If the Securities and Exchange Commission was hoping for quick action against Robert C. Morgan, there are signs it won’t get its way.
The federal agency last month filed a securities fraud lawsuit against the Rochester developer, accusing him of running a “Ponzi-scheme-like" operation that used newer investments to pay off earlier investors and loans instead of buying properties.
But already, the federal judge overseeing the case has raised the question: Where are the disgruntled investors?
"Have there been any defaults? Have investors not been paid?" U.S. District Court Judge Elizabeth Wolford asked SEC attorneys during a hearing in Buffalo earlier this month.
The questions, legal experts said, suggest the case may be a challenge to the federal regulatory agency.
"It certainly should create some real concern on the SEC’s part that a fundamental core of its allegations are in doubt with this judge," said David R. Chase, a securities law attorney in Fort Lauderdale, Fla., who spent five years as senior counsel for the Miami regional office of the SEC's enforcement division. "That may very well be a significant problem for the SEC."
The SEC in May filed the fraud lawsuit against Morgan on the same day he was charged in a criminal case accusing him and three others of mortgage, insurance and wire fraud related to real estate transactions in several states, including properties in the Buffalo area.
Morgan and the other defendants have denied the charges.
The SEC’s civil case has a narrow focus: the management of four investment funds that Morgan’s companies used to raise money for real estate deals.
Court proceedings on the SEC case so far show the challenge the agency may face in prosecuting a case without a clear demonstration of harm to investors – a point made not only by Morgan's defenders but by the judge.
Wolford denied the SEC’s initial request to freeze Morgan’s assets, but allowed other protections, including appointing an independent receiver to manage the funds.
“Right now, the SEC is a little bit hindered by the fact that there are no complaining investors,” said Christopher Bruno, a partner at Bruno & Degenhardt in Fairfax, Va., and a former senior counsel for the SEC in Washington. “But as the investigation goes on, disgruntled investors frequently come forward.”
Chase called the judge’s decision “not typical.”
"I don’t think it’s an embarrassment to the SEC, but it’s certainly a blow, and it’s not typical," said Chase. "Judges are typically inclined to grant the relief, particularly when there’s allegations of ongoing harm to investors."
In its May 22 lawsuit, the SEC laid out a series of accusations against Morgan – including that he ran a "Ponzi-scheme-like" operation. It asked the court for a series of urgent actions, such as freezing Morgan's assets, imposing a receiver to take over the funds, and demanding a full accounting of Morgan's personal finances.
The agency had gone to federal court immediately after the filing to obtain a temporary restraining order against Morgan.
"The SEC has brought this emergency motion to halt ongoing misconduct orchestrated by the defendant, Robert Morgan, and his companies," SEC attorney Lee Greenwood said.
In doing so, it was expected to provide the first demonstration of the strength of its case by showing it had a strong enough likelihood of success to justify the court order. But that's not what happened.
"None of the relief the SEC is seeking is merited," Joel Cohen, a partner at Gibson Dunn & Crutcher in New York City, who has been working with Morgan for over a year, told Wolford on June 5. "The SEC can argue that there’s something here, but they’re not even close, absent the hyperbole. We're left with name-calling."
The SEC did get a temporary restraining order preserving documents, barring other litigation against Morgan and mandating an accounting of the funds. But it didn't get the asset freeze it wanted.
‘No money has gone missing’
In its lawsuit, the agency argued that Morgan had deceived investors and misused their money by allegedly using newer funds to pay off earlier investors and loans instead of buying additional properties as intended. The SEC asserted that Morgan's behavior put investors at risk and would continue unless stopped by the court.
"The Commission has made a substantial showing that Morgan has violated" securities laws, the SEC claimed in a June 3 legal filing. It cited "compelling evidence of defrauding innocent retail investors," and suggested that Morgan's attorneys were trying "to distract the Court with a series of side issues" that ignore the law.
Instead, Wolford challenged two of the agency's three main examples of fraudulent behavior. She ruled in the preliminary hearing that it had failed to meet its initial burden of proof.
"They failed to establish a likelihood of success on the merits," Cohen told Wolford during the June 5 hearing. "When asked repeatedly where in the governing documents does it say Mr. Morgan was required to do something and failed to do it, they came up short."
