Category: Fraud

Subscription Credit Facility Fraud

Lots of private equity funds use a line of credit to fund acquisitions. It’s quicker to draw on the line than to call equity from investors. That line of credit is secured by the capital commitments to the private equity fund. Later the private equity fund calls the capital for the acquisition and pays down the line of credit. According to a criminal complaint a private equity fund manager is accused of forging subscription documents and an audit letter to get a line of credit.

JES Global was registered with the Securities and Exchange Commission as an Exempt Reporting Adviser. Its principal, Elliot Smerling, committed blatant fraud. It may have future implication for private funds and the work that will go into setting up a credit facility.

Elliot Smerling had an empire of private equity funds and reportedly lived a lavish lifestyle, with homes in Florida, New York and Brazil with a collection of luxury cars. Smerling is accused of committing fraud to keep his complex financial operation afloat, according to the criminal charges.

He set up a credit facility with Silicon Valley Bank for one of his funds. He handed the bank two subscription agreements. One purported a $45 million commitment from a New York University endowment and a second purported to be $40 million from an investment manager. The criminal complaint did not identify the two purported investors. Smerling is also accused of submitting a forged audit letter and a falsified bank statement showing a wire transfers from the purported investors.

According to the criminal complaint, Smerling produced fake documents. The University endowment has no record of the document or the wire and the signature does not match the CIO of the endowment. The investment manager has no record of the document or the wire and the signature does not match. The audit firm named on the audit letter was not engaged by Smerling or the fund. The address on the letterhead of the audit letter is an address that the firm has not operated at for several years.

This is the first time that I’ve heard of subscription facility fraud. I expect that there may be changes to the lending process

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Affiliate Funds Shuffling Funds

George Heckler, of Charleston, South Carolina, operated a decade-long fraud through three private hedge funds, Cassatt Short Term Trading Fund LP (Cassatt), CV Special Opportunity Fund LP (CV Special), and Conestoga Holdings LP (Conestoga). This fraud caught my attention because my brother and mom both live in South Carolina.

Heckler’s initial fund was Conestoga, which was formed in 1998. Unfortunately, the fund had a big investment in an illiquid investment and that investment went south, resulting in millions of dollars in losses.

Rather than admit to the problem, Heckler raised new cash to pay off Conestoga investors looking to exit. He raised the additional funds, in part, to repay the Conestoga investors. He convinced a fund administrator to help him with the fraud. He used the Cassat and CV Special capital raises to pay off investors in Conestoga. He falsely stated in those fund financial statements that the funds were properly invested.

Although Heckler has not agreed to the SEC charges, he did plead guilty to the criminal charges brought by the Department of Justice.

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A Shot of Tequila and Pilfered Investor Funds

Joseph Cimino wanted to make a great tequila and needed capital to make it happen. He raised almost $1 million and got 6 Degree tequila into production. Unfortunately, he apparently lied to his investors in raising the capital and then stole almost half of that capital.

Cimino created a 40-page booklet providing sales and expense forecasts and describing 6 Degree’s product and business plan. This booklet reported 2015 sales of approximately $260,000 and a net profit of approximately $40,000. But 6 Degree did not launch its operations until the spring of 2016, so those numbers were entirely fictitious.

In another example, Cimino gave a potential investor a financial update showing sales of over 800 cases in Puerto Rico, when the truth was less than 200 cases in sales. Puerto Rico was one of the few places 6 Degree was sold. In another report, Cimino falsely represented in an investor report and quarterly profit and loss statement that the company’s year-to-date sales totaled 3,410 cases, when its actual sales totaled only 350 cases.  

When he wasn’t lying to his investors and potential investors about the company’s results, he was allegedly stealing money from the company. He transferred approximately $472,000 from the company to his personal accounts. 

Mr. Cimino is currently subject to civil and criminal charges by the Securities and Exchange Commission and Department of Justice. According to the statement of the FBI agent in the criminal complaint, Mr. Cimino admitted to at least some of the false claims. He does not admit to illegally taking the cash.

