| Programming note: Money Stuff will be off tomorrow, back on Monday. It is silly season at the U.S. Securities and Exchange Commission, the few weeks leading up to the agency's Sept. 30 fiscal year end when it brings a slew of miscellaneous enforcement cases every day. Here's one from yesterday against an alleged $110 million Ponzi scheme run by a guy named John Woods, who allegedly ran both an investment advisory firm called Southport Capital and also an investment-fund-slash-alleged-Ponzi called Horizon Private Equity III LLC. The overall vibe seems to have been "generic Ponzi scheme"; from the SEC complaint: Woods and other investment adviser representatives at Southport told clients that they would receive returns of 6-7% interest, guaranteed for two to three years, for non-specific investments in a fund called "Horizon Private Equity." Woods and his cohorts at Southport generally told investors that Horizon would earn a return by investing their money in, for example, government bonds, stocks, or small real estate projects; investors were not told that their money would or could be used to pay returns to earlier investors.
The SEC lists the following things that Wood and friends allegedly told investors over more than a decade of alleged Ponzi scheming: That Horizon investments had a guaranteed rate of return; That Horizon investments carried little risk and were extremely safe and conservative; That there was no possibility of losing the principal investment in Horizon; … That the Horizon investment was an annuity; ... That there were no fees or costs associated with the Horizon investment; That Horizon would use the proceeds of investments to purchase government bonds that would be held to maturity; That Horizon would use the proceeds of investments to purchase collateralized mortgage obligations; That the risk of loss of a Horizon investment was minimal because Horizon had a very diversified investment portfolio; ...
It's just, you know, whatever. You put money in the pot and we use it to buy, ehhhhhh, whatever you'd prefer to think we buy with it. It's a private equity fund. It pays 6% a year guaranteed. It buys government bonds. Is it weird that the government bonds pay 6% a year? Fine it buys collateralized mortgage obligations. Does that sound risky? Well it's very diversified. Also guaranteed. Also an annuity. Just tell me what you want; it's that. I don't know, this sounds like a very lazy pitch to use to raise $110 million, but from the rest of the complaint Woods does not sound particularly lazy. The story starts in 2008, when Woods worked at a big investment advisory firm. (The SEC doesn't name it — it just calls it "the Institutional Investment Adviser" — but it seems to have been Oppenheimer & Co.) He started selling Horizon to his customers; at the time, Horizon "was nominally controlled by Woods's accountant," though the SEC says this "appears to have been a sham to avoid detection of Woods's undisclosed outside business activities by the Institutional Investment Adviser and the SEC." (If you work for an investment advisory firm, it is considered improper to also run your own investment fund and sell it to the firm's clients, particularly if it's a Ponzi.) And then for some reason he went out and bought another investment advisory firm? In 2008, Woods also purchased Southport, an SEC-registered investment adviser, from its owners, a wealthy family in Chattanooga, Tennessee. Woods did not disclose his ownership of Southport to the Institutional Investment Adviser at that time, nor did he disclose any interest in or relationship with Horizon. It is unclear at this time whether Woods used investor money to purchase Southport. Shortly after Woods purchased Southport, his brother ("the Brother"), who was also a registered investment adviser representative of the Institutional Investment Adviser, left the Institutional Investment Adviser and nominally became in charge of Southport. In fact, Woods was in charge behind the scenes the entire time the Brother was the Chief Investment Manager of Southport. Woods and the Brother continued to solicit investments in Horizon from Southport clients and from customers of the Institutional Investment Adviser the entire time Woods was employed by the Institutional Investment Adviser.
So he worked for one investment advisory firm, owned another advisory firm, put his brother in charge of it, and then used both that firm and his day job at Oppenheimer to pitch investors on the Ponzi scheme that he also owned and ran? Seems like a lot. Apparently this went on for eight years until his employer noticed: In 2016, the Institutional Investment Adviser became concerned that Woods was involved in an undisclosed outside business activity, ... and it ultimately asked Woods to resign. Woods began working full time at Southport, but he did not disclose to the SEC his involvement as a Southport owner and CEO until approximately December 2018. Woods also did not disclose his affiliation with Horizon to the SEC. …
Incredibly Oppenheimer seems to have noticed because Woods bought Southport from its founder with an initial down payment and a promissory note for future payments, and then stopped paying him, so the founder sued Woods for the rest of his money. Oppenheimer noticed that one of its investment advisers was being sued over another investment advisory firm that he owned, which is weird, so it investigated. Then this happened: Several months after the lawsuits with the Founder were settled, Woods called the Founder and asked him not to speak to the Institutional Investment Adviser's compliance personnel. Woods told the Founder that he was in danger of losing his job and that he had only months to live because he was suffering from cancer.
