Friday, April 27, 2012

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

SEC Charges Former Morgan Stanley Executive with FCPA Violations and Investment Adviser Fraud, April 25, 2012, (Litigation Release No. 22346)

Earlier this week, the SEC charged Garth R. Peterson (former managing director in Morgan Stanley's real estate investment and fund advisory business) with violating the Foreign Corrupt Practices Act (FCPA).  The SEC alleges that "Peterson secretly arranged to have at least $1.8 million paid to himself and the Chinese official that he disguised as finder’s fees that Morgan Stanley’s funds owed to third parties." In addition, Peterson and the Chinese official (as well as an attorney) acquired a valuable real estate interest from a Morgan Stanley Fund.  Peterson has agreed to pay more than a $250,000 in disgorgement and to give up in his interest in the valuable real estate interest (worth more than $3 million).

Attorney, Wall Street Insider, and Middleman Settle SEC Charges in $32 Million Insider Trading Case, April 25, 2012, (Litigation Release No. 22345)

The SEC alleged that an attorney (Matthew H. Kluger) leaked information concerning a dozen or so merger and acquisitions to a trader (Garrett D. Bauer), through the use a mutual friend (Kenneth T. Robinson), in advance of their public announcement.  For information about the specific events involved, see this SEC press release.  The settlement includes nearly $32 million, over $500,000 and nearly $900,000 in disgorgement and prejudgment interest for Bauer, Kluger and Robinson (respectively).  The three have plead guilty and are due to be sentenced in June of this year.

SEC Charges H&R Block Subsidiary Option One with Defrauding Investors in Subprime Mortgage Investments, April 24, 2012, (Litigation Release No. 22344)

Earlier this week, the SEC charged Option One Mortgage Corporation (now known as Sand Canyon Corporation) with "misleading investors in several offerings of subprime residential mortgage backed securities ("RMBS")."   The SEC alleges that in early 2007, Option One sold more than $4 billion of RMBS by promising investors that Option One would replace or repurchase mortgages that breached representations.  Option One failed to disclose its inability to repurchase said obligations as a result of Option One's worsening financial condition.  Option One has agreed to pay nearly $30 million to settle the SEC's fraud charges.

SEC Obtains Halts Fraudalent Scheme of Purportedly Selling Pre-IPO Facebook Shares, April 23, 2012, (Litigation Release No. 22343)

The US District Court for the Southern District of Florida (Miami) issued an order to halt Allen Weintraub's "ongoing fraudulent scheme of selling securities of an investment vehicle that he falsely represented owned pre-IPO shares of Facebook, Inc."  The sale of these shares allegedly occurred after a final judgment had been entered against Weintraub in Janurary of 2012 and as a result Weintraub could be held in contempt for his actions.  Weintraub operated through an alias (William Lewis) and through several entites including Private Stock Transfer, Inc.  Importantly the "Division of Enforcement urges anyone who believes that Allen Weintraub may have recently defrauded them to contact John Rossetti, Senior Counsel, at 202-551-4819."

SEC Charges Former CalPERS CEO and Friend with Falsifying Letters in $20 Million Placement Agent Fee Scheme, April 23, 2012, (Litigation Release No. 22342)

The SEC alleges that former California Public Employees' Retirement System (CalPERS) CEO Federico R. Buenrostro and his friend Alfred J. R. Villalobos falsified documents given to a private equity firm to foster the false impression that CalPERS had approved placement agent fee disclosure documents.  As a result, the private equity firm paid more than $20 million in placement agent fees to ARVCO Capital Research LLC (later known as ARVCO Financial Ventures LLC) it would not have paid without the falsified disclosure letters.   The SEC is seeking disgorgement in addition to financial penalties.

SEC Sues Chairman of SinoTech Energy for Misappropriating $40 Million of Company Cash, and SinoTech for Falsifying Asset Values, April 23, 2012, (Litigation Release No. 22341)

The SEC filed charges against SinoTech Energy Limited along with Qingzeng Liu  (SinoTech's Chairman),  Guoqiang Xin (SinoTech's CEO) and Boxun Zhang (SinoTech's CFO) alleging various violations including securities fraud.  SinoTech allegedly mislead investors concerning the usage of the IPO proceeds and subsequently overstated the value of the assets on its balance sheet.  Furthermore, SinoTech's chairman allegedly misappropriated more than $40 million from the company.  Beyond the injunctive relief and civil penalties sought for all defendants, the SEC is additionally seeking disgorgement from SinoTech and Liu.

