Friday, December 18, 2015

What is a Boiler Room?

A boiler room is typically a makeshift brokerage office that involves an aggressive sales team offering unsuspecting customers securities of certain issuers in large volume by telephone or direct mail. Generally, under this selling system, the sales team disregards the needs, suitability and financial situation of customers and coerces them to make hasty decisions to buy securities in an incredibly short timespan without disclosing material information about the issuer. 

In some cases, the sales team makes unreasonably high commissions on sales. This commission information is often undisclosed too.

Trailers from a couple of movies about boiler rooms can be watched below:

Boiler Room [R] (2000) via Wikipedia 

The Wolf of Wall Street [R] (2013) via Wikipedia

Thursday, December 17, 2015

What is a Ponzi Scheme?

A Ponzi scheme is a fraudulent investment system where an individual, firm or company takes investment funds from a round of new investors and uses those funds, instead of profit from the business, to pay a "return" on the investment funds provided by an earlier group of investors. 

You may have heard of this type of activity in a common expression: "robbing Peter to pay Paul."

To keep an operation like this going, the Ponzi scheme perpetrator must continually raise investment money to keep paying returns to earlier investors. Eventually, the schemes collapses when payments can no longer be maintained.

In some situations, Ponzi schemes begin as legitimate businesses and revert to fraudulent activity when promised returns cannot be achieved. 

Notable Ponzi Schemes

Tuesday, December 1, 2015

How to Find Critical Legal Entity Details Behind Your Investment Opportunities

Man Reading Business Newspaper

Every investment scheme comes with warning signs. Sure, those signs may be, and probably are, subtle at times, but they're there. 

The key to discovering potential investment schemes is knowing where to look. 

Today, I'm going to show you an area that may unlock some critical facts behind investment opportunities pitched your way. 

In a previous post, I talked about finding the legal entity details behind the issuers and brokerage firms offering and/or selling you securities.

Related Story

Former Edward Jones Broker Used Investor Funds to Renovate His House

Summary: Former broker uses shell company to misappropriate investor funds.

What are legal entity details?

Legal entity details can vary from state to state, but the following are the most common details that appear in state records:
  • members/governing persons, 
  • registration filing date, 
  • entity status, 
  • principal place of business,
  • registered agent and office and 
  • legal jurisdiction.
I'll go into these details and how to find them for your investment opportunities, but first, let's back up to a quick explanation about legal entities. 

What's a legal entity?

In the U.S, there are a handful of legal entities available. The most common legal entities are:
  • Profit Corporations (denoted by Inc., Co., Ltd., corporation, limited or incorporated)
    • Example: Google Inc.
  • Limited Liability Companies (denoted by LLC)
    • Example: Storyville Coffee Company LLC
  • Limited Partnerships (denoted by LP or L.P.)
    • Example: KKR & Co. L.P.
  • Limited Liability Partnerships (denoted by LLP)
    • Example: PricewaterhouseCoopers LLP
  • Sole Proprietorships (trade name registration only)
    • Example: Joe Smith doing business as Joe's Plumbing
With the exception of sole proprietorships, legal entities are state-formed "bodies" that have many of the same benefits a real person (as opposed to a corporate person, which is another phrase for legal entity) has when transacting business.  They can sue, be sued, enter into contracts, have bank accounts, own other businesses and more. 

A couple of the advantages of legal entities include a mix of tax benefits and asset protection for members, partners or shareholders. On the downside, legal entities can be expensive to maintain and require a significant amount of administrative work to maintain. 

Legal entity details are the details that are recorded for the legal entities described above.

Related Story

A Description of Legal Entities in Under 5 Minutes [via Whizkins]

Summary: A brief overview of common U.S. legal entities.

Why should legal entity details matter to an investor?

Legal entity details provide additional information that may not be included in your offering materials - information that should play a part in your overall assessment of your investment opportunity. 


If an issuer claims to be a subsidiary of a well-known, reputable company, you can verify this information by reviewing the legal entity details of the issuer to see if there is, in fact, a link to the claimed parent company.  A parent-subsidiary question like this could be solved by looking at the legal entity's members/partners/officers

1. Governing Persons/ Corporate Officers

Most state legal entity filings, such as a certificate of incorporation, articles of organization or certificate of authority, require the entity's management to be identified.  Management includes corporate officers, members, managers or partners, and for most states, management names will be listed in the legal entity details. (See Figures 1 and 2 below for Google Inc. management.)

As an investor, knowing who will be investing or managing your funds is integral to fully understanding if management is capable of achieving the returns you demand from your investment. Ideally, you'll want someone with a lot of experience and a history of success. Right? The only way to find that out is to dig into their backgrounds.

Related Story

Are Green Businesses the New Trend in Securities Fraud?

Summary: Real estate professional decides to become a private fund manager without any experience managing private funds.

Using the management names you find in the legal entity details, you can discover more their backgrounds:
  • Have they filed for bankruptcy?
  • Have they been convicted of crimes?
  • Do they have a social media presence?
  • Are there any liens on their assets?
  • Have they been in the news for anything unsavory? 
While researching the background of issuers and brokers sounds like a no-brainer, the amount of SEC actions I continue to read against repeat offenders who use their close personal networks to raise funds is staggering. 

No matter how much you "trust" someone, you should still invoke some professional skepticism before investing your money. 

Bonus Tip: When my clients or friends are faced with a level of awkwardness in asking for more information from a close acquaintance with an investment opportunity, my suggestion is to always ask anyway and blame the questions and cynicism on his/her attorney or an unnamed business partner.

Management Details Example 

I pulled up the corporate officers for the Google Inc. entity registered with Washington (Figure 1 below) and North Carolina (Figure 2 below). 
Figure 1 - Google Inc. Governing Persons
Here's how Google Inc.'s corporate officers look in the record books for the State of North Carolina: 
Figure 2 - Google Inc. Officers - North Carolina Registration
When you run your own search for legal entity details, you should also receive a list of individuals for your online searching pleasure.

Some states, such as Delaware, don't include management information, which, as a filer, could be beneficial if you prefer not to have your name and address publicly available. (See Figure 3 below.)  As an investor, however, the absence of this information can be annoying when researching businesses.  Fortunately, other states undo this protection by requiring filers to list their management information when applying for a certificate to transact business within their state boundaries. 
Figure 3 - Google Inc. - Delaware Registration
2. Existence of a Legal Entity

Whether a legal entity exists behind your investment opportunity is a simple legal entity detail, but it's important because when you find that information out, you'll know whose neck is on the chopping block in the event something goes wrong. 

Existence of Legal Entity Example

Let's compare fictional investment fund names Homewood Investment Fund III and Homewood Investment Fund III LLC.  

If the former isn't registered as a trade name for an actual registered legal entity (i.e. Patriot Investment Fund III LLC doing business as Patriot Investment Fund III), it would appear that the name Patriot Investment Fund III alone represents an individual or group of individuals collecting money on a whim. For me, not having a legal entity for a risky business would seem very unprofessional (which isn't what you want when you're handing over savings!), and I would ask more questions to understand why there isn't a registered legal entity.

As an attorney, I would specifically question why individuals soliciting investment money to be managed by a general partnership or sole proprietorship would be willing to accept so much risk by foregoing a legal entity that could provide liability protection. Under these circumstances, however, risk could be mitigated with insurance.  If that's the case, I would want to have details around, and probably a copy of, that insurance policy.

3. Registration Filing Date

Imagine two businesses in your state email you about an investment opportunity on November 23, 2015. 

Using the tips in this post, you find out the legal entity details behind each opportunity. 

One business says it registered with the state on November 23, 1971 and has always been an active entity since then. The other says it registered with the state on October 15, 2015. 

Between the two, which one raises a red flag? 

While not always indicative of something wrong afoot, the legal entity with the shorter life raises a red flag for me. It's a red flag because some investment schemes involve quickly (i) forming legal entities to look legitimate on the surface, (ii) soliciting funds, (iii) spending funds and (iv) moving on to another legal entity. 

For some of these schemes, the legal entities have short lives. While looking into other facts about an investment opportunity, I would wonder if this legal entity is one of those "fund and dump" arrangements too. To get some comfort, I would ask questions about prior funds and/or experience and an understanding on why the legal entity was only recently started.

(Ed. note: A lot of legitimate, successful investment funds have short lives on purpose, mainly because the investment plan calls for a short fund life.)

The short life of the legal entity would also cause me concern because it hasn't been around long enough to prove itself.  Again, comfort can be obtained by asking questions about the business, investment plan, experience, etc. 

4. Entity Status

Even when you find legal entity details, they won't be much help to you unless the legal entity is "active" with the state where its formed and/or authorized to transact business.  
Figure 4 - Active v. Inactive Status
An active status means the legal entity's governing body is regularly updating its information with the state and paying the appropriate fees.  To confirm the status of a legal entity, you can order a certificate of status/certificate of good standing or certificate of authority for the state when the entity is registered..

The last thing you want to have is an agreement signed by a legal entity that is considered inactive and/or dissolved. The inactive status would mean that legal entity is not authorized to transact business, and in effect, does not exist.  If there is indeed fraud involved, the court system would probably clear up an agreement described above, but you don't want to spend time and money going down this road. Plus, by the time the case was done, the money you invested would probably be long gone.

Note: For some states, you may have to pay additional fees in the range of $10.00 to $25.00 to obtain an official state certificate of good standing or even its status. 

5. Contact Information / Principal Place of Business

Imagine your investment starts to miss interest payments. You reach out to the issuer or broker, but you find the contact information they provided you is no good. Now what?

All isn't lost just yet.

Many states require legal entity filings to include an office address for the principal place of business. See Figure 5 below.
Google Inc - NC Corporation Search
Figure 5 - Google Inc., North Carolina Secretary of State Records
Not only do you have additional contact information through the legal entity details, but you can use the addresses identified in the record to determine if you're trusting someone who is working in a tiny operation from a house/apt. or as part of larger company from an office building. 

Using the Principal Office Address in Figure 5 above, we can see that Google Inc. has a sizable office in Mountain View, CA.
Figure 6 - Google Inc. 1600 Amphitheatre Parkway
If you do a similar Google Maps search on an issuer or broker, and the legal entity's principal office address shows an apartment complex in a questionable neighborhood, or another location that leaves you scratching your head, you'll want to get more answers. 

Bonus Tip: If you start digging around, and you're still not 100% sure about the address you've found in the details. You can cross-check that address with real property tax records to confirm who owns the parcel of land attached to the address. I've provided an example below using 800 S. Mint Street, Charlotte, NC 28202, which is better known as Bank of America Stadium. 
Bank of America Stadium Property Records
Figure 7 - 800 S. Mint Street, Charlotte, NC 28202
5. Registered Agent and Office

Looking back at Figure 5 above, you'll see Google Inc. has a Registered Agent address. The purpose of a registered agent is to receive official information from the state, such as a notice of dissolution or notice of an initiation of a lawsuit against the legal entity. Every state requires registered agent information for all legal entities filed under its laws. 

Registered Agent Example

Google Inc. is frequently under fire for privacy violations and has been sued for these violations. If you were to file a lawsuit against Google, the notice of your lawsuit would be delivered to Google's registered agent in the state where you filed your lawsuit. This registered agent has agreed to be the recipient of notices on behalf of Google. Once received by the registered agent, it will forward the notice of a lawsuit to its customer, i.e., Google Inc. 

The way registered agents work is that notice to the registered agent is notice to Google Inc. Having notice work this way in states is beneficial to plaintiffs because it prevents a defendant from claiming no notice received.  If defendants could claim no notice or avoid receiving notice by providing fake addresses, your lawsuit could be open for years, which would mean legal recourse for a wrong done to you could either take years to be decided or never happen. 

As a result, if a potential defendant has an active registered agent that has been paid on time and informed of a current address, the registered agent will forward notices to the defendant. Unanswered notices, even if the defendant never receives them, could result in a default judgment (i.e., an automatic judicial decision in favor of the plaintiff) against the defendant. 

Some business owners act as registered agents and put home addresses and temporary addresses as the registered agent address. This practice is legal to do.  Be weary of businesses with a home address as a registered address, however. If the address belongs to a business owner who is temporarily occupying that location, the owner could get up and move after successfully pulling off a scheme, making tracking difficult.  Some states offer protection under these circumstances by acting as registered agent on behalf of the defendant, whether they want to or not.

Overall, the idea with the registered agent is to provide you and a state a way to contact the business with official notices.

6. State of Incorporation/Legal Jurisdiction

State of Incorporation/legal jurisdiction information is important because for some legal entities, you may have to verify a certificate of authority (explained below) and a certificate of incorporation to ensure all legal entity information is active. 
Figure 8 - State of Incorporation/Legal Jurisdiction
State of Incorporation Example

Figure 8 above is a snippet from Washington Secretary of States records and shows Google Inc.'s state of incorporation is "Delaware."  You can think of Delaware as home base for Google Inc., and Delaware law will address many of the corporate legal questions, such as shareholders' rights, M&A activities, etc., that come up within Google Inc. Because Google Inc. formed under Delaware law, it is identified in Delaware records as a "domestic" corporation. (See Figure 9 below. Note "Domestic" listed next to "Residency.")

So you might be asking, "if Google Inc incorporated in Delaware, why did it register with Washington?" 

There's a lengthy legal answer to this question, but the basic answer is that Google Inc. does enough business within Washington that it felt it needed to get a certificate of authority, which authorizes Google Inc. to transact business within the state, from the state. 

To obtain a certificate of authority, Google Inc. must file an application with Washington and register under Washington laws as a "foreign" legal entity.  The term "foreign" used here relates only to where the legal entity was formed relative to where the legal entity is transacting business.  For example, Google Inc. was formed under Delaware law, making it a domestic corporation in Delaware's records, but it applied for a Certificate of Authority under Washington law as a foreign corporation.    
Figure 9 - Delaware - Google Entity Details 

Overall Legitimacy

All of these legal entity details help paint a picture of legitimacy of the issuer/broker asking for your money. Although these legal entity details can be fake or out-of-date, states do not let details remain incorrect.  Failure to update records and pay filing fees will result in the state dissolving the stale legal entity. 

Now that we've talked about legal entity details, let me show you how to find them.

How do you find the legal entity details behind your investment opportunity?

Find out the full legal name of the issuer or broker. This can be as simple as going through offering materials or asking the issuer or broker. If you're asking a broker, be sure to ask for the broker's information as well as the issuer's. 

Let's work through an example of researching this information by using a well-known company.

Legal Entity Search Example

Imagine you're back in 1999, and this unknown, California-based company called Google comes to you with an opportunity to invest in a search engine. (For simplicity, let's assume you're an accredited investor who lives in California.)

Curious about the opportunity, you ask for, and receive, offering materials to review. 

Embedded in the materials is contact information that says Google Inc., 1600 Amphitheatre Parkway, Mountain View, CA. 

Although you assume Google Inc.'s principal place of business is in California, you want to confirm that location, its authorization to do business in the State of California and other details.

Step 1 - Locate Secretary of State Search and Enter Business Name

To confirm your thoughts about Google Inc., you visit the California Secretary of State website. (Note: You can perform this search on any state corporate division website.)

Below I have the California Secretary of State corporation search feature. I went ahead and typed in "Google" and selected "corporation name" as the type. We know it's a corporation because of "Inc." in the offering materials.
California Secretary of State Search Example - Google
Figure 10 - California Secretary of State Search
Step 2 - Select the Most Appropriate Business Name

Our "Google" search in California Secretary of State records returns the following:
California Secretary of State - Google Inc
Figure 11 - California Secretary of State Search Results
There are two entities listed by Google Inc. We want the one with the "active" status. Click on the "Google Inc." with the "active" status.

Step 3 - Review Business Entity Details

After selecting the active Google Inc., you'll see the entity specific details:
Figure 12 - California - Google Business Entity Detail

Fig. # shows that Google Inc. is registered with the California Secretary of State, meaning it is legally authorized to transact business within the State of California. This registration makes Google Inc. subject to all of California's laws. So if you have an issue with Google, you can bring suit against them within California state court, and depending on the claims in the suit, the court will apply California statutory and/or case law.

With this information, we can also confirm that the name of the legal entity is Google Inc., that it has an active status and the legal entity's state of incorporation is Delaware. 

Step 4 - Review State of Incorporation

Looking at Figure 12, you'll see Google Inc.'s jurisdiction is Delaware, which means its state of incorporation is Delaware.  To check if Google Inc.'s information is up-to-date and active in Delaware we simply follow the search process we just completed with California Secretary of State but with Delaware - Division of Corporations
Figure 13 - Delaware - Division of Corporations Search
Here are the legal entity details from a "Google" search in the Delaware - Division of Corporations database. 
Figure 14 - Delaware - Google Entity Details 
Delaware likes to take advantage of its reputation for being home of corporations. As a result, they charge for checking statuses. We can still see Google Inc.'s information in Figure 14. 

If you want an actual document that can serve as legal confirmation of a status, you can purchase an official certificate of good standing, or a similar certificate of status/authorization, from states. These certificates come in handy periodically.  Examples where these documents might be requested:
  • Other states when reviewing an application for a certificate of authority to transact business within the state,
  • Banks when opening a savings/checking account in the name of the legal entity, and 
  • Attorneys when issuing a bond opinion pertaining to certain legal entities issuing debt.
Finding legal entity details becomes much easier after you do it a few time. Be sure to take advantage of list of legal entity search list I've put together.

CorporateCram Comments: Despite this lengthy post, there are still nuances involved when searching legal entity details behind investment opportunities. Has this post helped you get started on reviewing specifics behind your potential investment opportunities?

The information provided in this post is not, and should not be be construed as, legal advice or a substitute for a licensed legal services provider's opinion on your unique situation. This post is general in nature and cannot represent an answer for an incalculable amount of different facts and circumstances. For your situation and a specific answer for it, please contact a licensed legal service provider. 

Wednesday, November 25, 2015

[Investor Alert] How A Former Edward Jones Broker Used Investor Funds to Renovate His House

Does the thought of someone confusing you with a law-abiding person keep you up at night?

Are you worried that people will always trust you?

Here's one simple little trick to quickly get rid of those concerns:

Develop a fraudulent investment scheme that involves kicking families out of their homes. 

Using this strategy, you're sure to sleep without worry.

Curious to see this strategy in action?

Enter Bernard M. Parker of Indiana, Pennsylvania (BMP).  

According to the Securities and Exchange Commission (SEC), BMP offered unregistered and fraudulent securities to his own Edward Jones clients through a tax lien certificate investment scheme. 

How do tax lien certificates work?

Although I question whether it's ethical, purchasing tax lien certificates is completely legal. In fact, the government is the one that sells them.

How does it work?

When property owners fail to make tax payments, the local government typically places a tax lien against the home for the amount owed. As these payments remain outstanding, the amount owed increases because of penalties and interest. These outstanding tax amounts can exceed what some owners are able to satisfy.

Depending on where you live, the holder of a lien against your home can foreclose on your real estate to recover what you owe. Foreclosing on a home can be a lengthy and costly process. It's a process lienholders prefer to avoid.

Instead of actively recovering outstanding tax payments and/or foreclosing on properties, local governments can sell these tax liens in an auction. The auction winner can then try to collect the tax payments or choose to foreclose on the home to collect. It's the foreclosure process that could involve kicking families out on the street.

This practice is common in rural communities where families have owned land and homes for decades without any home loan payments.  Property taxes are still assessed against the property despite the real property being free of a home loan, and can quickly accumulate over time.  It's not uncommon to have an heir receive real property burdened with tax liens from a deceased family member.

What was the tax lien certificate investment plan?

According to the SEC, BMP created a shell company called Parker Financial Services (PFS), which only existed in name.

Using PFS, BMP started raising money from his own Edward Jones customers to purchase tax lien certificates in Florida, Arizona and Colorado. (This offering was done without knowledge to Edward Jones, which has a policy to report outside business activities.) 

In exchange for their investment money, BMP promised to (i) periodically make interest payments to investors on a quarterly, semi-annual or annual basis and (ii) return principal in full when the investment contract expired.

On account of BMP's representations, investors ponied up more than $1.2 million for his tax lien certificate investment plan. 

What went wrong?

As you can guess, BMP didn't come through on his promises:
  • Investment proceeds were not used exclusively for tax lien certificate purchases.
  • PFS did not hold any liens on properties. 
  • PFS did not make all interest payments to investors.
Where did the money go?

Between 2008 and 2014, BMP withdrew over $650,000 in cash from tellers, ATMs and checks cashed at stores. 

Here's the breakdown of the remaining investment proceeds:
  • $197,000 for point of sale transactions,
  • $150,000 for personal checks,
  • $169,000 for online bill payments,
  • an undisclosed amount for father-in-law's health expenses;
  • an undisclosed amount for renovations on BMP's home,
  • an undisclosed amount for car payments,
  • an undisclosed amount for insurance payment, and 
  • an undisclosed amount for other personal expenses. 
What were the red flags?

Parker Financial Services

The most noticeable red flag is Parker Financial Services.  Based on the SEC's report, PFS didn't have a website, written marketing materials or a legal entity registration. 

With the risks involved from both the broker's and investors' point of views, the lack of a registered legal entity would have signaled a lack of professionalism. For me, I would have been concerned that this person didn't understand, or didn't care about, the risks involved and the need to protect his own assets in the event investors might want to sue on account of a fail investment. 

The lack of a website and written marketing materials would have caused me to question the legitimacy of the offering. 

The Investors Contract

According to the SEC, investors were provided simple, one-page contracts. That's it. If you've done any investing, you know there is generally more to it than that. I speculate if BMP was able to take advantage of the trust of these investors because of his then tie to Edward Jones and prior services provided under Edward Jones to these investors.

