Friday, February 28, 2014

SEC Litigation Releases: Week in Review

SEC Settles Claims Against Attorney Retained by Funds Involved in Fraudulent Investment Scheme, February 27, 2014, (Litigation Release No. 22934)

A final judgment was entered against attorney Robert Custis for his involvement in a Ponzi scheme orchestrated by Yusaf Jawed through companies Grifphon Asset Management, LLC and Grifphon Holdings, LLC. Custis agreed to the final judgment which permanently enjoins him from future violations of the securities laws and prohibits him from appearing or practicing before the SEC as an attorney.

Jeremy Fisher Indicted for Fraud, February 25, 2014, (Litigation Release No. 22933)

On February 5, a grand jury charged Jeremy S. Fisher with four counts of wire fraud. The indictment "seeks forfeiture of property obtained as a result of the alleged criminal violations." The charges are based on "the same conduct underlying the Commission's September 30, 2013 Complaint against Fisher" which alleges that he raised $1.04 million from investors and then misappropriated funds for personal use. Additionally, Fisher allegedly "provided quarterly statements to investors which falsely represented that investors were earning money on their investments."

Previously, the SEC charged Fisher and his two companies with violating the Exchange Act and Securities Act and permanently enjoined them from future violations as well as ordered them to pay over $1 million in disgorgement, prejudgment interest, and civil penalties.

Court Enters Final Judgment by Default Against SEC Defendant Zheng Cheng, February 25, 2014, (Litigation Release No. 22932)

A final judgment was entered against Zheng Cheng, Chairman and CEO of China MediaExpress Holdings, Inc., for his alleged involvement in "a scheme to mislead and defraud investors by, among other things, grossly overstating China Media's cash balances." The final judgment permanently enjoins Cheng from future violations of the securities laws, imposes a permanent officer and director bar against him, and orders him to pay over $19.2 million in disgorgement, prejudgment interest, and penalties.

A previous final judgment was entered against China Media which enjoins it from future violations of the securities laws and orders it to pay over $49 million in disgorgement, prejudgment interest, and penalties.

SEC Charges Former Registered Representative with Fraud, February 24, 2014, (Litigation Release No. 22931)

Kevin O'Brien, a former registered representative, has been charged with fraud "in connection with the misappropriation of over $298,000 from the account of a customer between 1998 and 2008." O'Brien has consented to the entry of a final judgment that permanently enjoins him from future violations of the Securities Act and Exchange Act and orders him to pay over $350,000 in disgorgement and prejudgment interest. The payment of this amount has been waived based upon O'Brien's financial condition.

SEC Settles Claims Against Two Former Employees of Hansen Medical, Inc. Relating to Fraudulent Sales Scheme, February 21, 2014, (Litigation Release No. 22930)

Final judgments have been entered against Christopher Sells, Hansen Medical Inc's former Vice President of Commercial Operations, and Timothy Murawski, a former Vice President of Sales, for their alleged involvement in a scheme "to provide false information to Hansen Medical's finance department, resulting in publicly-disclosed financial statements that reported overstated revenue and sales numbers." The defendants have been permanently enjoined from future violations of the securities laws and ordered to pay $120,000 combined in civil penalties. A five-year officer and director bar has also been placed against Mr. Sells.

UBS Intentionally Misled Willow Fund Investors About its Troubled CDS Portfolio

By Geng Deng, PhD, CFA, FRM and Craig McCann, PhD, CFA

In three blog posts we explained how the UBS Willow Fund’s decision to make a large, highly-leveraged short bet on credit risk contrary to its repeated SEC disclosures caused investors to lose over $200 million between 2007 and 2012 . See Credit Default Swaps on Steroids: UBS’s Willow Fund, Willow Fund’s Hedging, Investing and Speculating in Distressed Debt With Credit Default Swaps and Further Reckoning of UBS Willow Fund’s CDS Losses.

As we demonstrated in our earlier blog posts, the second half of 2007 was when the Willow Fund began taking larger and larger short bets and paying ever larger CDS premiums. Up to and including the June 30, 2007 N-CSR the Willow Fund’s annual and semi-annual reports list the CDS premiums it paid as an expense item “Interest on credit swaps”. Reporting the periodic payments as an expense allowed investors to see how much the Fund was paying to bet against the credit of certain issuers.


Although there is some ambiguity about tax rules on swap contracts it is clear that the periodic payments made by the protection buyer – the Willow Fund in this case – should be expensed in the period they are paid.* We’ve estimated the Fund’s “Interest on credit swap” expense for each year and find our numbers closely track the Willow Fund’s reporting up to June 30, 2007 after which the Fund stopped reporting this expense item and buried it in the change in market value of securities it held or had disposed of.

Up to and including the June 30, 2007 C-NSRS the following sentence described the accounting for CDS premium:
The accrued expense related to the periodic payments is reflected as interest on credit swaps in the Statement of Operations.
Starting with the December 31, 2007 N-CRS, this language was changed to read:
The accrued expense related to the periodic payments on credit default swaps is reflected as realized and unrealized loss in the Statement of Operations.
This CDS expense skyrocketed after the Willow Fund stopped reporting it. We estimate that the Fund paid over $20 million per year on average in CDS premiums from 2008 to 2012. By changing how it reported this item from an expense to a change in the market value of the securities it held or had sold the Willow fund was able to mislead investors.

