## Friday, November 30, 2012

### Importance of Timing in Structured Products

By Tim Dulaney, PhD and Tim Husson, PhD

We've been looking through some historical issuances of structured products recently and we happened to come across a peculiar product issued by Morgan Stanley in September 2008.  The product (CUSIP: 617483664) offered investors bearish exposure to the S&P 500.  In other words, if the S&P 500 level declines as of the valuation date of the notes, then the product would exhibit a positive return.

Not only was the return positive if the S&P 500 went down, but it was leveraged six times -- capped at a maximum return of 108%.  So if the S&P 500 level declined by 18% or more between the issue date and the valuation date, the investor would have received more than double their initial investment from Morgan Stanley.  Here is the payout diagram from Morgan Stanley.

Obviously, this investment would do particularly well if the S&P 500 declines.  Amazingly, the pricing date for this product was September 23, 2008:  precisely before one of the largest market collapses in history:
You might think that whoever purchased this product was a genius.  Indeed, the timing of this issuance was impeccable; however, the proverbial stick in the mud is the fact that the valuation date wasn't until March 2010.  On September 23, 2008, the S&P 500 level was 1,188.22 -- this determines the initial index level.  At the close of business on the valuation date (March 26, 2010), the S&P 500 level was 1,166.59.  Not much of a loss on the S&P 500, and therefore not a mind-blowing return on this bearish structured product.

Even though the S&P 500 posted a closing level decline of over 40% during the term of the note, the closing level on the valuation date was only 1.8% lower than the initial index level.  Investors still earned nearly nearly 11% on their investment--much better than a direct investment in the S&P 500--but nowhere near the maximum return even given the financial crisis.

This product highlights one of the primary difficulties investing in illiquid securities:  not only did this structured product investor have to pick the right size and direction of a price difference, but also exactly when that difference would exist.  If the maturity date had been a little earlier or even a little later, the investor's return would have been very different, and since there is only limited secondary markets for structured products, he or she could not have sold the product when a similarly structured liquid investment would have been worth much more.

### SEC Litigation Releases: Week in Review

SEC v. John H. Pamplin, Jr., November 29, 2012, (Litigation Release No. 22550)

According to the complaint (opens to PDF), former TurboChef Technologies, Inc. employee John H. Pamplin, Jr. traded with insider information regarding TurboChef's pending acquisition by The Middleby Corporation in 2008 which resulted in a $68,000 illicit profit. According to the SEC, Pamplin violated the Exchange Act. The SEC seeks "permanent injunctive relief, disgorgement, prejudgment interest, and civil penalties." SEC Charges Two Brokers with Insider Trading Ahead of IBM-SPSS Merger for$1 Million Profit, November 29, 2012, (Litigation Release No. 22549)

According to the complaint (opens to PDF), in 2009 brokers Thomas C. Conradt and David J. Weishaus traded on nonpublic information regarding IBM Corporation's acquisition of SPSS Inc. Conradt allegedly learned of the acquisition from his roommate, a research analyst, who had learned the information "from an attorney working on the transaction." Conradt, Weishaus, and others they tipped earned over $1 million in illegal profits. In fact, "Conradt, Weishaus, and other downstream tippees invested so heavily in SPSS securities that the investments accounted for 76 percent to 100 percent of their various brokerage accounts." The SEC has charged Conradt and Weishaus with violating sections of the Exchange Act and seeks disgorgement, prejudgment interest, financial penalties and a permanent injunction against the defendants. Additionally, criminal charges have been announced against Conradt and Weishaus in a parallel action. SEC Charges Chicago-Based Investment Adviser with Defrauding Investors in Failing Private Equity Fund, November 29, 2012, (Litigation Release No. 22548) According to the complaint (opens to PDF), Joseph J. Hennessy and his firm, investment adviser Resources Planning Group, defrauded investors by falsely promising them high returns for investing in the Midwest Opportunity Fund. According to the complaint, Hennessy failed to tell investors that MOF was failing due to its inability to repay promissory notes. In 2007, "Hennessy financed MOF's acquisition of its largest portfolio company...by having the fund issue$1.65 million in promissory notes." When portfolio companies failed to pay management fees later that year, the MOF "lacked sufficient funds to repay the notes." From 2007 to 2010 Hennessy allegedly raised funds from investors by telling them "that MOF was viable and offered high returns" when in reality he was using their investments to make payments on the promissory notes. Additionally, Hennessy allegedly misappropriated $750,000 from three investors by using their "money to redeem another client's investment in the fund" instead of investing it in MOF. Twice in 2009, Hennessy allegedly "forged letters of authorization from a widowed RPG client to transfer$100,000 from her account to MOF in exchange for promissory notes that have yet to be repaid." Hennessey has been charged with violating sections of the Securities Act, Exchange Act, and Advisers Act and RPG has been charged with violating sections of the Advisers Act.

SEC Charges Oil Company CEO as Source in Insider Trading Case, November 28, 2012, (Litigation Release No. 22547)

