The Securities and Exchange Commission today charged four individuals for engaging in a fraudulent scheme to overvalue the commodity derivatives trading portfolio at Bank of Montreal (BMO), and thereby inflate BMO's publicly reported financial results.
The defendants include a former senior derivatives trader at BMO and the top two senior executive officers of Optionable, Inc., a publicly traded commodities brokerage firm.
The SEC's complaint alleges that David Lee, formerly the Managing Director of BMO's Commodity Derivatives Group, fraudulently overvalued BMO's portfolio of natural gas options by deliberately "mismarking" trading positions for which market prices were unavailable. Lee recorded inflated values that were then purportedly validated by Optionable, which held itself out to BMO and the public as a legitimate provider of independent derivatives valuation services. The SEC's complaint also alleges that Lee schemed with Optionable's CEO Kevin Cassidy, Optionable's president Edward O'Connor, and Optionable broker Connor to have Optionable simply rubber-stamp whatever inflated values Lee recorded. After the scheme was discovered, BMO restated its financial results by reducing net income for the first quarter of its 2007 fiscal year by approximately $237 million Canadian dollars ($204 million U.S. dollars), which reflects a 68 percent overstatement of BMO's net income for that quarter.
"As alleged in our complaint, these defendants engaged in an elaborate scheme to overvalue illiquid assets held on the books of a publicly traded bank," said Linda Thomsen, Director of the SEC's Division of Enforcement. "Today's enforcement action underscores the Commission's commitment to rooting out such deceptive schemes and protecting the integrity of the financial markets."
David Rosenfeld, Associate Director of the SEC's New York Office, added, "The Commission will take aggressive action when financial professionals engage in collusive schemes to overvalue assets. These schemes harm public shareholders and undermine confidence in our markets."
According to the SEC's complaint, filed in federal district court in New York, BMO was Optionable's largest customer, and BMO trades accounted for as much as 60 percent of Optionable's commodity brokerage business. Lee's trading accounted for virtually all of BMO's business with Optionable. As a result, Optionable's management, led by Cassidy, allegedly was willing to do whatever it took to keep Lee satisfied. When market prices were unavailable, BMO's risk management personnel sought to verify the accuracy of BMO's commodity derivatives traders' valuations of their positions, or their "marks," by obtaining supposedly independent valuations, or "quotes," for those positions from one or more third parties.
The SEC's complaint alleges that during the relevant period, Optionable was the primary source of the third-party quotes that BMO used to validate Lee's marks. The SEC alleges that Lee provided his marks directly to Cassidy, O'Connor, or Connor, who then simply forwarded Lee's marks virtually unchanged to BMO's risk management department as if they were Optionable's independent quotes. At first, Lee allegedly used this "u-turn" scheme to boost his trading profits and incentive compensation, but in 2006, the market turned against Lee and he used the scheme to hide substantial trading losses. In May 2007, BMO concluded that due to the Optionable scheme and other positions that Lee had also mismarked, Lee's trading book was overvalued by an aggregate total of $680 million (Canadian dollars) since the beginning of BMO's fiscal year ended Oct. 31, 2006.
The SEC alleges that Cassidy and O'Connor also defrauded Optionable's public shareholders by concealing Optionable's role in the scheme. Optionable's periodic reports touted the synergistic benefits of the derivatives valuation services that Optionable purportedly provided to multiple brokerage clients, but those reports, which Cassidy and O'Connor signed, never disclosed that BMO was the principal client for whom those "services" were performed and that the "valuation services" provided to BMO were a sham designed to defraud BMO.
The SEC further alleges that Cassidy and O'Connor defrauded the New York Mercantile Exchange (NYMEX) by selling more than $10 million of their own Optionable stock to NYMEX in April 2007. Both Cassidy and O'Connor represented to NYMEX that Optionable's periodic reports were materially accurate, but they never disclosed anything about their scheme with Lee to defraud the shareholders of BMO, Optionable's largest customer. On May 9, 2007, one day after BMO announced that it had placed Lee on leave and suspended its business relationship with Optionable, Optionable issued an announcement stating that the suspension would have an adverse effect on Optionable's business. Optionable's stock price fell almost 40 percent that day, from $4.64 to $2.81 per share, and dropped to below 50 cents per share one week later after Cassidy's prior criminal record was disclosed in press reports.
All four defendants are charged in the Commission's complaint with committing and/or aiding and abetting violations of Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5, as well as various corporate reporting, recordkeeping and internal controls provisions of the Exchange Act. Cassidy and O'Connor also are charged with violating Section 17(a) of the Securities Act of 1933. As to each defendant, the complaint seeks a permanent injunction against future violations, disgorgement of ill-gotten gains plus prejudgment interest, and civil monetary penalties. The complaint also seeks an order barring Cassidy and O'Connor from acting as officers or directors of a public company.
The U.S. Attorney's Office for the Southern District of New York (USAO), the New York County District Attorney's Office (NYCDA), and the United States Commodity Futures Trading Commission (CFTC) also filed parallel criminal and regulatory charges today arising from the same conduct that is alleged in the Commission's complaint. Lee pled guilty to parallel criminal charges filed by the USAO and the NYCDA. In connection with his guilty plea, Lee agreed to pay a total of $4.41 million in forfeiture.
Lee has agreed to settle the SEC charges by consenting, without admitting or denying the SEC's allegations, to the entry of a permanent injunction against future violations of various provisions of the federal securities laws. The Commission's claims for disgorgement and civil penalties against Lee, and all of its claims against the other three defendants, remain pending.
• The Commission's investigation is continuing. The Commission acknowledges the assistance and cooperation of the USAO, NYCDA, CFTC and the Federal Bureau of Investigation.