Friday, June 26, 2015

Enforcement Actions: Week in Review


SEC Charges Unregistered Brokers in EB-5 Immigrant Investor Program
June 23, 2015 (Litigation Release No. 127)
Ireeco LLC and its successor Ireeco Limited were charged with being unregistered brokers after the firms handled more than $79 million of investments. Ireeco brokered investments for more than 150 foreign investors through the governments EB-5 program. The EB-5 program allows foreigners who invest directly in a U.S. business or private “regional centers” that promote economic development a chance at gaining legal residency. Ireeco promised to guide investors to the right regional centers and businesses, but they directed the majority of their clients to a handful of region centers that gave Ireeco commissions of about $35,000 per investor. Ireeco has agreed to be censured and to cease and desist from committing similar violations in the future.

SEC Obtains Asset Freeze against China-Based Trader for Suspicious Activity Last Week
June 23, 2015 (Litigation Release No. 128)
The SEC alleges that Haijian Luo profited by more than $1 million by trading on private information on China-based Company Qihoo 360 Technology. Luo, who had no prior trading history with Qihoo 360, purchased around $700,000 of out-of-the-money options. Briefly following Luo’s order, Qihoo announced a buyout offer at a significant premium and Qihoo’s stock rose sharply. Luo consequently sold all of the options and transferred more than half of his $1 million proceeds to a foreign bank account. The SEC believes the timing of Luo’s order is suspicious and has frozen Luo’s brokerage account to prevent him from destroying any evidence.

SEC Charges Microcap Promoter with Illegally Selling Penny Stock Shares
June 23, 2015 (Litigation Release No. 129)
The SEC alleges Gregg R. Mulholland illegally liquated shares of Vision Plasma Systems, where he was the majority share owner. Mulholland accumulated over 84 percent of the company through various offshore front companies to gain effective control of the company. Subsequently, Mullholland sold his shares for proceeds of around $21 million without filing a registration statement. This is not Mullholland’s first run-in with the SEC as in 2011 the SEC charged him with a pump-and-dump manipulation of a sports drink company.

John Roeser Named Associate Director of the Office of Market Supervision
June 25, 2015 (Litigation Release No. 130)
The SEC named John C. Roeser as the Associate Director and deputy head of the Office of Market Supervision in the Division of Trading and Markets. The previous associate director, Heather Seidel, was named Chief Counsel for the Division of Trading and Markets in February. The Office of Market Supervision oversees U.S. securities exchanges, alternative trading systems, and self-regulatory organizations.

Thursday, June 25, 2015

The Worst Investment in the World!
Behringer Harvard’s Priority Income Fund

I. Introduction

What could be worse than a non-traded REIT? Well, REIT-sponsor Behringer Harvard has managed to create something even worse than a non-traded REIT: The Priority Income Fund. On May 9, 2013, Behringer Harvard and the manager of publicly traded BDCs, Prospect Capital Management, announced the initial public offering for their new joint-effort Priority Senior Secured Income Fund (PSSI) now renamed Priority Income Fund.i

The best thing that can be said of the Priority Income Fund is: After 2 years Behringer Harvard has only been able to sell about 3% of the shares it registered. The Priority Income Fund is so far beyond the “reasonable-basis suitability” pale, if your broker recommended this investment to you, you should fire your broker and look at what else they’ve tried to sell you.

The Priority Income Fund is a non-traded closed-end fund that invests almost all its assets in junior and equity tranches of collateralized loan obligations (CLOs) backed by ‘leveraged loans’ made to medium to large below investment grade companies. PSSI has many of the controversial features of non-traded REITs and BDCs, including high upfront fees, lack of price transparency, lack of liquidity and a remarkable 2/20 ongoing management fee, which is common in hedge funds but not in retail investments.

In 2013, my co-authors and I wrote about the Priority Senior Secured Income Fund. That paper, The Priority Senior Secured Income Fund, is available here. In this post, I summarize and bring our discussion up to date because the story has gotten even weirder.

II. Leveraged Loans

Leveraged loans are loans issued to below investment grade corporations.ii The loans are frequently large and extended by a syndicate of lenders intending to re-sell participations in the loans to other banks and institutional investors including hedge funds, mutual funds and CLO trusts.

S&P and the Loan Syndications and Trading Association (LSTA) produce benchmark indices of the market value of leveraged loans. Figure 1 plots the price and total return indexes from 2005 to 2015 for the largest loans of the type securitized into CLOs.iii The index level declined substantially in late 2008 and has rebounded since. This leveraged loan market pattern coincides with the high yield bond market decline and rebound.iv

Figure 1: S&P/LSTA Leveraged Loan 100 Index

The fairly modest decline in leveraged loan values in July 2007 circled in red in Figure 1 was enough to wipeout the value of equity tranches in CLOs – exactly the investments Priority Income Fund exclusively invests in. In 2012, my co-authors and I wrote about the failure of CLO equity tranches in “CLOs, Warehousing, and Banc of America's Undisclosed Losses” available here. Prompted by our research, Gretchen Morgenson wrote “An Investment Wipeout That Didn’t Have to Happen” for the New York Times, available here. As you can see in Figure 1, there are dozens of periods in the past 10 years when CLO equity tranches would lose most or all of their value.

III. CLO Equity Tranches

Collateralized Loan Obligations (CLOs) are securities issued by a trust which invests in leveraged loans. CLO trusts package exposure to the underlying leveraged loans into slices (called ‘tranches’) that represent varying degrees of risk. The leveraged loans serving as collateral for the CLO produce cash flows that used to pay the CLO investors. One of the CLOs the Priority Income Fund currently holds is the ING IM CLO 2013-3 Subordinated Notes due 2026.v

The ING IM CLO was a $518 million deal at issuance with five tranches paying floating interest based on LIBOR and one tranche of the subordinated notes).vi Figure 2 shows the capital structure of the ING IM CLO.