The SEC announced this week that former Delta Petroleum Corporation CEO Roger Parker has been charged with illegally tipping his friend Michael Van Gilder about Tracinda's impending investment in Delta. Previously, the SEC had charged Van Gilder for his alleged insider trading in the case and now has charged Parker as Van Gilder's source. In addition to his acquisition tips, Parker allegedly tipped Van Gilder about Delta's quarterly earnings in late 2007. In total, the "insider trading in this case generated more than $890,000 in illicit profits." The SEC has charged Parker and Van Gilder with violating sections of the Exchange Act and seeks disgorgement, prejudgment interest, financial penalties and permanent enjoinment, as well as an officer and director bar against Parker. Jury Returns Verdict of Liability Against Massachusetts Investment Adviser and His Advisory Firm, November 27, 2012, (Litigation Release No. 22546) On November 26, 2012 a jury found investment adviser EagleEye Asset Management, LLC, and its sole principal, Jeffrey A. Liskov liable for securities fraud for their "fraudulent conduct toward advisory clients." According to the SEC's original complaint, between 2008 and 2010, Liskov convinced at least six clients to "liquidate investments in securities and instead invest the proceeds in foreign currency exchange trading." The forex investments "were not suitable for older clients with conservative investment goals" and resulted in almost$4 million of losses for the clients. However, Liskov and EagleEye earned over $300,000 in performance fees for these investments. Not only did Liskov allegedly fail "to disclose material information to clients concerning the nature of forex investments, the risks involved, and his poor track record in forex trading for himself and other clients," but he also liquidated securities of two clients without their consent by forging asset transfer forms. The SEC charged EagleEye and Liskov with violating sections of Exchange Act and Advisers Act. Based on the jury's verdict, a hearing will be held on the SEC's request for injunctive relief, disgorgement, prejudgment interest, and financial penalties against EagleEye and Liskov. Court Orders Asset Freeze and Appointment of a Receiver in SEC Action Charging Hedge Fund Adviser and Its Principal with Securities Fraud, November 26, 2012, (Litigation Release No. 22545) On November 21, 2012 the Court entered judgments against Berton M. Hochfeld and Hochfeld Capital Management, L.L.C. in response to the SEC's charges that Hochfeld and his firm engaged in securities fraud "by misappropriating assets and making material misstatements to" investors in the Heppelwhite Fund, LP. Hochfield, who managed the Heppelwhite Fund, was also charged with violating a "2006 SEC Order barring him from associating with any broker, dealer, or investment adviser." Allegedly, Hochfield misappropriated around$1.3 million from the Fund." Additionally, Hochfeld and Hochfeld Capital allegedly "made material misstatements to Fund investors" by overstating the value of investments on periodic statements and failing to disclose" the 2006 SEC order against Hochfeld. Hochfeld and Hochfeld Capital consented to the Court's judgments enjoining them from violating sections of the Exchange Act, Securities Act, and the Advisers Act. They also agreed to "provide a full accounting of all assets currently under their control," an asset freeze against the defendants as well as the Heppelwhite Fund, disgorgement, civil penalties, and "the appointment [of] a receiver over the Heppelwhite Fund and Hochfeld Capital."

Court Enters Final Judgments by Consent Against SEC Defendants Pantera Petroleum, Inc. and Bozidar "Bob" Vukovich, November 26, 2012, (Litigation Release No. 22544)

The Court entered a final judgment against Pantera Petroleum, Inc. and stock promoter, Bozidar "Bob" Vukovich, in response to the SEC's complaint that Vukovich along with Pantera's former President Christopher Metcalf "engaged in a fraudulent broker-bribery scheme designed to manipulate the market for Pantera common stock." Pantera and Vukovich agreed to final judgments enjoining them from violating sections of the Securities Act and Exchange Act. Vukovich also agreed to a penny stock bar and to pay over $260,000 in disgorgement, prejudgment interest, and penalties. SEC Settles with Former Integral Systems Chief Financial Officer Charged with Securities Fraud, November 26, 2012, (Litigation Release No. 22543) Elaine Brown, the former Chief Financial Officer of Integral Systems, Inc, agreed to pay a$25,000 civil penalty to settle SEC charges that charged her "in connection with the concealment at [Integral Systems] of a de facto officer who was a securities fraud felon."

Attorney Virginia K. Sourlis Found Liable for Aiding and Abetting Securities Fraud by Issuing False Legal Opinion in Connection with Illegal Stock Offering, November 26, 2012, (Litigation Release No. 22542)

On November 20, 2012, in SEC v. Greenstone Holdings, Inc., et al. a judgment was entered against attorney Virginia K. Sourlis that holds her liable "for aiding and abetting securities fraud." According to the SEC, in 2006 Sourlis "intentionally authored a materially false and misleading legal opinion, which Greenstone used to illegally issue over six million shares of stock in unregistered transactions." Based on the Court's judgment, the SEC will seek injunctive relief, financial penalties, disgorgement, and a penny stock bar against Sourlis.

## Wednesday, November 28, 2012

### SEC Charges KCAP Financial with Overvaluing Assets

By Tim Husson, PhD and Tim Dulaney, PhD

The SEC alleges (PDF) that KCAP Financial, a publicly traded business development company (BDC), did not accurately report the fair value of its corporate debt and collateralized loan obligation (CLO) assets during the financial crisis, thereby misleading investors. According to the press release, KCAP valued some of their assets at cost, not at fair market value, overstating the net asset value by over 25% during the peak of the financial crisis.

BDCs are similar to REITs in that they hold primarily one type of asset, and receive special tax treatment if they distribute the vast majority of their earnings to shareholders every year. BDCs primarily invest in small or developing privately held companies, either through debt or equity, and are therefore similar to private equity funds. Traded BDCs (unlike non-traded BDCs) are listed on major stock exchanges and trade similarly to closed-end funds.

From the SEC's release:
“When market conditions change, funds and other entities must properly take into account those changed conditions in fair valuing their assets," said Antonia Chion, Associate Director in the SEC’s Division of Enforcement. “This is particularly important for BDCs like KCAP, whose entire business consists of the assets that it holds for investment.”
The SEC cites the Statement of Financial Accounting Standards No. 157 (PDF) -- also known as FAS 157 -- an accounting standard related to fair value measurements of assets. FAS 157 "focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)." By reporting assets at cost, KCAP was effectively valuing them at their entry price, even though selling those assets at that price was virtually impossible during the crisis.

According to the SEC's order:
KCAP used an enterprise value (“EV”) methodology to determine fair value for those debt securities that it determined were illiquid [...] The EV methodology did not, however, calculate or inform KCAP – or the public – what the exit price was for that security. Instead, the EV methodology provided KCAP an assessment of whether the entire principal balance owed to it was likely to be repaid by the debt issuer.
This action by the SEC highlights the importance of, and the difficulties with, reporting fair valuations for illiquid assets. We have seen numerous instances of asset managers misreporting asset values, even in the face of clearly deteriorating market conditions (see, for example, our work on non-traded REITs and on the warehousing of assets in CDOs).

While Level Three assets -- assets whose value is determined using more judgment than market observations -- are often difficult to precisely value, it is critical that mangers and trustees provide investors with whatever information is available regarding their current market values in order to avoid the kinds of unpleasant surprises that lead to litigation.