Here is the $2,562,680 line item in expense for “Interest on Credit Swaps” in the 2003 C-NSR.



Here is the $2,320,898 line item “Interest on Credit Swaps” in the 2004 C-NSR.


Here is the $2,007,607 line item “Interest on Credit Swaps” in the 2005 C-NSR.


Here is the $1,632,989 line item “Interest on Credit Swaps” in the 2006 C-NSR.


And finally the $539,662 “Interest on credit swaps” expense item in the June 2007 C-NSR.


But it is gone from the 2007 C-NSR.



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* See Lawrence Lokken, Taxation of Credit Derivatives, Urban-Brookings Tax Policy Center, November 19, 2009 at page 23: “Under the notional principal contract regulations, a credit protection buyer’s periodic payments are recognized as income to the seller and expense of the buyer for periods for which they are made.”

Monday, February 24, 2014

Inversionistas del Fondo Rochester de Oppenheimer Sufren Grandes Pérdidas por la Alta Concentración de Bonos Municipales de Puerto Rico

Por Craig McCann, PhD, CFA y Carmen Taveras, PhD English Version

Los inversionistas de bonos municipales de Puerto Rico sufrieron grandes pérdidas durante el año 2013. El gráfico 1 muestra un índice que abarca un amplio número de bonos municipales en los Estados Unidos (el Índice de Bonos Municipales S&P). Este gráfico también muestra un índice regional que se enfoca en bonos municipales de Puerto Rico (el Índice de Bonos Municipales puertorriqueños S&P). Entre los años 2000 y 2012, ambos índices presentaron movimientos muy similares. Sin embargo, durante el año 2013, el índice de Puerto Rico tuvo una caída mayor dada la prolongada recesión económica en la isla. Según la Junta de Planificación de Puerto Rico el PIB puertorriqueño cayó un 12% entre los años 2006 y 2012. En el 2013, el retorno total de los bonos municipales de Puerto Rico fue de -20.5%, mientras que el retorno del índice amplio de bonos municipales fue de -2.5%. Hemos tenido varias entradas en nuestro blog sobre las pérdidas sufridas por los inversionistas en los fondos cerrados UBS Puerto Rico, que sólo permitían inversiones hechas por residentes de la isla. Sin embargo, dado que los fondos municipales de Puerto Rico están exentos de impuestos federales, estatales y locales en los Estados Unidos, muchos fondos mutuos presentan grandes porciones de sus carteras invertidas en estos bonos. En esta entrada al blog, nos enfocamos en la concentración de bonos de Puerto Rico presentada por el fondo Rochester de Oppenheimer y sus pérdidas durante el año 2013.

Gráfico 1: Índice de bonos municipales S&P (SAPIMAIN) e Índice de
Bonos Municipales Puertorriqueños S&P (SAPIPR) (1)


Hay 20 fondos mutuos municipales en la familia de fondos Rochester, incluyendo cinco fondos administrados por madurez, dos fondos de mínimo impuesto alternativo (AMT por sus siglas en inglés), doce fundos especificados por estado, y un fondo de alto rendimiento. Según Morningstar, los fondos Rochester tienen más de $20 billones en activos netos. Los prospectos de los fondos no limitan la porción de las carteras asignadas a valores de Puerto Rico. Incluso los fondos especificados por estado, que invierten “principalmente en valores municipales emitidos por su estado” incluyen bonos exentos de impuestos de Puerto Rico en sus cálculos de valores estatales municipales.

El gráfico 2 presenta el retorno durante el año 2013 de los fondos Rochester y su porcentaje de la cartera asignado a bonos de Puerto Rico en el 31 de diciembre de 2012. El gráfico exhibe que los fondos con el mayor porcentaje de bonos puertorriqueños al final del 2012 tuvieron las mayores pérdidas durante el año 2013. El punto rojo de nuestro gráfico representa el fondo municipal Oppenheimer Rochester de Virginia (ORVAX); este fondo tenía más del 35% de su cartera asignada a bonos de Puerto Rico para finales del 2012 y sus retornos totales en el 2013 fueron de -15.5%.

Gráfico 2: Asignación de Bonos Puertorriqueños el 31 de Diciembre de 2012 y Retornos Totales
durante el año 2013 de los Fondos Rochester (2)


Parece ser que las grandes pérdidas causadas por los bonos municipales puertorriqueños no pueden ser contrarrestadas por ganancias anteriores. Como el gráfico 1 nos enseña, el índice de bonos municipales de Puerto Rico y el índice de bonos municipales de los Estados Unidos se movieron conjuntamente hasta el año 2012. Sin embargo, el Gráfico 3 demuestra que no hay relación alguna entre los retornos totales de los Fondos Rochester en el 2012 y la porción de la cartera asignada a bonos puertorriqueños el 31 de diciembre de 2011.

