## Thursday, December 10, 2015

### Nicholas Schorsch Cheated Investors in Recent Nontraded REIT Mergers

By Craig McCann and Regina Meng

Roll-ups

Recently we posted More Non-traded REIT Perfidy: The Roll-up Grift available here.

To re-cap: Non-traded REITs are required by state securities regulators to include language in their bylaws which closely tracks the 2007 North American Securities Administrators Association’s Statement of Policy Regarding Real Estate Investment Trusts (available here).1

NASAA guidelines protect shareholders in REITs which have not been trading for at least 12 months before being rolled-up. The protections include the requirement for a contemporaneous independent appraisal of the nontraded REIT and the option for the nontraded REIT investors who vote against a proposed roll-up to receive their pro rata share of the appraised value in cash.

January 20, 2012, Mr. Schorsch Refines His Nontraded REIT Scam

American Realty Capital’s Nicholas Schorsch has been a pioneer in the nontraded REIT industry. On January 20, 2012, Mr. Schorsch signed six Certificates of Correction for all six of the nontraded REITs he controlled. The six Certificates of Correction can be downloaded by clicking on the hyperlinks below.

___________________________________
1 We have extensively researched non-traded REITs and concluded that these illiquid direct participation programs have cost investors $50 billion compared to more liquid investments in traded REITs. Our Fiduciary Duties and Non-traded REITs (available here) provides a good overview of the problems with non-traded REITs and a summary of our empirical results. An Empirical Analysis of Non-Traded REITs (available here) contains a more detailed explanation of our research. Our previous blog posts on individual non-traded REITs are available here. With each Certificate of Correction, a passage in an American Realty Capital nontraded REIT’s Corporate Charter which read as follows “ROLL-UP TRANSACTION” means a transaction involving the acquisition, merger, conversion or consolidation either directly or indirectly of the Company and the issuance of securities of a Roll-Up Entity to the holders of Common Shares. Such term does not include: (a) a transaction involving securities of the Company that have been for at least twelve (12) months listed on a national securities exchange; or… was changed to read “ROLL-UP TRANSACTION” means a transaction involving the acquisition, merger, conversion or consolidation either directly or indirectly of the Company and the issuance of securities of a Roll-Up Entity to the holders of Common Shares. Such term does not include: (a) a transaction involving securities of a company that have been for at least twelve (12) months listed on a national securities exchange; or… You can be forgiven for missing the change. Mr. Schorsch changed “the Company” to “a company”. With this innocuous form, intended to be used to fix typos and other drafting errors, Mr. Schorsch eliminated shareholder protections he promised to investors as they were being duped into buying his nontraded REITs. These Certificates of Correction were not immediately filed with the Securities and Exchange Commission as stand-alone documents attached to a Form 8-K where they might be noticed. Instead, they were referenced in exhibit lists at the end of four lengthy Form 10-K filings, one S-3 Registration Statement and one post-effective amendment to an S-11 Registration Statement, filed with the SEC, on average, 50 days after these highly consequential changes were made. Mr. Schorsch is a Trailblazer; Cole Capital and Others Followed more than a Year Later It took a while even for the other studied practitioners of the REIT grift to catch on to what a brilliant move Mr. Schorsch had made. A year later, on January 25, 2013 Cole Capital’s D. Kirk McAllaster, Jr. signed Certificates of Correction for all five Cole Capital nontraded REITs as their Executive Vice President, Chief Financial Officer and Treasurer which were virtually identical to the ones Mr. Schorsch signed a year earlier. The Certificates changed “the Corporation” to “a corporation” in the REITs’ Corporate Charters, eliminating shareholder protections required by NASAA as if he were correcting a typo. None of the five Cole Capital Certificates of Correction were filed as stand-alone documents attached to a Form 8-K. All were referenced in exhibit lists at the end of lengthy Form 10-K filings, filed with the Securities and Exchange Commission on average 50 days after the change was made. Four more nontraded REITs played the Certificate of Correction sleight of hand in March and May 2014. Nontraded REIT Investors Have Suffered Real Harm as a Result of Mr. Schorsch’s Abusive Innovation Seven of the nontraded REITs that “corrected” away shareholder protections were subsequently involved in a Roll-ups. American Realty Capital Trust III, Cole Corporate Income Trust, Cole Credit Property Trust II and Griffin-American Healthcare REIT II were acquired in stock or stock and cash mergers while still nontraded REITs. American Realty Capital Healthcare Trust, American Realty Capital Trust and Cole Real Estate Investments were acquired in stock or stock and cash mergers after they became listed REITs but before they had been listed for 12 months. If the Sponsors for these seven REITs had not eliminated the Roll-up protections they committed to as a condition for registering securities for sale with abusive Certificates of Correction, shareholders would have been entitled to have an independent appraisal of the REIT they owned. Also, nontraded REIT shareholders who voted “No” would be entitled to receive their pro rata share of the appraised value in cash if the merger went ahead. The problem with these seven mergers is not just that more of the consideration investors received would have been paid in cash rather than stock if the abusive Certificates of Correction had not been invoked. “Correcting” away the shareholder protections changed voting incentives. With the protections in place, a “No” vote would have given the voting shareholder the option to receive cash if the merger went forward. Without the protections, shareholders receive the same outcome regardless of how they vote. Shareholders thus have less of an incentive to vote “No” if the Sponsor eliminates the protections than if the protections are in place. Without the protections in place, the nontraded REIT shareholders might vote “Yes” because they prefer a less-than-equitable merger over no merger. However, that does not mean the shareholders would have voted the same way if the protections had allowed the shareholders the additional choice of an equitable cash merger. Mr. Schorsch’s Abusive Innovation Took$100 Million at the Further Expense of Duped Investors