## Tuesday, November 27, 2012

### Structured Products Highlight: UBS Autocallable Linked to JOY

By Tim Dulaney, PhD

Today we're highlighting a structured product issued on July 25, 2012 by UBS.  This product (CUSIP: 90269T574) is a Trigger Phoenix Autocallable Optimization Security linked to Joy
Global Inc. (JOY).  Since this product is issued by UBS, purchasers of the notes were exposed to the possibility that UBS would have been unable to meet the obligations spelled out in the note's offering documents.

This particular note offered investors quarterly coupons (annualized rate of 12.84%) if JOY's stock price is above the coupon barrier -- $30.92, or 60% of the July 20, 2012 closing price of JOY -- on the quarterly coupon dates. This product has an embedded call feature that is automatically triggered if JOY's stock price exceeds the July 20, 2012 value on any quarterly coupon date. If the product is not called prior to maturity (July 22, 2013), investors receive their principal investment unless JOY's stock price is below the coupon barrier. If the stock price is below the coupon barrier at maturity and the product has not been called, investors lose a percent of principal for each percent decline of JOY's stock price over the term of the note. This particular autocallable recently had its first coupon date on October 22, 2012 and because JOY's stock price at the close of business on October 22, 2012 was above that value on the pricing date, the product was called. Investors received their principal as well as the quarterly coupon due ($0.3210 per $10 of principal). The following figure graphically depicts JOY's stock price and shows that the price increased during the first quarter of the note's term. At issuance, we valued this particular product at about$0.97 per dollar invested.  The difference is partially accounted for by the underwriting discount; however, the remainder is an indication that investors should have been compensated by a higher coupon rate on the notes by UBS.

## Monday, November 26, 2012

### Can Non-Financial Firms Issue Structured Products?

By Tim Husson, PhD and  Tim Dulaney, PhD

The simple answer is yes.  Structured products are for regulatory purposes corporate debt--that's why they are vulnerable to the credit risk of their issuers.  In theory, any firm that can issue corporate debt could issue a structured product, and could link that structured product to any underlying asset it choose.  In practice, no non-financial firm has done so in the US (to our knowledge), as there hasn't been a compelling reason for them to do so.

But according to Vita Millers at Risk.net, that might be changing.  In fact, non-financial firms may be the future of structured products.

The reasoning is simple.  Credit risk drastically effects the value of a structured product and by holding several structured products, an investor is exposed to the credit risk of the financial sector -- which is likely correlated.  So if non-financial firms began issuing structured products, investors could diversify the risk of issuer default amongst different sectors.  So says Stephen Black, managing director of Tier One Capital:
"If say, instead of being backed by Barclays, Royal Bank of Scotland or Société Générale, a FTSE 100 note is backed by a Tesco bond, a National Grid bond or a General Electric bond, it opens up the opportunity for structured products to proliferate across a portfolio in a far more usable and safer way. Spreading that counterparty risk beyond just the financial industry mitigates the downside of having undesirably high volumes of financial debt within the portfolio, and could see the continuing expansion of what is already a fast-growing part of the industry."
However, this line of reasoning may be problematic for a number of reasons.  In our experience, few investors hold a large number of structured products and so the concentration of credit risk will likely remain large.  Also, the non-financial firms would have to manage and sell these products, which would incur fairly substantial additional costs (mostly fees to investment banks).  Finally, there is a possibility that these products could become more idiosyncratic, and thus even more difficult to compare with alternatives and therefore less transparent.  So it's unclear what the upside would be for the purported issuer or if investors would truly benefit from this possible avenue for diversification in practice.

It has also been proposed that firms may benefit from using a particular type of structured product--a call-option enhanced reverse convertible--as a way of converting debt to equity in response to a stock collapse.  While this proposal was aimed at banks, a similar argument may be relevant to non-financial firms as well, though it remains to be seen what price investors would accept for this conversion risk.

We think that it is unlikely that structured products as they currently exist will become a significant component of most firms' corporate finance options.  Their complexity and regulatory uncertainty, with little clear benefit to the issuer, makes much more sense for banks (who have that expertise) than any other institution.  But who knows, maybe one day it will be more common to see a Ford reverse convertible than a Ford convertible in reverse...

## Friday, November 23, 2012

### SEC Litigation Releases: Week in Review

Brian Stoker Found Not Liable, November 21, 2012, (Litigation Release No. 22541)

On July 31, 2012, the United States District Court for the Southern District of New York found Brian H. Stoker, former Citigroup Global Markets Inc. employee, "not liable for violations of the Federal securities laws related to the issuance of a $1 billion collateralized debt obligation (CDO) called Class V Funding III." The SEC did not appeal the verdict, and "the time for appeal has expired." The SEC filed its suit against Stoker in October of 2011, alleging that "Stoker was the Citigroup employee primarily responsible for structuring the Class V III transaction." The SEC alleged that Citigroup "structured and marketed Class V III and exercised significant influence over the selection of$500 million of the assets included in the CDO" but then did not "disclose to investors the role that it played in the asset selection process or the short position that it took." The SEC continues to pursue its appeal in the "District Court’s denial of the proposed settlement with Citigroup in the related matter of Securities and Exchange Commission v. Citigroup Global Markets Inc."

District Court Dismisses Action Against Edward S. Steffelin, November 21, 2012, (Litigation Release No. 22540)

On November 16, 2012 the District Court approved a stipulation between the SEC and Edward S. Steffelin, which "dismiss[ed] with prejudice charges against Edward S. Steffelin for his role in the Squared CDO 2007-1 transaction." Furthermore, the stipulation "expressly provided that it was not intended and shall not be deemed an admission by either party of the merit or lack of merit of the claims and/or defenses asserted by either party."

