Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News January 4, 2016 Issue

SEC Accuses Hedge Fund Adviser of False Statements that Led to Fund’s Collapse

Honesty is the best policy, and telling the truth to investors is certainly at the heart of much of what the SEC is about. When the agency believes that an adviser fails that standard, expect it to come down hard – as one hedge fund adviser found out.

Owen Li and his hedge fund advisory firm, New York City-based Canarsie Capital, on December 16 settled with the SEC after being charged with making a series of false statements to investors that led to a fund losing $56.5 million – nearly all of its assets – in a little more than two weeks. As part of a settlement, the agency barred Li from the securities industry and required him and Canarsie to pay more than $3.4 million in disgorgement and interest.

Monetary sanctions are expected to be imposed as part of a parallel criminal proceeding against Li filed by the U.S. Attorney’s Office for the Southern District of New York.

"When investment advisers agree to manage client assets, they assume the duty of utmost good faith," said the Division of Enforcement’s Asset Management Unit co-chief Julie Riewe. "Li disregarded his fiduciary duty and secretly subjected investors and the fund to massive risk and an eventual collapse."

"The SEC’s order reads like a catalogue of misconduct that all investment advisers should avoid, including misrepresenting to investors skin in the game, fund performance, and the reasons for delay in distribution of fund administrator performance reports," said Mayer Brown partner Matthew Rossi.

"Perhaps more interesting," he said, "is the SEC’s finding that Li and Canarsie violated the investment mandate and risk management guidelines in fund offering memoranda, even though the mandate and guidelines apparently gave Canarsie broad discretion to trade a wide variety of financial instruments and the risk guidelines identified only ‘general’ position limits. Thus, advisers should be careful to adhere to investment mandates and risk guidelines provided to investors, even when those mandates and guidelines, as is frequently the case, grant the adviser broad discretion. In the SEC’s view, broad discretion is not unlimited discretion."

Percentages, fees and losses

The SEC noted that Li, who owns 70 percent of Canarsie, worked immediately after graduating from college in 2008 as a trading assistant at Galleon Management, the firm founded by Raj Rajaratrum, currently serving an 11-year sentence for insider trading. Following Galleon’s 2009 demise, Li worked as a trader for a registered investment adviser founded by a former Galleon colleague, the SEC said, then left that job in 2012 to form Canarsie.

Canarsie served as the investment adviser for the Canarsie Capital Fund Master and its two subsidiary funds – an onshore fund and an offshore fund. Li acted as the portfolio manager for the master fund, which paid Canarsie an annual management fee of 2 percent of its net assets, and a performance fee of 20 percent of the fund’s net income, subject to a high-water mark, according to the administrative order instituting the settlement.

According to the SEC, the master fund ended 2013 with a year-to-date performance return of 69 percent, and approximately $47.5 million in assets under management. Canarsie earned more than $1 million in management fees in 2013 and 2014. Of the earned performance fees for 2013, Li received approximately $2.2 million. During 2014, his salary was $120,000, the agency said.

"The master fund ended 2014 with approximately $58 million in AUM," the SEC said. "When the master fund collapsed in January 2015, it had a total of 41 investors who, collectively and since the fund’s inception, had invested approximately $52.1 million into the master fund."

What investors were told … or not told

The SEC’s administrative order contains multiple allegations that Li misled investors or prospective investors. Among them:

