A pashmina goat, of course.

Photographer: Tauseef Mustafa/AFP/Getty Images.

Pashminadepot.com Was Never Really About the Pashminas

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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A lot of investment scams are pretty simple. You tell someone you'll invest money for them, they give you money, you steal it, you run away to Namibia. Or, more likely, you fritter the money away day-trading Tesla stock because, realistically, criminals are dumb. But the stock market also has a long and charming tradition of needlessly complicated scams, where the basic process -- you give me money, I steal it -- is dressed up in multiple layers of storytelling designed to prey both on people's hopes and also on vulnerabilities in regulation.

Here is a fun fraud case about "undisclosed 'blank check' companies," a popular scheme but one that has always struck me as bizarrely convoluted. The background is that if you want to be a public company and sell your shares to regular investors, there are hoops you have to jump through. You have to file a registration statement with the Securities and Exchange Commission, with audited financial statements and a bunch of detail about your business. The SEC will review it and demand revisions to make sure that the registration statement is complete and gives investors sufficient disclosure. It's an expensive and time-consuming process, and if your business is oh I don't know fraud, you may (may) have a hard time smuggling that past the SEC.

But there is a loophole: If you are a private company, you can merge with a public company and inherit its public status. (Even if your business is fraud. ) This can be expensive if the public company you're acquiring is either (1) a good company (you have to pay up for it, and convince shareholders to sell) or (2) a bad company (you inherit a lot of liabilities). What you want is a nothing company, a company that does as little as possible other than have publicly traded shares.

Delightfully, there is an industry that does exactly that. Like, companies that do nothing but are publicly traded and available for merger are a product. The product has a name -- "blank check company" -- and there are people who specialize in building those companies and marketing them to private companies that want a cheap and somewhat shady way to go public. And there are rules governing their manufacture. The SEC, in particular, worries about it:

Blank check companies generally have no operations and no value other than their status as a registered entity, which makes them attractive targets for unscrupulous individuals seeking reverse mergers with clean shells ripe for pump-and-dump schemes.  The federal securities laws impose various requirements on blank check companies to prevent such illicit use.

Those requirements are not what you would call overwhelmingly onerous -- my favorite blank check company was Great Idea Corp., which went public "to seek to acquire assets or shares of an entity actively engaged in business which generates revenues" -- but at least the SEC keeps an eye on blank check companies to try to prevent them from being used for pumping and dumping.

So, of course, there are people who specialize in building black-market blank check companies, public companies that do nothing but pretend to do something, to get around the SEC's rules about companies that openly do nothing. The idea is, roughly:

  1. You incorporate a company with a fake business plan.
  2. You register it with the SEC as a real company, not a blank-check one.
  3. Your SEC review is pretty simple: Your financial statements show no operations and almost no assets, because you're claiming only to have a business plan, not an actual business.
  4. You go public, maybe sell a few shares to outsiders.
  5. You merge with another, private, company, possibly also with a fake business plan, so that that company can be public without SEC review.
  6. You make (possibly false) claims about the business successes of the merged company, sell a bunch of shares to dupes, pump, dump, etc.

Yesterday's SEC complaint is about some guys accused of building "undisclosed 'blank check' companies" on "a fine-tuned assembly line rife with fraud at each stage." The complaint describes various frauds at various stages: The defendants allegedly recruited straw-man "founders" for their shell companies, lied about their involvement in the companies, forged various e-mails and documents and notarizations, lied a lot when they merged the shell companies with existing private companies, took the proceeds of those mergers from the other rightful shareholders, etc. If the SEC is right, these defendants were mostly selling their expertise at getting around SEC rules in every aspect of registration.

But the other thing they were allegedly selling was fake business plans. Pages 10 and 11 of the complaint list the alleged blank check companies, and each one is its own tiny little story, a business that never existed, but that sounded plausible enough to fool the SEC into approving its registration statement. So there was Liquid Financial Engines, which said that it "intends to develop interactive customer management software targeted specifically at the capital markets"; it soon pivoted to mining gold and copper in Laos. There was We Sell for U Corp., which was going to "develop and provide service offerings to facilitate auctions on eBay for individuals and companies who lack the eBay expertise and/or time to list/sell and ship items they wish to sell"; it pivoted to "silver and base metal exploration in Central America and gem opportunities in Australia." (Mining seems to be a theme.) There was Pashminadepot.com, Inc., which hoped "to develop a website and sell pashmina and other accessories on that website"; it later moved into working on "a self-contained mobile water purification unit using a proprietary membrane filtration system, powered by highly efficient photovoltaic solar panels and hosted in standard-sized transportable containers," as well as a "high efficiency solar-powered air cooling/heating system."

And then there was Hidden Ladder, Inc., which was what it sounds like:

Hidden Ladder has designed a unique product for homeowners. The Hidden Ladder provides a hidden escape ladder for homeowners. It provides the homeowner comfort knowing that if there is a fire in their home they will be able to escape safely from the 2nd story. The ladder is both durable and aesthetic. It neatly folds up and hangs under the window and is not an eyesore in the home, but at the same time is easily accessible.

It's now an adult education company called Aspen Group, Inc. It's got a $20 million market capitalization, a web page, and accredited doctoral degrees. I don't know if it has sports teams, but if it does I hope they're called the Aspen Hidden Ladders. 

What is lovely about these allegations, if the SEC is right, is that the original stories were never designed to fool investors. Pashminadepot.com went public, sure, but it didn't do a public share offering to unsuspecting investors who just wanted exposure to the pashmina industry. Instead, according to the SEC, the promoters "solicited friends and family to invest in what they described in emails as 'my latest deal,'" "tightly controlled the roster of shareholders," and actually "rejected, for no legitimate business purpose, unsolicited investments from outsiders." They wanted these public companies to be public companies in appearance only, not in substance, so that they could more conveniently use them to take other companies public.  The only consumers of the story about the pashmina website, or the one about the hidden ladder, seem to have been financial regulators.  Somehow it warms my heart to think that even now there might be scammers out there somewhere, probably in Florida, writing fake business plans for only the SEC to read.

  1. I mean, it's discouraged. But the SEC review process is rather less stringent than it is for an initial public offering. Here is an SEC bulletin on "reverse mergers," which advises investors to be careful.

  2. They were also buying fake business plans, since they couldn't dream them all up on their own. From the complaint:

    McKelvey approached Hughes to be the sole officer of one of the Blank Check Companies, which became MIB Digital. Hughes agreed to act as the sole officer and use a defunct business plan he had previously devised as the purported plan for the company, despite knowing the company would never pursue the plan.

    McKelvey also asked Hughes if he knew of other business plans McKelvey could use for the other Blank Check Companies. Hughes knew McKelvey had a number of other such companies for sale. 

  3. Were those other companies designed to fool investors? The SEC doesn't say! It does say generally that blank-check companies are "attractive targets for unscrupulous individuals seeking reverse mergers with clean shells ripe for pump-and-dump schemes." So, y'know.

  4. In addition to the SEC, these companies sought Finra approval of Form 211 applications, making it easier to trade the companies' shares. This, again, made the blank check companies more useful to the private companies with which they merged.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net