Friday, May 25, 2012

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

SEC Charges Northern California Fund Manager in $60 Million Scheme, May 24, 2012, (Litigation Release No. 22375)

The SEC charged John A. Geringer with running a $60 million Ponzi scheme.  In Geringer's management of the GLR Growth Fund, he allegedly misrepresented the fund's historical returns -- double-digit annually -- in the marketing materials and then used new investor funds to finance the returns current investors purportedly realized.  Geringer went so far as to produce account statements detailing the fictitious returns.  Geringer also allegedly represented that the fund's financial statements had been independently audited when no such audit had taken place.  Geringer's actual trading record reflected consistent losses and he eventually even stopped trading all together.  Geringer and the related entities have "consented to the entry of a preliminary injunction and a freeze on the fund's bank account."

Stephen H. Guth Settles SEC Insider Trading Charge Concerning Omrix Tender Offer, May 24, 2012, (Litigation Release No. 22374)

Yesterday, the SEC charged Stephen H. Guth with insider trading in Omrix Biopharmaceuticals, Inc. stock ahead of the public announcement of the tender offer to be made by Johnson & Johnson, Inc. for the outstanding shares of Omrix.  Ahead of the tender offer, Guth was contacted by the CEO of Omrix to assist with due diligence questions.  As a result of the communication, Guth realized an acquisition was eminent and allegedly bought Omrix stock and realized trading profits of over $60,000 as a result of the tender offer.   Guth has consented to the entry of final judgment and has been ordered to pay over $100,000 in disgorgement, prejudgment interest and civil penalties.

SEC Charges New Jersey Man in Real Estate Investment Scam, May 22, 2012, (Litigation Release No. 22373)

The SEC recently charged David M. Connolly with operating a Ponzi-like scheme in which he promised investors monthly dividends financed through the rental income of apartment properties.  Connolly allegedly used new investors' money to pay dividends to existing investors when the rental profits did not meet projections.  In addition, Connolly allegedly misappropriated more than $2 million for his personal use, wrote $2.5 million worth of checks to "cash" and paid himself an annual salary of $250,000 out of the investor funds.  The scam ultimately collapsed when new investor funds dried up, resulting in the foreclosure of the rental properties and a loss of investor equity.  The US Attorney's Office also charged Connolly with one count of securities fraud as a result of a parallel investigation.

SEC Charges Former Yahoo Executive and Ameriprise Mutual Fund Manager with Insider Trading, May 22, 2012, (Litigation Release No. 22372)

Earlier this week, the SEC announced their filing of insider trading charges against Robert W. Kwok (a former Yahoo! Inc. executive) and Reema D. Shah (a former portfolio manager at a subsidiary of Ameriprise Financial, Inc.).  The SEC alleges that Kwok tipped Shah material, non-public information concerning the search engine partnership between Yahoo! and Microsoft.  Shah used this information to alter the portfolio of the funds she managed to realize nearly $400,000 in profits.  The SEC also alleges that Shah tipped Kwok material, non-public information concerning an impending acquisition, allowing Kwok to realize a small profit through trading ahead of the acquisition.

SEC Charges Seattle-Based Fund Manager for Secretly Diverting Client Funds to His Own Start-Up Companies, May 18, 2012, (Litigation Release No. 22371)

Late last week, the SEC charged Mark Spangler with defrauding clients of several private investment funds by investing nearly $50 million into two risky start-ups Spangler co-founded all the while representing to clients that "he would invest primarily in publicly traded securities."  Spangler invested nearly $42 million into one company whose total revenue was less than $100,000 for more than a decade of operation.  While the SEC is seeking financial penalties, the US Attorney's Office is pursuing a parallel criminal action again Spangler.

Tuesday, May 22, 2012

SLCG Research: Dual Directional Structured Products

By Tim Dulaney, PhD

Earlier this month, SLCG released a new research paper that values Dual Directional Structured Products (DDSPs).  DDSPs are debt securities that feature payoffs very much like a long straddle position on the underlying asset for small price movements -- the investor realizes gains if the underlying asset increases or decreases in price (the origin of the term 'dual directional') within a certain range during the term of the note.


