Tuesday, April 30, 2013

Resurgence of Commercial Mortgage Backed Securities and Decreased Underwriting Standards

By Tim Dulaney, PhD and Tim Husson, PhD

Late last week, Reuters reported that the issuance of so-called 'large-loan' Commercial Mortgage Backed Securities (CMBS) has recently spiked and that the increase in volume may be due in part to more lenient underwriting standards.  Large-loan CMBS issuance in the first few months of 2013 has already surpassed that of 2012.

CMBSs are created by securitizing a pool of commercial mortgage loans such that an investment in a CMBS is a claim on the future cashflows from the pool of commercial mortgages. Because of the complex nature of the securitization process, investors must rely upon the due diligence of the underwriters of the underlying mortgages.  When these standards begin to slip, investors could be put at risk.

Fitch Ratings, one of the few major national ratings organizations, takes issue with the "aggressive assumptions" being made with respect to the loan underwriting.  According to Reuters, "Fitch believes the combination of unique property-level attributes, the current low interest rate environment, the prevalence of interest-only loans and aggressive income growth expectations has created a need for extra vigilance amid deteriorating underwriting standards."

Large-loan CMBS are unique in that they are backed by only a single, often very large commercial loan.  Reuters uses the example of the Morgan Stanley Capital I Trust 2013-ALTM commercial mortgage passthrough certificates.  These certificates are backed by a $160 million mortgage on a mall located 15 minutes North of Orlando, FL.  The mortgage is a twelve year mortgage with a five year interest only period with only 14% of the principal amortizing prior to maturity in 2025.  Morningstar, Kroll and Standard & Poor's all issued presale reports giving the top tranche their highest ratings.  Based on Fitch's ratings criteria, Fitch would not have given their highest rating to the top tranche.

Reuters notes that demand has been strong for these deals even though the default rate has increased for such large balance loans.  We'll be interested to see if ratings agencies simply conform to one another to retain business or stick to their guns and require stricter underwriting standards. 

Monday, April 29, 2013

Equal Weighting versus Market Capitalization Weighting

By Tim Dulaney, PhD and Tim Husson, PhD

We often hear about different stock market indexes in the same breath:  on the evening news, you might hear that 'the Dow was up half a percent, the S&P gained three quarters of a percent, the NASDAQ was down a tenth of one percent'.  While it may seem that these indexes tend to move together on most days, there are important differences between equity indexes.  The one we hear about the most is that they are composed of different stocks:  the Dow Jones Industrial Average tracks only 30 companies, whereas the S&P 500 tracks 500 and the NASDAQ tracks 100 mostly technology stocks.  But one potentially overlooked difference between these indexes is how they weight each stock in the index.

An index weighting scheme determines the rules by which weights are determined for the components of an index.  Market capitalization indexes weight components with larger market capitalization more heavily than components with relatively smaller market capitalization.  The S&P 500 is a market capitalization index that includes 500 large capitalization US equities.  Apple (AAPL) is one of the heaviest weighted components in the S&P 500 and as a result has a larger effect on the returns of the index relative to smaller constituents.

Equal weighted indexes, like the S&P 500 Equal Weight Index, simple weight each component equally.  In the case, Apple has approximately the same weight (about 0.2%) as any other constituent of the index.  S&P recently released a report (PDF) on the equal weighted index, and Exhibit 2 in the report (reproduced below) shows the difference in weight for the constituents between the equal-weighted and cap-weighted S&P 500.


This equal-weighted version of the S&P 500 has garnered significant attention since it has performed much better than the market capitalization weighted index.  In the following figure we compare an investment in the SPDR S&P 500 ETF (SPY) -- which tracks that market-capitalization weighted version -- and the Guggenheim S&P 500 Equal Weight ETF (RSP) from May 2003 to yesterday.

The investment in RSP would be worth about $2,350 while an investment in SPY would only be worth about $1,700.  It has been suggested that RSP is more aptly compared to a midcap ETF, such as the SPDR S&P MidCap 400 ETF (MDY).  MDY tracks the S&P MidCap 400 Index which is market-capitalization weighted index focused on mid-capitalization US equities.  Indeed the performance of these two investments seem to resemble one another more closely (although, statistically speaking, RSP actually exhibits a lower correlation with MDY than SPY over this time period).


A $1,000 investment in MDY would be worth about $2,600 today.  MDY has a lower expense ratio (0.25% versus 0.40% of RSP) which should explain some of RSP's underperformance.  Vanguard's MidCap ETF (VO) has also been suggested as an even lower-cost alternative to RSP.  It makes some intuitive sense that an equal-weighted large-cap ETF resembles a market-capitalization weighted mid-cap ETF since the equal-weighted index decreases the weight on the megacaps and increases the weight on the lower capitalization components.

What is clear from S&P's report is that the weighting scheme of an equity index makes a big difference.  If an equal-weighted S&P 500 were reported on the news every night, investors might have a different impression of how the stock market has been doing.

Friday, April 26, 2013

SEC Litigation Releases: Week in Review

SEC Announces Settlements with Cache Decker and David Decker in SEC V. Zufelt, April 23, 2013, (Litigation Release No. 22684)

A final judgment was entered against Cache D. Decker and David M. Decker, Jr. for their alleged involvement in "Ponzi schemes operated by Anthony C. Zufelt" through his company Zufelt, Inc. and Silver Leaf Investments, Inc. The final judgment orders the defendants to pay over $257,000 in disgorgement, prejudgment interest, and penalties, as well as permanently enjoins them from future violations of the securities laws.  The SEC's action against Zufelt is pending.

SEC Charges Bahamian Broker-Dealer and its President for Operating Illegally in the United States and Participating in an Unregistered Offering, April 23, 2013, (Litigation Release No. 22683)

According to the complaint (opens to PDF), Bahamas-based Gilbraltar Global Securities, Inc. and its president Warren A. Davis "unlawfully operat[ed] as a broker-dealer in the United States, and...participat[ed] in an illegal unregistered offering and sale of over 10 million shares of a microcap issuer, Magnum d'Or." The SEC claims that the defendants made over $11 million from this illegal activity. The SEC seeks permanent injunction as well as payment of disgorgement, interest, and civil penalties.

Securities and Exchange Commission v. Mark D. Begelman, April 22, 2013, (Litigation Release No. 22682)

A civil action has been filed against Mark D. Begelman, charging him with insider trading "for purchasing Bluegreen Corporation stock in advance of BFC Financial Corporation's announcement that it would acquire Bluegreen." Begelman, a member of the World President's Organization, learned of this information from a fellow WPO member. Begelman allegedly made almost $15,000 in illegal profits from the trading. To settle the charges, Begelman has agreed to a final judgment that permanently enjoins him from future violations of the securities laws and orders him to pay over $30,000 in disgorgement, prejudgment interest, and civil penalties. Additionally, the final judgment bars "him from serving as an officer and director of a public company for a period of five years."

