Category: What is a Security?

So It’s a Security, But Maybe the Private Placement Was Okay?

Looks like a great investment?
Looks like a great investment?

The tale of Western Financial Planning Corporation and Louis Schooler first caught my eye because the Securities and Exchange Commission brought charges against a real estate company. I stuck with the story because Western Financial tried really hard to structure the investments to avoid being considered securities. Even thought it tried really hard, a court still found that Western was selling securities. Having lost that battle, Western is staying on step ahead of the SEC charges. Western is claiming that the investments were sold through a good private placement.

Western had structured the real estate investment vehicles as general partnerships and sold those partnership interests to investors. The presumption is that a general partnership interest is not a security. So if the investments are not securities, then there can’t be securities fraud, and the Securities and Exchange Commission loses the case. Western lost the securities argument and the court found that the interests met the Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir. 1981)  three part operational test for an “investment contract” as a security.

Western would lose on the charge of selling an unregistered security unless it could find an exemption from registration. The firm argued that the sale of interests qualified for the exemption under Rule 506. Western managed to hold on a bit longer and managed to survive to continue the fight. The SEC failed to prove that the sale failed the Rule 506 tests.

The main parts of the Rule 506 exemption are:

  1. There must be no more than 35 purchasers who are non-accredited.
  2. The non-accredited investors must have the knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.
  3. The interests can not be offered for sale by general solicitation or general advertising (from Rule 502).

The first stumbling block is whether there was one long continuous sale of interests or merely several separate sales. 17 C.F.R. §230.502(a) sets out a five factor test for whether the separate sales should be “integrated” into one long continuous sale:

(a) Whether the sales are part of a single plan of financing;
(b) Whether the sales involve issuance of the same class of securities;
(c) Whether the sales have been made at or about the same time;
(d) Whether the same type of consideration is being received; and
(e) Whether the sales are made for the same general purpose.

Although Western sold 23 different properties and 86 general partnerships, the court found that they were sold close enough together to be integrated into one offering. Point to the SEC. As a result of losing that point, Western does not get up to 35 non-accredited investors for each general partnership, but only 35 against all of them.

The SEC made a mistake and had no evidence about the net worth of the investors. The SEC did not prove that there were more than 35 non-accredited investors. That leaves a dispute of material fact which means you don’t get summary judgment, but a trial instead.

The court draws an interesting distinction in general solicitation and notes the SEC’s no-action letter: E.F. Hutton&Co., No-Action Letter, 1985 SEC No- Act. LEXIS 2917 (Dec. 3,1985).  A general solicitation for clients does not turn into a general solicitation for securities as long as a “sufficient time” passes between establishment of the relationship and the offer.

Western argues that its extensive use of cold calls, networking groups, and mailings by an affiliate was merely to solicit clients for the affiliate and not to sell Western’s securities. The SEC failed to provide sufficient evidence that there was insufficient time.

Largely, this is matter of pleading and the SEC failing to put together the right evidence to win on summary judgement. The court is allowing the SEC to refile the motion and fix the evidence mistakes.

This just goes to the charge of selling unregistered securities. It’s not addressing any actual fraud by Western.

Sources:

Miscounting Residents as Securities Fraud

courtyard

A recent SEC enforcement action caught my attention because it involved defrauding a landlord and miscounting residents. That left me scratching my head over why the Securities and Exchange Commission was involved with a senior living residence.

The SEC Enforcement Division alleges that then-CEO Laurie Bebo and then-CFO John Buono made false disclosures and manipulated internal books and records when it appeared likely that their company, Assisted Living Concepts Inc., would default on financial covenants in a lease agreement. Under the leases for the facilities, ALC was required to maintain occupancy levels as well as debt service coverage levels.

Like lots of fraud, it started off with a small bad act. Bebo and Buono wanted to include ALC employees who stayed overnight at the facilities as occupants. Then it got worse and they started counting employees who never stayed at the facility, family members, friends and people they interviewed for job openings. At the end of the fourth quarter 2011, the SEC alleges that between 45 and 103 reported occupants were non-residents.

The fraud was all directed at the landlord to avoid a default. ALC had publicly traded stock so the landlord fraud turned into public company accounting fraud.

Sources:

Can an ATM Machine Be a Security?

Woman Using Atm Machine

Nationwide Automated Systems offers turnkey ATM solutions. A turnkey ATM program addresses the need for ATM service, repair, system monitoring, and cash replenishment. Typically the ATM provide will split some of the fee income with the property owner where the ATM is located rather than pay a fixed rent.