Okay. I will say that the complaint makes a persuasive case that if you're going to run a big Ponzi scheme, you might as well also buy and operate a respected investment advisory firm, and keep them nominally separate: As a registered investment adviser, Southport and its individual employees owed their clients a fiduciary duty to act in their clients' best interest and to disclose any conflicts of interest to their clients. Woods and Southport's investment advisers cultivated relationships of trust with Southport's clients. Many Horizon investors had long-standing relationships with their individual adviser before being pitched the Horizon investment. These investors felt comfortable investing in Horizon in large part because of the trust they placed in their individual investment advisers at Southport. … The individual advisers who convinced their clients to invest in Horizon received significant compensation from Horizon in addition to their normal Southport compensation. For instance, the Cousin received nearly $600,000 from Horizon between January 1, 2019 and May 28, 2021, and another Southport investment adviser representative received more than $400,000 from Horizon during that same period
All of this is very bad of course: If you are a fiduciary investment adviser, (1) you should not get kickbacks from an investment fund when you convince your clients to invest in that fund and also (2) you should not recommend Ponzi schemes to your clients. But the point is that if you are running a Ponzi scheme anyway, you will get more money if you tell your clients "I am your fiduciary financial adviser and my only priority is doing what is best for you, and I think that you should invest in this little company we know called Horizon Private Equity, they're great, lotta government bonds, of course we have no affiliation with them but they've done well for our clients." As opposed to the normal Ponzi pitch of, like, "put some money in this bag and I will go away with it and do mysterious things to turn it into more money." Here's another SEC enforcement action against a former chief executive officer of a technology company called HeadSpin Inc. He's accused of a certain amount of book-cooking: Beginning at least in about 2018, Lachwani engaged in a fraudulent scheme to inflate HeadSpin's financial records in order to achieve high valuations of the company that would attract investors. Lachwani understood that the amount of the valuation depended, in large part, on a key financial metric called "annual recurring revenue," or "ARR," as well as ARR growth over time. ARR is a measure of the total revenue expected per year from committed customers with signed contracts. … Lachwani inflated HeadSpin's ARR by falsely increasing the values of several existing customer deals of all sizes, ranging from big deals with Silicon Valley heavyweights to low dollar-value deals with smaller companies, and relying on uncommitted amounts from non-binding agreements with other customers. He entered the fabricated amounts into the company's detailed ARR-tracking Spreadsheet that he alone controlled. For example, in about 2018, Lachwani sent an investor a version of the ARR Spreadsheet that claimed a reseller ("Customer 1") was contributing approximately $1 million in ARR. In reality, Customer 1 and Lachwani had signed a non-binding agreement that, among other things, set a maximum cap of $1.215 million on its purchases over two years from HeadSpin. Importantly, Customer 1 was not obligated to pay anything until HeadSpin sent invoices at a later date. In the end, Customer 1 only paid HeadSpin approximately $500,000 over two years—far less than the maximum cap. … In addition, Lachwani falsely inflated HeadSpin's actual revenue numbers, which were also shared with investors, using the same methods that he used to fabricate ARR. Lachwani dictated the inflated revenue numbers each quarter to HeadSpin's bookkeeper, who recorded those numbers in the company's financial statements. He frequently sent the numbers without supporting documentation (like contracts and invoices) notwithstanding the bookkeeper's regular requests for such backup, and he sometimes sent her fake or altered invoices that he had created, including the three fictional invoices related to Customer 2 and a doctored invoice related to Customer 1.
Well, yes, that all definitely sounds like accounting fraud. (He is also facing federal criminal charges.) What's unusual about it is that HeadSpin was not a public company; he was allegedly cooking the books in order to raise private investments from venture capitalists. It worked: Lachwani's scheme to fraudulently inflate HeadSpin's ARR and other financials had continued throughout 2019, and by the start of the Series C round, Lachwani knowingly or recklessly told investors that HeadSpin would reach approximately $80 million of ARR by year end. The company's impressive (but false) financials fueled a valuation of approximately $1.1 billion, a milestone that earned the startup "unicorn" status – a status touted by Lachwani and noticed by investors. Ultimately, 29 investors purchased HeadSpin stock at prices based on that inflated valuation.