Lack of Account Statement

The SEC reports that investors did not receive a statement of account regarding their investments. As an investor, you should expect a periodic statement on the performance of your investment or any transactions that took place within your account.

How can you protect yourself?

Evaluate the legal structure of the business

In some cases, businesses do not have to file any incorporation or organizational documents. When it comes to investments, however, check to make sure there is a registered legal entity that is in good standing associated with your investment opportunity. 

Having a registered legal entity that is in good standing does not mean your investment will be safe, as there are plenty of prior posts with scammers and registered legal entities. 

The registration only means you have one less red flag on your radar. 

To find out this information, search the Internet for your state's Corporate Division website. Once on that site, locate the search function that allows you to search for the business name asking for your investment money.  

If no results return with the business name, ask your contact if there is a different name for the legal entity or if you are looking in the correct state's corporate registration directory. 

In a situation where there is no registration at all, ask for an explanation. Hopefully, the explanation includes some type of insurance policy that covers your contact's liability risk. Be sure to ask for a copy of that insurance policy, if you're told there's one.

Use BrokerCheck by FINRA

If you're working with a broker, you can use BrokerCheck by FINRA to see if they are properly licensed to sell securities and there are any negative marks in their FINRA profile.

In today's investment scheme example, we had a registered broker, so it was easier to see his history and his current standing. For some issuers and brokers, the search for information might be a little more difficult. (To see an example of Bernard Parker's FINRA BrokerCheck report, click here [PDF].)

According to BMP's BrokerCheck by FINRA report, he had an existing questionable history before he initiated his tax lien certificate investment plan.  A simple search by investors would have revealed the following information:
Disclosure Event Detail Dated Filed
Employment Separation Discharged 11/26/2014
Judgment / Tax Lien $2,175.00 7/31/2012
Judgment / Tax Lien $3,780.00 8/20/2007
Judgment / Tax Lien $3,717.00 8/20/2007
Judgment / Tax Lien $26,149.00 12/24/2007
Judgment / Tax Lien $52,495.00 12/24/2007
Judgment / TaxLien $5,671.00 4/12/2004
Employment Separation Permitted to Resign 12/22/1992

After being an employee for Edward Jones from June 2006 to December 2014, BMP and Edward Jones parted ways after the details about the tax lien certificate investment scheme rolled out. 
BrokerCheck by FINRA - Edward Jones Discharge

To perform your own search, click the BrokerCheck by FINRA image below. 
BrokerCheck by FINRA
FINRA BrokerCheck Interface

After you click the link above, follow the instructions on the screen to find more information about the brokers and/or brokerage firm offering and selling you securities.

CorporateCram Thoughts: When someone is a registered broker working for a registered firm, finding red flags can pose more challenges. What other pieces of information could a prospective investors find to help evaluate the broker and the investment?

Disclaimer: The U.S. Securities and Exchange Commission alleges the claims stated above in this blog. BMP may not be found liable for any of the claims alleged in this SEC complaint.

Source: U.S. SEC v. Bernard M. Parker No.15-CV-1535 (W.D. Pa. November 23, 2015)

Monday, November 23, 2015

[Investor Alert] Are Green Businesses the New Trend in Securities Fraud?

Sadly, no one is off limits when it comes to being a victim of securities fraud.

Not grandmas.

Not professional athletes.

And as you'll find out today, not even the Amish community. 

So what's an investor to do?

Beside doing research (and I'll share some awesome tips later on in this post), you can keep an eye on trends that are being exploited.

What I'm starting to see lately are fraudsters pushing investments in eco-friendly businesses.

"Green," "eco-friendly," and "environmentally safe" are just a few of the sexy buzzwords being thrown around companies these day to recruit employees and to push products. 

They're also terms being thrown by scammers to get investors to open their wallets.

"Green" products make up part of the ruse allegedly used by Earl D. Miller (EDM) to pull in $3.9 million over 1.5 years from about 70 investors, some of which included members of a local Amish community.

So what happened?

Starting back in 2014, EDM decided to move from real estate development and sales to private investment management. 

The thing about managing private investments is that you need investment money from outside investors. And if you don't have the experience and reputation in managing private investments, what do you do? You pretend, and set up a few funds that look legitimate.

Enter 5 Star Commercial, LLC (5 Star Commercial) and 5 Star Capital, LLC (5 Star Capital). 