Mr. Schorsch has reportedly become a billionaire organizing and selling nontraded REITs through the third-tier, independent broker dealer network to trusting, unsophisticated, often elderly investors. That would certainly have been enough for most, but Mr. Schorsch is no run-of-the-mill grifter.

It’s difficult to disentangle the web of affiliated entities controlled by Mr. Schorsch and figure out how much he took as a result of the questionable mergers identified above. The proxies for the mergers involving American Realty Capital Trust and American Realty Capital Trust III reflect that while Mr. Schorsch had only de minimus investment in these two REITs, Mr. Schorsch and AR Capital, a company he controlled, took at least $139 million out of the merger proceeds otherwise available to investors in the nontraded REITs. The proxy statement for the American Realty Capital Trust III merger (available here) shows on page 10 that the nontraded REIT’s advisor received approximately$59 million as a result of the merger. Page v names the advisor as American Realty Capital Advisors III, LLC, “wholly owned by AR Capital, LLC.” The proxy statement for the American Realty Capital Trust merger (available here) spells out Mr. Schorsch’s personal payoff even more clearly. On page 9, the proxy reports that Mr. Schorsch owned 63.6% of AR Capital, and thus received $40.2 million of a$63.2 million fee paid to AR Capital. Page 11 lists another $16.8 million Mr. Schorsch personally received because of the merger. You can download a PDF copy of this post suitable for printing or emailing by clicking here. ## Monday, December 7, 2015 ### More Impossible Trade Prices Caused by Auto-liquidators: Option Combinations By Craig McCann, PhD and Mike Yan, PhD In three previous blog posts, we documented how auto-liquidators execute option trades at distorted prices to their clients’ detriment. The price distortions are caused by the price impact of large sell or buy orders on thinly traded securities. These distortions were reversed within minutes, but not before causing investors millions of dollars of unnecessary losses. In “The Recent Market Turmoil Spells Trouble for Auto-liquidators like Interactive Brokers” (available here), we showed that thinly traded long-dated, deep out-of-the money SPX put options were bought on August 24, 2015 at implausibly high prices, purportedly to cure margin deficiencies. We showed the price of one SPX put option increased from$4 to as high as $83 in seconds as a result of auto-liquidation transactions after which the option price quickly dropped back to around$4. These auto-liquidation trades converted an account from a credit balance to a debit balance in seconds when a rational liquidation would have cured the margin deficiency and left the account equity intact.

In “More Signs of Trouble for Auto Liquidators” (available here), we explained how rational liquidations would have saved an auto-liquidated account using another stylized example from an account that was liquidated to a debit balance during the morning of August 24, 2015. We used prices of near expiration, at-the-money call options on Barclay’s VXX ETN linked to the VIX index with different strikes to demonstrate the harm caused by auto-liquidations that occurred while an investor was blocked from making trades in alternative strike prices within the same options class.

