SEC CHARGES N.J.-BASED FIRM AND OWNER WITH MISLEADING INVESTORS IN A CDO

FROM:  THE U.S. SECURITIES AND EXCHANGE COMMISSION

The Securities and Exchange Commission today announced charges against a Morristown, N.J.-based investment advisory firm and its owner for misleading investors in a collateralized debt obligation (CDO) and breaching their fiduciary duties.

The SEC’s Enforcement Division alleges that Harding Advisory LLC and Wing F. Chau compromised their independent judgment as collateral manager to a CDO named Octans I CDO Ltd. in order to accommodate trades requested by a third-party hedge fund firm whose interests were not necessarily aligned with the debt investors.  Harding agreed to give the hedge fund firm rights in the process of selecting and acquiring a portfolio of subprime mortgage-backed assets to serve as collateral for debt instruments issued to investors in the CDO.  These rights, which were not disclosed to investors, included the right to veto Harding’s proposed selections during the “warehouse” phase that preceded issuance of the CDO’s debt instruments.  The influence of the hedge fund firm led Harding to select assets that its own credit analysts disfavored.

“A collateral manager’s independent selection of assets is an important selling point to potential CDO investors,” said George S. Canellos, co-director of the SEC’s Division of Enforcement. “Investors had a right to know that Harding and Chau had chosen to accommodate the interests of others and abandon their own obligations to act in the best interests of the CDO they advised.”

According to the SEC’s order instituting proceedings, the hedge fund firm was Magnetar Capital LLC, which had invested in the equity of the CDO.  Merrill Lynch, Pierce, Fenner & Smith Inc. structured and marketed the CDO, which closed on Sept. 26, 2006.  Merrill Lynch, Magnetar, and Harding agreed in the spring of 2006 that Harding would serve as collateral manager for the CDO.  Chau understood that Magnetar was interested in investing as the equity buyer in CDO transactions, and that Magnetar’s strategy included “hedging” its equity positions in CDOs by betting against the debt issued by the CDOs.  Because Magnetar stood to profit if the CDOs failed to perform, Chau knew that Magnetar’s interests were not necessarily aligned with investors in the debt tranches of Octans I, whose investment depended solely on the CDO performing well.

The SEC’s Enforcement Division alleges that while assembling the collateral for Octans I, Chau and Harding allowed Magnetar an undisclosed influence over the selection process.  Harding’s own credit analysis of many of the selected assets was disregarded, and Magnetar’s influence over the portfolio was omitted from materials used to solicit investors for the CDO.  Chau and Harding misrepresented the standard of care that Harding would use in acquiring collateral for Octans I.

The SEC’s Enforcement Division further alleges that Harding and Chau breached their advisory obligations to several other CDOs for which they served as investment managers.  As a favor to Merrill Lynch and Magnetar, Harding and Chau purchased bonds for those CDOs that Chau and Harding disfavored.  In accepting the bonds, Chau wrote in an e-mail to the head of CDO syndication at Merrill Lynch, “I never forget my true friends.”

The SEC’s Division of Enforcement alleges that by engaging in the conduct described in the SEC’s order, Harding and Chau violated Section 17(a) of the Securities Act of 1933 and Section 206 of the Investment Advisers Act of 1940.  Chau also is charged with aiding and abetting and causing Harding’s violations. The proceedings before an administrative law judge will determine what relief against Harding and Chau is in the public interest.

The SEC’s investigation, which is continuing, has been conducted by staff in the Complex Financial Instruments Unit and the New York Regional Office, including Steven Rawlings, Brenda Chang, Elisabeth Goot, Sharon Bryant, Kapil Agrawal, Howard Fischer, Daniel Walfish, and Douglas Smith.  The case was supervised by Reid Muoio, and the litigation will be led by Mr. Fischer, Mr. Walfish, Ms. Goot, and Ms. Chang.

SEC CHAIR MARY JO WHITE'S REMARKS AT MANAGED FUNDS ASSOCIATION OUTLOOK 2013 CONFERENCE

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
Hedge Funds – A New Era of Transparency and Openness
 Chair Mary Jo White
Managed Funds Association Outlook 2013 Conference, New York, New York

Oct. 18, 2013

Thank you very much Richard for that kind introduction. I am very happy to be here today and particularly pleased that I could join you at this conference at such an important time in your industry.

The Managed Funds Association has long been an important and constructive voice representing the private fund industry. And that voice is especially relevant today.

I. The Era of Transparency and Openness
Private funds, including hedge funds, play a critical role in capital formation, and are influential participants in the capital markets. And, perhaps more than ever before, the hedge fund industry as a whole is experiencing dynamic change — moving from what some would say was a secretive industry, to a widely-recognized and influential group of investment managers.

Today, I want to focus on this change within your industry, as well as on what the SEC must do as the primary regulator in this space.

There is little doubt that hedge funds have entered a new era of transparency and public openness – a transformation that I believe will benefit investors, the public and regulators. And, one that I believe will ultimately and significantly redound to your benefit as well.

It is a substantial and fairly sudden change brought on as a result of two recent and significant pieces of legislation: the Dodd-Frank Act[1] and the JOBS Act.[2] Although both are designed to promote additional transparency, they do so from different, but complementary perspectives.

The Dodd-Frank Act
The Dodd-Frank Act, as you know, required most advisers to hedge funds and other private funds to register with the SEC, resulting in public reporting of basic information regarding business operations and conflicts of interest.[3] Demonstrating leadership and a commitment to appropriate and effective regulation, the MFA supported this change.[4]

In addition, the Dodd-Frank Act directed the SEC to collect information, on a confidential basis, from private fund advisers regarding the risk-profiles of their funds.[5] And, again, the MFA weighed in constructively, taking the view that confidential reporting to a functional regulator could be beneficial to reducing potential systemic risk[6] – a view that I share.

