Monday, March 31, 2014

No. 38: Weakening of Disclosure Requirements Imposed by State Regulators on Insurance Companies

The National Convention of Insurance Commissioners (Convention) was created in 1871 in the wake of the 1868 U.S. Supreme Court decision in Paul v. Virginia, which held that insurance was not commerce. An important reason for creation of the Convention was to prepare uniform annual financial statement blanks that insurance companies could file in all states. The Convention became the National Association of Insurance Commissioners (NAIC) in 1939, and to this day a major function of the NAIC is the promulgation of uniform annual statement blanks.

Removal of Schedules
Over the years the NAIC removed several important schedules from the life insurance company blanks. Among the schedules removed were Schedule G (executive compensation), Schedule J (legal expenses), Schedule K (lobbying expenses), and Schedule M (life insurance policy dividends).

The NAIC once thought the information in those schedules was important. However, the life insurance industry lobbied the NAIC to remove the schedules from the blank, and the NAIC did so. Although there was public interest in the information in those schedules, the NAIC said the schedules served no useful regulatory purpose.

Removal of Schedule G
Public interest in the executive compensation information in Schedule G always has been strong. In the January 1987 issue of The Insurance Forum, in an article entitled "More Secrecy from the NAIC," I said removal of Schedule G from the NAIC blank ended a long tradition of executive compensation disclosure in life insurance company annual statements dating from legislation enacted in 1906 after the Hughes-Armstrong investigation of 1905.

A New York law requires life insurance companies doing business in New York to disclose executive compensation information in annual statements filed in New York. For that reason, the New York Department of Insurance, which is now the New York Department of Financial Services (DFS), had to retain Schedule G in the New York Supplement to the NAIC blank.

Decimation of the New York Law
In the October 2008 issue of The Insurance Forum, in an article entitled "The Decimation of New York State's Century-Old Compensation Disclosure Law," I described how the life insurance industry lobbied the New York legislature to curtail sharply the amount of executive compensation information that had to be disclosed. The amendment passed easily with no hearings, no debate, and no media scrutiny.

Until I received a tip after the amendment had cleared the legislature, I was not aware of the amendment even though its purpose was to reduce the amount of information available for my annual tabulations of executive compensation. I immediately wrote to then New York Governor David A. Paterson asking him to veto the amendment, but he signed it.

Special Treatment of Schedule G
Even in its decimated form, Schedule G is subject to special treatment. The DFS instructs companies to file Schedule G separately from the rest of the New York Supplement. Then the DFS posts the New York Supplement, without Schedule G, on the DFS's public portal. Thus a person who wants one or more Schedule Gs must file a formal request pursuant to the New York Freedom of Information Law and experience the delays associated with such requests.

On March 13, 2014, I asked Michael Maffei, chief of the life bureau of the DFS, to explain why the DFS gives special treatment to Schedule G. He did not reply. I think the life insurance industry lobbied the DFS, and the DFS agreed, to prevent the public from gaining easy access to executive compensation information.

General Observations
The history of Schedule G with the NAIC and the DFS vividly illustrates the contrast between the strong disclosure requirements in federal securities laws and the weak disclosure requirements in state insurance laws. Public companies are required to include executive compensation information in filings with the Securities and Exchange Commission (SEC). Most of the companies include the information in proxy statements, and a few include it in 10-K annual reports.

Those documents are readily available to the public on the SEC's website with no restrictions, no delays, no expenses, and no questions asked. One can only imagine the furor that would arise if shareholders, other investors, reporters, and the public had to incur the long delays associated with formal requests pursuant to the federal Freedom of Information Act to obtain access to executive compensation information.


Monday, March 24, 2014

No. 37: A Life Partners Attorney Sends Me a Letter

On March 19, 2014, I received a letter by e-mail from C. Alfred Mackenzie. He is special counsel for Life Partners, Inc. (Waco, TX), an intermediary in the secondary market for life insurance and a subsidiary of Life Partners Holdings, Inc. (NASDAQ:LPHI). The subject of his letter is my post No. 29 dated February 10, 2014. The text of his letter is shown below in boldface type, and my comments are in regular type.

As legal counsel for Life Partners, Inc., I am writing about the defamatory article on your website, at the following URL:

My post No. 29 was not and is not defamatory.

