Friday, December 28, 2012

SEC Litigation Releases: Week in Review

SEC Charges Two Brokers with Insider Trading, December 26, 2012, (Litigation Release No. 22581)

This week the SEC filed an amended complaint (opens to PDF) charging research analyst Trent Martin with tipping brokers Thomas C. Conradt and David J. Weishaus with nonpublic information about IBM Corporation’s acquisition of SPSS Inc. Martin learned of the impending IBM-SPSS transaction "from an attorney friend who was working on the deal." Martin, Conradt, and Weishaus allegedly traded on the nonpublic information, gaining more than $1 million in illicit profits. After learning of the SEC's investigation, Martin fled to Australia and now resides in Hong Kong. The SEC has charged the defendants with violating sections of the Exchange Act and seeks disgorgement, prejudgment interest, and financial penalties, and a permanent injunction against the brokers.

SEC Files Charges Against Two Others in Northern California Fund Manager's $60 Million Scheme, December 21, 2012, (Litigation Release No. 22580)

On December 21, 2012, the SEC filed additional charges to its original complaint (opens to PDF) against John A. Geringer who allegedly ran "a $60 million Ponzi-like scheme." The SEC has now charged Christopher A. Luck and Keith E. Rode "who along with Geringer were principals of GLR Capital Management LLC, which managed the GLR Growth Fund, L.P." According to the SEC's complaint, GLR Capital deceived investors by claiming it received high returns from investing" 75 percent of its assets in highly liquid investments tied to well-known stock indices" when in fact "the fund was heavily invested in two private, illiquid startup companies." In April 2009, Geringer allegedly "confessed to Luck and Rode that he had been lying to them about the balances in the fund's trading accounts." Luck allegedly continued to solicit new investors in spite of his knowledge of Geringer's dishonest activity. In addition, after Rode learned of Geringer's dishonesty he allegedly "continued to mail account statements to investors that contained grossly inflated cash balances that deceived investors about the fund's liquidity." The SEC's amended complaint charges Luck and Rode with violating or aiding and abetting the violation of various sections of the Securities Act, Exchange Act, and Investment Advisers Act. The SEC seeks financial penalties, disgorgement, and permanent injunctions from Luck and Rode.

SEC Charges Four Penny Stock Purchasers with Fraud, December 21, 2012, (Litigation Release No. 22579)

According to the complaint (opens to PDF), Danny Garber, Michael Manis, Kenneth Yellin, and Jordan Feinstein all engaged in penny stock fraud by "illegally acquir[ing] over a billion unregistered" penny stock shares "at deep discounts and then dump[ing] them on the market." The defendants sold their unregistered shares by "purporting to rely on an exemption for transactions that are in compliance with certain types of state law exemptions." Furthermore, to "create the appearance that the claimed exemptions were valid, [the defendants] created virtual corporate presences" in various states. The defendants, along with "12 entities that they operated in connection with the scheme," have been charged with violating sections of the Securities Act and Exchange Act. The SEC seeks disgorgement, prejudgment interest, financial penalties, permanent enjoinment, and penny stock bars against all of the defendants.

SEC Charges Former Chairman of Board In Connection With A Fraudulent Plan To Evade The Beneficial Ownership Reporting Requirements, December 21, 2012, (Litigation Release No. 22578)

According to the complaint (opens to PDF), Lee S. Rosen, former Chairman of the Board of New Generation Biofuels Holdings, Inc., "fraudulently evaded the reporting requirements concerning his ownership interest in New Generation shares held in five separate trusts." Rosen received at least $666,000 in profit from the trusts. The SEC has charged Rosen with violating sections of the Securities Act and the Exchange act. To settle the charges, Rosen has agreed to permanent injunction, an officer and director bar, and to pay over $911,000 in disgorgement, prejudgment interest, and penalties.

SEC Settles Pending Civil Fraud Charges Against Three Former Executives of Enron Broadband Services, December 21, 2012, (Litigation Release No. 22578)

Former Enron senior vice presidents, Rex T. Shelby and Scott Yeager, as well as former chief financial officer of Enron Broadband Services, Kevin A Howard, have agreed to pay $1.75 million in civil penalties to settle "the SEC's pending civil actions against them." In 2003, the defendants were charged with securities fraud, and Shelby and Yeager were charged with insider trading. The defendants have also agreed to permanent enjoinment from future violations of the securities laws and officer and director bars. In addition, Howard has been suspended "from appearing or practicing before the Commission as an accountant." 

Thursday, December 27, 2012

Copper ETP Market Review

By Tim Dulaney, PhD and Tim Husson, PhD

Last week we described how a physical copper ETF might lead to a copper shortage and disruption of world commodities markets.  This week we wanted to review the copper ETP market in a bit more detail to get an idea of what is currently being offered.

There are seven US ETPs available with exposure primarily to the copper market.  These include:
All told, these ETPs have amassed a measly $200 million in assets since their respective inception dates.  However, as we pointed out last week, the new ETF proposed by JP Morgan will be different in that it will own physical copper.  Currently existing funds hold either copper futures contracts (JJC, CPER, CUPM, LCPR, SCPR) or shares of copper industry companies (CU, COPX) -- therefore, they are only indirectly linked to the value of physical copper.

It's not clear how much interest there will be in a physical copper ETP, but it is clear that so far equity-like exposure to copper hasn't garnered especially significant investor interest.  For comparison, the largest natural gas ETP is UNG, with over $1.1 billion in assets, and the largest silver ETP is SLV with over $10.7 billion in assets.  So if a new copper ETF is really going to create a shortage in world copper markets, it will likely have to prove much more popular than any other copper ETP to date.

Wednesday, December 26, 2012

Auction Rate Securities Responsible for $9.6 Billion Loss to Taxpayers

By Maria Li

In a complaint (PDF) filed in Nevada against Goldman Sachs last year, the city of Reno states that it issued $73.45 million of Auction Rate Securities (ARS) in 2005 and $137.43 million ARS in 2006 on the advice of Goldman.  Like many other municipalities, Reno subsequently saw the market crash in 2008 and yields skyrocket, leading to a $9.6 billion loss for issuers.

