Learning Lessons From Gaffken & Barriger

I read through an occasional SEC complaint looking for lessons to be learned. Those involving real estate funds particularly catch my eye. I found the complaint against Lloyd V. Barriger (.pdf) and his management of his Gaffken & Barriger Fund to be full of lessons.

I don’t have any independent facts and am accepting the complaint at face value. Barringer has not settled with the SEC so I’m sure he has a different view of the events and disagrees with some of the statements. In large part it looks like he was trying to make it through the collapse of the housing market and the liquidity crunch of 2007 & 2008 by stretching his funds and his investments. Ultimately, his fund could not hold out any longer and collapsed.

“In the midst of the credit crisis, Barriger chose to lie about the solvency and liquidity of his fund rather than admit the somber truth of a collapsing business,” said George Canellos, Director of the SEC’s New York Regional Office. “He continued to solicit new investor funds based on the same misrepresentations up until the day before the fund collapsed.”

Gaffken & Barriger started off by investing in microcap securities. Then it, like many investors, was lured by the outsized returns of the real estate in 1998. Effective August 1,2005, the Fund’s stated purpose was “investing, holding, and trading in real estate, real estate loans, real estate securities, other securities and other financial instruments and rights thereto[.]” According to the PPM, the Fund’s primary strategy was “hard money lending”making high interest short-term bridge loans to real estate developers.

As you might guess with hindsight, the fund started experiencing higher delinquencies in 2005 and started experiencing losses. I would guess that he started stretching the truth hoping his investments would bounce back, only be trapped into bigger lies as the losses grew instead of decreasing.

I found it interesting that the SEC focused on the preferred returns to the limited partners in the fund. This is a practice that is common in many real estate funds. Investors often get a preferred return and the sponsor gets an over-sized portion of the profit above that return. I think the SEC got caught up in the tax allocations of the fund and took it as a bad fact. I’m not sure that warranted.

Another lesson to take away is that Dodd-Frank will not do anything to prevent this type of fraud. Given the size of Gaffken & Barriger it would not be SEC registered, but would be state registered. The SEC would still be able to investigate, but would not be the examiner.

That is a common theme I have noticed in SEC complaints against investment advisers and fund managers. They are mostly below the $100 million threshold for SEC registration. These troublemakers will need to be caught by state examiners. The SEC may be able to come riding in on its white horse to round up the bad guys, but will not be in a position to make an early intervention to prevent the fraud.