It appears that FINRA and the SEC have woken the hell up. And while change probably isn't coming to Wall Street, Broad and Water are certainly taking notice. At the very least, Main Street will be happy to hear that someone is being investigated, that someone is being held accountable and, yes, that someone will be perp walked with film at 11.
' The SEC's Division of Enforcement alleges that Morgan Keegan failed to employ reasonable procedures to internally price the portfolio securities in five funds managed by Morgan Asset, and consequently did not calculate accurate "net asset values" (NAVs) for the funds. Morgan Keegan recklessly published these inaccurate daily NAVs, and sold shares to investors based on the inflated prices. ' - SEC release
FINRA and the SEC brought down a sledgehammer upon Morgan Keegan today, citing one of the most egregious cases of blatant fraud in recent memory. The short of it is that two employees explicitly manipulated bond fund NAVs to hide horrible investment performances. The two in question, "actively screened and manipulated dealer quotes" ... "fraudulently published NAVs" ... made "price adjustments" that "were arbitrary and did not reflect fair value" ... "did not request" and "did not supply, supporting documentation" for these price adjustments ... "Fund Accounting did not record which dealer quotes had been overridden at Kelsoe's instruction." The list keeps going.
"This scheme had two architects — a portfolio manager responsible for lies to investors about the true value of the assets in his funds, and a head of fund accounting who turned a blind eye to the fund's bogus valuation process," - Robert Khuzami, Director of the SEC's Division of Enforcement
The long of it is that there was horrifically lax internal oversight, secondary accountants / auditors proved shameful at best and although Morgan Keegan itself was allegedly unaware of this rampant fraud, they knew that the holdings within these bond funds were complete and utter crap. If only that were the end of it.
"This misconduct masked from investors the true impact of the subprime mortgage meltdown on these funds." - William Hicks, Associate Director in the SEC's Atlanta Regional Office
Specifically, FINRA's complaint alleges that:
- In its research, investment advice and performance updates to its brokers regarding the Intermediate Fund, Morgan Keegan failed to disclose the material characteristics and risks of investing in the fund, misstated the appropriate use of the fund and otherwise portrayed the fund as a safer investment than it was, even though the firm was aware of material, special risks that made the fund unsuitable for many retail investors.
- Morgan Keegan failed to ensure the accuracy of the advertising materials prepared by the fund manager and distributed by the firm, and failed to ensure that those materials disclosed all material risks, were not misleading and did not contain exaggerated claims.
- Morgan Keegan failed to train its brokers regarding the features, risks and suitability of the fund and, in its communications with its brokers, the firm failed to adequately describe the nature of the holdings and material risks of the Intermediate Fund.
- When Morgan Keegan became aware, beginning in early 2007, of the adverse market effects on the bond funds, the firm failed to timely warn its brokers or revise its advertising materials to reflect the disproportionately adverse effect the market was having on the performance of the securities that comprised the bond funds – which Morgan Keegan brokers continued to sell widely. At this time, the firm reassured, rather than warned, its sales force about the riskiness of the bond funds. As a result, some of the firm's brokers were unaware of the then-turbulent market's effects on the funds and failed to disclose the negative effects caused by market forces.
The bark: Mary Shapiro's opening statement at today's SEC Open Meeting.
" Today, we are considering a recommendation that the Commission approve for public comment proposed rules that would fundamentally revise the regulatory regime for asset-backed securities.
The proposed rules are intended to better protect investors in the securitization market by giving them more detailed information about pooled assets, more time to make their investment decisions, and the benefits of better alignment of the interests of issuers and investors through a retention or "skin in the game" requirement. Finally, the rules would bring greater transparency to the private market as well.
As we know all too well, securitization — that is, the buying and bundling of assets such as housing, student or commercial loans into securities that are then sold to investors — played a central role in the financial crisis. Like most investment products, securitization has both its positive and negative attributes.
At one time, the securitization market provided trillions of dollars of liquidity to virtually every sector of the economy. This enabled lenders to make loans and credit available to a wide range of borrowers and companies seeking financing.
But, securitization has also fostered poor lending practices by encouraging lenders to shift their risk of loss to investors. In the area of mortgage-backed securities, sound underwriting practices sometimes took a back seat to immediate profits. When poorly underwritten mortgages began to default, the securities backed by the mortgages lost their value. Investors suffered significant losses, and have consequently largely withdrawn from the market.
