I have seen it from the inside. When the SEC believes that it has identified an ongoing investment fraud it spares no effort to gather evidence to find out whether those suspicions are correct and, if so, to get into Court seeking an order to shut down the alleged fraud and freeze assets that might otherwise find their way out of the country or into the pockets of people and organizations who have agreed to hold them for the accused. The SEC took such an action last week, halting what it believes to be an ongoing fraud in several St. Louis-based private investment funds. According to the SEC’s press release:
The Securities and Exchange Commission today announced that it has filed charges and obtained emergency relief, including an asset freeze and the appointment of a receiver, against several St. Louis, Missouri private investment funds and management companies. The SEC alleges that Burton Douglas Morriss, the principal of these entities, misappropriated over $9 million of investor assets.
The SEC alleges that Morriss told investors that his private investment funds and management companies would invest their money in a portfolio of financial services and technology companies. However, investors were unaware that for the past several years, Morriss had been misappropriating their money to the tune of millions of dollars through a series of fraudulent transfers to himself and another entity he controlled. To conceal his fraud, Morriss later disguised these fraudulent transfers as personal loans.
According to the SEC’s complaint filed in federal court in St. Louis, Missouri, at various times between approximately 2003 and 2011, Morriss, his two private investment funds, MIC VII, LLC and Acartha Technology Partners, LP, and his management firms, Gryphon Investments III, LLC and Acartha Group, LLC, raised at least $88 million from at least 97 investors to invest in preferred shares or membership interests in the defendant entities. The defendants represented to investors that the investment funds would invest in early to mid-stage companies in the financial services and technology sectors.
The SEC alleges that unbeknownst to investors, for the past several years, Morriss has misappropriated investor funds through transfers from his companies to himself and another entity he controlled, Morriss Holdings, LLC, to pay for personal expenses, including, mortgage and alimony payments, payment of personal loans, pleasure trips, and household expenses. In an attempt to conceal his scheme, the fraudulent transfers that Morriss made to himself were recorded as “loans” on the defendant entities’ books. In fact, these transfers were never truly loans because Morriss did not intend to repay them at the time of his misappropriation. Moreover, the funds transferred to Morriss for his personal use were inconsistent with the disclosures contained in the offering materials provided to investors.
The SEC’s complaint also alleges that Morriss concocted a scheme to recruit new investors to purchase membership interests in one of his private investment funds without the unanimous consent of existing investors, as required. This diluted the investments of the fund’s existing investors.
Without taking a position on whether the SEC’s allegations in this case are correct, emergency enforcement actions like this one are important. They stop an alleged ongoing scam from collecting more victims and more assets. The scam that the SEC shuts down today cannot defraud anyone else tomorrow. Those who argue against increasing the resources available to the SEC, therefore, are advocating for putting investors at increased risk.
But there are other things that the SEC and other securities regulators do not do as well. Think of it this way: is there any crime in your city? Muggings, murders, rapes, burglaries, car theft, drug crimes, or jaywalking? Of course. Does that mean that the local cops are incompetent? Of course not. What it means is that, while law enforcement can deter law-abiding people from committing crime, it cannot stop all crime before it happens. The best that it can do in most cases is to solve crimes and bring the perpetrators to justice. It is the same with the SEC and the state regulators who are so important to the regulatory framework. Those who ask the SEC to answer for the epidemic of investment fraud that has already begun to spread across the investing landscape misunderstand the role of the investment cops.
Who then can protect investors from fraud? Ideally the investment professionals who accept compensation in exchange for giving investment advice. I have spoken to many groups of such investment professionals and most of them willingly accept the role of protector of their clients’ assets. They understand that it is one of the many things that a reasonable client should be able to expect of his or her adviser. Does your adviser accept this role? If not, are you equipped to do the job yourself? While it might bring you some measure of satisfaction to see the person who spent your hard earned nest egg behind bars, it pales in comparison to being able to enjoy what you worked so hard to earn and save.
Pat, I think I agree but help me understand the practical implications please. Say an investment professional says they accept this role. How would you know this not just blah blah? Are there any observable indicators that you think have value? Thanks Raj
Dear Raj:
Thank you for the comment. It’s a good, practical question. From doing this for more than two decades I can tell you that skepticism implicit in your question is well-founded. When advisers do insufficient due diligence and lead their clients into a fraud, they defend by saying “you read the PPM and are a sophisticated investor. You knew what you were getting into.” It is a callous, cynical defense, but it sometimes works with arbitrators who don’t fully understand that suitability and due diligence are separate issues.
I think one change to current practice would make things much better on this score and allow folks to have some comfort around this issue. The duty to conduct a thorough due diligence investigation through independent sources should be written into the investment advisory agreement. I would also include a sentence stating that the client will rely, and is entitled to rely, upon the sufficiency of the adviser’s due diligence investigation. If an adviser will not include that language in the agreement, you know that his or her promises of protection are hollow.
An adviser who puts that language into the agreement knows that due diligence will be an issue in the event of any dispute. He or she, therefore, is more likely to do the kind of investigation that can protect both the client and the adviser from the nightmare of learning too late that the investment is not as it was represented. He or she also is more likely to have adequate E&O insurance to cover a mistake.
Of course, the gold standard for investigation involves getting an independent investigation. With most alternative investments, the adviser receives a due diligence fee. I have yet to find an adviser who actually uses that money for investigation. They usually just put it in their pockets or use it to buy a plane ticket to visit the offices of the issuer (not an independent source). An adviser with a written duty to perform a thorough investigation will be more likely to use that money as intended.
In a series of videos we’ve got coming on YouTube in the next few weeks, we encourage people to memorialize verbal assurances in a letter sent to the adviser. Something along these lines:
“Dear Adviser:
We discussed due diligence. You agreed to protect me from fraud, and from investments that are misrepresented in the offering materials, by performing a thorough due diligence investigation through independent sources on each unregistered investment you recommend. This will confirm that I am relying on you to do this.
If I have misconstrued your assurances about due diligence, please tell me so in writing right away. Your promise to protect me this way was a material factor in deciding to entrust my money to you. If I am mistaken about your promise, please stop all action in my account. I will be moving my money to an adviser who is willing to protect me.”
Bottom line, Raj, if they aren’t willing to put it in writing, they won’t take due diligence seriously enough.
Thanks again for the fantastic question.
Peace,
Pat
PS: Have you seen The Vigilant Investor on the shelves in the UK? I know that it is for sale on amazon/uk, but I can’t track sales over there.