Sec. v. David Lee
| Decision Date | 18 June 2010 |
| Docket Number | 09-CV-7557.,08-CV-9962,No. 08-CV-9961,09-CV-3677,08-CV-9961 |
| Parties | SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. David LEE, Kevin P. Cassidy, Edward O'Connor, and Scott Connor, Defendants. Commodity Futures Trading Commission, Plaintiff, v. Kevin Cassidy, Edward O'Connor Optionable Inc., David Lee and Robert Moore, Defendants. CMEG NYMEX Inc., Plaintiff, v. Optionable Inc., Kevin Cassidy, Pierpont Capital, Inc., Edward O'Connor, Ridgecrest Capital Inc., and Mark Nordlicht, Defendants. Bank of Montreal, Plaintiff v. Optionable Inc., MF Global Inc., Kevin P. Cassidy, Edward J. O'Connor, Mark A. Nordlicht, Ryan B. Woodgate Scott Connor and Jospeh D. Saab, Defendants. |
| Court | U.S. District Court — Southern District of New York |
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David Rosenfeld, Joseph O. Boryshansky, Brenda Wai Ming Chang, Scott Lawrence Black, Jess Anthony Velona, U.S. Securities and Exchange Commission, New York, NY, for Plaintiff.
Timothy Pierce Kebbe, Brunelle, Hadjikow & Weltz, P.C., Christopher L. Van De Water, Attorney General of the State of New York, Liam O'Brien, Marni Rae Robin, McCormick & O'Brien L.L.P., Michael J. McAllister, Satterlee Stephens Burke & Burke LLP, New York, NY Lawrence Robert Gelber, Brooklyn, NY, for Defendants.
Nicholas Stoloff Goldin, U.S. Attorney's Office, New York, NY, for Intervenor.
The Securities and Exchange Commission (“SEC”), Commodities Futures Trading Commission (“CFTC”), CME (as successor to the New York Mercantile Exchange) (“NYMEX”) and the Bank of Montreal (“BMO”) have each filed complaints stemming from an alleged fraudulent scheme perpetrated by a BMO trader, his supervisor and certain third-party brokerages between 2003 and 2007. On March 31, 2010, the defendants' motions to dismiss the SEC, CFTC and NYMEX complaints were denied. A conference relating to all four actions as well as further oral arguments relating to the motions to dismiss the BMO complaint were held on April 14, 2010. The Court has determined that issuing one combined decision is appropriate given the facts and issues common to each case. For the forgoing reasons, each of the motions to dismiss pursuant to Federal Rules of Civil Procedure 9(b), 12(b)(6) and the Private Securities Litigation Reform Act (“PSLRA”) is denied.
These four actions stem from a fraudulent scheme to overvalue oil and natural gas derivative options at the Bank of Montreal (“BMO”) resulting in extensive losses. 2 The derivative options at issue are illiquid instruments that are “marked to model,” as opposed to “marked to market,” requiring that their values be determined based on various factors. 3 BMO required that these values be calculated daily by its traders. BMO's market risk division (“Market Risk”) (sometimes referred to as its “back office”) would periodically verify its traders' prices by obtaining valuations from third parties. If there existed a discrepancy between a trader's price and the third-party valuation, BMO would record a reserve based on their “tolerance threshold.” Options can be traded on regulated exchanges, such as the New York Mercantile Exchange (“NYMEX”), or on unregulated exchanges, typically referred to as over-the-counter (“OTC”) exchanges. OTC transactions are inherently riskier than those conducted on a regulated exchange. 4
The alleged fraudulent scheme involved David Lee (“Lee”), a now former BMO trader, sending inaccurate (i.e. his own) pricing information relating to his positions to third-party brokerages, most notably Optionable, Inc. (“Optionable”), as well as MF Global Inc. (“MF Global”) (collectively the “Third-Party Brokerages”). 5 BMO was Optionable's largest client, BMO maintained non-discretionary accounts with the Third-Party Brokerages which, in addition to providing standard brokerage services, also provided valuations of Lee's positions. 6 Optionable and MF Global are accused of merely forwarding Lee's own quotes to Market Risk rather than providing an independent assessment of their validity. Quotes were forwarded by Optionable in three formats; the “broker bid/offer quotes” which simply involved forwarding Lee's bids back to BMO via e-mail; the “grid bid/offer quotes” which involved submitting grids suggesting that quotes were received from multiple sources via Optionable's OPEX Analytics RealMarks (“OPEX”) trading platform (designed to compete with other multi-party valuation services that BMO had been considering and began utilizing in 2006); and the “other market participants' bid/offer quotes” which involved the use of allegedly fraudulent instant messages (“IM's”) designed to mislead Market Risk into believing that they were quotes originating from other brokerages. MF Global provided price quotations on spreadsheets as well as through IM's. At the heart of the parties' dispute is whether Optionable and MF Global were providing “independently derived bids,” representing those available in the market place, or, at the very least, utilizing “other market participants” data in reaching a “consensus.”