The JOBS Act
The JOBS Act, meanwhile, facilitates greater transparency and openness in a different way. It directed the SEC to lift the decades-old ban on general solicitation that applied when companies or funds make private securities offerings under Rule 506 of Regulation D – a rule that private funds used to raise over $700 billion[7] in 2012.

As a result, as of September 23, 2013, hedge fund managers feel they have a new freedom to communicate with the public, to advertise, to talk to reporters, to speak at conferences and, most importantly, communicate with investors openly and frankly. And, you can do these things without the fear of securities regulators knocking on your door, or your outside counsel screaming at you.

For some of you, this rule change may not alter your practices significantly. But for others, the new rule will allow communication and engagement with investors in a way not permitted by the old rule.

Taken together, these are significant changes – creating an opportunity for a new era of openness, public engagement and the availability of information about your industry.

As leaders of the private fund community, you are in a unique position to guide your industry through this critical time. And, we – at the SEC – are committed to working alongside you to ensure that this transition is smooth – keeping in mind that your, and our, ultimate focus must be the interests of investors.

I will focus for a few minutes this morning on these changes within your industry and the responsibilities that flow from them. There are new and significant responsibilities that you have, but there are also important responsibilities that we as regulators shoulder in this new era.

I believe it is critical that we work together and each do our part to ensure that this new transparency and openness have a positive impact on capital formation and investor confidence.

Mandated Registration
As recently as 2010, regulators could only see a portion of the financial landscape comprised of hedge fund and other private fund advisers. That is because our view of the market was limited to those advisers who voluntarily registered with the Commission – or were required to do so because, for example, they also managed a mutual fund.

We knew that there was a gap in our knowledge. But, we did not know how many hedge fund managers existed and we did not know who they were -- we could not tell how big this slice of the market really was.

Commentators thought that many advisers would volunteer to register in the belief that an SEC registration would bestow greater credibility in the eyes of investors. And about 2,500 hedge fund and other private fund advisers did step forward. But, we did not know who else was out there.

In the wake of the Dodd-Frank Act, all of that changed. Hedge fund and other private fund advisers, for the first time, were required to become more visible. And, soon we saw over 1,500 new hedge fund and other private fund advisers, bringing the total number of registered advisers to private funds to just over 4,000. Until then, we did not know that we had not accounted for one-third of the industry. Today, as we now know, approximately 40% of the investment advisers, who are registered with the SEC, manage one or more hedge funds or other private funds.[8]

We do not take this new registration development, and what it has revealed, lightly. And we know that it was certainly an important milestone for your industry. It was significant both because of the historically private nature of your industry and because a requirement to register means much more to you than just checking a box on a form and letting us know that you exist.

Registration, as you know very well, requires, as an initial matter, making information about your operations and your funds public.

One immediate benefit of this requirement to your industry should be that transparency will enable you to shed the secretive, “shadowy” reputation that some would say has unfairly surrounded you – a myth that did not serve anyone well, least of all you.

Clearly, the increased transparency and openness creates benefits for you, your investors and the securities markets generally. But it carries with it new responsibilities and obligations as well, for both you as an industry and for us as your regulator. For you, it principally means sharing complete and accurate information with investors and regulators, whether through your registration forms, confidential regulatory reports, solicitation materials, or examination visits. For us, it principally means making sure our rules, examination and enforcement program are accurately tuned to a changing world and foster, not impede, the positive aspects of this growing transparency.

We want to work with you to make sure you are able to live up to your new regulatory responsibilities, but we also hope that you recognize their value. And we need your help when we craft rule proposals that affect your industry or when you find that existing rules are not appropriately calibrated for what you do.

II. The Responsibility of Transparency and Openness
Registration and Disclosure
The most basic regulatory responsibility is providing specific information to your investors and the public – information about the funds you manage, your operations and conflicts of interest. For some of you, providing this information when you registered with the SEC may have been the “first step” into this new era of transparency and openness. But it is familiar and common territory for many other entities across the securities industry.

The registration information you file with us is posted on the SEC’s website, making access for existing and prospective investors easy. In providing this information, you are helping investors understand your business and investment approach – and also helping to inform us by providing data through which we can assess a firm’s business operations, conflicts of interest and leadership.

Our knowledge of the markets and understanding of your businesses is also enhanced when you provide us with non-public data on your funds’ risk profiles, which is required by new Form PF mandated by the Dodd-Frank Act.[9] Form PF provides information on the types of assets you are holding to help to inform government regulators tasked with monitoring systemic risk. Using this information, regulators can then assess trends over time and identify risks as they are emerging, rather than reacting to them after they unfold. As part of this process, it is our responsibility to be sensitive to and safeguard the confidential nature of the data you provide.[10] We take that obligation very seriously.

This era of hedge fund transparency is also new for us. We need to continuously ensure that we – as regulators – are asking for the right information, in the most appropriate way; that we are training our staff to properly understand your business; and that, where necessary, we are hiring the experts who have been in your shoes at one time. We welcome your input on how we might further improve our disclosure and data gathering efforts.

* * *

In addition, the Commission recently proposed a rule[11] that would require you to provide information about offerings you and others conduct under Rule 506 of Regulation D, including those that use general solicitation and advertising.

