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.


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