You Never Want to Be Suckered This Badly

Even with due diligence, sophisticated investors still get hoodwinked by fraudulent businesses.

Completely plagiarized.

Photographer: Three Lions/Hulton Archive

This post originally appeared in  Money Stuff.

There is a common but erroneous belief that securities fraud is only securities fraud when it involves publicly traded companies. “If a public company did this, it would be securities fraud,” people sometimes say about stuff that private companies do that is in fact securities fraud. There is nothing particularly in the law to support this view, but there is an understandable intuition behind it. Regular people buy shares of public companies based on information provided by the companies: Mom-and-pop investors can read a company’s securities filings and decide to buy its stock on the stock exchange, and if those filings are full of lies then the company is entirely to blame and the investors are innocent victims.

But private transactions are a little different. Private companies, of course, disclose less information publicly than public ones do. But when venture capitalists buy stakes in private tech companies, or when private-equity firms do leveraged buyouts, they tend to get a lot more information about the companies than regular public investors do when they buy stock on the stock exchange. This is called “due diligence,” and the idea is that sophisticated private investors who are writing very large checks are supposed to be able to ask good questions, and get satisfying answers to those questions, before writing those checks.

In practice this often isn’t true—big sexy tech unicorns can raise money with essentially no financial information—but it actually matters that it is true in theory. If you are a sophisticated private-equity investor writing a $100-million check to buy a company, and you have the opportunity to do due diligence and interview company management and review the financial statements and talk to the auditors and examine the customer lists and so forth, and the company sends you a pack of lies, and you don’t catch them and buy the company anyway, then yes, of course, that is the company’s fault, and the company did a bad thing, but it is also your fault too, in a way that it isn’t a public investor’s fault. Your job is to notice that stuff!

And so for instance Theranos Inc.’s private investors, who were victims of a “massive fraud,” get quite unsympathetic press: They were rich and sophisticated and had every opportunity to do due diligence, and if they got hoodwinked then that reflects almost as badly on them as it does on the hoodwinkers. It is embarrassing to be the victim of securities fraud when you are a sophisticated large investor who had the opportunity to do due diligence, which means that these frauds are less likely to be pursued than frauds against public investors. Who would want to report them?

Yesterday the Securities and Exchange Commission and the Department of Justice brought civil and criminal securities-fraud cases against three former executives of Constellation Healthcare Technologies Inc. Constellation was actually a publicly traded company, but the fraud charges are not about its public trading—which occurred on  the London Stock Exchange’s AIM market and is therefore none of the SEC’s business—but about a going-private transaction that it completed in early 2017. The buyer was Chinh Chu, who left the Blackstone Group LP to start his own buyout firm, and who put up $82.5 million of equity and borrowed $130 million from banks to do the deal. “Sources who have spoken with Mr Chu say he’s ‘comfortable’ proceeding, having spent $7m and three months work on due diligence alone,” reported Paul Murphy at the time

It didn’t work! Constellation went bankrupt this March, and according to the SEC it was kind of fake. For instance, the SEC tells the story of Constellation’s acquisition of MDRX Medical Billing LLC for $30 million:

In reality, MDRX too was a fabrication that Defendants had created based on a genuine Akron, Ohio-based medical-billing business (the “Real Medical-Billing Business”). In October 2015, CHT was contacted by an investment bank about a potential acquisition of the Real Medical-Billing Business.

CHT entered into a non-disclosure agreement with the investment bank, which in turn gave Defendants a Microsoft PowerPoint presentation pitching the Real Medical-Billing Business. …

The Defendants then altered the investment bank’s PowerPoint presentation pitching the Real Medical-Billing Business to create a sham MDRX “Due Diligence Findings Draft Report” dated October 20, 2015. The sham MDRX report essentially left the entire description of the Real Medical-Billing Business, including the company’s organizational chart, untouched, but inflated the company’s financials and simply changed the company’s name to MDRX, an entirely fictitious entity.

Emails among Defendants evidence their fabrication of MDRX. On October 22, 2015, Chivukula forwarded the MDRX PowerPoint to Parmar and Zaharis, noting, “Attached is the updated internal document and presentation. I am not able to remove the background image of [the Real Medical-Billing Business] in the presentation.

And the executives allegedly provided all sorts of fake stuff during Chu’s due diligence; the SEC says that he “relied on Defendants’ materially false and misleading statements and false and fabricated documents in determining whether to enter into the transaction.” You would hope that, in a nine-digit transaction led by a top-tier buyout expert and financed with bank loans, with months of due diligence, someone would notice that, you know, the company’s medical billing business was plagiarized from a real business and still had the real business’s logo in the background. “The filings give us the impression the alleged fraud was less ‘large, complex and brazen’ than the bankruptcy declaration makes it sound, and rather more maladroit and hapless,” writes Alexandra Scaggs, and while I am not sure I completely agree, really you never want to be suckered as badly as this, even by a complex fraud. If the allegations are true then the perpetrators are bad and might go to jail, but it is hard to escape the feeling that the victims look bad too.

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