Category: Fraud

The Fall of Sam Israel

octopus sam israel guy lawson

Sam Israel is a scumbag. He is a liar and a cheat. He admits so in Octopus by Guy Lawson. Israel was the nefarious trader behind the Bayou Funds, one of biggest hedge fund ponzi schemes, at least until Bernie Madoff finally fell to Earth.

Lawson met with Israel while Israel was in prison. He want to write about Israel’s fraud at the Bayou Fund. Lawson found him to be devious, defiant, impossible to not like.

Israel started as a trader, not an investor. He made his money on the short movements of stocks. He made his big money by cheating. He would front run client trades. He would trade on inside information.

Then he decided he want to be his own boss, so he started the Bayou Fund. But he was not successful. Rather than disclose this to investors, he rebated a big chunk of brokerage fees to show a good return. He figured he could make it up in the next trade.

Then he missed again. Again, he didn’t want to admit his shortcomings so he chose the path of deceit. But now the amount was too much to fix with creative bookkeeping. He turned to a complete fabrication of financial results. Israel called this “The Problem.”

He kept trading to try to fix The Problem. He thought the next trade could make enough to fix The Problem. But it kept getting bigger as his actual results continued to be well below the result he was telling investors.

Then Israel ran into a shadowy figure that told him about a secret market for prime government bonds sold at huge discounts. He could get enormously wealthy by trading in the secret market. Israel thought he had found a solution to The Problem.

The publisher was nice enough to send me a copy of the book. It caught my eye because it offered an insight into the mind of a fraudulent fund manager and the machinations of a ponzi scheme. It’s a twisted mind. The tale of trying to fix The Problem is even more twisted.

Buckets of Money

buckets of money

Radio personality Raymond J. Lucia, Sr. got in trouble with the SEC. An administrative law judge made it official and issued an initial decision in the case. Lucia will barred from associating with any investment adviser, broker or dealer, the investment adviser registrations for him and his firm are revoked, and is stuck with a $50,000 penalty against him and a $250,000 penalty against his former IA firm.

Judge Elliot’s decision found that that firm had violated the investment adviser antifraud statutes and that Lucia had aided and abetted the firm’s violations. “Judge Elliot’s initial decision vindicates the Division of Enforcement’s original position that Lucia and RJLC misled the investors who attended their seminars by claiming that the Buckets of Money strategy had been successfully backtested when in fact it had not been,” said Michele Wein Layne, Director of the SEC’s Los Angeles Regional Office.

It’s not over yet. Lucia and RJLC have 21 days from the date of the decision to appeal the decision. I suspect they will appeal.

The SEC found four flaws in Lucia’s performance marketing, with the misleading application of:

  1. historical inflation rates
  2. investment adviser fee impact
  3. returns on Real Estate Investment Trust (REIT) securities, and
  4. reallocation of assets.

The biggest problem cited by the judge was the backtesting use of REITs in the fictional portfolios that went back to 1966. Lucia used an assumed dividend rate of 7%, but is alleged to have failed to disclose that it was an assumed rate. Another problem was using non-traded REITs in the backtest when non-traded REITs were not available during that period. The last problem was that Lucia failed to disclose the illiquidity of non-traded REITs.

Looking at the administrative order it seems that these deficiencies could have been fixed with proper disclosure. Maybe not fixed, but would have reduced the likelihood of the SEC bringing charges and an adverse decision.

One interesting carve-out by the judge was an exclusion of Lucia’s slideshows from the definition of written communications under Rule 206(4)-1(b). The SEC did not show that the slideshow was printed out and distributed.

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Failing to Disclose a Lack of Control

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Whenever I think of oil and gas syndications, I think of Dallas and J.R. Ewing. You can get screwed over in the wiggle of one of Larry Hagman’s luxurious eyebrows. The SEC’s complaint against Infinity Exploration for securities fraud in connection with oil and gas wells still caught my attention.