DDSPs differ from a conventional straddle position in a number of ways when the underlying asset's price changes more substantially.  If the underlying asset depreciates below a barrier (or trigger) during the term of the DDSP, the investor has the potential to lose some or all of their investment.  In addition, the potential return an investor can realize from the underlying asset appreciating in value is capped. See the following figure for a typical payoff at maturity.


While less than $20 million worth of DDSPs were issued in 2011, DDSPs have recently become a very popular structure for issuers with more than $250 million being issued in Q1 2012 alone.  For a break-down of the DDSP total notional amount by issuer between January 2011 to May 2012, see the following figure. 

DDSPs have recently garnered significant attention in the press.  Bloomberg Structured Notes covered DDSPs in their April 26, 2012 brief.  Risk.net also recently featured a story covering these products.

We decomposed each structure product in our sample into an equivalent combination of options and then priced the options using conventional valuation techniques.  Our research shows that, like most structured products, issuers charge investors substantial premiums to purchase these products.  We also find that the DDSPs that offer investors leveraged exposure on the upside tend to be more overpriced than their unleveraged counterparts. 

Friday, May 18, 2012

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

SEC Charges US Perpetrators in $35 Million International Boiler Room Scheme, May 16, 2012, (Litigation Release No. 22370)

The SEC filed charges this week against Nicholas Louis Geranio, Keith Michael Field, The Good One, Inc. and Kaleidoscope Real Estate, Inc. for their roles in an international boiler room scheme which ran from April 2007 to October 2009 and raised approximately $35 million in proceeds.  Geranio allegedly "organized eight U.S. Issuers, installed management (including Field), and entered into consulting agreements with them through his alter-ego entities The Good One and Kaleidoscope."  Money would be raised by the sale of Regulation S shares of the involved companies to offshore investors by boiler rooms (teams of unregistered telemarketers using high-pressure sales tactics).  The SEC complaint "further alleges that Geranio directed traders, including Field, to engage in matched orders and manipulative trades to establish artificially high prices[...]".  Everyone from the telemarketers, to the escrow agents, to the issuers to the defendants profited from this scheme -- except of course the investors (many of whom were elderly).  For additional information, see the SEC complaint (link opens PDF).

Former CEO of Presstek, Inc. Settles Regulation RD Charges, May 15, 2012, (Litigation Release No. 22369)

In March 2010, the SEC filed charges against Edward J. Marino and Presstek, Inc. alleging that in September 2006, Marino selectively disclosed material non-public information to a group of investors concerning Presstek's third quarter 2006 financials (in violation of the Securities and Exchange Act of 1934 and Regulation FD).  Marino has agreed to pay a $50,000 civil penalty and Presstek has been ordered to pay a $400,000 civil penalty.

SEC Charges China Natural Gas and Its Chairman for Concealing Loans to Benefit His Family, May 14, 2012, (Litigation Release No. 22368)

Earlier this week, the SEC filed charges in the US District Court for the Southern District of New York alleging China Natural Gas, Inc. and Qinan Ji (China Natural Gas, Inc.'s chairman and former CEO) defrauded investors by "loaning company funds to benefit Ji’s son and nephew while failing to disclose the true nature of the loans."  Perhaps ironically, Ji allegedly concealed the true nature of the loans' with the help of the company's internal audit chief (also his niece's husband).  For the SEC complaint in this matter, see here (link opens PDF).

SEC Charge Former Oil Company Executive with Insider Trading, May 11, 2012, (Litigation Release No. 22367)

The SEC recently charged Frank Lynn Blystone with insider trading.  Blystone, a former executive at Tri-Valley Corporation, allegedly liquidated his position in his former company's stock on the basis of material non-public information he received in email updates from the company concerning ongoing efforts to raise capital and problems with a recent securities offering.  Shortly after the public announcement, the stock dropped nearly 40% and Blystone avoided losses of approximately $36,000 according to the release.  To settle the charges brought by the SEC, Blystone has agreed to pay $75,000 without admitting or denying the allegations.

