Author: Doug Cornelius

You can find out more about Doug on the About Doug page

A Shot of Tequila and Pilfered Investor Funds

Joseph Cimino wanted to make a great tequila and needed capital to make it happen. He raised almost $1 million and got 6 Degree tequila into production. Unfortunately, he apparently lied to his investors in raising the capital and then stole almost half of that capital.

Cimino created a 40-page booklet providing sales and expense forecasts and describing 6 Degree’s product and business plan. This booklet reported 2015 sales of approximately $260,000 and a net profit of approximately $40,000. But 6 Degree did not launch its operations until the spring of 2016, so those numbers were entirely fictitious.

In another example, Cimino gave a potential investor a financial update showing sales of over 800 cases in Puerto Rico, when the truth was less than 200 cases in sales. Puerto Rico was one of the few places 6 Degree was sold. In another report, Cimino falsely represented in an investor report and quarterly profit and loss statement that the company’s year-to-date sales totaled 3,410 cases, when its actual sales totaled only 350 cases.  

When he wasn’t lying to his investors and potential investors about the company’s results, he was allegedly stealing money from the company. He transferred approximately $472,000 from the company to his personal accounts. 

Mr. Cimino is currently subject to civil and criminal charges by the Securities and Exchange Commission and Department of Justice. According to the statement of the FBI agent in the criminal complaint, Mr. Cimino admitted to at least some of the false claims. He does not admit to illegally taking the cash.

I assume that Mr. Cimino was initially just puffing the success of the company in order to entice investors. The classic, “fake it, ’til you make it.” The problem is that doing so in connection with raising capital, “faking it” is securities fraud. If you publish numbers in a fundraising document, you need to be able to substantiate that number. Moving the decimal point over is going to get you in trouble.

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Another Fake COVID Test Fraud

COVID vaccinations are continuing to roll out and we can hope to see an end to the pandemic. Regulators are continuing to roll out cases against people and companies that tried to illegally profit from the pandemic.

The latest case is against Arrayit Corporation, a life sciences company in Sunnyvale, California. Although a public company, the Securities and Exchange Commission had put a halt to the trading in its shares on public markets in 2015 because the company had failed to file annual reports with audited financial statements. The company failed to respond to auditors requests for information. That moved its share trading to the OTC pink sheets. 

The CEO of Arrayit, Rene Schena, and her brother Mark Schena, President of Arrayit, began telling investors that the reports were coming out and the company had some new revenue sources. 

In March of 2020 Arrayit began making statements to investors.

“Dear [investor], Confirming that we have a SARS-Cov-2 test and that the test is pending emergency approval.”

At that point Arrayit had no reagents needed for a test. Also, Arrayit had not actually applied for Emergency Use Authorization. 

Arrayit took it a step further and told investors that it had received more than 50,000 requests for its finger stick blood test. This was not true. As a result of the untrue or misleading statements Arrayit’s stock price traded up 50% and its volume increased 100%.

The SEC charged Arrayit, Rene Schena, and Mark Schena with fraud. Arrayit and Rene Schena have settled with the SEC. She will pay a $50,000 fine and is barred from acting as an officer or director. Mark Schena’s case is still pending. 

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Increased SEC Enforcement?

The annual number of enforcement actions by the Securities and Exchange Commission decreased each year during the Trump administration. Starting at the high of 1,063 in 2016 and dropping to 827 in 2019, according to a tabulation in the Wall Street Journal. Now there is a new President and new Acting Chair of the Securities and Exchange Commission. Are enforcement actions going to increase?

Acting Chair Allison Herren Lee broadened the delegation of authority to senior officers in the Division of Enforcement. Under former Chair Clayton during the Trump administration, only the two co-heads of the Enforcement Division could approve the issuance of a Formal Order of Investigation. Now a broader group of officials in the Enforcement Division can do so.

Will this result in more enforcement actions? My guess would be “no.” I think the number of enforcement actions is correlated more to the size of the enforcement staff. It was reduced by about 8% during the Trump administration. Enforcement staff can only handle so many cases per person.

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Is Your Real Estate Fund Invested in Real Estate?

