Wednesday, July 27, 2011

The Rights of Foreign Victims of U.S. Real Estate or Mortgage-Backed Securities Scams

A few previous blogs touched on the subject of real estate fraud that crosses national boundaries, and how difficult it can be for American victims to seek redress in foreign courts. I might have sounded xenophobic by focusing on scammers in Latin America, Canada and China, but international real estate fraud works both ways. There are also foreign victims of U.S.-based frauds.

Ethical standards in the U.S. should not be considered different from ethical standards elsewhere. It is not the nationality that matters, but the type of people the real estate industry attracts – people who want to make lots of money. If the real estate industry instead attracted saints, perhaps Mother Theresa herself would have devoted her life to selling condos to foreigners.

Prestige and fame matter little, too, in protection from fraud, as this blog will focus on extensive litigation against Goldman Sachs, an institution once so hallowed that our last three U.S. presidents have selected Goldman executives to become U.S. Secretary of the Treasury, including the present one.

U.S. Securities Laws are not Extra-Territorial

An overseas investor might also be surprised to find that U.S. securities laws do not apply to U.S. real estate investment securities marketed overseas, which includes mortgage-backed securities and real estate syndications.

For instance, Australian hedge fund Basis Yield Alpha recently lost its lawsuit against Goldman Sachs for a $78 million loss on its investment in a Goldman-sponsored CDO (collateralized debt obligation) known as Timberwolf 2007-1, which specialized in subprime mortgage loans. Goldman profited by betting against this CDO, as they have been known to do, even letting John Paulson design another CDO in which he was able to pick the nonprime packages that were “most likely to fail” and then invest in credit default swaps. The U.S. Securities and Exchange Commission sued Goldman and settled for $550 million one year ago this month.

Goldman, for this reason, faces other investor lawsuits from domestic investors, but Judge Barbara Jones dismissed the Australian lawsuit solely because U.S. securities law only governs securities sold within the United States. (As you may recall, This jurisdictional exception was upheld by the U.S. Supreme Court last year in the landmark case, Morrison v. National Australia Bank Ltd. This decision serves to bar the extraterritorial application of the U.S. Securities Exchange Act of 1934. In that case, although the lead plaintiff, Morrison, was American, the remaining plaintiffs were Australian and were victims of NAB’s (National Australia Bank) inaccurate accounting for its American mortgage servicing subsidiary, HomeSide Lending. The plaintiffs argued that the overvaluation of mortgage assets occurred in Florida, where the subsidiary was located, and U.S. securities laws should therefore apply, but the Court found that the securities were sold in Australia, by Australians, to Australians, and therefore U.S. law did not apply. Morrison, the American, could not prove damages, either.

Korean insurer Heunkuk Life Insurance is similarly affected in its lawsuit against Goldman Sachs.

These recent Federal court decisions do not preclude plaintiffs from suing in state courts or foreign courts.

Wednesday, July 20, 2011

GIC's Failed New York Real Estate Investment: An In-Depth Analysis

Stuyvesant Town. 

While recently in Singapore, I encountered lively debate about Singapore’s two sovereign wealth funds, the Government of Singapore Investment Corporation (known as “GIC”) and Temasek Holdings. Given Singapore’s reputation for clean government, some citizens grumbled about the lack of transparency with which these funds operate. I first became curious about GIC last year after learning of their $675 million + loss in the default of a New York apartment community known as Stuyvesant Town/Peter Cooper Village at the beginning of 2010.

The failure of Stuyvesant Town/Peter Cooper Village at the beginning of 2010 resulted in the largest real estate foreclosure [actually “deed in lieu of foreclosure”] in U.S. history. These two aging apartment communities, with a total of 11,250 apartments, were together purchased for $5.4 billion in 2006 in a syndication organized by Tishman Speyer and BlackRock; there was also $4.4 billion in first and mezzanine financing. The purchase price equated to $480,000 per apartment in two complexes that were built in the 1940s, equating to an annual gross rent multiplier of more than 30, unheard of for an American apartment property not headed for condo conversion (but perhaps common in Singapore).

73% of the apartments had rents restricted by New York’s Rent Stabilization Ordinance, and the average rent for a one-bedroom apartment was about $1300 per month at the time. At the time of purchase, market rents on one-bedroom apartments, once renovated, were estimated to be $3200 to $3500 per unit.

