Thursday, January 31, 2013

Crowdfunding and Real Estate Investing

By Tim Husson, PhD

The JOBS Act of 2012 was ostensibly designed to increase investment in small businesses.  One of its provisions was to allow private placement investments (such as hedge funds, oil and gas partnerships, etc) to advertise publicly.  Another provision is to allow for 'crowdfunding' of real estate and other investments, in effect allowing the sale of partial interests in speculative ventures to small retail investors.  Kaitlin Ugolik at Law360 has a great review of the implications of this provision for real estate law, which could represent a further erosion of investor protections.

Crowdfunding refers generally to collecting small investments from a large group of people, usually via websites such as Kickstarter, to fund a project of any kind.  Crowdfunding has become a popular way for artists and inventors to attract the initial funding they need to begin their creative works, and has been greatly facilitated by the rise of social media and the ability to spread the word about a project quickly and cheaply.

But crowdfunding also raises many legal and regulatory questions, such as whether investments in these projects constitute securities under the SEC's purview.  The JOBS Act addressed crowdfunding directly by mandating that the SEC not only allow for crowdfunded investments, but to create the markets ('portals') by which crowdfunding would take place.  The SEC has not yet implemented these provisions, and according to the Law360 article, there is a great deal of uncertainty regarding how it will be done.
Meanwhile, small developers and property owners looking to expand are waiting for the SEC to determine a variety of things, like what types of information they will have to provide potential investors, and how much. Perhaps most importantly, they await guidance on how the securities issued through crowd funding will interact with other securities issued by the same companies, experts say.
The article goes on to compare crowdfunded projects with condominium-hotel projects, which divided properties into many individually-owned rooms.  Such arrangements often lead to conflict amongst owners when developers or managers propose changes to the property or business plan.  Such conflicts are common among tenant-in-common investors, another form of private placement real estate investment, and may be a significant problem in crowdfunded projects as well.

We will eagerly await the SEC's guidance on this issue, as well as the other currently outstanding provisions of the JOBS Act.

Wednesday, January 30, 2013

What is a CDO, Anyway?

By Tim Husson, PhD and Tim Dulaney, PhD

We've talked a lot on this blog about collateralized debt obligations (CDOs), including a post just last week about how they might be regaining popularity.  We thought it might be worthwhile to step back and explain just what a CDO is and why it is considered such a risky investment.

Part of the complexity just has to do with terminology.  CDOs are a type of asset-backed security; so like a derivative, the value of a CDO is linked to the value of another asset.  Typically, CDOs are linked to an entire portfolio of assets, called the collateral, and for CDOs that collateral is usually corporate debt (hence, 'collateralized debt obligation').  There are numerous other types of asset-backed securities that follow a similar pattern:  if the collateral is a portfolio of loans, they are called collateralized loan obligations (CLOs), if they are mortgages, collateralized mortgage obligations (CMOs, also known as mortgage-backed securities or MBS), and so on.

When a traditional pooled-asset investment such as a mutual fund sells shares, each share is equally risky.  If the portfolio of assets loses 5%, each share in turn loses 5% in value.  This is referred to as a 'pass-through' security.  The way CDOs work is by selling different levels of risk to different investors.  A single CDO might issue several different types of securities (called 'tranches') that bear losses not together, but in turn.

This structure has what's referred to as a 'waterfall' of payments.  As the underlying portfolio generates income, investors are paid their share of that income in a distinct order:  senior investors are paid first, mezzanine investors are paid next, and equity investors are paid last.  The senior and mezzanine investors are paid fixed interest rates (say, 5% and 7%, respectively), but the equity investors are entitled to whatever remains after those payments.

If the collateral generates more income than expected, the equity investors get extra distributions; if it generates less, they be paid smaller distributions, or perhaps none at all.  At maturity, the same process happens with the value of the portfolio as a whole:  proceeds from selling the pool of assets are used to pay back the principal of the senior investors first, mezzanine investors next, and equity investors with the remainder.

But what makes CDOs especially risky is what happens when there are losses or defaults in the portfolio.  To see this, consider a simplified $1 billion CDO with a $900 million senior tranche, $55 million mezzanine tranche, and $45 million equity tranche:
Because of the waterfall structure, equity investors are in what is known as the 'first loss' position.  If the portfolio as a whole loses $10 million (1%), equity investors lose $10 million of their $45 million investment, or 22%.  If the portfolio loses $50 million (5%), equity investors are completely wiped out, and mezzanine investors lose $5 million.  Senior investors only lose value if the losses exceed the combined value of the equity and mezzanine tranches below them, or in this case $100 million.  As noted by former Federal Reserve Chairman Alan Greenspan, the "risk per dollar of notional amount of the "first loss," or equity, tranche can be thirty or forty times the risk per dollar of the senior tranche."

Equity tranches are especially risky.  While they can generate extra income when the portfolio of assets yields greater than expected returns, they have very leveraged exposure to losses and can be completely wiped out with even relatively small percentage losses in the collateral--as was the case in the 2007 Banc of America CLOs we have discussed before.  But in the depths of the 2008 financial crisis, even senior tranches bore considerable losses.

Of course, the higher the quality of the underlying collateral, the less likely CDO investors are to suffer losses.  However, we argue that CDOs are so complex and their risks so difficult to evaluate that they are almost always unsuitable for retail investors.

Tuesday, January 29, 2013

Persistence Scorecard

By Tim Dulaney, PhD and Tim Husson, PhD

Late last month, S&P Dow Jones Indices released their persistence scorecard (PDF) which tracks the "consistency of top [mutual fund] performers over yearly consecutive periods" using the University of Chicago's CRSP database.  This report aims to address the question "does past performance really matter?" by asking whether mutual funds can consistently deliver high returns over several consecutive years.

Their sample includes only actively managed domestic US equity mutual funds -- and only the largest share class of each fund.  The report, like the SPIVA scorecards, do not stand as a shining endorsement for the universe of actively managed mutual funds. 

According to the report, of the 700+ funds that were in the top 25% of mutual funds as of September 2010, only 10% remained in the top 25% at the end of September 2012.  In other words, only 2.5% of all actively managed mutual funds in their sample were in the top quartile in September 2010 and September 2012.

Based purely upon chance, one would expect that 25% of the funds would remain in the top half for three consecutive years.  The only category to do slightly better than random expectations was the small-cap category (29.4% remained in the top half for three consecutive years).  Again, based purely upon chance, you'd expect 6.25% of the funds to remain in the top half for five consecutive years.  In this case, no category met random expectations -- for example, only 3.2% of mid-cap funds remained in the top half for five consecutive years.

An actively managed equity mutual fund initially in the top quartile has almost a one in four chance of being in the bottom quartile after a three year period.  The same is apparently true when considering period of five years.   The takeaway message here is that when choosing between actively managed mutual funds, you likely won't beat a coin toss.