Former "Teach Me to Trade" Saleswoman and Infomercial Personality Linda (Knudsen) Woolf Agrees to Settle Securities Fraud Charges and Pay a $225,000 Penalty, April 19, 2013, (Litigation Release No. 22681)

Final judgments were entered against Linda (Knudsen) Woolf and Hands On Capital, Inc. ordering them to pay a civil penalty of $225,000 and permanently enjoining them from future violations of the Exchange Act. Woolf, "who sold securities trading products and services...[including] software called 'Teach Me to Trade' to investors," allegedly made false statements to investors. Woolf claimed she had become a successful trader from using 'Teach Me to Trade' methods, when in reality she was not a successful trader. Furthermore, "Woolf sold the products and services pursuant to an independent contractor agreement between Hands On Capital and Teach Me to Trade."

Thursday, April 25, 2013

529 College Savings Plans Underperform Similar Mutual Funds -- Morningstar

By Tim Dulaney, PhD and Tim Husson, PhD

On Monday, Morningstar Fund Research issued their 2013 529 College-Savings Plans Industry Survey (PDF), which reviews the performance of the 529 industry in 2012.  Their study finds that "college savers are continuing to invest in 529 college-saving plans at an impressive clip, even though their performance has lagged that of similar funds in recent years."

529 Plans are typically run by states and are used by investors to save for future education expenses such as college tuition on a tax-advantaged basis.  Such plans allow for tax-free appreciation of invested principal and is typically allocated between several diversified mutual funds (though many plans are starting to use ETFs for similar purposes).  The allocations typically change with the age of the beneficiary, similar to target-date retirement funds, which is known in the industry as a plan's 'glide path.'

Morningstar's report finds that "over the five-year period through Jan. 31, 2013, all but one Morningstar category of 529 investment options underperformed the analogous open-end fund category on an annualized basis."  The difference was larger for bond-heavy categories than equity-heavy categories.  Morningstar attributes most of this discrepancy to expense ratios, which tend to be higher in 529 plans relative to similar mutual funds:

Source:  Morningstar, Inc. (Exhibit 9, 2011 omitted)

While these higher fees may lead to underperformance of 529 assets relative to those of comparable mutual funds, the Morningstar study did not attempt to quantify the tax benefits of 529 plans, but note that "tax benefits should theoretically make up for much--if not all--of the shortfall."  It will also be interesting to see if 529 plans that more fully adopt ETFs, which often have lower expense ratios, make up any of this difference.

Do ETFs and Mutual Funds with Higher Fees Outperform?

By Tim Husson, PhD and Olivia Wang, PhD

There was a great comment on our post about FINRA's Mutual Fund Expense Analyzer.
Is there a positive correlation between fees and gross returns? In other words, are investors who pay higher fees compensated by higher returns?
On the one hand, one might expect that in order to garner high fees, a fund would have to earn higher returns; but on the other, it may be the case that higher fees simply erode profits and yield lower total returns.

We looked at data provided by Bloomberg on all US-domiciled ETFs.  We excluded a few outliers with very low reported fees (under 0.1%) or who did not provide data on either fees or 1 year total return.  The result was 1,020 funds, plotted below:
There does not appear to be a clear relationship between returns and fees--although there seems to be a negative correlation (supporting the idea that higher fees erode returns), the R-squared value is much too low to draw any conclusions. If we separate funds into quartiles based on their 1 year total return and average fees within each quartile, we see another negative relationship:  


But again, the scatter is enormous so the relationship is unclear.

We also looked at the 16 largest mutual funds by net asset value and compared their fees calculated using FINRA's tool (subject to data availability).  We assumed for this calculation an initial investment of $1,000 held for five years, and plot the total fees and sales charges over that period against the historical 5 year annualized total return of the fund:

Again, there is no clear relationship between returns and fees.  But it is interesting to point out the cluster of funds with high fees around 1-2% return are all from a single issuer, American Funds, and the cluster of funds with low fees but similar returns are all from Vanguard.

Wednesday, April 24, 2013

ISDA Announces Market Agreed Coupon Contract for OTC Interest Rate Swaps

By Tim Dulaney, PhD and Tim Husson, PhD

The International Swaps and Derivatives Association (ISDA) just announced the publication of a standardized form for over-the-counter (OTC) interest rate swaps called the Market Agreed Coupon (MAC) contract.  The contract attempts to standardize the offering of interest rate swaps in the OTC market by specifying available tenors (1, 2, 3, 5, 7, 10, 15, 20 and 30 years), coupon increments (25 basis points), effective dates (IMM dates) and currencies (USD, EUR, GBP, JPY, CAD and AUD).

The MAC contract was developed in concert with the asset management group of the Securities Industry and Financial Markets Association (SIFMA).   The MAC contract is meant to "present another alternative to the choice between bespoke interest rate swaps and deliverable interest rate futures" as well as "reduce or eliminate time-consuming unwind processes and market inefficiencies and improve transparency associated with bid/ask spread risk" according to the SIFMA rationale (PDF).

The idea behind these new standardized contracts is that when more participants use a smaller set of terms for their swap agreements, those positions can be more easily compared to one another in a process called 'compression'.  Compression in this context refers to the practice of netting off-setting interest rate swaps, which can reduce counterparty exposure and expenses.  In February 2012, the ISDA estimated (PDF) that compression reduced the size of the interest rate swap market by approximately 30%.  Also, with a smaller set of possible contract parameters, it may be easier to aggregate market prices for interest rate swaps, significantly improving the transparency of this very large and very important derivatives market.

The introduction of the MAC contract comes on the heels of other innovations in the interest rate swap sector including exchange-traded interest rate swap futures offered by the Eris Exchange and deliverable interest rate swap futures offered by the CME Group.  These swap futures will likely garner significant interest given the decreased margin requirements associated with futures (for a discussion, see the following Risk.net article from Peter Madigan).

The MAC contract essentially offers a solution in between the conventional, highly-customizable, OTC interest rate swap and the relatively new, highly-specific, exchange-traded interest rate swap futures.  It will be very interesting to see which of these solutions is more widely adopted.

Interest rate swaps have been a frequent topic of discussion here on the blog and we're excited to witness the evolution toward increased transparency and liquidity in one of the largest over-the-counter derivative markets in existence today.

Tuesday, April 23, 2013

Why So Many REITs?

By Tim Dulaney, PhD and Tim Husson, PhD

Real estate investment trusts (or REITs) have been all over the news recently.  The value of many traded REITs has increased dramatically as the US housing market has recovered (see, for example, Vanguard's REIT ETF VNQ which is currently trading at or above pre-crisis levels).  Many mortgage REITs have been making headlines for their rapid growth and potentially adverse effects on the financial system.  And of course, non-traded REITs continue to see criticism for reasons we've highlighted before here on the blog and in a working paper.

This past weekend, the Wall Street Journal's Nathaniel Popper had an excellent story on what has been called the REIT conversion boom -- the phenomenon that many companies, from telecoms to casinos to prison operators, have been converting to REITs instead of traditional tax-paying corporations.  At this point, we think it's worth stepping back and thinking about what it means to be a REIT and how the term now incorporates a wide variety of companies and investments.

A REIT is any company that qualifies as a real estate investment trust according to the Internal Revenue Service; therefore, the term 'REIT' is fundamentally a tax designation.  The primary motivation for converting to a REIT is to enjoy their special tax status, under which the company would be subject to very little (often zero) corporate taxes.  However, to do so, the company must pay out nearly all of its annual income to shareholders in dividends, and must derive 95% of its income from real estate related operations.  What counts as real estate operations, however, has become less clear as other firms with substantial real estate holdings pursue the REIT designation.

