A large investment bank agreed to pay nearly $50 Million in disgorgement, interest and penalties for failing to disclose certain upfront spread/fees received in connection with structuring and offering a CDO.  The SEC charges that the respondent did not disclose certain upfront points received with respect to credit default swaps even though the offering materials indicated that the CDO would operate “on an arm’s-length basis for fair market value.”  The SEC indicated that the respondent knew that the retention of the upfront points was unusual because (i) personnel working on the deal consulted in-house deal counsel about whether the firm could retain the points (which deal counsel ultimately identified a tax issue but failed to require disclosure) and (ii) the firm discussed the points with certain institutional investors who questioned the points.  Ultimately, the CDO failed, and investors lost $130 Million.  The SEC charged the firm with negligently causing the collateral manager, a registered investment adviser, to violate Section 206(2) of the Advisers Act and with violating Sections 17(a)(2) and 17(a)(3) of the Securities Act.

OUR TAKE: An investment bank warehouses securities, sells the securities to the CDO, and keeps a spread.  Then, it gets sued for negligently causing a third party firm to violate the Advisers Act’s antifraud rules (a cause of action we didn’t even know existed)?  Would investors not have purchased the CDO had they known that the bank kept a spread?  Isn’t the fact that certain institutional investors questioned the points but still invested indicative that the issue was not material?   Perhaps the real lesson here is that firms risk regulatory action when they make money but their clients do not.