Friday, March 29, 2013

SEC Litigation Releases: Week in Review

SEC Charges California-Based Hedge Fund Analyst and Two Others with Insider Trading, March 26, 2013, (Litigation Release No. 22660)

Hedge fund analyst, Matthew Teeple, has been charged by the SEC for allegedly trading on material non-public information regarding Brocade Communication Systems Inc.'s 2008 acquisition of Foundry Networks, Inc. According to the SEC, Teeple received the information from Foundry's chief information officer, David Riley, and then caused the "hedge fund advisory firm where he works to buy Foundry shares in large quantities in the days leading up to the public announcement." Additionally, Teeple allegedly tipped his friend John Johnson, who also traded on the information. The SEC has charged Teeple, Riley, and Johnson with violating various sections of the Exchange Act and Securities Act and seeks disgorgement, prejudgment interest, financial penalties, and permanent enjoinment. Additionally, the SEC seeks to "permanently prohibit Riley from serving as an officer or director of a public company."

In a separate action, criminal charges have been announced against Teeple, Riley, and Johnson.

SEC Charges Del Monte Foods Company Employee with Insider Trading, March 22, 2013, (Litigation Release No. 22659)

According to the complaint (opens to PDF), vice president of finance at Del Monte Foods Company, Juan Carlos Bertini, used his mother's brokerage account to trade on insider information regarding Del Monte's acquisition by an investor group. Bertini allegedly gained over $16,000 from the illicit activity. Bertini agreed to a judgment that permanently enjoins him from future violations of the Exchange Act and orders him to pay over $49,000 in disgorgement, prejudgment interest, and penalties. Bertini has also been barred from "serving as an officer and director of a public company for a period of five years."

SEC Charges Rengan Rajaratnam with Insider Trading, March 22, 2013, (Litigation Release No. 22658)

Rajarengan "Rengan" Rajaratnam has been charged by the SEC for his alleged role in "the massive insider trading scheme spearheaded by his older brother Raj Rajaratnam and hedge fund advisory firm Galleon Management." According to the SEC, from 2006 to 2008 Rengan Rajaratnam "repeatedly received inside information from his brother and reaped more than $3 million in illicit gains for himself and hedge funds that he managed at Galleon and Sedna Capital Management." Rengan Rajaratnam also allegedly participated in "his brother's scheme to cultivate highly placed sources and extract confidential information for an unfair advantage over other traders." He traded in the securities of "Polycom, Hilton Hotels, Clearwire Corporation, Akamai Technologies, and AMD." The SEC has charged Rengan Rajaratnam with violating sections of the Exchange Act and seeks permanent enjoinment, as well as payment of disgorgement, prejudgment interest, and financial penalties. "The SEC has now charged 33 defendants in its Galleon-related enforcement actions."

In a parallel action, criminal charges have been announced against Rengan Rajaratnam.

Vendor Settles SEC Charges of Aiding and Abetting Violations by Royal Ahold, March 22, 2013, (Litigation Release No. 22657)

A final judgment was entered against Joseph Grendys, for his alleged involvement in aiding and abetting "violations of the periodic reporting, books and records, and internal controls provisions of the federal securities laws by Royal Ahold." According to the SEC's complaint, Grendys signed a "materially false audit confirmation letter" and then sent it to the company's independent auditors. "At the time, Royal Ahold was the parent company of U.S. Foodservice, Inc. Grendys owns a vendor, Koch Poultry, which supplied U.S. Foodservice with certain products." Grendys agreed to the final judgment that permanently enjoins him from violations of the Exchange Act and orders him to pay a $25,000 civil penalty.

Securities and Exchange Commission v. Timothy J. Roth, et al., March 22, 2013, (Litigation Release No. 22656)

A judgment was entered against former investment advisor, Timothy J. Roth, who allegedly "misappropriated millions of dollars from the accounts of his advisory clients." According to the SEC, Roth secretly transferred over $16 million worth of his clients' mutual fund shares to an account under his control. The judgment permanently enjoins Roth from violating "the antifraud provisions of the federal securities laws."

Roth previously pleaded guilty to "one count of mail fraud and one count of money laundering" in a parallel criminal proceeding. Roth was then sentenced "to 151 months of incarceration and was ordered to pay $16,151,964 in restitution to his victims." Because of Roth's criminal conviction and "the $16 million in restitution ordered against him, the Court has also entered an order granting the Commission's motion to dismiss its monetary claims against Roth."

Thursday, March 28, 2013

TD Ameritrade Data Suggests Retail Investors Use ETFs in 'Sophisticated Ways'

By Tim Dulaney, PhD and Tim Husson, PhD

Exchange-traded funds (ETFs) are increasingly popular among retail investors.  ETFs tend to have lower expense ratios than comparable mutual funds, and can be traded intraday like stock, giving them a comparable advantage that has proven attractive.  The number of ETF issuers has grown, and that competition has driven down prices in what has become known in the financial press as the "ETF Fee War".

TD Ameritrade has produced an infographic (PDF) that shows how their clients use ETFs, and the results are pretty interesting.  Their headline is that
At TD Ameritrade, more investors, young and old, are using ETFs in increasingly sophisticated ways.
Indeed, while 45% of ETF assets held at TD Ameritrade are stock-based, only 10% are equity, and a full 28% are in commodities and alternative investment classes, which TD Ameritrade notes is mostly precious metals.  Also, the percentage of assets held in ETFs declines with age, suggesting that ETFs are more popular among younger investors (though it could also be that older investors have accumulated more funds in other investment classes).

But perhaps the most surprising finding is that more than half of the ETF trades at TD Ameritrade were not on ETFs themselves, but options on ETFs.  Options are derivatives that give investors the right to purchase or sell an asset (such as an ETF) in the future -- we covered the basics of options contracts in a previous post.  Most of the ETFs with large total assets under management also have option markets, such as those at the CBOE.  While these markets are common (we even have a paper on ETF options), and the underlying options often quite liquid, it is surprising that such a large percentage of ETF transactions are in options contracts, especially for retail investors.

ETFs offer several advantages to investors, most notably lower-cost access to index investing strategies.  However, because they can be traded intraday and can be linked to highly complex indexes, they can be very risky choices for derivatives trades and other complex strategies. John Bogle, founder of Vanguard and champion of index investing, has been vocal recently about these and other risks of ETFs, even stating: “The ETF is like the famous Purdy shotgun that’s made over in England. It’s great for big game hunting, and it’s great for suicide.”

Wednesday, March 27, 2013

JP Morgan's New Incarnation of Non-Agency RMBS Weakens Provisions from Pre-Crisis Version

By Tim Dulaney, PhD and Tim Husson, PhD

Last week, the Wall Street Journal covered the first non-agency residential mortgage-backed security (RMBS) offering from JP Morgan since the financial crisis.  This particular RMBS is a collateralized mortgage obligation (CMO) which is "supported by 752 jumbo mortgage loans [...] made to borrowers with high credit scores and with about 35% of their own money in a down payment for the property."  JP Morgan originated nearly half of the mortgage pool (48%) and First Republic Bank originated approximately 41% of the remaining loans.