Figure 2: Capital Structure of ING IM CLO 2013-3

The Class A notes at the top of the ING CLO capital structure have first priority in interest payments and principal repayment and so is the least risky tranche. The equity tranche - the Subordinated Notes – bought by the Priority Income Fund – is unsecured, subordinated and leveraged 12-to-1 in the underlying leveraged loans. The average initial offering leverage across the PSSI’s 44 holdings on March 31, 2015 was also 12-1.

Investors in the ING CLO are paid interest quarterly from the interest proceeds of the collateral, after base management fees, hedging costs and expenses are paid. The remaining proceeds are then used to pay accrued and unpaid interest to the Class A investors, then the Class B investors. At this point, the first “coverage test” is applied. If the test is passed, the remaining proceeds are used to pay Class C investors. Another coverage test is then applied. Remaining proceeds then pay the Class D investors, another coverage test is applied, then the Class E investors and a final coverage test is applied. Table 1 summarizes the criteria for the coverage tests.

Table 1: Summary of Ratio Tests for the IM CLO 2013-3

In the first few years of the deal, if the senior notes are not sufficiently collateralized then the remaining interest proceeds will be used to increase the collateralization of the senior notes. The subordinated management fee, administrative expenses and addition hedging costs are deducted from the remaining proceeds. If any proceeds remain, the subordinated notes may now be paid interest. If the annualized internal rate of return of the subordinated notes increases beyond 12%, an incentive management fee is then deducted from the remaining proceeds. Any proceeds remaining are paid to the subordinated notes. Principal repayment follows a similar payment waterfall where, again, the subordinated notes receive the leftovers resulting from the payment of fees, expenses and the senior tranches – if any remain.

The leveraged exposure to the underlying leveraged loans in each of these CLOs can be approximated by taking the ratio of total invested capital to the liquidation preference of the equity tranche. If the underlying collateral is adversely affected by market conditions, the coverage tests may begin to fail and at that point the likelihood of the equity tranche receiving any payments through the deal is greatly diminished.

PSSI’s prospectus states that during the investment period, the proceeds will be invested “cash, cash equivalents, U.S. government securities, money market funds, repurchase agreements and high-quality debt instruments maturing in one year or less from the time of investment”.vii Because the fees on PSSI are much higher than the yields on such instruments, the net asset value on the fund will likely decrease substantially during this period. The prospectus also states that regular cash distributions are to be determined quarterly and paid monthly starting within one calendar year of the completion of the minimum offering.viii Any distributions made before significant CLO assets could be purchased would either be a return of investor principal or proceeds from borrowing.

The PSSI prospectus makes the following claim regarding CLO assets and their relative risk and return tradeoff:
    The most junior tranches of all U.S. CLOs (typically referred to as CLO equity tranches) have delivered nearly 21% annual average cash yields since January 2003, as shown in the chart below, and, according to Moody's CLO Interest (July 2012) no CLO issued since 2002 has suffered a principal loss on a rated debt tranche (including during the credit crisis).ix
Many investors will not realize that while both statements may be technically accurate, they are misleading with respect to the PSSI portfolio.

First, PSSI invest in equity tranches. US CLO equity tranches are unrated and therefore the fact that rated tranches have not suffered principal losses is irrelevant to assessing the riskiness of PSSI. Second, equity tranches are typically not secured, and technically have no principal amount that could be written down even if its mark-to-market value of the tranche has declined. Put differently, CLOs are often under no obligation to return the amount invested in an equity tranche, only income remaining after paying all other tranches (if any). In a similar sense, most distressed bonds do not suffer principal losses as defined in the context of a CLO, even though there is a significant chance an investor may lose some of their investment. The important point is that equity and junior CLO tranches are typically very highly leveraged and “are subject to a higher risk of total loss”.x

IV. Fees and Expenses

PSSI embeds significant fees, both upfront and on an annual basis, summarized in Table 2 below.xi

Table 2: Upfront Fees and Annual Expenses of the Priority Senior Secured Income Fund.
There are additional expenses not included in Table 2. An example is the incentive fee, which is contingent upon the performance of the underlying assets exceeding the fixed fees for the fund by an amount that exceeds PSSI’s hurdle rate of 6% annually. In addition, performance fees charged on the underlying assets would also increase annual expenses depending on returns.

Expenses are increased through the use of leverage. For example, if PSSI’s Advisor borrows 10% of fund assets, this borrowing increases the base management fee by 10%. This borrowing would also incur interest costs that are not included in the annual expense estimates. If the interest rate is 5%, these two expenses alone would increase the annual expenses to over 9%.

V. Liquidity and Transparency

Shares of PSSI are very illiquid. The prospectus states that “you should not expect to be able to sell your shares regardless of how we perform” and “[i]f you are able to sell your shares, you will likely receive less than your purchase price”.xii On the other hand, the issuers intend to implement a limited share repurchase program in which the total amount of shares that can be repurchased is limited to 20% of the weighted-average shares outstanding.xiii

VI. Conclusions

We’ve written extensively about non-traded REITs and recently distributed our analysis of the 81 non-traded REITs that have had a liquidity event or updated their Net Asset Values. In “An Empirical Analysis of Non-Traded REITs” (paper available here), my coauthors and I found that the non-traded REIT industry has transferred at least $45.5 billion in wealth from investors to sponsors and the brokerage industry. The first 41 non-traded REITs had cost investors $25.5 billion in lost wealth and 40 additional non-traded REITs which had updated their NAVs had cost investors another $20 billion in lost wealth. In “Fiduciary Duties and Non-traded REITs” (paper available here), I point out that no advisor with fiduciary duties could recommend a non-traded REIT.

PSSI, like other non-traded investments, is an extremely high cost, illiquid, and risky offering. Its upfront fees (at over 9%) rival that of non-traded REITs, while its ongoing fees are very similar to the 2/20 fee structure employed by hedge funds. PSSI is not listed on a public exchange and therefore have neither observable market prices nor any opportunity to sell shares in the secondary market. PSSI’s portfolio of leveraged loans and junior and equity tranche CLO assets must be highly leveraged to overcome the onerous fees and expenses.

