The SEC’s weird case against Wing Chau

By Felix Salmon
October 19, 2013

Merrill Lynch closed its Octans 1 CDO in September 2006. By April 2008, a year and a half later, the CDO had completely imploded, inflicting roughly $1.1 billion of losses on its outside investors. Now, five and a half years after that, the SEC has finally got around to launching a lawsuit against the CDO manager, Wing Chau.

If that name seems familiar to you, it’s probably because you read The Big Short, Michael Lewis’s account of the men who made a fortune shorting subprime. The biggest villain in that story was Chau, who went on to (unsuccessfully) sue Lewis and his publisher for defamation. Chau’s complaint was that as a result of the publication of Lewis’s book, his “ability to work in his chosen profession has been severely diminished”. Given that his chosen profession is to manage CDOs, one would think his ability to work there would be severely diminished whether the book had been published or not: there’s precious little demand for such services these days. But in any case, if he retained any kind of professional life at all, this SEC lawsuit is likely to kill it stone dead.

That said, the SEC’s suit is a very weird thing. For one thing, the Octans 1 CDO was constructed and marketed not by Wing Chau but rather by Merrill Lynch. The SEC has been looking into Merrill’s CDO shenanigans since June 2011, but — for the time being, at least — Merrill has escaped any kind of CDO-related litigation, even as Citigroup, JP Morgan, Wells Fargo, UBS, and Goldman Sachs (in the notorious Abacus deal) have all paid substantial fines for such things.

And it’s Merrill’s marketing materials, much more than any action by Wing Chau, which are at the heart of the SEC’s case. The problem with Octans 1 is that a hedge fund called Magnetar had some control over its contents, and Magnetar’s role in helping to shape the contents of the CDO was not disclosed to investors. The SEC’s case rests wholly on the fact that the Octans 1 pitchbook and offering circular made no mention of “Magnetar’s rights in and influence over the collateral selection process”. This may or may not have been a felonious omission, but either way it’s hard to see how Wing Chau is really at fault.

The SEC should know this better than anybody. After all, they’ve been here before. In June 2011, it charged Edward Steffelin, another CDO manager, with basically exactly the same thing as it’s accusing Wing Chau of doing now. It makes sense that the SEC charged Steffelin before it charged Chau, because the case against Steffelin alleged all manner of juicy back-channel dealings between Steffelin and Magnetar:

In a complaint filed against Steffelin, who headed the team at GSC responsible for the Squared CDO, the SEC alleges that Steffelin allowed Magnetar to select and short portfolio assets. The complaint alleges that Steffelin drafted and approved marketing materials promoting GSC’s selection of the portfolio without disclosing Magnetar’s role in the selection process. In addition, unknown to investors, Steffelin was seeking employment with Magnetar while working on the transaction.

Those employment enquiries notwithstanding, however, the SEC’s case against Steffelin was ultimately pretty flimsy, and collapsed, ignominiously, in May 2012, with the SEC dropping all charges. James Stewart had an excellent column, a few months later, laying out the facts:

At first blush, Mr. Steffelin’s case may have looked like Goldman’s. The S.E.C. charged that Mr. Steffelin allowed a large investor in mortgage-backed securities, a hedge fund called Magnetar Capital, to help choose the assets in the C.D.O. that JPMorgan structured and marketed. The commission further contended that Magnetar was betting against some of those securities and that Mr. Steffelin should have disclosed this to investors, but did not.

Among the problems with this theory were Mr. Steffelin’s claim that Magnetar didn’t choose the assets that went into the deal, even if it was aware of some of them (JPMorgan made the final decision); that JPMorgan, not Mr. Steffelin, was responsible for the offering documents and that Mr. Steffelin accurately provided whatever information JPMorgan wanted; and that lawyers for GSC and JPMorgan scrutinized the offering materials and signed off on them, so Mr. Steffelin, who isn’t a lawyer, had every reason to believe they passed muster.

Replace “JP Morgan” here with “Merrill Lynch”, “Steffelin” with “Chau”, and “GSC” with “Harding”, and Stewart could have written exactly the same thing about the current case. Magnetar did not choose the assets in Octans 1: the deal was put together by Merrill Lynch so as to be acceptable both to Magnetar and to Chau. Chau was even more of an active participant in putting the CDO together than Magnetar was. The offering documents were Merrill’s, not Chau’s. And it’s a bit weird to prosecute Chau for failure to make certain disclosures, when firstly he’s not a lawyer, and secondly he wasn’t in charge of what was being disclosed in the first place.

So why is the SEC bringing this case against Chau, when its case against Steffelin collapsed, and the case against Merrill Lynch would appear to be much stronger? (JP Morgan didn’t even fight the Steffelin case: it settled, immediately, for $153.6 million.) Maybe they figure that Chau can’t afford to fight: Stewart reported that Steffelin’s legal fees ended up being more than $3 million, all of which was paid for by GSC’s insurer, AIG. Fresh off one legal defeat, it’s easy to see how Chau might not have a lot of appetite for another big fight.

Maybe it’s just that Chau is one of the few named villains of the financial crisis: if you’ve read one book on the subject, it’s probably Lewis’s, and Chau comes off very badly there. With the SEC looking for a slightly higher-profile individual scalp than Fabrice Tourre, they alighted on Chau. But the fact is that the SEC’s case is very weak, and this case looks not only tardy but also pretty desperate. If Chau has the financial and emotional wherewithal to fight it, I suspect he’ll win pretty easily.

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