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.

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