No broker should ever recommend the Priority Income Fund. Investors who previously paid $15 per share now have shares worth roughly $12. If any broker has recommended the Priority Income Fund to you, fire him or her and their brokerage firm. They clearly have a callous disregard for you and your financial well-being.

iThe initial offering document dated May 9, 2013and the rest of PSSI’s filings can be found at:
iiThe qualifier “leveraged” might just as well be replaced with “high-yield” but we follow industry convention and refer to them as leveraged loans. For an extended discussion of this market please see Antczak, Lucas and Fabozzi [2009], Tavakoli [2008] and Standard and Poor’s [2011].
iv The decline in the market value of leveraged loans in July 2007 was as a result of credit risk not liquidity risk as credit spreads on these loans increased dramatically in July 2007. See slide 18 of
vPSSI’s holdings as of March 31, 2015 are reported in its 497 filed with the SEC here
. vi The ING IM CLO prospectus can be downloaded here ING IM CLO 2013-3, Ltd..pdf
vii PSSI PPM pg. 13.
viii PSSI PPM pg. 17.
ix PSSI PPM pg. 61.
x PSSI PPM pg. 49.
xi We use the “Fees and Expenses” table (PSSI PPM pg. 19).
xii PSSI PPM pg. 1.
xiii PSSI PPM pg. 13.


Wednesday, June 24, 2015

Securities-Based Lending

 Paul Meyer

In this blog post I summarize my recently published working paper, “Securities-Based Lending,” available here.

The securities industry has long targeted the liability side of the customer’s balance sheet as an opportunity to cross-sell banking products, increase wallet share, and diversify revenue streams away from cyclical trading commissions. In the current euphoric market environment, with portfolio values soaring and borrowing rates historically low, lending to customers has become “Wall Street’s hottest business.”i However, the proliferation of these securities-based loans (“SBLs”) is cause for serious concern. While securities-based lending is a low-risk and very profitable business for the broker-dealer, the same cannot be said for the borrower. Broker-dealer lending creates serious conflicts of interest, saddling the customer with risks and potential long-term consequences he or she may not fully understand until the next bear market arrives.

Securities-Based Lending
There are two types of SBLs. The more familiar is the margin (or purpose) loan. Margin loans are “credit extended for the purpose of buying, carrying, or trading in securities.”ii Securities in the customer’s account serve as collateral. Broker-dealers are also permitted to extend credit, generally secured by a customer’s marketable securities, for purposes other than buying or carrying securities.iii These loans are known as good faith or non-purpose loans. The real growth in lending has come from non-purpose loans.

Margin loans and non-purpose loans are similar in many ways. The underwriting for either loan gives little or no consideration to the borrower’s credit rating, income, or debt ratios. The amount of credit extended primarily is a function of the value of the collateral securities, the liquidity and volatility of those securities, and the extent to which there is any concentration in a single security. Establishing either type of loan involves relatively little documentation compared to other types of lending. Each loan requires a minimum level of equity (loan-to-value) at inception and is subject to calls for additional capital if the value of the collateral falls below a stated minimum. Most SBLs charge variable interest rates at a spread pegged to either 30-day LIBOR (in the case of a non-purpose loan) or the broker call rate (in the case of a margin loan). Neither type of loan requires a fixed repayment schedule. Instead, interest is charged monthly and added to the loan balance.

In spite of these similarities, non-purpose loans are different from margin loans (and other conventional loans) in important ways. The primary difference is that a non-purpose loan may not be used to purchase or carry securities. Instead, these loans are often recommended to finance real estate transactions, buy automobiles or boats, or fund businesses. Brokers also recommend non-purpose loans to pay taxes,iv take a vacation, pay for a wedding, even to replace retirement account withdrawals in years when the equity markets are down.v

SBLs Are Highly Profitable
Substantial profit margins in the lending business make SBLs a lucrative product for broker-dealers. Last year alone Morgan Stanley and UBS earned a combined $4 billion in net interest income just by opening their doors for business. Brokers fund much of their operation by borrowing in the overnight repo market,vi where the Federal Funds Rate has been less than 0.15% for the past two years. See Figure 1. The difference between the Broker Call Rate and the Fed Funds Rate averaged 1.66% in 2003 and has grown to 1.93% in 2014 despite the dramatic decline in interest rates. Most loan customers are charged a variable interest rate pegged to a spread over LIBOR, allowing the broker to charge higher rates if its cost of funds increases.vii Spreads between the cost of funds and loan rates generally range from 200 basis points (for loans up to $10 million) to 500 basis points (for smaller loans),viii and the revenue is predictable and recurring.

Figure 1. Broker Call Rate and Fed Funds Rate

To market these loans, broker-dealers use advertising – disguised as client education – that is often misleading, one-sided, and not fairly balanced with disclosure of the risks associated with SBLs.ix UBS, for example, extols the wisdom of “borrowing with a vision for your future”,x and “maximizing the power of your invested assets.”xi Morgan Stanley portrays borrowing as a way to “unlock the value of [the customer’s] portfolio.”xii It claims that borrowing “puts the value of [the customer’s] assets to work.”xiii Merrill Lynch tells clients that borrowing money will “keep [their] investment strategy on track.”xiv After reading these characterizations of borrowing, a customer cannot not be blamed for concluding that he is imprudent if he is not borrowing against his portfolio.

Since adviser behavior is driven by personal financial considerations, broker-dealers offer meaningful incentives to their brokers for recommending SBLs. Morgan Stanley’s compensation plan is typical. The broker earns an annual gross commission of 0.40% to 0.50% of his clients’ loan balances outstanding. Morgan Stanley also pays its Financial Advisors based on growth in the volume of loans made to clients. For example, a broker who recommends $25 million in new loans is paid a cash bonus (deferred for only five years) of over $100,000. At UBS brokers are also paid based on the total value of the loans their clients have taken on. UBS even rewards secretaries suggesting SBLs as an alternative to customers who are calling to withdraw money from their accounts.

