The lesson of Long Term Capital Management

Over the years I have marveled at the fact that some of the most intelligent people in the financial markets repeatedly get blindsided by market action. Frequently it is because in the real world the markets do not act in accordance with their view of how the markets should act.

A great many intelligent people lost money when the markets crashed in 2000 and 2008 because in each instance they did not see the crash coming. Many fall back on “nobody” can predict the market when what they mean is that “they” failed to predict the market.

A great deal of the advice given by the Wall Street firms is conflicted. Even simple tools like asset allocation are grossly misapplied. Finding a better than average financial adviser can be hit or miss.

Many people agree that investing requires time, information, analysis and discipline. There is logic that suggests using computers and mathematics to make investment decisions has merit. Computers will certainly analyze more information in less time and can trade any account subject to a rigid discipline.

Success should be dependent upon analyzing the right information in the right way. Hiring really smart and accomplished people to decide which information to collect and how to analyze it would seem to enhance the chance of success. Except that it does not always work.

The most outrageous example may be the case of Long Term Capital Management (LTCM), a Connecticut based hedge fund that lost about $4.5 billion of investors’ money in 1998 and almost brought the markets down with it. The investors were some of Wall Street’s biggest banks and many of the individual executives who managed them.

LTCM was started in 1993 by Lee Meriwether, a very accomplished trader who had made substantial profits for Salomon Brothers. Showcased members of the team were Myron Scholes and Robert Merton, two economists who had devised a mathematical model for pricing options. Merton and Scholes won the Nobel Prize in Economics for that model in 1997 just before the downturn that wiped out LTCM.

LTCM performed arbitrage with its investors’ money. They looked for small discrepancies in the price of the same or similar instruments in different markets. They assumed that the markets would always efficiently close those gaps.

LTCM created sophisticated mathematical tools to identify those discrepancies and to evaluate the greater markets so they could estimate how those gaps would close. No one has suggested that LTCM’s math was wrong; it is just that the events that occurred were not in the database that they were analyzing.

In 1997 the government in Thailand devalued its currency. The ensuing defaults roiled the markets in Asia and caused a serious decline in the equity markets. Credit markets in Japan, a major US trading partner and the most important capital markets in Asia tightened significantly. It did not help that Russia defaulted on its own sovereign debt shortly thereafter.

Importantly, LTCM did not lose money when the devaluation occurred in 1997 but a year later. The LTCM fund was very profitable into 1998. Losses started to mount up when its mathematical models could not account for the shifting market conditions caused by the devaluation. They were useless to predict the effects of the often conflicting ways in which other Asian governments and central banks would deal with it.

The lesson to learn from LTCM is quite simple. Even the best mathematical models created by the smartest people should not be relied upon to tell us what the markets may do. No computer program can accurately predict the price of securities one month or one year from today.

Despite this fact, there are currently a multitude of “quant” firms that are developing and using ever more sophisticated mathematics to do just that. Most are focused upon making predictions of what will happen in the markets today not next month. I wish them luck but I would not give them any of my money to invest.

The markets will continue to evolve, globalize and expand. Developing mathematical models based upon how the markets have acted up until today will be less and less accurate and have less and less utility going forward.

Millennials think otherwise and are expected to invest trillions of dollars with robo-advisers who use mathematics in the same way. A substantial percentage of those funds will be lost the next time the market turns down.

Then the market”professionals” and pundits who currently sell and endorse robo-adviser programs will remind the millennials that “nobody can predict the market” because some things about the markets never change.

What The Crowdfunders Forgot ….The Crowd

My own interest in Crowdfunding goes back only about one year but there are few old timers like me in this now exploding corner of the capital markets. By now I have now read hundreds of articles and studies, spoken and corresponded with people who were instrumental in getting the JOBS Act passed and people who work in the Crowdfunding market every day.

I admit that I am fascinated by Crowdfunding. I see it as especially beneficial to smaller companies who can now raise capital in a regulated environment. Much of the literature focuses on the benefits of that capital to those companies and the benefits of those small companies to the general economy.

Very little seems to have been written on how this market will attract investors. If anything, there seems to be an attitude that suggests that ”if we build it, investors will come”.

Up until now, Crowdfunded offerings could only be purchased by “accredited investors”, wealthier people who are supposedly sophisticated enough to evaluate a private offering themselves and who are presumed to be wealthy enough to accept a loss if the investment tanked.

Before Crowdfunding accredited investors were sought out for private placements offered under Regulation D. Reg. D offerings are generally made through regulated brokerage firms where professional salespeople sell them to investors and are sometimes motivated by high commissions.

Crowdfunding is attempting to compete with these live salespeople using mostly passive portals and social media. It is not the same. Social media is just a tool. What Crowdfunding needs to embrace is a message that these investors want to hear.

A significant number of Reg. D offerings are real estate or oil and gas production syndications. In a great many of these offerings investors are promised a share of the rents or royalties or some other monthly or quarterly income stream. Some of these offerings offer tax benefits that are attractive to wealthy investors.

There are many established sponsors in the Reg. D market. These companies fund project after project through private placements. The larger sponsors can often point to a track record of success. By success I mean that prior investors were able to cash out for more than they invested.

Crowdfunding is too young for any company to post a similar track record. Crowdfunding counts its successes by how many companies get funded. As Crowdfunding matures it needs to judge its success by how many investors make money.

Only a small portion of the people who qualify as accredited investors actually invest in private placements. What exactly is the Crowdfunding industry doing to lure these private placement investors to Crowdfunding websites? The short answer is: not nearly enough.

The Securities and Exchange Commission (SEC) has recently opened Crowdfunding to all investors. Many smaller investors will be restricted to investing no more than $2000 on Crowdfunding portals each year. The SEC understands that with any Crowdfunded offering there is a high risk that the investors will could lose their entire investment.

