Harding Advisory LLC and Wing Chau, two of the subjects in Michael Lewis’ The Big Short: Inside the Doomsday Machinewere held liable last week in an administrative law judge’s initial decision before the Securities and Exchange Commission for misrepresentation, failure to follow an appropriate standard of care, and fraud for their role in the purchase of subprime mortgage-backed assets for certain collateralized debt obligations that subsequently were sold to investors. (The Big Short is a recount of certain investors who profited by trading against the subprime mortgage bond market during the 2008-2009 financial crisis.)

The SEC’s Division of Enforcement previously instituted these proceedings in October 2013.

The Division charged that, during 2006, Harding, acting as a collateral manager for one CDO—Octans I CDO Ltd.—structured and marketed by subsidiaries of Merrill Lynch & Co.—granted a third-party hedge fund—Magnetar—the right to review all collateral before purchase and effectively exercise veto rights. This was never disclosed to debt investors in Octans I, claimed the SEC. Subsequently, Harding deferred to Magnetar’s collateral suggestions, which was helpful to the hedge fund, but not to the CDO’s investors, claimed the SEC.

The SEC also charged that, during 2007, without adequate credit analysis, Harding acquired tranches of another CDO—Norma CDO I—to include in other CDOs that it managed—as a favor to Merrill and Magnetar—to the detriment of the other CDOs' investors.

At all relevant times, Harding was an SEC-registered investment adviser, while Mr. Chau was the firm’s owner and founder.

The judge ruled that Harding violated only some but not all of the specific allegations made by the Division, while Mr. Chau was primarily liable for and solely caused Harding’s Norma (not Octans)-related violations. Notwithstanding, the judge imposed penalties of over US $1 million in disgorgement and prejudgment interest against both respondents; imposed a fine of US $1.7 million against Harding and a fine of US $340,000 against Mr. Chau; revoked Harding’s investment adviser registration; and barred Mr. Chau from association with the securities industry.

A film version of The Big Short—starring Brad Pitt, Ryan Gosling, Christian Bale and Steve Carell—is expected in the near future (click here for details). A legal action by Harding and Mr. Chau against Mr. Lewis and others for libel was dismissed by a US federal court in New York in March 2013, and the dismissal was upheld by a US federal appeals court in November 2014 (click here for the decision).

Harding and Mr. Chau previously failed in their efforts before a United States federal court in New York to have the SEC litigate this case in a federal court and not before the SEC.