SEC Obtains $4.8 Million Judgment Against Marco Glisson, April 23, 2012, (Litigation Release No. 22340)

The US District Court of Nevada issued a $4.8 million judgment against Marco Glisson as a result of the civil injunctive action filed by the SEC.  The SEC complaint alleged that (between December 2005 and April 2007) Glisson "acted as an unregistered broker or dealer and illegally sold deregistered securities of CMKM Diamonds, Inc."  Glisson allegedly used internet chat rooms to make a market in the deregistered securities.  The judgment includes nearly $2.8 million in disgorgement, $1.4 million in civil penalties and a little under $700,000 in prejudgment interest.

Twin Brothers Allegedly Promote "Stock Picking Robot" for Pump-and-Dump Scheme, April 20, 2012, (Litigation Release No. 22339)

Earlier this month, the SEC charged Alexander John Hunter and Thomas Edward Hunter (twin brothers from the UK) with defrauding around 75,000 investors through a pump-and-dump scheme facilitated with a "stock picking robot".  Investors were allegedly told that the highly sophisticated program was the product of extensive R&D.  Some investors paid for an annual newsletter with information from the robot while others paid a larger amount for a "home version" of the program.  At the same time, the brothers allegedly were paid to suggest specific penny stock tickers to investors being advised by the "robot" leading to a predictable spike in both volume and price.  The SEC is seeking disgorgement, prejudgment interest and civil penalties.

Thursday, April 26, 2012

Rehypothecation or Filched Fund?

By Olivia Wang, PhD

The investigation of the MF Global scandal is still ongoing. A lot of details concerning the missing customer funds haven't been revealed.  At this stage there is no definitive answer as to whether MF Global blatantly transferred segregated customer funds to cover its own liquidity shortfall, or it merely used the often frowned-upon, but completely allowable practice of rehypothecation. In this blog post, I explain what rehypothecation is, as well as the controversy around it.

Rehypothecation refers to the practice of primary brokers of re-using collateral posted by their customers, mostly hedge funds, in their own borrowings and tradings. Different countries have implemented various levels of regulatory control over this practice: in Canada rehypothecation is not allowed at all; in the US a prime broker may pledge up to 140% of the client’s liability to the prime broker; in the UK, there is no upper limit on how much re-pledging is allowed, making the UK a hotbed of collateral recycling. Indeed, many banks --including the pre-crisis Lehman Brothers and the current MF Global -- used their UK subsidiaries to create funding for their US operations by taking advantage of the regulatory asymmetry.

Two researchers at IMF, Manmohan Singh and James Aitken, have carefully studied the role of rehypothecation in their 2010 research paper. According to the paper, after the collapse of Lehman Brothers in the fall of 2008, certain assets posted by Lehman’s investors were “rehypothecated and no longer held for the customer on a segregated basis and as a result the client may no longer have a proprietary interest in the assets.”

Unlike the Lehman Brothers’ case, details of the lost customer funds at MF Global are still scarce, and some may never be revealed. Whether it is rehypothecation, or upfront stealing, hopefully time will give us a clear answer.

Monday, April 23, 2012

Bill Luby on VIX-Related Exchange-Traded Products

By Tim Husson, PhD

Bill Luby, who writes at the VIX and More blog and Expiring Monthly: The Options Traders Journal, is one of the most respected voices on all things related to the CBOE S&P 500 Volatility Index, also known as the VIX.  We highly recommend anyone interested in the VIX and volatility-related derivates check out his blog, which has a variety of useful analysis and commentary.

