by T. GormanPosted on Posted in SECActions

The SEC resolved an action with Morgan Keegan and two of its officers based on the fraudulent pricing of subprime real estate mortgage backed securities. In the Matter of Morgan Asset Management, Inc., Adm. Proc. File No. 3-14847 (June 22, 2011). The action was brought in coordination with FINRA and a task force of state regulators from Alabama, Kentucky, Mississippi, Tennessee and South Carolina.

The proceeding named as Respondents: Morgan Asset Management Inc., a registered investment adviser; Morgan Keegan & Co., Inc., a registered broker dealer; James Kelsoe, the senior portfolio manager for Morgan Asset; and Joseph Weller, Morgan Keegan’s Controller and the head of its Fund Accounting Department reported to him. The order alleged violations of Investment Company Act Section 34(b) and Advisers Act Sections 206(1), 206(2) and 206(4) and related rules.

Morgan Asset, through Mr. Kelsoe as Portfolio Manger, managed several Funds from late 2004 through mid 2008. These Funds held varying amounts of securities backed by subprime mortgages. Many of those securities lacked readily available market quotations. Accordingly the Investment Company Act required that they be priced by the Funds’ Board of Directors using fair value methods.

In filings made with the SEC, the Funds stated that the fair value of the securities would be determined by Morgan Asset’s Valuation Committee using procedures adopted by their board of directors. Those valuation procedures required that the securities be valued in good faith by the Valuation Committee. A series of general and specific factors were to be considered. One factor was broker-dealer price confirmations. The prices in those conformations could only be overridden if there was a reasonable basis to believe they were not accurate. If that step was taken the reasons for the override were required to be documented.

In fact the Funds delegated the responsibility for determining fair value to Morgan Keegan which primarily staffed the Valuation Committee. According to the Order, neither Morgan Keegan nor the Valuation Committee reasonably satisfied their responsibilities under the Funds’ procedures.

Morgan Asset adopted its own procedures to determine fair value to assign to portfolio securities and to validate those values periodically. Those procedures required that each quarter a list of fair value securities be furnished to the board with explanatory notes for their review. Morgan Asset failed to fully implement this provision.

As the subprime market declined in the first half of 2007 Mr. Kelsoe furnished Fund Accounting with price adjustments to various portfolio securities. In some instances in making these price adjustments Mr. Kelso ignored broker dealer price confirmations. The reason for these actions was not documented. With regard to one broker dealer Mr. Kelsoe is alleged to have “screened” the price quotes. Some of his price adjustments were higher than the prices obtained from broker dealers. Ultimately many of his price adjustments were arbitrary and did not reflect fair value according to the Order. As a result of these actions Mr. Kelsoe fraudulently prevented a reduction in the NAVs of the funds according to the Order.

Mr. Weller, as a member of the Valuation Committee, knew, or was reckless in not knowing, that the valuation policies were not being properly implemented. He failed to take steps to correct these deficiencies. Indeed, Morgan Keegan largely failed to implement the Funds’ valuation policies. As a result Morgan Keegan did not calculate current NAV for the Funds. Nevertheless, the firm published daily NAVs of the Funds. Shares were sold and redeemed based on those NAVs despite the fact that Morgan Keegan did not know if they were accurate.

Each of the Respondents settled the action. Under the terms of the settlements:

  • Morgan Keegan was censured and a cease and desist order was entered based on Section 34(b) of the Investment Company Act. The firm will jointly and severally, along with Morgan Asset, disgorge $20,500,000 along with prejudgment interest and pay a civil penalty of $75 million to the SEC. The firm agreed to implement a series of undertakings as part of the settlement. In addition, the firm is paying $100 million into a state fund for investors.
  • Morgan Assets was also censured and a cease and desist order was entered based on Sections 206(1), (2) and (40 of the Advisers Act and Section 34(b) of the Investment Company Act. The firm also agreed to implement a series of undertakings.
  • Respondent Weller was ordered to cease and desist with respect to Rules 22c-1 and 38a-1 of the Investment Company Act. He was also suspended from association in a supervisory capacity in the industry and from participating in any penny stock offering for twelve months. In addition, he is denied the privilege of appearing and practicing before the Commission as an accountant with a right to reapply after two years. Mr. Weller also agreed to pay a civil penalty of $50,000.
  • Respondent Kelsoe was ordered to cease and desist with respect to Sections 206(1), (2) and (4) of the Advisers Act and Section 34(b) of the Investment Company Act. He was also barred from the industry and from participating in any penny stock offering. Mr. Kelsoe will pay a civil penalty of $250,000 to the SEC and $500,000 in penalties overall.

