LJM Fund Managers Face CFTC, SEC Charges; Chief Risk Officer Settles

The Commodity Futures Trading Commission and Securities and Exchange Commission have filed civil charges relating to losses incurred by the Chicago-based LJM fund complex amid the “volmageddon” volatility spike in February 2018.

The funds' risk-taking and communications to investors about those risks are central issues in the case. Chief risk officer Arjuna Ariathurai agreed to a settlement with the two agencies on financial penalties, a cease-and-desist order, and a ban from the industry with the possibility of re-entry after three years.

However, LJM founder and chairman Anthony Caine and chief portfolio manager Anish Parvataneni are contesting lawsuits that the CFTC and SEC filed at the end of May in U.S. District Court for the Northern District of Illinois.

With jurisdiction over LJM Funds Management Ltd. and LJM Partners Ltd. as commodity pool operators (CPOs), and LJM Partners also as a commodity trading adviser (CTA), the CFTC accuses the funds, Caine and Parvataneni of “defrauding or deceiving prospective and existing pool participants through false and misleading statements or omissions concerning worst-case scenarios for LJM's short options trading strategy and LJM's risk management tools” between 2016 and 2018.

Alleging violations by registered entities of antifraud provisions in federal securities laws, the SEC cites “material misrepresentations and breaches of fiduciary duty relating to the risks of an options trading strategy [the defendants] employed as investment advisers to a mutual fund, the LJM Preservation & Growth Fund [P&G], and/or several private investment funds, which collectively suffered over a billion dollars of losses in February 2018.” The defendants allegedly “lied to investors about the 'worst case' daily losses to expect from this strategy [and] falsely promised to maintain 'a consistent risk profile.'”

Two-Day Crash

Caine issued a statement vowing to “vigorously defend ourselves” and “demonstrate that the risk of loss was fully disclosed, LJM did not deviate from historical portfolio and risk management practices, and the losses sustained on February 5-6, 2018 occurred as a result of events outside of LJM's control.”

The regulators said that the $1 billion-plus in trading losses eroded more than 80% of the value of the funds LJM managed and resulted in the closure of the advisers' business.

Litigation could thus bring extensive and protracted scrutiny of management practices and principals' accountability, while the sanctions against the CRO underscore how regulators regard the responsibilities of that role.

“This case demonstrates the critical importance of fund advisers being truthful and transparent with investors about how they manage risk," said Daniel Michael, chief of the SEC Enforcement Division's Complex Financial Instruments Unit. “As alleged in the complaint, the defendants' alleged actions exposed investors to far greater risk of loss than they expected.'

“It is imperative that all participants in our markets receive full disclosure of material information and protection from fraudulent practices,” said CFTC acting director of enforcement Vincent McGonagle. “When companies or individuals make false or misleading statements about the risks of trading, or fail to diligently supervise their employees or agents' activities relating to their business as CFTC registrants, the CFTC will seek to hold them accountable.”

CRO Order

Ex-CRO Ariathurai neither admitted nor denied the agencies' findings, including that he knew of and participated in “false and misleading” representations to commodity pool participants. His costs in the two parallel orders - $150,000 civil money penalty, and disgorgement and prejudgment interest of $97,444 - may send a pointed message but are well under the $1.25 million charged in January 2020 by the Office of the Comptroller of the Currency to Michael Loughlin, formerly of Wells Fargo & Co., in one of the stiffest penalties levied for conduct while serving as CRO.

Among the “facts” as laid out in the CFTC's order:

- In early February 2018, the Cboe Volatility Index (VIX) spiked significantly, and LJM lost most of its investment value over the course of two days.

- LJM represented to prospective and existing pool participants that it ran reports using historical scenarios as part of its risk management - referencing Lehman Brothers' failure in 2008, the 2010 market flash crash and the 2011 S&P downgrade of U.S. debt - that CRO Ariathurai knew were false and misleading.

“On occasion,” the document says, “Ariathurai spoke directly to agents of prospective or existing pool participants about LJM's risk management of the portfolio. Ariathurai knew LJM was making false representations about historical scenarios in risk management in LJM's marketing materials to pool participants but failed to correct such misleading representations.”

- Ariathurai drafted an answer to “What is the estimated maximum risk on a total portfolio?” on a 2016 due diligence questionnaire, citing the historical scenarios and incorrectly saying, “General worst case losses can run in the order of 20% for P&G and 30-35% for more aggressive flavors of the strategy.”