The ARS structure was promoted by Goldman as liquid, cash-equivalent investments that would allow Reno to borrow money for long term projects whilst taking advantage of short-term interest rates. In our paper, Auction Rate Securities (PDF), we explore why ARS are in fact long-term floating rate bonds with a superficial similarity to short-term investments. In order to determine the interest rate, periodic auctions are held where buyers and sellers place their bids. The resulting market clearing coupon rate is paid by the issuer on the entire issue of ARS until the next auction. The complaint states that “unbeknownst to Reno…prior to February 2008, Goldman always placed a bid in every auction to prevent auction failure.” In the months leading up to the financial crisis, auctions started failing as market participants increased their assessment of ARS risk. On February 12, 2008 Goldman ceased to artificially support the municipal ARS market causing more than 50% of auctions to fail. Interest rates spiked sharply and auctions cleared above short-term market rates, usually at or even above long-term fixed rates resulting in unprecedented losses.

As an example, the following figure shows that the weekly auctions of ABAG Finance Authority’s ARS, which started failing in February 2008 and has failed consistently since June 2008.

The ARS issued by Reno in 2006 with Cusip 759861AY(3) had rates of 3 to 4% until February 2008 when the rate dramatically increased-- reaching 15% in February 2008.

In February 2008, Reno was forced to rapidly unwind its 2006 position and refinance its ARS thus incurring an early termination obligation of over $8 million.

The collapse of the municipal ARS market cost taxpayers and issuers an estimated $9.6 billion, which led many municipalities to question the financial advice they received and whether they had been exploited by Wall Street. Peter Mougey, an attorney for Reno, commented to Bloomberg that “It’s absolutely incredible how much money has come out of local governments because of this debacle.” 

Saturday, December 22, 2012

Traded and Non-Traded REIT to Merge

By Tim Husson, PhD

Earlier this week, American Realty Capital Properties (ARCP), a traded REIT under the American Realty Capital (ARC) family of real estate investments, announced that it will be merging with American Realty Capital Trust III (ARCTIII), a non-traded REIT in the same family.  Investors in ARCTIII will be entitled to either $12.00 in cash or $12.26 per share in ARCP stock, a significant premium over the $10 per share purchase price.

This merger is remarkable for a number of reasons.  While the combined company will trade under ARCP's name and ticker, ARCTIII is by far the larger company, with total assets of almost $1.7 billion compared to ARCP's $227 million.  Also interesting is that unlike many non-traded REITs, ARCTIII has relatively low amount of debt and a large amount of cash--in fact, its cash position is just over 40% of total assets.  According to the press release, ARCTIII has a broadly diversified portfolio of over 600 properties and 100% occupancy.

As pointed out by one commentator, it is very unusual for a non-traded REIT to have a 'liquidity event' (opportunity for investors to sell) so quickly--ARCTIII was first offered only a year and a half ago.  Typically non-traded REITs take several years to go public or liquidate, and it is not clear whether some first offered in the early to mid 2000s will ever.  Many of those non-traded REITs have current estimated per share values much less than their initial $10 offering price, as we have discussed previously.

It will be interesting to see how the newly merged ARCP will be received by investors.  The significant premium paid to ARCTIII investors is odd given its large cash position, and may reflect an optimistic view of the value of ARCTIII's real estate holdings.

Friday, December 21, 2012

SEC Litigation Releases: Week in Review

SEC Files Settled FCPA Charges Against Eli Lilly and Company, December 20, 2012, (Litigation Release No. 22576)

According to the complaint (opens to PDF), Eli Lilly and Company's subsidiaries in Russia, Brazil, China, and Poland made improper payments to foreign government officials in exchange for business. Lilly's Russian subsidiary allegedly paid "millions of dollars to third parties chosen by government customers or distributors" through offshore "marketing agreements "despite knowing little or nothing about the third parties beyond their offshore address and bank account information." Lilly has been charged with failing to curtail the inappropriate agreements when it became aware of the possible "FCPA violations in Russia." Additionally, Lilly's Chinese subsidiary allegedly "falsified expense reports in order to provide spa treatments, jewelry, and other improper gifts and cash payments to government-employed physicians," Lilly's Brazilian subsidiary allowed a pharmaceutical distributor to bribe government health officials, and Lilly's Polish subsidiary made improper payments to an official's charity in exchange "for the official’s support for placing Lilly drugs on the government reimbursement list." To settle the charges, Lilly has agreed to pay over $29.3 million in disgorgement, prejudgment interest, and penalties. Lilly has also been permanently enjoined from violating various sections of the Exchange Act and has agreed to retain an "an independent consultant to review and make recommendations about its foreign corruption policies and procedures."

SEC Charges TheStreet, Inc. and Former Executives In Connection With Accounting Fraud, December 18, 2012, (Litigation Release No. 22575)

According to the complaint (opens to PDF), in 2008 TheStreet, Inc. and three executives engaged in an accounting fraud "at a former subsidiary of TheStreet, Inc." The fraud "allowed TheStreet to report artificially inflated revenue and misstated operating income or loss in each period of 2008." A separate complaint against Eric Ashman, former CFO of TheStreet, charges him with aiding and abetting the fraud "by improperly and prematurely recognizing revenue based on several of the former subsidiary's transactions." The co-presidents of the subsidiary, Gregg Alwine and David Barnett, allegedly "aided and abetted the fraud by entering into sham transactions, and fabricating and backdating contracts and other documents." TheStreet has been charged with "lacking appropriate internal controls over its subsidiary's revenue and with violating books and records and reporting provisions of the securities laws." The defendants have agreed to pay $375,000 in penalties combined.

SEC Charges Company Based in Massachusetts and Canada and Other Parties in Stock Pump-and-Dump Scheme Involving Fictitious Buyout Offer, December 17, 2012, (Litigation Release No. 22574)

According to the complaint (opens to PDF), beginning in 2010 Spencer Pharmaceutical Inc., IAB Media Inc., and Hilbroy Advisory Inc., along with Spencer's controller, Jean-Fran├žois Amyot, Spencer's officers, Maximilien Arella and Ian Morrice, and two other companies controlled by Amyot, participated in a "'pump-and-dump' scheme involving Spencer’s stock." In order to artificially "pump up" the price of its stock, Spencer allegedly "disseminated false and misleading press releases claiming that it had received an unsolicited buyout offer from a Mideast company for $245 million when, in fact, the purported buyout offer was not real." Arella and Morrice have been charged with helping Amyot create and disseminate these releases. Amyot gained almost $5.8 million in illicit profit from the scheme. The SEC has charged the defendants with "violating securities registration provisions of the securities laws" and seeks permanent injunctions, disgorgement plus prejudgment interest, and civil penalties against them. Additionally, the SEC seeks penny stock bars and officer and director bars against Amyot, Arella, and Morrice.

