Friday, May 31, 2013

SEC Litigation Releases: Week in Review

District Court Enters Judgment Against Medical Software Company and Its CEO and CFO, May 30, 2013, (Litigation Release No. 22709)

Default judgments were entered against MedLink International, Inc., its CEO, Aurelio Vuono, and its CFO, James Rose, for allegedly "filing an annual report falsely stating that its audit had been completed and...defrauding a MedLink investor." The judgment orders permanent injunctions from violating sections of the Securities Act and Exchange Act and orders the defendants to pay over $930,000 combined in disgorgement, prejudgment interest, and civil penalties. Additionally, penny stock bars and officer and director bars were ordered against Vuono and Rose.

SEC Obtains Final Judgment and Issues Administrative Orders Against John A. ("Jack") Grant, May 30, 2013, (Litigation Release No. 22708)

A final judgment was entered against lawyer and former stockbroker, John A. Grant, for his alleged violation of "a July 1988 order barring him from association with brokers, dealers, and investment advisers." In 1988, the SEC charged Grant with selling $5.5 million of unregistered securities and misappropriating investors' funds. According to the SEC, Grant violated the bar "by associating with his son Lee Grant’s investment advisory firm, Sage Advisory Group LLC, and by acting as an investment adviser himself." Furthermore, "Jack Grant, Lee Grant, and Sage failed to inform their advisory clients that Jack Grant is barred from associating with investment advisers." Jack Grant has consented to a final judgment that orders him to pay over $201,000, permanently enjoins him from violations of the Investment Advisors Act, orders him to comply with the 1988 bar, orders him to notify his clients of the final judgment, and permanently bars him from associating with "any broker, dealer, or investment adviser" as well as permanently suspends him from practicing before the SEC as an attorney.

The SEC's case against Lee Grant and Sage remains pending.

SEC Charges Dallas-Based Trader with Front-Running, May 24, 2013, (Litigation Release No. 22707)

According to the complaint (PDF), Daniel Bergin, a trader with Cushing MLP Asset Management, LP, engaged in "trading ahead of client trades, insider trading, and failing to report trades to his employer" which resulted in at least $1.7 million in illegal profits. Bergin allegedly used his wife's brokerage accounts to conceal the trades. The SEC has named his wife, Jacqueline Zaun, as a relief defendant.

An emergency court order was granted that has frozen Bergin and Zaun's assets. The SEC has charged Bergin with violating the Exchange Act and Investment Company Act and seeks disgorgement, prejudgment interest, civil penalties, and a permanent injunction.

Thursday, May 30, 2013

Risks of Mortgage REITs

By Carmen Taveras, PhD

Instead of investing in real estate property directly like equity real estate investment trusts (REITs) do, mortgage REITs borrow in the repo markets and invest in mortgage backed securities (MBS) -- mostly residential MBS issued by Fannie Mae, Freddie Mac, and Ginnie Mae. The current environment of low interest rates has kept the borrowing costs low for mortgage REITs, facilitating their outstanding growth. The figure shows the market capitalization for all listed mortgage REITs and the total assets for the two largest players in the industry: Annaly Capital Management (NLY) and American Capital Agency Corporation (AGNC).


Even though their business model experienced setbacks during the financial crisis (due to lack of funding for short-term borrowing), the market capitalization of all mortgage REITs has increased by almost 15-fold in the last twelve years. Their growth accelerated from 2008 onward, when the Federal Reserve’s policies drove borrowing rates to record lows.

Retail investors can directly purchase mortgage REITs through their brokerage accounts. What they may not know is that mortgage REITs are not regulated investment companies and hence do not afford investors the benefits of the Investment Company Act (PDF). Many open-end and closed-end investment companies invest in agency MBS, just like mortgage REITs, but must comply with leverage limits established in the Investment Company Act.  For example, closed-end companies may only borrow up to 33% of their assets. By contrast, the average debt-to-asset ratio of listed mortgage REITs is over 84% according to REITWatch. This higher leverage can enhance returns when the market is doing well but it also poses a higher risk of losses in the event of a downturn.

The added risk caused by the leverage embedded in mortgage REITs is one of the reasons behind a 2011 inquiry by the Securities and Exchange Commission (SEC) into the mortgage REIT business. In the SEC’s concept release and request for comments (PDF), the SEC states that “certain types of mortgage-related pools today appear to resemble in many respects investment companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded from regulation under the Act.” It is likely that the sector’s outstanding growth and increasing risks will attract further attention from the regulators. 

Another issue that investors should consider is the management capabilities of some of the mortgage REITs. A negative consequence of the high growth in the sector is that REITs that started out as relatively small players and have benefited from outstanding growth may currently have an asset portfolio that exceeds their management capabilities. Armour Residential REIT Inc. (ARR), whose assets have ballooned from $250 million at the end of 2008 to over $20 billion at the end of 2012, has been described as an example of a mortgage REIT whose management may have difficulty keeping up with the risks of its growing balance sheet. 

As the economy shows signs of recovery, it seems likely that the Federal Reserve’s policy will shift in the near future. A rise in the short-term interest rates will directly affect the profitability of the mortgage REIT industry, by reducing the wedge between the interests earned on its long-term investments and its short-term borrowing costs. In addition, a large-scale sale of MBS by the Federal Reserve could depress the prices of MBS and negatively affect the price of the portfolio holdings of mortgage REITs.* The high leverage typical of the industry may exacerbate these risks. We will continue to monitor mortgage REITs and their rising risks.
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*  The Federal Reserve has amassed about $1 trillion in agency mortgage backed securities.  For the Federal Reserve's balance sheet, see the Federal Reserve Board’s flow of funds report (PDF).

Wednesday, May 29, 2013

Investors Returning to Capital-at-Risk Products

By Tim Dulaney, PhD

Yakob Peterseil of Risk.net recently noted that "[b]anks are boosting issuance of leveraged notes linked to US equity indexes and notes that pay out when yield curves steepen."  According to the article, reverse convertibles and buffered notes are seeing a resurgence as investors begin to be more optimistic about stock market growth.  In addition, principal-protected structures like structured certificates of deposit and principal-protected notes are falling out of favor as attractive terms are hard to come by and investors continue to hunt for yield.

The important thing investors need to remember is that even if they're generally optimistic about the future growth of the stock market this growth expectation is already priced into the structure of the product:  a reverse convertible might offer a slightly lower coupon rate or a buffered note might have a more stringent cap.  In the end, structured products are high-cost/high-risk debt securities that amount to a complex combination of derivatives and corporate bonds.  

An interesting case study of the risk embedded in reverse convertibles is contained in the notes linked to Apple common stock (AAPL).  Yakob mentions that "[w]hen Apple at one point lost more than 20% of its value, the notes converted into Apple shares at depressed prices – to the surprise of some investors."  We've discussed exactly this point when we wrote a paper (PDF) discussing the decline in market value of Apple-linked structured products earlier this year (see also the update located here).  

For more information on a particular structured product, visit our searchable structured product database   containing over 16,000 individualized structured product research reports.

Tuesday, May 28, 2013

Massachusetts Fines Five Brokerage Firms for Sale of Non-Traded REITs

By Tim Dulaney, PhD and Tim Husson, PhD

Secretary of the Commonwealth of Massachusetts William Galvin, who has previously come out swinging on behalf of investors in both warehoused CLOs as well as leveraged and inverse ETFsannounced yesterday  that the state has settled with five independent brokerage firms regarding improper sales of non-traded REITs.  Non-traded REITs are pooled real estate investments that have become notorious for high fees, lack of liquidity, and numerous potential conflicts of interest, as we detail in our working paper.

