7. Digging for Disclosure

In many corporate scandals that received massive media attention between 2000 and 2004, the problems of the executives under investigation were the same: disclosure. Martha Stewart did not disclose the reasons for her famous ImClone stock trade. Enron officers did not disclose all the details regarding the company’s financial status. The investment banking houses were fined for not properly disclosing the actions and timing of trades and relationships between the buy and sell sides, or for not disclosing the backdating of options granted or subprime mortgages bundled.

In the world of conducting character and integrity background investigations, nondisclosure equals dishonesty, and dishonesty is often a clue to other unethical or inappropriate behavior. Corporate Resolutions, Inc. has performed thousands of inquiries that support this statement. Whether the issues have been blaring, shocking, or routine, we have seen enough to know that one piece of information can truly change the way an investment appears. You have to wonder: If the facts have been misconstrued at the beginning of your business relationship, what makes you think the facts will not be tainted down the road when the issue involves your money? If your CEO inflates monthly expense reports, will he behave similarly when reporting numbers to the board?

The Situation: The Empty Suit

Board members of a convenience store chain were looking to expand the company and hired us to look into Richard Front, the youngest member of a three-person team slated to run the growing chain. As the investment in the company was relatively small, our client chose to do a background on only Front as he was the one with check-signing authority.

Initially, we found nothing material on Front. His background was so bare, in fact, it seemed that Front did not even have any real experience that qualified him for much of anything, let alone running the entire operation. After several discussions with the client, we suggested we do a little more digging, and the client agreed it was necessary.

We discovered that Front’s father, a member of the team and the person who had committed to investing a lot of money with the company, had been recently released from a federal jail for the sale and distribution of narcotics. We found out the other person involved in the potential growth of the chain was a prison buddy of Front’s father who had done time for money laundering.

If two of the investors and principals had a history of money laundering, was this convenience store chain their next target? An easy way for them to launder money? The board members did not want to take that risk and walked away from the deal.

The Whitest Lie Is Always Gray

High-profile executives have staged insurance frauds, hedge fund managers have highlighted Ivy League degrees on a resume when they never received any degrees, and fund analysts have boasted 35% returns on companies that never existed. The smallest brag or the biggest abuse of power can all be indicators of a problem waiting to happen. The convenience store tale described is just one among many.

An institutional investor was looking to get involved in an IPO of a young company. The firm hired us to conduct background checks on the founders of the company: a few guys in their mid-20s.

What they disclosed to the client: They were arrested for smoking pot on a street corner while they were in college.

What we found out: They were running a multi-state marijuana and cocaine drug ring, were criminally indicted on the federal level, and had served five years in prison.

Had our client not known the real story, the firm would have been publicly embarrassed when the backgrounds of these guys were released in SEC filings. Ultimately, our client moved forward with the deal, and the company went public. The founders remain primary shareholders, but they do not serve as officers or directors.

Navigating Through Nicholas Cosmo

Of course, having a criminal background rarely means a deal will go smoothly. Among the fraud scandals that were uncovered in early 2009 was Nicholas J. Cosmo’s. Cosmo was arrested and charged with running a $413 million Ponzi scheme through his company, Agape World, Inc. Despite what he had promised investors, Cosmo had been using investor money to fund his own lavish personal lifestyle. What is worse, in addition to using their money to pay for expensive jewelry, limousines, and hotel rooms, he also used investors’ money to pay restitution from his 1998 criminal conviction for mail fraud. Like the aftermath of Bernie Madoff, investors were left with nothing but shock, disappointment, and the unfortunate crisis of having to reassess their financial stability. (We discuss Bernie Madoff later in the book.)

When we looked into Cosmo’s background we found telling information about him that, had investors done their homework, they would most likely not have agreed to have him manage their savings. In 1998, less than six years before Cosmo started defrauding investors through Agape World, Cosmo was criminally charged with fraud in the U.S. District Court, Eastern District of New York. Cosmo was sentenced to 21 months in prison, 3 years of supervised release, and a host of fines. Because this criminal case was filed at the federal level, the information is easily accessed through PACER (Public Access to Court Electronic Records). PACER allows anyone to view civil records, criminal matters, and bankruptcy filings that have been filed on the federal level in every state throughout the country. PACER’s website, http://pacer.psc.uscourts.gov/, allows you to search by individual name, company name, or case number, and oftentimes you can access the docket sheet of the cases filed. In the instance of Cosmo, had you run a basic PACER search before investing with him, you would have not only found the 1998 criminal case, but also a May 1998 bankruptcy proceeding in which Cosmo sought Chapter 7 bankruptcy protection.

