Friday, September 27, 2013

SEC Litigation Releases: Week in Review

SEC Charges CEO of Video Game Company and Purported Consultant in Revenue Inflation Scheme, September 25, 2013, (Litigation Release No. 22813)

According to the complaint (PDF), in 2009 Troy Lyndon, CEO and CFO of Left Behind Games Inc, and his friend, Ronald Zaucha, schemed to "falsely inflate the company's revenue by nearly 1,300 percent in a one-year period through sham circular transactions." Left Behind Games "was founded in 2001 and touted itself as 'the only publicly-traded exclusive publisher of Christian modern media' and 'the world leader in the publication of Christian video games and a Christian social network provider.'" However, when the company faced financial problems in 2011, it was forced to terminate all of its employees and close its offices. Lyndon and Zaucha's scheme allegedly began in 2009, "in an apparent last-ditch fraudulent effort to save the company, which was unprofitable and severely undercapitalized at the time." At Lyndon's direction, Left Behind Games allegedly issued stock to Zaucha for "his so-called consulting services." According to the SEC, in reality Zaucha "performed few, if any, consulting services." Zaucha then sold all these shares for "approximately $4.6 million in proceeds. Zaucha then kicked back approximately $3.3 million of these proceeds to the company."

The SEC has charged the defendants with violating various provisions of the Securities Act and Exchange Act and seeks permanent injunctions, financial penalties, and penny stock bars against them, as well as an officer-and-director bar against Lyndon.

SEC Settles Action Against Oregon-Based Hedge Fund Manager Yusaf Jawed, Who Masterminded a Ponzi Scheme, September 25, 2013, (Litigation Release No. 22812)

Final judgments were entered against Yusaf Jawed and his entities, Grifphon Asset Management, LLC and Grifphon Holdings, LLC, for their involvement in a $30-plus million Ponzi scheme that Jawed allegedly ran through his two entities. The judgments order them to pay over $33.9 million in disgorgement and interest and bars "Jawed from association with any investment adviser, broker, dealer, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization."

SEC Charges Former President of California-Based Investment Firm with Fraud, September 25, 2013, (Litigation Release No. 22811)

According to the complaint (PDF), Larry Polhillused "used his company American Pacific Financial Corporation to buy and sell real estate and distressed assets, and he offered investors the opportunity to invest in the company through unregistered notes that would yield them interest payments of 5 to 17 percent per year." In reality, the "collateral that Polhill and APFC claimed made the investments secure was often non-existent or otherwise impaired." APFC eventually filed for bankruptcy and at that time it "named the investors as unsecured creditors who were owed nearly $160 million."

The SEC has charged Polhill with violating the Securities Act and Exchange Act. Polhill has agreed to an order that permanently enjoins him from future violations and places an officer-and-director bar against him.

SEC Charges TD Bank and Former Executive for Roles in Rothstein Ponzi Scheme in South Florida, September 23, 2013, (Litigation Release No. 22810)

Earlier this week, the SEC charged TD Bank and it former executive, Frank A. Spinosa, with "violating securities laws in connection with a massive...Ponzi scheme conducted by Scott Rothstein." TD Bank has agreed to pay $15 million to settle the charges. The SEC has charged Spinosa with violating the Securities Act and Exchange Act and seeks "disgorgement, prejudgment interest, financial penalties, and a permanent injunction."

Previously, the SEC charged "two feeder funds to the Rothstein Ponzi scheme."

Securities and Exchange Commission v. Lawrence J. Robbins, September 23, 2013, (Litigation Release No. 22809)

Earlier this week, the SEC charged Lawrence Robbins with insider trading on information about impending acquisitions of Millennium Pharmaceuticals Inc. and Sepracor Inc. Robbins learned of the information from his business partner, John Michael Bennett, who in turn learned of the information from his friend, Scott Allen. The complaint charges Robbins with violating the Securities Act and Exchange Act, and Robbins has agreed to pay over $1 million in disgorgement and prejudgment interest to settle the charges. Additionally, Robbins agreed "to be permanently enjoined from future violations of these provisions of the federal securities laws."

Previously, the SEC charged "Bennett and Allen for their roles in the scheme."

SEC Charges Atlanta-Area Defendants with Securities Fraud, September 23, 2013, (Litigation Release No. 22808)

According to the complaint (PDF), Stephen L. Kirkland and his company, The Kirkland Organization, Inc. made " false and misleading statements to investors." These false statements to investors include (a) if investors invested "with the defendants through a managed account at Westover Energy Trading Partners, LLC, there would be no risk of losing their principal; (b) they would earn 2% to 3% per month; (c) a specified New York real estate developer/owner was a manager of Westover; and (d) the...developer/owner’s substantial wealth would be used to indemnify investors against loss." The SEC has charged the defendants with violating various provisions of the federal securities laws and seeks "permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest, and civil penalties against the defendants."

SEC Charges Former Qualcomm Executive and His Financial Advisor with Insider Trading Through Secret Offshore Accounts, September 23, 2013, (Litigation Release No. 22087)

According to the complaint (PDF), "Jing Wang, a former executive vice president and president of global business operations at Qualcomm, used a secret offshore brokerage account to make illegal trades based on confidential information that he learned on the job." Wang received assistance with setting up the account from "Gary Yin, a former registered representative at Merrill Lynch." Yin additionally made his own "secret offshore account..and traded on the non-public information gleaned from Wang." Wang created his account in the name "of a BVI company called Unicorn Global Enterprises, and Wang’s older brother was listed as the owner." Yin created "his own BVI-registered entity named Pacific Rim and put it in his mother-in-law’s name." When Wang realized that "that insider trading in the offshore accounts still may be discovered by the SEC or other regulators, he concocted a plan to conceal his trading activity by claiming the trades were made by his brother." Yin then traveled to China to "go over the account statements with Wang’s brother so he could explain the trades if asked by investigators." Combined, Wang and Yin gained over $271,000 from the illicit trading.

The SEC has charged Wang and Yin with violating the Exchange Act and seeks disgorgement, prejudgment interest, financial penalties, and permanent injunctions, as well as an officer-and-director bar against Wang.

