SEC Brings Another Market Crisis CDO Case

SEC Brings Another Market Crisis CDO Case

 The market crisis ended but enforcement actions stemming from it have not. Battered financial giant JPMorgan, fresh from its settlement with the CFTC relating to the London Whale episode, reportedly is about to settle for its role in the mortgage debacles which many believe were at the center of the crisis. The price will be a record $13 billion. The settlement will be with the Department of Justice, not the SEC, for civil liability. The criminal investigations will continue, leaving the bank at risk.

The SEC also brought another market crisis related case at the close of last week. An administrative proceeding was brought against registered investment adviser and collateral manager Harding Advisory LLC and its principal, Wing Chau. In the Matter of Harding Advisory LLC, Adm. Proc. File No. 3-15574 (October 18, 2013).

The allegations in Harding are familiar, echoing those in Goldman Sachs, Citigroup and other market crisis cases. In the Spring of 2006 hedge fund manager Magnetar Capital LLC approached Merrill Lynch to arrange a series of CDO transactions. An arrangement was discussed under which Magnetar and Merrill would pick a mutually agreeable collateral manager that would work with the hedge fund manager who would play a significant role in structuring the composition of the portfolio. Magnetar would retain the equity, or lowest class, and Merrill would distribute the debt. Magnetar’s strategy, in part, was to hedge the positions in the CDO’s, meaning its interests were not aligned with the success of the entity.

Subsequently, Magetar and Merrill agreed on the selection of Harding as collateral manager for what would be known as Octans 1. Mr Cheu understood that Magnetar was interested in investing as the equity buyer in a series of potential CDO transactions. He also knew about the hedging strategy of Magetar.

Merrill, Harding and Magnetar then entered into the warehouse agreement which would govern the acquisition of the collateral for Octans 1. Under the agreement Magnetar would receive a percentage of the returns on the assets while they were carried. The agreement also gave the hedge fund manager the right to: 1) veto collateral selected by Harding; 2) agree with Merrill and Harding on the price paid; 3) and veto a designation by Merrill of any warehoused collateral as “ineligible.”

Harding also executed a Collateral Management Agreement in connection with the deal. It specified in part that Harding would perform its obligations with reasonable care and would use a “degree of skill and attention no less than that which [it] would exercise with respect to comparable assets that it manages for itself . . .” Nevertheless, as the collateral was selected, significant portions were disfavored by Harding. The manager understood, however, that it met the requirements of Magnetar.

The offering circular for Octans I reiterated the standard of care from the Collateral Management Agreement. The “pitchbook” used to solicit investors, drafted by Harding, described the firm’s approach and credit processes. Neither the offering circular nor the pitchbook mention Magnetar or its role and interests.

The Order alleges violations of Securities Act Section 17(a) and Advisers Act Sections 206(1) and 206(2). The proceeding will be set for hearing.

For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.

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