Friday, January 25, 2013

Apple's Declining Stock Price and Structured Products

By Geng Deng, PhD, FRM, Tim Dulaney, PhD, Craig McCann, PhD, CFA and Mike Yan, PhD

Jason Zweig at the Wall Street Journal has an excellent piece on a part of the Apple story that hasn't gotten much press: many equity-linked structured products are linked to the common stock of Apple.

SLCG has recently completed an analysis of the market value of outstanding structured products linked to Apple common stock (AAPL).  In the following figure, we plot the total quarterly issuance of AAPL-linked structured products in our database since the first quarter of 2009.
As Apple's common stock continued to increase in price, the total issuance of AAPL-linked structured products increased.  The price of AAPL has been on a steady decline since late September 2012 -- when the stock briefly traded above $700 -- with the stock currently trading in the mid $400's. Following Tuesday's conference call in which Apple provided details surrounding their operations for the quarter ending December 29, 2012 (SEC Form 8-K), the price of AAPL common stock fell more than 12% -- a loss of more than $50 billion in market capitalization.

We have conducted an analysis of approximately 450 equity-linked structured products linked to AAPL in 2012 to determine what effect this decline had on the market value of these derivative products. In particular, we have studied three types of structured products: reverse convertibles (example), single observation reverse convertibles (example) and autocallable reverse convertibles (example).

Each of these products can be thought of as a bond issued by the investment bank paying fixed coupons in combination with a short put option. In the case of a reverse convertible, this put option is actually a down-and-in barrier option. In the case of an autocallable reverse convertible, the underlying bond is callable. From our report:
 Reverse convertibles tend to pay higher coupon rates than traditional notes because, in addition to the issuer’s credit risk, the notes expose investors to the risk of a decline in the price of the reference security. 
For the 294 products that are outstanding as of January 24, 2013, we determined the fair value on Tuesday (before Apple’s earnings announcement) and on Wednesday (after Apple’s earnings announcement). We found that the value of these notes, which were on average already worth substantially less than their face value, declined another 12% -- amounting to mark-to-market losses approaching $50 million based upon SLCG's fair value estimates.

For more detailed information concerning these losses, please see our working paper on this issue. SLCG has compiled a database of over 14,000 structured product research reports including full valuation and analysis of each product.

What a CDO 'Resurgence' Might Mean for Investors

By Tim Husson, PhD and Tim Dulaney, PhD

Kaitlin Ugolik at Law360 had an article on Wednesday discussing the recent "bump in demand for collateralized debt obligations."  CDOs are complex derivatives that pool assets together and split the risk of that portfolio into tranches which are then sold to investors.  CDOs have been implicated in the financial crisis of 2008 and have seen a strong drop-off in new issuances since, though that tide may now be changing.

According to the article, some lenders are predicting a large increase in CDO sales in 2013, "reaching as much as $10 billion."  The sources quoted emphasize the differences between new CDO issuances and the 'toxic' products of years past:
Instead of utilizing layers of complex derivatives in order to maximize gains — which ultimately maximized losses in 2008 — the products currently in demand are simpler cash-driven structures more akin to the format first developed in the early 1990s, often with fixed pools of assets that might pull in a lower yield, but are seen as safer in the long run. 
“The problems with the CDOs from the last decade had much more to do with the quality of what was put in than any structural feature of a CDO in and of itself,” Weiner said. “The lessons of the last decade have not yet been forgotten completely and therefore people are paying more attention to the quality of the assets being put in.” 
As a result, the major difference practitioners likely will see in 2013's CDOs versus their 2008 counterparts will not be their structure, but their underwriting, he said.
 While there were certainly lots of problems with the assets put into CDOs and other asset-backed securities -- see, for example, our work on warehousing in 2007 CLOs -- the CDO structure itself can be highly risky and extremely complex, even in its most 'vanilla' form, especially to investors in the bottommost 'equity' tranches.  In fact, valuation of CDO tranches can be extremely complex and is the subject of a large literature in quantitative finance.

So while financial institutions may again be finding CDOs an attractive way to raise cash, the events of 2007 and 2008 demonstrate that such investments are unlikely to be appropriate for any but the most sophisticated institutional investors.

SEC Litigation Releases: Week in Review

Randy M. Cho Sentenced to Prison Term of 12 Years in Criminal Action, January 24, 2013, (Litigation Release No. 22601)

Randy M. Cho was sentenced in a criminal action to 12 years in federal prison on charges of "perpetrating an investment scheme between 2001 and October 2009, which resulted in almost $8 million in losses from 57 investors." In addition to the prison sentence, Cho has been ordered to pay restitution of almost $8 million. In 2009, the SEC permanently enjoined Cho from violating antifraud provisions of the securities laws for related charges. In 2010, the SEC "obtained a final judgment against Cho" which ordered him to pay over $7.9 million in disgorgement, prejudgment interest and civil penalties.

District Court Denies China-Based Company's Motion to Dismiss SEC Enforcement Action, January 24, 2013, (Litigation Release No. 22600)

AutoChina International Limited's motion to dismiss "an SEC enforcement action...for lack of proper venue, or in the alternative, to transfer venue to a federal court in New York" has been dismissed by the District Court for the District of Massachusetts. The SEC's original complaint charged AutoChina, Victory First Limited, Rainbow Yield Limited, Hui Kai Yan, Rui Ge Dong, Yong Qi Li, Ai Xi Ji, Ye Wang, Zhong Wen Zhang, Li Xin Ma, Yong Li Li, and Shu Ling Li with fraudulently trading "AutoChina’s stock to boost its daily trading volume." According to the complaint, "on some days, the defendants and related accounts’ trading accounted for as much as 70% of the trading of AutoChina’s stock." The defendants have all been charged with violating various provisions of the securities laws. The SEC seeks permanent enjoinment, disgorgement, prejudgment interest, and financial penalties against all of the defendants, as well as an officer and director bar against Hui Kai Yan.

SEC Charges Jonathan C. Gilchrist with the Unregistered Offer and Sale of Securities and Stock Manipulation, January 23, 2013, (Litigation Release No. 22599)

According to the complaint (opens to PDF), Jonathan C. Gilchrist "effected the unregistered offer and sale" of 6 million shares of The Alternative Energy Technology Center, Inc. (formerly Mortgage Xpress, Inc.) and "engaged in a stock manipulation scheme" that resulted in over $692,000 in illicit profit. Throughout the course of the scheme, which lasted from January through March 2008, Gilchrist "made unregistered sales of 229,661 shares." The SEC has charged Gilchrist with violating various sections of the Securities Act and Exchange Act and seeks permanent enjoinment, disgorgement, and monetary penalties against him as well as a penny stock bar and officer and director bar.

Judgment Entered Against Vision Securities, Daniel James Gallagher, Christopher Castaldo, and Corporate Communications Corp.; Claims Against Frank Zangara Dismissed, January 23, 2013, (Litigation Release No. 22598)

A final judgment was entered against  Daniel James Gallagher, Vision Securities, Christopher Castaldo, and Corporate Communications Corp. The SEC "voluntarily dismissed with prejudice" claims against Frank Zangara and B.H.I. Group, Inc. Gallagher, Vision Securities, and Castaldo have been ordered to pay over $460,000 (jointly and severally) in disgorgement, prejudgment interest, and penalties.

