SpongTech, Fraud Pants

Mon, 22 Nov 2010 12:08:51 +0000

Lets say you found yourself in the United States in early- to mid-2009. Lets go further and say you decided to spend an afternoon taking in the national past time, baseball. Once you realised it was similar to cricket (stick, ball and the occasional running) and there were no Pimms Cups to be found anywhere, your gaze may have wandered to the advertisements on the walls at the end of the playing field.

Chances are you would have noticed an advertisement for SpongeTech Delivery Systems. The company had signs in the outfield in about one third of all baseball stadiums and some sort of sponsorship in 28 of 30 stadiums, not to mention in almost all other major US sporting events. But who was this company calling itself “America's Cleaning Company” and later “The Smarter Sponge”? You might have passed it off as just some local brand unknown outside of the United States. The odd thing though is that the locals sitting next to you were probably wondering the same thing.

To relieve the suspense, SpongeTech made sponges with soap in the centre, including one made to look like the cartoon character SpongeBob SquarePants. But how exactly had a novelty sponge company become so ubiquitous at US sporting events? And more to the point, why had it become so pervasive while 99 percent of its reported sales were generated outside the United States?

The FBI shed some light on the matter when it arrested two of the corporate officers in May 2010. Both officers face criminal and civil fraud charges relating to a stock manipulation scheme described in The New York Times as “among the most aggressive penny-stock frauds ever” (if the charges turn out to be true).

Since the charges were filed, SpongeTech and its subsidiary, Dicon, have filed for bankruptcy. At the time of the filing, it had $11.8 million in unsecured debt outstanding, no cash―except $200 in an account belonging to Dicon―and, of course, worthless stock. (Updates to its bankruptcy case can be found here.) Employees, creditors, licensors and business partners have all been adversely affected.

Although SpongeTech Delivery Systems did not trade on any of the major US stock exchanges and operated in the sometimes dubious world of penny-stocks, it had licensing deals with well-established companies and the above-mentioned signage at major sporting events. All of which might give it some level of expected credibility.

A lot of the evidence in the court filings would not have been available in the public domain, but there were certainly some red flags that might have given individuals and corporations pause before getting involved with, investing in or extending credit to SpongeTech. Below we hope to outline many (but unlikely all) of those red flags using public sources.

But first, before we get to the red flags, here is a rundown of the alleged fraud. Yes, alleged. As a firm that has worked for the defence in criminal and civil cases, we know that just because allegations look clear-cut based on criminal and civil complaints, it does not mean the individuals running SpongeTech are necessarily guilty.

The Pump

According to the SEC civil complaint and the criminal complaint, SpongeTech CEO Michael Metter and CFO Steven Moskowitz started hyping the company’s stock in 2007 with fraudulent press releases and securities filings. The two claimed that SpongeTech had secured purchase orders from five companies outside of the United States that later turned out not to existent. Ultimately, sales to these companies amounted to 99 percent of SpongeTech’s reported revenue. Later, virtual offices and web sites were set up for many of the fictitious firms.

For the fiscal year ending 31 May 2007, SpongeTech reported sales of $55,112. By the following year, it was reporting annual sales of $5.6 million. On 9 January 2009, SpongeTech CEO Michael Metter did an interview on MoneyTV and said the company would likely make a profit of $7 million on $40 million in sales. On 1 September 2009, the number was upped yet again with a press release saying the company had booked $70 million in orders for the most recent quarter.

At the same time the company was reporting this astounding revenue growth to customers outside the United States, it was spending heavily on brand recognition within the United States. It was also funding some the advertising with sales of the inflated stock (see here ). SpongeTech had signage at Citi Field, Yankee Statium and Madison Square Garden, and deals with football and hockey franchises. (Here is a copy of a three-year, $1,199,539 contract between SpongeTech and Madison Square Garden.) And in a less subtle and slightly more desperate vain, according to financial journalist Roddy Boyd’s blog, one of Moskowitz’s former business partners bought up SpongeTech products to create the illusion of demand. SpongeTech also paid third-party traders to prop up the share price. (As a bit of a side note, Boyd also discovered that a credit card belonging to SpongeTech's subsidiary was used to purchase the service of a Zurich-based escort service.)