SEC v. CR Intrinsic Investors, LLC, November 20, 2012, (Litigation Release No. 22539)

The SEC charged hedge fund advisory firm CR Intrinsic Investors LLC and its former portfolio manager, Mathew Martoma, along with a medical consultant, Dr. Sidney Gilman, "for their roles in a $276 million insider trading scheme involving a clinical trial" for bapineuzumab, "an Alzheimer's drug being jointly developed by [the] two pharmaceutical companies" Elan Corporation and Wyeth. Allegedly, Dr. Gilman "tipped Martoma with safety data and eventually details about negative results in the trial about two weeks before they were made public in July 2008." In response, Martoma allegedly "caused several hedge funds to sell more than$960 million in Elan and Wyeth securities in just over a week." According to the SEC, Martoma "received a $9.3 million bonus at the end of 2008 - a significant portion of which was attributable to the illegal profits" that came from this scheme. Furthermore, Dr. Gilman was paid over$100,000 "for his consultations with Martoma and others at the hedge fund advisory firms" and he "received approximately $79,000 from Elan for his consultations concerning [bapineuzumab] in 2007 and 2008." The U.S. Attorney's Office for the Southern District of New York "announced criminal charges against Martoma and a non-prosecution agreement with Dr. Gilman" in a parallel action. Court Fines CEO Christopher Metcalf$50,000 and Imposes a Penny Stock Bar and Officer and Director Bar Against Him, November 20, 2012, (Litigation Release No. 22538)

A final judgment was entered on November 14, 2012 against Christopher Metcalf, former President and CEO of Pantera Petroleum, Inc., for his participation along with stock promoter Bozidar "Bob" Vukovich in "a fraudulent broker-bribery scheme designed to manipulate the market for Pantera common stock." The order imposed a $50,000 penalty as well as penny stock bar and officer and director bar against Metcalf. In a partial judgment previously entered against him, Metcalf was permanently enjoined from violating various sections of the Securities Act and the Exchange Act. SEC Charges Michigan Businessman Defrauded Investors in Real Estate Investment Scheme, November 20, 2012, (Litigation Release No. 22537) According to the complaint (opens to PDF), Joel I. Wilson "defrauded investors who bought unregistered securities offered by his company, Diversified Group Partnership Management, LLC, and sold through his brokerage firm, W R Rice Financial Services, Inc." From 2009 to 2012, Wilson raised around$6.7 million from investors claiming that "he would invest their money in real estate that would yield returns of 9.9% per year." According to the SEC, Wilson in fact used these funds to "to make unsecured loans to his real estate business...[and] diverted $582,000 of investor money to pay personal expenses." Furthermore, the SEC alleges that Wilson "raised additional funds for his real estate business through stock sales for another of his companies, American Realty Funds Corporation." American Realty allegedly made misrepresentations and omissions in reports it has filed with the SEC and has failed to file "its annual report on Form 10-K for the fiscal year ended June 30, 2012...and its quarterly report on Form 10-Q for the quarter ended September 30." The SEC has issued an order suspending the trading of American Realty Stock. Former Executive of Massachusetts-Based Company Found Guilty of Securities Fraud, November 20, 2012, (Litigation Release No. 22536) Former CFO and CEO of LocatePlus Holdings Corporation, James Fields, was found guilty "on twenty nine criminal charges, including securities fraud, false statements to company auditors, false statements and false certifications in SEC filings, aggravated identity theft and money laundering." Fields was charged in November 2010 along with former LocatePlus CEO Jon Latorella "with conspiracy to commit securities fraud for their role in a scheme to fraudulently inflate revenue at LocatePlus as well as a scheme to manipulate the stock of another company." Earlier this year, Latorella was found guilty and "sentenced to 60 months imprisonment in the criminal case, to be followed by three years of supervised release, and the payment of restitution to be determined at a later hearing." In July of this year, LocatePlus agreed to settle charges "it engaged in securities fraud from 2005 through 2007 by misleading investors about its funding and revenue" by consenting to "an administrative order which prevents it from selling its securities in the public market." Sentencing for Fields is scheduled for February 14, 2013. SEC Charges Ring of High School Buddies with Insider Trading in Health Care Stocks, November 19, 2012, (Litigation Release No. 22535) According to the complaint (opens to PDF), from 2007 to 2009 "three health care company employees and four others in a New Jersey-based insider trading ring of various high school friends generat[ed]$1.7 million in illegal profits and kickbacks by trading in advance of 11 public announcements involving mergers, a drug approval application, and quarterly earnings of pharmaceutical companies and medical technology firms." The alleged tippers in the scheme are John Lazorchak, Celgene Corporation's director of financial reporting, Mark S. Cupo, Sanofi S.A.'s director of accounting and reporting, and Mark D. Foldy, a marketing employee of Stryker Corporation. According to the SEC, the primary traders in the scheme are Cupo's friend Michael Castelli and Castelli's high school friend, Lawrence Grum. In addition, Lazorchak's high school friends Michael T. Pendolino and James N. Deprado also allegedly traded on the non-public information. By using a middleman between the insiders and traders, the defendants allegedly hoped to avoid detection. Grum reassured Cupo that their scheme could avoid detection, stating, “At the end of the day, the SEC’s got to pick their battle because they have a limited number of people and huge numbers of investors to go after.”

SEC Charges New York-Based Fraudster Who Spent Investor Funds on Drugs and Gambling, November 19, 2012, (Litigation Release No. 22534)