During the past year, we have worked hard to better understand the practices that contributed to the financial crisis, and to identify ways to prevent reoccurrence in the future. We — along with other financial regulators — have looked closely at ABS oversight both in the public and private markets for these instruments, and have concluded that we can and must do a better job of protecting investors.
The release that the Commission is considering today is the result of our comprehensive reevaluation of existing rules, and our conclusion that three fundamental things need to change in order to better protect investors and promote more efficient asset-backed securities markets.
First, investors must have better information about the pooled assets that "back" these securities. This information must be both granular and current enough to provide investors the data they need to accurately assess risk and value. It also must be provided in a manner, and within a timeframe, so that investors can access and use the information effectively.
Second, the interests of organizations that issue and sponsor these securities must be better aligned with the interests of investors.
And third, we must consider the impact that more rigorous rules for the public ABS market will have on the private ABS market, and make sure that we are not simply moving tomorrow's problems into a less regulated area.
There are likely many avenues to address these macro objectives. As staff will explain in more detail in a moment, the release proposes to address these issues in a number of specific ways.
First, to provide investors with better, more timely and usable information, the proposal would require ABS issuers to file with the Commission standardized information about the specific loans in the pool, allowing investors to better understand their investment. This "loan level information" would be required at the time that the asset is securitized and on an ongoing basis.
Additionally, these issuers would be required to file on the SEC Web site a computer program of the contractual cash flow provisions, or "waterfall." The waterfall is essentially the rules that dictate how the borrowers' loan payments are distributed to investors in the ABS, how losses or lack of payment on those loans is divided among the investors, and when administrative expenses (such as servicing fees), are paid to service providers.
This computer program could be used to analyze the loan level information and would give investors and the markets better tools to analyze asset-backed securities.
And lastly in this area, the proposal would for the first time give investors a minimum period of time — specifically five business days — to consider transaction-specific information, including the loan level data, before an ABS investment decision needs to be made.
Second, to better align interests — as well as improve the quality of securities that are offered through the shelf registration process — the proposal would remove references to the ABS' credit rating as an eligibility requirement for shelf registration, replacing this instead with four new eligibility criteria:
The chief executive officer of the ABS depositor would need to certify that the assets have characteristics that provide a reasonable basis to believe that they will produce cash flows as described in the prospectus.
The ABS sponsor would be required to retain five percent of the securitization, net of the sponsor's hedging, to ensure that the sponsor — like investors — has "skin in the game."
The ABS issuer also would be required to provide a mechanism whereby the investors could confirm that the assets comply with the issuer's representations and warranties, such as representations and warranties that the loans in the ABS pool were underwritten in a manner consistent with the lenders' underwriting standards.
The ABS issuer would have to agree to file Exchange Act reports with the Commission on an ongoing basis (rather than discontinuing reporting with the Commission in the first year, which the Exchange Act currently permits many ABS issuers to do).
And lastly, we need to re-examine the assumption, in light of the financial crisis, that sophisticated investors do not need the types of protections that come with registration under the Securities Act.
Further, as we make improvements to the disclosure provisions which apply in the public markets, we also must address the potential that these changes will further drive ABS transactions to the private structured products markets where some types of asset-backed securities (such as collateralized debt obligations) are sold.
As a result, we are proposing that when an SEC safe harbor is relied upon for the unregistered sale of securities (for example, under Rule 144A or Regulation D), the issuers would have to provide investors, upon request, the same information that would be required if the offering were in the public markets. This information would need to be provided at the time of the offering and on an ongoing basis.
The proposal also would require that an ABS issuer file a public notice of the initial placement of securities to be sold under Securities Act Rule 144A. This notice would require information tailored to ABS offerings and be publicly filed with the SEC in its EDGAR database. Form D, the notice of an offering made in reliance on Regulation D, also would be revised to collect information on structured finance products.
This release represents a fundamental revision to the way in which the ABS market would be regulated. I think changes are both necessary and critical components of restoring investor confidence. The 90-day comment period will provide an important opportunity for market participants to weigh in on the judgment calls that we have preliminarily made.
During this time, I have also asked our staff to continue to work with other financial regulators — the FDIC, the Fed, Treasury and the President's Working Group — to ensure that our work in this area is fully informed by the activities of our regulatory colleagues. "
The bite: FINRA slapping Morgan Keegan silly and seeking "the disgorgement of all ill-gotten profits and full restitution for affected investors."
The juicy details: from today's SEC filing.