Court Enters Final Judgment Against Defendants Philip Pritchard, Pietro Cimino, and Global Development & Environmental Resources, Inc., May 11, 2012, (Litigation Release No. 22366)

The US District Court for the Middle District of Florida entered a final judgment against Philip Pritchard, Pietro Cimino and Global Development & Environmental Resources, Inc. as a result of the May 2008 SEC complaint (Litigation Release No. 20598) which alleged the defendants participated in a "pump-and-dump" scheme.  The defendants have been ordered to pay (jointly and severally) over $2.6 million in disgorgement and prejudgment interest as well as a civil penalty of $130,000 each.

SEC Charges Apartments America and Its Owners in Scheme to Defraud Investors, May 11, 2012, (Litigation Release No. 22365)

Late last week, the SEC filed a complaint against Michael J. Stewart, John J. Packard and Randall A. Smith in the US District Court in Orange County, California.  The SEC complaint (link opens PDF) alleges that the trio misrepresented the track-record and assets of Apartments America, LLC by cherry-picking the few successful investments of their former bankrupt company Pacific Property Assets while at the same time removing any mention of this former company.  The defendants' misrepresentations allegedly facilitated their pooling of investor funds to invest in unregistered securities.  The SEC is seeking permanent injunctions against the defendants as well as financial penalties.

Friday, May 11, 2012

SEC Investigation into Largest Non-Traded REIT May Be A Sign of Things To Come

By Craig McCann, PhD, CFA and Carmen Taveras, PhD

As discussed in the financial press (see articles here and here) and the company’s latest quarterly reports (see here), Inland American Real Estate Trust is the subject of an ongoing SEC investigation. The SEC probe is determining whether the company incurred in any violations of the federal securities laws with regards to its fees, company organization structure, distributions paid to investors, and reported property impairments. Inland American is the largest non-traded REIT with 970 commercial properties and $11.2 billion in real estate assets.

Inland American’s last prospectus, dated January 7, 2009 (see here), lists the sizeable fees that are applied to an investment in this REIT. The prospectus is offering 500 million shares of common stock at a price of $10 per share, but only an estimated 88% of the gross offering proceeds would be used to purchase real estate assets. The remainder is to be spent on fees such as selling commissions, marketing contributions, due diligence expense allowances, organization and offering expenses, and acquisition expenses. Moreover, although the estimated total organization and offering expenses are around 12% of the offering proceeds, the prospectus states that the actual fees may be up to 15% of the offering proceeds.

Inland American’s organizational structure includes a long list of interrelated entities “that are either subsidiaries of the same entity, affiliates of each other, share some common ownership or were previously sponsored and managed by subsidiaries of IREC [Inland Real Estate Investment Corporation]” (prospectus).



These entities serve the roles of REIT Sponsor, Business Manager, Dealer Manager, and Property Managers. The close relationship between key entities involved in the different aspects of Inland American’s business may lead to substantial conflicts of interest. For example, dealers of Inland American shares are paid an estimated 7.5% commission on the share price. These rates are substantially higher than those paid on mutual funds and exchange-traded-funds, which have commission levels of 2-3%. The high fees may lead dealers to sell as many shares of the REIT as possible regardless of their suitability for a given investor.

In the past few years, Inland American’s dividend payments have exceeded its flow of funds from operations as well as earnings –that is, its dividend payments are financed by debt as opposed to sources related to the REIT’s real estate earnings. In fact, Inland American’s financial leverage defined as total assets divided by total equity was 234% by the end of 2011. Inland American’s high debt burden may compromise future earnings.

