The Securities and Exchange Commission (“SEC”) announced that Merrill Lynch has agreed to pay $131.8 million to settle allegations in an SEC administrative proceeding. The SEC’s charges stem from alleged misrepresentations by Merrill Lynch concerning two structured product collateralized debt obligations (“CDOs”) and for allegedly keeping inaccurate books and records for a third CDO.
The three CDOs involved are the Octans I CDO Ltd. (“Octans”), Norma CDO I Ltd. (“Norma”), and Auriga CDO Ltd. (“Auriga”).
A CDO is a structured product in which a special purpose vehicle (an “Issuer”) issues tranches of securities backed by a portfolio of assets owned by the Issuer. Typically, a designated collateral manager is responsible for selecting, acquiring, and monitoring the portfolio of assets used as collateral for the tranches of securities.
According to the SEC’s Order Instituting Administrative and Cease-And-Desist Proceedings (“Order”), the collateral used for the Octans, Norma, and Auriga CDOs were primarily credit default swaps (“CDS”) tied to subprime residential mortgage backed securities (“RMBS”).
CDS refers to a financial swap agreement in which the seller of the CDS agrees to compensate the buyer of the CDS in the event of a loan default. The buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if the loan defaults.
RMBS are securities whose cash comes from residential debt such as mortgages, home-equity loans and subprime mortgages rather than commercial mortgages.
The SEC’s Order alleged that Merrill Lynch failed to inform investors in the Octans and Norma CDOs that an undisclosed third party hedge fund firm – Magnetar Capital LLC (“Magnetar”) – had rights relating to, and exercised significant influence over, the selection of the collateral for the Octans and Norma CDOs.
Specifically, it was alleged that Merrill Lynch did not disclose to investors in Octans that Magnetar had a contractual right to object to the inclusion of collateral selected by the collateral manager. In addition, the SEC claimed that Merrill Lynch did not advise investors that approximately one-third of Norma’s portfolio assets were acquired by Magnetar, rather than by the collateral manager.
The SEC also alleged that Merrill Lynch violated books-and-records requirements contained in the Securities Exchange Act in concerning Auriga.