Monday, March 2, 2015

Enforcement Actions: Week in Review


SEC Charges Goodyear with FCPA Violations
February 24, 2015(Litigation Release No. 38)
The SEC found Goodyear Tire & Rubber Company to be in violation with the Foreign Corrupt Practices Act (FCPA) due to bribes paid by subsidiaries in Kenya and Angola to land tire sales. According to the SEC, Goodyear failed to prevent or detect over $3.2 million in bribes over a four-year period. Bribes were paid to employees of private companies and government-owned entities and local police and city council officials. Goodyear has agreed to pay more than $16 million in a settlement.

SEC Salt Lake Office Director Karen Martinez to Retire from Public Service
February 26, 2015(Litigation Release No. 39)
Karen Martinez is retiring this summer after serving as Regional Director of the SEC’s Salt Lake office since 2013. She first joined the SEC’s Salt Lake office as a Trial Counsel in 2002 and was promoted to Assistant Director in 2010. Ms. Martinez earned her bachelor’s degree from the University of Idaho and went on to earn a Master’s in Mathematics and a law degree from the University of Utah.

SEC Announces Agenda for March 4 Meeting of the Advisory Committee on Small and Emerging Companies
February 27, 2015(Litigation Release No. 41)
The SEC’s Advisory Committee on Small and Emerging Companies will next meet on March 4 and will discuss secondary market liquidity and the definition of “accredited investor.” The committee will primarily focus on ways to increase secondary market liquidity for investors in small and emerging companies, making it easier for investors to resell company shares. Small and emerging companies include any privately held small businesses and publicly traded companies with a market cap less than $250 million.

SEC Halts Ponzi-Like Scheme by Purported Venture Capital Fund Manager in Buffalo
February 27, 2015(Litigation Release No. 43)
The SEC issued an asset freeze on Gregory W. Gray Jr. and his firms Archipel Capital LLC and BIM Management LP to stop his Ponzi-like scheme. Gregory W. Gray allegedly raised $5.3 million for a fund to purchase 230,000 pre-IPO shares of Twitter. However, Gray only purchase 80,000 pre-IPO shares before Twitter went public in November 2013. When investors of the fund demanded their shares and profits, Gray stole money from three of his other unrelated funds to make up the difference. The majority of the money allegedly came from one investor who believed he was investing $5 million in Uber Technologies. In actuality, Gray did not purchase any shares of Uber Technology and used fabricated documents, including signature pages from another legitimate stock purchase, as proof of his Uber purchases to the investor. The investigation is still ongoing.

Monday, February 23, 2015

Enforcement Actions: Week in Review


SEC Halts Colorado-Based Pyramid Scheme
February 18, 2015(Litigation Release No. 35)
The SEC has announced fraud charges against and emergency asset freezes on Kristine L. Johnson and Troy A. Barnes for their involvement in an alleged Ponzi/pyramid scheme. The SEC alleges that Johnson and Barnes’ company, Work With Troy Barnes Inc., raised over $3.8 million since April of last year by luring investors in with promises of 700% returns. These returns were claimed to be possible through an investment algorithm created, according to Barnes, by an expert programmer. The SEC alleges the company had no actual business operations, investors were being paid “returns” using money coming from new investors, and that Johnson and Barnes were using investor funds to pay for personal expenses such as credit card bills and a vehicle purchase. The investigation is ongoing.

SEC Charges New York-Based Brokerage Firm and CEO With Committing Fraud During CDO Liquidation Auctions
February 19, 2015(Litigation Release No. 36)
The SEC has charged NYC brokerage firm VCAP Securities and its CEO, Brett Thomas Graham, with deceiving participants of their CDO liquidation auctions. VCAP and its affiliates were barred from participating in the auction by their agreement with the CDO trustees. In order to secure CDOs that would bolster funds managed by VCAP, Graham conspired with a third party broker-dealer. He used confidential bidding information in order to guarantee the CDOs would go to the third party who would later sell them to the investment advisor affiliate. Over the course of five auctions, the investment adviser affiliate won 23 CDOs. VCAP and Graham have agreed to pay disgorgements and prejudgment interests of $1,149,599 and $127,733, respectively. Graham has been fined an additional $200,000 penalty and has been barred from the securities industry for at least three years.

SEC Charges Brothers-in-Law in Louisiana With Insider Trading
February 19, 2015(Litigation Release No. 37)
The SEC has announced charges against Scott Zeringue (former company executive of The Shaw Group, a Fortune 500 company) and his brother-in-law, Jesse Roberts III, with violations of the antifraud provisions of the federal securities laws. Zeringue had tipped Roberts with nonpublic information ahead of the company’s merger, making them and others (tipped by Roberts) nearly $1 million in combined illicit profits. Zeringue has previously pled guilty, settling the SEC’s charges by paying a total of $96,018. Zeringue will be prohibited from serving as an officer or director of a public-traded company for 10 years.