In what could be considered a product of the multitude of misrepresentations by originators and mortgage sellers leading up to the financial crisis, JP Morgan has now decided to weaken the embedded repurchase provisions of the RMBS.  Fitch specifically stated that while the
transaction benefits from strong [representation] providers, Fitch believes the value of the [Representation and Warranty] framework is significantly diluted by qualifying and conditional language that substantially reduces lender loan breach liability and the inclusion of sunsets for a number of provisions including fraud. While the agency believes that the high credit quality pool and clean diligence results mitigate the [Representation and Warranty] risks to some degree, Fitch considered the weaker framework in its expected loss estimation and credit enhancement analysis. 
For comparison, we obtained the prospectus for a similar structure issued prior to the financial crisis.  The JP Morgan Mortgage Trust 2007-S3 was a $1.83 billion CMO backed by a mortgage pool with a weighted-average-maturity of just over 23 years, a weighted-average loan-to-value ratio of about 72% and a large geographic concentration in California.  In the prospectus, JP Morgan states that the "Originator or the Seller will be obligated to purchase or substitute a similar mortgage loan for any Defective Mortgage Loan" where a "Defective Mortgage Loan" is defined as
[a]ny Mortgage Loan as to which there exists deficient documentation or as to which there has been an uncured breach of any such representation or warranty relating to the characteristics of the Mortgage Loan that materially and adversely affects the value of such Mortgage Loan or the interests of the Certificateholders in such Mortgage Loan.
On the other hand, the Kroll BondRatings report on the JP Morgan Mortgage Trust 2013-1 notes that 
The originators will only be responsible for curing loans where the Reviewer has determined that the breaches were a material factor in the loss experienced on the loan and that certain borrower events, such as a death, disability, illness, divorce or job loss, were not the cause of the loss.
So if, for example, an originator misrepresents the details of a mortgage (borrower credit score, documentation, etc.), but the borrower loses their job after the securities are issued and the loan subsequently defaults, JP Morgan would likely argue that the default was a result of the life-event and independent of the misrepresentation.  As a result, the mortgage would not be replaced in the pool and investors would be on the hook for the losses.

For ratings agencies views on this deal, here is the announcement from Kroll, as well as a similar announcement from DBRS.  The full Kroll report can be found here (PDF) and the Fitch report is available here (PDF).  Matt Levine of Dealbreaker has additional commentary on this subject.

Tuesday, March 26, 2013

SPIVA Scorecard Year-End 2012

By Tim Dulaney, PhD and Tim Husson, PhD

S&P Dow Jones Indices recently released their year-end 2012 report comparing the performance of actively managed mutual funds against their benchmark indices (we covered the year-end 2011 report previously).  The S&P Indices Versus Active Funds (SPIVA) Scorecard once again shows that, for the most part, mutual funds tend to underperform their benchmarks:
The year 2012 marked the return of the double digit gains across all the domestic and global equity benchmark indices. The gains passive indices made did not, however, translate into active management, as most active managers in all categories except large-cap growth and real estate funds underperformed their respective benchmarks in 2012. Performance lagged behind the benchmark indices for 63.25% of large-cap funds, 80.45% of mid-cap funds and 66.5% of small cap funds.
On the other hand, the scorecards states that small cap funds "continue to outperform the benchmark regardless of the period being measured, indicating that active management opportunities are still present in this space."

Moreover, the SPIVA scorecard was not confined to the equity markets.  Within the fixed income universe, the report finds the although many fixed income funds outperformed their benchmark in 2012 -- for example, only 21.8% of "Global Income Funds" were outperformed by their benchmark -- when the investment horizon is increased to three or even five years these funds begin to exhibit characteristics more in line with their equity counterparts.  The only category to consistently outperform their benchmark using a five-year horizon is the "Investment-Grade Intermediate Funds" which have the Barclays Intermediate Government/Credit index as their benchmark.

The general inability of managers to consistently outperform their benchmarks is likely related to the results of another S&P study that we recently covered.  That study showed that high performing funds tend not to maintain that performance for long.  Since active funds not only underperform their benchmarks but cannot maintain overperformance, the value of relatively high-cost active strategies could be considered suspect.   As issuers continue to make low-cost ETF clones of their relatively high-cost mutual funds, investors may want to consider these alternatives.

Interestingly, CalPERS, one of the largest pension funds in the US, has recently indicated that it may be moving to a passive-only investment strategy, a strategy consistent with the SPIVA results.  That article also points to an increase in the percentage of ETF and mutual fund assets that are now considered passively managed, though active funds are still some 72% of the market.

Friday, March 22, 2013

SEC Litigation Releases: Week in Review

Fake Hedge Fund Manager Sentenced to 40 Months in Prison, March 20, 2013, (Litigation Release No. 22655)

Andrey C. Hicks was sentenced to "40 months in prison in connection with criminal charges...[of] committing wire fraud, attempting to commit wire fraud, and aiding and abetting wire fraud." Hicks was also "ordered to pay $2.3 million in restitution." In 2011, the SEC charged Hicks and his investment advisory firm, Locust Offshore Management, LLC, "with misleading prospective investors about their supposed quantitative hedge fund and diverting investor money to the money manager's personal bank account." The SEC also claimed that Hicks and his firm "made misrepresentations about [Hick's] education, work experience, and the hedge fund's auditor, prime broker/custodian, and corporate status when soliciting individuals to invest in the purported hedge fund, called Locust Offshore Fund, Ltd." Final judgments were entered against Hicks and Locust Offshore Management in 2012 ordering them to pay jointly and severally over $2.5 million in disgorgement and prejudgment interest and over $5 million in civil penalties. Hicks was also barred from associating with "an investment adviser, broker, dealer, municipal securities dealer, municipal advisor, transfer agent, or national recognized statistical rating organization" and Locust Offshore Management was barred from "acting as an investment adviser."

SEC Settles with Matthew Proudfoot and Laurie Vrvilo in Gold Mining Offering Fraud Case, March 20, 2013, (Litigation Release No. 22654)

Final judgments were entered against Matthew Dale Proudfoot and Laurie Anne Vrvilo for their alleged involvement in "a gold mine investment scheme" in which they "falsely promised investors whopping returns from a gold mining operation while investors' money was actually spent on family cars, jewelry, vacations, and vitamin supplements." The original complaint charged Harry Dean Proudfoot III along with his children, Matthew Proudfoot and Laurie Vrvilo, with raising "$2.7 million from...investors...through their...company 3 Eagles Research & Development LLC." The complaint also charged Dennis Bukantis with selling securities "as an unregistered broker." Matthew and Laurie agreed to a final judgment that includes permanent injunctions, and holds them "jointly and severally liable for the disgorgement of the approximately $2.72 million" plus prejudgment interest. The case is still pending against 3 Eagles, Harry Proudfoot, and Dennis Bukantis.

California Hedge Fund Manager Agrees to $1.8 Million Settlement in Galleon-Related Insider Trading Case, March 20, 2013, (Litigation Release No. 22653)

A final judgment has been entered approving "a $1.8 million settlement between the SEC and hedge fund manager Douglas F. Whitman and his firm Whitman Capital." In its original complaint, the SEC charged Whitman and Whitman Capital with trading on insider information "perpetrated by Raj Rajaratnam of Gallon Management and other hedge fund managers." Whitman was tipped by his neighbor, Roomy Khan (an associate of Rajaratnam's) concerning "details about Polycom Inc.'s fourth quarter 2005 earnings and Google Inc.'s second quarter 2007 earnings." Hedge funds that were managed by Whitman Capital gained over $900,000 in illicit profits. Last August, Whitman was convicted in a parallel criminal case "of two counts of conspiracy to commit securities fraud and two counts of securities fraud," sentenced to two years in prison, and ordered to "pay forfeiture of $935,306, and a $250,000 criminal fine." The final judgment in connection with the SEC's complaint permanently enjoins the defendants from future violations of the Securities Act and Exchange Act and "requires Whitman and Whitman Capital to jointly and severally disgorge $935,306, and orders Whitman to pay a civil penalty in the amount of $935,306." Whitman has also been barred from the securities industry.

