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 Brad Updike, a Mick energy-sector specialist, reviewed each of the
23 deals, known as private placements. In one of his reports, Updike
wrote that while on a visit to the Dallas, Texas, company,
Provident's founder "showed me several strategic-planning maps"
where efforts were under way to drill and complete wells.
In a subsequent 2008 report, Updike said he wanted more information:
"We would like to see audited financial statements or alternatively
a report from an independent accounting firm that validates the
information reported by Provident." Even so, Updike concluded that,
based on the information Provident provided, the deal could allow
investors "diversification within their natural resource
portfolios."
Last year, in federal district court in Plano, Texas, Provident
founder Brendan Coughlin and three other former principals were
convicted of fraud related to the 23 oil and gas deals. The men were
fined and received prison sentences of varying lengths for, among
other things, using money from more recent investors in Provident's
projects to pay earlier investors, according to the U.S. Justice
Department. In effect, Provident was operating a Ponzi scheme.
Bryan Mick, the 49-year-old lawyer who heads the Omaha, Nebraska,
firm that bears his name, said it isn't his job to catch frauds. He
added that alerting regulators to any red flags raised in his
reports would violate attorney-client privilege.
"If people out there that are raising capital from investors have
larceny in their hearts, they'll find ways to defraud people,
notwithstanding my best efforts," Mick told Reuters in a December
interview.
He's right about his limited duties as a watchdog. Mick's firm and
other third-party due diligence providers for private placements
aren't covered by any regulatory regime that would require them to
report suspicious activity to regulators, law enforcement officials
or investors.
SCANT REGULATION
Private placements are a form of fund-raising whereby a company
issues securities — shares, bonds, promissory notes and the like — to relatively few investors through private sales by broker-dealers,
rather than through a general offering on a public exchange. Under
U.S. law, these issues are exempted from the extensive financial
reporting requirements that govern public offerings. One aim is to
make it easier for small businesses to raise capital by selling
securities or investment pools like Provident's.
In this corner of the investing world, oversight is light and risks
are high. Issuers of private placements provide only basic
information to the U.S. Securities and Exchange Commission, such as
the issuer's address and the amount of money raised.
The Financial Industry Regulatory Authority, the industry's
self-regulating body, requires that broker-dealers conduct "a
reasonable investigation" of a private placement before selling it
for the issuer. That's the due diligence. At a minimum, FINRA
requires that for each new placement, the broker's investigation
entail a review of the issuer and its management; its business
prospects; assets it holds or plans to acquire; the intended use of
proceeds from the offering; and claims made in any offering
documents.
Some brokers lack the resources to cover all of that, so they rely
on reports supplied by third-party due diligence firms. The reports
are paid for by the issuer of the private placement. Brokers are
meant to use the reports to help them decide whether to market the
placements. They don't typically show the reports to clients.
The set-up constitutes what many see as a fundamental conflict of
interest: Companies that raise money through private placements,
such as Provident, are paying due diligence firms to review their
deals so that broker-dealers will sell them. "They have to write
these reports in such a manner that it's gotta be acceptable" to the
issuer, said Michael Miller, a due diligence officer at Sigma
Financial, a broker-dealer in Ann Arbor, Michigan.
"The point of due diligence is that it is supposed to be
independent," said Barbara Roper, director of investor protection at
the Consumer Federation of America, a nonprofit advocacy group. "If
the due diligence provider is paid by the issuer, that independence
is called into question."
Under FINRA guidelines, the broker-dealer is responsible for
identifying and resolving any shortcomings in a report it relies on
from a third-party due diligence provider. That may include pursuing
documentation from the issuer that the due diligence firm didn't
obtain. Failure to do so can lead to disciplinary action against a
broker-dealer, as it did for many in the wake of the Provident case.
"FINRA remains focused on the due diligence requirements that firms
have, whether conducted by the broker-dealer or provided by an
outside third party," said FINRA spokeswoman Nancy Condon. "Areas of
concern with third-party reports include whether the reports are
independent and whether reasonable due diligence is conducted." She
confirmed that FINRA does not have jurisdiction over third-party due
diligence providers.
A spokesman for the SEC declined to comment on the third-party due
diligence business, beyond noting that it does not fall under the
agency's purview. The Consumer Financial Protection Bureau declined
to comment.
