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Securities and Exchange Commission v. J.P. Morgan Securities LLC

United States District Court, District of Columbia

January 4, 2017

J.P. MORGAN SECURITIES LLC, et al., Defendants.


          JAMES E. BOASBERG United States District Judge

         The Securities and Exchange Commission has, to its detriment in this case, taken too literally the immortal admonition of the famed 1990s pop-music trio TLC: “Don't go chasing waterfalls.” The fountainhead of the current dispute is located in a settlement between Plaintiff SEC and Defendants J.P. Morgan Securities LLC and various related entities. The Commission thereby obtained nearly $75 million in disgorgement, prejudgment interest, and civil penalties for that company's misrepresentations in its offerings of residential mortgage-backed securities.

         Two Investors, EP Structured Credit Strategies Fund, Ltd. and CXA-13 Corporation, now object to the SEC's proposed pro rata distribution plan of those sums. They contend that higher-priority investors should instead be paid out first - in a so-called “waterfall” payment structure - and that the Commission failed to ask the Internal Revenue Service whether such a scheme would be feasible under the tax code. Because the Court concludes that the SEC should have chased down this waterfall and assessed its viability, as required by the settlement agreement, it will direct the Commission to do so and then submit a new distribution plan.

         I. Background

         This lawsuit is best characterized as a vehicle to distribute settlement proceeds obtained by the SEC. Although the case originated with a Complaint, as most do, Defendants simultaneously consented to the Court's entry of judgment. See ECF Nos. 1 (Complaint), 1-2 (Consent), 1-3 (Proposed Judgment). J.P. Morgan did so “[w]ithout admitting or denying the allegations of the complaint.” Consent, ¶ 2; see generally SEC v. Vitesse Semiconductor Corp., 771 F.Supp.2d 304, 308-10 (S.D.N.Y. 2011) (retracing history of “neither admit nor deny practice” in SEC enforcement actions).

         This Opinion must nevertheless provide some background. In doing so, the Court primarily relies on the Complaint's telling of the relevant facts (while drawing from the parties' submissions as necessary), realizing that J.P. Morgan has not conceded that any of the below events actually happened.

         A. Structure of RMBS Trusts

         As with many residential-mortgage-backed-securities (RMBS) disputes, this one began before the financial crisis. Around October 2006, J.P. Morgan purchased nearly 10, 000 subprime mortgage loans from WMC Mortgage Corporation, a loan originator, in a deal worth roughly $2 billion. See Compl., ¶¶ 19, 61, 66. Following several transactions within the J.P. Morgan family of companies, Defendant directed that 9, 637 loans would be held by J.P. Morgan Mortgage Acquisition Trust 2006-WMC4. Id., ¶ 67. The Trust, in turn, sought to attract investors.

         Much has been said about how financial firms mold loans into investments. In describing the process, perhaps movies such as Inside Job, Too Big to Fail, or The Big Short are of greater use than the Complaint, which assumes some fluency in Wall Street-ese. Here is the basic vocabulary. Residential mortgages require monthly payments from homeowners. Gather enough of these mortgages together, and the owner of the loans can reap an ample monthly cash flow. Id., ¶¶ 22-25. For investors looking for long-term revenue, a collection of mortgages may fit the bill. In this case, the WMC4 Trust held one such pool. Id., ¶ 67. That Trust remains active today.

         Pooling mortgages may also offer benefits for smaller investors. For an individual seeking a steady income stream, a percentage share of a bundle of mortgages may be more attractive than owning a single mortgage worth that same value. Where a single homeowner may default, it is less likely - though still possible, as the financial crisis made clear - that many in a pool will simultaneously do so. The next step is thus to structure the mortgage-ownership opportunity so that many different types of investors can buy in.

         To attract all the partygoers to the fete, a company (like J.P. Morgan) thus divvies up the ownership interests of a single mortgage bundle. In this case, the WMC4 Trust would sell to investors securities (i.e., certificates representing discrete ownership interests) backed by the group of residential mortgages (hence, RMBS). Id., ¶ 28. As discussed, the securities would then entitle those investors to a long-term share of the Trust's monthly cash flow. Id. Because the WMC4 Trust, in effect, only passed through homeowners' mortgage payments to investors, it had the added benefit of qualifying as a Real Estate Mortgage Investment Conduit (REMIC) under tax law and was thereby exempt from taxation. Id., ¶ 27.

         One further wrinkle is relevant here. Because investors typically have different risk tolerances based on their financial strategies, RMBS trusts can vary the risk profiles of their securities offerings. In this case, that was done by allowing investors to purchase securities in different-level tranches of the pool. Id., ¶¶ 28, 87-88. Broadly speaking, each month, investors in higher (or senior) tranches would be paid before those in lower (or junior) tranches. Id.

         Because junior investors might receive less or nothing at all, their securities were riskier and thus entitled them to a higher rate of return. Id.

         This tiered-tranche setup is known as a “waterfall” structure. For a casual reader, this metaphor may seem confusing at first because, as seen below, all water that enters a waterfall inevitably ends up in a pond at the bottom:

         (IMAGE OMITTED)

         The proper metaphor would instead be a champagne tower, where the bottom investors are left thirsty until ...

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