To raise capital Nationwide create a sale-leaseback with third party investors. The investor buys the machine from Nationwide, then leases it back to Nationwide for ten years in return for rent. The rent is payable as $0.50 per approved transaction.

The Securities and Exchange Commission claims that Nationwide did not actually own the machines is was selling and was generating very little revenue from ATM transactions. The SEC is accusing Nationwide of using new investor investments to pay old investors’ guaranteed returns. The SEC slapped the Ponzi label on Nationwide.

According to the SEC complaint, there was fraud. Nationwide had entered into more than 31,000 ATM sale-leaseback transactions. The SEC investigator only found records of Nationwide owning a few hundred. The SEC also found records of Nationwide selling the sale ATM machine to multiple investors.

Even if there is fraud, the Securities and Exchange Commission can only get involved if there are securities. The SEC needs to prove that the sale-leaseback arrangement was essentially an investment contract. That leads back to some derivation of the Howey case to determine if there is an investment contract, and look at whether there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

The SEC latched onto a non-interference provision in the leaseback. The ATM owners are prohibited from interfering with operations of the ATM or contacting the locations where ATM is located. That provision is to keep busybodies from showing up at the ATM location and making a nuisance of themselves.That didn’t prevent one suspicious investor from calling the location where her ATM was located, only to have the hotel manager tell her there was no ATM as the hotel.

For a legitimate arrangement that non-interference provision is a perfectly valid provision. The SEC is interpreting it as part of the fraud.

I think this case will hinge on the provisions in the ATM lease. If the investor has some right to end the lease and do something else with the machine, then this is a real estate transaction and not a securities transaction. That means the SEC is out of the picture and the California authorities would need to step in.

The big sign of fraud is the guaranteed return. No investment should have a guaranteed return of 20% per year over 10 years.

The other sign is the cost of the machine. You can buy a basic ATM machine for $2,000. Nationwide is getting a big markup on the sale part of the sale-leaseback.

Nationwide ran into trouble in August when it ran out of cash and bounced checks to investors.

According to the SEC complaint, from August 20 to September 8, 2014 Nationwide deposited almost $4 million into its bank account. Only $52,463 was from ATM transaction revenue. During that same time frame, Nationwide paid over $2 million in “guaranteed” lease payments to existing investors.

I’m impressed with how quickly the SEC brought this case one the checks starting bouncing.

Sources:

Combining Immigration Fraud and Investment Fraud

USA-NYC-Ellis_Island_crop

The EB-5 Immigrant Investor Program sounds like a scam so I’m not surprised to see it pop up in actual scams. The EB-5 program provides foreign investors who can demonstrate that their investments are creating jobs in this country with an expedited path to lawful permanent residency in the United States. EB-5 is not common with real estate investors because construction does not provide the permanent jobs required by the program. (The exception is hotels.)

The Securities and Exchange Commission brought charges against Justin Moongyu, Rebecca Taewon Lee and Thomas Edward Kent for combining an EB-5 program with an investment scam. The three raised $11.5 million for investment in a Ulysses, Kansas ethanol production plant. According to the SEC complaint the three were promoting a positive investment return coupled with a path to legal residency in the United States.

The SEC alleges that the three diverted over $7 million of the investor’s money to unrelated projects and personal use. The plant was never built.

As you might expect, the SEC complaint spends a chunk of the pleading showing that the fraud involves securities. The SEC states a case that (1) there was investment of money, (2) there was a common enterprise, and (3) profits were to be derived from the efforts of others.

Although it’s not clear from the case filings, I assume the investors not only lost their money, but also lost their path to citizenship.

Sources:

USA-NYC-Ellis Island
CC BY-SA 3.0

By: Ingfbruno

 

Not Securities Fraud By Reason of Insanity

insanity

Some investment fraud schemes sound crazy, but leave just a enough truthful-sounding bits to catch people. But Thomas Lawler’s scheme sounds completely bonkers. He established the Freedom Foundation to offer investors the chance to erase their debts and collect lucrative profits through the purchase of “administrative remedies”.

Never heard of profit-making “administrative remedies”? Lawler can sell you the secret.

Lawler investigated the banking system and discovered the startling “truth.” At birth, we each have an account established in our name. When you borrow from the bank, you are actually borrowing your own money that resides in your account. For a mere $1000, Lawler will prepare notices to the creditors, using the Uniform Commercial Code, international admiralty law, and papal decree to cancel the debt.

