Category: Fraud

Trustee Charged As A Failed Gatekeeper

When a fraud is uncovered, the Securities and Exchange Commission not only wants to get the fraudsters, it also wants to get those who should have stopped the fraud: the gatekeepers. Recently, the SEC has brought charges against a fund administrator and fund auditors. The latest is a case against

Château de Crécy-la-Chapelle: Gate

The Securities and Exchange Commission announced that a subsidiary of Oklahoma-based BOK Financial Corporation agreed to pay more than $1.6 million to settle charges that it concealed numerous problems and red flags from investors in municipal bond offerings to purchase and renovate senior living facilities. According to the SEC’s order, BOK Financial failed in its gatekeeper role as indenture trustee and dissemination agent for the bond offerings.

In a case brought last year, the SEC filed charges against Christopher F. Brogdon for dozens of municipal bond and private placement offerings in which investors supposedly earn interest from revenues generated by the nursing home, assisted living facility, or other retirement community project supported by their investment. But Brogdon secretly commingled investor funds instead of using the money to finance the project described to investors in the disclosure documents for each offering and diverted investor money to other business ventures and personal expenses.

According to the SEC’s order, BOK Financial, and a former senior vice president at the bank, Marrien Neilson, became aware of numerous red flags:

  • Brogdon was withdrawing money from bond offering’s reserve funds and failing to replenish them.
  • He had failed to file annual financial statements for the bond offerings.
  • The nursing home facilities serving as collateral for one of the bond offerings had been closed for years.

But Neilson allegedly warned others that disclosing red flags could impair future business and fees from Brogdon, upset bondholders, and cause regulatory issues for bond underwriters. So Neilson and BOK Financial decided not to inform bondholders as required.

BOK Financial settled the charges. Neilson is challenging the charges, so we only have the SEC’s side of the story.

Neilson was the primary recipient of bonus compensation awarded on the basis of the fees paid to BOKF for the Brogdon Bond Offerings. She also received bonus compensation for other bond offerings that financed the sale of Brogdon-owned nursing homes and assisted living facilities to third parties. The SEC charged that she knew or recklessly disregarded that Brogdon was supposed to make disclosures to the bondholders about the red flags.

In the SEC Order, there are numerous emails showing Neilson in a poor light:

“In a March 1, 2010 email to one of Brogdon’s assistants regarding late debt service payments for an offering, Neilson states that the late payment put her “in an extremely awkward position” because “the Reserve Fund has previously been used and not replenished and I did not call a default.” In the same email, Neilson states that “[b]ondholders are going to want to know why we don’t used [sic] the Reserve Fund.” Neilson also states that “we need to disclose the other Reserve funds if they are not replenished,” asking Brogdon’s assistant “if you want a list of them and how much?”

I assume Brogdon was trying to keep his enterprise afloat and Neilson was helping him kick the can down the road. Perhaps a little more debt can buy a little more time to get cash flow positive. That didn’t happen and the debt facilities finally went into default and bankruptcy.

The gatekeeper should have stopped the fraud. Instead, it helped with a dozen more offerings expanding the scope of the fraud.

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Château de Crécy-la-Chapelle: Gate by Baishiya 白石崖
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When Is Fraud Just A Breach Of Contract?

If you are going to originate some shady mortgages, maybe you shouldn’t nickname the program the “hustle.” If you package up the mortgages and sell them as good mortgages, it would seem you are committing fraud. But maybe not.

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It may come as no surprise that the company running the “hustle” was Countrywide. According to Countrywide, the High Speed Swim Lane or HSSL (or hustle) was an automated program created to improve loan quality by limiting the number of people who processed loans. According to the government, the Hustle program was meant to churn out home loans, rewarding employees for speed rather than quality and removing financial penalties that employees could incur for making bad loans. In the end Countrywide made $165 million from the program while Fannie Mae and Freddie Mac had net losses of $131 million.

Countrywide had a contract with Fannie Mae and Freddie Mac to sell Acceptable Mortgages. As you might expect, the Hustle mortgages did not all meet the Acceptable Mortgage standard, so it was delivering some sub-standard mortgages under the contract.

The government claims fraud and Countrywide claims that it was merely a breach of contract.

A jury ruled in favor or the government and the judge ordered $1.27 billion in penalties. The Second Circuit overturned that decision and the judgment. It was was merely a breach of contract.

The Second Circuit phrased the question like this:

“B’s Fraud theory is that A knowingly and intentionally provided substandard widgets in violation of the contractual promise—a promise A made at the time of contract execution about the quality of widgets at the time of future delivery. Is A’s willful but silent noncompliance a fraud—a knowingly false statement, made with intent to defraud—or is it simply an intentional breach of contract?”