SEC Charges Former Technology Company Executive for Role in Rajaratnam Insider Trading Scheme, September 23, 2013, (Litigation Release No. 22806)

Last Friday, the SEC charged Akamai Technologies' senior director of marketing, Kieran Taylor, with "illegally tipping non-public information about the company’s financial predicament as part of the insider trading scheme operated by now-imprisoned Galleon Management hedge fund founder Raj Rajaratnam." Taylor allegedly tipped his close friend Danielle Chiesi in 2008 and Chiesi in turn tipped Rajaratnam. Additionally, Taylor "traded on the non-public avoid losses of $20,635." The SEC has charged Taylor with violating the Exchange Act and Securities Act and Taylor has agreed to pay over $145,000 to settle the charges. Taylor has also agreed to a five-year officer-and-director bar and to be "permanently enjoined from future violations of these provisions of the federal securities laws."

The SEC "has charged a total of 34 firms and individuals in its Galleon-related enforcement actions."

SEC Files Injunctive Action Against South Carolina Father and Son for Fraudulent Program Designed to Profit from Fate of Terminally Ill, September 23, 2013, (Litigation Release No. 22805)

According to the complaint (PDF), "Benjamin Sydney Staples and his son, Benjamin Oneal Staples...operat[ed] a fraudulent investment program designed to profit illegally from the deaths of terminally ill individuals." The Staples "deceived bond issuers out of at least $6.5 million by lying about the ownership interest in bonds they purchased in joint brokerage accounts opened with people facing imminent death who were concerned about affording the high costs of a funeral." From 2008 to 2012, the Staples allegedly operated an Estate Assistance Program and "recruited at least 44 individuals into the program."

The SEC has charged the defendants with violating sections of the Securities Act and Exchange Act and seeks disgorgement, prejudgment interest, financial penalties, and permanent injunctions. The complaint also names "another son of Benjamin Staples, Brian Staples, a relief defendant."

Securities and Exchange Commission v. Jenifer E. Hoffman, John C. Boschert, and Bryan T. Zuzga, September 20, 2013, (Litigation Release No. 22804)

The SEC has charged former Assured Capital Consultants, LLC principals, Jenifer E. Hoffman and John C. Boschert, and the company's purported escrow agent, Bryan T. Zuzga, "for their involvement in a fraudulent prime bank offering and Ponzi scheme." According to the SEC, the defendants raised at least "$25 million from investors, through false representations and fake documents." The defendants then used these funds for personal use and to "make payments to other investors in Ponzi fashion." The SEC has charged the defendants with violating various provisions of the securities laws and seeks "financial penalties, disgorgement of ill-gotten gains plus prejudgment interest, and permanent injunctions."

Securities and Exchange Commission v. Tibor Klein and Michael Shechtman, September 20, 2013, (Litigation Release No. 22803)

According to the complaint, Tibor Klein, president of Klein Financial Services, traded "in his own account and client accounts based on non-public information [...] about Pfizer Inc.’s planned acquisition of King Pharmaceuticals." Klein tipped his close friend, Michael Shechtman, who also traded on the insider information. Klein allegedly gained over $300,000 in illicit profits for himself and his clients, and Shechtman gained over $100,000 in illegal profits. The SEC has charged Klein and Shechtman with violating the Exchange Act and seeks "disgorgement of ill-gotten gains, financial penalties, and permanent injunctive relief against Klein and Shechtman to enjoin them from future violations of the federal securities laws."

Wednesday, September 25, 2013

SEC Proposes Rule for "Pay Ratio" Disclosure

By Tim Dulaney, PhD, FRM

Last week, the Securities and Exchange Commission (SEC) released a rule proposal that would require "public companies to disclose the ratio of the compensation of its chief executive officer (CEO) to the median compensation of its employees."  The proposed rule gives companies flexibility with respect to the methodology used to calculate the pay ratio.  This flexibility allows for a variety of approaches that are appropriate for each company's size and structure.

Although the SEC does not specify the methodology companies have to implement, each company must disclose the "methodology used to identify the median, and any material assumptions, adjustments or estimates used to identify the median or to determine total compensation."  Companies would be required to disclose this ratio on any form that already requires a discussion of executive compensation.

In order to determine the median employee, companies can use a sample of employees as long as a reasonable sampling method is used.    Once a median employee is chosen, the company must calculate total compensation in a way that is consistent with the calculation used for the CEO's compensation.

The proposed rule would fulfill a mandate by the Dodd-Frank act for the implementation of such a rule, but it's not clear what if any impact such a disclosure will have on investor relations (or even executive compensation in particular).  The porposed rule will, as usual, feature a 60 day comment period.  For more discussion of the rule, see Rueters or Law360.  The text of the proposed rule can be found here (PDF).

Monday, September 23, 2013

SEC Approves Municipal Adviser Registration Requirement

By Tim Dulaney, PhD, FRM

Late last week, the Securities and Exchange Commission (SEC) voted to adopt rules requiring municipal advisors to register with the commission if the advisor "provides advice on the issuance of municipal securities or about certain 'investment strategies' or municipal derivatives."  This permanent registration requirement was required by Dodd-Frank (Section 975) and replaces the temporary registration requirement  (PDF) previously implemented by the SEC.

The registration requirement is meant to standardize the conduct and qualifications of the advisors hired by municipalities to determine what sort of bonds to issue, when to issue them and whether or not to use derivative products to alter their exposure to market conditions.   During the financial crisis, municipalities "were often unaware of any conflicts of interest the [advisors] may have had" and therefore were unable to determine the objectivity of the advice offered.

The final rule (PDF) provides for several exemptions that circumvent unintented implications (public officials providing internal advice need not register) as well as duplicative registration requirements (e.g. registered investment advisors, swap dealers, registered commodity trading advisors are each already required to be registered with a regulatory agency).  Individuals involved in municipal securities transactions that are not providing investment advice (e.g. underwriters, engineers involved with feasibility studies, accountants, attorneys) are also exempt from registration as long as they act within the confines of their duties.

