Lecture 2.3.

Seminar: Case studies and practice questions

CASE 10 KELLOGG’S “MATCHED” AND “WASHED” TRADES (Peck, 2011):

TAX AVOIDANCE OR MARKET MANIPULATION?

Peter R. Kellogg was the former head of Wall Street’s top market maker, Spear, Leeds &
Kellogg. He sold Spear, Leeds to Goldman Sachs for $3.5 billion in 2000. Kellogg was charged
by the National Association of Securities Dealers (NASD) with committing fraudulent
‘‘matched’’ and ‘‘washed’’ trades in August of 2003. Washed trades are trades of securities
without a real change in ownership of the securities trades. Matched trades are trades to buy
or sell securities that are entered with knowledge that a matching trade on the opposite side has
been or will be entered. These charges were the result of a two-week period in which Kellogg’s
personal accounts and business entities conducted transactions that resulted in little change in
ownership of stock but caused abnormal market activity. In addition, these actions allowed his
corporations to account for gains that market prices would not have supported. The transactions
created tax exemptions. The NASD reversed these charges 9 months later because they deemed
the buying and selling of the securities to be solely for tax purposes—a legal activity.

Kellogg, a registered broker-dealer, owned four companies: Equity Holding Inc., IAT
Reinsurance Syndicate, MMK Reinsurance, and MCM Inc. MMK Reinsurance was a unit of
IAT. Through these companies, he engaged in two distinct series of transactions.

In the first transaction, Equity Holding Inc. sold 700,000 shares of Thoratec Corp. to IAT
Reinsurance Syndicate. Kellogg did not use market prices for the transactions, but rather set
the price of Thoratec at $18 a share, $1 over the market price. As a result, Equity Holding Inc.
had a reported tax loss. IAT showed a gain. But IAT was held in trust for Kellogg’s children and
the gains were tax exempt. Shortly after, IAT sold 1,000,000 shares back to Equity. This
created an increase in holding of only 300,000 shares by Equity. But there was no change in
substantive ownership, because Kellogg owned both companies.

In the second transaction, IAT sold 500,000 shares of Thoratec to Kellogg’s personal account
and 500,000 shares to MMK Reinsurance, a unit of IAT. In total, 1,000,000 shares of Thoratec
stocks were transferred from IAT into two separate accounts. Again, shortly after, both
Kellogg and MMK sold 500,000 shares of Thoratec respectively back to IAT. As a result,
there was no change of ownership in Thoratec. The trades from these two transactions
accounted for 54 to 84 percent of the daily volume in Thoratec stock.
DISCUSSION QUESTIONS

1. What do you think Kellogg’s intentions were in making the trades? If a trader doesn’t intend
to manipulate the market by trading, but his or her actions result in false market
information, is the trading activity still unethical? Does your judgment about whether
the activity is ethical depend on the trader’s professional background?

2. Under what conditions do you think trading for tax purposes is ethical? Unethical?

3. Do you think reporting the transaction at prices other than the market prices was ethical?

4. Who might have been hurt by Kellogg’s actions? NDT nhỏ lẻ

CASE 16 MERRILL LYNCH AND BANK OFAMERICA MERGER: BONUSES PAID

TOMERRILL EMPLOYEES—EXCESSIVE COMPENSATION? (Peck, 2011)

Bank of America agreed to merge with Merrill Lynch in fall 2008. The merger was to be
completed early in 2009 and was prompted by huge losses sustained by Merrill. The company
had suffered losses in mortgage-backed securities (MBS) and collateralized debt obligations
(CDOs). These securities were bundles of loans. Bundling was assumed to minimize the risk of
these securities. When home prices collapsed and defaults increased, the value of these securities
dropped dramatically. The merger was intended to bail out Merrill Lynch and create
opportunities for Bank of America to expand through an acquisition. Merrill was bought for
$50 billion, a 70 percent premium over the market value of Merrill at the time of the agreement
with Bank of America.

Merrill’s policy was to pay out bonuses in January. Because of the merger, bonuses instead
were paid out in early December before the firm’s year-end results were available. About
$3.6 billion in total was paid out to the top 200 employees. John Thain, the CEO of Merrill
Lynch, was paid a $10 million bonus. The bonuses were based on a formula that provided for a
bonus pool that was 41 percent smaller than the pool for the prior year. In the prior year,
Merrill’s share price had fallen by 65 percent.

Subsequent year-end results showed fourth-quarter losses of $13.8 billion. These losses were
not known either at the time of merger or when the bonuses were paid out. In addition, there
was some concern that traders may have mismarked their books to earn bonuses.

For example, a Merrill currency trader in London, Alexis Stenfors, earned a bonus on a trading
profit of $120 million. While Stenfors was on vacation, Bank of America risk officers discovered
irregularities in his trading accounts, which showed substantial losses. Stenfors was also
investigated by British regulators.

After the award of bonuses, Merrill Lynch traders also marked down trades on some credit
default swaps by several hundred millions of dollars. Credit default swaps are insurance
policies issued on bonds. If the originator of the bond defaults, the issuer of the credit default
swap agrees to make up the loss. A premium is charged for the swap, as with an insurance
premium. In fall 2008, the market for these instruments had become illiquid and the write-downs
were based on a bond index.

DISCUSSION QUESTIONS

1. In the context of both the merger and Merrill Lynch’s shareholder losses, do you think
the bonus payments were fair? Why or why not?
CEO chấp nhận rủi ro để được bonus nhiều.
2. Was the payout of the bonuses in December, before fourth-quarter results were known,
ethical?
3. Do you think subsequent write-downs of trades reflect that the original trades were
recorded unethically?

Question 3:

Question 4:

A member describes an interest-only collateralized mortgage obligation as guaranteed by the

U.S. government because it is a claim against the cash flows of a pool of guaranteed mortgages,
although the payment stream and the market value of the security are not guaranteed. Is there any
violation in this case?
Question 5

Question 6:

Question 7:
Question 8:
Alvise Lorenzo is a portfolio manager and a close friend of Mario Sabatini, the CEO of LOS
Corporation. During a private conversation with Sabatini, Lorenzo found out that LOS is likely
to lose an important lawsuit. This information has not been made public. Lorenzo advises his
clients to reduce their investment in LOS Corporation. Which standard did Lorenzo least likely
violate:

A. Preservation of Confidentiality.

B. Independence and Objectivity.

C. Material Non-public Information.

Question 9: Which of the following is correct under the Code and Standards?

A. Financial analysts are free to act on conclusions based on both public and nonmaterial
nonpublic information.

B. Financial analysts can act on material nonpublic information if it’s provided by industry
experts.

C. Financial analysts from large firms can disseminate inside information of a company than
analysts from small firms.

Question 10
Bronson provides investment advice to the board of trustees of a private university
endowment fund. e trustees have provided Bronson with the fund’s financial information,
 including planned expenditures. Bronson receives a phone call on Friday afternoon from
Murdock, a prominent alumnus, requesting that Bronson fax him comprehensive
financial information about the fund. According to Murdock, he has a potential
contributor but needs the information that day to close the deal and cannot contact any of
the trustees. Based on the CFA Institute Standards, Bronson should:

A. Send Murdock the information because disclosure would bene t the client.

B. Not send Murdock the information to preserve confidentiality.

C. Send Murdock the information, provided Bronson promptly notifies the trustees.