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SEC Complaint V. Edward S. Steffelin

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SEC Complaint V. Edward S. Steffelin UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK U.S. SECURITIES AND EXCHANGE COMPLAINT COMMISSION, [Securities Fraud] Plaintiff, 11-CV-___________ ( ) v. ECF CASE EDWARD S. STEFFELIN, Jury Trial Demanded Defendant. Plaintiff Securities and Exchange Commission (“Commission”) alleges as follows against the defendant Edward S. Steffelin: SUMMARY 1. The Commission brings this securities fraud action relating to the structuring and marketing of a largely synthetic collateralized debt obligation (“CDO”) called Squared CDO 2007-1 (“Squared”). The investment portfolio for Squared consisted primarily of credit default swaps (“CDS”) referencing other CDO securities whose value was tied to the United States residential housing market. J.P. Morgan Securities LLC (f/k/a J.P. Morgan Securities Inc.) (“J.P. Morgan Securities”) structured and marketed to investors notes in this $1.1 billion “CDO squared” in early 2007 when the housing market and the securities referencing it were beginning to show signs of distress. Synthetic CDOs like Squared contributed to the recent financial crisis by magnifying losses associated with the downturn in the housing market. 2. The marketing materials for Squared – including the pitch book, term sheet, and offering circular – all described the process by which GSCP (NJ) L.P. (“GSC”), a registered investment adviser with experience analyzing credit risk in CDOs, purportedly selected the investment portfolio of Squared. Undisclosed in the marketing materials and unbeknown to investors or to the special purpose vehicles (“SPVs”) that issued the securities to investors in Squared, a large hedge fund, Magnetar Capital LLC (“Magnetar”), with economic interests adverse to investors in Squared, played a significant role in the portfolio selection process. While participating in the Squared portfolio selection, Magnetar shorted a substantial portion of the assets that it participated in selecting by entering into CDS to buy protection on them. The collateral Magnetar shorted had a notional value of approximately $600 million, representing over half of the Squared investment portfolio. (Magnetar also invested $8.9 million in Squared’s subordinated notes, or equity.) 3. Magnetar’s role in selecting and shorting assets in the Squared investment portfolio was undertaken with the knowledge and assistance of GSC. Edward S. Steffelin (“Steffelin”) was in charge of the team at GSC that implemented the process for purportedly selecting the investment portfolio for Squared. Steffelin executed the engagement letter and warehouse agreement with J.P. Morgan Securities, permitted Magnetar to participate in the selection of assets knowing it planned to short those assets, and reviewed and participated in the drafting of the pitch book and other marketing materials before they were provided to investors. In particular, Steffelin helped draft the portion of the pitch book addressing GSC’s CDO investment approach, i.e. the process for selecting the portfolio. The description of GSC’s CDO investment approach set forth in the pitch book made no mention of Magnetar’s involvement in the portfolio selection process. Steffelin knew, however, that Magnetar was directly involved in the portfolio selection process and had a substantial short interest in Squared. Also undisclosed in the marketing materials and unbeknown to investors and the SPVs, Steffelin was seeking employment with Magnetar during the relevant period. 2 4. J.P. Morgan Securities offered and sold approximately $150 million of the so-called “mezzanine” tranches of Squared’s liabilities (“Notes”) – representing the riskiest notes of the deal after the equity – to a group of approximately 15 institutional investors (“Mezzanine Investors”). The Mezzanine Investors included a faith-based not-for-profit membership organization headquartered in Minneapolis, Minnesota (Thrivent Financial for Lutherans), a company that provides insurance and retirement products based in Topeka, Kansas (Security Benefit Corporation), and financial institutions located in East Asia (Tokyo Star Bank, Far Glory Life Insurance Company Ltd., Taiwan Life Insurance Company Ltd., and East Asia Asset Management Ltd.). 5. The Squared transaction priced on April 19, 2007, and closed on May 11, 2007. Steffelin, on behalf of GSC, executed the collateral manager agreement with the CDO when the deal closed. GSC was paid $1.4 million in management fees, consisting of a $350,000 up front fee at closing plus annual management fees. Steffelin was paid a $250,000 base salary and a $1 million bonus in 2007. A portion of Steffelin’s bonus was based on the profits of the structured products group he supervised at GSC, and a portion was based on the overall profits of GSC. 6. Squared declared an event of default on January 18, 2008. By January 29, 2008, 50 percent of the CDO securities in the investment portfolio had been downgraded and another 34 percent of the portfolio was on negative downgrade watch. The Mezzanine Investors lost most, if not all, of their principal. 