The law does not permit a fraud claim merely on a contractual breach. Fraud turns on the parties intention when the contractual obligations and representations were made. The party claiming fraud need to prove that the other party had fraudulent intent at the time the party entered into the contract.

So to prove fraud, the government would need to prove that Countrywide did not intent to perform its obligations when it entered into the contract.

[T]he Government has never argued—much less proved at trial—that the contractual representations at issue were executed with contemporaneous intent never to perform, and the trial record contains no evidence that the three Key Individuals—or anyone else—had such fraudulent intent in the contract negotiation or execution. Instead, the Government’s proof shows only post-contractual intentional breach of the representations. Accordingly, the jury had no legally sufficient basis on which to conclude that the misrepresentations alleged were made with contemporaneous fraudulent intent

This is a fairly arcane area. The court agrees with this arcane assessment. I think the decision also hinges on the way the contract was structured. The contract did not call for a restatement of the representations when each mortgage was delivered. Many contracts are structured with the restatement of representations to avoid this arcane treatment.

It does not mean that Countrywide is off the hook. It’s still liable for damages from the contractual breach. It does mean that Countrywide did not commit fraud under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and is not liable for the ensuing civil penalties.

The big loser in this was Ed O’Donnell. He was the whistleblower in this case. He is doing okay. He had already been awarded $58 million as a result of the $16.65 billion that Countrywide paid for the contractual breaches and mortgage securities fraud. I assume he would have been eligible to get a chunk of the $1.27 billion fine in this case.

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SEC Charges Fund Administrator as a Failed Gatekeeper

The Securities and Exchange Commission charged Steven Zoernack and his firm EquityStar Capital Management with fraud for stealing investor money and hiding his criminal past. The SEC brought fraud charges against ClearPath Wealth Management and its principal, Patrick Evans Churchville, for operating a fraudulent scheme that resulted in at least $11 million in losses to investors. One thing in common between the two firms was that both used the same fund administer.

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SEC investigations found that Apex Fund Services missed or ignored clear indications of fraud while record-keeping and preparing financial statements and investor account statements for funds managed by ClearPath Wealth Management and EquityStar Capital Management.

This is another case of the SEC charging a gatekeeper for failing to identify and stop fraud.

The SEC’s order finds that in regard to ClearPath Apex failed to act appropriately after detecting undisclosed brokerage and bank accounts, undisclosed margin and loan agreements, and inter-series and inter-fund transfers made in violation of fund offering documents. Apex failed to correct previously issued accounting reports and capital statements and continued to provide materially false reports and statements to the funds’ independent auditor. Apex should have known that ClearPath would use Apex’s false reports to communicate financial positions and performance to the ClearPath funds’ investors.

The SEC’s order finds that in regard to EquityStar and Zoernack, Apex accounted for more than $1 million in undisclosed withdrawals as receivables owed to the funds, despite no evidence that it was able or willing to repay the withdrawals. Apex confronted Zoernack about the withdrawals and concluded he was unlikely to repay the funds. But Apex still did not properly account for Zoernack’s withdrawals even as they started to consume a significant portion of the funds’ assets. Apex sent monthly account statements to investors that it knew or should have known materially overstated the investors’ true holdings in the funds.

Apex was a failed gatekeeper. The SEC will bring charges for not taking appropriate steps. In this case, Apex knew its reports were false and still sent them to investors or to the funds knowing that they would be given to investors.

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Château de Crécy-la-Chapelle: Gate by Baishiya 白石崖
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Investment Fraud and Online Dating

Most good financial advisers will tell you that referrals are their best source of business. The same is true for fraudsters. Affinity fraud is just using a network to funnel new “investors” into a fraud. The Boston office of the Securities and Exchange Commission brought charges against an alleged fraudster using an unusual network.

The word Fraud appearing behind torn brown paper.

The SEC alleges that Thomas J. Connerton told investors that his company, Safety Technologies LLC, was developing a material to make surgical gloves better resistant to cuts or punctures. He claimed that several major glove manufacturers wanted the technology and Safety Technologies was on the brink of imminent deals that would result in large payouts for investors in his company. But no deals have ever been anywhere close to materializing.

Instead, the SEC alleges that Connerton has been emptied the company’s bank accounts for his own expenses. Those expenses include a $20,000 for an engagement ring for his latest online date.

She is also an investor.

Of the 50+ investors in the company, six are women Connerton met through online dating. There are 14 others who are family or friends of those women. A third of his “investors” and half of the money are tied to Connerton’s online dating activities.

And you thought your ex had problems.

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A Chairlift to Securities Fraud

The Securities and Exchange Commission brought charges against the owners of Jay Peak resort in Vermont’s Northeast Kingdom just as ski and snowboard season is winding down. The Miami-based ownership was allegedly using fraudulent EB-5 offerings to raise money and take a bit off off the top for themselves.