Shamoil Shipchandler, the prosecutor who handled the Provident case
in Texas federal court, said Mick & Associates reports "were used to
lend legitimacy to the fraud. … The ‘something else' that
corroborates the claim that the investors are going to make a lot of
money was those outside reports." But, he said, the due diligence
firm wasn't party to fraud. The law firm, unlike Provident, "didn't
intend for the investors to lose money," he said. That still leaves
open the question of whether the firm "should have done better due
diligence."
REALITY GAP
The discrepancy between professional assessments by due diligence
providers and the sometimes fraudulent reality has been repeated in
scores of private placements in recent years.
Mick & Associates is the largest provider of these reviews. Reuters
independently examined five of the Mick reports on Provident deals,
including four offerings made in the year before Provident's
collapse. In none of the five reports did Mick & Associates
recommend to broker-dealers that they not sell the placements to
clients.
Mick and other employees at his firm noted that some of their
reports concluded with "negative" assessments of the deals. But they
did not point to any reports showing an explicit warning to
broker-dealers not to sell a deal. Typically, their "negative"
reports ended with the statement that they "cannot unqualifiedly
recommend" the investment.
Mick has delivered reports on about 200 deals from Provident and
other companies later exposed as frauds, out of a total of nearly
2,000 reports the firm said it has written.
No one collects data on the frequency of fraud among private
placements. The number of such deals overall has been rising,
tracking the performance of the stock market. The SEC said it
received roughly 18,000 proposals for private placements in 2012,
compared with slightly fewer than 14,000 in 2009. These deals had a
median amount raised of $1.5 million.
Now, the Jumpstart Our Business Startups Act of 2012 is making it
easier for private placements to reach more investors.
Until recently, private placements could be marketed only through
broker-dealers. But that's changing under the JOBS Act, which is
intended to help small U.S. businesses raise money and thus boost
hiring. The act contains a provision that, since September last
year, has allowed issuers of private placements to advertise deals
on TV, the Internet and other media. That means they can pitch
directly to the smaller, less-sophisticated investors most likely to
fall prey to fraud.
"You're expanding the universe of who's going to be affected," said
Joseph Borg, director of the Alabama Securities Commission and a
member of the board of the North American Securities Administrators
Association. "If the private placements become more prolific, then I
think there has to be more scrutiny on them."
In addition to Mick, three other firms dominate the business.
Buttonwood Investment Services, in Littleton, Colorado, examined
many of the same private placements Mick did. Buttonwood founder
Dana Woodbury said his firm's Provident reports were so negative
that Provident never distributed them to brokers. Buttonwood
declined to provide Reuters with copies of the reports.
Another leading provider is FactRight, in Schaumburg, Illinois.
FactRight's senior vice president in charge of due diligence, Chari
Aweidah, said she wasn't aware that the firm had issued any reports
on any fraudulent deals described in this article. Officials at
Buttonwood and FactRight, both of which are consultants rather than
law firms, said they would notify regulators if they found hard
evidence of fraud.
The fourth major due diligence provider is law firm Snyder Kearney,
in Columbia, Maryland. Its founder, Tom Snyder, declined to comment
for this article. He said attorney-client privilege prevented him
from talking about deals his firm reviewed. Snyder Kearney announced
in early March that its principals and many employees would join RCS
Capital Corp of New York to create a new research business.
'SCRUBBING' DEALS
In a squat, glass-fronted building on the western edge of Omaha,
lawyers and other employees of Mick & Associates analyze
private-placement proposals to determine whether investors stand a
chance to make money on them. The analysts use paid databases and
internet searches to delve into the histories and activities of
clients. They call the process "scrubbing the deal."
Many Mick & Associates assessments don't gloss over causes for
concern. But they typically stop short of recommending that
broker-dealers not sell the deals to investors. Instead, the reports
often hold out optimism that the issuing company will address the
concerns raised by the due diligence.
"My approach … is to try to push sponsors to do things, to
renegotiate structures when I get a chance to try to, you know,
structure deals and change the economics when I can to try to
enhance the investment for the ultimate retail investor," Mick said
in October 2010, in testimony to Massachusetts securities
regulators.
Updike, the firm's energy specialist, told Reuters that about half
the private placements he reviews are "this kind of mediocre …
B-minus to C-minus type product.… But if they do x, y and z and they
maybe clean up their balance sheet and they get rid of some
leverage, maybe they can get into that good category in two years."
According to a presentation Updike recently prepared, his firm has
reviewed about 250 energy investment deals offered by roughly 80
separate investment companies over the past eight years. Updike
rejected 20 of those proposals as unfit for investors. None of the
rejections were for Provident deals.
