Lessons of a real-estate fund's fast fall
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For almost a decade, Phoenix Four appeared to be a rock-solid investment. The real-estate fund racked up double-digit returns for clients across Europe, including Credit Agricole SA, Fortis Bank and Rothschild Bank. It claimed to hold more than $360 million in assets.
But in 2003, it collapsed: It stopped letting shareholders withdraw funds, prompting a legal imbroglio that continues to unfold. Among allegations in a lawsuit filed in federal court and a related arbitration matter: The fund suffered from a basic flaw in its structure, causing it to act like a Ponzi fund, with $4 of every $5 of new money invested being used to pay redeeming shareholders. To disguise its wobbly condition, the managers allegedly goosed up the valuations of its holdings.
New York-based Strategic Resources Corp., which ran the fund, denies wrongdoing. "SRC and its principals categorically deny the allegations levied against them by Phoenix Four's new board of directors and do not wish to comment on matters that are the subject of pending litigation," they said in a written statement.
Phoenix's downfall, detailed in court and arbitration filings, depositions and minutes of board meetings, holds lessons for investors far and wide. While it had characteristics of a hedge fund, Phoenix Four technically was a U.S.-based mutual fund sold to overseas investors. The legal actions illustrate the tricky valuation issues facing investors in any kind of fund that stretches beyond frequently traded stocks and bonds, revealing how even big institutional investors can be trapped in an investment gone wrong.
Ideally, funds use actual trades as the basis for calculating holdings' values. If something else is used, potential exists for misguided judgments -- and blatant price manipulation, especially because most money mangers are paid based on the values of their holdings.
The issue surfaced in the mutual-fund world in 2000, when two Heartland Advisors Inc. funds slashed the values at which they were carrying many nonrated bonds, causing one fund's share price to plummet 70 percent in a single day. The Securities and Exchange Commission charged the Milwaukee firm with deliberately overstating the value of the funds' high-risk bonds. Heartland denies wrongdoing.
Valuation also was an issue in the SEC's August 2004 sanctioning of Van Wagoner Capital Management. The agency accused fund manager Garrett Van Wagoner of mispricing securities, mainly stakes in technology companies that weren't publicly traded. Mr. Van Wagoner and his company agreed to pay $800,000 to settle civil charges that he defrauded investors, neither admitting nor denying the allegations.
Regulators acknowledge that there often is no right or wrong price for a fund holding. For U.S. mutual funds, the guidepost is establishment of a "fair value" that the fund "might reasonably receive ... upon a current sale." Funds can use different methodologies for deciding what fair value is.
In one Phoenix Four instance, a difficult-to-design property development called RiverAir, to be built above a landmark Manhattan synagogue, tripled in value on Phoenix Four's books in just two years, even though no progress had been made on the project, the plaintiffs allege. In another, Phoenix Four's estimated value of a stake in a start-up business for renters' insurance soared to $101.7 million from $15 million in two years, even though the company had no staff, no clients and no license to operate, the plaintiffs allege.
Phoenix Four was launched in 1994, as a decade-long boom in real-estate prices was getting rolling. Its founders were college dropouts Paul Schack and James Hopkins. A third partner was Christian Van Pelt, a New Jersey lawyer from a family with ties to wealthy individuals in Belgium. By the end of 1995, the fund had $23 million under management, mostly from Mr. Van Pelt's friends and family in Antwerp, Belgium.
Real estate is tough to sell quickly, but Phoenix Four's bylaws let investors pull money out of the fund once a month. Often, real-estate funds impose stricter limits on withdrawals, so they aren't forced to sell property quickly to meet redemptions.
Phoenix Four faced a cash shortage early on. At the fund's annual board meeting in January 1996, the directors noted the fund was having trouble generating enough cash to pay Strategic Resources its $790,684 performance fee. "It is imperative to raise more capital," the board concluded, according to minutes of the meeting. In July 1999, the board called the cash shortage "perhaps the single most important thing ... to focus on over the next to 6-12 months."
That was when Strategic Resources allegedly goosed up the valuations, plugging too-optimistic estimates into models that had been developed in 1994 for Phoenix Four by an accountant at BDO Seidman LLP, which served as Phoenix Four's independent auditor. The models were a variation of a commonly used method for valuing a property. In short, they involved estimating the income a property would collect over time -- usually five years -- and adjusting the stream for various risks, such as losing tenants.
For 1999, Phoenix Four reported a 17.3 percent gain on its properties -- with half the fund's total increase in shareholder equity accounted for by property valuations that were higher than independent appraisals at the time, according to a May 2004 report by an outside firm, FTI Consulting, hired by the fund's board to review the fund's fees and valuation practices.