Inland American’s Dividends, Earnings, and Flow of Funds from Operations



Non-traded REITs have reported constant prices per shares even during the recent crash of the real estate bubble. Inland American, in particular, reported a fixed $10 per share from 2005 to 2009. In 2010 and 2011 it reported a price per share of $8.03. Late and partial recognition of property impairments may have allowed Inland American to fix its reported share price at the issue price through 2009, even when real estate prices were on a steep decline in most of the country.

The issues of high fees, complicated corporate structure, reliance on debt to fund dividend payments, and lack of price transparency are addressed in more detail in our paper on non-traded REITs (see paper). As described in our paper, these problems not only affect Inland American but are rather commonplace among non-traded REITS. It will be interesting to see whether the SEC expands its investigations to other non-traded REITs.

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

Georgia Doctor Consents to Order in Settlement of SEC Insider Trading Charges, May 10, 2012, (Litigation Release No. 22364)

In a September 2010 complaint (Litigation Release No. 21644), the SEC alleged that Dr. Bobby V. Khan traded Sciele Pharma, Inc. (a Georgia-based pharmaceutical company) stock based upon material non-public information concerning a tender offer that was to be made by a Japanese company.  Yesterday, the US District Court for the Northern District of Georgia entered a consent order requiring Khan to pay over $100,000 (more than double his illicit trading profits).

SEC Charges Manhattan Resident with Carrying Out a Complex Market Manipulation Scheme, May 10, 2012, (Litigation Release No. 22363)

In their complaint, the SEC alleged that David Blech opened more than 50 brokerage accounts "to buy and sell significant amounts of stock in two biopharmaceutical companies in order to create the artificial appearance of activity in their securities so he could maintain their market price and use it to his own financial advantage."  Although Blech had previously been convicted of securities fraud and despite being barred from acting as a broker-dealer, Blech allegedly solicited investments in these (and other)  biopharmaceutical  companies.  The SEC also named Blech's wife Margaret Chassman for her involvement in the sales of unregistered securities.

SEC Charges Former Detroit Officials and Investment Adviser to City Pension Funds in Influence Peddling Scheme, May 9, 2012, (Litigation Release No. 22362)

The SEC filed charges against Kwame M. Kilpatrick (former Detroit mayor),  Jeffrey W. Beasley (former city treasurer) and the city's public pension fund adviser alleging that the group received gifts in exchange for influence over the pension funds' investment process.  Kilpatrick and Beasley allegedly solicited and received $125,000 worth of perks from MayfieldGentry Realty Advisors, LLC to encourage the pension funds to invest over $100 million in a REIT controlled by MayfieldGentry.  When the pension funds "voted to approve the REIT investment, and MayfieldGentry received millions of dollars in management fees."  The SEC complaint in this matter can be found here (link opens PDF).

SEC Charges Arizona Resident with Securities Fraud, May 8, 2012, (Litigation Release No. 22361)

The SEC filed charges against Gerald D. Kegley and his company Prism Financial Services, LLC alleging that the defendants "participated in a fraudulent 'Prime Bank' scheme."  The defendants allegedly raised nearly $2 million in investor funds by representing that the funds would be held in escrow until bank guarantees were issued.  The investors were told that they could draw upon the bank guarantees without having to repay the funds and that commissions would only be paid if the investors received the bank guarantee.  The investor funds were allegedly misappropriated upon receipt and the defendants were paid commission soon after receiving the investor funds.

SEC Charges Movie Producer and Ring of Relatives and Business Partners with Insider Trading, May 8, 2012, (Litigation Release No. 22360A)

This week, the SEC charged Mohammed Mark Amin, Robert Reza Amin (Mohammed's brother), Michael Mahmood Amin (Mohammed's cousin), Sam Saeed Pirnazar (Mohammed's business manager), Mary Coley and Ali Tashakori (Reza's friends) with insider trading in DuPont Fabros Technology, Inc. (a REIT whose common stock is listed on the NYSE).  The defendants allegedly traded based on material, non-public information Mohammed Mark Amin learned prior to a company board meeting.  The defendants allegedly realized over $600,000 in illicit profits when DuPont Fabros stock precipitously rose after an earnings release that details the material, non-public information on which they traded the stock.  The group has agreed to pay nearly $2 million in disgorgement, prejudgment interest and penalties to settle the charges.