According to the complaint (opens to PDF), Stephen A. Colangelo, Jr. raised over $3 million for four start-up companies, Brickell Fund LLC, Hedge Community LLC, Start a Hedge Fund LLC, and Under the Radar SEO LLC, by misleading investors about his professional and educational background as well as his past achievements as an investor. In addition, three investors gave him over$1 million to invest on their behalf as their investment adviser. Colangelo falsely told investors that he had studied finance at Nyack College from 1986 to 1989 when in fact he has not even graduated high school. He allegedly hid past criminal activities from potential investors and "siphoned off at least $1 million in investor funds to pay such unauthorized personal expenses as his federal income taxes, illegal narcotics, gambling, cigars, and travel for him and his family." In a parallel action, criminal charges have also been announced against Colangelo. SEC Charges J.P. Morgan Securities LLC with Misleading Investors in RMBS Offerings, November 16, 2012, (Litigation Release No. 22533) On November 16, 2012, the SEC charged J.P. Morgan Securities LLC and affiliated entities "with misleading investors in offerings of residential mortgage-backed securities (RMBS)." According to the SEC, JP Morgan "misstated information about the delinquency status of mortgage loans that provided collateral for an RMBS offering in which it was the underwriter." For the$1.8 billion RMBS offering that occurred in December 2006, JP Morgan represented that four loans "(.04 percent of the total loans collateralizing the transaction) were delinquent by 30 to 59 days," when in fact JP Morgan "actually had information showing that more than 620 loans (above 7 percent of the total loans collateralizing the transaction) were, and had been, 30 to 59 days delinquent, and the four loans represented as being 30 to 59 days delinquent were in fact 60 to 89 days delinquent." JP Morgan and J.P. Morgan Acceptance Corporation I settled the charges by agreeing to pay $74.5 million in disgorgement, prejudgment interest, and penalties. JP Morgan; EMC Mortgage, LLC; Bear Stearns Asset Backed Securities I, LLC; Structured Asset Mortgage Investments II, Inc.; and SACO I, Inc.agreed to pay over$222 million in disgorgement, prejudgment interest, and penalties. The SEC will distribute these funds to harmed investors through two Fair Funds.

Court Enters Final Judgment by Consent Against SEC Defendant Bruce Grossman, November 16, 2012, (Litigation Release No. 22532)

## Monday, November 19, 2012

### Do Leveraged ETFs Contribute to Share Price Volatility?

By Tim Husson, PhD and Tim Dulaney, PhD

We've talked a lot about leveraged and inverse Exchange Traded Funds (LETFs) and the problems that can arise from their rebalancing.  A recent paper from a group at York University asks two simple but interesting questions:  does this rebalancing affect the volatility of the underlying assets?  If so, can a sophisticated trader exploit that effect to achieve excess returns?

On the first question, the authors find two main results.  First, the directional trades LETF providers and counterparties must undertake to hedge their exposure "can impact share prices, despite leveraged ETFs' relatively small aggregate net asset values in comparison to the overall market."  Second, "the impact is economically significant only on days when the underlying market has experienced a large price swing."

The authors then speculate that these intuitive results could allow for traders to front-run LETFs and profit from the resulting increased volatility.  The most profitable strategy based on their analysis had the following backtested returns:

Their results clearly demonstrate that front-running ETF rebalancing has the largest potential gains during periods of high volatility.

We've been on the record before saying that these ETFs are generally not suitable for buy-and-hold investors due to their complexity and the deteriorating effect of the frequent rebalancing.  That these ETFs could also be the victim of, to use the authors' words, "predatory traders" taking advantage of the predictable trading patterns resulting from the daily rebalancing of these ETFs further highlights that they are suitable only for traders, not investors.

## Friday, November 16, 2012

### SEC Litigation Releases: Week in Review

BP to Pay $525 Million Penalty to Settle SEC Charges of Securities Fraud During Deepwater Horizon Oil Spill, November 15, 2012, (Litigation Release No. 22531) According to the complaint (opens to PDF), BP p.l.c misled investors by understating the flow rate of oil that was escaping from its Deepwater Horizon oil rig in 2010. According to the SEC, while BP reported the flow rate was about 5,000 barrels of oil a day, it had "at least five different flow rate calculations, estimates, or data indicating a much higher flow rate." Furthermore, when a government task force "determined the flow rate estimate was actually more than 10 times higher at 52,700 to 62,200 barrels of oil per day...BP never corrected or updated the misrepresentations and omissions it made in SEC filings for investors." BP agreed to settle the charges "by paying the third-largest penalty in agency history at$525 million." Additionally, BP has agreed to permanent enjoinment from violating sections of the Exchange Act. The SEC has plans to "establish a Fair Fund with the BP penalty to provide harmed investors with compensation for losses they sustained in the fraud." BP also plead guilty to criminal conduct in a related case, United States v. BP Exploration and Production, Inc.

SEC Charges Miami-Based Adviser with Hiding Trading Losses and Diverting Client Funds, November 9, 2012, (Litigation Release No. 22530)

According to the complaint (opens to PDF), Anand Sekaran and his firm Wasson Capital Advisors Ltd. "fabricated documents showing illusory profits after [Sekaran's] trading strategy became unprofitable in 2008." According to the SEC, Sekaran had given investors spreadsheets that "inaccurately show[ed] that Wasson was profitable." In addition, Sekaran allegedly inflated account balances on some clients' account statements, and used investor funds for personal expenses including "personal mortgage and maintenance payments, restaurant and travel expenses, entertainment and event tickets, employee salaries and health insurance, and rent and office expenses." Sekaran and Wasson have consented to a final judgment enjoining them from violating sections of the Exchange Act and Investment Advisers Act. Sekaran has agreed to being barred from the securities industry and penny stock industry and is required to pay $2.3 million "to satisfy restitution and forfeiture orders in the criminal matter." SEC Charges Former Officers and Auditor of Electronic Game Card, Inc. with Fraud, November 9, 2012, (Litigation Release No. 22529) According to the complaint (opens to PDF), from 2007 to 2009 Lee Cole and Linden Boyne, chief executive officer and chief financial officer of Electronic Game Card Inc. respectively, attracted investors by falsely claiming that Electronic Game Card Inc. had "millions of dollars in annual revenue, [held] millions of dollars in investments, and own[ed] an off-shore bank account worth more than$10 million." In actuality, many of the contracts were fake, "the purported investments were merely in entities affiliated with Cole or Boyne, and the bank account did not exist." Cole and Boyne reaped over $12 million in illicit profits through their alleged deception. Furthermore, the SEC has charged their auditor, Timothy Quintanilla, and the public accounting firm Mendoza Berger & Co. LLP with "knowingly or recklessly misrepresent[ing] that the firm had conducted audits of EGMI's financial statements 'in accordance with the standards of the Public Company Accounting Oversight Board,'" when in fact, critical aspects of EGMI's financial statements had been overlooked. Finally, the SEC alleges that Kevin Donovan, who replaced Cole as CEO, "ignored many red flags about the accuracy of the company's public statements and the integrity of Cole and Boyne." The SEC has charged Cole and Boyne with violating sections of the Securities Act, Exchange Act, and Sarbanes-Oxley Act, and has charged Donovan and Quintanilla with violating sections of the Securities Act and Exchange Act. SEC Charges South Florida Man with Recruiting Victims of Ponzi Scheme, November 9, 2012, (Litigation Release No. 22528) According to the complaint (opens to PDF), from 2004 to 2011, James F. Ellis "fraudulently solicited investors for George Elia," who operated "pooled investment vehicles under the names of Investor Funding Club and Vision Equities Funds." While Elia told investors he traded in stocks and "earn[ed] annual returns as high as 26 percent," in reality he was running a Ponzi scheme. Ellis was allegedly paid over$2.1 million by Elia to entice prospective investors. Ellis falsely told these investors that "he had personally invested with Elia $5 million...and that he earned 16% to 20% annual returns on his investment...or that he earned$20,000 to $24,000 per month." The SEC has charged Ellis with violating sections of the Securities Act and the Exchange Act and seeks permanent injunctions, disgorgement with prejudgment interest and civil penalties against Ellis. Separate criminal charges have also been announced against Ellis for his participation in the scheme. SEC v. Aamer Abdullah, November 9, 2012, (Litigation Release No. 22527) The SEC has finalized its settlement with Aamer Abdullah, former portfolio manager of ICP Asset Management, LLC, who was charged in June 2010 with "mismanagement of several collateralized debt obligations." In addition to a broker, dealer and investment advisor bar he to which he had previously agreed, Abdullah has agreed to pay over$275,000 in disgorgement, prejudgment interest, and civil penalties.

