In 2010, the economic development agency for Rhode Island was keen to lure former Red Sox pitcher Curt Schilling’s startup video game company, 38 Studios, to the Ocean State.

What better way than to offer $75 million in municipal bonds to investors and then use the proceeds to lend money to the pre-revenue company so it could complete development of its “massively multiplayer” online video game code-named Project Copernicus?

Rhode Island can issue such bonds because of a state government program to spur economic development and increase employment opportunities.

But in its all-out-effort to attract Schilling and his company, the Rhode Island Economic Development Corp. and bond underwriter Wells Fargo Securities glossed over some of the funding risks when communicating to prospective investors in the bonds, the U.S. Securities and Exchange Commission alleges.

The bond offering document, according to the SEC, did not disclose that even with the proceeds of the loan financed by the 38 Studios bonds, the company faced a known shortfall in funding rendering the offering document “a misleading half-truth.”

After obtaining the net proceeds from the bonds, about $51 million, 38 Studios attempted to land the additional financing it would need to complete Project Copernicus, but was unable to do so, according to the SEC. The firm in 2012 defaulted on its loan payments to the agency and then filed for bankruptcy.

38 Studios was founded by former MLB pitcher Curt Schilling.

38 Studios was founded by former MLB pitcher Curt Schilling.

On Monday, the SEC charged the Rhode Island agency, since renamed the Rhode Island Commerce Corp., and Wells Fargo Securities (as well as two agency executives and a Wells Fargo banker) with defrauding investors in the bond offering.

“Municipal issuers and underwriters must provide investors with a clear-eyed view of the risks involved in an economic development project being financed through bond offerings,” Andrew Ceresney, director of the SEC enforcement division, said in a press release. “We allege that the RIEDC and Wells Fargo knew that 38 Studios needed an additional $25 million to fund the project yet failed to pass that material information along to bond investors, who were denied a complete financial picture.”

Former executives of the Rhode Island agency Keith W. Stokes and James Michael Saul were responsible “through recklessness or negligence” for the agency’s failure to make complete and truthful disclosures in the offering document, according to the SEC’s complaint. The two were charged by the SEC with aiding and abetting the fraud, and both agreed to settle the charges without admitting or denying the allegations, each paying a $25,000 penalty. They are also prohibited from participating in any future municipal securities offerings.

The offering document also failed to disclose the full amount of compensation that the offering’s lead placement agent, Wells Fargo, was receiving from the transaction, the SEC charged. Wells Fargo’s actual compensation from the offering was almost double that which was disclosed, as the result of a side deal that Wells Fargo had with 38 Studios. This undisclosed compensation, which created a potential conflict of interest, was material and should have been disclosed, the SEC said.

Wells Fargo’s lead banker on the deal, Peter M. Cannava, was responsible for the bank’s failure to ensure that the offering document contained complete and truthful disclosures both about the need for additional funding — beyond the bonds — to complete the project being financed and Wells Fargo’s compensation, according to the SEC.

The SEC’s litigation continues against Cannava, Wells Fargo, and the Rhode Island agency.

“Contrary to what the SEC is trying to suggest, Cannava was not the lead banker on this matter,” Cannava’s attorney Brian Kelly told Bloomberg. “The SEC is trying to scapegoat a mid-level banker instead of focusing on the mistakes of Rhode Island politicians. We will fight this vigorously.”

“Rhode Island lawmakers have occasionally floated the notion of failing to pay on the bonds, causing Moody’s Investors Service and Standard & Poor’s to threaten downgrades to the state’s credit,” Bloomberg wrote.

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