The Dump

Between 2007 and 2009, Metter and Moskowitz unloaded 2.5 billion SpongeTech shares in unregistered transactions through multiple companies, including RM Enterprises, a company that they directly controlled. They were able to convince SpongeTech’s transfer agent to lift the restrictive legends, which allowed them to be resold to the public, by providing the transfer agent with false and forged legal opinions. The SEC alleges that two attorneys, Joel Pensley and Jack Halperin, authored opinion letters with false information possibly unknowingly―but with a fiduciary duty to know. Moskowitz also allegedly sent the transfer agents forgeries of additional Pensley and Halperin opinion letters, along with letters from a fictitious lawyer from a fictitious law firm.

Now on to the red flags........

Even before the SEC and the federal prosecutor brought their complaints, there were some reasons to be wary of doing business with SpongeTech Delivery Systems. These red flags could be found without even hitting the pavement, talking to witnesses or using professional databases.

The Lawyer

Joel Pensley, who is charged along with SpongeTech in the civil and criminal complaints, is also listed as one of the sources for legal opinions for SpongeTech’s first registration statement with the US SEC. According to an SEC administrative order, Pensley was barred from practicing before the SEC from January 1999 until January 2002. According to the SEC, Pensley and others “circumvented the registration requirements for sales of securities to the public” when raising capital for Visual Cybernetics, and prepared and filed reports with the SEC that were “materially false and misleading” Pensley ended up neither admitting nor denying the charges, paying a fine and receiving the suspension. It was roughly nine months after his suspension expired that he approved the registration statement for SpongeTech.

The Auditor

SpongeTech withdrew its registration statement in 2004. When it resubmitted in 2005, it used auditors Drakeford & Drakeford, who, despite the name, was just a one-man shop. The same firm signed off on SpongeTech filings through its August 2008 annual report. By June 2009, Drakeford & Drakeford was banned from auditing public companies for a year.

The Employees

SpongeTech “international sales” employees Frank Nicolois and Thomas J. Cavanagh were both charged criminally with helping to avoid currency-reporting requirements by cashing checks below the $10,000 threshold. In 2004, Nicolois and Cavanagh pleaded guilty to criminal perjury in US federal court and were ordered to pay $18 million in relation to a civil suit filed by the SEC for their participation in a pump-and-dump scheme.

Curiously, one of their co-defendants in the SEC case, Maier Lehmann, and another stock promoter, were murdered in 1999. According to The New York Times, Lehmann and the other victim were both cooperating with authorities at the time of their deaths. While the murders remain unsolved, there has been speculation that the deaths were Mafia-related and not connected to Nicolois and Cavanagh's case. (See here for SEC testimony. Here is an article about mob ties of the other victim.)

This red flag is a bit unfair on our part. It is unlikely an outsider would have known either one of these individuals was working for SpongeTech. That said, it is rather telling.

The South and Central American Customer

While the criminal indictment of Metter, et al. states that the scheme did not start until January 2007, it seems possible that SpongeTech's public filings were including non-existent foreign customers as early as 2004.
In its March 2004 registration statement, SpongeTech said that it was in negotiations to sell “150,000 single sponges and 350,000 kits” to an unnamed South and Central American importer. (It amended this statement several times, withdrew it, and then submitted again in 2006.) By July 2005, the name of the South American exporter was revealed as Hebco, Inc., of Caracas, Venezuela. In November 2005, it was still in negotiations with Hebco, Inc. By December 2005, the SEC asked for more detail on the deal. SpongeTech responded by saying, “we have deleted the disclosure regarding Hebco. The Company has determined, at this time, to concentrate its sales efforts to the continental United States.”

We have not confirmed whether a company named Hebco, Inc. was ever registered in Venezuela, but we are pretty sure a Venezuelan company would not have used the US abbreviation “Inc.” for incorporation. A “Hebco” of Caracas, Venezuela would more likely be Hebco, S.A. (Sociedad Anónima) or Hebco, CA (Compañía).

The CEO

Some of the CVs of company management were listed in SpongeTech's registration statement. It lists Metter as working for a series of broker/dealers from 1981 to 2001, during which he accrued quite a history of dodging fines, lawsuits and bankruptcy.