## Tuesday, November 13, 2012

### Structured Products Highlight: Reverse Exchangeable Linked to Apple

By Tim Dulaney, PhD

We here at SLCG have been working on research reports to educate investors concerning recent offerings of structured products.  We've talked a lot about structured products on this blog and we wanted to start describing the features of individual products and how we analyze their value.

Today we're highlighting a structured product issued in August 2012 by JP Morgan.  This product (CUSIP: 48125V4K3) is a Reverse Exchangeable Note linked to Apple stock (AAPL).  Reverse exchangeables -- also known as reverse convertibles --  generically pay periodic coupons.  If the underlying asset does not close below the product's trigger price throughout the term, the product returns principal.  If the underlying asset does close below the trigger price at some point during the term and the closing price on the maturity date is below the initial price, the notes are converted into a specified number of shares and/or cash at maturity.  Since this product is issued by JP Morgan, purchasers of the note are exposed to the possibility that JP Morgan will be unable to meet the obligations spelled out in the note's offering documents.

This particular reverse exchangeable had an offering size of nearly $2 million, pays monthly coupons at an annualized rate of 9.25% and matures on August 30, 2013. The trigger price was set to$538.90 (80% of the trade date price).  If a trigger event has occurred (AAPL closed below $538.90 between August 31, 2012 and August 28, 2013) and AAPL's price on August 28, 2013 is below$673.63, then the note will convert to 1.48 shares of AAPL stock.  The following figure illustrates the payoff at maturity for these notes.

At issuance, we believe the product's fair value was roughly $0.955 per dollar invested based upon the decomposition we used. The difference between this fair value and the purchase price is the compensation JP Morgan receives for offering the notes (4.5%). Since this amount is beyond the 3.5% of fees and commissions collect on the notes, JP Morgan has not offered a sufficiently high coupon to compensate investors for the put option they have sold JP Morgan on the issue date. Just last week -- on November 8, 2012 -- AAPL closed below$538.90 for the first time since the August 31, 2012 and so a trigger event has occurred.  As a result, if AAPL closes below $673.63 on August 28, 2013, the notes will be converted into 1.48 shares of AAPL stock. ## Monday, November 12, 2012 ### Dual Directional Structured Products are Risk.net's "Trade of the Month" By Tim Dulaney, PhD and Tim Husson, PhD Last week a UK firm called Meteor launched a "Bull and Bear Growth Plan" linked to the FTSE 100 that has a payoff similar to a structured product that has garnered significant interest recently: Dual Directional Structured Products (DDSPs). Dual directional products are Risk.net's 'Trade of the Month', and they have chosen this issue as their featured product. Generically speaking, DDSPs pay out a positive return if the underlying index or stock linked to the product changes in value (appreciates or depreciates) within a specified range. DDSPs do not offer principal protection, but typically offer leveraged and capped exposure to upside returns as well as buffered exposure to downside returns (see figure below). We studied these structured products in depth in a recent research paper and noted that these products typically offer investors less than 95 cents per dollar invested. The cap is used by the DDSP issuer to finance the positive returns investors are owed if the underlying asset decreases in value but remains above the barrier level. A few things that makes the Meteor product interesting is (1) the lack of a cap, (2) the leverage on both the upside and the downside, and (3) the extremely long term of the product--over six years. Also, while the product is branded and issued by Meteor, the guarantor is Morgan Stanley and as a result investors will be exposed to Morgan Stanley's credit risk. To understand how this product works, consider an initial investment of$10,000.  If the FTSE 100's level on November 2, 2018 is:
• greater than the FTSE 100's level on 11/2/2012, then the product pays back principal plus 1.25 times the appreciation (if any) of the FTSE 100.  For example, if the FTSE 100 increased by 40%, the product would pay $10,000*(1+1.25*40%) =$15,000.
• less than the FTSE 100's level on 11/2/2012, but greater than the barrier level -- equal to 50% of the FTSE 100's 11/2/2012 level -- then the product pays back principal plus 1.25 times absolute value of the depreciation (if any) of the FTSE 100.  For example, if the FTSE 100 decreased by 20%, the product would pay $10,000*(1+1.25*|-20%|) =$12,500.
• less than the barrier level, then the product loses value at a rate of 1% for each percentage decline in the level of the FTSE 100 since 11/2/2012.  For example, if the FTSE 100 decreased by 60%, the product would pay $10,000*(1-60%) =$4,000.
A graph of the possible total returns an investor could expect to experience as a function of the final level of the FTSE 100 is given below.

