In browsing through enforcement actions I look for lessons learned. In some cases it’s compliance doing its job and stopping a fraud before it gets too big. The case against Owen Li caught my eye. His trades were not working so he made a last ditch effort to make it all back. Given that this about an enforcement action, you can guess how that trade worked out.
Mr. Li was an alumnus of Galleon Capital. After that firm imploded, he went to work for another firm and then left in 2012 to start his own firm: Canarise Capital. He managed to raise $50 million of capital.
As part of the fundraising, the documents stated that risks would be managed through limits on position sizing and market exposure. Generally, no position would exceed 10% of the fund’s assets.
The first trouble came in February of 2014 when Mr. Li must have fallen in love with Facebook and Groupon. Those each accounted for 20% of the fund’s capital. He was operating outside of his investment mandate.
Then Mr. Li started playing games with orders at his prime broker to keep his margin balance high. When the prime broker got wind of the bad behavior it cancelled the margin allowance and placed trading restrictions.
The Custody Rule worked to an extent in this case. The NAV that the fund sent out differed materially from the NAV sent by the fund administrator directly to investors. He blamed the error on the fund administrator. That seemed to work twice.
Mr Li must have sensed that it would not work a third time. He put off approving the NAV distribution for November 2014. The NAV he told investors and the NAV that would be sent out by administrator would differ materially. He delayed and then decided to go all in.
He liquidated fund cash and other positions to buy long positions in market index options with short-dated expirations. He had eliminated all short positions in the account. He basically took all of the fund’s assets and pushed them all in to one position. Hardly a sound way to manage to risk. Certainly, it was outside the investment promises he made to his investors.
If it worked well, there was a huge upside. I assume thought his investors would forgive his past sins.
But rarely do enforcement actions come from a happy result. Mr. Li had bet wrong. When the options expired he incurred $39 million in losses, leaving the fund with less than $200 thousand in assets. Over the course of the year he had caused the fund to lose $56.5 million.
In years past, a manager might have been able to keep the lie going. Look at Madoff. I suspect something similar, although less catastrophic happened to Madoff. With no third-party reporting on the investments, he could keep going.
Without the Custody Rule, maybe Mr. Li could have put up a big Madoff lie and tried to go all in again in the future. But since investors were getting statements directly there was no place for him to hide. The Custody Rule worked.
Sort of worked. It prevented a Ponzi scheme from forming. It did not prevent the investors from being wiped out.
As for the enforcement, the SEC charged Mr. Li with failing to adhere to his investment limitations and labeled that a fraudulent action under Section 206.
Sources:
Poker Face by Lawrence
CC BY NC SA