Remember collateralized debt obligations, those complex mortgage securitizations that shouldered much of the blame for the financial crisis? They were back in the news again this week when Merrill Lynch, a division of Bank of America, agreed to pay $131 million to settle allegations of wrongdoing related to those financial products.

On Thursday, the SEC announced the settlement with Merrill Lynch over making faulty disclosures about the collateral selection for two CDOs it structured and marketed to investors, and for maintaining inaccurate books and records for a third CDO.

The SEC's order instituting settled administrative proceedings finds that Merrill Lynch failed to inform investors that hedge fund firm Magnetar Capital had a third-party role and “exercised significant influence” over the selection of collateral for its Octans I CDO and Norma CDO I products. Magnetar bought the equity in the CDOs and “its interests were not necessarily aligned with those of other investors because it hedged its equity positions by shorting against the [them],” the order says.

“Merrill Lynch marketed complex CDO investments using misleading materials that portrayed an independent process for collateral selection that was in the best interests of long-term debt investors,” said George Canellos, co-director of the SEC's Division of Enforcement, in a statement. “Investors did not have the benefit of knowing that a prominent hedge fund firm with its own interests was heavily involved behind the scenes in selecting the underlying portfolios.”

According to the SEC's order, Merrill Lynch engaged in the misconduct in 2006 and 2007.After four Merrill Lynch representatives met with a Magnetar representative in May 2006, an internal email explained the arrangement as “we pick mutually agreeable [collateral] managers to work with, Magnetar plays a significant role in the structure and composition of the portfolio ... and in return [it] retains the equity class and we distribute the debt.” 

Magnetar's willingness to buy the equity in a series of CDOs gave the firm substantial leverage to influence portfolio composition and the SEC alleges that one-third of the assets for the portfolio underlying the Norma CDO were acquired by it, rather than by the designated collateral manager, NIR Capital Management. 

NIR initially was unaware of Magnetar's purchases, but eventually accepted them and allowed Magnetar to exercise approval rights over certain other assets for the CDO, even though the disclosure Merrill Lynch provided to investors incorrectly stated that the collateral would consist of a portfolio selected by NIR, the SEC says. Merrill Lynch also failed to disclose in marketing materials that the CDO gave Magnetar a $35.5 million discount on its equity investment and separately made a $4.5 million payment to the firm referred to as a “sourcing fee.” 

The SEC also alleges that Merrill Lynch violated books-and-records requirements for another CDO, Auriga CDO managed by one of its affiliates, by not recording many of the warehoused trades at the time they occurred to benefit itself.

Merrill Lynch, without admitting or denying the SEC's findings, agreed to pay a disgorgement of $56,286,000, prejudgment interest of $19,228,027, and a penalty of $56,286,000.

The SEC also announced a settlement with two managing partners of NIR -- Scott H. Shannon and Joseph G. Parish III -- accusing them of “compromising their independent judgment and allowing a third party with its own interests to influence the portfolio selection process of a CDO offered to investors.”

Shannon himself called at least one of the residential mortgage-backed securities ultimately included in the portfolio, amid pressure from Magnetar, a “real stinker.” Magnetar bought the equity in the CDO but also placed short bets on collateral in the CDO and therefore had an interest not necessarily aligned with potential long-term debt investors that relied on the CDO and its collateral to perform well.

Shannon agreed to be barred from the securities industry for at least two years and pay disgorgement and prejudgment interest of $140,662 and a penalty of $116,553. Parish agreed to be suspended from the securities industry for at least 12 months and pay disgorgement and prejudgment interest of $140,662 and a penalty of $75,000. Neither admitted, nor denied, the SEC's findings.The SEC orders did not fine or sanction Magnetar.

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