“SEC Halts $155 Million Fraudulent Oil and Gas Offering Scheme”

“A real estate guru peddling the ‘deal of a lifetime’ was really a fraud, prosecutors say”

“SEC Charges Convicted Fraudster in Real Estate Ponzi Scheme”

These are just a few of the headlines in the press as of late. With the distress in the market resulting in tighter cash flow and capital calls (and in some cases losses such as the large Houston apartment portfolio foreclosure), passive investors are more likely to reach out to the Securities and Exchange Commission (SEC) to complain, i.e. such headlines are likely to be an even more frequent occurrence.

According to the Federal Trade commission, investment fraud was among the top five fraud categories and investment scam losses nearly doubled from $1.8 billion to $3.8 billon. The growth and development of Artificial Intelligence (AI) will make fraud even more difficult to spot in the future.

In my career I have been able to stop three fraudulent schemes. Based on my own experience, the signs of fraud are not always financial.

We will stay away from philosophical or psychological discussions on why such events may occur and re-occur. Instead in today’s quick snippet we will focus on what we can learn from such events, so one can apply these lessons and best efforts to spot such fraudulent schemes or financial scams.

1. Real people. Meet the sponsor and the operator. Ultimately you want to ensure you are doing real business with real people. Are they public figures and well known in their community and the industry? How long have they been in business? What is their overall reputation among other active investors, passive investors, and strategic partners such as attorneys, insurance brokers, lenders?

2. Real business. Visit the asset or have someone you trust do a drive by or walk the premises, if you are not local to the area. Sponsors may not always offer to have LPs tour the property during diligence due to seller constraints. However, you will at least have the address (to do a visit) and can then review the purchase and sale agreement or other offering documents to confirm they document the purchase of the subject asset, etc. Syndication investment are regulated by the SEC and documents and investment offerings are handled by licensed SEC attorneys, which serves as another checkpoint on this.

3. History of operations. How long the particular sponsors have or the group he/she is partnering with been in business? What is their track record?

4. Guaranteed or high returns over a short period of time. If something is too good to be true, it is probably not true or at a minimum comes with a higher level of risk. Real estate is a long term play. Especially in multifamily value add projects, it takes some time to turn the units (at least a year as most leases have 12-month terms). Some capex projects even take longer as realistically speaking, not all projects are completed at the same time for example. Noone can predict where the markets will be either. For example, no one could have foreseen that the Fed would raise rates 12 times in 15-18 months. All that to say that, that one should at least try to understand the drivers for such projections and immediate and high return guarantees.

5. Understand the underlying business model (especially for alternative investments where you are underwriting the operating business too vs. plain vanilla apartment). I was presented with a similar oil and gas investment opportunity, as the one in the article noted above. The risk profile and cash flow stream timing did not align with my own investment criteria, and so I passed. However, beyond that I also felt that I did not have sufficient understanding of the business model. As it was outside of my investment parameters, I did not peel the onion further. Unfortunately, as noted in the article, the operators kept raising money both directly with investors or via other sponsors who may or may not have taken the time to the peel the onion.

6. Perform background checks on the sponsor team. While doing that will not prevent future misdeeds, it at least provides a look back history.  For example, if anyone had looked up Bernie Madoff, they would likely not have found derogatory criminal history. In fact he passed three SEC audits before his Ponzi scheme was uncovered (it was uncovered during the market downturn, see a commonality here?). In the SEC fraudster article above, the sponsor was previously indicted in 2008 and had been just released out of jail in 2017. However, he operated under an alias and a different company name (see points #1-3 above).

7. Lack of transparency or transactions that are too complex to understand. The real estate guru article or my personal story of the oil and gas carbon recapture (see #5 above) are good example of that. The sponsor should be able to explain to you in simple terms how cash flow will be generated and what the associated risk is. If they are not sharing the requested information or if they become defensive or appear frustrated (or even agitated when you continue to press for the answer or to ask additional questions), these are red flags you may want to pay attention to.

8. Ponzi schemes where new investors feed current investors – e.g. Madoff or the two SEC articles above, which unfortunately are one of many examples. Such Ponzi schemes tend to do well in up markets and quickly crumble during a shock or a market downturn.

9. High pressure to move quickly and rush through the information skipping over details or leaving questions unanswered. While it is true that once a property is under contract, there is a limited amount of time to close and while in addition SEC regulations dictate when investment opportunities can be first shared with investors (which further compresses the timeline), there is usually a period of about thirty days give or take (depending on the deal) where investors have an opportunity to review the materials, ask questions, etc. If you feel too rushed to move (and without being provided with the information needed to make an investment decision), then you might want to wait for the next opportunity.

10. Third Party validation by other parties like CPAs, attorneys, lenders, insurance companies. Now, this is NOT always a guarantee of a clean slate (Ask me how I know!). However, it at least brings some comfort that various other (licensed) professionals have vetted the deal and/or the sponsor/sponsor group over a period of time.

Even with all these checkpoints unfortunately, one may still fall victim of fraud, especially when dealing with sophisticated criminals. Nevertheless ask the questions you feel and think you need to ask. Peel the onion. Look under the hood, if you can. And most importantly, trust your gut.

Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.

Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.