The suitability principle applies both to individual transactions and overall investment strategies.xv It requires that any recommendation, including the recommendation of an SBL,xvi be consistent with the interests of the customer.xvii Even if a customer wishes to take out an SBL, the broker may not make that recommendation if the loan would not be suitable. SBLs must be considered part of an investment strategy and subject to FINRA Rules 2090 and 2111. Investing with borrowed funds only makes sense if the expected returns net of the borrowing costs are sufficient to warrant the risks of the additional investments. For low risk, low return investments, SBLs give investors certain but negative returns. For higher risk, higher return investments, SBLs give investors small positive expected returns but expose them to substantial losses.

Central to the overwhelming case for diversification is the observation that competition among investors bids up the prices of securities so that the expected returns to portfolios of stocks and bonds exceed the risk free rate of interest by just enough to compensate for the risks of those portfolios. The expected return to making additional investments on margin, for investors who pay more than the risk free rate to buy securities, is therefore less than what the market requires for bearing those risks. For example, with risk free rates around 2% and the equity risk premium about 6%, if an investor borrows at 5% the expected net return is only 3% (2% + 6% - 5%) for bearing risk investors in the aggregate demand 6% net returns.

Leverage and borrowing costs are not the only suitability considerations associated with SBLs. Unlike home mortgages or car loans, which require the borrower to make a monthly payment, most SBLs simply add each month’s interest charge to the loan balance, thus compounding the interest expense.xviii In addition to the financial risks, SBL borrowers have no protection from actions taken by broker-dealers to preserve their collateral. Loan accounts are susceptible to forced liquidation at unfavorable prices because, as the value of the securities declines, the borrower must either deposit additional collateral (which he often does not have) or sell multiples of the amount of his margin call.xix Furthermore, the broker can effect these sales without contacting or seeking the permission of the borrower.xx The broker can even choose unilaterally which securities it wishes to sell. A customer with no means of meeting margin calls other than by selling the collateral is generally not suitable for an SBL.

When recommending an SBL, the broker must consider virtually all aspects of the clients financial condition: income, which would determine ability to service the debt; other assets, liquid and illiquid; other debt outstanding; and the client’s ability (and willingness) to tolerate the risks of an SBL.
    Several questions should be considered before a broker-dealer recommends an SBL:
    • How much debt (from all sources) does the client currently carry?
    • Will this loan create more debt than is justified by the client’s financial circumstances?
    • What are the client’s liquid assets, apart from the collateral securities? Does the client have sufficient liquidity to meet margin calls?
    • Is the additional risk created by the financial leverage suitable for the client?
    • Does the client understand all the risks of an SBL?
    • To what purpose is the loan being applied? Will the client have a means of repaying the loan?
    • Are asset sales a better alternative?
Non-purpose loans, by definition, are not invested in liquid securities. In fact, many non-purpose loans are not used to purchase assets of any kind; the funds are simply consumed by taxes, vacation costs, or similar consumption expenditures. This situation raises a major red flag for the recommending broker because it suggests the customer does not have the capacity to meet margin calls other than by liquidating the collateral securities. In those circumstances the broker would have a difficult time justifying as suitable the recommendation of a non-purpose loan because the borrower’s “financial ability to meet such a commitment”xxi is in doubt.

Securities-based lending presents some of the most serious conflicts of interest in the broker/client relationship. It puts brokers and RIAs, who are supposed to be investment professionals, in the position of recommending an action that often is detrimental to their clients’ long-term goals of wealth preservation and capital growth. Almost two-thirds of American households headed by someone age 55 or older are already in debt.xxii Debt is a drag on net worth and a lien on future income. Debt inhibits the client’s ability to accumulate retirement savings. Reducing debt, on the other hand, increases net worth and improves cash flow.

Each bull market develops its own excesses, thus planting the seeds for the next correction. Investors with already illiquid balance sheets are flocking to SBLs today in unprecedented numbers, due in no small part to the aggressive marketing of SBLs and the attractive financial incentives offered to brokers who recommend them. One way or another, however, these loans will eventually come due. For too many borrowers that due date will come near the bottom of the next bear market. These customers will be the last ones out, and the effects will be financially devastating.

iJoshua Brown, The Rise of Rich Man’s Subprime,, December 10, 2014.
iiRegulation T, §220.2.
iiiSee, FINRA Rule 4210(e)(7), “In a nonsecurities credit account, a member may extend and maintain nonpurpose credit to or for any customer without collateral or on any collateral whatever;” “The term ‘nonpurpose credit’ means an extension of credit other than ‘purpose credit’ as defined in Section 220.2 of Regulation T;” see also, Regulation T, §220.6.
ivSee for example Morgan Stanley, Tax Payment Strategies: Portfolio Loan Account.
vSee Investment News, The hazards of securities-based lending as a source of retirement income,February 11, 2015, Michael Crook, head of portfolio planning and research, UBS, says an SBL can be used in lieu of cash withdrawals as a source of retirement income.

viEric S. Rosengren, President & Chief Executive Officer, Federal Reserve Bank of Boston, Keynote Remarks: Conference on the Risks of Wholesale Funding, sponsored by the Federal Reserve Banks of Boston and New York (August 13, 2014), “Short-term collateralized loans called repurchase agreements are a major source of funding for [broker-dealers].”

viiPutting Stocks in Hock: Securities Are Backing for More Big Loans, Wall Street Journal, March 4, 2013, “Non-purpose loans, by contrast, can typically be completed in a few days requiring little paperwork beyond a credit report and a financial statement.” “Another big benefit: For wealthier investors, interest rates on non-purpose loans can be attractive compared with alternatives. At UBS, for instance, investors borrowing between $1 million and $2.5 million pay 2.95% based on the latest London interbank offered rate. By contrast, the national average rate for a home-equity line of credit is 5.15% and for a 30-year "private" jumbo mortgage it is 4.08%, according to, which tracks the data.”