Metter apparently did well for himself in the brokerage industry, until the 1987 US stock market crash. A late-1990s New York Times article notes that Metter was forced to sell both his 37-foot boat and his house in the Hamptons after the crash. (Metter apparently economized in the 1990’s by buying his “Bentleys used.” By the 2000’s, they were leased, but more about that later.) Things seem to have gone downhill from there. A SpongeTech registration statement says he worked for Prudential-Bache Securities from 1988 to 1989. According to Crain’s New York Business (article behind a pay wall), Metter was fired in 1989 “for violating procedures concerning client orders”.

In 1992, Metter and his employers were sued for making excessive trades on his clients brokerage account to generate commissions for himself, along with other breaches. The case was dropped because the plaintiff was pursuing an adversarial proceeding against Metter in bankruptcy court. Without doing additional research, we cannot confirm if Metter actually filed for bankruptcy in the early 1990’s, but given the above, it seems likely.
After leaving Prudential-Bache, Metter worked for three more brokerage firms before landing at the boutique firm First Cambridge Securities at the end of 1994. He stayed there until 1998 or May 1997, depending on which SpongeTech registration you read (see here or here ). From its activities between 1994 and 1998, First Cambridge racked up at least $850,000 in fines by the National Association of Securities Dealers (NASD), now the Financial Industry Regulatory Authority, or FINRA, got into a trademark battle with JP Morgan, and had its CEO pleaded guilty in US federal court for money-laundering for a kickback scheme that was also administratively prosecuted by the SEC.

First Cambridge Securities was incorporated in 1987 as Herold Securities. It changed its name to J.J. Morgan & Company in February 1994 and had to change its named again in 1995 after being sued by J.P. Morgan for trademark infringement. (See here for a New York Times article referencing J.J. Morgan and other firms using similar names to larger Wall Street institutions. Here is a copy of an annual report filing for J.J. Morgan listing Metter as the president.)

Metter was involved in four sizeable NASD cases from his time at First Cambridge Securities. In one NASD case, First Cambridge and its CEO were ordered to pay a $543,000 award for a fraud claim. Interestingly enough, Metter was able to avoid this case, because “[i]mmediately prior to the hearing, respondent Metter notified NASD Dispute Resolution, Inc. that he had filed for bankruptcy. Pursuant to Section 362 of the Bankruptcy Code, all actions against this Respondent are stayed.” This quote looks past tense right? That said, the hearing dates were 12–14 December 2000, and the arbitration award was signed on 27 February 2001. As you can see from this filing, Metter did not actually file for bankruptcy until April 2001 (more about this later). He did list this case as a possible liability in his bankruptcy, but it is nowhere to be found in final distribution to creditors.

The three other aggrieved First Cambridge clients collectively sought $1.5 million from Metter; two received substantially lower amounts. (Information on the complaints is here, here and here. The distributions are page four of this document.)

According to SpongeTech’s fourth amendment to the registration statement, in September 1997, Metter moved on to broker/dealer Madison Capital Corporation, where he was the president for about a year. One Madison client received an NASD award against Madison Capital and Metter for $250,000. Another got $14,709.30 out of Metter’s estate in bankruptcy court after receiving a $250,000 NASD award against Madison Capital. (The bankruptcy claim is here.)

When Metter left Madison Capital, he went to work for broker/dealer Security Capital Trading, Inc., where he stayed until February or April 2001. (Again the dates vary depending on which SpongeTech filing you read, here or here.) Security Capital Trading went on to become Vertical Capital Partners, Inc., then VC Arjent, Ltd., and then Arjent Ltd. It was expelled from FINRA in 2008 for failing to pay a fine from a previous case. It also got in trouble with the SEC.

To be fair, none of Security Capital Trading’s problems date from Metter’s time there, but he did maintain a relationship with the firm after leaving. In May 2003, a publicly traded company of which Metter was a director, American United Global, hired Vertical Capital Partners, Security Capital Trading’s name at that time, to raise funds. Earlier that year, American United Global lent $25,000 to SpongeTech (SEC filing here ). Also, in May 2003, Vertical Capital gave a fairness opinion for a stock purchase agreement for Western Power & Equipment Corp. Metter became a director of Western Power & Equipment in February 2003. As far as we can tell, this relationship was not disclosed in the fairness opinion or any other SEC filings. To make the relationship slightly more incestuous, American United Global owned 12.1 percent of Western Power & Equipment's shares during that time period.

