WILL THE COURT APPROVE THE J.P. MORGAN SETTLEMENT?

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.