The Securities and Exchange Commission has filed charges against a Morristown, NJ-based investment advisory firm and its owner for misleading investors in a collateralized debt obligation (CDO) and breaching their fiduciary duties.

The SEC’s Enforcement Division alleges that Harding Advisory LLC and Wing F. Chau compromised their independent judgment as collateral manager to a CDO named Octans I CDO Ltd. in order to accommodate trades requested by a third-party hedge fund firm whose interests were not necessarily aligned with the debt investors.

Harding agreed to give the hedge fund firm rights in the process of selecting and acquiring a portfolio of subprime mortgage-backed assets to serve as collateral for debt instruments issued to investors in the CDO.

These rights, which were not disclosed to investors, included the right to veto Harding’s proposed selections during the ‘warehouse’ phase that preceded issuance of the CDO’s debt instruments. The influence of the hedge fund firm led Harding to select assets that its own credit analysts disfavored.

George S. Canellos, co-director of the SEC’s Division of Enforcement, said: "A collateral manager’s independent selection of assets is an important selling point to potential CDO investors. Investors had a right to know that Harding and Chau had chosen to accommodate the interests of others and abandon their own obligations to act in the best interests of the CDO they advised."

According to the SEC’s order instituting proceedings, the hedge fund firm was Magnetar Capital LLC, which had invested in the equity of the CDO. Merrill Lynch, Pierce, Fenner & Smith Inc. structured and marketed the CDO, which closed on Sept. 26, 2006.

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Merrill Lynch, Magnetar, and Harding agreed in the spring of 2006 that Harding would serve as collateral manager for the CDO. Chau understood that Magnetar was interested in investing as the equity buyer in CDO transactions, and that Magnetar’s strategy included ‘hedging’ its equity positions in CDOs by betting against the debt issued by the CDOs.

Because Magnetar stood to profit if the CDOs failed to perform, Chau knew that Magnetar’s interests were not necessarily aligned with investors in the debt tranches of Octans I, whose investment depended solely on the CDO performing well.

The SEC’s Enforcement Division alleges that while assembling the collateral for Octans I, Chau and Harding allowed Magnetar an undisclosed influence over the selection process. Harding’s own credit analysis of many of the selected assets was disregarded, and Magnetar’s influence over the portfolio was omitted from materials used to solicit investors for the CDO.

Chau and Harding misrepresented the standard of care that Harding would use in acquiring collateral for Octans I.

The SEC’s Enforcement Division further alleges that Harding and Chau breached their advisory obligations to several other CDOs for which they served as investment managers.

As a favor to Merrill Lynch and Magnetar, Harding and Chau purchased bonds for those CDOs that Chau and Harding disfavored. In accepting the bonds, Chau wrote in an e-mail to the head of CDO syndication at Merrill Lynch, ‘I never forget my true friends.’

The SEC’s Division of Enforcement alleges that by engaging in the conduct described in the SEC’s order, Harding and Chau violated Section 17(a) of the Securities Act of 1933 and Section 206 of the Investment Advisers Act of 1940. Chau also is charged with aiding and abetting and causing Harding’s violations.
The proceedings before an administrative law judge will determine what relief against Harding and Chau is in the public interest.

The SEC’s investigation, which is continuing, has been conducted by staff in the Complex Financial Instruments Unit and the New York Regional Office, including Steven Rawlings, Brenda Chang, Elisabeth Goot, Sharon Bryant, Kapil Agrawal, Howard Fischer, Daniel Walfish, and Douglas Smith. The case was supervised by Reid Muoio, and the litigation will be led by Mr. Fischer, Mr. Walfish, Ms. Goot, and Ms. Chang.