Category: Ponzi Schemes

The One That “May” Pay Commissions

EquiAlt is in the business of snapping up distressed properties in Florida. That takes capital and it raised it through a series of funds through debt offerings. That seems like mismatched cash flow to me. You have to make interest payments on investments in real estate that are not generating cash flow. The SEC took an even more skeptical view and accused the firm of being a Ponzi Scheme and defrauding investors.

“The SEC’s filings present an inaccurate picture of Mr. Rybicki’s business dealings,” Washington D.C. attorney Stephen L. Cohen said in an email to the Tampa Bay Times. “We look forward to addressing these matters with the court.”

Since it was a real estate company it caught my attention, a found a few items that were worth exploring.

As with most alleged frauds, the SEC lists a bunch of luxury items by the alleged fraudsters. The EquiAlt’s principals apparently bought Ferraris, Porsches and a Rolls Royce. Plus expensive watches and private jet charters.

Lesson: Just assume that if the SEC shows up at your office and sees a Rolls Royce or a Ferrari out front, the SEC is going to be immediately suspicious.

The SEC got hung up on the use of “may” is the private placement documents. EquiAlt was is accused of using in-house employees and unlicensed external sales agents to to raise investor money. According to the SEC, they were ALWAYS paid commissions. The SEC is taking the position that the fundraising documents should not have said that the funds MAY pay commissions.

I hate that the SEC raises this issue. But it does.

Lesson: If you always pay some kind of fee, especially to an affiliate, make sure you use a more forceful term than “may.” Or I suppose you could find a time to forego the payment so that “may” is more accurate.

The last thing that caught my attention was a claim that the fund raising documents falsely stated that a certain individual was EquiAlt’s Chief Financial Officer when that person did not do so.

Lesson: Always make sure you get your firm’s personnel right in the fund-raising documents.

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The One with the Missing Solar Generators

Jeff and Paulette Carpoff had what sounds like a great idea to me: mobile solar generator units. These are solar generators that would be mounted on trailers that could provide emergency power to cellphone towers and lighting at sporting events. Plus there were generous federal tax credits due to the solar nature of the generators.

I’m willing to hand over a check just hearing the idea. Others agreed and gave Carpoff almost $1 billion in investments to create over 17,000 of the generators.

“A million dollars isn’t cool. You know what’s cool? A billion dollars.”

Sean Parker – The Social Network

What’s not cool is that the Carpoffs only had about 6,571 of the generators.

The conspirators pulled off their scheme by selling solar generators that did not exist to investors, making it appear that solar generators existed in locations that they did not, creating false financial statements, and obtaining false lease contracts, among other efforts to conceal the fraud. 

There is a “What is a Security?” twist to the charges. Some of the fake generator investments were structured as sale-leaseback arrangements. The investors paid to purchase generators from DC Solutions, while simultaneously leasing them to DC Distribution. DC Distribution would then sub-lease the Generators to end-users. The investors would profit from the investments due to tax credits, depreciation on the generators, and lease payments. If the purchase of the generator is tied to the lease and exclusive, then there is a line of cases finding that to be an investment contract. Just like the orange grove in Howey. However a bulk of the investments were made to a fund, pooling money for a bulk purchase and lease of generators.

As interesting as I may find this topic in the charges, the conspirators are going to jail and probably have less interest in the arcane corners or securities law.

I’m going to assume that the Carpoffs started the business with good intentions. They did create thousands of these generators and leased at least some of those for legitimate purposes. They seem to have made at least $18 million in revenue. It seems that the business just did not scale. They could find enough end users to satisfy the investment demand.

As with many Ponzi schemes, they weren’t willing to be honest with their investors about the failure and engaged in false and misleading. There was much more money to be made in collect cash from investors than from leasing the generators.

As with any good fraud fraud charges they list out the extravagant items bought by the fraudsters. This comes up short on the itemization.