Your article reports that the jury returned a verdict on February 3, 2014, in a civil lawsuit brought by the Securities and Exchange Commission (SEC) against Life Partners and three of its executive officers. At the outset, I should point out that the terms "guilty" and "not guilty" are applicable to criminal prosecutions, but not a civil action such as the case against Life Partners.

It would have been more precise for me to refer to the jury findings as "yes" or "no" on each question of whether Life Partners and its officers "violated" federal securities laws and regulations.

More importantly, however, in keeping with journalistic standards, it is reasonable for Life Partners to expect that you will update your reporting to inform your readers that Life Partners has been cleared of all fraud charges asserted by the SEC. As you are probably aware from recent news reports, on March 12, 2014, the United States District Court for the Western District of Texas ruled that the SEC failed to prove any of its fraud claims against Life Partners and its CEO, Brian Pardo, and General Counsel, Scott Peden. The ruling followed a jury finding in February that neither Life Partners, Mr. Pardo, nor Mr. Peden committed securities fraud under Rule 10b-5 and that Mr. Pardo and Mr. Peden did not engage in insider trading.

From court records I was aware of the March 12 ruling and I intended to post a follow-up soon. Because The Wall Street Journal reported the ruling immediately, I felt no urgency to report it quickly. Given the Mackenzie letter, however, I will reply to his comments rather than prepare a separate post. When further important developments in the case occur, I will report them. I do not operate a daily newspaper, and lately I have been posting one item per week. A majority of my posts are on subjects other than Life Partners. On March 17, however, I posted No. 36 about an Oregon consent order directed at a Life Partners agent in connection with securities violations. I think the case is important and to my knowledge it has not been reported in the major media.

Although the jury had found in favor of the SEC's fraud claim under Section 17(a) relating to the company's revenue recognition policies, that claim, which a government attorney characterized as "a lead" claim in the case, was challenged by Life Partners on the basis that it was not supported by any evidence. Senior U.S. District Judge James R. Nowlin agreed with Life Partners that there was no evidence to support the revenue recognition claims for the period of time in question and ordered that judgment be entered in favor of Life Partners, Mr. Pardo, and Mr. Peden on that issue. As a result of this ruling, the Company, Mr. Pardo, and Mr. Peden have been completely exonerated from any allegations of fraud alleged by the SEC. The Court let stand the jury's findings against Life Partners relating to bookkeeping, reporting and certification by the CEO on the company's financial statements, none of which involve fraud or knowingly or recklessly misleading shareholders.

If I had posted a follow-up, I would have said Judge Nowlin rejected one jury finding of violations and retained three jury findings of violations. I also would have said that the text of LPHI's 8-K (material event) report filed with the SEC on March 14 did not describe the ruling, that the text of the 8-K merely referred to an attached press release, that the press release was entitled "Life Partners Cleared of All Fraud Claims," that Judge Nowlin's retention of three jury findings of violations was not mentioned until the third paragraph of the press release, and that the press release was posted on LPHI's website.

Because Life Partners has now been cleared of all fraud charges asserted by the SEC, I am requesting, on behalf of Life Partners, that you correct the statements on your website that have now become misleading and set the record straight. Your prompt attention to this matter is greatly appreciated.

My statements were not and are not misleading or incorrect.


Monday, March 17, 2014

No. 36: A Life Partners Agent Runs Afoul of the Oregon Securities Law

On February 21, 2014, the securities regulator in Oregon issued a press release announcing a consent order directed at James Walter Malanowski, a resident of Oregon and an agent of Life Partners, Inc. (LPI). LPI, based in Waco, Texas, is an intermediary in the secondary market for life insurance policies. The consent order, issued August 13, 2013, provides a rare glimpse into the activities of an LPI agent.

In 1983, Malanowski became licensed as a resident producer by the Insurance Division of the Oregon Department of Consumer and Business Services (Department). In 2010, he became an LPI agent. He was not licensed by the Department's Division of Finance and Corporate Securities (DFCS) to offer or sell securities.

