SEC CHARGES HEDGE FUND MAMAGER IN BATON ROUGE, LA., WITH DEFRAUDING INVESTORS



Credit:  Wikimedia Commons

FROM: SECURITIES AND EXCHANGE COMMISSION

Washington, D.C., Nov. 8, 2012 — The Securities and Exchange Commission today charged a hedge fund manager in Baton Rouge, La., with defrauding investors by hiding millions of dollars in losses suffered during the financial crisis from investments tied to residential mortgage-backed securities (RMBS).

The SEC alleges that Walter A. Morales and his firm Commonwealth Advisors Inc. caused the hedge funds they managed to buy the lowest and riskiest tranches of a collateralized debt obligation (CDO) called Collybus. They sold mortgage-backed securities into the CDO at prices they had obtained four months earlier while knowing that the RMBS market had declined precipitously in the meantime. As the CDO investments continued to perform poorly, Morales instructed Commonwealth employees to conduct a series of manipulative trades between the hedge funds they advised (called cross-trades) in order to conceal a $32 million loss experienced by one of the funds in its Collybus investment. Morales and Commonwealth lied to investors about the amount and value of mortgage-backed assets held in the hedge funds, and they created phony internal documents to justify their false valuations.

"Morales and Commonwealth Advisors concealed significant hedge fund losses from investors, including pension fund investors, instead of owning up to them and facing the consequences," said Robert Khuzami, Director of the SEC’s Division of Enforcement. "Investors put their fundamental trust in the hands of their investment adviser, and they deserve better than being manipulated and lied to through deceptive trades and phony documents."

According to the SEC’s complaint filed in U.S. District Court for the Middle District of Louisiana, Commonwealth’s hedge fund clients included pension funds and individual investors. Morales and Commonwealth invested a significant portion of hedge fund assets in RMBS. When the mortgage markets began to decline dramatically in 2007, bond rating agencies began to aggressively downgrade subprime RMBS. Therefore, Commonwealth clients were sustaining heavy investment losses and Morales knew those losses would probably continue.

The SEC alleges that rather than come clean with investors, Morales directed Commonwealth to execute more than 150 deceptive cross-trades from two hedge funds they advised to another one of their hedge funds in June 2008 at prices below Commonwealth’s own valuation for those securities. After the trades, Morales directed a Commonwealth employee to mark the securities at fair market value, which created a fraudulent $19 million gain for the acquiring hedge fund at the expense of the funds that sold. Morales ordered the cross-trades even though Commonwealth had represented in forms filed with the SEC that it would not execute such trades between these hedge fund clients. Moreover, when the trades raised concern from the prime broker, Morales falsely represented that the transactions were for a legitimate business purpose and at prevailing market prices.

The SEC further alleges that Morales deceived Commonwealth’s largest investor about its exposure to the CDO. Morales agreed to limit the investor’s exposure to Collybus through its investment in a particular Commonwealth hedge fund to 10 percent of that hedge fund’s equity. Morales, however, abided by this agreement only temporarily, and the investor’s exposure to Collybus more than doubled by mid-2008. After the large investor learned that Commonwealth was not following its stated valuation procedures, the investor requested valuation committee meeting minutes to review. Morales prepared false minutes that were delivered to the investor purporting to describe meetings that never occurred.

The SEC’s complaint charges Morales and Commonwealth with violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, and Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8. The SEC also alleges that Commonwealth violated Sections 204, 206(4), and 207 of the Advisers Act and Rules 204-2, 206(4)-2, and 206(4)-7, and that Morales aided and abetted Commonwealth’s violations of Section 10(b) of the Exchange Act, Rule 10b-5, and Sections 204, 206(1), 206(2), 206(4), and 207 of the Advisers Act and Rules 204-2, 206(4)-2, 206(4)-7, and 206(4)-8. Morales was a controlling person of Commonwealth pursuant to Section 20(a) of the Exchange Act, and is therefore liable as a control person for Commonwealth’s violations of the Exchange Act.

The SEC’s investigation, which is continuing, has been conducted by Gary M. Zinkgraf, Carol E. Schultze, Jacob D. Krawitz, and Paul Gunson in coordination with members of the SEC Enforcement Division’s Structured and New Products Unit and Asset Management Unit. Matthew Rossi and Jan Folena will handle the SEC’s litigation.

GAMING EXECUTIVES CHARGED BY SEC WITH LYING TO INVESTORS

Photo Credit:  SEC.

FROM: U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C., Nov. 8, 2012 — The Securities and Exchange Commission today charged three executives with repeatedly lying to investors about the operations and financial condition of an Irvine, Calif.-based company that purported to sell credit card-size electronic games. The SEC also charged the company’s independent auditor with facilitating the scheme.

