SEC Alleges Securities Fraud—Company May Be Doomed
On March 2, the Securities and Exchange Commission (SEC) formally charged Oregon-based Sunwest Management, its former CEO Jon Harder and several related entities with securities fraud and is seeking an emergency court order freezing its assets. The SEC complaint alleges that Sunwest lied to investors about its operations and concealed the risks of the investments. According to the complaint, Sunwest raised more than $300 million from investors between 2006 and 2008, and that at least half the properties that were purchased with that money had lost money, a fact that Sunwest allegedly concealed from these investors. The complaint also alleges that Sunwest made its promised “10% return” from a “pot of cash” of commingled funds as well as mortgage refinancings and loans from Harder himself.
The SEC complaint continues to allege that even as the world was beginning to crash in on Sunwest as it encountered difficulties refinancing properties and as lenders began to foreclose, it continued to raise money from investors through June 2008, and continued to misrepresent that the funds were designated for a specific property when, according to the SEC, they were “being used to prop up the failing business.” By June 2008, according to the SEC complaint, Sunwest was operated “virtually as a Ponzi scheme.” The SEC is seeking relief, including disgorgement and civil monetary penalties, from Sunwest, Harder (and his wife), Canyon Creek Development, Canyon Creek Finance and related entities. The SEC also seeks disgorgement from “relief defendants” Darryl Fisher (the COO), Wallace Gutzler (General Counsel) and Hamstreet & Associates (Chief Restructuring Officer) and its principal, Clyde Hamstreet.
Unfortunately, little of this comes as a surprise to many people in the industry, including some of Sunwest’s lenders, as no one could understand how they were beating out almost all bidders on acquisition targets—and we are not talking about a 1% differential—at prices that seemed to make little sense when many of these properties were either losing money or would be after the mortgage debt used for the acquisition. The alleged Ponzi scheme, as it turned out, was the only way it would work. Could the company have kept on growing if the capital markets had not stopped the money flow? Perhaps, but everything, including increasing occupancy and profitability, would have had to be working on all six cylinders to prevent a collapse. Eventually, however, these things always seem to come to a crashing end, and there was no reason why Sunwest should be any different, and more reasons why it should have happened earlier.
For the past several years, tenant-in-common (TIC) equity financing was a very common and rapidly growing financing tool for real estate in general, which quickly spread into the seniors housing sector. Simplistically, this allows real estate investors to reinvest their proceeds (profits) from the sale of one real estate asset into another to defer any capital gains tax they might have had to pay on the price appreciation, which was happening with unusual regularity the past five years. These investors were usually promised a certain cash-on-cash return, which according to the SEC complaint was 10% with Sunwest’s TIC investors, and then were told that they would be taken out when the property was either refinanced at a higher value or sold, also at a higher value. This is great, when properties are increasing in value, the capital markets are flush with money to lend and when operators can improve operations and cash flow significantly to increase value. It is not so great when all three disappear.
Apparently, in 2004 Sunwest raised approximately $26 million from TIC investors, $62 million in 2005 and $122 million in 2006. In total, the SEC says it raised at least $300 million from more than 1,300 investors, by “promising a steady income stream and touting its success in running the properties.” The question is, how does anyone properly run that many additional communities (four to five properties acquired per month, on average, for up to five years), especially when so many of the targets were either underperforming or not performing at all? The answer, of course, is you don’t, unless you have a huge operations staff with turnaround and management experience and the deep pockets to fund the turnaround. In this case, the SEC says the pockets weren’t deep, they just kept moving funds from one pocket to another, from the property with cash to whichever property that needed it. Obviously, this was not what the TIC investors thought was happening, and that is why they are furious. We also assume these same TIC investors sent boxes of their documents to the SEC.
According to the SEC complaint (derived from Sunwest’s own financial records), in the nine-month period ended September 30, 2007, 59% of the communities managed by Sunwest had negative cash flow. It didn’t improve much a year later, as during the nine-month period ended September 30, 2008, 58% of the communities had negative cash flow, and we assume this is after debt service and, presumably, Sunwest’s customary 7% management fee. The point is, according to many buyers in the market, Sunwest was overpaying for properties that in many cases would not be profitable after debt service, yet promising investors a 10% annual cash return. Either management believed their own bull about improving operations, or they knew all along what the game was. You pick.
What is very disturbing about the whole affair is what appears to be the alleged intentional deception. According to the SEC, when cash went from one facility to another, Sunwest created a Note Receivable asset on the balance sheet of the haves and a Note Payable liability on the balance sheet of the have-nots, with no due date or other commercial terms. Consequently, the TIC investors never knew what they really had nor the financial strength of their particular property, and excess cash that should have been theirs went out the door to an unrelated entity, according to the SEC.
The SEC claims that a bank account was set up at Wells Fargo Bank in the name of Jon Harder and his wife, and that they used the account to facilitate the transfer of funds between facilities. In addition, according to the SEC, on certain occasions funds raised from investors went directly into this Harder business account and then were used to plug cash-flow holes in other facilities. What the complaint doesn’t say is who else knew about this account and who had access to the funds besides the Harders. We would also like to know where the auditors were during the last several years and whether they even had a clue as to what was going on with investors’ funds.
We have heard that due diligence on the acquisitions during the buying spree was limited, to say the least, and reminds us of the stories about the former Beverly Enterprises doing its fly-by due diligence, literally in a plane, during the 1980s. We have to wonder whether everyone else was duped as to what was going on, or did they really believe that Sunwest could turn around that many properties, in that many states and with no real track record of doing so, especially when their focus was on continued buying and not operations? How many underperforming properties can be purchased for $5 million (top bidder), appraised for $7 million on a “pro forma, as stabilized” basis and financed for 80% of that appraised value before things start to collapse? The answer, we have now learned, is about three to four years, or faster when the financing dries up. Buyers we have spoken with couldn’t understand how Sunwest kept on paying the top prices over and over again when the economics just didn’t seem to work, but now they understand.
We always thought, perhaps naively so, that Jon Harder was the classic case of someone who got too big for his britches, too quickly, and that he never had any insidious or illegal intentions and just got caught up in the ego-driven, bull market swagger that has felled far greater men. If the SEC allegations are proven to be mostly true, either he was incredibly reckless (the phrase the SEC uses is “reckless in not knowing”) or he knew exactly what was going on and simply was in too deep to dig himself out, especially once the capital markets dried up. Other than his personal real estate, and there is plenty of that, we always heard that Harder reinvested everything he had back into the business, as did his senior employees, so they have also lost millions as the house of cards collapsed. Did they not know? Did they not want to know? We may never find out the answer. The private jet is apparently gone, but the ranch, houses and condos in Oregon, plus a request for a $50,000 per month “allowance,” are just beyond belief at this point. We can only hope that someone is staying on top of the operations at Sunwest’s remaining communities, and that the quality of care and services doesn’t deteriorate. The industry doesn’t need an even bigger black eye at this point. We don’t know if there will be another bonfire at his beachside condo as the weather turns warmer, but if we are invited, we’ll make sure there are hotdogs this time.