Charles Schmitt, who is reportedly in the custody of Hong Kong police, is alleged to have been defrauding investors in a fund of hedge funds managed by Charles Schmitt & Associates since the establishment of the vehicle, the CSA Absolute Return Fund, in 2002. The alleged fraud was not picked up by the firm's auditor, Ernst & Young, nor by its fund administrator, Bank of Bermuda (since acquired by HSBC) - but by his own senior managers.

Shortly after the Securities and Futures Commission slapped a restriction order on CSA's assets late on Tuesday evening, June 15th, the firm's managing director of sales and marketing, Brian MacDougall, sent an e-mail message to investors and advisors.

"This is by far the most difficult e-mail I have ever had to write," says his message, which was forwarded to FinanceAsia. "Last week my colleague, Jennifer Carver, and I came across some internal documents that led us to suspect irregularities in the CSA Absolute Return Fund, managed by Charles Schmitt. Based on our suspicions we approached the HK Securities and Futures Commission for guidance. Jennifer and I and all of the CSA staff are now conducting our own internal investigation, as well as working with the relevant authorities... There is nothing I can possibly say to express how sorry we are."

Yesterday (Wednesday) the SFC issued another statement that acknowledged its investigation was prompted by a report by CSA senior management.

Carver, who spent Tuesday night on the phone with CSA's European and American investors, says two of the firm's three funds are not at risk: the Dublin-listed version of the Absolute Return Fund, and the CSA Absolute Return Plus. None of the funds are authorized in Hong Kong, where CSA has been headquartered since its founding in 1992.

Insiders allege funds raised for the one fund in question, the CSA Absolute Return Fund, which was established in February, 2002, were not invested in the 10 underlying sub-funds. Without the knowledge of his colleagues, CSA founder and CEO Schmitt allegedly created dummy companies whose names were almost identical to the legitimate sub-funds. No one apparently noticed that assets designated for these sub-funds went to the dummy companies instead - which turned out to have Hong Kong bank account numbers linked to Schmitt's name.

Because CSA's other two funds were genuinely investing in their designated sub-funds, Schmitt allegedly got away with reporting identical NAV and performance numbers for the dummy companies that exactly matched what should have gone to the genuine sub-funds. Apparently the sub-funds themselves were unaware they were supposed to be receiving investments.

Only when MacDougall and Carver accidentally discovered some dubious paperwork was the alleged embezzlement discovered.

Foremost among this case's unresolved questions must be how CSA's auditor and fund administrator were snookered for over two years. Ernst & Young officials did not return phone calls and HSBC officials declined to comment. The SFC declined to comment beyond its announcements.

Secondly, the public does not yet know the exact amount of assets that may have been misappropriated, or the number of clients affected. CSA has over $200 million of assets under management among its three funds.

It is also not yet clear what impact, if any, this will have on the growing Asian hedge fund community, or on local institutions or family offices' approach toward investing in funds of hedge funds. Industry professionals are shell-shocked and realize this may irritate their marketing efforts, but hope investors will realize this may turn out to be an individual case of fraud, not a systemic failing.

Yesterday, to follow up on Tuesday night's restriction notice, the SFC announced it had obtained an interim injunction against Schmitt from the High Court to prevent him from dealing with any assets he holds or controls. The SFC says Schmitt failed to provide satisfactory answers regarding this case in an interview on Tuesday.