viiiJames P. Gorman, Chairman and Chief Executive Officer, Morgan Stanley, Strategic Update, January 20, 2015, Morgan Stanley currently enjoys a 280 basis point spread between its cost of funds and its interest income. They believe that spread will increase to almost 400 basis points in 2015.

ixSee generally FINRA Rule 2210(d)(1)(A), Communications with the Public, Content Standards, “All member communications with the public shall be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service. No member may omit any material fact or qualification if the omission, in the light of the context of the material presented, would cause the communications to be misleading;” see also, Morgan Stanley publishes a 1600-word brochure, Securities-Based Lending: Portfolio Loan Account, that devotes only eight words to the risk of leverage in a portfolio: “market conditions can magnify any potential for loss;” see also, FINRA Regulatory and Examinations Priorities Letter (2015), FINRA “is concerned about how [SBLs] are marketed.”
x, January 13, 2015.
xiiMorgan Stanley, Securities-Based Lending: Portfolio Loan Account.
xivMerrill Lynch, LMA account.
xvThe concept of investment strategy “is to be interpreted broadly,” FINRA Rule 2111, Supplementary Material.
xviOffice of the Comptroller of the Currency, Comptroller’s Handbook, Retail Non-deposit Investment Products, January 2015, “Margin credit, however, is not suitable for all clients due to the associated risks and requirements with having margin in an account.”
xviiSee, for example, FINRA 2015 Regulatory and Exam Priorities Letter, “A central failing FINRA has observed is firms not putting customers’ interests first. This principle should be observed whether the firm “must meet a suitability or fiduciary standard.”
xviiiMerrill Lynch calls this feature “flexible repayment options,” Merrill Lynch, Loan Management Account.
xixSee FINRA, Investing with Borrowed Funds: No “Margin” for Error, “Investors who cannot satisfy margin calls can have large portions of their accounts liquidated under unfavorable market conditions. These liquidations can create substantial losses for investors.”
xxSee generally FINRA Margin Disclosure Statement.
xxiRule 2111.06.
xxiiCraig Copeland, Ph.D., Debt of the Elderly and Near Elderly, 1992-2013, Employee Benefit Research Institute.

Friday, June 19, 2015

Enforcement Actions: Week in Review


Swiss Trader to Pay $2.8 Million to Settle Insider Trading Charges
June 15, 2015 (Litigation Release No. 119)
The SEC alleges that Swiss trader Helmut Ansheringer bought stock and call options based on non-public information that AuthenTec, a company that provides fingerprint sensors and software, would be purchased by Apple Inc. AuthenTec’s public announcement that they would become a wholly-owned subsidiary of Apple led to a roughly 60% increase in their stock price, which garnered Ansheringer $1.8 million. Ansheringer has agreed, without admitting or denying wrongdoing, to pay $2.8 million to settle the charges.

Investment Advisory Firm’s Former President Charged With Stealing Client Funds
June 15, 2015 (Litigation Release No. 120)
Former president of SFX Financial Advisory Management Enterprises Brian J. Ourand has been charged for allegedly stealing $670,000 over five years from his clients’ accounts. SFX is an investment advisory firm based in Washington D.C. that specializes in providing financial services to current and former professional athletes. SFX and its CCO, Eugene S. Mason, have been charged separately and agreed to settle charges by paying $150,000 and $25,000, respectively.

SEC Announces Charges Against Retirement Plan Custodian in Connection With Ponzi Scheme
June 16, 2015 (Litigation Release No. 121)
The SEC has charged Ohio self-directed IRA provider Equity Trust Company for their involvement in selling fraudulent investments from Ephren Taylor and Randy Poulson. The SEC alleges that Equity Trust representatives attended events put on by Taylor and Poulson and encouraged attendees to move their retirement savings from traditional IRAs to self-directed IRAs at Equity Trust so that they could invest in Taylor and Poulson’s offerings. It is alleged that Equity Trust ignored red flags that these offerings were fraudulent. In March 2015 Taylor was sentenced to 20 years in prison for conducting a Ponzi scheme. Poulson was charged in May, also for conducting a Ponzi scheme.

SEC Charges Investment Adviser With Fraudulently Funneling Client Assets to Companies in Owner’s Interest
June 17, 2015 (Litigation Release No. 122)
Massachusetts investment advisory firm Interinvest Corporation and its owner, Hans Peter Black, have been charged for fraudulently investing clients’ funds into four Canadian penny stock companies that Black had undisclosed interests in. Black served on the board of directors of these companies, which have collectively paid $1.7 million to an entity owned by Black. The SEC alleges that Black’s clients have lost up to 70% of the $17 million that was invested in these companies. The SEC is pursuing a court order to freeze Interinvest’s assets and have them relinquish authority over their clients’ accounts.

SEC Announces Enforcement Action for Illegal Offering of Security-Based Swaps
June 17, 2015 (Litigation Release No. 123)
Silicon Valley company Sand Hill Exchange was subject to an SEC enforcement action because of their violation of Dodd-Frank provisions disallowing the offering of security-based swaps to non-eligible contract participants. Sand Hill offered, bought and sold these security based swaps for seven weeks on their website before the SEC detected the violation. The platform was shut down in compliance with the SEC’s order and Sand Hill has agreed to pay a $20,000 penalty.

SEC Charges Investment Adviser and Mutual Fund Board Members With Failures in Advisory Contract Approval Process
June 17, 2015 (Litigation Release No. 124)
Commonwealth Capital Management, majority owner John Pasco III, and former trustees J. Gordon McKinley III, Robert R. Burke and Franklin A. Trice III have agreed to settle the SEC’s charges without admitting or denying allegations for violations that include failure to satisfy the mutual fund advisory contract approval process. As majority owner, Pasco caused violations of the Investment Company Act of 1940 based on the incomplete and inaccurate information that was provided by Commonwealth Capital Management to two mutual fund boards. Pasco and the firms have agreed to settle the SEC’s charges which consists of a $50,000 penalty; the trustees have agreed to each pay penalties of $3,250.