Even while earning $125,000 in 1999 and $242,000 in 2000, the NASD awards among other expenses apparently started to get to Metter; he filed for bankruptcy in April 2001. At filing, he listed nine NASD cases and one judgment related to an NASD sanction. He listed $5,087,975 in unsecured liabilities and $30,275.19 in assets. No used Bentleys were listed among the assets. The Bentley was listed under “contracts” as, dare we say it? “Leased.”

On second look through the accounts, we saw two mortgages totalling $1,061,000. But there is no house listed in the assets section – where did it go? It turns out that in May 1998, Metter transferred his ownership interest in his home to his wife. Metter’s bankruptcy trustee brought a case against her for fraudulent conveyance and settled for $150,000. In 2006, she transferred it back to joint ownership with Metter. It is not entirely clear if he anticipated his financial trouble when he transferred the ownership. Most, if not all the complaints filed against him at the NASD post-date the transfer of property. That said, In May 1997, First Cambridge was suspended by the NASD for failure to cooperate with their investigation.

In the bankruptcy filing, Metter was required to list any income going back through 1999 and any business he was an officer or director of for the previous six years. It may have been an oversight, but he did not list earnings from ERC Corp., where he had supposedly served as a vice president since May 2000 (see here ).

Conclusion

Again, the above is by no means an exhaustive search into the background of people and companies associated with SpongeTech. But if a company or individual had done a little bit of research or hired a company with this kind of research expertise, they could have learned much before entering into a business relationship with the company, and may have saved themselves significant money, time and anguish.

Dinolt (UK) Ltd. is due diligence consultancy in London, UK. We can be reached at info@dinolt.co.uk.

Alleged Ukrainian fraud by way of US, Belize and Niue

Tue, 28 Sep 2010 20:41:43 +0100

In mid-September, Ukrvakstina, a Ukrainian state-owned enterprise, filed a civil racketeering claim in United States federal court in Portland, Oregon against a Salem, Oregon corporation for its alleged role in a procurement fraud scheme.

The suit, filed against Olden Group LLC, is the first result of an ongoing audit of the previous Ukrainian government, ordered by the administration elected earlier this year.

While the audit has the appearance of being politically motivated, it has shed light on the ease with which a company with an opaque ownership structure can be set up in the United States (or at least some states) and used for illicit economic activity.

Complaint

According to the complaint, Olden Group and a Ukrainian medical supplies company overcharged Ukrvakstina for millions of dollars worth of swine-flu vaccine and routed the payments through US banks and into one Latvian bank account. The complaint charges that Olden Group acted as the middleman on paper, but served only to obscure the true price charged by the manufacturer. The plaintiff puts damages conservatively at $26 million, but the true loss is as yet unknown.

Politics

The suit was brought by Washington, DC law firms Trout Cacheris and Akin Gump (with the assistance of investigative conglomerate Kroll), after the Ukrainian government hired them earlier this year to audit its accounts for the time period when Yulia Tymoshenko was Prime Minister. (If you can't place the name, you'll recognise her face - she's got the most eccentric hair for a head of state since former Japanese Prime Minster Junichiro Koizumi.) While the suit doesn't yet allege any involvement by Ukrainian politicians, Intelligence Online makes that leap. They assume the complaint is meant to target Tymoshenko because it discusses transactions with Olden Group that occurred during the time when she was in power. Her party, the Tymoshenko Bloc, felt the need to defend itself with a statement released a few days after the court filing. It said that the accusations “were groundless” and alleged that the investigation used government funds to pay “foreign specialists in black PR.”

You can see why she thinks the investigation might be politically-motivated. Tymoshenko was somewhat pro-West, while the new government investigating her administration is more pro-Russia. As Prime Minister, she was a vocal advocate for removing Swiss-registered RosUkrEnergo as the intermediary in natural gas deals between Gazprom (the Russian state gas monopoly) and Naftogaz Ukrainy (the Ukrainian energy monopoly).

