Category: Fraud

SEC Brings AI Washing Cases

Back in December, Chair Gensler gave a speech to an AI Summit and warned about companies overstating their use artificial intelligence tools. From there, you can see the SEC approaching the concerns as part of fundraising fraud and marketing fraud. Chair Gensler probably knew that the Securities and Exchange Commission was actively working on two enforcement cases that got announced this week.

  • “the first investment adviser to convert personal data into a renewable source of investable capital”
  • “uses machine learning to analyze the collective data shared by its members to make intelligent investment decisions”
  • “turns your data into an unfair investing advantage”
  • “put[s] collective data to work to make our artificial intelligence smarter so it can predict which companies and trends are about to make it big and invest in them before everyone else”
  • “expert AI driven forecasts”
  • “first regulated AI financial advisor”
  • “the models are outperforming IMF forecasts by 34%, and the platform keeps improving”

These are quotes from the marketing materials for Delphia (USA) Inc. or Global Predictions Inc.

Section (a)(2) of the Marketing Rule says that an advertisement may not:

(2) Include a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the Commission;

When asked by SEC examiners to substantiate those claims.

They could not. These appear to be the first cases by the SEC against investment advisers for AI-washing. And two of the few cases under the Marketing Rule.

Sources:

    The One with the Fake WeWork Bid

    The Securities and Exchange Commission brought charges against Jonathan Larmore, his real estate investment company ArciTerra and its affiliate Cole Capital, based in Phoenix. According to the charges, Mr. Larmore was siphoning million of dollars from his investors in the ArciTerra funds to pay for his lavish lifestyle.

    The SEC discovered this fraud because Mr. Larmore made a bid to purchase WeWork on the Friday before WeWork filed for bankruptcy. It was an attempt at stock manipulation.

    Mr. Larmore had purchased call options for over 7 million shares in the days prior, with strike prices between $2 and $5 that were scheduled to expire at 4:00 on Friday November 3. The stock was then trading around $1. Those call options would be worth $0 if the share price of WeWork did not rise about the strike prices on Friday.

    On the morning of November 3, Mr. Larmore sent Schedule TO to the SEC indicating that he intended to make a tender offer for WeWork at a price of $9. He also tried to publish a press release through the business wire service that morning.

    “We have consulted with God, legal, financial and other advisors to assist us with this transaction. We stand ready to proceed timely.”

    Larmore was not ready to proceed timely. He and Cole Capital did not have the financial resources to acquire the shares. Nor did they have any prospects for securing capital to proceed.

    Larmore also did not know how to release a press release on the wire service. It had been rejected for formatting issues and other irregularities. It wasn’t fixed and released until 5:12 pm on November 3. That was after the public markets had closed and after his call options had expired.

    He botched his stock manipulation and opened himself to further SEC inquiry which highlighted his other misdeeds.

    It’s not clear how much of the SEC’s case outside of the stock manipulation is coming from its own inquiries. There are several lawsuits and accusations of fraud against Mr. Larmore and his real estate company. Mrs. Larmore noted in an April filing in her divorce from Mr. Larmore that “there appears to be some sort of SEC investigation in process, potentially against the entities or Jon.”

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    Twitter Pump and Dump

    It should be obvious that some random twitteratti handing out investment advice is going to be a shady character. Right? There are lots of them. I’m not sure any get dragged before the Securities and Exchange Commission on charges.

    @AlexDelarge6553 made thousands of tweets encouraging his numerous followers to buy stocks. No surprise that the man behind @AlexDelarge6553 held a bunch of those stocks he encouraged his followers to buy. The SEC named Steven M. Gallagher as the man behind the twitter handle. He bought a bunch of the stock, encouraged his followers to but the stock. The price went up and @AlexDelarge6553 sold out of positions as the price rose.

    Classic pump and dump scheme or scalping scheme. Of course the stocks involved were penny stocks at tiny prices and tiny volumes. That made it easier to manipulate the stock price.

    Kudos for the SEC for bringing the case. Bigger kudos to @AlexDelarge6553’s broker who tried to shut him down and, I assume, alerted the SEC to the problem.

    “Despite repeated, written warnings from his brokerage firm (“Broker A”) that he appeared to be engaged in manipulative trading in violation of securities laws and regulations, Gallagher continued to engage in manipulative trading and scalping. On September 9, 2021, Broker A informed Gallagher that it was closing his trading account effective October 9, 2021, and that it would immediately prevent him from making new stock purchases, restrict his account to just liquidating transactions, and not allow him to open a new account in the future.”

    Of course, since he was still allowed to liquidate his holdings, he could keep flogging his followers to buy as he sold out of his positions.

    The fun part for the SEC is they have the transaction data from @AlexDelarge6553’s broker and his public tweets. It’s really easy to match the timing of the tweets to the timing of the transactions.

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    The One with Trading in Foreign Currency when There is No Money

    Minnesota residents Jason Dodd Bullard and Angela Romero-Bullard raised millions from investors, mostly friends and family, and said it would be used to trade foreign currencies. Instead, the Securities and Exchange Commission claims that the two diverted the money to other uses and falsified account statements. In the classic Ponzi scheme fashion, they used new investors’ money to pay redemptions by earlier investors.

