Friday, September 28, 2012

SEC Litigation Releases: Week in Review

Court Enters Final Judgments by Consent Against SEC Defendants Shay Keren and Lawrence Steven Cohen, September 27, 2012, (Litigation Release No. 22498)

The SEC announced that final judgments have been entered against Shay Keren and Lawrence Steven Cohen which permanently enjoins them from violating sections of the Securities Act and Exchange Act as well as bars them from "participating in an offering of penny stock for a period of five years." The SEC filed a complaint in September 2008 against Glenn Grossman, Lawrence Steven Cohen, Shay Keren, and John Zanic for allegedly engaging "in a fraudulent broker bribery scheme designed to manipulate the market for the common stock of Guyana Gold, Corp."

SEC Charges Investment Bank Analyst with Illegally Tipping College Friend About Nonpublic Merger Deals, September 27, 2012, (Litigation Release No. 22497)

According to the complaint (opens to PDF), Jauyo "Jason" Lee shared nonpublic information he learned as an employee of Leerink Swann LLC with his longtime college friend, Victor Chen. Specifically, in 2009 Lee told Chen about Syneron Medical Ltd. negotiating an acquisition of Candela Corporation and then in 2010, Lee tipped Chen about Somanetics Corporation's acquisition by Covidien plc. Chen then traded with this insider information and made over $600,000 in illicit profits. Chen also used his sister Jennifer Chen's account to make some of his trades. The SEC alleges Lee and Chen violated sections of the Exchange Act and seeks "disgorgement of ill-gotten gains with prejudgment interest, financial penalties, and permanent injunctions against Lee and Chen." Jennifer Chen has been named as a relief defendant "for the purposes of recovering the illegal profits in her account."

SEC Brings Charges in $42 Million Offering Fraud Targeting Seniors, September 27, 2012, (Litigation Release No. 22496)

The SEC charged Bradley A. Holcom (PDF) and Jose L. Pinedo (PDF) in connection with a "fraudulent scheme that sold $42 million of promissory notes to more than 150 investors...many of whom were senior citizens." Holcom allegedly lured investors into his scheme by offering "guaranteed monthly interest payments on purportedly safe deals." Holcom promised that investor funds would be used to finance "the development of specific pieces of real estate," with the guarantee that "each investment would be fully secured." In actuality, these investments were unsecured. Furthermore, the complaint claims that Holcom ran a classic Ponzi scheme, using investor funds "to make interest and principal payments on promissory notes as they came due." Holcom's scheme collapsed in 2008, causing investors to lose over $25 million in principal. The SEC claims that Pinedo, who served as "Holcom's bookkeeper and as an officer or manager of Holcom's numerous corporate entities, routinely signed promissory notes and other false and misleading documents that were sent to investors." The SEC claims Holcom violated sections of the Securities Act and Exchange Act and seeks permanent injunction, disgorgement plus pre- and post-judgment interest, and civil penalties against him. Pinedo agreed to settle the matter and consented to a final judgment enjoining him from violating sections of the Securities Act.

SEC Charges Company and its Two Principals and Attorney in Stock Manipulation Scheme, September 27, 2012, (Litigation Release No. 22495)

The SEC charged 8000, Inc., along with its principals and attorney, Jonathan E. Bryant, Thomas J. Kelly and Carl N. Duncan, respectively, for engaging in a scheme to manipulate 8000, Inc.'s stock price. According to the complaint (opens to PDF), from November 2009 to October 2010, the defendants misrepresented 8000, Inc.'s financial condition to investors thereby increasing the volume of trading in 8000, Inc. by 93%. Allegedly, as Bryant and Kelly drove the stock price higher through misleading financial reports and press releases, Bryant sold "restricted" shares and Kelly bought and sold the company's securities in the secondary market. Duncan allegedly provided "false legal opinions to the company's transfer agent that improperly removed the restrictions on Bryant's shares" as well as provided "false legal opinions to OTC Markets that ensured that 8000, Inc.'s common stock would continue to be quoted on OTC Pink." Duncan received one million shares of 8000, Inc. from Bryant.  Duncan has agreed to a final judgment enjoining him from violating sections of the Securities Act and "from preparing or issuing any opinion letter in connection with the offer or sale of securities." The final judgment also includes a penny stock bar against Duncan and requires him to pay over $40,000 in disgorgement, prejudgment interest, and civil penalties.

Former "Teach Me to Trade" Salesman Agrees to Settle Securities Fraud Charges and Pay a $200,000 Penalty, September 26, 2012, (Litigation Release No. 22494)

On September 5, a settled final judgment was entered against David Gengler and Lashaico, Inc. in the case SEC v. David Gengler, et al. filed in 2008. According to the SEC's complaint, "Gengler sold securities trading products and services such as classes, mentoring and software called 'Teach Me to Trade' to investors who wanted to learn how to trade securities." Gengler, president of Lashaico, Inc., claimed he was a successful trader using Teach me to Trade methods but, according the SEC, these claims were untrue. Gengler has agreed to pay a civil penalty of $200,000. The final judgment permanently enjoins Gengler and Lashaico from violating sections of the Exchange Act, and from "receiving compensation for participating in the development, presentation, promotion, marketing or sale of any classes, workshops, or seminars...given to actual or prospective securities investors concerning securities trading and designed to influence their securities trading."

