Monday, July 30, 2012

Hedge Fund "Side Pockets" Explained

By Tim Husson, PhD

Hedge funds can be extremely complicated investments, and one of the features that contributes to their lack of transparency is their so called 'side pocket' accounts.  Side pockets have drawn scrutiny from the SEC and have been the subject of high profile investigations (see also) due to their potential for abuse from hedge fund managers eager to hide losses from investors.

Side pockets are essentially separate accounts that a hedge fund may use to separate illiquid or thinly traded assets from the primary fund itself.  Side pockets are typically structured as an independent private equity fund, and are typically not available to new investors in the primary hedge fund.

Side pockets were originally designed to protect investors.  Hedge fund managers have an inventive to record hard-to-value assets at inflated prices in order to maximize apparent returns and thus their performance fees.  Keeping illiquid securities in a separate account, and therefore independent of the manager's performance fee, was thought to reduce that incentive.

However, several funds have been accused of using their side pocket accounts to hide losses from investors during the financial crisis.  In addition, side pocket investments may be particularly difficult to withdraw from, since many include provisions that liquidation may only take place at the manager's discretion and not in response to investor withdrawal requests.  According to the Wall Street Journal, hedge funds have since changed the terms of their fund agreements to allow more extensive use of side pockets to freeze holdings, suggesting that the problems surrounding these investments may only increase.

Friday, July 27, 2012

SEC Litigation Releases: Week in Review

SEC Charges Aider and Abettor of Penny Stock Company's Disclosure of Fake Investment,  July 25, 2012, (Litigation Release No. 22424).

The SEC lodged a complaint against Ronald Feldstein who allegedly filed a false press release announcing a "fictitious $6 million investment in a penny stock company, Interlink-US Network, Ltd." Feldstein was paid by Interlink's management to play the role of a prospective investor. Feldstein, posing as President of LED Capital Corp., entered into a phony investment agreement with Interlink, where he claimed LED would pay $6 million for Interlink shares "that, at the time, had a market value of under $1.2 million." Feldstein also aided Interlink in drafting Form 8-K to disclose the supposed agreement to the market. The Commission seeks "injunctions from future violations" of provisions of the Securities Exchange Act, "disgorgement of ill-gotten gains, and a civil monetary penalty."

SEC Charges Close Friend of Staffing Company CEO with Insider Trading Around Acquisition,  July 25, 2012, (Litigation Release No. 22423).

According to the complaint (opens to PDF), Ladislav "Larry" Schvacho used inside information to trade around the acquisition of Comsys IT Partners Inc. by Manpower Inc. Schvacho gained the insider information from his close friend Larry L. Enterline, a Comsys CEO. The two had been close friends since the 1970s when they worked at the same company. Over the years, they maintained their close friendship even after Enterline moved to Houston when he became the Comsys CEO in 2006. Schvacho used information he overheard from Enterline's telephone calls about the potential acquisition in November and December 2009 to purchase over 70,000 shares in Comsys stock before its public announcement in February 2010 of its acquisition by Manpower Inc. Schvacho made approximately $511,000 in illegal profits from the insider trading. The SEC seeks "permanent injunctive relief, disgorgement of ill-gotten gains, plus pre-judgment interest, and civil penalties" against Schvacho.

Investment Advisor Charged by SEC with Fraud Sentenced to 51 Months in Prison,  July 25, 2012, (Litigation Release No. 22422).

On July 5, 2012, Renee Marie Brown was sentenced to "51 months in federal prison followed by three years probation, and restitution in the amount of $618,408." On May 11, 2011, Brown was charged with securities fraud, wire fraud and transactional money laundering that led to a misappropriation of $1.1 million from her advisory clients. From July 2009 through March 2010, Brown transferred more than $1.1 million to Investors Income Fund X, LLC, "a sham fund formed and controlled by Brown." She falsely represented the fund as a bond fund and even distributed false "returns" to investors to convince them Fund X was legitimate. She then used these funds for personal use, including purchasing a condominium and office space for her business. The SEC obtained a temporary restraining order and asset freeze against her on April 8, 2010. Brown pled guilty to the charges on February 15, 2012.

Defendant Matthew Brown Settles Penny Stock Manipulation Charges,  July 25, 2012, (Litigation Release No. 22421).