The settlements amount to about $6 million in restitution to investors and fines of $975,000, and are available here.*  The five brokerage firms, with respective restitution and fines, are:

Firm Restitution Fine
Ameriprise Financial Services Inc. $2.530 million $400,000
Commonwealth Financial Network $2.074 million $300,000
Securities America Inc. $0.778 million $150,000
Lincoln Financial Advisors Corp. $0.504 million $100,000
Royal Alliance Associates Inc. $0.059 million $25,000
Total:
$5.945 million $975,000

In December of last year, Massachusetts also charged LPL Financial (PDF) for similar abuses related to the sale of non-traded REITs, a matter which was settled in February for $2 million in restitution and $500,000 in fines.  Regarding the most recent action, Secretary Galvin noted that:
Our investigation into the sales of ­REITs, triggered by investor complaints, showed a pattern of impropriety in the sales of these popular but risky investments on the part of independent brokerage firms where supervision has historically been difficult to maintain.
Non-traded REITs have been sold to retail investors based on potentially misleading representations.  For example, because they are non-traded, these REITs do not have market prices and historically have been held at cost in client portfolios, even through the worst of the real estate collapse in 2008.  This lack of price transparency, however, was for a time actually touted as a feature (a purported 'lack of volatility'), rather than a deficiency.  Such claims are now specifically prohibited by the SEC.

Sales commissions on non-traded REITs can also be very high, up to 7% of offering proceeds.  This could be a reason why brokers might push non-traded REITs rather than diversified real estate mutual funds or traded REITs, which may offer similar exposure at significantly lower cost.

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* It should be noted that most news outlets covering this story report a restitution of $8.6 million and a fine of $975,000.  The first of these numbers, however, includes the $2 million in restitution and $500,000 in fines stemming from the LPL Financial settlement.

Friday, May 24, 2013

SEC Litigation Releases: Week in Review

SEC Charges Atlanta-Area Registered Representative and Registered Investment Adviser Representative with Securities Fraud, May 23, 2013, (Litigation Release No. 22706)

According to the complaint (PDF), since at least 2008 Blake Richards, "a registered representative of a broker dealer, misappropriated at least $2 million from at least seven investors." Allegedly, the "majority of the misappropriated funds constituted retirement savings and/or life insurance proceeds from deceased spouses." An order was issued that "temporarily restrained Richards from further securities laws violations, froze Richards’s assets, prevented the destruction of documents, and expedited discovery." The SEC has charged Richards with violating various provisions of the Securities Act and Exchange Act and seeks permanent injunction, disgorgement, prejudgment interest, and civil penalties.

SEC Charges Director's Brother, and His Friend and His Relative, with Insider Trading in Shares of a Medical Professional Liability Insurer, May 22, 2013, (Litigation Release No. 22705)

According to the complaint (PDF), John A. Stilwell along with his friend, Dr. Michael C. Moore, and sister-in-law, Jillian M. Murphy, traded on insider information that Stilwell gained from his brother, an American Physicians Capital, Inc. director. The insider information involved ACAP's possible acquisition by The Doctors Company. Moore and Murphy allegedly each tipped another person. In total, the four tippees made almost $62,000 in illicit profits. The defendants agreed to settle charges by agreeing to a final judgment that permanently enjoins them future violations of the Exchange Act, as well as orders them to pay disgorgement, prejudgment interest, and financial penalties.

Securities and Exchange Commission v. Ren Hu, May 20, 2013, (Litigation Release No. 22704)

A final judgment was entered against China Yingxia's former chief financial officer, Ren Hu. Hu allegedly made "fraudulent representations in Sarbanes-Oxley certifications" and failed to "implement internal controls, aided and abetted China Yingxia's failure to do so, and made materially misleading statements to auditors concerning such controls and potential fraud by the CEO." The final judgment imposes a permanent injunction against Hu from future violations of the Exchange Act and also "imposes a 3-year officer and director bar against Hu but does not include any civil monetary penalty based on Hu's financial condition."

SEC Charges Chicago-Area Father and Son Conducting Cherry-Picking Scheme At Investment Firm, May 17, 2013, (Litigation Release No. 22703)

According to the complaint (PDF), father-and-son duo, Charles J. Dushek and Charles S. Dushek, along with their investment advisory firm, Capital Management Associates, Inc., (CMA) defrauded "CMA clients in a cherry picking scheme that garnered the Dusheks nearly $2 million in illicit profits." The scheme went on for 17 quarters and caused at least one of "Dushek Sr.’s personal accounts [to] increase...in value by almost 25,000 percent." The SEC has charged the defendants with violating various provisions of the securities laws and seeks permanent injunctions, civil penalties, disgorgement, and prejudgment interest. Additionally, Margaret Dushek was named as a relief defendant.

SEC Charges Resident in the Atlanta Area and His Firm with Fraud in Connection with Prime Bank Scheme, May 17, 2013, (Litigation Release No. 22702)

According to the complaint (PDF), Robert Fowler and his company, US Capital Funding Series II Trust 1, defrauded " investors in a 'prime bank' investment scheme." Last August, the defendants allegedly "raised at least $350,000 from investors by falsely promising high profits for investing in standby letters of credit or bank guarantees that would purportedly grant the investors loans, the proceeds of which would be invested for a significant profit." These funds were misappropriated by Fowler and US Capital  for "personal and business use." According to the SEC, Fowler preyed on "foreign-born small business owners with little or no experience in finance or investing." The SEC has charged Fowler and US Capital with violating the antifraud provisions of the securities laws and seeks "permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest, and civil penalties."

Final Judgments Entered Against Connecticut-Based Investment Adviser and His Firm Charged with Fraud for Stealing Investor Funds, May 16, 2013, (Litigation Release No. 22701)

Final judgments were entered against Stephen B. Blankenship and his investment advisory firm, Deer Hill Financial Group, LLC for allegedly engaging in a scheme that defrauded investors of at least $600,000. The final judgment enjoins the defendants from future violations of the securities laws. Additionally, the SEC has "barred Blankenship from working in the securities industry."

Criminal charges arose from the same alleged misconduct and on December 5, 2012 Blankenship was sentenced "to forty-one months imprisonment plus three years of supervised release and ordered...to pay a fine of $7,500 and restitution in the amount of $607,516.81."

Thursday, May 23, 2013

SEC Charges South Miami with Defrauding Investors

By Tim Dulaney, PhD and Tim Husson, PhD

Yesterday the Securities and Exchange Commission (SEC) charged the City of South Miami with defrauding investors over the tax-exempt status of some municipal offerings.

In 2002, the City of South Florida obtained access to tax-exempt financing through a pooled conduit municipal bond issued by the Florida Municipal Loan Council (FMLC) to fund the construction of a mixed-use retail and parking structure in the city's commercial district.*   The 2002 FMLC bond offering can be found here (PDF).  The funding was meant to cover the portion of the construction costs attributable to the parking structure in which the city would remain full control and receive all parking revenues.  The city's access to tax-exempt financing depended critically on the limited role of the for-profit developer.

City officials became concerned with the municipality's ability to pay the debt service on the bonds and subsequently cancelled the project.  Litigation with the developer followed and a settlement was reached in which the developer would lease the entire project (including the parking structure), jeopardizing the tax-exempt status of the bonds.