As explained in the consent order, LPI buys a life insurance policy directly from the insured or through a broker. LPI resells the policy to an institutional buyer for more than LPI paid for it, or sells fractionalized interests to individual buyers. In the latter case, if the insured outlives the estimated life expectancy, the buyer of a fractionalized interest must pay additional premiums for his or her portion of the policy.

Malanowski's Workshop
Malanowski used various techniques to sell fractional interests. In one instance, he hired a company in Irvine, Texas, to advertise, through a mailer, a free meal at a "Senior Financial Workshop" held in a Portland-area restaurant. The mailer went to about 4,500 Portland-area residents and said the workshop would introduce "some options and useful financial strategies which [the recipient] may not have been aware existed."

The Sale to WMH
In February 2011, WMH, a 77-year-old resident of Oregon, attended the workshop. There he learned about life settlements and agreed to a private meeting with Malanowski. In March 2011, at the private meeting, Malanowski recommended that WMH, the owner of a Roth individual retirement account (IRA), surrender the Roth IRA and use the proceeds to buy fractionalized interests.

Malanowski told WMH he had to be an "accredited investor" to buy fractionalized interests. According to Rule 501 promulgated by the Securities and Exchange Commission (SEC) in connection with Regulation D, an individual must have a net worth of at least $1 million or an annual income of at least $200,000 to qualify as an accredited investor. The consent order said:
Malanowski then provided WMH an LPI Suitability Questionnaire, which required WMH to attest to his accredited investor status. WMH initialed the space providing: "I hereby affirmatively represent that I am an accredited investor as defined in SEC Rule 501 under Regulation D for one or more of the foregoing reasons which I decline to specify due to issues of financial privacy."
Malanowski took no further steps to verify WMH's accredited investor status. WMH later told DFCS that he had neither the net worth nor the annual income to qualify for accredited investor status, and that Malanowski had counseled him to initial the questionnaire as though he qualified for that status.

WMH opened a self-directed Roth IRA with IRA Plus Southwest, LLC (IPS) of Dallas, Texas. IPS was a custodian recommended by LPI. WMH transferred about $35,000 from his Roth IRA to the IPS Roth IRA. Malanowski then sold WMH fractionalized interests in the policies of three insureds—Newmark, Zayonts, and Lesser—for a total of about $35,000. The fractionalized interests were not registered as securities with the DFCS in accordance with the Oregon Securities Law. Malanowski did not disclose to WMH that he—Malanowski—was not licensed to sell fractionalized interests in Oregon.

The consent order describes the three fractionalized interests that WMH purchased. With regard to Newmark, for example, the consent order—in exactly the following language—illustrates a significant discrepancy in LPI documents:
The Newmark Policy Funding Agreement specifically stipulated that "both parties understand and agree that their relationship is one of principal and agent and does constitute the sale of a security[.]" (Emphasis added.) Other documents provided to WMH contained statements that the LPI interests were not securities.
WMH paid $11,650, which was treated as a "loan" to LPI, for a fractionalized interest of about 0.25 percent in the $8 million Newmark policy. Upon Newmark's death, WMH was to receive about $20,000 to repay the "loan." However, if Newmark outlived his 84-month estimated life expectancy, WMH would be required to pay additional premiums.

The Department's Findings
The director of the Department found that the fractional interests were securities under Oregon law, that Malanowski offered and sold three unregistered securities to WMH, and that Malanowski sold securities in Oregon without being licensed to do so. The director also found that Malanowski made misleading statements in violation of Oregon law, that he failed to disclose the fractionalized interests were not registered, and that he failed to disclose he was not licensed to sell securities in Oregon.

The director ordered Malanowski to cease and desist from violating Oregon laws, and denied him for at least two years the use of exemptions to registration requirements. The director assessed a civil penalty of $40,000, with a dollar-for-dollar reduction for the amount Malanowski paid to WMH as restitution and with an upper limit of $35,000 in the amount of the reduction in the civil penalty. Malanowski returned the entire $35,000 to WMH, and therefore the net civil penalty was $5,000. The director also ordered Malanowski to pay $1,000 to the Department's consumer protection trust fund.

Malanowski neither admitted nor denied the facts and allegations in the consent order. However, he agreed to cooperate with any investigation by the director into the business dealings of LPI or any of its associated companies, and into any interests similar to those sold by LPI. Cooperation includes but is not limited to providing testimony at any interview, deposition, administrative hearing, or trial.

