Scheme or slump? – Investment advisor Walter Morales battles new allegations of fraud in a lawsuit by the SEC.

For years, Walter Morales was one of the best-known and well-respected money managers in Baton Rouge, with a reputation for delivering consistently better-than-average returns, a portfolio that approached $750 million at its peak, and a roster of clients that included retired local professionals, state pension funds and, even, the billionaire Bass family of Texas.

But a lawsuit filed earlier this month by the Securities and Exchange Commission paints a troubling picture of how Morales and his firm, Commonwealth Advisors, were making money. According to the allegations in the suit, Morales lied to his clients about big losses in the risky mortgage-backed securities where he’d invested their money, then tried to hide those losses through a complex series of trades between his various hedge funds using fraudulent prices.

While the SEC suit is civil and alleges no criminal wrongdoing, observers say the damage is already done to Morales’ firm and its reputation. Financial websites and publications plastered the story across their pages in the wake of the filing in early November, and local investors noted that the federal suit validates what they have been saying since filing their own suit against Morales and his firm two years ago.

For his part, Morales is denying the charges. Before the ink on the SEC suit was even dry, his attorney had prepared a statement disputing the SEC’s version of events. In sum, Morales argues Commonwealth got caught in the 2008 crash of the mortgage-backed securities market, and engaged in complex, little understood transactions to try to help, not hurt, its investors. As for fraud, he says it simply didn’t happen.

It will be up to a federal judge to decide. Settlement negotiations between Morales and the SEC fell through earlier this fall. Regardless of the outcome, observers say the case raises interesting questions not only about the local investment firm but also about the industry as a whole.

“As we always say, you never know who is swimming naked until the tide goes down,” says attorney Phil Preis, who is not involved in the case but has represented local clients against the Stanford Group. “The question is, was he swimming naked while the tide was up?”

In a post-Madoff world, in a city where investors were hit particularly hard by the Stanford debacle, the Morales suit seems eerily familiar. More than 100 investors lost millions of dollars they’d invested with a respected and trusted money manager amid federal allegations of fraud.

But there are a couple of important differences. Besides the fact the Morales suit is on a much smaller scale, it’s a civil not criminal case. What’s more, at no point does it actually accuse Morales of stealing clients’ money or misappropriating funds, as he is quick to point out.

“The SEC is not alleging that we took any money we were not entitled to,” he says. “They are not accusing us of running a Ponzi scheme, nor are there allegations in any of the SEC stuff of any money coming to Commonwealth that wasn’t supposed to.”

But some might argue that’s a hairline distinction because the SEC suit does allege that Morales defrauded his clients, particularly a single, “large investor” that had some $149 million invested in various Commonwealth funds.

The suit does not identify the large investor but sources close to the case tell Business Report it is Crestline Investors, which through its various funds manages the wealth of the billionaire Bass brothers of Fort Worth. A spokesman for Crestline declined to comment on the case or confirm Crestline’s identity.

According to the SEC suit, the large investor had $149 million invested in Commonwealth funds. That’s a relatively tiny portion of Crestline’s portfolio, which at times has exceeded $5 billion. But for Commonwealth it was a significant chunk of change, to say nothing of a prestigious client. In fact, Morales describes the “large investor” as his biggest client, though he declines to identify the investor by name.

Commonwealth had other investors, too, and they have filed their own suit against Morales. They include pension funds like the Firefighters Retirement System, the Municipal Employees Retirement System and the Registrars of Voters Employees’ Retirement System. They also include well-known retired doctors, lawyers and professionals, like Dr. Joseph Broyles, who’d invested his life savings with Morales.

“(Morales) had established a reputation of being a really honest, conservative guy,” says Patrick Broyles, who is representing his father and the other local investors in the two-year-old case.

While Morales had that reputation around town, he was also known for delivering consistently better-than-average returns. That’s in large part because as far back as the 1990s, he invested in distressed assets and mortgage-backed securities, as well as the safer, lower-yielding stocks, bonds and mutual funds.

In the Broyles suit, investors argue they didn’t realize how risky their investments were. They also allege Morales misrepresented the types of funds into which he was investing the savings of older, conservative retirees.

“They didn’t know what they were invested in,” says Patrick Broyles of his clients. “They would get these statements that their money was in all these different funds. They just thought they were mutual funds.”

Morales says that’s not true, though he has never formally responded to the allegations in court documents. He says Commonwealth has always been known as a distressed-debt manager and made no bones about it.

“At the end of the day we are a distressed-debt manager,” he says. “The success our clients have had has been on the backs of relatively complicated residential mortgage-backed securities.”

Whether Morales’ clients knew they were invested in hedge funds made up of residential mortgage-backed securities is not at issue in the SEC suit, which is an important distinction between the two cases. What is at issue in the federal suit is what Morales allegedly did to hide losses in those hedge funds that began occurring in 2007, when the market for mortgage-backed securities began to tank.