SEC Charges 36 Firms for Fraudulent Municipal Bond Offerings
June 18, 2015 (Litigation Release No. 125)
The SEC has filed enforcement actions against 36 municipal bond underwriting firms over fraudulent municipal bond offerings. These are the first penalties under the Municipalities Continuing Disclosure Cooperation (MCDC) Initiative, the agency’s voluntary self-reporting program targeting inaccuracies in municipal bond offering documents. Between 2010 and 2014, the 36 firms violated federal law by providing inadequate due diligence and sold municipal bonds using inaccurate and false documentation. All of the firms have agreed to settle the charges without admitting or denying allegations. Under the MCDC terms, they will pay civil penalties under different circumstances that include the size of the fraudulent offerings and the size of the firm; the maximum penalty imposed is $500,000. To view the MCDC initiative, click here.

SEC Charges Microcap Oil Company, CEO, and Stock Promoter With Defrauding Investors
June 18, 2015 (Litigation Release No. 126)
The SEC has charged Norstra Energy, CEO Glen Landry, and stock promoter Eric Dany for falsifying information on Norstra Energy’s property, profitability and prospects. Norstra Energy, Landry, and Dany defrauded investors with misleading claims, promises and inaccurate information on the location of the property as well as the reserve estimates. The reserve estimates were exaggerated and claimed to have 8.5 billion barrels of oil with the wells having a 99 percent chance of profitability. In June 2013, the SEC suspended trading since the stock price increased nearly 600 percent in a three-month period after these false claims. The SEC seeks final judgements, and the SEC seeks to bar Landry from serving as an officer or director of a public company or participating in a penny stock offering.

Thursday, June 18, 2015

A Non-traded REIT Investor Fights Back

 Craig McCann

On June 5, 2105, I wrote that American Realty Capital’s latest listing of a non-traded REIT was further evidence of the harm caused by sponsors of non-traded REITs. I also pointed out that, contrary to the common pattern in non-traded REIT listings, Schorsch and ARC used their control of the non-traded REIT version of GNL to tie the hands of shareholders and management in the subsequent GNL traded REIT and to opportunistically transfer wealth to themselves. I pointed out that similar self-dealing was observed in ARC’s listing last year of NYRT. See “Nicolas Schorsch and American Realty Capital Lay Another Egg” available here.

See my prior NYRT posts: “NYRT’s Listing is More Evidence That Even the Non-Traded REITs Winners Are Losers” [April 17, 2014] available here and “How is NYRT Doing?” [May 9, 2014] available here.

This week a large investor in NYRT, Sorin Capital Management, wrote an open letter urging the NYRT board to sever ties to Schorsch and ARC. The letter is available here. Good luck to Sorin and other current investors undoing the harm done by Schorsch and ARC’s self-dealing. While Sorin may not have invested while NYRT was a non-traded REIT, NYRT management brought the worst of the non-traded REIT world forward past the April 2014 listing with it. It is no surprise at all that NYRT has underperformed its obvious peer SLG by 30% since NYRT listed.

This morning - perhaps in response to the Sorin letter – an advisory firm has proposed to replace the Schorsch controlled advisor on terms more favorable to NYRT shareholders. In early trading today, NYRT is up 8%. Pressure should now mount on the NYRT Board to start behaving like fiduciaries and putting investors first. This picture is a dramatic testament to how easy it would be for the Board to fix what ails NYRT.

The problems GNL and NYRT highlight are endemic in the non-traded REIT and DPP industry. These products wrap mundane investments in illiquid wrapper with enormous commission coupons attached to them. Unscrupulous brokers sell these awful investments to unsuspecting investors. My co-authors and I have determined that the non-traded REIT industry has transferred at least $45.5 billion in wealth from investors to sponsors and the brokerage industry. The first 41 non-traded REITs had cost investors $25.5 billion in lost wealth and 40 additional non-traded REITs which had updated their NAVs had cost investors another $20 billion in lost wealth. See “An Empirical Analysis of Non-Traded REITs” available here and “Fiduciary Duties and Non-traded REITs” available here .

Friday, June 12, 2015

Enforcement Actions: Week in Review


SEC Names Richard R. Best as Regional Director of Salt Lake Office
June 8, 2015 (Litigation Release No. 113)
Richard R. Best will be succeeding Karen Martinez as Regional Director of the SEC’s Salt Lake office. Mr. Best’s qualifications include: serving as senior director and chief counsel in the Department of Enforcement for FINRA in New York, holding other supervisory and investigative positions within FINRA’s Enforcement function, and having 10 years of experience as a prosecutor in the Office of the Bronx County District Attorney. Also, Mr. Best has a law degree from Howard University School of Law.

Agencies Issue Final Standards for Assessing Diversity Policies and Practices of Regulated Entities
June 9, 2015 (Litigation Release No. 114)
Collective standards for assessing diversity policies and practices have been issued from six federal agencies. In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the Federal Reserve Board, Consumer Financial Protection Bureau, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, and the Securities and Exchange Commission, and SEC each created an Office of Minority and Women Inclusion (OMWI), each of which developed standards for assessing the diversity policies of the entities their agencies regulate. These individual standards as well as extensive consultation led to the final joint standards. Click here to view the final interagency policy statement.

Trader to Pay $1 Million for Short Selling Violations
June 9, 2015 (Litigation Release No. 115)
Trader, Andrew L. Evans, has agreed to pay more than $1 million to settle SEC charges ($582,175 disgorgement, $63,424 prejudgment interest and a $364,389 penalty). Evans reportedly made $582,175 in illegal profits by short selling shares, violating Rule 105 which prohibits this sort of manipulative trading where issuers may raise significant capital from the attrition of pricing integrity. Evans has agreed to prohibit any future violation of Rule 105.

