We Don't Need No Stinking Accounting

I just sat through 15 minutes of the most senseless banter ever conducted on national television. It was an interview of Steve Forbes on CNBC. In that interview, Forbes advanced a novel idea for addressing the problems befalling our debt laden economy...don't mark assets to the market!

 

What a brilliant solution! In one fell swoop, with a single stroke of the pen, all of our problems could be resolved. The entire financial mess has been rectified. Bear Sterns can be resurrected. Lehman does not need bankruptcy protection. And AIG can remain unscathed.

 

Just think of the simplicity. No rating agencies to worry about. Certainly no reporting problems to the stockholders. With one bold pronouncement, all counter party risk is eliminated. Gone are the days of accountability. All we have to do is say we intend to hold these assets to maturity and all the mark to market problems are resolved.

 

With thinking like this, there ought to be a public outcry for Forbes for President...or Chairman of the SEC...or president of the Financial Accounting Standards Board...at least mayor of some town somewhere.

 

This is the kind of advise the McCain campaign is getting. This is a recommendation from one of this countries financial leaders. It's time to pray for the republic.

Tzolov and Butler

On September 3, 2008 the US Securities Exchange Commission filed a Complaint in US District Court for the Southern District of New York against Julian T. Tzolov and Eric S. Butler, two former employees of Credit Suisse Securities. The Commission requested the court to restrain and enjoin the defendants from violating various sections of the securities laws; order the payment of civil penalties; order the disgorgement of "ill-gotten" gains; and anything else the SEC could want.

 

But what did these two "bad actors" really do? What was it that they did that violated the laws of the United States?

 

According to the complaint filed, there two nefarious characters had contracted with certain customers to purchase auction rate securities backed by student loans. Instead, from February of 2005 until August of 2007, these two breached the contracts and purchased auction rate securities backed by non-student loan assets. 

 

Because of the breach of contract, the customers "...were stuck with at least $817 million..." in securities. Presumably, the SEC is saying these two owe their customers the entire $817 million since no loss is claimed.

 

The SEC is claiming that the breach of contract is a violation of the securities laws which prohibit fraudulent interstate transactions [15 USC Section 77q(a)] or to employ, in connection with the purchase or sale of a security, any manipulative or deceptive device [15 USC Section 78j(b)].

 

But what does the complaint allege? Only that these two breached a contract. What the complaint does not state is:

 

1. What gives the SEC jurisdiction over contract violations;

2. What gives a federal court jurisdiction over contract violations;

3. What was the fair market value of the auction rates securities owned by the customers versus the acquisition price;

4. What was the device employed in misrepresenting the price.

 

  These are relatively simple questions that I know the Commission is reluctant to answer. [Hint to SEC: Try an ex parte proceeding in the Western District of Pa.]

 

Hopefully, defense attorneys will ask the questions.

SEC probes Wachovia

The Securities and Exchange Commission enforcement division is expected to recommend to the Commission that it file civil proceedings against Wachovia for "anti-competitive" practices in the bidding for the investment of proceeds from tax exempt bonds issued by municipalities. But possibly in these instances, the SEC has managed to exceed its jurisdiction. It must be remembered that the SEC does not have jurisdiction over contracts. As a matter of fact, there is no federal jurisdiction over civil contracts.

 

From the SEC's own web site: "The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."

 

Look at the transaction the SEC is attempting to control. The municipalities solicited Wachovia and at least two other firms to enter into an agreement with the municipality to guarantee a rate of return on the municipality's investment of fund borrowed at tax exempt rates. The terms of the contract were prepared by the municipality pursuant to federal regulations. The fair market value of the contract was determined pursuant to those regulations.

 

So now we have a two party contract that the SEC is attempting to state falls under their jurisdiction. But that's not all.

 

The SEC is investigating because there may have been some bidding irregularities, specifically some sort of collusion. Assume the SEC is right and there was collusion. So what. Was the investor, the entity the SEC is to protect, harmed? There has not been such an allegation made in any investigation to date. And there is a reason.

 

Under federal regulations, the municipality that invests bond proceeds is limited to the amount of earnings it is allowed to keep. The balance must be sent to the IRS. That is why there has never been an allegation that the municipality was harmed. In all likelihood, even if there were collusion, did that event harm the municipality.

 

Now I'm sure that the SEC can overcome the problem of extending its jurisdiction to private contracts. All they have to do is find a friendly judge, in an ex parte proceeding, to say it is an investment contract. Of course that judge will find that a private two party contract was really "...an investment in a common enterprise with an expectation of profits to be generated through the efforts of others...." [HINT: To the SEC, try the Third Circuit]

 

But where the SEC will fail, is not stating what the market value of the investment contract should have been, but for the alleged collusion, and how that difference in market value really hurt the investor.

 

Enough for today. Sorry it has been such a long time between posts. I will do better in the future.

 

Stay tuned...lots more to come.