C. THE FRAUDULENT SCHEME
11. During various periods between at least January 2007 and July 2007, the daily net asset value3 (“NAV”) of each of the Funds was materially inflated as a result of the fraudulent conduct of Respondents. Kelsoe, an employee of Morgan Asset and Morgan Keegan, was the portfolio manager for the Funds. Weller was an officer and treasurer of the Funds and signed and certified their periodic reports to the Commission.
13. The Funds’ valuation policies and procedures required that dealer quotes be obtained for certain securities. Unbeknownst to Fund Accounting and the Funds’ independent auditor (“Independent Auditor”), Kelsoe actively screened and manipulated the dealer quotes that Fund Accounting and the Independent Auditor obtained from at least one broker-dealer. Kelsoe also failed to advise Fund Accounting or the Funds’ Boards of Directors when he received information indicating that the Funds’ prices for certain securities should be reduced.
14. Each Fund held securities backed by subprime mortgages, and the market for such securities deteriorated in the first half of 2007. Kelsoe’s actions fraudulently forestalled declines in the NAVs of the Funds that would have occurred as a result of the deteriorating market, absent his intervention. Morgan Keegan fraudulently published NAVs for the Funds without following procedures reasonably designed to determine that the NAVs were accurate.
19. Between at least January 2007 and July 2007, Kelsoe had his assistant send approximately 262 “price adjustments” to Fund Accounting. These adjustments were contained in approximately 40 emails sent by the assistant to a staff accountant in Fund Accounting who calculated the Funds’ NAVs. The adjustments were communications by Kelsoe to Fund Accounting concerning the price of specific portfolio securities. In many instances, these adjustments were arbitrary and did not reflect fair value.
21. Kelsoe knew his prices were being used to compute the Funds’ NAVs. Among other things, he received bi-weekly reports on the Funds’ holdings and their prices which, by comparison with previous reports, indicated that his price adjustments were being used and were directly affecting the NAVs.
22. Fund Accounting did not request, and Kelsoe did not supply, supporting documentation for his price adjustments. Fund Accounting and the Funds did not record which securities had been assigned prices by Kelsoe.
24. When month-end dealer quotes were received by Fund Accounting, an employee of Fund Accounting performed a cursory review to estimate whether they contained any securities prices that varied from current portfolio prices by more than five percent. If so, then Kelsoe determined whether the current price should be maintained or a new price—which may or may not have been the price given by the broker-dealer—should be assigned to the security. Thus, Fund Accounting routinely allowed Kelsoe to determine whether dealer quotes were used or ignored.
25. Fund Accounting did not record which dealer quotes had been overridden at Kelsoe’s instruction.
26. Weller was the head of Fund Accounting and a member of the Valuation Committee. He knew, or was highly reckless in not knowing, of the deficiencies in the implementation of valuation procedures set forth above, and did nothing to remedy them or otherwise to make sure fair-valued securities were accurately priced and the Funds’ NAVs were accurately calculated. Among other things, Weller knew that: (i) the Valuation Committee did not supervise Fund Accounting’s application of the valuation factors; (ii) Kelsoe was supplying fair value price adjustments for specific securities to Fund Accounting; (iii) the members of the Valuation Committee did not know which securities Kelsoe supplied fair values for or what those fair values were, and did not receive supporting documentation for those values; and (iv) the only pricing test regularly applied by the Valuation Committee was the “look back” test, which compared the sales price of any security sold by a Fund to the valuation of that security used in the NAV calculation for the five business days preceding the sale. The test only covered securities after they were sold; thus, at any given time, the Valuation Committee never knew how many securities’ prices could ultimately be validated by it. Weller nevertheless signed the Funds’ annual and semi-annual financial reports on Forms N-CSR, filed with the Commission, including certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002.
27. Morgan Keegan, acting through Weller and Fund Accounting, failed to employ reasonable procedures to price the Funds’ portfolio securities and, as a result of that failure, did not calculate accurate NAVs for the Funds. Despite these failures, Morgan Keegan recklessly published daily NAVs of the Funds which it could not know were accurate and, as distributor of the Funds’ shares, sold shares to investors based on those NAVs.