Lee was a natural gas trader at BMO from 2000 until 2007. (CFTC Cplt. ¶ 7.) He traded a variety of exchange-traded and over the counter (“OTC”) options. ( Id. ¶ 28.) Optionable and MF Global provided brokerage services in commodity derivative transactions. ( At the end of each trading day, Lee was required to assign a value to the option positions that comprised his “book” and did so using a computer based “mark to model” method that utilized mathematical equations to forecast the value of each position. (CFTC Cplt. ¶¶ 24, 28.) Depending on the profitability of his trades, Lee was eligible for salary increases and bonus payments. ( Id. ¶ 16.) In order to verify its traders' positions, BMO employed certain procedures known as the independent price verification process (the “IPV Process”). ( Id. ¶ 29.) The IPV Process' was utilized to ensure that BMO's trading books were reasonably in line with market prices quoted by external sources. ( Id.) Optionable was BMO's primary source for brokerage information related to the IPV Process. ( Id. ¶ 33.) BMO's employees involved in the IPV process “believed that the bid/offer quotes they received from brokers represented the brokers' independent assessment of the bids and offers currently available in the market for certain option strips.” ( Id. ¶ 30.) If the IPV process resulted in a discrepancy between a trader's model and the brokers' assessment, BMO would make a valuation adjustment based upon their “tolerance threshold.” ( Id. ¶ 32.) In addition to the IPV Process, BMO's Market Risk Division employed a volatility skew verification process (the “VSV Process”) to ensure that BMO's trading books were in line with other market participants skews. ( Id. ¶ 34.)
In spite of BMO's safeguards, Lee was able to mis-mark his book by approximately C$221,875,297 as of January 21, 2007 and C$257,801,706 as of March 30, 2007. ( Id. ¶ 35.) On April 27, 2007, BMO announced that, due in large part to Lee's mis-marking, it would suffer losses between C$350,000,000 and C$450,000,000. ( Id.) On May 17, 2007, BMO announced that it had re-estimated its losses to be approximately C$680,000,000. ( Id. ¶ 41.)
Lee was able to carry out his mis-marking by fabricating bid/offer quotes and transmitting them to the Third-Party Brokerages, chiefly Optionable, who would in turn re-submit them to BMO employees carrying out the IPV process. ( Id. ¶¶ 44-48.) This process is referred to as “u-turning.” (SEC Cplt. ¶ 25.) The price quotes Lee sent to Optionable and MF Global were generally more favorable to his positions than actual market prices, allowing Lee to overstate the value of his positions and bypass BMO's internal controls. (BMO Cplt. ¶¶ 37, 53.) Over time, these tactics became more elaborate. For instance, Optionable developed a service called “OPEX Analytics RealMarks” (“RealMarks”) which claimed to provide a greater array of independent quotes, but in fact involved Lee fabricating bids and offers and emailing them in grid format to Optionable from his home computer. (CFTC Cplt. ¶ 50.) Optionable would then submit Lee's grids to BMO's back office. ( Id.) “RealMarks” was designed by Optionable to compete with Totem RealMarks (“Totem”), another multi-contributor service which BMO was considering, and ultimately subscribed to (BMO Cplt. ¶¶ 65-73.) In order to circumvent the VSV Process, Lee and Cassidy engaged in a similar practice of submitting falsified IM's that were recorded by BMO's Market Risk Division to monitor volatility skews by comparing their own skews to those of supposed other market participants. ( Id. ¶ 52.) The three aforementioned practices are referred to individually as the “broker bid/offer quotes” the “grid bid/offer quotes” and the “other market participants' bid/offer quotes”. ( Id. ¶ 55.) MF Global also submitted price quotes in spreadsheet and IM format. (BMO Cplt. ¶¶ 44-52).
These practices are alleged to have allowed Lee to mis-value his positions and enter into higher-value, riskier trades including “1x2” trades 7 designed to circumvent BMO's “value-at-risk” (“VaR”) models and “exchange of options for options” (EOO 8 ) trades designed to circumvent BMO's internal controls. Lee also mis-valued certain paired option or “straddles” amongst other trades. (CFTC Cplt. ¶¶ 37-39.) Lee's supervisor was Robert Moore (“Moore”) who served as the executive managing director of BMO's Commodity Derivatives Group during the relevant period. ( Id. ¶ 8.) Moore is claimed to have knowingly permitted Lee to make these trades and further the alleged fraudulent scheme. ( Id. ¶¶...
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