Friday, February 13, 2015

Enforcement Actions: Week in Review


SEC Proposes Rules for Hedging Disclosure
February 9, 2015(Litigation Release No. 26)
The SEC has announced the approval of the issuance of proposed rules. The proposed rules require a company to disclose whether its directors, officers, and other employees are permitted to hedge the company’s equity securities. The proposed rules are mandated by Section 955 of the Dodd-Frank Act, and the rules are intended to better inform shareholders by increasing the transparency of hedging policies.

SEC Charges Former Brokerage CEO for His Role in Fraudulent Scheme
February 10, 2015(Litigation Release No. 27)
The SEC has charged Craig S. Lax for having ConvergEx subsidiaries under his control who engaged in a fraudulent scheme. The ConvergEx subsidiaries misled customers to pay greater amounts than disclosed commissions for buying and selling securities. The ConvergEx Group subsidiaries were previously charged by the SEC, paying $107 million to settle charges. In addition, the SEC has charged two former employees in that enforcement action, and the SEC even later separately filed a case against a different former ConvergEx subsidiary CEO. Lax admitted wrongdoing and agreed to settle the SEC’s charges by paying more than $783,000. Lax has agreed to be barred from the securities industry for at least five years.

SEC Announces Half-Million Dollar Clawback from CFOs of Silicon Valley Company That Committed Accounting Fraud
February 10, 2015(Litigation Release No. 28)
In compliance with an SEC order, former Saba Software CFOs, William Slater and Peter E. Williams III, have agreed to return almost a half million dollars to their former employer. Slater and Williams received $337,375 and $141,992, respectively, as bonuses and stock sales profits during the same time that their company was altering financial statements. From 2008 to 2012, during their consecutive terms as CFOs, Saba Software has been found to have overstated pre-tax earnings and made materially false statements concerning their revenue recognition protocol. Under Section 304 of the Sarbanes-Oxley Act, Slater and Williams must return profits and bonuses they received during the time of the fraud, regardless of whether they were involved. Neither has been personally charged with the fraud. Saba Software and two other former executives were charged by the SEC with accounting fraud last year.

SEC Announces Charges Against Atlanta Man Accused of Insider Trading in Advance of Tender Offer
February 11, 2015(Litigation Release No. 29)
Charles L. Hill Jr. has been accused for insider trading and charged by the SEC for exploiting nonpublic information that he learned from person who was a friend of a Radiant Systems executive. Hill illegitimately made approximately $740,000 by misusing nonpublic tender offer information, trading in the stock of Radiant Systems. The matter is scheduled for a public hearing and it is to be decided if any remedial actions are to be placed.

Heather Seidel Named Chief Counsel in SEC’s Division of Trading and Markets
February 11, 2015(Litigation Release No. 30)
The SEC has announced that Heather Seidel has been appointed as Chief of Counsel for the SEC’s Division of Trading and Markets. Given her new role, Seidel will be providing legal and policy advice to the Commission on matters that affect broker-dealers and securities markets along with other duties. Seidel’s professional experience that qualifies her the Chief of Counsel title include being an Associate Director in the Office of Market Supervision and having worked in the division as an Assistant Director, Senior Special Counsel, and Attorney Fellow.

SEC Charges Mutual Fund Adviser in Connection With Improper Handling of Fund Assets
February 12, 2015(Litigation Release No. 31)
An investment adviser was charge in connection to Water Island Capital LLC’s mismanagement of fund assets. Millions of dollars of the funds’ cash collateral were being maintained at broker-dealer counterparties instead of the funds’ custodial bank. Water Island Capital LLC was charged for failing to ensure that all cash collateral was held in the custody of the funds’ bank, roughly $247 million in cash was improperly handled. Water Island Capital LLC has agreed to the SEC’s cease-and-desist order, paying a $50,000 penalty to settle the SEC’s charges.

SEC Announces Agenda, Panelists for Proxy Voting Roundtable
February 12, 2015(Litigation Release No. 32)
The SEC has announced the schedule, topics and panelists for its roundtable on possible improvements to proxy voting. The roundtable, scheduled for February 19th, will consist of two, one and a half hour panel discussions: “Universal Proxy Ballots” and “Retail Participation in the Proxy Process”. The first panel, consisting of ten, will be moderated by Keith Higgins, Director of the Divison of Corporate Finance and Michele Anderson, Chief of the Office of Mergers and Acquisitions, Division of Corporate Finance. The second panel, consisting of twelve, will be moderated by Keith Higgins and David Frederickson, Chief Counsel and Associate Director, Division of Corporate Finance. The roundtable will begin at 9:30 a.m. at the SEC’s DC headquarters and is open to the public. The event will also be shown live on the SEC website.