The City of South Miami sought additional funding from FMLC in 2006 to continue the project.  However, in seeking this new funding the city omitted information concerning the new lease with the developer.  FMLC issued pooled municipal bonds (PDF) in 2007 based on this omission and other material misrepresentations.  City officials were reportedly aware of the failure to comply with IRS rules for tax-exempt financing and continued to issue certifications that the city was in compliance with the terms of the loan agreements.

It was not until July 2010 that the city formally recognized the adverse impact of the renegotiated lease with the developer on the tax-exempt status of the 2002 and 2007 bonds.  The City of South Miami has settled with the IRS resulting in nearly $1.5 million in additional costs.  From the viewpoint of the bondholders, the settlement effectively preserved the tax-exempt status of the bonds.

The City of South Miami has agreed to retain an independent third-party consultant to review financial disclosures and ensure compliance. The SEC order instituting cease-and-desist proceedings can be found here (PDF).
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* A pooled municipal bond offering is one in which an issuer uses the proceeds from a bond issuance to make loans to a set of municipalities.  A conduit municipal bond is issued by a municipality that then loans the proceeds to a private entity.  The private entity then repays the loan to the issuer and the issuer pays bond investors from the proceeds.  Typically the municipality is not responsible for making up shortfalls on loan-repayments and as such these bonds are considered more risky than vanilla/non-conduit bonds.  For more information about the basics of municipal bonds, see the Municipal Securities Rulemaking Board's website.

Wednesday, May 22, 2013

Higher Expected Returns Only Come from Higher Risk: The Case of 130/30 Strategies

By Tim Dulaney, PhD and Tim Husson, PhD

JP Morgan recently released an "Investment Insight" that puts the spotlight on 130/30 strategies, which are used by several mutual funds and ETFs from a variety of issuers.  A 130/30 strategy involves selling short 30% of the assets in a portfolio and using the proceeds to leverage the long securities to 130% of initial assets.  The securities that are shorted are expected by the portfolio manager to depreciate during the holding period (overvalued) while the assets that are purchased are expected to appreciate in value during the holding period (undervalued).  The report offered the following illustration of the strategy:

Source:  JP Morgan
The JP Morgan report also notes that 130/30 strategies can increase returns while keeping the portfolio's beta--its relationship to the broader market--the same as a long-only portfolio.  However, this does not mean that 130/30 strategies achieve riskless profits.  Shorting securities involves a number of additional risks (including the potential for > 100% losses), even for large cap, highly liquid stocks.  In addition, the 130/30 ratio is not fixed for all funds -- shorting is limited to 50% of assets by the leverage limits imposed by the Federal Reserve Board's Regulation T.

But perhaps the most important risk of 130/30 strategies is that they depend on the manager's ability to pick overvalued assets and undervalued assets.  We've seen evidence, including recently updated evidence, that managers are not great at picking stocks within a given fund to beat a benchmark.  Furthermore, there is evidence that managers often do no better than chance when outperforming their peers.  In other words, if you're looking for a manager who will outperform half of their category peers, you are no better off looking at past performance than you are by flipping a coin.

Given this evidence, how much trust do you want to put into a fund that leverages their exposure to the manager's (or some proprietary algorithm's) stock picking ability?  In 2009, a report on 130/30 funds found that their performance was severely lacking, and many 130/30 funds closed shortly after the financial collapse.  That report, titled "130% Gimmick/30% Good Idea", included sweeping criticisms of the fundamentals of this strategy, especially that it is almost entirely dependent on hard-to-identify manager skill.

A fundamental concept of finance is the fact that higher expected returns only come at the cost of additional risk.  Although JP Morgan states that there is no additional "market risk", there is additional risk and investors should not think that such strategies are a free lunch.  As usual, investors should also be conscious of fees.  Fees for these funds can be high and higher fees have a significant detrimental effect on realized investor returns.

Tuesday, May 21, 2013

Fitch Rolls Out New Ratings Indenture Abstract

By Tim Dulaney, PhD and Tim Husson, PhD

It is looking more and more like collateralized debt obligations (CDOs) and other asset-backed securities-- the 'toxic' assets highlighted as some of the worst excesses of the financial crisis--are back.  And while the agencies that rate asset-backed securities are still at the center of the debate over the validity of these investments, at least one of them is trying to improve its explanation of their labyrinthine terms and conditions.

Fitch has recently published the first example of their new "Indenture Abstracts," which provide a relatively digestible summary (at least to those familiar with these structures) in a form that is easier to navigate and more logically organized.  The example* covers the Race Point VIII Collateralized Loan Obligation (CLO) which closed on February 20 of this year.

The March 13, 2013 prospectus for Race Point VIII CLO can be found on the Irish Stock Exchange's website.  You'll notice that the prospectus is a staggering--though by no means unusual--three hundred pages of dense text that is cumbersome to parse.  What Fitch has done with their new indenture abstracts is to provide a synopsis of some of the most important features of the deal in less than fifteen pages.

In addition, Fitch compares each deal with other similarly structured deals priced around the same time.  On page 2 of the indenture abstract, Fitch compares Race Point VIII to it's predecessor Race Point VII CLO as well as two other deals of comparable size priced within a month of Race Point VIII.  The comparison covers a broad range of important characteristics ranging from coupon rates of senior debt to the minimum weighted average spread on the portfolio constituents.

Perhaps our favorite feature is their abbreviation of principal and interest waterfall payments (page 7).  These waterfalls determine if, when, and how much investors will receive for their investment in the CLO.  This abbreviated structure allows investors to easily locate themselves in the waterfall and determine if that is where they would like to be in the priority of payments.

Obviously by dropping nearly three hundred pages from the prospectus, important information and disclosures are going to be lost.  Any document of this type will not replace the prospectus, which still must be reviewed carefully by any potential investor.  That said, good summaries of asset-backed securities are hard to find, and Fitch's abstracts are a significant improvement over previous descriptions.  We applaud Fitch for their efforts to bring more transparency to this often murky market.
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* Access to the abstract is free, but you will need to create an account with Fitch.

Monday, May 20, 2013

Options Strategies Embedded in Exchanged Traded Products

By Tim Dulaney, PhD and Tim Husson, PhD

In theory, exchange traded products (ETPs) can be linked to almost any underlying asset, including derivatives.  While many ETPs are linked to portfolios of bonds or stocks, some are linked to portfolios of futures contracts, which we have discussed at length before.  Bill Luby at VIX and More has written a couple posts on ETPs that are linked to portfolios of options, which are gaining some traction with investors.  As usual, we greatly enjoyed Bill's posts and thought we'd explain some of the mechanics behind the option strategies embedded in these ETPs.    More information about the basics of options can be found here.

The first strategy we'd like to talk about is referred to as a "covered call" or "buy-write".  This is the strategy implemented by PowerShares S&P 500 BuyWrite ETF (PBP), iPath CBOE S&P 500 BuyWrite Index ETN (BWV),  Credit Suisse Gold Shares Covered Call ETN (GLDI) and, most recently, Credit Suisse Silver Shares Covered Call ETN (SLVO).  In options parlance, a covered call refers a position that is both long some asset and short a call option on that asset: the short call is 'covered' by the long position in the underlying asset. The figure below explains the profit and loss of this combined position graphically.
The covered call strategy generates income by selling call options (thus earning the option premium), but in doing so misses out on any increase in the value of the asset above the call strike.  This strategy is particularly effective in markets without significant appreciation (since the investor would miss out on said appreciation) or depreciation (since the option premium would provide little protection against losses).  Generally speaking, the closer the strike price is to the current asset price, the more income is generated and more upside potential is lost.

Another closely related strategy that has been implemented in ETPs is the put-write strategy.  One ETP that implements this strategy is the ALPS US Equity High Volatility Put Write (HVPW).  You might have noticed that the covered-call strategy looks very much like a short put option.  Well, that is the essence of the put-write strategy.  The strategy sells put options and profits when the put options expire worthless.  This strategy has gained significant attention since the CBOE began publicizing the PUT index (noting that the PUT index returned a staggering 1150% compared to the S&P 500 returning 800% between 1986 and 2012).

What makes these ETPs interesting is that it gives investors a way to invest in moderately complex option strategies without really understanding their mechanics.  If an investor wanted to implement a covered call on their own, they'd have to worry about when (and how) to sell the call, when to cover the short position and rolling the position forward periodically (repeating this process all over again).  ETPs wrap this process up into (a perhaps too easily) digestible package.  

Friday, May 17, 2013

SEC Litigation Releases: Week in Review

Final Settlements Reached in "Golden Goose" Wall Street Insider Trading Case, May 15, 2013, (Litigation Release No. 22700)

Earlier this week final judgments were entered against Jamil Bouchareb, Daniel Corbin, and Corbin's companies, Cobin Investment Holdings, LLC and Augustus Management LLC, for their alleged involvement in a widespread insider trading scheme. Bouchareb and Corbin have agreed to pay over $1.2 million in disgorgement and prejudgment interest to settle the charges. Additionally, the final judgment enjoins all of the defendants from future violations of the securities laws. Their disgorgement includes "the entities’ trading profits,...profits generated by [Bouchareb’s] parents’ trading, trading profits generated by [Bouchareb’s] girlfriend, relief defendant Maria Checa and her entity, relief defendant Checa International, Inc" as well as "profits generated by [Corbin's] father, relief defendant Lee Corbin."

In parallel criminal cases, "Bouchareb was sentenced to 30 months’ imprisonment followed by two years of supervised release and ordered to pay a $20,000 fine and forfeit $1,582,125" and "Corbin was sentenced to serve six months in prison followed by two years of supervised release and ordered to forfeit $1 million."

SEC Charges RINO, Its CEO, and Its Chairman of the Board with Scheme to Overstate Revenues and Divert Money for Personal Use, May 15, 2013, (Litigation Release No. 22699)

According to the complaint (PDF), RINO International Corporation, along with its Chief Executive Officer, Dejun “David” Zou, and its Chairman of the Board, Jianping “Amy” Qiu, overstated RINO's revenues from the first quarter of 2008 through the first three quarters of 2010. Additionally, Zou and Qiu allegedly diverted proceeds for personal use, including the purchase of a $3.5 million family home, automobiles, and designer clothes and accessories.

The defendants have consented to the entry of a judgment that permanently enjoins them from future violations of the Securities Act and Exchange Act and orders them to pay over $3.75 million in disgorgement and civil penalties. Additionally, the final judgment bars Zou and Qiu "from serving as officers and directors of a public company for a period of ten years."

Wednesday, May 15, 2013

What Buying a House and Structuring an Asset Backed Security Have in Common

By Tim Dulaney, PhD and Tim Husson, PhD

When you buy a house, it's generally a good idea to get it inspected so you know if there are any expensive problems you might have to pay for after the deal closes.  It's also a good idea to make sure that the person inspecting the house be independent, knowledgeable and perhaps most importantly objective -- not paid by or otherwise conflicted with the seller.  Otherwise, they might overlook problems to make sure the deal goes through.

Asset backed securities (ABS) -- such as mortgage backed securities (MBSs), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and auction rate securities (ARSs) -- are also 'inspected' before they are sold to investors.  The inspectors are Nationally Recognized Statistical Rating Organizations (NRSROs), and there are only a handful; Moody's, Fitch, and Standard & Poor's are the big three in the industry.  So in both a housing transaction and an ABS deal, you rely on a third party to make sure the structure is sound.

The current status quo of the credit rating industry is that issuers hire the rating agencies.  If they don't like a rating from one particular rating agency, they could just try another.  For example, a recent deal linked to car loans was essentially denied the highest ratings from Moody's and Fitch (each citing the lack of investor protections) but had little problem obtaining the best possible rating from S&P.  For a similar story, check out JP Morgan's recent non-agency RMBS deal (one of the first since the financial crisis).

The fact that issuers can shop around to receive the highest possible rating for a deal leaves little protection for investors and reduced value in the ratings received.  By analogy, home inspections would have little value to potential buyers if the seller simply found an inspector willing to overlook flaws and not report objectively on the quality of the home.  This issue has called into question the objectivity and reliability of credit ratings, but it is not clear what could replace them.

Recently, the SEC has been looking into how to improve the ratings systems to remove this conflict of interest (SIFMA has also investigated the issue).  One proposal involves the government assigning rating agencies to particular ABS deals, rather than the issuer 'shopping around' between different agencies to get the best possible rating.  This proposal has been criticized by Standard and Poor's, who claim that it "could create new conflicts."  It is also unclear how the government could fairly allocate this business between the various ratings agencies, especially among relative newcomers such as Kroll, Egan-Jones, and DBRS.

Perhaps a better system would be for the SEC to require that ratings agencies disclose all ratings inquiries that it has received from ABS issuers.  If they publicly disclosed who made the inquiry, whether a preliminary rating was assigned, and what that quoted rating was, then investors could determine whether the ratings reported by the issuer are fair and objective or if they represent the highest rating attainable in the open market.

Monday, May 13, 2013

FINRA, SEC Issue Investor Alert on Pension and Structured Settlement Income Streams

By Tim Dulaney, PhD and Tim Husson, PhD

Last week, both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) issued investor alerts concerning pension and structured settlement income streams.  The SEC's investor bulletin can be found here (PDF) and FINRA's investor alert can be found here.  We haven't discussed the potential problems surrounding pension or structured settlement income streams before, but these regulatory notices highlight some of the potential issues that we think are important for recipients and investors to understand.

A structured settlement is typically a stream of payments representing the resolution of litigation (e.g. personal injury lawsuits).  Similarly, pensions represent a defined-benefit income stream compensating an employee during retirement.  These income streams are valuable assets and salespeople are hoping to convince recipients to exchange the stream of payments for a lump-sum payment.  Unfortunately, the compensation investors are receiving in exchange for these income streams are often risky, complex and (in many cases) insufficient.*  In addition, there may be substantial tax consequences of participating in such a transfer that might not be understood or appreciated by investors.

The SEC offers guidance on the questions that investors should ask before entering into such a transaction.  For example, are there better alternatives (e.g. bank loans)?   Is the transaction even legal?  The regulators also suggest checking out the company's Better Business Bureau record, as well as the salesperson on the SEC's Investment Advisor Search, FINRA's BrokerCheck, the appropriate state securities regulator or the National Association of Insurance Commissioners.

On the other side of the coin, salespeople are selling investors the rights to pension and structured settlement income streams that they have purchased from other recipients.  These investments often advertise yields exceeding 5% or even 7%, but there are numerous potential risks:  reliable information might not be available for these products, investors "may encounter commissions of 7 percent or higher," the products are usually hard to sell once bought, and investors may face legal challenges enforcing the income stream if it is based upon someone's pension.

Furthermore, investors are exposed to the credit risk of the company or organization that is required to make the stream of payments.  According to the SEC investor bulletin,"if that entity goes bankrupt or becomes insolvent, it may stop paying the income stream."

Investors should be very cautious before entering into one of these transaction (if at all).  There are many risks that are often not fully disclosed and may have long-term financial consequences.
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* Some states require that companies that offer such an exchange, called "factoring companies", disclose the difference in value to avoid the exploitation of income stream beneficiaries.  For more information, see the following document (PDF) from the Los Angeles County Bar Association.

Friday, May 10, 2013

Missouri Action Against Morgan Keegan Over Municipal Bond Issue Also Illustrates Markup Abuse

By Geng Deng, PhD and Craig McCann, PhD

On April 3, 2013 Missouri’s Secretary of State of the State submitted a Petition for an Order to Cease and Desist and to Show Cause against Morgan Keegan over taxable municipal bonds Morgan underwrote for the City of Moberly in July 2010.  The petition is available here (PDF) and the Offering Circular for the bonds is available here (PDF).   The story has been picked up by The Bond Buyer and Law360.

Setting aside the Petition’s allegations, the trading in this set of bonds highlights markup abuse we have found is rampant. Trading in these bonds (and hundreds of thousands more) can be viewed at the MSRB’s EMMA website. Trading in one of the Moberly bonds underwritten by Morgan Keegan can be found here. We excerpt some of the trading in the following table.


The $3,025,000 par amount in this series was sold to investors in the offering. There was no further trading until October 21, 2010 when two positions totaling $1,110,000 face value were sold to a dealer (or less likely to two different dealers). This dealer then sold the bonds to investors over the next four weeks for $1,143,090 – a $33,090 or $2.48 average markup over the $100.50 paid to the selling customers. Setting aside for another day whether the markups charged in total were excessive or not, three trades call out for special appreciation.

On October 22, 2010 a dealer charged a customer $105.419 for a $25,000 trade despite three other customer trades for $25,000 the same day at $102.669 and two trades for $20,000 the day before at $102.671. The $105.41 price was clearly unfair and the markup charged excessive. It appears the same dealer a few days later made sales of $20,000 and $10,000 at $105.414 despite a sale of $10,000 at $102.664 the same day. The $105.414 charged twice on October 27, 2010 was unfair and the markup excessive.

We wonder whether the SEC, the MSRB, FINRA or the Missouri Secretary of State has looked at the trading in the City of Moberly bonds. We think this trading is illustrative of excessive markups and the ease with which the public and other non-public data would allow regulators to identify unfair prices and excessive markups.

More to come shortly.

SEC Litigation Releases: Week in Review

SEC Charges China-based Company and Former Chief Financial Officer in Fraudulent Scheme involving Non-Existent Computing Business, May 8, 2013, (Litigation Release No. 22698)

According to the SEC's complaint (PDF),  China-based company, Subaye Inc and its former CFO, James T. Crane, "misrepresented the company’s business and operations, deceived the company’s auditors, and misled investors about the company’s true status and revenues." The SEC alleges that the defendants claimed Subaye had over 1,400 sales and marketing employees in 2010, "with reported revenues of $39 million that fiscal year and projected revenues of more than $71 million for 2011," when in fact the company had "no verifiable revenues, few...real customers, and no infrastructure to support its claimed cloud computing business." Additionally, Crane allegedly falsified books and records to mislead outside auditors. Crane and his firm were sanctioned in 2011 by the PCAOB, and Crane was barred from "being associated with a registered accounting firm or being associated with any public company in an accounting or financial management capacity."  Crane allegedly violated this order by remaining as Subaye's CFO until March 2011.

The SEC has charged the defendants with violating various provisions of the securities laws and seeks permanent injunction, as well as payment of disgorgement, prejudgment interest, and penalties.

Court Enters Final Judgments Against Richard Verdiramo and Vincent L. Verdiramo, Esq., May 7, 2013, (Litigation Release No. 22697)

According to the SEC's complaint (PDF),  Richard Verdiramo, RECOV Energy Corp.'s former Chairman, CEO, President, and CFO, committed "fraud and violat[ed] the securities registration requirements based on his issuances of RECOV stock for his and his father’s personal benefit." His father, attorney Vincent L. Verdiramo, allegedly "facilitated the misconduct." Previously, the Court ordered the defendants to pay full disgorgement and suspended Vincent L. Verdiramo from appearing or practicing before the SEC as an attorney. An April 2013 judgment requires the defendants to pay over $1.06 million in additional disgorgement, prejudgment interest, and penalties. It also places a penny stock bar against Vincent L. Verdiramo.

Court Orders Former Hedge Fund Manager Gad Grieve and Firm to Pay Over $26 Million in Disgorgement and Penalties, May 3, 2013, (Litigation Release No. 22696)

Final judgments were entered against Grant Ivan Grieve and his Finvest advisory firms ordering them to pay over $26 million in disgorgement and civil penalties. The defendants allegedly "fabricated and disseminated false financial information for their Finvest Primer hedge fund that was 'certified' by a sham back-office administrator and phony auditing firm that Grieve himself created." Both defendants were charged with violating various sections of the Securities Act, Exchange Act, and Investment Advisors Act.

Securities and Exchange Commission v. Kevin J. Wilcox, Jennifer E. Thoennes, and Eric R. Nelson, May 3, 2013, (Litigation Release No. 22695)

Eric R. Nelson and Kevin J. Wilcox settled charges with the SEC and a default judgment was entered against Jennifer E. Thoennes, "arising from their alleged participation in a Ponzi scheme operated by Joseph Nelson." Eric R. Nelson and Wilcox have been permanently enjoined from future violations of the securities laws and have been ordered to pay almost $350,000 in disgorgement and prejudgment interest. However, all but payment of $23,230 has been waived due to the financial conditions of the defendants. A final judgment was entered last December, permanently enjoining Thoennes from future violations of the securities laws and ordering her to pay over $94,000 in disgorgement, prejudgment interest, and penalties.

Wednesday, May 8, 2013

Update on Apple-Linked Structured Products

By Tim Dulaney, PhD and Tim Husson, PhD

A few months ago, SLCG issued a working paper (PDF) that studied the decline in value of Apple-linked structured products.  Jason Zweig of the Wall Street Journal also wrote a piece about these findings, most notably that Apple's stock price decline had serious repercussions in the structured product market.  Apple's stock price has continued to fall and we recently updated the paper to show how this decline is still affecting investors in structured products.* 

Since reaching $700 in September of 2012, Apple's stock price (AAPL) has fallen dramatically -- trading in the high $300's for a few days in April 2013.  The previous version of the paper focused on the losses experience by Apple-linked structured product investors as a result of their January 23, 2013 earnings announcement (SEC Form 8-K) after which the price of Apple common stock fell more than 12% -- a loss of more than $50 billion in market capitalization.

The updated analysis shows that Apple-linked structured product investors continue to bleed value.  The following figure shows the aggregate market value (as calculated by SLCG) of Apple-linked structured products outstanding between January 23, 2013 and April 24, 2013.
The aggregate market value of the 283 products in the sample fell over $37.6 million following the January 23, 2013 earnings announcement.  Between January 24, 2013 and April 24, 2013, SLCG estimates that these products lost an additional $37.2 million in value.**  These results should reinforce the fact that investors in equity-linked structured products are exposed to extraordinary market risks.

For more detailed information concerning these losses, please see our working paper on this issue. SLCG has also compiled a database of over 16,000 structured product research reports (over 800 linked to Apple) including full valuation and analysis of each product.

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* The types of structured products considered in the study were reverse convertibles (example), single observation reverse convertibles (example) and autocallable reverse convertibles (example).
** The aggregate market value of these products correlated very strongly (correlation higher than 0.99) with the closing price of Apple stock.

Tuesday, May 7, 2013

Variable Prepaid Forward Contracts

By Tim Dulaney, PhD and Tim Husson, PhD

Recently we've been working a lot with variable prepaid forwards (VPFs) in our casework and we decided to take a step back and explain these complex investments.   A VPF is an over-the-counter contract between two parties involving a stock position, an upfront payment and option positions. VPFs are often used to defer taxes on appreciated stock, which has been a matter of some controversy.

Perhaps the best way to explain a complex investment is by example.   Consider an investor who purchased 10,000 shares of Apple common stock (AAPL) in May 2007 for $100 and assume that at this point this position represents the majority of the investors wealth.  If the investor would like to diversify her position, she would need to sell some of her stake in Apple and replace it with other securities.

If the investor sold her position now, when the shares are worth roughly $450, she would be forced to pay capital gains tax on $3.5 million ($4.5 million current value minus $1 million initial investment).  As an alternative, she could enter into a VPF with a financial institution in which she would pledge the 10,000 shares to be delivered in a three years and receive an upfront payment of $3.6 million (or about 80% of their fair value).*  A benefit of a VPF is that the investor can use the upfront payment to purchase other securities, potentially diversifying her overall portfolio.  Also, the investor defers capital gains taxes for the term of the VPF.

In addition to the upfront payment, the investor retains some exposure to Apple via the embedded options positions in the VPF.  VPFs typically specify a "Forward Floor" (usually between 90% and 110% of the current asset price) and a "Forward Cap" (usually between 120% and 160% of the current asset price) that limit the number of shares to be delivered at the expiration of the contract.  The investor remains exposed to the underlying stock for price changes between the "Forward Floor" and the "Forward Cap".  Suppose that for our example the "Forward Floor" is $450 and the "Forward Cap" is $630 (140% of the current asset price).

At expiration, the investor typically has the choice of settling the contract physically (by delivering the shares) or in cash (by delivering an equivalent amount of cash).  If the investor chooses to cash settle the contract independent of the final share price, then the amount she would be required to pay at the end of the contract is given by the following figure.


If the stock decreases in price beyond the floor, the investor actually benefits (she is long a put option) since less cash is required to settle the contract.  If the price increases beyond the cap, the investor does not benefit (she is short a call option) since more cash would be required to settle the contract.  For those with some knowledge of option strategies, this should remind you of a collar.

VPFs can be useful instruments for diversifying a concentrated stock holding or delaying the realization of capital gains taxes.  On the other hand, these complex securities are often hard for unsophisticated investors to understand and often embed significant fees in an obscure way.

Frequently the compensation an investor receives (in the form of upfront payments and embedded options) may not be sufficient payment for the obligations they are taking by entering into the VPF (delivery at expiration).  We covered an example of this a few months ago when JP Morgan collected over $2 million from a Trust by selling them a series of VPF contracts.
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*Equivalently, the upfront payment is compensation for the commitment to return the payment plus interest.  The implied interest rate is determined by the upfront payment (including the value of the option positions), the current value of the pledged stock and the term of the contract.

Monday, May 6, 2013

New FINRA Guidelines for Non-Traded and Private REITs

By Tim Dulaney, PhD and Tim Husson, PhD

In recent months, FINRA has been investigating how non-traded and private real estate investment trusts (REITs) are presented to retail investors.  Last week, FINRA alerted broker-dealers that they had uncovered "deficiencies" in how these investments are sold, and issued Regulatory Notice 13-18 (PDF) "to provide guidance to firms on communications with the public concerning unlisted real estate investment programs, including unlisted real estate investment trusts (REITs) and unlisted direct participation programs (DPPs) that invest in real estate."

Non-traded and private REITs are sold primarily through independent broker-dealers.  As noted by several reports, regulators have been pushing recently to resolve some of the issues that we have described at length in the past.  From the Notice:
Recent reviews by FINRA of communications with the public regarding real estate programs have revealed deficiencies. For example, some communications have contained inaccurate or misleading statements regarding the potential benefits of investing in real estate programs. Other communications have emphasized the distributions paid by a real estate program and failed to adequately explain that some of the distribution constitutes return of principal. In addition, some communications have not provided sufficient discussions of the risks associated with investing in the products in order to balance the presentation of benefits.
As we discussed last week, one of the issues with non-traded and private REITs is that their market value is unknown.  For example, most non-traded REITs were sold at a constant share price (typically $10) even through the real estate collapse of 2007-8.  Some broker-dealers described this 'lack of volatility' as a feature, 'protecting' investors from 'market fluctuations.'  In actuality, the assets of the non-traded REITs' were declining in value, but such declines were masked by the constant offering price.  FINRA's new guidelines specifically prohibit this type of misrepresentation.

Another issue is that non-traded and private REITs tend to pay out large distributions to investors soon after their initial offering, likely before they have acquired enough income-generating properties to justify that kind of outflow.  In our white paper on non-traded REITs, we note that non-traded REIT distributions were often far larger than their operating income, meaning that a significant portion of these payments were a return of investor capital or funded from debt rather than operations.  FINRA is now requiring a breakdown of distributions into components that show what portion of anticipated distributions will be from operations.

Along with the breakdown of the distribution of components, the communications must prominently state that if distributions include return of principal, "the program will have less money to invest" and, if the distributions include proceeds from debt issuance, "the distribution rate may not be sustainable."

Many of these issues will come as no surprise to those familiar with non-traded REITs.  But FINRA's improved guidance may be the first step in preventing some of the most egregious misrepresentations that have unfortunately become commonplace in the non-traded and private REIT industry.

Friday, May 3, 2013

SEC Litigation Releases: Week in Review


Commission Obtains Temporary Restraining Order and Asset Freeze Against Massachusetts Man Who Defrauded Investors of At Least $5.5 Million, May 1, 2013, (Litigation Release No. 22694)

Earlier this week, the SEC obtained an asset freeze and temporary restraining order on Steven Palladino and his MA-based Viking Financial Group, Inc. in which he served as owner, president and vice president at various times.  According to the SEC's complaint (PDF),  Viking Financial Group raised almost $5.5 million from a group of about thirty investors under the pretense that the funds would be used to make short-term loans secured by first interest liens on non-primary residences at high interest rates (in the range of 7-15%).  Instead, the funds were used to pay personal expenses incurred by Palladino and to make Ponzi payments to earlier investors.  In March 2013, following larceny charges by the Suffolk County District Attorney's Office  it became clear that the lending business was a ruse and investors began to demand redemption of the promissory notes issued by Viking Financial Group.  Unable to meet such redemptions, Palladino began to miss the interest payments due to noteholders.

The SEC is seeking permanent injunctions, disgorgement of ill-gotten gains plus interest as well as civil fines. A hearing for the case is scheduled for later today.


Foreign Trader Agrees to Settle SEC Charges in Nexen Insider Trading Case, May 1, 2013, (Litigation Release No. 22693)

Choo Eng Hong has agreed to pay over $566,000 in disgorgement and financial penalties to settle insider trading charges brought against her by the SEC. Last July, the SEC alleged that "Well Advantage Limited and other unknown traders purchased Nexen stock based on confidential details" about its impending acquisition by CNOOC Ltd. Choo was later identified as one of the unknown traders. Choo has also agreed to permanent enjoinment from future violations of the Exchange Act.

Defendant in SEC Action Sentenced On Related Criminal Charges, Receives 17 Year Sentence, April 30, 2013, (Litigation Release No. 22692)

Arnett L. Waters, principal of broker-dealer A.L. Waters Capital, LLC and investment adviser Moneta Management, LLC, was sentenced to 17 years in federal prison for "orchestrating a securities fraud and for defrauding rare coin investment customers." In addition to the 17 year sentence, Waters was also "sentenced to three years of supervised release" and ordered to pay "$9,025,691 in restitution and forfeiture."

In May 2012, the SEC filed an emergency enforcement action against Waters for allegedly defrauding investors and misappropriating their funds. His assets were frozen and he was required "to provide an accounting of all his assets to the Commission." In August 2012, the SEC "filed a civil contempt motion against Waters, alleging that he had violated the court's preliminary injunction order by establishing an undisclosed bank account, transferring funds to that account, dissipating assets, and failing to disclose the bank account to the Commission." Two days later, the U.S. Attorney "filed a separate criminal contempt action against Waters based on the same allegations." Waters pled guilty to these charges in October 2012. The SEC then barred Waters from the securities industry based on his guilty plea. In addition to its charges of criminal contempt against Waters, the U.S Attorney charged Waters with securities fraud and other violations in October 2012. In November 2012, Waters pled guilty "to sixteen counts of securities fraud, mail fraud, money laundering, and obstruction of justice."

Securities and Exchange Commission v. Adondakis et al., April 30, 2013, (Litigation Release No. 22691)

Level Global Investors LP has agreed to pay over $21.5 million in disgorgement, prejudgment interest, and civil penalties to settle charges that its co-founder and portfolio manager, Anthony Chiasson, along with former analyst, Spyridon "Sam" Adondakis, and six other defendants "engaged in repeated insider trading in the securities of Dell Inc. and Nvidia Corp." The six other defendants included five investment professionals and hedge fund advisory firm Diamondback Capital Management. An order was entered against Level Global that enjoins it from future violations of the Exchange Act and Securities Act.

Previously, Adondakis pled guilty "to parallel criminal charges and agreed to a settlement with the SEC in which he admitted liability for insider trading." The SEC's case against Chiasson, "who was convicted in December 2012 of securities fraud in a parallel criminal proceeding," is still pending.

SEC Charges City of Victorville, Underwriter, and Others with Defrauding Municipal Bond Investors, April 29, 2013, (Litigation Release No. 22690)

According to the complaint (opens to PDF), the City of Victorville, CA, along with its Assistant City Manager and former Director of Economic Development, Keith C. Metzler, the Southern California Logistics Airport Authority, and Kinsell, Newcomb & De Dios (the underwriter of the Airport Authority's bonds) "defrauded investors by inflating valuations of property securing an April 2008 municipal bond offering." KND owner, J. Jeffrey Kinsell, and KND Vice President, Janees L. Williams, were also named in the complaint for allegedly making false and misleading statements about the 2008 bond offering.

According to the SEC, in 2008 the Airport Authority issued bonds to "refinance part of the debt incurred to construct...hangars, and other projects." The SEC alleges that "the principal amount of the new bond issue was partly based on Metzler, Williams, and Kinsell using a $65 million valuation for the airplane hangars even though they knew the county assessor valued the hangars at less than half that amount." This allowed the Airport Authority to issue more bonds and raise more funds "than it otherwise would have." Furthermore, "the SEC's investigation found that Kinsell, KND, and another of his companies misappropriated more than $2.7 million in bond proceeds that were supposed to be used to build airplane hangars for the Airport Authority." Kinsell and KND Affliates took the $2.7 million through unauthorized fees for overseeing construction and then "managing" the hangars. "The SEC alleges that Kinsell and KND Affiliates hid these fees from the Airport Authority representatives and from the auditors who reviewed KND Affiliates' books and records."

The SEC has charged the defendants with violating various provisions of the securities laws and seeks payment of disgorgement, prejudgment interest, and financial penalties, as well as permanent injunctions against all of the defendants. In addition, the SEC seeks "the return of ill-gotten gains from relief defendant KND Holdings, the parent company of KND."

District Court Enters Judgment of Permanent Injunction and Other Relief Against Defendant Innovida Holdings LLC, April 26, 2013, (Litigation Release No. 22689)

A Judgment of Permanent Injunction by consent was entered against InnoVida Holdings, LLC based on SEC charges that InnoVida, Claudio E. Osorio and Craig Toll violated the antifraud provisions of the federal securities laws. The judgment enjoins InnoVida from future violations of the Exchange Act and Securities Act and also orders it to "disgorge any ill-gotten gains with pre-judgment interest and to pay a civil penalty, with the amounts to be determined at a later date upon a motion of the Commission."

Remaining Claims Dismissed in Litigation with AOL Time Warner Executives, April 26, 2013, (Litigation Release No. 22688)

The court ordered "the entry of a stipulation of dismissal by plaintiff Securities and Exchange Commission of all remaining claims against Mark Wovsaniker, in SEC v. John Michael Kelly, Steven E. Rindner, Joseph A. Ripp, and Mark Wovsaniker." Wovsaniker, former AOL Time Warner Inc. Senior Vice President for Accounting Policy, was charged with participating in "an effort by which AOL Time Warner overstated its online advertising revenue."

District Court Enters Permanent Injunction Against Defendants Joseph Hilton, F/K/a Joseph Yurkin and New Horizon Publishing Inc, April 26, 2013, (Litigation Release No. 22687)

Judgments of Permanent Injunction by consent were entered against Joseph Hilton, f/k/a Joseph Yurkin and New Horizon Publishing Inc. for their alleged violations of various provisions of the securities laws. The order enjoins them from future violations of the securities laws and orders Hilton to "to comply with the broker-dealer bar the Commission previously issued against him" as well as orders New Horizon to pay disgorgement, prejudgment interest, and a civil penalty to be determined at a later date.

Court Finds Brokerage Firm and Two Former Executives Liable for Over $2.74 Million in a Fraudulent Misappropriation Case, April 26, 2013, (Litigation Release No. 22686)

New York's federal court found "Joshua Constantin and Windham Securities, Inc. jointly and severally liable for over $2.49 million" and Windham's former managing director, Brian Solomon "liable for over $249,000 in disgorgement, pre-judgment interest, and civil penalties." According to the SEC's 2011 complaint, Constantin, Windham, and Solomon made false claims to "investors about the intended use of the investors' funds and about Windham's investment expertise and past returns...misappropriat[ing] the investors' funds and then provid[ing] false assurances to the investors to cover up their fraud." The court found relief defendants "Constantin Resource Group, Inc. and Domestic Applications Corp. jointly and severally liable with Constantin and Windham for over $760,000 and $532,000, respectively, of disgorgement and pre-judgment interest."