Broker-dealers and bond lawyers have voiced their general approval for the form of the final rule, but others remain concerned about the rules broad exemption of underwriters.  "We continue to be concerned that the registration rule will not capture those underwriter firms who provide advice to municipal entities [...] and we fear that this will lead to a continuation of [pre-Dodd-Frank Act] market abuses," said National Association of Independent Public Finance Advisors president Jeanine Rodgers.

Firms will have to file a Form MA to register as a municipal advisor and individuals will have to file Form MA-I through SEC's EDGAR.   Advisors will be required to be registered "on a staggered basis beginning July 1, 2014."

Friday, September 20, 2013

SEC Litigation Releases: Week in Review

Court Enters Final Judgment by Consent Against SEC Defendant Roland Kaufmann, September 19, 2013, (Litigation Release No. 22802)

Yesterday the US District Court for the Eastern District of New York entered a final judgment against Roland Kaufman.  The judgment bars Kaufman from participating in penny stock offerings and from serving as a director or officer of a public company.  The judgment stems from a July 2012 SEC complaint that alleged Axius, Inc., Jean-Pierre Neuhaus, and Roland Kaufmann "engaged in a fraudulent broker bribery scheme [involving kickbacks] designed to manipulate the market for the common stock of Axius, Inc."

SEC Charges Imaging Diagnostic Systems, CEO, and CFO With Fraud, September 18, 2013, (Litigation Release No. 22801)

The SEC has filed a complaint against Imaginig Diagnostic Systems with making material misrepresentations about their application with the FDA and with failing to pay payroll taxes to the IRS.  The company is involved with the development of a technology to be used for the detection of breast cancer.  Although the Linda Grable (CEO) and Allan Schwartz (CFO) knew their projections for the FDA review process to be without basis, the company disclosed the projections in their filings.  In addition, the executives did not disclose their failure to remit payroll taxes in their MD&A, and did not file beneficial ownership reports from 2009 to 2011.  The SEC is seeking financial penalties as well as director-and-officer bars for the Grable and Schwartz.

SEC Charges Indiana-Based Company and Executives for Defrauding Investors in Renewable Fuel Production Scheme, September 18, 2013, (Litigation Release No. 22800)

On Wednesday, the SEC charged a group of conspirators with running a scheme to conceal "extensive illegal activity" under the guise of a legitimate biodiesel production business.  While receiving significant government subsidies for their biodiesel business, E-Biofuels used middlemen (Caravan Trading LLC, Cima Green LLC, and CIMA Energy Group) to buy finished biofuel then falsely represented that it was the raw material used to produce the fuel.  E-Biofuels -- through their owners Craig Ducy, Chad Ducy and Brian Carmichael -- then allegedly turned around and sold the biodiesel for as much "as double the price it paid for it."  When Imperial Petroleum bought the company, Imperial CEO Jeffrey Wilson allegedly learned of the scheme and continued to conceal the operation.  Imperial's revenue, and stock price, soared after the purchase and collapsed once the scheme was exposed "resulting in a market loss of approximately $60 million."  Each stage of the scheme was facilitated by false reporting and complicity.  The SEC is seeking "disgorgement of ill-gotten gains, financial penalties, and permanent injunctions against further violations of the securities laws."

SEC Charges Purported Money Manager in New York Who Schemed Investors and Lied to SEC Examiners, September 17, 2013, (Litigation Release No. 22799)

The SEC has charged Fredrick D. Scott -- owner of ACI Capital Group -- with making false statements amounting to extreme exaggeration of his assets under management for his investment advisory firm.  Scott allegedly used the pretense of significant assets to accumulate investor funds with the promise of "too-good-to-be-true investment opportunities".  Rather than paying any returns to investors, Scott used investor funds to pay for his personal expenses.  Scott has plead guilty to related criminal charged filed by the US Attorney's office.

Joseph Paul Zada Indicted for Fraud, September 17, 2013, (Litigation Release No. 22798)

Earlier this week, a grand jury indicted Joseph Paul Zada with "21 counts of mail fraud, two counts of wire fraud, two counts of money laundering, and two counts of interstate transportation of stolen property."  The indictment stems from allegations that Zada attracted several investors to invest a total of over $20 million based upon material misrepresentations and omissions.  Rather than investing the funds in purported Saudi oil ventures, Zada alleged used the funds to finance his indulgent lifestyle and pay "returns" to earlier investors. A hearing date has been set for October. For more information, see the November 2010 litigation release.

Thursday, September 19, 2013

What is Black-Scholes, Anyway?

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

In the past, we have reviewed the basics of options as well as included some discussion of more exotic options, such as binary options and barrier options, but we haven't talked in detail about option pricing.  There are a lot of great models for valuing options, but they can be a bit intimidating for the uninitiated, even though the underlying ideas are simple.

Any option's value is dependent upon the probability and timing of payouts.  For example, how much would you be willing to pay for an option that will pay $100 immediately with a 50% probability and pay $0 with a 50% probability?  You certainly shouldn't pay more than $50, and the seller would likely not take anything less than $50.  So the value of the option is $50 = 50%*$0 + 50%*$100.  What if this option paid the owner a year from now?  Certainly you'd pay less for the option since there is some opportunity cost for the funds that will be invested in the option.  These ideas are the essence of option pricing, and really securities valuation in general.

European options are perhaps the most simple type of option (see our post on option basics for a review).  To value these options, we need to have a distribution of values for the underlying asset at the end of the option's term.  This distribution will give us the probability of a given payout and, just like the example used above, we use these probabilities to determine the present value of the option.

One of the most simple and straight-forward models for the distribution of asset prices is the Black-Scholes model, also known as the Black-Scholes-Merton model.  The model assumes that asset returns are independent and identically distributed (IID) and that asset prices follow a log-normal distribution.  The IID assumption simply means that, at any given time, the likelihood of the stock increasing or decreasing by some amount is the same as, and independent of, any other time.  The log-normal distribution for asset prices is motivated by both the empirical distribution of stock returns as well as the simple fact that asset prices cannot be negative.