On July 2, 2012, a final judgment was entered against Matthew W. Brown in SEC v. Dynokowski, et al. Pawel P. Dynkowski along with other accomplices were involved with various schemes that sold "large blocks of shares for penny stock companies in exchange for a portion of the proceeds." The defendants inflated the market price of the stocks artificially through "wash sales, matched orders and other manipulative trading." Dynokowski orchestrated the scheme with Brown in 2006 for GH3 International, Inc. Stock. At the time, Brown operated a penny stock website, Not only did Brown engage in manipulative trading, but he also issued false press releases. Nearly $750,000 in illicit profits were generated from this specific scheme. Additionally, Brown planned a manipulation scheme involving the stock of Asia Global Holdings, Inc. that generated over $4 million in illicit profits. Brown consented to the final judgment that orders him to pay over $100,000 in disgorgement and prejudgment interest and bars him from participating in any offering of a penny stock. In a related case, U.S. v. Brown, Brown was sentenced to four years in prison and ordered to pay over $4.75 million in criminal forfeiture.

SEC Charges Stock Promoter in Internet-Based Scalping Scheme,  July 23, 2012, (Litigation Release No. 22420).

According to the complaint (opens to PDF), Jerry S. Williams, a stock promoter, along with the two companies he controlled, Monk's Den, LLC, and First in Awareness, LLC, were involved with a scalping scheme which resulted in over $2.4 million in profits for Williams. From 2009 to 2010, Williams recommended stocks Cascadia Investments, Inc. and Green Oasis Environmental, Inc. to a group of potential investors. He used his "internet-based message board (called "Monk's Den"), in-person seminars (called "Monkinars"), and other means to encourage people to buy, hold, and accumulate" these stocks. Unbeknownst to investors, Williams had been hired by Cascadia and Green Oasis to promote their stock. In return for the promoting, Williams received millions of free and discounted shares of these stocks. Williams secretly sold these shares while he encouraged potential investors to buy, hold and accumulate these stocks, making over $2.4 million. The SEC seeks "permanent injunctions, disgorgement, prejudgment interest, and civil penalties against each defendant and, as to Williams only, a penny stock bar." 

SEC Charges CEO with Insider Trading in Secondary Offering of Company Stock,  July 20, 2012, (Litigation Release No. 22419).

According to the complaint (opens to PDF), Manouchehr Moshayedi, CEO of STEC, Inc., used insider information "in a secondary offering of...stock shares with knowledge of confidential information that a major customer's demand for one of its most profitable products" had significantly declined. From January to August 2009, STEC's stock price increased more than 800 percent as the company "reported higher revenues, sales, and margins for its products, particularly its flagship flash memory product called 'ZeusIOPS.'" This rise in stock came as STEC announced in July 2009 that its largest customer, EMC Corporation, had agreed to buy $120 million worth of ZeusIOPS in the third and fourth quarter of that year. However, Moshayedi learned that EMC would only purchase $34 million in the third quarter, and then would never again enter into a similar agreement with STEC. In response, Moshayedi entered into a secretive side deal with EMC to meet "the third quarter consensus revenue estimates." On July 29, EMC was convinced by Moshayedi to purchase $55 million of ZeusIOPS product in the third quarter "in exchange for an undisclosed additional $2 million price discount on the product in the fourth quarter." Moshayedi also withheld from investors that EMC would not make further volume commitments. The SEC seeks disgorgement, prejudgment interest, financial penalties, and a permanent barring of Moshayedi from serving as an "officer and director of any registered public company."

Wednesday, July 25, 2012

FINRA Issues Warning on ETNs

By Olivia Wang, PhD

The Financial Industry Regulatory Authority (FINRA) recently issued an Investor Alert regarding the risks of exchange-traded notes (ETNs).

ETNs are a type of unsecured debt instrument typically issued by banks and other financial institutions. Similar to its close cousin the exchange-traded fund (ETF), ETNs track the returns of a specified asset class--often an index. However, unlike ETFs, ETNs do not hold actual assets tracked by the underlying index. This means investors in ETNs can suffer significant loss if the ETN issuer defaults, as there are no assets to recover, only the creditworthiness of the issuer itself. Issuers of ETNs compute the so-called "indicative value" based on the index price the ETN tracks. Theoretically the market price of the ETN should closely track the indicative value, but recent ETN market has witnessed quite dramatic deviation of the market price from the indicative value.