    The two produced false account statements for over 14 years. Although the account statements showed good returns, in reality the two had suffered large losses. In October, the two sent an investor a statement showing a balance of over $1.4 million. Unfortunately, the two only had $30,000 in the trading accounts.

    The two told some investors that they were not required to be registered with any government agency. They told other investors that they were registered. In response to one investor’s redemption request they told the investor that the withdrawal request had to be approved by regulators. FYI: redemption requests do not have to be approved by government financial regulators.

    Instead of investing in foreign currencies, the SEC claims that the two diverted the cash to other businesses they owned, including a horse racing stable, a limousine service and a fitness studio.

    Sources:

    The One with the “Dealmaker”

    It’s one thing to make a deal. It’s another to execute on the business plan agreed to in the deal you make. Matthew Skinner calls himself a deal maker. The Securities and Exchange Commission says that he didn’t execute on his deals.

    Mr. Skinner was building a real estate empire, developing residential properties in southern California, an apartment building in Arizona and unidentified multifamily real estate. It looks like some of the deals went sideways. There was litigation over property rights and cost overruns. Problems happen. You tell your investors and move forward. Looks like Mr. Skinner did not.

    This is real estate, so why is the Securities and Exchange Commission involved? Mr. Skinner was selling securities to fund his real estate empire. He was purported to be using the Rule 506 option for fundraising. According the the SEC, Mr. Skinner and his funds were “engaged in general solicitation for each offering, broadly targeting members of the public with whom they had no preexisting relationship.” According to the complaint, at least some of the investors were not accredited and Mr. Skinner did not take steps to determine their status as accredited investors.

    The other key part of fundraising is identifying the use of proceeds. In particular, how much, if any, is going to the sponsor of the fundraising. Mr. Skinner’s fundraising documents listed certain fees to which he was entitled. However, the SEC has accused him of taking much more than was detailed in the fundraising documents.

    The last thing that caught my eye was using COVID as an excuse. I think we’ll start seeing more of this in fraud cases. Mr. Skinner “falsely cited economic dislocation caused by the COVID-19 pandemic as the reason why he could not pay [his investors] and would need to defer distributions.”

    Sources:

    The One with King, Trout, and Legacy

    Randy King, his son Matthew King, and Andrea Trout founded and ran The Legacy Group, Inc. a real estate investment firm based in Colorado Springs. The firm’s business model was to provide mezzanine loans to real estate projects. These Legacy mezzanine loans would be junior to the secured mortgage loans on the project. 

    Legacy raised its capital to make these mezzanine loans from over 200 investors in dozens of states. The investors would purchase notes that were tied to a specific project.  

    Unfortunately, as some projects would run into financial difficulty, Legacy would use the proceeds from selling the notes to help fund those projects, in addition to the projects the notes were intended to fund.

    In some instances, Legacy mislead investor about the status of the projects. In one case, Legacy failed to tell incoming investors that project was in the middle of foreclosure proceeding with the senior lender. There are other instances where Legacy failed disclosed that there were other investors and loans in the ownership structure of an investment that would affect the investment.  

    The notes did not say that funds from the notes could be used to make payments to the Kings and Trout, but Legacy paid hundreds of thousands of dollars to them. The firm also paid over $400 thousand in undisclosed origination fees to King and Trout when closing on an investment.  

    The case shows the importance of (1) only putting investor funds into items allowed by the investment documents and (2) not paying fees to affiliates that are not permitted by the investment documents.

    The defendants have consented to the judgements. 

    The One with Failing to Meet Investment Criteria

    Knight Nguyen Investments raised millions from its retail investor clients to invest in securities that met the firm’s investment criteria: 

    (a) always allocate “secured” capital to attract at least 10% returns, and would select entities 

    (b) with taxable income to support returns and that often do over $10 million of revenue;  

    (c) that are already making money and not dependent on investor funds; and  

    (d) that have financials that have been audited by KNI.    

    Instead, the firm put its clients into extremely risky investments that did not meet the stated investment criteria. Instead, the firm invested its clients’ capital into high risk or fraudulent companies that, in most cases, were owned, controlled, or associated with principals of the firm. 

    One was investments in promissory notes issued by a Seychelles-based company that was purportedly involved in the purchase and sale of gold from a Lebanese refinery. The company later defaulted on the notes and the firm’s clients lost their capital.  

    Another was a Florida bioscience company that purportedly held patents for peptides that have potential applications ranging from cancer and burn treatments to crop solutions. The investment was speculative and did not meet the investment criteria, because the company de minimis revenues, its financials were not audited, and it was not actually offering secured investments. 

    A Texas widow lost her entire $30,000 retirement investment. A Nevada individual lost his entire $92,000 retirement portfolio. A Kansas veteran and military professor, who was months away from retirement, lost almost all of his $320,000 retirement savings. An Alabama retiree lost $105,000. A retiree in Houston who had been seriously injured at work, and feared she could never work again, was seeking safety and income from her investments. Instead, says the SEC, she lost her entire $75,000 retirement portfolio. The SEC mentions others who lost between $30,000 and $150,000 their retirement accounts.

