Month: January 2013

SEC Charges Real Estate Executives with Investment Fraud

cay clubs 1

The Securities and Exchange Commission brought charges against Cay Clubs Resorts and Marinas and several of its executives for defrauding investors. The case 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 defendants have not settled with SEC, so I’ll be assuming the allegations in the complaint are true for this analysis.

Executives of Cay Clubs Resorts and Marinas raised more than $300 million from investors to develop resorts in Florida and Las Vegas. They promised investors a guaranteed 15% return through a two-year leaseback agreement and future income through a rental program. The developments didn’t succeed, so the investment turned to a ponzi scheme. New investments were used to ay the 15% return to earlier investors.

A with most investment frauds, the executives spent lavishly with the investors’ money. They bought homes, planes, cars, and boats. At least they diversified and spent some of the cash on buying gold mines, coal refining machinery, and a rum distillery.

That all sounds like investment fraud. But the charges are under sections 5(a), 5(c), and 17(a) of the Securities Act and 10(b) of the Exchange Act. The SEC is saying that the defendants sold securities, and did so fraudulently. They were selling real estate interests, or at least what looked like real estate.

According to Cay Clubs’ marketing materials, the Company would finance the purchase of the properties, renovation of the units, and development of the luxury resorts with funds raised from investors through the sale of units, which ranged in price from $300,000 to more than $1 million, and a required membership fee ranging from $5,000 to $35,000 per unit.

Cay Clubs promised a 15% return by leasing back the units from the buyers. The materials stated the leaseback was optional, but 95% of the investors entered into the arrangement. To participate, purchasers would have to pay a membership fee in excess of $5,000. The 15% return would be needed by the investors to cover carrying costs. Cay Clubs even managed to find lenders who would provide 100% mortgage financing.

During the leaseback, purchasers were restricted from using their units. They could only use the units for 14 days per year. Cay Clubs owned the common areas and controlled access to the units. Cay Clubs had a right of first refusal on the sale of a unit. Cay Clubs controlled the renovation of the resorts and the units. Under the master leasing program, Cay Clubs would rent out the units, with 65% going to the unit owner.

You can go back to the Howey case and use the four part test to determine if there is an investment contract, where 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.

This reminds me of the Boutique Hotel case. In that case the judge found that the investment was not an investment contract because the owners were not required to participate in the rental program. An owner could chose to not rent out its condominium or rent it out on its own. That means the business arrangement did not have a reliance on the entrepreneurial or managerial efforts of others. Therefore it was not an investment contract.

That distinguishes the Boutique Hotel arrangement from the one being contested in the Salameh / Hard Rock San Diego case. Hard Rock San Diego restricted the rental program to the one run by the seller/issuer. That was found to be an investment contract.

The Hard Rock case is still under appeal and the Boutique Hotel case is still running its course, so those are ones to keep en eye on.

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How Well is the SEC’s Whistleblower Program Working?

sec-seal

Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act created the SEC’s whistleblower program, awarding cash to individuals who report misdeeds that result in successful SEC cases. If the SEC collects more than $1 million, the whistleblower can receive between 10% and 30% of the award. Section 922 also required the Office of Inspector General to conduct a review of the whistleblower program within 30 months.

Surprisingly, the Inspector General had only good things to say about the program, with only two minor recommendations. I say ‘surprisingly’ because the reports from the Inspector General have recently been harsh criticisms. Not this time.

The implementation of the final rules made the SEC’s whistleblower program clearly defined and user-friendly for users that have basic securities laws, rules, and regulations knowledge. The whistleblower program is promoted on the SEC’s website and the public can access OWB’s website from the site in four or more possible ways to learn about the whistleblower program or to file a complaint with the SEC. Additionally, OWB outreach efforts have been strong and the SEC’s whistleblower program can be promptly located using internet search engines such as Google, Yahoo, and Bing.

The two recommendations from the OIG are both related to adding metrics to in the program to better monitor program performance. For example there is no standard on how long a filing should stay in the manual “triage” step in the program. The average is 31 days. By adding thoughtful metrics and performance goals the SEC could help to avoid degradation in performance and longer response times.

One key finding in the report is that there is no current need to create a private right of action based on the facts of a whistleblower complaint. The OIG report points to a possible reduction of the government’s ability to shape and develop the law. Private suits could lead to wasteful, detrimental developments that are inconsistent with executive and judicial interpretations.

But the concept is not dead. The OIG promises to revisit the private action concept in a few years after there is more data from the new whistleblower program.

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How Effective is Your Gate?

tight security

Does your compliance program sometime feel like this gate? A tool working alone is not necessarily effective. It may be a great tool, but still not be effective.

If it’s easy to get around then it’s not effective. Do you even know if people are going around? Is it even possible to know if they are going around?