FINRA points out that investing in ETNs involve various types of risks. Probably the most prominent risk is the credit risk as we pointed out before. Other than that, market fluctuation might lead to change in the benchmark index with adverse effect on the ETN investment, generating substantial market risk. Also, despite the fact that ETNs trade on exchanges, there might still be a lack of liquid market for some ETNs. If an ETN is leveraged, inverse, or inverse-leveraged, investors could also be subject to holding-period risk due to compounding effects. Callable ETNs or ETNs subject to early redemption bear extra risk.

FINRA specifically warned about the risk that "the issuer will default on the note or take other actions that may impact the price of the ETN." One recent example was the roller-coaster price movement experienced by TVIX, a leveraged ETN issued by VelocityShares, Credit Suisse's ETF/ETN brand. TVIX is a member of a large family called "volatility-related ETPs, " which are exchange-traded products based on VIX, the S&P 500 volatility index complied by Chicago Board Options Exchange (CBOE). TVIX attempts to provide a daily return which is twice of the return of a daily rolling portfolio in both the first and second month VIX futures. As we discussed before on this blog, after Credit Suisse announced its decision to stop creating new shares of TVIX on February 21, TVIX started to trade at a huge premium over its indicative value. At its peak the premium exceeded 80% of the indicative value. The wide gap between the market price and the indicative value only dissipated after Credit Suisse decided to issue new shares again on a limited basis on March 22.

In the Investor Alert, FINRA warns that "paying a premium relative to the indicative value to purchase the ETN in the secondary market—and then selling the ETN when the market price no longer reflects the premium—can lead to significant losses for an investor. " Therefore, FINRA advises investors to compare an ETN's indicative value with the its market price before making purchase decisions. Other factors that should be taken into account, as FINRA points out, include the ETN issuer, the index the ETN tracks, whether the ETN is callable, whether the ETN is leveraged and if so, how frequently it is rebalanced, the cost and fee structure, and the tax consequences.

Monday, July 23, 2012

Buffered and Capped Closed-End Funds

By Olivia Wang, PhD

Last Friday the Wall Street Journal reported on a new product which combines features of both structured notes and closed-end funds. The eUnit 2 Year US Market Participation Trust II was first issued by Boston-based investment company Eaton Vance on May 30. This was the second offering by Eaton Vance of such a product: the first trust with identical name debuted on Jan 26.

In essence, the eUnit Trust is like a structured note with capped upside potential and buffered downside loss. At the end of the trust's two-year holding period, if the S&P stock index rises, investors will get an return equal to the index return subject to a cap, with the cap being 17.85% for the first trust and 20.5% for Trust II. If the S&P index drops in value, investors will not get any positive return but won't lose money either as long as the drop does not exceed 15%. If the drop exceeds 15%, however, investors will start to lose money. The payoff structure can be seen from the following graph from Eaton Vance's website.

The innovation in the eUnit Trust lies in the fact that unlike structured notes, the eUnit Trust holds primarily U.S. Treasurys as underlying collateral, thus significantly reducing the default risk suffered by structured notes, as pointed out by our own Craig McCann in the report. By structuring it as a closed end fund which trades actively on the exchanges, the eUnit Trust also reduces the liquidity risk associated with structured notes to a certain extent.  According to the Wall Street Journal, "experts say it could be the first of similar products to follow."

However, investors should still exercise caution when they purchase this new product. For example, trading on the exchange does not mean that the product is not subject to liquidity risk. In fact, both eUnit trusts have been very thinly traded, as shown by the following two figures. The figures depict the market price and the net asset value following the left axis and the daily trading volume following the right axis. The maximum trading volume of the eUnit 2 Year US Market Participation Trust II was no more than 4500 shares, and for two consecutive weeks the trading volume was below 250 shares. 

eUnit 2 Year US Market Participation Trust II                                             
eUnit 2 Year US Market Participation Trust

Friday, July 20, 2012

SEC Litigation Releases: Week in Review

SEC Obtains Final Judgment in Case Involving Ponzi Scheme and Promotion of China Voice Holding Corp.,  July 19, 2012, (Litigation Release No. 22418).