SEC Charges Bank Executives in Nebraska with Understating Losses During Financial Crisis, September 25, 2012, (Litigation Release No. 22493)

The SEC charged Gilbert G. Lundstrom (PDF), former CEO and chairman of the board at TierOne Bank, along with president and chief operating officer James A. Laphen (PDF) and chief credit officer Don A. Langford (PDF) for "participating in a scheme to understate millions of dollars in losses and mislead investors and federal regulators at the height of the financial crisis."When TierOne expanded into riskier types of lending it experienced a "significant rise in high-risk problem loans." The Office of Thrift Supervision (OTS), TierOne's primary banking regulator, "directed TierOne to maintain higher capital ratios as a result of the bank's increase in high-risk problem loans." To "comply" with these heightened capital requirements, Lundstrom, Laphen, and Langford allegedly "disregarded information showing that the collateral securing certain TierOne loans and real estate repossessed by the bank was overvalued due to the bank's reliance on stale and inadequately discounted appraisals." The truth about TierOne's losses surfaced in late 2009 when OTS required TierOne to get new appraisals for its impaired loans. TierOne then disclosed its losses, which totaled more than $130 million and, as a result, TierOne's stock dropped over 70% eventually leading to the company's backruptcy.  Civil penalties totaled more than $1 million for those involved in these misdeeds.

SEC Charges Four Defendants in Fraudulent Investment Scheme, September 24, 2012, (Litigation Release No. 22492)

According to the complaint (opens to PDF), Rudolf D. Pameijer, Lindsay R. Sayer, Ryan W. Koester and his entity Rykoworks Capital Group, LLC ran a fraudulent investment scheme in which they misappropriated almost $1.7 million from investors. "Koester held himself out as an expert foreign currency trader" telling investors his unique trading strategy offered "investors a principal guaranteed investment opportunity." Koester agreed to share profits with Pameijer, who worked to bring investors into Rykoworks. In 2010 Pameijer and his daughter, Sayer, began to solicit clients to invest in Rykoworks "through promissory notes which purported to guarantee investor principal while offering risk free returns from forex trading." All of the defendants allegedly used investor funds for personal use including (but not limited to) luxury automobiles, home renovations, wedding and honeymoon expenses, and college tuition. The SEC has charged all defendants with violating sections of the Exchange Act and Securities Act and seeks "injunctions, disgorgement with prejudgment interest, and civil monetary penalties."

SEC Charges Tyco with Making Illicit Payments to Foreign Officials, September 24, 2012, (Litigation Release No. 22491)

According to the complaint (opens to PDF), Tyco International Ltd. "violated the books and records, internal controls, and anti-bribery provisions of the Foreign Corrupt Practices Act." Following a "settled accounting fraud, disclosure, and FCPA injunctive action" filed by the SEC in April 2006, Tyco "committed to and commenced a review of its FCPA compliance and a global internal investigation of possible additional FCPA violations." The violations alleged in this week's complaint are a result of that review and investigation. From 2006 to 2009, Tyco subsidiaries allegedly "operated twelve illicit payment schemes." Additionally, the complaint claims that Tyco's"books and records were misstated as a result of the misconduct and that Tyco failed to devise and maintain internal controls sufficient to detect the violations." Furthermore, the complaint "alleges that payments by a sales agent to Turkish government officials violated the anti-bribery provisions of the FCPA." Tyco has agreed to pay over $13 million in disgorgement and prejudgment interest to settle the charges.

SEC Charges Registered Representative with Fraud for Issuing False Account Statements and Misappropriating Investor Funds, September 24, 2012, (Litigation Release No. 22490)

According to the complaint (opens to PDF), David L Rothman, a registered representative, Vice President, and minority owner of Rothman Securities, "conduct[ed] fraud by issuing false account statements and misappropriat[ed] investor funds." From 2006 to 2011, Rothman created and issued false account statemetns that overstated the value of investment accounts to certain elderly and unsophisticated investors.  Rothman allegedly "engaged in a scheme to conceal his fraudulent conduct by agreeing to pay...the investment returns he reported on the false account statements" to investors who had discovered their account values had been overstated. The complaint further alleges that Rothman misappropriated funds from another investor and two trust accounts for which he serves as trustee to make these payments. The SEC has charged Rothman with violating sections of the Exchange Act and Securities Act and seeks permanent injunction, disgorgement with prejudgment interest, and civil penalties. "Criminal charges have also been filed against Rothman in a parallel criminal case."

SEC Charges Revolutions Medical Corp. and its CEO for Fraudulently Issuing False and Misleading Press Releases, September 21, 2012, (Litigation Release No. 22489)

According to the complaint (opens to PDF), between August 2010 and July 2011, Revolutions Medical Corp. and its CEO, Rondald L. Wheet, "fraudulently issu[ed] false and misleading press releases concerning the company's flagship product, a retractable, medical safety syringe." These statements allegedly conveyed that the syringe had been fully developed, was slated for "mass manufacturing and commercial distribution," and that Revolutions Medical "had entered into, or was on the cusp of entering into, binding mass sales and distribution agreements." According to the complaint, the statements in these press releases were false, and  these false press releases caused Revolutions Medical's shares to become artificially inflated. Furthermore, the complaint alleges that Revolutions Medical sold shares to a "third-party hedge fund at inflated prices."

