/>iAs all who practice securities law (or have ever seen an advertisement for Fisher Advisors) are acutely aware, investment advisers are different from brokers/dealers. Investment advisers are fiduciaries. While the precise distinction can be a bit complex, it is safe to specify 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? One possible consequence, if the adviser is registered with the U.S. Securities and Exchange Commission (“SEC”), is the imposition of sanctions both operationally and financially. Knowing that, just image how troubling it would be to discover that the adviser, while seeking to ameliorate the negative consequences of its breach of fiduciary duties, engaged in an arrangement that only made matters worse! Because that is exactly the case now before us.
Catalyst Capitol 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 March 29, 2023, CCA reported some $7.1 billion in assets under its management. Until February 2020, CCA was headquartered in Huntington, Long Island, NY. Its principal place of business is now San Juan, Puerto Rico. CCA is investment adviser to 18 of the 86 series of the Mutual Fund Series Trust, one of which is the Catalyst Hedged Futures Fund (“CHFF”). The Trust and all its series, including CHFF, are SEC-registered open-ended investment companies, i.e., mutual funds. CHFF had an insurance policy providing coverage (subject to a deductible and a ceiling) for liability arising from claims against CHFF for violations of the securities laws and related fiduciary obligations. CCA had no 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 started Harbor Assets in 2005 and sold shares 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 would receive 60% of the net fees received by the resulting CCA-operated entity, CHFF, until CHFF reached $20 million in size, when Walczak’s share would drop to 50%. By the end of 2016, CHFF had grown to almost $4 billion; Walczak received 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 adviser to CHFF with Walczak as the Senior Portfolio Manager, CHFF registered with the SEC as a mutual fund and sold shares in CHFF. Disclosure materials approved by Walczak emphasized “Risk Management – Hedges are built into every position when it is initiated and stop loss trigger points are used to limit draw downs.” Those materials also stated that CHFF had “metrics [that] 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 the following protective steps taken by CHFF to limit risk:
- 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 20% of its value, some $700 million, due to its option trading strategy. In the ensuing investigation by the Complex Financial Instrument Unit of the SEC’s Division of Enforcement, the Commission discovered there was effectively NO Risk Management at CHFF. From December 2016 through 2017, CHFF’s Assistant Portfolio Manager repeatedly warned Walczak of the cascading losses in its positions, but he either refused to take corrective steps or simply ignored her. During the investigation, Walczak admitted that he did not regularly review 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.
The SEC sued Walczak on Jan. 27, 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. He was permanently enjoined from engaging in similar violations in the future, and subjected to a civil penalty, and ordered to disgorge his ill-gotten gains with prejudgment interest. That same day, in a parallel administrative proceeding brought by the U. S. Commodity Futures Trading Commission (“CFTC”), Walczak settled claims for abuses of federal commodities regulations. On Jan. 27, 2020, CCA and its CEO, Jerry Szilagyi, were ordered, in an SEC administrative enforcement action, to cease and desist breaching their respective fiduciary duties to CHFF and its investors. Szilagyi, specifically, was ordered to cease failing to supervise subordinates engaged in managing CHFF, especially Walczak. The SEC’s Jan. 27, 2020, Press Release concerning the SEC’s actions noted 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. Civil penalties were also imposed: $1.3 million for CCA, and $300,000 for Szilagyi. The Commission did report, in its Jan. 27, 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 Order directed that a Fair Fund be established to reimburse the injured investors and required CCA to compute the amount to be distributed to each investor and submit those computations to the Commission for approval.
In addition to the SEC investigation, two private lawsuits were triggered by the $700 million lost by CHFF investors by February 2017: 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 the shareholder litigations. In fact, they selected the same counsel to represent them both in all of those matters. Appropriately, according to the SEC’s April 29, 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.
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. Further, it noted 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 striking that CCA and CHFF entered into 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.
In March 2021 the Commission’s staff began an inquiry into CHFF’s payment of legal fees. CHFF, according to the 2024 Order, in consultation with the counsel representing both entities, and with separate legal counsel for the independent trustees of CHFF, agreed to an allocation of fees: $1,277,388 to CCA and the rest, $1,403,681, to CHFF. CCA paid additional amounts to CHFF to meet the agreed allocations. In connection with continuing work on these matters and input from CHFF’s insurer, CCA, in December 2023, reimbursed CHFF an additional $183,757 for amounts billed to CHFF.
In its 2024 Order, the Commission asserted that CCA had illegally benefited from the billing arrangement by deferring legal costs for multiple years and by ultimately agreeing to an allocation that was more favorable to CCA than the amount finally determined by CHFF’s insurance carrier. Consequently, the SEC determined that CCA had: i) violated Section 17(d) of the Investment Company Act of 1940, as amended, and Rule17d-1 thereunder for having a joint arrangement with a registered investment company (like CHFF) without special SEC approval; and ii) violated Section 206(2) of the Investment Advisers Act of 1040, as amended, for engaging in a course of business which operated as a fraud on a client. In a phrase, CCA was once again found to have breached its fiduciary obligations as an investment adviser. As a result, the Commission ordered: a) that CCA cease and desist from further violations of those provisions; b) that CCA be censured; c) that CCA disgorge $280,902 representing unreimbursed legal expenses, offset by the December 2023 payment of $183,757 to CHFF, with net disgorgement of $97,145 plus prejudgment interest of $30,081; and d) that CCA pay a civil penalty of $200,000.
The CCA story reflects error on error, with little or no regard for the primary obligations to the managed fund (CHFF) or the people who invested in it. In a 1913 Harper’s Weekly article, Justice Brandeis made his famous statement that “Sunlight is said to be the best of disinfectants.” Hopefully CCA and Szilagyi will prosper in the sunlight of Puerto Rico, having learned the importance of accepting one’s errors; and not compounding them by some additional self-protective act or concealment.