  • Misrepresentations and omissions. Li, "in or around late 2012," according to the agency, misled prospective investors about his own investment in the onshore fund. "Specifically, Li falsely told at least three prospective investors – all of whom later invested – that Li was investing his own money in the onshore fund," the SEC said, when, in fact, according to the administrative order, he did not invest any of his money into the Canarsie funds until January 2014, when he invested more than $527,000 of the performance fees he earned in 2013. At the time he allegedly misled the prospective investors, Li "had virtually no personal assets, having lost nearly all of his earnings from his prior employer through his personal trading during 2012," losses the agency said he did not inform these prospective investors about.
  • Investments and offering memorandums. The SEC noted that Li took significant equity positions in Facebook, Groupon and IWM. By February 2014, the master fund’s equity position in these three issuers represented, respectively, 20 percent, 23 percent and 19 percent of the master fund’s total equity position, according to the administrative  order, which noted that Li increased the master fund’s equity positions in Facebook and Groupon to 27 percent and 28 percent, respectively, in March of 2014. "These concentrated positions were inconsistent with the risk management guidelines in the Offering Memos and increased the risk of loss for the Master Fund and its investors," the SEC said. The offering memoranda, the agency said, stated that "no position, whether long or short, was to exceed 10 percent of the fund’s assets."
  • Concealed trades. On a number of occasions from approximately April 2013 through January 2015, "Li manually deleted certain trades from Canarsie’s [internal order management system] to conceal such trades from others at Canarsie," according to the SEC. When an operations assistant discovered a discrepancy between the onshore fund’s positions as shown in the firm’s prime brokerage account and as shown in the internal order management system, he demanded that Li begin copying him on all daily emails from brokers recapping trades. Li terminated the employee the following week, the agency said.
  • Fictitious trades. "In March and April 2014, Li began reporting fictitious ‘sell’ trades to Canarsie’s prime broker at that time, as if Canarsie had executed these trades when, in fact, as Li knew, Canarsie had not," the SEC said. This pattern of reporting sell trades to the prime broker and then subsequently cancelling the trades before they settled "created the false appearance on the trade date that Canarsie’s long positions in certain stocks (and thus the margin in the account) were decreasing," the agency said. "This concealed risk in the portfolio, avoided a margin call from [the prime broker], and permitted the Master Fund to avail itself of more margin from [the prime broker] than it otherwise would have extended to the Master Fund."
  • The consultant. The prime broker, in April 2014, sent a letter to Canarsie, stating that it was imperative that misreported trade activity not happen again, the SEC said. In addition, according to the agency, the broker required the advisory firm to hire an experienced independent control person "who can verify the activity in the trader’s book compared to the activity reported by the brokers with whom you have executed trades and that the advisory firm "retain a consultant to review your processes and control." Canarsie hired a consultant, which then issued best practice recommendations, but, the SEC said, failed to implement any of them.

There are a number of lessons that investment advisers should take away from this case, said Faegre Baker Daniels partner Jeffrey Blumberg. Among them:

  • Ensure that trading and reconciliation are bifurcated. These should be independent responsibilities, said Blumberg. You don’t want the person submitting the trades to be then matching them up with the brokerage reports.
  • Provide appropriate direct access to counterparties. People who have a legitimate business need to reach counterparties must have that access, he said. "In this case, if what the SEC alleged is true, an operations analyst with direct access to the broker would likely have uncovered the alleged fraudulent trading activity sooner."
  • Only compliance or supervisory personnel should have user rights to delete trades in a firm’s trading/portfolio system. If the system supports this type of security, that right of access should not be granted to traders or portfolio managers, Blumberg said. In this case, Li was the majority owner of the firm, and denying him those rights would have been difficult, but a firm interested in doing the right thing would nonetheless do so.

The catastrophic loss

Beginning on or around December 31, 2014 and continuing through January 15, 2015, Li used cash in the account and proceeds from stock sales to buy long positions in market index options, according to the administrative order. "Virtually all of these purchases were in long call options with an expiration date of January 17 – in other words, short-dated long options," the agency said. "At the same time, Li took down and eventually eliminated all short positions in the account. The result was an entirely long portfolio with no hedge."

What happened was this: On January 16, the market for index options moved against Canarsie’s positions, "resulting in losses of approximately $39 million …, leaving the master fund with no equity, short or options positions, and only $211,685 in cash (plus approximately $289,568 in its bank account)," the SEC said. "As a result of Li’s risky trading, Li caused the master fund to incur approximately $56.5 million in losses between December 31, 2014 and January 16, 2015, substantially depleting all of the master fund’s assets." Li,on January 16, according to the agency, sent a letter to investors that expressed his "extreme sorrow and deep regret for engaging in a series of transactions over the last several weeks …. In an attempt to recover losses that the fund suffered in December, I engaged in a series of aggressive transactions over the last three weeks that – generally speaking – involved options with strike positions pegged to the broader market increasing in value, but also involved some direct positions. Unfortunately, these positions rapidly declined in value over the past two week as the market struggled – and I was unable to mitigate the fund’s losses." The attorney representing Li and Canarsie did not respond to requests for comment.