General Observations
The punishment in this case seems modest. However, the consent order is significant because of the details it provides in areas such as the perennial question of whether LPI's offerings are securities and the role played by LPI in the marketing of its life settlements to individual buyers.

The "neither admit nor deny" language is common not only in insurance and securities settlements, but also in settlements in all industries. Currently, however, some regulators—the SEC is an example—are trying to force wrongdoers to acknowledge wrongdoing as part of settlements.

I am offering the 12-page consent order as a complimentary PDF. Send an e-mail to and ask for the consent order in the Malanowski case.


Monday, March 10, 2014

No. 35: Life Partners Holdings and Selective Disclosure

Life Partners, Inc. (Waco, TX) is an intermediary in the secondary market for life insurance policies and the operating subsidiary of Life Partners Holdings, Inc. (NASDAQ:LPHI). In post No. 22 entitled "A Devastating Setback for Life Partners," I mentioned LPHI's practice of disclosing good news immediately and delaying disclosure of bad news. I decided on this follow-up after LPHI failed to disclose promptly a recent Texas appellate court decision that may have a material adverse effect on the company.

Regulation FD
Regulation FD (Fair Disclosure) promulgated by the Securities and Exchange Commission (SEC) has been in effect since October 23, 2000. The SEC said the regulation addressed the issue of "selective disclosure of material information by issuers," which "bears a close resemblance ... to ordinary 'tipping' and insider trading." The SEC also intended to address "the potential for corporate management to treat material information as a commodity to be used to gain or maintain favor with particular analysts or investors."

8-K Reports
Among the documents public companies file with the SEC and thereby make publicly available are 10-K annual reports, 10-Q quarterly reports, and 8-K reports. I call an 8-K a "material event report," and the SEC calls it a "current report on Form 8-K." The SEC says the 8-K "provides investors with current information to enable them to make informed decisions."

Numerous categories of information are disclosed in an 8-K. Here are three examples: Item 1.01 is "entry into a material definitive agreement," Item 2.02 is "results of operations and financial condition," and Item 5.07 is "submission of matters to a vote of security holders."

The 8-K category on which I focus here is Item 8.01, which is "other events." The SEC says: "This is the place where companies may report anything that they believe is important but is not specifically required elsewhere in the 8-K."

LPHI's Recent 8-K Reports
Consider LPHI's ten most recent 8-K reports. The following seven of them contain an Item 8.01 disclosure, with the date of the event and the date LPHI filed the 8-K shown in parentheses:
  1. The denial of class certification in a consolidated class action lawsuit against LPHI (7/9/13; 7/10/13)
  2. LPHI's announcement of the declaration of a quarterly dividend to shareholders (9/6/13; 9/12/13)
  3. A Texas state appellate court reversal of a lower court decision that had been favorable to LPHI (8/28/13; 9/16/13)
  4. The plaintiffs' withdrawal of the class action lawsuit referred to in (1) above (12/2/13; 12/4/13)
  5. LPHI's announcement of the declaration of a quarterly dividend to shareholders (12/17/13; 12/17/13)
  6. LPHI's announcement of a verdict following the jury trial in the SEC's lawsuit against LPHI (2/3/14; 2/4/14)
  7. LPHI's announcement of the declaration of a quarterly dividend to shareholders (3/4/14; 3/5/14).
Events 1, 2, 4, 5, and 7 above were good news for LPHI and the 8-K reports were filed within four business days after the event. Under SEC rules, an 8-K generally is supposed to be filed within four business days.