“Morales and Commonwealth Advisors concealed significant hedge fund losses from investors … instead of owning up to them and facing the consequences,” says Robert Khuzami, director of the SEC’s Division of Enforcement.

Specifically, the SEC suit claims Morales and “a large investment bank,” which has been identified in other court documents as Cantor Fitzgerald & Co. of New York, created a collateralized debt obligation—essentially a big fund of pooled assets—as a way of hiding the losses from investors.

In the end, it was all a big shell game, according to the suit. Morales allegedly put his clients’ funds into the lowest and riskiest classes of the CDO, without their knowledge. Then, as the market continued to go down and the CDO investments continued to plummet, he directed his employees to conduct a series of so-called cross trades between the firm’s hedge funds in order to hide losses from the investors. Those trades were allegedly conducted using fraudulent prices Morales made up to reflect gains for one fund, or group of investors, at the expense of another.

Morales also lied to his large investor about its exposure to the CDO, according to the lawsuit. The large investor had told Morales it didn’t want more than 10% of its equity in the fund that owned the CDO, but Morales allegedly increased the large investor’s exposure to more than double that through a series of deceptive trades.

“What the firm allegedly was doing was investing clients’ money in risky investments—in some cases more than they wanted—and then flipped, swapped and lied to hide the losses so the clients would continue to invest with him,” says one local industry observer.

Eventually, the managing director for the large investor discovered the alleged fraud and requested a complete redemption of its funds. Though the suit does not say how much of the $149 million the investor got back, the redemption was suspended because it would have caused a run on the bank, says Morales’ attorney Fred Tully.

For his part, Morales denies he was trying to hide losses from anyone. Rather, he says Commonwealth and Cantor Fitzgerald together formed the CDO to pool poor-performing securities with better ones and therefore get a better rate of return for his investors.

“The CDO was designed to make our securities better,” he says. “It was created to put them in a bigger pool with fresh ratings on it that would be more liquid and hopefully trade better in the marketplace.”

As for the allegations that he fixed prices on the trades, Morales says that’s not true. However, Tully concedes there were “some pricing irregularities we admit to by subordinate employees” who are no longer with the firm. “When Walter found out about that, he stopped it,” says Tully.

Morales also denies misleading the large investor about its exposure to the CDO. In fact, he says, the large investor had so much money with Commonwealth, it had negotiated, “unprecedented transparency into all the funds. … They had reports.”

But sources familiar with the case says after extensive due diligence, Crestline feels it was misled. “They discovered too many misstatements or outright lies from Morales,” says a source close to Crestline who declined to be identified. “After that they no longer wanted to be in business with him.”

It’s a complex web of allegations, and the SEC suit only scratches the surface. For the local investors, who have been embroiled in a lawsuit against Commonwealth and Morales since 2010, the SEC action is seen as a significant, positive development. Even though it centers on the large investor, not them, they say it validates their arguments and paints a more complete picture of the alleged fraud.

“We think it’s pretty significant that the SEC determined Walter was fixing prices and engaging in illegal cross trades and we, doing our own investigation with limited documentation, came to basically the same conclusion,” says Broyles. “You have two very different roads that lead to the same place.”

Whether it will help them recover the millions they lost is another question. Late last year, Commonwealth placed nine of its hedge funds in voluntary bankruptcy. Morales says the purpose of that action was to expedite a settlement to the litigation and help his clients get some of their money back. But like most federal bankruptcy cases, nothing happens fast.

In the meantime, Tully says, the funds have continued to perform and investors have gotten some principal and interest from their investments, though those returns were halted by the trustee in the bankruptcy case.

It’s unclear whether the large investor is seeking anything. Crestline has not filed suit against Commonwealth and is not asking for money in any court filings. The SEC is asking that Morales pay “disgorgement,” but it does not mention a specific dollar amount.

As for Morales’ future, it remains cloudy at this point. Some believe he could still face criminal charges, though industry experts speculate that because the SEC took the lead in filing a civil suit, criminal charges from the Department of Justice are unlikely.

Gerry Hodgkins, an associate director with the SEC, will not comment except to say, “the Department of Justice is not the SEC, so we cannot speak to whether they are looking at this and why or why not they did not file a criminal complaint.”

Hodgkins is also vague about whether Morales’ securities license could be at stake. The suit does not seek to revoke it, but sources familiar with the procedure say if the courts rule against Morales, the SEC will probably seek to revoke his license through a separate, administrative procedure.

Of course, Morales could settle before then. Though previous talks with the SEC fell through, they could always resume and he could reach a monetary agreement with the agency under which he would repay a certain amount of money without having to admit wrongdoing. He could also fight the SEC charges in court and ultimately be vindicated.

In the meantime, Commonwealth is continuing to do business. The firm has lost some clients, but Morales says it has some new ones, too.

“It’s a hell of a black eye, and it’s a lot to deal with and a lot to put our clients through,” he says. “But the firm has survived and done relatively well.”