Hedge Fund Fraud Case Study — CSA

Written by Darren Leung and Shinya Deguchi, May 2, 2014

Abstract:

Charles Schmitt was well-respected FOHF operator in Hong Kong, having raised $200 million for his CSA Absolute Return Fund from 2001 to 2004. Everyone who had money with Charles was having a great time as his fund continuously outperformed the peers with very little volatility. However, it was revealed as another too-good-to-be-true story when Charles’ colleague noticed some irregularities in a monthly statement over one summer weekend.

Case Profile:

Background:

June 15, 2004 — it was already summer in Hong Kong. Jennifer McLennan (“Jennifer”), still couldn’t believe what she found in the weekend. She was in the office of her boss, Charles Lee Schmitt (“Charles”), and ran across some misfiled documents. She was COO of Charles Schmitt &Associates Limited (“CSA”), a fund of hedge fund operator with $300 million with three different funds. Jennifer was an experienced hedge fund investor with a number of experiences in operations and had seen a number of month-end statements from the fund administrators. At first, they were small, unobtrusive inconsistencies in the documents, but that small strangeness she found led to reveal a large web of lies Charles weaved over the last 3 years. If it weren’t her, nobody would have noticed. Jennifer reported her findings to the Securities and Futures Commission (“SFC”), Hong Kong’s financial regulator, and the government sent a team from Commercial Investigation Bureau to CSA. Charles was arrested and kept under custody. The SFC gave Jennifer 2–3 hours to contact the firm’s 1,600 clients before publishing a press release. She was up all night answering questions from shocked investors in Europe and the United States.

Charles was born and raised in St. Louis. He graduated from New York University with MBA in Finance and from Georgetown University with Master in International Economics. Then, he got a job at the New York Stock Exchange, where he helped manage the NYSE’s pension fund and portfolios for large financial institutions, such as Citibank and John Hancock Life Insurance. In 1990, soon after he married Bronwyn Alexander, Charles moved to Hong Kong with his wife and established a full-service global investment advisory business SEARC Limited, which later became CSA, in 1992. He started investing in absolute return strategies since 1997 and the business grew rapidly as his investment strategy generated strong returns. By Feb 2003, his portfolios averaged 16.5% per year with only 5 down months (out of 73) when the average hedge fund strategy achieved 9.3% per year with 27 down months, according to HFR.

CSA’s flagship fund of hedge funds, CSA Absolute Return Fund Limited (the “Flagship Fund”) was launched in October 2001. In January 2003, CSA Absolute Return Plus Fund was launched with VAN Hedge Fund Advisors International, Inc. with a goal to generate an average of 25%+ return through investing in 20 different funds. The firm also launched CSA Absolute Return Fund (Dublin), a mirror fund of the successful Flagship Fund, in 2004. CSA’s business was undoubtedly successful and money piled in.

Track Record of The Flagship Fund

Source: PWC

The assets under management for the Flagship Fund reached almost $200 million while the other two vehicles managed about $100 million. Most of investors were high net worth individuals with two options: Class A and Class B. Everyone who had money with Charles was having a great time as his fund continuously outperformed the peers with very little volatility.

Class A and Class B Fee Structure

Source: PWC

Problems:

Subsequent to Jennifer’s report, the SFC officially launched an investigation on CSA and the Flagship Fund. They found that the Flagship Fund did not invest in 10 hedge funds it claimed to invest in; instead, it invested in 10 “shadow funds” with very similar names.

List of Shadow Funds

Source: Secretary For Justice v. Schmitt Charles Lee, 2008

In contrast to his fabulous track record, the Flagship Fund experienced mounting losses and Charles tried to cover them up by setting up shadow funds, which invested in ‘increasingly aggressive investment strategies.’ Charles was able to avoid the fund’s auditor (Ernst & Young) and administrator (Bank of Bermuda) questioning him because he was able to create fake statements using the actual performance of the funds he was purportedly invested in from two other funds managed by CSA. Charles also created four offshore companies, which acted as “fund administrators”. Those fake administrators helped Charles to send fake statements to Bank of Bermuda.

List of Fake Administrators

Source: Secretary For Justice v. Schmitt Charles Lee, 2008

CSA — Relationship Map

By 2006, PriceWaterhouseCoopers, a court-appointed liquidator, received $164.7 million and distributed about $150 million after fees. The liquidator sued both Ernst & Young and HSBC (which acquired Bank of Bermuda) based on breaches of the terms of their engagement and the duty of care owed to the fund. In June 2009, both parties settled with the liquidator without disclosing the detail of this settlement. After the settlement, the liquidator received a total sum of $16 million, most likely from the auditor and the administrator. The total losses from CSA’s Ponzi scheme was approximately $44 million, or 22.6% of the AUM at the point of Charles’ arrest, including approximately $20 million loans made to companies associated with Charles and purchasing a $3.3 million property in Hawaii.

