On December 12, 2013, the Securities and Exchange Commission (“SEC”) filed an Order Instituting Administrative and Cease-and-Desist Proceedings (“Order”) stating that Merrill Lynch, Pierce, Fenner & Smith, Inc., through its affiliate Merrill Lynch International (collectively referred to as “Merrill Lynch”), made various misrepresentations during the marketing of a series of collateralized debt obligation transactions (“CDO”) during 2006 and 2007. In a CDO transaction, a special purpose vehicle issues securities that are backed by collateral owned by the issuer. CDOs have collateral managers who are responsible for the selection and monitoring of the portfolio of assets that backs the CDO.
This SEC Order involved CDO Issuers Octans I CDO Ltd. (“Octans I”), Norma CDO I Ltd. (“Norma”) and Auriga CDO Ltd. (“Auriga”), all of which were collateralized by credit default swaps referencing Residential Mortgage Backed Securities (“RMBS”). According to the SEC Order, Merrill Lynch failed to inform investors in Octans I and Norma that an undisclosed third party hedge fund, Magnetar Capital LLC (“Magnetar”), exercised significant influence over the selection of the CDO’s collateral. According to George S. Canellos, co-director of the SEC’s Division of Enforcement, “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 . . . 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.” Further, the Order states that the Merrill Lynch also failed to keep accurate books and records for Auriga by failing to record trades of the underlying collateral properly in order to avoid paying interest and to allow it to trade out of positions.
The Order was issued after Merrill Lynch agreed to settle the SEC charges, without Merrill Lynch admitting or denying the SEC’s findings. The SEC fined Merrill Lynch approximately $132 million, which consists of $56,286,000 in disgorgement, $19,228,027 in pre-judgment penalties, and a civil penalty of $56,286,000.
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