One of the challenges with real estate funds is staying within the various requirements of a real estate fund at the beginning of its life and at the end of its life. At start-up, the fund may be sitting on substantial non-real estate while it is starting to invest. Similarly at the end of its life, a fund may be sitting on substantial non-real estate while its real estate investments have been sold off. Then the fund has to run through the muddy area of whether any of its non-real estate holdings are “securities”. That analysis is key when addressing the definitions and exemptions under the Investment Company Act.

Landwin Partners Fund I ran into this problem and got hit with an action from the Securities and Exchange Commission. The action was against the fund manager and the principal of the fund manager.

The fund manager, like all of us, noticed that the fund’s cash holdings were producing little to no interest. The fund’s bank/financial company offered some short-term bank notes to earn some interest. That spread to bonds, preferred stock and common stock that were unrelated to real estate.

According to the SEC order, $2.4 million of the fund’s $20 million of capital was in these non-controlling, non-real estate interests. The first problem was that the fund’s offering documents didn’t authorize investments in anything other than real estate. That put beyond its organizational powers.

The second problem was that the high ownership level of true securities implicated the Investment Company Act. Section 3(a)(1)(C) of the Investment Company Act defines an “Investment Company” as

“engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis”

The Securities and Exchange Commission lumped the fund’s holdings in real estate-related limited partnership interests and mortgage loans together with the publicly traded securities to take the position that the fund had exceeded that 40% threshold in the definition of an “Investment Company.”

I was surprised to see real estate partnership interests and mortgage loans being included in the definition of “security” for the purposes of the definition of an “Investment Company.” The fund had over 300 investors so it could not use the 3(c)1 exemption which imposes a 100 investor cap. I would assume that the investor base did not qualify the fund for exemption under 3(c)7 which requires the investor base to be “Qualified Purchasers.”

That would leave the fund looking to use the 3(c)5 exemption for investments in real estate. I assume the SEC took the position that the investments were securities and not the type of investments that qualify for the 3(c)5 exemption.

The SEC order didn’t go into details about the failure of the fund to meet those exemptions. It merely states that the fund failed to meet any exemption.

Similarly, the SEC order didn’t provide any information on why the real estate limited partnership interests or mortgage loans should be considered “securities.”

Mortgage loans as securities? Maybe. Sure, bonds and participating interests are more likely to be considered securities. If the fund was the lender, I didn’t think the loan would be considered a security. The order doesn’t tell us anything about the nature of the mortgage loans that made them securities. I would think that a mortgage loan would be considered an asset that qualified under the 3(c)5 exemption as “…(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”

Similarly, real estate limited partnership interests could be considered a security. It should depend how much control the limited partner has over the partnership. I believe that having major decision rights and some control over management moves the interest out of the definition of a security. As with mortgage loans, I would think that real estate-related limited partnership interests would be considered an asset that qualified under the 3(c)5 exemption as “…(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”

Real estate fund managers who are not registered as investment advisers should be concerned about this case. It sounds like the SEC is possibly taking an aggressive approach on what is a security and the availability of the 3(c)5 exemption for real estate fund managers.

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Real Estate or the Lottery

Viktor Gjonaj thought he had figured out a way to make money. He was a commercial real estate broker and convinced members of his Albanian-American community in Detroit that he had lucrative real estate investment opportunities. He raised over $26 million.

Gjonaj had a promising plan. It involved lottery tickets instead of real estate. Gjonaj diverted his investors’ cash to playing the Michigan Lottery Daily 3 and Daily 4 games.

Maybe he had system that worked. He apparently won millions from the lottery. Unfortunately, it appears that he spent millions more buying the tickets. According to the complaints filed by the Securities and Exchange Commission and the US Attorney, Gjonaj was betting $1 million per week on the lottery using the money that was supposed to be put towards real estate investments.

His scheme unraveled. It appears that most of the investor money is gone. He is subject to lawsuits by his investors, an action by the Securities and Exchange Commission, and criminal charges from the US Attorney.

