REITs are supposed to be safe: Why this one’s flirting with bankruptcy

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It didn't take much to trigger Rachelle Berube's BS detector. League Assets Corp.'s investment strategy baffled her from the get-go.

In 2008, the plain-spoken property manager was researching real estate investing, hoping to make some serious money, when she came across League's ads touting returns of 10 per cent to 15 per cent annually. Intrigued, she ordered a copy of "The Blue Book of Real Estate Syndication," a "plain-language" bible of the League approach to investing.

But the scripture didn't teach her much; nor did it instill confidence. It read more like a sales pitch, and a woolly one at that, than a strategy. The "Blue Book" suggested that investing in real estate would help "improve the quality of human lives worldwide," and declared that every time League brought wealth to a new investor or bought a new property, "we add strength to the fabric of our free society."

The guide glossed over the risks of investing in real estate. It also painted the company's co-founders as sophisticated–without explaining how they acquired their expertise. When putting money in League, "you can be sure that your investment is in experienced and reliable hands," the "Blue Book" states. "If somebody says 'trust me,' I'm immediately extremely suspicious of anything they say after that," Berube says.

As Berube learned more about League, which eventually touted assets under management of more than $1-billion, her doubts were heightened–and she wasn't shy about expressing her views on the website she runs and on other online forums. At her most pointed, she accused League, headed by co-founders Adam Gant and Emanuel Arruda, of running a Ponzi scheme that amounted to "thievery." League responded by denying her allegations and filing a $2.6-million defamation lawsuit in May, 2013.

It was a rare and little-noticed outbreak of rancour in a national real-estate scene that had been scorching hot since the financial crisis. As the rising tide lifted all boats, both quality companies and risky bets saw their valuations soar. Investors hungry for yield in an era of rock-bottom interest rates flocked to the sector, especially real estate investment trusts (REITs) like League's, which paid monthly distributions, and are widely viewed as safe investments.

Regulators had to work hard to stay on the ball as valuations skyrocketed. REITs owe their secure reputation to the fact that they normally buy income-producing properties and then pay out most of their monthly rental income to investors. But the frothy market added a new dynamic: A slew of new real estate companies were going public, and many firms already in the market were bulking up by either acquiring additional properties at a fast clip or, in select cases, adding development projects. That latter strategy entailed new risks and years of waiting for cash flow, in contrast to the safer model of banking on existing bricks and mortar.

The trend toward development was particularly worrisome for neophyte management teams that had yet to live through a bust. "Real estate is highly cyclical," says Shant Poladian, a former Bay Street real estate analyst who heads FAM REIT. "Over these cycles, the two things that keep coming back to haunt the industry are too much debt and too much development."

League had an appetite for both—and it would have $363-million of investors' money to play with.

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Created in 2005, League was designed to help individuals invest in large-scale commercial, industrial and residential real estate across Canada. The company often upgraded the strip plazas and apartment buildings it acquired, and then brought in new tenants who paid higher rents – a common industry practice.

League's largest investment vehicle is IGW REIT, which owns numerous properties. The company also offered investments in single-property projects. But IGW is the investment that took off, thanks to the federal government's decision in October, 2006, to stamp out the tax advantages enjoyed by income trusts. Although REITs, like income trusts, pay out most of their income to shareholders as distributions, they were spared the pain.

League faced stiff competition, but IGW had some unique attractions. Most importantly, its 10.05 per cent annual distribution paid investors more than most rivals in 2007. RioCan REIT, an industry stalwart, paid roughly a 6 per cent distribution at that time. And instead of being listed on a public stock exchange, like the vast majority of its peers, IGW was held privately, with only a handful of other REITs in the same boat.