SEC Charges Edward Tackaberry for Acting as an Unregistered Broker-Dealer in Violation of Law and Prior SEC Order, September 21, 2012, (Litigation Release No. 22488)

The SEC has charged Edward Tackaberry with "acting as, or associating with, an unregistered broker-dealer...despite a Septemeber 27, 2007 order issued by the SEC barring him from associating with any broker or dealer." From 2007 through 2009, Tackaberry allegedly "acted as an unregistered broker-dealer, and/or associated with an individual acting as an unregistered broker-dealer, in connection with the soclitation of investors in several New York LLCs." Tackaberry "discuss[ed] investment transactions with prospective investors, negotiat[ed] the terms of the investments on behalf of the LLCs, and, if an agreement was reached, document[ed] those transactions." Tackaberry has agreed to a final judgment which enjoins him from further violations of the Exchange Act.

SEC Charges Oregon-Based Hedge Fund Manager with Running $37 Million Ponzi Scheme, September 21, 2012, (Litigation Release No. 22487)

According to the complaint (opens to PDF), investment advisor Yusaf Jawed "perpetrated a long-running Ponzi scheme that raised over $37 million from more than 100 investors." Allegedly, Jawed lured investors into investing in several hedge funds he managed through at least two companies he controlled: Grifphon Asset Management LLC and Grifphon Holdings LLC. He used false marketing materials to gain these investors and then "created phony assets, sent bogus account statements..., and manufactured a sham buyout of the funds to make investors think their hedge fund interest would soon be redeemed." In actuality, Jawed allegedly invested very little of the $37 million, using the money instead to pay redemptions to investors in other funds and for personal expenses. Furthermore, as the funds were collapsing, Jawed allegedly told investors that "independent third parties were buying the Grifphon funds' alleged assets at a premium."  The SEC has charged Robert P. Custis, Jawed's attorney, with sending false and misleading statements to investors about the status of the purported purchase of the Grifphon funds' assets. The SEC filed two separate complaints against individuals in connection with Jawed's scheme. Attorney Jacques Nichols (PDF) allegedly told investors that "an independent third party would pay tens of millions of dollars to buy the hedge funds' alleged assets at a premium." Lyman Bruhn (PDF), Jawed's associate, has been charged with running a separate Ponzi scheme and inducing investments "through false claims he was investing in "blue chip" stocks."

SEC Freezes Assets of Insider Trader in Burger King Stock, September 21, 2012, (Litigation Release No. 22486)

The SEC obtained an emergency court order to freeze the assets of stockbroker Waldyr Da Silva Prado Neto. According to the complaint (opens to PDF), Prado used nonpublic information of Burger King Holding, Inc.'s acquisition by 3G Capital Partners Ltd. to illegally trade in Burger King stock, making $175,000 in illicit profits. Prado learned of the acquisition from a client while working at Wells Fargo Advisors, LLC. Prado went on to allegedly tip at least four of his customers, one of which made over $1.68 million in illegal profits. The SEC seeks permanent injunctions against Prado from violating sections of the Exchange Act and seeks "disgorgement with prejudgement interest and monetary penalties."

Wednesday, September 26, 2012

Regulators Fine High-Frequency Trader for Manipulative Trading

By Tim Dulaney, PhD

FINRA recently announced the censure and fining of Hold Brothers On-Line Investment Services, LLC ("Hold Brothers").  This action is in lockstep with that of NYSE Arca (PDF),  NASDAQ (PDF), NASDAQ OMX BX (PDF) and BATS (PDF) as well as the SEC (PDF).  Hold Brothers is a registered self-clearing broker-dealer and a member of FINRA operating as a "day-trading firm by facilitating direct market access to customers and to its proprietary traders."

The action centers primarily on the trading activity in one large account ("Demonstrate, LLC") wholly owned, funded and controlled by Hold Brothers.  Several hundred thousand trades were placed through this account on average each trading day between January 2009 and December 2011.  One particular alleged illicit trading activity involved a process known as "spoofing".  "Spoofing" is trading activity involving non-bona fide trades within NBBO primarily to elicit other traders to expand NBBO.   Because other high-frequency trading algorithms base their decision on when to trade on order book depth, the algorithms interpreted these orders as increased demand.  Other illicit trading activities alleged by the regulators include: layering, wash selling and pre-arranged trading.

According to FINRA, by writing an algorithm to exploit the simplicity of another trader's algorithm, Demonstrate manipulated the market.  As algorithms become more complex, it is likely that we will see more actions like this one: algorithms taking advantage of the simple assumptions in other algorithms to produce small profits at a high frequency.   Consistent with most cases of this nature, Hold Brothers "neither admitted nor denied the charges, but consented to the entry of FINRA's findings" and has been fined nearly $6 million dollars for their involvement in this market manipulation and anti-money laundering activity.

Tuesday, September 25, 2012

Repackaging Securities Means Repackaging Risks: the Case of STRATS 2005-2

By Tim Husson, PhD and Tim Dulaney, PhD

On July 12, an exotic structured security that was trading at approximately $25 per share was suddenly redeemed at $14.69 by its issuer, Wells Fargo Advisors.  Needless to say, some investors were surprised by the event, which did not appear to be anticipated by the market.  Indeed, the securities--Floating Rate Structured Repackaged Asset-Backed Trust Securities Certificates, Series 2005-2 (abbreviated STRATS 2005-2)--had embedded risks that resulted from repackaging the same underlying cash flows several times.