The value of an option in the Black-Scholes model depends critically on one parameter that is not directly observable: implied volatility.  This parameter determines the width of the log-normal distribution of asset prices (put differently, it determines how uncertain future prices are).  Practitioners will typically solve for this parameter after observing the price of an option as well as the characteristics of the underlying asset and the option contract.

The Black-Scholes model can be used to derive equations for the value of European options.  They require that we specify properties of the underlying asset (current price and the dividend yield), properties of the option contract (option type, strike price, and time to maturity) as well as current interest rates (usually a risk-free rate).  The resulting equations are a little too complex for pen-and-paper calculations, but are easy to program and fast to compute -- so fast, in fact, we've embedded a Black-Scholes calculator into this very post.

Talking through the example in the tool, let's imagine we have a European call option with a strike price of , expiring in  months, on an asset with a current price of .  Assume the underlying asset has a dividend yield of  and the risk-free rate is currently .  Using the Black-Scholes model with an implied volatility of , the value of this  call option is .

SLCG Option Value Calculator (Black-Scholes)


Feel free to play around with the calculator to get a sense for how the price of calls and puts is dependent upon each of the different factors.  Black-Scholes isn't perfect -- the IID and log-normal assumptions are often criticized -- but it does provide good intuition for the sensitivity of option prices to asset and option specific features.

Wednesday, September 18, 2013

FINRA Investor Alert: Private Placements

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Many of the riskiest financial products we have seen are sold as private placements.  Generally speaking, private placements are investments sold directly to accredited investors, and are not registered with the SEC.  Private placements include hedge funds, oil and gas partnerships, private real estate investment trusts, and other speculative investments.

Yesterday, FINRA released an Investor Alert on private placements.  In it, they warn investors that sales abuses and even fraud have been found in some private placement offerings, and that as unregistered offerings, their disclosures and projections can be meager or sparse.  In our experience, the private placement format enables poor reporting and questionable sales practices since neither the public nor the regulatory authorities can even observe what securities are being offered and how they are being represented.

Take for example tenant-in-common (TIC) interests -- private placement real estate investments that were sold in large numbers during the real estate boom.  We have written a research paper describing the deficiencies in the financial projections distributed to TIC investors, including aggressively optimistic assumptions for future rental revenue, low vacancy, and projected sale prices.  In reality, many TICs wound up in foreclosure, and many investors -- who were persuaded to exchange their business, ranch, or other income-generating property for large allocations to TICs -- faced significant losses.

But while those issues were endemic to TICs, they were not unique to them.  We have seen other private real estate funds, oil and gas partnerships, etc. that project unrealistic and poorly supported distribution levels.  The FINRA Investor Alert includes many helpful tips for spotting these deficiencies.

One last point to note is one we have been discussing since last year:  the 2012 JOBS Act may soon allow private placements to advertise to the general public.  We think this could open the door to a wide array of fraudulent private placement investment schemes.  Also, the JOBS Act removes several investor protections, especially related to crowdfunded ventures.  Given this loosening of regulatory policy, it's no wonder FINRA feels the need to warn investors.

SEC Cracks Down on Firms for Short Selling Violations

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Yesterday, the Securities and Exchange Commission (SEC) announced "enforcement actions against 23 firms for short selling violations" stemming from their investigation of improper participation in initial public offerings (IPOs).  Firms are prohibited from selling short stocks in the five business days immediately preceeding an IPO.   The restriction is meant to prevent firms from artificially lowering the price just prior to the IPO.

The SEC alleges that the 23 firms "bought offered shares from an underwriter, broker, or dealer participating in a follow-on public offering after having sold short the same security during the restricted period." All but one of the firms have reached a settlement with the SEC over the alleged rule violations.  The table below sorts the settlements according to total monetary penalty from largest to smallest and includes links to each settlement document (PDF).
Firm   Disgorgement     Prejudgment
JGP Global Gestão de Recursos$2,537,114.00 $129,310.00 $514,000.00
Manikay Partners$1,657,000.00 $214,841.31 $679,950.00
Deerfield Management Company$1,273,707.00 $19,035.00 $609,482.00
Hudson Bay Capital Management$665,674.96 $11,661.31 $272,118.00
Vollero Beach Capital Partners$594,292.00 $55,171.00$214,964.00
D.E. Shaw & Co. $447,794.00 $18,192.37 $201,506.00
Pan Capital AB$424,593.00 $17,249.80 $220,655.00
Southpoint Capital Advisors$346,568.00 $17,695.76 $170,494.00
Blackthorn Investment Group$244,378.24 $15,829.74 $260,000.00
M.S. Junior, Swiss Capital Holdings, et al. $247,039.00 $15,565.77 $165,332.00
Meru Capital Group$262,616.00 $4,600.51 $131,296.98
War Chest Capital Partners$187,036.17 $10,533.18 $130,000.00
Polo Capital Management$191,833.00 $14,887.51 $76,000.00
Ontario Teachers’ Pension Plan Board$144,898.00 $11,642.90 $68,295.00
Philadelphia Financial Management of San Francisco$137,524.38 $16,919.26 $65,000.00
Claritas Investments Ltd.$73,883.00 $5,936.67 $65,000.00
PEAK6 Capital Management$58,321.00 $8,896.89 $65,000.00
Soundpost Partners$45,135.00 $3,180.85 $65,000.00
Western Standard$44,980.30 $1,827.40 $65,000.00
Talkot Capital$17,640.00 $1,897.68 $65,000.00
Merus Capital Partners$8,402.00 $63.65 $65,000.00
Credentia Group $4,091.00 $113.38 $65,000.00
$9,614,520.05 $595,051.94 $4,234,092.98

The settlements have produced over $9.6 million in disgorgement, nearly $600,000 of prejudgment interest, and over $4.2 million in penalties.  The only firm that has not agreed to a settlement with the SEC, G-2 Trading LLC, is still dealing with their administrative proceeding (PDF).  

According to the SEC, "this new program of streamlined investigations and resolutions of Rule 105 violations, [the agency is] sending the clear message that firms must pay the price for violations while also conserving agency resources."  