I assume that Mr. Cimino was initially just puffing the success of the company in order to entice investors. The classic, “fake it, ’til you make it.” The problem is that doing so in connection with raising capital, “faking it” is securities fraud. If you publish numbers in a fundraising document, you need to be able to substantiate that number. Moving the decimal point over is going to get you in trouble.

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Another Fake COVID Test Fraud

COVID vaccinations are continuing to roll out and we can hope to see an end to the pandemic. Regulators are continuing to roll out cases against people and companies that tried to illegally profit from the pandemic.

The latest case is against Arrayit Corporation, a life sciences company in Sunnyvale, California. Although a public company, the Securities and Exchange Commission had put a halt to the trading in its shares on public markets in 2015 because the company had failed to file annual reports with audited financial statements. The company failed to respond to auditors requests for information. That moved its share trading to the OTC pink sheets. 

The CEO of Arrayit, Rene Schena, and her brother Mark Schena, President of Arrayit, began telling investors that the reports were coming out and the company had some new revenue sources. 

In March of 2020 Arrayit began making statements to investors.

“Dear [investor], Confirming that we have a SARS-Cov-2 test and that the test is pending emergency approval.”

At that point Arrayit had no reagents needed for a test. Also, Arrayit had not actually applied for Emergency Use Authorization. 

Arrayit took it a step further and told investors that it had received more than 50,000 requests for its finger stick blood test. This was not true. As a result of the untrue or misleading statements Arrayit’s stock price traded up 50% and its volume increased 100%.

The SEC charged Arrayit, Rene Schena, and Mark Schena with fraud. Arrayit and Rene Schena have settled with the SEC. She will pay a $50,000 fine and is barred from acting as an officer or director. Mark Schena’s case is still pending. 

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Real Estate or the Lottery

Viktor Gjonaj thought he had figured out a way to make money. He was a commercial real estate broker and convinced members of his Albanian-American community in Detroit that he had lucrative real estate investment opportunities. He raised over $26 million.

Gjonaj had a promising plan. It involved lottery tickets instead of real estate. Gjonaj diverted his investors’ cash to playing the Michigan Lottery Daily 3 and Daily 4 games.

Maybe he had system that worked. He apparently won millions from the lottery. Unfortunately, it appears that he spent millions more buying the tickets. According to the complaints filed by the Securities and Exchange Commission and the US Attorney, Gjonaj was betting $1 million per week on the lottery using the money that was supposed to be put towards real estate investments.

His scheme unraveled. It appears that most of the investor money is gone. He is subject to lawsuits by his investors, an action by the Securities and Exchange Commission, and criminal charges from the US Attorney.

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Performance Advertising and the Funds That Weren’t There

Eric Malley decided that buying buy hundreds of luxury Manhattan residences on the cheap and leasing them to corporate tenants would be a great way to make money. He would let others in on his plan as investors. He created MG Capital Management Residential Fund III and raised $23 million from about 60 investors. It seemed successful enough that he launched a follow up Fund IV that raised $35 million.

You may be asking yourself: What about Fund I and Fund II?

The marketing materials for Fund III and Fund IV described very successful predecessor funds. In the Fund III PPM the outcome was described as

Fund I:
(1) raised $350 million of investor capital;
(2) earned a gross return on investment (ROI) of 38.99% and a net ROI of 30.81% during its six-year investment term from 2007 through 2013;
(3) outperformed the S&P 500 Index by 4.5-to-1; and
(4) sold its 74-property portfolio to two buyers for $750 million

and

Fund II:
(1) raised $55 million of investor capital in only 30 days; and
(2) achieved an average gross ROI of 38.06%,
cumulative unrealized gains on equity of 154.55%, and
a gross investment multiple of 2.55x.

In the complaint filed by the Securities and Exchange Commission, there is no evidence that these funds existed. Nor is there any evidence that MG controlled the $1.8 billion portfolio of real estate supposedly owned by the funds.

