Photo By: Town Crier File photo
When the Securities and Exchange Commission (SEC) filed a complaint against Small Business Capital Corp. last month, it claimed that the Los Altos company was operating a Ponzi-like scheme from its San Antonio Road offices.
Since then, investors have learned that at least three-quarters of the company’s $42 million assets remain safe in liquid assets and a performing loan portfolio. Yet a federal judge found the SEC’s evidence of fraud compelling enough to grant a preliminary injunction and rule that “good cause exists” to review the allegations.
Interviewing approximately a dozen investors this month, none of whom were willing to identify themselves publicly, the Town Crier heard from many local residents befuddled by the collapse of a company that still, by some measures, appears successful. As many are learning, the term “Ponzi scheme” sometimes describes practices that don’t look exactly like the fraudulent business that originated the phrase in the first place.
When Charles Ponzi launched a pyramid scheme in 1919, he promised investors a 50 to 100 percent return on their investment over a three-month span. His Securities Exchange Company claimed to deal in postal reply coupons but in fact primarily gathered money from an increasing pool of investors and paid that cash out as “returns” to earlier investors. Ponzi’s scheme brought down banks and cheated thousands of investors. But it pales in comparison to Bernie Madoff’s $13 billion pyramid scheme a century later, which incurred 50 times more inflation-corrected loss.
Whether SB Capital and its CEO, Los Altos resident Mark Feathers, committed fraud remains subject to future court hearings. Feathers denies the charges, but until he proves his innocence, a court-appointed receiver will continue to manage and potentially dismantle his business.
The receiver, Thomas Seaman, has taken over SB Capital and could substantially transform the company as he attempts to return money to investors.
Feathers continues to maintain that the company was profitable, and transparently communicating its practices to investors, when seized. He said investors have been ill-served by the cancellation of $10 million in loans scheduled for initiation this month.
In a July 10 filing, Seaman reported that the company held a performing portfolio of loans that continue to bring in money. But he claimed the income flowing into SB Capital was “not alone sufficient to fund monthly distributions to investors.” In other words, SB Capital allegedly exaggerated its profits to investors, paying returns that did not reflect the firm’s intake.
Paying fictitious interest, derived from sources other than genuine profits, is the behavior associated with the term Ponzi-like. But the company was also generating legitimate profits via its relationship with a federal program meant to pump up small business growth across the U.S.
Small business loans bring government support
SB Capital had established a specific niche as an issuer of loans through the Small Business Administration, federal government initiatives that provide some of the capital for loans to small businesses. The 504 Loan Program offers small businesses financing for expansion or modernization and is billed as an “economic development” program.
The $10 million in new mortgage loans Feathers mentioned, canceled at the last minute by the receiver last month, had initially received backing from the Small Business Administration. But Seaman reported that the SBA withdrew its support, making the loans a riskier investment.
Licensed lenders like SB Capital invest in tandem with the SBA to offer financing to small businesses in the 504 program, with both sides fronting money for the loan. The loans have requirements – for instance, that borrowers occupy the business in question – which make 504 loans typically high performing because they are directly tied to fixed assets, according to SBA spokesman Mike Stamler.
Case targets CEO
The SEC’s case addresses allegedly fraudulent action on the part of SB Capital as a company but also focuses on payments made to Feathers specifically. His personal assets, now frozen, came under scrutiny in court this month.
When Seaman’s agents took possession of SB Capital’s San Antonio Road office June 26, they recovered a $100,000 cashier’s check that raised eyebrows when mentioned in court. The check, payable to Feathers, was allegedly withdrawn at 4:55 p.m. June 26 from Heritage Bank of Commerce. The bank had received an asset freeze order at 3:15 p.m. According to the receiver, when Heritage Bank employees (who work in the same office building as SB Capital) informed Feathers of the order to freeze his account, he then asked the bank to issue him a check and it did so.
Suzanne Ziermann, senior vice president at Heritage Bank, said the bank respectfully disagrees with the receiver’s account of that check, and that the bank is working to correct the report. She declined to provide more detail.
In a letter to investors last week, Feathers said he requested the funds from a business account he did not know was frozen, because “most of my net worth is tied up in the business and it was necessary for me to obtain enough liquidity for what I thought would be my family’s living needs for some period.”
Feathers wrote in an email that he and his family had to leave their Los Altos home temporarily out of fear for their security. His family has been drawn into the case in part because SB Capital had become something of a family venture. His wife, Natalie Taaffe, left her banking career to work for SB Capital 18 months ago. Feathers’ two 9-year-old sons and a caregiver were all on the payroll at SB Capital, a practice he described as “like many family-owned small businesses.” He said that after his wife took a significant pay cut to work for SB Capital, the company also paid for child care.
After discussing Feathers’ family assets, Seaman said he hadn’t identified any other people against whom to bring a lawsuit, but he mentioned the possibility of disgorgement, the forced return of ill-gotten profits.
In rare instances, such as the ongoing investigation into Madoff’s estate, a judge can rule that fictitious profits are liable to being seized from otherwise innocent investors.
Former SB Capital investors who cashed out, with seemingly legitimate accrued interest, might be on the hook for a “claw-back” of their gains, as might collaborators who profited from their work with SB Capital.
Although only Feathers and his wife have had their assets pursued by the receiver thus far, Seaman recommended exploring whether there were “third parties who aided Feathers in connection with this enterprise” and evaluating whether they should be liable for damages.
The SB Capital case as pursued by the SEC is a civil investigation, and thus penalties would relate largely to money. Criminal prosecution – that could result in a prison sentence – would have to be pursued independently by a state or federal attorney.
Transferring funds for profit
SB Capital investors placed their money in two funds, Investors Prime Fund and the SBC Portfolio Fund. Both touted returns of at least 7.5 percent, and one offered even higher returns, but with associated higher risk.
At the heart of the SEC complaint lies the allegation that SB Capital’s two funds transferred loans between themselves at least 17 times, allegedly generating $1.4 million in “additional management fees” for Feathers and other SB Capital employees in 2012.
Feathers doesn’t deny the transfers. Instead, he says they were a transparent part of the company’s business model and investors were consistently informed that the operating model for SB Capital paid fund managers through premiums.
“Each loan sold for a premium was accompanied by an economic analysis outlining the basis for the premium,” he wrote in an email. The transfers generated “sufficient revenues and income to the fund manager to continue operations, cover expenses, and provide a return on capital justifying the investment made into the company.”
The SEC also alleged that although investors were told 96-98 percent of proceeds would be reinvested as loans, instead more than 14 percent of the funds' combined assets were diverted into transfers to SB Capital. Seaman, the court-appointed receiver, reported at the July 10 hearing that SB Capital drew more than $6 million from its investment funds to pay the company’s operating expenses, including a nearly $500,000 payout to Feathers. That money was listed as “receivables” on the company’s balance sheets, that is, as money owed to the funds.
Whether the fund transfers and withdrawals were reasonable business practice, or instead activity that violated investors’ best interests and amounted to fraud, stand as the question to be hashed out in court.