Securities and Exchange Commission v. E-Monee.com, Inc. et al., March 19, 2013, (Litigation Release No. 22651)

The SEC has charged E-Monee.com, Inc, its president, Estuardo Benavides, and one of its directors and licensed attorney, Robert B. Cook, "for offering shares in E-Monee to investors under the false pretense that the company owned Mexican bonds worth billions of dollars." According to the complaint, "the Mexican bonds the company owned, in reality, were essentially worthless and there was no valid basis for the claims by Benavides and Cook that E-Monee’s shares would substantially increase in value." The defendants have been charged with violating sections of the Securities Act and the SEC seeks permanent injunctions and civil penalties against them, as well as penny stock bars against Benavides and Cook.
 
Defendant in SEC Enforcement Action Sentenced to Over Seven Years in Prison and Ordered to Pay Over $3 Million, March 19, 2013, (Litigation Release No. 22652)

Former investment advisor, Gary J. Martel, was sentenced to "eighty-seven months imprisonment plus three years of supervised release, and ordered...to pay restitution in the amount of $3,274,031.41." Martel previously pled guilty to "three counts of mail fraud and to wire fraud." Last June, the SEC charged Martel, "who conducted business under the names Martel Financial Group and MFG Funding," with having investors invest in fictitious bonds and investment pools, and using investors' funds for purposes other than he promised "including making payments to earlier investors." The SEC barred Martel from the securities industry and a final judgment was entered against him ordering him to pay over $7.21 million in disgorgement, prejudgment interest, and civil penalties.

Securities and Exchange Commission v. Sigma Capital Management, LLC et al., March 19, 2013, (Litigation Release No. 22650)

According to the complaint (opens to PDF), Sigma Capital Management along with "several hedge fund managers and analysts including Jon Horvath, a former analyst at Sigma Capital," were involved in an insider trading scheme regarding the quarterly earnings of Dell and Nvidia Corporation. The complaint alleges that Sigma Capital gained $6.425 million in illicit profits from the insider trading. Sigma Capital has agreed to pay almost $14 million in disgorgement, prejudgment interest, and penalties to settle the charges. The SEC has named two affiliated hedge funds, Sigma Capital Associates and S.A.C. Select Fund, as relief defendants.

Massachusetts Federal Court Enters Judgments Against Two Defendants Charged in Investment Frauds, March 19, 2013, (Litigation Release No. 22649)

According to the complaint (opens to PDF), 211 Ventures, LLC "purported to offer direct investments in fraudulent and non-existent trading programs, promising high returns and guarantees against loss" and Anderson "offered investors fictitious trading programs through an entity called E-Trust, based on gold or precious metals, medium term notes, or other assets, and received investor funds that he used for his personal gain." The defendants have been ordered to pay over $2.3 million combined in disgorgement, prejudgment interest, and civil penalties, and are permanently enjoined from future violations of the securities laws. The SEC's complaint also charged 211 Ventures' owners, Diane Glatfelter and Robert Rice, and K2 Unlimited, Inc. "of which Glatfelter is sole shareholder." The action against these three defendants remains pending.

SEC Obtains Asset Freeze Against Massachusetts-Based Investment Adviser Stealing Money from Clients, March 19, 2013, (Litigation Release No. 22648)

According to the complaint (opens to PDF), Gregg D. Caplitz and Insight Onsite Strategic Management "raised at least $1.1 million from clients that was used for purposes other than investing in the hedge fund they purported to manage." Investor funds were instead transferred to "Rosalind Herman, his friend who works at the firm. Investor funds also were transferred to her sons Brad and Brian Herman, daughter-in-law Charlene Herman, and a company called Knew Finance Experts." Investor funds were then used to pay personal expenses. An asset freezewas granted against Caplitz and Insight Onsite Strategic Management. The SEC has charged the defendants with violating various sections of the securities laws and seeks permanent injunction, disgorgement, prejudgment interest, and penalties. The SEC named the four Hermans and Knew Finance Experts as relief defendants and seeks disgorgement and prejudgment interest against them.

Securities and Exchange Commission v. CR Intrinsic Investors, LLC et al., March 18, 2013, (Litigation Release No. 22647)

According to the complaint (opens to PDF), CR Intrinsic Investors engaged in insider trading "involving a clinical trial for an Alzheimer's drug being jointly developed by" Elan Corporation and Wyeth. One of CR Intrinsic's portfolio managers, Mathew Martoma, "illegally obtained confidential details about the clinical trial from Dr. Sidney Gilman, who was selected by the pharmaceutical companies...to present the final drug trial results to the public." In an amended complaint, the SEC added "investment advisory firm S.A.C. Capital Advisors, LLC and hedge funds CR Intrinsic Investments, LLC, S.A.C. Capital Associates, LLC, S.A.C. International Equities, LLC, and S.A.C. Select Fund, LLC as relief defendants." CR Intrinsic has agreed to pay over $600 million in disgorgement, prejudgment interest, and penalties to settle the charges. "The settlement filed in federal court in Manhattan is the largest ever in an insider trading case."

Former Mercury Interactive General Counsel Settles Suit Alleging Stock Options Backdating and Other Misconduct, March 15, 2013, (Litigation Release No. 22646)

The SEC settled charges with Susan Skaer, former "General Counsel and Secretary of Mercury Interactive Corporation," that arose "from an alleged scheme to backdate stock option grants and from other alleged misconduct." Along with other senior Mecury officers, Skaer allegedly perpetrated a scheme "to award Mercury executives and other employees undisclosed, secret compensation by backdating stock option grants and failing to record hundreds of millions of dollars of compensation expense." Skaer agreed to a final judgment that enjoins her from future violations of the securities laws and orders her to pay over $850,000 in disgorgement and penalties. She has also been suspended from appearing or practicing before the Commission as an attorney. "The settlement with Skaer, if approved, will conclude the litigation."

SEC Charges San Diego Lawyers and Others in an International Market Manipulation Scheme, March 15, 2013, (Litigation Release No. 22645)

According to the complaint (opens to PDF), "stock promoters John Kirk, Benjamin Kirk, Dylan Boyle, James Hinton, and their associates, used false and misleading promotions to pump up trading in the stock'" of Pacific Blue Energy Corporation and Tradeshow Marketing Company Ltd. "and made millions when they secretly dumped their own shares." The promoters used two websites they controlled, Skymark Research and Emerging Stock Report, to send investors "false and misleading emails about the companies." They also used "'boiler room' sales calls to tout the stocks, falsely claiming that the recommendations were based on independent research by Skymark and Emerging Stock Report." According to the SEC, attorneys Luis Carrillo and Wade Huettel "helped the promoters conceal their ownership interests in the companies, drafted misleading public filings, and provided misleading legal opinions." Their law firm, Carrillo Huettel LLP in turn received "proceeds of stock sales in the form of a sham 'loan.'" Furthmore, the SEC claims that "Gibraltar Global Securities, a Bahamian broker-dealer, provided false affidavits and misleading statements that allowed Benjamin Kirk to secretly sell shares of the companies he was promoting." Warren Davis, Gibraltar's president, allegedly signed "misleading representations on behalf of Gibraltar." According to the complaint, "Tradeshow president Luniel de Beer, who served as chairman of Pacific Blue, received more than $330,000 in secret kickbacks for his part in the scheme." de Beer and Pacific Blue President Joel Franklin, also allegedly made "misleading representations and facilitated the promoters' stock sales."
All defendants have been charged with violating various provisions of the securities laws and the SEC seeks disgorgement and prejudgment interest from all the defendants, and penny stock and officer and director bars against Carrillo, Huettel, de Beer, John Kirk, Benjamin Kirk, Boyle, and Hinton. "The SEC also seeks civil monetary penalties from Carrillo Huettel LLP, Carrillo, Huettel, and de Beer."

