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.
The Deutsche Bank enforcement action is notable in several respects, according to a recent piece by Matthew Goldstein in the New York Times. http://www.nytimes.com/2015/05/27/business/dealbook/sec-says-deutsche-bank-misvalued-derivatives.html. It was one of few cases brought by regulators involving valuation of securities, possibly due to the complex nature of the derivatives, CDOs and other products that were involved in trading that gave rise to the fiasco that was the financial crisis. Second, according to Scott Friestad, an SEC lawyer who handled the case and is quoted in the NY Times article, the Deutsche Bank enforcement action was the only enforcement action where the SEC alleged that a major bank failed to properly value a “significant portion of its portfolio of complex securities”. Finally, and equally importantly, the case was assisted by at least two whistle-blowers, former Deutsche Bank employees who reported and detailed wrongdoing at the bank and assisted in the investigation.
In addition to the $55 million penalty, the SEC’s order requires Deutsche Bank to cease and desist from committing or causing any violations or future violations of multiple sections of the Securities Exchange Act of 1934 and related Rules. Deutsche Bank neither admits nor denies the SEC’s findings in the order.