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Archegos Capital Management founder Bill Hwang and its former chief financial officer, Patrick Halligan, were indicted on securities-fraud and racketeering charges Wednesday in what prosecutors said was a massive fraud and manipulation scheme that nearly jeopardized the U.S. financial system.

Archegos collapsed in March 2021, leaving banks with more than $10 billion in losses and sparking calls for more regulatory oversight. More than $100 billion in stock market value vanished in a matter of days.

Damian Williams, U.S. attorney for the Southern District of New York, described the purported scheme as historic in scope, alleging that defendants and their co-conspirators lied to banks to obtain billions of dollars in loans, which they then used to inflate the stock price of publicly traded companies.

“The lies fed the inflation, and the inflation fed more lies,” Mr. Williams said at a news conference. “Last year, the music stopped. The bubble burst. The prices dropped. And when they did, billions of dollars evaporated overnight.”

Messrs. Hwang and Halligan, who were arrested Wednesday morning, face charges including securities fraud, wire fraud and racketeering conspiracy. They pleaded not guilty in Manhattan federal court Wednesday afternoon. A federal judge released Mr. Hwang on a $100 million bond and Mr. Halligan on a $1 million bond.

Mr. Hwang’s lawyer Lawrence Lustberg said in a statement that his client is entirely innocent and that there is no evidence whatsoever that he committed any kind of crime.

“A prosecution of this type, for open-market transactions, is unprecedented and threatens all investors,” Mr. Lustberg said. A lawyer for Mr. Halligan, Mary Mulligan, said her client is innocent and will be exonerated.

Two other former Archegos employees, William Tomita, who was Archegos’s head trader, and Scott Becker, who was its chief risk officer, have pleaded guilty for their roles in the alleged scheme and are cooperating with the government, prosecutors said. Lawyers for both men didn’t respond to requests for comment.

At Archegos, Mr. Hwang built up big, concentrated positions in companies and held some investments in a mix of cash and swaps, derivative contracts struck with banks for a fee, with money borrowed from banks across Wall Street. Mr. Hwang favored total-return swaps that gave Archegos the profits and losses on the stocks underlying the swap contracts while its lenders held the securities.

Mr. Hwang’s use of swaps allowed him to manipulate the prices of stocks in his portfolio because the agreements prompted Wall Street firms to buy shares of the stocks too, the indictment alleges. As the size of Archegos’s swaps grew, so did the amount of shares bought by the Wall Street firms, pushing up prices in the process. Prosecutors also allege that Archegos traded at certain times of day and in other manipulative ways to prop up stocks in its portfolio, including to keep share prices from falling too much.

How total-return swaps work

A total return swap allows an investor, such as a hedge fund, to invest in assets without owning them. In the deal, the fund makes payments to an investment bank based on fees and an interest rate such as Libor.

Hedge fund

Hedge fund

Total-return swap

If the underlying assets falter, the hedge fund must pay the bank an amount based on the negative returns plus the regular fees it has agreed to pay.

The investment bank buys assets, such as a basket of stocks, and makes payments to the hedge fund based on the total return of the assets.

With heavily

leveraged positions, the bank may make

a margin call,

requiring a client to put up more collateral. If the client fails to comply, the bank may sell the assets, triggering more declines in price.

The bank owns the assets, not the hedge fund. So while a hedge fund may have heavy exposure to a stock through swaps with multiple banks, it isn’t subject to disclosure laws that a very large shareholder would be.

How total-return swaps work

A total return swap allows an investor, such as a hedge fund, to invest in assets without owning them. In the deal, the fund makes payments to an investment bank based on fees and an interest rate such as Libor.

Hedge fund

Hedge fund

Total-return swap

If the underlying assets falter, the hedge fund must pay the bank an amount based on the negative returns plus the regular fees it has agreed to pay.

The investment bank buys assets, such as a basket of stocks, and makes payments to the hedge fund based on the total return of the assets.

With heavily

leveraged positions, the bank may make

a margin call,

requiring a client to put up more collateral. If the client fails to comply, the bank may sell the assets, triggering more declines in price.

The bank owns the assets, not the hedge fund. So while a hedge fund may have heavy exposure to a stock through swaps with multiple banks, it isn’t subject to disclosure laws that a very large shareholder would be.

How total-return swaps work

A total return swap allows an investor, such as a hedge fund, to invest in assets without owning them. In the deal, the fund makes payments to an investment bank based on fees and an interest rate such as Libor.

Hedge fund

Hedge fund

Total-return swap

If the underlying assets falter, the hedge fund must pay the bank an amount based on the negative returns plus the regular fees it has agreed to pay.

The investment bank buys assets, such as a basket of stocks, and makes payments to the hedge fund based on the total return of the assets.

With heavily

leveraged positions, the bank may make

a margin call,

requiring a client to put up more collateral. If the client fails to comply, the bank may sell the assets, triggering more declines in price.

The bank owns the assets, not the hedge fund. So while a hedge fund may have heavy exposure to a stock through swaps with multiple banks, it isn’t subject to disclosure laws that a very large shareholder would be.

How total-return swaps work

A total return swap allows an investor, such as a hedge fund, to invest in assets without owning them. In the deal, the fund makes payments to an investment bank based on fees and an interest rate such as Libor.

Hedge fund

Total-return swap

The investment bank buys assets, such as a basket of stocks, and makes payments to the hedge fund based on the total return of the assets.