Gant and Arruda played up this feature, arguing in their literature and advertisements that IGW "doesn't succumb to the fluctuations of the market." They didn't dwell on the problems that could arise if investors in a private REIT rushed for the exit. Since such a firm doesn't have a stock exchange listing, investors wanting to get out could only sell their shares back to the company. Moreover, since it was private, League didn't have to disclose financial information nearly as frequently, or in as much detail, as its publicly traded peers. Nor was it followed by research analysts on Bay Street.

Investors didn't seem to mind. They were too enthralled by the company's juicy returns and compelling taglines. IGW, for instance, stood for the appealing concept of "intergenerational wealth." The co-founders proclaimed a credo of "core values, guiding principles and ethical standards and practices" in the many ads they purchased in magazines like MoneySense and online.

"The credo was never meant or used as a marketing trick," Arruda says. "It was actually to do the opposite. It was meant to filter [sleazy] people out, not to drag them in." All Arruda wanted was to create lasting wealth for his investors so that they wouldn't have to worry about money and could concentrate on their family lives. "Selling people securities was never my passion," he says. "When it comes to the numbers side of the business, it's not my thing."

Arruda and Gant constantly pitched to groups of modestly well-off people in venues such as hotel conference rooms. At these gatherings and in marketing materials, the two men touted their investing prowess. Yet neither had experience in running a large real-estate firm. Gradually, Gant took the leading role as the public face of the company.

Arruda, 43, studied human biology at the University of Toronto, then started his own firm, Absolute Advertising, in the early '90s. The business involved providing marketing services for companies and making promotional "comp cards" for models and actors. As Arruda got to know people in the movie industry, he took on a few small acting and voice-over gigs on the side himself. Arruda ultimately sold his advertising firm, and by 2004 he had decided to move into real estate full-time.

Arruda and his then-wife packed up their Toronto house and drove to British Columbia, where they lived in their motorhome and put together plans to flip houses, beginning in Nanaimo. One day, while they were parked in a remote part of Vancouver Island, Arruda's laptop charger went bust, so he drove to Victoria to buy a new one. While in town, he was introduced to Gant.

Gant, 33, grew up in Kelowna and studied engineering at the University of British Columbia. Tall, with an athletic build, he rowed on the Canadian national team in 2001-2002. Former colleagues had heard that he dabbled in real estate during university, buying a rooming house or two and flipping them. (Gant declined to be interviewed for this story.) In his early 20s, he did stints at several small real-estate firms, including two years as director of sales at Exit Realty Abacus in Victoria.

Gant and Arruda combined forces and launched League – as in "a league of like-minded people"– in 2005. They quickly made good headway, buying properties such as Arbutus Industrial Park on Vancouver Island, and by 2007 claimed the portfolio they were crafting was already worth over $250-million.

League's growth was certainly impressive. But it was also complicated. The firm sprouted myriad entities and investment options. Early on, League offered only single-property investments. Later, clients flocked to IGW REIT, whose units were similar to common shares, paying a big dividend. But after a few years, IGW also offered income-priority units, or IPUs. These securities offer investors a fixed interest rate for a preset number of years.

League's overarching strategy also changed. By 2008, Gant and Arruda had decided to build properties from scratch. It's a lucrative business, but one that enters a new world of risk: These projects would take years to build.

The co-founders focused much of their attention on Capital City Centre, a development in Colwood, on the outskirts of Victoria. It would boast more than three million square feet of office, retail and residential space in a town of just 16,000. The project was expected to take at least 15 years to complete; the first phase alone was expected to cost $250-million.

Right when Gant and Arruda were ready to break ground on Colwood, the global financial crisis descended. Having taken on debt from acquiring properties and planning developments, League was suddenly stuck in limbo, its growth plans stalled. Grappling with the new reality, Gant and Arruda made a major move in 2010: They acquired a 33 per cent stake in Charter REIT, a small publicly traded company that owned 10 mid-sized shopping centres in Ontario and Quebec. Charter was quickly renamed Partners REIT, and Gant was named CEO.