Court Enters Final Judgments Against Defendants in Market Timing Case, May 8, 2012, (Litigation Release No. 22359)

In February 2005 (Litigation Release No. 19069), the SEC filed a civil fraud complaint against James Tambone (former president of Columbia Funds Distributor, Inc.) and Robert Hussey (a former sales executive of Columbia Funds Distributor, Inc.) made short-term trading arrangements contrary to the disclosures made in the prospectuses used to sell their company's mutual funds.  The arrangements were never disclosed to the long-term fund shareholders or the trustees of the funds.  Earlier this week, a Massachusetts federal court entered a final judgment against Tambone and Hussey ordering the pair to pay over $250,000 in disgorgement, prejudgment interest and civil penalties.

SEC Obtains Final Judgment on Consent Against James Fleishman, May 8, 2012, (Litigation Release No. 22358)

The US District Court for the Southern District of New York entered a final judgment against James Fleishman as a result of the SEC complaint alleging a vast insider trading scheme.  The scheme produced profits in excess of $30 million through trading on material, non-public information concerning technology companies.  In particular, Fleishman "facilitated the transfer of material nonpublic information from [Primary Global Reseach, LLC] consultants to [Primary Global Reseach, LLC] clients."  Fleishman was found liable for nearly $50,000 in disgorgement and, as a result of a parallel criminal action, was sentenced to thirty months in prison.

Former Paralegal and Her Father Charged with Insider Trading, May 7, 2012, (Litigation Release No. 22357)

Earlier this week, the SEC charged Angela Milliard and her father, Kenneth Milliard, with insider trading.  The father and daughter pair allegedly traded the stock of Semitool (a Montana based Semiconductor company where Angela Milliard was a paralegal) ahead of the company's merger with Applied Materials, Inc. using the confidential deal information obtained by Angela Milliard concerning a tender offer to be made to Semitool stock holders.  The Milliards used this information to buy the stock ahead of the tender offer and to realize significant trading profits.  Together the Milliards are responsible for approximately $175,000 in disgorgement, prejudgment interest and penalties.

Commission Obtains Preliminary Injunction and Asset Freeze Against Massachusetts-Based Parties Who Misappropriated Investor Funds, May 4, 2012, (Litigation Release No. 22356)

Late last week, the SEC announced that it filed charges against Arnett L. Waters as well as A. L. Waters Capital, LLC and Moneta Management, LLC alleging that the defendants "used fictitious investment-related partnerships to draw in investors, misappropriate their investment money, and spend it on personal expenses."  To conceal this scheme, the defendants allegedly made misrepresentations to investors, FINRA and the SEC.  The SEC obtained a preliminary injunction from the US District Court in Massachusetts as well as an asset freeze for the defendants named in the complaint (link opens PDF).

Thursday, May 10, 2012

The Small Price of Big Favors

By Tim Dulaney, PhD and Craig McCann, PhD

Yesterday the Securities and Exchange Commission issued a press release announcing that it had filed a complaint (link opens PDF) alleging Detroit officials -- including former mayor Kwame M. Kilpatrick and former city treasurer Jeffrey W. Beasley -- influenced the city’s pension fund investments to favor an advisor, MayfieldGentry Realty Advisors LLC, in exchange for personal gifts. This story illustrates an all too common occurrence in municipal finance. According to the SEC, Kilpatrick and Beasley requested and accepted $125,000 in personal gifts from MayfieldGentry to facilitate the city’s pension funds’ $106 million investments in the MGRA Genesis REIT.

Municipal officials have control over billions of pension fund dollars ($9 billion in the case of Kilpatrick and Beasley).  When municipal officials are corrupted by unscrupulous advisors, pension beneficiaries pay dearly -- often hundreds of millions of dollars a year as we've seen.  Without complete transparency, competent salaried employees, fee-only investment advisors and independent second opinions on all major investments, public pensions will continue to follow the advice of the highest bidder. This story reminds us how small the price is for such big favors.