These recent REIT conversions cloud an already complex landscape.  REITs are already divided into several subgroups depending on their line of business, such as residential, retail, industrial, etc.  These categories have expanded to include timberland, health care, storage, and other less traditional real estate operations.  Mortgage REITs, which have seen total assets rise from "$159 billion in 2009 to $450 billion as of the end of last year" according to the WSJ, invest not in actual properties but in the mortgages that finance them.  The term might be stretched even further if crowdfunded real estate becomes popular with retail investors.

Also, there is a very important distinction between REITs based on how shares can be purchased.  Traded REITs are listed on major public exchanges, trade like any other publicly listed stock, and have extensive analyst coverage and SEC filings.  Non-traded REITs can be purchased through brokers but are not listed on public exchanges.  They are required to file periodic statements with the SEC, but have far less transparency and typically far higher transaction and other costs.  Private REITs can only be purchased by accredited investors and have no public information whatsoever.

Clearly, the term REIT has come to include a very wide array of business and investors should be very careful to differentiate between them.

Monday, April 22, 2013

Are ETF Flows Costly to ETF Investors?

By Tim Dulaney, PhD and Tim Husson, PhD

Exchange-traded funds (ETFs) are often lauded for their ability to efficiently create or redeem shares in response to changes in demand for the fund (known as fund flows).  However, new research suggests that some ETFs that hold international securities may face transactional frictions that prevent them from tracking their benchmarks as well as other ETFs.

When there is an imbalance between supply and demand for an ETF, authorized participants (APs) create or redeem shares of the ETF to increase or decrease supply to match demand.  If the fund begins trading at a premium to NAV (representing excess demand), APs create shares of ETFs by delivering to the fund sponsor a basket of securities constituting one creation unit.  For a fee, the sponsor exchanges the creation unit for a specified number of shares of the ETF.  This process essentially works in reverse for a fund trading at a discount to NAV (representing excess supply).  This process serves to remove discrepancies between the market prices of ETF shares and the NAV of the fund.

As the ETF industry has evolved, it has become more difficult for some ETFs to conduct these so-called in-kind exchanges and as a result many funds are now offering cash exchanges.  In a cash exchange, the fund itself transacts the underlying securities to produce the exposure offered by the fund (as opposed to the APs). Cash exchanges are similar to the liquidity provided by open-end mutual funds and it has been shown that such short-term trading by mutual funds has a detrimental effect on the wealth of long-term investors.

Brian Henderson and Gerald Buetow have written a paper entitled "Are Flows Costly to ETF Investors?" that explores whether cash creation and redemption is costly to ETF investors.  The paper was recently accepted to the Journal of Portfolio Management and should be appearing in the next few months.

The study focuses on the daily returns of ETFs traded on US exchanges with at least $25 million in AUM, average daily turnover of at least 10% of the shares outstanding and at least six months of data (excluding commodity ETFs, leveraged ETFs and currency ETFs).   The sample consists of 330 funds that feature in-kind exchanges and 49 funds with cash exchanges.*

The study finds that fund flows (the net effect of daily creations and redemptions) can have a detrimental effect on the wealth of investors in ETFs tracking international benchmarks.  In particular, the funds that feature cash exchanges underperform their benchmark indices by almost 2% relative to in-kind funds on an annual basis.  The authors argue that a portion of the performance differential most likely results from the transaction costs shouldered by the fund due to such things as the difference in trading hours of the underlying assets and the ETF shares.

These results have important implications for the ETF market, especially for investors in ETFs that track international benchmarks, although it may be hard to avoid such frictions.
_________________________________________________
* Cash exchanges are a relatively recent innovation in ETFs and as a result their representation in the sample is relatively small.

Friday, April 19, 2013

SEC Litigation Releases: Week in Review

SEC Files Subpoena Enforcement Action Against Andrew Farmer and Iridium Capital, Ltd. for Failure To Produce Documents in Market Manipulation Investigation, April 18, 2013, (Litigation Release No. 22680)

Last week, the SEC filed a subpoena enforcement action against Andrew Farmer and Iridium Capital, Ltd. "According to the filing, the SEC is investigating possible market manipulation in connection with transactions in the securities of Chimera Energy Corporation." Subpoenas were issued last December ordering Farmer and Iridium Capital, Ltd. "to produce documents to the Commission...[including] materials related to their transactions in Chimera securities and to Chimera’s business." However, Farmer has failed to do so. The SEC is now "seeking an order from the federal district court compelling Farmer and Iridium to produce all materials responsive to the subpoenas and compelling Farmer to provide sworn testimony."

SEC Files Insider Trading Charges Against Former Trader Joseph Mancuso, April 17, 2013, (Litigation Release No. 22679)

According to the complaint (opens to PDF), Joseph Mancuso, "former proprietary trader at the registered broker-dealer Schottenfeld Group, LLC," traded on inside information ahead of the "announced acquisitions of Avaya, Inc., 3Com Corp., Axcan Pharma Inc., Hilton Hotels Corp. and Kronos Inc" in 2007. Mancuso gained this information from colleague and friend, Zvi Goffer, who allegedly learned of the acquisitions from attorneys, Arthur Cutillo and Brien Santarlas, and another former propreitary trader, Gautham Shankar. Shankar allegedly gained his insider knowledge from Thomas Hardin, "a managing director at the hedge fund adviser Lanexa Management," who in turn had been tipped by Roomy Khan, "a consultant to a New York-based investment adviser." Kahn allegedly "had received the inside information from her friend, a credit rating company analyst." According to the complaint, Goffer paid kickbacks for the inside information he received. The SEC has charged Mancuso with violating various sections of the Exchange Act and permanently enjoins him from future violations as well as orders him to pay disgorgement and prejudgment interest.

Goffer, Cutillo, Santarlas, Goldfarb, Shankar, Hardin, and other defendants were previously charged by the SEC in connection with this scheme.

Former Investment Bank Analyst and His College Friend Plead Guilty to Insider Trading Scheme, April 17, 2013, (Litigation Release No. 22678)

Jauyo "Jason" Lee and Victor Chen have pled guilty "to one count of conspiracy to commit securities fraud and one count of securities fraud for their roles in an insider trading scheme." The criminal charges "arose out of the same facts that were the subject of a civil action...the SEC filed against Lee and Chen" last September. According to the SEC, Lee, then an employee of Leerink Swann LLC, gained  information about Syneron Medical Ltd.'s acquisition of Candela Corporation and Covidien plc.'s acquisition of Somanetics Corporation from two unsuspecting coworkers. Lee then tipped Chen, and Chen made over $600,000 in illegal profits from trading on this information. Chen's sister, Jennifer Chen, has been named as a relief defendant because Chen made some of his trades using her account. The SEC has charged Lee and Chen with violating sections of the Exchange Act and seeks disgorgement, prejudgment interest, civil penalties, and permanent injunctions.