The first question is whether the interests would be securities or real estate. The SEC complaint focused on two offerings: Matagorda and New Mexico 10. Both were pooled investment vehicles. Infinity will have to battle its own statement. The PPMs for the investments both state that the offering consists of “securities” and that the investments are being offered pursuant to Regulation D.

One of the main charges is that Infinity mischaracterized what the pooled investment vehicles owned. The PPMs stated that the investment objective was to acquire, own, and deal with the prospect and that Infinity would perform drilling, testing and operations of the well. The SEC charges that Infinity was merely raising funds to invest in a joint venture with another firm and that Infinity would not be in a control position. The PPMs never disclosed that investors were purchasing an interest in an entity that would merely hold interests in another joint venture. The SEC also lays out a long list of other false or misleading statements in the PPMs.

Assuming the SEC view is correct, the lesson is to properly disclose the nature of the investments when fund raising. Real estate often has several layers of ownership and control. The key is to properly disclose those layers and how your investment fits into the mix.

The second big failure is that Infinity mischaracterized the use of proceeds. The PPM said that 80% would go to pay well-related costs, and the balance to administrative and overhead costs. The SEC charges that the 80% went to the third party joint venture partner who was actually doing the well work and Infinity kept the 20% as a commission.

It all fell apart when the joint venture partner went belly up. One investor had put in $37,500 with promises of immediate income and return of 100% of principal within a year. He ended up with a grand total of $667 in revenue. That is less than the annual grooming cost was for the late Larry Hagman’s eyebrows.

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Trouble on Top of Trouble

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MayfieldGentry Realty Advisors mastered the one-two by disclosing to a client that the firm stole their funds on the evening before they were brought up on charges for a pay-to-play violation.

In May, 2012, the Securities and Exchange Commission charged former Detroit mayor Kwame M. Kilpatrick, former city treasurer Jeffrey W. Beasley, and MayfieldGentry in a secret exchange of gifts to peddle influence over the city funds’ investment process. The SEC alleges that Kilpatrick and Beasley, who were trustees to the pension funds, received $125,000 worth of private jet travel and other perks paid for by MayfieldGentry. That would currently be a violation of SEC Rule 206(4)-5.

As long as the firm was going down, MayfieldGentry decided to also disclose that the firm had stolen $3.1 million. The SEC brought new charges against the firm for that theft.

In reading the complaint, assuming the facts are true, it looks like MayfieldGentry was as best sloppy and lazy. The firm had an agreement to buy two shopping centers for $7.4 million and obtained a bank loan for $4.3 million of the price. That left the firm needing $3.1 million of equity, but only had $200,000 of cash. The easy answer was to have its client, the Police and Fire Retirement System of the City of Detroit, fund the equity.

The problem is that MayfieldGentry didn’t bother to get approval from the pension fund. Even worse, it purchased the property in a subsidiary wholly-owned by MayfieldGentry. The firm didn’t transfer ownership of the subsidiary to the pension fund.

Apparently, the plan was to have another investor purchase the property and transfer the cash back to the pension fund’s account. Bad timing trapped the firm. The acquisition happened in March 2008. Then the financial markets imploded and the value of the shopping centers collapsed.

Since the case involved real estate, perhaps the SEC lacks jurisdiction? No, MayfieldGentry was registered with the SEC as an investment adviser.

Maybe the case was an instance of an adviser making a mistake, then failing to remedy the problem. Would the pension fund have agreed to investment? We don’t know. I assume the answer was “no”, otherwise the firm would have transferred the properties to the pension fund.

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Relying on the Fat Finger Excuse

compliance and fat fingers

David Miller was a big Apple enthusiast. He saw the growing stock price and must have been scheming of ways to make some extra cash by jumping on board Apple’s express train to riches. He saw the golden ticket when a client asked him to make a series of Apple stock purchases. Instead of following the client’s instructions to buy 1,625 shares, he could add a few zeroes and buy 1,625 thousand shares.