A final judgment was entered against Ilya Drapkin on July 6, 2012, which permanently enjoins him from violating various sections of the Securities Act and ordered Drapkin, along with his companies, MG TK Corp. and SMI Chips, to pay over $5.8 million in disgorgement and penalties. This amount represents "profits gained by Drapkin, MG TK, and SMI Chips from a Ponzi scheme run by China Voice's former CFO, David Ronald Allen, and other associates." The SEC filed a complaint in April 2011, alleging that China Voice, Allen, and former Ceo and President William F. Burbank IV  misled investors about China Voice's financial condition and business prospects. China Voice shareholders Drapkin and Gerald Patera were charged by the SEC with "financing stock promotion campaigns regarding China Voice." Daivd Ronald Allen, Alex Dowlatshahi and Chistopher Mills, were also charged with launching a Ponzi scheme that tried to raise at least $8.6 million from investors.

Mizuho to Pay $127.5 Million to Settle SEC Charges of Misleading Investors in CDO July 19, 2012, (Litigation Release No. 22417).

The SEC has charged Mizuho Securities USA Inc. and three of its employees with "misleading investors in a collateralized debt using 'dummy assets' to inflate the deal's credit ratings." In 2007, Mizuho structured and marketed Delphinus CDO 2007-1, which was backed by subprime bonds. Alexander Rekeda headed the group that structured Delphinus, Xavier Capdepon modeled the transaction, and Gwen Snorteland was the transaction manager "responsible for structuring and closing Delphinus." By July 17, 2007 all of the collateral assets had been purchased for Delphinus. On July 18, Standard & Poor's announced changes to its CDO rating criteria. Mizuho realized that the Delphinus transaction, which was scheduled to close on July 19, would not meet the new criteria. "To enable Delphinus to close anyway, the Mizuho employees e-mailed multiple alternative portfolios to S&P that contained dummy assets that were superior in credit quality to the assets that had been actually acquired for the CDO." The SEC has also charged Delaware Asset Advisers, which served as the collateral manager for Delphinus and Wei (Alex) Wei, who was the DAA portfolio manager for Delphinus. Mizuho has consented to a final judgment that permanently enjoins it from violating various provisions of the Securities Act, and requires it to pay $127.5 million in disgorgement and penalties. Rekeda and Capdepon have "each agreed to pay a $125,000 penalty." A decision has yet to be reached on whether or not Snorteland will face a penalty.  Delaware Asset Advisers has agreed to pay over $4.8 milllion in disgorgement and penalties. 

SEC Charges Family-Run Business Promising Investors Stake in Purported $11 Billion Gold Mine July 17, 2012, (Litigation Release No. 22416).

According to the complaint (opens to PDF), between September 2009 and October 2011, Harry Dean Proudfoot III along with his son, Matthew Dale Proudfoot, and his daughter, Laurie Anne Vrvilo, raised $2.7 million from about 140 investors in 23 different states. The family raised these funds through their company 3 Eagles Research & Development LLC by telling investors the company would extract more than $11 billion worth of gold from gravel pits in central Ohio. Investors were promised they could earn 35 times their initial investment. The family sold investors "royalty units" which supposedly were used to purchase mining equipment and conduct mining operations.The family hired an unregistered securities broker, Dennis Ashley Bukantis, to sell the royalty units. In reality, 3 Eagles did not have rights to most of the property it claimed to be mining for gold. Instead of using investor funds for mining, the family used the funds for personal expenses, including $80,000 on automobiles, $235,000 in personal travel and more than $30,000 annually for vitamins and nutritional supplements.  Bukantis is also being charged with the Proudfoots in the Commission's complaint. The complaint "seeks permanent injunctions, disgorgement with prejudgment interest and civil monetary penalties."

Former Chief Investment Officer and Portfolio Manager for the Schwab YieldPlus Fund Agrees to Settle Charges July 16, 2012, (Litigation Release No. 22415).

Kimon P. Daifotis, former lead portfolio manager for the Schwab YieldPlus Fund (related SLCG research), has agreed to settle litigation the SEC filed against him January 11, 2011. Daifotis, who was also the Chief Investment Officer for Fixed Income for Charles Schwab Investment Management, a Senior Vice President at Charles Schwab & Co., Inc., and an officer of Schwab Investments, has agreed to pay $325,000 in penalty and disgorgement. Additionally, he would be enjoined from future violations of certain provisions of the federal securities laws and would be barred from the securities industry, with the right to apply for reentry after three years. In its 2011 complaint, the SEC charged Daifotis with misleading investors about the risks of the YieldPlus Fund, as well as misleading investors about the large redemptions YieldPlus experienced in August 2007.

