The SEC settled public administrative proceedings against Merrill, Lynch, Pierce, Fenner & Smith Inc. (the “Sponsor”) relating to the structuring and marketing of three collateralized debt obligations (“CDOs”) and separately against Scott H. Shannon and Joseph G. Parish III (the “Collateral Manager Principals”), the two principals of the unregistered investment adviser that served as collateral manager for one of the CDOs (the “Collateral Manager”).  The SEC found that the Sponsor (i) made faulty disclosures about the independence of the collateral selection process for two of the CDOs, and (ii) maintained inaccurate books and records for the third CDO.  The SEC found that the Collateral Manager Principals compromised their independent judgment and allowed a third party with its own interests to influence the portfolio selection process for the CDO for which their firm, the Collateral Manager, served as collateral manager.  This article provides a high level summary of the SEC’s detailed findings with respect to the Sponsor and the Collateral Manager Principals, which the respondents have neither admitted nor denied, and of the sanctions imposed, as set forth in each of the settlement orders.

Faulty Disclosures Regarding Collateral Selection Process for CDOs

The SEC found that the Sponsor engaged in misconduct in 2006 and 2007 when it failed to inform investors that a hedge fund firm (the “Hedge Fund Firm”) had a third-party role in and exercised significant influence over the selection of collateral with respect to two of the CDOs. 

The Hedge Fund Firm purchased the lowest quality tranche or “equity” portion in each of those two CDOs (the equity portion of a CDO transaction typically being the hardest to sell, and therefore, the greatest impediment to closing a CDO).  The SEC found that because the Hedge Fund Firm also took short positions opposite certain of the CDOs’ assets to hedge its equity positions in the CDOs, its interests were not necessarily aligned with those of the other investors in the CDOs.  The Hedge Fund Firm was given a contractual right to object to the selection by the collateral manager of one CDO (“CDO I”) of any collateral for inclusion in CDO I’s portfolio.  There was a three party agreement in place between the Sponsor, the collateral manager for CDO I, and the Hedge Fund Firm regarding the selection of collateral, however, disclosure to investors in CDO I incorrectly stated that the agreement was only between the Sponsor and the collateral manager for CDO I.  (The SEC has separately commenced administrative proceedings against this collateral manager and its CEO/CCO.)

The SEC also found that one-third of the assets for the portfolio underlying the second CDO (“CDO II”) were acquired by the Hedge Fund Firm during the “warehouse phase” of CDO II, and not selected by the Collateral Manager, which served as CDO II’s collateral manager.  At first, the Collateral Manager did not know of the acquisitions made by the Hedge Fund Firm on behalf of CDO II, but eventually accepted them despite the fact that the Collateral Manager Principal responsible for the credit default swap (“CDS”) selection process and the Collateral Manager’s credit analysts viewed portions of the Hedge Fund Firm’s CDS selections as undesirable, and further allowed the Hedge Fund Firm approval over certain other collateral selected for inclusion in CDO II’s portfolio.  In contrast, the disclosure that the Sponsor made available to investors in CDO II stated that collateral would be selected solely by the Collateral Manager.  The SEC also found that the Sponsor failed to disclose in its marketing materials for CDO II that (i) CDO II made a $4.5 million payment to the Hedge Fund Firm for sourcing collateral to CDO II and (ii) CDO II gave the Hedge Fund Firm a $35.5 million discount on its investment in CDO II’s equity.

Recordkeeping

With respect to the third CDO (“CDO III”), the SEC found that Sponsor failed to comply with certain requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) to maintain accurate books and records.  The Sponsor agreed to pay the Hedge Fund Firm an amount equal to the interest or returns accumulated on CDO II’s warehoused assets (a “carry” payment).  The Sponsor improperly recorded 68 of 79 trades made during the “warehouse phase” for this CDO and delayed the recording of such trades on the CDO’s books and records.  As a result of such improper recording, the Sponsor’s obligation to make a carry payment to the Hedge Fund Firm was delayed until a time when it was reasonably certain that the trades would be included in the CDO’s portfolio.

Violations and Sanctions

The SEC found that the Sponsor willfully violated Sections 17(a)(2) and (3) of the Securities Act of 1933, as amended (the “Securities Act”), and Section 17(a)(1) of the Exchange Act, and Rule 17a-3(a)(2) thereunder.  The Sponsor agreed to pay disgorgement of $56,286,000, prejudgment interest of $19,228,027, and a penalty of $56,286,000.  The Sponsor agreed to a censure and to cease and desist from future violations of Sections 17(a)(2) and (3) of the Securities Act and Section 17(a)(1) of the Exchange Act.

The SEC found that the Collateral Manager Principal principally responsible for selecting the CDS investments that constituted approximately 90% of CDO II’s collateral had violated Sections 206(1) and (2) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and that the second Collateral Manager Principal had violated Section 206(2) of the Advisers Act.  The former agreed to be barred from the securities industry for at least two years and to pay disgorgement and prejudgment interest of $140,662 and a penalty of $116,553.  The latter agreed to be suspended from the securities industry for at least one year and to pay disgorgement and prejudgment interest of $140,662 and a penalty of $75,000.  The Collateral Manager Principals agreed to cease and desist from violations of the aforementioned provisions of Sections 206 of the Advisers Act, and to dissolve the Collateral Manager.

In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Incorporated, SEC Release No. 34-71051.

In the Matter of Joseph G. Parish III and Scott H. Shannon, SEC Release No. IA-3735.

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