By reining in this type of behavior, the SEC is helping to ensure investors who purchase shares in stock offerings are not subjected to market manipulation of the prices they pay and/or receive for such securities. We applaud the SEC's efforts with respect to the enforcement of short selling violations.  For more information, see the SEC's risk alert on short selling prior to public offerings (PDF).

Tuesday, September 17, 2013

FDIC Goes After Directors of Failed Banks

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

In recent months, the Federal Deposit Insurance Corporation (FDIC) has been filing a significant number of lawsuits against bank executives to recoup losses stemming from the onslaught of bank failures following the financial crisis.  The annual number of bank failures reached a peak at 157 in 2010 and has declined steadily since.

Source: FDIC Failed Bank List
These bank failures were a significant test of the FDIC system.  The fund backing the FDIC guarantee has been depleted by nearly $90 billion over the past five years as the agency has worked to deal with these bank failures.   According to a recent report by Cornerstone Research, damage claims by the FDIC in director and officer lawsuits are typically in the 5%-25% range (see page 9).

According to Law360, the FDIC's recent action is likely due to the three-year statute of limitations imposed on litigation concerning officer and director wrong-doing.  The investigation of a bank failure typically takes the FDIC roughly 18 months, so the bank failures that occurred at the peak are now commencing litigation.  Law360 is also reporting that the FDIC was emboldened by a $169 million judgment against former executives of IndyMac, who were found to have approved risky commercial loans which led to that institution's eventual FDIC takeover.  The Cornerstone report notes that:
To date, the FDIC has claimed damages of $3.6 billion in the 69 lawsuits that have specified a damages amount. The average damages amount has been $53 million, with a median value of $27 million.
The FDIC's increased pressure on individuals mirror's the SEC's recent emphasis on prosecuting individuals as well as financial institutions.  This new regulatory approach may help prevent impropriety at the executive level by increasing the personal consequences for the key decision makers.  It will be interesting to see how this approach will be received by the courts.

Monday, September 16, 2013

SLCG Research: Structured Product Based Variable Annuities

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

In 2010, AXA Equitable began issuing a new kind of variable annuity that, in addition to traditional mutual fund-like subaccounts, also included an option for a structured product-like crediting formula linked to an underlying index such as the S&P 500.  Our firm had done a lot of work on both structured products and variable annuities, so in late 2011 we started analyzing the structured product embedded in AXA's product, eventually writing a short research paper on the subject which we released in early 2012.  In this paper, we warned about the complexity of this type of annuity, and showed how its value to investors was critically dependent on the cap level and expectations about future volatility -- features that most retirement investors might not fully appreciate.

Since then, the idea of a structured product based variable annuity (spVA) has apparently taken hold.  Not only has the original AXA Structured Capital Strategies sold over $2.2 billion since it was issued, but MetLife has introduced their Shield Level Selector product, which has many of the same features as the AXA Structured Capital Strategies Variable Annuity including the embedded structured product option.  Moreover, Allianz has recently filed a prospectus for their Index Advantage annuity which also embeds structured product-like crediting options.  With all these changes in the marketplace, we decided to completely revise our previous paper on spVAs, and we are happy to announce that it is now available on SSRN and the SLCG website (PDF).

In it, we review each of the three currently available spVAs, highlighting their key similarities and differences.  One of the most important features of spVAs is the embedded cap on index-linked returns.  The cap is chosen by the issuer, and as we had shown previously, has a huge effect on the value of the annuity.  In our paper, we solve for the cap level that would compensate investors for their exposure to the underlying index.  We calculate the fair cap levels for three underlying indexes (S&P 500, NASDAQ 100, and Russell 2000) at various buffer levels and terms, all the way back to 2005.  We also provide extensive backtesting of spVA crediting formulas.

spVA Fair Cap Levels Over Time

One of our key findings is that the fair cap level is very dependent on current market conditions, especially the implied volatility of the underlying index.  This fair cap level is often surprisingly high, and in some market conditions, there in fact exists no cap level that could fairly compensate investors for certain spVA crediting formulas.

Investors considering an spVA should understand that their choice of buffer level, term, and underlying index make a big difference in how their account accumulates over time.  We argue that spVAs are markedly different investments than traditional variable annuities, and their additional complexity makes comparing their features very difficult.  We hope that our paper offers some insight into how to make those choices, or whether to purchase an spVA at all.

Check it out, and let us know what you think!

Friday, September 13, 2013

SEC Litigation Releases: Week in Review

SEC Charges Atlanta-Based Investment Adviser Representative with Securities Fraud, September 12, 2013, (Litigation Release No. 22797)

Earlier this week, the SEC charged Paul Marshall, Bridge Securities, LLC, Bridge Equity, Inc. and FOGFuels, Inc. with misappropriation of client funds as well as violations of Securities Exchange Act of 1934, the Securities Act of 1933 and the Investment Advisers Act of 1940.  The SEC alleges that over the past two years, Marshall has misappropriated "at least $2 million from advisory clients" through the companies he controlled.  Rather than using client funds for investment purposes, Marshall used the funds for vacations and "private school tuition for his children."  The SEC is seeking a "permanent injunction, disgorgement of ill-gotten gains with prejudgment interest, and civil penalties."

Final Judgments Entered Against CFO and Real Estate Finance Company, September 11, 2013, (Litigation Release No. 22796)

Final judgments were entered by consent against Owen Mark Williams and True North Finance Corporation, f/k/a CS Financing Corporation. The SEC's original complaint charged the defendants with overstating "revenue in True North's filings with the Commission in 2008 and 2009." The final judgment permanently enjoins the defendants from violating sections of the Securities Act and Exchange Act and orders Williams to pay a $40,000 civil penalty.

SEC Defendant Indicted in $30 Million Ponzi Scheme and Affinity Fraud Targeting Haitian-American Investors, September 10, 2013, (Litigation Release No. 22795)

Criminal charges have been filed against George Louis Theodule based on charges in "a now settled SEC action." The 40-count "indictment charges Theodule with securities fraud, wire fraud, and money laundering." The SEC's original complaint charged Theodule's with perpetrating a $30 million Ponzi scheme through Creative Capital Consortium, LLC and Creative Capital Concept$, LLC that targeted Haitian-American investors. In 2009 and 2010, judgments were entered against Theodule that enjoined him from future violations of various provisions of the securities laws and ordered him to pay over $5.5 million in disgorgement, prejudgment interest, and a civil penalty.