RosUkrEnergo was set up in July 2004 with Gazprom a 50 percent shareholder. The owners of the other 50 percent remained a secret until 2006, when it was disclosed to be Ukrainian businessmen Dmitriy Firtash and Ivan Fursin. According to Intelligence Online, Kroll and Akin Gump (both part of the audit team) have previously worked for Dmitry Firtash.

RosUkrEnergo held a complete monopoly over Ukraine gas from 2006 until Tymoshenko negotiated their exit as an intermediary in January 2009. According to the Financial Times, RosUkrEnergo might be back on the scene, after the Stockholm Arbitration Tribunal ordered Ukraine to return gas worth more than £3bn to RosUkrEnergo.

Tymoshenko has claimed that RosUkrEnergo's shareholders are associates of Serhiy Lyovochkin, the current Ukrainian president's chief of staff, and Yuriy Boyko, Ukraine's current energy minister. While Boyko has denied being a shareholder in RosUkrEnergo, he represented RosUkrEnergo owner Dmitriy Firtash in a recent divorce case.

Ownership

Regardless of who turns out to be the eventual owners of Olden Group, the company's structure provides a good illustration of how easy it is to keep owners private, possibly to avoid taxes, and even commit fraud.

Olden Group was registered as an Oregon Corporation in 2003. It lists two owners: a company incorporated in Belize and one incorporated in the South Pacific island of Niue. Niue has a population of a little under 1,400 (that’s not a typo) and can boast being the first country to have free national Wi-Fi. On a less positive front, in 2000, the US Treasury Department asked financial institutions to give “enhanced scrutiny” to all financial transactions having to do with Niue. In 1994, the country made itself an offshore financial centre, and by 2000, it had 3,000 international business companies and almost no anti-money laundering regulation. That year, Belize was identified as meeting the OECD technical criteria of being a tax haven (a status granted to Niue that year as well). In 2010, it was still facing sanctions by the G20 over tax secrecy issues.

Without going into the specifics of secrecy jurisdictions, nominee owners and the like, it is probably worth pointing out that (as best as I can tell) Oregon LLCs don't pay taxes. Their owners do, but when those owners are not residents of Oregon, there is no local tax. According to the Kiev Post, Ukraine doesn't seem to regulate transfer pricing. Our guess (and we emphasise guess) is that a company with a structure like Olden Group's would have minimal tax liability, can conduct business in US dollars, and keep its ownership opaque.

The owners – or more likely nominees for the real owners of firms like Olden Group – can incorporate (or organise) in the United States with minimal scrutiny. As the complaint against Olden Group rightly states, Niue closed its International Business Companies registry in 2006 (the act can be found here). It told the OECD that it eliminated its offshore sector. So how exactly could Olden Group still claim to be owned by the Niuen firm some four years later? More interestingly, the Niue and Belize firms have been jointly listed as either owners or directors in multiple other companies registered in Oregon, Washington, Nevada, Arkansas and Florida. We counted 60 and stopped (it got a bit tedious). At least 30 are still active in Oregon. The firms list principal addresses in the UK, Austria, Germany, Switzerland, Denmark, Italy, France and Azerbaijan, or even at the same Oregon address as Olden Group. At least three of the addresses are hotels (including two here in London).

None of the firms similar to Olden Group seem to truly have any economic connection to the United States, apart from paying incorporation fees to US states.

Of the firms incorporated (or organised) in Oregon with the same owners and local registered agent, there are:

• a Ukrainian satellite company
• a Spanish parts supplier to the shipping industry
• a ship owner who flies the Russian flag
• a partner to a subsidiary of a Russian steel conglomerate accused of being involved in a VAT-avoidance scheme. (The partner prevailed in court.)
• a firm whose business is undeclared, but it is likely involved in import/export with Ukraine (based on decisions of the Ukraine Parliament).

Conclusion

It may be advisable for the Ukrainian government to broaden the scope of its audit, given that it appears to be more motivated by payback than the pursuit of honesty and transparency.

Several US states need to clean up their incorporation procedures as well. It's relatively easy to incorporate a firm without disclosing its true owners. This secrecy can lead to tax evasion and even fraud.

At the very least, I give Oregon credit for being transparent. I can think of multiple other states that provide far less information.

Dinolt (UK) Ltd. is due diligence consultancy in London, UK. We can be reached at info@dinolt.co.uk.