The loans were underwritten not according to present income but according to pro forma income expected in 2011, five years hence. Net operating income was forecasted to triple in five years! Tishman reportedly planned to more actively manage the property than previous owner MetLife, and thought rents could be raised through renovation and the eviction of or renegotiation with illegal tenants, estimated to occupy about 1000 units. MetLife previously also had a plan to convert the units into luxury apartments, but found itself legally confounded by tenant litigation. They basically tried the same strategy before and failed.

Enterprising New Yorkers sometimes pretend to keep possession of apartments with restricted rents while subletting to other unrelated parties. Tishman planned to aggressively raise rents on these illegal subletters. One problem, though, was that under the Rent Stabilization Ordinance, stabilized rents below $2000 per month are not eligible to be raised to market value, and most of the units were earning less than $2000 per month.

My personal observation is that New York is a very litigious city (I had an appraisal office there in the 1990s). I have been threatened with lawsuits just for calling up buyers or sellers and asking them what they paid for their properties. MetLife had already been stymied by tenant lawsuits, so Tishman should not have been surprised that its aggressive rental increase program would also attract a class action lawsuit on more than 4000 units. The courts judged $200 million in rental increases to be illegal and awarded $4000 to each renter.

Besides ruinous legal expenses, the financial industry meltdown had hit the New York apartment rental market hard, and market rents were falling. Asking rents on one bedroom apartments at Stuyvesant/Cooper had declined to $2255 per month at the time of foreclosure, not including a $500 move-in bonus.

The first mortgage loan was underwritten at a 1.7 debt coverage ratio based on pro forma Year 2011 NOI, but actual first year debt coverage in year 2006 was only .48! Having worked for America's largest multifamily lender in the 1990s, a deal like this would never have been done. Including the mezzanine debt, the 2011 DCR would have been only 1.2. Even more surprising was that there were two pieces of mezzanine debt, and GIC held the subordinate piece, $575 billion, which became worthless at the time of foreclosure. The superior mezzanine lien at least received $45 million.

What this meant for equity investors was years of red ink before the property could earn positive cash flow. When the projections became unattainable, there was no more reason for the investors to hold on to the properties, and the lenders took possession.

The most recent appraisal of this complex estimated market value at about $2.8 billion, meaning a potential loss of about $2.6 billion for the consortium of lenders which include Wachovia (now Wells Fargo), Merrill Lynch (now Bank of America), GIC and the other mezzanine lender.

Friday, July 8, 2011

The Beijing Gateway Plaza fraud controversy

Almost any real estate valuation report in the world has the same “limiting condition” buried within the report which reads more or less as follows:

We have relied to a very considerable extent on the information provided by the owners and have accepted their representations of tenancy, occupancy, financial performance, site area and floor area, which we assume to be true and accurate. We take no responsibility for inaccurate client-supplied data and subsequent conclusions related to such data.”

What if the property owner lied, though? Then, the accuracy of the valuation is compromised. This is a problem the world over, particularly when the property owner is the one who hired the valuer.

This week’s lawsuit by Tin Lik, a Hong Kong developer, against the trustees of the RREEF China Commercial Trust is an interesting example of the consequences of misrepresentations. This lawsuit came immediately after the June 30th judgment against Tin Lik in the case of HSBC Institutional Trust Services v. Tin Lik, decided by The High Court of the Hong Kong Special Administrative Region.

HSBC Institutional Trust Services was the trustee of the RREEF China Commercial Trust, a Hong Kong REIT having the Beijing Gateway Plaza office complex as its sole asset. On June 4th, 2007 the Trust bought Gateway Plaza from Tin Lik based on Tin Lik’s representations of rental income, representations which were discovered to be false by the newly appointed REIT manager, RREEF China REIT Management Limited, who then calculated the financial value of the discrepancies to be HK$278,526,708. These discrepancies and the estimation of financial loss were later reviewed and confirmed by an independent subcommittee which included an un-named international accounting firm.

On September 7, 2007, Tin Lik agreed to pay the full sum of HK$278,526,708 and promised to make further payments if that sum was later found to be insufficient. Such an action is tantamount to a guilty plea.

A new valuation of the property was done on September 30, 2007, establishing a value of HK$3,699,000,000. After taking into consideration the HK$278 million already paid by Tin Lik, the Net Asset Value attributable to all the unit holders was still HK$69,663,000 lower than if the rents had never been misrepresented.