The story begins in 2004, when a subsidiary of JPMorgan Chase issued the JPMorgan Chase Capital XVII Capital Securities, Series Q, a type of security known as a trust preferred security.  Trust preferred securities were a way for financial institutions to raise capital in a tax-efficient manner (see our paper on preferred stock portfolios for more details).  Instead of issuing fixed-rate bonds, which required periodic interest payments, the banks would create special purpose companies that issue securities and pay 'distributions' at a fixed rate.  They would fund those distributions by purchasing junior subordinated debt of the parent bank, in this case JPMorgan Chase.  In effect, the bank could raise money from investors but pay 'distributions' from the special purpose company instead of interest payments to bondholders.  For many years, trust preferred securities were allowed to be considered Tier 1 capital, making them a highly advantageous source of funds.


Some of this trust preferred security was purchased by Wachovia Securities (later to become Wells Fargo Advisors), which combined them with an interest rate swap to convert their 5.85% fixed-rate payments to a floating rate payments floored at 3% and capped at 8%.  This repackaged trust preferred security plus interest rate swap was therefore a floating rate security based ultimately on JPMorgan Chase's junior subordinated debt.

What was apparently not well appreciated was the fact that most trust preferred securities contained provisions that called for early redemption if their regulatory treatment ever changed (if they could no longer be treated by the bank as Tier-1 capital -- referred to as a "Capital Treatment Event").  Interestingly, this is precisely what happened to the JPMorgan Chase trust preferred securities underlying the STRATS 2005-2:  under the Dodd-Frank Wall Street Reform and Consumer Protection Act of July 2010, trust preferred securities were no longer to be treated as Tier-1 capital, and many have been redeemed since.

This caused the STRATS 2005-2 product to unravel.  JPMorgan eventually announced that they would be redeeming the trust preferreds at $25.65, removing the fixed-rate cash flow to the STRATS.  All that remained was the interest rate swap, which Wells Fargo determined to be worth $10.97 per share, leaving investors with a $14.69 payout.

It is not clear whether Wells Fargo's valuation of the swap was fairly priced; however, what is clear is that the market did not successfully price in the redemption risk which was effectively inevitable.  The market price of the STRATS 2005-2 did not move drastically in response to the passage of Dodd-Frank, but jumped to near par when the Federal Reserve announced the impending regulatory change for trust preferred securities on June 7, 2012 (PDF version available here).  Clearly, investors believed that they were entitled to full repayment of the trust preferred securities, not to the value of the trust preferreds net of the interest rate swap.


The moral of this story is that structured finance can lead to surprising risks.  Repackaging securities into a larger structure requires issuers to anticipate every potential outcome for the underlying securities, and to fully disclose the effects of those risks to investors.  In this case, it appears that an unexpected event that disrupted the market for one security caused a chain reaction that led to substantial losses in another.  This example highlights the highly interconnected risks that can come about due to structured finance.

Friday, September 21, 2012

SEC Litigation Releases: Week in Review

SEC Charges Atlanta-Based Adviser with Operating Ponzi-Like Scheme Involving Private Investment Funds, September 19, 2012, (Litigation Release No. 22485)

Earlier this week, the SEC filed a civil complaint (PDF) charging Angelo A. Alleca with "defrauding investors in a purported “fund-of-funds” and then trying to hide trading losses by creating new private funds to make money to pay back the original fund investors in Ponzi-like fashion."  Rather than investing investor funds in Summit Investment Fund, LP, Alleca allegedly actively traded the client funds and realized significant losses.  According to the SEC, Alleca used profits from new funds (Private Credit Opportunities Fund, LLC and Asset Class Diversification Fund, LP) to meet early redemption requests from the older funds all the while issuing false account statements to investors.  When the new funds began to experience losses, the scheme began to fall apart. Alleca allegedly raised approximately $17 million in this Ponzi-like scheme.  The US District Court has issued an asset freeze and expedited discovery process.

SEC Charges Former CEO and Chairman of Mamtek US with Fraud in the Offer and Sale of Municipal Bonds
, September 18, 2012, (Litigation Release No. 22484)

The SEC recently charged Bruce Cole (former CEO and Chairman of Mamtek, US) with "fraud related to the offer and sale of municipal bonds."   In July 2010, the City of Moberly, Missouri offered $39 million worth of bonds to finance a processing plant to be built and operated by Mamtek.  Cole allegedly encouraged Mamtek employees to "create false documentation for a nonexistent company to falsely justify fictitious expenses for the [processing plant]."  These expenses were then allegedly wired to Cole's wife and used for personal expenses "under the false pretense that she was an agent of the sham company."  The SEC is seeking financial penalties and has named Cole's wife, Nanette Cole as a relief defendant.

SEC Obtains Final Judgments Ordering More Than $135 Million in Monetary Relief in “Green” Investment Ponzi Scheme
, September 18, 2012, (Litigation Release No. 22483)

Earlier this month, the US District Court for the District of Colorado "entered final judgments against Troy B. Wragg, Amanda E. Knorr, Speed of Wealth, LLC, Wayde M. McKelvy, and Donna M. McKelvy ordering disgorgement, prejudgment interest, and civil penalties totaling more than $135 million."  This final judgment is the result of a 2009 SEC complaint that allegedly the McKelvy's made material misrepresentations about "green" initiatives and promised investors exorbitant annual returns, sometimes in excess of a hundred percent.  The returns paid to investors were almost entirely funded by investments from new investors, according to the SEC.