Since we are speaking of only $2000 of non-essential income, it would seem more logical that people might opt to take that amount money to Las Vegas and put one dollar at a time into a slot machine. Statistically, slot machines pay out about 97% of the money that people put into them. Whether you ultimately win or lose has a lot do with when you stop. If you play a slot machine for long enough the casino is likely to buy you a beverage.

Investing that same $2000 in a small business through a Crowdfunding portal would have a significantly higher risk of loss and demonstrably less entertainment value. I see a lot of ads for Crowdfunded offerings and to date none has included a drink coupon.

The allure of Crowdfunding to any investor is the chance to cash out big. For the vast majority of Crowdfunded businesses that is very unlikely to happen even if the funded company is successful.

To date, there is no meaningful secondary market for Crowdfunded offerings. An investor who invests in a company that does well may still not get their money back to spend or invest in other offerings.

What will the Crowdfunding portals offer to entice any investor to bring money?

There is a lot in the Crowdfunding literature regarding the use of social media campaigns to sell offerings. This reliance upon social media actually highlights a weakness in the Crowdfunding system.

Investors who are solicited by a single company because they are suppliers or customers of that company or friends of the management have no reason to evaluate any other offering on the same portal or other portals. The portals should not expect these investors to become repeat customers.

If an investor does not get interest or a regular share of the profits, cannot cash out and has worse odds of success than at a slot machine, it is easy to see that the Crowdfunding industry still has will have some work to do. Once the “newness” of Crowdfunding wears off investors will need better deals and better incentives for investors.

 

Elder Financial Abuse-the Fiduciary Rule and Broker/Dealer compliance.

There are two general rules in the financial markets that you should never forget: 1) the higher the yield or growth potential for any investment the higher the risk of loss, and 2) investments that have a higher risk frequently pay a higher commission to the stockbrokers who sell them.

Seniors and retirees often want to draw as much as possible from their retirement accounts every month. Stock brokers are constantly tempted to give the customers what they want (higher yields) because it puts more money in their own pockets at the same time. The end result is that a lot of seniors are steered into making investments that are riskier than they wanted or could afford.

To address this temptation head on, the Securities and Exchange Commission (SEC) has proposed a new standard of conduct for all stockbrokers. The SEC’s proposed rule states:
“The standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”

Although Registered Investment Advisers have lived and prospered under this “fiduciary” standard for decades, the financial services industry has organized an effort to assure that this standard will not apply to most stock brokers. This rule squarely hits the industry’s bottom line.

The rule is very much the result of many years of seniors being steered into riskier investments to increase the industry’s profits. In May 2015 the staff of the SEC and FINRA published a joint report of their examination of brokerage firms selling investments to seniors. The staff asked firms to provide a list of the top revenue-generating securities purchased by their senior investors by dollar amount. http://www.sec.gov/ocie/reportspubs/sec-finra-national-senior-investor-initiative-report.pdf

Variable annuities were among the top revenue generating financial products sold to seniors at 68% of the firms examined. Non-traded REITs, alternative investments such as options, leveraged inverse ETFs and structured products made the list at between 10% and 20 % of the firms.

A variable annuity usually comes with a significantly higher than average commission to the salesperson. While variable annuities do offer tax deferrals and other benefits that might be attractive to some investors, no one disputes that variable annuities are high cost, high risk and high commission products. It is no secret that the high load and withdrawal charges that can go on for years make variable annuities less suitable for investors as they get older.

All stock brokerage firms are required to have procedures in place where managers officially supervise all employees. As part of their supervisory efforts, most firms employ a compliance department, usually populated by professionals tasked with the supervision of every account on the firms’ books and every order that the firm handles.

Most compliance departments compile daily exception reports of the previous days’ trades that were uncharacteristic or fit within pre-determined parameters as potential problems. It is much easier to fix problems with trades before the settlement date.

There should be a similar system that would identify the sale of a variable annuity to a 70 year old retiree as outside the norm of expected behavior. If the surrender charges extend out for 10 years, the customer’s access to his own money is restricted until the customer is 80 years old. Throughout, the investment portfolio will be exposed to market risk. Often the customer could substitute a mutual fund or funds for the same investment purpose at much less cost.

Where surrender charges extend out for ten years it often means that the sales commission on this transaction might be a high as 10%. That is why the SEC’s proposed rule focuses upon the “financial or other interest of the broker”.

The industry firms sell more and more variable annuities each year and make a lot of money doing so. I am certain that their shareholders expect nothing less. If you have been thinking about the “Fiduciary Rule” debate on a philosophical level, this is where the regulation meets the cash register.

The risk tolerance of each customer, for each transaction, is considered by the stock broker, the supervisor, and the compliance department. An investor’s risk tolerance can be easily ascertained with the question: how much of the money that you are investing are you prepared or willing to lose?

Many non-traded REITS began their lives as private placements issued under Regulation D. Once you buy them, selling them can be very difficult if not impossible. If the market turns against you, you have to ride the investment all the way down. In 2008-2009 many non-traded real estate investments lost significant value or went bankrupt. An investor in a non-traded REIT can often suffer a total loss.

Again, the SEC is keenly aware that these private placements often pay very high sales commissions. The SEC also knows that there are a multitude of comparable REITs that are liquid because they trade in the public markets and can be bought or sold for normal brokerage commissions and on any day the markets are open for trading.

Is it fair, then, to ask why a professional compliance department would not think it odd that a great many seniors seem willing to invest large amounts in clearly speculative investments when similar investments are readily available with much less risk and much less cost? Can the industry make a plausible argument that higher commissions do not drive these sales?

The industry is fighting for the right to set commissions at levels it deems fit without due consideration of whether the extra cost makes any sense from the investors’ point of view. Adopting this rule should lower commissions and customers costs overall and promote market efficiency. Diverting seniors to safer, less expensive products at the same time cannot be anything but positive.

