How To Avoid Getting Arrested When Mismarking Your Month-End Bond Book

Mismarking one's book, especially in illiquid, OTC securities usually for month-end, P&L purposes is nothing new.

We noted it several years ago in the case of the JPM London Whale where, as we reported back in May 2012, JPM's CIO unit "was valuing some of its trades at prices that differed from those of its investment bank, according to people familiar with the matter. "I’ve never run into anything like that,” said Sanford C. Bernstein & Co.’s Brad Hintz in New York. “That’s why you have a centralized accounting group that’s comparing marks” between different parts of the bank “to make sure you don’t have any outliers,” said the former chief financial officer of Lehman Brothers Holdings Inc."

As we then added, "Iksil was merely abusing the little loophole used by every CDS trader since time immemorial" namely to show some creative book marking at month end, and "override" official marks while using prices, in many cases fabricated, to show a better performance.

JPM was not the first. Recall also from 2012 the story of a UBS trader who was fired for mispricing securities: Ramon Braga, a trader on the bank’s corporate-credit desk in London, was fired for collusion in the alteration of “marked-to-market” values of credit default swaps by Denis Minayev. Minayev, a proprietary trader, “re-marked” Braga’s trading book on 66 occasions, even though he shouldn’t have had the authority to do so, UBS investigator Richard Kennedy said.

“If you shift one of those markers, it can give a completely false picture,” employment Judge Graeme Hodgson said at the hearing. Braga, who is suing for unfair dismissal, was an inexperienced trader who was “thrown in at the deep end,” his lawyer, Amy Sander, said at the hearing. He wasn’t aware of many of the changes Minayev made, she said, and thought his actions were permitted by managers. Braga was also accused by UBS of “procuring a false broker quote,” she said.

The unspoken truth here is that virtually anyone who has traded illiquid OTC securities like CDS and bonds, either Level 2 or especially Level 3, has most likely fibbed on occasion, especially if it made their performance look better. However, like in the case of JPM or even UBS, nobody had actually gone to jail, or even been arrested for such a transgression.

Until yesterday.

On Wednesday, a hedge fund manager working for NY-based Visium Asset Manager, was charged with trading on confidential tips about drug approvals, in one of the biggest insider trading cases since a 2014 court ruling made it harder for U.S. prosecutors to pursue them. U.S. Attorney Preet Bharara in Manhattan accused Sanjay Valvani of fraudulently making $25 million by gaining advance word about U.S. Food and Drug Administration approvals of generic drug applications. Prosecutors said the inside information was provided by Gordon Johnston, a consultant who got tips from a friend and former FDA colleague still working at the agency. Valvani passed some of these tips to Christopher Plaford, then a Visium portfolio manager, who made his own illegal trades, prosecutors said.

Valvani, who lives in New York, has been at Visium since its inception and was put on leave in April. He managed pharmaceutical investments and as much as $2 billion, including borrowed money. He pleaded not guilty in Manhattan federal court and was released on $5 million bond.

However, while Valvani's alleged violation was a clear case of trading on inside information, and hardly notable, in a less noticed part of the complaint the government also charged former Visium employee Stefan Lumiere over a separate scheme involving the alleged mismarking of securities, precisely the kind of scheme discussed above. Lumiere was arrested Wednesday and released on $1 million bond. His lawyer said he’s innocent. Lumiere was charged with using sham broker quotes to mismark the value of as many as 28 securities a month. The two secretly passed the fake prices via cell phone or a flash drive delivered by a courier from 2011 to 2013. The inflated fixed-income values pushed up returns, increasing management fees by more than $5.9 million, the U.S. said.

Unfortunately for Lumiere, he was the designated fall guy for the government hell bent to crack down on a practice that countless others have openly and repeatedly engaged in - think of it simply as non-GAAP marking - after all, mismaking positions ultimately catches up with you unless the marks go your way.

Then again, when reading the complaint, it appears that Stefan did take it a little bit too far.

So for those curious what not to do when "overriding" month-end bond prices with fabricated marks in order to avoid arrest, here it is straight from the criminal complaint.

First, a quick recap of just why Lumiere was arrested:

From at least in or about 2011 through at least in or about September 2013, STEFAN LUMIERE, the defendant, Cooperating Witness 1 (CW-1), and Cooperating Witness 2 (CW-2) participated in a scheme to defraud Fund-i's investors and potential investors by deceptively mismarking each month the value of certain securities held by Fund-1. The objective of the scheme was two-fold: (1) to inflate Fund-i's NAV, which was a calculation of the Fund-i's total value by determining the market value of each of its holdings minus its liabilities; and (2) to mislead investors about the liquidity of Fund-I's holdings. Investment Advisor-A assessed performance fees to be paid by investors each year based on Fund-l's profits and losses. LUMIERE's mismarking was in violation of Investment Advisor-A's internal valuation procedures and contrary to Investment Advisor-A's representations to investors. The effect of the scheme was to overstate Fund-l's NAV, often by tens of millions of dollars as calculated at the end of each month, which resulted in higher payments to Investment Advisor-A and higher bonuses for LUMIERE, among other benefits. The effect of the scheme was also to deceive investors into believing that certain securities were properly categorized as Level II, when, in fact, these securities were highly illiquid Level III investments.

