Month: March 2017

The SEC Is Using Satellites To Hunt For Fraudsters

I did not find the headline to be remarkable: SEC Charges Mexico-Based Homebuilder in $3.3 Billion Accounting Fraud. The subtitle caught my attention:

SEC Uses Satellite Imagery to Crack Case

We learned from the Rajaratnam insider trading case that the SEC was using wire taps and informants as part of its securities fraud investigations. The SEC is clearly stepping up a notch by using satellites to hunt for fraudsters.

The Securities and Exchange Commission caught Mexico-based homebuilding company Desarrolladora Homex S.A.B. de C.V. in a lie and forced it to admit that it had reported fake sales of more than 100,000 homes during a three-year period. From at least 2010 through 2013 Homex improperly recognized billions of dollars of revenue by systematically and fraudulently reporting revenue from the sale of tens of thousands of homes annually that it had neither built nor sold.

This all comes to late for investors in Homex. Its securities were, until April 2014, dually listed on the New York Stock Exchange and the Mexican Stock Exchange. In 2013 Homex had begun defaulting on its debt obligations and repeatedly failed timely to file quarterly and annual reports with the SEC. In April 2014, Homex filed for the Mexican equivalent of bankruptcy reorganization.

Homex’s Real Estate Project 877 (named “Benevento” and located in the Mexican state of Guanajuato) is illustrates the fraud. Homex’s senior management identified Benevento to the SEC as one of the Company’s top ten real estate development projects by revenue. Homex provided Benevento’s project plan (identifying the location, block and lot number of each planned housing unit), and details (by block, lot number, sale price and sale date) of the Benevento sales that Homex had included in its financial statements. These documents stated that all of Benevento’s planned units had been built and sold, and that Homex had recognized and reported that revenue by December 31, 2011.

However the SEC pulled up satellite images taken in March 2012 that reveal that hundreds of those very same Benevento units remained unbuilt.

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Compliance Bricks and Mortar for March 3

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

Detecting Managed Earnings With CEO Profiles by Tri Nguyen, Chau Duong and Sunitha Narendran in the CLS Blue Sky Blog

We offer the PSCORE, a composite grouping of individual characteristics linked with a higher likelihood of earnings management by prior research. We identified nine individual variables or signals from existing research to develop the PSCORE. These signals or variables can be sorted into four categories: financial expertise, personal reputation, internal power, and age. We used finance-related working experience and qualifications as the signals for financial expertise. The length and performance of a CEO’s tenure as well as how often the media mentioned the CEO were used as signals for personal reputation. The signals for internal power included information about other significant positions a CEO held in a company (e.g. chairman, founder). Age was captured from curricula vitae in the public domain disclosing the actual age and distance from retirement of a CEO. [More…]

SEC Opinions Underused by Enforcement Targets, Official Says by Rob Tricchinelli in Bloomberg BNA

Parties accused of wrongdoing by the SEC don’t take full advantage of the commission’s opinions in guiding their defense, a top agency enforcement official said Feb. 24.

As it handles enforcement cases, the Securities and Exchange Commission often issues legal opinions, which cover many areas of securities laws that federal-court cases don’t reach as frequently.

“It’s really a missed opportunity to not be aware of what they are,” Joseph K. Brenner, chief counsel in the SEC’s Enforcement Division, said at a panel during the Practising Law Institute’s “SEC Speaks” event in Washington. [More…]

Will Blockchain Transform Compliance? by Tom Fox in the FCPA Compliance Report

This is made even more powerful in the area of financial reporting. Typically, a search is “horizontal (across the web) and vertical (within particular websites). What you find can be out-of-date or inaccurate in other ways. On a blockchain, though, there’s a third dimension: sequence. In addition to being able to obtain a historical picture of the company since it was incorporated, you can see what has occurred in the last few minutes.” The authors correctly note, “The opportunity to search a company’s complete record of value will have profound implications for transparency as it brings to light off-book transactions and hidden accounts. People responsible for records and reports will be able to create filters that allow stakeholders to find what they are searching for at the press of a button. Companies will be able to create transaction ticker tapes and dashboards, some for internal use”. This would be extremely helpful in the difficult vetting of third parties around financial information. [More…]

And the Oscar for Control Failures Goes to… by Matt Kelly in Radical Compliance

If a company has multiple versions of a report floating around (which, in abstract terms, is what happened here), that tells me to look more at the risk assessment and control activities. Someone handing an announcer the wrong envelope is not a far-fetched risk to imagine; when you include the sky-high reputation consequences for PwC, it seems like a singularly easy risk to identify and anticipate. (COSO Principle 7: “Identify and analyze risks.”)[More…]

The SEC Is Serious About Protecting Seniors

It was a real estate fraud action that caught my eye, but the victims that kept me reading. The Securities and Exchange Commission filed charges against Paul Garcia and his fund management company, Caliber Capital, for defrauding investors.