Gráfico 3: Asignación de cartera en Bonos Puertorriqueños al 31 de diciembre de 2011 y
Rendimiento totales durante el año 2012 de los Fondos Rochestrer. (3)

Aunque los fondos divulgaron su inversión en deuda puertorriqueña, no está claro si los inversionistas fueron informados sobre la débil economía de la isla y su inminente crisis de endeudamiento. (ver aquí). El Secretario del Estado de Massachusetts, William Galvin, anunció una investigación en las prácticas de ventas y divulgación de riesgo hecha por Oppenheimer y otros administradores de fondos con grandes asignaciones en deuda de Puerto Rico. Nosotros también creemos que una investigación es necesaria con respecto a las prácticas de venta y la información de riesgo divulgada en relación a los fondos Rochester.

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(1) Los datos fueron obtenidos de Bloomberg, al menos que se indique lo contrario.

(2) Las carteras fueron obtenidas usando la función en Bloomberg. La proporción de la cartera asignada a bonos de Puerto Rico equivale a la suma del valor del mercado de los bonos emitidos por Puerto Rico entre el valor del mercado de todos los bonos en la cartera. El valor de mercado de algunos bonos no está disponible en Bloomberg. En promedio, 13% de los valores de los fondos no se encuentra disponible en la base de datos de Bloomberg. Estos valores fueron excluidos en los cálculos de la fracción asignada a valores de Puerto Rico.

(3) Los datos de Bloomberg a la fecha del 31 de diciembre de 2011 eran más escasos. El 39% del valor de mercado de los bonos no estaba disponible.

Structured Product Based Variable Annuites are Riskier Than Advertised

By Tim Husson, PhD, FRM

My colleagues and I have a paper in the current (Winter 2014) Journal of Retirement about structured product based variable annuities (spVAs), which are variable annuities with index-linked accounts that have a payoff similar to structured products.  We have been following the market for spVAs since they were first introduced in 2010, and distributed our first working paper in 2011.  Since then, three issuers have sold more than $3 billion worth of spVAs, according to a recent article in InvestmentNews.

As spVAs garner more attention, it is important for investors to recognize that spVAs are extremely complex and risky investments.  spVA marketing materials highlight that, unlike traditional variable annuities, spVAs 'buffer' downside losses to a certain extent (10-30%).  However, as we show in our paper, issuers can more than make up for this 'protection' by setting a cap level, which reduces the potential for large gains, and by linking to index values rather than the total return of a indexed mutual fund-like subaccount.

For example, we calculated what a fair cap level would be for investments linked to the S&P 500 for various buffer levels, terms, and linked indexes.  As described in the paper, we use a Black-Scholes model to value the embedded derivative position in the spVA as of each day from January 2005 to April 2013.  The resulting fair cap levels for a one year term and three common indexes are shown below:

Fair Cap Levels for One-Year spVA Segment with Various Buffer Levels and Indexes

Clearly, the fair cap level must be very high in order to compensate investors for the embedded derivative position.  In fact, for some combinations of indexes, terms, and buffers, no cap level could fair compensate investors for this position.

These complexities are in addition to the other unfavorable features of variable annuities, such as onerous surrender penalties and illiquidity.  Investors are typically much better off investing directly in low-cost, diversified mutual funds or exchange-traded funds.

The InvestmentNews article notes that many broker-dealers view spVAs as too complex, and that additional training would be required before they would sell it.  However, the article also notes that some brokers are selling spVAs "as an alternative to other fixed-income products."  spVAs are not comparable to bonds or bond portfolios (just as structured products are not fixed income substitutes, either), and are vastly more complex.  It is important that brokers and investors understand these distinctions, especially before entrusting retirement savings to such a risky investment.

Moreover, the SEC now requires structured product issuers to report a fair value for each product when it is issued. We are not aware of a similar disclosure requirement for structured products within variable annuities. This disclosure loophole could lead to serious mis-pricing of structured products based variable annuities. Today’s InvestmentNews story didn’t address this fundamental issue which needs far more attention.

High Concentration in Puerto Rico Municipal Bonds Results in Losses for Investors in Oppenheimer Rochester Funds

By Craig McCann, PhD, CFA and Carmen Taveras, PhD Versión en Español

2013 was a tough year for investors in Puerto Rican municipal bonds. Figure 1 shows a broad index of U.S. municipal bonds--the S&P Municipal Bond Index--and a regional index focusing on Puerto Rican municipal bonds--the S&P Municipal Bond Puerto Rico Index. While both indexes moved in tandem from 2000 until 2012, the Puerto Rico index shows a much sharper drop in 2013 as the island’s economy continued its prolonged contraction. Puerto Rico’s 2012 GDP was 12% below its 2006 GDP, according to the Puerto Rico Planning Board. The total return for Puerto Rican municipal bonds was -20.5% in 2013, compared to a total return of -2.5% on the broad index over the same period. We have had several blog posts on the losses suffered by investors in the UBS Puerto Rico closed-end funds, which only allowed investments from Puerto Rico residents. But Puerto Rico municipal bonds also make up large fractions of the portfolios of many mainland mutual funds at least in part because Puerto Rico municipal bonds are typically exempt from federal, state, and local income taxes in all U.S. states. In this post, we focus on the Oppenheimer Rochester funds’ concentration in Puerto Rico bonds and the funds’ 2013 losses.