Court Enters Final Judgment Against Defendants, March 14, 2013, (Litigation Release No. 22633a)

Final judgments were entered against J.C. Reed & Company and Barron A. Mathis. According to the SEC's 2008 complaint, "John C. Reed, the founder of JC Parent and JC Advisory, and Mathis facilitated the offer and sale of more than $11 million of JC Parent stock in unregistered transactions." The defendants also allegedly made false and misleading statements to investors and "JC Advisory used JC Parent’s inflated stock values to falsely report assets under management as JC Advisory’s basis for registration with the Commission and on reports filed with the Commission." The final judgment holds Mathis and JC Parent liable for over $30.8 million combined in disgorgement, prejudgment interest, and civil penalties. Mathis has also been enjoined from future violations of the securities laws.

SEC Charges Edmund E. Wilson and Walter L. Ross with Violations of the Federal Securities Laws, March 14, 2013, (Litigation Release No. 22644)

According to the complaint (opens to PDF), Edmund E. Wilson and Walter L. Ross "raised approximately $11 million from at least 60 investors through the fraudulent and unregistered sale of securities in Fountain Group." Investors' funds were then transferred to "other entities [Wilson] owned and controlled where the funds were spent on expenses related to those businesses" and Wilson's personal expenses. The SEC has charged Wilson and Ross with violating sections of the Securities Act and Exchange Act and seeks "a permanent injunction as well as disgorgement, prejudgment interest and a civil penalty from Wilson and Ross."

Wednesday, March 20, 2013

US Supreme Court Rules on Class Action Fairness Act

By Tim Dulaney, PhD and Tim Husson, PhD

Yesterday, Justice Breyer delivered the unanimous US Supreme Court decision (PDF) in the matter of "The Standard Fire Insurance Co. v. Greg Knowles."  The decision could be significant for investors involved in securities class action suits, which often involve specific claims as to the total damage suffered by class members.  In particular, it will likely mean that more of those cases will be handled by federal rather than state courts.

The case revolved around a particular section of the Class Action Fairness Act (CAFA) of 2005 (PDF) that states "[t]he district courts shall have original jurisdiction of any civil action in which the matter in controversy exceeds the sum or value of $5,000,000, exclusive of interest and costs".   The purpose of this act was to "restore the intent of the framers of the United States Constitution by providing for Federal court consideration of interstate cases of national importance under diversity jurisdiction."

The respondent Knowles made a stipulation to the Arkansas state court that a proposed class action against Standard Fire Insurance Company would seek less than $5 million in damages.  The important point here is the time of the stipulation (which is binding for the party that makes it).  The class was in the pre-certification stage and "a plaintiff who files a proposed class action cannot legally bind members of the proposed class before the class is certified".  Since Knowles could not have known what the total damages would be prior to class certification, this stipulation essentially ties the hands of members of a class that hadn't yet been defined.  In fact, the District Court subsequently "found that [the] resulting sum would have exceeded $5 million but for the stipulation".

The decision will likely make it harder for plaintiffs to use state courts over federal courts by subdividing classes into smaller portions that meet the CAFA jurisdictional threshold.  Traditionally, some state courts have been more favorable to certain types of complaints than federal courts, allowing a certain degree of flexibility in choosing a venue for a particular claim; indeed, this variability was a motivation for the CAFA in the first place.  The new ruling will likely limit that flexibility, meaning potential class action claims must meet the potentially higher standards of federal courts.

Law360 has had extensive coverage of this ruling.  They note that "[t]he case came with high stakes for defendants that prefer to see class actions play out in federal court."  On the other hand, they point out that this decision will likely lead to plaintiff claims that are not artificially capped to remain in state courts, and that potential class members may also benefit from having their potential damage claims reduced by plaintiffs' lawyers making decisions based solely upon jurisdictional outcomes.

Monday, March 18, 2013

Barclays' Structured Product Linked to a Basket of ETFs and Indexes

By Tim Dulaney, PhD and Tim Husson, PhD

RISK.net recently posted an article entitled "IWM urges investors to think about risk-adjusted returns" in the structured products portion of their website.  The article describes in detail a Barclays product for which Institute for Wealth Management, LLC (IWM) served as the basket selection agent.  Interestingly, the basket is composed mostly of ETFs, which have been appearing in structured products more frequently as the ETF industry itself has become more mature.  IWM's Matt Medeiros talked about the use of ETFs in structured products as a marketing feature:
So it all comes down to how it's introduced. Most investors are already familiar with ETFs, so a basket of ETFs in a protected strategy like a structured note is a relatively easy thing to introduce to them, and it's been pretty well received.
Given the description of the product, we were able to determine that the particular note is Barclays' Buffered SuperTrack Notes due February 19, 2019 (CUSIP: 06741TNZ6).*  Consistent with the description in the RISK article, the basket consists of ten ETFs (EFA, DBC, XLP, DVY, LQD, EWJ, EEM, XLV, QQQ and TIP) and two indexes -- the S&P 500 and the Russell 2000.  The largest index component is the S&P 500, at 34.5%, and the largest ETF component is the iShares MSCI EAFE Index Fund (EFA), at 9%.   The remaining components range between 3.5% and 8% of the basket.

According to the note's PPM, Barclays Capital receives $2.50 in commissions and  IWM receives $20.00 in compensation as "Basket Selection Agent" for each $1,000 note.  How is Barclays Bank PLC paying for these services?  The answer is that the investor is footing the bill.  From the pricing supplement, Barclays states that IWM's "fee is included in the original issue price of the Notes." Let's look at these notes more closely to see how Barclays prices in the fees.

The notes do not pay interest and have a 34% buffer.  This means that if the basket has decreased by less than 34% from the pricing date to the final valuation date, that investors will be owed at least their original investment.  Investors risk losing at most 66% of their investment (if the basket value decreases to zero) subject of course to Barclays ability to meet their obligations as they become due.

The payout investor's are due at maturity is dependent upon the return on the basket as shown in the figure below.
This note is equivalent to a zero coupon Barclays corporate bond with an embedded European at-the-money put option and a short European out-of-the-money (66% moneyness) put option.  Valuation of the product involves estimating the correlation as well as the volatility of the basket components.  We used three years of historical monthly returns to estimate these correlations.  For the volatility, we used the implied volatility of the longest term options for which there was reliable data available.**

We obtained a valuation of $925.57 for each $1,000 investment in this Barclays note as of the pricing date.  This value -- less than the face value net of stated fees and expenses -- implies that investors are not receiving sufficient compensation for the risk they are bearing by buying this structured product.

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*Barclays also refers to these notes as "Global Medium-Term Notes, Series A, No. E-7755."  This product is slated to be issued tomorrow (February 19, 2013).
**All of the terms were much shorter than six years and as a result this valuation can be seen as conservative (since implied volatility tends to increase with term).