At least that is according to the SEC’s complaint. I checked out the Freedom Club USA website to find more information. The website is a big collection of crazy.

Here is a snippet:

The Vatican created a world trust using the birth certificate to capture the value of each individual’s future productive energy. Each state, province and country in the fiat monetary system, contributes their people’s value to this world trust identified by the SS, SIN or EIN numbers (for example) maintained in the Vatican registry. Corporations worldwide (individuals became corporate fictions through their birth certificate) are connected to the Vatican through law (Vatican to Crown to BAR to laws to judge to people) and through money (Vatican birth accounts value to IMF to Treasury (Federal Reserve) to banks to people (loans) to judges (administration) and sheriffs (confiscation)

The website includes ramblings about a lost 13th amendment to the Constitution, the illegality of the 1040, the Cosmic Time Plan, and an audio recording from the Prime Creator.

In sorting through the crazy, it’s hard to tell if it’s a securities fraud issue. It’s certainly a fraud. Anyone giving money to this kind of full-blown crazy is throwing their cash away. It sounds like Lawler may be selling a service and not an investment. There is too much crazy on the website for me to discern what Lawler is actually selling.

You can look to the Howey four-part definition of an investment contract. There is certainly an investment of money and the reliance on others. There is a reasonable expectation of profits. Cancelling debt is income, so the SEC can probably get over that hurdle.

But I’m not sure there is a “common enterprise.” Lawler’s scheme seems more like fraudulent credit reduction scheme than a securities investment.

Sources:

Image of Insanity by Albert Einstein by Marla Elvin
CC BY SA

Massachusetts Stops Real Estate Scam

Flag-map_of_Massachusetts.svg

Secretary of State William Galvin claims Cabot Investment Properties LLC and its principals, Carlton P. Cabot and Timothy J. Kroll, stole more than $5 million from Massachusetts residents. Cabot was offering tenant-in-common interests to investors. But I remember from law school that a tenant-in-common interest is real estate. So why are the defendants charged with securities fraud?

Tenant-in-common arrangements are common for real estate. (More often you see joint tenancy, where the other party gets the whole when the other dies.) The tenant-in-common arrangement is more often used in commercial properties as part of a 1031 exchange. It’s a way to park cash from the sale of another asset to defer the payment of taxes.

A TIC Interest is a co-ownership structure that allows multiple investors to share undivided fractional ownership in a property such as an office building or shopping center. The owners share equally in the management and other property decisions. If it was organized as a partnership or fund, the investment would not be considered real estate and therefore not subject to the tax deferral of 1031.

The challenge is getting collective decision-making and management from a group of unrelated investors to manage the commercial property. That means the group will have to layer some management rights onto the tenant-in-common relationship. That means the investor may be relying the efforts of others for success of the project.  This is not a novel issue. Tenant-in-common sponsors have been wrestling with their treatment as securities. The twist is that the investment can be considered real estate for tax purposes and a security for regulatory purposes. The structuring of a TIC is more focused on meeting the IRS rules for treatment as real estate than the SEC’s view of what is a security.

It looks Cabot treated the TIC interests as securities because the Administrative Complaint mentions the offering documents which include a private placement memorandum. You’re not likely to have the document for a real estate investment. In searching through EDGAR its easy to find many of the Form D filings for Cabot’s TIC offerings.

I don’t have access to the documents, but one item in the list of an investor’s real estate documents is a master lease and a property management agreement. Those will likely leave management of the property firmly in the hands of the sponsor.

From there, the charges run through pilfering money and commingling money among the investments. In reading the complaint it’s hard to tell what was poor management or poor disclosure or poor communications with investors or fraud. The investments failed and investors lost money. According to the complaint and other lawsuits, a substantial sum was diverted outside the investment TIC structure to Cabot.

This seems to be a clear case of real estate being turned into a security.

Sources:

Update on the Cay Clubs

cay clubs 1

The Securities and Exchange Commission brought charges against several executives of Cay Clubs Resorts and Marinas for defrauding investors. The case originally caught my eye because it involved real estate and would likely play a role in my continuing quest to figure out what’s a security. The SEC’s complaint stated that the defendants “offered investors the opportunity to purchase undervalued condominium units and obtain an immediate 15 percent return through a two-year leaseback agreement with Cay Clubs.” Cay Clubs was not named as defendant in the action against its CEO Fred Davis Clark Jr.; Clark’s wife, Cristal Coleman; sales director Barry Graham; investor-relations director Ricky Lynn Stokes; and CFO David Schwarz.