In a subsequent email response to questions from Reuters, Updike
said that based on what he knows now about Provident, he would,
among other things, "have given less emphasis to the potential
upside of the investment plan and demanded unconditional financial
reporting transparency from day one."
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Issuers of private placements pay Mick & Associates up front. But
issuers do get a chance to see the reports before they are
published. In at least one case, Mick & Associates changed the
investment recommendation in a report to a more favorable one after
the investment company's principals saw it. Later, that company
collapsed in a case of fraud.
That was DBSI Inc, a real estate investment company in Meridian,
Idaho. Between 2003 and 2008, DBSI raised $1 billion from investors
in private placements of notes that it said would return as much as
7 percent a year on commercial property. In November 2008, DBSI told
investors it was suspending payments to them. Soon after, it
declared bankruptcy.
Gary Bringhurst, DBSI's chief operating officer, pleaded guilty in
April last year to conspiracy to commit securities fraud and began
cooperating with investigators. Four others, including DBSI's
co-founders, are awaiting sentencing after each was found guilty in
federal district court in Boise, Idaho, last week on 44 counts of
securities fraud.
SUBTLE CHANGE
Joshua Hochberg, the appointed examiner in DBSI's bankruptcy in
Delaware court, wrote in his 2009 report on the case: "Some e-mail
communications evidence a familiar working relationship between
Bryan Mick and DBSI personnel." Hochberg described a February 1,
2008, draft report on a DBSI offering that Mick showed to the DBSI
principals before publication. The report, Hochberg wrote, "includes
the concluding statement that Mick ‘cannot unqualifiedly recommend
approval' of the offering. Handwritten notes on a copy of this
report from bracketed that statement and wrote the word ‘Negative.'
"
By the time the report was distributed to brokers, according to
Hochberg, "the statement that Mick cannot unqualifiedly recommend
approval was replaced with a qualified recommendation."
According to Hochberg's report, by the time DBSI went bankrupt in
2008, it had paid Mick $1.4 million for due diligence work.
Mick declined to explain why he changed the report. He said he
doesn't allow issuers to suggest changes to his reports.
DBSI's principals declined to comment.
Buttonwood, one of the other due diligence firms, also came in for
criticism from Hochberg for its DBSI work. Buttonwood's reports, he
wrote, did not indicate that the firm "engaged in any considerable
effort to verify or audit the information provided by DBSI."
Woodbury, Buttonwood's founder, said the examiner's finding didn't
take into account his firm's first report on DBSI. That was a
"sponsor report," which focuses on the business as a whole, rather
than a particular deal. "We could not confirm a master lease list;
we could not confirm whether funds were commingled or not," Woodbury
said. "That was a concern that we listed in our sponsor report."
Reuters was unable to confirm the contents of the sponsor report.
Mick told Reuters that it was impossible to detect the fraud at DBSI.
No one could have seen it without the help of forensic accounting,
he said.
Nothing prevents due diligence firms from performing a forensic
analysis of a client's deal, if the issuer agrees to submit to one.
It is not the industry norm.
In its report on the DBSI 2008 Notes Corp private placement, one of
DBSI's last issues before it collapsed, Mick & Associates did raise
questions about the structure of the deal. The firm noted that DBSI
planned to use almost half of the money raised to pay down debt owed
to affiliates of the company.
The conclusion begins with similar warnings, and then wraps up with:
"Other than as may be expressed above, we have no further concerns
with the offering but can recommend approval of the same only upon
the prospective recommendation that Note investors understand the
financial conduction of and allocation of Note proceeds to the
operating technology companies discussed herewith."
THE INFLATION FACTOR
Wording like that illustrates what critics say is the problem with
many due diligence reports: Potentially alarming findings are often
obscured in multiple pages of recondite language, with no definitive
conclusions. "They're these long-winded things that bury things that
might be important inside boilerplate disclosures," said Jennifer
Johnson, a professor at Lewis & Clark Law School in Portland,
Oregon, who has written extensively about the private-placement
business.
Due diligence firms say their reports aren't designed to be read or
understood by investors. Rather, they are meant to help brokers
decide whether to recommend private placements to their customers.
"Individual investors are not without guidance," Buttonwood founder
Woodbury said.
Issuers of private placements are allowed to raise money from
institutions and "accredited investors." These are defined under
U.S. law as individuals with a net worth of more than $1 million,
not including their primary residence, or an annual salary of
$200,000 or more.
