Barnett and Company

Bernie Madoff Redux: The Case of Southport Capital

By now, most of the public has at least heard of the Ponzi scheme of John Woods, majority owner of Southport Capital, a Chattanooga, TN brokerage firm which has, in a complaint filed with the SEC, received $110 million from some 400 investors over the last ten years. These investors were told that their monies were invested in government debt and real estate projects that would produce a return of 6-7 percent per annum. Instead, the funds coming in were in part paying the interest to the earlier investors. Less than 20 percent of the monies raised went into any sort of investment, and the investments were not those which paid 6-7 percent right out of the gate, if ever. While the accounting is a bit murky at this point, it is assumed that John Woods and his co-conspirators were the principal beneficiaries of the fraud while it lasted.

The vehicle for the fraud was a private equity fund called Horizon Investments. It was managed by Mr. Woods and a few close associates. The investment was sold through the brokers at Southport as a private placement. Southport is a “dual-listed” company that has both a brokerage arm and an advisor branch called Livingston Group Asset Management Company. The advisor part charges a fee for managing the Horizon Fund. The brokerage arm executes the trades for the advisor side and sells the packaged financial products assembled by the advisor (Livingston) for a commission. The conflicts should have been apparent instantly. Because it was an unregistered “private placement” and promoted as a non-marketable security, the conflicts were either not disclosed or not made obvious to the investor in the venture.

This investment falls under the rubric “Alternative Investing.” As interest rates have fallen, investors needing income have become increasingly desperate for investments that have a steady return on the level of 12-15 years ago. Such investors were receptive to the blandishments of Southport brokers, some of whom may have been in the dark themselves and who touted the Horizon investments as ones that investors could retrieve their principal back in 30-90 days. This is the same promise made by Bernie Madoff, from whom Woods might have obtained his operating concept.

Many will fault the Securities and Exchange Commission for this occurrence. However, Woods never registered Horizon Fund with the SEC, making it impossible for them to oversee until someone brought it to the SEC’s attention. Also, the SEC’s enforcement budget is a fraction of what it was a decade ago, thanks to Congress, while the proliferation of financial products has risen exponentially. Finally, investors of private placement products are usually required to sign a statement called a “big boy” letter saying that they are an “accredited investor.” Such a statement states that the investor has a net worth of at least $1 million (home excluded) or income of at least $200,000 per year in each of the two most recent years, the SEC-mandated minimum standards for purchasing a risky financial product. These amounts have not been changed in 39 years. The idea is that if an investment is risky, the investor must demonstrate that they can afford to lose the amount invested. The SEC spends more time going after those who are trying to fleece unsophisticated investors than in providing needed assistance to the investors themselves.

Aside from a lack of inflation adjustment in the threshold amounts, the problem is that the investor’s financial information operates on a self-policing honor system. This data is notarized but never verified. It is assumed that the investor providing the information is presenting truthfully his or her financial status. Some people overstate their wealth in order to invest in a product that is supposedly only offered to those of means. They sometimes do this in order to obtain status since investing in such products is a subtle way to tell others of your presumed income or net worth. Some investors hope that investing like the “big shots” will enhance their own investment return. What people do not realize is that falsification of such information can impair their ability to sue for recovery. If you are this well off, you are more likely to be able to afford to lose your investment. At this time, it is not clear if the investors in the Horizon Private Placement were ever asked to sign such a statement validating their income or net worth. If not, the situation becomes even more criminal for the organizers.

How can an investor protect himself or herself from situations such as this? The first thing is to demand a separation of functions. Those profiting from selling the investment should be different from those managing the same. In this case, the separation superficially existed, given the Livingston Group Asset Management Company appeared to be a separate entity from Southport Capital. The problem was that both were part of the same organization and shared common ownership. What looked like a separation, in fact, did not exist. An SEC database search would have revealed this. The sales brochures probably did not.

The second thing is to insist on investments that can be converted to cash quickly and are valued by a third party. The lack of transparency of the Horizon Private investment gave the manipulators the ability to carry on a charade as to its worth for years. Many investors get vertigo following the stock market up and down. What they do not appreciate is that the fluctuation in prices is not the same thing as risk. Not all non-marketable investments have the soundness of a certificate of deposit, which is often the first experience most investors have with something that does not fluctuate in price.

Third, submit a proposed investment to a reality test. A return of 6-7 percent a year on a US government investment does not currently exist. The return for a 30-year Treasury bond is less than 2 percent. If someone is promoting something too good to be true, it usually is.

Finally, support more financial resources for the SEC. A tax of 0.1 cents per share transacted would greatly add to the budget of those who are mandated to protect the well-being of the investing public. States are hamstrung as well, for the same reasons. It is time to give those whom we entrust to safeguard our financial system the means to do so.

The Economy

The economy is getting ready to downshift due to the end of the federal stimulus program. While the program has been blamed for disincentivizing workers for low-wage jobs, the reality is that those states who had previously eliminated federal unemployment support are seeing a deceleration in economic activity relative to the states that have not, with no material uptick in numbers employed.

Nationwide, the number of those not working roughly equals the number of jobs being listed as available. The problem is in the details. Many jobs are in areas where people do not want to move to due to family or community ties, the cost of living in the new locality (especially housing), a lack of complementary job skills, the cost and availability of daycare, a lack of social skills to secure service-type jobs, age of the jobless and the like.

Interest Rates

Internationally, interest rates have been slowly going up. Governments in other parts of the world (South Korea, Chile, Hungary) have already started raising rates. The question is how fast this trend will accelerate.

The aggressiveness of interest rate increases will be a function of the ending of the Federal Reserve’s program of buying bonds. This provides liquidity and lowers interest rates by increasing the amount of currency in circulation. At present, the portfolio of bonds and other debt securities owned by the Federal Reserve is between $8 and $9 trillion. If the Fed were to simply stop buying bonds and let their portfolio mature, about $200 billion would be taken out of the money supply each quarter.

Inflation

The favorite word that is attached to inflation these days is “transitory”. People are trying to convince themselves that whatever inflation occurred this year will not be around going forward.

This is being done because the alternative is perhaps too alarming to contemplate. Still, with labor shortages as prevalent as they are currently, it is somewhat wishful thinking to assume that inflation will go back to the level of pre-COVID. Expect inflation to be a more prominent topic of conversation going forward.

The Stock Market

Stocks seem to be grinding higher, supported by post-COVID profit increases that seem dramatic compared to 2020, less so when compared to 2019. The liquidity provided by the stimulus has helped greatly to keep the market on an upwards trajectory.

Watch China. The current conduct of the country hardly reflects its self-interest. Its economy is slowing down. The issue is whether it will take other economies with it.

Mark Hulbert recently quoted one of the fathers of contrarian investing, Humphrey O’Neill, saying “When everyone thinks alike, everyone is likely to be wrong.” There are still attractive stocks. The issue is whether there is an attractive stock market. Especially for those who invest in packaged products, the slope will soon get steeper. Index investing works when the broad sweep of the market propels it. Valuations would suggest that such tailwinds are going to slow down if not reverse.

Warren M. Barnett, CFA
August 30, 2021

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