Articles Posted in Complex Products

Deutsche Bank has agreed to pay a fine of $55 million to settle charges by the SEC that it filed misstated financial reports during the height of the global financial crisis relating to a multibillion dollar portfolio of derivatives.

The SEC’s multi-year investigation culminated in an Order Instituting a Settled Administrative Proceeding, available on the SEC’s website. According to investigators, the bank overvalued a portfolio of derivatives consisting of Leveraged Super Senior (“LSS”) trades, through which it purchased protection against credit default losses. This leverage created a “gap risk”, which the bank initially took into account in its financial statements, by adjusting down the value of the LSS positions. However, according to the SEC’s Order, when the credit markets started to deteriorate in 2008, Deutsche Bank steadily altered its methodologies for measuring the gap risk. Each change in methodology reduced the value assigned to the gap risk until Deutsche Bank eventually stopped adjusting for gap risk altogether. In other words, the bank slowly tweaked its formula over the months so that the risk didn’t show in its financial reports.

Therefore, “at the height of the financial crisis, Deutsche Bank’s financial statements did not reflect the significant risk in these large, complex illiquid positions”, according to Andrew J. Ceresney, Director of the SEC’s Division of Enforcement.

What are non-traditional exchange-traded funds (ETFs) and non-traded real estate investment trusts (REITs)? Why are independent broker dealers selling these complex products without proper supervision? FINRA wants to know and just slammed LPL Financial for doing such a thing.

This week, FINRA censured and fined LPL $10 million for broad supervisory failures in the sale of complex products such as leveraged ETFs and non-traded REITS. It also ordered LPL to pay an additional $1.7 million in restitution to certain customers who bought non-traditional ETFs.

This is a watershed moment for these and other complex products. First, LPL has over 14,000 brokers nationwide and is by a wide margin the largest independent broker dealer in the U.S. (Lincoln Financial Network with over 8,000 brokers is second). The biggest independent broker-dealer getting hit like this by FINRA is the equivalent of FINRA fining the old Merrill Lynch in wire house terms.