Since it was a real estate fraud, it caught my eye. But I didn’t have to dive into the murky waters of what is a security and what isn’t a security. Garcia is alleged to be selling interests in a fund and then not using the money as he said he would. I don’t see any argument that passive interests in an investment fund could be anything other than securities.

Mr. Garcia enticed investors to invest in a golf course purchase and shuffled money to keep things going. Things did not go well and Caliber Partnership filed for bankruptcy in January 2016. The lender foreclosed and the investors are likely left with no assets from the partnership. Even with the underlying asset being real estate, it does not change the nature of the interests.

What caught my eye in the case was the SEC inclusion of one investor in particular in the press release and the complaint:

“The investors included an eighty two-year-old who invested $250,000 in Caliber.”

This may be a common tactic for the SEC to gain sympathy for the investors and to paint the alleged fraudster as being particularly sinister.

I went back to the SEC’s 2017 priorities. One of the priorities for examinations is senior investors and the issues around them. I expect we may see more SEC press releases mentioning the little old lady from Pasadena who got bilking by a fraudster.

If your investors include that little old lady from Pasadena, the SEC is going to use that fact.

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Changes to the Accredited Investor Standard?

The Securities and Exchange Commission has three mandates: (1) protect investors, (2) maintain fair, orderly, and efficient markets, and (3) facilitate capital formation. Regulation of private securities transaction through the accredited investor standard falls squarely in the conflict between these mandates.

The general statement about why certain investors can invest in securities subject to less regulatory oversight is that they are able to handle the risk. The standard for handling risk is the accredited investor standard and it’s based on tests of income or net worth. In theory, if you had a certain amount of money you could handle the risk.

The existing thresholds for an accredited investor were created in the 1980s. The big change was Dodd-Frank that excluded primary residence from the net worth calculation. The income and net worth test are not pegged to inflation and therefore have become more inclusionary over the past decades.

Last week, Acting Chairman Michael S. Piwowar quoted William Graham Sumner’s Forgotten Man in adding his view of securities regulation. He gave his view on accredit investors:

“Distinguishing investors who can fend for themselves from those who cannot is a line-drawing exercise fraught with peril. The Commission did just that in 1982 when it adopted Regulation D, dividing the world of private offering investors into two categories: those persons accorded the privileged status of “accredited investor” and those who are not.”

Here he steps into a fallacy. Or at least what I believe is a fallacy. He tags private placements as “high-risk, high-return securities available only to the Davos jet-set.”

First, the tests for accredited investor are not so high that you need to be in the Davos Jet-set.

Second, private placements are not all high-risk, high-return investments.

Perhaps the SEC is suffering from a lack of data on private placements. Private placements are investments that the issuer can sell to a smaller group of investors without having to go through the cost of a public offering.

Congressional mandates, SEC regulation, and shareholder lawsuits have made being a public company less attractive. There are additional costs and risks with allowing your securities to trade publicly. Until a few weeks ago, a public company had to worry about [the resource extraction rule conflict materials in its supply chain] and how to calculate the pay ratio between the CEO and its workers.

The risk for private placements is really not the loss of capital. It’s loss of liquidity.

Private placements have limited opportunities for investors to achieve liquidity. That generally means a long hold period. If the investor needs cash, the investor will have to look for other holdings to sell to get that liquidity. Private placements do not have a market for resale, so the investor needs to find a willing buyer in secondary sale process or wait for the liquidity event, if one ever comes.

Using income and net worth tests make sense because of the liquidity risk associated with private placements. The accredited investor will more likely have the income or capital to address the liquidity.

Within the world of private placements there are very risk investments and low risk investments when looking at an investors likely return of capital.

For example look at hedge funds, they may be more or less risky than a mutual fund depending on the investing style. As an investor, you have limited opportunities to receive back your investment and any returns. Most hedge limits have significant notice periods for redemption and often limited redemption to a few times each year for investors to get their hands on cash.

There seems to be a lot of focus on the high-risk early stage investing associate with private placements. Those are only good investments if you can make lots of them. You see something like 5% of startups making money and rest essentially going to zero. Assuming those odds, you need to make 20 investments. The accredited investor standard ends up being low if you just focus on those risky investments and ignore the more plentiful lower risk investments.

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