Published in the Securities Arbitration 2003 Handbook PLI.

In a previous paper, Dr. McCann outlined the portfolio approach to assessing the excessiveness of trading in churning cases. In this paper, Dr. McCann and Dr. Luo demonstrate that cost-to-equity ratios of more than 4 or 5% or commission to equity ratios of 2 or 3% in accounts with turnover ratios of 2 indicate excessive trading in common stock portfolios.

Collateralized Loan Obligations (CLOs) are issued by trusts which in turn invest the proceeds from issuing the CLO securities in portfolios of bank loans. This note explains the conflicts of interest created when an investment bank accumulates loans for potential securitization prior to the issuance of a CLO through a practice known as ‘warehousing.’ Warehousing appears to have resulted in some CLO trusts issuing securities without disclosing to investors that the securities had lost almost all their value because the CLO trust was committed to paying substantially more than the market value of the warehoused loans.

We provide two examples of such problematic CLO offerings in which Banc of America appears to have transferred at least $35 million of losses to investors in July 2007 and which ultimately led to approximately $150 million in losses in just these two CLOs. $35 million of those $150 million in losses occurred before Banc of America sold the securities to investors and only $115 million occurred after investors bought the CLO securities. The problem we identify is more widespread than Banc of America and broader than CLOs.

The Private Placement Memoranda for the products mentioned in the paper:
– Bryn Mawr II PPM
– LCM VII PPM
– Symphony IV PPM

The LCM VII Marketing Deck and the LCM Trustee Reports which document the decline in the value of the LCM VII loans before July 31, 2007 are available to read.

News Article:
– American Banker – B of A Subpoenaed by Massachusetts Over CLOs by Allison Bisbey
– The New York Times, February 5, 2012 – A Wipeout That Didn’t Have to Happen

Recent Award:
– Hayes v Banc of America Securities – $1.4 million CLO Award

Dr. O’Neal describes a pattern of consistent losses relative to NAV observed after the IPO of closed end funds. Closed-end funds IPO at a 5% premium to their NAVs and within 6 months trade at a 5% discount to their NAVs. It appears that investing in a closed-end fund at the IPO is dominated by investments in seasoned mutual funds. This suggests that closed-end fund IPOs don’t pass the NASD’s ‘reasonable basis’ suitability test and recommendations to buy a closed-end fund at the IPO should therefore be per se unsuitable.