SEC Charges Biotech Employee, Two Stockbrokers With Insider Trading on Nonpublic Information About Pharmaceutical Trials and Merger
June 9, 2015 (Litigation Release No. 116)
The SEC has charged Michael J. Fefferman, Chad E. Wiegand, and Akis C. Eracleous for insider trading on nonpublic information about pharmaceutical trials and merger, violating the antifraud provisions of the federal securities laws. Senior director of information technology at Ardea Biosciences Inc, Fefferman, had given nonpublic information to his brother-in-law Wiegand who further passed on this information to his friend Eracleous, leading to approximately $530,000 in illegal profits. Wiegand and Eracleous will be barred from the securities industry, and both men will be facing criminal charges placed by the U.S. Attorney’s Office for the Southern District of California. All three men have agreed to settle SEC charges which are to be determined.

SEC Charges Phony Hedge Fund Manager With Theft of Money Invested by Small Businesses
June 10, 2015 (Litigation Release No. 117)
The SEC has placed fraud charges on Nicholas Lattanzio for misusing investor money by posing as a hedge fund manager, violating the Securities Act of 1933, Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. Lattanzio defrauded more than $4 million from small companies who believed that they would generate substantial returns by investing in his Black Diamond Capital Appreciation Fund. Instead, Lattanzio used the investor money for his lavish lifestyle, misusing investor funds for himself and his family by purchasing a million-dollar home, buying a luxurious car, paying off debt, and more. Also, Lattanzio has charges placed on him from the U.S. Attorney’s Office for the District of New Jersey as well as the New Jersey Bureau of Securities within the State Attorney General’s Division of Consumer Affairs.

SEC Publishes Request for Public Comment on Exchange-Traded Products
June 12, 2015 (Litigation Release No. 118)
The SEC is seeking public comments in order to assist in the evaluation on exchange-traded products (ETPs) which will help establish standards for listing new ETPs. There will be a 60 day open comment period to the public which will follow the publication of the comment request in the Federal Register. Click here to view the review the material for comment.

Friday, June 5, 2015

Enforcement Actions: Week in Review


Merrill Lynch Admits Using Inaccurate Data for Short Sale Orders, Agrees to $11 Million Settlement
June 1, 2015 (Litigation Release No. 105)
An SEC investigation found some of Merrill Lynch’s programs to execute short sale trades were using inaccurate and old data. Merrill Lynch and other broker-dealers are required to maintain an up to date easy-to-borrow (ETB) list composed of stocks that are readily accessible to borrow for short sale orders. Merrill Lynch appropriately removed stocks from their ETB list when access became restricted, but their execution platforms would continue processing short sale orders on these securities until the end of the day. The execution programs would not receive the updated ETB list until the beginning of the next trade day. Additionally, for a period leading up to 2012, Merrill Lynch’s platforms would occasionally access day-old data when constructing ETB lists. Merrill Lynch has admitted to wrongdoing, paid $11 million in penalties and disgorgement, and agreed to retain an independent compliance consultant.

SEC Charges Investment Adviser with Defrauding Retired Teachers
June 1, 2015 (Litigation Release No. 106)
The SEC charged Phil Donnahue Williamson with operating a Ponzi scheme through his investment fund Sterling Investment Fund. Williamson primarily targeted public sector retirees, such as teachers and law enforcement officials, who sought safe investments to preserve their retirement savings. Williamson advertised that his fund mostly invested in mortgages and real estate in Florida and Georgia and promised 8 to 12 percent annual returns. However, like other such Ponzi schemes, new investments deposits would often go to Williamson’s personal accounts or to pay returns to previous investors. Williamson has agreed to settle the case and will pay $748,050.01 in disgorgement.

SEC Charges Four with Insider Trading Ahead of Secondary Offerings
June 3, 2015 (Litigation Release No. 107)
A former day trader Steven Fishoff, his brother-in-law Steven Costantin, and his two friends Ronald Chernin and Paul Petrello, the later a former day trader himself, were charged with insider trading for stealing confidential information from investment banks and trading on that information. The group of four posed as portfolio managers to deceive investment banks into sharing confidential information about upcoming secondary offerings. They would then short sell the issuer’s stock, which would typically decrease following the public announcement of the secondary offering. Their scheme eventually included buying stocks prior to positive corporate announcements. The scheme involved 15 stocks and created $4.4 million in profits. The U.S. Attorney’s Office for the District of New Jersey also announced criminal charges against the four men.

SEC Warns of Purported Financial Professionals Using False Credentials to Attract Investors
June 3, 2015 (Litigation Release No. 108)
The SEC’s Office of Investor Education and Advocacy issued an investor alert cautioning investors to conduct proper background checks on people claiming to have impressive credentials or an impressive past performance record. Investors can check if someone is licensed and registered with the SEC, Financial Industry Regulatory Authority, or a state regulatory authority in the “Ask and Check” section of SEC’s website. The SEC announced two cases of fraud against investment advisers. The first against Michael G. Thomas of Oil City, Pa who claimed he was named a “Top 25 Rising Business Star” by Fortune Magazine, an award that does not exist, and misrepresented his past investment performance to promote his private fund Michael G. Investments LLC. Todd M. Schoenberger of Lewes, Del was also charged for fraud for soliciting investors to purchase promissory notes issued by his firm LandColt Capital LP. Schoenberger claimed he would repay the notes through fees he earned from managing his private fund. In reality, LandColt was not only not a registered advisory firm, Schoenberger never actually launched the fund or had any capital investments to the fund. Both Schoenberger and Thomas have settled their charges with the SEC.

SEC Staff Provides Additional Analysis Related to Proposed Pay Ratio Disclosure Rules
June 4, 2015 (Litigation Release No. 109)
The SEC released new analysis on its proposed rules on pay ratio disclosure, conducted by its Division of Economic and Risk Analysis (DERA). The rules, proposed by the commission back in 2013, required public companies to report the median compensation for all employees, the total annual compensation for the CEO, and the ratio of the median compensation for all employees to the annual compensation of the CEO. The analysis done by DERA considered the potential effects of excluding different percentages of employees from the pay ratio calculation. Employees that might be excluded from the calculation include employees in foreign countries and part-time or temporary workers.