Sometimes you have a great tool, but the tool does not work for your organization.

Image from There I Fixed It.

Private Equity Enforcement Concerns

sec-seal

Bruce Karpati, chief of the SEC’s Enforcement Division’s Asset Management Unit laid out a clear picture of the SEC’s expectations and concerns about private equity in a recent speech. He was speaking at Private Equity International’s annual CFOs and COOs Forum. The speech was centered around five main questions.

Q1:  How has the creation of the Asset Management Unit impacted the Commission’s activities in the private equity space?

Q2: The Commission hasn’t traditionally brought many private equity enforcement actions. Do you expect that to change?

Q3: What are some of the Unit’s concerns about practices in the private equity industry?

Q4: You’ve spoke before about AMU’s Risk Analytic Initiatives. What are they and are there any currently under way in the private equity industry?

Q5: What can a private equity COO or CFO do to reduce the risk of inquiry by the Division of Enforcement?

It seems clear that the SEC is focused on two area: valuations and fees.

Private equity investments are inherently illiquid and therefore requires the fund manager to make judgment calls about pricing. Poor judgment can lead to poor valuations. Fraudulent judgment can lead to fraudulent valuations.

Fees and revenue generation are always a focus of the SEC for investment advisers and funds, whether private or public mutual funds. Private equity merely has some additional ways of generating revenue. It seems clear from Karpati’s speech that that SEC has been looking closely at those revenue streams.

  • The shifting of expenses from the management company to the funds including utilizing the funds’ buying power to get better deals from vendors — such as law and accounting firms — for the management company at the expense of the fund.
  • Charging additional fees especially to the portfolio companies where the allowable fees may be poorly defined by the partnership agreement.
  • Broken deal expenses rolled into future transactions that may be ultimately paid by other clients.
  • Improper shifting of organizational expenses, where co-mingled vehicles foot the bill for preferred clients.

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Compliance Bricks and Mortar for January 25

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These are some of the compliance related stories that recently caught my attention.

The SEC at a Crossroads: Can Things Be Turned Around? by Broc Romanek in the CLS Blue Sky Blog

Over the past fifteen years, the SEC’s reputation has been routinely sullied – in the press, by the Courts and certainly in the halls of Congress. Although the mud slung at the SEC has intensified since the 2008 financial crisis and revelations of the Bernie Madoff Ponzi scheme, the Commission’s problems began well before then.  Particularly, the Enron and World.com scandals forced editors to move journalists into the financial realm where bashing the SEC became good copy. More and more, the SEC has been losing major decisions in the Courts.  Professor John Coffee of Columbia Law School recently indicated that “the SEC’s batting average is close to ‘zero for 2008’ in the few cases that it has taken to trial stemming from th[e] financial crisis.”   And the SEC’s major case losing streak extends well before the 2008 crisis. In addition, recently departed SEC Chairman Mary Schapiro was asked by Congress to testify at what is likely a record rate for a SEC official. Those hearings almost never went well for poor Mary.

Chesapeake Lighthouses and Lighting the Way for Compliance by Tom Fox

I thought about the story of these lighthouses and how they literally lit the way for sailors for over 200 years when I read an article in the Q2 issue of Ethisphere Magazine, entitled “Imagination Working with Integrity: How General Electric Creates a Global Culture of Ethics”, by Michael Price. Price discusses how General Electric (GE) has made “ethics and compliance a benchmark of its operations around the world, and is, in many ways the gold standard that other companies look to when it comes to modeling global compliance and ethics programs.”

SEC Faces A Swarm Of Legal Issues In Considering The Investor Advisory Committee’s Recommendations Concerning General Solicitation by Keith Paul Bishop in California Corporate and Securities Law

The SEC’s Investor Advisory Committee held another meeting last week with Elisse B. Walter making her first public appearance as SEC Chairman.  She and Commissioner Luis A. Aguilar had many kind words for the Committee’s recommendations with respect to lifting the ban on general solicitations in Rule 506 offerings.  The insouciance of their remarks, however, was in sharp contrast with the missed deadlines and many legal issues swirling around the Committee and its recommendations.

Final FATCA Regulations Released in Compliance Avenue

While the Final Regulations will be effective when published in the Federal Register (expected to occur on January 28, 2013), the timelines for the various due diligence, reporting and withholding provisions incorporate the delayed deadlines set out in IRS Announcement 2012-42 and are being phased in to allow firms to develop the necessary systems and procedures and to align them with any intergovernmental agreements.  For example, withholding agents, which may be U.S. or non-U.S. entities, will not be required to implement U.S. account verification procedures prior to January 1, 2014, and the deadline for foreign financial institutions (“FFIs”), generally including offshore investment vehicles, to file any required FATCA reports for fiscal years 2013 and 2014 will be March 31, 2015.