SEC Charges Santa Monica-Based Hedge Fund Manager in Cherry-Picking Scheme, December 14, 2012, (Litigation Release No. 22573)

According to the complaint (opens to PDF), Peter J. Eichler, Jr., and his firm Aletheia Research and Management, Inc., conducted a "'cherry-picking' scheme by steering winning trades to their own trading accounts and favored clients to the detriment of certain hedge fund investors." In addition, Aletheia allegedly failed "to implement policies, procedures, or a code of ethics that could have prevented a cherry-picking scheme from occurring." Furthermore, Aletheia and Eichler allegedly failed to "disclose [the hedge fund's] financial troubles to clients until immediately before a bankruptcy filing." Eichler and Aletheia have been charged with violating sections of the Exchange Act and Advisers Act. The SEC seeks "permanent injunctions, disgorgement of the defendants' ill-gotten gains plus pre-judgment interest, and penalties."

Thursday, December 20, 2012

Why a Physical Copper ETF Might be a Really Big Deal

By Tim Husson, PhD and Tim Dulaney, PhD

JP Morgan recently obtained approval by the SEC to launch a new copper ETF that, instead of holding derivatives linked to copper, will actually accumulate physical copper itself.  While this may not seem like a thrilling market development, there are serious concerns that if this ETF becomes popular and garners significant assets, the world market for copper might be upended.  Here's why:

Think of demand for copper as having two components:  demand for industrial or productive uses and demand as an investment.  Currently, the two are fairly separate, in that investors typically purchase copper futures (or ETFs which purchase copper futures) and non-investors buy physical (or 'spot') copper.*

But with a physical copper ETF, the economics of the physical copper market might change.  Consider that when an ETF purchases physical copper and stores it in a warehouse, that copper is no longer available for productive use.  Therefore the amount of physical copper that is actually available for use has been reduced.  As the ETF grows, it removes physical copper from world supply, perhaps leading to a shortage.  There is some academic research providing evidence that large players in a market have the ability to, perhaps unintentionally, manipulate prices and increase market volatility -- even adversely impacting other asset prices.

However, this type of shortage would be different than artificial shortages caused by market manipulation. When someone tries to corner a copper market as 'Mr. Copper' did in the 1990s, the price of copper increases and traders respond by shorting. But as the manipulator keeps buying at higher and higher prices, a 'short squeeze' is created where traders have to buy in order to cover their shorts, sending the price even higher. Presumably, traders would not short in response to increased copper prices resulting from the ETF's purchases, because those traders would know that price change reflects actual market demand. Nevertheless, if the ETF grows and must hold large quantities of copper, that reduction in supply could increase copper prices, which may have an effect on construction and industrial costs.

Interestingly, almost two years ago JP Morgan made a large purchase of physical copper, and some suspected it was intended as the initial purchase for a physical copper ETF.  That initial purchase alone amounted to "between 50% and 80%"  of the reserve supply at the London Metals Exchange (LME) where copper is most actively traded  -- if JP Morgan has held that copper since then, they've incurred a pretty hefty loss.

The SEC has apparently been studying the effects of a physical copper ETF on world copper markets, but some commentators argue that their approach misses the point and that the risks are apparent and real. It remains to be seen how world markets will respond if this ETF accumulates substantial assets.

Another consequence of a physical copper ETF would be to move some of the investment demand for copper from the futures markets to the spot market. All else equal, this should lower futures contract prices and raise spot market prices, leading to increased backwardation (or a moderation of contango) in the copper market.

We'll be looking more closely at the copper ETF market and the possible effects this move could have on the term structure of copper futures contracts.
* Since some companies may also use copper futures to hedge exposure to copper price fluctuations, there is some overlap in this classification.

Wednesday, December 19, 2012

Derivatives in Active ETFs

By Tim Husson, PhD

Over two and a half years ago, the SEC initiated a moratorium on approvals for new ETFs that made extensive use of derivatives such as options and futures contracts. Much of the concern at that time was that derivatives-based ETFs, particularly leveraged, inverse, and futures-based ETFs may not have investor protections or oversight commensurate with their level of risk. Regular readers of this blog know that we have spent a good deal of time discussing those issues in addition to our research work on the subject.

As reported by Brendan Conway at Barron's as well as IndexUniverse, the SEC will allow more lax regulation of the use of derivatives in actively-managed ETFs. The key word here is actively-managed--typical leveraged, inverse, and futures-based ETFs are actually structured as passively managed funds, which is to say they follow a predefined strategy and target a specific index to track (before fees). Actively-managed ETFs are different in that they rely on the judgment of a fund manager, and have only recently become common in the ETF space.

So in some sense, the SEC's announcement does not address the primary concerns that led to the 2010 moratorium. In the meantime, the two main issuers of leveraged and inverse ETFs in the US (ProShares and Direxion) have enjoyed an effective duopoly, as noted by Brendan Conway:
It’s funny how the policy has worked. The makers of popular plain-vanilla ETFs often face five, six or more direct competitors. The crowding of new products has been a good thing for investors. But ProShares and Direxion essentially have the leveraged ETF market — so distrusted by regulators — to themselves. Which isn’t good for competition or choice.
Indeed, the SEC will not be lifting the moratorium for leveraged ETFs in the near future.

But there is an even larger issue here. ETFs can be purchased quickly and easily by almost any retail investor. If ETFs have complex embedded derivatives positions, positions that would be unsuitable for unsophisticated investors if purchased directly, are the ETFs themselves suitable? The answer is likely complex, as mutual funds and other more traditional investments make use of derivatives for many risk-management purposes. But the use of derivatives can also be used to create positions that retail investors and brokers may not understand or use properly, and it is still not clear what kind of regulation will prevent those types of investments from finding their way into retirement and other conservative portfolios.

Tuesday, December 18, 2012

FINRA and BBB Launch Smart Investing Website to Educate Consumers on Financial Fraud

By Maria Li

The FINRA Investor Education Foundation in conjunction with the Better Business Bureau (BBB) announced the launch of their new website, BBB Smart Investing, last Friday. Smart Investing provides investors with “tools and information to help [them] better protect and manage” their money.