Eventually someone told the board of directors that most of the revenue was fake, the directors investigated, and then they very responsibly de-unicorned the company: In March 2020, the company's Board of Directors was alerted to concerns about the accuracy of the financial and customer information provided to investors and discovered, through an investigation, significant issues with HeadSpin's reporting of customer deals. HeadSpin then determined, based on a subsequent review of its financial information, that HeadSpin's ARR at the end of 2019 was closer to $10 million, as opposed to the $80 million represented to investors. … HeadSpin revised its valuation from approximately $1.1 billion down to approximately $300 million. The company also returned approximately 70% of principal to investors in the Series B and C funding rounds.
You don't see that every day, a company that "revised its valuation" downward after closing on a fundraising round. "You bought stock at a $1.1 billion valuation but we think we were only worth $300 million so here's 70% of your money back." I suppose when the valuation difference is due to accounting fraud, a mutually agreed (or unilaterally offered) valuation reduction is better than getting sued. Though we have talked before about why getting sued for fraud is rare in startups. I once wrote: When a private startup says something untrue, even in connection with a sale of stock, the victims will often be sophisticated venture capital firms. These firms are less likely to sue, for a couple of reasons. For one thing, they want to invest in other startups, so they want to cultivate a reputation for being founder-friendly, and suing founders for fraud is not friendly. For another thing, they want to raise money from pensions and endowments and allocators, so they want to cultivate a reputation for being smart and doing good due diligence; calling attention to how they got tricked is not helpful. For a third thing, they are looking, in their venture capital investments, for high-risk, high-reward bets. The ideal founder, for them, is someone who promises the impossible and then delivers it. If a founder promises the impossible and then does not deliver it, well, you know, that's okay, most startups fail.
Generically speaking if you told me "the founder of a startup signed a non-binding agreement with a big company to sell a small amount of product to that big company once, and then he went back to his board of directors and investors and said or at least implied that he had signed a binding agreement with the big company to sell a large amount of product to that company every year forever," I would be like "yeah that sounds like a startup founder all right." Transforming small non-binding one-time revenue into large binding recurring revenue, first in your imagination and ideally later also in reality, seems like a big part of the startup business. Still you shouldn't fudge the spreadsheets I guess. Here is HeadSpin's February 2020 announcement of its unicorning; the round was "led by Dell Technologies Capital and ICONIQ Capital with participation from institutional investors Tiger Global Management, Kearny Jackson, and Alpha Square Group." I suppose they will all be embarrassed to varying degrees, except I guess Tiger Global, whose whole schtick is "we invest in startups quickly and without making a big deal about it." I bet Tiger Global will make a little case study of this investment and hand it out to other startups. "We threw a bunch of money at HeadSpin and their CEO was just imagining revenue and typing it into a spreadsheet, if you want an easy venture capitalist to deal with you won't do better than us." Rather cruelly the HeadSpin announcement also lists a bunch of individual "leading angel investors" who put in money, listing their names and where they worked; I am not sure if a track record of investing in an accounting fraud is good or bad for their reputation as angels. It is helpful, I think, to have a very simple model of "last look" in foreign-exchange trading. Last look is the practice where a dealer quotes a price on a currency, and then a customer accepts that price, and then the dealer has a little time to back out of the trade. Here is the rough model: - The pound is trading at $1.372.
- A dealer puts out a market on an electronic platform saying "I will buy pounds for $1.372" or whatever.
- A customer sends a message on the platform hitting that bid, saying "you're done, I sell you 1 million pounds for $1,372,000."
- The dealer receives that message and thinks for a moment.
- After that moment, the dealer checks to see where the pound is trading.
- If the pound is trading at $1.371, the dealer thinks "wait why would I buy pounds for $1.372 if they're only worth $1.371," and refuses to do the trade. It took a last look and said no.
- If, instead, the pound is still trading at $1.372, the dealer does the trade it originally proposed.
- If, instead, the pound is trading at $1.373, the dealer does the trade it originally proposed (buying pounds for $1.372) and has nice quick little profit. Why wouldn't the dealer buy pounds for $1.372 if they're now worth $1.373?
