FINRA Expels a Crowdfunding Portal

FINRA has expelled its first crowdfunding portal. The firm, UFP (uFundingPortal) of Herndon, Virginia has only been active since May 2016. In five months it apparently listed 16 offerings which FINRA found to be questionable. UFP signed a consent order agreeing to allow FINRA to expel it from membership. The settlement illustrates how FINRA expects crowdfunding portals to operate.

A central allegation in FINRA’s action against UFP was that the portal knew that none of the 16 issuers had made the filings with the SEC that the issuers were required to make. It is as straightforward as an enforcement action can get; either the required filings were made or they were not. If the portal had asked for copies of these filings it would have known that the filings had not been made and, presumably, declined to list the offerings which is clearly what it should have done.

This is the third regulatory action against crowdfunded offerings and the first against a portal.  The organized crowdfunding industry has greeted this action with a yawn as it did the first two.  The industry has its head buried in the sand because it is populated by a lot of people who have never worked in finance and who keep telling each other that they know what they are doing when they clearly do not.

The first regulatory action against a crowdfunded offering, filed by the SEC in October 2015, was against a company called Ascenergy which raised money from investors on four crowdfunding websites. Ascenergy claimed it was going to drill for oil on land where it had no rights to drill. The principals of the company essentially stole the investors’ money. The SEC did not name the websites in the action. If the websites had conducted appropriate due diligence on the offering investors would not have been defrauded.

I wrote, at the time, about the SEC action against Ascenergy and suggested that it was only a matter of time until the regulators would sanction one of the crowdfunding sites. The crowdfunding industry ignored it. Now it has happened and the industry still does not understand that it is a target for regulators and what to do about it.

In October 2016, the SEC filed its second action against a crowdfunding offering. It halted the Regulation A offering of a company called Med-X. The allegation was that Med-X had not made its required filings to the SEC about its financial condition. The Med-X case is ongoing and an action by FINRA or the SEC against the portal may still be filed. Again, if the portal had merely asked for a copy of the filing, it would have known that the filing had not been made.

The FINRA action against UFP paints a pretty clear picture of what FINRA expects from a funding portal.  FINRA said that it expects “a funding-portal intermediary such as UFP to, among other things, deny access to its platform if the intermediary has a reasonable basis for believing that the relevant issuer or offering presents the potential for fraud or otherwise raises concerns about investor protection.”

Thirteen of the 16 issuers listed by UFP did not have any assets or history of operations and each claimed an unrealistic and unwarranted $5 million equity valuation. FINRA was concerned because these companies had “an impracticable business model, oversimplified and overly-optimistic financial forecasts and other warning signs.”

Obviously, the portal cannot know if it should be concerned about fraud if it does not look.  Federal and state law is crystal clear that the portal or other intermediary is liable for a fraudulent securities offerings if they do not investigate the offering with “due diligence.” Most of the portals do not have a full time due diligence department and there seems to be a lack of understanding across the crowdfunding industry as to what is really required.

When FINRA highlights the fact that the issuers offered by UFP had no assets or history of operations, it is reminiscent of the actions that the SEC brought against so-called “penny stocks” back in the late 1970s.  I represented one of the brokerage firms offering penny stocks back then and the SEC was all over them for taking companies public that were not ready to go public. Nothing in the JOBS Act changed that.

The same is true for financial projections. FINRA requires that there be a reasonable basis for the projections given to investors. If the company has yet to make a sale, what basis is there to project the sale of 2 million units in the first two years?  It is usually wise to conduct a test marketing campaign or prepare a good marketing study before an offering is made. Those are few and far between for crowdfunded offerings.  But if you do not have a reasonable basis to make a projection, you should not make it.

There are fewer than two dozen Title III portals registered with FINRA and I have spoken or corresponded with management, compliance officers or lawyers for a few of them. Some are up to the task and some clearly are not.

The lawyer for one of the portals told me that he saw a gap in the regulators’ thinking. He said: “on one hand (the portal) was not supposed to ‘discriminate’, whatever that means, at the same time they were supposed to reject fraudulent offerings.”

I do not see a gap or a problem. If the offering is questionable or has an “impractical business plan” you do not put it on your website, period. The overriding regulation for the crowdfunding industry is not to allow fraudulent offerings to reach the public. No platform should believe that the SEC would sanction them if they refused to list an offering that they thought was going to be a fraud. Just the opposite is true.

The compliance director at another portal told me that their FINRA registration applied only to the Reg. CF (Title III) offerings it listed. “With respect to Regulation A offerings” she told me, we are “solely a technology platform established to host those offerings. Our FINRA membership has nothing to do with Reg. A offerings and imposes no diligence obligations result from such hosting.”

When I asked if she had a letter confirming that FINRA saw it the same way, she failed to respond.  It was a rhetorical question because FINRA was very unlikely to issue that opinion.

When a firm agrees to join FINRA as a Title III portal, it agrees to abide by all of the rules that are authorized by FINRA’s by-laws. Those rules include a requirement that the firm conduct all of its business in accordance with just and equitable principals of trade and not to commit or “aid and abet” securities fraud in regards to any aspect of its business. A registered representative can be expelled from FINRA for a DUI. The idea that FINRA is only concerned with a firm’s Reg. CF offerings is preposterous.