SEC Files Civil Injunctive Action Against Alleged Perpetrator and Unregistered Broker in Fraudulent Promissory Note Offering, September 9, 2013, (Litigation Release No. 22794)

According to the complaint (PDF), Brian G. Elrod allegedly conducted "a fraudulent offering of promissory notes for which Nova Dean Pack acted as an unregistered broker." The pair allegedly raised almost $2 million from investors "who invested in high-yield promissory notes issued by CFS Holding Company LLC, a Colorado company owned and managed by Elrod." Rather "than use investor money for legitimate business purposes," Elrod allegedly "used most of the investor funds to make substantial payments to himself and family members and to pay for personal expenses, to pay Pack significant commissions for referring investors, and to make interest payments back to investors." The defendants have agreed to settle the charges by consenting to a final judgment that enjoins them from future violations of the Securities Act and Exchange Act and orders them to pay over $3.9 million in disgorgement, prejudgment interest, and civil penalties. However, Pack's ordered payment has been waived based upon his financial condition.

SEC Charges Projaris Management LLC and Victory Partners Financial with Fraud, September 9, 2013, (Litigation Release No. 22793)

According to the complaint (PDF), Projaris Management, LLC, Victory Partners Financial , Joe G. Lawler, Brandt A. Lawler, Michael S. Lawler, Ryan G. Lawler, Timothy J. Lawler, and Pamela Hass were all involved in "an offering fraud that raised approximately $1.4 million." Allegedly, "the primary function of the defendants’ scheme was to convince investors to participate in a fraudulent pooled investment that purportedly invested in metals, commodities, real estate, and a fund that, among other things, invested overseas." The defendants "then siphoned off the invested funds for their own purposes and to continue to perpetuate the fraud." The SEC has charged the defendants with violating various provisions of the securities laws and seeks permanent injunctive relief, disgorgement, prejudgment interest, and civil penalties.

SEC Halts Florida-Based Prime Bank Investment Scheme, September 9, 2013, (Litigation Release No. 22792)

The SEC obtained an emergency court order to "halt a prime bank investment scheme by a Miami attorney and others who have promised investors exorbitant returns to be derived from a program based on the trading of bank instruments." According to the complaint (PDF), "Bernard H. Butts, Jr.; Fotios Geievelis, Jr., a/k/a Frank Anastasio; Worldwide Funding III Limited LLC; Douglas J. Anisky; Sidney Banner, Express Commercial Capital LLC; and James Baggs raised over $3.5 million" from investors both in the United States and abroad. The SEC claims in reality "no funds were used to acquire bank instruments and that Geivelis used investor funds to travel and gamble." According to the SEC, "Anisky, Banner, Express Commercial Capital, and Baggs all sold interests in the fraudulent scheme." The complaint charges all of the defendants with violating the Securities Act and Exchange Act and seeks permanent injunctions, disgorgement, and financial penalties. The complaint also names  Bernard H. Butts, Jr. PA; Butts Holding Corporation; Margaret A. Hering; Global Worldwide Funding Ventures, Inc.; and PW Consulting Group, LLC as relief defendants.

Thursday, September 12, 2013

FINRA Study: Financial Scams Prevalent

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Financial fraud is estimated to cost Americans between $40 and $50 billion annually (PDF).  Last fall, the Financial Industry Regulatory Authority (FINRA) commissioned a study on the financial vulnerability of Americans to classic investor scams.  The online study surveyed a sample of more than 2,000 Americans aged 40 and above, chosen to represent the approximate age, ethnicity, and census region distribution reflected by the 2010 census.1

According to the report (PDF), the survey found that approximately 84% of respondents have been targeted by scammers and that approximately 11% have lost most as a result of investing in a scam.  Investors over age 65 were the most likely to be solicited (93%) and the most likely to have lost money on a scam (16%).

Those in the highest household income category were most likely to have invested in a potentially fraudulent investment (49%) and, perhaps counterintuitively, the likelihood of losing money in a scam actually increased with more education -- 54% of those with post-graduate education versus 29% of those with only high school diplomas.

The survey also studied a subsample of "self-reported victims" of investment fraud.  By far the most likely way the fraudster was introduced to the victim was through a mutual friend (34%).  Many victims did not report the fraud because they were unsure where to report it.

These results suggest we have a long way to go in preventing financial fraud.  Prior to putting money into any unsolicited investment, we suggest running it through the FINRA Scam Meter as well as speaking with an independent financial advisor (or two).  You can also follow FINRA and SEC investor alerts about particular investments or scams, and it may also be useful to follow recent SEC actions and investigations to see what kind of scams are out there.

1For a similar study of Canadians, see the National Investment Fraud Vulnerability Report (PDF).

Wednesday, September 11, 2013

SEC Halts Florida-Based Prime Bank Investment Scheme

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

On Monday, the SEC charged a Miami-based group with perpetrating a prime bank investment fraud. The group, which includes Florida attorney Bernard H. Butts, Jr., purported financial services provider Fotios Geivelis, Jr. (a/k/a "Frank Anastasio"), several sales agents, and their allegedly fraudulent business entities (Express Commercial Capital LLC and Worldwide Funding III Limited LLC), are also subject to an emergency asset freeze.  You can find the full complaint here (PDF).

Prime bank programs promise high returns and are purported to be backed by some well-known international agency, such as the World Bank, International Monetary Fund, or the central bank of a sovereign nation.  The SEC's investor alert on prime bank programs uses no uncertain terms [emphasis added]:
If someone approaches you about investing in a so-called "Prime Bank" program, "Prime World Bank" financial instrument, or similar high-yield security, you should know that these investments do not exist. They are all scams.
The group charged on Monday allegedly lured investors by promising to obtain a standby letter of credit (SBLC), that would allow for an international securities trading program that would generate returns on their behalf.  The SEC claims that from April 2012 to the present, they raised at least $3.5 million from US and international investors by claiming future returns on the order of 14% per week (!) for up to 42 weeks.

