The US Securities and Exchange Commission (SEC) recently charged and settled with hedge fund Galois Capital Management LLC over a private fund that primarily invested in cryptocurrency. The SEC alleges that Galois Capital failed to comply with client asset safeguarding requirements, particularly with crypto assets labeled as securities. As a result, Galois Capital agreed to pay a $225,000 civil penalty to settle the charges, with the funds to be distributed to harmed investors.
Violation of Investor Protection Obligations
Corey Schuster, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, expressed concerns about Galois Capital’s lack of compliance with the Custody Rule provisions. By not securing its assets with a qualified custodian, the firm exposed investors to risks such as potential loss, misuse, or misappropriation of fund assets, including cryptocurrency. Schuster emphasized the SEC’s commitment to holding advisers accountable for violating their core investor protection obligations.
The SEC discovered that starting in July 2022, Galois Capital violated the Investment Advisers Act’s Custody Rule by holding digital assets in online trading accounts on platforms like FTX, which were not qualified custodians. This lack of proper custody led to approximately half of the fund’s assets under management being lost when FTX collapsed in November 2022. Additionally, Galois Capital misrepresented redemption notice periods, allowing some investors to redeem funds with shorter notice periods than disclosed.
In response to the SEC’s findings, Galois Capital consented to cease further Advisers Act violations, accept a censure, and pay the imposed civil penalty without admitting or denying the charges. Co-founder Kevin Zho revealed that around $40 million in funds were locked up in FTX after the exchange froze customer withdrawals. Despite gaining notoriety in 2022 for predicting the collapse of the Terra ecosystem, Galois Capital ultimately closed its operations and sold its claims on FTX at a significant loss. A payment plan was announced to return up to 90% of the funds not retained on FTX to clients, with the remaining 10% withheld pending the completion of the hedge fund’s auditing process.
The case of Galois Capital serves as a cautionary tale for investment firms operating in the cryptocurrency space. Proper compliance with regulations, especially concerning the safeguarding of client assets, is essential to maintain trust and protect investors. The SEC’s enforcement actions underscore the importance of transparency and integrity in the asset management industry, highlighting the consequences of neglecting core investor protection obligations. Going forward, firms must prioritize regulatory compliance and investor safety to avoid facing similar repercussions from regulatory authorities.