One useful feature that we've noted on the blog before is the FINRA BrokerCheck, a free search engine for disclosures, regulatory action and fines against brokers and brokerage firms. The search generates a report which provides comprehensive background information on investment professionals and firms. BrokerCheck provides investors with an easy way to research their broker or brokerage firm before committing to an investment. For example, a search for Morgan Keegan & Company, Inc. generates a FINRA BrokerCheck Report that shows the firm’s profile, history, operations, as well as a detailed list of 48 regulatory events and 189 arbitrations.

Another useful tool on the Smart Investing website for public investors is Ask and Check, which includes tips on how to detect investment fraud and steps for identifying scams. The website also has a list of upcoming events with detailed information on where workshops are being held.

According to the Federal Trade Commission (FTC), financial consumer fraud was responsible for $1.5 billion of losses in 2011. The BBB Smart Investing website will serve as an online tool to educate consumers on financial fraud and prevent investment scams. This partnership will combine the investigative skills of the BBB with the financial expertise of the FINRA Foundation, providing consumers with another great source of financial education.

Monday, December 17, 2012

Another Non-Traded REIT Revises Share Value Downwards

By Tim Husson, PhD

Following in the footsteps of several other large non-traded REITs, Wells Timberland REIT has revised its estimated per share value down to $6.56, from approximately $9.50 reported in the company's last 10-Q. The shares were sold for $10.00 per share starting in August 2006 and as late as December 2011.

Non-traded REITs are largely illiquid real estate investments that can be sold to retail investors but are not traded on major exchanges (see our white paper on non-traded REITs for details). Many non-traded REITs had initial offerings before the real estate collapse, but did not update their sale prices to reflect the likely declining value of their holdings. FINRA recently required non-traded REITs to provide good faith estimates of that per share value, and the results have not been pretty--several non-traded REITs have revised their estimated per share values downwards over 25% (over 50% in some cases).

Remarkably, this lack of revision to the offering price was touted as an advantage by many non-traded REITs and broker-dealers. But because the long-maintained $10 values were not market values, they did not reflect the declining value of most classes of real estate. It's important to note that the recent revaluations are still not market values, but are management's estimates and likely do not reflect what an investor would receive in the very limited secondary market.

It is not clear whether a truly transparent market will ever exist for non-traded REIT shares, nor is it guaranteed the value will ever return to or exceed the $10 per share most investors paid. While some non-traded REITs have issued shares on public markets and become traded REITs, it is not clear why any investor would prefer an illiquid, non-transparent, and high-fee product when there are numerous traded REITs and real estate mutual funds to choose from.

CFTC Amendment to Rule 4.5 Survives Challenge

By Tim Dulaney, PhD

Last Thursday, a Federal judge ruled on a challenge to the CFTC's February 2012 amendment to Rule 4.5 (PDF) that will require mutual funds and ETFs that have sufficient non-hedging participation in derivative markets to register with the CFTC as commodity pool operators (CPOs).  The CFTC defines a CPO as a "person engaged in a business similar to an investment trust or a syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity futures contracts or commodity options."

This decision is the result of a legal challenge to the newly adopted rule change filed by the US Chamber of Commerce and the Investment Company Institute in April of this year.  The President of ICI stated that the amendment "will impose significant compliance costs on mutual fund advisers and, ultimately, these costs will come out of shareholders’ pockets."  The challenge claimed that the CFTC registration was unnecessary given that the funds already must register with the SEC and that the amendment "violate[s] the Administrative Procedure Act as well as the Commodity Exchange Act."

The CFTC defended the amendment in June stating that an "agency need not refrain from action where data is unavailable or incomplete" and, in July, the business groups shot back claiming that the CFTC is "painting with a broad brush."  On Wednesday, the US District Court in DC tossed the suit stating that "the CFTC considered the relevant factors, acted well within its discretion, and that there was nothing arbitrary or capricious about the CFTC’s actions in promulgating the final rule."

Under the rule, fund advisers will have to register with the CFTC as CPOs or satisfy the de minimis threshold requirements (PDF) on their trading.  The threshold requirement limits either the aggregate initial margin or the aggregate notional value of derivative positions (swaps, options and futures) for non-bona fide hedging trades. 

It is unclear whether this new regulatory hurdle will benefit investors through more stable financial markets or harm them through the increased cost of regulatory compliance.  We'll continue to follow this issue as funds contend with this new rule.

Friday, December 14, 2012

SEC Litigation Releases: Week in Review

SEC Charges Massachusetts Company, CEO and Promoters With $9 Million Securities Fraud, December 14, 2012, (Litigation Release No. 22572)

According to the complaint (opens to PDF), BioChemics, Inc., its CEO, John Masiz, and two individuals paid to solicit investors, Craig Medoff and Gregory Kroning, "made false statements to investors about collaborations with major pharmaceutical companies and the status and results of drug trials of [BioChemic's] main product." Additionally, the SEC claims "that they created fraudulent valuations of the company’s stock in order to raise" at least $9 million from investors. The SEC alleges that while Masiz claimed investor funds would be used "to fund clinical trials and [to pay] for operating expenses," he actually used some of the funds for personal expenses including "meals, massages, clothes, and sporting goods and to make interest-free loans of over $200,000 to Kroning in addition to paying for his personal expenses including a leased BMW." Masiz and Medoff had previously been sued by the SEC and Medoff had been barred from associating with brokers, dealers, and investment advisers. The current complaint charges all defendants with violating sections of the Securities Act and the Exchange Act and seeks injunctive relief, disgorgement, and civil penalties, as well as an officer and director bar against Masiz.

Defendant in SEC Enforcement Action Sentenced and Ordered to Pay Restitution, December 14, 2012, (Litigation Release No. 22571)

Stephen B. Blankenship was sentenced to forty-one months imprisonment plus three years of supervised release as well as ordered to pay over $615,000 in fines and restitution based on his "his guilty plea to one count of Mail Fraud and one count of Securities Fraud." Blankenship was charged by the SEC for allegedly operating a scheme through Deer Hill Financial Group, LLC, where he falsely "represented to numerous investors that he had investment opportunities that were safe and would pay a consistent return to investors."