SEC Obtains Asset Freeze and Other Relief in Microcap Fraud, September 17, 2012, (Litigation Release No. 22482)

On Monday, the SEC filed a complaint (PDF) alleging that Michael Borish and Michael Ciarlone -- through Freedom Financial Services, Inc. -- violated several federal securities laws including antifraud and officer certification provisions.  According to the SEC, Borish (former CEO of Freedom Financial Services, Inc.) was removed by the company's board of directors but orchestrated a scheme to remain the de facto CEO of the company.  Borish allegedly caused Freedom Financial Services to file several false or misleading reports to the SEC and in some cases to not file a report when one was required.  Furthermore, the SEC contends that Borish and Ciarlone stole corporate funds to pay personal expenses.

SEC Charges Former Systemax Director in Compensation Scheme, September 17, 2012, (Litigation Release No. 22481)

The SEC filed a complaint against Gilbert Fiorentino (former CEO of Systemax's Technology Products Group) received "over $400,000 in extra compensation directly from firms that conducted business with Systemax."  As a result of this and other alleged misappropriations, Fiorentino's compensation was under-reported to Systemax's shareholders.  Fiorentino has consented to the entry of an injunctive order penalizing him $65,000 and barring him from serving as an officer or director of a public company.  

Friday, September 14, 2012

SEC Litigation Releases: Weekly Review

SEC Charges a Solar Panel Manufacturer and Three of its Former Executives with Defrauding Investors, September 6, 2012, (Litigation Release No. 22475).

The SEC charged Worldwide Energy and Manufacturing USA Inc. (WEMU), a San Francisco based solar panel manufacturer, and WEMU executives Jimmy Wang, Mindy Wang, and Jeffrey Watson with "concealing the transfer of nearly half of the ownership stake in its Chinese subsidiary to three individuals in China who manage the subsidiary."  According to the complaint (pdf), WEMU intended to expand the subsidiary--which represented 77% of WEMU's revenue--using approximately $9 million from US investors.  However, WEMU did not disclose to its board, auditors, or investors that the company had previously signed an agreement to transfer a 49% stake in that subsidiary to its three managers.  All four defendants agreed to settle the charges for a combined $200,000 penalty and permanent officer and director bars.

SEC Shuts Down San Diego-Based Real Estate Investment Fraud Scheme, September 10, 2012, (Litigation Release No. 22476).

The SEC has frozen the assets of Western Financial Planning Corporation (WFPC) and its owner, Louis V. Schooler, alleging that WFPC sold partnership units in real estate investments in Nevada based on misrepresentations of the property's value.  WFPC and Schooler allegedly presented false comparable properties to investors and did not disclose that the partnerships were encumbered by mortgages, then "paid 'hush money' to silence investors who discovered they had been defrauded, allowing the scheme to continue."  WFPC and Schooler "raised approximately $50 million from hundreds of investors nationwide."

ICP Asset Management and Thomas C. Priore Agree to Settle SEC Charges of Defrauding Several Collateralized Debt Obligations, September 10, 2012, (Litigation Release No. 22477).

The SEC had previously alleged (pdf) that Priore and ICP caused the Triaxx CDOs "to lose tens of millions of dollars" by purchasing assets for the CDOs at inflated prices and collecting "advisory fees and undisclosed profits" based on those inflated values.  Disgorgement, prejudgment interest, and penalties for Mr. Priore, ICP Asset Management, and ICP Securities totaled approximately $23 million.  The SEC also withdrew claims against Priore, his wife Lori, and Bertrand Smyers for allegedly transferring assets out of his name upon learning of the SEC's impending charges related to the CDOs.

The Triaxx CDOs were insured by AIG through a credit protection arrangement known as a basis swap, and were acquired by the Federal Reserve in its Maiden Lane III portfolio.  They were recently sold to Bank of America Merrill Lynch.  They have also been the subject of other litigation related to ICP.  ICP and Priore were the subject of a recent NY Times article for using their database of mortgages developed for Triaxx to help investors identify problematic loans.

SEC Charges Massachusetts-Based Corporation and Senior Officers in $26 Million Fraudulent Securities Offering, September 10, 2012, (Litigation Release No. 22478).

According to the complaint (pdf), several officers of Bio Defense Corporation, "which purports to develop, manufacture and sell a machine for combating the use of dangerous biological agents through the mails," were involved in a scheme to sell unregistered securities in the US and abroad from at least 2004 through July 2010.  The SEC alleges that by mid 2008 Bio Defense's primary income was through the sales of these securities, not revenues, and that they made false claims regarding the compensation of employees and officers.  Also, the SEC alleges they used 'boiler room' promotion firms to push the securities on unwitting investors.

SEC Charges Connecticut-Based Broker for Stealing Investor Funds, September 13, 2012, (Litigation Release No. 22479).

The SEC has charged Stephen B. Blankenship and Deer Hill Financial Group, LLC of with misappropriating at least $600,000 from at least 12 customers from 2002 through November 2011.  According to the complaint (pdf), Blankenship misled investors into thinking he would invest their money through Deer Hill, and provided fake account statements to that effect, when in fact he used investor inflows to make "Ponzi-like" payments to other investors and for personal expenses.  The SEC is seeking a permanent injunction, disgorgement of ill-gotten gains with prejudgment interest, and penalties.

Two Former Officers of Sterling Financial Corp. Subsidiary Sentenced to Lengthy Prison Terms and Ordered to Pay $53 Million in Restitution for Conducting Financial Fraud, September 13, 2012, (Litigation Release No. 22480).

