by T. GormanPosted on Posted in SECActions

In significant market crisis based actions, the SEC and the U.S. Attorney for Manhattan brought, respectively, civil and criminal charges against former Credit Suisse Group traders centered on the overpricing of subprime bonds. SEC v. Kareem Serageldin, Civil Action 12 CIV 0796 (S.D.N.Y. Filed Feb. 1, 2012). The SEC’s complaint names as defendants for former bank traders: Kareem Seregeldin, Global Head of Structured Credit Trading at Credit Suisse, David Higgs, Managing Director and Head of Hedge Trading who reported to Mr. Serageldin, Faisal Siddiqui, vice president in Credit Suisse Group’s CDO Trading Group in New York who reported to Mr. Higgs, and Salmaan Siddiqui, vice president in Credit Suisse Group’s CDO Trading Group in New York who also reported to Mr. Higgs.

In late 2007 and 2008 the defendants specialized in structuring and trading mortgage backed securities. During this period they engaged in a fraudulent scheme to overstate the prices of more than $3 billion of subprime bonds owned by Credit Suisse. Mr. Seregldin initiated the scheme which was implemented by the other defendants, according to the complaint which is based in part on recordings of conversation involving the defendants.

The bonds held on the books of the bank had to be priced daily to record their fair value. As the fair value price declined in 2007 and after, recording the write downs would cause millions of dollars in losses for the bank. It would also eliminate Defendants’ hopes for large bonuses and jeopardize a promotion sought by Mr. Serageldin.

Beginning in late August 2007 defendants marked the bonds to the P&L rather than to fair value to avoid the impact of the required write downs. Defendants knew for example, that pricing a $3.5 billion of AAA rated bonds backed by subprime mortgages known as ABN1 at fair value would result in millions of dollars in losses. Despite having what the complaint calls “ample market data” showing that the bonds were over priced, the defendants maintained them at false high prices.

In mid-January Mr. Serageldin approved his units year end P&L results without correcting the incorrect year end prices. Indeed, shortly thereafter he directed that the prices for the bonds be increased above the prior year end level to achieve favorable P&L results at the end of January.

In mid-February Credit Suisse reported net income of CHF 8.55 or $7.12 billion, with fourth quarter earnings of CHF 1.3 or $1.16 billion. Those results were incorrect.

Shortly after reporting the fourth quarter results, Credit Suisse senior management began to unravel the fraud. They detected abnormally high prices on certain bonds controlled by Defendants. On February 19, 2008 the firm issued a press release stating that its financial results were incorrect. Subsequently, the bank revised net income for 2007 downward from CHF 8.55 or $7.12 billion to CHF 7.76 or $6.47 billion and for the fourth quarter of 2007 from CHF 1.3 or $1.16 billion to CHF 540 or $471 million. The write downs centered on the defendants’ ABN1 book which recognized a write down of about $1.3 billion.

The SEC’s complaint alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). The case is in litigation.

In its press release the SEC, citing its Seaboad Report, took the unusual step of explaining the reasons it chose not to bring an action against Credit Suisse. In this regard the Commission stated that it was influenced by several factors including:

  • The isolated nature of the wrongdoing;
  • Credit Suisse’s immediate self-reporting to the SEC and other law enforcement agencies;
  • Its prompt public disclosure of corrected financial results;
  • The voluntary termination of the four bankers involved;
  • Its implementation of enhanced internal controls to prevent a reoccurrence; and
  • Its cooperation with the SEC’s investigation which included timely access to evidence and witnesses.

Messrs. Higgs, Fiasal Siddiqui and Salmaan Siddiqui also cooperated with the SEC.

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by T. GormanPosted on Posted in SECActions

While insider trading typically garners all the headlines, the Commission has also brought a series of cases focused on another type of trading which also can have pernicious market effects – naked short selling. Recently, the Commission has brought a number of actions centered on claimed violations of Reg. SHO, which deals which short selling

Reg. SHO does not ban short selling. Rather, the regulation was adopted to curb short selling which can have a negative market impact. In adopting Reg. SHO the Commission concluded that naked short selling can have a negative impact on the market, particularly where there are persistent failures to deliver the security not just within the usual three day settlement period but for an extended period. In some instances the amount of “fails to deliver” may be greater than the total public float for the security. This can adversely impact the rights of the buyer of a security, according to the Commission.

To avoid this result Reg. SHO has a “locate requirement” which specifies generally that that market participants seeking to effect a short sale borrow, arrange to borrow, or at least have reasonable grounds to believe that a security can be borrowed within the delivery time. There is a market maker exemption. A second facet of the rule has a “close out” provision which generally requires that a clearing broker who has a failure to deliver for thirteen consecutive days close the position by purchasing the securities in a bona fide transaction.

The action brought against Jeffery Wolfson, his brother Robert, and the firm where they were employed, Anchor Trading II, LLC, alleges repeated violations of both of these provisions of Reg. SHO. In the Matter of Jeffrey A. Wolfson, Adm. Proc. File No. 3-14726 (Jan. 31, 2012). According to the Order, over a one year period beginning in July 2006, the Respondents earned at least $17,375,000 in illicit trading profits in violation of Reg. SHO and specifically Rules 203(b)(1) and 203(b)(3). The profits were made by employing three key schemes to evade the requirements of the Regulation:

Reverse conversions: This transaction ties a short stock sale to a synthetic long position with the same trader and hedges the short position. The synthetic long is created by selling a put option and buying a call option with the same expiration date and strike price. In executing this type of transaction, typically for hard to borrow threshold securities, the Respondents did not comply with the locate or close out requirements. The transaction did however permit them to attract business from prime brokerage firms seeking to create inventory for stock loans on hard to borrow securities.

Reset transactions: In this type of a transaction Respondents appeared to comply with their obligation to purchase the security sold short but in reality did not. Here the security was actually purchased while simultaneously buying from the same counterparty a short term, deep in the money put option (or the reverse). In reality the pairing of the transactions was simply a mechanism to borrow the stock for a day. Stated differently, it was a sham transaction, according to the Order.

Assist transactions: This is essentially the opposite side of the reset transaction. Here Respondents would assist their reset transactions as well as those of others.

This is not the first Commission case in which traders have utilized these types of tactics to try and circumvent the requirements of Reg. SHO (here). It may however be one of the largest.

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