Monday, July 16, 2012

FDIC Warns Investors about Structured CDs

By Tim Husson, PhD

Earlier this year, the Federal Deposit Insurance Corporation issued a warning about structured certificates of deposit (CDs), which are hybrid investments combining features of both traditional CDs and structured products.  FINRA has also recently investigated the market for structured CDs, which has been estimated to be as large as $30 billion.

Structured CDs are essentially bank deposits whose interest payments depend on the value of a reference index instead of a predefined fixed or floating interest rate.  The reference index is typically an equity index such as the S&P 500, a single equity such as Apple stock, or an interest rate; however, any reference index may be used and some products have enormously complex payoff structures.  In this way, structured CDs are very similar to structured products.

Because structured CDs are fundamentally bank deposits, they are generally eligible for FDIC insurance, despite often being very risky bets on volatile assets.  The FDIC's warning highlights these potential risks, including restrictions on withdrawals, long maturities, and more market risk than many investors may realize.  Our own work on structured CDs has found that many of these products are similar to principal protected structured products, and are usually sold at a substantial premium.

Friday, July 13, 2012

SEC Litigation Releases: Week in Review

Court Issues Final Judgment Enforcing Prior Order of the Commission Against Rodney R. Schoemann July 12, 2012, (Litigation Release No. 22414).

On July 11, 2012, the District Court ordered Rodney R. Schoemann to pay over $1.3 million in disgorgement and prejudgment interest. Rodney R. Schoemann had violated "the registration provisions of the federal securities laws in connection with his sales of stock in Stinger Systems, Inc. in November 2004" and had been ordered to pay disgorgement and prejudgment interest. At the time the action to enforce this order was filed, Rodney had not paid any of the amount. 

SEC Charges Five Physicians with Insider Trading in Stock of Medical Professional Liability Insurer July 10, 2012, (Litigation Release No. 22413).

According to the complaint (opens to PDF), in 2010 Apparao Mukkamala, resident of Grand Blanc, MI, shared confidential information about the upcoming acquisition of American Physicians Capital, Inc. (ACAP) by The Doctor's Company with fellow physicians Suresh Anne, Jitendra Prasad Katneni and Rao A.K. Yalamanchili, as well as his brother-in-law Mallikarjunarao Anne. At the time Mukkamala served as the chairman of ACAP's board. Based on the insider information, the physicians bought over $2 million in ACAP stock and made more than $600,000 in illegal profits. The physicians have agreed to pay nearly $2 million to settle the charges and Mukkamala has been "barred from acting as an officer or director of a public company."

SEC Charges Orthofix International with FCPA Violations,  July 10, 2012, (Litigation Release No. 22412).

According to the complaint (opens to PDF), from 2003 to 2010 Promeca S.A. de C.V., a subsidiary of Orthofix International N.V., violated the Foreign Corrupt Practices Act by paying routine bribes to Mexican officials to obtain contracts with government hospitals. Over the period of the bribes, the company gained nearly $5 million in illegal profits. Promeca recorded the largest bribes as promotional and training costs. Orthofix launched an investigation after Promeca's training and promotional expenses were well over budget. After discovering the bribe payments, Orthofix self-reported the matter to the SEC. Orthofix as agreed to pay $5.2 million to settle the charges and will also pay over $2 million in penalties as the result of a related U.S. Department of Justice investigation.

Final Judgment Entered Against Connecticut Man Who Misappropriated Over $1 Million From Vulnerable Investors,  July 9, 2012, (Litigation Release No. 22411).

A final judgment has been entered by the Court ordering Florin S. Ilovici and his wife, Diana Ilovici, to pay over $1 million in disgorgement plus prejudgment interest. Additionally, Florin S. Ilovici is required to pay a $900,000 civil penalty. From 2008 to 2011, Ilovici raised over $1 million in investment funds from "two elderly woman who lived alone, had little or no family, and had health problems." He then invested these funds in his personal accounts and either lost the funds to risky investments or used them for personal expenses.

SEC Charges Company, CEO, and Stock Promoter with Market Manipulation,  July 6, 2012, (Litigation Release No. 22410).