Friday, March 15, 2013

SEC Litigation Releases: Week in Review

Court Orders Former Prudential Securities Broker to Pay Over $763,000 Related to Deceptive Mutual Fund Market Timing Practices, March 13, 2013, (Litigation Release No. 22643)

A final judgment was entered against Frederick J. O'Meally, a former registered representative of broker-dealer Prudential Securities Inc, for allegedly using "deceptive practices to evade blocks by mutual fund companies on his market timing trading." The judgment orders O'Meally to pay over $763,000 in disgorgement, prejudgment interest, and penalties.

SEC Shuts Down Real Estate Investment Scheme in Redondo Beach, March 12, 2013, (Litigation Release No. 22642)

According to the complaint (opens to PDF), Alvin R. Brown raised over $3 million from investors through a scheme where he "falsely promised high profits for investing in his companies that were purportedly funding commercial and residential rental properties in California and other western states." In reality, "Brown and his companies - First Choice Investment and Advanced Corporate Enterprises - instead used investor funds to make Ponzi-like payments to pre-existing investors, and Brown routinely withdrew cash for personal use." One of Brown's targeted investors included an "elderly investor suffering from a stroke and dementia." In addition to falsely promising high returns, Brown and his companies never revealed to investors that Brown "had twice filed for bankruptcy." The SEC's request for an asset freeze and temporary restraining order was granted, and Krista Freitag was appointed "as a temporary receiver over the companies." The SEC has charged the defendants with violating various sections of the Exchange Act and Securities Act and seeks "preliminary and permanent injunctions, appointment of a permanent receiver, disgorgement of ill-gotten gains with prejudgment interest, and financial penalties" against the defendants.

British Twin Brothers Agree to Pay $175,000 to Settle Microcap Pump-and-Dump Charges, March 12, 2013, (Litigation Release No. 22641)

Twin brothers Alexander John Hunter and Thomas Edward Hunter have agreed to settle charges for their alleged violation of the antifraud provisions of the securities laws. According to the SEC, when "the Hunters were just 16 years old...they began disseminating subscription-based e-mail newsletters through a pair of websites they created to tout stocks selected by a 'stock picking robot.'" This robot allegedly was a "highly sophisticated computer trading program that was the product of extensive research and development." In reality, the "Hunters were...paid to send selected penny stock ticker symbols to their subscribers, who were misled to believe that the stock 'picks' were the product of the robot." The brothers have agreed to pay a total of $175,000 in penalties to settle the charges, and have been enjoined from future violations of various sections of the Securities Act and Exchange Act.

SEC Charges Former International Paper Company Executive with Insider Trading, March 11, 2013, (Litigation Release No. 22640)

According to the complaint (opens to PDF), Michael Dale Lackey, "a former Vice-President and General Manager of International Paper Company," traded on material non-public information regarding International Paper Company's potential acquisition of Temple-Inland, Inc. He learned of the potential acquisition through "a private conversation with an International Paper Company Executive while attending a charity event." Lackey has agreed to settle the charges by agreeing to permanent enjoinment from future violations of sections of the Exchange Act, and to pay over $116,000 in disgorgement, prejudgment interest, and penalties. In addition, a five-year officer and director bar has been imposed on him.

SEC Halts "Plasma Engine" Investment Scheme Operated by John Rohner and His Nevada Companies, March 8, 2013, (Litigation Release No. 22639)

According to the complaint (opens to PDF), John P. Rohner "and his companies Inteligentry, Ltd., PlasmERG, Inc. and PTP Licensing, Ltd., have been operating a fraudulent investment scheme" by falsely telling investors "they have developed, tested and patented an operational 'plasma engine' fueled by abundant and inexpensive noble gases." In reality, these claims are false as "Rohner and his companies have never run an engine fueled by noble gases, nor have they obtained patents relating to the engine or the plasma technology." Additionally, Rohner falsely told investors he has advanced degrees from Massachusetts Institute of Technology and Harvard University. The complaint alleges that "Rohner, Inteligentry, PlasmERG, and PTP Licensing used investor funds to pay Rohner’s personal expenditures as well as business expenses."  A request for a temporary restraining order was granted "to prevent Rohner, Inteligentry, PlasmERG, and PTP Licensing from further engaging in the issuance, offer, or sale of any security in an unregistered transaction." The SEC charges the defendants with violating various provisions of the securities laws and seeks "permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest thereon, and civil monetary penalties against each defendant, and a bar prohibiting Rohner from serving as an officer or director of any public company."

Securities and Exchange Commission v. Brian R. Reiss, March 8, 2013, (Litigation Release No. 22638)

Last week, the SEC charged Brian Reiss with "fraudulently churning out baseless legal opinion letters for penny stocks through his website" 144letters.com, "without researching and evaluating the individual stock offerings." According to the SEC, Reiss "steered potential customers to his website by making bids on search terms through Google's AdWords, and then relied on a computer-generated template to draft his opinion letters within minutes absent any true analysis of the facts behind each stock offering." The SEC has charged Reiss with violating various sections of the Exchange Act and Securities Act and seeks disgorgement, prejudgment interest, financial penalties, and a penny stock bar against Reiss.

SEC Obtains Final Judgment Against Scott Kupersmith, March 7, 2013, (Litigation Release No. 22637)

A final judgment was entered against Scott I. Kupersmith for his alleged orchestration of "a 'free-riding' scheme" where he "[sold] stocks before paying for them." This scheme "allowed him to reap approximately $640,000 in illicit profits, while causing approximately $2 million in losses to the victim broker-dealers that he used to operate the scheme." The final judgment permanently enjoins Kupersmith from violating sections of the Exchange Act and Securities Act, and orders him to disgorge $650,000. In May 2012, Kupersmith plead guilty to criminal charges in a parallel criminal action, United States v. Kupersmith and was sentenced to 33 months in prison and ordered to pay over $1.7 million in restitution. In May 2012, Kupersmith also plead guilty to criminal charges in a related criminal action, State of New York v. Scott Kupersmith et al. and was "sentenced to a one-to-three year state prison term to run concurrently with the federal prison sentence and ordered to pay $684,703 in restitution, including a five-percent administration fee."

Thursday, March 14, 2013

More Trouble for Inland American Real Estate Trust

By Carmen Taveras, PhD

Inland American’s March 2012 quarterly report revealed that the company was the subject of an ongoing SEC investigation (we wrote about this here). Inland American’s 2012 annual report further disclosed that several stockholders have sued the company seeking recovery of damages (see filing here). According to the information in Inland American’s SEC filings, both the SEC investigation and the stockholder demands question Inland American’s high fees, the potential conflicts of interests between the interrelated parties in the company structure, its price transparency, and the timing and amount of distributions paid to investors.

Inland American, the largest non-traded Real Estate Investment Trust (REIT) with 794 commercial properties and $10.7 billion in real estate assets, held its estimated price per share at a constant $10 from inception in 2005 and until late 2010. This was a common practice among non-traded REITs. In fact, most non-traded REITs updated their estimate of the per share value of their common stock only after a regulatory notice from FINRA required them to do so (see here). On its December 2010 annual report Inland American reported its estimated per share value to be $8.03. On December 19, 2012, the company announced that its estimated per share value was $6.93. This estimated per share value, however, is no indication of what an investor can receive if he sells his shares. In fact, the REIT makes no guarantees that its estimate of the per share value is close to the actual market price of the common stock and provides very little information regarding how they arrived at their estimate. In fact, according to the December 2012 Direct Investment Spectrum report, the average trade price of Inland American’s common stock in the secondary market was $5.92. The true value of the common stock of Inland American is at the core of the SEC investigation and the stockholder suits.