Figure 1: S&P Municipal Bond Index (SAPIMAIN) and 
S&P Municipal Bond Puerto Rico Index (SAPIPR) (1)

The family of Rochester funds is made up of 20 municipal mutual funds, including five maturity-managed funds, two alternative minimum tax (AMT) free funds, twelve state-specific funds, and one high-yield fund. According to Morningstar, the Rochester funds have combined net assets of over $20 billion. The funds’ prospectuses do not limit the fraction of the portfolio allocated to Puerto Rico securities as even the state-specific funds which invest “mainly in municipal securities issued by its state” include tax-advantaged Puerto Rico bonds in their calculation of state municipal securities.

Figure 2 plots the Rochester funds’ 2013 total return and the percentage of the portfolio allocated to Puerto Rican bonds on December 31, 2012. The figure shows that the funds with the highest exposure to Puerto Rican bonds at the end of 2012 had the most negative total returns in 2013. The Oppenheimer Rochester Virginia Municipal Fund (ORVAX), with over 35% of its portfolio in Puerto Rican bonds at the end of 2012, stands out with a -15.5% total return in 2013 (see red dot).

Figure 2: Rochester Funds’ December 31, 2012 Allocation to Puerto Rican Bonds 
and 2013 Total Returns (2)

Furthermore, it does not seem like the large losses caused by the Puerto Rico municipal bonds in 2013 can be offset by prior gains in such bonds. As Figure 1 showed, the Puerto Rico municipal bond index and a broad index of U.S. municipal bonds moved together up to 2012. Figure 3 below shows that there is no relationship between the Rochester funds’ 2012 total return and the fraction of the portfolio allocated to Puerto Rican bonds on December 31, 2011.

Figure 3: Rochester Funds’ December 31, 2011 Allocation to Puerto Rican Bonds 
and 2012 Total Returns (3)

Although the funds’ filings disclosed investments in Puerto Rican debt, it is unclear whether investors were made aware of their exposure to the island’s limping economy and its looming debt crisis (see here). William Galvin, the Secretary of the Commonwealth of Massachusetts, has announced a probe into the sales practices and risk disclosures made by Oppenheimer and other large fund managers with high allocations to Puerto Rico debt. We think that the sales practices and risks representations made by financial advisors selling shares of the Rochester funds also merit investigation.

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(1) Data is from Bloomberg, unless otherwise stated.

(2) The portfolios are obtained from the function <PORT HD> on Bloomberg. The fraction of the portfolio allocated to Puerto Rican bonds is the sum of the market value of the bonds issued in Puerto Rico as a fraction of the market value of all bonds in the portfolio. The market value for some of the bonds is not available on Bloomberg. On average, Bloomberg does not have market value data for roughly 13% of the securities in the funds. Such securities are excluded from the portfolio in the calculation of the fraction allocated to Puerto Rico securities.

(3) The Bloomberg data on market values is more sparse for the December 31, 2011 portfolio, with 39% of the bonds missing a market value.

Friday, February 21, 2014

SEC Litigation Releases: Week in Review

SEC Charges Three California Residents Behind Movie Investment Scam, February 20, 2014, (Litigation Release No. 22929)

According to the complaint (PDF), Samuel Braslau, Rand Chortkoff, and Stuart Rawitt defrauded "investors in a purported multi-million dollar movie project that would supposedly star A-list celebrities and generate exorbitant investment returns." Braslau set up "companies named Mutual Entertainment LLC and Film Shoot LLC to raise funds from investors for the movie project," a film first titled Marcel and later changed to The Smuggler. According to the defendants, investors' funds would go to fund the production costs of the movie. The defendants allegedly claimed "well-known actors ranging from Donald Sutherland to Jean-Claude Van Damme would appear in the movie when in fact [these actors] were never even approached." Braslau, Chortkoff, and Rawitt allegedly spent most of the funds on their own personal expenses, instead of production expenses as promised.

The SEC has charged the defendants with violating various provisions of the Securities Act and Exchange Act and seeks financial penalties and a permanent injunction against them. In a parallel action, criminal charges have been announced against the defendants.

Connecticut-Based Stock Promoter Ordered to Pay Over $9.6 Million in Stock Touting and Scalping Scheme, February 19, 2014, (Litigation Release No. 22928)

Judgments were entered last week against stock promoter Jerry S. Williams and two companies that he controlled, Monk's Den, LLC and First In Awareness, LLC, for allegedly operating "a fraudulent Internet-based stock touting and scalping scheme." According to the SEC, Williams promoted Cascadia Investments, Inc. and Green Oasis, Inc. stock through his companies. Williams failed to disclose to investors that he had been "hired by Cascadia and Green Oasis to promote their stock and had been compensated with millions of free and discounted shares of these stocks." While encouraging investors to buy shares, Williams secretly sold his shares, making a profit of over $2.3 million.

The defendants have consented to the entry of the final judgments which enjoin them from future violations of securities laws, order them to pay over $9.6 million in disgorgement, prejudgment interest, and penalties, and impose a penny stock bar against Williams.

Wednesday, February 19, 2014

Further Reckoning of UBS Willow Fund’s CDS Losses

By Geng Deng, PhD, CFA, FRM and Craig McCann, PhD, CFA

In previous blog posts we explained how the UBS Willow Fund completed its spectacular multi-year collapse in 2012 largely as a result of its leveraged portfolio of credit default swap (CDS) contracts. See Credit Default Swaps on Steroids: UBS’s Willow Fund and Willow Fund’s Hedging, Investing and Speculating in Distressed Debt With Credit Default Swaps. Through these CDS contracts, the Willow Fund made a large, highly-leveraged short bet on credit risk contrary to its repeated SEC disclosures. In this post, we will explain the significance of the CDS premium that the Willow Fund paid each year in causing the losses suffered by investors.