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Jay Peak is wonderful mountain for snowsports, but you need to spend quite a lot of extra time getting there. Historically, there was not much at the mountain except for the mountain. Lately, the resort has added a hotel and an indoor water park. According to the SEC, the owners were involved in some shenanigans when raising money for these improvements.

The EB-5 Visa program allows an immigrant and family to live or work or retire in the United States. It requires investment in an enterprise that creates jobs for US citizens. The minimum amount of money to invest is $500,000 for an investment in a rural or high unemployment area. The EB-5 immigrant investor visa program is intended to attract foreign capital into the US and create jobs for American workers.

The Jay Peak program, combined with a similar strategy at nearby Burke Mountain and a biotech research building, was one of the biggest projects to be financed in this way.

According to the SEC complaint, the problem started with the purchase of the ski mountain. The head of the company, Ariel Quiros commingled funds from two separate investment programs to help fund the acquisition. Inexplicably, investor money was deposited in a brokerage account and Mr. Quiros arranged for margin loans and cross-collateralized the accounts across investment programs.

The final straw appears to be the biotech building. The offering documents misrepresented that there was FDA approval in place. The SEC also alleges that Quiros pocketed some of the investor money.

The SEC complaint is full of charges of mismanagement, theft and fraud.

I fear that the result will be a terrible blow to Jay Peak. I assume that half-completed projects will sit decaying in the ground for years, if not decades. The resort itself will not have the capital to operate well.

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Racing, Compliance and Cheating

With the Boston Marathon on Monday, the legend of Rosie Ruiz comes up as one of the most infamous sports cheats. Races have since added controls, but cheaters still look for ways around the controls.

Rosie Ruiz, center, is helped by Boston police after winning the women's division of the Boston Marathon, April 21, 1980. Ms. Ruiz had a partial unofficial time of 2 hours, 31 minutes, and may have broken the women's record set in 1979. (AP Photo)

For those of you not familiar with the history of the Boston Marathon, Rosie Ruiz was declared the winner of the 1980 Boston Marathon with a time of 2:31:56. At that time, it was one of the fastest female marathon runs. Currently, the female elite runners leave before the men. In 1980, women were back in the pack and harder to track.

Now, racers have a timing chip that notes when the athlete passes certain points in the course. It makes it harder to cheat because you need to figure a way to get the chip to each of those points.

According to a recent article in the New York Times on an ironman athlete, the athlete tried to circumvent the system by claiming that her timing chip fell off. The general rule for most races is that if you don’t finish with your timing chip, you don’t get a finishing time. She plead for reinstatement, and had her time reinstated. That also made her the winner of her division.

In looking at running portion of the race course, it seems clear that the course failed in having enough timing checkpoints. The course consisted of two laps, with several points that a cheater could cut across the route.

The other element helping to catch cheaters is the prevalence of spectators that can provide meaningful race data. We all have mini-computers in our pockets with phones that accurately capture time and location. Race officials were able to identify the time and place of the athlete on certain parts of the course that did not match her claimed performance based on spectator images.

Officials should not have had to rely on extrinsic data. There should have been more timing mats. Race officials should not have allowed reinstatement of her time. They should particularly not allowed reinstatement when it gave the athlete a win in her division.

Controls are in place to prevent cheating, allowing circumvention of the controls is a compliance failure by the race officials. It takes well-deserved recognition from the athletes who followed the rules.

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Videogame Failure and Securities Fraud

As a Red Sox fan, Curt Schilling is an iconic player to me, leading the team to break the curse of the Bambino. I don’t think that leads to him being a successful entrepreneur or video game developer. Nonetheless, he invested a great deal of his own wealth and raised a big pile of capital to create 38 Studios and start production of a massive multi-player video game. Despite his greatness as a pitcher, he was not able to close the deal and publish the game. The company folded and laid off its employees.

Now the Securities and Exchange Commission has brought charges of securities fraud in connection with the raising of capital.

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Rhode Island was looking to bring jobs to the state and lured 38 Studios to relocate to the Ocean State. The Rhode Island Economic Development Corporation agreed to issue bonds and raise $50 million of capital for 38 Studios through a $75 million offering. The remaining $25 million was for offering expenses and a reserve fund.

The EDC hired Wells Fargo as the placement agent to sell the bonds. However, Wells Fargo had already been hired by 38 Studios to raise capital. According to the SEC complaint, the bond offering documents should have disclosed more about Wells Fargo’s role and how much it was getting paid.

