A New York-based investment advisor and the firm he co-founded have agreed to pay $10.5 million to settle charges with the Securities and Exchange Commission for misleading investors about the management of risk in a mutual fund.

According to the SEC, Huntington, N.Y.-based Catalyst Capital Advisors (CCA) and Jerry Szilagyi, the firm’s president and CEO, told investors that the firm abided by a strict set of risk parameters for the Catalyst Hedged Futures Strategy Fund, but it breached those parameters and failed to take the required corrective action during a majority of the trading days between December 2016 and February 2017. As a result, the fund lost hundreds of millions of dollars, the SEC said.

In a separate action, the SEC filed a complaint in federal district court in Madison, Wis., against the senior portfolio manager, Edward Walczak, for fraudulently misrepresenting the fund’s risk management procedures. The SEC alleged that Walczak, of Madison, told investors that the fund employed a risk management strategy involving safeguards to prevent losses of more than 8%, when in fact no such safeguards limited losses and Walczak did not otherwise consistently manage the fund to an 8% loss threshold.

The complaint said before becoming associated with CCA in 2013, Walczak had started and managed a predecessor private fund, trading options on S&P 500 futures contracts. Walczak managed the Catalyst fund using the same investment objectives, policies and guidelines as before, after the relaunching of the pooled investment sponsored by Catalyst.

The complaint said upon conversion to a public mutual fund, the fund held approximately $7 million in assets, but grew to hold more than $4 billion by November 2016.   

The complaint said a core selling point of the fund was its purported use of “strict risk management procedures” devised to limit the extent of any losses. Walczak and CCA highlighted this risk management strategy as a distinguishing feature of the fund in various disclosures to prospective and current investors and their advisors. It was promoted in fund prospectuses, wholesaler talking points, due diligence questionnaires, quarterly investor presentations and “open house” conference calls, the SEC said.

It was believed that Walczak, as the fund’s day-to-day manager, proactively monitored changes in the risk profile of the fund through the use of sophisticated options analysis software, then he adjusted investment positions as needed to comply with the fund’s risk metrics and, moreover, adhered to a stop-loss rule of 8%.

However, the complaint said Walczak and CCA misrepresented the fund’s risk management procedures and failed to manage the fund consistently with their disclosures. The SEC said the fund’s so-called “strict” risk parameters were largely discretionary, and that the fund’s risk was not mitigated by “stops” or “triggers” that would limit losses to 8%. And Walczak did not otherwise consistently manage the fund to an 8% loss threshold. 

The complaint said by December 2016 when the S&P was trending upward, Walczak had expected and positioned the fund to profit if the S&P dropped. But he had also exposed the fund to a greater than 8% loss if the market continued to rise. 

As the fund’s net asset value often decreased when the S&P increased, and it regularly breached its risk metrics, the assistant portfolio manager proposed that “booking losses” of $167 million could avoid additional losses of $500 million, according to the complaint. In other words, a potential loss well above the 8% threshold could be avoided by realizing a loss comfortably below it. But rather than heeding the advice or following the risk management procedures disclosed to investors, the complaint says, Walczak hoped a market downturn would allow him to avoid having to book such substantial losses.

The fund ultimately lost some 20% of its net asset value between December 2016 and February 2017, the majority of the trading days, including more than 15% in February alone. The fund’s total loss of more than $700 million was comparable to the $667 million loss forewarned by the fund’s assistant portfolio manager.

The SEC's order finds that CCA violated the antifraud provisions of the federal securities laws, and that Szilagyi was a cause of CCA's violations and failed reasonably to supervise Walczak.

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