Pamela C. Dyson Named SEC Chief Information Officer
February 12, 2015( Litigation Release No. 33)
The SEC has announced the official appointment of Pamela C. Dyson as Chief Information Officer, who has served as acting CIO since October of last year. Since joining the SEC in 2010, Ms. Dyson has held other key positions including Deputy CIO, Office of Information Technology and Assistant Director, Enterprise Operations. As Chief Information Officer, Ms. Dyson be in charge of integrating technology with the efforts of the SEC in order to better serve investors and promote healthy, efficient markets.

SEC Announces Fraud Charges Against Purported Hedge Fund Manager
February 13, 2015(Litigation Release No. 34)
The SEC has charged Moazzam “Mark” Malik with stealing money from his investors. Malik conned investors into supporting his expensive lifestyle. Malik built up a façade claiming to be a hedge fund manager of Wolf Hedge LLC which supposedly had roughly $100 million in assets under management. In reality, Malik’s fund never held more than $90,177 in assets, and Malik was soliciting investors promising them consistent high returns when in reality. The SEC’s investigation is continuing. In the meantime, the SEC seeks final judgment to disgorge their ill-gotten gains, prejudgment interest and penalties, and seeks a temporary restraining order to freeze Malik and his fund’s assets to avoid further violations.

Thursday, February 12, 2015

Oil and Gas DPPs From Just Two Sponsors Have Caused $3.7 Billion in Losses

By Joshua Mallett , Craig McCann and Regina Meng

We have written extensively about direct participation programs, or DPPs. Our posts on non-traded REITs are here, and our discussion about equipment leasing DPPs is here. Oil and gas DPPs are another strain of the DPP epidemic: illiquid exposure to an existing underlying asset, loaded with confiscatory fees, conflicts of interest and unnecessary risk.

Oil and gas DPPs use some of investors’ money to drill and operate oil and gas wells. Oil and gas DPPs are sponsored and managed either by investment companies or oil and gas exploration companies, each of which suffers from its own conflicts of interest. We examine funds sold by Ridgewood Energy Corp, an investment company, and funds sold by Atlas Resource Partners, an energy exploration company.

Exploration companies acting as sponsors and managers, such as Atlas Resource, are incentivized to use the DPP to perform exploratory drilling that is in the best interest of the company, not the DPP. An exploration company can force a DPP it manages to drill many wells and, after seeing which wells succeed, can drill wells nearby for the benefit of the exploration company rather than the DPP. In addition, the exploration company’s ability to profit from knowledge of the DPP’s successful wells provides incentives for the exploration company to drill wells in more high-risk, high-return areas since the DPP investors bear all of the downside risk of dry holes but share the upside of producing wells with the exploration company.

The exploration company managers also take advantage of the DPPs by selling the DPPs they manage drilling services at a large mark-up and charging upfront costs that are not related to the success of the DPP. Finally, the managing companies keep an extra portion of net revenues for themselves. In short, energy exploration companies like Atlas Resource use oil and gas DPPs to charge retail investors high fees for accepting some of the exploration company’s risk without the corresponding reward.

The DPPs run by an investment company like Ridgewood Energy are exposed to some of the same conflicts of interest as the DPPs run by energy exploration companies. For example, Ridgewood Energy charges high upfront fees, a 2.5% annual management fee, and keeps 15% of any distributions despite having not invested in the DPP. Since - as with non-traded REITs and equipment leasing DPPS - some of the distributions to oil and gas DPPS are a return of investors’ capital, Ridgewood and similar investment companies are taking high upfront fees off the top, holding investors’ cash and returning a portion of it after deducting a further, large haircut.

DPP Investors Suffered $1.75 Billion in Net Out-of-Pocket Losses

We analyze 33 registered DPPs sponsored by Atlas Resource or Ridgewood Energy. Atlas Resource registered 19 funds with the SEC between July 2000 and April 2010 and raised $1.9 billion. The Atlas funds’ filings can be accessed here and here. Ridgewood registered 14 funds between April 2004 and October 2009 and raised $1.3 billion. The Ridgewood funds’ filings can be accessed here. Only one of the 33 DPPs paid investors back their entire initial investment. That is, 32 of the 33 funds suffered net out-of-pocket losses. The losses were not due to market forces, as an investable energy mutual fund beat all but two of the oil and gas DPPs. The persistently poor performance of the DPPs is driven by high fees, conflicts of interest (poor management incentives), and unnecessary risk.

Figure 1 shows that all of the Atlas funds we examined had out-of-pocket losses. The 19 funds lost a combined $1.1 billion of the invested $1.9 billion by December 31, 2013. The upfront fees accounted for $216.5 million of the losses.

Because the DPPs do not have a liquid secondary market, we estimate the value of the funds on an annual basis using data provided in each fund’s most recent 10-K. Specifically, we estimate the fund’s value as the sum of the standardized measure of discounted future net cash flows from known reserves, plus cash and short-term investments in marketable securities. We net the estimated value and the distributions paid against the contributed capital to calculate out-of-pocket losses.

Figure 1. Losses in Atlas DPPs as of December 31, 2013

Figure 2 presents the out-of-pocket losses for the 14 Ridgewood funds, which had total losses of $642 million as of December 31, 2013. Upfront fees and asset management fees are responsible for more than $349 million of the losses, and conflicts of interest are responsible for much of the remaining $293 million.

Figure 2. Losses in Ridgewood DPPs as of December 31, 2013
DPP Investors Missed an Additional $1.9 Billion in Returns

With the high fees, conflicts of interest, and unnecessary risk, it is no surprise that oil and gas DPPs consistently underperform other investments with similar exposure. For example, the Vanguard Energy mutual fund (ticker: VGENX) charges low fees (0.38% per year), and is independently managed, diversified, and liquid. Figure 3 compares the returns for each of the 19 Atlas Resource funds to the returns investors would have experienced if they had instead purchased shares of VGENX. All of the Atlas funds lost money, and all of them performed worse than the Vanguard energy fund. Even in the two cases where the energy benchmark lost money, it performed much better than the DPPs. Overall, by December 31, 2013, the VGENX benchmark had gained $1 billion while the DPPs had lost $1.1 billion. Thus, investing in the 19 Atlas DPPs had cost investors $2.2 billion.

Atlas Resource became publicly traded shortly before Atlas America Series 27-2006 started raising capital. This allows us to compare the performance of the DPPs to the performance of the manager, which itself is an oil and gas exploration company. Investors in Atlas America 27-2006 and the 8 subsequent registered DPPs have suffered $870 million in combined net out-of-pocket losses. If these same investments had been made directly in Atlas Resource, investors would have earned $8.5 billion in net gains. This $9.4 billion shortfall reflects, at least in part, the DPPs’ high upfront costs and Atlas Resource’s ability to transfer resources and opportunities from its DPP investors to itself.

Figure 3. Out-of-Pocket Gains for the Atlas DPP Benchmark (VGENX) as of December 31, 2013
Figure 4 presents a similar analysis for the Ridgewood Energy funds, with similar findings. For each of the 14 funds, the VGENX investment would have resulted in a net gain instead of a net loss. In total, investors would have earned $860 million instead of losing $642 million if they had invested in the benchmark index instead of the DPPs. Thus, investing in the 14 Ridgewood DPPs had cost investors $1.5 billion as of December 31, 2013.

Figure 4. Out-of-Pocket Gains for the Ridgewood DPP Benchmark (VGENX) as of December 31, 2013
High Upfront Fees

The DPPs’ consistent losses can be partially explained by the investments’ high fees, conflicts of interest, and unnecessary risk. The 19 funds Atlas Resource registered with the SEC between July 2000 and April 2010 raised $1.9 billion in total and charged 12.5% in upfront fees on average. The fund sizes and fee rates are shown in Figure 5. Atlas Resource stopped registering new funds in 2010, but its 2013 10-K shows it sold more than $100 million in DPPs each year from 2011-2013. This suggests Atlas Resource made a conscious choice to reduce the transparency of the high-risk, high-fee investments it sells.

Figure 5. Upfront Fees Charged in Atlas Resource’s FundsFigure 6 presents the fund sizes and fee rates for the 14 funds Ridgewood Energy registered with the U.S. Securities and Exchange Commission between April 2004 and October 2009. The funds, which raised $1.3 billion in total, charged 16% in upfront fees on average. Ridgewood has not registered any new funds since early 2009, but was offering new funds as late as January 2014 (see article). Like Atlas Resource, Ridgewood chose to move away from transparency.

Figure 6. Upfront Fees Charged in Ridgewood Energy’s Funds
Although both sponsors charged high upfront fees, they went about it in different ways. Atlas Resource, which is an energy exploration company, contributed equipment, leases, and the upfront fee costs to the drilling programs, and claimed to not charge investors the upfront fees because the fees were paid out of the sponsor’s capital account. Ridgewood, on the other hand, contributed nothing to the drilling program and directly charged investors the upfront fees. Either way, the sponsors took the upfront fees and gave investors a 13-16% loss on the first day.

Sponsors’ Incentives

The problems with oil and gas DPPs continue after day one. Sponsors’ interests are, in many cases, exactly opposed to investors’ interests. These misaligned incentives include the sponsor’s ability to receive flat fees and operating profits while avoiding losses, the sponsor’s use of the DPP as exploratory drilling for its own benefit, and the sponsor’s mark-up on drilling and operating services performed for the DPP.

One way to see the incentive problems inherent in having an exploration company manage an oil and gas DPP is to look at how else the sponsor could have financed the wells. The exploration company sponsor is an oil and gas exploration company, and so already has all of the equipment, labor, and land necessary to drill wells. If it needs money, it can issue more stock or borrow from a bank. Those investors would then have exposure to the company’s entire operation, which should have a system of checks and balances designed to control risk and maximize the company’s value.

Instead, the sponsor creates a separate entity (the DPP), controlled entirely by the oil and gas exploration company, and uses it to raise money. The new entity charges high upfront fees to investors, which the investors would have avoided by investing in the company itself. The exploration company then sells equipment, labor, and land to the DPP. Because the sponsor/manager/operator has absolute control, the DPP often pays an above-market rate for the equipment, labor, and land. For example, the 2010 10-K for Atlas Resources Public 18-2009C states, “Drilling contracts to drill and complete wells for the Partnership are charged at cost plus 18%. The cost of the wells includes reimbursement to the Partnership’s [sponsor] of its general and administrative overhead cost” (p. 32). In other words, Atlas has passed on all of its costs to the DPP, at an 18% mark-up. Atlas also charges the DPP additional administrative costs and monthly fixed-rate well supervision fees (see 2010 10-K, p. 32).

The structure of the DPP also encourages the sponsor to take more risk than it otherwise would. The sponsor has invested little if any money in the DPP, and so does not have much downside risk. On the other hand, the sponsor often receives a large portion of profits. For example, Atlas Resource receives an additional 10% of revenues beyond its contributed capital. In addition to the sponsor’s risk-reward imbalance that encourages risky behavior, the sponsor is encouraged to take risks with the DPP because the sponsor can apply what it learns from the successes and failures of the DPP’s wells to the sponsor’s proprietary drilling.

Like Atlas Resource, Ridgewood Energy has misaligned incentives. However, because Ridgewood is not an energy exploration company, it cannot profit from marking up drilling costs. Instead, Ridgewood charges a higher upfront fee and a 2.5% annual management fee. In addition, Ridgewood keeps 15% of all distributions, despite not having invested in the fund. These different incentives encouraged different behaviors by the sponsors. Atlas was incentivized to drill as many holes as quickly as possible, while Ridgewood was incentivized to prolong the drilling and pay out high distributions. Importantly, in neither case was the primary incentive to drill and operate successful wells.

Unnecessary Risk

The high fees and incentive problems discussed above should make anybody wary of investing in a DPP. However, even if those problems didn’t exist, the unnecessary risks inherent in DPPs should warn off investors and advisors alike. There is not an active secondary market for oil and gas DPPs, meaning investors’ DPPs are extremely illiquid. Lack of liquidity is a risk, and investors should be compensated for it by receiving a higher return. However, DPPs do not have a way to generate the required higher return. The DPPs are drilling wells exactly like the much more liquid energy exploration companies, so the best a DPP can expect to do is earn the industry average. Because it is not possible for DPPs to compensate investors for the liquidity risk, investors are taking an unnecessary, uncompensated risk by investing in a DPP. In addition to the uncompensated liquidity risk, DPPs are exposed to small company risk and concentration risk. The high fees and poor sponsor incentives make it impossible to achieve outcomes sufficient to overcome the small company and concentration risks. By investing in an energy index or even just a publicly traded energy exploration firm, investors could drastically reduce their risk while increasing their expected return. While we don’t advocate a focused investment in oil and gas exploration, if you’re so inclined an oil and gas DPP is the worst way to get this exposure.

We have written extensively about direct participation programs, or DPPs, in prior posts. Each type of DPP share such undesirable traits that no retail investors should buy these products and no unconflicted advisor would recommend them. Virtually all of the oil and gas DPPs we have seen failed to return investor capital as a result of high fees, conflicts of interest, and unnecessary risk, while mutual funds with similar exposures posted large gains.