The Danger of a “Paper” Compliance Program by Michael Volkov in Corruption, Crime & Compliance

The FCPA Guidance contains many important compliance reminders which should be incorporated into every anti-corruption compliance program. Perhaps the most important observation included in the FCPA Guidance was the statement that:

DOJ and SEC have often encountered companies with compliance programs that are strong on paper but that nevertheless have significant FCPA violations because management has failed to effectively implement the program even in the face of obvious signs of corruption.

DOJ/SEC’s observation should be taken seriously. Every company should ask itself this basic question: Have we “effectively” implemented our compliance program?

Science Ruining Everything Since 1543
Science: Ruining Everything Since 1543

Saturday Morning Breakfast Cereal is a daily-updated comic strip that’s a GeekDad favorite. The author, Zach Weiner, announced a new collection of his science related comics are being published in a single book: Science: Ruining Everything Since 1543. He’s creating this book as a Kickstarter project. Give him money now, and you get the book when he’s done. Plus there’s more great stuff if you want to open your wallet a bit wider.

Network Security, Compliance, and Out-Sourcing Your Job To China

made in china

You may have heard the story about the computer programmer who outsourced his work duties and sat in is office watching cat videos all day. “Bob” was an “inoffensive and quiet” programmer in his mid-40’s, with “a relatively long tenure with the company” and “someone you wouldn’t look at twice in an elevator.”

His company noticed some “anomalous activity” in their VPN logs and called in a consultant. Unfortunately for Bob, his company was a U.S. critical infrastructure company. That anomalous activity was traced back to a connection in China. Red flags were raised and security alarms went off in people’s minds. The company thought it was being hacked, spied on, or infected with spyware from an unknown force in China, putting US infrastructure at risk.

Two things caused the investigators to scratch their heads: (1) The company had a two-factor authentication for these VPN connection. That means you needed a rotating token RSA key fob for network access. (2) The developer whose credentials were being used was sitting at his desk in the office.  As a result, the VPN logs showed him logged in from China, yet the employee was sitting at his desk. Even worse, the VPN connection to China was shown to go back many months, before the company was even monitoring the VPN.

Fearing that Bob’s computer was infected with a trojan horse or other malware, the investigators cloned Bob’s desktop and searched its contents. Instead of nasty computer viruses, they found hundreds of .pdf invoices from a third party contractor in China.

It turned out that this was Bob’s typical day:

9:00 a.m. – Arrive and surf Reddit for a couple of hours. Watch cat videos
11:30 a.m. – Take lunch
1:00 p.m. – Ebay time.
2:00 – ish p.m Facebook updates – LinkedIn
4:30 p.m. – End of day update e-mail to management.
5:00 p.m. – Go home

Bob had physically FedExed his RSA token to China so that the third-party contractor could log-in under his credentials. The contractor worked for a fifth of the cost of his salary. Bob pocketed the difference, surfed the internet, and managed his contractor.

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Lance Armstrong – A Lying Liar Just Like Madoff

sad lance armstrong

It’s tough to see a hero fall. I didn’t consider Lance Armstrong to be a hero for riding. But what he did for cancer survivors was remarkable.

Until recently, cycling was filthy with doping. Take a look at the podium finishers for the Tour de France. Only two of the podium finishers in the Tour de France from 1996 through 2005 have not been directly tied to likely doping through admission, sanctions, public investigation or exceeding the UCI hematocrit threshold. The sole exceptions are Bobby Julich – third place in 1998 and Fernando Escartin – third place in 1999.

I could forgive Armstrong for doping. It seems clear that everyone was doping. It leaves open the question of whether Armstrong was one of the greatest cyclists or merely one of the greatest dopers. We have no way of knowing whether his regime of doping merely leveled the playing field or elevated him above the level of his also doping competitors. Were his competitors lesser cyclists or merely less capable at doping?

What caught my attention about the Armstrong interview was the window into the mind of a pathological liar. Armstrong had been telling the lie over and over and over. He lied to the public. He lied to the press. He lied to cancer survivors. He lied under oath.

Beyond that, he attacked those who accused him of doping. He ruined the careers of journalists who dared accuse him of doping. He ruined the careers of riders who accused him of doping.

I put Mr. Armstrong in the same group as Bernie Madoff. Two men who lived their lies for decades. They both seem to regret that they got caught, not that they were lying and stealing money. Granted Mr. Armstrong’s theft was a bit more indirect.

I don’t believe most of what Mr. Armstrong told Oprah in the interview. He’s been lying too long to think that he is now telling the whole truth. But there may be bits of truth mixed in his interview. He did clearly admit to doping.

As with most pathological liars, Mr. Armstrong expressed more remorse that he was caught, than for the harm he caused. He found justification for his bad acts.