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Performance Advertising and the Funds That Weren’t There

Eric Malley decided that buying buy hundreds of luxury Manhattan residences on the cheap and leasing them to corporate tenants would be a great way to make money. He would let others in on his plan as investors. He created MG Capital Management Residential Fund III and raised $23 million from about 60 investors. It seemed successful enough that he launched a follow up Fund IV that raised $35 million.

You may be asking yourself: What about Fund I and Fund II?

The marketing materials for Fund III and Fund IV described very successful predecessor funds. In the Fund III PPM the outcome was described as

Fund I:
(1) raised $350 million of investor capital;
(2) earned a gross return on investment (ROI) of 38.99% and a net ROI of 30.81% during its six-year investment term from 2007 through 2013;
(3) outperformed the S&P 500 Index by 4.5-to-1; and
(4) sold its 74-property portfolio to two buyers for $750 million

and

Fund II:
(1) raised $55 million of investor capital in only 30 days; and
(2) achieved an average gross ROI of 38.06%,
cumulative unrealized gains on equity of 154.55%, and
a gross investment multiple of 2.55x.

In the complaint filed by the Securities and Exchange Commission, there is no evidence that these funds existed. Nor is there any evidence that MG controlled the $1.8 billion portfolio of real estate supposedly owned by the funds.

As for the Fund III and Fund IV, well, they did not perform well. According to the SEC complaint, Fund IV “earned $1.6 million in rent and incurred operating expenses of $8.3 million, resulting in net operating losses of approximately $6.7 million” and “$4.7 million in unrealized losses on portfolio investments, bringing Fund IV’s total net loss to approximately $11.4 million.”

As you might expect, MG is accused of illegally siphoning money from the funds. The SEC claims that (1) MG retained cash rebates from the sellers of the properties purchased by the funds and (2) charged the fund for unearned brokerage fees.

MG Capital and its principal Eric C. Malley are subject to civil charges by the SEC, criminal charges by the Department of Justice, and civil suits by investors. We haven’t heard their side of the story. Take the information above as a clear statement of what you should not do.

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Division of Examination

Goodbye Office of Compliance Inspections and Examinations.
Hello Division of Examination.

The Securities and Exchange Commission decided that OCIE, with 23% of the SEC employees, is probably more than an office and elevated it to the level of “Division” by naming it the Division of of Examinations. That puts it on equal name status with Corporate Finance, Investment Management, Trading and Markets, Economic and Risk Analysis and Enforcement.

I’m not sure I ever felt that OCIE was somehow less important because it was an “Office” and not a “Division.” Names do matter and its good to see that the examination staff can now carry around a more prestigious division name.

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Corporate Transparency Act

I’m not sure what Anti-Money Laundering has to do with the United States military, but Congress included big changes to anti-money laundering law in the National Defense Authorization Act for 2021. After a veto by President Trump and an override by Congress, NDAA has become the law, including Section 6401-6403, the Corporate Transparency Act.

It’s really easy to create a corporation, limited liability company or limited partnership in the United States. There are many, many legal, reasonable and important reasons to be able to do so. From the law enforcement and government sanctions parties, they see the company structure merely as an impediment to their ability to push bad guys out of the US banking system. The government side won and it may have a dramatic impact on the creation and reporting of companies.

The Corporate Transparency Act will require companies to submit a report of their beneficial interest to the U.S. Department of the Treasury’s Financial Crimes and Enforcement Center. For new companies, this information has to be submitted at the time of formation. Existing companies will have to submit this information within two years. All companies will have to update the information for a change of ownership within one year after the change.

The reporting requirement will not apply to all companies, just to any company that fits into the definition of “Reporting Company.” That definition has a lengthy list of companies that are exceptions and fall outside the scope of the Reporting Company definition. Of the twenty-four exceptions, there are some obvious types: public companies, banks, and broker-dealers.

I really wanted to focus on the possible impact on me and private fund managers.

Section 6403 of the NDAA adds a new section 5336 to Title 31 of the US Code. I focused on this exception in 31 USC 5336(a)(11) from the definition of “Reporting Company”:

‘‘(xi) an investment adviser—
(I) described in section 203(l) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3(l)); and
(II) that has filed Item 10, Schedule A, and Schedule B of Part 1A of Form ADV, or any successor thereto, with the Securities and Exchange Commission;

So registered investment advisors that report their ownership on Form ADV are not Reporting Companies and don’t have to report ownership. Obviously, they are already reporting ownership.