Beyond the fundamental PACER search, which clearly gives enough information about Cosmo to send any investor running, we found more negative information about him through our other research efforts. When we took a look at Cosmo’s employment history, we noticed he had been employed by Continental Broker-Dealer Corp. in the late 1990s. In 1998, Continental Broker-Dealer Corp. sued Cosmo in Nassau County, New York. When an individual is sued by a former employer, we always recommend looking into the matter to learn more about it. Sometimes these cases are filed as breach-of-contract cases, but then when you review the court documents, you see there is often more to the story.

Our media searches found articles that suggested Cosmo was connected to controversial mafia families. And when we conducted our customary review of national and international regulatory actions, we identified a January 2008 arbitration case filed with FINRA against Nicholas Cosmo that alleged fraud, among other things. Further, in 1999, the NASD censured and fined Nicholas Cosmo $68,209 and then barred Mr. Cosmo from acting in any capacity with an NASD member firm. In this action, the NASD claimed Nicholas Cosmo “replaced a public customer’s name on an account transfer form with the name of an account at a member firm over which he had sole control, and attached to the transfer form a letter authorizing the transfer of the customer’s account to the firm account he controlled, without the customer’s knowledge or consent.” The findings also stated that Cosmo provided the customer with false account statements and fictitious trade confirmations.

Cosmo’s background cannot be overlooked or minimized. With Cosmo’s documented history of fraud that was detected by regulatory agencies, criminal prosecutors, civil litigators, and media reporters, combined with his rumored connections to organized crime, it is no surprise that Cosmo defrauded investors again.

The Tactic: Capturing Criminal Records

As you saw with Nicholas Cosmo, searching criminal records on the state and federal levels can yield pertinent information that will directly impact your investment decisions. Federal-level criminal records can be found using PACER (as specifically described in this chapter and in previous chapters). On the state level, criminal records must be searched in each county where the person has lived and worked. In some states, such as New York, a statewide criminal record search is offered. You must check the state/county you are searching to find out if the records can be searched online or in person.

When information is kept under wraps, it does not always indicate a criminal past. There have been times when an individual hid information in order to protect others or to avoid embarrassment. We have also seen individuals who are compulsive liars and scam artists. Those situations are the most difficult to comprehend.

The Situation: Cocktail Party Perpetrator

Thomas Fikshun was introduced to Jake Walden through a mutual friend. Actually, Walden doesn’t really remember which of his friends knew Fikshun first, but Walden was at a cocktail party at a friend’s house in Westchester County, New York, when they met. Walden noticed Fikshun because he was the only one at the party whose navy blue blazer was decorated with military stars and not monogrammed cufflinks. As Walden recalls, Fikshun was standing among a group of men, most of them friends of Walden’s, telling a story about his daughter’s decision to work for “Doctors Without Borders” and describing how difficult it was for him to be so far away from his daughter. Walden’s interest was piqued, and he joined in.

That night, Fikshun told several stories that painted an impressive picture: He had gone to an elite liberal arts college and then became a Navy SEAL, and after spending a few years working in London with an investment banking firm, Fikshun returned to New York and started working for a “green” company and was trying to raise money for this firm. Walden, a venture capitalist who also spent years as an investment banker, asked Fikshun to send information about the company and Walden would take a look. That was their first meeting.

Three months later, Walden and Fikshun had become friends. They hit golf balls together at the driving range at Chelsea Piers and had dry Grey Goose martinis after work. At that point, Walden had verbally committed to investing money in Fikshun’s green venture and agreed to find institutional investors for him. One night, Walden arrived home from work and told his wife of his financial intentions with Fikshun. “You barely know this guy!” Mrs. Walden said. Walden realized his wife was right (as she always is) and called us and asked us to run a background check on Fikshun. Walden did not want to do anything behind Fikshun’s back, so Walden asked Fikshun to sign a release form allowing us to review his credit report and confirm other information. Walden explained that if Fikshun wanted investor money for his venture, a background check was inevitable. Fikshun agreed.

We checked with National Student Clearinghouse (the company that maintains school records and verifies attendance and degrees received at colleges and universities throughout the country) to confirm Fikshun’s liberal arts education. No record was found.

We submitted a request with the National Archives and Records Administration to confirm Fikshun’s honorable discharge as a former Navy SEAL. No record was found.

Also, Fikshun told Walden he was a former partner in a start-up company that closed down because of lack of funding. Yet, when we went to the archived website of this company, we saw a list of all of the former partners in the company, but there was no mention of Fikshun.

Last, we found out that Fikshun was indeed “far away” from his daughter. But the distance was not a result of her magnanimous endeavors with “Doctors Without Borders” but rather a consequence of her being incarcerated for identity theft and serving a seven-year prison term.

Fikshun’s entire story was a lie.

Walden was devastated. He could not come to terms with the reality that Fikshun had swindled him. Walden wondered why Fikshun would agree to sign the release form if he knew Walden would eventually find out the real story. It did not make sense. At first, Walden felt he should approach Fikshun. Maybe there was a reason Fikshun lied? But Walden realized he was just a pawn in Fikshun’s game and decided it was best to slowly sever ties with him. He explained to Fikshun that the financial commitments he had hoped to give were no longer available, and in no time, Fikshun was gone, and Walden never heard from him again.

Fikshun’s lack of disclosure is obviously more egregious than most. But the principle is the same: Without proper disclosure by the investee, the investor cannot make a sound investment decision.

The Tactic: Debunking The Deceit

We debunked the myth of Fikshun by checking with National Student Clearinghouse (which we have discussed in previous chapters) and by confirming his military service (or, rather, his lack of it). When you need to confirm someone has served in the U.S. military and has been honorably discharged from his or her service, you submit a request with the National Archives and Records Administration. The website, www.archives.gov, clearly outlines how to submit a DD Form 214 (the required form to confirm military service) and what information you need to provide to complete the request.

Last, we found Fiskhun had lied about his partnership in a start-up company by checking archived websites on the “Way Back Machine.” This website, www.archive.org, allows you to see older versions of websites and the dates the websites were modified. So if someone was an executive at a company and then left the firm, you can check the archived website of that company to see what was said about the executive at the time and also to compare corporate biographies from then to now. Maybe the person used to say he was an attorney in New York but was later disciplined by the bar, and so the bio you see does not mention the attorney’s license. Checking archived websites is another tool we use to make sure an individual’s background is as consistent and clear as the person claims it to be.

Best Practices

In the mass public discussion of recent Ponzi schemes and financial frauds, the term “disclosure” has gained some publicity. Investors of all sizes need to understand that they are entitled to have access to a firm’s processes, operations, and strategies. When information is not disclosed, you have to wonder why. To accommodate the growing number of clients who have become necessarily cautious about future investments, we have developed some best practices that we urge you to follow. In addition to conducting background checks, our recommended steps include the following

• After the background check is complete, interview the manager or executive to document his or her explanation of any discrepancies, involvement in regulatory infractions, pending lawsuits, controversies, and so on that were uncovered in the background investigation.

• Interview former employees of the firm to find out why they left to ensure there are no underlying issues of impropriety.

• Verify the fund manager’s net worth and that he or she is invested in the firm. Some of this information can be done pursuant to FINRA Rule 3050 or NYSE Rule 407.

• Conduct annual or biennial updates on background checks of the management team to ensure no new problems have surfaced.

• Interview employees if/when they leave the firm.

• Continuously monitor the company and executives. This means monitoring chat rooms, blogs, media sources, regulatory filings, and court records to stay on top of any information that is released or discussed about the firm or its management team.

• Conduct limited scope background checks on all employees of the firm, especially those who are responsible for making investment decisions and/or financial decisions.

• Interview prime brokers, accountants, fund administrators, and attorneys to verify relationships and statements.

• Implement an Ethics Hotline (discussed in a later chapter).

Like a babysitter, you need to stay on top of the people who control your funds. These steps will give you awareness of who is managing your money and will alert you to any problems along the way so you can properly avert a disaster, such as fraud.