According to the complaint, neither the trading program nor the SBLC actually existed and the funds were used for travel and gambling expenses.  After raising the funds, the attorney Butts and Geivelis (Anastasio) each took about 45% with the remaining being used to compensate the sales agents.  The group is also accused of using Butts' status as an attorney to lure investors into a false sense of security.

Tuesday, September 10, 2013

CFTC: Concept Release on Risk Controls and System Safeguards for Automated Trading

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Yesterday, the Commodity Futures Trading Commission (CFTC) produced their concept release on "Risk Controls and System Safeguards for Automated Trading Environments" (PDF).  The CFTC is hoping to evaluate the efficacy of currently implemented risk control mechanisms that may have been sufficient for "human judgment and speeds" but may no longer be sufficient in the present environment of automated and interconnected high-frequency trading.

After reviewing the present status of automated trading and the CFTC's regulatory actions to date (application of risk-based limits on customer and proprietary accounts, oversight and supervision of trading automated trading programs, etc.), the release mentioned market events that demonstrate the need for additional risk controls.  The examples included the 2012 Knight Capital Group incident, the May 2010 flash crash, as well as recent incidents such as the Goldman debacle and the NASDAQ trading suspension.

The scope of this release is very broad.  The CFTC identifies 124 questions related to high-frequency trading, including whether certain limits should be set, what types of messaging should be allowed between exchanges, and even questions regarding the definition of high-frequency trading.  Some of the CFTCs questions seem to relate to potential solutions to high-frequency trading issues proposed by others, such as minimum time period for which orders must stay active.  The breadth of questions raised by the CFTC shows just how complicated automated trading issues have become.

The CFTC is seeking public comment on their catalog of existing industry practices and the need for additional measures.  After the release is published in the Federal Register, the public will have 90 days to comment.  The CFTC will post responses to the concept release on their website as they become available.

Monday, September 9, 2013

Illiquid ETFs and SEC Market Maker Incentives

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

There is now nearly $1.5 trillion invested in exchange-traded products (ETPs) in some 1,400 exchange-traded funds and exchange-traded notes.  However, not all of that huge sum is distributed evenly.  Some funds, like SPY, have huge assets under management, while many others struggle to top $10 million.  Often, issuers will close lightly-traded ETPs (leading to substantial turnover each year), but if they don't, the market price of an ETP can often deviate from the net asset value of its holdings or otherwise price inaccurately.

To address this concern, the SEC recently approved a proposal that opened the door for an NYSE Arca Exchange Traded Product (ETP) Incentive Program "designed to encourage market makers to take [lead market maker] assignments in certain lower volume ETPs by offering an alternative fee structure [...] if the [lead market maker] meets or exceeds certain performance standards".1  Essentially, they will pay traders to make a markets in illiquid ETPs.

The program is meant to "enhance the market quality" for low volume ETPs by incentivizing market makers to take assignments for which making a market could be more challenging.  For the purposes of the rule, an ETP is considered "low volume" if the consolidated average daily volume is less than or equal to one million for the three months preceding entry and the ETP has not halted share creation or redemption.2

The program will alter the NYSE Arca's fees and charges for exchange services (PDF) to provide for "fixed quarterly payments, rather than variable enhanced transaction rates, in return for meeting their monthly [lead market maker] quoting obligations".  These additional payments will be funded by issuers of the ETPs on a voluntary basis and will run the issuer between $10,000 and $40,000 per annum.3

Although the optional incentive fee is meant to enhance the market for low volume ETPs, issuers are not eligible to receive a refund even if the lead market maker (LMM) does not meet the performance requirements -- for example: the LMM is required to maintain quotes or orders at or inside of the National Best Bid or Offer (NBBO).4  The participating LMM is paid only if the performance requirements are satisfied for a given month (1/3 of the incentive fee less a 5% NYSE Arca administrative fee).

In addition, some commentators are concerned that many potential market makers could be high-frequency traders, who could take advantage of the relative illiquidity of these products with no tangible benefit to investors.  We'll follow the implementation of the pilot program to see how many issuers participate and how the liquidity of their ETPs change as a result of their participation.
The March 2012 SEC filing for the incentive program can be found here (PDF).
For an example of a halted share creation, see TVIX or AMJ.
This fee charged to the ETF issuer would be separate from the listing and annual fees.
4For more information on LMM requirements, see Section I(D).

Friday, September 6, 2013

SEC Litigation Releases: Week in Review

SEC Charges Perpetrator of Fraudulent Free-Riding and Securities Offering Schemes, September 3, 2013, (Litigation Release No. 22791)

According to the complaint (PDF), Ronald Feldstein and his entities, Mara Capital Management LLC and Vita Health of America LLC, "engaged in illegal free-riding by purchasing stock" through broker-dealers to whom Feldstein portrayed himself as a money manager. The alleged "free-riding" scheme resulted in "over $2 million in losses" to the broker-dealers. Additionally, Feldstein allegedly raised approximately $450,000 from investors by promising to use their investments to "purchase stock for them in a certain penny-stock issuer,...invest in a fashion company's initial public offering, and...invest in a hedge fund that Feldstein falsely described as substantial and successful." Feldstein instead allegedly used these funds for his own personal use. The SEC has charged the defendants with violating sections of the Exchange Act and Securities Act and seeks injunctions from future violations, payment of disgorgement by the defendants and relief defendant, Trademore Capital Management LLC, payment of civil monetary penalties, and a penny stock bar against Feldman.

SEC Charges Former Chairman and CEO of CECO Enviromental Corp. and API Technologies Corp. with Insider Trading and Other Violations, September 3, 2013, (Litigation Release No. 22790)

According to the complaint (PDF), Phillip J. DeZwirek, "former CEO, Chairman, and 10% beneficial owner of both CECO Environmental Corp. and API Technologies Corp.," has been charged "with insider trading...and engaging in hundreds of violations of the trade reporting and ownership disclosure rules of the federal securities laws." DeZwirek has agreed to settle the charges by paying over $1.5 million in disgorgement, prejudgment interest, and a civil penalty. He has also agreed to a five year officer and director bar.

