Friday, December 12, 2014

Enforcement Actions: Week in Review


SEC Sanctions Eight Audit Firms for Violating Auditor Independence Rules
December 8, 2014 (Litigation Release No. 272)
The SEC sanctioned the following firms for violating auditor’s independence criteria: BKD LLP, Boros & Farrington Accountancy Corporation, Brace & Associates PLLC, Robert Cooper & Company CPA PC, Lally & Co LLC, Lerner & Sipkin CPAs LLP, OUM & Co LLP, and Joseph Yafeh CPA Inc. While performing audits for their broker-dealer clients, these firms also prepared their clients’ financial statements, jeopardizing the impartiality of the audits. The firms agreed to settle their cases and will collectively pay $140,000 and comply with several undertakings to prevent future violations.

SEC Sanctions Operator of Bitcoin-Related Stock Exchange for Registration Violations
December 8, 2014 (Litigation Release No. 273)
The SEC sanctioned Ethan Burnside for operating two online exchanges (BTC Virtual Stock Exchange and LTC-Global Virtual Stock Exchange) without registering the venues as broker-dealers or stock exchanges with the SEC. The two exchanges offered account holders the opportunity to trade securities using the virtual currencies Bitcoin and Litecoin. The two exchanges executed nearly 430,000 trades. Burnside will be fined $68,387.07, $58,387.07 in profits he made from the websites plus interest and a $10,000 penalty, and will be barred from the securities industry for at least two years.

SEC Penalizes Morgan Stanley for Violating Market Access Rule
December 10, 2014 (Litigation Release No. 274)
The SEC has fined Morgan Stanley $4 million for violating the market access rule, which requires broker-dealers to implement sufficient risk controls prior to giving customers access to security markets. The violation occurred when a trader from Rochdale Securities LLC purchased approximately $525 million in Apple Stock via Morgan Stanley’s electronic trading desk, even though Rochdale’s pre-set daily trading limit only amounted to $200 million. The trader was committing fraud as he altered a customer order to purchase 1,625 Apple shares into a purchase of 1,625,000 shares. The trader has been charged and sentenced to 30 months in prison.

SEC Announces Fraud Charges Against Buffalo-Based Firm and Co-Owners Accused of Misleading Investors in Hedge Fund
December 10, 2014 (Litigation Release No. 275)
The SEC announced fraud charges against Timothy S. Dembski and Walter F. Grenda Jr. for advising their clients at Reliance Financial Advisors to invest in Prestige Wealth Management, a hedge fund managed by Scott M. Stephan. Both Dembski and Grenda greatly exaggerated Stephan’s experience in the securities industry and convinced their clients to invest approximately $12 million in his hedge fund. The hedge fund began trading in April 2011, but did not generate positive returns and lost about 80 percent of its value by late 2012. In addition, the SEC alleges Grenda borrowed $175,000 from two of his clients to grow his advisory business, but he instead spent the money on personal expenses. Stephan has agreed to be permanently barred from the securities industry.

SEC Names Karol Pollock to Lead Exam Program in Los Angeles Office
December 10, 2014 (Litigation Release No. 276 )
The SEC announced that Karol Pollock will be named as the new Associate Director of the exam program in the Los Angeles Office. As Associate Director, she will oversee around 60 examiners, accountants, and attorneys responsible for examining firms in Southern California, Nevada, Arizona, Hawaii, and Guam. Pollock has 25 years of experience in securities enforcement and has notably played a role in the case against the former CEO and CFO of Gemstar-TV Guide International for their complex scheme that inflated licensing and advertising revenues.

SEC Announces Agenda for Meeting of the Advisory Committee on Small and Emerging Companies
December 11, 2014 (Litigation Release No. 277 )
The Advisory Committee on Small and Emerging Companies meeting on December 17 will focus on the definition of an “accredited investor” the SEC announced today. Certain securities are not required to be registered with the SEC if the securities are sold to an accredited investor. The meeting will begin at 9:30 in the multipurpose room at the SEC Headquarters in Washington D.C. The meeting is open to the public and will also be webcast live on the SEC’s website.