We have modeled this product, taking into account the credit risk of Morgan Stanley as well as the other product specific parameters, and have found that this product is worth approximately 96 cents per dollar invested.  That's pretty typical for DDSPs and structured products in general, but we should note that this is a valuation after upfront fees, which according to the offering documents could be as much as 7%.

So despite the very unique features of this product that could seem attractive, the extremely long term of the investment (and thus significant credit and inflation risk) make this 'Trade of the Month' pretty typical of what we have seen before.

## Friday, November 9, 2012

### SEC Litigation Releases: Week in Review

SEC Charges Purported Credit Union and Its Principal with Offering Fraud, November 8, 2012, (Litigation Release No. 22526)

The SEC filed a civil injunctive action against Stanley B. McDuffie and his entity, Jilapuhn, Inc (which has done business as Her Majesty's Credit Union) this week. According to the complaint (opens to PDF), from 2008 to 2012 McDuffie and HMCU enticed investors to purchase CDs "through the HMCU website and a branch office in the U.S. Virgin Islands," assuring investors that HMCU was a "secure, legitimate, regulated credit union." Furthermore, McDuffie and HMCU promised investors "above-market interest rates, and assured [them] that their deposits were insured by Lloyd's of London or the U.S. Virgin Islands' government." According to the SEC, in reality HMCU was "an unregulated, illegitimate credit union that never held share insurance covering investor deposits, and McDuffie and HMCU misappropriated investors' funds." The SEC has charged McDuffie and HMCU with violating various sections of the Securities Act and the Exchange Act.

## Thursday, November 8, 2012

### SEC Sues Commonwealth Advisors Over Collybus I CDO

By Craig McCann, PhD and Olivia Wang, PhD

The Securities and Exchange Commission filed a Complaint today against Commonwealth Advisors, Inc. and Walter A. Morales in connection with the Collybus I CDO offering in November 2007. The SEC Complaint can be downloaded by clicking here (PDF) and the Collybus I CDO Offering Document can be downloaded by clicking here (PDF).

The SEC alleges amongst other things that the Defendants used the Collybus I CDO offering to shift losses from its hedge funds by causing the CDO to purchase impaired RMBS from Commonwealth’s hedge funds at values which did not reflect recent market declines. Commonwealth Advisors was the Collateral Manager for the Collybus I CDO. Because the Collybus I CDO Trust purchased RMBS from Commonwealth’s hedge funds at above market prices, investors in the lower tranches of the Collybus I CDO suffered substantial undisclosed losses on the CDO’s issue date.

We have previously written about LCM VII and Bryn Mawr II CLOs issued by Banc of America in July 2007 which had similar defects. Our working paper on the Banc of America CLOs can be found here (PDF) and our previous blog post can be found here. Prompted by our research and a New York Times article, these CLOs were the subject of a subpoena issued by Massachusetts to Bank of America (WSJ story available here).

### Back to the Future: Stock Prices Quoted with Fractions

By Tim Dulaney, PhD and Tim Husson, PhD

The Wall Street Journal recently reported that the SEC is considering reverting back to an old system in which stock prices were quoted using fractions.  Using fractions for stock prices in the US has its roots in a Spanish colonial currency whose smallest denomination was 1/8 of a doubloon, hence prices were quoted in eights. The NYSE, founded in 1792 within the Buttonwood agreement, modeled their listing system off the Spanish system (for more on this interesting story see here).

The largest number used for the denominator in the fraction, which determines the tick size, has varied over time and between exchanges.  This number also determines the smallest possible spread that can be quoted between those willing to buy and those willing to sell.  To illustrate this, suppose prices are only quoted in eighths ($0.125 increments). That would imply that the smallest possible spread -- the difference between the price people are willing to sell a security and the price people are willing to pay for it -- would be$0.125, much larger than one cent.

Following an amendment (PDF) to the Securities Exchange Act of 1934 passed by Congress in 1997, the SEC implemented a controlled phase-in process requiring exchanges to list prices of equity securities and options on those securities based on dollars and cents.  Some argue that this decimalization has decreased spreads and, as a result, lowered transaction costs.  In fact, one SEC official was quoted in the WSJ article saying the decimalization switch "transferred billions of dollars from the pockets of brokers into the pockets of investors."

But the arguments presented in favor of the switch back to fractional stock prices seem disingenuous at best.  One executive at an investment bank essentially claims that if the bankers are able to collect more money on transaction fees (through higher spreads), then they could conduct more research and somehow spark growth in the financial sector.  That his company's bottom line would benefit from such an inflow of transaction fees is a more likely reason for his enthusiasm.

In fact, some have proposed the opposite change:  to allow stock quotes to take sub-penny quotes.  The idea here is that if the spread could be very small, high frequency trading would become less profitable and therefore less likely to affect stock prices or cause 'flash crashes' in markets.

Our take on this is that unless the change to fractions results in spreads that are subpenny (e.g. 1/200 increments of a dollar), it is unlikely that such a policy revision is in the best interest of investors.  We think market makers should be in the business of reducing transaction costs, not racing each other for rounding errors, and that larger spreads only lead to more rent-seeking from market makers.  It will be interesting to see if the SEC acts on this idea and what reasons the SEC cites for their action or inaction.