Court Enters Final Judgment Against Massachusetts Investment Adviser and its Principal, Orders Payment of Over $1.7 Million in Illicit Gains and Penalties, December 14, 2012, (Litigation Release No. 22570)

A final judgment was entered against investment adviser EagleEye Asset Management, LLC and its principal, Jeffrey A. Liskov. According to the SEC, Liskov "made material misrepresentations to several advisory clients to induce them to liquidate investments in securities and instead invest the proceeds in forex trading." EagleEye and Liskov have been charged with violating sections of the Exchange Act and Investment Advisers Act, and have been ordered to pay over $1.7 million combined in disgorgement, prejudgment interest and civil penalties.

Securities and Exchange Commission v. Tiger Asia Management, LLC, et al., December 14, 2012, (Litigation Release No. 22569)

Sung Kook "Bill" Hwang, manager of Tiger Asia Management and Tiger Asia Partners, has been charged with insider trading. According to the SEC, Hwang used information he received in private placement offerings for Bank of China stock and China Construction Bank stock to short sell stocks and make over $16.2 million in illicit profits. The head trader of the two hedge funds involved, Raymond Y.H. Park, has also been charged by the SEC for his alleged involvement in the trading. In addition to the $16.2 million, Hwang and Park also collected almost $496,000 in inflated management fees for the funds. The SEC has charged Hwang, the firms, and Park with violating sections of the Exchange Act and Securities Act. Additionally, Hwang and the firms have been charged with violating sections of the Investment Advisers Act, while Park has been charged with "aiding and abetting those violations." Hwang, Tiger Asia Management, and Tiger Asia Partners are required to pay approximately $44 million in disgorgement, prejudgment interest, and penalties. Park has agreed to pay $74,000 in disgorgement, prejudgment interest, and penalties.  For more information, see our recent post on this action.

SEC Charges U.S. Based Consultants to Numerous Chinese Reverse Merger Companies with Securities Fraud, December 11, 2012, (Litigation Release No. 22568)

According to the complaint (opens to PDF), Huakang "David" Zhou and his consulting firm Warner Technology and Investment Corporation "engaged in varied misconduct from at least 2007 through 2010." Zhou's alleged misconduct includes engaging in the unregistered sale of securities, acting as an unregistered securities broker, making material misrepresentations and omissions to investors and conducting "an elaborate scheme in an apparent effort to list another client, a Chinese real estate company, on a national securities exchange." The SEC has charged Zhou and Warner Investment with violating sections of the Securities Act and the Exchange Act.

SEC Charges New York-Based Fund Manager with Two Widespread Fraudulent Trading Schemes Spanning Nearly Four Years, December 11, 2012, (Litigation Release No. 22567)

According to the complaint (opens to PDF), Steven B. Hart "used his control of Octagon Capital Partners, LP...and his position of authority at an investment fund for which he was employed as a portfolio manager to direct thirty-one matched trades between the two investment funds, benefiting Octagon at the expense [of] his employer's fund." This illegal matched trading resulted in over $580,000 in profit for Octagon. Additionally, the SEC has charged Hart with trading "on behalf of Octagon while in possession of material nonpublic information concerning the offerings" resulting in over $240,000 in illicit profit. The SEC has charged Hart with violating sections of the Securities Act, Exchange Act, and the Investment Advisers Act. Hart has consented to a judgment enjoining him from future violations and has agreed to pay over $1.3 million in disgorgement, prejudgment interest, and penalties.  SLCG has conducted independent research (PDF) concerning such personal trading abuses.

SEC Charges Oil and Gas Company and Principal with Offering Fraud, December 11, 2012, (Litigation Release No. 22566)

According to the complaint (opens to PDF), from June 2001 through April 2012, Rodney Ratheal, principal of Premco Western, Inc., "raised over $4 million...through the fraudulent and unregistered sale of undivided fractional working interests in two oil and gas wells located along the Utah/Arizona border." Ratheal has been charged by the SEC with making false and misleading statements including telling investors that the company's purported geologist " had discovered a 'Super Giant' oil and gas field under Premco's 1,000 acres of federal mineral leases," and that drilling was successful when in fact " neither of the two wells drilled with investor funds produced any oil." Furthermore, Ratheal told investors that "only 10% of the investment proceeds would [go] to cover his living expenses. In reality, approximately nearly $3 million (or 70%) of investor funds were used to support Ratheal's lavish lifestyle." Premco and Ratheal have consented to a judgment enjoining them from violating sections of the Securities Act and Exchange Act and have consented to pay over $7.3 million in disgorgement and prejudgment interest.

Court Enters Final Judgements Ordering Dwight Flatt and David Della Sciucca, Jr. to Pay Disgorgement, Prejudgment Interest and Civil Penalties, December 11, 2012, (Litigation Release No. 22565)

Final judgments have been entered against Dwight Flatt and David Della Sciucca, Jr. for their alleged involvement in a kickback scheme involving the stock of Magnum d'or Resources, Inc. Flatt has been ordered to pay over $4.6 million in disgorgement, prejudgment interest, and penalties. Sciucca has been ordered to pay over $1.3 million in disgorgement, prejudgment interest, and penalties.

Securities and Exchange Commission v. InnoVida Holdings LLC, Claudio Osorio and Craig Toll, December 7, 2012, (Litigation Release No. 22563)

According to the complaint (opens to PDF), InnoVida Holdings LLC, its former CEO, Claudio Osorio, and its former CFO, Craig Toll, "perpetrated an offering fraud that raised at least $16.8 million mainly from investors located in Miami, Florida." InnoVida, "a manufacturer of alternative housing structures," allegedly claimed "that its product was fire and hurricane proof and could be produced at economically advantageous prices." According to the SEC, Osorio used "fraudulent pro forma financial statements to persuade investors to fund InnoVida's alternative housing business." Toll allegedly prepared the pro formas, "which falsely reflected that InnoVida had more than $35 million in cash and cash equivalents in its bank accounts, and more than $100 million in equity." Additionally, the SEC claims that Osorio "diverted at least $8.1 million of investor monies to fund his lavish lifestyle."