Kenneth A. Dachman Sentenced to 10 Years in Prison and Ordered to Pay Over $4 Million in Restitution, January 23, 2013, (Litigation Release No. 22597)

Last week, Kenneth A. Dachman was sentenced in a criminal action to "120 months in prison on 11 counts of wire fraud and pay more than $4 million in restitution to his victims." From 2008 to 2010, Dachman allegedly raised over "$4 million from investors for his now-defunct sleep disorder businesses, Central Sleep Diagnostics, LLC and Advanced Sleep Devices, LLC" and "misappropriated more than $2 million of commingled investor funds." The SEC filed a civil injunctive action against Dachman last February. The action "has been stayed pending the outcome of the criminal case."

Thursday, January 24, 2013

Another Non-Traded REIT to be Absorbed into a Traded REIT

By Tim Husson, PhD and Tim Dulaney, PhD

Spirit Realty Capital, a large traded real estate investment trust (REIT), announced on Tuesday that it has acquired Cole Credit Property Trust II (CCPT II), a non-traded REIT.  This is the second major merger between a traded and non-traded REIT; we covered the first last month.  Like the previous deal, it appears that the non-traded REIT is the larger entity, but the resulting company will be market traded and assume the traded REIT's brand and ticker (SRC).

A major question for non-traded REIT investors is how much their shares would be worth in the event of a merger, tender offer, or other liquidity event.  In the case of CCPT II, it appears that investors may receive SRC shares worth about $9.17-$9.36 per CCPT II share.  From the announcement:
Based on Spirit Realty’s closing price of $17.82 per share on January 18, 2013, the exchange ratio implies a value of $9.36 per CCPT II share and reflects a positive cumulative total return including dividends of 20-42% for shareholders of CCPT II, depending on the shareholder holding period. When compared to the volume weighted average price of Spirit’s share price from the date of its inclusion in the Russell 2000 Index through the closing price on January 18, 2013, which was $17.66, the exchange ratio implies a value of $9.27 per CCPT II share. Based on the volume weighted average price of Spirit Realty over the last 20 trading days of $17.47 per share, the exchange ratio implies a value of $9.17 per CCPT II share. Following the close, CCPT II shareholders are expected to own approximately 56% and Spirit Realty shareholders approximately 44% of the common shares of the combined REIT.
Non-traded REIT shares were typically sold for $10 per share even through the real estate crash of 2007-8, when the value of REIT assets likely declined substantially.  This lack of price transparency has been a major issue for non-traded REIT investors, especially as several issuers have recently reported significantly lower per share values than many investors paid.  It will be interesting to see if other non-traded REITs merge with traded REITs and if so what value investors can get for their shares.

According to the Direct Investments Spectrum, CCPT II is the seventh largest non-traded REIT with total assets of over $3.3 billion.  This makes it almost twice as large as American Realty Capital Trust III, the last non-traded REIT to merge with a traded REIT.  Also unlike that transaction, CCPT II and Spirit Realty Capital are not affiliated, though Spirit's senior vice president Mark L. Manheimer -- hired in April 2012 -- was Director of Acquisitions at Cole Real Estate Investments as recently as 2012.

The two merger between Spirit Realty Capital and CCPT II will result in the "second largest publicly traded triple-net-lease REIT in the United States with a pro forma enterprise value of approximately $7.1 billion" and "will own or have an interest in 2,012 properties in 48 states" according to the announcement by Spirit Realty.  Spirit Realty contends that the resulting merged portfolio will be more diversified with respect to geography, tenant base and industry, and that the combined company will have greater access capital markets.

Upon announcement of the merger, Spirit Realty's stock price jumped 7% and experienced the largest intraday variation since the company was listed on the NYSE in September 2012.

Wednesday, January 23, 2013

European Traders May Face Financial Transaction Tax

By Tim Husson, PhD and Tim Dulaney, PhD

Earlier this week, eleven European countries were given the green light to implement a financial transaction tax according to an article from the Associated Press (AP).  The story was subsequently picked up by the Wall Street Journal (WSJ). 

According to the AP, the European Commission proposed "that trades in bonds and shares be taxed at 0.1 percent and trades in derivatives at 0.01 percent."  Since these taxes will be based upon notional values for derivatives, the tax could be a large increase in the transaction costs associated with these instruments.  For a similarly structured proposal within the United States, see the HR4191 bill introduced in the US Congress in December 2009.

The logic is that a small transaction tax would discourage risky bets and, as an ancillary benefit, fund the rescue of banks. Algirdas Semeta hailed the agreement as "a milestone in global tax history."  The tax is estimated to raise upwards of €57 billion per year if it were applied across the European Union.

Oliver Wyman conducted a study (PDF) in January 2012 on the impact of the financial transaction tax on FX markets and concludes that such a tax would "increase transaction cost for all transactions by 3-7x and by up to 18x for the most liquid part of the market." 

One problem with implementing such a tax is that it needs to be implemented universally or else the transactions will likely just take place elsewhere. In fact, according to the Wyman report the implementation will "cause a relocation of volumes that could reduce liquidity and thereby increase indirect transaction costs by up to a further 110%."

The relocation problem has been addressed by imposing the transaction tax "on both the buyer and the seller of a financial instrument, as long as either of the two parties is based in one of the participating countries or acting on behalf of someone based in one of those countries," according to WSJ article. 

It is possible that such a tax would be a significant hindrance to high frequency traders if a suitable relocation scheme is not possible.  These traders typically have the largest volume of trades and some of the slimmest margins (frequently limited by the tick size of the asset).  It seems unlikely that such a tax will discourage low-frequency risky bets and more likely that the costs will simply end up increasing costs associated with pension funds and retirement accounts.  We'll be watching this story closely as it develops.

Tuesday, January 22, 2013

FINRA Dispute Resolution Statistics 2012

By Tim Dulaney, PhD

Last week, we covered NERA's analysis of SEC settlements during FY2012.  This week, we're taking a look at FINRA's recent release of their dispute resolution summary statistics.   FINRA arbitration is a common way for investors to pursue restitution for damage caused by fraud, negligence, or other fiduciary breaches.   FINRA provides a detailed summary of the arbitration process and claims can be filed either online or by mail.

Through December of this year, FINRA reports that the number of new case filings have fallen just over 9% from 4,729 in 2011 to 4,299.  The following figure illustrates the number of cases filed and cases closed each year since 1997 and through December 2012 -- the peak to peak difference in timing is consistent with FINRA's 12-15 month turnaround time for the arbitration process.
As of December 2012, the number of disputes involving unauthorized trading increased by nearly 10% and the number of cases involving churning saw a modest 4% increase.  On the other hand, the number of arbitration cases involving virtually every other type of controversy -- e.g. negligence or misrepresentation -- saw a 15% decline.  FINRA's summary also shows that the percentage of cases in which customers were awarded damages was essentially unchanged at 45% from 2011 and down from the five-year high in 2010 of 47%.