While Apple stock continued its stratospheric rise in price, Miller would share the profits from the “mistake” with his client. But the balloon popped and the train crashed. Apple had less than stellar quarterly numbers. The stock price decreased. Miler and his firm were sitting on a $5.3 million loss.

Needless to say the client was not happy about the unauthorized trade on his behalf, leaving the firm to take a sour bite and eat the loss. Apparently Miller’s excuse was supposed to be a “fat finger” excuse. Miller accidentally added a few zeroes. Maybe that was a good excuse. The message from client could be misread:

“AAPL . . . b 125 ok (per ½ hr)”

That excuse could have worked except Miller also placed another unauthorized trade to sell 500,000 shares of Apple stock. That makes it really difficult for Miller to claim the fat finger excuse. One mistake might get a pass, but the second shows bad intent. That bad intent got him a fine from the SEC and a criminal charge from the DOJ.
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Cherry Picking Trades

compliance and cherry picking

A recent SEC action shows you exactly how to NOT allocate trades. The SEC brought charges against Howard Berger for not allocating trades until the end of the trading day.

Berger would routinely allocate the profitable trades to his wife’s account and the unprofitable trades to his private investment fund account. Since Berger would usually sell his positions at the end of the day, it was easy to see which trades worked and which ones lost money.

One trading platform seemed to be agnostic about allocations. When that trading platform went of business he switched to a second that better tracked the changes in allocations. That trading platform’s activity logs showed hundreds of instances where Berger switched allocations from the fund’s account to his wife’s account.

That’s a combination of theft and stupidity. he was blatantly stealing his client’s money and not bothering to notice the trail of breadcrumbs showing the theft.

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The Obnoxious LIBOR Emails

compliance and email

It seems clear that the LIBOR figures were subject to manipulation. Many banks are under investigation. The Royal Bank of Scotland agreed to pay $610 million in fines to UK and U.S. regulators for its role in the Libor rate-rigging scandal. As part of that settlement, the U.K.’s Financial Services Authority released emails and other communications between traders, employees who submitted Libor rate information, and in some cases, traders and other employees outside the three banks. They tell a sad tale of manipulation and fraud.

Trader C: “The big day [has] arrived… My NYK are screaming at me about an unchanged 3m libor. As always, any help wd be greatly appreciated. What do you think you’ll go for 3m?”
Barclays Submitter: “I am going 90 altho 91 is what I should be posting”.
Trader C: “[…] when I retire and write a book about this business your name will be written in golden letters […]”.
Submitter: “I would prefer this [to] not be in any book!”

Rarely do you find the email that exonerates you. It’s always the email with something stupid that makes you and your company look bad. Sometimes, the communication is out of context. Sometimes, it’s just the stupidity of the sender who thinks the message is as ephemeral as a nod in the hallway.

Martin Lomasney created a famous saying on the importance of discretion: “Never write if you can speak; never speak if you can nod; never nod if you can wink.”

From one trader to another broker:

“if you keep 6s [i.e. the six-month Japanese Libor rate] unchanged today… I will f***ing do one humongous deal with you … Like a 50, 000 buck deal, whatever. I need you to keep it as low as possible … if you do that … I’ll pay you, you know, 50,000 dollars, 100,000 dollars … whatever you want … I’m a man of my word.”

He may have been a man of his word. But he was not a man of honor or ethics. He sought blatant market manipulation for his own gain. Foolishly, we wrote it down, leaving his mark of dishonor for all to see.

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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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Another Real Estate Ponzi Scheme

The Securities and Exchange Commission is claiming that Wayne L. Palmer and his firm, National Note of Utah, were operating a real estate-based Ponzi scheme that bilked $100 million from investors. U.S. District Judge Bruce Jenkins issued a temporary restraining order, froze the assets of National Note, and appointed attorney Wayne Klein as a receiver to take over the company’s operations.

So far, the statements in the SEC complaint have not been proven and Mr. Palmer is contesting the charges. As I have with other cases, I look at lessons from the filings, assuming they are true, to highlight issues that should be warning.

A first warning is the use of bank account names.