With real estate prices plummeting since 2006 it is highly unlikely that Inland American’s real value per share remained constant until December 2010. It is more likely that Inland American’s estimated per share value did not reflect potential property impairments that occurred during the housing crisis.

The problem with Inland American and other real estate investments that do not trade on an exchange is that without the benefit of price discovery arising from active trading, any estimate of the price per share is flawed at best. Perhaps this is the reason why many non-traded REITs have had significant changes in the last few months. Some of them, like American Realty Capital Trust III, have merged successfully with publicly traded REITs (see ARCP). Others have publicly acknowledged that they have experienced difficulty raising additional common stock. TNP Strategic Retail Trust, for example, has withdrawn a proposed follow-on public offering of $900 million in common stock citing market conditions as the cause (see SEC filing here).

Wednesday, March 13, 2013

Private Equity Fund Advisers Charged with Misleading Investors about Valuation and Performance

By Tim Dulaney, PhD and Tim Husson, PhD

Earlier this week, the SEC charged Oppenheimer Asset Management (OAM) and Oppenheimer Alternative Investment Management (OAIM) with misrepresenting the performance of the Oppenheimer Global Resource Private Equity Fund I L.P. (OGR) in their marketing materials.  The SEC found that OGR's manager used his own valuation methodology to value the fund's largest investment, Cartesian Investors-A LLC ("Cartesian"), at a significant markup.  This inflated valuation led to a ten-fold increase in OGR's internal rate of return.

Cartesian is managed by Cartesian Capital Group, LLC and was formed solely to purchase shares of S.C. Fondul Proprietatea S.A. which is a "holding company set up by the Romanian government to compensate citizens whose property was seized by the communist regime."

The former Oppenheimer employees also represented that the inflated value of Cartesian was due to a third-party and that the funds held by OGR had been audited by third-party auditors when in fact Cartesian had not been.   According to the order instituting proceedings (PDF), OAIM's former employees "succeeded in raising approximately $61 million in new investments in OGR" during the period in which the misrepresentations occurred.

Oppenheimer has been ordered to pay nearly $3 million in forfeitures and penalties to settle the SEC charges as well as related charged by the Massachusetts Attorney General--some of which will be returned to two Massachusetts pension funds.

Tuesday, March 12, 2013

SEC Charges the State of Illinois for Misleading Pension Disclosures

By Tim Dulaney, PhD and Tim Husson, PhD

Yesterday, the Securities and Exchange Commission (SEC) charged the State of Illinois with misleading municipal bond investors by making inaccurate or incomplete statements concerning their statutory plan to fund the state's pension obligations.  In particular, the "SEC investigation revealed that Illinois failed to inform investors about the impact of problems with its pension funding schedule as the state offered and sold more than $2.2 billion worth of municipal bonds from 2005 to early 2009."

The statutory plan, established by the state in 1994, aimed for a 90% funding level by 2045 and had a ramp-up period in which state contributions to the plans would increase to the required annual level by 2010.  By "backload[ing] the majority of pension contributions far into the future," the schedule has left the state's pension obligations significantly underfunded.  Although the plan was meant to address the funding problems, the plan actually exasperated the situation leading to a $57 billion increase in liabilities according to the SEC order (PDF).

In addition, the SEC found that Illinois did not sufficiently disclose the effect of the "Pension Holidays" in 2006 and 2007 on the state's ability to fund the pension obligations and the state's creditworthiness.   

The SEC has found that the state of Illinois did not make sufficient efforts to disclose their ability to meet the pension obligations to municipal bond investors and as a result investors did not have a clear picture of the financial condition of the state of Illinois.  As evidence that these obligations were significant, the SEC cites the ratings downgrades in between 2010 and 2012 over Illinois' pension financing.

In 2010, the SEC charged the state of New Jersey for failing to disclose to municipal bond investors that the state's two largest pension plans--the Teacher's Pension and Annuity Fund (TPAF) and the Public Employee's Retirement System (PERS)--were inadequately funded.   Following this action, Illinois "began to implement a series of remedial measures" including retention of disclosure counsel and required review of disclosure documents by several state commission and offices as well as the pension systems themselves.

For example, while the official statements for general obligation bonds in 2006 (see for example this offering) devoted roughly 10 pages to a discussion of the pension system similar documents for 2011 general obligation bonds (see here for example) devoted over twenty.  In fact, the presence of the disclosure counsel responsible solely for this section is now prominently placed on the front page of the disclosure.

Interestingly, the adoption of the Asset Smoothing Method in 2009 masked the precipitous decline in asset value resulting from the financial crisis.  This resulted in reported funding ratios of 50.6% and 45.4% for fiscal years 2009 and 2010 while the fair value method, used in previous years, resulted in funding ratios of 38.5% and 38.3% respectively.

For more on this story, see Michael Corkery and Jeannette Neumann's article in the WSJ, Edward Siedle's article in Forbes or coverage by the Associated Press's John O'Connor.


Monday, March 11, 2013

Persistence and Mean Reversion in VIX Rolling Futures Indexes

By Tim Dulaney, PhD and Tim Husson, PhD

In our last post we followed up on Jason Voss's discussion of the Hurst exponent as a measure of persistence or mean reversion in market data.  We compared the Hurst exponents of the S&P 500 to that of the VIX index, and found that the S&P 500 is largely a random signal (Hurst exponent near 0.5) but that the VIX exhibits characteristics of a 'switching' or mean reverting signal (a Hurst exponent between 0 and 0.5).

Much has been made of VIX mean reversion in the financial blogosphere.  One idea is that if you could purchase the VIX when it is at historical lows--such as we have seen recently--then you could profit from its eventual reversion to its historical mean (a level of approximately 20).  However, the VIX isn't an investible index, so most people who want 'volatility exposure' look to VIX options, VIX futures, and increasingly to VIX exchange-traded products which essentially wrap these derivatives into a convenient package.

We have two papers on volatility exchange-traded products (PDFs here and here), and one of our main points is that these products do not behave like the VIX itself.  The details are a bit complicated, but in essence these products mimic a strategy of continuously buying and selling VIX futures.  The transaction costs involved with this strategy can significantly affect returns.  The most popular volatility exchange-traded product is an ETN known as VXX, which currently has a market cap over $1 billion.



Just looking at these two time series suggests that they exhibit different persistence properties; specifically, VXX seems persistent (downward) and VIX seems more mean reverting.  We decided to see what the Hurst exponent says about these two signals.

The underlying index that VXX tracks is known as the S&P 500 VIX Short-Term Futures Index Total Return (or SPVXSTR), which has data going back to late 2005.  If we calculate the Hurst exponent of the VIX index over this period, we obtain a similar result to what we had found before, namely that the VIX index exhibits mean reverting properties (though somewhat less so than over the longer time period previously considered):


SPVXSTR, however, exhibits persistent behavior, with a Hurst exponent of 0.60*:


These results--though limited by a relatively short time period--suggest that the VIX index has different time series properties than SPVXSTR and that using SPVXSTR to take advantage of mean reversion in the VIX may not be an effective strategy.  These results mirror those of our paper on hedging the S&P 500 with volatility products (PDF), which finds that while the VIX itself may be have useful hedging properties, volatility exchange-traded products do not.