As for the Fund III and Fund IV, well, they did not perform well. According to the SEC complaint, Fund IV “earned $1.6 million in rent and incurred operating expenses of $8.3 million, resulting in net operating losses of approximately $6.7 million” and “$4.7 million in unrealized losses on portfolio investments, bringing Fund IV’s total net loss to approximately $11.4 million.”

As you might expect, MG is accused of illegally siphoning money from the funds. The SEC claims that (1) MG retained cash rebates from the sellers of the properties purchased by the funds and (2) charged the fund for unearned brokerage fees.

MG Capital and its principal Eric C. Malley are subject to civil charges by the SEC, criminal charges by the Department of Justice, and civil suits by investors. We haven’t heard their side of the story. Take the information above as a clear statement of what you should not do.

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Robbing Peter to Pay Paul

In browsing the charges against Michael Barry Carter, it seemed like a typical case of a financial adviser stealing from his clients. The total amount was large. The math of how much he stole from his clients and how much he pocketed confused me in browsing the two press releases.

The US Attorney’s headline has Mr. Carter stealing $6 million and the SEC’s story says he transferred millions. After reading through the complaint, it seems clear that he was stealing to enrich himself and repay some of the thefts to cover his tracks. The classic scenario of robbing Peter to pay Paul.

Mr. Carter has plead guilty to the US Attorney for the criminal charges. The SEC investigation is continuing.

According to the SEC complaint, Mr. Carter started his misdeeds, sadly, by stealing from an elderly relative in 2007. He accomplished this by falsifying authorization forms, diverting the real account statements and producing fake account statements.

He continued pilfering from other clients.

It ended when one of Mr. Carter’s victims applied for loan and the credit review discovered that an $800,000 line of credit has established at Mr. Carter’s brokerage firm without the victim’s knowledge or permission. The brokerage firm investigated and found that Mr. Carter had transferred millions from his clients without authorization.

In the end, Mr. Carter stole over $6.1 million and pocketed at least $4.3 million of that. The rest was used to pay his other victims to cover his misdeeds, robbing Peter to pay Paul.

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The One with the Inflated Loan Values

The Securities Exchange Commission followed up on whistleblowers’ complaints against TCA Fund Management for inflating the value of the assets in its Global Credit Master Fund. In January, investor redemption requests exceeded the liquidity of the fund and it eased operations.

The SEC complaint against TCA Global alleges that TCA was booking fees before they were received.

The SEC claims that TCA was booking loan fees as revenue at the non-binding term sheet stage, instead of when the loan closed. The SEC also claimed that the TCA was booking investment banking fees at the time the firm was engaged and not when the fee was earned . TCA would only be paid if a transaction closed. According to the SEC complaint these practices resulted in over $155 in improperly recognized revenue.

As for the value of the TCA assets, the SEC called it “grim.”

“For 2017 and 2018, the Funds’ auditor issued a qualified opinion with respect to Master Fund’s income and assets, including, for 2018, a qualified opinion with respect to 89% of Master Fund’s NAV. By May 2019, Master Fund had only 5% of its assets in cash, with most of the balance of the assets consisting of amounts owed to Master Fund on loans to thinly capitalized borrowers, a substantial amount of which are in default.”

Strangely, however, the SEC complaint does not accuse TCA of overstating its assets. The whistleblowers accuse the firm of not writing down asset value. I’m not sure why the SEC pulled its punch on the valuation issue.

The other issue that the SEC did not highlight in its complaint is that TCA would likely have been receiving excessive fees from the fund based on the inflated values. I assume the fee had some basis on NAV. With the NAV inflated, the fees would have been inflated.

According to the NBC News story, the problems first surfaced in a 2016 SEC exam. TCA had restated some values as a result of the process. The whistleblowers stepped up when they felt the SEC has missed the full extent of the fund’s misconduct.

Of course, we haven’t heard TCA’s side of the story. I’m just looking at this as a compliance lesson.

Valuation should be the number one issue for compliance in funds with illiquid assets. They are harder to value so more effort should be put into making sure the values can be justified.

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SEC Going After COVID-19 Fraud

There is no greater villain right now that fraudsters trying to profit from the COVID-19 pandemic. The Securities and Exchange Commission is more than willing to go after these bad guys.