In its first stumbling block, the Securities and Exchange Commission failed to include a copy of the purchase agreement for the sale of the investments. The judge ruled in July 2013 that without that document the court could not apply the Howey test to see if the investment was an “investment contract.”

Apparently, the Securities and Exchange Commission fixed that mistake, but ran into a bigger stumbling block: time.

The SEC filed its charges over a year ago in January 2013. However, it appears that the investment sales had stopped in 2007. Several of the individuals had left Cay Clubs in October 2007. That’s more than five years and beyond the statute of limitations. Under 28 U.S.C. §2462 the SEC must bring an action for enforcement of any civil fine or forfeiture within five years from the date the claim first accrued.

Finding that the Securities and Exchange Commission “failed to meet its serious duty to timely bring” an enforcement action, the federal judge in Miami closed the case. He dismissed the action with prejudice, noting that “the SEC waited” despite an exhaustive seven-year investigation.

“In essence, the SEC’s argument in this case is that because the words ‘declaratory relief,’ ‘injunction,’ and ‘disgorgement’ do not appear in §2462, no statute of limitations applies.”

Judge King disagreed and cited the U.S. Supreme Court’s decision last year in Gabelli v. SEC.

We are not going to reach the substance of the case and the point of my original interest: were they selling “real estate” or were they selling “investment contracts.”

Resources:

Can a Vending Machine Be a Security?

virtual concierge and compliance

The Securities and Exchange Commission brought charges against Joseph Signore and Paul Lewis Schumack, II in connection with an alleged investment fraud concerning the sales and marketing of a “Virtual Concierge” machine. The machine looks like an ATM, but carries advertising and can print tickets and coupons. It looks shady, but a machine alone is not a security. Does the SEC have jurisdiction?

According to the SEC complaint, Signore and Schumack offered two investment options. The first is the aggressive option. The investor is responsible for placing the machine. The second option is the passive option where the investor makes an investment and lets the company do the work in exchange for a guaranteed payment of $300 per month.

Under the passive option, the investment arrangement could be considered an “investment contract” under the definition of a security. I assume the court will use some derivation of the Howey case to determine if there is an investment contract, and look at whether there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

I would guess that the aggressive option would not meet the test. But the passive option is likely to meet the test. The virtual concierge investors pay $3500, do nothing, and get $300 per month. It sounds like the investors are relying on the managerial efforts of others to generate profits.

The virtual concierge contractual arrangement sounds a lot like the orange grove investment in Howey. The actual investment is in real estate or a tangible good. But the investment is wrapped with a management contract that turns the investment into a passive investment that is likely to meet the definition of an “investment contract.”

From the criminal complaint, it sounds like Schumack and Signore were very good at convincing people to make the investment. A confidential witness states that they sold approximately 16,000 units. However, the company was only able to place 46 machines.

Of course, this story is based solely on the government’s accusations and the defendants have not had an opportunity to respond the charges. The story caught my eye as part of my continuing to quest to define a “security.”

References:

Are Oil and Gas Investments “Securities”?

oil well and compliance

The Securities and Exchange Commission brought an enforcement action against Jeffory D. Shields, GeoDynamics, Inc., and several other business entities affiliated with Mr. Shields, alleging securities fraud. The businesses are oil and gas exploration and drilling ventures and Mr. Shields, as managing partner of GeoDynamics, marketed the interests Joint Venture Agreements. The district court granted defendants’ motion to dismiss and the SEC appealed. The point of contention was that despite their labels, are the JVs actually “investment contracts” and therefore “securities” subject to federal securities regulations.

The District Court dismissed the action because it concluded that the JVs were not investment contracts. The appeals court was not willing to draw a bright line in the sand that the JVs were not “investment contracts.” The SEC wins the appeal and goes back to court to prove that the JVs are securities.

It sounds like Mr. Shield’s strategy was fraudulent. Even the appeal court call his business a “boiler room” making hundreds of calls a day promising annual returns between 256% and 548%. But the SEC does not have jurisdiction over all frauds. It only has jurisdiction over securities fraud.

The investment was structured as a general partnership with GeoDynamics as the managing venturer. The offering documents state that the interests are not securities. The partners grant broad powers to GeoDynamics with the sole power to bind the partnerships.

Investors had the right, by 51% vote to remove GeoDynamics as the managing venturer and to terminate the partnership. The investors also had certain right to call meetings and to inspect records.

