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SEC Partially Overturns Administrative Law Judge’s Fraud Findings In Harding Advisory Case, But Increases Disgorgement For Others
01/16/2017On January 6, 2017, the Commissioners of the United States Securities Exchange Commission (“SEC”) partially overturned an administrative law judge’s (“ALJ”) initial decision finding that Harding Advisory LLC (“Harding”), and its principal, Wing F. Chau, committed fraud in connection with selecting assets for certain collateralized debt obligations (“CDOs”) in violation of the Securities Act of 1933 (“Securities Act”) and the Investment Advisers Act of 1940 (“Advisers Act”). In the Matter of Harding Advisory LLC and Wing F. Chau, Admin. Proc. File No. 3-15574 (Jan. 6, 2017) (opinion of the commission). Specifically, the Commissioners overturned the ALJ’s determination that Harding failed to follow its standard of care in selecting certain collateral, while agreeing with the ALJ’s determinations that Harding had an undisclosed conflict of interest and violated its fiduciary duties in connection with the selection of other collateral. In addition, the Commissioners increased the amount of disgorgement ordered, finding that Harding had engaged in “extreme recklessness” by favoring certain clients over others.
At issue were two CDOs, Octans I CDO Ltd. (“Octans”) and Norma CDO I (“Norma”) that Harding managed on behalf of the hedge fund Magnetar Capital LLC (“Magnetar”). In its role as the CDO’s collateral manager, Harding allegedly selected qualifying mortgage-backed securities to include in the CDOs. Harding, at Magnetar’s suggestion, allegedly followed a strategy of purchasing the ABX Index, an index of the twenty most liquid Residential Mortgage Backed Securities (“RMBS”) at each credit level, and Magnetar would short any individual bonds that Harding rejected during its credit review. The ALJ concluded that Harding had violated the Securities Act by negligently departing from the standard of care described in its pitch book, which stated that Harding’s selections were built around a “collaborative, methodical and disciplined investment process.”
The Commissioners, however, disagreed. The Commissioners pointed to evidence suggesting that two Harding senior analysts collaborated in their analysis of individual bonds, and they also noted that the analysts shared a work space and may have communicated in person. In addition, the Commissioners cited a spreadsheet prepared by a junior analyst that suggested that the junior analyst had communicated with a senior analyst about the bonds. Finally, the Commissioners determined that any possible departure was later cured when, just prior to closing, Harding re-analyzed each of the assets.
The Commissioners separately upheld the ALJ’s determination that Chau agreed to purchase the BBB-rated tranche of Norma as a favor to the investment bank that structured Norma, however. Notwithstanding red flags raised by Harding analysts, the Commissioners found that Chau purchased the BBB-rated bonds and allocated the bonds to two CDOs that Harding managed. The ALJ had found that Harding and Chau violated their fiduciary duties to the purchasers of the CDOs by allocating the bonds from Norma with red flags; the Commissioners agreed, finding that Chau and Harding abdicated their duty to pick those assets that they believed were best for their clients in violation of the Advisers Act — essentially choosing to curry favor with the investment bank that structured Norma over choosing the best collateral for its own CDO investors. Even though these CDO investors were special purpose vehicles essentially controlled by the same investment bank that structured Norma, the Commissioners found that Harding owed separate duties to these investors.
In addition, the Commissioners increased the amount that Harding and Chau must disgorge from $1 million to nearly $5.8 million and required Harding and Chau to disgorge all fees they earned from the two CDOs containing the BBB-rated Norma tranche, whereas the ALJ had only required Harding and Chau to disgorge the fees prorated by the percentage of Norma collateral that was placed into each CDO. The Commission’s decision demonstrates an arguably punitive approach to disgorgement by requiring Harding and Chau to disgorge 100% of their fees earned from the two CDOs containing the BBB-rated Norma bonds, even though the Norma bonds comprised less than 2% of the total collateral for each of the CDOs.