There is an exception for pooled investment vehicles operated or advised by investment advisers:

‘‘(xviii) any pooled investment vehicle that is operated or advised by a person described in clause (iii), (iv), (vii), (x), or (xi)

Although the definition of “pooled investment vehicle” is very specific:

(A) any investment company, as defined in section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a–3(a)); or
(B) any company that—
(i) would be an investment company under that section but for the exclusion provided from that definition by paragraph (1) or (7) of section 3(c) of that Act (15 U.S.C. 80a–3(c));
and
(ii) is identified by its legal name by the applicable investment adviser in its Form ADV (or successor form) filed with the Securities and Exchange Commission.

Later, there is a broader exception:

‘‘(xxii) any corporation, limited liability company, or other similar entity of which the ownership interests are owned or controlled, directly or indirectly, by 1 or more entities described in clause (i), (ii), (iii), (iv), (v), (vii), (viii), (ix), (x), (xi), (xii), (xiii), (xiv), (xv), (xvi), (xvii) (xix), or (xxi);

Companies owned or controlled, directly or indirectly, by a registered investment adviser also fall outside the definition of “reporting company.”

This would seem to be good for private fund managers. The funds and fund subsidiaries seem to fall outside the definition of Reporting Company.

There is still a long path until we get to the point of having to do this reporting. FinCEN will have to establish the regulatory framework and the database to hold this information. It’s not clear how the reporting requirement will specifically interact with the various state secretaries of state who are responsible for company formation.

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Doubling Down on Disgorgement

Back in 2017, the Supreme Court in Kokesh v. Securities and Exchange Commission pointed out that the disgorgement claims made by the Securities and Exchange Commission are penalties and therefore subject to the five-year statute of limitations. The Kokesh decision left some question about whether the SEC could pursue disgorgement at all. The Supreme Court did not mean to kill it and earlier this year upheld the SEC’s disgorgement power in Liu v. Securities and Exchange Commission.

Congress managed to tuck some some goodies in the National Defense Authorization Act. Sure, that went through gyrations after President Trump vetoed it because it didn’t have some things he wanted in it. On Jan. 1, Congress overrode President Trump’s veto of the defense spending bill.

Section 6501 of the NDAA specifically authorizes disgorgement and allows for a 10 year period in some instances.

SEC. 6501. INVESTIGATIONS AND PROSECUTION OF OFFENSES FOR VIOLATIONS OF THE SECURITIES LAWS.
(a) In General.–Section 21(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78u(d)) is amended–
…
(3) by adding at the end the following:

(7) Disgorgement.–In any action or proceeding brought by the Commission under any provision of the securities laws, the Commission may seek, and any Federal court may order, disgorgement.

(8) Limitations periods.–
(A) Disgorgement.–The Commission may bring a claim for disgorgement under paragraph (7)–
(i) not later than 5 years after the latest date of the violation that gives rise to the action or proceeding in which the Commission seeks the claim occurs; or
(ii) not later than 10 years after the latest date of the violation that gives rise to the action or proceeding in which the Commission seeks the claim if the violation involves conduct that violates–
(I) section 10(b);
(II) section 17(a)(1) of the Securities Act of 1933 (15 U.S.C. 77q(a)(1));
(III) section 206(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-6(1)); or
(IV) any other provision of the securities laws for which scienter must be established.

The 10-year period is only for scienter-based claims. The SEC will have to allege intentional fraud.

What’s not clear in the statutory change is whether the Liu limiting principles will still apply to disgorgement claims. The Supreme Court laid out three limitation on disgorgement claims:

  • Disgorged funds should be returned to the victims.
  • Joint and several liability theory may not apply;
  • Should be limited to “net” profits, allowing deduction of legitimate business expenses

I’ll leave figuring out whether they still apply to the legal scholars and, inevitably, future court cases.

In addition to the disgorgement extension, there is a new anti-money laundering scheme as part of the NDAA. More to come on that.

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