SEC Freezes Profits from Scheme to Manipulate Avon Stock
June 4, 2015 (Litigation Release No. 110)
The SEC froze two U.S. brokerage accounts for connections to the manipulation schemes of Avon and other stocks. Last month, a false Avon tender offer was filed on the SEC’s EDGAR sytem by PTG Capital Partners Ltd to artificially boost the price of Avon’s stock. Strategic Capital Partners Muster Ltd and Strategic Wealth Investments Inc. each held one of the frozen brokerage accounts that profited off of Avon. The two accounts were also involved in a similar scheme in 2014 where a false press release on Tower Group International Ltd resulted in more than $20,000 in profits between the two accounts.

SEC Charges CSC and Former Executives with Accounting Fraud
June 5, 2015 (Litigation Release No. 111)
Computer Sciences Corporation (CSC) and former executives have been charged with accounting fraud for manipulating and concealing financial results from the company’s largest contract with United Kingdom’s National Health Service (NHS). The SEC alleges that the fraud began when the company learned it would lose money on its multi-billion dollar contract with NHS because it wouldn’t be able to hit certain deadlines. To avoid the large hit on earnings, financial executives allegedly altered accounting models to base profits on proposed amended contracts CSC sent NHS instead of the actual contract they already had. CSC was able to avoid reporting earning reductions in 2010 and 2011 even though these proposed contracted were rejected by NHS. To cover their tracks and meet their cash flow targets, CSC agreed in a prepayment arrangement with NHS where CSC would borrow large sums of money from NHS at a high interest rate. This prepayment arrangement was also concealed from investors. Five out of the eight former executives charged with fraud have settled. The other three, Robert Sutcliffe, Edward Parker, and Chris Edwards, are contesting the charges.

Daniel Gregus Named Associate Director for Broker-Dealer Exam Program in Chicago
June 5, 2015 (Litigation Release No. 112)
The SEC has named Daniel Gregus to be the Associate Director for the broker-dealer examination in the Chicago Regional Office. Gregus is a graduate of the University of Illinois College of Law where he graduated magna cum laude. He spent seven years in private practice before joining the SEC’s enforcement division in 1993. He joined the broker-dealer examination program in Chicago in 2007 and has been acting as the Associate Director since February 2014.

Nicolas Schorsch and American Realty Capital Lay Another Egg

GNL: American Realty Capital Lays Another Egg

On Tuesday, non-traded REIT American Realty Capital Global Trust Inc. - rechristened Global Net Lease, Inc. - began trading on the NYSE under the ticker GNL. GNL is at least the 42nd non-traded REIT to have listed, or merged into or been acquired by another REIT since 1997 and adds to the mounting wealth toll non-traded REITs have extracted from unsophisticated investors.

My co-authors and I have determined that the non-traded REIT industry has transferred at least $45.5 billion in wealth from investors to sponsors and the brokerage industry. The first 41 non-traded REITs had cost investors $25.5 billion in lost wealth and 40 additional non-traded REITs which had updated their NAVs had cost investors another $20 billion in lost wealth. (We will soon be updating this analysis with several additional non-traded REITs that have had liquidity events or updated NAVS.)

GNL Listing Illustrates Extraordinary Harm Done by Non-traded REITs

Global Net Lease raised $1.78 billion between October 1, 2012 and March 31, 2015 – most of it in the first six months of 2014. As of March 31, 2015 there were 179.6 million shares outstanding so investors paid, on average, $9.91 per share for GNL shares.

At the close of the first day of trading Tuesday, GNL shares were worth $9.32, giving investors a total value of $1.674 billion. Including the $114.7 million in distributions GNL had paid by March 31, 2015, investors received approximately $1.79 billion from their $1.78 billion investment. This is a gain of only $10 million, or 0.56%, over three years.

If instead of being sold GNL investors had put their $9.91 into Vanguard’s REIT Index fund (VGSIX) in the first six months of 2014 and took out the same amounts as GNL distributed, the VGSIX investment would have between worth $1.918 billion at Tuesday’s close. Investors in GNL are thus $244 million worse off than they would have been if they had been recommended liquid, diversified, low-cost REITs instead of the illiquid, undiversified, high-cost American Realty Capital Global Trust Inc. Figure 1 presents the value disparity graphically.

Figure 1. Total value of GNL investment vs same investment in VGSIX index fund

Non-Traded REITs Continue to Destroy Shareholder Wealth After Listing

The harm investors suffer from this newly listed REIT is unlikely to end Tuesday. Yesterday after three days of trading, GNL closed at $9.06. Investors who didn’t sell on June 2 lost $47 million over the next two days and now have lost on average $37 million as a result of investing in this non-traded REIT.

Concurrent with the NYSE listing, GNL entered into a new long-term contract with its Advisor (controlled by American Realty Capital executives). The new contract increases the Advisor’s conflicts of interest, and makes it harder for the REIT to fire the Advisor.

GNL’s move to strengthen its ties with its affiliated Advisor is contrary to most non-traded REITs. Normally, non-traded REITs internalize the advisory function at the time of a listing, thus severing relations with the Sponsor and slashing inflated expenses which had been paid to entities controlled by the Sponsor. Interestingly, New York REIT (NYSE: NYRT), another REIT recently listed by American Realty Capital, also chose to maintain its relationship with a conflicted Advisor rather than internalizing the advisory function. Since its listing on April 15, 2014, New York REIT has underperformed a comparably Manhattan-focused REIT by 30%, suggesting that failing to break ties with the Sponsor may cause poor future performance (see Figure 2). If so, the worst may be yet to come for GNL.

Figure 2. $100 investment in NYR and SLG: April 15, 2014 - June 3, 2014