The Willow Fund suffered substantial losses on its common stock and corporate bond and loan portfolio in addition to its CDS losses. The relative importance of credit default swaps on the Willow Fund is not readily apparent from the SEC filings because the bonds and loans received coupon interest while the Fund paid out over $120 million in premiums on its CDS contracts. Similarly, the relative significance of CDS on corporate bonds versus CDS on sovereign debt is obscured by the differences in CDS premium the Willow Fund paid across the different types of reference obligations.

CDS versus Stocks, Bonds and Loans

Table 1 reports the estimated capital losses suffered by the Willow Fund on CDS contracts and all other investments – mostly common stock and corporate bonds and loans - estimated from the fund's quarterly holdings reported on SEC filings from 2007 to 2012.* We estimate that market value gains of $22,635,151 on the swaps partially offset $115,527,918 in losses on other investments. Looking only at the capital losses derivable from the Fund’s quarterly holdings it appears that the CDS contracts were profitable and that common stock and corporate bonds and loans were responsible for the losses from 2007 to 2012.

The Willow Fund however received $20 million in interest and dividends on the stock, bonds, loans and other investments and paid out $136 million in premiums on the CDS contracts. Thus, properly reckoned, the CDS contracts accounted for $116 million or 55% of the $210 million in losses the Fund suffered from 2007 to 2012. Everything else in this distressed fund accounted for only $94 million or 45% of the losses.

Table 1: Willow Fund Losses on CDS Contracts and Other Investments, 2007-2012



Figure 1: Willow Fund Losses on CDS Contracts and Other Investments, 2007-2012


Sovereign versus Corporate CDS

A similar phenomenon obscures the relative significance of CDS on corporate debt versus CDS on sovereign debt. If we only look at capital losses derivable from the Fund’s SEC filings, it appears that two thirds of the CDS losses in 2012 came from contracts betting against the credit quality of sovereign issuers like France, Germany, Ireland, Mexico, Spain, Sweden and the United Kingdom. This is misleading because the CDS contracts on corporate bonds required much higher premiums (2.38% on average) than CDS contracts on sovereign debt (0.82% on average) and CDS contracts on state and municipal bonds (0.36% on average).

You can find the annual CDS premium the Fund paid on its contracts in a schedule near the end of each annual and semi-annual report. Consider the Willow Fund 2008 Annual Report which can be downloaded here. I have excerpted the first part of the CDS Table which starts on page 22 of that filing in Figure 1. The second column labeled “Interest Rate” is not an interest rate but rather the annual CDS premium the Willow Fund committed to pay on the notional value in the fourth column for the term of the CDS contract. Focusing on the contracts with Goldman Sachs, you can see that the Willow Fund paid as little as 0.1% to insure German sovereign debt and as much as 4.05% or 40 times as much to insure Pulte Homes debt.

Figure 1: Partial Listing of Willow Fund’s CDS Contracts as of December 31, 2008


Table 2 reports a breakdown of capital losses on CDS contracts by type of underlying debt, corporate sovereign and municipal from 2007 to 2012. The Fund paid $85.1 million in CDS premium on corporate debt versus $48.0 million on sovereign debt over the 2007-2012 period. If we include the high CDS premiums the Willow Fund paid, over the entire 2007-2012 period, the Willow Funds’ $85.4 million in losses from CDS contracts on corporate debt was nearly twice as much as the $43.8 million in losses from CDS contracts on sovereign debt even though it purchased CDS contracts on twice as much sovereign debt as corporate debt. Even looking at 2012 in isolation, the proportionate losses on the corporate CDS were greater than on sovereign CDS so replacing the sovereign CDS with corporate CDS would have increased the Fund’s losses in 2012 as well as over the entire 2007-2012 period.

Table 2: Losses on Corporate, Sovereign and Municipal CDS, 2007-2012



Figure 2: Losses on Corporate, Sovereign and Municipal CDS, 2007-2012



We’ll have another blog post on the Willow Fund next week in which we compare the losses investors suffered in the Willow Fund to investors’ experience in distressed debt more generally. We also compared how Willow Fund investors fared compared to the general partner which was a UBS affiliate.

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* We estimated the capital gains and losses as the change in the reported market value per unit multiplied by the minimum number of units held at the beginning or end of the quarter. We estimated the CDS premiums paid as the CDS rate multiplied by the average notional value of each contract at the start and end of each quarter. The complete details of our estimation are available in our upcoming working paper on UBS’s Willow Fund.

Tuesday, February 18, 2014

The Inland Group's Non-Traded REITs Destroyed $11.9 Billion of Investor Wealth

By Tim Husson, PhD, FRM, Craig McCann, PhD, CFA, and Carmen Taveras, PhD

Last week we wrote about how investors in a non-traded REIT, Inland Diversified Real Estate Trust, had lost $200 million compared to traded REITs even though it announced a merger with a traded REIT here.