The Sale and Purchase Agreement by which the Trust acquired Beijing Gateway from Tin Lik established monetary “set-offs” for other discrepancies as well, such as breach of warranties. Tin Lik had warranted certain equipment such as lifts (elevators) and HVAC as being in good repair and reasonable working order, having been regularly and properly maintained and not dangerous or obsolete, but some of the equipment had to be repaired or replaced.

There was also a guarantee of billboard rental income of RMB35 million for the first year, 38 million for the second year, and 40 million for the third year, but the tenant defaulted.

Based on the breach of warranties, the REIT manager calculated further “set-offs” due from Tin Lik as being:

HK $216,890,160 in 2007
HK $ 35,270,591 in 2008
HK $ 11,533,376 in 2009 and
HK $ 12,902,544 in 2010, which adds up to HK$276,596,671 additionally due to the Trust from Tin Lik.

Tin Lik disputed the set-offs and on May 20, 2010, sent a letter demanding repayment of the HK$287,497,000 he paid on September 7, 2007 to settle discrepancies related to rental income. Unfortunately, the property was sold to Mapletree India China Fund on February 3, 2010, and after the sale, a Special Resolution of the unitholders was passed on March 31, 2010 to terminate the Trust and delist it from the Hong Kong Stock Exchange.

Tin Lik is now contending that he was coerced into admitting fraud and making the HK$287,497,000 payment to the Trustees in his new lawsuit, which seeks to recover that payment.
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Monday, July 4, 2011

"Independent Valuation" Problems in Chinese Equity Offerings

One notable scandal this last month was the public accusation that Sino-Forest, a Chinese forestry resources company traded on the Toronto Exchange (TRE.TO), is no more than a Ponzi scheme. The accusation was made by Hong Kong equity research firm Muddy Waters, LLC, in a 40-page research report reminiscent of Harry Markopolos’s expose of the Madoff Ponzi scheme.

I will not comment on the merits of the accusation other than to say that there is enough fraud coming out of China that I don’t see a reason for an analyst to make up false stories. On U.S. exchanges alone, eleven Chinese companies have had their securities registrations revoked by the SEC (Securities and Exchange Commission) and 24 more have been forced to address accounting irregularities or auditor resignations, and of the 19 most recent filings of class action securities lawsuits in the U.S., at least 5 have been against Chinese companies. The simple observation that Sino-Forest has produced no free cash flow or dividends in 16 years in spite of escalating revenues is cause for suspicion. John Paulson dumped his shares right away after the MW report.

Some of you may wonder about the CFE initials in my by-line. They stand for "Certified Fraud Examiner", a credential awarded by the Association of Certified Fraud Examiners. One thing we were taught in our educational program is that fraud is a crime of opportunity. It will move to areas where the controls are weakest, opacity is greatest, and greed and a miraculous story get in the way of due diligence and reason. This makes China an ideal place to commit fraud, just as Florida and Las Vegas were 5 years ago.

Foreign investors are wowed by China's reported 10% annual GDP growth rate and accept Chinese financial reporting with the assumption that auditors and valuers know everything going on within a Chinese company. Many Chinese companies create a labyrinth of offshore entities in the British Virgin Islands and Cayman Islands to hide transactions or owners from view. Sino-Forest and Hui Xian have both done that.

As for Sino-Forest, Muddy Waters specifically addressed the reliability of the "independent valuation" report, as follows:

"TRE provides fraudulent data to Poyry, which
produces reports that do nothing to ensure that TRE is


"TRE became more sophisticated – engaging Jakko Poyry to write valuation reports, all the while giving Poyry manipulated data and restricting its scope of work. Thus more and more investors are drawn into TRE’s fraud every year as it falsifies timber investments and manipulates Poyry further."

One common theme of the Muddy Waters analysis and my own blogs about Perennial China Retail Trust and Hui Xian REIT is the use and abuse of so-called “independent valuation reports” from respected firms with valuers possessing respected credentials. In each case, the sponsors that hired the valuers restricted the scope of work or imposed assignment conditions which impaired the reliability of the reports. Each example is explained as follows:

Independent valuation of Sino-Forest (TRE.TO)

As Muddy Waters describes, the independent valuation firm Jaakko Poyry couched its valuation opinion with multiple disclaimers such as follows:

• “Poyry has not viewed any of the contracts relating to forest land-use rights, cutting rights, or forest asset purchases.”