  • 150 cars
  • dozens of properties
  • 1978 Firebird previously owned by actor Burt Reynolds
  • a minor-league professional baseball team
  • share in a jet service
  • Nascar sponsorship

Jeff and Paulette Carpoff are scheduled to be sentenced by U.S. District Judge John A. Mendez on May 19. Jeff Carpoff faces a maximum statutory penalty of 30 years in prison. Paulette Carpoff faces a maximum statutory penalty of 15 years in prison. The actual sentences, however, will be determined at the discretion of the court after consideration of any applicable statutory factors and the Federal Sentencing Guidelines, which take into account a number of variables.

Four defendants have previously pleaded guilty to federal criminal charges related to the fraud scheme since October. Joseph W. Bayliss, 44, of Martinez, and Ronald J. Roach, of Walnut Creek, each pleaded guilty to related charges on Oct. 22, 2019. Robert A. Karmann, 53, of Clayton, pleaded guilty to related charges on Dec. 17, 2019. Ryan Guidry, 53, of Pleasant Hill, pleaded guilty to related charges on Jan. 14, 2020. A seventh co-conspirator is scheduled to plead guilty on Feb. 11. The investigation into the fraud remains ongoing.

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Pair of Ponzis with Real Estate

Real estate related fraud cases with the Securities and Exchange Commission catch my attention. Two real estate-ish cases popped up in a flurry of cases filed before Labor Day weekend. One was for timber and the other for mobile home parks.

Timber operates in a gray area between real estate and extraction. Clearly, the land has value for capital and the trees have value as product. Of course you have to own the land or have the right to harvest the trees.

In the case of Madison Timber Properties, LLC, the SEC claims that the company and its principals didn’t own the land or have the harvesting rights. In other instances, the SEC claims the company would pledge the same tracts to more than one investor. Instead of using the money to acquire land or harvesting rights, the company diverted investor capital for other uses.

Last week, the SEC brought charges against Terry Wayne Kelly and his company for selling the notes that funded Madison Timber. At the base level, Kelly and his firm were not registered as broker-dealers. The Madison Timber notes were not registered nor did the sales properly use an exemption from registration.

Further, the SEC charged that Kelly was aware of the red flags at Madison Timber. At a meeting with unnamed financial institutions, Kelly and Madison were confronted about the business practices at Madison. The SEC charged that Kelly is civilly liable for negligently and recklessly selling the securities.

In a separate action, the SEC accused Tytus Harkins and the Hartman Wright Group with defrauding investors in connection with mobile home parks. They misrepresented the

Unlike Madison, Hartman Wright owned the real estate. But according to the SEC, Madison overstated the purchase price for the mobile home parks.

In both cases, the firms used some of the cash provided by later investors to redeem or make payments to earlier investors. That gives each scheme the label of a Ponzi scheme.

The question that I’m left with is how the firms expect to exit from these schemes. There would not be enough cash to pay off investors at the end of the day. Eventually the scheme would unravel.

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Affiliate Transactions as a Ponzi Scheme

Actions by the Securities and Exchange Commission against real estate companies will catch my attention. A recent complaint against Robert Morgan and his affiliated real estate funds did just that.

The SEC complaint is just charges, so we don’t know if the statements are true or what Morgan’s response will be. I’m just using it as a learning tool.

The main charge against Morgan is a criminal complaint for mortgage fraud. In a Department of Justice press release:

The defendants provided false information to financial institutions and government sponsored enterprises overstating the incomes of properties owned by Morgan Management or certain principals of Morgan Management. The false information induced financial institutions to issue loans: (1) for greater values than the financial institutions would have authorized had they been provided with truthful information; and (2) that the financial institutions would not have issued at the time of issuance had they been provided with truthful information.

The SEC grabbed a piece of the action when it was discovered that Morgan has raised four private funds from investors to finance Morgan properties. The funds, managed by Morgan, made what look like mezzanine loans to the properties owned by Morgan.

See if you if you can spot the conflict? Yes it’s obvious.

According to the complaint, Morgan did not treat these as third-party loans in terms of documentation or valuation of the underlying assets. Morgan also used funds to pay off loans that were maturing and owed to other funds.