Continuing our blog posts and working papers on non-traded REITs, today we report on how investors fared in five non-traded REITs sponsored by affiliates of The Inland Real Estate Group of Companies.1 Inland raised over $18.1 billion from investors in these REITs. Inland’s affiliated companies served as conflicted property managers, dealer managers, and business managers (see one of our early blog posts on the interrelated entities involved in Inland American Real Estate Trust).

Two of the five non-traded REITs, Retail Properties of America (RPAI) and Inland Real Estate Corporation (IRC), became listed REITs, Inland Retail Real Estate Trust merged with a publicly-listed REIT, Developers Diversified REIT (DDR), and Inland Diversified Real Estate Trust last week announced a merger with Kite Realty Group (KRG). Inland American Realty Trust has not listed or merged with a listed REIT but has provided an updated net asset value (NAV) per share.2

We gathered data on gross proceeds, distributions, and share redemptions from the REITs' SEC filings, starting from each REIT's registration date, up to the earliest of today or the day the REIT's shares first listed on an exchange.3 We calculate the market value of the common shares at the time each REIT's shares became publicly listed, a merger was announced, or the REIT last reported an NAV per share. We refer to this market value as the value of the REIT upon price discovery (see Table 1 below).

We apply the daily net investment in each of the non-traded REITs to the Vanguard REIT Index (VGSIX) - a liquid, diversified mutual fund of traded REITs. We compare the market value of the common shares of the non-traded REITs upon price discovery to the value of an equal size investment in the diversified traded REIT mutual fund to determine whether investors benefited from their involvement with Inland’s non-traded REITs.

For example, the black line in Figure 1 plots the value of RPAI gross proceeds invested in the Vanguard traded REIT mutual fund. RPAI listed one-fourth of its common shares on the NYSE on April 5, 2012 and its remaining non-traded shares became listed over the following 18 months. RPAI’s 194 million post reverse-split shares were worth $1.7 billion (denoted by the orange dot on the figure) on April 5, 2012. The same $4.9 billion invested in diversified, liquid traded REITs would have been worth $7.1 billion. RPAI thus managed to destroy $5.4 billion or 76% of real estate investors’ wealth.

Figure 1: RPAI Investors Lost $5.4 billion or 76% Compared to Diversified Liquid REITs

Table 1 summarizes our analysis for the five Inland non-traded REITs (click the image to enlarge). We find that investors’ $18.1 billion combined net investment in Inland’s five non-traded REITs was worth $13.7 billion on their price discovery date. Had stockholders invested the same $18.1 billion over the same time period in traded REITs, they’re investments would have been worth $25.5 billion. Thus, Inland has destroyed $11.9 billion or 46.5% of real estate investors’ wealth through its non-traded REITs.

Table 1: $12 Billion Aggregate Investor Wealth Destroyed by Inland’s Non-Traded REITs* 
(Dollar amounts are in billions) 
 
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1. There is a sixth Inland non-traded REIT called Inland Real Estate Income Trust that commenced its initial public offering in October 2012 and has not listed, merged with a listed REIT, or provided an updated net asset value per share. We exclude this REIT from our analysis because there is no information on its market price.

2. Inland American reported a $6.93 NAV per share as of September 30, 2013. While equal to the REIT’s dividend reinvestment and share repurchase program price, the NAV is 14.5% higher than observed secondary market trade prices for Inland American's shares. In our calculations we use Inland American's September 30, 2013 NAV in calculating a likely upper bound for the market value of its common shares, likely underestimating investor losses.

3. We have gathered data from prospectus supplements (424B3) filings and annual reports (10-K) for all of the REITs. Additionally, we have gathered data from the quarterly reports (10-Q) from the date of the last annual report until the listing of the common shares, the announcement of merger, or most recent update to the NAV.

Friday, February 14, 2014

SEC Litigation Releases: Week in Review

SEC Charges James Y. Lee for Defrauding His Advisory Clients, February 14, 2014, (Litigation Release No. 22927)

According to the complaint (PDF), James Y. Lee defrauded his advisory clients in several ways including "charg[ing] some clients fees...based on false performance and conceal[ing] from them that they had actually incurred realized losses," failing to disclose information about his background including"a criminal conviction for embezzlement and an SEC cease-and-desist order for his role in illegal unregistered penny stock offerings," and misleading "clients about his promise to share in realized losses and the risks of his options trading strategy."  The SEC has charged Lee with violating the antifraud provisions of the securities laws and seeks "a permanent injunction as well as disgorgement, prejudgment interest and civil penalties." The complaint also names "several relief defendants including Lee's girlfriend, his son and his close business associate as well as their respective companies."

In a related matter, cease-and-desist proceedings were settled against Ronald E. Huxtable II, for his alleged role in aiding and abetting Lee in charging "certain clients fees for the month of February 2011 based on false performance and conceal[ing] the fact that they had actually incurred net realized losses for that month."

Court Enters Judgments Against All Defendants in Insider Trading Action, February 12, 2014, (Litigation Release No. 22926)

A final judgment was entered against David J. Weishaus in the SEC's insider trading case, SEC v. Thomas C. Conradt, et al. The court had previously entered judgments against Thomas C. Conradt and Trent Martin. According to the SEC, the defendants illegally traded on "material nonpublic information about International Business Machines Corporation's 2009 acquisition of SPSS Inc." The final judgment against Weishaus permanently enjoins him from future violations of the securities laws and orders him to pay over $475,000 in disgorgement, prejudgment interest, and a civil penalty. The final judgments against Conradt and Martin order them to pay over $11,000 combined in disgorgement and prejudgment interest. Furthermore, the SEC has permanently suspended the defendants from "association with any broker, dealer, investment adviser, municipal securities dealer, or transfer agent" and has barred them "from participating in any offering of a penny stock." Conradt has also been suspended "from appearing or practicing before the Commission as an attorney."