Arbitration filings involving corporate bonds continued their decline from the 2009 high of 373 cases to only 124 cases filed through December 2012.  The number of cases involving variable annuities was the only category to see an increase in the number of FINRA filings.  The most dramatic decline occurred within the derivative securities segment -- down 85% from 2011, 96% since 2010 and 99% since 2008.  These statistics suggest that, at least in the short term, variable annuities represent an area of risk for potential investors.

Monday, January 21, 2013

NERA Releases Annual Report on SEC Settlement Trends

By Tim Dulaney, PhD and Tim Husson, PhD

Last week, NERA released their annual report (PDF) on trends in SEC settlements for the 2012 fiscal year.   The report represents the annual update to NERA's analysis of their proprietary database of SEC litigation releases and administrative proceedings published since July 21, 2002.  We've been covering these reports for about a year now and we were excited to see the results of this updated study.

According to the report, the number of settlements rose nearly 7% from FY11.  While the number of settlements with individuals reached a level not seen since 2005, SEC settlements with companies decreased by over 10%.  Exhibit 3 in NERA's report summarizes the number of settlements over the past decade:

Interestingly, the number of settlements involving insider trading increased by over 90% from FY11.

Although none of the ten largest settlements in FY12 were record-breaking, Citigroup took the prize for the largest settlement in FY12 with their $285 million dollar settlement over charges of misrepresentations to financial services customers.  The largest settlement involving individuals amounted to about $115 million, involving Amanda E. Knorr and Tony B. Wragg and their Ponzi scheme.  The report finds that the median "settlement values for individuals have more than doubled since 2009 from $103,000 to $221,000."  The report notes that "the high number and value of settlements with individuals are consistent with the SEC’s continued commitment to hold individuals accountable for corporate decisions."

The SEC's settlement practices have been criticized for lacking teeth, as some observers have noted that cases against corporations often end with a promise not to violate the laws in the future or other weak penalties.  Pursuing actions against individuals may have a larger deterrence effect and avoid the often costly legal battles that can ensue from actions against corporations.

Friday, January 18, 2013

Structured Product Issuers Under Pressure to Disclose Estimated Value

By Tim Husson, PhD and Tim Dulaney, PhD

According to securities law firm Morrison & Foerster's Structured Thoughts newsletter (PDF), the SEC may soon require issuers of structured products to disclose the estimated value of the product on the front page of the prospectus.  From the newsletter:
Elaborating on the [SEC's] sweep letter, the Staff noted that issuers must disclose the “issuer estimated value” on the cover page of the offering document, and share this information with investors prior to the time of sale. This estimated value should be based on the value of the “bond” element and the “derivative” element of the offered structured note. It seems that the Staff continues to think about a structured note as a “compound” security, comprised of two components. Disclosure documents should include a description of the estimated value, and any models used in the calculation of this amount. In calculating the value of the bond component, an issuer may use its internal funding rate or prevailing spreads. In discussing the value of the derivative component that has factored into the estimated value, the issuer should discuss any valuation models or assumptions.
Structured products are essentially bundles of bonds and derivatives (mostly options).  To value a product, an analyst can value that bundle of options -- or calibrate to options traded on an exchange -- and compare it to the purchase price of the structured product.

We have valued thousands of structured products and have found that structured products are typically valued between 92 and 98 cents on the dollar, values that are also supported by the academic literature.  Issuers, of course, perform this valuation to ensure that their product can be hedged profitably in the open market.

It looks like they will now have to disclose that value, and thus that profit margin, to investors.  As pointed out by Kevin Dugan in this week's Bloomberg Structured Notes Brief, some issuers have already begun disclosing initial values on their structured products offering documents.  For example, Goldman's disclosure reads, with emphasis added:
The estimated value of your notes at the time the terms of your notes were set...was equal to approximately $965 per $1,000 face amount, which is less than the original issue price. ...the price (not including GS&Co.’s customary bid and ask spreads) at which GS&Co. would initially buy or sell notes (if it makes a market, which it is not obligated to do) and the value that GS&Co. will initially use for account statements and otherwise equals approximately $990 per $1,000 face amount, which exceeds the estimated value of your notes as determined by reference to these models.
Until this change is fully adopted, you can always find our valuations for recently issued products in our structured product database, along with other helpful analysis tools.

SEC Litigation Releases: Week in Review

SEC Charges Georgia Resident with Insider Trading, January 17, 2013, (Litigation Release No. 22596)

According to the complaint (opens to PDF), John M. Darden III traded with non-public information regarding the merger between Southwest Airlines Company and AirTran Holdings, Inc. Darden, who gained over $150,000 in profits from the illicit trading, agreed to a final judgment that provides permanent injunctive relief and orders him to pay over $325,000 in disgorgement, prejudgment interest, and penalties.

SEC Files Settled Insider Trading Charges Against Former Trader Eric Rogers, January 17, 2013, (Litigation Release No. 22595)

According to the complaint (opens to PDF), Eric Rogers participated in an insider trading scheme concerning the 2007 acquisition of 3Com Corp that generated $207,000 in illegal profits. Rogers, a former proprietary trader at Spectrum Trading LLC, allegedly gained the insider knowledge from coworker Emanuel Goffer, who learned of it from his brother Zvi Goffer, a proprietary trader at Schottenfeld Group LLC. Zvi Goffer gained the information from two former attorneys at Ropes & Gray LLP, Arthur Cutillo and Brien Santarlas.  Rogers has agreed to a final judgment that enjoins him from violating sections of the Exchange Act and orders him to pay over $125,000 in disgorgement and prejudgment interest. However, due to Rogers' financial condition, the payment obligations have been waived. Additionally, Rogers has agreed to a penny stock bar and a bar from associating with "any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization."

SEC Obtains Significant Relief in Summary Judgment Win Against Defendants Charged with Defrauding Investors in Fictitious Offerings, January 15, 2013, (Litigation Release No. 22594)

A summary judgment was entered against Francis E. Wilde, Steven E. Woods, Mark A. Gelazela, Bruce H. Haglund, and their entities, Matrix Holdings LLC, BMW Majestic LLC, IDLYC Holdings Trust, and IDLYC Holdings Trust LLC, for their involvement in "two 'prime bank' or 'high yield' investment schemes that defrauded investors out of more than $11 million." The two schemes allegedly began in April 2008 and Ocotber 2009. The final judgment permanently enjoins "Francis E. Wilde, Steven E. Woods, Mark A. Gelazela, Bruce H. Haglund, and entities they control, from violations of the antifraud and other securities law provisions" and imposes an officer and director bar against Wilde and Haglund. The judgment also orders Wilde and Matrix to pay over $13.5 million in disgorgement and prejudgment interest, plus a civil penalty "equal to the amount of disgorgement plus prejudgment interest." In addition, Woods, Gelazela, Haglund, BMW Majestic, IDLYC and IDLYC LLC have been ordered to pay over $6.7 million in disgorgement and prejudgment interest, plus a civil penalty "equal to the amount of disgorgement plus prejudgment interest." Finally, relief defendants IBalance LLC, Maureen Wilde, and Shillelagh Capital Corporation have all been ordered to pay over $2.3 million combined in disgorgement and prejudgment interest.