This proposal is designed, in part, to provide more transparency to enable us to better monitor the private placement market. It would enable us to learn more about the size of the market, those who conduct offerings, and the characteristics of those who are unsuccessful in completing an offering. It also would provide us access to the solicitation materials that are being used and better assure that investors are getting some baseline level of information about risks.

It is part of our effort to ensure that this new market, which private funds dominate,[12] is conducted in a manner that furthers both new capital formation and investors’ interests. We are sincerely interested in your thoughts and constructive input on these topics.

To date, we have received more than 450 comment letters on the proposed amendments,[13] including one we recently received from the MFA. And, recently, we extended the time for the public to comment on the proposal.

This is an important proposal, and there are a lot of different views about it, so it is important to have an opportunity to consider these views. Issues raised in the comment process contribute meaningfully to all of our rulemakings.

But, for investors’ sake and the sake of the new marketplace, we need to move expeditiously toward adoption, following appropriate consideration of the comments. And we must get it right if we are going to make this new era of transparency and openness workable.

Contemporaneously with lifting the ban on general solicitation, the SEC staff has undertaken an interdivisional effort designed to monitor how the ability to advertise and “generally solicit” is actually occurring – how companies and hedge funds are taking advantage of the new rule. It includes assessing the impact of general solicitation on the market for private securities and –importantly –on identifying fraud if it is occurring. If it is, we can seek to stop those in their tracks, who would inappropriately take advantage of this new more open environment.

In a similar vein, because of the SEC’s new “bad actor” rule, which was adopted at the same time the ban on general solicitation was lifted, those who commit securities law violations after the effective date of the new rule (which was September 23, 2013) will be prohibited from participating in this private offering process going forward. There also will be disclosure of past “bad actors” involved in private offerings, to the extent they exist.

We need to keep a very close eye on core investor protection issues as the new “public-oriented” market for private securities initially develops. Our goal is not just to react to investor harm, but also to prevent it.

I think we are all aligned in this effort. We all want this new marketplace to thrive – efficiently, but honestly – for the benefit of entrepreneurs and investors alike.

Examinations
Of course, the new era of transparency and openness includes more than just registering with the SEC, filing information publicly and communicating more freely with the public.

Registering with the SEC also requires compliance with business conduct rules. These rules are there to help protect investors and safeguard our markets, but they are also rules that should strengthen your operations.

Transparency also means being subject to an occasional visit by a team of our professional compliance examiners – who will review your records and sit with you to evaluate whether your firm is being run in compliance with these business conduct rules and other requirements.

This may not be the most welcome aspect of the new age of transparency for hedge fund advisers. But it is a very important component of our regulatory work because well-conceived rules are of little value if they are not being followed. So, our examinations are designed to evaluate compliance, but also to assist you as you work to achieve your compliance objectives.

Since registering with the SEC, some of you may already have received your first visit from an SEC examination team. And, hopefully, you found them to be informed, professional and constructive. Certainly, that is something you deserve and should expect. And something we continuously seek to foster in our teams.

Now, I know questions have been raised about whether inclusion of private fund advisers in our examination program makes sense, given the often sophisticated nature of hedge fund investors. The question is legitimate and, as the head of a regulatory agency, I need to continuously assess whether our resources are being deployed in the most productive, cost-effective manner.

That being said, the SEC has a mission of investor protection that runs across the investor landscape. It applies to all investors, and all investors in the U.S. markets deserve to know that there is a regulator on the block, looking around corners and concerned about their interests.

We should also recognize that, while many hedge fund investors are considered to be “sophisticated” or “institutional,” those terms apply to a wide swath of investor types. And the investment performance of institutional investors can affect the lives of people on the street. Institutional investors, for example, include pensions funding workers’ benefits, college endowments and charities. These “sophisticated investors” can and do have a real impact on main street investors.

So, yes, our examiners are in your space. We are, however, trying to be “smart” about how we examine.

That is why we launched an initiative to conduct focused exams of newly registered advisers. These examinations, known as “presence exams,” establish our regulatory presence with registered private fund advisers in a very tangible way. Our examiners are on-the-ground, in-person, discussing issues of importance to hedge fund advisers and their investors.

These presence exams, which are shorter in duration and more streamlined than typical examinations, are designed both to engage with newly-registered hedge fund and other private fund advisers and to permit our examination team to examine a higher percentage of new registrants.

The goal of the examinations is not to play “gotcha.” It is instead to make sure newly-registered private fund advisers are aware of their obligations under the SEC’s rules. And it is to promote investor-oriented business practices through, among other things, the sharing of best practices.

To foster a two-way street of transparency, we are making known the areas that are of interest to us. For instance, in a letter we sent to senior leadership of newly-registered private fund advisers, we explained that the staff is pursuing five focus areas for the presence exams:

marketing;
portfolio management;
conflicts of interest;
safety of client assets; and
valuation.[14]
We will work cooperatively with you to address any irregularities. But, should we find fraud, we will pursue it, just as you, your investors, and your fellow market participants would expect us to do.

III. The Regulator’s Responsibilities
Making Sure our Rules Work
Just as you have many new responsibilities, we too have additional obligations.

For instance, at the SEC, we need to fully understand your business and take into account the private fund business model and the needs of private fund investors. And, we have been striving to do that.

In August, for example, the SEC staff put out guidance[15] on how our custody rule[16] should apply to private stock certificates. That rule seeks to protect investors by imposing certain requirements on those private funds that hold stock certificates that represent the underlying ownership interests of the fund.

Through our engagement with the industry, however, the staff recognized that applying the custody rule in the private fund, and particularly, the private equity fund context may not work as intended.