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Social Media Access by Employers

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There was a kerfuffle in the news about employers demanding access to employees’ social media site. The stories stated the employers asked for the employees’ passwords, in addition to their usernames. In response, at least six states have started the legislative process to prevent employers from demanding that access.

As you might expect, the tricky part is defining “social media.” William Carleton put together a collection of the proposed definitions and grades for the legislative definition of social media.

Her is New Jersey’s attempt, as an example:

“’Social networking website’ means an Internet-based service that allows individuals to construct a public or semi-public profile within a bounded system created by the service, create a list of other users with whom they share a connection within the system, and view and navigate their list of connections and those made by others within the system.”

Not surprisingly, the best rated definition was the one that did not have a definition. By defining a social media site, you risk the sites evolving to no longer fit within the definition.

My beef was that the definitions were focused like a laser on Facebook, LinkedIn, and Twitter. They fail to cover web publishing sites like blogs. There is a follow-up post that offers some suggested improvements.

My two cents was that these social media sites should allow employers to monitor employees:

“In the financial services industry, there are regulatory requirements to monitor employees’ interactions with customers. That’s easy to do with platforms controlled by the firm, like email, but difficult with the ever-changing platforms in social media. The solution. The social media platform should allow a company to monitor an employee’s account provided the company pays a monitoring fee. Of course the employee will need to consent to the monitoring. The platform gets a revenue stream and the company gets the monitoring and record-keeping it needs. The employee ends up with ‘big brother’ but only if the company thinks it’s a big enough problem that it is willing to pay the monitoring fee.”

If you charge the company, they will limit the explicit monitoring to those instances when the cost/benefit makes economic sense.

With the constantly evolving privacy settings on the platforms, it’s often hard to be certain who can see what piece of information can be seen by whom. But it should not be hard on the back end for a social media site to create an archive for monitoring purposes.

This will also open up these sites for more prolific use by those who have a regulatory requirement that otherwise limits access.

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Cash Transactions, Money Laundering, and a CCO Going to Jail

check-cashing

When I see a story about a chief compliance officer going to jail it catches my attention. Judge John F. Walter in the Central District of California sentenced Humberto Sanchez, the compliance officer of G&A Check Cashing to 60 months in prison. Private fund managers rarely have to worry about check cashing and bags of cash. The case is a good reminder that cash transactions have specific limitations.

In this case, G&A Check Cashing was sending customers off with cash in excess of $10,000. Under the Bank Secrecy Act, financial institutions, including private funds, are required to file a Currency Transaction Report with the Department of Treasury for any transaction involving more than $10,000 in currency. As part of the Currency Transaction Report, the financial institution is required to verify and accurately record the name and address of the individual who conducted the currency transaction, the individual on whose behalf the transaction was conducted, as well as the amount and date of the transaction.

G&A was very bad and engaged in multiple transactions involving over $8 million, in which the firm did not file the required Currency Transaction Reports.

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Crowdfunding and the Ban on General Solicitation

18 Rabbits Bars

While entrepreneurs are looking to create crowdfunding portals under Title III of the JOBS Act, small business owners looking to raise capital should keep an eye on the regulatory changes under Title II of the JOBS Act. That may do a better job of opening the spigot for capital than the avalanche of crowdfunding portals likely to appear.

Look at the case of Alison Bailey Vercruysse, a maker of granola-based foods, and her company 18 Rabbits. According to a story in yesterday’s Washington Post, her products attracted a loyal following, but she could not tap those fans for capital as she tried to grow her firm.

“People would come up to me in different places and say: ‘I’m interested in investing in your company. How can I do that?’ ” Vercruysse said. “I couldn’t say we were trying to raise money. I’d end up saying things like; ‘Buy our granola. That would help us.’ ”

Without the ban on general solicitation, the company could put a message on its packaging or its website for accredited investors interested in investing.

Currently, the Securities and Exchange Commission has a ban on the use of general advertising and solicitation for raising private capital under the most popular exemption, Rule 506. Title II of the JOBS Act requires the SEC to remove that ban for offering where all investors are accredited. The agency tried to rush the rules last summer to meet the Congressional deadline, but investor advocates demanded that the SEC slow down. The SEC is gathering public comment before finalizing the rule.

Two SEC commissioners, Dan Gallagher and Troy Paredes, were in favor of immediately lifting the ban. SEC Commissioner Luis Aguilar did not like the rule, saying it lacked adequate investor protections. The fourth SEC Commissioner, Elise Walter voted for the proposal, but expressed concerns. She has stated the SEC must consider ways to mitigate potential harm to investors. The fifth and presumably deciding Commissioner’s seat is vacant with the departure of Mary Shapiro. Looking into my crystal ball, it would seem that the rule is not going to be finalized anytime soon. At least not until the vacancy is filled.

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