SEC Files Securities Fraud Charges Against Owner of Home Restoration Business in Upstate New York
December 12, 2014 (Litigation Release No. 278 )
The SEC announced securities fraud charges against David Fleet for selling unsecured notes to finance his real estate business Cornerstone Homes Inc. Fleet failed to inform his investors about many important aspects about his business, including lying about using bank financing after mortgaging company-owned real estate. After the real estate market went down, Fleet used investor money to secretly invest in stock options to try and save his business. Fleet subsequently lost $3-$4 million in investments and Cornerstone filed for bankruptcy.

SEC Charges Manhattan-Based Attorney With Conducting Ponzi Scheme
December 12, 2014 (Litigation Release No. 279 )
The SEC charged attorney Charles A. Bennett for running a Ponzi scheme and defrauding his clients. Bennett claimed he had a close connection with a Wyoming-based investment fund, which mainly invested in European real estate mortgage-backed securities. Bennett claimed these securities yielded anywhere from 6 to 25 percent over short periods of time. Bennett was able to raise around $5 million, but he did not have a connection with a Wyoming-based investment fund and did not use the investors’ money to purchase any securities. Instead, Bennett used the money to finance his own expensive lifestyle.

Friday, December 5, 2014

Enforcement Actions: Week in Review


SEC Charges California Resident With Fraudulent Sales of Stock
December 2, 2014 (Litigation Release No. 268)
The SEC has charged Vinay Kumar Nevatia for fraudulently selling $900,000 of private shares of CSS Corp. The SEC contends that Kumar, living in Palo Alto under several aliases, sold shares in 2011 and 2012 that he had already sold in 2008. Kumar has never been registered with the SEC.

SEC Announces Fraud Charges Against Two Executives in Scheme Involving Fake Occupants at Senior Residences
December 3, 2014 (Litigation Release No. 269)
Ex-CEO Laurie Bebo and ex-CFO John Buono have been charged by the SEC for fraud. The SEC alleges that during their management of Assisted Living Concepts Inc. they falsely claimed additional residents in order to meet minimum occupancy rates outlined in their facilities’ lease agreements. Failing to meet those terms would have meant default on their lease with Ventas Inc., a Chicago based REIT.

SEC Charges Montana Man in Pump-and-Dump Scheme Involving Virginia-Based Penny Stock Company
December 4, 2014 (Litigation Release No. 270)
The SEC has charged Montana penny stock promoter, Matthew Carley, with security fraud. The SEC alleges that Carley, acquired shares of Red Branch Technologies through reverse merger. Following this, Carley promoted Red Branch through email campaigns at the same time false information regarding Red Branch’s operations was released. Following a rise in price, Carley sold his shares for $789,478. He has agreed to settle with the SEC.

SEC Charges Virginia Beach-Based Bank Holding Company With Accounting Violations
December 5, 2014 (Litigation Release No. 271)
A Virginia holding company and its former CFO, Neal Petrovich, have agreed to settle with the SEC over improper accounting practices. Hampton Roads Bankshares overstated their deferred tax asset, not including a valuation allowance in spite of their own internal reports. Losses on their income statements for 2009 and the first quarter of 2010 were understated as a result. The company and ex-CFO have agreed to pay $200,000 and $25,000 penalties, respectively.

Thursday, December 4, 2014

15 Days in Puerto Rico Cost UBS Clients Over $1 Billion

By Craig McCann, PhD, CFA

We’ve shown in recent posts that UBS underwrote $1.7 billion of unmarketable ERS bonds and bought them into the UBS PR Funds. You can find our earlier blog posts here. UBS made room these ERS bonds by selling out of the Funds other bonds UBS didn’t underwrite. UBS bought the ERS bonds it underwrote in 2008 because there was no other market for the bonds it was underwriting.

Recently we illustrated how UBS-underwritten conflicted bonds purchased by UBS into the funds in 2008 caused losses in the UBS funds at three to four times the rate as the rest of the Funds’ portfolio holdings. See our post What Hell Hath UBS PR Wrought.

What Did UBS Know and When Did it Know It

We’ve highlighted in the past a substantial change in the planned 2008 ERS Offerings. See UBS Succumbed to Conflicts and Purchased $1.7 Billion of Employee Retirement System Bonds into its Puerto Rican Municipal bond Funds in 2008.