So far so good: hardly news to any bond PMs (yes, you know who you are). As the complaint further details, there was hardly anything novel about Lumiere's method:

The fraud took at least two forms. First, STEFAN LUMIERE, the defendant, CW-1, and CW-2 solicited, obtained, and relied on false and fraudulent price quotes from employees of broker-dealers—such as Broker-1 and Broker-23—in order to improperly override prices calculated by the Administrator and artificially inflate Fund-i's NAV each month. For each month-end valuation, LUMIERE and/or CW-2 would begin by reviewing an inventory of Fund-i's investments, and proposed valuations for each, prepared by the Administrator and Investment Advisor-A's back office. LUMIERE and/or CW-2 would then identify those relatively illiquid securities as to which they disagreed or disliked the proposed price, and create a list of prices reflecting where they wanted each security to be marked for month-end valuation purposes (the "Override List"). That price was often significantly higher or lower than the price available from public price data. Typically, LUMIERE, CW-1, and/or CW-2 would then contact one or two "friendly" brokers- most often Broker-1 and Broker-2 - and dictate to the friendly brokers the price quotes that LUMIERE, CW-1, and/or CW-2 needed. The brokers would then parrot back the price quotes from their Bloomberg email account, giving the price quotes the appearance that they had come from an independent broker, and thus were in compliance with the Fund's alternative pricing methodology. LUMIERE, OW-I, or CW-2 then submitted the friendly brokers' sham quotes as purportedly independent bases for that security's valuation to Investment Advisor-A's accounting department ("Accounting"), for the eventual submission to the Administrator.

Also a perfectly familiar practice to thousands. However, where Stefan did take it a little too far was in several specific examples, such as ATI Enterprises:

Investment Advisor-A's internal records, which contained data from Markit (a service that provides market data related to, among other assets, debt traded over-the- counter, and which is used by firms for valuation and trading purposes), priced the ATI Senior Debt at $32.50 for the month ending September 2011. At this valuation, Investment Advisor A's position in this bond would have been valued at approximately $6,495,456.


On or about September 30, 2011, Broker-1 sent a Bloomberg to STEFAN LUMIERE, the defendant, that included a quote for, among other assets, "ATI 1st," or the ATI Senior Debt. The quote indicated an offer to buy the debt at $85 (the "bid") and sell it at $92 (the "ask").


On or about October 3, 2011, Broker-2 sent a Bloomberg to STEFAN LUMIERE, the defendant, with an offer to buy the ATI Senior Debt at $86 and sell it at $90.


For the month of September 2011, CW-2 sent CW-1 an Override List that included CW-2's valuation of $88.50 for senior debt issued in connection with the acquisition of ATI Enterprises in or about September 2011 (the "ATI Senior Debt"). Based on this valuation, Investment Advisor-A's total position in the ATI Senior Debt for the month September 2011 was at $17,687,628 (the vast majority held in Fund-1), which was over $11 million more than Investment Advisor-A's valuation of its share of the ATI Senior Debt.

So taking a 32.50 price and boosting it by 172%... not bad.

The next example, Nebraska Book Company, was not quite so egregious:

SEC Price Data from TRACE (which records historical trade information for bonds, such as the Nebraska Book 10% Bonds) indicated that the Nebraska Book 10% Bond traded between $70 and $77.75 on December 30, 2011 (the last day of trading for the month). The Administrator initially valued Fund-i's position of Nebraska Book 10% Bonds using a price of $70.50. On or about December 6, 2011, Broker-2 sent a quote to, among others, STEFAN LUMIERE, the defendant, and CW-2 at Investment Advisor-A, indicating an offer to buy Nebraska Book 10% Bonds for $80. On or about December 12, 2011, Broker-2 sent another quote indicating an offer to buy the Nebraska Book 10% Bonds for $82. As was the case with the $80 offer on December 6th, this quote was sent to LUMIERE and CW-2 at Investment Advisor-A. On or about December 30, 2012, Broker-2--in spite of the quotes Broker-2 had sent earlier in the month, and the actual trades executed on December 30, 2011-   sent LUMIERE a  price quote offering to buy the Nebraska Book 10% Bond at $90 and sell at $93. In addition, on or about January 3, 2012, Broker-3 sent LUMIERE a price quote offering to buy the Nebraska Book 10% Bond at $90 and sell it at $92.


These quotes ultimately were sent to the Administrator, who changed the valuation of Fund-l's position of Nebraska Book 10% Bonds using a price of $91. This change--from $70.50 to $91--caused the overall valuation of Fund-1's holdings of Nebraska Book 10% Bonds to be increased by approximately $2,473,735.