In “Only a Faulty Auto-liquidator Pays More for An Option Than it Can Ever Be Worth” (available here) we documented transactions executed by auto-liquidators which no informed, self-interested trader would execute, because the buyers paid more for a security now than it can ever be worth in the future. Our examples in that post were closing trades in short put options in which the buyers paid more than the put options’ strike prices. Since the put options’ payoffs at maturity will be received in the future and can never be more than the strike price, no one would pay a price greater than or equal to the put options’ strike prices.

In this post, we provide additional examples of transactions involving option strategies - combinations of options - at theoretically impossible prices.

Option Strategies

Option investors can trade several different options on the same underlying asset at the same time instead of buying or selling a single put or call option. For example, a calendar spread trade involves selling one option and buying another option on the same underlying asset with the same strike price but with a longer maturity.

Combining options on the same underlying asset with different maturities or strike prices is a common strategy to get some leveraged, but limited, exposure to the underlying asset’s returns. All component options in the option strategy are usually purchased at the same time. In fact, the option trader can submit a single order for certain option combinations specifying the maximum price he is willing to pay for the package and each component is executed simultaneously. There is no need to specify the price for the individual component. For example, Interactive Brokers illustrates how to search a spread strategy and bid the option strategy using its trading software . If the order is marketable, IB will fulfill the order no greater than the spread price specified. The order, which involves purchasing or selling several options is executed at the same time.

Figure 1: Interactive Brokers Spread Order Combo Selection

A bull call spread is a standardized option strategy, involving the purchase of a call option and the simultaneous sale of another call option with a higher strike price but otherwise identical. In Figure 2, we draw the final payoff of the bull call spread created by buying a call option with a $13 strike price and selling a call option with a$15 strike price.

___________________________________
1 https://www.interactivebrokers.com/en/index.php?f=610

Figure 2: Payoff of Bull Call Spread

At maturity, if the underlying price is below $13 both options expire worthless and the holder of this bull call spread receives nothing. If the underlying price closes between the strike prices, i.e., between$13 and $15 in our example, only the lower strike call option pays off and the holder of the bull call spread receives the amount by which the underlying asset closes above$13. If the underlying asset closes above the higher strike price, the holder receives the excess of the underlying asset’s closing price over $13 but gives up the excess of the underlying asset’s closing price over$15 – netting exactly $2 in our example. No investor would ever pay more for a put option than its strike price because that is the most the option will ever be worth. The same logic applies to option combinations like the bull call spread illustrated in Figure 2. Since that option combination can never pay more than$2 - and will often pay less than $2 - no trader will willing pay$2 or more for this option combination.

However, it appears that an auto-liquidator recently executed this option combination trade at theoretically impossible prices. We list simultaneous August 24, 2105 trades in VIX call options expiring on September 16, 2005 in Table 1. A $13 strike price call option was purchased for$15 and, simultaneously, a $15 strike price call option was purchased for$12.4. Somebody paid $2.6 for the call bull spread with a maximum payoff of$2 at maturity. Even though both prices fall within their national best bid and offering (“NBBO”), the price paid for this option combination was theoretically impossible.

The payoff of the bull put spread is similar to the payoff of the bull call spread. The bull put spread involves selling a put option and buying a put option with a lower strike price. Instead of paying a premium for the bull call spread, the buyer of the bull call spread receives a premium, the difference in the prices of the options that she purchased and sold. The maturity payoff to a bull put spread with $169 and$173 strike prices is plotted in Figure 3.
Bull put spreads, like bull call spreads, have higher payoffs when the underlying asset’s price is higher, rather than lower, at expiration. An investor with a bull put spread will have to payout between $0 and$4 if the price of the underlying asset closes between $169 and$173 when the option expires. If the underlying asset closes below $169, the investor pays out$4; if the underlying asset closes above $173, the investor pays out nothing. An investor with a bull put spread can close out this position by buying the higher strike price put option and selling the lower strike price put option. The maximum payoff to buying the higher strike price put option and selling the lower strike price put option is the difference in strike prices. The most an informed trader would be willing to pay to close out the bull put spread thus is the difference in strike prices. Figure 4: Payoff of Closing Bull Put Spread On August 21, 2015, a bull put spread trade on the SPDR Dow Jones Industrial Average ETF expiring that day was executed at a theoretically impossible price. The options’ strike prices were$169 and $173 so the spread’s maximum theoretical price was$4 but the spread trade was executed at $4.16 (i.e.$5.90 - \$1.74). See Table 2.