Recently there has been a lot of coverage related to TVIX and other exchange-traded products linked to the VIX.  Here at SLCG, VIX exchange-traded products are a continuing research effort, as these products are highly complex yet often sold to unsophisticated investors.  Mr. Luby was interviewed by Bloomberg Structured Notes Briefs in the April 12 edition (ungated version not available for link) and had a lot to say about this issue:
I get a lot of basic questions about VXX or VIX options. Generally, someone buys something and the next day the VIX goes up 10 percent and VXX goes up 1 percent or they have VIX options and they’re unchanged. Then they’ll come to me and say, ‘How come I’m not making money if the VIX is up 10 percent?’ They have no idea that these products are based on VIX futures; they are not familiar with concepts like roll yield, term structure, contango, etc. A lot of people don’t realize you can’t trade the VIX directly. 
They obviously didn’t read the prospectus saying the ‘long-term value of your ETN will be zero.’ I even get hedge funds or people who discreetly don’t want me to know they’re hedge funds looking for background on VIX, ‘What does term structure mean?’ 
There is a level of basic ignorance starting with the retail investor, including advisers, less so now, but definitely in the past, including the hedge fund community as well.
He also suggests that some suitability requirements may be in order:
The knowledge required to trade them effectively is comparable to the knowledge required to trade options or futures. I could see some sort of requirement being cleared for a minimum balance or experience.  This TVIX thing has been a boon for investors’ education. It’s been an expensive education.
As for his readers' trading positions?
I would guess most of the people who read my blog are short the VIX exchange-traded product in a big way.

Friday, April 20, 2012

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

SEC Announces Settlement of Accounting Fraud Charges Against Former CSK Auto Corporation Management, April 18, 2012, (Litigation Release No. 22338)

The US District Court in Phoenix entered a final judgment against three former CSK Auto Corporation employees: Don W. Watson (former CFO, Treasurer and Senior VP), Edward W. O'Brien (former controller) and Gary M. Opper (former director of credit and receivables).  The judgment is a result of the SEC allegations in which the officers overstated CSK's pre-tax income as much as $37.4 million annually from 2002 to 2004 -- so large that the company reported a pre-tax gain rather than a loss in 2003.  O'Brien and Opper were ordered to pay over $40,000 and $10,000, respectively in penalties.  Watson was ordered to reimburse O'Reilly Automotive, Inc. (which acquired CSK) over $600,000 in bonuses and stock profits pursuant to the Sarbanes-Oxley Act.

SEC Charges Los Angeles-Based Perpetrator for Municipal Bond Fraud Scheme, April 17, 2012, (Litigation Release No. 22337)

Earlier this week, the SEC froze the assets of Michael Anthony Gonzalez after it was discovered that he had allegedly been orchestrating a municipal bond investment fraud.  Gonzalez allegedly told potential investors he would invest their money in tax-exempt municipal bonds, but after raising more than $1 million, Gonzalez deposited the money into his personal bank account.  In an effort to cover up his fraud, he issued phony confirmation statements to his investors.  The commission's complaint can be found here (PDF).

Former Gateway CFO Settles SEC Fraud Action, April 18, 2012, (Litigation Release No. 22335)

Last week, the SEC announced that a final judgment against John J. Todd -- former CFO of Gateway, Inc. -- had been entered.  The judgment stems from the complaint filed by the SEC that alleged Todd had misrepresented "Gateway’s financial condition in the third quarter of 2000 in order to meet financial analysts’ earnings and revenue expectations"  Todd has consented to the decade-long officer and director bar as well as financial penalties amounting to over $400,000.

Penny Stock Promoters Enjoined and Barred, April 17, 2012, (Litigation Release No. 22334)

The US District Court for the Northern District of Texas enjoined a large group of individuals and entities for their evasion of securities registration laws by offering and selling securities (penny stocks) of companies with effectively no registration statements.  The court has ordered the group to pay disgorgement totaling over $12 million plus prejudgment interest as well as civil penalties of over $100,000 each.

SEC Charges Petr Murmylyuk with Fraudulent Brokerage Account Intrusion Scheme, April 17, 2012, (Litigation Release No. 22333)

Earlier this week, the SEC filed a civil action in the US District Court for the District of New Jersey against Petr Murmylyuk.  The complaint alleges that Murmylyuk created a brokerage account using a stolen social security number to transact with the online account of an individual to which he had gained access.  In particular, Murmylyuk would sell thinly traded options from his fraudulent account the victim's account and then immediately buy them back at a lower price.  The SEC alleges that Murmylyuk caused the victim's account to lose approximately $140,000 through this trade matching scheme -- with $30,000 directly going to Murmylyuk.

