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Monthly Archives: February 2010

Credit Default Swaps: Dangerous And Thriving

Credit default swaps are blamed for instigating the nation’s financial crisis, helping to bring companies like American International Group (AIG) to its knees after it could no longer pay the many claims it owed on the swaps contracts. Nearly three years after the fact, credit default swaps and other complex derivative instruments are still a booming fixture on Wall Street and, unexplainably, largely untouched by financial reform efforts.

This irony is the subject of Gretchen Morgenson’s Feb. 28 column in the New York Times. In the article, she writes that Congressional reform plans for credit default swaps are “full of loopholes,” a fact that almost guarantees “that another derivatives-fueled financial crisis” is right around the corner.

According to the Bank for International Settlements, credit default swaps with a face value of $36 trillion were outstanding in the second quarter of 2009.

Morgenson’s article includes comments from Martin Mayer, a guest scholar at the Brookings Institution and a noted author on banking and finance-related issues. On the subject of credit default swaps, Martin says the following:

“Credit default swaps are a way to increase the leverage in the system, and the people who were doing it knew that they were doing something on the edge of fraudulent… They were not well-motivated.

Mayer’s criticism of credit default swaps dates back several years. On May 20, 1999, he penned an Op-Ed piece in the Wall Street Journal, titled The Dangers of Derivatives. Some of his selected comments include the following:

These over-the-counter derivatives – created, sold and serviced behind closed doors by consenting adults who don’t tell anybody what they’re doing – are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall. These instruments are creations of mathematics, and within its premises mathematics yields certainty. But in real life, as Justice Oliver Wendell Holmes wrote, “certainty generally is an illusion.” The derivatives dealers’ demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions. The more certain you are, the more risks you ignore; the bigger you are, the harder you will fall.

“Meanwhile the rules of this game – adopted and enforced by the world’s banking supervisors – further shrink what are already low time horizons in the financial markets. Measuring their positions every day through the algorithms of “value at risk” analysis, players must make constant adjustments of hedges and options to control the losses they may suffer from unanticipated volatility of market prices. In real markets, often enough, you can’t do that.

“The current [plat du jour] – the credit derivative – is the most dangerous instrument yet, and neither the risk controllers at the big banks nor the bank examiners seem to have any good ideas about how to handle it. A vehicle by which banks can swap loans with each other apparently gives everybody a win – banks can diversify their portfolios geographically and by category with the click of a mouse.

“But the system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries – their knowledge of their borrowers, and their incentive to police the status of the loan.

“When a loan is securitized, nobody has the credit watch. Researchers at the Federal Reserve Bank of New York concluded that in the presence of moral hazard – the likelihood that sloughing the bad loans into a swap will be profitable – the growth of a market for default risks could lead to bank insolvencies.”

Fast forward to 2008 and 2009 and Mayer’s predictions became reality. Morgenson contacted Mayer for her Feb. 28 column, asking for his thoughts on solutions to the problems that credit default swaps have produced. Among his recommendations:

  • Companies that trade in credit default swaps should be required to put up more capital to back them, Mayer says. That way, if a client asks for payment, the issuer actually has the funds available to make good on the payment.
  • Increased regulatory oversight of credit default swaps needs to become the rule, according to Mayer. In addition, he suggests that credit default swaps must be exchange-traded so that their risks are more transparent.

“The insistence that you mustn’t slow the pace of innovation is just childish,” Mayer said in the NYT’s article. “Innovation has now cost us $7 trillion,” a price tag that refers to the loss in household wealth resulting from the financial crisis. “That’s a pretty high price to pay for innovation.”

Two Virginia Insurance Agents Face Charges Over Promissory Notes

Two Virginia insurance agents – Julius Everett “Bud” Johnson and Walter Ray Reinhardt – face accusations by the Virginia State Corporation Commission (SCC) of misleading investors regarding $1.7 million in sales of promissory notes.