According to the complaint (opens to PDF), Axius, Inc., along with its President and CEO, Roland Kaufmann, and its stock promoter, Jean-Pierre Neuhaus, engaged "in a fraudulent broker bribery scheme designed to manipulate the market for Axius' common stock." In January 2012, Kaufmann and Neuhaus agreed to pay kickbacks between 26% and 28% to an individual claiming "to represent a group of registered representatives with trading discretion over the accounts of wealthy customers." The individual agreed to have the registered representatives use the customers' accounts to purchase up to $5 million in Axius stock for the kickbacks. Furthermore, Kaufmann instructed the individual to purchase around $49,000 of Axius shares from February 16 to 17 through matched trading. Kaufmann then paid the individual bribes of $13,700 following the purchases. The SEC seeks "permanent injunctive relief, disgorgement of ill-gotten gains, plus pre-judgment interest, and civil penalties from all defendants." The Commission also seeks to bar Kaufmann from serving as an officer or director of a public company.

Wednesday, July 11, 2012

Big Wall Street Firms Pressure Their Salesmen to Favor House-Brands

By Paul Meyer, MA, Tim Husson, PhD, and Tim Dulaney, PhD

Financial advisors and brokers are bound by ethical guidelines to analyze and recommend investment products that are suitable and appropriate for their clients' investment objectives and tolerance for risk. In general, they are obliged to put their clients' best interests ahead of their own.

The New York Times reported Monday on the recent admission from a former JPMorgan mutual fund advisor that he sold JPMorgan funds over similar offerings from outside JPMorgan for no other reason than to attract management fees for his employer. JPMorgan is in some ways unique for selling its own funds, a practice many other banks eschew due to the clear conflicts of interest their brokers would face. From the article:
“It said financial adviser on my business card, but that’s not what JPMorgan actually let me be,” said Mathew Goldberg, a former broker who now works at the Manhattan Wealth Management Group. “I had to be a salesman even if what I was selling wasn’t that great.”
JPMorgan is also accused of lax disclosure related to the funds, including misleading marketing materials showing hypothetical, rather than realized, returns. 

At SLCG, we have seen numerous cases of firms pushing risky or underperforming investments on their clients—“recommending” (i.e., selling) proprietary products, rather than a better suited outside product. These conflicts of interest often occur with structured products, non-traded REITs, and many other high-cost, often highly complex investments. Investors should use caution when choosing investments and keep a close eye on the suggestions from their advisers. Investors should understand the sources of fees and try to minimize these fees as much as possible when meeting their investment objective.

Monday, July 9, 2012

Consumer Financial Protection Bureau Report on Reverse Mortgages

By Tim Husson, PhD

Most American investors are likely aware of the SEC, and may also be aware of FINRA as an important regulatory institution (certainly, readers of this blog should be).  But they may be less aware of the relatively new Consumer Financial Protection Bureau (CFPB), which also has a mandate to protect consumers from financial malpractice.  The CFPB was created out of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and President Obama appointed its first director in January 2012.  The CFPB website has a variety of resources for investors, including a frequently updated blog, and several research reports.

Last month, the CFPB released their latest report to Congress, on reverse mortgages (PDF of the full report available here).  Reverse mortgages have become highly controversial, as they are primarily marketed to elderly homeowners who may not fully understand their structure and risks.  FINRA released an Investor Alert on reverse mortgages in 2010.

A reverse mortgage is similar to a home equity loan, in that a homeowner can borrow against the equity in their home as either a lump sum payment, periodic payments over their lifetime, or as a line of credit.  The homeowner is not required to make payments under a reverse mortgage (except for property tax and insurance), but is obliged to pay off the full amount either upon death or sale of the home, and any accrued interest is added to the mortgage balance.

From the CFPB:
Our study finds that reverse mortgages are complex products that are difficult for consumers to understand. Borrowers are also increasingly using reverse mortgages in ways that are different from what was intended. Nearly half of recent borrowers were in their 60s, and nearly 3 out of 4 borrowers took all of their money upfront in a lump sum. The Bureau is concerned that these borrowers will have fewer resources to pay for everyday and major expenses later in life. 
Deceptive marketing is a long-standing problem in this market, with many older Americans receiving solicitations implying that a reverse mortgage is a government benefit rather than a loan. Prospective borrowers are required to attend counseling, but these deceptive advertisements and an increased array of product options make the counselor’s job very difficult.
We will continue to follow the CFPB's research and advisory efforts about reverse mortgages and other consumer investment topics.

