The brokerage firm of Merrill Lynch will pay $131.8 million to settle charges it misled investors about two collateralized debt obligations (CDOs) it structured and marketed, as well as maintaining inaccurate books and records for a third CDO. The Securities and Exchange Commission (SEC) announced the settlement on Thursday.
The SEC’s order found that Merrill Lynch failed to inform investors that the hedge fund firm Magnetar Capital LLC had a third-party role and exercised significant influence over the selection of collateral for the CDOs titled Octans I CDO Ltd. and Norma CDO I Ltd. According to the SEC, Magnetar bought the equity in the CDOs and its interests were not necessarily aligned with those of other investors because it hedged its equity positions by shorting against the products.
“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,” said George S. Canellos, co-director of the SEC’s Division of Enforcement, in a statement. “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.”
Merrill Lynch agreed to the settlement without admitting or denying the SEC’s findings.
All of the actions in question took place before Merrill Lynch was acquired by the Bank of America in 2009. Specifically, according to the SEC’s order, Merrill Lynch engaged in the misconduct in 2006 and 2007 when its CDO group was a leading arranger of structured product CDOs. After four Merrill Lynch representatives met with a Magnetar representative in May 2006, an internal email explained the arrangement as “we pick mutually agreeable [collateral] managers to work with, Magnetar plays a significant role in the structure and composition of the portfolio … and in return [Magnetar] retain[s] the equity class and we distribute the debt.”
The email further noted that the Merrill Lynch reps agreed in principle to conduct a series of deals with largely synthetic collateral and a short list of collateral managers. The equity piece of a CDO transaction is typically the hardest to sell and the greatest impediment to closing a CDO. Magnetar’s willingness to buy the equity in a series of CDOs therefore gave the firm substantial leverage to influence portfolio composition.
You can read the SEC’s entire decision here.