Using Freedom of Information Requests To Find Red Flags

During his recent interview with Tobias, Scott Jackson, CIO at Ravenwood Capital Management discussed how he uses Freedom of Information Requests To Find Red Flags. Here’s an excerpt from the interview:

Tobias: How are you identifying the weakness in the internal controls? You looking for that particularly in the auditor’s report?

Scott: Yeah. Well, we’re looking for the language, but then we also look for red flags, like net income higher than operating cash flow. And then, stuff with high cash flow, but doesn’t really– things that have high earnings and low cash flow, stuff like Wirecard that was just one that just went down. Then, on the other side, we have some primary information to too. We do reduce risk. We think it reduces risk because micro caps, I think one of your biggest risks is fraud and just getting blindsided. We do FOIA requests with various government agencies, but mostly we do it with the SEC. And the way it’s set up, the SEC will tell you if there’s an active investigation going on– they can’t tell you that there’s an active investigation going on. But they have to tell you whether documents are being withheld. And so, that’s a B7A Exemption is what it’s called.

And so, quarterly, we do requests on all the companies on the portfolio just to make sure. And we’ve gotten ahead of a few of them, and their routine– I think like every three years companies get reviewed by the Department of Corporate Finance for the SEC. But the investigations are different because they’re done by the enforcement division. When you get basically records being withheld, it says for investigative purposes and law enforcement purposes, that doesn’t have anything to do with the division of corporate finance. That’s all the enforcement division. So, we look for stuff like that and we just don’t take any risk on that. Typically, where there’s smoke, there’s fire. If something’s cheap, it might be because somebody’s figured out something like that and they short it.

There’s a company right now that we did four requests on the short side. There was another FOIA request for this company called Tactile Medical Systems. And there’s been a couple short reports on it, and they basically came to the conclusion that their revenues are being overstated. So then, I see that– and I do one with the VA. It’s just for one year. We have ones out for more years to increase the sample size of it, but I think that the revenues based on what the VA are telling me– they’re overstated by about, I think about $6 million for, I think, it was 2018-19.

Tobias: How material is that to what they’re earning?

Scott: I don’t remember the split between. They sell basically one product, so it’s super easy to track. And then, most of the revenues are from CMS, for Center for Medicaid, and I forget exactly what it stands for. That one’s like very overstated. And then, the one from the VA, I think they told me that there are– they had $25 million in product sales and the company reported 30, 31 or something like that. So, it’s quite a bit. But then, there’s also short reports on kickbacks for the company and all kinds of stuff. I don’t know what’s going on there, but we find stuff like that. And then, we’ve got a couple more FOIA requests to the SEC. I follow a lot of the short sellers on Twitter and when they start talking about names and fighting over with the longs and stuff, like I’ll just go run FOIA requests on stuff and then send it to some of the people that are talking on Twitter. And just be like, “Hey, you guys got an active investigation on this thing.”

Tobias: I think it’s super interesting. I think it’s one of the main reasons that I wanted to talk to you because part of your strategy, you find these companies– and I didn’t actually appreciate that you’re doing this for your whole portfolio, but you submit Freedom of Information Act requests to see what’s happening. And so, you submit them to the SEC, and they’re prevented from– they can’t release the documents, but they can tell you if there’s an active investigation going on. But you’ve been doing this for long enough that you know that every three years or so, these companies get ordered by– or they get approached by the SEC. So, that’s not unusual. You’re looking for something that’s been handed across to enforcement. Is that what I’m understanding?

Scott: Right. So, it’s basically the government’s giving you somewhat nonpublic information. The power that information is determines whether an investigation is disclosed or undisclosed. A lot of the times, the investigations are undisclosed. And for the record, I don’t have a long or short position in Tactile. It’s just something that I’ve been digging into.

Tobias: Just walk us through the process. How do you submit a Freedom of Information Act request?

Scott: Yeah. So, if you go to foia.gov in the US here, you can basically– it pops up with a box for the agency you want to submit a FOIA request to. A lot of them are on there. Some of them, you have to go to the website for Department of Homeland Security, I think. And then, I believe– I’m not sure there are a couple others that you have to submit, just straight through email because they don’t have electronic systems developed. But let’s say you want to do it– I think the SEC, it funnels it through the SEC website. And then, you input your information and then the company and then you have a list of like what information you want. You can pull complaints to the SEC. That one’s always fun, reading some of the complaints. A lot of the times when you pull up the complaints to whether it’s the SEC or the FTC, it’s the longs complaining about short attack sellers.

[laughter]

Scott: It’s pretty entertaining sometimes.

Tobias: Have you ever found anything in there that’s helped you make a decision one way or the other?

Scott: Oh, yeah. For sure. Yeah, definitely. We found a couple of active investigations on stuff that we own that weren’t disclosed. One of them was GAIN Capital. I think we got one through the SEC, but then we also got one through the CFTC, which was the main governing body from an [unintelligible [00:25:12] standpoint. And then you go back, and you search through the legal documents and there’s just a ton of complaints on stuff. It seems like that they’re not good for the stock price. There’s no way to tell if other people are really figuring out. You can see through the FOIA logs what other people are requesting. So, when I look for on the short side, I just download all of the SEC’s FOIA logs, and then I’ll just search the name of the company and see who all has done requests on that specific company.

And then I’ll go, and sometimes I’ll request the requests that have been done on that company to see what some of these hedge funds and some of these firms that are contracted by hedge funds are looking for.

Tobias: The companies don’t have to disclose that to the market?

Scott: I think it’s subjective. Sometimes, I think they can make the case that it’s not a material event or– obviously if there’s some big huge fraud, they’re going to try not to disclose it. Yeah, a lot of the times, they don’t. One of the first things I do after I submit the FOIA request and ask for– and I have a specific language that I use to ask for, and I think it’s like six types of records, like subpoenas, Wells notices, anything that speaks to the conduct of officers and directors involved with that company and its subsidiaries. And then, I’ll also search– I’ll go on EDGAR and I’ll pull up all the correspondence. So, if you type on EDGAR or Bloomberg, CORRESP is the code for 10-K you’d punch into EDGAR. And then, you can start reading. If there’s any letters, you can see when the last communication was. You can see what the division of corporate finance was interested in if they had any back-and-forth dialogue that they have to publish. I think they do have to publish any communications with the company, like any increase in responses and stuff like that.

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