The SEC alleges that chief executive officer Lee Cole and chief financial officer Linden Boyne orchestrated a scheme in which Electronic Game Card Inc. (EGMI) enticed investors by claiming to have millions of dollars in annual revenue, hold millions of dollars in investments, and own an off-shore bank account worth more than $10 million. In reality, many of the company’s purported contracts were phony, the purported investments were merely in entities affiliated with Cole or Boyne, and the bank account did not exist. As a result of EGMI’s false claims, the company’s outstanding common stock was once valued as high as $150 million. EGMI is now bankrupt and its stock is worthless.

The SEC charged the company’s outside auditor — certified public accountant Timothy Quintanilla — with repeatedly issuing clean audit opinions about EGMI based on reckless and deficient audit work. Also charged is Kevin Donovan, who later replaced Cole as CEO and ignored many red flags about the accuracy of the company’s public statements and the integrity of Cole and Boyne. He provided false information during conference calls with analysts and investors.

"Cole and Boyne played a game of make-believe with a publicly-traded microcap company," said Andrew M. Calamari, Director of the SEC’s New York Regional Office. "We will continue to fight microcap fraud and bring charges against not only the company executives but also the auditors or other gatekeepers who legitimize a fraud and allow investors to be victimized."

According to the SEC’s complaint filed in federal court in Manhattan, EGMI’s material misrepresentations and omissions in SEC filings and public statements occurred from 2007 to 2009. The company repeatedly reported non-existent revenues and assets, misrepresented its business operations, and failed to disclose related-party transactions. Those misrepresentations and others like them were just part of a scheme that Cole and Boyne orchestrated through EGMI to reap approximately $12 million in unlawful gains. While they were making material misrepresentations to inflate EGMI’s stock price, Cole and Boyne also secretly funneled millions of shares of EGMI stock to entities based in Gibraltar that they secretly controlled. They directed the Gibraltar entities to sell the shares, and proceeds of those sales were transferred to people or entities associated with Cole and Boyne or to EGMI itself. Cole and Boyne bolstered their lies by providing falsified documents to the company’s outside auditors.

The SEC alleges that as EGMI’s engagement partner, Quintanilla and the public accounting firm Mendoza Berger & Co. LLP issued clean audit opinions for EGMI’s year-end financial statements for 2006, 2007, and 2008, even though those statements were riddled with material misstatements and omissions. Mendoza Berger and Quintanilla knowingly or recklessly misrepresented that the firm had conducted audits of EGMI’s financial statements "in accordance with the standards of the Public Company Accounting Oversight Board (United States)." Mendoza Berger’s opinion stated that EGMI’s financial statements "present[ed] fairly, in all material respects, the financial position" of EGMI. In fact, Mendoza Berger had not audited critical aspects of EGMI’s financial statements, and its work did not conform to the standards of the Public Company Accounting Oversight Board (PCAOB). Quintanilla had no meaningful basis to have Mendoza Berger issue an opinion on EGMI’s financial statements.

The SEC further alleges that shortly after Donovan became CEO, he was notified of many red flags related to the company’s public statements about its operations, finances, and share count. Donovan violated the antifraud provisions of the securities laws when he led several public conference calls with securities analysts and investors in 2009, and knowingly or recklessly relayed false financial information about the company that had been provided to him by Cole and Boyne.

The SEC’s complaint alleges that Cole and Boyne violated Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933; Sections 10(b), 13(b)(5), 13(d), and 16(a) of the Securities Exchange Act of 1934 and Rules 10b-5, 13a-14, 13b2-1, 13b2-2, 13d-1, 13d-2, 16a-2, and 16a-3; and Section 304 of the Sarbanes-Oxley Act of 2002. The SEC also alleges that Cole and Boyne are liable as control persons and for aiding and abetting violations of Sections 10(b), 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1 and 13a-13. The SEC charges that Donovan violated Sections 17(a)(1) and 17(a)(3) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5. The SEC alleges that Quintanilla violated Section 17(a) of the Securities Act and Sections 10(b), 10A(a)(1), and 10A(b)(1) of the Exchange Act and Rule 10b-5. Quintanilla also is charged with aiding and abetting violations of Sections 10(b), 10A(a)(1), and 10A(b)(1) of the Exchange Act and Rule 10b-5 thereunder.

The SEC’s complaint seeks, among other things, a final judgment ordering Cole, Boyne, Donovan, and Quintanilla to pay financial penalties and permanently enjoining them from future violations of the securities laws; enjoining Cole, Boyne, and Donovan from serving as officers and directors of public companies and from participating in penny stock offerings; and ordering Cole, Boyne, and Quintanilla to disgorge their ill-gotten gains with prejudgment interest.

The SEC’s investigation, which is continuing, has been conducted by Michael Paley, Stephen Larson, James Addison, Gwen Licardo, and Aaron Arnzen of the New York Regional Office. Mr. Arnzen will lead the SEC’s litigation. The SEC thanks the PCAOB for its assistance in this matter.