Initially, Charles was charged for theft in 2004, however, the charge was modified to a false accounting in 2005. Charles was sentenced to 4.5 years’ imprisonment, but later lengthened to 6 years and 8 months as the court of appeal decided that the sentence imposed previously was manifestly inadequate.

Recommendation:

From the investor’s point of view, CSA was a difficult case to conduct due diligence and to identify a potential misconduct when both the auditor and administrator couldn’t notice it. Conducting due diligence check with the auditor and administrator should not have revealed any material issue, unfortunately. Those fake administrators were only visible to Ernst & Young and Bank of Bermuda. Without prior knowledge, it would be impossible for an investor to address this issue. However, there were a few actions a prospective and existing investor could have done.

Compare performance to other funds managed by the same investment manager.

• Since CSA Absolute Return (Dublin) Fund, which was managed by Jennifer, was established as a mirror fund to the Flagship Fund, it is reasonable to assume that performances of those two funds should be similar. In reality, their performance was quite different and this fact should have raised a concern. (note that for some reason the track record of CSA Absolute Return (Dublin) Fund goes back in 2001 although some media reports indicate the fund was launched in 2004)

Flagship vs. Not Flagship

Source: Bloomberg

Analyze the financial statements and check the names of underlying hedge funds.

• Since the Flagship Fund invested only 10 funds, most of investments represented more than 5% of the fund’s net asset value. If the Flagship Fund’s financial statements were prepared accordingly to the US Generally Accepted Auditing Standard (Regulation S-X, Rule 5–02–17), those investments must be disclosed separately. If this disclosure was available, an investor could see the names of hedge funds different from actual names. However, for a typical investor of a fund of hedge funds, who are not familiar with a legal name of those underlying funds, this analysis could have been extremely challenging and impractical.

Event Timeline:

1992: Charles Schmitt established CSA Management Ltd.

Oct 2001: CSA Absolute Return Fund (CSAARF) Limited was established. Consisted of three funds: CSAARF, CSAARF (Dublin) and CSA Absolute Return Plus

Jan 2003: CSA established CSA Absolute Return Plus Fund

Jan 2014: CSA established CSA Absolute Return Fund (Dublin)

Jun 15, 2004: Jennifer McLennan, former COO found discrepancies in the records of CSAARF and reported SFC, which subsequently launched investigation. Hong Kong’s Commercial Crimes Bureau arrested Charles Schmitt. After the arrest of Charles Schmitt, Jennifer sent an email to CSA’s investors to explain the situation. Later that day, SFC issued restriction notice on the company.

21 June 2004: PWC was appointed as liquidator to CSAARF.

January 2005: The High Court of Hong Kong wounded up the CSAARF Limited.

September 2005: Charles Schmitt court case commenced. Charles Schmitt was charged for theft.

2006: Liquidators recovered US$164.7 million, minus US$14 million of fees, reporting a loss of US$43.9 million. Losses consisted of loans made to companies associated with Charles Schmitt and expenses incurred by those companies, including the purchase of property in Hawaii that costs US$3.1 million.

September 2006: Charles Schmitt was charged to counts of false accounting and pleaded guilty. He received a sentence of 4.5 years’ imprisonment and had a 10-year disqualification as a director of any company. He was also banned for life by the SFC to obtain any investment license in Hong Kong.

June 2008: The Secretary For Justice and Charles Schmitt went to the court of appeal and Charles sentences were increased from 4.5 years to 6 years and 8 months’ imprisonment.

January 2010: Charles was released early because of good conduct.

Source:

Court Documents

Secretary For Justice v. Schmitt Charles Lee, Jun 17, 2008, High Court of The Hong Kong Special Administrative Region Court of Appeal, http://legalref.judiciary.gov.hk/lrs/common/ju/ju_frame.jsp?DIS=61484&currpage=T

Randolph Shane Menton v. CSA Absolute Return Fund Limited, November 15, 2004, High Court of The Hong Kong Special Administrative Region, Court of First Instance, http://legalref.judiciary.gov.hk/lrs/common/ju/ju_frame.jsp?DIS=44686&currpage=T

From Liquidator

PwC HK — CSA Absolute Fund Limited (In Liquidation), http://pwchk.com/home/eng/csa_news.html

Other Documents

“CSA fraudster’s dummy company scheme unveiled,”

“Charles Schmitt Fund Put In Liquidation By Hong Kong Court”, June 25, 2004, Financial Express, http://www.financialexpress.com/news/charles-schmitt-fund-put-in-liquidation-by-hong-kong-court/108531

Interview with Charles Schmitt,

“Ex-NYSE Manager Jailed for Hong Kong Hedge-Fund Fraud”, October 25, 2006, Bloomberg, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=awixEgYhQoS0

“CSA of Hong Kong and Van Hedge fund Announce Alliance”, March 17, 2003, Business Wire, http://www.businesswire.com/news/home/20030317005192/en/CSA-Hong-Kong-Van-Announce-Alliance#.U2Jlhl76nvg

“HSBC, Ernst & Young Face Compensation Calls After Fund Fails”, July 24, 2006, Bloomberg