Although League did not have majority ownership of Partners, Gant and Arruda wielded considerable influence because League became Partners' asset manager. Unlike corporations, where executives are typically ensconced in-house, REITs often have external asset managers run the show. The outside firm generally is paid a flat fee based on the value of the REIT's assets. The external managers also receive bonuses, such as payments every time they acquire a new property. Partners paid League 0.5 per cent of the total price for any property the REIT purchased.

As Partners grew in the public market, League drew criticism from its private investors. In 2012, IGW, League's private REIT, shocked investors by halting distributions and capping the amount of money they could redeem each month. Some clients were told it could take up to five years to get their money back.

A slew of investors were perplexed. As a long-time League client who says he had sunk $1.6-million into the company's securities after selling his auto-repair business in Vernon, B.C., Paul Dunbar wasn't sure what to think. Although he'd once earned 10 per cent annually from them, he'd become uneasy about IGW REIT's regular units and, in 2010, transferred much of his money out of them and into IGW's fixed-rate units, which were sold to him as a very low-risk investment.

Other investors tried to cash out, and the timing couldn't have been worse for League. By 2012, the company was finally on the cusp of starting construction on the Colwood development, which required heavy cash infusions. Management was loath to divert funds toward investor redemptions. To solve the problem, Gant and Arruda concocted a plan: Take League public. The idea was that investors who wanted their money back would be able to sell their shares to new buyers.

In an interview with The Globe and Mail at the time, Gant didn't link the redemption requests with the distribution cut, nor with concerns about the company's operations. Many IGW investors were approaching retirement age, he said, and management worried that if too many of them withdrew their money in a short period, the REIT wouldn't have enough cash on hand to fund the payouts. "It's almost unfair for the people still invested," he argued, adding that a redemption rush could force the REIT to sell assets in a fire sale to raise cash.

Gant also brushed off questions from The Globe about the odd structure of League's public offering. Typically, when companies go public, they raise money at the same time. League wasn't. Nor did he think it was unusual for a REIT to seek a public listing when it couldn't pay monthly distributions.

Not long after Gant and Arruda filed documents to go public, the British Columbia Securities Commission, the provincial stock-market watchdog, sent the company a letter outlining some questions and concerns the regulator said needed to be addressed. League had until Sept. 8, 2012, to reply. It never did.

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League's redemption troubles were only a portion of the problems Gant had to deal with in 2013. He also had a war to fight with Partners' board.

Although League had day-to-day operating control of Partners through its asset management agreement, Gant still had to answer to Partners' board of trustees–and they were not on the same page. After many months of disagreements, Gant was pushed out of the CEO's chair, according to people familiar with the decision, and was relegated to the non-executive role of vice-chairman.

The board didn't stop there. To the surprise of observers in the real estate community, Partners' independent trustees announced plans in May to internalize their management team: They would bring the REIT's executive roles in-house and "break the chains" of League's control, according to their proxy circular.

"On several occasions [League] has brought forward proposals whereby the REIT would purchase properties held by its affiliates or other entities in which Mr. Gant is involved," the disgruntled board members said in the filing. "The Independent Trustees, after many attempts to introduce a better process around these conflicts of interest, have determined that they are not comfortable with the scope, detail and accuracy of the disclosure they are receiving." In other words, they alleged that Gant would try to stuff Partners with League properties, even if it wasn't in the public REIT's best interest. In an interview, John van Haastrecht, an independent director who was chairman of the investment committee, asserts that "The information received from Gant was not sufficiently factual and detailed. There was discomfort from the board with his operating and management style."

The frustrated trustees were fighting an uphill battle–they didn't control many votes, while League still owned about 15 per cent of Partners, making it the biggest shareholder. Also, the majority of Partners' shares are held by retail investors, who typically do not vote in proxy battles. To win over the few who likely would, Gant launched an offensive, proposing his own slate of trustees and arguing that the board initiated the proxy battle because its members had heard that he was trying to oust them. "This is the one thing they can do that can potentially provide the optics that they're working for the best interests of unitholders," he told The Globe in May.