## Wednesday, November 7, 2012

### JOBS Act Double-Take

By Tim Husson, PhD

Senator Carl Levin (D-MI) and colleagues have written two letters (available in PDF format here and here) to the SEC "to express [Congress's] concerns with, and offer improvements to, the Commission's Proposed Rule to implement Section 201 of the Jumpstart Our Business Startups Act (the JOBS Act)."  Basically, the Senators argue that the SEC has misinterpreted the JOBS Act as allowing for widespread solicitation for private placement investments, when apparently Congress had no such intent.  From the second letter:
In addition, the Proposed Rule appears to misconstrue Section 201 as a mandate to remove any and all regulation of such general solicitation. However, the statute and legislative history reflect the intent to only remove the prohibition on general solicitation.  Congress could have removed from the Commission any authority to condition, limit, or otherwise regulate the manner or substance of general solicitation. Instead, Congress clearly elected to allow the Commission to retain its authority to regulate this new allowance for general solicitation in offerings exempt from registration pursuant to Rule 506 or Rule 144A. As such, we believe that the Proposed Rule should be significantly revised to provide clear, objective, and meaningful regulation of the manner and substance of general solicitations that may be allowed in private offerings.
They are apparently arguing that because the SEC was not expressly prohibited from regulating private placements, it was in fact required to do so.  They add that:
In providing a solid regulatory framework within which to permit general solicitation regarding certain private offerings, the Commission should distinguish between issuers that engage in operational businesses and those that are merely investment vehicles.
While the point of view expressed by the Levin letters makes sense from an investor protection standpoint, it is difficult to find evidence for that interpretation in the language of the Act itself (see section 201), so it is hard to blame the SEC for proposing the rule changes that it has.  That said, if the door is now open for the SEC to implement more stringent protections against the kind of abuses people are concerned about, that could be a huge win for investors.  As we've been discussing lately, these provisions could be a shot in the arm to all sorts of unsuitable or fraudulent investments.

But the Senators' letters do not offer a great deal more guidance than the original legislation.  Apparently it is still quite unclear how the government will come down on this issue, even though the clock has already run down on the SEC's 90-day window to implement the changes.  Whatever the final result, it is sure to have a very significant impact on retail investors--a fact appreciated by Senator Levin, who notes:
Section 201 removes the long-standing ban on general solicitation and advertising in some so-called "private" offerings. Yet, because the total dollars raised by these types of offerings now exceeds the dollars raised through registered offerings, how the Commission implements the changes to such offerings in Section 201 is critically important.
Indeed.

## Monday, November 5, 2012

### ETFs in 529 Plans

By Tim Husson, PhD and Tim Dulaney, PhD

We've talked before about the possibility that ETFs will replace mutual funds in many 401(k) retirement plans and the implications that might have for retirees.  While most 401(k) plans have not yet adopted ETFs in their investment lineups, ETFs are becoming more common in another type of long-term savings plan known as a 529 Plan.

529 Plans are typically run by states and are used to save for future education expenses such as college.  There are several ways to take advantage of 529 Plans.  One common approach is to use a 529 as a savings plan that credits growth based on the value of one or more investments.  Typically, 529 Plan investments have been mutual or money market funds, similar to those conventionally found in 401(k) funds.  Recently, however, several states have begun including ETFs in their investment lineups, which could have major effects on retirees.  ETF issuers have created branded 529 Plan options, which have recently received favorable ratings by Morningstar.

Including ETFs in 529 or 401(k) plans may have several advantages.  ETFs typically have lower fees than comparable mutual funds, and those fees have dropped even lower recently amongst intense competition.  There are also now a wide variety of ETFs available which can be used for asset class diversification and other sophisticated strategies.

But ETFs can also be very risky.  ETFs can be vastly more complex than mutual funds, and use leverage and derivative products to a much larger extent.  Newer ETFs are also more likely to fail than established ETFs, and issuers may push failing funds into 529 plans in an attempt to increase fund flows.

We've pointed out before that active funds rarely beat passive funds on an after fee basis.  If passive ETFs are replacing passive mutual funds, there could be a cost savings, but 529 investors will not be able to benefit from the more frequent tradability of ETFs.  This is because 529 plans typically only allow an infrequent (annual) allocation change and as a result, there is very little difference between holding an ETF or a mutual fund if their holdings are identical (when it comes to tradability at least).  If, on the other hand, active ETFs are used, the cost savings might be small since active ETFs often have higher fees.

Bottom line: ETFs and mutual funds are similar in many ways but are in fact very different types of investments.  A shift from mutual funds to ETFs in tax-advantaged savings plans such as 529 or 401(k) plans would be a major development that would require a significant amount of investor education.

## Friday, November 2, 2012

### SEC Litigation Releases: Week in Review

Commission Files Subpoena Enforcement Action Against Adam Bielski, November 1, 2012, (Litigation Release No. 22525)

On October 24, 2012, the SEC filed an application for "an order to enforce an investigative subpoena served on Adam Bielski." In August the SEC "issued a formal order of private investigation authorizing its staff to investigate...potential compliance and security deficiencies at a Massachusetts-based investment adviser...registered with the Commission." Specifically, the staff investigated "whether the IA's compliance and security policies and procedures were reasonably designed to protect against recent instances of attempted and actual theft of client assets managed by the IA." One instance of this alleged theft involved funds being transferred by "an apparent hacker" to Bielski's bank account. Bielski -- in voluntary interviews with the SEC -- admitted to receiving funds from Faith Collins, a woman whom he has had a six-year long association with on the internet, at least once in June 2012. A subpoena was issued against Bielski by the SEC on August 31, but according to the SEC "Bielski has failed to produce many of the responsive documents in his possession" and he "does not have a credible justification for his failure to comply with the subpoena." A hearing on the SEC's application is scheduled for November 9, 2012.

Former Deloitte Partner Sentenced to 21 Months for Insider Trading, October 31, 2012, (Litigation Release No. 22524)

Thomas P. Flanagan, former Deloitte and Touche LLP partner, was sentenced to 21 months of incarceration followed by supervised release of 12 months, and was ordered to pay a $100,000 penalty for engaging in insider trading. These charges came from "the same facts that were the subject of a civil action...filed against Flanagan and his son, Patrick T. Flanagan." Flanagan, who worked at Deloitte for 38 years, allegedly "traded on nine occasions between 2005 and 2008...while in possession of nonpublic information that he learned through his duties as a Deloitte partner." On four occasions, Flanagan shared this information with his son, who also traded on it. In total, the pair gained over$480,000 in illicit profits. In addition, the SEC found that Flanagan "violated the SEC's auditor independence rules on 71 occasions between 2003 and 2008." Both Thomas and Patrick Flanagan were charged with violating various sections of the Exchange Act. The pair has been ordered to pay over \$1.17 million in disgorgement, prejudgment interest, and penalties.