Despite having no background in private investment management, EDM took control of both 5 Star companies and decided on a few attractive investment opportunities he would offer: 
  • 5 Star Commercial
    • Investments to purchase and/or develop residential and commercial real estate.
  • 5 Star Capital
    • Investments in "green energy saving product (sic) that save the average American consumer hundreds of dollars each year," as quoted by 5 Star Capital's offering materials.
At this point, here we are:

Legal entities. Check.

Investment opportunities. Check.

So that leaves investors as the remaining open item.

Who invested?

When you don't have a background or experience in private investment management, what type of investor would you go after? 

Someone who is new to investing. 

And that's exactly what happened. 

To get investment money, EDM reached out to a network of new investors, some of whom were members of the local Amish community. 

How were the investors convinced to invest?

According to the Securities and Exchange Commission (SEC), EDM told a handful of false statements to prospective investors:

What was Said What was Done
He would never get paid for managing the funds. He misappropriated over $1 million for personal expenses and debt.
5 Star Commercial's fund would be used exclusively for real estate. 5 Star Commercial used investment proceeds to invest in highly speculative companies that supposedly made and sold "green" products.
5 Star Capital owned patents "green" products. 5 Star Capital did not own any patents on "green" products.
He would manage 5 Star Capital's risks. No due diligence was performed on the "green" companies that received most of 5 Star Capital's investment proceeds.
5 Star Capital would also invest in real estate. Majority of investment proceeds did not go towards real estate.
Claimed his entities owned $60+ million in real estate. Had substantially less than $60 million in real estate.
Claimed his entities had over 300 private investors. Had substantially less than 300 private investors.

To obtain Amish investors, EDM advertised in Amish newspapers, promoted his Amish heritage and set up meetings with Amish families to discuss his investment opportunities.

How much money did 5 Star Commercial and 5 Star Capital raise?

5 Star Commercial raised $2.28 million from at least 45 investors in six states. 

5 Star Capital raised $1.62 million from at least 27 investors in three states.

Total amount raised is $3.9 million by an unlicensed, inexperienced fund manager for 2 unregistered funds with unregistered and non-exempt securities. 

Most of the investment money consisted of investors' retirement funds and life savings. 

In exchange for their investment money, EDM gave investors fixed-rate promissory notes with rates ranging from 8% to 12%. Interest payments were scheduled be paid monthly. 

How did these investments end for our investors?

The majority of the investment proceeds used by 5 Star Capital for "green" products failed to achieve any returns. According to the SEC, those investments failed as soon as they were made. 

5 Star Commercial didn't turn out any better. If you'll remember, most of the funds were in the form of promissory notes. Monthly interest payments were made between March 2015 and July 2015, but they eventually ceased when the investment money ran out. 

To make matters worse, some of these loans went undocumented (i.e., no actual written note), so there was never any paperwork supporting these loans from a legal standpoint. And yes, this lack of loan documentation is on top of not having any security interests in the real estate EDM claimed the investors would have. 

How can you protect yourself?

Verify intellectual property claims

EDM claimed 5 Star Capital owned patents on "green" products. Despite this claim, the company has never owned any patents for any products - let alone "green" products.

So what happens if you hear the same claims by someone pushing you for an investment? 

Simply ask your contact for the patent numbers, which look like this: 6,874,408. Then, with your patent number, visit the Patent section of United States Patent and Trademark Office (USPTO) website.  You can use this link to search by patent number. 

Enter the patent number and run your search. 

If the search returns a filed patent application, you'll want to look at the "Inventor," "Applicant" or "Assignee" information to see if the names listed match any of the names related to your prospective investment. Using the patent number above, 6,874,408, here's our result:
Patent No. 6,874,408
In this example, the Inventors are Alan Backus and Ron Popeil, and the rights attributed to this patent have been assigned to Advantage Partners IP, LLC.

If your own search returns "Inventor," "Applicant" or "Assignee" with names that don't sound familiar, ask your investment contact for an explanation. 

At the end of the day, you should have a valid patent number of the patent in which you're planning to invest and some sort of documentation showing who owns it and/or has a right to use it.

Obtain proof of security interests in assets

The investors in 5 Star Capital were told they would personally receive a secured interest in any purchased real estate as a guarantee of their investment. 

But according to the SEC, the investors didn't receive any type of security interest in any real estate. This means the investors don't have an easy way to reclaim the money they loaned to EDM. 

Ideally, if you're in this situation, you'll have a properly filed mortgage, deed of trust or some other security agreement that will allow you to foreclose on the property when your payments stop.