The court goes back to the Howey test of “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). It uses the variation on 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.” Hous. Found., Inc. v. Forman, 421 U.S.  at 852.

The court starts with a strong presumption that a general partnership interest is not a security. But then goes on to three examples of when a general partnership interest can be a security:

(1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or

(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or

(3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manger of the enterprise or otherwise exercise meaningful partnership or venture powers.

The appeals court found enough to state that the presumption that investments were not securities. It did not go so far as state that the investments were securities or that they were not securities. It’s back to court with a small victory for the SEC. The case offers a great summary of the testing of general partnership interests as securities.

References:

Image is Pumpjack located south of Midland, Texas by Eric Kounce

When a Real Estate Investment Empire Turns Into a Ponzi Scheme

money compliance ponzi real estate

Real estate investment is capital intensive. Most opportunistic and value-add real estate investments are not cash flow positive for the entire ownership of the asset. As some point, an investment may be using equity to pay outstanding interest on debt. The line between a ponzi scheme and long term investment can hinge on the nature of disclosure and the form of financing.

The use of notes issued to investors instead of partnership interests is going to cause a cash crunch when times get bad. There is not enough equity to take the loss. Proper disclosure can help. It’s theoretically possible that the proper disclosure that new investment money is being used to pay interest on other notes will cure the problem. (Of course, it will greatly diminish your chances of getting new investors.) Lying to the new investors will get you into trouble.

Michael Stewart and John Packard  are charged with lying to investors. SEC and DOJ charges against real estate companies usually catch my eye. Bad behavior reflects poorly on the industry as a whole. Stewart and Packard got into trouble with their Pacific Property Assets empire. Like many real estate investments, the investments were not cash flow positive. The investments realized returns when the real estate had appreciated in value and was either sold or re-financed. I assume things were running fine for several years as the company was investing, refinancing, and selling apartments in southern California and Arizona.

Then 2007 came along and the real estate debt markets starting cooling down and residential real estate started decreasing in value. According the criminal indictment, this is when they stepped over the line. (Stewart and Packard have not had a chance to defend themselves and I only have the government’s side of the facts.)

According to the indictment throughout 2008 and the early part of 2009, they continued to solicit new investor but failed to disclose the changing fortunes of the company. Stewart and Packard raised over $35 million in promissory note offerings. According to the prosecutors, the disclosure documents were materially misleading, deceptive or fraudulent.

Stewart and Packard claimed to have obtained over $15 million in refinancing proceeds during the first six months of 2008. According to the indictment, they actually obtained $0.

Their last offering was an opportunity fund in 2009 in which they raised $9 million claiming it would be used to “acquire, renovate and operate additional workforce level apartments.” Instead, the proceeds were used to pay other investors and their own salaries.

The investment scheme collapsed in May 2009 when they defaulted on repayment of the notes and filed for bankruptcy in June 2009.

The FBI dug deeper and also found bank fraud. In applying for a loan from Vineyard Bank, Stewart and Packard submitted false financial statement for Pacific Property Assets. That got them the mortgage loan, but also got them a criminal charge for bank fraud under 18 U.S. Code §1344.

To top it off, Stewart and Packard transferred cash out of the company after they defaulted on the loans but before they declared bankruptcy. They hoped to save some cash. Instead, they got another criminal charge.

I read the complaint as two guys trying to hold their real estate empire together as times turned hard, hoping they could hold out until prices once again increased. But instead they great recession grabbed hold and they had no hope of getting out of the hole they dug. They dug the hole deeper each time they lied to their investors and banks.

That didn’t seem to deter them because they came back in 2010 with a new partner and new company: Apartments America. The SEC brought charges against them in 2012. (The DOJ filed the charges on the older scheme in January 2014 and just beat the statute of limitations.)

The new scheme involved selling membership units in LLCs that would purchase apartment buildings. They used general solicitation to do so, with newspaper ads, websites, and cold calls. They cherry-picked investments and showed great returns. They failed to disclose the Pacific Property bankruptcy.

In looking through the defense motions, the lawyers did not challenge the jurisdiction of the Securities and Exchange Commission. I see the potential that the LLC membership interests might not be securities. It would depend on the investors rights under the LLC agreement. It appears from the pleadings that the SEC approached them and they made some changes to the advertisements. But the SEC was not happy with the changes to the website. That lead to enforcement and likely lead to the DOJ involvement.

References: