New York City-based MG Capital Management made headlines recently when its founder and former CEO Eric Malley pled guilty to securities fraud in relation to two Manhattan-focused real estate investment funds. Combined, MG Capital Management Residential Fund III and IV raised more than $58 million from 335 investors over a span of about five years. He now admits that he lied to investors about his prior experience, his investment track record and the nature and characteristics of the two funds.
Malley is now awaiting sentencing, which could be up to 20 years in prison. Such cases are a harsh reminder that even sophisticated investors need to be cautious of potential fraud when investing in private real estate deals. In a competitive private equity fundraising market where there is plenty of posturing to promote deals, when does it cross the line into fraud? “Fraud is something more than speculation or puffery where there is an exaggerated or overly optimistic perspective,” says Bonnie Hochman Rothell, a partner and chair of the Litigation Practice at Morris, Manning & Martin LLP in Washington, D.C.
Cases of fraud involve knowingly misrepresenting or misstating facts. For example, if a sponsor says an investment will double its profits in a year, that might not be fraud so much as it is speculation. However, if the sponsor reports the current value of an asset as $5 million when it is really $3 million, or if they say they have raised a certain amount of equity investment that they don’t really have, those are misstatements of facts that would constitute fraud. Fraud also can occur in actions, such as cases where money is being funneled out of a project or fund.
“A private placement memorandum is a lot like a resume, and there is always going to be a little bit of puffery,” adds Jonathan Kurry, a Miami-based real estate finance partner at the law firm of Reed Smith LLP. Kurry tends to see fraud pop up when a sponsor is touting a great investment opportunity and is quick to tell investors that other people are banging down the door, and they need to get their money in tomorrow or lose out. “That sounds good, but let’s slow down and see some of the back up,” he says. “When you start asking about specifics, things tend to fall apart.”
Building a case for fraud
Oftentimes, suspicions of fraud are raised when an investment does not go well, and disgruntled investors are either losing money or not receiving the returns that were expected. “If there is a big delay, that is usually the first indication that there is potential fraud or something’s not right,” says Kurry. Obviously, there are a lot of factors that can cause delays, such as market changes or entitlements that a sponsor thought were in place that aren’t. That’s when investors need to start asking questions. Is it bad luck or was this obstacle something that a sponsor knew about and didn’t disclose?
The recourse investors have when a deal goes sour depends on the nature of the fraud. Some cases are easier to uncover than others. The terms of the investment also play a role. Some investment agreements give investors the right to request information and documents. If an investor suspects fraud, one option is to file a lawsuit. However, an investor does have to present a good faith basis that goes beyond just speculation.
Based on general litigation principles, allegations of fraud are supposed to be pled with some level of particularity, notes Rothell. Depending on what’s triggering the suspicion, an investor would need to put something of substance in a complaint. That means an investor would need some level of specificity to include in a claim of fraud. Some examples could be a prior fact that turns out to be false or money moved out of a fund or spent inappropriately.
At the end of the day, fraud is not necessarily difficult to prove if investors can get access to third party reports or correspondence with other insiders or other investors. There also is strength in numbers. A group of investors has a stronger position than one individual who could be written off as disgruntled. However, there also is an opportunity for an investor who has a suspicion of some wrongdoing to negotiate a deal with the sponsor, such as an early exit from a deal. That may give them the ability to recoup all or part of their original investment. In order to protect their reputation, a sponsor may be willing to negotiate such a deal, says Kurry. “These sorts of things are ripe for mediation, and sometimes these agreements do have arbitration clauses that are enforceable,” he says.
For investors that do pursue recourse through mediation or litigation, there can be a smoking gun to provide substance to the case. For example, if a sponsor lied about their experience or market data or fabricated a report, that can be fairly easy to prove. “There also could be a pattern of lack of disclosure, exaggerating the truth or leaving out numbers,” says Kurry. Those patterns can be more difficult to prove, but often times there are a number of discrepancies that stack up to show that there is more at play than just coincidence, he says.
Watching for red flags
The private real estate space is by no means riddled with fraud. However, sponsors do have a lot of latitude in private equity deals, and even sophisticated investors can run into deals that aren’t on the up-and-up. “It’s really important to know who you’re getting into bed with and do the research, because there are certainly investment vehicles where folks are left to their own devices and there aren’t a lot of checks and balances,” says Rothell.
Although there are always exceptions, thorough diligence does help to expose potential bad actors. As a consultant and chief investment officer at High Speed Alliance, an investment advisory firm, Cliff Lipscomb is tasked with conducting due diligence on private equity deals and also the sponsors behind the deals. One issue that raises a red flag for Lipscomb is anything out of the ordinary in the work history, such as gaps or frequent job changes. “In some cases, there can be a reasonable explanation, but you have to ask for the explanation and it needs to be verifiable,” says Lipscomb.
High Speed Alliance also uses third party providers or law firms that generate due diligence reports, such as FactRight, Buttonwood Due Diligence and vCheck Global. In some cases, Lipscomb also will look at previous settlement statements to confirm that investors did get paid out what they were supposed to receive.
Face-to-face meetings with sponsors are another valuable part of the due diligence process because they can tell you things that you can’t read on paper, adds Lipscomb. In-person meetings reveal cues such as facial expressions and body language, which can be more difficult to pick up on in video calls. “I have heard of people who always have a meal with potential sponsors so they can get insights into how they treat the waitstaff,” he adds. “In this business, you want to like the people you are around, and in some ways, there is no substitute for in-person meetings.”
It also is important for investors to pay close attention to the terms and structure of the deals they are going into to make sure there is sufficient oversight and reporting to investors. Some deal agreements specify that a sponsor is required to provide monthly or quarterly reporting to investors, while other deals may have no reporting requirement.
“Most people are honest and want the investment to be successful, but you should always go into every investment with open eyes and do your due diligence beforehand,” says Rothell. It’s wholly appropriate to ask questions, and if the sponsor is unwilling to answer questions, that might be a sign that there is a problem, she says. “I would urge investors not to simply trust but verify and ask for documentation,” she adds.