SEC Seeks to Halt Scheme Raising Investor Funds Under Guise of Jobs Act, April 25, 2013, (Litigation Release No. 22685)

According to the complaint (opens to PDF), Daniel F. Peterson and his company USA Real Estate Fund 1 falsely "promised investors that they could reap spectacular returns from an upcoming offering in a 'secured' product backed by prominent financial firms." He allegedly claimed the 2012 JOBS Act "would enable him to raise billions of dollars by advertising the offering to the general public, and produce big profits for early investors." The SEC claims that Peterson "preyed upon investors' sense of patriotism by promising to invest the proceeds of the offering in exclusively American businesses, and help assist in Washington State's economic recovery." Peterson claimed to investors that he had partnered with two prominent Wall Street financial firms and "that the firms had conducted due diligence on USA Real Estate Fund and were structuring sales agreements and pricing."

In reality, Peterson allegedly "has no guaranteed investment product to offer, the projected returns were either fictitious or based on implausible and unsupported analyses, and he has no affiliation with any financial firm to underwrite his purported future offering." The complaint states that Peterson used investor funds for personal expenses, including "to pay for his rent, food, entertainment, vacations, and a rented Mercedes Benz SUV." The SEC has charged Peterson and USA Fund with violating various sections of the Securities Act and Exchange Act and seeks disgorgement and financial penalties "as well as a preliminary injunction restraining USA Real Estate Fund and Peterson from engaging in conduct that would allow them to continue their scheme, and restraining them from further violations of the securities laws."

Thursday, May 2, 2013

SEC Charges Victorville, CA and Airport Authority with Securities Fraud

By Tim Dulaney, PhD and Tim Husson, PhD

Earlier this week, the SEC charged the City of Victorville, California and several other entities with municipal bond fraud. The charges relate to a $13.3 million 2008 bond offering by the Southern California Logistics Airport (SCLA) Authority, which was intended to refinance an "ill-conceived" redevelopment project for airplane hangers at the former George Air Force Base, which closed in 1992.

Municipal bonds are sometimes considered among the safest investments available. Municipal bond markets have been tested in recent years by increasing public debt burdens in many cities as well as the high profile default by Stockton, California. The alleged fraud in Victorville reveals some of the difficulties in municipal finance, which in this case may have led city officials and others to mislead investors and the public about the financial condition of certain assets.

According to the complaint (PDF), the city sold three tax increment bonds:
each underwritten by Kinsell, Newcomb & DeDios (KND), "a broad-based, enterprising investment banking firm". The SCLA borrowed an additional $35 million in short-term funding in February 2008 through a private placement with an unnamed bank. The authority issued $13.3 million Subordinate Tax Allocation Revenue Bonds in April 2008. The bonds were issued to repay part of the debt in the private placement as a result of the exercise of an option by the bank that bought the February 2008 bonds (paragraph 62 of the complaint).

This April 2008 financing was based upon a $65 million valuation of four airport hangars. This valuation was in spite of the fact that the county assessor had previously valued two of the four hangars at a little less than $9 million a piece. Prior to the April bond offering and after the February private placement, the county assessor provided a valuation of less than $10 million for the third hangar and estimated the fourth hangar would be similar since it was "identical". As a result, the county assessor valued the four airplane hangers at $27.7 million; however, in the April bond offering documents, the value of the hangers was reported to be $65 million.

The valuation of the hangars is of paramount importance for the bond investors since the value of the bonds is based upon incremental tax revenue. In other words, payment is based upon the "increase in property tax revenues resulting from an increase in the aggregate assessed value of the property within the relevant redevelopment area."

According to the SEC, the reason for the misstatement was that as credit markets were tightening in 2007-2008, investors were requiring higher debt service ratios than before. Debt service ratios, in the context of tax increment bonds, compare the amount of incremental property tax revenue that is available to pay off a bond with the total payments required on that bond. For example, a ratio of 1.5 would mean that the available tax revenue was 1.5 times the amount required to service the debt. According to the SEC, "nearly all of the tax increment available to the Authority had been used to secure its prior bond issuances," and the debt service ratios required by investors increased from 1.10 to 1.25.

The SEC alleges that the mis-statement of the value of the hangers was false and misleading, and have charged the City, the SCLA Authority, KND, and several related individuals with securities fraud.

Wednesday, May 1, 2013

Valuations of Non-Traded REITs

By Tim Dulaney, PhD and Tim Husson, PhD

Earlier this week, the Investment Program Association (IPA) presented their guidelines for the valuation of publicly registered non-listed REITs. According to the IPA, these guidelines are supposed to "enhance the independence of the valuation process" and "enhance the quality of valuation disclosures to the investing public."  For a discussion of the guidelines, see Brian Louis's recent story on Bloomberg.com.
Non-traded REITs -- real estate investment trusts that are registered with the SEC but do not trade on a public exchange -- have come under a lot of scrutiny in the past few years (see our many posts on the subject).  One of the many criticisms of non-traded REITs is that it is very difficult to determine how much their shares are worth; that is, they have very little price transparency.

Typically, non-traded REIT shares have been sold at a set price.  For most non-traded REITs, that price was $10 per share, and stayed $10 per share even through the real estate collapse of 2007-8.  So while the value of the REIT's assets were declining, the price investors paid was the same.  This was made worse by the high upfront fees and commissions on non-traded REITs, which left as little as 85-90% of the invested capital going towards actually purchasing properties.  Even though the real estate collapse was big news, it was often difficult for investors to know if or how that collapse affected the properties owned by the REIT since there was almost no market analyst coverage of the non-traded REIT industry.

For a while, this lack of transparency was even touted as a feature, not a problem, by non-traded REIT sponsors and brokers.  They claimed that non-traded REITs 'lacked volatility' and weren't susceptible to 'market fluctuations.'*  But just because the price charged for each share didn't change, didn't mean the value of each share wasn't fluctuating -- or plummeting.  When FINRA started requiring non-traded REITs to publish per-share net asset value (NAV) figures, many REITs showed prices per share of less than $7, and some even less than $5 or worse.

Which brings us to today.  The non-traded REIT industry has backed away from their claims about 'lack of volatility' and are now thinking about the best way to calculate NAV for non-traded REITs.  It's actually a tricky problem.  Real estate assets are seldom bought or sold and are appraised only infrequently.  Most valuations depend on assumptions about future vacancy, rent rates, and other factors that are hard to predict.  So it's not so easy coming up with a valuation for a whole portfolio of different types of properties.

For REITs that are publicly traded, this isn't a problem.  Shares of traded REITs are traded just like any other stock, so their market price reflects the demand for shares in a liquid market.  The market essentially values the REIT's portfolio for them, using the public disclosures required of traded securities.

So far, non-traded REIT valuations have been largely at the discretion of the REIT's management, which means each REIT uses a different methodology and per-share values aren't directly comparable.  Also, there is an inherent conflict of interest when a company values its own shares.  This is in addition to the fact that valuations based on the underlying assets are often stale -- based on data many months or even years old.

The objectives of the IPA's guidance highlight the need for quick, independent, and standardized calculations.  But it makes you wonder--if it's so difficult for even the REIT itself to value its portfolio, why are non-traded REITs being sold to retail investors in the first place?  And if greater transparency is the goal, why not list on a major exchange?
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* This claim was specifically addressed by the SEC in disclosure guidelines dated December 2011 (see section "Volatility"):
Some non-traded REITs have proposed sales material that cites their static offering price as evidence that there is no volatility in the value of the security. Unless the offering price is based on a valuation of the security, we object to these statements and instruct these registrants to remove statements in the sales material that suggest a static offering price indicates a stable investment.