Commission Settles with Four Defendants in Sedona Corporation Market Manipulation Fraud, January 15, 2013, (Litigation Release No. 22593)

Final judgments have been entered against Andreas Badian, Jeffrey "Danny" Graham, Pond Securities Corporation, and Ezra Birnbaum," for their alleged "fraudulent manipulative trading in the securities of Sedona Corporation." The final judgment permanently enjoins Badian, Pond, and Birnbaum from violating various securities law provisions and ordered Badian, Graham, Pond, and Birnbaum to pay approximately $675,000 combined in disgorgement, prejudgment interest, and civil penalties.
United States District Court Enters Final Judgments in Penny Stock Distribution Scheme Charged by the SEC, January 14, 2013, (Litigation Release No. 22592)

Final judgments were entered against Christel S. Scucci, her mother Karen S. Beach, their companies Protégé Enterprises, LLC and Capital Edge Enterprises, LLC, and their attorney, Cameron H. Linton, for their involvement in a scheme "to unlawfully acquire and sell shares of penny stock that were never registered for sale to the public." The court entered a judgment against Linton in September 2012, permanently enjoining him from violating Section 5 of the Securities Act as well as ordering him to pay over $13,000 in disgorgement and penalties. In addition the judgment ordered a penny stock bar against him and suspended him from "from appearing or practicing before the Commission as an attorney." In November 2012, final judgments were entered against Beach, Scucci, Capital Edge, and Protégé permanently enjoining them from violating Section 5 of the Securities Act, and ordering them to pay over $1.8 million combined in disgorgement, prejudgment interest and penalties. In addition, a penny stock bar has been ordered against these defendants as well.

Final Judgment Entered Ordering Massachusetts-Based Investment Adviser to Pay Over $7.2 Million, January 11, 2013, (Litigation Release No. 22591)

Final judgments were entered against investment adviser Gary J. Martel, who conducted business under the names Martel Financing Group and MFG Funding, for allegedly "selling fictitious investment products and using the funds raised for purposes other than making the investments he promised." The final judgment permanently enjoins Martel from violating various sections of the securities laws and ordered him to pay over $7.2 million in disgorgement, prejudgment interest, and civil penalties. In December 2012, Martel pled guilty to criminal charges brought against him based on the same charges.

Court Finds in Favor of Three Remaining Defendants in Penny Stock and Accounting Fraud Case, January 11, 2013, (Litigation Release No. 22590)

Final judgments were entered in favor of attorneys Daniel G. Chapman and Sean P. Flanagan, and consultant James L. Ericksteen on January 7th, 2013. The defendants had been charged with directly violating and aiding and abetting "others in violating antifraud provisions of the federal securities laws" in connection with the stock manipulation and accounting fraud with The Court found that there was insufficient evidence presented at trial to "prove that defendants Chapman, Flanagan, and Ericksteen committed the violations alleged in the complaint." Previously, the Commission "obtained judgments against ten [other] defendants"  in connection with its original complaint.

SEC Charges Volt Information Sciences, Inc. and Two Former Officers with Securities Fraud, January 11, 2013, (Litigation Release No. 22589)

According to the complaints against Volt Information Sciences, Inc. and Volt's former Chief Financial Officer, Jack J. Egan, Jr. (open to PDF), Egan "participated in a scheme to materially overstate revenue" by over $7.55 million. In addition, Egan allegedly misled Volt's external auditors and "signed one or more certifications required by Section 302 of the Sarbanes Oxley Act that were false and misleading." The SEC also named Debra L. Hobbs, Volt's former chief financial officer, in its complaint against Volt. The complaint charges Egan with violating various provisions of the securities laws and seeks permanent enjoinment, an officer and director bar, and a civil monetary penalty against Egan. In response to the SEC's complaint, Volt and Hobb agreed to permanent enjoinments against violations of various sections of the securities laws and Volt undertook "significant remediation efforts."

Thursday, January 17, 2013

Barrier Options

By Tim Dulaney, PhD and Tim Husson, PhD

Earlier this week we introduced binary options, a type of exotic derivative that is embedded in some retail structured products such as dual directionals.  Today we're going to go over barrier options, which are another exotic option contract that happens to be embedded in one of the most popular types of structured products: reverse convertibles.

Like vanilla options, barrier options have a payoff that compares the final asset price to the strike price of the option.  In addition,  the payoff of barrier options depends on the value of the underlying asset relative to a barrier level throughout the term of the contract.  If the asset price breaches a prespecified barrier, a trigger event occurs and the option is either knocked-in -- resulting in the option becoming effective -- or knocked-out -- resulting in the option becoming ineffective.

Recall that binary options pay out if an asset crosses a threshold level.  You can think of barrier options as essentially binary options, but instead of delivering an asset or a fixed amount of cash, they deliver a vanilla option contract with a given strike price.  That would be a knock-in barrier option; a knock-out option would be like the other side of that trade, which has to give up a vanilla option if the barrier level is breached.  Barrier options also come in call and put varieties, and can be American, European, or any other exercise style.

Let's first look at a knock-in call option.  In this case, let's assume that the barrier is above the strike (this is sometimes called an up-and-in call option).  If the underlying asset appreciates above the barrier level during the term of the contract, then the option pays off like a vanilla call option (positive payout if the underlying price is greater than the strike at expiration).  On the other hand, if the asset does not appreciate above the barrier price, then the option expires worthless.  The following figure illustrates this payoff.
The red dotted line represents the realized profit or loss at maturity if the barrier is breached during the term of the contract while the solid orange line represents the profit and loss realized at maturity if the barrier is not breached.   The premium for these options is always lower than those for vanilla options with the same strike price and expiration because the payoff at maturity is less than a vanilla option if the barrier is not breached.

Similarly, a knock-in put option essentially becomes a vanilla put option if the barrier level is breached.  The following figure illustrates a down-and-in put option in which the barrier level is below the strike price
Let's now turn to knock-out options.  A knock-out call option functions like an ordinary call option unless the barrier is breached during the term of the contract; otherwise the option expires worthless.  The following figure illustrates this payoff with barrier level above the strike price (referred to as an up-and-out call option).
Notice that the once the barrier is breached, there is no payoff at maturity and the holder of the barrier option realizes a loss independent of the underlying asset price at the contract's expiration.