Gant won the fight. Partners installed a brand-new slate of trustees. For the first few months, it seemed like it would be smooth sailing. League was in the process of going public and Partners' new board members were learning the REIT's operations.

On Oct. 18, the revival crumbled. League filed for creditor protection under the Companies' Creditors Arrangement Act, blindsiding its 3,500 investors.

Gant spun the announcement in a positive light, arguing that the restructuring would consolidate many of the company's sprawling subsidiaries into a much cleaner organization. League said that its net asset value was $200-million.

At best, both statements were wishful thinking.

As part of the CCAA process, the court appointed PricewaterhouseCoopers to go through League's books. By November, PwC determined that the company's properties were worth $48-million–a far cry from the $363-million it owed investors, and a tiny fraction of the $2-billion Gant and Arruda had recently suggested League would ultimately be worth.

PwC's work showed that League had overvalued its properties. The Colwood development, in particular, was valued at many multiples of its true worth.

The CCAA filing hadn't come a moment too soon. By October, according to PwC reports, employees were paying for expenses on their personal credit cards, the company was behind $3.6-million in property taxes, 22 of League's 63 bank accounts were in overdraft and League had taken on expensive debt just to keep funding itself.

Now League investors are all asking themselves the same question: How did it come to this?

It is possible Gant simply assumed that he could overcome any market dynamics. "When we were talking complex matters dealing with real estate and financing, it was way over his head," van Haastrecht says. Nonetheless, Gant presented well. He "basically convinced all these retirees [and] professional people who are looking for better returns with very aggressive marketing."

PwC boils the drama down to a few key problems–the biggest of which was excessive debt. League was in hock to no less than 26 mortgage lenders. The monthly payments on IPUs it had sold to retail investors were a further drain.

League's development properties, particularly Colwood, also played a large role. Gant and Arruda were so hell-bent on proceeding that they pushed the development ahead in 2012 without having sufficient construction financing in place. This departure from industry practice meant League had to find other ways to foot the bill. To make it work, they funnelled money from other entities, such as IGW REIT, into Colwood – something investors may not have known about. By the end of 2012, the Colwood subsidiary owed $72-million to IGW; it borrowed another $16-million from IGW in 2013. "Nobody realized what they were doing," Dunbar says.

The related-party transactions didn't stop there. Internal documents obtained by The Globe show that asset management fees Partners owed to League were sometimes paid early, and in some cases these advances amounted to more than what was actually owed.

During the first three months of 2013, for instance, Partners advanced League some asset management fees. At the end of the first quarter, League returned $150,000 that was an overpayment. While League may have simply been sending back acquisition fees for deals that got delayed and would not close until the second quarter, the flowback would have been hard for an external observer to catch. The problem was later compounded when Partners gave the money to League yet again, and then some, with management approving a $700,000 advance for April 1, the very first day of the new quarter.

Partners CEO Patrick Miniutti, a close ally of Gant's and a former League executive, says the payments to League were always reconciled at the end of the quarter. In an interview, Miniutti stressed that while he approved the advances, he never knew what League did with the money. Whether League used it to fund its own redemptions, or to fund project development, he had no idea. "Quite frankly, I couldn't tell you what they used it for," he said.

But internal documents suggest that wasn't always the case. Around the time that Partners units declined in June, 2013, Miniutti approved an advance to League, saying it was to help with a margin call on units owned by Green Tree, an investment vehicle 50 per cent owned by Gant and Miniutti. (Margin calls typically occur when firms that lend people money to buy stock become worried they won't be paid back, so they force the borrowers to put down more collateral.)

After this instance was put to Miniutti, he was less categorical, writing in an e-mail that "the staff of Partners REIT rarely had any insight as to the timing or reasons for a particular payment."