Lots of conflicts for sure. According to the complaint, the offering materials stated that the loans from the funds would be going to affiliates managed by the funds’ manager. According to the complaint, one fund’s loan to a Morgan affiliate was often used to fund the repayment of another fund’s loan. The SEC labels these pay-off as “Ponzi scheme-like payments.”

The SEC brought its charges for violating the anti-fraud provisions of the Securities Act and Exchange Act.

Numerous affiliate transactions like those in the Morgan empire are full of conflicts and issues. It can be done, with lots of controls and documentation in place. The SEC complaint makes it sound like those were not in place.

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The One with Video Problem

If you are running a Ponzi scheme, don’t send a video to your investors that you are running a Ponzi scheme.

According to the Securities and Exchange Commission Complaint, EquityBuild was selling notes secured by real estate by promising safety and high returns. (Hopefully, you realize those things don’t go together.) In reality, EquityBuild was charging high fees to investors by valuing real estate well above cost and using new investor money to pay returns to older investors.

The wheels fell off earlier this year and EquityBuild finally told investors that there were issues.

According to the SEC complaint, Equitybuild emailed a video recording to investors telling them about the problems.

(a) states that Equitybuild’s properties are “negatively cash flowing,” (b) acknowledges that investor interest payments have stopped and that principal has not been returned, (c) discloses that Equitybuild had funded investor interest payments using “fee income” from later investors, but that fees charged to later investors could no longer satisfy the interest payments to earlier investors, (d) warns investors not to file lawsuits against Equitybuild, (e) states that investors will not receive payments until Equitybuild’s rental income exceeds its expenses, and (f) advises that Equitybuild was cutting staff down to a “skeleton crew” and would not be able to respond to investor inquiries.

Read (c) again.

I’ve not been able to get my hands on a copy to hear exactly what was said. But according to the SEC complaint, EquityBuild admitted to being a Ponzi Scheme.

EquityBuild and its principals are currently fighting the charges, so we will have to wait to hear their side of the story.

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The One With The Floundering Hedge Fund

I’m a local homer, so fraud cases in Massachusetts catch my attention, especially when they involve private funds. The case of the floundering hedge fund, MC2 Capital, founded by Yasuna Murakami, is the usual example of greed and failure to acknowledge one’s mistakes.

Mr. Murakami had big dreams and in the glory days of 2007 thought he could graduate from business school and start a hedge fund. According to the order from the Massachusetts Secretary of State, he had no professional experience trading securities.

He convinced a business school classmate who had been working at Bear Stearns in 2007 to join with him to form MC2 Capital. They were able to raise $3.6 million. The fund was supposed to focus primarily on small to medium cap US stocks with an emphasis on value-oriented investments. However, in reality it had no strategy and had significant holdings in extractive industries and used margin loans for its trading.

It should come as no surprise that inexperienced managers with no strategy lost a great deal of money for the fund investors. By August 2011, the fund had only $33,577.51 in net equity. MC2 lied to investors and covered up the losses. Investors got fake K-1s and account statements.

The trading losses did not deter them. They started a second fund, and then a third fund for Canadian investments.

For the Canadian investments, MC2 managed to eventually link up in 2011 with a successful Canadian asset management firm and fund manager who agreed to run the investments for 70% of the fund fees. That firm cancelled the arrangement in 2015. To make up for the loss, MC2 made up a fake firm as the replacement asset manager.

By the end of 2016, the combined worth of all three funds was less than $10,000. Yet, MC2 told one if its investors that its investment was worth over $4.5 million, with a year to date gain of 18.7%.

It should come as no surprise that some of the investor money was not just lost in trading, but ended up directly in Mr. Murakami’s pocket.

As you might expect, MC2 was using new investor money to pay redemption requests. MC2 turned into a Ponziu scheme.

The Massachusetts fraud case did not pull in the other MC2 partner, Avi Chait. The SEC action does and implicates Mr. Chait in the wrongdoing. It may be that Mr. Chait was not aware of Mr. Murakami’s wrongdoing. The SEC complaint has this quote from Mr. Chait to Mr. Murakami, “I am trying to sell a fund that I know nothing about at all.” It all became too much for him in 2016 and Mr. Chait redeemed his interest and his relatives’s interest, pocketing the fake returns.