This time only a 29% mark up. Worth of a golf clap, but nothing to write home about.  But things got really aggressive with China Media Technologies, a Chinese company with public bonds... which just so happened had just filed for bankruptcy, whose assets could not be found, and whose CEO disappeared:

On or about August 3, 2012, China Med publicly announced in a 6-K report that on July 27, 2012, a Cayman Islands' bankruptcy court had appointed liquidators in connection with a June 15, 2012 bankruptcy filing by China Med. STEFAN LUMIERE, the defendant, and CW-2 received that 6-K report on or about August 7, 2012. On or about August 31, 2012, media reports on the China Med bankruptcy noted that China Med had "in various documents list[ed] operations in Beijing, Hong Kong and the Cayman Islands," but that, as of that date, "the liquidators ha[d] been unable to locate any other [China Med]. assets anywhere in the world outside the Cayman Islands." One of the liquidators was quoted as saying, "[I]t appears the company's financial troubles resulted from alleged 'fraudulent transfers' of assets and that the money is missing." 


For the month ending August 31, 2012, the SEC Price Data, which contained data from TRACE, indicated that particular bonds issued by China Med with a four-percent coupon rate and a maturity date of August 15, 2013 (the "China Med 4% Bonds") had last traded in August 2012 at a price of $16. The Administrator initially valued Fund-l's position of China Med 4% Bonds using a price of $13.


On or about September 4, 2012, in connection with Fund-l's month-end valuation for August 2012, STEFAN LUMIERE, the defendant, received a quote from Broker-2 for China Med 4% Bonds. In that quote, and despite the publicly available information regarding China Med's bankruptcy and the market's corresponding historical trading information,. Broker-2 provided an offer to buy the bonds at $36 and sell for $40. Similarly, on or about September 11, 2012, LUMIERE received a quote from Broker-1 offering to buy the China Med 4% Bonds for $37 and sell them for $41.


Broker-i's and Broker-2's quotes were ultimately sent to the Administrator, who changed the valuation of Fund-i's position of China Med 4% Bonds using a price of $38. This change in price--from $13 to  $38--caused the overall valuation of Investment Advisor-A's holdings of China Med 4% Bonds to be increased by approximately $9,244,500.

So from 13 to 38, a 192% mark up. Truly Impressive, especially considering this was on a bankrupt company, and one, which as the filing also adds, "the pricing was "not legitimate," because the CEO of China Med went missing."

But wait, that's not all. Lumiere also came up with the rather ingenious idea of building up substantial positions, and then using tiny, oddlot money losing trades to reprice positions, aka "painting the tape."

[O]n or about October 28, 2011, LUMIERE and CW-2 caused Fund-1 to purchase an additional 760,000 China Med 4% Bonds at $71.50, just two days after, as Lumiere and CW-2 knew, the fund had paid $63.51 for 585,000 of the same bonds. There was only a small amount of trading activity in the China Med 4% Bonds between Fund-1's October 26 and October 28 trades, never at or higher than $64. Thereafter, Reuters increased its pricing for the bonds to $71.88, which LUMIERE and CW-2 used for the October 2011 month-end valuation of Fund-l's position.


In addition, on or about March 23, 2012, LUMIERE and CW-2 caused Fund-1 to purchase an additional 784,000 of China Med 4% Bonds at $43.25. Earlier that week, the same bonds had traded no higher than $30. LUMIERE and CW-2 later marked the China Med 4% Bonds at $43.50 for their March 2012 month-end valuation. Reuters, however, valued the China Med 4% Bonds at the end of March 2012 at $28.80.

There are many more such examples, which while not original per se, were rather sizable (and can be found in the full filing below). How sizable?

As just one example of the monthly inflation of Fund-i's performance by STEFAN LUMIERE, the defendant, and CW-2, for the month-end of April 2012, Fund-i's NAV was approximately $451,294,620. However, at least approximately $26,347,352, or 6.2%, was attributable to LUMIERE's and CW-2's mismarking of particular bonds on the Override List--the price for which was supported by Sham Broker Quotes--insofar as LUMIERE's and CW-2's prices for those bonds were markedly higher than the price of those bonds as determined by publicly available pricing sources.

What is the take home message from all of this? Simple: while month end window dressing and painting the tape have for years been a favorite pastime of modestly underwater portfolio managers, it seems those days are now over, and the DOJ and SEC are now actively cracking down on perpetrators. Too bad that they did not do anything when JPM did precisely what this "small fry" Visium portfolio manager did, and instead let all the CIO guys walk, when they were guilty of this and much more, especially since their mismarks resulted in hundreds of millions in unearned profits.

Sadly for Stefan, his greatest crime was not doing what so many other credit PMs have done, and still do every single day, but getting caught.

And as is by now common knowledge, the only people who have immunity from that are the "golden children" who happen to be CEOs of the Too Big To Prosecute banks, at the biggest, taxpayer bailed out banks, the ones which have given generously to Hillary Clinton's campaign and paid $250,000 a pop to "listen" to her speak.

Everyone else is now fair game.

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Full FBI complaint below (link)