SEC v. Ascenergy; Crowdfunding’s First Black Eye

The Securities and Exchange Commission (SEC) has brought its first fraud enforcement action that occurred on a Crowdfunding portal  http://Ascenergy LLC et al. (Release No. LR-23394; October 28, 2015).  The Commission alleges that a Texas oil company called Ascenergy raised $5 million from 90 investors on at least four Crowdfunding portals including crowdfunding.com, equitynet.com, fundable.com and angel.com.

Ascenergy claimed to be raising funds to drill oil wells on leases that it had evaluated and secured. The investors were defrauded because Ascenergy had not secured any leases. The person whom the company claimed had evaluated the leases had not done so, did not work for the company and had not agreed to allow his name or resume to be used by Ascenergy to raise money.

Ascenergy used false and misleading facts and omissions to create a false legitimacy which the portals and the public readily accepted. The Commission noted that Ascenergy’s website contained false claims of partnerships or associations with several legitimate companies whose logos appeared on Ascenergy’s website, also without permission.

Investors were told that investing in Ascenergy was “low risk” and that its shares were “liquid” when they were neither. The vast bulk of the money raised was spent on what the SEC calls ”personal expenses” of the person who thought up this scam and who might have gotten away with it.

Scams like this are common in the mainstream Regulation D private placement market. It is more likely that the due diligence process at a Financial Industry Regulatory Authority (FINRA) member firm would not have passed Ascenergy along to investors. No FINRA firm would likely have allowed Ascenergy to call its offering “low risk” or “liquid”.

The SEC’s complaint charges Ascenergy with fraud under the same sections of the federal securities laws that the SEC has been citing for decades. The SEC has made it clear that it expects Crowdfunding portals to actively seek to keep scams off their websites. The SEC has been just as clear that the anti-fraud provisions of the securities laws absolutely apply to Crowdfunding transactions.

The final Crowdfunding rules encourage and almost mandate portals to become members of FINRA. FINRA has established guidelines for due diligence investigations for private placement offerings. The FINRA due diligence standards seem reasonable to adequately keep scam artists away from public investors.

As scams go Ascenergy was not particularly novel or complex. FINRA firms have conducted thousands of due diligence investigations of oil drilling programs over the years. No due diligence investigation properly done by a FINRA member firm would have let Ascenergy claim to have secured leases without verification.

The portals generally do not conduct anything close to this type of due diligence investigation. The investigations can be costly and most portals elect not to spend the money. Very few of the Crowdfunding portals even attempt to conduct a substantive investigation sufficient to catch the “bad actors” let alone the “bad” deals. But do the portals assume the risk?

If you were one of the 90 investors who purchased Ascenergy on one of the four portals listed above, send the portal an e-mail and ask for your money back. Tell them that you have been defrauded because the portal failed to do its homework. Please copy me on the correspondence. I am curious to see how much denial the Crowdfunding industry is in.

Let me predict the future. The next SEC enforcement action will not mention the Crowdfunding portals in passing. The next SEC enforcement action (or the one after that) will find the portals being named as defendants and subjected to significant fines. The SEC has no real budget for Crowdfunding enforcement. In my opinion the SEC’s Enforcement Division is more likely than not to make an example out of an offending portal to send a clear message to the Crowdfunding industry that they must actively attempt to keep fraudulent offerings off their websites. That is, if the industry did not get the message the Enforcement Division delivered in its complaint against Ascenergy.

If any of the portals or their advisers disagrees I would like to hear from them as well. The literature surrounding Crowdfunding is rife with experts who have little or no experience actually preparing securities offerings or raising money from investors. I have seen many articles by “good” lawyers suggesting that a due diligence investigation is an unnecessary cost or that a superficial investigation is sufficient for a small Crowdfunded offering.

The problems that the SEC found with the Ascenergy offerings should not have occurred. Investors should not have had their $5 million stolen. The four portals that facilitated Ascenergy’s fraud owe at least an apology to the investors who got scammed.

Some people in the Crowdfunding industry have already suggested that Ascenergy is an isolated case. As I have written elsewhere, there are a great many portals that are currently offering securities for companies that are obviously not telling investors the whole story. Perhaps it is a little easier for me to spot an investment scam because I have seen so many, but that is exactly the expertise that the portals need and lack.

The Crowdfunding industry projects $40 billion in Crowdfunded offerings next year. The bulk of these offerings will be executed by buyers, sellers and portals that are mostly novices in an uncharted and unregulated market. If you wanted to commit securities fraud, what better opportunity could you find?

The Crowdfunding industry is justifiably jubilant about its prospects for success. Small companies have good reason to cheer this large infusion of new capital. But are the investors jubilant? Certainly not the 90 people who put up $5 million for the securities sold by Ascenergy.

I would advise crowdfunding.com, equitynet.com, fundable.com and angel.com to carefully consider their position should any defrauded customer correspond or a member of the financial press come knocking. A public pronouncement that due diligence is unnecessary or that a cursory investigation is sufficient will likely be used against you in a court of law.

The crowdfunding industry has very few investors who are loyal to one portal over another. It should be obvious to the industry that exposing investors to scams like this will not build loyalty, but will send investors back to their stockbrokers at mainstream brokerage firms.

What is an APP worth? Finding Rational Valuations in an Irrational World

Determining the value of any business can be an interesting process. Even in a data-filled discipline like economics, business valuation often remains very subjective.

If you stayed awake in Economics 101 you might have learned that in a liquid market, we believe that prices are determined by rational buyers and sellers of goods and services, each assessing the transactions in regards to their own self-defined best interests.

Price theory was developed in the 18th Century for a mercantile economy where the buyers and sellers were primarily merchants. Adam Smith considered merchants to be rational because they all wanted to buy goods for a price less than the price for which they could re-sell them. Little consideration was given to how the ultimate consumers might act or think.