Cohen also questioned the use of the phrase "Ponzi scheme," arguing that "no money has gone missing."
"It's actually frankly offensive that they've said it," Cohen said. "There’s no indication that any money has been used for something else."
That's despite having at least nine months to develop a case, in part using evidence previously gathered by the FBI and U.S. Attorney's Office, the attorney noted.
"They haven’t shown any evidence of any violation," Cohen said. "They have no evidence of it here, after nine months of looking, and there’s a good reason for that – because there isn’t any."
According to the SEC, Morgan raised more than $110 million from private investors from 2013 through September 2018, including $80 million for four specific "Notes Funds."
Those funds were supposed to be used to finance purchases of apartment buildings or new projects that the developer was working on, the agency said. The funds were designed to make "portfolio loans" to Morgan's "affiliate borrowers" for up to two years, at rates high enough to cover an 11% interest payment to investors, according to the SEC.
Instead, the SEC argued, Morgan and his fund managers misled investors and engaged in three types of "fraudulent conduct":
• Improperly transferring at least $15.6 million from later funds to redeem earlier investors and repay loans from prior funds that were maturing.
• Using the funds to make the 11% interest payments that were owed to investors, because the properties weren't generating enough revenues and Morgan "did not want to make good on his personal guaranty."
• Using the funds to pay off an $11 million loan and $2.6 million in prepayment penalties on the Eden Square Apartments property in Pennsylvania.
Morgan's attorneys, in court documents filed before the hearing, denied that the offering materials were misleading because nothing in the governing documents prohibited the sale of portfolio loans from one fund to another.
In a memo, they cited the "broad discretion" that Morgan and his fund managers had under the agreements to "make loans for myriad purposes," arguing that the funds could be used to reduce the cost of capital or even to pay interest owed to investors.
And they criticized the SEC for seeking the emergency relief, saying it hadn't shown any reason for it, especially since the criminal investigation against Morgan has been public since The Buffalo News first reported it in September 2017.
The memo also said the SEC "ignores the many unprompted efforts" by Morgan to reassure the agency. It said Morgan voluntarily contacted the SEC in April, offered to repay investors "at an accelerated rate," and sought to hire a "highly recommended" third-party – Goldin Associates – as an independent fund manager.
"In an effort to distract from its insufficient allegations and manufactured urgency, the Commission resorts to inflammatory and unsupported allegations," the memo continued. "The court cannot rely on the Commission's bald representations absent supporting evidence."
Duty to disclose
Wolford agreed, sharply questioning the SEC attorney in court.
"Is there anything in the governance documents that provided that the fund manager could not use it in that fashion?" she asked the SEC's Greenwood. "Is there any language here that says it couldn't be the same lender or type of lender?"
She ruled that "it is not clear, at this point in the proceedings," that Morgan had misrepresented how the fund dollars would be used.
That decision surprised Bruno. “That’s the crux of these fraud cases,” he said. “These cases come down to a hard analysis about what the investors were told about the use of proceeds. That really goes to the level of sophistication here, that investors are still of the belief that their funds are safe."
However, Wolford did side with the federal agency that Morgan had failed to disclose to investors that the earlier funds had met their 11 % returns as promised primarily because the portfolio loans had been purchased by later funds, not because they performed as expected.
"The court further finds it likely that defendants had a duty to disclose this information," Wolford wrote in her ruling.
In the meantime, the SEC submitted three candidates for the judge to name as receiver, while Morgan submitted one – Goldin.
That firm had initially been hired by Morgan on May 13, with a $75,000 retainer, to independently manage the funds, and was poised to assume control before the criminal indictment and SEC lawsuit were filed, Morgan's attorneys said.
But Wolford on Wednesday went with one of the SEC's choices, naming Robert Knuts, of New York City law firm Sher Tremonte LLP, as receiver to take control of the funds, removing Morgan. Knuts is a former SEC trial attorney in the agency's Division of Enforcement, who previously served as a receiver in other cases.
Story topics: Elizabeth Wolford/ insurance fraud/ jonathan d. epstein/ Morgan Communities/ morgan management/ mortgage fraud/ Robert C. Morgan/ SEC/ Securities and Exchange Commission/ securities fraud/ U.S. District Court