In particular, the staff noted that existing mechanisms, such as the financial statement audit, provided appropriate investor protections and maintenance of stock certificates with a separate custodian often resulted in additional costs to investors and firms, with little added benefit. So, our staff advised that maintenance of private company, non-transferable stock certificates with a custodian is not necessary if the private fund is audited as required by the custody rule.[17]

Although I understand that we may need to take further steps, the staff guidance on the custody rule exemplifies our efforts to tailor the application of SEC rules to hedge funds and other private funds, while at the same time promoting meaningful investor protection.

As with the custody rule, we are also regularly considering our rules related to advertising – an area that is front and center in light of the JOBS Act and the new freedom that hedge fund advisers have to advertise. Even before the JOBS Act, hedge fund advisers had questioned SEC rules prohibiting testimonials and the meaning of the ban on “past specific recommendations.”[18]

And, I can imagine we will receive additional questions regarding the effectiveness of our advertising rules as hedge funds begin to “generally solicit” under the new rules implementing the JOBS Act.

From my perspective, I want to know if we are targeting the right areas, and if our rules, written decades ago, are still relevant and effective today.

Should, for example, the SEC or some other organization attempt to mandate standardized performance disclosure for hedge funds consistent with a recommendation from our Investor Advisory Committee?[19]

These are just some of the questions we are asking at the SEC and, for our rules to work right, we need your input.

A Focused Enforcement Program
Finally, because of the greater transparency, the SEC will have a clearer picture of the players and practices in your industry – including those who engage in fraud or sharp practices. This clearer picture gives us a window into the whole industry and enables us to craft an enforcement program that is more focused and directed.

Recently, the SEC has been quite active in bringing enforcement cases involving private funds. These cases have involved charges related to: insider trading; false advertising and performance claims; overvaluing assets in order to charge excessive fees; benefitting favored investors at the expense of other investors; and using private fund assets for the personal benefit of the fund’s adviser.

The existence of bad actors and outright fraudsters in the private fund industry hurts investors and obviously damages the industry’s reputation. None of us should stand for it.

It is essential, on our part, that the SEC have strong and vigilant examination and enforcement programs to root out these bad actors in order to build investor confidence in the fairness and integrity of our markets. It is important to you as an industry that we succeed in these efforts. And we welcome your support.

IV. Conclusion
Going forward in this new era of transparency and regulatory oversight, we want to work with you because we both shoulder new and important responsibilities. We know you will take these new requirements seriously and we do too.

We want to hear about the tools we use to gather information. And we want to hear about our efforts to stay current on your industry. We welcome your input on our regulatory effectiveness.

We also want to hear how our rules, examination and enforcement focus can be better targeted to the needs of private fund investors.

As hedge fund leaders, you have close relationships with your investors. You communicate with them regularly. You understand their needs. We need for you to share their perspectives with us.

My bottom line: we look forward to continuing to work with you constructively in this new era of transparency. If we do, our markets will be strengthened, investors will be protected, and your businesses can operate from a more transparent and stronger platform.

Thank you.

# # #


[1] Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[2] Pub. L. No. 112-106, 126 Stat. 306 (2012).

[3] Section 403 of the Dodd-Frank Act (codified at Section 203(b) of the Investment Advisers Act of 1940, as amended).

[4] Testimony of Richard H. Baker, President and Chief Executive Officer, Managed Funds Association, for the Hearing on Capital Markets Regulatory Reform: Strengthening Investor Protection, Enhancing Oversight of Private Pools of Capital, and Creating a National Insurance Office, before the Committee on Financial Services, U.S. House of Representatives (October 6, 2009)., available at http://www.managedfunds.org/downloads/MFA%20testimony%20October%206%20final.pdf .

[5] Section 404 of the Dodd-Frank Act (codified at Section 204(b) of the Investment Advisers Act of 1940, as amended).

[6] Testimony of Richard H. Baker, President and Chief Executive Officer, Managed Funds Association, for the Hearing on Systemic Regulation, Prudential Matters, Resolution Authority and Securitization, before the Committee on Financial Services, U.S. House of Representatives (October 29, 2009), available at http://www.managedfunds.org/downloads/MFA%20Written%20Testimony.pdf .

[7] Vladimir Ivanov and Scott Bauguess, Capital Raising in the U.S.: An Analysis of Unregistered Offerings Using the Regulation D Exemption, 2009-2012 (July 2013), available at: http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered-offerings-reg-d.pdf, Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Advisers Act Release No. 3624 (Jul. 10, 2013) [78 FR 44771 (Jul. 24, 2013)], available at http://www.sec.gov/rules/final/2013/33-9415.pdf.

[8] “ Dodd-Frank Act Changes to Investment Adviser Registration Requirements,” available at http://www.sec.gov/divisions/investment/imissues/df-iaregistration.pdf.

[9] Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Investment Advisers Act Release No. 3308 (October 31, 2011), 76 FR 71128 (November 16, 2011), available at http://www.sec.gov/rules/final/2011/ia-3308.pdf.

[10] Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Investment Advisers Act Release No. 3308, at Section II.D, “Confidentiality of Form PF Data” (October 31, 2011), 76 FR 71128 (November 16, 2011), available at http://www.sec.gov/rules/final/2011/ia-3308.pdf.

[11] Amendments to Regulation D, Form D and Rule 156, Securities Act Release No. 9416 (Jul. 10, 2013) [78 FR 44806 (Jul. 24, 2013)], available at http://www.sec.gov/rules/proposed/2013/33-9416.pdf.