    There looked to be a lot of other shenanigans going on at the firm. The big one problem the SEC hung its charges on was how the actual investments differed from the promised investment criteria.

    Sources:

    The One with the Pre-IPO Shares

    Peter Quartararo met with potential investors and told them that he had access to “pre-IPO” stock in Peloton, WeWork, and Airbnb.  

    The first potential investor was an acquaintance that had done a favor for Mr. Quartararo. He offered to let the investor buy the shares in WeWork and AirBnB at his cost, with was less than $2.00. That investor wrote a check for $96,000 to Quartararo’s firm, Private Equity Solutions, with the notation “Stock Purchase IPO.” 

    A few weeks later, Quartararo came back to this investor with access to pre-IPO shares in Peloton. That investor wrote a check for $71,000. That investor shared the opportunity with some friends and Mr. Quartararo also sold them some shares. In all, Quartararo raised $436,000 from this pool of investors. 

    After Peloton and AirBnB had their public offerings of shares, the investors began asking for the shares to be sold and the profits sent to them. Mr. Quartararo kept putting them off.  

    According to the Securities and Exchange Commission and the Nassau County District Attorney, Mr. Quartararo never had access to the shares in those companies. Instead, Mr. Quartararo pocketed the cash and used it for personal purposes, including to buy a Maserati. 

    If the investors had checked the BrokerCheck system, they would have seen that he was barred from acting as a stockbroker. The bar was imposed in 2013 because Mr. Quartararo stolen money from a client. He had a prior history of other misdeeds before  being barred.  

    Sources:

    The One That is a Hollywood Story

    Zach Horwitz was struggling actor using the stage name “Zach Avery.” His IMDB entry lists him in minor parts in mostly bad movies. His biggest movie role is an uncredited part as a medic in Brad Pitt’s “Fury.” 

    Mr. Horowitz couldn’t figure out how to get rich and famous, but he did hatch a plan to get rich.  

    Mr. Horwitz told investors that he had acquired and distributed dozens of cheap films including titles such as “Active Measures,” “Ruin Me” and “Slasher Party.” He produced contracts signed by HBO or Netflix executives showing he was doing business with the streaming platforms. He paid great returns to his early investors.  

    Those early investors were mostly college friends. Those friends  offered the opportunities to their friends and family members to enter into loans with Mr. Horowitz’s production company. That lead to larger investors making loans. 

    One investor urged his partners to finance deals more films.  “This is the goose that lays the golden egg guys, lets just hope they keep coming month after month.”  He brushed off his partners’ annoyance at Mr. Horwitz for refusing to let them see his business records. “If anything not sending us financials proves to me even more that they are not desperate, they don’t need our money.” 

    As you might expect, Mr. Horowitz was not sending financials because it was a massive fraud. The documents were fake. He had not purchased any films and had no connection to the streaming platforms for distribution. Those early returns to investors were paid with money received from later investors. The classic Ponzi scheme. 

    Maybe he was a better actor than the studios gave him credit. He managed to raise $690 million dollars from investors by convincing them his production company was real. That must take some acting skill.  

    It looks like Mr. Horowitz will end up famous for his fraud. Whatever riches he briefly held have evaporated as the fraud came to an end.  

    Sources:

    The One With the Lack of Write-Downs

    I think many frauds start with a failure to recognize mistakes. Yes, it’s hard to tell your investors that you lost some of their money. It makes it harder to attract new investors and additional investments. It gets really hard to do that when you go to jail.

    Martin Silver was the co-founder, managing partner, and chief operating officer of the International Advisory Group LLC. The firm was an investment adviser that specialized in trade finance lending—risky loans to small- and medium-sized companies in emerging markets. The firm also sponsored three private funds to invest in the trade finance loans.

    One of the funds had assets of about $300 million. The firm learned that a South American coffee producer had defaulted on a $30 million loan. Fearing that existing investors would flee the fund and that ongoing fundraising efforts would suffer if the loss were disclosed, Silver decided to conceal the loss by incorrectly valuing the loan on the fund’s books. Later, he replaced the defaulted the loan with fake loans to prop up the value of the fund after auditor inquiries.

    Then, a second loan in the fund’s portfolio defaulted. Silver continued his actions of not writing down the value of the loan and eventually replacing it with fake loans.

    Eventually, faced with liquidity demands for redemptions, Silver formed the second and third funds to buy the fake loans from the initial fund. Eventually, the schemes collapsed and charges were brought.

    Of course the scheme collapsed. You can never find the out-sized returns to make up for the big loss.

    Mr. Silver pled guilty to one count of conspiracy to commit investment adviser fraud, securities fraud, and wire fraud, which carries a maximum sentence of five years in prison; one count of securities fraud, which carries a maximum sentence of 20 years in prison, and one count of wire fraud, which carries a maximum sentence of 20 years in prison.

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