Friday, July 6, 2012

Another ETN Halts New Share Redemptions, Creates Premium

By Tim Husson, PhD and Olivia Wang, PhD

In March we reported on TVIX, the leveraged volatility-linked exchange-traded note (ETN) which started trading at a very large premium to indicative value after its issuer halted the creation of new shares.  Bloomberg's Matt Robinson is reporting that AMJ, a JPMorgan ETN linked to oil partnerships, has also limited new share creations and is developing a similar premium.

JPMorgan limited new share creations on June 14, and the premium to indicative value (the value of the underlying index) has been increasing ever since the limit was hit--only days after the announcement of the halt:

Typically, ETNs track their underlying indexes very closely, as they are essentially debt that promises payouts linked to the level of that index.  Premiums to NAV arise in ETNs due to supply-demand imbalances, such as when issuers restrict new share creations.  This imbalance can create attractive short positions, as traders bet that the issuer will soon allow new shares to be created and the premium will collapse.  So far, however, it does not seem that short interest in AMJ has increased due to the premium:

It is not always clear why issuers may want to limit new share creations.  Credit Suisse limited TVIX shares as a result of unspecified 'internal position limits,' presumably related to their hedge position for the notes.  Like TVIX, open interest in AMJ has grown in early 2012 (by just over 38%), meaning JPMorgan may similarly require a much larger hedge position; alternatively, the share halt could be related to JPMorgan's recent derivatives losses.  So far, JPMorgan has not offered an official explanation.

SEC Litigation Releases: Week in Review

SEC Freezes Assets of Missing Georgia-Based Investment Adviser July 3, 2012, (Litigation Release No. 22409).

According to the complaint (opens to PDF), Aubrey Lee Price has gone into hiding after allegedly "orchestrating a $40 million investment fraud." Price, who started his scam in 2008, not only raised money from more than 100 investors by "selling shares in an unregistered investment fund" but also made illiquid investments in South American real estate and a failing bank. Price then fabricated account statements with false account balances and returns to hide the increasing loss of investors' funds. Price admitted he falsified account statements in a June 2012 letter to some of the investors. Price and his related companies, PFG, LLC; PFGBI, LLC; Montgomery Asset Management, LLC (Florida); and Montgomery Asset Management, LLC (Georgia), have all been charged by the SEC. A temporary restraining order and asset freeze has been placed on Price for the benefit of the investors.

SEC Charges Gold Standard Mining Corp. and Others for False and Misleading Statements Concerning Russian Gold Mining Operations July 3, 2012, (Litigation Release No. 22408).

According to the complaint (opens to PDF), between May 2009 and April 2011 Gold Standard Mining Corp filed materially false and misleading statements about its Russian gold mining operations. Gold Standard, its Chief Executive Officer/Chief Financial Officer Panteleimon Zachos, attorney Kenneth G. Eade, auditor E. Randall Gruber and his firm Gruber & Company LLC have all had a civil action filed against them by the SEC. Gold Standard and Zachos, along with the assistance of Eade, Gruber, and Gruber & Co., are allegedly responsible for these false statements. Furthermore, Edward Randall Gruber misrepresented in audits from 2007 to 2009 that the company had been audited in compliance with the standards of the Public Company Accounting Oversight Board. Gold Standard and Zachos have consented to the final judgments that enjoin them from violating various sections of the Securities Exchange Act and Exchange Act. "Zachos will also be barred from serving as an officer or director of a public company." The SEC "seeks permanent injunctions, disgorgement, prejudgment interest and civil penalties against Eade, Gruber and Gruber & Co. and seeks to bar Eade from serving as an officer or director of a public company."

SEC Charges Peter Madoff with Fraud and False Statements to Regulators June 29, 2012, (Litigation Release No. 22407).

Peter Madoff, the brother of Bernie Madoff, has been charged with "committing fraud, making false statements to regulators, and falsifying books and records in order to create the false appearance of a functioning compliance program over Madoff’s fraudulent investment advisory operations." Peter Madoff  served as Chief Compliance Officer and Senior Managing Director of Bernard L. Madoff Investment Securities LLC (BMIS) from 1969 to December 2008. Allegedly, Madoff created a multitude of compliance documents detailing policies, reviews, certifications, and procedures that were never implemented. Peter Madoff helped Bernie Madoff distribute money to family, friends, and favored investors before the scheme's collapse in late 2008. Peter Madoff pocketed tens of millions of dollars through the scheme. "Among other things, the SEC's complaint seeks permanent injunctions, financial penalties and a court order requiring Peter Madoff to disgorge his ill-gotten gains."