Last fall, the SCC ordered Johnson, Reinhardt and their companies to stop selling the notes for 120 days, alleging that they were illegal securities because neither the notes nor the sellers were registered with the state of Virginia. As for investors – many of whom were reportedly told that their money was guaranteed – they want answers.

“All I got was a runaround,” said James Kelley, a Chesterfield County, Virginia, man who invested $25,000 that was supposed to be repaid in January but wasn’t, according to a Feb. 3 article in the Richmond Times Dispatch.

Kelley said he went to speak with Johnson at his office, where he was told Johnson was out. When Kelley waited in the parking lot, however, he says he saw Johnson leave a few minutes later out of a back entrance of the building.

Gerald Crant is another investor who placed $100,000 with Johnson. He claims Johnson told him the promissory notes were insured by the Federal Deposit Insurance Corp. Now he’s worried because he hasn’t received his January interest payment.

According to the Times Dispatch article, Kelley says that Johnson told him he would get more information in the coming weeks, while Crant says he received a letter from Johnson’s lawyer stating that the slow economy was the reason he had to stop making interest payments.

The SCC, which regulates securities transactions in the state of Virginia, lists a litany of allegations against both Johnson and Reinhardt and the 12 companies they operate, including:

· Making material misrepresentations and material omissions;

· Failing to provide financial disclosures;

· Failing to provide investment-risk disclosures;

· Failing to provide a litigation or compliance disciplinary disclosure;

· Failing to disclose that the securities offered were not registered; and

· Falsely stating that the securities were exempt from registration.

In addition, the SCC’s records accuse Johnson and his companies of operating as a fraud. The allegations include issuing corporate promissory notes for one issuer then transferring the money to another entity and using new investors’ money to pay interest to previous investors – something typically associated with a Ponzi scheme.

In September 2009, SCC records show that Johnson and Reinhardt stated they had sold $1.7 million of notes to 38 Virginians, and that the notes were private offerings and complied with federal regulations. A senior investigator with the SCC says he found documents showing Johnson guaranteed $3.2 million of the companies’ debt, while Johnson declared he did not know the outstanding balance on the notes.

The companies that the SCC cites as those operated by Johnson are: Benefit Contract Administrators, MHC Linen Service LLC, River City Cleaners LLC, Roberts Awning Restoration and Renewal LLC (formerly known as Roberts Awning LLC).

Other defendants in the case include Benefit Contract Administrators LLC, Mid Atlantic Insurance Agencies, LivingWell Healthcare of Virginia LLC, Everett Awnings doing business as Roberts Awnings, and FIC Financial Group.

Reinhardt operates three businesses: First Fidelity Financial of Richmond LLC, Commonwealth Assurity LLC and Capital Investor Group.

Reinhardt is accused of selling illegal securities between 2005 and now. He also is accused of operating as the broker-dealer in offerings and selling the illegal promissory notes of Benefit Contract Administrators, MHC Linen Service, River City Cleaners, Mid Atlantic Insurance Agencies, LivingWell Healthcare of Virginia, Roberts Awning Restoration and Renewal and FIC Financial Group.

As an aside, if the securities in the Johnson and Reinhardt case had been registered, investors might have learned some important information about the people and companies behind their investments. Specifically, Reinhardt had previously been barred twice from selling securities in North Carolina.

If you suffered investment losses in connection to either Julius Everett Johnson or Walter Ray Reinhardt, contact us to tell your story.

Behringer Harvard REIT, Risky Investments for Investors

Investors turned to the Behringer Harvard REIT for safe investing, but are now stuck holding essentially worthless positions.

In an attempt to avoid the risk of investing in the stock market, some investors chose real estate investment trusts (REITs). REITs are specialized entities that own or manage income-producing real estate. They are established to avoid corporate taxes, allowing pass-through taxation to the investors.