Massachusetts v Merrill Lynch

On July 31, 2008 the Commonwealth of Massachusetts filed an Administrative Complaint against Merrill Lynch. Secretary of the Commonwealth William Galvin alleged that Merrill had acted in a fraudulent, dishonest and unethical manner which ultimately resulted in "...thousands of investors being abandoned with illiquid investment." Those investments were the now infamous Auction Rate Securities.

The complaint filed, which can be read on Sec. Galvin's web site, is an interesting piece of reading. It is huge for a complaint, 80 pages long with 188 pages of exhibits. The introductory summary alone is over 12 pages. It will be quite a while before anyone could read the entire document and give an impartial opinion.

An observation, isn't it amazing how the press can read something as complicated as this complaint and write a story summarizing what was filed. Almost makes you think that they were given a release prepared by the government.

Regardless of the length, to me one thing stood out after reading the summary. The Commonwealth of Massachusetts is not accusing Merrill of having offered, purchased or sold the auction rate securities at non-market values. Sure the complaint alleges that Merrill did some things that appear to be improper, such as issuing reports that may have been overly exuberant.

From what I've read there does not appear to be anything that Merrill did wrong in a transaction. Sure people lost money and yes some are still holding the securities. No one like to lose money.

It must be remembered that Merrill is a publicly owned company and as such owes a fiduciary duty to its stockholders. It appears that Mr. Galvin's claim is that Merrill should have put itself out of business rather than having investors lose money.

At some point, the investors must take responsibility for their own actions.

As time permits, I will attempt to analyze the complaint and post my analysis.

An Interesting Week

What a week it was for the legal system as everybody involved in the potential bid rigging scandal, the auction rate securities fiasco, and the municipal derivatives investigation all ran to their local courts to file lawsuits against every financial institution of any size.

Los Angeles sued the mono-line insurance companies (as if they need any more problems) and also sued a laundry list of financial firms ranging from Merrill, Bank of America, Wachovia, Morgan all the way down to a relatively small firm, Investment Management Advisory Group (IMAGE). Just to make sure they got everyone, LA also included "Does 1-50".

Massachusetts sued Merrill, Connecticut and Florida are investigating, Stockton Ca sued anyone they could find while New York sued UBS. The hits just keep coming.

As far as the lawsuits involving municipal bid rigging, I will again state my position that these law suits brought by the municipalities seem to be more an effort to cast themselves as a party harmed. Especially since the federal government is very close to bringing its own action. The last thing the municipalities want is to be charged with some form of complicity in the bidding procedure.

Despite the bravado of LA City Attorney Rocky Delgadillo, ["Today we're sending the message that if you cheat the city, we will come at you with everything we've got, whether you're a gang banger or a Wall Street titan"], I think most of these suits should be dismissed because the plaintiffs will have a hard time proving they were harmed.

On July 29, in a piece written by Michael B. Marois, Bloomberg stated that US "Tax rules also stipulate that profits made by selling bonds at tax-exempt rates and then investing the proceeds at higher yields must be repaid as taxes."

While the profits on investing is not really a tax, more of a confiscation because the federal government takes everything, the concept is correct. The municipalities cannot keep the profits from investing. They cannot use that money generated through their own investing activities as any other citizen for the building of schools, roads, hospitals or any other worthwhile project. They must send the money to the IRS.

The bottom line is: the plaintiffs in the bid rigging lawsuits probably got all the profits they could get. The actions by the financial community probably did not harm those who filed the complaints. But what is unknown is how much did the municipalities know about the bidding procedure they are now challenging.

Eventually, we may all know the answer to that.

Analysis of the Indictment

The indictment filed against Cioffi and Tannin appears to be a further step in the ongoing effort on the part of employees of the Department of Justice to thoroughly punish those whose businesses fail resulting in the loss of investor funds. Despite the opinions of all the "experts" on CNBC or the members of the press or any other members of the blogging community, what the government is attempting to accomplish here is not in the best interests of either the investing community, business owners or investment advisors.

A case can be made that if the government should be successful in this prosecution, the result will be a further deterioration of the financial markets...but that is for another day.

What the government is trying to do is pin the loss of  "...approximately $1.4 billion" on the two Bear Stearns hedge fund managers. However, the indictment fails to draw the necessary lines to connect the dots.

Count one of the indictment alleges violations of the securities laws, specifically 15 USC Sections 78j(b) and 78ff. It also alleges violations of 18 USC Sec. 1341 for wire fraud.

First the easy one...for there to be a violation of wire fraud, Cioffi and Tannin must "...knowingly and intentionally devise  a scheme and artifice to defraud...." Therefore there must have been a scheme. [Wire fraud requires the existence of a "scheme" in order for there to be wire fraud.]

So now the government must prove that the two actors created a "scheme or device" designed to take money from investors. In other words, the government "...must prove (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation."

And what does the government offer as violations?

1. Cioffi said to a Bear Stearns broker on 3/3/2007 that the funds represented an awesome opportunity.

2. Tannin said on 3/21/2007 he was going to invest more.

3. Cioffi and Tannin on 4/25/2007 was on a conference call and did not tell everyone on the call that the market and the funds were not in good shape.