Wednesday, May 9, 2012

Massachusetts Securities Regulators Fine RBC for Selling Unsuitable Leveraged and Inverse ETFs

By Tim Husson, PhD

RBC Capital Markets has agreed to pay $2.9 million in restitution to Massachusetts investors related to the sale of unsuitable leveraged, inverse, and inverse-leveraged ETFs.  Secretary of the Commonwealth of Massachusetts William Galvin, who has previously investigated Bank of America over warehousing of CLO assets, issued the complaint in July 2011, accusing RBC and its registered representative Michael D. Zukowski of selling these products "to clients who did not understand what these products were, the risks associated with the products or, how these products were to be properly used in an investment portfolio."  The complaint also documents RBC's failure to appropriately supervise and adequately train representatives who sold these products to investors.

This settlement comes on the heels of FINRA's recent sanctions on four major sellers of leveraged and inverse ETFs, which received considerable media attention.  Interestingly, the FINRA complaint only covered the period from January 2008 through June 2009, leading one commentator to suggest that unsuitable sales of exotic ETFs was limited to "a brief and well-publicized episode of cowboy capitalism," and was a "tempest in a teapot" rather than a systematic problem in the industry.  However, the Massachusetts action against RBC covers a much larger time period--January 1, 2006 to December 22, 2009--suggesting that the sale of unsuitable ETFs has been a much bigger problem than the latest FINRA action alone would suggest.

Our research has confirmed that leveraged and inverse ETFs are extremely complex investment products.  Because of daily rebalancing, these products can deviate substantially from stated returns over periods longer than a single day, and are therefore more suitable for traders than buy-and-hold investors.  The continuing regulatory actions against firms who sell leveraged and inverse ETFs suggests that these risks may not be accurately communicated to potential investors.

Tuesday, May 8, 2012

The "New" Non-Traded REITs Look a Lot Like the Old Ones

By Tim Husson, PhD and Carmen Taveras, PhD

Yesterday's Wall Street Journal had an article describing the "new versions" of non-traded real estate investment trusts (REITs), which purport to solve some of the transparency issues which have made non-traded REITs the subject of regulatory scrutiny. In particular, several non-traded REITs are now offering daily updated net asset values (NAV) in an attempt to calm concerns regarding the lack of transparency in the pricing of non-traded REITs.

However, a review of the prospectus for American Realty Capital Daily Net Asset Value Trust, one of the new non-traded REITs, reveals that the daily updated net asset values for the new non-traded REITS may be far from any meaningful valuation for the securities. The most recent prospectus for American Realty Capital Daily Net Asset Value Trust provides the following description of the calculation of the NAV:
The fair value of our assets will be based on appraisals provided by the independent valuer and in accordance with our valuation guidelines. However, because such fair value calculations involve significant subjective judgments concerning factors such as comparable sales, rental and operating expense data, capitalization or discount rate, and projections of future rent and expenses, valuations will be only estimates, and ultimate realization depends on conditions beyond our, the advisor’s, or the valuer’s control. Additionally, valuations do not necessarily represent the price at which we would be able to sell an asset. As there is no rule or regulation that requires us to use a particular methodology in calculating our NAV and there is no standardized practice established among public REITs for NAV calculations, other public REITs may use different methodologies to calculate NAV. [Emphasis added]
In addition, the appraisals used in calculating the NAV can be up to a year old. In summary, the advisor’s calculation of the NAV is based on stale real estate appraisals, need not follow a specified methodology, and is not an indication of market price. So far, inflows to these "new" non-traded REITs has been modest, and it remains to be seen whether investors will show interest in daily NAV products. But the question remains: if an investor is interested in daily updated market prices, why not simply purchase a traded REIT instead?