In our modern consumer economy rationality plays a diminished role. Many consumer transactions are emotionally based. If you do not believe me consider the vast amount of economic activity that emanates from a single, strategically placed dab of perfume. The human mating ritual is full of transactions that are not based upon a rational allocation of resources.

It would seem easier to find rational buyers and sellers in the financial markets. People buy stocks because they believe that the market price of the shares will increase. The people who are selling those same shares in the same transaction may be doing so because they believe that the price will rise no higher. A buyer and seller in each transaction may be assessing the exact same data and reaching opposite conclusions. Each still acts rationally.

We seem willing to accept that a company’s value as being equal to the number of shares that it has outstanding in the market times the last price at which the shares were sold. But is it?

In active trading markets, the price of a stock may change constantly. For any stock, the last trade of the trading day is the price upon which margin accounts are valued and capital computations will be made throughout the global banking system. All that actually occurred between the next to last trade and the very last trade of the day was that one person bid the stock up or down. Valuing a company’s shares at the last trading price of the day eliminates the rational thinking of the other market participants who traded the shares seconds or minutes earlier.

Consider the case of Uber. Recent reports suggest that the not yet public company might have a value of $50 billion.This valuation was assessed at the time of its latest round of financing in mid-2015.

For a private company that is fairly new, an actual value of $50 billion would be quite rare. There are not a lot of larger companies that could spend $50 billion to purchase Uber. It would require $25 billion to take one-half of the company public and more to maintain a liquid secondary market.

Uber has demonstrated that its business model is viable and expandable and should certainly be profitable, given that its direct cost to provide the labor that it sells is zero. Uber operates in more than 200 cities, worldwide, cultivating its brand and customer loyalty.

At its core, Uber is essentially an APP, which the company itself will tell you. The company has structured its business so that the “employees” whose labor is the primary source of the company’s revenue are not employees at all. They are independent contractors.

The independent contractors (drivers) utilize the APP to connect with customers who might hire them. Once hired, the APP does the billing, Uber takes its cut, and the contractor gets a check. It is not a complicated concept.

If one assumes that Uber captures $2 (net) per transaction worldwide, it would need ½ billion transactions per year and a 50/1 price to earnings ratio to achieve a $50 billion valuation. Even with a lot of customers and a lot of drivers to service them, that is a lot of rides. There is no indication that Uber has ramped up to that level.

The replacement cost of Uber’s APP would seem to be a fraction of that $50 billion value. The APP is, of course, just a few million lines of code. Its functionality now defined, could not 1000 code writers replicate the APP’s functions in 1000 days, more or less?

Uber already has credible competitors. Some amount of Uber’s “loyal” customers could be coaxed away with price incentives and clever advertising. Some number of Uber drivers could be incentivized to change firms for a higher payout or a different business model. Certainly the $50 billion valuation for Uber seems high.

Valuation is one of the most elusive concepts in economics. If Uber’s value may be off by $10 or $20 billion despite its simple business model, what values can we trust?

For their first week’s home work assignment, I would send my Economics students into one of the large department stores in San Francisco’s Union Square. I would instruct them to make a purchase but not to pay the price on the product’s tag. Rather, I wanted the students to actively bargain and to convince the sales clerk or department manager to let them have the item for less. You would be amazed how easy it is to accomplish this.

Modern economics is based on price theory. We just have to remember that prices are rarely rational and always negotiable.

Sex and crowdfunding

Crowdfunding is very much an exercise in self-funding. The companies that are raising funds on the crowdfunding platforms are often expected to solicit their own customers, suppliers, friends and family to become investors in the business as part of the crowdfunding process.

There is a burgeoning industry of consultants who will help companies that want to raise money on these platforms. These consultants exist because there is still far too little capital available in this market. These consultants specifically help companies compete for that capital, but the crowdfunding process is still largely hit or miss.

It seems to be common knowledge that a good social media campaign should accompany any equity offering on a crowdfunding platform. Like all advertising, a social media campaign is a “numbers” game. Its goal is to bring enough eyeballs to your offering so that all of the shares you are offering will get sold.

If eyeballs are what you need to successfully crowdfund a company, it would seem logical then that the easiest company to crowdfund might be one selling a line of lingerie. No crowdfunding consultant worth his/her fee would likely tell the company not to include its product catalog in its presentation to investors if that catalog had pictures of models wearing lingerie.

Titillation aside, lingerie companies sell products that may be easily and inexpensively sourced and which can often be sold at substantial mark-ups. But that is not what the conversation is likely to be about.

In a perfect economic world, investors would travel to the “efficient frontier” (a great name for a crowdfunding platform, in my opinion) and select investments suited to their taste for a blend of risk and reward. Illiquid shares received by crowdfunding investors will always be speculative, so reducing the risk or increasing the potential reward seems to be the obvious way for the platforms to gain the most customers.

When a crowdfunded business finally monetizes the investors’ “bet” there should be every expectation that the investors will be well compensated. Greed, not sex, should be the emotional basis for any crowdfunding investment.

The crowfunding platforms are filled with companies seeking funding for real estate projects, technology projects, electronics, toys, bio-tech, consumables, films and office applications. A prospective investor visiting a few of the larger platforms would likely find a few hundred very different offerings to consider. As the offerings attempt to distinguish themselves one against the other, there seems to be more showmanship than substance.

The classic business model for offering new securities to the market would have them underwritten by an investment bank or brokerage firm. This model works for the companies that are being funded because they get funded. It is also exceedingly profitable for the investment banks.

Investors in an underwritten offering can expect to get a reasonably investigated, intelligently structured investment into which someone at the investment bank, independent of the company, has given some time, thought and analysis. The value added to a funding transaction by an investment bank is the judgment that they bring to the transaction. Investors who may know nothing about the company seeking funds will invest if they have relied upon the bank’s judgment in the past and made money.

I was only able to find one crowdfunding platform that even attempted to offer this type of assistance to companies that were listing on it. Only one platform that seems to see what everyone else is missing.

I should not have to tell you that many of the companies that are currently seeking funding on the crowdfunding platforms are very weak. Even companies which have a “cool” new product created by a great team of engineers will often employ no one with the experience to effectively get the product to market.

There are many start-ups on these platforms that are not yet in business. Someone independent of the company issuing its shares still needs to ask the question: “can you get this to market, on time, sell it and make a profit?” In the crowdfunding marketplace, at least up until now, no one really asks this question because no one considers it their job to do so.

Sooner or later, the platforms will likely realize that they are in the business of selling equity shares to investors and step up. Goldman Sacks is also in that same business and makes a lot of money doing it. As billions of dollars find their way to these platforms in the next few years, there will be a lot of money to be made as the crowdfunding industry matures.

The crowdfunding industry will have matured, in my opinion, when the social media messages change direction. Eventually, the current outgoing “please buy my offering” messages will be replaced by the incoming ”I wonder what the ‘Efficient Frontier’ crowdfunding platform is offering this week?”

Looking back ten years from now, will any of the crowdfunding platforms now operating be able to boast that “97% of the companies funded on our platform in the last 10 years are still operating” or anything close? Certainly the platforms should realize that this type of track record would draw a lot of new investors to their offerings and encourage loyalty from the investors that they already have.

Crowdfunding success or failure should never really be determined by sexy catalogs or the size of your social media campaign. The cream should always rise to the top. The crowdfunding market is new and growing rapidly. All that it needs to succeed is an infusion of a little judgment and some common sense.

Due Diligence by Dummies

Due diligence is one of the most misunderstood concepts in the financial world.

As an attorney, I have examined and cross-examined quite a few due diligence officers and experts employed by FINRA brokerage firms. Even those people who are specially tasked with the job of conducting due diligence investigations often do not know what they are doing or why.

The why is easy. Lawyers and underwriters who prepare securities offerings are required to include all the material facts in the offering documents. To do it properly, the lawyers and underwriters must independently investigate the facts to make certain that the sales materials given to potential investors are accurate, complete and the sales pitch for the security is honest.

The law does not presume that the management of any business will necessarily tell their lawyers or underwriters the whole truth. Management, especially management that is in the process of raising money, will often emphasize the positives about the business and leave the negatives out entirely. A good due diligence investigation is always infused with a healthy amount of skepticism about the managements’ claims for the business.

The large Wall Street investment banks usually do a pretty good job of due diligence. The bankers and lawyers usually charge the issuers at Wall Street billing rates to get the investigation done as part of the underwriting process. They frequently bring in experts with unique knowledge of the industry that the business is in.

A good due diligence investigation is the best way for these bankers and lawyers to protect themselves against investors’ claims of misstatements or omissions in the offering documents down the road. For securities lawyers, a good due diligence investigation is their insurance carrier’s best friend.

The due diligence team needs to have a sense of the business that they are investigating. They need to understand the cash flow, the real risks facing the business and how its competitors are positioned.

Even the best sometimes make mistakes. Those who really do not understand the process and those who focus on cutting costs make mistakes more often. Billions of dollars in offerings for Ponzi schemes that were sold by FINRA firms would not have made it to the market if the FINRA firms conducted real investigations of the facts they were presenting to their customers.

Here are some examples of poor due diligence from actual cases:

1) A few years back one of the larger Wall Street firms raised $60 million for a real estate developer who was planning to build a new high-end residential community in Southern California. The carefully calculated projections that came with the offering documents promised that 300 homes could be built and sold in the first year. Only after the money was raised was it discovered that the County in which the development was located, which had been through several years of drought, was not authorizing that many new residential water hook-ups.

2) In a case where a single office building was being syndicated to investors, no one bothered to have the building inspected by a professional building inspector. If they would have done so, they probably would have discovered that the roof of the building leaked, and leaked badly. Most prudent people would not purchase a home without an inspection. Many lenders insist upon it. The brokerage firm executives, some of whom had partied on the promoter’s yacht, apparently did not think that an inspection was necessary.

3) A prospectus will frequently describe the people behind the company as “successful”. Investors value prior success and many people who are raising money claim that they were successful in prior ventures. One real estate developer was described as successful even though he had put his only prior development into bankruptcy. I have asked a lot of due diligence officers to produce their files on an executive’s participation in the success of prior ventures. Very few could produce one.

4) For example, one real estate promoter who raised hundreds of millions of dollars in Reg. D offerings through FINRA firms was described in the prospectus as having previously been the owner of a successful financial firm. Due diligence officers at each of the FINRA firms that sold the offerings failed to discover that the SEC had determined that the financial firm was actually owned by someone else and that the promoter had lied to the SEC when they asked him about it. The SEC case was a matter of public record.

5) Banks frequently use their own appraisers when making a loan because they are risking their own money. A brokerage firm that is risking only investors’ money will often accept the appraisal that the promoter provides. That is never prudent, nor diligent.

I have seen two appraisals that were issued by the same appraiser on the same day for the same property. The one that went to the brokerage firms estimated that the property was worth 5% more than the amount they gave to the bank. Giving a false appraisal to a bank is a felony which is often prosecuted. Giving a false appraisal to a brokerage firm’s due diligence officer is not. Underwriters need to get appraisals from appraisers that they trust and who they pay for, even if ultimately reimbursed by the issuer for the cost.

6) Several large and respected VC funds and investment banks invested funds to build a $500 million processing plant for a company that claimed to have a new process to produce ethanol from wood scraps. The company claimed that the process was proprietary and ready to go which was why they were seeking funds for construction of a large plant to begin producing ethanol. After the bankruptcy, it was determined that the process did not actually work and had never been patented. None of the firms hired a chemical engineer to review the patents or the process. They saved $5000 by not doing so and wrote –off over $500 million because they did not.