Financial advisors have recommended people invest a substantial portion of their nest egg in REITs, representing them as safe and conservative investments for retirement. The advisors may not disclose the REITs underlying financial condition and the risks of the investment becoming illiquid. One such example is the Behringer Harvard REIT I. This REIT never made any money and is now completely illiquid, thereby preventing investors from selling their positions. The REIT was sold to inexperienced and conservative investors, who are now stuck holding essentially worthless positions.

Failure to disclose these and other potential risks to investors could be violation of Securities laws and could also lead to a host of other viable legal claims, such as breach of fiduciary duty.

If you have suffered investment losses from REITs, contact us to tell us your story. We want to counsel you on your options.

Pacific Cornerstone, Former CEO Latest To Face Disciplinary Actions Over Private Placements

News of private placement deals run amuck keeps coming. The latest concerns private placement offerings – also known as Regulation Ds – involving Pacific Cornerstone Capital and former CEO Terry Roussel. The two were fined $750,000 in December by the Financial Industry Regulatory Authority (FINRA) for making misleading statements and, in some instances, omitting facts in connection to sales of two private placement deals: Cornerstone Industrial Properties LLC and CIP Leveraged Fund Advisors LLC.

FINRA also charged Pacific Cornerstone and Roussel with advertising violations and supervisory failures.

Cornerstone Industrial Properties and CIP Leveraged Fund Advisors were affiliated businesses of California-based Pacific Cornerstone. Pacific Cornerstone’s largest single shareholder happens to be Roussel.

According to FINRA, Pacific Cornerstone sold private placements in Cornerstone Industrial Properties and CIP Leveraged Fund Advisors via offering documents and accompanying sales literature that contained targets as to when investors would receive the return of their principal investment and the yield on their investment.

The offering documents included statements that the affiliated entities targeted returns of principal in two to four years and targeted an unrealistic yield on a $100,000 investment in excess of 18%. The alleged actions took place from 2004 to 2009.

In total, investors placed more than $50 million into the two deals. FINRA has not stated how much, if any, of clients’ money may be missing.

Over the five-year period in question, FINRA says that Roussel told investors that all was well with their investments. In addition, he periodically sent letters to investors that portrayed a positive yet unrealistic outlook for their investments. The letters also failed to include required risk disclosures, as well as a complete financial picture of Cornerstone Industrial Properties and CIP Leveraged Fund Advisors.

Maddox Hargett & Caruso is investigating ongoing complaints by investors who sustained losses in private placement offerings related to Medical Capital Holdings, Provident Asset Management LLC and Pacific Cornerstone Capital. If you’ve suffered financial losses in any of these investments, contact us to tell your story.

Securities America Up In Arms Over Medical Capital Allegations

Securities America has fired off an angry letter to the Massachusetts Securities Division over its lawsuit against the broker/dealer for allegedly misleading investors who bought high-risk private placements in Medical Capital Holdings. The story was first reported Feb. 17 by Investments News.

According to the article, Securities America is outraged by the charges and contends Massachusetts regulators don’t understand the workings of private placements and Regulation D offerings.

The complaint that Securities America is referencing accuses the broker/dealer of misleading investors who bought nearly $700 million of private placements issued by Medical Capital from 400 Securities America representatives. The Massachusetts lawsuit also alleges that between 2003 and 2008, a group of Securities America executives repeatedly failed to heed the warning of an outside due-diligence analyst regarding the risks of the Medical Capital investments.

In July 2009, the Securities and Exchange Commission (SEC) charged Medical Capital with securities fraud. A number of lawsuits and arbitration claims have since been filed by investors who allege that various securities firms, including Securities America, failed to disclose the risks associated with the investments. As for Medical Capital, it currently is in receivership.

Reverse Convertibles Demolish More Investors’ Portfolios

Investments in reverse convertibles are proving disastrous for more investors, many of whom are retirees and were allegedly misinformed about the products from their broker/dealers. In January and February, the Financial Industry Regulatory Authority (FINRA) took action, issuing a regulatory notice to members about the ways in which reverse convertibles are marketed and sold to retail investors.