Joseph M. Braas and Michael J. Schlanger were officers of Equipment Finance, LLC (EFI), a wholly-owned subsidiary of Sterling Financial Corp (Sterling).  The SEC had filed a civil action (pdf) against the two in January of 2011, alleging that from February 2002 to April 2007 the two "orchestrated a pervasive and wide-ranging scheme using fraudulent underwriting and reporting practices to hide mounting losses and defaults within EFI's commercial loan portfolio from Sterling's senior management and auditors." They allegedly altered documents, manipulated accounts, and fabricated loans to sidestep Sterling's internal controls and independent auditors, and reported false information in quarterly and annual statements to the SEC.  Their actions resulted in Sterling writing off $281 million related to EFI.

Braas and Schlanger were sentenced to 15 and 20 years in federal prison, respectively, followed by five years of supervised release, and ordered to pay $53 million in restitution.  The sentence was handed down by Judge Paul S. Diamond of the US District Court for the Eastern District of Pennsylvania.

Wednesday, September 12, 2012

As New ETFs Come and Go, Big Ones Remain Big

By Tim Husson, PhD and Olivia Wang, PhD

A recent Seeking Alpha article argues that with six new ETFs coming into the market and 18 being closed or redeemed, the past August signaled the beginning of a consolidation process in the ETF industry. There are good reasons to believe the author is right: with ETF issuers rolling out more and more ETFs each month, those having failed to catch investors’ eyes quick enough are bound to disappear with the ever-intensifying competition. On the other hand, it also got us curious: what about the winners in the ETF industry? Has there also been turnover at the top?

The answer turned out to be no, at least over the past four years. The table below lists the ten largest ETFs by total assets as of September 7, 2012.* The table also includes each fund’s total assets for the previous three years. SPY, the SPDR S&P 500 ETF, has been the largest ETF by total assets in all four years. Its share of the overall ETF industry have also been relatively stable: 8.3% for September 2012, 8.4% for September 2011, 7.7% for September 2010, and 10.8% for September 2009**.

Ticker Name Total Assets (MM) Sep 2011 Sep 2010 Sep 2009
SPY  SPDR S&P 500 ETF TRUST $102,871 $88,939 $63,161 $72,585
GLD  SPDR GOLD TRUST $68,320 $71,825 $52,159 $32,606
VWO  VANGUARD MSCI EMERGING MKT $53,537 $45,437 $30,346 $11,537
EFA  ISHARES MSCI EAFE INDEX FUND $35,067 $35,440 $32,097 $33,283
QQQ  POWERSHARES QQQ NASDAQ 100 $35,025 $22,184 $15,802 $16,370
EEM  ISHARES MSCI EMERGING MKT IN $33,993 $33,496 $39,767 $30,268
IVV  ISHARES S&P 500 INDEX FUND $30,414 $26,314 $20,906 $19,814
LQD  ISHARES IBOXX INV GR CORP BD $24,121 $14,659 $14,370 $12,970
TIP  ISHARES BARCLAYS TIPS BOND $22,995 $20,658 $20,590 $15,405
VTI  VANGUARD US TOTAL STOCK  $22,488 $18,720 $13,628 $11,880

The list of the ten largest ETFs has been surprisingly stable. In fact, these ten ETFs have been the top ten funds since at least 2010 (though the order did switch from time to time). The 2009 top ten list was only slightly different from those in the latter years with IWM, the iShares Russell 2000 in the 9th position and VWO having not made the list yet. The combined total assets of the top ten ETFs at any given time in terms of the overall ETF industry are again amazingly stable: 34.7% for 2012, 35.6% for 2011, 37.0% for 2010, and 38.1% for 2009. It seems that as investors have poured money into the fast-expanding ETF industry, the largest ETFs never lost favor.



*: Source: Bloomberg LP.
**: We here use data as of September 7 of each year.  


Tuesday, September 11, 2012

ETFs: Easy Come, Easy Go

By Tim Husson, PhD

Last month we pointed out a growing number of ETF closures across a variety of issuers.  Hot on their heels, several issuers announced new ETF issuances offering a wide variety of strategies, including many actively managed ETFs, which seem to be all the rage these days.

UBS recently announced (pdf) that it would redeem 12 of its 13 volatility-linked ETNs on September 12.  These twelve funds are actually six pairs of 1x long and 1x inverse notes linked to the performance of VIX futures portfolios with constant weighted average maturities of 1-6 months.  These funds were first issued in September 2011, but did not attract the same level of investor inflows as older products.* Hot on their heels, First Trust has issued a new volatility ETF (VIXH) that combines S&P 500 exposure with a small allocation to VIX options.

Clearly, the ETF marketplace is evolving very quickly.  Issuers seem to be trying out a wide array of different strategies and implementations, and quickly shuttering any products that do not take off.  As we have discussed before, liquidation risk can be significant as investors may not be able to receive the full value of their holdings as of a certain date.  Also, it remains unclear if the more innovative ETFs and ETNs are suitable for all retail investors, since those products are often linked to derivatives positions which would otherwise be unsuitable for many unsophisticated investors.  In any case, it will be interesting to see which products survive in the long run.


* There have been rumors that UBS is planning leveraged versions of these six strategies.