SEC Wins Jury Trial Against Connecticut-Based Fund Manager Who Facilitated Petters Ponzi Scheme, February 11, 2014, (Litigation Release No. 22925)

A jury found Marlon M. Quan and his firms Stewardship Investment Advisors LLC, Acorn Capital Group LLC and ACG II LLC "liable for securities fraud in connection with a multi-billion dollar Ponzi scheme operated by...Thomas Petters." The SEC seeks permanent injunction against the defendants as well as disgorgement, prejudgment interest, and financial penalties.

SEC Concludes Its Case Against Former Siemens Executives Charged with Bribery in Argentina, Obtaining Judgments over $1.8 Million, February 10, 2014, (Litigation Release No. 22923)

Final judgments were entered against former Siemens Argentina CFO, Andres Truppel, and former Heads of Major Projects at Siemens Aktiengesellschaft, Ulrich Bock and Stephan Signer, for "their role in a decade long bribery scheme at Siemens and its regional company in Argentina." The SEC alleges that "between 2001 and 2007, the defendants paid bribes to senior government officials in Argentina to retain a $1 billion contract to produce national identity cards for Argentine citizens." The final judgments entered against the defendants enjoin them from future violations of the securities laws and order them to pay over $1.5 million in disgorgement, prejudgment interest, and penalties. These final judgments conclude the SEC's case.

Previously, a final judgment was entered against "Uriel Sharef, a former officer and board member of Siemens, for his role in the long standing bribery scheme." The final judgment "enjoined him from violating the anti-bribery and related books and records and internal controls provisions of the FCPA, and ordered him to pay a $275,000 civil penalty."  Bernd Regendantz "settled with the Commission when the complaint was filed, and allegations against Herbert Steffen and Carlos Sergi were dismissed."

SEC Obtains $9.5 Million Money Judgment Against Onyx Capital Advisors, LLC, Roy Dixon, Jr. and Michael A. Farr, February 7, 2014, (Litigation Release No. 22922)

A final judgment was entered against Onyx Capital Advisors, LLC and Roy Dixon, Jr. for allegedly "rais[ing] $23.8 million from three public pension funds for a start-up private equity fund and then illegally [withdrawing] money invested by the pension funds to cover personal and other business expenses." Dixon's friend, Michael A. Farr, was also charged for allegedly "assisting Dixon in the scheme." The final judgment against Dixon and Onyx Capital Advisors permanently enjoins them from future violations of the securities laws, orders them to pay over $3.1 million in disgorgement plus pay prejudgment interest and orders them to pay over $3.1 million in a civil penalty. The judgment against Farr permanently enjoins him from aiding and abetting future violations of the securities laws and orders him to pay over $2.3 million in disgorgement and to pay a $1 million civil penalty.

Securities and Exchange Commission v. Hao He a/k/a Jimmy He, February 7, 2014, (Litigation Release No. 22921)

Last week, the SEC filed insider trading charges against Hao He a/k/a Jimmy He "alleging He purchased short-term put option contracts in the securities of Sina Corporation" based on material nonpublic information He obtained "concerning Sina's upcoming, negative, future earnings guidance." According to the SEC, He gained almost $170,000 in illicit profits. He has consented to a final judgment that permanently enjoins him from future violations of the Exchange Act and orders him to pay over $345,000 in disgorgement, prejudgment interest, and a financial penalty.

Tuesday, February 11, 2014

More Non-Traded REIT Carnage: Inland Diversified’s Investors Have Lost 40%, Not Gained 31%

By Tim Husson, PhD, Craig McCann, PhD, CFA, and Carmen Taveras, PhD

As we have explained in several blog posts and working papers, non-traded REITs are illiquid, poorly diversified real estate investments that destroy investor’s wealth compared to liquid, diversified real estate investments.

Inland Diversified Real Estate Trust, Inc. ("Inland Diversified") is a non-traded REIT that invests in retail properties, office properties, industrial properties, and multi-family properties. Yesterday, Inland Diversified announced that it was merging with Kite Realty Group ("Kite", KRG), a retail property REIT listed on the New York Stock Exchange.

Inland Diversified's shareholders will receive between 1.65 and 1.707 shares of Kite Realty Group per share of Inland Diversified. Based on the $6.15 closing price for Kite's common shares as of February 7, 2004 and the 1.707 merger ratio, the consideration paid to Inland Diversified stockholders is $10.50 per share. The merger announcement touts that stockholders who invested in September 2009 will have received a 31% return on their investment. This bit of salesmanship doesn’t mention an investment in the Vanguard REIT Index (VGSIX) - a liquid, diversified mutual fund of traded REITs - would have earned 115% over the same period.