Event 3 was bad news for LPHI. A three-judge panel of a Texas state appellate court ruled unanimously that LPHI's life settlements are securities under Texas law. The court handed down the decision on Wednesday, August 28, 2013. LPHI filed the 8-K on Monday, September 16, the 12th business day after the event. In the 8-K, LPHI said it strongly disagreed with the decision and will appeal. In recognition of the materiality of the decision, LPHI also said:
Should the decision ever become final, it would result in a material adverse effect on our operations and require substantial changes in our business model.
Event 6 related to a federal jury verdict in the recent case of SEC v. LPHI. As I discussed in post No. 29, LPHI and its top two officers were found guilty of some and not guilty of other civil securities violations. The verdict was clearly a material event. LPHI promptly filed an 8-K, but the two-sentence text of the 8-K did not describe the verdict. Instead, the text said LPHI had issued a press release, had attached the press release to the 8-K as an exhibit, and had posted the press release on LPHI's website. However, LPHI cleverly and falsely titled the press release "Life Partners Prevails in SEC Lawsuit." In the press release, LPHI featured the "not guilty" elements of the verdict in the first few paragraphs, and briefly mentioned the "guilty" elements later in the press release. Also, LPHI prominently displayed the title of the press release at the top of the home page of the company's website with a link to the press release.

Another Adverse Court Decision
On Thursday, February 6, 2014, as I discussed in post No. 30, a three-judge panel of another Texas appellate court unanimously reversed a state district court judgment that had been favorable to LPHI. This was another ruling that LPHI's life settlements are securities under Texas law. An LPHI attorney told a reporter for The Wall Street Journal and me that LPHI plans to petition the Texas Supreme Court to review the decision.

As of the close of business on Friday, March 7, the 20th business day after February 6, LPHI had not filed an 8-K disclosing the decision. I believe that LPHI decided not to file an 8-K about the decision, and instead to mention it deep in LPHI's next major report, in the "Legal Proceedings" section of the report. LPHI's next major report will be the 10-K for the fiscal year ended February 28, 2014. LPHI filed its 10-K last year on May 29, 2013.

General Observations
In my opinion, LPHI's practice of disclosing good news immediately and delaying disclosure of bad news is precisely the type of selective disclosure about which the SEC has expressed concern. Whether LPHI will be called to account for its practice of selective disclosure remains to be seen.


Monday, March 3, 2014

No. 34: Bitcoins Suddenly Become Big News

For some years there has been discussion of "Bitcoins," a form of "virtual currency" or "cryptocurrency," but in recent weeks they have suddenly become big news. The subject is of interest to me because of the significant risks assumed by people who invest in virtual currency.

What Are Bitcoins?
Later in this blog I discuss the federal indictment of a prominent promoter of Bitcoins. In that case, a special agent of the Federal Bureau of Investigation (FBI) provided this definition of Bitcoins:
Bitcoins are an anonymous, decentralized form of electronic currency, existing entirely on the Internet and not in any physical form. The currency is not issued by any government, bank, or company, but rather is generated and controlled automatically through computer software operating on a "peer-to-peer" network. Bitcoin transactions are processed collectively by the computers composing the network....
Bitcoins are not illegal in and of themselves and have known legitimate uses. However, Bitcoins are also known to be used by cybercriminals for money-laundering purposes, given the ease with which they can be used to move money anonymously.
A Civil Lawsuit by the SEC
On July 23, 2013, the Securities and Exchange Commission (SEC) filed a civil lawsuit in federal court against 30-year-old Trendon T. Shavers (McKinney, TX), the founder and operator of a Bitcoin company. The SEC alleged that Shavers "falsely promised investors up to 7% interest weekly" and claimed that "risk is almost 0." The SEC also alleged that Shavers operated a Ponzi scheme in which he used funds from new investors to make interest payments and cover withdrawals by earlier investors, and that he exchanged Bitcoins for U.S. dollars to pay his personal expenses. Shavers does not yet have an attorney.

On August 6, 2013, a federal magistrate issued an order in which he found that Bitcoin investments are securities. He thus found that the court has jurisdiction in the case.

On December 30, 2013, the magistrate issued an order laying out the timetable for the case. If the timetable is followed, the case would come to trial on March 12, 2015. (SEC v. Shavers, U.S. District Court, Eastern District of Texas, Case No. 4:13-cv-416.)

A Federal Criminal Lawsuit
On September 27, 2013, a special agent of the FBI filed a complaint in federal court in New York against 29-year-old Ross William Ulbricht, also known as "Dread Pirate Roberts," "DPR," and "Silk Road." Ulbricht was identified in part through a Texas driver's license. The FBI agent said Bitcoins were the "only form of payment accepted on Silk Road," sought an arrest warrant, and alleged that Ulbricht was part of a conspiracy to violate U.S. narcotics laws.