Finally, a knock-out put option functions like an ordinary put option unless the barrier level is breached during the term of the contract.  The following figure illustrates this payoff with barrier level below the strike price (referred to as an down-and-out put option).
Interestingly, there is a parity relationship between barrier options and vanilla options.  Think about an investor who buys two barrier call options, identical in every way except that one is a knock-in call option and the other is a knock-out call option.
The investor pays a higher total premium since the premium for each barrier option must be funded.  If the barrier is breached during the term of the contracts, the knock-out option expires worthless and the knock-in option converts to a vanilla call option.  If the barrier level is not breached during before expiration, the knock-in option expires worthless and the knock-out option pays off like a vanilla call option.  As a result, buying these two barrier options is the same as buying one vanilla call option.

You can find barrier options --particularly down-and-in puts -- embedded in reverse convertibles.  These options give reverse convertibles their characteristic downward slope in the event of a barrier level being breached (the slope is downward because reverse convertibles embed a short down-and-in put).  Barrier options also appear in a variety of other structured products, and can add an enormous amount of additional complexity to already complicated option positions.

Monday, January 14, 2013

Binary Options

By Tim Dulaney, PhD and Tim Husson, PhD

Last week, we went through the basics of traditional options including their terminology and payoff structure. Today we're going to talk about another, more complex, type of option:  the binary (or 'digital') option.  This type of option pays either one thing (for example a stock or cash) or nothing depending on the price of an asset relative to the strike price of the option.

Binary options are considered 'exotic' options because they are not traded on major exchanges the way traditional options are.  However, they bear certain resemblances:  they have a strike price, they are linked to an underlying asset, and they come in 'call' and 'put' varieties.  Also, an investor can both buy ('long') and sell ('short') binary options.  Unlike traditional options, binary options deliver either the underlying asset (in an asset-or-nothing binary option) or an amount of cash (in a cash-or-nothing binary option).

An asset-or-nothing call increases in value as the underlying asset appreciates relative to the strike price.  The price an investor pays to buy the option is the option premium.  However, it only pays off if the asset is worth more than the strike price.

A cash-or-nothing call is similar except it pays out a prespecified amount of cash instead of the asset itself.
Asset-or-nothing puts are a bit more confusing.  Because they are puts, they pay out only if the underlying asset has decreased below the strike price.  But because they deliver the underlying asset, the value of that payout declines as the value of the asset declines, leading to a somewhat unusual payoff structure.
Cash-or-nothing puts are more straightforward because they deliver a fixed cash amount.
Traditional call options can be decomposed as a long asset-or-nothing call and short K cash-or-nothing call options where K is the strike price of the options.  Similarly, put options can be decomposed as long K cash-or-nothing puts and short an asset-or-nothing put where K is the strike price of the options.  Binary options can be replicated to a certain approximation (and hedged) with traditional options, particularly a call spread strategy.

While binary options are unlikely to be purchased directly by retail investors, binary options are embedded in several types of retail investments, such as dual directional structured products and some structured CDs.  We have created a spreadsheet (Excel format) that graphs and values binary options given certain user inputs.  We encourage you to play around with these values to get a sense for the complexity of these options.

Friday, January 11, 2013

SLCG Research: Tenants-in-Common Interests

By Tim Husson, PhD

While we've spent a great deal of time talking about non-traded REITs on this blog, so far we've given less attention to another kind of real estate investment that has also been sold to investors based on questionable merits:  tenants-in-common (TIC) interests.  TICs are private placement investments that were very popular during the real estate boom of 2002-2008, but have suffered tremendously when the markets turned sour.  We discussed TICs in our paper on non-traded REITs, but we felt that the subject deserved a more thorough treatment and are happy to announce a new working paper, What is a TIC Worth?, now available on our website and SSRN.

In it, we construct a stylized example of a TIC financial projection as it would appear in offering documents.  We demonstrate that the "cash on cash" returns highlighted by TIC marketing materials are often inflated or manipulated representations of the actual value of the property.  We also demonstrate that the tax benefit of a TIC, when used as part of a 1031 like-kind exchange, is overwhelmed by the high fees TIC sponsors charge for organizing the deal.

Our results suggest that a thorough financial analysis of TIC projections would reveal that TICs often have little benefit to the investor and frequently exhibit a significantly negative present value under reasonable assumptions.  Like many other private placement investments, and as reflected in FINRA's Notice to Members (PDF), TIC offering documents must be rigorously analyzed to determine exactly how the reported returns could be supported by operating income--because sometimes, they can't.

SEC Litigation Releases: Week in Review

Court Orders New York-Based Hedge Fund Manager and Firm to Pay Nearly $5 Million in Disgorgement and Penalties, January 9, 2013, (Litigation Release No. 22588)

Final judgments were entered against hedge fund manager Chetan Kapur and his firm ThinkStrategy Capital Management for allegedly overstating the performance of their ThinkStrategy Capital Fund, "inflat[ing] the firm’s assets, exaggerat[ing] the firm’s longevity and performance history, and misrepresent[ing] the size and credentials of ThinkStrategy’s management team." In addition, Kapur and ThinkStrategy allegedly "misstated the scope and quality of due diligence checks on certain managers and funds selected for inclusion in" the TS Multi-Strategy Fund, a second hedge fund that they managed. This resulted in the TS Multi-Strategy Fund making "investments in certain hedge funds that were later revealed to be Ponzi schemes or other serious frauds, including Bayou Superfund, Valhalla/Victory Funds, and Finvest Primer Fund." The final judgment orders the defendants to pay almost $5 million in disgorgement and civil penalties, and permanently enjoins them from future violations of the Securities Act and Investment Advisers Act. In addition, Kapur has been barred from associating with "any investment adviser, broker, dealer, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization."

SEC Charges Three Former Senior Officers of Commonwealth Bank with Understating Losses and Material Misstatements During Financial Crisis, January 9, 2013, (Litigation Release No. 22587)

According to the complaint (opens to PDF), from 2008 to 2010 Bank of the Commonwealth's former CEO, President, and Chairman of the Board, Edward J. Woodward, Jr., along with Chief Financial Officer and Secretary, Cynthia A. Sabol, and Executive Vice President and Commercial Loan Officer, Stephen G. Fields, "understat[ed] millions of dollars in losses...masking the true health of the bank's loan portfolio at the height of the financial crisis." Woodward and Sabol have been charged with violating sections of the Exchange Act and Securities Act, and Fields has been charged with violating sections of the Exchange Act.

SEC Obtains Judgments Against Former Spongetech Executives Michael E. Metter and Steven Y. Moskowitz, January 4, 2013, (Litigation Release No. 22586)

Final judgments were entered against Michael E. Metter, former Chief Executive Officer of Spongetech Delivery Systems, Inc., and Steven Y. Moskowitz, Spongetech's former Chief Financial Officer, for their involvement in a scheme that illegally increased the demand for "the unregistered sale...[of] Spongetech stock by...'pumping' up demand for the stock through false public statements about non-existent customers, fictitious sales orders, and phony revenue." During this scheme, Metter and Moskowitz allegedly flooded the market with "false public information." Metter and Moskowitz consented to the judgment that imposes a penny stock bar and officer and director bar against them, as well as enjoins them from future violations of the federal securities laws. In addition, the judgment orders them to pay penalties and disgorgement that will be determined at a later date.