SEC Announces Entry of Consent Judgment and Issues Order Against CPA Charged for his Role in Massive Life Settlement Bonding Investment Fraud, April 16, 2012, (Litigation Release No. 22332)

The US District Court for the Eastern District of Virginia entered a final judgment against Jorge L. Castillo ordering him to pay nearly $100,000 in disgorgement and prejudgment interest for his actions outlined in the January 2011 SEC release (Litigation Release No. 21818).  In particular, Castillo represented himself as an outside and independent auditor of Provident Capital Indemnity (PCI) Ltd.  In this capacity, Castillo allegedly misrepresented PCI's ability to satisfy obligations and included a fictitious asset that comprised up "to 80% of PCI’s total reported assets for the period in question."

SEC Shuts Down Ponzi Scheme Targeting Persian-Jewish Community in Los Angeles, April 13, 2012, (Litigation Release No. 22331)

According to the SEC, Shervin Neman has been running a Ponzi scheme for the past two years in which he has defrauded members of the Los Angeles Persian-Jewish community of over $7 million.  Neman allegedly told investors he was investing in shares of hot technology IPOs and foreclosed residential real estate that would be flipped for a quick profit.  The SEC alleges that "more than 99% of the money Neman raised was used either to pay returns to existing investors, or to fund his lavish lifestyle."  The SEC is seeking disgorgement, prejudgment interest as well as financial penalties against Neman and his wife, Cassandra C. Neman.

Tuesday, April 17, 2012

SEC Sends Letter to Issuers of Structured Notes

By Olivia Wang, PhD and Tim Dulaney, PhD

Recently the SEC sent out a letter to certain financial institutions regarding their offerings of structured notes. The letter was sent by Amy M. Starr, the Chief of the Office of Capital Markets Trends, Division of Corporation Finance. In the letter the SEC urges the structured note issuers to disclose key information with regard to the offerings, such as product pricing and use of issuing proceeds.

The SEC highlighted a number of potentially confusing aspects of structured notes and their offerings.  The letter specifically mentions the tax consequences of investing in the structured notes, the potential misuse of positive-identifiers (such as "principal protected") in naming conventions, as well as the adequacy of disclosures related to liquidity and issuer-credit-risk.  According to the letter, the SEC is even seeking to compile some of the more mundane -- but important -- details of structured note offerings: everything from the format of the documentation to the plan of distribution.

There are a few things that the SEC is not asking for that we believe may be of interest to potential structured note investors.  For example, potential reverse convertible investors might appreciate knowing how often the underlying was delivered or the distribution of returns investors have realized on products with similar payoffs.  Investors considering a callable structured note might want to know how often a similarly structured debt security was called by the issuer.  Even more generally, an investor might want to know how the product would have performed historically given the same product structure and underlying asset.

We think this letter shows that the SEC is looking to correct some of the many disclosure shortfalls present in the offering documents of structured notes.  Although we think they could have asked for more information and thereby suggest more details to be disclosed in offering documents, we believe this letter represents a step in the right direction.

Friday, April 13, 2012

SEC Litigation Releases: Week in Review (Part II)

By Tim Dulaney, PhD

Due to the high volume of SEC litigation releases over the previous week, we are summarizing the releases in two parts.  This is the second of the two parts.

SEC Charges Ephren J. Taylor, II with Operating a Ponzi Scheme, April 13, 2012, (Litigation Release No. 22330)

The SEC charged Ephren J. Taylor, II, City Capital Corporation and Wendy Connor (Former COO of City Capital) for their roles in a Ponzi scheme that targeted investors in church congregations.  The SEC alleges that "Taylor assured investors he had a long track record of success, that investor funds would be used to support businesses in economically disadvantaged areas and a portion of profits would go to charity."  The SEC alleges that the funds were in fact used to finance personal expenses and fund the operations of City Capital Corporation with "no meaningful amounts of investor money were ever sent to charities."  The SEC is seeking penalties as well as officer and director bars against Taylor and Connor.

Robert Stinson, Jr. Sentenced to 33 Years in Prison and Ordered to Pay $14 Million in Restitution for Orchestrating Multimillion Dollar Ponzi Scheme, April 11, 2012, (Litigation Release No. 22329)

The US District Court for the Eastern District of Pennsylvania sentenced Robert Stinson, Jr. to 33 years in federal prison and ordered him to pay more than $14 million in restitution for the numerous acts he committed related to a multimillion dollar Ponzi scheme that defrauded hunderds of investors.  Rather than investing the funds as Stinson represented, Stinson misappropriated the funds for personal use and used new investor funds to pay old investors.  For more information, see the June 2010 release (Litigation Release No. 21584).