“As a result,” the order concluded, “respondent Ariathurai employed a device, scheme, or artifice to defraud prospective and existing pool participants and engaged in a transaction, practice, or course of business that operated as a fraud or deceit upon prospective and existing pool participants.”

He is required by the CFTC to cooperate in related investigations and litigation over a five-year period. The SEC, barring the former CRO from investment industry involvement, said he has “the right to apply for re-entry after three years to the appropriate self-regulatory organization, or if there is none, to the commission.”

Lawsuits and Reaction

In the lawsuits naming Anthony Caine and Anish Parvataneni, which could be destined for jury trial, the CFTC and SEC are seeking permanent injunctions, disgorgement of ill-gotten gains, and civil penalties.

“This enforcement action addresses defendants' material misrepresentations and breaches of fiduciary duty relating to the risks of an options trading strategy” that they employed as fund advisers, the SEC complaint begins. They allegedly “lied to investors” about “worst case daily losses . . . as well as falsely promised to maintain 'a consistent risk profile.' As a result, defendants were able to grow their assets under management, which resulted in them receiving millions of dollars of compensation.”

The risks of their “short volatility strategy,” using margin to sell out-of-the-money options on S&P 500 futures contracts, were “remote but extreme,” the complaint says. In response to concerns brought to their attention by investors, the LJM managers “crafted an effective, yet false, marketing narrative which touted their purported 'risk centric' approach to investing and avowed their 'managing principle' was to maintain a consistent risk profile and consistent risk levels, even if it meant lower returns.

“More specifically,” the SEC continues, “defendants claimed that: (a) they stress tested the portfolios against specific historical scenarios to estimate worst-case daily losses; (b) based on those stress tests, the estimated worst-case daily loss was 20% for the P&G Fund and 30 to 35% for the private funds; and (c) they managed these funds to maintain consistent risk levels. All of these statements were false.”

Categorically denying the charges, LJM owner and chairman Caine stated, “The suggestion that LJM committed fraud has no factual basis and is undermined by the fact that I personally lost over $100 million on February 5-6, 2018, and LJM portfolio managers invested more than $500,000 new capital on February 1, 2018, in the same funds as LJM investors.”

He pointed to an analysis by Integritas Financial Consulting concluding that the single-day increase in the VIX of 20.01 points, or 115%, “was a 13.7 standard deviation event.”

Historical Record

Caine hit back at the CFTC and SEC, saying that in their three-year investigation, “neither regulator ever asked the most important question: What caused the losses? LJM presented extensive and compelling data indicating that VIX manipulation was the primary cause of the losses, further exacerbated by FCM [futures commission merchant] system failures and improper FCM forced position liquidation. LJM is pursuing financial recovery for its investors in lawsuits pending in federal court in Chicago and New York.”

Caine said LJM over 20 years “compiled an impressive track record of annualized returns ranging from 9% to 18% for its three core funds,” and “successfully managed multiple periods of extraordinary market volatility, including the 2008 financial crisis.

“It is highly ironic,” he added, “that the SEC and CFTC are now filing claims against LJM, which was harmed by their failure to oversee markets and prevent manipulation in VIX and SPX [S&P 500] options markets.”

In December 2019, in one of a number of class actions against LJM, law firm Deutsch & Lipner announced that investors in the P&G Fund would receive pennies on the dollar in a settlement. It quoted an earlier arbitration judgment that “lack of correlation between LJM's performance and that of the stock market did not mean that the investment was less risky than equities or bonds . . . LJM was subject to a 'tail risk'; an outlier risk of a catastrophic event, exhibited by LJM Fund's negative skew."

Two months later, Criden & Love, a Florida law firm that says it has settled several LJM class actions, announced a proposed agreement for Caine to “provide an assignment of 20% of any monies he recovers” from LJM Partners litigation alleging manipulation of the VIX.

In March this year, three organizations settled Financial Industry Regulatory Authority (FINRA) charges for supervisory failures in their sales of the P&G Fund, according to Cadwalader, Wickersham & Taft's Cadwalader Cabinet. The most severe fine, $400,000 (plus $3.1 million in restitution), was imposed on Cambridge Investment Research for permitting “the sale of LJM on its platform without conducting reasonable due diligence and without a sufficient understanding of its risks and features, including the fact that the fund pursued a risky strategy that relied, in part, on purchasing uncovered options,” FINRA said.