Trading Suspension

According to speech last week by Steven Peiken, the SEC’s Co-Chief of Enforcement,  the SEC has suspended trading in the securities of more than 30 issuers as a result of questions about the adequacy and accuracy of coronavirus-related information since early February. .

Do you have masks?

Praxsyn Corporation claimed to be able to obtain large quantities of N95 masks used to protect you from COVID-19. The SEC suspended trading in the company’s shares. It turns out that that Praxsyn had been offered millions of masks from a Mexican company. Turns out the masks were no good.

Do you have test kits?

Applied BioSciences Corp. issued a press release on March 31 stating that it had begun offering and shipping supposed finger-prick COVID-19 tests to the general public that could be used for “Homes, Schools, Hospitals, Law Enforcement, Military, Public Servants or anyone wanting immediate and private results.”

No. The SEC charged that the tests were not intended for home use by the general public and could be administered only in consultation with a medical professional. The SEC further charged that Applied BioSciences had not shipped any COVID-19 tests as of March 31. And furthermore, the SEC charged the company for failing to disclose that the tests were not authorized by the U.S. Food and Drug Administration.

The SEC suspended trading in the company’s securities and is seeking relief.

Do you have a fever?

Turbo Global claimed to have a multi-national public-private partnership to sell thermal scanning equipment to detect individuals with fevers. In a press release with its supposed corporate partner, Turbo claimed the technology is 99.99% accurate.

Turbo Global had no agreement to sell the product, there was no partnership involving any government entities, and the CEO of Turbo Global’s supposed corporate partner did not make or authorize the statements attributed to him. 

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The One with the Fake Pot Ownership

With the growth of marijuana businesses across several states, many see it at a sector ripe for investment with the possibility of big returns. While states approve the sale of marijuana, it’s not entirely legal. Federal law still lists it as a controlled substance. That makes banking difficult and oversight difficult for investors. It also makes it a target for less than scrupulous middlemen.

That’s where we find Guy Griffitthe and Robert Russell. Mr. Russell and his wife had created a company in Washington that held a license to grow marijuana under the state’s recreational cannabis laws.

According to the SEC complaint, Russell cut a deal with Griffithe to offer a stake in his marijuana growing business. That was the first problem.

Under the Washington law for marijuana businesses, ownership is tightly controlled and regulated. Russell couldn’t sell an ownership interest without approval from the state Liquor and Cannabis Board. According to the complaint, Russell and Griffithe tried to structure it as a right to receive profits and not an ownership interest. I don’t think it worked.

That didn’t seem to stop Griffithe from selling interests in the company that bought the interest in the marijuana growing company. The pitch was that the investment would help the marijuana grower to expand by providing capital for equipment, land and physical facilities.

The next problem is that Griffithe didn’t register the securities for sale and didn’t make sure the sale was happening within an exemption. He used a website and openly advertised the sale of the securities.

The third problem was that they spent most of the $4.85 million they raised on non-business purchases. The SEC loves to list out the extravagant purchases made by fraudsters with their ill-gotten cash. This was no exception.

  • 2008 Bentley Continental
  • 2012 Mercedes Benz C Class
  • 2013 Ford Mustang (I’ll assume this was a Boss 302 or Shelby GT500 model)
  • 2015 Porsche Panamera
  • $250,000 towards a 65-foot Pacific Mariner yacht

The final straw was that the marijuana growing business was not actually profitable. According to the SEC, it never made a profit. Meanwhile Griffithe’s marketing material proclaimed a 40% profit margin. They faked the profitability by using some of the investor paid-in capital to make distributions. That turned it into a Ponzi scheme.

Fraudulent investment activity in marijuana business has become so widespread that the SEC has published an Investment Alert: Marijuana Investments and Fraud.

This case points out one of the shortcomings in that SEC alert. It fails to point out the very common limitation on changes of ownership in marijuana businesses. Even if the investment is legitimate, the likely requirement of approvals for the acquisition and later sale will have a big impact on the investment.

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