SEC Charges Florida-Based Lawyer with Forging Attorney Opinion Letters for Microcap Stocks, December 7, 2012, (Litigation Release No. 22562)

According to the complaint (opens to PDF), Guy M. Jean-Pierre wrote and issued attorney opinion letters "in the name of his niece by applying her signature without her consent" after he was banned in April 2010 from issuing attorney opinion letters. This ban resulted from the "'repeated missing information and inconsistencies' about the issuers and his lack of due diligence in his past letters." Jean-Pierre (also known as Marcelo Dominguez de Guerra) tried to "evade the ban by forming a new company called Complete Legal Solutions and misrepresenting that his niece was conducting the legal work that was allegedly performed." His plan was allegedly formed within two weeks after the original ban had been placed on him. The SEC has charged Jean-Pierre with violating sections of the Securities Act and the Exchange Act and seeks disgorgement, prejudgment interest, financial penalties, a permanent injunction, and a penny stock bar against him. 

SEC Charges Tiger Asia Executive with Insider Trading

By Maria Li

Earlier this week, the Securities and Exchange Commission (SEC) charged two New York-based hedge fund managers with insider trading. Sung Kook “Bill” Hwang of Tiger Asia Management and Tiger Asia Partners admitted to using material non-public information to short sell shares of Bank of China Ltd. and China Construction Bank Corp resulting in nearly $17 million in unlawfully gained profits. Tiger Asia covered its short positions with private placement shares that were obtained at a discount. Hwang agreed to settle with the SEC and pay $44 million in restitution and damages.

Tiger Asia Management focuses on trading in Asia. It is a spinoff from Tiger Management which was once one of the world’s largest hedge funds with $22 billion in assets under management in mid-1998. A four year-long probe by the Hong Kong Securities and Futures Commission (SFC) for insider trading forced Tiger Asia to return investor money in August 2012. In January 2009 and again in April 2010, the SFC sought to bar Tiger Asia from trading on the Hong Kong Stock Exchange and to freeze up to $38.5 million of the fund’s assets. Interestingly enough, Tiger Asia has no physical presence in Hong Kong because they have no office space or staff based primarily in the region.

Following news of the SEC’s charges, Japan’s Securities and Exchange Surveillance (SESC) proposed a $786,000 fine against Tiger Asia for manipulating the stock price of Yahoo Japan Corp. This ruling, if awarded, will set the record for the highest SESC fine for unfair trading.

News of the SEC settlement continues to set the trend for aggressive prosecution of illegal offshore trading. It is becoming increasingly clear that entities will no longer be able to evade charges simply by hiding behind a multitude of shell companies.

Thursday, December 13, 2012

CFTC Chief Economist Finds High Frequency Trading Harms Traditional Investors

By Tim Dulaney, PhD and Tim Husson, PhD

Andrei Kirilenko, chief economist at the Commodity Futures Trading Commission (CFTC), recently released a report (PDF) that purports to show that the "high-speed trading firms that have come to dominate the nation's financial markets are taking significant profits from traditional investors" according to an article posted by Global Association of Risk Professionals (GARP) as well as the New York Times.

The report categorizes HFT firms as 'aggressive', 'mixed' or 'passive' depending upon the proportion of their trades that are immediately filled.  Firms are categorized as aggressive if trades are liquidity taking more than 40% of the time and passive if trades are liquidity taking less than 20% of the time.  The firms that fall in the middle are deemed mixed.

According to Table 8 in the report, high frequency traders realized an average daily short-term profit of $1.9 million in one particular market (S&P 500 E-mini futures contracts) in August 2010.  On the other hand, retail investors realized an average daily short-term loss of about $123,000.  The report finds that profits were concentrated in aggressive HFTs which "reveals deviations from market efficiency at very short intervals."  The following figure depicts the profit per contract realized by each type of HFT trading strategy during the period analyzed.

Given that HFT firms are highly profitable, the question becomes whether they benefit markets as a whole.  One of the primary ways HFT firms justify their activities is by arguing that they provide liquidity to markets.  This study found that about 60% of HFT firms are net liquidity providers, but that the 'aggressive' HFT firms were liquidity takers on average.  The authors note that "aggressive HFTs could be predatory and extract rents from slower or less informed traders, or they may provide value by correcting transient price deviations and thus leading to lower volatility and better price discovery."

They also note that "an arms race for ever-increasing speed and technological sophistication raises questions about whether the speed of information incorporation into the market at the millisecond time horizon has social value."  It appears from their (admittedly limited) sample that not all HFT firms are the same, and that those identified as 'aggressive' may have less benefit than others.

These findings could provide guidance to regulators about how to most effectively regulate HFT firms to prevent abusive rent-taking while still encouraging productive liquidity.  While its scope is limited, this study makes an important contribution to our understanding of these relatively secretive and unstudied firms who may have a disproportionate impact on financial markets.

Wednesday, December 12, 2012

Massachusetts Securities Regulators Getting Tough on Non-Traded REITs

By Tim Husson, PhD

LPL Financial, the largest independent broker-dealer in the US, is being sued by Massachusetts securities regulators for "numerous regulatory violations in connection with the sale of non-traded REITs."  We have covered non-traded REITs extensively on this blog, as well as in a detailed working paper (PDF), and it appears that many of the problems that have been identified with these products are finally attracting attention from regulators.

According to the complaint (PDF), the action is specifically targeted at LPL's sales of Inland American, one of the largest and most well-known non-traded REITs.  However:
The Enforcement Section's investigation revealed significant and widespread problems with LPL's adherence with product prospectus and Massachusetts requirements. Through LPL Representative testimony, the Enforcement Section uncovered similar issues with other non-traded REITs. In many ways, the Division's investigation unearthed a boat with many holes.
It's important to note that the state's action is not directed at Inland American or any other non-traded REIT sponsor or affiliate; rather, it is directed at a major broker-dealer who sold those products to retail investors without proper training or supervision.  According to the complaint, LPL sold approximately $28 million of Inland American shares to Massachusetts residents from 2006 through 2009, accumulating $1.8 million in gross commissions.  Apparently a whopping 569 out of the 597 transactions involving Inland American were in violation of prospectus requirements.

It is our opinion that non-traded REITs are fundamentally flawed and have many features that make their basic economics untenable.  But unlike private placement investments or hedge funds, non-traded REITs can be sold to retail investors under certain conditions which were designed to help ensure that investors had an appropriate risk tolerance and no immediate liquidity needs.  LPL Financial will have to prove it followed these restrictions.

While it's encouraging to see actual enforcement of these protections, we think it is worth asking whether non-traded REITs are suitable for anyone.