The other problem was that the bond offering was not enough money to finish production of the video-game.  The original projection was for the full $75 million to go to 38 Studios. By only getting $50 million, it had a capital shortfall. It would run out of money by the end of 2011. According to the SEC complaint, the offering documents should have disclosed this shortfall and did not.

38 Studios managed to last longer than projected. It did not default on the bond payments until the Spring of 2012. Then it filed for bankruptcy in June 2012.

The SEC does not spell it out, but clearly the myth of Curt Schilling was the selling point for the deal. Wells Fargo’s ability to sell the bonds was based on the myth of Curt Schilling.

The ability of 38 Studios to successfully produce a videogame was a myth. The job creation behind the bond offering was myth. According to the SEC suit and various other lawsuits it looks like a lot of people thought they could make money from the myth of Curt Schilling.

The first tenet of our securities laws is disclosure. Making money from the myth is not inherently illegal. Failing to disclose is.

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Phishing for Losses

You’re security is only as secure as your employees. I was struck by this when I received an email from the head of my firm wanted to discuss a wire. I was being subject to a phishing attack.

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I think we all see this often. Personally, I always find it curious when a bank sends me an email with a a warning about my account. I’m not worried since I don’t have an account at that bank. Of course that also leads to me ignoring emails from my own bank.

I pay a bit more attention when the CEO sends me an email.

Email business scams may caused more than $2 billion in losses over the last two years.

It’s not just advisers or fund managers that need to worry. At least one publicly listed company has suffered a loss from this scam. The company had to admit in it’s quarterly report that $46.7 million had gone missing.

As good as a firm’s systems may be to deter external threats and hackers, it’s the social engineering attacks at a firm that are becoming more successful.

Convincing an employee to authorize a wire takes less technical skill than hacking into a firm’s network. It all starts with a simple email.

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The Good, Bad and the Ugly of Lending

In browsing through the Wall Street Journal I ran into three stories side by side:

Each is a different side of specialty loans.

Cash in the grass.

The Ezubo fraud story caught my attention first. That is a lot of money for a Ponzi scheme. There is no proof that it is actually a fraud at this point. But employees of legitimate companies do not generally bury the firm’s accounting books in a field.

I found the LendingClub loan story to be interesting because the loans were sold at premium to the outstanding balance. The buyer thought it would get its money back and then generate more revenue through those borrowers.

The liar loans are a vestige of the housing boom when lenders were underwriting loans on value and not the borrowers’ ability to repay the loan. There is some need for these products for borrowers whose income is hard to document. But largely they are known as liar loans for poor documentation and cheating on behalf of the borrower. I though they had gotten buried in hole, never to be seen again.

It’s the liar loans and the Ezubo loan that are most alike. The loans (or “loans” in the case of Ezubo) are driven by lender demand. It’s Wall Street banks that are looking for pools of liar loans. In Ezubo’s case its the small investors looking generate returns for peer-to-peer loans. In neither case is an increase in loans being driven by legitimate consumer demand. Its lenders searching for yields.

The LendingClub loans are driven by consumer demand. These loans are also better documented and have credit worthy borrowers. The story states that the average FICO score was about 700.

Good documentation and controls generated the best returns. I think that makes any compliance professional happy.

It’s Hard to Tell What the Next Form of Cheating Will Look Like

One of the problems with compliance is that the fraudsters seem to be one step ahead of the regulators. The regulators try to push out rules to prevent bad behavior. Regulators look at their charges to find cheating. But the cheaters are often one step ahead. We saw this in professional cycling over the weekend.

Femke Van den Driessche

Professional cycling has been rife with cheating throughout its history. It’s a brutal sport so contenders are always looking for a little edge to get them to the finish line first.

Of course, there was Lance Armstrong and the doping of the 1990s. Cycling was not alone. Baseball had its own issues at the same time. Regulators seem to have caught up with cheaters, flushing a lot of the doping out.

This weekend regulators found a new kind of cheating.

Race officials found a motor in the bike of Belgian cyclist Femke Van den Driessche. Yes, a motor. In her bike frame.

A rumor about motor doping popped up last year. During the 2015 Tour de France race officials checked several bikes, but never found anything. It seemed like a possibility that battery technology could catch up to make a motor and power sources small enough to fit unnoticed in a bike frame. The key would reducing the weight so that whatever power was generated would not be overcome by the additional weight of the machinery.

Apparently that time has come. Although Ms. Van den Driessche denies she cheated:

“I didn’t know anything about it. I don’t know how that bike got there. I was surprised to see that bike standing there. It’s not my bike. There’s been a mistake.”

Incidentally, Van den Driessche’s brother Niels is currently suspended for doping.

Regardless of whether she cheated, it is clear that the technology is here. Regulators will have a new round of checks on race winners, looking at their bikes as well their blood.

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