SEC Charges Two Arizona-Based Brokers with Defrauding Investors in Tankless Water Heater Venture, April 16, 2013, (Litigation Release No. 22677)

According to the complaint (opens to PDF), Jeffrey Stebbins and Corbin Jones stole "$1.8 million of investor money for their personal use and fraudulently obtained more than $6 million in stock for themselves to the detriment of investors." The funds came from a project to develop tankless water heaters. According to the SEC, Stebbins and Jones diverted almost 30 percent of the funds "they raised to pay unrelated business expenses and support their lavish lifestyles, including the lease of luxury automobiles." They also allegedly "duped certain shareholders in one of the companies, Noble Systems, to swap their private shares for publicly-traded shares in another company, Noble Innovations." This stock swap enabled "Stebbins and Jones to reap more than $6 million worth of Noble Innovations stock at the expense of these shareholders who were left with almost nothing." Furthermore, "Stebbins and Jones never reported their significant holdings in Noble Innovations as they were required to do under the securities laws." The defendants have been charged with violating sections of the Exchange Act and Securities Act. The SEC seeks an injunction, disgorgement, financial penalties, and a penny stock bar against the defendants. Additionally, the SEC revoked "registration of each class of Noble Innovations, Inc.'s securities due to the company's failure to make required periodic filings."

Former Siemens Executive Uriel Sharef Settles Bribery Charges, April 16, 2013, (Litigation Release No. 22676)

A final judgment was entered against Uriel Sharef, "a former officer and board member of Siemens Aktiengesellschaft", for his role in "Siemens' decade-long bribery scheme to retain a $1 billion government contract to produce national identity cards for Argentine citizens." The judgment orders him to pay a $275,000 civil penalty and permanently enjoins him from future violations of the securities laws.

Final Judgments Entered Against Distributor and Investment Adviser, April 16, 2013, (Litigation Release No. 22675)

Final judgments were entered by consent against Michael Bozora, Timothy Redpath, Capital Solutions Distributors, LLC and Capital Solutions Management, LP, for making "several written and oral representations to" investors in Capital Solutions Monthly Income Fund "that were materially misleading because they claimed the Fund was enjoying success and weathering disruptions in the credit and real estate markets." Bozora and Redpath, owners of Capital Solutions Distributors, LLC, allegedly "failed to make any meaningful disclosure of the default by the Fund's sole borrower, the Fund's subsequent foreclosure on the borrower's assets, and the resulting loss of any significant investment income to the Fund." Additionally, Bozora allegedly "made unsuitable recommendations for investors to purchase a note issued by CS Financing Corporation, an entity at which Bozora served as the President." The final judgment imposed permanent injunctions against the defendants and orders them to pay over $6.5 million combined in disgorgement, prejudgment interest, and penalties.

SEC Charges Former Investment Banker with Insider Trading, April 16, 2013, (Litigation Release No. 22674)

According to the complaint (opens to PDF), Richard Bruce Moore used insider information to purchase ADRs of Tomkins plc "ahead of an announcement that the Canada Pension Plan Investment Board (CPPIB) and a Canadian private equity firm had approached Tomkins with a takeover offer." Moore learned of the information through his position at Canadian Imperial Bank of Commerce. Moore allegedly gained over $163,000 in illegal profits from the insider trading. The SEC has charged Moore with violating sections of the Exchange Act. Moore consented to a final judgment that enjoins him from future violations and orders him to pay over $340,000 in disgorgement, prejudgment interest, and penalties. Moore has also agreed to be barred from associating with "any broker, dealer, investment adviser, municipal securities dealer, or transfer agent, and from participating in any penny stock offering."

The Ontario Securities Commission also announced charges against Moore "based on his trading in Tomkins common shares and his trading in a second, unrelated, stock."

Court Enters Preliminary Injunction Against Inter Reef d/b/a Profitable Sunrise and Extends Asset Freeze Order, April 16, 2013, (Litigation Release No. 22673)

This week a preliminary injunction was entered against Inter Reef, Ltd. dba Profitable Sunrise as well as four Czech companies, Melland Company S.R.O., Color Shock S.R.O., Solutions Company S.R.O. and Fortuna-K S.R.O. According to the SEC's original complaint (opens to PDF), Inter Reef, Ltd. "operated a fraudulent securities offering over the internet under the name of Profitable Sunrise that has been targeted towards investors in the United States." The four Czech companies received funds from investors "at the direction of Profitable Sunrise." The court found that the SEC has "established a prima facie case that Inter Reef had violated" various sections of the securities laws and has "continued its freeze on the assets of Inter Reef and the relief defendants."

SEC Charges Parker Drilling Company with Violating the Foreign Corrupt Practices Act, April 16, 2013, (Litigation Release No. 22672)

According to the complaint (opens to PDF), Parker Drilling Company violated the Foreign Corrupt Practices Act by authorizing  payments "to a Nigerian agent totaling $1.25 million...despite former senior executives knowing that the agent intended to use the funds to 'entertain' Nigerian officials involved in resolving Parker Drilling's ongoing customs problems." After the Nigerian agent finished his work, Parker Drilling "received an unexplained $3,050,000 reduction of a previously assessed customs fine, and the company was permitted to nationalize and sell its Nigerian rigs."

Parker Drilling has agreed to pay over $4 million in disgorgement and prejudgment interest to settle the charges and has agreed to a final judgment that permanently enjoins it from future violations of the Exchange Act. In parallel criminal proceedings, the company agreed to pay an $11,760,000 penalty.

SEC Charges Former Rochdale Securities Broker for Rogue Trades, April 15, 2013, (Litigation Release No. 22671)

According to the complaint (opens to PDF), David Miller, institutional sales trader at Rochdale Securities LLC, "concocted a scheme to personally profit from placing a series of unauthorized orders to buy a total of more than 1.6 million shares of Apple, Inc. stock on October 25, 2012." After receiving an order to buy 1,625 shares of Apple from a customer, Miller "instead entered a series of orders to purchase a total of 1,625,000 shares." If Apple's stock increased, Miller planned to share in the customer's profit from selling the shares later that day. However, if Apple's stock decreased, "Miller planned to claim that he inadvertently misinterpreted the size of the customer's order, and planned for Rochdale to take responsibility for the unauthorized purchase and suffer the losses." Apple's price fell, "the customer denied buying all but 1,625 Apple shares, and, as Miller planned, Rochdale took responsibility for the unauthorized purchase." This resulted in a $5.3 million loss for Rochdale and caused "Rochdale's available liquid assets to fall below limits required by SEC rules applicable to broker-dealers." Consequently, "Rochdale effectively ceased operations shortly thereafter." The SEC has charged Miller with violating sections of the Securities Act and Exchange Act and seeks a permanent injunction as well as a civil penalty. Miller has agreed to be barred from "any future association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization, and to be barred from participating in any offering of penny stock."

Miller pled guilty in a parallel criminal proceeding to "one count of conspiracy to commit securities and wire fraud and one count of wire fraud."

SEC Charges Former KPMG Partner and Friend with Insider Trading, April 11, 2013, (Litigation Release No. 22670)

According to the complaint (opens to PDF), Scott London, the former partner in charge of KPMG's Pacific Southwest audit practice, tipped his friend, Bryan Shaw, "with confidential details about five KPMG audit clients and enabled Shaw to make more than $1.2 million in illicit profits trading ahead of earnings or merger announcements." In exchange for the tips, "Shaw paid London at least $50,000 in cash that was usually delivered in bags outside of his Encino, Calif. jewelry store...[and] also gave London an expensive Rolex watch as well as other jewelry, meals, and tickets to entertainment events." London recently informed KPMG, his employer for nearly 30 years, "that he was under investigation by the SEC and criminal authorities for insider trading in the securities of several KPMG clients.  The firm immediately terminated him." The SEC has charged London and Shaw with violating sections of the Exchange Act and seeks permanent enjoinment as well as payment of disgorgement, prejudgment interest, and financial penalties.