Thursday, September 5, 2013

Five Broker-Dealers Ordered to Pay over $10 Million in Restitution for Non-Traded REIT Sales

By Tim Husson, PhD

Back in May, Massachusetts securities regulators ordered five independent broker-dealers to pay over $6 million in fines and restitution for improperly selling non-traded REITs.  It also settled separately with another broker-dealer, LPL Financial, for an additional $2.5 million.  Just yesterday, Secretary of the Commonwealth William Galvin announced an additional settlement with the same five broker-dealers for an additional $10.75 million in additional restitution for improper sales of non-traded REITs.
“These investments are popular, but risky,” Mr. Galvin said in a statement. “Our investigation showed widespread problems with adherence to the firms' own policies as well as the state rule that an investor's purchase of REITs cannot be more than 10% of that person's liquid net worth.”
Interestingly, the distribution of fines and restitution payments is very different between this settlement and the one in May.  In particular, Securities America was leveled with a much higher restitution payment.

Firm May
Ameriprise Financial Services Inc. $2.530 million $400,000 $1.6 million
Commonwealth Financial Network $2.074 million $300,000 $0.534 million
Securities America Inc. $0.778 million $150,000 $7.7 million
Lincoln Financial Advisors Corp. $0.504 million $100,000 $0.841 million
Royal Alliance Associates Inc. $0.059 million $25,000 $0.125 million
$5.945 million $975,000 $10.75 million

Looking at the May signed consent orders, Securities America was found to have sold $6.5 million in shares of four non-traded REITs:  Inland Retail Real Estate Trust, Inland Western Real Estate Trust, Inland Diversified Real Estate Trust, and the largest non-traded REIT by total assets, Inland American Real Estate Trust, which we have discussed specifically.  Securities America was found to have sold these shares in violation of concentration limits and other securities laws.

Non-traded REITs are risky, high cost, illiquid investments that are in many ways inferior to publicly traded REITs and real estate mutual funds -- please see our research paper for more details.  Nonetheless, the non-traded REIT industry is on pace to sell $17 billion in shares this year, potentially its biggest year yet, suggesting that broker-dealers are still aggressively marketing these problematic investments.

Wednesday, September 4, 2013

Risk Retention in Collateralized Loan Obligations

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Last week we covered the SEC's proposed risk retention rules for securitized assets such as collateralized debt obligations (CDOs) and mortgage backed securities (MBS).  One of the reasons why these types of structured deals are so complex is because they are divided into many different securities, called 'tranches,' with different levels of risk.  We explained tranching in our post, What is a CDO, Anyway?

The new proposed rules require sponsors of securitizations to keep at least 5% of each tranche, known as a 'vertical slice,' or keep 5% of the equity tranche, or a 'horizontal slice.'  The idea is that if issuers have 'skin in the game,' they are less likely to misrepresent the riskiness of the underlying assets or otherwise create unfavorable terms for investors.

However, these rules provide an additional option for collateralized loan obligations (CLOs).  Instead of holding a slice of the securitization, they can simply hold a percentage of each underlying loan.  According to Creditflux, this might not be a viable option:
The new proposal introduces an alternative to this form of risk retention for CLOs. It would allow a deal to tick the skin-in-the-game box if the arranger of each loan in the CLO retains a 5% stake in that loan. However, in a note published yesterday RBS researchers say this is not a viable option for CLOs. “Loan arranging banks do not typically retain any portion of the leveraged term loan tranches bought by CLOs,” says the note. “Rather, they participate in the revolver or create a separate tranche to retain.”
We bring this up because CLOs are currently being issued in relatively large amounts, so any regulatory treatment which may change their risk profile could affect many investors.

Source:  Bloomberg

Tuesday, September 3, 2013

Why Do Volatility ETPs Reverse Split?

By Tim Husson, PhD

We still get a lot of questions about VXXTVIX, and all of the other VIX-related exchange-traded products (ETPs).  We've talked before about the persistent loss of value due to negative roll yield, as well as issues surrounding TVIX's suspension of share creations.  We've also talked about some of the newer volatility products that attempt to mitigate some of the issues with the older generation of products.  We've also analyzed whether VIX-based ETFs could serve as a hedge to equity portfolios, and examined persistence and mean-reversion in the VIX and in futures-based VIX ETPs.

One issue we haven't discussed is that volatility ETPs tend to declare big reverse splits, and do so relatively frequently.  Reverse splits essentially reduce the total number of shares outstanding by a certain factor.  For example, in a 2-for-1 reverse split, one new share is issued for every two old shares that are cancelled.  When this happens, the value of each new share becomes twice what one original share was trading at, because each share now represents twice the original ownership amount.

Just last month Credit Suisse announced that it would implement a 10-for-1 reverse split on TVIX and several related volatility ETPs under its VelocityShares brand -- the second reverse split since inception in November 2010.  Why now?  Because since the last split, TVIX's share price has dropped almost 80%:

Source:  Bloomberg

Volatility ETPs lose value over time (Vance Harwood estimates that rate at about 90% per year!), so when the share price gets too low, reverse splits raise it back up to a reasonable trading range.  This is precisely what Credit Suisse did for the last split, which occurred as TVIX started trading under $1 per share.

VXX follows a similar strategy.  Whenever its per share value gets low, it reverse splits:

It is important to note that the reverse splits do not themselves lead to a loss of value -- the loss of value is due to roll yield, compounding, and issues we have discussed before.1  Reverse splits are simply a way of keeping volatility ETPs at reasonable share prices, even as they persistently lose massive amounts of value.  In fact, VXX has lost over 99% of its original value, and yet remains the largest volatility ETP with over $1.5 billion in assets.

1 There is still some disbelief that volatility ETPs can lose so much value without some kind of structural flaw.  Our paper on VXX suggests there is no such flaw (that VXX does exactly what it is designed to do, even if that means losing tremendous amounts of value).  If you don't take our word for it, Robert Whaley, the inventor of the original VIX, has a new paper which says volatility ETPs "are virtually guaranteed to lose money through time."  This was understood even shortly after its inception.