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* We also calculated the Hurst exponent of the S&P 500 VIX Mid-Term Futures Index Total Return (SPVXMTR) and obtain a Hurst exponent of 0.61 over the same time period.

Friday, March 8, 2013

SEC Litigation Releases: Week in Review

SEC Charges Robert Crane for Market Manipulation, March 7, 2013, (Litigation Release No. 22636)

According to the complaint (opens to PDF), in 2010 Robert Crane manipulated the market of two penny stocks: Argentex Mining Corporation and ERHC Energy Inc. The complaint charges Crane with violating sections of the Securities Act and Exchange Act. A court order was entered against him that permanently enjoins him from future violations of those laws and also imposes a penny stock bar against Crane.

Securities and Exchange Commission v. M. Mark McAdams and R. Dane Freeman, Civil Action No. Civil Action No. 4:10-CV-00701-TLW (D.S.C.), March 7, 2013, (Litigation Release No. 22635)

Final judgments were entered against M. Mark McAdams and R. Dane Freeman for engaging in alleged fraud "in connection with sales of securities interests in Global Holdings." The judgment enjoins the defendants from future violations of the Securities Act and Exchange Act and orders them to pay over $4.5 million jointly and severally in disgorgement, prejudgment interest, and civil penalties.

Court Enters Final Judgment Against Arizona Resident, March 7, 2013, (Litigation Release No. 22634)

A final judgment was entered against Gerald D. Kegley for his alleged participation in a fraudulent scheme in 2010. In this alleged scheme, misrepresentations were made to investors and funds were misappropriated. The final judgment permanently enjoins Kegley from future violations of the Securities Act and Exchange Act and orders him to pay over $209,000 in disgorgement, prejudgment interest, and civil penalties.

Court Enters Final Judgment Against Defendants, March 7, 2013, (Litigation Release No. 22633)

Final judgments were entered against J.C. Reed & Company, J.C. Reed Advisory Group, and Barron A. Mathis for their participation in the alleged "offer and sale of more than $11 million of JC Parent stock in unregistered transactions." In addition, the defendants were also charged with misrepresenting and omitting facts to investors. The final judgment holds J.C. Reed & Company and J.C. Reed Advisory Group liable for over $14.9 million in disgorgement and prejudgment interest. The final judgment permanently enjoins Mathis from future violations of the securities laws and holds him liable for over $15 million in disgorgement and prejudgment interest.

Securities and Exchange Commission v. Colin McCabe (D/B/A Elite Stock Report, The Stock Profiteer, and Resource Stock Advisor), Civil Action No. 2:13-cv-00161, March 5, 2013, (Litigation Release No. 22632)

According to the complaint (opens to PDF), stock promoter Colin McCabe (who did business as "Elite Stock Report, The Stock Profiteer and Resource Stock Advisor") disseminated "false and misleading information to investors when recommending penny stocks to them." He also allegedly failed to tell his newsletter subscribers that "he was being paid substantial sums...to promote some of the same stocks he recommended to them in his other publications." Additionally, the complaint alleges that McCabe "falsely represented that Guinness Exploration Inc. had acquired a mining property well before discoveries in May 2009 turned the region into 'a red-hot area play,' when, in fact, the property was not acquired until ...November 2009. " The SEC seeks permanent enjoinment from future violations of the Exchange Act and for McCabe to pay civil penalties, disgorgement, and prejudgment interest.

SEC Charges Advisers to the RAHFCO Hedge Funds with Fraud, March 4, 2013, (Litigation Release No. 22631)

According to the complaint (opens to PDF), RAHFCO Management Group, LLC, along with its principal, Randal Kent Hansen, its sub-adviser/portfolio manager, Hudson Capital Partners Corporation, and HCP's principal, Vincent Puma, engaged in "the fraudulent offer and sale of limited partnership interests in two hedge funds -- RAHFCO Funds LP and RAHFCO Growth Fund LP." The complaint alleges that the defendants made material misrepresentations to investors and "siphoned off the invested funds for [their] own purposes." The SEC has charged the defendants with violating various provisions of the securities laws and seeks "permanent injunctions, third-tier civil penalties, disgorgement plus prejudgment interest, and other relief against all of the defendants."

SEC Charges Falcon Ridge Development, Inc. and Its President and CEO for Market Manipulation Scheme, March 1, 2013, (Litigation Release No. 22630)

According to the complaint (opens to PDF), in 2008 Falcon Ridge Development, Inc. and its President and CEO, Fred M. Montano, engaged "in a fraudulent scheme to manipulate the market for Falcon Ridge’s common stock." Montano allegedly "arranged with an individual...he believed had connections to corrupt registered representatives to generate purchases of the company’s stock in exchange for cash kickbacks." In reality, the individual was, "at all times, secretly cooperating with the FBI." The SEC seeks permanent injunctions, disgorgement, prejdugment interest, and civil penalties against the defendants, as well as penny stock and officer and director bars against Montano.

Former Officer of Massachusetts-Based LocatePlus Holdings Corporation Sentenced to 60 Months' Imprisonment for Securities Fraud, March 1, 2013, (Litigation Release No. 22629)

James C. Fields, the former chief financial officer and former chief executive officer of LocatePlus Holdings Corporation, was sentenced to 60 months' imprisonment on "28 criminal charges including securities fraud, false statements to company auditors, false statements and false certifications in SEC filings." In 2010, Fields and another former LocatePlus chief executive officer, Jon Latorella, were charged "with conspiracy to commit securities fraud for their role in a scheme to fraudulently inflate revenue at LocatePlus as well as a scheme to manipulate the stock of another company." The SEC "amended a previously-filed civil injunctive action against LocatePlus arising out of the same conduct, to add both Fields and Latorella as defendants." This action is still pending and has been stayed "until the conclusion of the criminal cases against Fields and Latorella."

Securities and Exchange Commission v. Walter Ng, Kelly Ng, Bruce Horwitz, and The Mortgage Fund, LLC, Civil Action No. C-13 0895-NC (U.S. District Court for the Northern District of California), February 28, 2013, (Litigation Release No. 22628)

Walter Ng, his son, Kelly Ng, and Bruce Horwitz have been charged with fraudulently "using the assets of a new real estate fund to rescue an older, rapidly collapsing fund." The SEC alleges that the defendants "lured investors into their real estate fund called Mortgage Fund '08 LLC by claiming it was safe and secure and would replicate the success of their earlier real estate fund, R.E. Loans LLC." However, at this time R.E. Loans "could no longer make payouts to its investors, so the Ngs funneled millions of dollars from MF08 to prop up R.E. Loans." The defendants have been charged with violating various provisions of the securities laws, and the SEC seeks "injunctive relief, disgorgement of wrongful profits, and financial penalties" against the defendants.

Securities and Exchange Commission v. Keyuan Petrochemicals, Inc. and Aichun Li, Civil Action No. 13-cv-00263 (D.D.C.), February 28, 2013, (Litigation Release No. 22627)

According to the complaint (opens to PDF), Keyuan Petrochemicals, Inc., with the aid of Keyuan's former chief financial officer, Aichun Li, failed to "disclose in its SEC filings numerous material related party transactions" and operated "an off-balance sheet cash account that was kept off the company’s books by the former Vice President of Accounting." This account was used to pay cash bonuses to senior officers, reimburse CEOs for expenses, and fund gifts for Chinese government officials. Aichun Li, allegedly "signed Keyuan’s registration statements and quarterly reports that failed to disclose material related party transactions" despite encountering "red flags that should have indicated that the company was not properly identifying or disclosing related party transactions." The defendants have been charged with violating various provisions of the securities laws. Keyuan and Li have agreed to a final judgment that permanently enjoins them from future violations of the securities laws and orders Keyuan and Li to pay a $1,000,000 and a $25,000 civil penalty, respectively. Additionally, Li has been suspended from "appearing or practicing as an accountant before the Commission with the right to apply for reinstatement after two years."