Thursday, April 18, 2013

Taking the Teeth out of the STOCK Act

By Tim Dulaney, PhD and Tim Husson, PhD

NPR reported earlier this week that Congress has quietly overhauled important provisions of the STOCK Act (PDF).  For those that don't know, the STOCK ("Stop Trading on Congressional Knowledge") Act was signed into law in April 2012 and sought to prevent "Members of Congress and employees of Congress from using nonpublic information derived from their official positions for personal benefit, and for other purposes."

The STOCK Act was supposed to prevent Members and Congressional staff from trading on insider-information by (1) increasing transparency through open public access on official websites of financial disclosures, (2) supplementing ethics requirements thorough bans special IPO access, pension forfeiture for corrupt members, and other measures, and  (3) "expressly affirm[ing] that Members of Congress and staff are not exempt from the insider trading prohibitions of federal securities laws."

However, on Monday the provision which sought to increase transparency was nullified in a matter of seconds, without debate or vote, through unanimous consent.  Now the records will be stored--on paper--in the basement of the Cannon House Office Building and searchable only in the most inefficient manner.  The reasoning for this nullification was based upon a report by the National Academy of Public Administration that found "online financial disclosure requirement can harm both federal agency missions and employees."

While some were concerned about the privacy of federal employees -- notably, the ACLU filed a lawsuit on their behalf that was later dismissed without prejudice according to documents available on LexisNexis -- most saw the STOCK Act as a major step in the fight against insider-trading by federal employees.  Its revision will make it much harder to identify potential conflicts of interest and other financial improprieties by government employees.

Wednesday, April 17, 2013

FINRA Fines Merrill Lynch for Failing to Provide Best Execution to Customers

By Tim Dulaney, PhD and Tim Husson, PhD

FINRA announced yesterday that it has fined Merrill Lynch more than one million dollars "for failing to provide best execution in certain customer transactions involving non-convertible preferred securities executed on one of its proprietary order management systems (ML BondMarket)" as well as inadequate supervision.

FINRA's Department of Market Regulation found what amounts to a systematic issue in the ML BondMarket software that prevented customer orders from being evaluated at the most favorable price.  The software only considered the price quotations published on the primary exchange for non-convertible preferred securities, effectively ignoring any better quotations from other exchanges.  FINRA identified over 12,000 transactions between 2006 and 2010 in which users of the ML BondMarket system were harmed by this issue.  The customers involved in these transactions lost almost $325,000 as a result of the programming problem and Merrill Lynch has been ordered to repay this amount plus interest.

FINRA notes that Merrill Lynch failed to "perform any post-execution review of non-convertible preferred transactions" conducted on the automated ML BondMarket software.  FINRA fined Merrill Lynch $650,000 for best execution violations and $400,000 for supervision violations.  Merrill Lynch's neither admitted or denied the findings (PDF) but accepted the fine to settle the matter.

A representative of Bank of America noted that this "matter, which pre-dated Bank of America’s acquisition of Merrill Lynch, was caused by a processing issue that has been corrected".  It is unclear how much weight such statements will have on restoring confidence in the ML BondMarket software.

Tuesday, April 16, 2013

New Study Comparing Indexed and Actively Managed Funds

By Tim Dulaney, PhD and Tim Husson, PhD

NerdWallet, a San Francisco based personal investing site, has performed a historical study of the returns on almost 8,000 mutual funds and ETFs over a ten year period and found that passive indexed funds tend to outperform actively managed funds on average.  In fact, they found that only 24% of actively managed funds outperformed the average return of the indexed funds.  These results are consistent with the annual SPIVA Scorecard produced by S&P Dow Jones Indices, which found in both 2012 and 2011 that mutual funds tend to have lower returns than their benchmarks.*

Interestingly, NerdWallet also found that before fees the actively managed funds did have higher returns over the period, but that they "charge more in fees than the value they create."  They also found that actively managed funds had lower risk (as measured by the annualized volatility of quarterly returns), and that the risk-adjusted returns of passive and active funds were, on average, nearly the same.**

SOURCE:  NerdWallet

The study also notes that they restricted their sample to the 7,943 mutual funds and ETFs available to US investors for the entire 10 year period between January 1, 2002 and December 31, 2012.  This leads to a selection bias because funds that failed during that period--which presumably realized low returns--are excluded.  In their words, "this survivorship bias implies that index fund returns are even more superior to active fund returns than the numbers indicate," though it is not necessarily the case the more actively managed funds failed with low returns than indexed funds.  This analysis also excludes any fund with an inception date after January 1, 2002, and therefore excludes most ETFs.

While these results are more superficial than those of the SPIVA analysis, this study contributes to growing sentiment that active management may not be preferable to passive index investing.  Indeed, even CalPERS, one of the largest pension funds in the US, may be switching its entire $255 billion portfolio to non-actively managed investments.  It will be interesting to see if this trend towards index investing will continue.
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* This study has a number of drawbacks not present in the SPIVA study, including survivorship bias and a fixed observation period.
**  Unfortunately, the study did not report the variance of its measurements nor statistical significance.

Monday, April 15, 2013

Major Tenants-in-Common Sponsor Charged with Fraud

By Tim Dulaney, PhD and Tim Husson, PhD

Four former executives of DBSI, one of the largest sponsors of tenants-in-common (TIC) interests, have been indicted on 83 counts of securities fraud, wire fraud, mail fraud, and interstate transportation of stolen property.  The indictment is seeking approximately $169 million in forfeiture of properties and assets, alleging that the executives misrepresented the financial condition of DBSI to potential investors.  The executives named were former president Douglas Swenson, general counsel Mark Ellison, and David and Jeremy Swenson (sons of Douglas Swenson) who were assistant secretaries.

TIC interests are real estate investments that became popular in the early to mid 2000s.  TICs were used as part of a 1031 exchange, whereby an investor who owned an income-generating property could exchange that property for another real estate investment (the TIC interest) and thereby defer any capital gains taxes on the sale.  TICs typically hired external property managers (sometimes affiliated with the TIC sponsor), and were marketed to investors as passive income generating properties.  TICs were sold to thousands of small investors across the country, with over $14 billion in equity investment since 2002 according to the Wall Street Journal.  Our own research on tenants-in-common interests suggests that TIC interests were saddled with extremely high fees and were often marketed with over-optimistic cashflow assumptions.

Bruce Kelly of InvestmentNews notes that:
DBSI was acting like a Ponzi scheme, relying on new investor funds, including investor money that the company said would be used only in particular circumstances, to continue operations and pay returns to other investors, according to the indictment.
In addition to syndicating TIC interests, DBSI also issued high yield notes through private placements.  Both TIC interests and real-estate related private note programs were common in 2005-2008.  DBSI declared bankrupcy in 2008, and on Wednesday its former COO Gary Bringhurst was indicted on similar charges and agreed to plead guilty to one count of conspiracy to commit securities fraud.