Specifically, FINRA reiterated to firms that their registered representatives must perform due diligence when it comes to explaining features and full extent of risks associated with reverse convertibles to investors. FINRA also cautioned that broker/dealers must ensure that an adequate suitability analysis is performed before the products are recommended to clients.

Reverse convertibles are short-term bonds connected to stocks. Once the notes mature – their terms generally last from three months to a year – investors get their principal back. On the downside, if the underlying stocks fall to a certain threshold – usually 20% down – investors get the depressed stocks instead of their full principal.

Hundreds of thousands of investors found this out the hard way in 2008 and 2009 as stocks fell to record lows. Nonetheless, Wall Street continues to push reverse convertibles much to the detriment of investors who may not be fully aware of what they’re buying.

Lawrence Batlan is one of those investors. The 85-year-old retiree suffered a loss of almost 20%, according to a June 19, 2009, story on reverse convertibles in the Wall Street Journal. The article says that Batlan’s broker talked him into moving out of preferred stocks in 2007 and buying $400,000 of exotic securities, which supposedly offered higher interest and safety.

In Batlan’s case, the reverse convertibles were linked to four well known stocks, paying between 6.25% and 13% when the yearly yield on 10-year Treasurys was around 5%. Then everything changed, and the bear market took hold. The share prices for the underlying stocks that Batlan’s reverse convertibles were linked to fell below the 20% threshold. As a result, Batlan found himself out $75,000.

“I had no idea this could happen,” says Batlan in the article. He has since filed a complaint with FINRA in an attempt to recover his losses.

Harvey Goodfriend, 77, also was quoted in the Wall Street Journal story. Goodfriend says he was never told about the risks of reverse convertibles. He ended up losing 36% of the almost $250,000 that his Stifel Nicolaus & Co. broker placed into reverse convertibles two years ago.

For years, critics of reverse convertibles have cautioned that the complexity of the products make them unsuitable investments for most retail investors. As it turns out, those words are ringing loud and clear for a growing number of investors who’ve lost their nest eggs to reverse convertibles.

If you’ve suffered investment losses in reverse convertibles because a broker/dealer failed to disclose specific details about the products, contact us.

Oren Eugene Sullivan: Keeping Track Of Bad Brokers

Oren Eugene Sullivan is the disgraced South Carolina broker who recently pled guilty to mail fraud in connection to a multimillion dollar, decades-long Ponzi scheme. In January, Sullivan admitted in federal court that from 1995 through 2008 he ran the Ponzi scheme, selling fake investments to individuals and groups of investors, according to the U.S. Attorney’s Office in South Carolina.

So why does the Web site of the Certified Financial Planner Board of Standards still list Sullivan as a CFP in good standing, with no public disciplinary history? It’s a question that was first raised in a Feb. 14 article in Investment News.

As the story aptly points out, designating authorities are finding it more and more difficult to keep up with the bad deeds and misconduct of financial representatives like Sullivan.

Monitoring conduct is an arduous and difficult task. The CFA Institute, which says that 85% of its investigations begin as a result of self-disclosures and 10% from news reports and regulatory Web sites, has two investigators who monitor professional conduct. Most of that work is primarily done via the Internet, according to the Investment News article.

Other designation groups follow similar investigative routes, as well as perform internal investigations before deciding upon punishment. The process, however, can be a lengthy one, ranging from several weeks to a year or more.

Case in point: Oren Eugene Sullivan.

Records with the Financial Industry Regulatory Authority (FINRA) state that Sullivan sold clients nearly $4 million of fake promissory notes between 1995 and 2008. He repaid about $1.5 million before getting caught by authorities. In August 2009, Sullivan was barred by FINRA. In January 2010, he pled guilty to one fraud charge and faces a maximum of 20 years in prison and a fine of $250,000.

