Aequitas Lawsuit Offers Clues to What Caused Investment Losses: Should Financial Advisors Have Foreseen the Aequitas Implosion in 2012?

Due diligence. It’s what financial advisors should do before they recommend an investment to their clients, and it’s what they should keep doing when their clients have millions of dollars in alternative assets, like the promissory notes issued by Aequitas Capital. (To read an earlier post summarizing events at Aequitas, click here.)

Shockingly, good due diligence might have raised red flags about Aequitas as early as 2012, but investment advisors kept right on recommending Aequitas to investors.

In 2012, American Student Financial Group, Inc. (ASFG) filed a lawsuit in San Diego federal court against Aequitas Capital Management. The lawsuit focused on Aequitas’ largest investment, hundreds of millions of dollars invested in student loan portfolios purchased from Corinthian College, a large, for-profit education company.

According to documents from the lawsuit, Aequitas only received this opportunity through American Student Financial Group, and entered into an agreement with ASFG to pay ASFG commissions on all Corinthian loans Aequitas purchased, as well as consulting fees, disposition payments if such loans were sold, and a percentage of profits earned from loan collection activities.

It now appears that Aequitas underpaid ASFG by at least $4.5 million, and possibly much more. Trial is set for this case on March 14, 2016 and, in its current weakened state, Aequitas has suggested that it may file for bankruptcy rather than proceed to trial.

As significant as this potential liability is, this case also highlights important defects in Aequitas’ Corinthian-fueled growth strategy.

First, these documents indicate that Corinthian anticipated student default rates in excess of 40% (even 25% default rates are considered high in the private education industry).

Financial advisors pushing Aequitas investments on investors claimed that this was not a problem because most of the Corinthian-originated debt was purchased “with recourse,” meaning that if Aequitas was unable to collect on the debt, it could sell the uncollectable debt back to Aequitas. However, this safety valve only protected investors to the extent that Corinthian stayed in business and was able to repurchase these loans.

This type of risk—counterparty risk—meant that investors were only safe as long as Corinthian was able to hold up its end of the bargain, and there were plenty of warning signs that it could not. While Corinthian’s background is beyond the scope of this article, it is significant that the U.S. Secretary of Education was quoted in the New York Times as saying Corinthian “brought the ethics of payday lending into higher education.” Corinthian filed for bankruptcy in 2015.

Second, lawsuit filings suggest that Aequitas was never able to reduce risk by diversifying its student loan portfolio. Private student loans with high default rates are already risky business, but one of the ways to reduce that risk is to diversify the student loan portfolio. If Aequitas had been able to have student loans from Corinthian and  ITT Tech and other private colleges, then the impact of any single private school going under would have had less of an impact on Aequitas.

While deposition transcripts indicate that Aequitas tried to diversify their student loan portfolio by purchasing debt from ITT Tech and other private schools, it appears that Aequitas completely failed to do so.

Third, court filings indicate that Aequitas did nothing to reduce the magnitude of its exposure to Corinthian College debt. Aequitas’ investment in these loan portfolios dwarfed all of its other investments, meaning that failure to eke out a profit on these loans was fatal—not just to this program—but to Aequitas as a whole.

To reduce this risk, the appropriate thing to do would have been to resell part of the loan portfolios Aequitas purchased from Corinthian, whittling the portfolio down to a manageable size, but it failed to do so.

The warning signs were there for investment advisors conducting due diligence to see. Instead, it appears that many financial advisors relied almost entirely on conversations with Aequitas management and information supplied by Aequitas.

Aequitas might have been able to convince investors that this case lacked merit, but a court order issued by Judge Cathy Benciviengo in June 2014 highlighted the weakness of that argument. ASFG had filed a motion for a writ of attachment, which would force Aequitas to set aside millions to ensure that ASFG would get paid if it won its case. Under California law, such a writ can only be granted if a plaintiff will probably prevail on its claim. Judge Benciviengo granted this motion, explicitly holding that ASFG—not Aequitas—was likely to prevail in this case.

Now, while Aequitas informs investors that it has retained “restructuring consultants,” it has told the judge in this case that it has hired bankruptcy attorneys, and may well file for bankruptcy prior to the trial set for March 14, 2016.

To receive a complimentary copy of select court filings from this case, give Investor Defense Law LLP a call at 800.487.4660 or fill out the form on our homepage and we will email them to you. This suit was filed in the U.S. District Court of the Southern District of California in San Diego. The case number is 12-cv-2446-CAB.

To read about the SEC lawsuit recently filed against Aequitas, click here.

Investor Defense Law LLP is a law firm dedicated to helping investors in California, Georgia, and Washington State recover investment losses.

We understand investment fraud and financial advisor malpractice. Our lawyers know how to sue investment advisors, brokerage firms, and financial advisors. To receive a free consultation, contact an investment fraud attorney at 800.487.4660.