The SEC charged two of DBSI's real estate investments, known as MedCap and Provident, with securities fraud in 2009, which shut down shortly thereafter.  Those investments led to FINRA actions against broker-dealers who sold those investments without proper due diligence.

DBSI and indeed much of the TIC industry highlights the risks of private placement investments, which often lack sufficient transparency for investors to appreciate the often substantial underlying risks.

Friday, April 12, 2013

SEC Litigation Releases: Week in Review

Securities and Exchange Commission v. Glenn Hoppes, United States Energy Corp., TN-KY Development Fund LP, TN-KY Development Fund II LP and TN-KY Development Fund III LP, April 8, 2013, (Litigation Release No. 22669)

According to the complaint (opens to PDF), Glenn Hoppes and four companies he controls ("United States Energy Corp., TN-KY Development Fund LP, TN-KY Development Fund II LP, and TN-KY Development Fund III LP") fraudulently offered "unregistered investments in oil drilling projects" through Joseph Hilton. Hoppes hired Hilton to sell "limited partnership units in three oil drilling projects in 2011 and 2012 and financially supported Hilton’s boiler room despite [allegedly] knowing Hilton was barred from acting as a broker by a 2008 SEC enforcement action." US Energy raised almost $2.5 million through Hilton's efforts. The complaint also alleges that Hoppes "misled investors about US Energy’s oil well assets and omitted information from offering material concerning his personal bankruptcy." The SEC has charged the defendants with violating sections of the Exchange Act and the Securities Act and seeks payment of disgorgement, prejudgment interest, and civil penalties as well as permanent injunctions against the defendants.

Securities and Exchange Commission v. Matthew John Ryan, et al., April 8, 2013, (Litigation Release No. 22668)

A final judgment was entered against Prime Rate and Return, LLC, a company which also has done business as American Integrity Financial Company. According to the SEC, Prime Rate "defrauded investors through a multi-million dollar Ponzi scheme operated...by Prime Rate’s sole owner and manager, Matthew Ryan." Prime Rate consented to a final judgment enjoining it from future violations of the securities laws and ordering it to pay over $7.1 million in disgorgement and prejudgment interest. However, disgorgement was deemed satisfied by "the $71,927 recovered by the receiver plus any additional amount the receiver recovers, after certain court-approved payments and fees, from the sale of a property in which Prime Rate owns an interest."

Ryan was convicted of securities fraud "in a criminal case arising out of the same conduct underlying the Commission’s case." The SEC's case against Ryan remains pending.

Final Judgment Entered Against Former Sales Agent of Massachusetts Company, April 5, 2013, (Litigation Release No. 22667)

A final judgment has been entered against former sales agent of Inofin, Inc., David Affeldt, for his involvement in promoting "the offering and sale of unregistered securities." According to the SEC, Inofin through its former executives Michael J. Cuomo, Kevin Mann, Sr. and Melissa George "illegally raised at least $110 million" from investors "through the sale of unregistered notes." The defendants allegedly "materially misrepresented how the Company [used] investor money and the Company’s financial performance." Affeldt and Thomas K. Keough were charged with promoting the unregistered securities and Keough's wife, Nancy Keough, was named as a relief defendant.

The final judgment against Affeldt permanently enjoins him from future violations of the securities laws and orders him to pay over $200,000 in disgorgement, prejudgment interest, and civil penalties.  Final judgments were previously entered against Cuomo and Mann "which included permanent injunctions." The SEC's case against Inofin, George, and the Keoughs remains pending.

SEC Obtains Temporary Restraining Order Against UK Company Operating Fraudulent Profitable Sunrise Internet Scheme and Names Czech Companies as Relief Defendants April 5, 2013, (Litigation Release No. 22666)

According to the complaint (opens to PDF), Inter Reef Ltd. "operated a fraudulent securities offering over the internet under the name of 'Profitable Sunrise'." Profitable Sunrise offered investors "returns of between 1.6% and 2.7% per business day, compounded daily, on funds invested in various programs that were purportedly to be used to provide loans to businesses at even higher rates." The SEC has charged that the defendant "promised impossibly high rates of return and misrepresented that investments in the program were insured by a leading investment bank." The SEC has named Czech companies,  Melland Company S.R.O., Color Shock S.R.O., Solutions Company S.R.O., and Fortuna-K S.R.O., as relief defendants for allegedly receiving funds "from investors...through transfers at the direction of Profitable Sunrise."

A temporary restraining order was granted against Inter Reef as well as an order "directing an accounting, allowing expedited discovery, preventing the destruction of documents and providing for an asset freeze." At a later time, the SEC may also seek preliminary and permanent injunctions, disgorgement, prejudgment interest, and civil penalties.

Thursday, April 11, 2013

Credit Spread Futures and the Futurization of CDS

By Tim Dulaney, PhD and Tim Husson, PhD

Yesterday S&P Dow Jones Indices announced (PDF) the launch of three credit spread indices based upon constituents of the S&P 500.   The indices are part of a suite (PDF) of indices that "are designed to track the credit default swap market for global corporate credits, including those in distinct Global Industry Classification Standard (GICS®) sectors and sub-industries".*

S&P Dow Jones licensed the indices to the electronic exchange trueEX -- "the world's first CFTC-designated, Dodd-Frank compliant exchange" --  for the creation of futures contracts based upon the credit spread indices in the "first real adoption of [the] S&P-branded CDS indexes" according to J.R. Rieger, S&P Dow Jones Indices's VP of fixed income indexes.

Credit Default Swap (CDS) contracts are agreements between two parties that transfer credit risk from the credit protection buyer to the credit protection seller.  The credit protection buyer pays a premium (usually quarterly) to the seller and the seller compensates the buyer for losses incurred from a credit event for the debt on which the protection was bought.  Traditionally, CDS contracts have been sold in over-the-counter (OTC) markets, as opposed to public exchanges.

This development, paralleling that of the Intercontinental Exchange's licensing of Markit's CDS Indices, is part of a larger effort to move OTC instruments such as interest rate swaps and credit defaults swaps to a more transparent marketplace.  According to the Wall Street Journal, the futures contracts on the trueEX will be different from those on the Intercontinental Exchange (ICE) because "the trueEX contract will be settled based on existing auction procedures already in use in the CDS market" rather than settling "based on an index that isn't determined until the day of final settlement."

The indices mentioned in the release are:
  • S&P/ISDA US Corporate 120 Credit Spread Index is composed of reference entities whose primary corporate issuer's sector is not financial.  The top 120 eligible reference entities are included in this index.
  • S&P/ISDA US Financial 30 Credit Spread Index is composed of reference entities whose primary corporate issuer's sector is financial.  The top 30 eligible reference entities are included in this index.
  • S&P/ISDA US 150 Credit Spread Index is simply the combination of the constituents of the two indices above.  
According to the methodology, the indices are rebalanced five business days prior to the quarterly IMM dates and each series matures fives years later.  The reference entities must be rated investment grade by the majority of the three major ratings agencies that rate the reference entity (S&P, Moody's and Fitch).  In addition, the reference entities must have long-term senior public debt and CDS priced by CMA.  The indices are equal weighted with each reference entity having a notional value of $5 million.

