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Editor: Eric C. Chaffee
Univ. of Toledo College of Law

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Tuesday, June 21, 2011

SEC & JP Morgan Chase Settle Fraud Charges Involving CDO Sales

The SEC announced that J.P. Morgan Securities LLC will pay $153.6 million to settle SEC charges that it misled investors in a complex mortgage securities transaction just as the housing market was starting to plummet. In settling the SEC’s fraud charges against the firm, J.P. Morgan also agreed to improve the way it reviews and approves mortgage securities transactions.

The SEC alleges that J.P. Morgan structured and marketed a synthetic collateralized debt obligation (CDO) without informing investors that a hedge fund helped select the assets in the CDO portfolio and had a short position in more than half of those assets. As a result, the hedge fund was poised to benefit if the CDO assets it was selecting for the portfolio defaulted.

The SEC separately charged Edward S. Steffelin, who headed the team at an investment advisory firm that the deal’s marketing materials misleadingly represented had selected the CDO’s portfolio.

According to the SEC’s complaint, the CDO known as Squared CDO 2007-1 was structured primarily with credit default swaps referencing other CDO securities whose value was tied to the U.S. residential housing market. Marketing materials stated that the Squared CDO’s investment portfolio was selected by GSCP (NJ) L.P. – the investment advisory arm of GSC Capital Corp. (GSC) – which had experience analyzing CDO credit risk. Omitted from the marketing materials and unknown to investors was the fact that the Magnetar Capital LLC hedge fund played a significant role in selecting CDOs for the portfolio and stood to benefit if the CDOs defaulted.

The SEC alleges that by the time the deal closed in May 2007, Magnetar held a $600 million short position that dwarfed its $8.9 million long position. The SEC further alleges that in March and April 2007, J.P. Morgan knew it faced growing financial losses from the Squared deal as the housing market was showing signs of distress. The firm then launched a frantic global sales effort in March and April 2007 that went beyond its traditional customer base for mortgage securities.  By 10 months later, the securities had lost most or all of their value.

According to the SEC’s complaint, J.P. Morgan sold approximately $150 million of so-called “mezzanine” notes of the Squared CDO’s liabilities to more than a dozen institutional investors who lost nearly their entire investment.

Without admitting or denying the allegations, J.P. Morgan consented to a final judgment that provides for payment of $18.6 million in disgorgement, $2 million in prejudgment interest and a $133 million penalty. Of the $153.6 million total, $125.87 million will be returned to the mezzanine investors through a Fair Fund distribution, and $27.73 million will be paid to the U.S. Treasury. The settlement also requires J.P. Morgan to change how it reviews and approves offerings of certain mortgage securities. In addition, J.P. Morgan’s consent notes that it voluntarily paid $56,761,214 to certain investors in a transaction known as Tahoma CDO I. The settlement is subject to court approval.

 

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