• “It is important to understand that this is not a confirmation of forest ownership, but rather a verification of the mapped and recorded areas of stocker forest

These types of disclaimers naturally arouse suspicion, as in Shakespeare’s famous phrase, “The lady doth protest too much, methinks.” Why would the valuer feel the need to make such statements unless he knew something was wrong?

Independent valuation of Perennial China Retail Trust (N9LU.SI)

Here’s a situation in which the annual base fee to the Sponsor is established by independent valuation, but the “independent valuer” was asked to assume that all five properties had been acquired and developed and leased to full occupancy, when only one of five properties had been built and two only existed as purchase options. The inflated appraised value of about $1.1 billion SGD is 54% above market capitalization at the close of markets on July 4th. The $1.1 billion SGD appraised value translates to an annual base fee of $3,850,000.

The valuation firm also performed limited due diligence, as they explained as follows in the valuation report that was included in the IPO prospectus:

Whilst CB Richard Ellis has endeavoured to assure the accuracy of the factual information, it has not independently verified all information provided by the Trustee-Manager (primarily copies of leases and financial information with respect to the Properties as well as reports by independent consultants engaged by the Trustee-Manager).

CB Richard Ellis has relied upon property data supplied by the Trustee-Manager which we assume to be true and accurate. CB Richard Ellis takes no responsibility for inaccurate client supplied data and subsequent conclusions related to such data.

This confidential document is for the sole use of persons directly provided with it by CB Richard Ellis (Pte) Ltd. Use by, or reliance upon this document by anyone other than Perennial China Retail Trust Management Pte. Ltd. (as Trustee-Manager of Perennial China Retail Trust) is not authorised by CB Richard Ellis and CB Richard Ellis is not liable for any loss arising from such unauthorised use or reliance. This document should not be reproduced without our prior written authority.”

Independent valuation of Beijing Oriental Plaza (Hui Xian REIT)

The owners had been receiving valuations of its only property, Beijing Oriental Plaza, from DTZ Debenham Tie Leung Limited on an annual basis. The valuation was RMB 11.2 billion at the end of 2009 and RMB 20 billion as of October 31, 2010, based on a decline in market capitalization rates and an increase in rents of 2% for offices and 6.7% for retail tenants.

Nevertheless, for the purposes of the IPO and the estimation of a “revaluation surplus” distribution to the previous owners, a different valuer was chosen – American Appraisal China Limited -- who estimated market value to be RMB31.4 billion as of January 31, 2011, just three months after the DTZ valuation of RMB 20 billion, a further increase in value of 57%. Despite this new valuation, though, the IPO sponsors priced the entire offering at between RMB 26.2 billion and 27.9 billion, 11 to 17% below appraised value. Why would the Sponsors price below appraised value unless they didn’t believe the appraised value of AAC? Why did they switch valuation firms? As of July 5th, market capitalization has dropped to RMB 23.45 billion, which is only 75% of appraised value.

More specific concerns about the valuation report are presented in my Hui Xian blog.

The appraised value of RMB 31.4 billion was used to establish a “revaluation surplus” of RMB 7.775 billion payable to the previous owners, although the market capitalization of the entire REIT was never that high, and current market capitalization suggests that no such surplus value exists. The amount of “revaluation surplus” was based on subtracting net book value of RMB 23.635 billion from the appraised value of RMB 31.41 billion, but current market capitalization of RMB 23.45 billion suggests that no revaluation surplus is warranted, and that the RMB 7.775 billion is money that has been taken from investors through a dishonest scheme.

The new valuers also performed limited due diligence, as they explained as follows:

We have not carried out on-site measurements to verify the areas of the Property and assume the areas contained in the documents provided to us are correct. We have no reason to doubt the truth and accuracy of the information as provided to us by BOP and Commerce and Finance Law Offices on PRC law. We have also been advised by BOP that no material facts have been omitted from the information so supplied. We consider we have been provided with sufficient information to reach an informed view.”


Allowing IPO and subsequent offering sponsors to order “independent valuations” is a blatant conflict of interest, although this is a problem that is not unique to China. Moreover, an "independent valuation" that refuses or is not permitted to perform verification of factual information, such as ownership, financial operations, or property size, is useless and misleading to investors.

Investors should understand that valuers typically put disclaimers and limiting conditions in their valuation reports to prevent liability for passing on fraudulent data. They basically assume that everything the property owner states is true. This does nothing to ensure that valuers rely on accurate data, but deceives investors into thinking that the valuation reports are thorough and accurate.

Disclosure: I do not have any short or long positions in these stocks.