Default Judgment Entered Against David E. Howard II, Flatiron Capital Partners, LLC, and Flatiron Systems, LLC, April 11, 2012, (Litigation Release No. 22328)

The US District Court for the Central District of California entered a final judgment against David E. Howard II, Flatiron Capital Partners, LLC, and Flatiron Systems, LLC for a scheme in which investors lost over $3 million through misrepresentation and misappropriation.  Howard and Flatiron Systems are jointly and severally liable for over $1 million while Howard and Flatiron Captial Partners are jointly and severally liable for over $500,000.  In addition, Howard was ordered to pay a civil penalty of nearly $400,000.

Glencoe, Illinois Resident Kenneth A. Dachman Ordered to Pay Over $2 Million for Misappropriation and Offering Fraud, April 11, 2012, (Litigation Release No. 22327)

The US District Court for the Northern District of Illinois entered a final judgment by default against Kenneth A. Dachman over the charges brought by the SEC alleging Dachman had misrepresented "how investor funds would be used and his academic and business backgrounds."  Dachman misappropriated nearly $2 million of investor funds for personal use that included vacations, collectibles and personal expenses.  Dachman has been ordered to pay over $2 million in disgorgement and prejudgment interest.

SEC Charges China-Based Company and Others with Stock Manipulation, April 11, 2012, (Litigation Release No. 22326)

The SEC recently filed a complaint in the US District Court of Massachusetts alleging AutoChina International Limited and several investors participated in a stock manipulation scheme to create the appearance of liquidity in AutoChina's stock.  The fraudulent trades that included matched orders and wash trades occurred hundreds of times over a period of several months.  Prior to the scheme, the average daily trading volume for AutoChina stock was approximately 18,000 shares while during the scheme this number increased to nearly 140,000 shares.  The fraudulent trades allegedly accounted for as much as 70% of the trading volume.  The SEC is seeking disgorgement, prejudgment interest, civil penalties and officer or director-bars.

SEC Obtains Final Judgments on Consent against Diamondback Capital Management LLC, April 10, 2012, (Litigation Release No. 22325)

The SEC announced earlier this week that the US District Court for the Southern District of New York entered a final judgment against Diamondback Capital Management, LLC -- a hedge fund advisory firm -- requiring it to pay just over $6 million in disgorgement and prejudgment interest as well as a civil penalty of $3 million.  The final judgment stems from an earlier SEC complaint in which an analyst at Diamondback passed material non-public information to a Diamondback portfolio manager concerning quarterly earnings reports of Dell and Nvidia.  The information was then used to garner millions in illicit profits for Diamondback.

SEC Litigation Releases: Week in Review (Part I)

By Tim Dulaney, PhD

Due to the high volume of SEC litigation releases over the previous week, we are summarizing the releases in two parts.  This is the first of the two parts.

Fromer Syntax-Brillian Corp. CEO Ordered to Pay More than $11 Million for Insider Trading and Financial Fraud, April 9, 2012, (Litigation Release No. 22324)

The US District Court for the District of Arizona entered a final judgment against James Li -- former CEO and Director of Syntax-Brillian Corp. -- ordering him to pay over $2 million in disgorgement and prejudgment interest as well as over $9 million in insider trading and civil penalties.  The final judgement stems from an August 2011 SEC complaint (Litigation Release No. 22075) that alleged "Li and other members of Syntax’s senior management engaged in a complex scheme to overstate Syntax’s revenues and earnings and artificially inflate its stock price."  Other members of the senior management have been similarly penalized and punished for their actions related to this scheme.

SEC Alleges Silicon-Valley Businessman Misrepresented IPO Opportunities, April 9, 2012, (Litigation Release No. 22323)

Earlier this week, the SEC alleged that Benedict Van raised millions in investor funds by representing to investors that two Internet start-ups -- hereUare, Inc. and eCity, Inc. -- were going to go public (with the help of Goldman Sachs and an international law firm) in the coming months and would generate millions in profits.  In reality, Van relied on the investor funds to keep the companies afloat and when this income stream dried up, the businesses ceased operations.  Due to Van's inability to pay disgorgement and other penalties, the only punishment he faces is a permanent prohibition from holding an officer or director position in any public company.