[12] See Vladimir Ivanov and Scott Bauguess, Capital Raising in the U.S.: An Analysis of Unregistered Offerings Using the Regulation D Exemption, 2009-2012 (July 2013), available at: http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered-offerings-reg-d.pdf, Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Advisers Act Release No. 3624 (Jul. 10, 2013) [78 FR 44771 (Jul. 24, 2013)], available at http://www.sec.gov/rules/final/2013/33-9415.pdf.

[13] Comments are available at “Comments on Proposed Rule: Amendments to Regulation D, Form D and Rule 156 under the Securities Act,” http://www.sec.gov/comments/s7-06-13/s70613.shtml.

[14] See “Letter Regarding Presence Examinations,” available at http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.

[15] “IM Guidance Update: Custody of Privately Offered Securities,” (August 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-04.pdf.

[16] 17 CFR 275.206(4)-2.

[17] “IM Guidance Update: Custody of Privately Offered Securities,” (August 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-04.pdf.

[18] 17 CFR 275.206(4)-1(a)(1) and (2).

[19] Recommendations of the Investor Advisory Committee Regarding SEC Rulemaking to Lift the Ban on General Solicitation and Advertising in Rule 506 Offerings: Efficiently Balancing Investor Protection, Capital Formation and Market Integrity (January 2013), available at http://www.sec.gov/spotlight/investor-advisory-committee-2012/iac-general-solicitation-advertising-recommendations.pdf.

FINAL JUDGEMENT ENTERED IN SEC CASE INVOLVING ALLEGED SECURITIES AND ACCOUNTING FRAUD

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
Court Enters Final Judgment by Consent Against Defendant Ronald Baldwin, Jr.

The Commission announced today that a Massachusetts federal court entered a final judgment by consent on October 16, 2013 against Ronald Baldwin, Jr. ("Baldwin"), the only remaining defendant in a fraud action filed by the Commission in 2012. The Commission alleged in its complaint that JBI, Inc. ("JBI"), its CEO, John Bordynuik ("Bordynuik"), and its former CFO, Baldwin, engaged in a scheme to commit securities and accounting fraud in 2009. In the consent judgment, the Court ordered Baldwin to pay $25,000 in civil monetary penalties. The final judgment against Baldwin successfully concludes this litigation, as the Court has previously entered final judgments against JBI and Bordynuik.

The Commission filed its action on January 4, 2012, alleging that during two reporting periods in 2009 and in contravention of Generally Accepted Accounting Principles ("GAAP"), JBI stated materially false and inaccurate financial information on its financial statements. The Complaint alleged that the defendants misrepresented and overstated the actual value of certain assets, known as media credits, by almost 1,000%, in an effort to bolster JBI's balance sheet. JBI then used the overvalued financial statements in two private capital raising efforts (Private Investment in Public Equity or PIPES) that raised over $8.4 million from unwitting investors just before the company issued a public statement indicating its financial statements could no longer be relied upon, in part, due to the erroneous valuation of the media credits and other assets on the balance sheet. According to the Complaint, despite being aware of the issues regarding the valuation of the media credits, and of the significance of the value of the media credits for JBI's balance sheets and other financials, Baldwin failed to conduct any reasonable due diligence on the appropriate accounting for the media credits when he certified the financial statements contained in JBI's Form 10-K for the year ended 2009. In addition, the Complaint alleged that Baldwin misrepresented JBI's financial position during a presentation to shareholders after JBI filed the Form 10-K.

Without admitting or denying the allegations in the Commission's complaint, Baldwin consented to a final judgment entered by the Court. The final judgment permanently enjoins Baldwin from violating Section 17(a) of the Securities Act of 1933 ("Securities Act") and Sections 10(b) and 13(b)(5) of the Securities Exchange Act of 1934 ("Exchange Act") and Rules 10b-5, 13b2-1 and 13a-14 thereunder, and aiding and abetting violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder, and orders Baldwin to pay a civil penalty of $25,000. Baldwin is also barred for five years from acting as an officer or director of a public company.

The Commission considered Baldwin's financial condition as part of its agreement to accept a $25,000 civil penalty.

The Court previously entered final judgments by consent against JBI (on March 20, 2013) and Bordynuik (on June 26, 2013). JBI was ordered to pay a civil monetary penalty of $150,000 and Bordynuik was ordered to pay a penalty of $110,000. Bordynuik was also barred for five years from acting as an officer or director of a public company.

REMARKS BY CFTC COMMISSIONER O'MALIA AT CFTC COMPLIANCE FORUM

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Keynote Address by Commissioner Scott D. O'Malia, Edison Electric Institute CFTC Compliance Forum, Washington, DC
October 17, 2013

The topic of today's conference is "Compliance and Implementation Issues." I must say such a topic gives us plenty of room to have a wide-ranging discussion, as there are so many questions and concerns regarding industry compliance and on-going implementation.

As we all know, the Dodd-Frank Act was enacted following the G-20 agreement in Pittsburgh in September 2009 to undertake comprehensive financial reform. The G-20 agreement proposed four main objectives of derivatives reform. First, report all data to a data repository. Second, require that all standardized derivatives contracts be exchange traded "as appropriate." Third, require clearing to be done through central counter parties. Fourth, impose higher collateral charges for all uncleared over-the-counter (OTC) products.

Since the passage of Dodd-Frank, the CFTC has been busy with an aggressive schedule of rule promulgation. Today we have finalized just over 60 rules including Dodd-Frank and non-Dodd Frank rule.

This new regulatory regime has had a profound impact on market structure as it has imposed new obligations, higher levels of transparency, and higher standards for risk management. Many of these new rules will have a positive impact on financial markets.

