More On Legal & Compliancefrom The Advisor's Professional Library
- Dealings With Qualified Clients and Accredited Investors Depending upon an RIAs business model and investment strategies, it may be important to identify “qualified clients” and “accredited investors.” The Dodd-Frank Act authorized the SEC to change which clients are defined by those terms.
- Client Commission Practices and Soft Dollars RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC suggested that an RIAs failure to stay within the scope of the Section 28(e) safe harbor may violate the advisors fiduciary duty to clients, so RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and that they do not negatively impact the best execution of clients transactions.
The Securities and Exchange Commission said Tuesday that J.P. Morgan Securities LLC would pay $153.6 million to settle SEC charges that it misled investors in a complex mortgage-securities transaction. J.P. Morgan also agreed to improve the way it reviews and approves mortgage securities transactions.
According to the SEC, the transaction took place as the housing market was starting to plummet, and -- under the settlement -- investors would receive their money back. It entailed a synthetic collateralized debt obligation (CDO),
which was sold to investors without the disclosure that a hedge fund had helped select the assets in the CDO portfolio and had a short position in more than half of those assets. As a result, the hedge fund was poised to benefit if these CDO assets defaulted, the SEC says.
“J.P. Morgan marketed highly-complex CDO investments to investors with promises that the mortgage assets underlying the CDO would be selected by an independent manager looking out for investor interests,” said Robert Khuzami, director of the SEC’s division of enforcement, in a press release.
“What J.P. Morgan failed to tell investors was that a prominent hedge fund that would financially profit from the failure of CDO portfolio assets heavily influenced the CDO portfolio selection,” Khuzami (left) explained. “With [Tuesday’s] settlement, harmed investors receive a full return of the losses they suffered.”
Without admitting or denying the allegations, J.P. Morgan agreed to a payment of $18.6 million in disgorgement, $2 million in prejudgment interest and a $133 million penalty. Of the $153.6 million, $125.87 million will be returned to the mezzanine investors through a Fair Fund distribution, and $27.73 million will be paid to the U.S. Treasury.
The settlement also requires J.P. Morgan to change how it reviews and approves offerings of certain mortgage securities. In addition, J.P. Morgan’s consent notes that it voluntarily paid $56,761,214 to certain investors in a transaction known as Tahoma CDO I.
According to the SEC’s complaint, Squared CDO 2007-1 was structured primarily with credit default swaps referencing other CDO securities with their valuations tied to the U.S. residential housing market. Marketing materials stated that the Squared CDO’s investment portfolio was selected by GSCP (NJ) L.P. – the investment advisory arm of GSC Capital Corp. (GSC). However, the marketing materials failed to state that Magnetar Capital LLC hedge fund played a significant role in selecting CDOs for the portfolio and stood to benefit if the CDOs defaulted.
The SEC alleges that by the time the deal closed in May 2007, Magnetar held a $600 million short position that dwarfed its $8.9 million long position. In an internal e-mail, a J.P. Morgan employee noted, “We all know [Magnetar] wants to print as many deals as possible before everything completely falls apart.”
The SEC alleges that in March and April 2007, J.P. Morgan knew it faced growing financial losses from this deal, and that the firm launched a “frantic global sales” effort at this time that “went beyond its traditional customer base for mortgage securities.”
According to the regulators, a J.P. Morgan employee in charge of Squared’s global distribution said in a March 22, 2007, email that, “We are soooo pregnant with this deal, we need a wheel-barrel to move around. … Let's schedule the cesarian (sic), please!”
Some 10 months later, the securities had lost most or all of their value.
J.P. Morgan sold about $150 million of the so-called “mezzanine” notes of the Squared CDO’s liabilities to more than a dozen institutional investors, including
- Thrivent Financial for Lutherans of Minneapolis;
- Security Benefit Corp. of Topeka, Kan.;
- General Motors Asset Management of New York;
- Financial institutions in East Asia including Tokyo Star Bank, Far Glory Life Insurance Co. Ltd., Taiwan Life Insurance Co. Ltd., and East Asia Asset Management Ltd.
The settlement is subject to court approval.
In early June, the Financial Industry Regulatory Authority fined Northern Trust Securities $600,000 for “deficiencies in supervising sales of collateralized mortgage obligations (CMOs) and failure to have adequate systems in place to monitor certain high-volume securities trades,” the group said in a press release.
FINRA fined Credit Suisse Securities (USA) LLC $4.5 million and Bank of America's Merrill Lynch $3 million in late May for “misrepresenting delinquency data and inadequate supervision in connection with the issuance of residential subprime mortgage securitizations (RMBS).”
“We are pleased to resolve this matter, which pre-dated Bank of America’s acquisition of Merrill Lynch. Merrill Lynch identified this problem and corrected it by September 2007,” Bank of America said in a statement.
In its communications with FINRA, Merrill said that on or about June 2007, it discovered that it had posted inaccurate information on its Reg AB website that both under- and overstated delinquencies.
“These errors in delinquency reporting had been caused by an incorrect data feed that populated information from the wrong column of the database that Merrill Lynch used to populate the Reg AR website after Merrill Lynch took this function in-house,” Merrill stated in its agreement letter. “These errors, which variously understated or overstated mortgage pool delinquencies, affected static pool information for 61 subprime securitizations posted on the Reg AB website from January 2006 through June 2007.”