Our focus was on the evolution of UBS’s understanding that there was no non-Puerto Rican market for the Series B bonds and not even a Puerto Rican market for the ERS bonds on the terms they were being offered.

The January 29, 2008 Series A Offering Circular said the Series B bonds would only be sold to non-Puerto Rican investors but by the time the May 28, 2008 Series B Offering Circular game out, the bonds were only going to be sold to Puerto Rican residents, effectively really only to be bought by the UBS Puerto Rican Funds.

The January 29, 2008 ERS Series A Offering Circular is available here. The ERS May 28, 2008 Series B Offering Circular is available here. The ERS Series C Offering Circular is available here.

But It Gets More Interesting…

A Conway MacKenzie, Inc., October 2010 report, Review of the Events and Decisions That Have Led to the Current Financial Crisis of the Employees Retirement System of the Government of Puerto Rico available here found that Merrill Lynch attempted unsuccessfully to sell $7 billion of ERS Pension Obligation Bonds in 2007 and was replaced by UBS as advisor and lead underwriter of the January 29, 2008 ERS Series A Offering.

Sometime between 2007 and 2008 ERS and Merrill Lynch’s plan to issue $7 billion in Pension Obligation Bonds to investors off the island transformed into ERS and UBS’s plan to sell $2.94 billion of which $1.7 billion had to be bought by the UBS Funds.

I just came across Moody’s January 4, 2008 Ratings Report available here and Standard & Poor’s January 14, 2008 Ratings Report here. It is clear that at least as late as January 14, 2008 ERS and UBS were intending to issue $4 billion of ERS POBs in the two weeks left in January 2008 and another $3 billion later in the year.

Whatever happened in the fifteen days between January 14, 2008 and January 29, 2008 it was dramatic. ERS and UBS realized they could only sell $1 billion – not $4 billion – of the ERS bonds on the terms they were being offered in January 2008. $650 million of the $1.6 billion Series A bonds were bought by the UBS Funds so there was a market for at most $1 billion. It must have become clear no one else would buy the bonds and UBS was about to lose out on lucrative underwriting fees.

The correspondence within UBS and between UBS and ERS in January 2008 would make for fascinating reading. Our interest isn’t idle curiosity. Investors in the UBS Funds lost $1 billion on the $1.7 billion of ERS bonds UBS stuffed into the Funds.

Tuesday, November 25, 2014

Equipment Leasing DPPs

By Craig McCann, PhD, CFA

We’ve written extensively about the evils of non-traded REITs. You can find our non-traded REIT blog posts here. As bad as non-traded REITs are – and they’re so bad no one should ever buy one – registered, non-traded Equipment Leasing Direct Participation Programs (DPPs) are worse.

Examples of equipment leasing DPPs include the series of LEAF and ICON trusts we discuss below. Equipment leasing DPPs provide a stark illustration of the DPP deceit which infects non-traded REITs, non-traded BDCs and oil & gas and managed futures DPPs. These investments can only be sold because of the motivation provided by high DPP sales commissions and the lack of price transparency and market discipline.

Direct Participation Programs are registered with the SEC and sold to retail investors but not listed on public exchanges. Without an active secondary market for the shares, there is no reliable way for retail investors to independently judge the prices charged by sponsors and brokerage firms. This lack of secondary trading in shares of DPPs also allows inefficient and self-serving management that would be disciplined by the market for corporate control to persist and harm DPP investors.

In an equipment leasing DPPs a sponsor sells limited partnership units, deducts substantial offering costs and invests the remainder in a pool of equipment leases leveraged up with additional borrowing. Like other DPPs, equipment leasing DPPs market a predictable income stream but a substantial portion of distributions to investors are a return of capital not of income. Equipment leasing partnerships promote the tax benefits investors can achieve through depreciation deductions and interest payments on borrowing used to leverage. The depreciation and interest deductions can only be used to offset income from other passive investments and so this “benefit” is trivial for most investors.

The purchased leases can either be operating leases or full-payout leases. In operating leases, the trust retains ownership of the equipment and counts on the residual value of the equipment to be great enough, when combined with the lease payments received over the term of the lease, to pay the cost of the equipment including borrowing costs and return a profit to investors. In financing or “full payout” leases the trust has no residual interest in the equipment but is instead just financing the operator’s purchase and use of the equipment. Investors in equipment leasing DPPs are effectively putting up capital and borrowing money to make loans backed by equipment to poor credit-quality borrowers.