Earlier this year, final judgments were entered against RM Enterprises International, Inc., "a Spongetech affiliate," and George Speranza, which imposed full injunctive relief against both of them, imposed a penny stock bar against Speranza, and ordered Speranaza to pay over $135,000 in  disgorgement, penalties, and prejudgment interest. In addition,, Inc. and Blue Star Media Group, Inc. were named as relief defendants.

In May 2010, Metter and Moskowitz were arrested in a parallel criminal action. Later that year in October, a superseding indictment was filed against George Speranza, a stock promoter, and "four former Spongetech employees – Andrew Tepfer, Seymour Eisenberg, Thomas Cavanagh, and Frank Nicolois – on charges including securities fraud, obstruction of justice, money laundering, structuring, and contempt." All defendants, excluding Metter, pled guilty to the charges.

Thursday, January 10, 2013

The Basics of Options Contracts

By Tim Dulaney, PhD and Tim Husson, PhD

In a lot of our research work, we break down complex financial products into simpler pieces and then value those simple pieces one at a time.  Often, those smaller components are options contracts (especially in our structured product work), which are relatively easy for practitioners to value.  However, options contracts use a peculiar terminology that can be confusing to the uninitiated, so we thought we would lay out exactly what we mean when we talk about options.

Options contracts are derivatives that give the holder the right, but not the obligation, to purchase or sell a security at a specified price on a specified date (or dates).  The price specified in the contract is known as the option's strike price and the last date the option can be exercised is known as the option's expiration.  The buyer of an option pays the seller -- who is called the option writer -- a premium for the right specified in the contract.  Options can be traded in a standardized exchange-traded format -- such as on the Chicago Board Options Exchange (CBOE) -- or in customizable over-the-counter bilateral agreements.

Options that can only be exercised at maturity are called European options -- S&P 500 index options on the CBOE, for example -- and options that can be exercised at any time prior and on the options expiration are called American options -- equity options on the CBOE, for example.  Other types of options exist, but these two are by far the most common.

Options that give the holder the ability to purchase at a specific price are called call options whereas options that give the holder the ability to sell at a specific price are called put options.

Call Options

Buyers of call options believe that the asset on which the option is written will appreciate in value prior to the expiration of the option.  If the asset is more valuable than the strike price specified in the option contract, the option holder can exercise their right to buy the underlying asset at the strike price from the option seller and then sell the asset at the current market price to realize a profit.

If the asset is less valuable than the strike price, the holder of the option is not obligated to exercise the option and will simply allow it to expire.  The following schematic summarizes the profit and loss (or payoff) a call option buyer can realize as a function of the underlying asset price upon exercise of the option.
Call option buyers only realize a profit if the underlying asset is worth more than the strike by at least the option premium.  Buyers of call options can lose at most the option premium (if the underlying asset is below the strike at expiration) but can realize any level of profit.

Put Options

Buyers of put options, on the other hand, believe that the underlying asset will depreciate in value prior to the expiration of the option.  If the asset is less valuable than the strike price specified in the option contract, the option holder can buy the underlying asset at the current market price and then exercise their right to sell the underlying asset at the strike price to realize a profit.

If the asset is less valuable than the strike price, the holder of the option will simply allow the option to expire -- the option holder is not obligated to exercise the option.  The following schematic summarizes the profit and loss (or payoff) a put option buyer can realize as a function of the underlying asset price upon exercise of the option.

Put option buyers only realize a profit if the underlying asset is worth less than the strike price by at least the option premium.  Since the underlying asset can not be worth less than zero, put option buyers have limited profit potential (at most realizing the strike price less the option premium) and, like call option buyers, can lose at most the option premium.

Of course, sellers of calls and puts have the opposite payoffs--a seller of a call option profits if the asset does not appreciate more than the option premium, and a seller of a put profits if the asset does not depreciate more than the the option premium.  Sellers are said to be short a call or put whereas buyers are said to be long the option.

American and European puts and calls are the most prevalent type of options contracts, but many more exotic types of contracts exist, such as barrier and binary options.  We hope to cover these in depth in later posts, as they are important in understanding structured products like reverse convertibles and dual directionals.

Wednesday, January 9, 2013

SLCG Research: Dual Directional Structured Products [Update]

By Tim Dulaney, PhD and Tim Husson, PhD

We have significantly updated our working paper on dual directional structured products (or simply dual directionals).  Since our first version of the paper, our work has been covered by and in November of 2012 named a dual directional as their trade of the month. The latest version of the paper is available from the SLCG website and SSRN.

In this version of the paper, we expanded our scope by studying all dual directionals registered with the SEC since 2008.  We divide dual directionals into two broad categories: knock-out dual directionals (KODDs) and single observation dual directionals (SODDs).  KODDs have a final payoff that depends on the linked assets value throughout the term of the note while SODDs have a payoff that depends only on the linked asset's value at the final valuation date.  For an example KODD, see JP Morgan's SEC filing for their product linked to the S&P 500.  For an example SODD, see Morgan Stanley's SEC filing for a product linked to Apple stock.

KODDs have embedded barrier options that encode the dependence on the linked asset's price.  These products can be decomposed as follows:
Our sample included 38 KODDs and we found that on average these products were worth approximately $0.973 per dollar invested on their issue date (lower than the principal investment minus the average underwriting fee of $0.0133).

SODDs have embedded binary options that lead to discontinuities in the final payoff for the dual directional.  These products can be decomposed as follows:

We valued 65 SODDs and found that their average issue date value was approximately $0.957 -- again, less than $1 minus the average stated fee of $0.0159.  

The current version of the paper also expands on the first version by including downside leverage (a feature offered by some SODDs).  This feature is essentially equivalent to the buffer in buffered notes.

Dual directionals are interesting because these products embed a straddle position into a structured product and because issuers have begun to issue these products more frequently in recent months.  Like most structured products, the notes are exceedingly complex for retail investors and are often priced at a premium to the present value of the options embedded in them.

Tuesday, January 8, 2013

Structured Products: 2012 Year-End Market Review

By Tim Husson, PhD and Tim Dulaney, PhD

Last year, we covered Bloomberg's summary of the 2011 structured product market by noting that almost "$45.5 billion worth of SEC registered structured products were sold in the US in 2011, down only slightly from $49.4 billion in 2010."  In 2012, 7,909 notes totaling just over $39 billion worth of SEC registered structured products were sold in the US -- a decrease of nearly 15%.