National Note investors initially deposit their funds into an account at JP Morgan Chase Bank titled “investor trust account.” National Note immediately wires nearly all these investor funds to an account at Wells Fargo titled “investor interest account.” National Note’s internal accounting classifies the investor funds as income upon transfer to the Wells Fargo investor interest account. From the Wells Fargo investor interest account, the funds are used to pay returns to other investors.

Why the need to fund interest payments? According to the SEC complaint, the Palmer companies only generated $300,000 in revenue and was obligated to pay $1 million in interest to not holders. Palmer was selling notes that paid a 12% interest rate.

Another warning sign is that the notes were marketed as guaranteed, with a complete safety of principal. The safest investment is US treasuries and it pays less than 2%. You can’t expect a 12% return to not have significant risk.

Another is his use of EMS  and CCFMB after his name. They are impressive acronyms, but I can’t figure out what they stand for. EMS typically stands for Emergency Medical Services, but that doesn’t sound right for a real estate professional. I searched LinkedIn for CCFMB and Mr. Palmer was the only person who came back.

Another warning is where the money from the sale of notes is being deployed. The claim is that it purchases real estate notes and real estate equity that generates returns of 15% to 20 annually. According to the complaint all of the capital is being deployed into related entities controlled by Palmer.

It looks like Palmer’s scheme unraveled in October 2011 when it failed to make interest payments. The complaint does not point out when Palmer’s business went from legitimate to Ponzi. The SEC goes as far back at 2009 when the scheme raised $18.6 million while paying back $14 million in investors.  Palmer has been in the real estate business for many years. So I’m skeptical that his operation has been a fraud from the outset. I would guess that he ran into trouble in 2008, just like everyone else on the planet. Rather than be honest and open about losses, he tried to cover them up and hope things would recover fast enough to dig him out of his hole.

Scott Frost, Paul Feindt, Matthew Himes and Alison Okinaka of the SEC’s Salt Lake Regional Office conducted the investigation; Thomas Melton will lead the litigation.

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Mortgage Fraud Rises in 2011

The Financial Crimes Enforcement Network released its full year 2011 update (.pdf) of mortgage loan fraud reported suspicious activity reports. It  reveals a 31% increase in submission.It also shows some of the trends that lead to the 2008 financial crisis.

Financial institutions submitted 92,028 MLF SARs in 2011, compared to 70,472 submitted in 2010. Financial institutions submitted 17,050 MLF SARs in the 2011 fourth quarter, a 9 percent decrease in filings over the same period in 2010 when financial institutions filed 18,759 MLF SARs. While too soon to call a trend, the fourth quarter of 2011 was the first time since the fourth quarter of 2010 when filings of MLF SARs had fallen from the previous year.

Since 2001, the number of mortgage loan fraud SARs has grown each year.

The report pins the sharp increase in 2011 on mortgage repurchase demands. Those demands prompted a review of mortgage loan origination files where filers discovered fraud. In 2011 a majority of the SAR filings related to fraud that was more than 4 years old. So this is the fraud leading up to the bubble now being detected.

Simply redo the chart by focusing on the year of the fraudulent activity instead of the date of filing.

You can see the rise in fraud tracking the heights of the real estate bubble in 2005 through 2008.

Going back to the 2011 reports:

  • 21% involved occupancy fraud, when borrowers claim a property is their primary residence instead of a second home or investment property
  • 18% involved income fraud, either overstating income to qualify for a larger mortgage or understating to qualify for hardship concessions.
  • 12% involved employment fraud

The up and coming frauds are related to the repercussions of the housing bubble.

Short sales are a source of fraud. SAR filers noted red flags in short sale contracts, such as language indicating that the property could be resold promptly, or “common flip verbiage” in the sales contract, or discovered that the “buyer’s
agent” was not a licensed realtor.

Several SAR filers described borrowers who “stripped” or removed valuable items from their foreclosed homes before vacating the premises. In one SAR, borrowers removed $33,000 worth of fixtures from the home, including major appliances and fixtures.

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