If you're ever told you'll own security interest in an asset you're funding, ask for a copy of the mortgage, deed of trust or some other type of security agreement. This way, you can check the parcel of land that's being secured under the mortgage and/or deed of trust and see if your name is listed on the document. 

Research prospective investments

As an investor in the primary market, you should receive a description on how the proceeds will be used. The Use of Proceeds section in offering materials acts as a representation by the issuer on how it plans to use the investment proceeds.  Here's an example:
Use of Proceeds Example
Use of Proceeds Example
In our story, EDM claimed 5 Star Capital would use investment proceeds to invest in "green" products. 5 Star Capital did invest in "green" products, but the issues arise when we look into the "green" products developers. 

Approximately $1.1 million went into several developmental, fledging companies that claimed to be developing "green" products. The two people who controlled these companies didn't have great records:
  • one filed a personal bankruptcy in 2001, which wasn't discharged until 2009, and
  • the other had seven civil judgments against himself and prior businesses.

Either EDM didn't know about these backgrounds, or he knew, and ignored, which makes the behavior reckless. In addition, to failing to check into the business owners, EDM didn't receive any business plans, sales statistics, proof of customer orders or any other details about the financial condition of the companies that claimed to be developing "green" products. 

For you, if you receive a Use of Proceeds and notice that your proceeds will go towards other companies you're not familiar with, take a few minutes to ask the issuer what research was performed on those other investments, and then ask for any documents they claim to have received. 

Verify claims of customer agreements

The 5 Star Capital private placement memorandum contain the following statement: 
"[t]he company owns patents on many of these products and will distribute them through large chain stores such as Bed Bath and Beyond."
This statement is a little confusing because it references Bed Bath & Beyond as a potential retailer but doesn't exactly say it is a customer. 

When an issuer claims to have customers on the hook already, ask for copies of the signed customer contracts and/or sales orders. As a potential investor, feel comfortable enough to confirm those contracts with those customers by emailing or calling them. 

Search your state's securities division for administrative actions

Depending on your state, you may be able to search online for any administrative actions your state, or any other state, may have taken on someone who is offering and/or selling securities to you. 

As an example, let's check out what the State of Indiana says about EDM. 

To do this, I went to the Indiana Secretary of State - Securities: Administrative Action search, and pulled up EDM's name. Here are the results:

Indiana Secretary of State - Securities: Administrative Actions Search
If there's anything in your own search results (hopefully, there's not), you can check out the information and how any causes against that person were settled, if they were. 

For EDM, here's the order [PDF] again him, alleging the offer and sale of unregistered and non-exempt securities. Despite this order being filed in April 2015, EDM continued to use investment proceeds on himself through July 2015 - at least that's what the SEC says.

As an investor, these administrative actions are exactly the type of information you want to know before handing over your life savings.

Search your state's court records for civil and criminal actions

EDM had an order against him by the State of Indiana Securities Division. 

And between the two owners of the companies supposedly developing "green" products, there was a bankruptcy filing against and seven civil judgments against the other and his businesses. 

As an investor, you'll want to find legal actions against issuers, brokers, advisers and business owners prior to handing over life savings and retirement funds to them. 

For licensed brokers, you can use BrokerCheck (see below). For others, you may have to visit your state's online court system and search. Here's an example for the State of Washington Courts: 

Washington Courts
Washington Courts - Search Cases
With these searches, you can find both criminal and civil cases. If results appear about your contact and/or the issuer, you'll want to ask them to clarify. Try to get this information through email, so you'll have a record of the explanation.  

Use BrokerCheck by FINRA

If you're working with a broker, you can use BrokerCheck by FINRA to see if they are properly licensed to sell securities and there are any negative marks in their FINRA profile.

BrokerCheck by FINRA
FINRA BrokerCheck Interface
Simply click the link above and follow the instructions on the screen to find more information about the brokers and/or brokerage firm offering and selling you securities.

CorporateCram Thoughts: What other tips do you have to avoid smooth-talking fund managers and issuers? What do you think about this post? More information? Less?

Disclaimer: The U.S. Securities and Exchange Commission alleges the claims stated above in this blog. EDM, 5 Star Commercial, LLC and 5 Star Capital Fund, LLC may not be found liable for any of the claims alleged in this SEC complaint.

Source: U.S. SEC v. Earl D. Miller, 5 Star Commercial, and 5 Star Capital Fund, LLC No.15-CV-00519 (N.D.Ind. November 5, 2015)