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.