IBM Switches to Annual 401(k) Contributions

By Tim Dulaney, PhD and Tim Husson, PhD

The Associated Press recently posted a story concerning IBM's effort to cut costs by switching from regular contributions to employees' 401(k) accounts on each paycheck to a lump-sum contribution at the end of each year.  This move, clearly in the best interest of shareholders, has real and significant implications to the 401(k) accounts of IBM employees.  According to the article, only a minority of companies use this type of arrangement.
About 7 percent of employers offering 401(k)s make contributions once a year, benefits consultant Mercer estimates. About 88 percent make contributions each pay period, with a smaller number using monthly or quarterly distribution schedules.
To get an idea of how an employee could be effected by this change, consider an employee with 25 years to retirement.  Suppose the employee's current salary is $60,000 and that it increases 4% annually each January.  Suppose the employee is paid bimonthly and on each paycheck the employee contributes 6% and the employer matches 6%.  If the 401(k) account grows at a rate of 10% annually, then the employee will end up with an account value of approximately $920,000 at retirement.

If the employer chose to match employee contributions to the 401(k) annually instead of on each paycheck, the account value would be approximately $23,000 lower.  Employees with more years to retirement stand to lose more: if the employee has 30 years to retirement, the difference is about $40,000.  In each example, the difference amounts to about 2.5% of the 401(k) account value at retirement.

We have created a spreadsheet that models the effect of this change for several variable parameters such as years to retirement, salary growth, etc.  It is available for download in Excel format here.

Another reason IBM may be choosing this approach is that if an employee chose to leave the company before the annual contribution date, the employee would effectively give up the annual contribution.  At a company with high turnover, those savings could be significant.  In that case, much of the cost savings IBM would enjoy would be at the expense of departing employees and this move could be seen as a way to curb attrition.

Whatever the motivation, there is no upside for IBM employees.  The cost savings or increased short-term cash flexibility will likely be significant (IBM has over 400,000 employees), but it comes at the expense of their own workers.

Structured Products Highlight: Citigroup ELKS Linked to YAHOO!

By Tim Dulaney, PhD

Today we're highlighting a structured product issued on May 25, 2011 by Citigroup.  This product (CUSIP: 17317U501) is an Equity LinKed Security (ELKS) linked to Yahoo! (YHOO).

ELKS are similar to reverse exchangeables in that the notes pay periodic coupons (monthly at an annualized rate of 9.50% in this case) and protect principal on a limited basis (if YHOO's price remains above the $13.08 trigger during the term of the note).  In contrast to reverse exchangeables, once a trigger event occurs during the term of the note, the notes convert to a fixed number of shares of the underlying stock (0.61 shares per $10 note).  This feature exposes investors to both depreciation and appreciation of the asset whereas reverse exchangeables only expose investors to the depreciation if a trigger event occurs. See the following figure for more details.

A trigger event occurred on August 2, 2011 -- the closing price of YAHOO! was $12.76, below the $13.08 trigger -- and the notes converted to 0.61 shares of YAHOO!.  At the November 21, 2011 valuation date, the closing price of YAHOO! was $14.99 -- 8.31% below the pricing date value of $16.35.  As a result, investors realized a loss of about 7.1% including the coupon payments received during the six month term of the notes. 

Tuesday, December 11, 2012

SEC Charges Morgan Keegan Directors with Failing to Oversee Asset Valuations

By Sandy Ouano

The SEC has charged eight former Morgan Keegan directors with failing to provide accurate valuations for mortgage-backed securities during the subprime crisis of 2007. We wrote a paper in 2009 (PDF) explaining the collapse of the RMK bond funds and how they relate to these very same securities.

The mutual funds at issue are 1) RMK High Income Fund, Inc.; 2) RMK Multi-Sector High Income Fund, Inc.; 3) RMK Strategic Income Fund, Inc.; 4) RMK Advantage Income Fund, Inc.; and 5) Morgan Keegan Select Fund, Inc. The Select Fund was an open-end company which contained three open-end series—the Select High Income portfolio, the Select Intermediate Bond portfolio, and the Select Short Term Bond portfolio.

The RMK funds were essentially the same fund. They behaved in the same manner and held many similar securities. Below is a graph of the return if someone invested $100 on December 31, 2005 with reinvested dividends. By December 2008 an investor would have loss about 90% of the investment.

These funds did not behave like their peers. Below is a graph which compares the total returns of the RMK closed-end funds with non-RMK closed-end high income funds from January 2007 to December 2009.

Six of the eight directors sat on the Fund’s Audit Committee and were designated as “Audit Committee Financial Expert.” Their task was to oversee the process of determining the fair value of the funds. According to the SEC order, the directors did not provide any guidance on how to determine fair value. 

Many of these securities were in structured finance that were below investment grade. Also, they were highly leveraged and illiquid. Some of the reported values for these illiquid securities went unchanged for several months before the turmoil in the subprime MBS market.

In our 2009 paper, we calculated that about 60% or more of the gross assets of these funds were in structured finance. We also calculated that more than 80% of the losses between March 2007 and December 2007 were in asset backed securities and/or from internally priced securities--the securities that the SEC alleges the eight directors had a responsibility to accurately value.

RMK Funds Were Structured Finance Funds
March 31, 2007
% of Gross Assets in Structured Finance
% of Gross Assets in Corporate Bonds
Select High Income
Select Intermediate Bond
High Income
Strategic Income
Advantage Income
Multi-Sector High Income

Morgan Keegan also misrepresented some of these asset backed securities as corporate bond or preferred stock. For example, most of all of the securities classified as “Corporate Bonds – Special Purpose Entities” are asset backed securities. Moreover, RMK misrepresented the riskiness of the funds. The RMK funds were four to six times as volatile as their benchmark during the 1-year, 2-year and 3-year periods ending on March 31, 2007. They were more than 12 times as volatile as their benchmark.

RMK Funds Were Much More Volatile Than Benchmarks
(annualized standard deviations, ending March 31, 2007)
Prior Three Years
Prior Two Year
Prior One Year
April 2007 to September 2007
13.8% (4.8 ×)
14.0% (5.2 ×)
16.1% (6.2 ×)
(12.3 ×)
12.0% (4.2 ×)
11.7% (4.3 ×)
12.7% (4.9 ×)
(12.7 ×)
12.2% (4.3 ×)
12.0% (4.4 ×)
13.2% (5.1 ×)
(12.7 ×)
11.3% (4.2 ×)
11.3% (4.2 ×)
12.0% (4.6 ×)
(13.2 ×)
3.5% (1.2 ×)
3.4% (1.3 ×)
3.5% (1.3 ×)
(4.9 ×)
Benchmark (VWEHX)
Benchmark (HYG)
2.4% (0.5 ×)
2.3% (0.6 ×)
2.3% (0.6 ×)
(3.4 ×)
Benchmark (VBIIX)

In June of 2011 the SEC settled with Morgan Keegan & Company and Morgan Asset Management for $200 million and barred former portfolio manager James C. Kelsoe Jr. and suspended comptroller Joseph Thompson Weller.