Friday, September 7, 2012

SEC Litigation Releases: Weekly Review

SEC Files Settled Insider Trading Action Against Pharmaceutical Company Executive and His Father-In-Law,  September 6, 2012, (Litigation Release No. 22474).

On September 6, 2012, the SEC filed a civil injunctive action against APP Pharmaceuticals, Inc.'s former Director of Contract Marketing, Arthur H. Reed, as well as Reed's father-in-law, Allan F. Derusha. According to the complaint (opens to PDF),the pair engaged in "insider trading and/or tipping in advance of APP's July 7, 2008 public announcement that it was being acquired by Fresenius SE." In total, the pair allegedly reaped over $430,000 in illegal profits. Reed has consented to a final judgment enjoining him from violating sections of the Exchange Act and he has agreed to pay over $405,000 in disgorgement, prejudgment interest, and penalties. Derusha has consented to a final judgment enjoining him from violating sections of the Exchange Act and he has agreed to pay over $258,000 in disgorgement, prejudgment interest, and penalties.

SEC Charges Public Relations Executive with Insider Trading in Client's Stock,  September 6, 2012, (Litigation Release No. 22473).

On September 5, 2012, the SEC charged Renee White Fraser, CEO of Fraser Communications, with insider trading. According to the complaint (opens to PDF), Fraser traded with information she gained from East West Bancorp when it approached her firm "for marketing and public relations support during its acquisition of United Commercial Bank." Fraser allegedly gained over $43,000 in illegal profits. Fraser has agreed to pay over $91,000 to settle the SEC's charges and has also agreed to a permanent injunction and a permanent officer and director bar.

SEC Charges Attorney and Two Other South Florida Residents in $27.5 Million Investment Fraud,  September 6, 2012, (Litigation Release No. 22472).

 According to the complaint (opens to PDF), James C. Howard III, founder and former president of Commodities Online LLC and Commodities Online Management LLC, along with Louis N. Gallo III, the company's vice president, and Michael R. Casey, led a $27.5 million investment scheme. This scheme led "investors to believe they were purchasing securities consisting of 'pre-sold' commodities contracts with a pre-determined profit." In reality, "the majority of 'profits' allocated or distributed to investors were not profits from completed commodities transactions, but instead [were] taken from the funds of other investors." Additionally, Howard and Gallo allegedly dispersed investor funds to sham companies, stealing these funds for their own use. In 2010, Howard stepped down as president due to an arrest for an unrelated investment fraud. Casey, who then became president, misled investors about "Howard's continuing control over Commodities Online while also misrepresenting the profitability, structure, and existence of the purported commodities contracts." Gallo, who "ran an in-house 'boiler room' of telephone sales agents and a network of approximately 20...sales offices" failed to tell investors he was a convicted felon and misled them about Howard's role at Commodities Online. 

Howard, Gallo, and Casey have all been charged with violating various sections of the Securities Act and Exchange Act. Commodities Online and Commodities Online Management have been charged with violating sections of the Exchange Act. The SEC seeks disgorgement, prejudgment interest, financial penalties, and permanent injunctions against Howard, Gallo, and Casey. The complaint also names Sutton Capital LLC, J&W Trading LLC, American Financial Solutions LLC, and Minjo Corporation as relief defendants. 

SEC Charges California Man for Illegal Tips to Hedge Fund Manager,  September 5, 2012, (Litigation Release No. 22471).

According to the complaint (opens to PDF), Hyung Lim received $15,000 and stock tips for "regularly providing a fellow poker player, Danny Kuo" with insider information concerning Nvidia's quarterly earnings. Lim gained this information from a friend who worked for Nvidia over phone calls and would then immediately relay the information to Kuo. According to the complaint, Kuo, a hedge fund manager, then would illegally trade with this information and pass it on to hedge fund advisory firms Diamondback Capital Management LLC and Level Global Investors LP. In total, the hedge funds made nearly $16 million from trading the securities based on Lim's tips. Kuo and his firms were charged earlier this year by the SEC. The SEC charges Lim with violating anti-fraud provisions of the U.S. securities laws and seeks disgorgement, prejudgment interest, penalties, and permanent enjoinment from future violations as well as barring Lim from serving as officer or director of a public company. 

SEC Charges China Sky One Medical and Top Executive with Inflating Financial Results Through Phony Sales,  September 4, 2012, (Litigation Release No. 22470).

According to the complaint (opens to PDF), from 2007 through 2010 China Sky One Medical, Inc. (CSKY) and its CEO and chairman, Yan-qing Liu, conducted fraud by "recording fake sales of a weight loss product to inflate revenues in the company's financial statements by millions of dollars." CSKI purportedly created $19.8 million in phony export sales to Malaysia and devised a "purported strategic distribution agreement with Takasima Industries." In reality, Takasima allegedly purchased less than $200,000 of the slim patches in 2007, and purchased none in 2008. Furthermore, it never entered into any distribution agreement with CSKI. Allegedly, CSKI claimed its top two customers in 2007--Ningbo Yuehua International Trading Company and Guangzhou Xinghe International Trading Company--were sales agents for Takasima, when in fact "Takasima never had any relationship with these two entities." The SEC has charged CSKI and Liu with violating various sections of the Exchange Act. The SEC seeks financial penalties against CSKI and Liu, as well as disgorgement from Liu. The SEC also seeks "to have Liu reimburse CSKI for certain incentive-based compensation he received during the period affected by the fraud," to bar Liu from acting as an officer or director of a public company, and permanent enjoinments from future violations of the federal securities laws.

