Personal Finance

Beware of risks and conflicts of interest in exempt-market offerings.
By Steven G. Kelman | 19/05/17

I'm not a fan of speculative real estate and speculative real-estate debt instruments that are sold to unsophisticated investors as exempt issues, in some cases by unsophisticated salespeople. I also have a problem with the concept of so-called referral agents who are not registered to sell securities but earn commissions by referring people to exempt-market dealers. Likewise, I believe more regulatory oversight is required for exempt issues. As the sub-head in my column on First Leaside stated, "Lax rules for exempt issues paved the way for devastating losses."

About the Author
Steven G. Kelman is president of Steven G. Kelman & Associates Limited. His company provides specialty publications and training for the mutual fund industries. Steven is the author of several personal finance books and is author or co-author of courses offered by the Investment Funds Institute of Canada, including the Ethical Conduct and Behaviour continuing education course and the Labour-Sponsored Investment Funds course. He received a B.Sc. from McMaster University, an MBA from York University and holds a Chartered Financial Analyst designation.

Unfortunately, massive losses by ordinary retail investors in risky exempt-market issues that they should never have bought are a recurring theme. Investors are ill served when there are questionable valuations, conflicts of interest, and a lack of alignment between the interests of investors on one hand, and exempt-issue promoters and their salespeople on the other.

The latest sorry tale involves exempt securities distributed by Walton Capital Management Inc., an exempt-market dealer operating in all provinces. On April 28, the Alberta Securities Commission announced the suspension of Walton Capital. By May 1, investors knew that Walton Capital, its parent Walton International Group Inc., and some 31 Canadian investor entities were operating with creditor protection under the Companies' Creditor Arrangement Act. Management blames its problems on the recession in Alberta, losses of $67.3 million in Walton International Group in the past three years, a decrease in the availability of investor capital, tightening credit and the inability of some of the investor companies to meet requests from bankers to pay down debt.

Ernst & Young Inc. is the court-appointed monitor of the companies operating with creditor protection, and its website has relevant documents. These include more than 800 pages of affidavit documents as well as frequently asked questions (FAQs).

At this stage, it is impossible to tell how much of investor capital will be lost and, indeed, what is at risk. The corporate structure of the Walton group of companies is byzantine, with hundreds of direct and indirect subsidiaries. The parent company of the group, Interborder Holdings Ltd., is a private company owned by members of the Doherty family, of which William K. Doherty is director and CEO of Walton international Group Inc.

The Walton group of companies are known for their land-development operations on 80,000 acres in the U.S. and 25,000 acres in Canada. Walton's website valued these at $5.1 billion as of June 30, 2016. An unsecured-bond offering memorandum a few years ago stated that Walton International Group Inc. had nearly 86,000 investors in North America, Europe and Asia. It would be an understatement to say those investors are unhappy.

According to the documents filed, the game plan is to sell off the assets of the companies operating under CCAA protection to pay off debt and distribute whatever is left to investors by early fall of this year.

The intention for Walton noteholders and other unsecured creditors of Walton International Group is to offer them the fair value of all of Walton International Group's assets. If I were a noteholder, I wouldn't be happy about a specific aspect of this: One of William K. Doherty's affidavits states that there are a large number of Walton's retail noteholders, all of whom have relatively small holdings. He believes it is appropriate that a single Walton noteholder committee be established to represent the interests of noteholders. His candidates are people who were directly involved in the marketing and sale of Walton notes and who he states are intimately familiar with the business model and operations of the Walton Group.

A bondholder FAQ states: "The bondholder committee is an independent steering committee which has been approved by the court, and includes representation from different market sectors to provide a balanced voice on behalf of the bondholders. The committee will be responsible for reviewing and negotiating the treatment of bondholders under any CCAA plan with WIGI". The FAQ adds: "The committee cannot approve the plan or compromise the interests of bondholders without a vote by bondholders."

I do not get a warm and fuzzy feeling from reading this FAQ. Maybe I'm missing something, but putting the people responsible for the marketing and sales of highly speculative, unsecured, not guaranteed and illiquid debt instruments to represent the retail investors who bought these seems inconsistent with the principle of fairness and avoidance of conflicts of interest. I hope that the Investment Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association (MFDA) will be looking at the due diligence performed by their members who sold these notes and other Walton issues. The same goes for the various provincial securities commissions who regulate the exempt-market dealers who sold Walton securities.

Walton used referral agents. I suspect that some real-estate brokers and life-insurance agencies are looking to see if any of their employees referred their clients to Walton and what they told their clients.

More than 70 other Walton entities sold to Canadian investors as limited partnerships are not directly affected by CCAA proceedings. Nevertheless, they are caught up in the quagmire because they receive administrative or planning services from one or more Walton entities which have filed for CCAA protection. In any event, some of the limited partnerships will be looking at selling their assets to pay off debt and distribute whatever is left to investors. Others, according to the affidavits, may end up restructured into "one or more new investment vehicles such as a large limited partnership or a public entity. The intention is to potentially deliver more liquidity to the investments and to diversify their exposure."

I wonder how many of the 86,000 investors and, indeed, the people who advised them or referred them to dealers, read the documentation available. In preparing this column I looked at a number of Walton offering documents including offering memorandums, a prospectus and some marketing material.

A Cole's Notes version of some marketing material covering a deal in Florida speaks volumes about the Walton business model. It says that the directors and officers of the investment corporation and the general partner are also management, directors and or employees of other Walton entities and may receive compensation from them. As a result, these people may be influenced by the interests of Walton entities other than the partnership or investment corporation.

Walton Florida will buy the property for about US$9,600 an acre and sell it to the Partnership for US$19,200 an acre. The difference between the two prices is the compensation that Walton Florida will receive. It and its parent corporation will use this compensation to pay for their costs and expenses and to generate a profit for the Walton Group. The vast majority of these costs will not be directly related to the Florida property.

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