On October 1, 2013, federal agents arrested Ulbricht in California. He is now in a federal jail in New York, where he is being held without bond. 

On February 4, 2014, a federal grand jury indicted Ulbricht. U.S. Attorney Preet Bharara of the Southern District of New York filed the indictment. The four counts are "narcotics trafficking conspiracy," "continuing criminal enterprise," "computer hacking conspiracy," and "money laundering conspiracy."

The indictment alleges that Ulbricht "created an underground website known as 'Silk Road,' designed to enable users across the world to buy and sell illegal drugs and other illicit goods and services anonymously and outside the reach of law enforcement." The indictment also alleges that "Silk Road emerged as the most sophisticated and extensive criminal marketplace on the Internet." Further, the indictment alleges that "seeking to protect his criminal enterprise and the illegal proceeds it generated," Ulbricht "pursued violent means, including soliciting the murder-for-hire of several individuals he believed posed a threat to that enterprise."

On February 7, 2014, Ulbricht was arraigned before U.S. District Judge Katherine B. Forrest. Ulbricht entered a plea of not guilty. Judge Forrest set the jury trial for November 3, 2014. (U.S.A. v. Ulbricht, U.S. District Court, Southern District of New York, Case No. 1:14-cr-68.)

Investor Alerts
On July 23, 2013, the day the SEC filed the Shavers lawsuit, the SEC's Office of Investor Education and Advocacy issued an investor alert entitled "Ponzi Schemes Using Virtual Currencies." The purpose was "to warn individual investors about fraudulent investment schemes that may involve Bitcoin and other virtual currencies." Alerts also have been issued by other agencies such as the Texas State Securities Board, the Securities Division of the Louisiana Office of Financial Institutions, and the Missouri Secretary of State.

Media Coverage
On November 23, 2013, The Wall Street Journal ran an article entitled "Bitcoin or Bust." The article asked: "Is it just the latest in a long line of speculative manias, or could it have staying power?" The article quoted people from across the spectrumsome saying Bitcoins have potential, some saying it might be a good idea to speculate with a small amount of Bitcoins in the hope of making a killing, and some saying they should be avoided altogether.

On February 25, 2014, The New York Times ran an article entitled "Apparent Theft Rattles the Bitcoin World." The article reported that Mt. Gox, the most prominent Bitcoin exchange, was on the verge of collapse after the discovery of what appeared to be a major theft.

On February 26, The Wall Street Journal ran an article entitled "Shutdown Rattles Bitcoin Market." The article reported that Tokyo-based Mt. Gox stopped all transactions and that its website had disappeared.

On February 27, The New York Times ran an article entitled "Now, Nations Mull the Ways to Regulate Bitcoin." The article reported that a spokesman for the Japanese government told a news conference: "At the moment, we are still in the information-gathering stage." It also reported that, in the U.S., federal prosecutors, the FBI, and the Internal Revenue Service have been examining Bitcoin, and that the Commodity Futures Trading Commission and the New York State Department of Financial Services are considering the matter.

On March 1, Bitcoin stories flooded the major media. For example, in a page one story entitled "Almost Half a Billion Worth of Bitcoins Vanish," The Wall Street Journal reported Mt. Gox's bankruptcy filing and its admission that it had lost about 750,000 of its customers' Bitcoins and about 100,000 of its own.

Little or nothing has been said in the major media about Bitcoin investigations conducted in 2013 relating to its potential for use in drug trafficking, money laundering, and other illegal activity. However, the subject has been discussed extensively in specialized media. For example, on October 3, 2013, Ars Technica posted on its website a detailed article about the Ulbricht case. On February 5, 2014, Ars Technica posted another article containing an interview with a person who supposedly is the new operator of Silk Road. These articles suggest that at least some Bitcoin promoters are libertarians with extreme anti-government views.

General Observations
I do not pretend to understand fully how Bitcoins work. Even if I did, I would not invest in them. I am too conservative in money matters to even consider the possibility of investing in such a scheme. I would not touch Bitcoins or any other virtual currency with a ten foot pole.

I am offering as a complimentary PDF the 12-page indictment filed by U.S. Attorney Bharara. Send an e-mail to and ask for the indictment in the Ulbricht case.