Interest rate products continued their decline in popularity with a decrease of almost 30% from 2011 to 2012.  Equity-linked products continued to garner significant issuance with nearly 2 out of every 3 products issued (by issue size) being equity-linked in 2012.  Reverse convertibles saw a drastic decline in popularity -- less than $2.5 billion in 2012 compared to almost $5.5 billion in 2011.
According to sources quoted in the Bloomberg Brief:  Structured Notes 2012 Review & 2013 Outlook (unfortunately not publicly available), the primary reason for the dropoff in structured product issuance is the persistent low interest rate environment, which is likely to continue into and beyond 2013.  However, that same low interest rate environment could also lead investors to seek riskier products to help achieve required rates of return, boosting structured product sales relative to other products such as certificates of deposit.

Structured products continue to be an active area of research at SLCG, and we now have a variety of research papers on important structured product issues. We also have a database of  over 10,000 structured product reports available free of charge. We will continue to closely monitor the structured product market, as it is one of the most innovative financial markets today.

SOURCE: Bloomberg L.P.

Monday, January 7, 2013

SLCG Research: Volatility Smiles from Leveraged ETF Options

By Tim Dulaney, PhD

Leveraged ETFs are a perennial subject on our blog.  I thought I'd take this opportunity to highlight a recent research project (PDF) entitled "Crooked Volatility Smiles: Evidence from Leveraged and Inverse ETF Options" that I recently completed with my colleagues Geng Deng, Craig McCann and Mike Yan.  

While studying options data on leveraged and inverse ETFs, we began to notice a pattern such that deep-in-the-money call options -- contacts whose strike price is well above the current spot price -- on inverse leveraged ETFs were more expensive than similar deep-in-the-money call options on positively leveraged ETFs.   A the same time, we noticed that far-from-the-money call options -- current spot price is below the option's strike price -- on inverse ETFs were cheaper than similar far-from-the-money options on positively leveraged ETFs.

As an example, the following figure shows the market prices of three-month call options on ProShares UltraPro Short S&P 500 ETF (SPXU) and ProShares UltraPro S&P 500 ETF (UPRO) on October 19, 2009.
UPRO is a daily (3x) leveraged ETF and SPXU is a daily (-3x) inverse leveraged ETF.  If we were to believe the classic model -- Black-Scholes model for those in finance -- for option pricing, these two lines should be on top of one another since both ETFs track the S&P 500.

My colleagues and I looked beyond the classic model and found that a popular stochastic volatility model can explain this phenomenon neatly.   We showed further that this stochastic model can properly predict the price at which options on pairs of ETFs have the same value -- graphically this is the intersection point in the figure above.  The SSRN entry for the paper can be found here.

Friday, January 4, 2013

SEC Litigation Releases: Week in Review

SEC Charges California Company and CEO with Defrauding Investors in Nevada Gold Mining Venture, January 3, 2013, (Litigation Release No. 22585)

According to the complaint (opens to PDF), Nekekim Corporation and its CEO, Kenneth Carlton, "induced hundreds of investors to pour $16 million into a fruitless gold mining venture." From 2001 to 2011, the defendants attracted investors claiming that a physicist (who in reality "had no scientific training") helped "develop a confidential gold extraction technique licensed by Nekekim." In addition, the defendants allegedly  represented that one of Nekekim's mine sites "contained gold deposits worth at least $1.7 billion" by using test results that used unconventional testing methods. Carlton failed to inform investors that the reliability of the two labs that produced these results had been questioned by geologists and a government study. Carlton has agreed to settle the charges by paying a $50,000 penalty and has been prohibited from future violations of the securities laws as well as selling securities for Nekekim and managing the company. Nekekim has been prohibited from future violations of the securities laws and is required to disclose "these sanctions in any offering of securities for the next three years."

Final Judgment Entered Against Defendant in SEC Action Involving Rhode Island-Based Offering Fraud, January 2, 2013, (Litigation Release No. 22583)

This week the SEC announced the resolution of charges it made against David G. Stern and Online-Registries, Inc. Its original complaint alleged that "Stern and OMR made false and misleading statements to investors" that were "related to OMR's business ventures, the status of its technology, [and] its number of customers." The complaint also alleges investors were misled about Stern's background, which includes "disbarment from the practice of law and a prior criminal conviction...relat[ed] to financial wrongdoing." The SEC named Michele Ritter as a relief defendant, but then dismissed the charges against Ritter on December 27, 2012. The final judgment permanently enjoins Stern from violating sections of the Securities Act and the Exchange Act, and holds Stern liable for over $225,000 in disgorgement and prejudgment interest. However, the final judgment "waives the payment of disgorgement and prejudgment interest and does not impose a civil penalty based upon the representations in Stern's sworn statement of financial condition." OMR has been permanently enjoined from violating sections of the Securities Act and Exchange Act and has been ordered to pay over $222,000 in disgorgement and prejudgment interest.

SEC Obtains Final Judgment on Consent as to Raj Rajaratnam, December 27, 2012, (Litigation Release No. 22582)

A final judgment was entered against Raj Rajaratnam for allegedly trading on nonpublic information he learned from business associate, Rajat K. Gupta. The insider information was about "Berkshire Hathaway Inc.’s $5 billion investment in Goldman Sachs in September 2008...[and] Goldman Sachs’s financial results for both the second and the fourth quarter of 2008." In a parallel criminal case, Gupta was convicted of "one count of conspiracy to commit securities fraud and three counts of securities fraud" and "sentenced to two years in prison and one year of supervised release," as well as "ordered to pay a $5 million criminal fine." The final judgment against Rajaratnam orders him to disgorge the profits and avoided losses he gained from the insider trading and to pay prejudgment interest. The SEC's charges against Gupta "remain pending."

ETP Turnover in 2012

By Tim Husson, PhD and Tim Dulaney, PhD

2012 was a busy year for the exchange-traded product (ETP) market.  As we've noted before, many new funds have been created, and many others have been closed and liquidated.  The analysts at IndexUniverse have been keeping track, and have produced the final year-end tally for 2012.

In all, 178 ETFs or ETNs were launched in 2012.  iShares (BlackRock) was the largest issuer in terms of number of new funds, but the market was highly divided such that 44% of funds were launched by the smallest 26 issuers:
94 ETFs or ETNs were closed in 2012, up from 30 in 2011.  Russell, FocusShares, ETRACS ETNs and Global X Management had the largest number of closings in 2012 with the remainder of the 94 distributed evenly across 9 issuers.  Russell had over a quarter of all ETP closures in 2012 (see WSJ coverage and press release):
We've discussed previously the risks that can arise when ETNs or ETFs close.  Typically, it is the smaller funds that get the ax, presumably because they have failed to attract enough investor assets to reap significant fees.  These may also be the least liquid funds, and therefore may have issues with tracking error and efficient market transactions.

If 2013 is anything like 2012, there will likely be still more turnover in the ETF and ETN markets, and it will be interesting to see how the recent ETP price war will affect different issuers.  As the ETP market matures over time though, we will likely see the number ETPs opened and closed within a year decline as the market becomes saturated with products covering the popular strategies, exposures and assets.  Of course regulatory changes could also make older ETPs obsolete and cause a revolution in the ETP market.  We look forward to seeing what 2013 brings to this highly innovative market.