While these futures contracts are likely still far too complex for retail investors, the move to public exchanges could decrease barriers to entry for traders to express opinions on credit risk.  According to the WSJ article, the size of the futures contracts will be significantly smaller, which would likely increase liquidity and accessibility.  In any case, like the futurization of interest rate swaps, the futurization of CDS contracts could be a major step in the movement of OTC 'exotic' derivatives to transparent and regulated exchanges.
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* For more information about GICS®, see the following from MSCI.

Tuesday, April 9, 2013

CFTC Investigating Potential Manipulation in Interest Rate Swap Market

By Tim Dulaney, PhD and Tim Husson, PhD

Bloomberg's Matthew Leising is reporting that the Commodity Futures Trading Commission has issued subpoenas to current and former employees at swap brokerage firm ICAP (IAP) "and as many as 15 Wall Street banks" for alleged manipulation of a key benchmark price in the interest rate swap market.

The benchmark, known as ISDAfix, "provides average mid-market swap rates for six major currencies at selected maturities on a daily basis."  Similar to LIBOR, the rates are set based on end-of-day polling of major banks (not on actual transactions) and is calculated and published by Thompson Reuters.  The CFTC's investigation is focusing on whether "ICAP brokers colluded with dealers who stand to profit from inaccurate quotes, including failing to update published prices after trades occur."  The article also notes the similarity between this investigation and the recent LIBOR bid-rigging scandal that also involved collusion between the bank employees who set the rate and derivative traders who could profit from a known change in that rate.  According to the Financial Times, "ICAP has placed several people on leave in connection with [the LIBOR] probe," as well.

According to the article, ICAP is the largest broker of interest rate swaps, trading an average of $1.4 trillion in notional transactions daily.  The article notes that ICAP has been "nicknamed 'Treasure Island' because of the size of the commissions it earns."  The interest rate swap market is one of the largest financial markets in existence and is a way for institutions to match the cashflows between their income and liabilities, amongst other purposes.  While traditional interest rate swap deals are conducted over-the-counter, rather than on a public exchange, there has been a move recently towards replacing interest rate swaps with economically equivalent deliverable interest rate swap futures, which could trade on a public exchange and thus increase transparency.

Certainly any manipulation of a key benchmark rate is big news and could affect literally trillions of dollars in notional value of derivatives. We will continue to follow this story as it develops, both here and through our Twitter feeds.

Fees on Structured Products Rise as Sales Increase

By Tim Dulaney, PhD and Tim Husson, PhD

Kevin Dugan recently reported that fees on structured products linked to stocks have risen to their highest level in three years.  In particular Kevin notes that "issuers and underwriters earned $137.7 million in disclosed fees, or 1.95 percent of the $7.08 billion of equity-tied securities" that have a stated commission.  Average fees have ranged from less than 1.5% to nearly 2% over the past three years.

The increase in average fees is likely due to the increase in average term for products offered during the last quarter.  In particular, Kevin reported a few weeks ago that sales of long-term callable structured products linked to stocks have exploded -- issuers sold almost as much last quarter as they did in all of 2012.  See the following figure from the March 28, 2013 Structured Notes Bloomberg Brief.


As the term for a structured product increases the fees also generally increase.  For example, structured products linked to interest rates generally have higher fees and longer terms than structured products linked to stocks.  Brokers therefore have an incentive (higher commissions) to sell longer-dated structured notes over shorter term, generally lower-commission, products.  This can and sometimes does lead to brokers suggesting products to clients that do not meet their stated goals and constraints.

While the risk of a given investment is perhaps the primary investor concern, fees are an important consideration as well.  Products with higher fees have a deteriorating effect on realized returns and investors should focus on fee minimization in light of their investment objectives and constraints.

Friday, April 5, 2013

SEC Litigation Releases: Week in Review

SEC Obtains Final Judgment Against Former Chief Investment Officer of Gibraltar Asset Management Group, LLC, April 3, 2013, (Litigation Release No. 22665)

A final judgment was entered against Maurice G. Taylor in relation to charges that he collaborated with Garfield M. Taylor, Benjamin C. Dalley, Randolph M. Taylor, William B. Mitchell, and Jeffrey A. King in a "multi-million dollar Washington-area Ponzi scheme operated through Gibraltar Asset Management Group, LLC and Garfield Taylor, Inc." The judgment orders him to pay over $514,000 in disgorgement and prejudgment interest and permanently enjoins him from future violations of the Securities Act.

The SEC's case remains pending against defendants Garfield M. Taylor, Jeffrey A. King, GTI, Gibraltar, and The King Group, LLC.

Father and Son Found Guilty in Real Estate Investment Fraud, April 1, 2013, (Litigation Release No. 22664)

Last week, John J. Bravata was convicted on "one count of conspiracy and 14 counts of wire fraud" and his son, Antonio M. Bravata was convicted on "one count of conspiracy to commit wire fraud" for their role "in the fraudulent BBC Equities securities offering, which raised more than $50 million from...investors by offering them membership interests in a purported real estate investment fund with promised annual returns of 8 to 12 percent." Richard J. Trabulsy, John Bravata's partner, "previously pleaded guilty in the same action."

The criminal charges arose from an SEC civil action filed in 2009. "The SEC's action was stayed during the parallel criminal case, and remains pending."

Foreign Traders Agree to Pay $3.3 Million to Settle Charges in Nexen Insider Trading Case, April 1, 2013, (Litigation Release No. 22663)

On March 29, 2013, Ren Feng and his wife, Zeng Huiyu, agreed to settle SEC charges that "they loaded up on the securities of Nexen Inc. while in possession of nonpublic information about an impending announcement that the company was being acquired by China-based CNOOC Ltd." According to the complaint (opens to PDF), Ren and Zeng along with "Ren's private investment company CT Prime Assets Limited and four of Zeng's brokerage customers on whose behalf she traded" made over $2.3 million in illicit profits from the trading. Ren, Zeng, CT Prime, and Zeng's brokerage customers, Wong Chi Yu and her company Giant East Investments Limited, Wang Wei, and Wang Zhi Hua have agreed to pay over $3.3 million combined in disgorgement and penalties.

District Judge Approves SEC Settlement with Sigma Capital, April 1, 2013, (Litigation Release No. 22662)

The court approved a settlement reached with Sigma Capital Management in which Sigma Capital and hedge fund affiliates, Sigma Capital Associates and S.A.C. Select Fund, "agreed to pay nearly $14 million to settle charges that [they] engaged in insider trading based on nonpublic information obtained through...analysts about the quarterly earnings of Dell and Nvidia Corporation." Last year the SEC charged several hedge fund managers and analysts "including Jon Horvath, a former analyst at Sigma Capital,...[who] agreed to a settlement in March 2013 in which he admitted liability."

"Bob" Hancher Sentenced to Over 8 Years in Prison and Ordered to Pay Restitution of Over $ 3.1 Million, April 1, 2013, (Litigation Release No. 22661)

Last week, Lowell Gene "Bob" Hancher was sentenced "to 97 months in prison on one count of wire fraud and one count of securities and commodities fraud and ordered...to pay $3,139,232 in restitution to his victims." In January 2011, the SEC filed an action against Hancher for allegedly "misappropriating funds from [Cycle Country Accessories Corporation] and engaging in a manipulative stock trading scheme involving shares of a third company." The $3.1 million Hancher has been ordered to pay includes "funds that [he] stole from investors in a fraudulent stock offering he led on behalf of Scott Contracting, Inc.,...and funds that [he] misappropriated from Cycle Country."