Kelsoe’s Fraudulent Manipulation of the Funds’ Securities Prices
Kelsoe's Fraudulent Manipulation of the Funds' Securities Prices
28. Between at least January 2007 and July 2007, Kelsoe manipulated the dealer quotes obtained from at least one broker-dealer (“the Submitting Firm”). At about the time Fund Accounting or the Independent Auditor sent requests for dealer quotes to the Submitting Firm, Kelsoe would confer by e-mail or phone with his contact there (the “Salesman”) regarding the quotes. Among other times, Kelsoe had such conversations concerning the month-end quotes for December 31, 2006, February 28, 2007, and March 31, 2007.
29. In some instances, even after causing the Submitting Firm to increase its quotes, Kelsoe subsequently provided price adjustments to Fund Accounting that were higher than even the Submitting Firm’s increased quotes. These adjustments were not consistent with the Funds’ procedures. Kelsoe and the Salesman also discussed, and the Submitting Firm frequently provided, interim quotes that were lower than the prices at which the Funds were valuing certain bonds, but higher than the initial quotes that the Submitting Firm had intended to provide. The interim quotes were accommodations to Kelsoe to enable him to avoid marking down the securities to the fair value in one adjustment. Kelsoe knew that the interim quotes did not reflect fair value, that the Submitting Firm would provide lower quotes in response to future pricing validation requests, and that he would be required to mark down the securities over time, but he did not disclose that information to Fund Accounting, the Funds’ Boards of Directors or the Independent Auditor.
30. For example, on April 25, 2007, the Salesman and Kelsoe spoke by phone about dealer quotes that would be submitted in connection with the March 31, 2007 audit by the Independent Auditor. The Salesman then told Kelsoe that the Submitting Firm’s trading desk had priced down many of the bonds in the Funds. Kelsoe asked the Salesman not to provide low dealer quotes that reflected actual bid prices.
31. As a result of the conversation, on April 30, 2007, the Submitting Firm provided quotes to the Independent Auditor reflecting interim prices for certain bonds, which were higher than the quotes the Submitting Firm originally intended to supply, but lower than the Funds’ then current values. For example, the Submitting Firm priced down one bond (“the Long Beach bond”) from the previous confirmation price of $81 to $65 as an “interim” step. This interim reduction to $65 was approximately half of the mark-down to $50 that the Submitting Firm’s trading desk initially had told the Salesman to communicate to the Independent Auditor for the Long Beach bond. On April 26, 2007, Kelsoe sent a price adjustment to Fund Accounting marking down the price of the Long Beach bond from $78, the price at which the Funds’ were valuing the bond at that time, to $72. Fund Accounting promptly entered the $72 price, which was substantially higher than fair value, into the spreadsheet used to calculate the Funds’ NAV.
32. The Submitting Firm also refrained from submitting certain quotes to Fund Accounting, where the quotes would have been lower than the current valuations being used by the Funds, as the result of conversations between Kelsoe and the Salesman.
33. Kelsoe did not disclose to Fund Accounting or the Funds’ Boards that he had received quotes from the Submitting Firm which were lower than the current valuations recorded by the Funds, and that the Submitting Firm had refrained from submitting quotes to Fund Accounting or had submitted quotes at higher prices than it had originally planned. Kelsoe also did not disclose that he caused the Submitting Firm to alter or withhold quotes.
Misrepresentations to Investors and the Funds’ Boards of Directors
40. Kelsoe also made fraudulent misrepresentations and omissions of material fact directly to the Funds’ investors concerning the Funds’ performance. Specifically, in each of the Funds annual and semi-annual reports filed with the Commission on Forms N-CSR during the relevant period (including, among others, the Annual Report for the Morgan Keegan Select Fund, Inc. for the year-ended June 30, 2007 filed with the Commission on October 4, 2007), Kelsoe included a signed letter to investors reporting on the Funds’ performance “based on net asset value.” Given his actions to manipulate the Funds’ NAVs, Kelsoe knew the performance he reported was materially misstated. Kelsoe and, through him, Morgan Asset made untrue statements of material fact concerning the Funds’ performance in the Funds’ annual and semiannual reports filed with the Commission on Forms N-CSR. Morgan Asset, through Kelsoe, also defrauded the Funds by providing a quarterly valuation packet reflecting inflated prices for certain securities to the Funds’ Boards, failing to disclose to the Funds’ Boards information indicating that the Funds’ NAVs were inflated, and that Kelsoe was actively screening and manipulating dealer quotes and providing Fund Accounting with unsubstantiated price adjustments. In addition, the prospectuses described Morgan Asset as responsible for fair valuation of the Funds’ portfolios.