7. By engaging in the conduct described in this complaint, Steffelin violated Sections 17(a)(2) and (3) of the Securities Act of 1933 [15 U.S.C. §77q(a)(2) and (3)] (“Securities Act”) 3 and Section 206(2) of the Investment Advisers Act of 1940 [15 U.S.C. §80b-6(2)] (“Advisers Act”). The Commission seeks injunctive relief, disgorgement of profits, prejudgment interest, civil penalties and other appropriate and necessary equitable relief from the defendant. JURISDICTION AND VENUE 8. This Court has jurisdiction and venue over this action pursuant to Sections 20(b), 20(d) and 22(a) of the Securities Act [15 U.S.C. §§ 77t(b), 77t(d), 77v(a)] and Sections 209(d) and 214 of the Advisers Act [15 U.S.C. §§80b-9(d), 80b-14]. Steffelin engaged in acts and transactions in this judicial district constituting the violations and, directly or indirectly, made use of the means or instrumentalities of interstate commerce, or of the mails, or the facilities of a national securities exchange in connection with the transactions, acts, practices, and courses of business alleged herein. DEFENDANT 9. Edward S. Steffelin, age 41, was a Managing Director at GSC and an unregistered investment adviser during the relevant period. Steffelin was in charge of the team that purportedly selected the collateral for Squared. Steffelin worked at GSC’s offices in New York City during the relevant period. He obtained his Series 7 and 63 licenses in March 2010 and is currently a registered representative with a broker-dealer based in Scottsdale, Arizona. Steffelin resides in New York, New York. RELATED ENTITIES 10. J.P. Morgan Securities is and was the principal United States broker-dealer of J.P. Morgan Chase & Co., a global investment banking, securities, and investment management firm headquartered in New York City. J.P. Morgan Securities structured and marketed Squared. 4 11. GSC is and was a Delaware limited partnership and registered investment adviser headquartered in Florham Park, New Jersey. GSC served as collateral manager for a number of CDOs, including Squared. As of December 31, 2006, GSC had closed nine structured finance CDO transactions, had more than $12.9 billion in structured finance assets under management, and over $22 billion in total assets under management. GSC filed for Chapter 11 bankruptcy protection on August 31, 2010. 12. Magnetar is and was an asset manager headquartered in Evanston, Illinois. Magnetar hedge funds purchased the equity tranche of Squared and took the short counterparty position in over half of the assets in the Squared portfolio. 13. Squared CDO 2007-1, Ltd. (“Squared CDO Caymans”) was an SPV incorporated in the Cayman Islands on April 10, 2007. Squared CDO Caymans entered into a collateral management agreement with GSC, purchased the collateral of Squared at closing and issued Squared’s notes to investors. 14. Squared CDO 2007-1, Inc. (“Squared CDO Delaware”) was an SPV incorporated in Delaware on April 5, 2007, and served as co-issuer of Squared’s notes to investors. Squared CDO Delaware did not enter into the collateral management agreement with GSC or purchase any of Squared’s collateral. FACTS A. GSC’S PORTFOLIO SELECTION PROCESS FOR SQUARED GSC Agrees to Select the Portfolio for Squared 15. On or about January 11, 2007, GSC and J.P. Morgan Securities executed an engagement letter pursuant to which J.P. Morgan Securities agreed to arrange and place a CDO 5 squared with an investment portfolio of primarily cash and synthetic investments in CDOs, and GSC agreed to select and manage that portfolio. Steffelin signed the engagement letter on behalf of GSC. 16. GSC was a registered investment adviser with knowledge of the domestic housing market and expertise in analyzing CDO securities. GSC promoted itself as relying upon proprietary research and modeling that included extensive quantitative and qualitative processes to select and manage CDO investment portfolios. The Warehousing and Collateral Selection Process 17. A CDO squared is a complex, highly-leveraged structured product. Investors receive payments out of the interest and principal received on an investment portfolio of CDO securities or, where the CDO squared is synthetic, payments related to CDS referencing CDO securities (collectively, “CDO securities”). Squared was a synthetic CDO. The majority of Squared’s assets were CDS that referenced other CDOs. 18. The Squared CDO transaction followed a structure common to many CDOs sold during the relevant period. For this transaction, two SPVs (Squared CDO Caymans and Squared CDO Delaware) were created to issue notes entitling the holders to payments derived from the underlying assets held by one of the SPVs. 19. The cash flow necessary to make payments on the notes was to be generated primarily through a CDS contract referencing a pool of CDO securities that Squared CDO Caymans entered into on the closing date with a J.P. Morgan affiliate. The notes issued by the SPVs were securities with defined risk profiles determined by a hierarchical, tranched structure.
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