7) An offering for a franchised hotel stated that its occupancy would be largely dependent upon events at a new arena being built just across the freeway. The projections indicated that the arena had sporting events, concerts and other events scheduled 340 days a year. A call to the arena box office confirmed that the arena was largely dark for its first few years of operation and was never projected to be occupied 340 days a year. Had a due diligence officer made the same call at the time the securities were being offered and the correct projections given to investors, there probably would not have been any litigation.

8) The SEC just recently brought actions against 22 banks and brokerage firms for failing to conduct adequate due diligence investigations on municipal bond offerings. You can almost hear the due diligence officers saying: “it is a municipality, why spend the time and money investigating it?”

Economic problems are sometimes best viewed along the margins of the markets. The new crowdfunding industry is certainly on the margin of the capital markets. Although each funding project is relatively small, no one doubts that hundreds of billions of dollars will be raised on these platforms as time goes on. Investors on these platforms are entitled to the same honest disclosures of material facts as are any other investors.

At the same time, because the offerings are small, the crowdfunding industry has loudly denounced the need for audited financial information because of the added expense. The probable result will be a great many small companies who will claim solvency when they are not and who will use investors’ funds to pay off undisclosed debts rather than expanding their business as promised.

The SEC always tells investors to investigate before they invest. Underwriters, attorneys and crowdfunding platforms are equally charged to investigate before they offer securities to the public. It is just common sense.

Will securities fraud kill crowdfunding?

I have started to get a lot of e-mailed advertisements from crowdfunding platforms established under the JOBS Act. Many people see crowdfunding as a simple way for small companies to raise capital. Companies that are selling their securities can offer their shares or notes on a platform (website) for potential investors to consider.

Each of these offerings is still subject to the anti-fraud provisions of the federal securities laws and also the anti-fraud provisions of the states in which any investor lives. These provisions are not that hard to understand. Purchasers of securities are entitled to receive all of the facts that they would need to know in order to make an intelligent decision whether or not to make the investment. It is up to the people selling the securities to supply that information.

Liability for making a false statement or omitting a material fact falls on anyone who participates in the offering or sale of the securities. This generally includes the company issuing the shares or notes, its officers and directors and the lawyers and accountants who put the offering documents together. Liability will certainly adhere to the platforms that list the securities for sale without making certain that the proper disclosures are being made.

With this in mind, I looked at a number of different offerings on crowdfunding platforms. I was specifically looking for red flags, things that said to me that something might just not be right.

I limited my search to crowdfunding platforms that specialized in real estate offerings. I have seen more than a few fraudulent real estate private placements over the years. They frequently sound good until you look under the hood.

I came across one platform that caught my attention. It is aggressively advertising for investors under the new general solicitation rules for private placements. It is syndicating hard money loans to accredited investors. For reference, let us call the platform the HMLM Co. (Hard Money Loans to the Masses), not its real name.

What caught my attention was the sales pitch. The loans that HMLM is syndicating promise to pay investors double digit returns. The loans are secured by real estate that has been appraised. The loans are short term, usually for a one year term. There are often personal guaranties by at least one principal of the company that is borrowing the money. The website states that none of the people who have invested on the platform have ever lost money.

This is very similar to the sales pitch of a real estate fund that I called the Construction Investment Fund (CIF) in my book (Investment Schemes, Scams and Strategies Retirees Should Avoid ). Investors in that fund lost 80% of their investment ($400 million) in the last market cycle. I believe that people who invest on the HMLM platform are likely to experience a similar fate.

A hard money lender who is making loans at a 50% LTV has a lot of collateral and is usually not concerned where the real estate market might be 12 months down the road when the loan matures. As long as the lender is confident that the market price of the property will not come down by more than 50% they are still well collateralized.

Many of the loans on the HMLM platform were at 70% LTV which can be more of a problem. If you buy a property today, pay 15% interest on 70% of the purchase price for 12 months and then sell it with outgoing real estate commissions of 6% it is easy to see where the purchase price of property would need to appreciate by almost 20% just to break-even.

There are not that many markets in the US where real estate is likely to appreciate that much next year or the year after. If the people who are borrowing the money are likely to have difficulty selling the property down the road, why would any lender make the loan?

Logic suggests that a real estate investor with a string of successful projects, good credit, adequate collateral and a personal guarantee would not be interested in borrowing funds at 15% or more. It is one thing to tell investors that they might lose their money. It is quite another to advertise the security as a good investment when it clearly is not.

The platform describes its borrowers as “seasoned” real estate investors. To me “seasoned” would imply experience in real estate for at least a full 15 year market cycle. If you started in the real estate business in 2009 you might have some experience by now and you have probably been successful. If you started in 2000 and went through the 2009 bust then it is possible that you took some losses but at least you got “seasoned”.

I went to the webpage where the management of the platform disclosed its own business history. Not a lot of “seasoned” real estate people there, either. This platform does not sell toasters. It sells complex financial transactions which it has packaged as investments. Management really needs to understand its products. How else can they be certain that all of the material facts about these investments are being disclosed?

To clarify this point a little further, on some of the loans on this platform the names of the individuals who own the companies that are borrowing the money was redacted. If the platform does not believe that the names of people behind the companies who are borrowing your money is a “material fact” that investors would want to know, it certainly begs the question of what other information they are not disclosing.

No one questions that the platform is selling securities and that the securities are exceedingly speculative. Seniors and retirees are drawn to investments that claim to be secured and promise to pay double digit returns. Will this platform accept investments from seniors or allow people to invest their retirement funds? You bet.

Is the HMLM platform committing fraud when it sells these securities? I will leave that determination to the class action lawyers who will clean up the mess likely to result when the real estate markets inevitably turn down. There certainly are red flags that would warrant further investigation.

I singled out this platform because I found many of its shortcomings to be obvious. They would not be obvious to the average investor. There are many, many other platforms out there which I am certain are equally deficient. It is an issue that the crowdfunding industry and its regulators need to address and need to address quickly. If investors begin to realize that crowdfunding platforms cannot be trusted to tell them what they need toknow about any of their offerings, investors will take their money elsewhere.

