October/November 2005 FOCUS — Newsletter of the AICPA
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A little-known fact is that the federal government is the largest single investor in U.S. private equity funds. At the end of fiscal year 2004, the U.S. Small Business Administration (SBA) had close to $5.75 billion invested in 448 funds, plus another $6.7 billion in available commitments. Together with private capital topping $13.3 billion, the program totals more than $25 billion in private equity capital dedicated to America’s entrepreneurs.  The investments are made through the Small Business Investment Company (SBIC) program, which is part of the SBA. The program was created in 1958 to fill the gap between the availability of venture capital and the needs of small businesses in start-up and growth situations. The creation of these public-private partnerships helped to generate jobs and contributed to economic prosperity. For CPAs, the SBIC program has provided opportunities to assist clients in obtaining an SBIC license, audit the required annual report, and, as in my case, conduct a forensic investigation if fraud is suspected.

The SBIC Process

Recently, the SBIC program attracted undesirable attention, when the Securities and Exchange Commission (SEC) alleged that Amerindo Investment Advisors and its cofounders and principals, Alberto W. Vilar and Gary A. Tanaka, were guilty of fraud and misappropriation of client funds. (See the sidebar “A Case of False Promises” on page 6.) The SBA was not defrauded by Amerindo or its principals. Instead, the alleged perpetrators used the SBIC process to explain to the defrauded investor why quarterly returns promised on her investment were delayed.

SBICs are licensed by the SBA, which invests alongside private investors. They must be privately managed, for-profit investment companies formed to provide equity or debt capital to U.S. small businesses. Under current regulations, an experienced team of private equity managers must secure minimum commitments from private investors of either $10 million for either a debenture fund or an equity fund. For every $10 million in private equity, SBIC licensees are eligible to receive up to a $20 million SBA commitment (2:1 public-private leverage), substantially enhancing prospective portfolio returns.

SBICs may invest only in “small businesses,” which are defined as businesses with a net worth less than $18 million and prior two years’ average after-tax income of less than $6 million. Failing this test, a company may still qualify as a small business under certain other conditions. An SBIC is permitted to control, either directly or indirectly, a small business for a maximum of seven years. With SBA’s prior written approval, an SBIC may retain control for such additional period as may be reasonably necessary to complete the divestiture of control or ensure the financial stability of the portfolio company. During the period of my firm’s representation of the SBA SBIC program, the minimum commitment from private investors was substantially smaller, the public-private leverage was 3:1, and the bona fides of the SBIC managers were not investigated.

Vulnerability to Fraud

Although it seems naïve today, not so long ago SBA regulators did not imagine that criminals would use an SBIC as a vehicle to launder money. They did not consider that SBICs may be attractive to money launderers because of the opportunity they provide for mixing U.S. government leveraged funds with the proceeds of an ongoing criminal enterprise and investing in legitimate business activities.

Several years ago, during a period of smaller minimum commitments from private investors, larger public-private leverage, and less SBA oversight, the office of the U.S. Attorney engaged my firm on behalf of the SBA to assist with an ongoing SBA lawsuit for the recovery of U.S. government leveraged SBIC funding and with an investigation into the financial history and practices of a certain SBIC. The SBA strongly suspected violations of the prohibition against encumbered contributions, laundering of criminal proceeds through investments in the formation and operation of SBICs, and conflicts of interest regarding the substantive ownership of portfolio company shares.

This engagement uncovered almost every possible violation of SBIC startup and operating regulations. The shareholders of the SBIC that was the subject of the litigation and investigation had knowingly received private startup financing from a CPA who was laundering money for Colombian cocaine cartels. He frequently flew his executive jet to Panama with footlockers full of U.S. dollars for deposit in Panamanian banks. Until his arrest, his money laundering business on behalf of the cartels was prosperous. Nevertheless, he was tried, convicted, and sentenced to a long federal prison term.

Complicit Cohorts

After the money launderer’s conviction and sentencing, some of his associates, who coincidentally were shareholders in an SBIC, were engulfed in suspicion about potential conflicts of interest concerning the shareholdings of the portfolio companies.

During the course of our investigation into the formation and operation of the SBIC and its financing of the portfolio companies on its balance sheet, numerous violations of regulations regarding the source of its leveraged funds became apparent. The nominal shareholders of the SBIC had no personal access to the clean, unencumbered investment funds necessary for its financing. Its startup investment funds came exclusively from sources owned or controlled by the convicted CPA money launderer.They were invested entirely in companies owned by family members.

Every company in the portfolio of the SBIC, except one, was eventually bankrupted by the funneling of both the laundered investment funds and U.S. government leveraged funds into numerous personally owned properties. The remaining portfolio company was used to bid for state and local government fire safety management contracts. Through the five-year period of its existence until the conviction of the CPA money launderer, the SBIC paid him astonishingly large accounting and audit fees as another method of laundering money.

At the conclusion of our investigation, the SBIC was dissolved and its shareholders (who coincidentally were judged to be the actual shareholders of the remaining portfolio company) were required to make restitution to the U.S. SBA.

Deterring Fraud

For several years thereafter, the SBA investigated other possible misuses of the SBIC program leading to the conviction of various persons in various geographical areas of the United States, including politicians and judges. The SBA learned what controls needed to be strengthened to enhance fraud detection and deterrence by investigating cases involving bank fraud; the misapplication and diversion of SBIC funds; the making of material false statements, conspiracy, embezzlement; and money laundering. The result is that today, an SBIC licensing applicant must undergo a rigorous licensing process. Upon receiving a license, the SBIC is subject to annual regulatory audits by the Office of SBIC Examinations to ensure that SBICs’ operations conform to the regulations or to uncover instances when they do not. Once the SBIC is licensed, it must undergo an annual audit by the Office of SBIC Examinations.

Potential fraud is usually uncovered after an SBIC has been transferred to the Office of SBIC Liquidation. However, fraud is suspected or found infrequently. These cases may be referred to the Office of the Inspector General for investigation and possible referral to the Assistant U.S. Attorney for prosecution.

Although fraud is far from rampant among SBICs, opportunities may still arise to be engaged to investigate fraud. In addition, the annual Financial Report is the responsibility of the SBIC licensee, and the audit must be performed by an independent CPA. The Annual Report consists of the financial statement and other schedules included in SBA Form 468. A link to this form is located at www.sba.gov.

Practitioners may also be interested in the valuation guidelines found at www.sba.gov/INV/ valuation.pdf.

Stanley Foodman, CPA, is a forensic accountant based in Miami, Florida.

October/November 2005 — Vol. 1, No. 4

By Stanley Foodman, CPA