The SEC swooped in May, after Massachusetts has already brought its action in January and fund investors had brought their suit in November.

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Stealing from Peter to Pay Paul

I generally think of fraudsters in two buckets. Some are trying to take the money and run. Some are using the ill-gotten money to cover up a prior loss, hoping to earn it all back. I think most ponzi schemes fall into the later category. A splashy fraud case this week highlighted this second type.

money

Andrew W.W. Caspersen had a pedigree of wealth. He graduated from Princeton University and Harvard Law School. He was a partner at a major financial advisory firm. He could do no wrong.

But according to the SEC and DOJ something did go wrong. He lost money. He was so desperate to cover up the losses he pitched a falsified investment in a legitimate private equity firm to institutional investors. He got one investor to put in $25 million.

According to the complaints, the scheme fell apart when that investor was contemplating putting in more money. The investor did some diligence, found the email addresses to be slightly different and phone numbers were incorrect. The DOJ alleges that Caspersen posed as executive at the private equity firm to answer questions from the investor and created a fake website and email addresses.

According to the complaint, Caspersen appears to have been using the money to cover an earlier loss and take a risky investment bets that did not pay off. The $25 million dwindled down to $40,000.

According to the Wall Street Journal, Caspersen was arrested Saturday evening at New York’s LaGuardia Airport. It’s not clear if he was merely heading out of town for business or vacation.

Or if he was turning into the first type of fraudster and making a run for it.

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Weekend Watching

You may have missed Madoff on ABC this week. It’s four hours on the life of the fraudster, portrayed by Richard Dreyfuss. If you have a few hours this weekend, it’s worth watching.

madoff

Mr. Dreyfuss does a great job portraying Madoff, capturing him lying, cheating and stealing, but looking upstanding in the eyes of his investors. A con man in a fancy office. He nails it.

Blythe Danner is even better as Ruth Madoff, enjoying the luxuries of life and clueless about her husband’s deception. Then she is torn when her sons make her choose between them and Bernie.

Frank Whaley is over the top as Harry Markopolos. He is portrayed with an extra bit of lunacy spewing out indecipherable phrases to the SEC about uncovering Madoff’s fraud.

I didn’t like how the movie painted a stark line between the legitimate Madoff brokerage and the fraud in the management side. The main trading floor is full of rich furniture and decoration. The fraud center on the 17th floor is a smoke-filled, windowless den of iniquity. Why are there no windows? (There were windows.) Michael Rispoli, as Frank DiPascali, is straight out of the Sopranos. The rest of the fraud crew are poorly dressed and unkempt, while the trading floor remains beautiful.

The show also fails to show much of the greed of the feeder funds who were happy to take big management fees while Madoff was content to live off the brokerage fees. There is one pair of fund managers who nearly jump with joy when they find out the arrangement.

The movie also fails to add the color that many investors thought Madoff was cheating. But they thought he was front-running trades in the brokerage. That group of investors was happy to have their money with a cheater, as long as he was cheating someone else and not them.

The SEC Tries to Shut Down Another Failed Real Estate Investment Scheme

One of the challenges faced by the Securities and Exchange Commission when encountering a real estate scam is finding jurisdiction. The SEC is limited to securities and a real estate investment is not a security. But a real estate investments may involve securities or be a securities-like investment. That is the case the SEC is trying to make against Marquis Properties and its principals, Chad R. Deucher and Richard Clatfelter.

marquis properties

The SEC has two challenges in its case. First it needs to prove that there was fraud. Second it needs to prove that the case involves securities.

Marquis, Mr. Deucher and Mr. Clatfelter have not agreed to the charges, so I’m relying on the SEC’s side of the story to look at the real estate versus securities part of the case. It does not take much time browsing in internet search results to find a long line of disgruntled investors who feel that were ripped off by Marquis.

Marquis main strategy appears to be helping investors put money into turnkey residential rentals. Marquis promises to source the investments, buy the property and manage it for the investor. That structure would likely leave little room for the SEC to get involved. That does not mean its a good investment and not a scam. It’s just not a securities transaction.