Happy (We Hope) Madoff Day

By Tim Husson, PhD and Tim Dulaney, PhD

It was four years ago today that Bernie Madoff was arrested for perpetrating his estimated $65 billion fraud.  Coming right on the heels of the SEC and FINRA's year-end investor warnings, Paul Sullivan at the New York Times has suggested that December 11 should be declared Madoff Day, where we reflect upon how to protect ourselves from investment fraud.
Protecting yourself against fraud, or simply bad advice, is easier said than done. The most common advice is to make sure your money is held by an independent custodian or firm whose job is to keep your money safe. That wasn’t the case with either the Madoff or Stanford fraud. But that is only one small step.
The article goes on to discuss the importance of checking out your adviser for any disciplinary history as well as not trusting any sizable amount to a single adviser.  Prudent advice to be sure.

But sometimes it is simply very difficult to tell a genius from a charlatan.  As discussed in the article, Madoff's returns have been found to be statistically improbable, a result echoed by other academic work.  But of course, unsophisticated investors cannot be expected to perform and interpret such calculations themselves -- and the academics didn't find this fraud statistically improbable until after the fact.  This is similar to the information asymmetry that exists in lots of fraudulent investment schemes, especially those that rely on personal relationships with clients.

So we at SLCG propose that on this Madoff Day, we should not just consider how to protect our own investments from fraud and mismanagement, but think of what we can all do to educate others about financial safety.  Analysts, reporters, advisers, brokers, or anyone who takes the responsibility for advocating for retail investors should take this time to think of how they can be even more vigilant in identifying and drawing attention to financial impropriety in all of its forms.

Monday, December 10, 2012

SEC and FINRA Issue Investor Alert RE: Year-End Investment Considerations

By Tim Dulaney, PhD and Tim Husson, PhD

Late last week, FINRA and the SEC's Office of Investor Education and Advocacy issued an investor alert encouraging investors to take stock of their investments and finances at year-end.  This alert is rather brief, but offers sound advice to prevent disputes that could lead to the kind of arbitration or litigation we see every day.

In particular, the two regulatory bodies suggest reviewing asset allocations and consider rebalancing.  Conventional wisdom tells us that investing in more than one asset class generally decreases the risk of a portfolio's returns and leads to greater holding period returns on average.  Moreover, since assets held in a portfolio vary in value over time, it is possible that a buy-and-hold investors portfolio could become over (or under)-weighted in a particular asset class or market sector.  It is important that investors take stock of their portfolio and realize any potential problems with current allocations.  FINRA also points out that investors can -- and should! -- check the background of their broker or investment adviser.

The investor alert also stresses the importance of tax considerations at this time of year.  If an investor believes that tax rates on capital gains may rise in the next year or so, it could be prudent to realize capital gains before the end of the year and take advantage of 2012 capital gains tax rates.  A similar issue has been the focus of media scrutiny lately, as many corporations have increased dividends in anticipation of higher tax rates resulting from the Fiscal Cliff debate.

It is also important to update financial records and ensure that these documents are in a location easily accessible in case of an emergency.  Based on our litigation and arbitration experience, we certainly agree that investors who have well-maintained records and copies of all pertinent agreements between themselves and their brokers or advisers are much better prepared if those investments turn sour.

Friday, December 7, 2012

Deliverable Interest Rate Swap Futures

By Tim Husson, PhD and Tim Dulaney, PhD

Interest rate swaps are important tools used by many financial and non-financial firms to manage their interest rate exposure. Earlier this week, the CME Group launched a new derivative product called Deliverable Interest Rate Swap Futures with the contention that the product offers "maximum efficiency for managing interest rate exposure." This move is close in spirit to the recent move by the Eris Exchange to offer interest rate swaps on an open exchange. Both of these products are designed to move the interest rate swap market from an over-the-counter format to transparent, cleared exchanges.

But the new deliverable interest rate swap futures are particularly interesting. They are in some ways very similar to US Treasury futures (PDF)--they are futures contracts that on a particular date promise delivery of a standardized financial product, just as a commodity futures contract promises delivery of a standardized commodity (oil, wheat, etc) on a given date.  These futures contracts are the standardization of forward swap contracts that firms use to manage their interest rate exposure at some point in the future.

Because the value of the futures contract will reflect the expected value of the product on that date, the value of an interest rate swap futures contract will fluctuate with the value of the underlying interest rate swap. From the CME Group:
This product has the same economic exposure as an interest rate swap, the margin and liquidity benefits of a futures contract, and at expiration all open positions will deliver into a CME Cleared Interest Rate Swap. The product will be a standardized future, trading both electronically on CME Globex and via open outcry, and will be eligible for privately negotiated transactions. 
Futures contracts will be listed for quarterly expiration on [International Monetary Market (IMM)] dates, for physical delivery of OTC US dollar interest rate swaps at key terms to maturity (2, 5, 10, 30 years). Contracts will be quoted on a price basis, with a fixed coupon for each contract that is set by the Exchange when the contract is listed for trading. At expiration the holder of a long futures position will become the fixed rate receiver and floating rate payer in an OTC interest rate swap cleared by CME Clearing.
According to the CME Group, "Credit Suisse, Citi, Goldman Sachs and Morgan Stanley" have already expressed interest in being market makers for these products.  The CME Group also offers some examples of how these new contracts can be used, for example, to make bets on the evolution of the swap term structure.

Clearly, interest rate swap futures are sophisticated tools.  What makes this new product so interesting, though, is that by structuring interest rate swap exposure as a futures contract, interest rate swaps may become more prevalent in other types of products.  Currently, many ETFs hold futures contracts, and are then sold to retail investors.  It may now be possible for deliverable interest rate futures to begin appearing in other retail products, despite being likely unsuitable for all but the most sophisticated traders.