However, I have serious concerns about the Commission’s rule making process and schedule, as well as the statutory foundation of many rules and their overall impact on end-users.

Today, I would like to discuss three topics. First, I would like to address the implementation of the rules, both in terms of compliance already under way and what we need to think about going forward. Second, I would like to discuss the regulatory impact on end-users. Finally, I would like to discuss my concerns about the Commission’s preparedness to oversee the implementation of the Dodd-Frank regulatory regime.

The Process: Sacrificing Transparency and Certainty for Speed

From the beginning of my time at the Commission, I have been very concerned with the Commission's rulemaking process. As you may know, I have been disappointed with the Commission’s failure to develop a transparent rulemaking schedule that would enable market participants to plan for compliance with the massive new obligations imposed by these rules. In addition, I believe the Commission has rushed the rulemaking process, prioritizing getting rules done fast over getting them done right. This approach has compromised the legal soundness and consistency of our rules.

Stark evidence of the Commission’s flawed rules, and their unachievable compliance deadlines, can be seen in the massive number of exemptions and staff no-action letters issued to provide relief from them. To date, we have issued over 130 exemptions and staff no-action letters. That amounts to more than two exemptions for every rule passed. In nearly two dozen cases, the relief provided is for an indefinite period of time – thus making them de facto rulemakings, which didn't go through the Administrative Procedure Act or proper cost-benefit analysis. It is clear that the Commission has abused the no-action relief process.

Market participants are confused regarding the application of our rules, and how or when they must be applied. Further, since the Commission doesn't vote on staff no-action letters, they don't appear in the Federal Register. And you won't find the exemptive letters in our rulebook either. This lack of transparency and consistency will drive a compliance officer crazy.

One area where the Commission has made one of its biggest process fouls is the lack of robust cost-benefit analysis. Without a doubt, the comprehensive nature of the Dodd-Frank regulatory regime will have a significant cost impact on all market participants, and yet the Commission has failed to conduct appropriate and rigorous quantitative and qualitative analysis of our proposed rules. Understanding whether the benefits of the rules outweigh the costs is a common sense tool to determine the least burdensome solution to the problem.

The Commission has so far been able to get away with such inadequate cost-benefit analysis because the current governing statute sets a low bar. I support Congressional efforts to revise our statutory cost-benefit obligations in order to require the Commission to undertake a more rigorous quantitative and qualitative analysis, putting us on par with other federal agencies. I support Chairman Conaway's efforts (H.R. 1003) and hope the House and Senate will pass this legislation.

Implementation: What's Coming

While I have a longer list of process fouls committed by the Commission, I would like to turn to upcoming rules that will have a significant impact on end-users in particular.

The Commission is currently considering the position limit rule do-over. When I say the Commission, I mean that literally. During the shutdown there is no staff available to discuss this rule proposal. We can't make revisions. We can't ask questions about the rationale or justification. We can't even discuss with staff whether or not the proposed limits would have an appropriate impact to curb "excessive speculation."

The Commission is pursuing a dual track on position limits. Later this year, an appeals court will hear our argument urging it to overturn a federal district court’s ruling to vacate the original position limit rule. The district court found that the Commission failed to provide a finding of necessity as directed by the statute. Simultaneously, we are drafting a nearly identical rule arguing more strenuously that Congress made us do it, and that Congress really didn't want to know whether these rules are "necessary" or "appropriate."

Frankly, I find it interesting that the proposed rule will argue on one hand that Congress wanted position limits and that we aren't bound to apply an appropriateness standard – and then, on the other hand, argue in the cost-benefit analysis that these rules are well considered and will have the intended impact based on our analysis.

Another important rulemaking that will be before the Commission shortly is the application of capital and margin for all OTC trades. While I am pleased that the international community has worked together to make the standards consistent, make no mistake: these rules will increase the cost of hedging. End-users will be spared from mandatory margin exchange. However, nobody will receive a break from the new capital charges. These are new costs imposed on banks to offset the risk posed by OTC trades. Needless to say, these costs will be passed on to end-users.

I agree with Sean Owens, an economist with Woodbine Associates, who stated that under Dodd-Frank, "end users face a tradeoff between efficient, cost-effective risk transfer and the need for hedge customization. The cost implicit in this trade off include: regulatory capital, funding initial margin, market liquidity and structural factors."1

There is no doubt that these new requirements will have serious economic consequences for financial markets. And regulators should not take this lightly. In an effort to coordinate with international regulators, the Commission will re-propose its capital and margin rules. But even under the more accommodating margin requirements, the Commission must evaluate additional costs to end-users by conducting an in-depth cost-benefit analysis.

Happy Anniversary: 1st Anniversary of Futurization

It was one year ago, almost to the day, that the energy markets switched from trading swaps to futures. This huge shift was triggered by the then-impending effective date of the swap and swap dealer definitions. To avoid trading swaps and being caught in the unnecessary, costly and highly complex de minimis calculation imposed on swap dealers, energy firms shifted their trading from swaps to futures, literally overnight.

Based on the complexity of our swaps rules and the cost-efficiency of trading futures, it makes sense that participants would make this change. I'm interested to hear more from end-users like you how this shift has impacted your hedging strategies.

I must warn you that there are several more changes coming up that will continue to impact energy markets. First, the Commission is considering a draft futures block rule that will be proposed to limit the availability of block trades.

Second, as I noted before, OTC margin and capital rules will increase the cost of OTC bilateral deals. This draft rule should be published by the end of the year.