Friday, May 4, 2012

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

SEC Charges Two Former Investor Seminar Salespeople with Securities Law Violations, May 1, 2012, (Litigation Release No. 22354)

This week, the SEC filed a settled civil injunctive action against Darlene Nelson Powell and Robert Eldridge -- independent contractors of Long Term-Short Term Inc. (BetterTrades) -- derived from allegations that the two made misrepresentations concerning their trading experience.  As a result, legitimate investors purchased instructional courses and mentoring programs to educate themselves on successful trading strategies.  Powell has been ordered to pay over $200,000 in penalties (Eldridge was not similarly penalized due to his sworn Statement of Financial Condition).

SEC Files Injunctive Action Against Investment Advisers RKC Capital Management LLC, RKC Capital LLC, and Russell K. Cannon, May 1, 2012, (Litigation Release No. 22353)

The SEC recently filed a complaint against RKC Capital Management LLC, RKC Capital LLC and Russell K. Cannon alleging that the defendants "artificially inflated the assets of a hedge fund they managed, RKC Matador Fund LLC (“Matador”), to defraud Matador investors."  The defendants allegedly instructed the fund administrator to record a price for the fund's holdings above the actual market price for about five quarters.  The overstated holdings and returns facilitated the collection of excessive advisory fees by the defendants.

SEC Charges Attorney and Clients in Scheme to Unlawfully Sell Billions of Penny-Stock Shares, May 1, 2012, (Litigation Release No. 22352)

Earlier this week, the SEC charged Christel S. Scucci, Karen S. Beach, their companies Protégé Enterprises, LLC, and Capital Edge Enterprises, LLC and their attorney Cameron H. Linton with a scheme of acquiring and subsequently selling billions of penny-stock shares that were never registered for sale to the public.  Scucci and Beach allegedly realized proceeds of more than $1.5 million through the sale of the supposedly unrestricted stock facilitated by Linton's "baseless legal opinions".   The SEC is seeking disgorgement, prejudgment interest and civil penalties.

Defendants Kenneth A. Wolkoff and George Sobol Settle Charges of Securities Registration Violations in SEC Action, April 30, 2012, (Litigation Release No. 22351)

Last week, the US District Court for the District of Columbia entered a final judgment against Kenneth A. Wolkoff and George Sobol stemming from the SEC allegations that the defendants participated in an unregistered stock offering of e-Smart Technologies, Inc. and in doing so acted as unregistered broker-dealers.  Wolkoff and Sobol were ordered to disgorge all e-Smart stock and to pay penalties of $40,000 and $30,000 respectively.

SEC Files Charges Against Former Attorney for Mutual Benefits, April 30, 2012, (Litigation Release No. 22350)

The SEC recently filed a complaint against Michael J. McNerney for "his involvement in Mutual Benefits Corp.’s (“MBC”) offering fraud which raised more than $1 billion from approximately 29,000 investors."  For a period spanning nearly a decade, McNerney concealed the fraud and facilitated the filing of false reports to regulators in his role as primary securities counsel.  In addition to the five years in prison McNerney received for his involvement, he is ordered to pay over $825 million in restitution with his co-conspirators.

Court Dismisses Appeal of Leila C. Jenkins, Owner of Investment Adviser Locke Capital Management, Inc., April 30, 2012, (Litigation Release No. 22349)

Last June, Leila C. Jenkins and Locke Capital Management, Inc. were found jointly and severally liable for nearly $2 million in disgorgement and prejudgment interest stemming from the May 2009 SEC Charges (Ligitation Release No. 20936).  Jenkins allegedly used a fictitious high-net-worth client to attract ligitimate investors.  The SEC alleges that Jenkins "perpetuate[d] her scheme by lying to the Commission staff about the existence of the invented client and furnish[ed] the Commission’s staff with bogus documents in 2008[...]".  Last month, the US Court of Appeals for the First District dismissed Jenkins appeal.