SEC Charges Griffin, Georgia CPA and Others with Insider Trading,  September 4, 2012, (Litigation Release Nos. 22469, 22468, 22467, 22466, and 22465).

According to the various SEC complaints, in December 2009 R. Jeffrey Rooks and Thomas D. Melvin, both Georgia based CPAs, along with Michael S. Cain, Joel C. Jinks, Peter C. Doffing, C. Roan Berry, Ashley J. Coots and Casey D. Jackson, traded with insider information regarding a pending tender offer from Sanofi-Aventis for Chattem, Inc. Melvin received this insider information from confidential conversations and meetings with an independent board member of Chattem. This board member, who was Melvin's client, met with Melvin to discuss "potential methods of ameliorating the effect of an acquisition of Chattem on his tax liability."  

All together, Rooks, Jackson, Coots and Berry have agreed to pay nearly $200,000 in disgorgement, prejudgment interest, and penalties. The SEC seeks permanent injunctions, disgorgement with prejudgment interest, and civil monetary penalties against Melvin, Cain, Jinks, and Doffing. 

Hedge Fund Manager and His Firm Ordered to Disgorge More Than $2 Million of Illicit Profits from Insider Trading Scheme,  August 31, 2012, (Litigation Release No. 22464).

On August 29, 2012, a final judgment was entered against Clay Capital Management, LLC and its former Chief Investment Officer, James F. Turner II, "for their roles in an insider trading scheme involving the securities of three companies--Moldflow Corporation, Autodesk, Inc. and Salesforce.com, Inc." Clay Capital and Turner have been ordered to pay over $2 million in disgorgement and prejudgment interest. In its August 2011 complaint, the SEC alleged that in May 2008 Turner traded with non-public information he learned  from his brother-in-law, a director at Autodesk. The complaint also alleges that in February 2008, Turner traded with inside information regarding Salesforce's performance that he learned from a close friend who was a manager at Salesforce. Additionally, Turner passed the information along to other friends and family, and "traded on the inside information in Clay Capital's hedge fund's account." In December 2011, Turner pled guilty to securities fraud in a related case, U.S. v. James Turner, was sentenced to one year in prison, and ordered to pay a $25,000 fine. 

SEC Charges Former Mississippi Investment Adviser, Now Based in Bahamas, with Fraud,  August 31, 2012, (Litigation Release No. 22463).

According to the complaint (opens to PDF), from March 2010 through August 2010, Anthony K Welch, former Chairman and CEO of eHydrogen Solutions, Inc. and ChromoCure, Inc., committed fraud by issuing false and misleading press releases. Among other things, the press releases allegedly contained false information about "technologies acquired by and revenues generated by eHydrogen and ChromoCure." The releases also "coincided with suspicious price and trading volume increases in the common stock" of both companies. The complaint "further allege[s] that in multiple instances such statements were [...] distributed by Welch for no purpose other than to incite trading activity and artificially inflate the price and trading volume" of the companies.

Thursday, September 6, 2012

Is FINRA Arbitration Constitutional?

By Paul Meyer, MA

Since 1987, when the Supreme Court upheld the mandatory arbitration provision found in brokerage customer agreements (Shearson/American Express v. McMahon - 482 U.S. 220 (1987)), most disputes between broker-dealers and their customers or employees have been adjudicated through the FINRA Dispute Resolution process. Their proceedings are not open to the public, no public record is kept, and most decisions are not explained. FINRA arbitrators come from all walks of life, although many are attorneys. Most FINRA arbitrators have little or no experience in the securities industry.

Recently a federal judge in Philadelphia ruled that a judicial-arbitration program used in the Delaware Court of Chancery is unconstitutional. She found that the arbitration process was “essentially a civil trial” and that under the First Amendment the public has a right to access the proceedings. “Public accountability encourages honesty from witnesses and reasoned decision-making by jurists.” Interestingly, she made her finding in spite of the fact the parties mutually agreed to binding arbitration. Clients of brokerage firms, by contrast, are compelled into arbitration.

In too many cases, FINRA arbitration has become “essentially a civil trial.” It is not unusual for cases to take a year or longer to be heard, nor is it uncommon for hearings to span several weeks. At the end of the process the litigants do not get a reasoned award (with rare exceptions).

Opposition to mandatory arbitration is widespread, especially among the claimants’ bar, in part because there is very little real accountability built into the FINRA arbitration process. It will be interesting to see if this judge’s view of First Amendment rights gains traction in other similar forums.

Tuesday, September 4, 2012

S&P Downgrades Illinois

By Tim Dulaney, PhD

Due to unfunded pension liabilities, S&P downgraded the state of Illinois last week.  In conjunction with this ratings action, S&P also downgraded several Illinois issuers.

As Reuters reports, this ratings action -- which downgrades Illinois' credit rating from A+ to A -- now makes Illinois the second lowest rated state (after California which is currently rated A- by Standard & Poor's).  According to S&P's credit analyst Robin Prunty
[t]he downgrade reflects the state's weak pension funding levels and lack of action on reform measures intended to improve funding levels and diminish cost pressures associated with annual contributions [...]  [t]he downgrade also reflects continued financial weakness despite significant measures in the past two years to improve structural budget performance.
These ratings downgrades will likely become more and more common as states begin to recognize the poor state of their books and especially their pension liabilities.