SEC Charges Franklin Bank Corporation Executives with Fraud, April 6, 2012, (Litigation Release No. 22321)

The SEC filed a complaint in the US District Court for the Southern District of Texas alleging Anthony J. Nocella and J. Russell McCann -- Franklin Bank Corporation's CEO and CFO, respectively -- "implemented increasingly aggressive loan modification programs [...] to hide from investors the true amount of Franklin’s non-performing assets and to artificially inflate Franklin’s net income and earnings."  The defendants allegedly overstated net income by over 300% in one quarter and understated non-performing assets by more than 40%.  The SEC is seeking disgorgement, prejudgment interest, penalties and bonus repayment pursuant to the Sarbanes Oxley Act of 2002.

SEC Freezes Accounts of Six Chinese Citizens and One Offshore Entity Charged with Insider Trading, April 6, 2012, (Litigation Release No. 22320)

Last week, the SEC filed a complaint in the US District Court of Chicago alleging six Chinese citizens -- Siming Yang, Caiyin Fan, Shui Chong (Eric) Chang, Biao Cang, Jia Wu, and Ming Ni -- and one British Virgin Islands entity --  Prestige Trade Investments Limited -- had traded Zhongpin Inc. common stock and call options ahead of the public announcement of a stock buyback that offered a substantial premium over the closing price.  The trades allegedly resulted in illicit gains approaching $10 million.  The SEC has frozen the assets of the defendants and is seeking disgorgement, prejudgment interest and penalties.

SEC Charges South Florida Man with Fraud in Phony Stock-Trading Funds, April 6, 2012, (Litigation Release No. 22319)

Earlier this month, the SEC filed a complaint in the US District Court for the Southern District of Florida alleging that George Elia and International Consultants & Investment Group Ltd. Corp. had misrepresented his trading experience to raise investor funds and then misappropriated those funds.  Elia covered up his actions by "providing bogus account statements that reflected fictitious profits."

Court Sentences Defendant for Conspiracy to Commit Mail and Wire Fraud, April 5, 2012, (Litigation Release No. 22318)

The US District Court for the Southern District of Florida handed down a sentence of five years imprisonment followed by three years of supervised release to Gaston E. Cantens stemming from the charges brought by the SEC in March 2010 (Litigation Release No. 21430).  According to the 2010 SEC complaint, Cantens and his wife allegedly operated a $135 million Ponzi scheme targeting Cuban-American investors in which investors bought promissory notes -- backed by recorded mortgage assignments -- claiming annual returns of up to 16%.  The Cantens allegedly misappropriated a significant portion of the investor funds for personal use and unrelated business ventures.

Wednesday, April 11, 2012

High-Frequency Trading and Market Volatility

By Olivia Wang, PhD

The “flash crash” of May 6, 2010 -- when the Dow Jones Industrial Average dropped by 9% in a few minutes and quickly regained ground -- has naturally drawn wide attention. Although the sharp drop was not directly triggered by high-frequency traders (traders who execute trades based on complex algorithms and rarely hold a position more than a day), they have been blamed for fueling the selling after a mutual fund complex initialized a program to sell a large amount of E-Mini S&P 500 contracts. Not surprisingly, heated debates concerning the effect of high frequency trading on stock market volatility followed.

In September, 2011, X.Frank Zhang -- an associate professor of accounting at Yale -- published a paper arguing that stock market volatility is exacerbated by an increase in high-frequency trading. Using firm-level data from 1985 to 2009, Zhang found that the positive correlation between volatility and high-frequency trading was especially strong for firms with large market capitalization. As to the liquidity added to the market, which some believe is the major contribution of high-frequency trading, Zhang found that once the share of high-frequency trading exceeds the threshold of 50%, a “hot potato” volume effect with traders passing the same positions between themselves, starts to dominate.  

Around the same time, Professor Alex Frino -- affiliated with the University of Sydney Business School and CEO of Capital Markets Co-operative Research Centre -- argued that high frequency trading reduces price volatility in equity markets rather than increasing it. His research is based on several equity markets around the world and rather than identifying a positive relationship between an increase in high frequency trading and in increase in price volatility, he found a negative relationship. 