Consumer advocates point out that those defining parameters haven't
changed since 1982. Adjusted for inflation, according to the Bureau
of Labor Statistics, the same minimally qualified accredited
investor today would have a net worth of at least $2.4 million or
annual income of $487,000 or higher.
As a result, many people who qualify today aren't necessarily
sophisticated investors. Some are retirees — small-business owners
who have sold out, or professionals who saved for decades — with no
experience in high-risk investing.
And brokers don't always check to ensure that their clients meet
even the minimum standards. James Despot, a California nurse, lost
about $150,000 of his savings in an oil and gas deal five years ago
issued by Provident, the Dallas-based Ponzi scheme. Despot never did
qualify as an accredited investor, according to his lawyer, who said
Despot's broker never checked. The broker did not respond to
requests for comment.
Despot, now 65, said his broker assured him he would be building up
his savings with low-risk Provident private placements that other
clients were snapping up. Despot said he put money into Provident
"to feel like you weren't doing the wrong thing, when all these
other people are doing this and that."
Despot never saw the Mick & Associates report on the Provident deal
his broker sold him. It was about 60 pages long, single-spaced. Many
of its paragraphs were stuffed with lists of numbers. It included
sentences like this: "At that time, the company's liabilities were
reported as $5.06 million, substantially all of which was
attributable to inter-company payables." Elsewhere, the report
provided slightly more clarity on that point: "It is difficult to
appropriately discern the actual asset and liability positions due
to the presence of inter-company transactions that need to be
adjusted."
Updike's conclusion suggested that Provident "develop financial
statements that are more transparent and user-friendly to
broker-dealers and interested parties." But he balanced his warnings
with positive points about the company's leadership and its
increasing experience in the field of gas well operations. He noted
that he "would generally view Provident's prior experience in
dealing with key industry stakeholders … as a positive development."
SLEW OF BANKRUPTCIES
The broker-dealer firm that sold Despot the investment was
Omaha-based QA3 Financial. It went out of business three years ago
along with a slew of others. They were wiped out by litigation costs
associated with selling investment products from Provident and a
company called Medical Capital Holdings.
That Tustin, California, business for six years claimed it was
raising money from investors to buy discounted medical debt. MedCap,
as it was known, turned out to be a Ponzi scheme, too. By the time
it collapsed in 2009, MedCap had collected $2 billion from 20,000
individual investors. Joseph J. Lampariello, former president,
pleaded guilty to wire fraud in May 2012 and faces up to 21 years in
federal prison. He is scheduled to be sentenced in December.
Buttonwood co-founder Woodbury said his firm's reports on MedCap
were "so negative" that "none of the broker-dealers taking
Buttonwood's reports, to Buttonwood's knowledge, signed any selling
group agreements" to market the investments for MedCap.
Reuters could not verify Woodbury's account.
Mick & Associates reviewed MedCap deals, too. Johnson, the Lewis &
Clark Law School professor, has read many of Mick's reports on
MedCap. In general, she said, they "put a whole bunch of risk
factors in but never say 'don't do it.' "
The conclusion to Mick's August 8, 2005, report on a MedCap issue
called Medical Provider Financial Corporation III begins with this
statement: "MCH is very experienced in the medical receivables
factoring business and has contractually performed under its various
securitized financing vehicles."
The rest of the section strikes a more cautious note. It advises
broker-dealers to require from MedCap "monthly distribution checks
or other regular communication," such as monthly reports on
collateral levels for outstanding loans. The report warns that no
investor should "concentrate a material amount of an income-oriented
portfolio to this investment." And it suggests that brokers show the
report to their customers to ensure they understand the risks
involved.
Mick said his firm "had grave concerns that were expressed several
times" about MedCap.
Trustees of the Provident and DBSI bankruptcies sued Mick &
Associates and Mick himself to recover money paid by the schemers
for due diligence reports. The trustees argued that Mick aided and
abetted Provident and DBSI in their breaches of fiduciary duty to
investors by failing to adequately warn brokers to avoid the deals.
Updike said his firm recently settled with the Provident trustees;
terms weren't disclosed.
Mick described the lawsuits as "specious" and said the trustees in
both cases "are more abusive than the failed business plans of the
sponsors."
In the December interview, he said: "You cannot approach this
industry as, ‘Everybody out here's a guarantor, and if somebody
loses money, it's somebody else's fault.' That's a problem we have
in this country."
(Edited by John Blanton)
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