Thursday, July 5, 2012

LIBOR Manipulation

By Tim Dulaney, PhD and Tim Husson, PhD

An ongoing investigation into the manipulation of LIBOR has exploded recently with the revelation that Barclays was actively manipulating LIBOR since 2005, possibly at the behest of Paul Tucker (a leading candidate to become the next governor of the UK central bank). As evidenced by several forms of electronic communication, some employees were submitting false data to boost profits.

Such accusations of LIBOR rate manipulation are not new. In 2008, the British Bankers Association (BBA) accelerated their investigation of LIBOR discrepancies and a study performed by Wall Street Journal analysts indicated that several banks under-reported borrowing costs and, as a result, overstated the health of the banking system.

LIBOR is an acronym for the London InterBank Offered Rate. The rate is supposed to be indicative of the cost of borrowing between leading banks and is considered to be one of the most important benchmarks of short-term interest rates. The leading banks report their best estimation for their cost of borrowing and the rates are then calculated and published as an average of these reported rates by Thomson Reuters on behalf of the BBA. The rates are calculated daily for various maturities ranging from overnight to one year and in ten currencies.

LIBOR is the common thread running through both everyday credit (such as mortgage payments or credit card payments) as well as exotic financial derivatives (such as interest rate swaps, corporate debt and forward rate agreements). As a result, LIBOR determines the interest accrued on literally hundreds of trillions of dollars of transactions.

Each currency has a panel of several leading banks, selected annually, that are representative of the London money market. LIBOR rates for each currency are then determined by taking the submissions from the panel members, throwing out the lowest and highest quartiles and then taking the average of the middle two quartiles.

As a result of the way LIBOR is calculated, it would take widespread under-reporting of borrowing costs for the rate to be effected. According to the Wall Street Journal, "Barclays is the only bank so far to resolve Libor-fixing allegations, but roughly a dozen banks have acknowledged being under criminal or civil investigation in various countries in the matter." Up until 2008, Barclays had been submitting some of the highest borrowing costs and only after the suggestion of Mr. Tucker did Barclays begin submitting lower rates, more in line with the other banks on the panel.

As a result of this revelation, Barclays has agreed to pay a $453 million fine and several of the bank's executives (including the CEO, COO and chairman) have resigned. Barclays former chairman, Marcus Agius, has become a focus of the investigation since he was also serving as the chairman of the BBA.

Tuesday, July 3, 2012

Variable Annuity Regulation: Speech by Susan Nash

By Tim Husson, PhD

Last Tuesday, Susan Nash, Associate Director of the Division of Investment Management at the SEC, gave an interesting speech at the URI 2012 Government, Legal & Regulatory Conference regarding variable annuities.  Variable annuities continue to grow in sales--according to Ms. Nash's comments, sales of variable annuities grew by approximately 12% in 2011--but have been the subject of numerous FINRA Investor Alerts and Regulatory Notices due to their high costs and complex risks.

Ms. Nash commented on the changes that have taken place in the variable annuity market, especially reductions in investment choices and living benefits.
Each of these moving parts affects the performance of a variable contract, and together they may significantly reduce the benefit of the contract to the investor. For this reason, it is essential that offering materials clearly highlight the costs and limitations associated with living benefits, so that investors can make an informed decision.
She also discussed the "disparity in the servicing of older and newer contracts," whereby issuers would "orphan" older contracts by discontinuing features or investment options, or by encouraging the exchange of older contracts for newer ones.  According to Nash, issuers often choose to represent new features as 'enhancements' to older contracts, and "the juxtaposition of new contract features with changed and sometimes discontinued features can make it extremely difficult for an investor — or a financial advisor — to identify the information that is relevant."  The SEC is reportedly considering a new disclosure framework for variable annuities to improve the understandability of these contracts.

However, variable annuities are highly complex, and the variable annuity marketplace is highly innovative and responsive to change.  Ms. Nash's comments suggest that even within such long-term investments as annuities, insurance companies can wield a significant amount of control over the ultimate value of the product to the investor.  As many investors look for low-risk investments to guarantee their retirement savings, variable annuities may grow even more popular, and even more complex.