4. Tannin told a counter-party he expected no large redemptions on 5/3/2007

5. In May of 2007, Cioffi told a Bear broker he had $5.5 million invested in the funds.

 

This indictment is a sham. The government has failed to even get close to meeting its burden of alleging a crime.

It is obvious the government must go back to the drawing boards and try to produce an indictment that alleges that these two men caused the investors in the two funds to lose money. Without causation, this indictment must be dismissed.

More later....

What Cioffi and Tannin are Facing

In Cioffi and Tannin’s indictment, at paragraph 55, the government states “Eventually, investors were told that the Funds had both lost 100% of their respective values, resulting in a total investor loss of approximately $1.4 billion."

So what penalty are these two men facing? That answer is contained in the United States Sentencing Guidelines. Those guidelines contain the convoluted method of assigning points to the dollars lost and certain surrounding events. A full version of the Fraud section of the Sentencing Guidelines are here. This is a copy of the table for crimes of “Basic Economic Offenses” (Non applicable sections have been deleted):

1. THEFT, EMBEZZLEMENT, RECEIPT OF STOLEN PROPERTY, PROPERTY DESTRUCTION, AND OFFENSES INVOLVING FRAUD OR DECEIT

§2B1.1. Larceny, Embezzlement, and Other Forms of Theft; Offenses Involving Stolen Property; Property Damage or Destruction; Fraud and Deceit; Forgery; Offenses Involving Altered or Counterfeit Instruments Other than Counterfeit Bearer Obligations of the United States

(a) Base Offense Level:

…

(2) 6, otherwise.

(b) Specific Offense Characteristics

	Loss(Apply the Greatest)	Increase in Level
(A)	$5,000 or less	no increase
(B)	More than $5,000	add 2
(C)	More than $10,000	add 4
(D)	More than $30,000	add 6
(E)	More than $70,000	add 8
(F)	More than $120,000	add 10
(G)	More than $200,000	add 12
(H)	More than $400,000	add 14
(I)	More than $1,000,000	add 16
(J)	More than $2,500,000	add 18
(K)	More than $7,000,000	add 20
(L)	More than $20,000,000	add 22
(M)	More than $50,000,000	add 24
(N)	More than $100,000,000	add 26
(O)	More than $200,000,000	add 28
(P)	More than $400,000,000	add 30

(2) (Apply the greatest) If the offense—

(A) (i) involved 10 or more victims; or (ii) was committed through mass-marketing, increase by 2 levels;

(B) involved 50 or more victims, increase by 4 levels; or

(C) involved 250 or more victims, increase by 6 levels.

…

(13) (Apply the greater) If—

(A) the defendant derived more than $1,000,000 in gross receipts from one or more financial institutions as a result of the offense, increase by 2 levels; or

(B) the offense (i) substantially jeopardized the safety and soundness of a financial institution; (ii) substantially endangered the solvency or financial security of an organization that, at any time during the offense, (I) was a publicly traded company; or (II) had 1,000 or more employees; or (iii) substantially endangered the solvency or financial security of 100 or more victims, increase by 4 levels.

(C) The cumulative adjustments from application of both subsections (b)(2) and (b)(13)(B) shall not exceed 8 levels, except as provided in subdivision (D).

(D) If the resulting offense level determined under subdivision (A) or (B) is less than level 24, increase to level 24.

…

(15) If the offense involved—

(A) a violation of securities law and, at the time of the offense, the defendant was (i) an officer or a director of a publicly traded company; (ii) a registered broker or dealer, or a person associated with a broker or dealer; or (iii) an investment adviser, or a person associated with an investment adviser; or

(B) a violation of commodities law and, at the time of the offense, the defendant was (i) an officer or a director of a futures commission merchant or an introducing broker; (ii) a commodities trading advisor; or (iii) a commodity pool operator,

increase by 4 levels.

To determine the number of levels, it is just an addition problem:

Basic Offense 6

Total Loss exceeds $400 million 30

Assume less than 50 “victims” 4

Safety of institutions 4

Violation of securities laws 4

Grand Total 48

With that total of 48 levels, a judge then goes to the “Sentencing Table” to determine the sentence. The full version is here. This is an excerpt.

Offense Level	Months
19	30-37
20	33-41
21	37-46
22	41-51
23	46-57
24	51-63
25	57-71
26	63-78
27	70-87
28	78-97
29	87-108
30	97-121
31	108-135
32	121-151
33	135-168
34	151-188
35	168-210
36	188-235
37	210-262
38	235-293
39	262-327
40	292-365
41	324-405
42	360-life
43	life

The table above starts at 19 for simplicity in addition to which it is inconceivable that with the bloodlust created by the press and fostered by the government a sentence less than level 19 could be imposed. As you can see, the table only goes to a level 43 which mandates a life sentence.

These men are looking at life in prison! And they have not even been accused with causing any loss! In future posts, I will begin dissecting the indictment, not from a legal viewpoint, but from the viewpoint of one who has already gone through the process.