So who's right? Perhaps no conclusive answer could be drawn at this stage. In fact, it is very hard to disentangle the overall effect of high-frequency trading on volatility for at least a few reasons. First, there are different types of traders involved in high frequency trading: momentum driven traders, arbitrage-seeking traders, and liquidity-providing traders. Although the arbitrage-seeking traders are more likely to pursue trades which reduce mispricing, the momentum driven traders could add to market correlation and volatility. It will be very difficult to find data which separate different types of trading activities. Second, as the research by economists Josh Lerner and Peter Tufano has shown, it is very hard in general to estimate the effects of financial innovation on society due to the externality generated by such innovation.

The debate may still be ongoing, but regulators should consider monitoring high-frequency trading and reinforce surveillance in asset markets.

Monday, April 9, 2012

Is There No Tracking Error for ETNs?

By Olivia Wang, PhD

Some investors may think that while ETFs are subject to various tracking errors, ETNs are not. The argument goes that index-tracking ETFs often hold part or the entire portfolio underlying their targeted index and are thus subject to imperfect tracking and transaction costs. ETNs, on the other hand, are debt instruments, and have returns guaranteed by their issuers. 

It turns out, however, that the daily return of an ETN investment may not necessarily equal the leverage ratio times the daily return of the index the ETN is supposed to track, and there are several reasons for this. Here we will use TVIX, a “2x long” ETN tracking the S&P 500 VIX Short-Term Futures Index ER (SPVXSP), as an example.

First, the way the TVIX ETN tracks the SPVXSP index is through the calculation of the so-called “Closing Indicative Value”. Basically this is a value starting from $100 on the inception date, and then updated on each calendar day based on its value on the previous day and a computed daily return. Although 2 times the SPVXSP is an important, or probably the most important component of this computed daily return, it also includes a daily accrual return and a daily investment fee. Both of these two factors could contribute to the deviation of the Closing Indicative Value return from the leveraged index return. 

Second, a TVIX holder may redeem the notes he holds at the Closing Indicative Value, but this redemption is subject to an early redemption charge which will be equal to 0.05% of the Closing Indicative Value. 

Third, when TVIX are traded in the secondary market on an exchange, its price may deviate significantly from the Closing Indicative Value. As one of our previous blog posts has shown, in certain days of this February and March, TVIX has been traded above the Closing Indicate Value by a large amount. Again, this means that the return an investor obtains from trading TVIX on exchange deviates from the leverage index returns.    

Fourth, although it may be unknown to many investors, the Closing Indicative Value for TVIX has a lower bound of zero. In other words, if the Closing Indicative Value ever hits the level of zero, it will remain zero afterward. In this case, the ETN will stop tracking any movement of the underlying index.

The following figure depicts the three types of annualized daily returns in percentage point since the inception of TVIX: the return on the closing price of TVIX, the return on the Closing Indicative Value of TVIX, and 2 times the return on the SPVXSP index. Although there seems to be frequent discrepancies between the return on the price of TVIX and that on the leveraged index return, the Closing Indicative Value return mostly overlaps with the leveraged index return. In fact, since the inception of TVIX, the largest deviation between the daily returns of the Closing Indicative Value and the leveraged index return is 0.054% after annualization. This means the third factor we identified above, namely the discrepancy between the Closing Indicative Value and the trading price, seems to be playing the biggest role in driving TVIX’s return away from its leveraged index return, at least for now.


Friday, April 6, 2012

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

Court Holds Defendant in Contempt in SEC Action Involving Rhode Island-Based Offering Fraud, April 5, 2012, (Litigation Release No. 22317)

In October 2010, the SEC filed a civil injunctive action against David Stern alleging that he misrepresented several key characteristics of his company -- Online Registries, Inc. -- in order to raise investor funds.  The SEC also alleged that Stern then misappropriated these funds.  The court entered an Order for Other Equitable Relief in March 2011.  Last August, the SEC filed an application for civil contempt against Stern after he allegedly formed a new company -- Instant Medical Access LLC -- nearly identical to his previous company and allegedly violated the injunctive orders against him.  Earlier this week, the US District Court for the District of Rhode Island entered an order of civil contempt requiring documentation of his new business venture to be divulged and barring him from activities related to this or any related venture.