Previously, Hancher was permanently enjoined from violating various provisions of the securities laws, ordered to pay over $3.1 million in disgorgement, prejudgment interest, and fees, as well as banned "from serving as an officer or director of a public company or participating in a penny stock offering."

Thursday, April 4, 2013

Goldman Sachs Uses JOBS Act to Sidestep Volcker Rule


Evan Weinberger at Law360 is reporting that Goldman Sachs may have found a way around the Volcker Rule--the ban on proprietary trading by banks, which also prohibits sponsoring hedge funds and private equity funds--by using another controversial regulatory measure, the 2012 JOBS Act (of which we have spoken before):
By setting up an independent business development company in which it will hold a minority stake and limited leverage exposures, Goldman will be able to engage in at least limited proprietary trading. And because the firm will be small enough to qualify for as an emerging growth company under the 2012 Jumpstart Our Business Startups Act, the New York-based bank's new entity will also be freed from other regulatory requirements.
The basic idea is that Goldman will set up a business development company (BDC) that invests in other companies, especially small privately-owned companies.  BDCs have special tax status and are required to pay out most of their annual earnings in dividends to investors.  Under the JOBS Act, if a BDC is under a certain size (qualifies as an "emerging growth company"), it could be exempt from certain securities regulations.  For example, exemptions from certain sections of the Sarbanes-Oxley Act will result in more lenient reporting requirements for the company.

On the other hand, Goldman could sell this entity as a private equity fund it might otherwise be prohibited from sponsoring under the Volcker Rule.  Goldman's BDC will be called "Goldman Sachs Liberty Harbor Capital, LLC", and has already filed a preliminary registration document with the SEC.

The registration document itself is very interesting.  For example, the company will be 'externally managed' by Goldman Sachs Asset Management (GSAM), but that management appears to include a wide variety of services:
We expect to benefit from GSAM’s control, operational, administrative and support infrastructure, which we believe is one of the best in the financial services industry. Our risk monitoring will be provided by GSAM’s global risk management team, the same team that monitors risk for all of GSAM. We will utilize GSAM’s proprietary information technology systems, which we believe enhances our ongoing monitoring of our portfolio, among other things. Finally, we will be served by GSAM’s legal and compliance teams, which bring a wealth of experience gleaned over many years of support to GSAM.
However, Goldman Sachs itself will not be a majority investor.  The filing also notes that the company intends to leverage its investments as much as 200%.  This could, therefore, be seen as a way for Goldman Sachs to offer a private equity fund to investors in a format that would be compatible with the Volcker Rule.

It is unclear at this point if regulators will allow this registration to move forward--or if the Volcker rule, when finalized, will negate this possibility--but if it does, it may be a remarkable example of one regulation effectively (and unintentionally) nullifying another.

Wednesday, April 3, 2013

Stockton California May Proceed with Chapter 9 Bankruptcy

By Tim Dulaney, PhD and Tim Husson, PhD

Yesterday a federal judge in California ruled that, despite the objections of bondholders and bond insurers, the city of Stockton could proceed in the process of Chapter 9 bankruptcy.  Stockton is a city of almost 300,000 located about 90 minutes east of San Francisco   Stockton was hard hit by the housing bubble and saw a 16% decline (page 345 of the PDF) in general fund revenue from FY 2008-2009 to FY 2009-2010.

After facing "an immediate and severe fiscal crisis" in early 2012, Stockton became the largest municipality to file for bankruptcy after negotiations with creditors in June 2012 failed to alleviate a budget shortfall for the following fiscal year.  Stockton had approximately $700 million in bond debt and CalPERS -- the California Public Employees Retirement System -- has the largest claim with nearly $150 million in unfunded pension liabilities according to Reuters.  See the following list of creditors (PDF) for more information.  More information about the bankruptcy including objections from creditors can be found here.

Opponents of the bankruptcy filing contended that Stockton "didn’t meet eligibility requirements because it had failed to negotiate in good faith with creditors [...] before filing for bankruptcy and because it was not actually insolvent." These opponents argued that Stockton could have further raised taxes and cut expenses in order to pay back obligations.  Several of the creditors further contended that the Plan of Adjustment the municipality's debt was unfair since CalPERS was given special treatment over other creditors such as bond insurer Assured Guaranty.

Judge Klein, presiding over the case, disagreed with this argument and ruled in favor of the City of Stockton finding that the municipality "had done more than necessary to demonstrate its eligibility."  As Stockton navigates through the Chapter 9 proceedings, it will be closely watched by other municipalities drowning in pension costs.  As NPR notes, "[i]t's possible that more cities will declare bankruptcy in the future — or threaten to, in their negotiations with creditors — if it becomes a way to get out from under crippling pension debt."

Monday, April 1, 2013

Eaton Vance, Transparency, and Exchange-Traded Managed Funds (ETMFs)

By Tim Dulaney, PhD and Tim Husson, PhD

Eaton Vance (EV) made a splash yesterday when they announced an application with the SEC for approval of a new type of open-end fund they call "Exchange-Traded Managed Funds" or ETMFs.  The PDF of the announcement can be downloaded here.  Since the announcement, several bloggers have commented on the implications of such products, such as Brendan Conway at Barrons and Olly Ludwig at IndexUniverse.

In August 2011, the Financial Times reported the uncovering of patents -- U.S. Patent Nos. 7,444,300, 7,689,501, 7,496,531, 8,131,621, 8,306,901 and 8,332,307 according to the SEC application -- that detail the intellectual property used to create this new instrument.  At the time, Eaton Vance claimed that "ETMFs offer the potential to provide the tax efficiency and lower portfolio trading costs of an ETF and the alpha-generating ability of an actively managed mutual fund."

Eaton Vance believes that investors are harmed by the transparency of ETFs because traders can 'front-run' the behemoth passive instruments before they make their moves.  A front-running strategy attempts to take advantage of known purchases or sales of securities by large funds.  For example, if a large fund claims to purchase particular futures contracts on a certain day each month, traders might purchase those futures contracts before the fund does, anticipating a potentially significant price increase due to the fund's demand.  Front-running has been a concern with ETFs for several years, but has been a more significant issue as the ETF market continues to expand.  In fact both Blackrock and Precidian have similar filings with the SEC.

The reason why front-running is less of an issue for mutual funds is that (a) they aren't traded intraday, limiting the ability of traders to time their purchases, and (b) their strategies are only disclosed quarterly and on a lagged basis.  Eaton Vance's ETMF product would change (a) but not (b), based on the contention that decreased transparency reduces the potential for front-running, therefore saving investors the cost imposed by that kind of trading.  But the downside to keeping strategies and holdings secret is that investors do not fully understand what the fund is doing and how it plans to achieve its investment objectives.

Also, the value of actively managed funds is debatable, and there is some evidence that suggests active management on average leads to lower returns for investors and that success doesn't persist over time.  So it is unclear how much, if any, "alpha generation" investors might realize by Eaton Vance making a more mutual fund-like exchange-traded product.