Published on Dec 12th, 2013 | Posted in Articles

The Securities and Exchange Commission today charged Merrill Lynch with making faulty disclosures about collateral selection for two collateralized debt obligations (CDO) that it structured and marketed to investors, and maintaining inaccurate books and records for a third CDO.

Merrill Lynch agreed to pay $131.8 million to settle the SEC’s charges.

The SEC’s order instituting settled administrative proceedings finds that Merrill Lynch failed to inform investors that hedge fund firm Magnetar Capital LLC had a third-party role and exercised significant influence over the selection of collateral for the CDOs entitled Octans I CDO Ltd. and Norma CDO I Ltd.  Magnetar bought the equity in the CDOs and its interests were not necessarily aligned with those of other investors because it hedged its equity positions by shorting against the CDOs.

“Merrill Lynch marketed complex CDO investments using misleading materials that portrayed an independent process for collateral selection that was in the best interests of long-term debt investors,” said George S. Canellos, co-director of the SEC’s Division of Enforcement.  “Investors did not have the benefit of knowing that a prominent hedge fund firm with its own interests was heavily involved behind the scenes in selecting the underlying portfolios.”

According to the SEC’s order, Merrill Lynch engaged in the misconduct in 2006 and 2007, when its CDO group was a leading arranger of structured product CDOs.  After four Merrill Lynch representatives met with a Magnetar representative in May 2006, an internal email explained the arrangement as “we pick mutually agreeable [collateral] managers to work with, Magnetar plays a significant role in the structure and composition of the portfolio ... and in return [Magnetar] retain[s] the equity class and we distribute the debt.”  The email noted they agreed in principle to do a series of deals with largely synthetic collateral and a short list of collateral managers.  The equity piece of a CDO transaction is typically the hardest to sell and the greatest impediment to closing a CDO.  Magnetar’s willingness to buy the equity in a series of CDOs therefore gave the firm substantial leverage to influence portfolio composition.

According to the SEC’s order, Magnetar had a contractual right to object to the inclusion of collateral in the Octans I CDO selected by the supposedly independent collateral manager Harding Advisory LLC during the warehouse phase that precedes the closing of a CDO.  Merrill Lynch, Harding, and Magnetar had finalized a tri-party warehouse agreement that was sent to outside counsel, yet the disclosure that Merrill Lynch provided to investors incorrectly stated that the warehouse agreement was only between Merrill Lynch and Harding.  The SEC has charged Harding and its owner with fraud for accommodating trades requested by Magnetar despite its interests not necessarily aligning with the debt investors.  

The SEC’s order finds that one-third of the assets for the portfolio underlying the Norma CDO were acquired during the warehouse phase by Magnetar rather than by the designated collateral manager NIR Capital Management LLC.  NIR initially was unaware of Magnetar’s purchases, but eventually accepted them and allowed Magnetar to exercise approval rights over certain other assets for the Norma CDO.  The disclosure that Merrill Lynch provided to investors incorrectly stated that the collateral would consist of a portfolio selected by NIR.  Merrill Lynch also failed to disclose in marketing materials that the CDO gave Magnetar a $35.5 million discount on its equity investment and separately made a $4.5 million payment to the firm that was referred to as a “sourcing fee.”  The SEC also today announced charges against two managing partners of NIR.

According to the SEC’s order, Merrill Lynch violated books-and-records requirements in another CDO called Auriga CDO Ltd., which was managed by one of its affiliates.  As it did in the Octans I and Norma CDO deals, Merrill Lynch agreed to pay Magnetar interest or returns accumulated on the warehoused assets of the Auriga CDO, a type of payment known as “carry.”  To benefit itself, however, Merrill Lynch improperly avoided recording many of the warehoused trades at the time they occurred, and delayed recording those trades.  Therefore, Merrill Lynch’s obligation to pay carry was delayed until after the pricing of the Auriga CDO when it became reasonably clear that the trades would be included in the portfolio.

“Keeping adequate books and records is not an elective requirement of the federal securities laws, and broker-dealers who fail to properly record transactions will be held accountable for their violations,” said Andrew M. Calamari, director of the SEC’s New York Regional Office.

Merrill Lynch consented to the entry of the order finding that it willfully violated Sections 17(a)(2) and (3) of the Securities Act of 1933 and Section 17(a)(1) of the Securities Exchange Act of 1934 and Rule 17a-3(a)(2).  The firm agreed to pay disgorgement of $56,286,000, prejudgment interest of $19,228,027, and a penalty of $56,286,000.  Without admitting or denying the SEC’s findings, Merrill Lynch agreed to a censure and is required to cease and desist from future violations of these sections of the Securities Act and Securities Exchange Act.

The SEC’s investigation was conducted by staff in the New York Regional Office and the Complex Financial Instruments Unit, including Steven Rawlings, Gerald Gross, Tony Frouge, Elisabeth Goot, Brenda Chang, John Murray, Sharon Bryant, Kapil Agrawal, Douglas Smith, Howard Fischer, Daniel Walfish, and Joshua Pater.  Several examiners in the New York office assisted, including Edward Moy, Luis Casais, Thomas Shupe, William Delmage, George DeAngelis, Syed Husain, and James Sawicki.