As if that wasn’t bad enough, the sponsor and its affiliates deduct high up front and annual fees which guarantee that investors will lose money. Figure 1 is a table from the LEAF III prospectus available on the SEC website here.

Figure 1. Fee Table excerpt from LEAF III Prospectus

In this altogether typical equipment leasing DPP, upfront fees are 21.27% and reserves are 1% of investor’s capital. The Sponsor was to take $25,527,491 in fees from the $120,000,000 raised, set aside $1,200,000 in reserves and invest only $93,272,509 in leases. In a competitive market the investment returns on $93.3 million in leases cannot generate returns sufficient to compensate investors for risks borne on $120,000,000 of invested capital.

In addition to the cash investments in leases, LEAF III financed 80% of its lease portfolio with debt. The Sponsor received a 2% acquisition fee and 4% of gross rental revenue on operating leases and 2% of gross revenue on full payout leases each year. Thus, the Sponsor was paid for enlarging the lease portfolio quickly without regard for the financing costs or the quality of the leases bought, creating enormous conflicts of interest and ensured investors would lose money.

Completely predictably, LEAF III investors suffered significant losses. Figure 2 summarizes LEAF III results from 2007 to 2013. LEAF III investors’ losses are indicative of losses suffered by investors in equipment leasing DPPs more generally. The amortized offering costs, acquisition and management fees charged by the Sponsor can only be covered by lease revenues if there are no credit losses on leases extended to bad credit quality borrowers who face less penalty upon default than if they defaulted on bonds. That is, these equipment leasing programs might work if and only if the leases were backed by the full faith and credit of the US Treasury. Not surprisingly, credit losses have been substantial.

Figure 2. LEAF III’s Predictable Losses

Figures 3 and 4 present investors’ experience in the LEAF and ICON leasing programs. For each equipment leasing DPP we calculate the amount investors have made or lost. Investors in the LEAF series have lost $224.5 million and investors in the ICON series have lost $177.5 million as of December 31, 2013. Investors in bonds, stocks and even stocks of publicly traded equipment leasing companies earned substantial returns.

If an investor wanted equity exposure to equipment leases, he/she could buy common stock in equipment leasing companies. The losses investors suffer in equipment leasing DPPs are a result of high fees and shocking conflicts of interest – not problems in the equipment leasing or broader stock market. Figure 3 reports that had the same investments investors made in the LEAF funds been made instead in a market-capitalization weighted portfolio of publicly traded leasing companies, investors would have made $292 million. Thus, LEAF program investors lost $515 million by virtue of LEAF’s high costs and conflicts of interest. If the LEAF investors had invested the same amounts, at the same times, in the broad stock market they would have earned $186 million and would have earned $83 million in Treasury securities.

Figure 3. LEAF Equipment Leasing Programs1

Figure 4 reports that had the same investments investors made in the ICON funds been made instead in a market-capitalization weighted portfolio of publicly traded leasing companies, investors would have made $969 million. Thus, ICON program investors lost $1,146 million by virtue of ICON’s high costs and conflicts of interest. If the ICON investors had invested the same amounts, at the same times, in the broad stock market they would have earned $684 million and would have earned $363 million in Treasury securities.

Figure 4. ICON Equipment Leasing Programs
Thus despite being tied up in risky, illiquid investments for many years, investors in equipment leasing DPPs received substantially less than their original investments when investors in the equipment leasing industry, and in the broad stock and bond markets earned substantial returns.

1 Observant readers will note that the first two LEAF funds were called “Lease Equity Appreciation Fund I and II. It appears in the review process the SEC required LEAF to insert this language into the Lease Equity Appreciation Fund II registration statement. “Despite being named "Lease Equity Appreciation Fund II, L.P.," our equipment leases will not have any equity appreciation.” See None of the Lease Equity Appreciation Fund I filings or previous versions of the registration statements for Lease Equity Appreciation Fund II contained this language undoing the blatantly misleading naming of the funds.