Last look gives the dealer a chance to, as it were, look a little bit into the future: It offers to trade at a price, and then waits a moment, and then trades at that price if it's still favorable and doesn't if it isn't. I once wrote that "it is the perfect Will Rogers trading strategy: 'If it don't go up, don't buy it.'" People really don't like this, but I don't think there's anything especially nefarious about it. It makes life more pleasant for market makers; they have less risk of the price moving against them, so they can generally offer tighter spreads to their customers. If you know you'll never buy pounds and watch them go down immediately, you'll be willing to pay a bit more for pounds. The customers will get better execution sometimes (tighter spreads when the market doesn't move in their favor), and worse execution other times (missing out when the market does move in their favor), and their lives will be a bit less predictable and more annoying, but foreign exchange seems like a fairly competitive market and maybe the overall economics for customers are better. To me the fun part about last look is that nobody can ever quite say the simple model, because it looks so rude ("we make you a price, but then only trade at that price if we feel like it"), so they say weird other things. We talked a while back about an enforcement action by the New York Department of Financial Services against Barclays Plc: Barclays advertised that it used last look only to protect itself against "toxic order flow," but then, said the DFS, it "did not seek to distinguish toxic order flow from instances in which prices merely happened to move in favor of the customer and against Barclays after the customer's order was entered on Barclays's systems." On my dumb simple model, "toxic order flow" means "orders where the price moves against you quickly," so there was no need (or way) for Barclays to distinguish those things, but the New York DFS disagreed. Barclays said the nice complicated thing and then did the rude simple thing. Or here is a fun story from Bloomberg's Greg Ritchie yesterday about "the global currency market's four-year quest to crack down on a controversial trading practice that allows dealers to back out of transactions if prices move against them." You might think that quest would be, like, "trying to ban last look," but it isn't. It's just that the Global Foreign Exchange Committee's proposed Global FX Code wants to make last look feel fairer: Last look should be applied in a "fair and predictable manner," according to the new GFXC document. The practice should be used only to ensure there is sufficient available credit to close the transaction, and that the price at which the request was made remains consistent with the current level. Liquidity providers should apply these checks without delay and "promptly" decide whether to accept or reject trades. The committee is also "strongly encouraging" liquidity providers to fill out disclosure sheets on their last-look practices.
I have added emphasis there. "Dealers should only use last look to make sure that the price hasn't moved against them."[1] What else would it be used for![2] ("Dealers can also pull out of trades if market prices move against them, but not when prices move by a similar amount in their favor," Ritchie notes. Well of course!) And: "Obviously the liquidity providers should not be going out of their way to rip off customers, but at the same time we're trying to give customers the information and the tools in a comparable way to assess how they're being treated," Guy Debelle, chair of the GFXC, said in a phone interview. He added the working group doesn't get a final say over Global FX Code regulations.
They should not be going out of their way to rip off customers, but surely they can rip off the customers a little, if it's right there in front of them? Just, like, the regular amount? I feel like there is a general pattern here. There is a practice that (1) insiders (or dealers) in some market find normal and necessary but (2) outsiders (or customers) in that market find kind of shady. Something goes wrong and the practice suddenly gets a lot of attention, and people shout about how shady it is. In response, there is a rush to make new rules so the practice isn't shady anymore. And the way the new rules work is that they codify the existing form of the practice, the thing that the insiders found normal and necessary, and ban extreme weird extensions of the practice. So the rules say "well of course you can use last look to reject trades if the price moves in the customer's favor, that goes without saying, just don't go use it to go out and front-run the customer," and then all the insiders nod and say "great we've solved the shadiness problem," and then all the outsiders are like "wait that's exactly the thing we were objecting to." Mostly this just makes me feel old: When Vincent Gallarte was laid off in July, the Manila IT analyst found an unusual financial lifeline: an online game that rewards players in cryptocurrency. In his first two weeks of Pokémon-like questing and battling, Gallarte earned more than 37,000 pesos ($732), three times what he would have made at his "real job." Like a lot of newcomers to so-called play-to-earn games, the 25-year-old Gallarte hadn't had any particular interest in the world of Bitcoin, Ether and other cryptocurrencies. Now he imagines a lucrative side-hustle. "I started playing Axie the same day my employer terminated my contract," he said. "I'm so grateful." Axie Infinity is among the biggest — and most polarizing — of these new games, which allow players to accumulate tradeable crypto coins. To investors like billionaire Mark Cuban and Reddit co-founder Alexis Ohanian, who were part of a $7.5 million funding round for Vietnamese game-maker Sky Mavis in May, it's a gateway to crypto for people around the world. Others look at the buy-in cost, now more than $600, and the influx of newbies "working" for low-value tokens and see evidence the Axie Infinity model is unsustainable. … In Axie Infinity's virtual world of Lunacia, players steer colorful, blob-like creatures called Axies to acquire two kinds of coins. Smooth Love Potions (SLP) are awarded for successful battles and can be cashed out or used in the game to breed new Axies. Axie Infinity Shards (AXS) can be earned in seasonal tournaments or for selling Axies in the game's marketplace. AXS can be cashed out too, but like other governance tokens, they're designed to function like shares: Sky Mavis says holders will eventually be able to vote on new game features or corporate spending proposals. … But players need three Axies to get started, at a minimum of around $200 apiece. That was far too much for the newly unemployed Gallarte. He sought out a sponsor, someone who lends his Axies to new players in exchange for a percentage of their in-game takings, sometimes as much as 90%. Anything a player earns with a borrowed Axie accrues to its owner, who is then supposed to wire the player his cut.