FINRA Arbitration – How investors actually fare

Arbitration is arguably the most efficient way for public customers to resolve a dispute that they may have with their stockbroker. I have personally been a participant in a great many more securities industry arbitrations than most people.

But the arbitrations themselves have become suspect. Too many customers who have clearly been defrauded by their stockbrokers are walking away uncompensated and shaking their heads. A brief case study will illustrate the point.

I located only 35 awards in the FINRA Arbitration Awards database concerning securities issued by a company called DBSI. DBSI was a national real estate syndicator that filed for bankruptcy protection in 2008 and was shown to have been operating as a Ponzi scheme.

I chose DBSI claims for three reasons:

First, the Examiner working for the DBSI’s Bankruptcy Trustee filed a comprehensive report detailing how DBSI had operated as a Ponzi scheme from at least 2004 at which time DBSI was already insolvent. Like any classic Ponzi scheme, DBSI was using funds collected from new investors to pay obligations to prior investors.

Second, virtually every private placement offering that DBSI made after 2004 (approx. $800 million in total) contained an un-audited balance sheet that stated, falsely, that the company was actually solvent. This was important because with each offering the company was taking on financial obligations to the investors, mostly lease payments for the buildings that it was syndicating.

Third, brokerage industry standards require the firms that sell private placements to verify the information that they are handing out in the private placement memorandums s (PPMs). Verifying DBSI’s claim that it was solvent when it was not would not have been possible. Logic and experience suggest that the approximately 100 brokerage firms that sold DBSI securities failed to conduct a reasonable due diligence investigation if they conducted any investigation at all.

So, we have an independent report filed with the Bankruptcy Court that would seem to establish that investors were given false financial information about DBSI at the time the brokerage firms sold the DBSI securities to them. The principal of DBSI was also convicted of fraud, on basically the same facts, at his criminal trial.

We also have aggrieved investors who begin the FINRA arbitration process knowing that the investment that their stockbroker had sold to them was a Ponzi scheme. The public investors should have a reasonable expectation that a securities industry arbitration panel would find that selling interests in a Ponzi scheme to be beneath industry standards and be willing to award the investors adequate compensation.

So how did the complaining investors actually fare?

Of the 35 awards involving DBSI securities that I could locate in the FINRA Arbitration Awards database, the results were as follows:

In 8 of those claims the brokerage firm had either filed for bankruptcy protection or defaulted and failed to appear at the hearing. In two of these claims the brokerage firm was not a named party presumably because it had gone out of business. A substantial number of the brokerage firms that sold DBSI securities did exactly that. Had they not, I would think that there would have been a lot more claims.

The arbitrators made awards in several of these “defaulted” claims where the customers were able to prove up their claim and establish their damages. There is no indication that the defaulting firms actually paid anything to these customers. A brokerage firm that will not defend a claim will generally not pay the award.

In FINRA statistics these count as a win for investors because an award was made, even though the customers did not actually receive compensation for their losses. FINRA does not require its member firms who sell these private placements to have either adequate net capital or adequate insurance. FINRA does not take any steps to enforce an award against the principals of a firm who sell Ponzi schemes and then close up shop.

In 10 of the 15 claims where the brokerage firm was present and represented by counsel the arbitrators dismissed the claim or awarded the investors nothing. One has to wonder why these 10 panels of arbitrators could not be convinced that selling a Ponzi scheme to public customers was conduct for which the customers should be compensated.

In the 5 fully adjudicated claims where the arbitrators did make an award in the customers’ favor, in only one did the panel order the offending DBSI investment rescinded and the customers fully compensated. The rest of the awards were for much less than the amount that the firms’ customers had invested.

In one of the adjudicated claims the panel dismissed the claim for one DBSI investment and made a small award on a second. Both of these offerings contained fraudulent financial information about DBSI. What could these arbitrators have been thinking?

Twelve of the claims brought by customers seeking compensation for DBSI losses were settled for undisclosed amounts. Pre-hearing settlements are often based upon each party’s evaluation of what might be their worst result if the claim is given to the arbitrators to decide. The fact that only one panel deemed it appropriate to rescind the DBSI transactions and fully compensate the customers would certainly impact the brokerage firms’ idea of what might be the worst result that they might suffer if they did not settle.

When you boil this down to the fact that in only one claim in 35 did the customer get all or a substantial award from the FINRA arbitration panel when all were clearly defrauded, it does give one pause to consider than something may just not be right.

Perhaps it might help to look at the expungement phase of some of these hearings. Claims like these are routinely expunged from the record of the individual registered representatives when the claims settle.

After a settlement, the arbitrators conduct a live or telephonic hearing to determine if the claim should be wiped from the representative’s record. The claimants and their representatives do not usually appear at this hearing, nor should they need to appear. Left alone with the arbitrators some industry firms may be taking advantage.

In more than one claim the expungement order noted that the claim (for selling a Ponzi scheme to a public customer) was factually impossible. In others, the panel held that the offering materials (which contained fraudulent financial information) were within industry standards or that the due diligence (which, if done correctly could not have verified that DBSI was solvent as it claimed to be) was adequate and also within industry standards. I personally refuse to believe that industry standards have fallen that low.

These findings by the panels are often supported by “experts” whom the brokerage firms bring to the expungement hearings to educate the panels without cross-examination. If an arbitrator hears this recitation of “industry standards” from an expert or two provided by the industry over several cases, many apparently start to believe it.

It is certainly logical to assume that after many claims involving DBSI and several other large Ponzi schemes that were sold to public customers in the last market cycle (Medical Capital, Provident Royalties, etc.) the arbitrator pool around the country may have been tainted by the patently false “opinions” of these industry “experts”. Arbitrators get no training in securities law or industry standards from FINRA.