The figure below shows the value of $100 invested on September 1, 2009 in the VGSIX index mutual fund. The two red dots represent the $100 invested in Inland Diversified in September 1, 2009 and its current value of $131 based on the merger announcement.*  $100 in the VGSIX index invested on September 1, 2009 with reinvested dividends would be worth $215 on February 7, 2014. Thus, early investors in Inland Diversified now after four and a half years have $131 in value or 40% less than the $215 they would have if they had invested in a liquid, well diversified real estate portfolio instead of the non-traded REIT.

Value of $100 invested in Inland Diversified and Vanguard’s Traded REIT Fund from September 1, 2009 until February 7, 2014


If Inland Diversified’s capital raised from August 2009 until today had been invested in the Vanguard REIT mutual fund, shareholders would have about $1.4 billion today rather than the $1.2 billion Inland Diversified market value implied by the merger announcement. The $173 million difference in value between Inland Diversified and the traded-REIT mutual fund is investors’ aggregate wealth destroyed by Inland Diversified.

Investors’ Net Investments in Inland Diversified Applied to Vanguard’s Traded REIT Fund


*  The 31% total return reported by the REIT appears to not include re-investment returns on dividends.  Reinvesting the dividends would increase the $131 value slightly.

Friday, February 7, 2014

SLCG's Own Dr. Tim Dulaney to Join the SEC

By Tim Husson, PhD, FRM

I am sad to report that one of SLCG Blog’s commentators, Dr. Tim Dulaney, will be leaving us for an exciting opportunity at the Division of Investment Management at the Securities and Exchange Commission. While we will greatly miss his skills and camaraderie, we are glad that he will not be going far.

Dr. Dulaney has made enormous contributions to our research and advocacy work over the past two and a half years. He has co-authored eleven working papers and peer-reviewed publications (!), been a prolific contributor to the blog, and worked tirelessly to improve our capabilities. His efforts have helped us keep pace with financial innovation, working on projects dealing with exchange-traded products, structured products, structured certificates of deposit, portfolio optimization, optimal liquidation, complex annuities…the list goes on and on. In his new role with the SEC, he will continue to investigate complex investments and their impact on retail investors.

It has been an honor and a pleasure working with Tim, who has made a profound impact on everything we do at SLCG. We know the SEC and, in turn, all investors will benefit tremendously from his extensive skills and keen intellect. Congratulations, Tim!

SEC Litigation Releases: Week in Review

Court of Appeals Denies Stay of Order Compelling Investigative Testimony; Affirms District Court's Exercise of Discretion, February 6, 2014, (Litigation Release No. 22920)

This week the court issued a "summary order denying Edward Daspin’s motion for a stay" on a December 2013 order. This means that Daspin is required "to appear for investigative testimony in compliance with an SEC investigative subpoena" and was denied a "request that the SEC be required to pay for Daspin’s physician to attend the testimony."

SEC Obtains Final Judgments Against Joseph Paul Zada and Zada Enterprises, LLC, February 5, 2014, (Litigation Release No. 22919)

Final judgments were entered against Joseph Paul Zada and Zada Enterprises, LLC for their involvement in a scheme where Zada allegedly "raised at least $27.5 million from at least 60 investors between January 2006 and August 2009 through the fraudulent offer and sale of unregistered securities in the form of promissory notes." The final judgment permanently enjoins the defendants from future violations of the securities laws and orders them to pay over $121,000 in disgorgement, prejudgment interest, and civil penalties.

Jury Finds Stephen Kovzan Not Liable for Securities Violations, February 4, 2014, (Litigation Release No. 22918)

In December a federal jury found that Steven Kovzan is "not liable for violating various provisions of the federal securities laws." In 2011, the SEC had filed a complaint against Kovzan "alleging that he violated certain provisions of the federal securities laws by concealing perquisite compensation of the former Chief Executive Officer of NIC, Inc."

Jury Finds Defendants Not Liable for Insider Trading, February 4, 2014, (Litigation Release No. 22917)

Last week, following a nine day trial, a federal jury "declined to find Rex C. Steffes and his three sons, Cliff M. Steffes, Bret W. Steffes and Rex R. Steffes, liable" for insider trading in Florida East Coast Industries, Inc.'s securities.

SEC Obtains Asset Freeze and Other Relief Against Michael P. Zenger, February 4, 2014, (Litigation Release No. 22916)

The SEC obtained "a temporary restraining order and an emergency asset freeze in an offering fraud orchestrated by" Michael P. Zenger (PDF). According to the complaint, "Zenger solicited at least $200,000" and then misappropriated $100,000 of those funds "to pay personal expenses, including airplane rentals, monthly credit card bills, payments to BMW and Mercedes Benz, purchases at Saks Fifth Avenue, Nordstrom and Costco, and other personal expenses." The SEC has charged Zenger with violating the Securities Act and Exchange Act and seeks "a preliminary and permanent injunction as well as disgorgement, prejudgment interest and civil penalties from Zenger."

SEC Charges Bermudian Investment Adviser and Principal for Illegal Short Selling, February 3, 2014, (Litigation Release No. 22915)

According to the complaint (PDF), Revelation Capital Management Ltd. and its principal, Christopher P.C. Kuchanny, illegally short sold in connection with "Central Fund of Canada Limited's November 2009 offering" and thereby violated Rule 105. The SEC seeks permanent injunctions, disgorgement, prejudgment interest, and civil penalties.