Court Enters Final Judgment against Defendant Anthony M. Cimini, Sr., April 3, 2012, (Litigation Release No. 22316)

In May 2008, the SEC alleged that Anthony M. Cimini, Sr. "participated in a fraudulent 'pump and dump' scheme to evade the registration provisions of the federal securities laws and then sell purportedly unrestricted Global shares during a fraudulent promotional campaign."  The US District Court for the Middle District of Florida entered a final judgment this week ordering Cimini to pay over $40,000 in disgorgement, prejudgment interest and penalties for his conduct outlined in the May 2008 SEC complaint (Litigation Release No. 20598).

SEC Sues Two Former ArthroCare Corporation Officers over Accounting Fraud, April 2, 2012, (Litigation Release No. 22315)

The SEC filed a complaint in federal court against Michael A. Baker and Michael T. Gluk -- respectively the former CEO and CFO of ArthroCare Corporation -- to "recover bonus compensation and stock sale profits they received during a period when the company’s financial statements were misstated due to accounting fraud."  Although the executives are not charged with personal misconduct, the executives are required to reimburse ArthroCare for bonuses and stock profits received during the period in which false financial statements were filed pursuant to the Sarbanes-Oxley Act.

Court Enters $98.6 Million Final Judgment against UK Hedge Fund Adviser Pentagon Capital Management PLC and its CEO Lewis Chester, March 30, 2012, (Litigation Release No. 22314)

Last week, the US District Court of the Southern District of New York entered a final judgment against Pentagon Capital Management and its former CEO Lewis Chester ordering total monetary relief approaching $100 million.  The final judgment stems from a previous opinion in which the court found "that Defendants 'intentionally, and egregiously,' violated the antifraud provisions of the securities laws by engaging in a late trading scheme to defraud United States mutual funds."  For more information, see the previous litigation releases here and here.

Court Enters Final Judgment against Defendants Frederick S. Schiff and Richard J. Lane, March 30, 2012, (Litigation Release No. 22313)

The US District Court in New Jersey entered final judgments against Frederick S. Schiff and Richard J. Lane in connection with an SEC allegation that, from early 2000 to late 2001, the executives participated in a "channel-stuffing" scheme in order to deceive the public about the health of Bristol-Myers Squibb Co.'s business.  The SEC complaint alleged that "Bristol Myers used financial incentives to induce wholesalers to buy its pharmaceutical products in excess of prescription demand in order to artificially inflate its results[.]"  Schiff has been order to pay over $130,000 and Lane has been order to pay over $35,000 to cover disgorgement and prejudgment interest.

British Virgin Islands Corporation and Resident of Switzerland Settle Changes of Insider Trading in the Options of Intermune, Inc., March 30, 2012, (Litigation Release No. 22312)

The US District Court for the Southern District of New York entered a settled final judgment against Michael S. Sarkesian and Quorne Ltd. in connection with an insider trading complaint filed by the SEC.  In the complaint, the SEC alleged that Sarkesian and Quorne traded InterMune, Inc. options on material non-public information.  According to the release, the "alleged illicit trading by Sarkesian and Quorne took place ahead of a December 17, 2010 announcement that the European Union’s Committee for Medicinal Products for Human Use, or CHMP, had recommended to the European Commission that it permit InterMune to market [a] developmental drug[.]"  Quorne and Sarkesian consented to the entry of final judgment and have been ordered to pay (jointly and severally) over $700,000 in disgorgement and penalties.

Monday, April 2, 2012

Latest Non-Traded REIT Valuations: Not Good...

By Tim Husson, PhD

Non-traded REITs are real estate investments sold to retail investors despite significant liquidity, transparency, and other risks.  We've done a great deal of work on non-traded REITs (including a paper here and blog posts here), and have warned that their dividend payments and debt levels are often not sustainable.  Almost all non-traded REITs are reported in customer accounts at acquisition cost, despite widespread declines in real estate values.

FINRA has recently required non-traded REITs to report updated share values.  The results so far have been very revealing, as most all non-traded REITs now report values significantly below their offering prices.  InvestmentNews now reports that several large non-traded REITs recently reported enormous declines in per-share values, highlighting again the discrepancy between the price and the value of these investments.