The bank owns the assets, not the hedge fund. So while a hedge fund may have heavy exposure to a stock through swaps with multiple banks, it isn’t subject to disclosure laws that a very large shareholder would be.

Hedge fund

If the underlying assets falter, the hedge fund must pay the bank an amount based on the negative returns plus the regular fees it has agreed to pay.

With heavily leveraged positions, the bank may make a margin call, requiring a client to put up more collateral. If the client fails to comply, the bank may sell the assets, triggering more declines in price.

Prosecutors alleged that Mr. Hwang avoided publicly disclosing his positions to regulators and market participants by using swaps rather than buying stocks outright as his positions in companies approached 5%, a level above which requires public disclosure.

Mr. Hwang’s alleged fraud pumped Archegos’s portfolio from $1.5 billion to $35 billion in one year, ending in March 2021, and inflated its market size from $10 billion to $160 billion during that period including its borrowings from Wall Street firms, according to prosecutors.

The indictment draws attention to hidden stock-market risks from large derivative transactions, such as swaps, which allowed Archegos to control secretly more than 50% of shares of certain companies last year, including ViacomCBS Inc., which is now known as Paramount Global. Archegos also repeatedly made up more than 35% of the daily trading volume in several companies, prosecutors said.

The charges also point to unseen risks posed by so-called family offices—private entities set up to manage the fortunes of wealthy families—whose positions aren’t monitored by regulators. In recent years, many large hedge funds have converted to such family offices.

The case marks the biggest financial-crime charges to come out of the Southern District of New York under the leadership of Mr. Williams, who has pledged to root out corruption in financial markets.

The Securities and Exchange Commission, in a separate civil-fraud complaint, sued Archegos, along with Messrs. Hwang, Halligan, Tomita and Becker. The Commodity Futures Trading Commission filed a civil complaint against Archegos and Mr. Halligan, and settled with Messrs. Tomita and Becker.

Criminal charges involving so called “open market” stock manipulations based on trades that are legitimate—rather than phony or fraudulent trades—are unusual and hark back to the days of the 1980s insider-trading scandal involving Ivan Boesky. when his business associate John Mulheren was charged with manipulating shares of Gulf & Western Industries Inc., according to lawyers. Those charges were reversed on appeal. Mr. Mulheren died in 2003.

“There haven’t been many of these cases,” said Harvey Pitt, a former SEC chairman who represented Mr. Boesky. “They aren’t easy to win.”

The indictment lays out in detail how Archegos dominated trading in certain stocks through its use of derivatives.

Archegos Capital Management founder Bill Hwang.

Photo: Bloomberg

Prosecutors allege that Messrs. Halligan, Tomita, Becker and others, with Mr. Hwang’s blessing, repeatedly lied about Archegos’s portfolio to the firm’s counterparties across Wall Street in an attempt to get them to trade with, extend credit to and hide the grave risk of doing business with Archegos. Archegos also intentionally worked with several lenders to break up its trades, the indictment alleges, which allowed the firm to conceal the scope of its activities.

U.S.-listed Chinese companies were among Archegos’s largest positions, and manipulated stocks included ViacomCBS, Discovery Inc., now known as Warner Bros. Discovery Inc., WBD -5.04% GSX Techedu Inc., now known as Gaotu Techedu Inc., China Internet search company Baidu Inc. BIDU 5.89% and luxury online retailer Farfetch Ltd., according to the indictment.

By late March 2021, the indictment said, Archegos had positions of more than $10 billion in GSX, Baidu and Tencent Music Entertainment Group, TME -0.99% and more than $20 billion in ViacomCBS.

In a text-message exchange with an analyst in June 2020, Mr. Hwang said a recent uptick in ViacomCBS’s share price was “a sign of me buying,” followed by a “tears of joy” emoji, according to the SEC’s complaint.

The SEC said ViacomCBS shares rose about 150% in three months, during a period when Archegos was aggressively buying shares and swaps.

At times, Mr. Hwang coordinated trades in GSX with a “close friend and former colleague” partly to maximize the impact of Archegos’s trades, the indictment alleges. People familiar with the matter said that person is Tao Li, who worked for Mr. Hwang when Mr. Hwang ran a hedge fund called Tiger Asia Management. Mr. Li now runs his own hedge fund called Teng Yue Partners LP, which had a stake in GSX at the time of Archegos’s collapse.

Mr. Li didn’t return a call for comment left at Teng Yue, and a lawyer for Mr. Li didn’t comment.

The dynamics favoring Mr. Hwang had shifted by March 2021, by which time his strategy had left Archegos highly vulnerable to volatility in a small number of stocks. Already pressured by mounting losses in companies including Baidu and Farfetch, the announcement of additional financing by ViacomCBS in late March sent its stock price falling and effectively triggered the unraveling of Archegos.

Rather than selling positions to meet margin calls from lenders, prosecutors allege, Mr. Hwang told his traders “to engage in a desperate buying spree in an attempt to reverse the price declines of stocks underlying Archegos’s core positions.” But the efforts couldn’t stanch the bleeding.

Among the banks suffering losses in Archegos’s collapse were Credit Suisse Group AG CS -3.40% , Nomura Holdings, NMR -1.07% Morgan Stanley MS -0.19% and UBS Group AG UBS 2.49% .

Write to Corinne Ramey at Corinne.Ramey@wsj.com, Susan Pulliam at susan.pulliam@wsj.com and Juliet Chung at juliet.chung@wsj.com

How Archegos Roiled the Markets

Copyright ©2022 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8

Source: WSJ

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