Third, the European Union (EU) is considering whether it will find acceptable the U.S. rules allowing a minimum one-day margin liquidation requirement for futures and swaps on energy products. Europe might not recognize U.S. centralized counterparties as qualified and, as a result, ban EU persons from accessing these markets. The EU is insisting on a two-day margin liquidation minimum. I am told that this would have the practical effect of increasing margin requirements for energy trades by 40 percent. I’m not sure how this will be resolved, but I suspect it will be closely tied to U.S. recognition of the European regulatory regime.

End-Users

Now let me turn to my second topic: how our rules treat end-users.

Congress was very clear about protecting end-users from Dodd-Frank's expansive regulatory reach. As a result, many end-users assumed that they wouldn't be impacted by these rules. Clearly, they are no longer under such misconceptions.

The swap dealer definition is a good example of how the Commission failed to accurately interpret Dodd-Frank and broadly applied the swap dealer definition to all market participants. The Commission ignored the express statutory mandate to exclude end-users from its reach. The swap dealer final rule requires entities to navigate through a complex set of factors on a trade-by-trade basis, rather than provide a bright line test. While I appreciate that the Commission set an $8 billion de minimis level to exclude trades from a dealer designation, it remains challenging to determine what is in and what is out from this safe harbor.

As part of the complexity of the swap dealer definition, the Commission has applied inconsistent and incoherent requirements around bona fide hedging as part of the dealer calculation. The hedge exclusion from the dealer definition applies only to physical, but not financial, transactions. The Commission should apply a consistent definition for hedging.

Another complexity that the Commission has imposed on end-users is the definition of a volumetric option. Specifically, to determine whether a volumetric option is a forward or a swap, the rule applies a seven-part test. But the real kicker is that under the seventh factor, contracts with embedded volumetric optionality may qualify for the forward contract exclusion only if exercise of the optionality is based on physical factors that are outside the control of the parties. This is in contradiction to how volumetric options have been traditionally used by market participants, makes no sense and provides absolutely no certainty for market participants.

The Commission has seemingly gone out of its way to create complex rules that generally result in an outcome of heads we win, tails you lose. We need to clean up the definition and create reliable and well-defined safe harbors. If we don't, I would encourage Congress to revisit the statute.

Commission Readiness: The Consequences of a “Ready, Fire, Aim” Approach

Let me move now to my third main topic: Commission readiness to properly oversee the implementation of its Dodd-Frank regulatory regime. There are two questions I have regarding this issue. The first question is pretty straightforward: is the Commission prepared to effectively oversee the new swaps markets? I believe the answer to this question is "no."

Take the area of registration. The Commission’s new swaps regime has created multiple new categories of Commission registrants, and in each category there has been an inconsistent and uncertain process with the bar constantly moving for applicants. For example, it has been ten months since the first swap dealer application arrived. Today, we have 89 temporarily registered applications totaling over 180,000 pages and we haven’t signed off on single application as complete or final.

With regard to swap data repository (SDR) registration, it has taken the Commission eight to ten months to register just three SDRs under temporary status. We have exceeded our own self-imposed limit of 180 days in some cases and we still haven’t issued a final SDR determination.

As for the registration of swap execution facilities (SEFs), while we have registered 18 entities under a temporary basis, I can only imagine how long it will take for a SEF to secure final approval, especially when we admit that we didn’t read the rulebooks in order to meet the arbitrary October 2 effective date. My guess is that it will be a long and painful process as we insist on evolving revisions to SEF rulebooks while trading is going on.

Another area where the Commission has not been adequately prepared to do its job is in connection with swap data being submitted under new reporting regulations. Despite imposing aggressive compliance requirements on the market, the Commission doesn't have the tools in place to effectively utilize the new data being reported to SDRs, and it doesn't have a surveillance system in either the futures or swaps market that I would regard as adequate or modern.

Today, the data we receive from SDRs requires extensive cleaning and changes to make it useful. As chairman of the Commission’s Technology Advisory Committee (TAC), I have devoted significant TAC attention and resources to aid this effort. Stemming from our TAC meeting in April, a working group including Commission staff and the SDRs has been established and is working to harmonize data fields to aid in our ability to easily aggregate and analyze data across SDR platforms. It will take time before we are able to access, aggregate and analyze data efficiently.

I am also disappointed with our current stance on the oversight of SEFs. Despite the October 2 start-up date for SEFs, the Commission relies on self-regulatory organizations to send data via Excel spreadsheet. There is no aggregation capacity and I am not aware of any plan to automate this process for the less than two thousand swap trades that occur on a daily basis.

My second question: is the Commission sufficiently familiar with the readiness of the market to adapt to our rules? The answer to this question is also "no." As I discussed earlier, evidence of this failure can be found in the Commission’s extensive use of no-action relief tied to arbitrary deadlines. The Commission needs to do a better job of understanding the significant compliance challenges facing market participants as a result of new regulations.

Pre-Trade Credit Checks: Time for the TAC to Revisit the Issue

Let me give you a brief example of one challenge we are dealing with today. The Commission has been working toward a goal of straight-through processing of trades and clearing to prevent any trade failures due to credit issues. Just recently, the Commission has started insisting that SEFs provide functionality to pre-check all trades for adequate credit at the futures commission merchant (FCM) to guarantee a trade. In general, I support this objective. However, market participants were not prepared to comply with this new requirement by October 2, the date SEFs began operation.

Consistent with the Commission’s practice of issuing last-minute ad-hoc relief, the day before the SEF start-up date, staff issued a delay of the pre-trade credit checks for one month until November 1. We are just two weeks away from this new deadline and it is clear that not all SEFs, FCMs, credit hubs and customers are fully interconnected. Without end-to-end fully tested connectivity, I suspect trades will continue to be done over the phone – stalling limit order book trading.

