I tripped across an enforcement case that was so full of wrong things that I had to re-read it. In one sense, I saw a clever way to exploit an investment feature. On the other hand, the whole investment felt morally wrong, was deceptive and violated at least one important rule under the Investment Advisers Act.
Given my station in life, I had not come across bonds with a “survivor option.” It’s a feature that allows an investor’s heirs to redeem the bonds at par value upon the investor’s death. It’s an attractive investment feature for older investors who are concerned that rising interest rates will hurt the value of their bond holdings. The survivor option allows a bond to be redeemed at face value. If the bond has decreased in value because of higher interest rates, the investor’s principal is protected at death.
If you are clever, terminally ill, and want to leave cash to your heir, there is a way to exploit this feature.
Step one: find some bonds with a survivor option that are trading at a discount.
Step two: buy those bonds.
Step three: die quickly.
Step four: have your heir redeem the bonds at face value, turning the purchase discount into a gain.
If you are morally challenged and have a terminally ill family member, perhaps you could convince them to make this investment for your benefit.
If you are morally challenged and want to make some money, you could seek out terminally people, befriend them, open a joint account and invest together in the bonds.
If you are Donald Lethen, as least according to the Securities and Exchange Commission, you could raise capital to do this and break a bunch of security laws in the process.
According to the SEC Order, Mr Lethen created an investment fund managed by his Eden Arc Capital Management firm to invest in these bonds with survivor options. He used contacts as nursing homes and hospices to find patients with less than six months to live. He gave them a fee and then opened joint accounts with the patients to invest in the bonds with survivor options that were trading at a discount.
The SEC alleges that Mr. Lethen was merely a nominee for the investment fund that had funded the purchase of the bond. The fund could not be joint account owner and receive the survivor benefits. Mr. Lethen himself was the joint owner of the account funded with the investment fund’s money to buy the bonds.
Let me know if you see the Investment Advisers Act rule violation.
Let’s look at the other issues while you think about it.
Mr. Lethen does not seem to be misleading the patients. They get paid for their involvement in the scheme.
He may be misleading the bond issuers. That would depend on the wording of the survivor option. Mr. Lethen was the named joint account holder. It’s not clear if he was making untrue statements to exercise the survivor option.
Back to the Advisers Act issue. Do you see the problem?
The Custody Rule.
Mr. Lethen is putting the fund money into a joint account controlled by Mr. Lethen. The account was not in the fund’s name or controlled by the fund’s general partner/investment manager. Mr. Lathen failed to custody the fund assets in accounts in the fund’s name or in an account that contained only fund assets controlled by the fund manager.
Sources:
- Fund Operator Probed for Death-Put Strategy
- Hedge Fund Manager Charged in Scheme Involving Terminally Ill
- SEC order
