SEC Charges Baton Rouge-Based Investment Adviser With Hiding Losses from Mortgage-Backed Securities Investments

Friday, November 9th, 2012

The Securities and Exchange Commission (the “SEC”) recently announces that it has charged a hedge fund manager in Baton Rouge, La., with defrauding investors by hiding millions of dollars in losses suffered during the financial crisis from investments tied to residential mortgage-backed securities.

The SEC alleges that Walter A. Morales and his firm Commonwealth Advisors Inc. caused the hedge funds they managed to buy the lowest and riskiest tranches of a collateralized debt obligation called Collybus. They sold mortgage-backed securities into Collybus at prices they had obtained four months earlier while knowing that the residential mortgage-backed securities market had declined precipitously in the meantime. As the CDO investments continued to perform poorly, Morales instructed Commonwealth employees to conduct a series of manipulative trades between the hedge funds they advised (called cross-trades) in order to conceal a $32 million loss experienced by one of the funds in its Collybus investment. Morales and Commonwealth lied to investors about the amount and value of mortgage-backed assets held in the hedge funds, and they created phony internal documents to justify their false valuations.

According to the SEC’s complaint filed in U.S. District Court for the Middle District of Louisiana, Commonwealth’s hedge fund clients included pension funds and individual investors. Morales and Commonwealth invested a significant portion of hedge fund assets in residential mortgage-backed securities. When the mortgage markets began to decline dramatically in 2007, bond rating agencies began to aggressively downgrade subprime residential mortgage-backed securities. Therefore, Commonwealth clients were sustaining heavy investment losses and Morales knew those losses would probably continue.

The SEC alleges that rather than come clean with investors, Morales directed Commonwealth to execute more than 150 deceptive cross-trades from two hedge funds they advised to another one of their hedge funds in June 2008 at prices below Commonwealth’s own valuation for those securities. After the trades, Morales directed a Commonwealth employee to mark the securities at fair market value, which created a fraudulent $19 million gain for the acquiring hedge fund at the expense of the funds that sold. Morales ordered the cross-trades even though Commonwealth had represented in forms filed with the SEC that it would not execute such trades between these hedge fund clients. Moreover, when the trades raised concern from the prime broker, Morales falsely represented that the transactions were for a legitimate business purpose and at prevailing market prices.

The SEC further alleges that Morales deceived Commonwealth’s largest investor about its exposure to Collybus. Morales agreed to limit the investor’s exposure to Collybus through its investment in a particular Commonwealth hedge fund to 10 percent of that hedge fund’s equity. Morales, however, abided by this agreement only temporarily, and the investor’s exposure to Collybus more than doubled by mid-2008. After the large investor learned that Commonwealth was not following its stated valuation procedures, the investor requested valuation committee meeting minutes to review. Morales allegedly prepared false minutes that were delivered to the investor purporting to describe meetings that never occurred.

The foregoing information, which is publicly available on the SEC’s website, is being provided by The White Law Group.  The White Law Group is a national securities fraud and investor protection law firm with offices in Chicago, Illinois and Boca Raton, Florida.  For more information on The White Law Group visit http://www.whitesecuritieslaw.com.

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