According to the SEC complaint, Marquis offered three investment options: (1) turnkey real estate investments, (2) joint ventures, and (3) promissory notes secured by real estate. That covers the spectrum going from pure real estate to more securities-like.

The SEC in the complaint paints the turnkey real estate investments as “investment contracts.” In reading the complaint, I’m not moved by the SEC’s view. The SEC fails to lay out the key features of an investment contract: “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” (328 U.S. at 301). Or the other variation of the third prong of whether the investment was premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

The SEC does a better job of at least describing the joint ventures as “investment contracts.”

“Joint venture investors have had no participation in management or decision-making for the joint venture and have relied solely on Marquis’ efforts to locate and purchase properties, renovate, and sell the properties to earn a profit on their investments.”

However, if the investors actually have the contractual right to be involved in management, regardless of whether they actually do, the SEC may lose the argument that the joint ventures are investment contracts.

As for the promissory notes, Marquis seems clearly in the “securities” business with this option. If the note was actually the single mortgage note, there is an argument to be made. But pooled investment notes used to fund real estate investments are going to be securities.

Maybe Marquis was a legitimate business at one point. If the SEC complaint’s statements are mostly true, Marquis was very cash flow negative in 2015. The company was paying out more to investors than the properties were making. The shortfall was paid from new investor cash. The classic ponzi scheme situation.

You can get your own taste of those involved in this video:

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Going All In To Save The Fund

In browsing through enforcement actions I look for lessons learned. In some cases it’s compliance doing its job and stopping a fraud before it gets too big. The case against Owen Li caught my eye. His trades were not working so he made a last ditch effort to make it all back. Given that this about an enforcement action, you can guess how that trade worked out.

poker face

Mr. Li was an alumnus of Galleon Capital. After that firm imploded, he went to work for another firm and then left in 2012 to start his own firm: Canarise Capital. He managed to raise $50 million of capital.

As part of the fundraising, the documents stated that risks would be managed through limits on position sizing and market exposure. Generally, no position would exceed 10% of the fund’s assets.

The first trouble came in February of 2014 when Mr. Li must have fallen in love with Facebook and Groupon. Those each accounted for 20% of the fund’s capital. He was operating outside of his investment mandate.

Then Mr. Li started playing games with orders at his prime broker to keep his margin balance high. When the prime broker got wind of the bad behavior it cancelled the margin allowance and placed trading restrictions.

The Custody Rule worked to an extent in this case. The NAV that the fund sent out differed materially from the NAV sent by the fund administrator directly to investors. He blamed the error on the fund administrator. That seemed to work twice.

Mr Li must have sensed that it would not work a third time. He put off approving the NAV distribution for November 2014. The NAV he told investors and the NAV that would be sent out by administrator would differ materially. He delayed and then decided to go all in.

He liquidated fund cash and other positions to buy long positions in market index options with short-dated expirations. He had eliminated all short positions in the account. He basically took all of the fund’s assets and pushed them all in to one position. Hardly a sound way to manage to risk. Certainly, it was outside the investment promises he made to his investors.

If it worked well, there was a huge upside. I assume thought his investors would forgive his past sins.

But rarely do enforcement actions come from a happy result. Mr. Li had bet wrong. When the options expired he incurred $39 million in losses, leaving the fund with less than $200 thousand in assets. Over the course of the year he had caused the fund to lose $56.5 million.

In years past, a manager might have been able to keep the lie going. Look at Madoff. I suspect something similar, although less catastrophic happened to Madoff. With no third-party reporting on the investments, he could keep going.

Without the Custody Rule, maybe Mr. Li could have put up a big Madoff lie and tried to go all in again in the future. But since investors were getting statements directly there was no place for him to hide. The Custody Rule worked.

Sort of worked. It prevented a Ponzi scheme from forming. It did not prevent the investors from being wiped out.

As for the enforcement, the SEC charged Mr. Li with failing to adhere to his investment limitations and labeled that a fraudulent action under Section 206.


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Poker Face by Lawrence
CC BY NC SA