Trustee alleges brokers bribed fund manager
A suit from bankruptcy court shines a light on the unusually close relationship between a collapsed fund and two traders from FTN Financial.
NEW YORK (Fortune) -- A lawsuit filed in the wake of the spectacular explosion of a once-sleepy cash management firm in the summer of 2007 is pointing to a corrupt business relationship between its head trader and some brokers as the basis for its collapse.
Sentinel Management Group's August 2007 bankruptcy filing stunned the financial markets principally because the company - a cash management firm investing surplus capital for Chicago's commodity and futures brokers - held itself out as an ultra-conservative custodian of its client's money. Indeed, the Northbrook, Ill. based firm stated on its Web site and in marketing materials that it invested in only the most liquid and highly-rated government and corporate bonds. When the firm collapsed, it froze $1.6 billion in client assets, decimating dozens of brokers who needed the cash to meet their own trading needs and leading to about $550 million in losses.
But the reality of Sentinel's trading was vastly different than its promises to clients, alleges a lawsuit filed last week by Frederick Grede, the appointed bankruptcy trustee in Illinois Federal court.
In the trustee's filing, Sentinel is described as little more than a covert structured products hedge fund, complete with an undisclosed $230 million loan from The Bank of New York (BK, Fortune 500), illegally secured by client assets. In essence, Sentinel - like dozens of other brokerages and hedge funds - was seeking to put on a carry trade, in which low-interest loans enable the purchase of higher-yielding assets, with income derived from the spread between the two rates.
Named as defendants in the suit are a trader and salesman from First Horizon's FTN Financial Securities unit, one of the larger so-called regional brokers serving institutions often overlooked by larger Wall Street firms, as well as FTN Financial itself.
Grede's suit, which was first noted on the Naked Shorts blog, spares little detail in accusing Memphis-based FTN of concocting a multi-year scheme to "co-opt," "dupe," and "bribe" Sentinel's head trader, Charles Mosley, into buying hundreds of millions of dollars worth of dubiously-valued CDOs from the firm.
To get Sentinel to buy securities that were almost comically unsuitable for its portfolios took little more than one hell of a travel and entertainment budget, according to Grede's claim.
The suit accuses FTN's Chicago-based FTN trader Stephen Folan and an ex-salesman, Jacques De Saint Phalle (now working at Sandler O'Neill) as having spent an inordinate amount of time and money to "suborn and compromise" Mosley. Folan declined comment; De Saint Phalle did not reply to an e-mail and a voice message seeking comment.
Mosley's lawyer declined comment, citing pending litigation, including possible action by federal prosecutors.
For its part, a spokesman for FTN's parent, First Horizon (FHN), e-mailed a statement to Fortune.
It said: "We have received a copy of the complaint filed by the Sentinel Management Group bankruptcy trustee against First Horizon National Corp.'s FTN Financial Securities Corp. subsidiary relating to FTN Financial's sale of securities to Sentinel. FTN Financial has substantial legal and factual defenses and will vigorously defend itself against the trustee's claims."
While entertaining clients with dinner and drinks or at sporting events and concerts is a long-standing Wall Street business practice, Grede's claim details an unusual amount of entertainment that the suit claims was worth "thousands of dollars annually."
FTN's Folan and De Saint Phalle are accused of repeatedly providing Sentinel's Mosley with complementary airfare and hotels in New York, St. Louis, Memphis and Florida, use of vacation homes, golf, frequent expensive meals and liquor, limousines, and the best tickets to numerous pro and collegiate sporting events.
The alleged booze-soaked excess is all the more eye-opening in light of the whirlwind Jefferies Group reaped when it tried to win equity order-flow business from mutual fund giant Fidelity Research & Management by plying its traders with strippers, free wine and lavish Miami Beach bachelor parties. At one such party paid for by Jefferies in 2003, activities included dwarf-tossing.
In response, FINRA, the securities industry's self-regulatory arm, put in place rules that prohibit gifts worth more than $100 per person.
The aggressive purchasing of CDOs was certain to prove deeply problematic for Sentinel at some point, given the fact that CDOs were much less liquid than the short-term Treasury bills the fund told its customers it was trading.
These were not just "garden-variety" CDOs however, but rather a security that FTN and another investment bank, Keefe, Bruyette & Woods, had developed called Preferred Term Securities Limited (or PreTSLs), which would help banks with their capital requirements. Many pieces of these PreTSLs were unrated and illiquid, with no real secondary market apart from whatever KBW or FTN (firms with much less ability to buy and hold securities than their larger rivals) were willing to pay. In one instance, the suit claims, FTN and De Saint Phalle arranged for an unnamed ratings agency to give one PreTSL transaction an investment-grade rating, which cost Sentinel "tens of thousands of dollars."
Adding insult to injury, the suit alleges that FTN's Folan and De Saint Phalle represented to Mosley that a specific PreTSL backed by loans from HomeBanc had little sub-prime mortgage market exposure and was in solid shape, credit-wise. HomeBanc - whose heavy exposure to the sub-prime mortgage market was well known - filed for bankruptcy that August.
According to Grede's claim, the wining and dining paid off in spades.
At one point, with just $13 million in non-customer capital, Sentinel had purchased $185 million of these securities, many of them from FTN, sending millions of dollars of fees to its trading desk.
Of course, fairly valuing these bonds proved difficult given the absence of a secondary market.
Grede's suit alleges that FTN's De Saint Phalle advised Sentinel's Mosley to devise an illegal strategy for valuing the paper at a profit. (In an ironic twist, the suit claims that De Saint Phalle had been warned in 2005 by a supervisor at his then firm, KBW, that selling these sorts of bonds to Sentinel was inappropriate given the nature of its business.)
In essence, he allegedly suggested Mosley enter trades in Sentinel's computer system at a lower interest rate than they actually were slated to pay. This would create an automatic profit when the higher interest rate was paid, which in turn could be used to offset losses incurred when Sentinel sold the paper at what FTN was willing to buy it back for. If true, it appears to be a textbook case of improper valuation.
Likely just as troubling to Sentinel's burned creditors, the trustee's suit claims that FTN labored to arrange a series of dubious repurchase transactions at the end of 2006. These trades allowed Sentinel to get the paper off its books for a short period, as well as provide its clients (who had no knowledge they were exposed to these securities) with year-end cash.
In another instance, the suit alleges that in April of 2007, FTN's Folan helped engineer a series of trades with no economic value that allowed Sentinel's Mosley to book an inflated $1.6 million gain for himself (resulting in a $160,000 bonus), while allowing FTN to unload more illiquid securities to Sentinel.
Grede's suit claims the scheme unraveled in July of 2007 when Sentinel's various repo counter-parties demanded more collateral to continue financing the positions. Coupled with client demands for their assets, the firm was forced to suspend redemptions.
In May, Sentinel's head, Phillip Bloom, and his son Eric, settled litigation with investors for $10.7 million, which a statement said was "substantially all" of the pair's assets.
This June, both the Securities and Exchange Commission and Commodities Futures Trading Commission filed a civil suit charging Eric Bloom and Mosley with orchestrating a fraud using customer money to engage in inappropriate and self-serving transactions.
Calls to two of Bloom's lawyers were not returned.
For its part, First Horizon, FTN's bank-holding company parent, will be able to soldier on in the securities business, having received an $866 million infusion of government cash under the Treasury's TARP [troubled assets recovery program] program.