Somehow Sullivan’s actions didn’t mar his CFP designation with the CFP Board, however. Investment News did note that the CFP Board was aware of the allegations against Sullivan, but wouldn’t confirm whether they were actually investigating him.

Main Street Natural Gas Bonds: Did Brokerages Disclose Risks?

Main Street Natural Gas Bonds

The September 2008 bankruptcy filing of Lehman Brothers Holdings is unlikely to fade from the memory of investors anytime soon. That’s because the bankruptcy had a ripple effect on other investments tied to Lehman, including investments in Main Street Natural Gas Bonds.

Main Street Natural Gas Bonds were marketed and sold by many Wall Street brokerages as safe, conservative municipal bonds. Instead, the bonds were complex derivative securities backed by Lehman Brothers. When Lehman filed for bankruptcy protection in September 2008, the trading values of the Main Street Bonds plummeted.

Many investors who put their money in Main Street Natural Gas Bonds allege that the brokers in question never disclosed all of the risks associated with the bonds nor did they reveal the fact that the bonds were connected to the financial health of Lehman Brothers.

If you were sold Main Street Natural Gas Bonds as a safe, low-risk investment, you may have a viable claim for recovery. Please contact our firm to tell us your story.

Leveraged And Inverse ETFs Not For The Uninformed

Leveraged and inverse ETFs have found themselves under the regulatory microscope recently, which makes it all the more interesting that ProShares has decided to launch eight new exchange-traded funds that aim to magnify their benchmark exposures by 300%. The story was first reported Feb. 12 by Investment News

Leveraged and inverse ETFs try to achieve a return that is a “multiple” of the inverse performance of the underlying index. For Proshares’ new series of ETFs, that means the funds seek a +300% or -300% return of their indices for a single day before fees and expenses. 

In the summer of 2009, several investors initiated lawsuits and arbitration claims involving the Ultra ProShares Funds and UltraShort ProShares Funds. Specifically, investors accuse ProShares of issuing “false and misleading registration statements, prospectuses and additional information” in connection to the funds. As a result of the alleged false promotion of the products, many investors suffered enormous losses. 

In June, the Financial Industry Regulatory Authority (FINRA) issued a statement on leveraged and inverse ETFs, reminding broker/dealers that the products “typically were unsuitable for retail investors” who hold them longer than a single day. FINRA later restated its position, saying that member firms could recommend leveraged and inverse ETFs to retail investors provided that the broker/dealer conducted a suitability assessment of the investor and the ETF itself. 

Massachusetts Secretary of State William Galvin also has taken up the issue of leveraged and inverse ETFs. In July 2009, Galvin began an investigation of the sales materials of companies that sold the funds. The state later sent letter to three ETF leaders – ProShares, Direxion Funds and Rydex Investments. 

The bottom line: Leveraged and inverse ETFs are not for everyone. These types of ETFs provide leverage on a daily basis. Above all, leveraged and inverse ETFs are not a save-and-hold investment – a fact that many retail investors were woefully unaware of. 

Inland American REITs Unsuitable For Some Investors

Sales of Inland American REITs have produced a firestorm of financial headaches for investors, many of whom were sold on the products based on inappropriate recommendations from broker/dealers. Investments such as the Inland American Real Estate Trust and the Inland Western Retail Real Estate Trust are non-traded, or unlisted, REITs – financial products that have come under increasingly scrutiny lately because of the potential risks they may carry.

Non-traded REITs are not listed on a stock exchange, and investor redemptions are usually limited to a specified time frame. Most important, non-traded REITs can be pricey to get into, with fees as high as 15%.

In conversations with several investors, Maddox Hargett & Caruso has learned that many individuals who invested in non-traded REITs, including the Inland American Real Estate Trust and the Inland Western Retail Real Estate Trust, were ill-informed by their broker/dealer of the high fees, illiquidity and other risks tied to the products. If you suffered investment losses in either of these REITs or another non-traded REIT, contact us to tell your story. 


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