In my previous post I asked somewhat rhetorically what else banks had felt able to do during the credit crunch if the belief had arisen that “market stability” (sc. bank survival”) trumped criminal law. The U.S. Securities and Exchnage Commission (“SEC”) has obligingly provided an example.
Yesterday (19 July 2012) the Securities and Exchange Commission charged the U.S. investment banking subsidiary of Japan-based Mizuho Financial Group and three former employees with misleading investors into purchasing a collateralised debt obligation (“CDO”) by using “dummy assets” to inflate the deal’s credit ratings. The SEC also charged the firm that served as the deal’s collateral manager and the person who was its portfolio manager.1
According to the SEC’s complaint against Mizuho Securities USA, Inc., the firm made approximately USD10 million2 in structuring and marketing fees in the deal. Mizuho agreed to pay $127.5 million to settle the SEC’s charges, and the others charged also agreed to settle the SEC’s actions against them.
The SEC alleges that Mizuho structured and marketed Delphinus CDO 2007 – 1, a CDO that was backed by subprime bonds at a time when the housing market was showing signs of severe distress. The deal was contingent upon Mizuho obtaining credit ratings it used to market the notes to investors. When its employees realized that Delphinus could not meet one rating agency’s newly announced criteria intended to protect CDO investors from the uncertainty of ratings downgrades, they submitted to the rating firm a portfolio containing millions of dollars in dummy assets that inaccurately reflected the collateral held by Delphinus. Once the firm rated the inaccurate portfolio, Mizuho closed the transaction and sold the notes to investors using the misleading ratings. Delphinus defaulted in 2008 and eventually was liquidated in 2010. Mizuho sustained substantial losses from Delphinus.
“This case demonstrates once again that bankers and market participants who embrace a ‘get the deal done at all costs’ strategy will be identified, charged, and punished,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. Interestingly, he added:
“This is a constant theme throughout the many SEC enforcement actions arising out of the financial crisis, and is one that everyone involved in securities transactions and our financial markets would be well-advised to respect.”
According to the SEC’s complaint against Mizuho filed in federal court in Manhattan, all of the collateral assets for Delphinus had been purchased by July 17, 2007, and the transaction was scheduled to close on July 19. However, around noon on July 18, Standard & Poor’s (S&P) issued a press release announcing changes to its CDO rating criteria requiring certain categories of subprime residential mortgage-backed securities (“RMBS”) to be adjusted downward for purposes of calculating their default probability. The Mizuho employees knew that Delphinus’s actual portfolio contained a substantial amount of RMBS that were subject to the downward ratings, and that Delphinus, as constructed, could not meet its rating targets under these tougher standards. To enable Delphinus to close anyway, the Mizuho employees e-mailed multiple alternative portfolios to S&P that contained dummy assets that were superior in credit quality to the assets that had been actually acquired for the CDO. Once the necessary ratings were secured by the use of dummy assets, the Delphinus transaction closed by mid-afternoon on July 19 and securities were sold based upon these higher ratings. Investors were thus misled to believe that the Delphinus notes had achieved the advertised ratings that the actual closing portfolio would not support.
According to the SEC’s complaint, in connection with Delphinus’s subsequent request for a required rating confirmation from S&P, Mizuho employees provided and arranged for others to provide further inaccurate information about the composition of Delphinus’s assets. Primarily, they misrepresented that Delphinus’s effective date was August 6 rather than July 19. S&P then provided Delphinus with the ratings confirmation using the improper effective date of August 6.
Everyone charged by the SEC agreed to settlements without admitting or denying the charges.
On the egregiousness scale this is not as bad as the case of Crown Corporation, the London listed entity the entire assets of which allegedly lay in the form of a single bond in a South American bank, which bond did not and had never existed. It is however more concrete than the anecdotally reported incidences, albeit common, of rating agencies revising their ratings of notes on the basis of whether structurers have provided sufficient corporate hospitality. Your author asks whether the SEC will extend its arm to possible instances where structurers have transferred assets into SPVs for the purposes of rating and issuance, only to transfer them back whence they came when the notes had got away.