It was tough for League and Partners investors to know any of this was going on because disclosures, if made, were often buried in regulatory filings. Investor Jeff Cohen didn't feel privy to details of money transfers between League subsidiaries – despite having been an investor since 2005 and, he says, ultimately putting more than $600,000 into League securities. He argues that money managers have a duty to better disclose these dealings, because few clients have the knowledge, or the inclination, to track what's happening with even the most basic sort of securities. "Do most of us really know when we buy into a mutual fund what actual holdings they have?" he asks.

Yet Cohen was lucky. Because he had invested early on, he was able to earn back about 75 per cent of his principal over the years from distributions. "If somebody just came around last year and put $1-million in, that can be their life savings [gone]," he says.

"If you talk to some people, they're going to tell you that [League] didn't know what they were doing from the very beginning ... I don't believe that," he says. "I believe they actually started a real estate pool and somewhere along the line, it became so easy for them to get money off of wealthy people [that they said to themselves], 'Okay, we can make more money if we develop from the ground up.' Suddenly they were the Reichmanns. Only they didn't have 30 years of experience."

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Over the years, the British Columbia Securities Commission held up a few IGW transactions because the company didn't file documents with the commission properly. The regulator became more aggressive in 2013, alleging in August that one of League's affiliates promoted IGW REIT to investors without disclosing that the two firms belong to the same family of companies. Gant and Arruda settled the violation in October, paying fines of $250,000 between the two of them. In the settlement agreement, Gant and Arruda acknowledged that they had broken securities law.

The watchdog won't say if it is doing further work. To determine more about what happened, a full forensic investigation is necessary. PwC has started that process – but it will be costly to investors who are already fighting over scraps.

While investors wait to see what happens next, League is selling off some assets to pay back people it owes, relying on John Parkinson, the company's former CFO, to lead the effort. Gant and Arruda relinquished their roles as co-heads after filing for CCAA protection. The current restructuring – or possible bankruptcy–is expected to carry on until June, so it could take months to determine if there is any money left for retail investors.

There is also a flurry of activity at Partners. The REIT slashed its own distribution by more than 20 per cent in November, and it now has a new major shareholder, McCowan & Associates of Barrie, Ontario, after IGW sold its almost 15 per cent stake to raise cash. In November, Partners' chief investment officer and its chief financial officer were fired by Miniutti, and, shortly after, three of the four board members who were installed in June stepped down.

League investors can only watch the drama with dismay. "If they had stuck to the original plan, it probably would have been okay," Dunbar says. Gant and Arruda "got desperate the last few years. They were just robbing Peter to pay Paul, to do whatever they could to try to pull the rabbit out of the hat."

Arruda has a different take. "Had that credit crisis not happened, and had we not had that insane clown posse of detractors, we'd be in a whole other place right now," he says. This posse he refers to is the small group of online commenters, including property manager Berube, who raised questions about League's business on the Internet. These writers sometimes suggested that investors should call the BCSC, and Arruda argues the calls to the regulator helped persuade the watchdog to hold up League's plans to go public. "There were delays, and those delays cost everything."

As for the credit crisis, he says the financial shocks stacked the odds against League. Instead of packing it in, he and Gant tried to recover, in part because their friends and family members were some of the early investors and would have lost money. "Our credo said we don't give up ...We did the right thing. In hindsight, was it the smart thing?"

It's something Arruda says he not only thinks about, but feels. He personally guaranteed some of League's commercial mortgages, so his home has at least one lien on it, and he says he borrowed $45,000 and then lent it to League to help with liquidity, making him an unsecured creditor.

For her part, Berube can't help but feel relieved. The men who came after her with a lawsuit are watching their empire crumble, and the legal proceedings against her are now held up because of League's CCAA filing. But she derives scant pleasure from League's downfall, having heard the heartbreak stories of investors who assume the money they gave to Gant and Arruda is gone, down to the last cent.

"It's grim, man."