses of Federal commodities regulations. Although both the Commission and the CFTC have had some success in the parallel enforcement actions, the proceedings against Walczak remain pending.
On 27 January 2020, CCA and its CEO, Jerry Szilagyi, were ordered by the SEC in an administrative enforcement action to cease and desist breaching their respective fiduciary duties to CHFF and its investors; and in the case of Szilagyi, to cease to fail to supervise subordinates engaged in managing CHFF, especially Walczak. The SEC’s Press Release of 27 January 2020 concerning the SEC lawsuit and administrative proceeding notes that CCA and Szilagyi were censured, and CCA was ordered to disgorge $8,176,722 in ill-gotten fees plus pre-judgment interest of $731,722. In addition, CCA was ordered to pay a civil penalty of $1.3 million, while Szilagyi was ordered to pay a civil penalty of $300,000. The Commission did report in its 27 January 2020 Order on the degree of cooperation received from CCA and Szilagyi, including CCA voluntarily retaining a consultant to review and report on the training of CCA personnel, and the operating and control procedures followed by the firm. That same 2020 Order also directed the establishment of a Fair Fund to reimburse the injured investors, including requiring CCA to compute how much was to be distributed to each investor and to submit those computations to the Commission for approval.
In addition to the SEC investigation of CCA and CHFF, the $700 million lost by February 2017 by investors in CHFF triggered two private lawsuits: a class action in the Federal Court for Eastern District of New York (filed in April 2017) and a derivative action in an Ohio State Court (filed in August 2017). Both CCA and CHFF retained counsel to represent them in dealing with the SEC and to represent them in shareholder litigations. CCA and CHFF selected the same counsel to represent each of them in all those matters. Appropriately, according to the SEC’s 29 April 2024 Order Instituting Administrative and Cease-And-Desist Proceeding Against CCA (the “2024 Order”):
The engagement letter between …[CHFF] and Counsel acknowledged that conflicts might develop between CCA and …[CHFF] but did not address how legal fees and other expenses would be allocated between CCA and …[CHFF], including in circumstances when legal services were being rendered simultaneously to both entities. The invoices did not delineate the fees and expenses of each of CCA and…[CHFF], respectively.
As the 2024 Order noted:
“[b]eginning in February 2017 and continuing through October 2020 CCA and …[CHFF] incurred $2.7 million in legal costs associated with the … [SEC investigation] and [the] two private lawsuits, which involved overlapping facts and legal issues. The 2024 Order notes that “in order to maximize the amount of legal fees covered by …[CHFF’s] insurer, CCA arranged to have all the legal bills associated with the… [SEC investigation] and … [the private lawsuits] paid by…[CHFF] and subsequently submitted to …[CHFF’s] insurer.”
CCA paid CHFF’s portion of a private settlement and continued to have bills for additional legal costs paid by CHFF before the SEC began to investigate the billing arrangement. It is more than noteworthy that CCA and CHFF entered this bill-paying arrangement “without the knowledge or approval of the independent trustees of …[CHFF’s] Board of Trustees and without making an application to the Commission regarding a joint arrangement”, something expressly required by SEC Rule 17d-1 under the Investment Company Act.