Securities industry arbitration has always been considered to be efficient because it costs less than state court litigation. The cost of the forum should be irrelevant if the customers cannot realistically expect to obtain a reasonable recovery of their losses in cases like this. I cannot fathom that a series of 35 juries sitting in civil courts around the country would come up this many defense victories. If I am right then clearly there must be some defect in the FINRA arbitration system.

As importantly, the lack of compensation awarded to these aggrieved investors in FINRA arbitration forums re-enforces a business model where a broker/dealer can be inadequately funded, carry no insurance, affirmatively flaunt the rules, conduct inadequate due diligence and sell millions of dollars of fraudulent investments to thousands of investors. Once exposed, the principals can simply close up shop and open up across the street under a new broker/ dealer and start over.

Either way, if FINRA intends to advocate its forum as fair and equitable to the public investors, it should take steps to see that it really is.

7 Reasons Why Robo-Investing Will Not Work. Millennials – Wake Up

Robo-investing is the next really big, really dumb thing. Millennials are expected to pour enormous amounts of money into these programs in the next few years. That would be an enormous mistake.

Robo-investment programs promise to help users to set up investment portfolios now and then to help manage those portfolios for the next 25 or 30 years. The portfolio with which you will end up, all those years down the road, is likely to be a disappointment.

I looked at a number of the websites and advertisements for these programs as I was writing this article. One proposes that a”moderate risk” portfolio would have 90% held in stocks. Another has a member of their investment team who takes a “holistic” approach to financial planning. That may be fine for some people but is not a serious approach to managing your money as far as I am concerned.

These computer programs do not have what it takes to intelligently construct a portfolio for you now or to manage it over a period of many years. Years from now, you will wish that you had a portfolio put together and monitored by a well trained and intelligent flesh and blood investment adviser. By then it will be too late.

Robo-investment advisers tout the fact that they cost less than a human investment adviser would cost. It does not really matter. Robo-investment advisers are inexpensive because they provide investors with little or no value.

If you have any doubt that these robo-investment adviser programs are less than worthless, here are seven obvious reasons why the actual portfolio that you will get from a robo-investment adviser program is likely to perform poorly.

Number One: It is not about your age.
One of the few personal questions that a robo-investment adviser program will ask is your age. If you are thirty the program will assume that you can afford to take on more risk than a person who is sixty. If it is suitable for you to take on more risk then your recommended portfolio will get more stock funds or ETFs and fewer bond funds and bond ETFs.

Investing based upon your age assumes that your age and the markets are somehow related. What you should or should not buy today is dependent upon the market, not upon your age. If you start down this path, what you will have bought or sold over the years that you stay with the program will have had nothing to do with what might have been a good investment at any time.

Number Two: Today might not be a good day to invest in either stocks or bonds.
Let us say that the program suggests that you create a portfolio that is 35% bond funds or bond ETFs and 60% stock funds or stock ETFs with 5% held in cash. In truth, it does not seem that most of these programs ever hold a lot of your funds in cash which always increases the portfolio risk.

If you begin investing this year when the stock market averages are making new highs it is reasonable to expect that next year or the year after the market might correct. It is very possible that five years down the road 60% of your portfolio will be worth less than it is today.

After seven years of forced low interest rates is this a good time to put 35% of your money into bond funds or ETFs? Savvy investors know that bond funds do not do well when interest rates rise. The computer will not adjust for the hike in interest rates that everyone knows is coming until after it happens and the portfolio has taken the loss.

Number Three: It is about the right math, the right data and more.
Robo-investment advisers claim to have sophisticated algorithms that will crunch the numbers and produce good results. The algorithms may be good but these programs look at the wrong numbers. A robo-investment adviser never gets past a limited set of gross market data. A robo-investment adviser never actually looks at any company’s balance sheet. They are an example of the GIGO principle of statistical analysis; garbage in, garbage out.

It is not only about the numbers. Before I would invest in any company I would want to know about products that the company might have in the pipeline, what its competitors were up to and what the CEO is thinking about. I am not alone. A robo-investment adviser is never interested in these things that most other investors would want to know.

Number Four: Investing cannot be done in a vacuum.
The computer program does not get a live news feed and would not know if Germany had invaded Poland so events leading up to any crisis that might affect the markets and the portfolio would necessarily be ignored. The program does not concern itself with current commodity prices, currency rates or international politics. Intelligent investors do.

To my mind, using a robo-investment adviser to construct and manage your long-term portfolio is the same as making all of your investment decisions from inside a small closet with the lights off and the door closed.

Number Five: The markets will not be static for the next 25 years.
The noted theorists upon whose works Modern Portfolio Theory and asset allocation are based were examining data from the markets prior to 1990. The financial markets have evolved significantly in the last 25 years. It is not just the speed or the technology. The markets are now global, there are a lot more participants and there is a lot more money in play. How the markets will continue to evolve and operate in the next 25 years is anyone’s guess and is certainly not built into any robo-investment program.

Number Six: The data that the program uses to select portfolios is based upon the past performance of the markets and past performance only. I should not have to tell you that past performance is an unreliable indicator of future results. If you invest with any one of these programs future results are exactly what you are trying to achieve. Why use data that is unlikely to get you there?

Number Seven: Human beings are actually necessary.
The sales pitch for these robo-investment advisers suggests that can do better than any human financial adviser. One company even touts that its program alleviates the risk of human error.

Using a robo-investment adviser will inevitably lead to portfolio losses every time the stock market goes down or interest rates go up. It will never tell you to avoid downturns or to get out of the markets all together before a crash. Likewise, the program never looks for new companies that might do very well or for any other investment opportunities that might make you money.

Severe market downturns can be scary. Investors are prone to panic. When your account value is dropping you are going to want someone to call. The robo-investment adviser will offer neither solace nor advice. That will only come from a knowledgeable human being. For that you have to pay a little more.