In the legal actions, the plaintiffs accuse BDO Seidman of standing by while the fund managers assigned the rosy valuations, enabling the managers to pull in high fees -- $94 million over 10 years -- based on the purported strong performance. They contend BDO's ability to function as a disinterested watchdog was compromised: The accountant who developed the valuation models, Joel Shapiro, retired from BDO in June 2000 to take a new job -- consultant for Phoenix Four. In the job, which paid $15,000 a month, Mr. Shapiro acted as a liaison between Phoenix and BDO.
The BDO partner who took over the Phoenix Four account, Stuart Eisenberg, said in an April deposition that he didn't recall whether there were discussions at the accounting firm about whether Mr. Shapiro's new role would impair BDO's independence.
"BDO Seidman acted at all times consistent with professional standards," the firm said in a statement. In a deposition, Mr. Shapiro said the relationship between his new consulting firm and SRC was structured to avoid a conflict of interest with his former firm, BDO.
As the dot-com bubble burst in 2000 and the broader stock market tanked, Phoenix Four still reported double-digit annual returns. Many investors saw a chance to take much-needed profits and withdrew more money. By April 2001, the fund's properties generated only one-tenth the income needed to cover expenses.
Phoenix borrowed from some shareholders and board members to make ends meet; two directors -- Paul Hottlet and Jacques DeLodder -- lent nearly $2 million at interest rates nearly three times the prime rate. Fund investors footed the bill for the loans. Mr. DeLodder didn't return calls seeking comment. Mr. Hottlet said the higher interest rate reflected the fact that it was an unsecured loan.
At BDO, an internal memo said that given the fund's swelling size, the weak economy and concerns about the direction of the real-estate market, "professional skepticism should be heightened" and the valuations placed by Phoenix Four on its investments "should be challenged."
Still, valuations continued to outpace those offered by independent appraisers, the documents show. One of the biggest jumps in value took place at RiverAir, the would-be residential tower above the Manhattan synagogue, which doubled in value to $30 million in 2001 despite the lack of progress, the plaintiffs allege.
Meanwhile, the fund invested in the insurance start-up operation, Insurent. It was proposed by a Phoenix Four director, although it was a departure from the fund's usual real-estate holdings. BDO approved Phoenix Four's decision to value the Insurent stake at $26.7 million on its books -- even before the planned $11.5 million investment was made.
In his deposition, Mr. Eisenberg defended BDO's decision on Insurent, citing an agreement Phoenix Four made to provide funding for the company. Asked in the deposition about the BDO memo, he didn't recall seeking any changes to the fund's valuation assessments.
Without the boost to the values of RiverAir and the addition of Insurent to the portfolio, the value of Phoenix Four shares would have fallen 15 percent for 2001, according to calculations by The Wall Street Journal. Instead, investors were told their shares increased 8.6 percent and that assets totaled $360 million.
The cash problem was hitting crisis proportions. By December 2002, 80 percent of money invested in the fund was going out the door to pay off redeeming shareholders. On Feb. 17, 2003, in an emergency session, the board decided to cut off redemptions.
Midyear statements mailed later that year contained another surprise: Investors were told the fund's holdings were valued 30 percent lower than just six months earlier. The news triggered a shareholder rebellion. The next annual meeting, attended by about 200 well-dressed bankers, degenerated into a shouting match with accusations of fraud, according to several attendees. In early 2004, investors forced out Phoenix Four's board.
"Accounting must be a true reflection of the reality," says Bernard Lempereur, who oversaw an investment made by Fortis in the fund.
In April 2004, a new manager, Pyne Cos., took Strategic Resources' place. One of its first decisions was to price Insurent and RiverAir to a combined one-tenth of their former values.
RiverAir was later placed under bankruptcy-court protection and is still waiting to be built. Insurent has yet to open for business.
A settlement was reached between Mr. Shapiro and Phoenix Four in the lawsuit filed by the fund's new board in federal court in Manhattan; terms haven't been disclosed. The board's suit against Strategic Resources, seeking $150 million, continues as the board appeals a federal judge's decision to grant the defendants' request to move the matter to state court in New York. Meanwhile, Strategic Resources is suing the fund for $5.5 million in fees in state court in New York. The $77.8 million claim brought against BDO by the fund on behalf of shareholders is working its way through arbitration.
This summer Pyne Cos. received approval from fund shareholders to convert Phoenix Four to a closed-end format, meaning its shares will be traded on an exchange and investors could cash out of the fund. The fund is seeking to list on the Luxembourg Stock Exchange.
First Published December 4, 2006 12:00 am