SEC Charges VoIP Company and its Owners with Conducting Fraudulent Offering Targeting Christian Investors, April 30, 2012, (Litigation Release No. 22348)

The SEC recently filed a complaint against Terry E. Wiese and Scott A. Wiese alleging that the two used promises of ten-fold returns on investment in their company Usee, Inc. to raise funds which were eventually either misappropriated or used for Ponzi payments.  The Wiese's and Usee agreed to pay over $6 million in disgorgement, prejudgment interest and civil penalties.  For the SEC complaint in this matter, see here (PDF).

Thursday, May 3, 2012

SLCG Research: Day-Count Conventions

By Tim Dulaney, PhD and Tim Husson, PhD

Earlier this month, SLCG finished a short research paper on the ubiquitous, but often overlooked, aspect of interest-bearing investments: day-count conventions.  Day-count conventions (DCCs) refer to the various procedures used to compute the amount of time elapsed for the purposes of interest accrual.  These conventions effect the payments we receive/pay on everything from mortgages to credit cards, from savings accounts to interest rate swaps.

Usually these conventions are written as a fraction with the numerator denoting the number of days in a month and the denominator denoting the number of days in a year.  For example, the day-count convention ACT/360 computes the actual ('ACT') number of calendar days elapsed between two dates and then divides the result by 360 to determine the fraction of a year elapsed.

One may think that the amount of time elapsed between two dates was the same for every type of investment, but this is simply not the case.  For example, the fraction of year between January 1, 2012 and February 1, 2012 is given by 0.0820 for 30/ACT and 0.0861 for ACT/360.  Two people making interest payments based upon the same interest rate, but using different DCCs will end up paying a different amounts of interest and this effect can become large over the term of the interest-bearing security.

We point out that a person with an interest-bearing obligation would prefer a DCC with a larger denominator (30/ACT is preferred over 30/360) while a person with an interest-bearing asset would prefer a DCC with a larger numerator (ACT/360 is preferred over 30/360) for the same interest rate.

In our research paper, we study the effect of day-count conventions on interest rate swaps in particular since the DCC used on each leg of the agreement depends on the needs of the counterparties, and can therefore differ contract-by-contract.  We show that the effect of a misapplied DCC is larger with a longer term of the agreement and that the effect is dependent more on the changes in expected future interest rates rather than the levels.  We emphasize that the day-count convention can be used to hide an undisclosed transfer of wealth in a subtle, but important, way.

Tuesday, May 1, 2012

FINRA Issues Sanctions on Sellers of Leveraged and Inverse ETFs

By Tim Husson, PhD

Today FINRA issued sanctions on four firms for selling leveraged and inverse exchange-traded products.  The story has also been picked up by the New York Times [UPDATE:  the Wall Street Journal too].  The offending firms, with links to their respective Letters of Acceptance, Waiver, and Consent ('AWC's), were:
These firms faced a total of $9.1 million in fines and restitution for sales occurring between January 2008 and June 2009.  From the press release:
[T]he firms did not have adequate supervisory systems in place to monitor the sale of leveraged and inverse ETFs, and failed to conduct adequate due diligence regarding the risks and features of the ETFs. As a result, the firms did not have a reasonable basis to recommend the ETFs to their retail customers. The firms' registered representatives also made unsuitable recommendations of leveraged and inverse ETFs to some customers with conservative investment objectives and/or risk profiles. Each of the four firms sold billions of dollars of these ETFs to customers, some of whom held them for extended periods when the markets were volatile.
Our research on leveraged and inverse ETFs has shown that these products can deviate significantly from their stated objectives for holding periods longer than a single day, raising serious concerns about the suitability of these products for retail investors.  Other firms have begun to acknowledge that these products are designed for traders, and that most investors do not have the sophistication to use them properly.

While this and other regulatory actions will go a long way in preventing the sale of unsuitable investments, it is still not clear that advisors and representatives fully understand the risks of these products.  We have several ongoing research projects which we hope will help illuminate the complex features of these exotic investments.  We will keep abreast of regulatory and industry actions in this space.