by T. GormanPosted on Posted in SECActions

The SEC issued an Order which charged investment manager Lynn Tilton, known as the Diva of Distressed Debt according to news reports, and her entities with fraud. Specifically, the Order Instituting Proceedings issued by the SEC, claims that Ms. Tilton overvalued certain funds in a manner which was contrary to the authorizing documents and unknown to investors. This resulted in the payment of unnecessary management fees by investors and compromised their rights. In the Matter of Lynn Tilton, Adm. Proc. File No. 3-16462 (March 30, 2015).

Ms. Tilton has managed what are called the Patriarch entities for years. Those entities, named as Respondents, are: Patriarch Partners, LLC (Patriarch), Patriarch Partners VIII, LLC, Patriarch Partners XIV, LLC and Patriarch Partners XV, LLC. Each is indirectly owned by either Ms. Tilton or the manager and a trust for the benefit of her daughter. Ms. Tilton, the CEO of Patriarch, and their employees, run the business of the three other Patriarch Partners entities, each of which is a registered investment adviser and a collateral manager for the Zohar Funds.

The Zohar Funds are CLOs, a securitization vehicle in which a special purpose entity raises capital by issuing secured notes. Proceeds from the note sales are used to acquire a portfolio of commercial loans. The cash flow and other proceeds from the collateral are used to repay the investor note holders of the fund.

The collateral management agreement for each fund permitted the manager to select and manage the collateral held by the fund. The Zohar Funds invested in private, mid-sized distressed companies. The goal was to improve the operations of the distressed portfolio companies to pay off the debt and eventually make a profit. Two tiers of fees are paid. One, the Senior Collateral Management Fee, ties to assets. The other, the Subordinated Fee, is linked to valuation.

The indenture for each Zohar CLO contained certain numeric tests that must be met each month. Once ratio is the so-called Overcollateralization Ratio. It measures the cushion between the value of the collateral and the principal amount of the investor notes. If the specified ratios fall below certain levels, the investors control over the fund can increase and result in the early repayment of the principal. The indenture also requires the collateral manager to categorize each asset every month. The classification is included in a report of the trustee. Specific categories are included in the indentures.

Rather than following the dictates of the indenture, Ms. Tilton used her discretion to determine how an asset should be categorized. The valuation category of an asset was not lowered unless she approved. As a result few assets of the Zohar Funds were downgraded to the lower valuation categories.

If Ms. Tilton had used the methodology for categorization in the indentures the number of assets in the default investment category would have “looked very different,” according to the Order. Certain portfolio companies failed to pay as much as 90% of the interest owed to the Zohar Funds but were not downgraded. The failure to properly classify these assets resulted in the overpayment of almost $200 million in Subordinated Fees to Respondents.

Ms. Tilton’s discretionary approach was not disclosed to investors. Failing to disclose that approach created a significant conflict of interest. The assets also were not valued in accord with GAAP as represented in the financial statements.

The Order alleges willful violations of Advisers Act Sections 206(1), 206(2) and 206(4). The proceeding will be set for hearing.

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by T. GormanPosted on Posted in SECActions

The SEC brought another case tied to Chinese reverse mergers. This one differs from many earlier actions which focused on the company and or the executives. This action names as defendants one broker-dealer and two of its employees as defendants. It centers on two public offerings of the shares of Puda Coal, Inc. which, by the time of the offerings, lacked its primary asset — a fact unfortunately not known to those who purchased the shares in the secondary offerings. SEC v. Macquarie Capital USA), Inc., Civil Action No. 15 cv 02304 (S.D.N.Y. Filed March 27, 2015).

Puda Coal, Inc.is the product of a Chinese reverse merger. Its primary asset when it entered into the U.S. markets in 2009 and was listed on the NYSE was Shanxi Coal, a Chinese coal mining company established under the laws of the PRC in 1995. Previously, Puda indirectly owned 90% of Shanxi Coal.

Defendant Macquarie is a Commission registered broker-dealer that is a wholly owned subsidiary of Macquarie Group Limited, a global financial services firm based in Australia. The firm served as lead underwriter and joint bookrunning manager for Puda’s follow-on public stock offerings. Defendants Aaron Black and William Fang are both employees of the broker-dealer. Mr. Black served as a Division Director in the Sydney office while Mr. Fang was an investment banking associate and registered representative in the New York office.

Puda had an off-shore ownership structure that was typical for public companies with operations in the PRC. Its primary business was initially as a supplier of cleaned coking coal used in the manufacture of steel. In 2009 the firm modified its strategy and entered into the coal mining business as a result of certain provincial regulations. In September of that year Puda’s chairman caused its 90% interest in Shanxi Coal to be transferred to himself without the approval or knowledge of the public shareholders or the board of directors. As a result of other transfers he eventually held 99% of Shanxi Coal. Later he entered into a series of transaction through which control of Shanxi Coal was pledged as collateral for a loan to the firm. These transactions were not reflected in the public filings of Puda.

On February 18, 2010 Puda completed the offering and sale of 2.86 million shares, obtaining net proceeds of about $14.5 million. Subsequently, on December 16, 2010 the firm completed the sale of another 9 million shares, obtaining net proceeds of $101.5 million.

Prior to the offerings the Underwriting Committee of the firm directed the Puda transaction team, which included Mr. Black, to engage Kroll Associates Inc., an investigative firm, to prepare a report on Puda and its officers and directors. The firm was aware of the heightened risk of the deal, as reflected in its papers. Kroll identified documents showing that Shanxi was owned by others. Although Mr. Fang read the report and Mr. Black reviewed portions of it, neither pointed out the fact that Kroll had obtained documents showing the mine belonged to others. The firm did not have sufficient systems in place to properly assess the report, according to the complaint.

The offerings went forward using disclosure documents which did not disclose that the largest asset of Puda was no longer owned by the firm. To the contrary, the offering documents continued to list Shanxi as the primary asset of Puda.

In April 2011 an internet report on Puda disclosed some of the asset transfers and transactions involving Mr. Zhao and others. Just before the report became available the share price was at a high of over $16 per share, $4 above the offering price. The day the report surfaced the stock closed at $6 per share. A subsequent investigation by the audit committee uncovered the fraud which was then reported on a Form 8-K. Subsequently, Puda’s auditor resigned, stating that further reliance should not be placed on its prior audit reports. The shares were delisted and now trade in the grey market.

The Commission’s complaint alleges violations of Securities Act Sections 17(a)(2) and (3). The firm has agreed to settle with the Commission by paying a $15 million penalty and covering the cost of setting up a fair fund to compensate investors who suffered losses. The individuals have not settled. See Lit. Rel. No. 23222 (March 27, 2015).

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