Thursday, March 7, 2013

Persistence and Mean Reversion in Market Data

By Tim Dulaney, PhD and Tim Husson, PhD

Jason Voss at the CFA Institute has recently written a very interesting series of posts on the Hurst exponent, which is "a method for detecting persistence, randomness, or mean reversion in financial markets."  The Hurst exponent measures the degree to which a signal depends on previous values--a phenomenon known as autocorrelation--and specifically whether values tend to 'switch' (e.g., high values followed by low values) or 'persist' (e.g., high values followed by other high values).  Jason discusses the interesting history of this metric and walks step-by-step through calculating a Hurst exponent for the daily returns of the S&P 500 since 1950.

A Hurst exponent of between zero and 0.5 suggests a 'switching' signal, whereas a value between 0.5 and one suggests a persistent signal (a fully random signal has a Hurst exponent of 0.5).  Jason calculates that the daily returns of the S&P 500 since 1950 are characteristic of a random signal.

We thought this was pretty darn interesting.  Specifically, we wondered what the Hurst exponent might be for signals that are often considered mean reverting, such as the CBOE Volatility Index, known as the VIX.  Mean reversion has been extensively studied in the context of the VIX, even in the academic literature.  So what does the Hurst exponent method have to say about the VIX?

We have applied the methodology of Andrew Lo and Craig MacKinlay's book "A Non-Random Walk Down Wall Street," available online in its entirely at Princeton University Press.  Specifically, we apply the non-modified rescaled range analysis in chapter 6, section 3 to the VIX between January 29, 1993 and March 1, 2013.  We chose this start date so that we could compare the results to both the S&P 500 (SPX) and the SPDR S&P 500 ETF Trust (SPY) over the same time period.

The Hurst exponent of the VIX (the beta of the linear regression shown below) is approximately 0.36 suggesting a switching signal.
Both the S&P 500 and the ETF tracking the S&P 500 have a Hurst exponent of about 0.6 suggesting a much more persistent signal than the VIX calculation above.  Here is the result for the S&P 500:
 and for the SPDR S&P 500 ETF Trust:

Jason obtained a Hurst exponent of 0.49 for the period of January 3, 1950 through November 15, 2012 indicated basically a random signal.  We reproduced his analysis and found a result of 0.478 using log returns and 0.482 using arithmetic returns (as Jason does).  Our measured Hurst exponents over the period 1993 to 2013 are indicative of a slightly more persistent signal.

Consistent with expectations, the VIX fell squarely within the "long-term switching" regime by this metric while the S&P 500 and SPY have shown characteristics of a weakly persistent signal in the last twenty years.  It would be interesting to see how the Hurst exponent changes as more data becomes available for the VIX and volatility-related ETFs.

Friday, March 1, 2013

SEC Litigation Releases: Week in Review

Defendant Adam S. Rosengard Settles SEC Charges in Penny Stock Manipulation Case, February 27, 2013, (Litigation Release No. 22626)

A final judgment was entered this Monday against Adam S. Rosengard for his alleged involvement in a stock manipulation scheme. According to the SEC's original complaint, Pawel P. Dynkowski and other defendants manipulated the price of Xtreme Motorsports of California, Inc.'s stock through "wash sales, matched orders and other manipulative trading." Rosengard then allegedly "acted as a nominee account holder in the scheme" by giving Dynkowski "access to a brokerage account for the purpose of selling shares of Xtreme Motorsports stock." Rosengard has agreed to a final judgment that permanently enjoins him from future violations of the Securities Act, orders him to pay over $186,000 in disgorgement and prejudgment interest, and imposes a penny stock bar against him. Due to Rosengard's financial condition, "no civil penalty was imposed, and part of the disgorgement obligation was waived."

SEC Charges Connecticut Hedge Fund Managers With Securities Fraud, February 26, 2013, (Litigation Release No. 22625)

According to the complaint (opens to PDF), hedge fund managers David Bryson and Bart Gutekunst, along with their advisory firm, New Stream Capital, LLC, lied to investors "about the capital structure and financial condition of their hedge fund." In addition, the complaint also charges "New Stream Capital (Cayman), Ltd., a Caymanian adviser entity affiliated with New Stream, Richard Pereira, New Stream’s former CFO, and Tara Bryson, New Stream’s former head of investor relations," for their alleged involvement in the scheme. In 2008, Bryson and Gutekunst revised "the fund’s capital structure to placate their largest investor, Gottex Fund Management Ltd., by giving Gottex and certain other preferred offshore investors priority over other investors in the event of a liquidation." However, New Stream's marketing department, led by Tara Bryson, "continue[d] to market the fund as if all investors were on the same footing." Pereira allegedly "falsified the hedge fund’s operative financial statements to conceal the March 2008 revisions to the capital structure." In March 2011, New Stream filed for bankruptcy. The defrauded investors are expected to "receive approximately 5 cents on the dollar -- substantially less than half the amount that Gottex and other investors in its preferred class are expected to receive."

All the defendants have been charged with violating various provisions of the securities laws. The complaint seeks permanent enjoinment, disgorgement, prejudgment interest, and financial penalties. Tara Bryson settled charges by agreeing to a final judgment that permanently enjoins her from future violations of the securities laws, and bars her "from associating with any investment adviser, broker-dealer, municipal securities dealer, or transfer agent."

Former StarMedia Executive Agrees to Settlement in SEC Litigation, February 26, 2013, (Litigation Release No. 22624)

A settled final judgment was entered against Peter R. Morales, former Controller and Vice President, Finance, for StarMedia Network, Inc., for his alleged involvement in misstating StarMedia's revenue for "fiscal year 2000 and the first two quarters of fiscal year 2001." Morales agreed to the final judgment, that permanently enjoins him from future violations of the securities laws and orders him to pay a civil penalty of $10,000.

Executives to be Permanently Enjoined, to Pay Civil Penalties and Disgorgement, and to Reimburse Company Pursuant to Section 304 of Sarbanes-Oxley; Former CEO/Chairman also to be Barred for Five Years from Serving as an Officer and Director of any Public Company, February 21, 2013, (Litigation Release No. 22623)

The SEC settled charges this week against Amnon Landan and Douglas Smith, former Chairman and Chief Executive Officer and former Chief Financial Officer (respectively) of Mercury Interactive, LLC. In 2007, Landan, Smith, and two other former senior Mercury officers were charged with "perpetrating a fraudulent and deceptive scheme from 1997 to 2005 to award themselves and other Mercury employees undisclosed, secret compensation by backdating stock option grants and failing to record hundreds of millions of dollars of compensation expense." Landan and Smith have both agreed to a final judgment that permanently enjoins them from violating various sections of the securities laws. Combined, they have been ordered to pay over $9.8 million in disgorgement, prejudgment interest, reimbursements to Hewlett-Packard (Mercury's parent company) and penalties. The reimbursements have been deemed partially satisfied by the defendants' prior repayment to Mercury.