This is a topic that we discussed at the recent TAC meeting on September 12. It was clear at that meeting that the pieces were not in place and additional time is needed.

With the arbitrary November 1 deadline looming and the Commission yet to provide confused swap market participants with necessary guidance on a host of unresolved issues, often stemming from a lack of clarity in the SEF rules, I believe additional time is required. The Commission has not provided adequate time to complete the on-boarding process and conduct the technology testing and validation that is necessary. We should also consider phasing in participants, similar to our approach with clearing, in order to avoid a big bang integration issue.

Again, I offer to use the TAC to identify a path forward if that will be useful, but the issues identified in September still remain.

Conclusion

In many respects it is quite remarkable the work that has been accomplished – by both the Commission and the market – to put in place trade reporting, mandatory clearing, and now the first stages of swap exchange trading. However, the Commission process by which all of this was accomplished is certainly not to be replicated.

We need to continue to make sure we follow Congressional direction to protect end-users and focus more on outcomes rather than setting arbitrary timetables tied to an individual agenda. Rather than relying on the ad-hoc no-action process, the Commission should take responsibility of fixing the unworkable rules – swap data reporting and the swap dealer definition come to mind.

If we are going to impose rules, let’s make sure they are informed by data and will not interfere with the fundamental function of hedging and price discovery in the markets – I’m thinking about position limits and our proposed futures blocks.

Finally, let's keep an eye on the costs – putting these markets out of reach for commercial hedgers doesn't help anyone. Let's sharpen the pencil and consider all the options. There is no reason why we should not be able to quantify the solution as the most cost-effective rule for the market.

Thank you again for the opportunity to speak with you today.

1 See Sean Owens, Optimizing the Cost of Customization, Review of Futures Market (July 2012).

Last Updated: October 17, 2013

SEC ANNOUNCES CHARGES AGAINST OPERATORS OF WORLD-WIDE PYRAMID SCHEME

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION

The Securities and Exchange Commission today announced charges and asset freezes against the operators and promoters of a worldwide pyramid scheme that falsely promises exponential, risk-free returns to investors in a venture that purportedly sells Internet-based children’s educational courses.

The SEC alleges that five entities based in Hong Kong, Canada, and the British Virgin Islands that collectively operate under business names “CKB” and “CKB168” are at the center of the scheme.  Through the efforts of three CKB executives who live overseas and several promoters living in the U.S., the scheme has ensnared at least 400 investors in New York, California, and other areas with large Asian-American communities.  These promoters have raised more than $20 million from U.S. investors, and millions of dollars more from investors in Canada, Taiwan, Hong Kong, and other countries in Asia.

According to the SEC’s complaint unsealed late yesterday in U.S. District Court for the Eastern District of New York, the scheme’s promotional efforts seek to exploit close connections among members of the Asian-American community.  The scheme’s operators and promoters use Internet videos, promotional materials, and seminars to create the appearance of a legitimate enterprise.  But in reality, CKB has little or no real-world retail consumer sales to generate the extraordinary returns promised to investors.  In fact, CKB has no apparent source of revenue other than money received from new investors.  Bank records show that the bulk of the money raised has been paid out to accounts controlled by CKB executives and as commissions to promoters of the pyramid scheme.

The court has granted the SEC’s request for an asset freeze against the CKB entities and the operators and promoters charged in the SEC’s complaint.

“CKB’s operators and promoters profited by abusing relationships of trust within the Asian-American community and promising investors they can earn more money by recruiting other investors instead of selling actual products,” said Antonia Chion, an associate director in the SEC’s Division of Enforcement.  “What CKB really sells is the false promise of easy wealth.”

SEC ANNOUNCES DEFAULT JUDGEMENT AGAINST PETER MADOFF

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Commission announced that, on October 11, 2013, the Honorable Laura Taylor Swain, United States District Court for the Southern District of New York, entered a default judgment against Peter Madoff, former chief compliance officer and senior managing director at Bernard L. Madoff Investment Securities LLC (BMIS) from 1969 to 2008.

The Commission’s complaint alleged that Peter Madoff created stacks of compliance documents setting out supposedly robust policies and procedures over BMIS’s investment advisory operations. However, no policies and procedures were ever implemented, and none of the reviews were actually performed even though Peter Madoff represented that he personally completed the reviews.

The SEC’s complaint also alleged that in addition to creating false compliance materials, Peter Madoff created false broker-dealer and investment advisor registration applications filed by BMIS. He also failed to implement and review required policies and procedures, and falsified the firm’s books and records. Peter Madoff was richly rewarded for his misconduct, pocketing tens of millions of dollars through salary and bonuses, fake trades, sham loans, and direct, undocumented transfers of investor funds to himself from the bank account that BMIS used to perpetrate the Ponzi scheme.

Peter Madoff failed to answer, move or otherwise respond to the Commission’s complaint. The default judgment permanently enjoins Peter Madoff from violating or aiding and abetting violations of Sections 10(b), 15(b)(1), 15(c) and 17(a) of the Securities Exchange Act of 1934 and Rules 10b-3, 10b-5, 15b3-1 and 17a-3 thereunder, and Sections 204, 206(1), 206(2), 206(4) and 207 of the Advisers Act of 1940 and Rules 204-2 and 206(4)-7 thereunder. The default judgment orders no monetary relief in light of Peter Madoff’s criminal conviction and the $143 billion in restitution ordered in the parallel criminal proceeding United States v. Peter Madoff, 10 Crim. 228 (S.D.N.Y.) (LTS).