The disgorgement, prejudgment interest and penalties paid to the SEC will be paid into a Fair Fund for investors.

by T. GormanPosted on Posted in SECActions

Is the SEC heading for another confrontation with the court? In two prior high profile market crisis cases the court would not approve the settlements until the Commission made changes to the settlement terms. This happened in Bank of America and Citigroup. Part of the difficulty in each instance was the complaint. Each detailed intentional conduct tied to the market crisis. Those allegations appeared out of sync with the terms of the settlements.

Now the SEC has brought its latest market crisis cases, SEC v. J.P. Morgan Securities LLC, Civil Action No. 11-04206 (S.D.N.Y. Filed June 21, 2011) and SEC v. Steffelin, Civil Action No. 11-04204 (S.D.N.Y. Filed June 21, 2011). The complaints appear to be built on intentional conduct. The events center on the market crisis. The charges in each complaint are based on negligence however. The settlement in one is based on negligence.

These cases center on the marketing and sale of a largely synthetic collateralized debt obligation or CDO called Squared CDO 2007-1 according to the court papers. Built primarily out of credit default swaps, the CDO was tied to the subprime housing market. The portfolio manager was GSCP (NJ) L.P. or GSC, an investment advisory firm with experience in analyzing credit risk in CDOs. Defendant Edward Steffelin was a Managing Director at GSC and an unregistered investment adviser. He was in charge of the team designated to select the collateral for Squared.

In early 2007 as the market was beginning to crumble J.P. Morgan Securities marketed notes in the $1.1 billion CDO squared. The Squared transaction priced on April 19, 2007 and closed on May 11, 2007.

About $150 million of the mezzanine tranches of Squard’s notes were sold to a group of fifteen institutional investors. They included Thrivent financial of Lutherans, a faith based non-profit organization in Minneapolis, Security Benefit Corporation, a Kansas based provider of insurance and retirement products, General Motors Asset Management, a New York asset manager for GM pension plans and several financial institutions in East Asia.

In the months before the closing J.P. Morgan Securities acquired most of the CDO related securities that would become the Squared portfolio. The process is known as warehousing. Magnetar Capital LLC, a large hedge fund, participated in the collateral selection process along with GSC and Mr. Steffelin. In some instances Magnetar negotiated with the investment firm about the collateral selection. As collateral was acquired in many instances the hedge fund took short positions as J.P. Morgan Securities, GSC and Mr. Steffelin knew.

In late February 2007 J.P. Morgan closed the warehouse because of disruptions in the credit markets. At the time the firm had suffered a $40 million mark-to-market accounting loss on the collateral being held in the warehouse. That loss could be avoided, as the firm knew, if they could sell the notes and transfer the collateral to a special purpose vehicle at closing. By closing, the hedge fund had a $600 million short position and an $8.9 million equity position in Squared according to the court papers.

The marketing materials for Squared detailed the process by which GSC selected the investment portfolio. What those materials failed to mention is the role of Magnetar in the selection process, the huge short position of the firm or the fact that Mr. Steffelin was seeking employment with Magnetar at the time.

By January 18, 2011 Squared declared an event of default. By January 29, 2008, according to the court papers, 50% of the CDO securities in the investment portfolio had been downgraded and another 34% was on negative downgrade. The Mezzanine Investors lost most, if not all, of their principal. J.P. Morgan Securities and its affiliates sustained losses of nearly $880 million but avoided potentially substantial losses on the Mezzanine notes. Mr. Steffelin was paid his salary and a $1 million bonus. According to the complaint against him “Synthetic CDO’s like Squared contributed to the recent financial crisis by magnifying losses with the downturn in the housing market.”

The complaint against Mr. Steffelin alleges violations of Securities Act Sections 17(a)(2) & (3) and Advisers Act Section 206(2). The case is pending.

J.P. Morgan Securities settled with the SEC, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) & (3). The firm also agreed to pay $18.6 million in disgorgement, prejudgment interest and a $133 million penalty. $125,869,721 of the total paid will be returned to the mezzanine investors through a Fair Fund distribution. Part of the settlement calls for the investment firm to take certain remedial steps in its review and approval of offerings of certain mortgage securities. In addition, J.P. Morgan Securities voluntarily made payments totaling $56,761,214 to certain investors in a transaction known as Tahoma CDO.

The settlement with the investment firm is subject to court approval. While courts frequently defer to the SEC in settling cases as Bank of America and Citigroup demonstrate, that is not always the case. That may be particularly true with cases such as this where the allegations in the complaints do not match the charges and the settlement.

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