Is it fun, do you think? The game? This video game, is it fun to play? Or do you, you know, notice that you're grinding to earn money to pay off your debts in a weird virtual world after losing your livelihood in a deadly pandemic? Doesn't it feel like the dystopian future we deserve? Like in a decade everyone will make their living by steering colorful blob-like creatures around to acquire coins in a virtual world, but ownership of the colorful blob-like virtual creatures will be concentrated among a hereditary elite of people who, like, bought Dogecoin in 2014, and in order to scrape together enough to live on you will need to indenture yourself to a member of that elite, steering their blob-like virtual creatures around to earn coins for them and getting a few crumbs for yourself. And you'll work 16-hour days in the Smooth Love Potions mines just to feed your children, but every once in a while in a rare free moment you will stop and ask yourself "wait why do our overlords want all these Smooth Love Potions anyway?" Meanwhile the overlords will form a leisure class and devote themselves to philosophy and philanthropy. They'll keep busy collecting non-fungible-token art and putting their names on virtual library buildings in the metaverse and writing manifestos about how cryptocurrency enhances human freedom and levels the playing field for everyone. And maybe in some virtual library in the metaverse a disaffected philosopher of the overlord class will be busy creating a new theory, a theory about how the relentless accumulation of Axies in the hands of a smaller and smaller elite will lead to an increasingly disaffected proletariat of colorful-blob-like-virtual-creature steerers, who will one day, through the inexorable logic of metaversal history, rise up to throw off their chains and steer their colorful blob-like virtual creatures to tear down the virtual palaces of their virtual oppressors. Blob-like-creature steerers of the world unite, this new prophet will tell them, you have nothing to lose but your Axie Infinity Shards. U.S. Authorities Probing Deutsche Bank's DWS Over Sustainability Claims. Yale's 36-Year-Old Endowment Chief Was Molded in Swensen Way. Distressed debt funds sparkle in Covid recovery. Evergrande EV Stock Loses $80 Billion in World's Worst Rout. TCW's Investment Chief and CEO Set Departures After Employees Threaten to Quit. Purdue Pharma Says Its Bankruptcy Deal Is Fairest to Creditors. SEC Charges Netflix Insider Trading Ring. "With the volatility in the market that we've all seen, it's good to have an ATM program in place so that if you feel that your stock price has risen to some level you can issue shares." Desperate U.S. Cities Pitch Wall Street-Style Sign-On Bonuses. "One colleague collected bourbon, he learned, while another invested in meme stocks." Zoo Bans Woman Having 'Affair' With Chimpanzee From Seeing Him. "Everyone has a plan until they get punched in the face." If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] The GFXC says "that the process is intended to be used for the price and validity checks only, and for no other purpose." And Principle 17 of the Global FX Code explains: "The price check should be intended to confirm whether the price at which the trade request was made remains consistent with the current price that would be available to the Client." But surely "price checks" are what people worry about. [2] Actually if you read Principle 17 of the code, the implication is that the other bad thing it could be used for is "information gathering." You get a big buy order, you take a last look at it, you reject the order, and you turn around to buy a bunch on the assumption that that order is still out there and the price will go up. It is a kind of front-running (you get a client order and, rather than filling it, you go out and trade for yourself on the same side as the order), and the code prohibits it. | 
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