What, exactly does FINRA expect from crowdfunding portals? Three things. FINRA wants to know that each firm 1) has systems in place and written procedures to foster compliance; 2) has trained compliance personnel in place to carry out those procedures and 3) is vetting the offerings to make certain that what they tell investors is true, reasonable and represents a real business with at least a chance of success.

At the same time, there is no excuse for a Title II platform which is not a FINRA member not to adopt the same procedures and to take the same care that they do not list a fraudulent offering.  These procedures are expenses and few platforms want to pay what it takes implement them correctly.

There is some fraud and the potential for more throughout the crowdfunding industry on both Title II platforms and Title III portals.  I see it. Other people see it and the regulators see it. More than one “knowledgeable” person in the crowdfunding industry has told me that fraud is minimal because the regulators have brought only these three actions. That, too, is preposterous because fraud is fraud whether the regulators catch it or not.

The industry for the most part is in denial because it does not want to see fraud.  In many cases people in the industry would not know a fraudulent offering if they did see one. I am certain that the crowdfunding industry is not interested in eliminating offerings with “impractical business plans” because that describes a great many offerings that appear on both Title II and Title III sites.

Only about 30% of the equity offerings that list on crowdfunding sites actually achieve their funding goals. Issuers incur many costs to list these offerings. The crowdfunding sites are doing no one a favor by listing offerings that investors should not want to consider in the first place.

If crowdfunding platforms exercised some judgment and discouraged companies from raising funds until they were ready to do so, it would help the industry raise that percentage of funded offers. There would be fewer offers but each would stand a better chance of fulfilling the promise of crowdfunding for small businesses and the jobs and opportunities they create.

Selling Private Placements

Why aren’t people buying crowdfunding? That question has people flocking to conferences and spending a lot on so-called experts looking for the reason that most equity crowdfunding campaigns fail to raise the money that they want.  Let me save you some money and a week on the road by stating the obvious: people are not buying crowdfunding offerings because no one is selling them.

I recently had a conversation with an entrepreneur who was funding his business on a crowdfunding website. I had viewed his offering and asked for more information. He sent me an e-mail and we scheduled a phone call.

He was professional throughout the conversation.  He was knowledgeable about his product, his customers and his competition. His sales projections were realistic and he seemed to have a good team in place.

What he lacked was any real sales skill. He had certainly spoken with dozens of potential investors before he got to me. It was obvious that he did not know how to close the sale.

Compare that with a professional stockbroker. Stockbrokers sell private placements and they are highly incentivized to do so. Private placements pay brokers higher commissions than almost any other financial product.

One of the first things that I learned when I started working on Wall Street was that people do not buy investments, rather people are sold investments. That is the lesson that the crowdfunding industry does seem ready to learn.

People are often surprised to learn that far more money is raised through private placements than public offerings every year. The JOBS Act which enabled crowdfunding to compete with mainstream stockbrokers actually made it easier for the brokers to sell the same private placements in direct competition with the crowdfunding platforms.

When the SEC adopted Regulation D in 1982 to provide a safe harbor for these private, non-registered offerings it defined a class of accredited investors, wealthy individuals with $1,000,000 in net worth or $200,000 in annual income. At the time this was a relatively small group of people. Due mainly to inflation this group has grown substantially since 1982. Many accredited investors who might consider investing in a start-up already have a stockbroker.

By the end of the 1980s there were a number of brokerage firms that specialized in selling private placements and many companies that packaged these investments for them. Most of these private placements were for various types of real estate or oil and gas investments. That is still true today.

A lot of these investors were baby boomers because they had money to invest and many were retirees or near retirement age. These people were specifically looking for investments that would provide steady income to help offset their retirement expenses.  Many private placements were sold based upon projections of monthly or quarterly income.

Selling an investment that throws off a substantial monthly check should not be that difficult, but it is. Virtually every security offered through a private placement has a substantial risk that the investor will suffer a complete loss of their investment.

In part because the universe of individuals who might want to take that risk is limited, the brokerage industry charges a hefty commission to sell these investments. Even the largest firms that package real estate or oil and gas investments as private placements frequently pay a 10% commission to the brokerage firms that sell them.

When you add legal, due diligence and marketing costs, the up-front expenses for a private placement can often add up to 15% or more. Those syndication costs are taken out of the offering proceeds. Some private placements also burden investors with pre-arranged exit costs if the property is sold.  I have seen real estate syndications where the property needed to appreciate by 30% for the investors to break even.

Reg. D offerings were not supposed to be “public” offerings and brokers were constrained to sell them only to people with whom they had a prior business relationship. Advertising a private placement or what is called “general solicitation” was always prohibited.

Given the high commissions that rule was often overlooked. It was not uncommon for a broker to hold a seminar where a sponsor would present the details of an offering that had just closed.  At the end of the presentation, the participants would be invited to sign up if they wanted to be notified when the next offering became available.

Attendance at a seminar was probably not the SEC’s idea of a prior business relationship but these went on for years.  The sponsors paid for the seminars and compliance directors at the brokerage firms looked the other way.

The JOBS Act eliminated the rule against general solicitation. That opened the door for general advertising of private placements. The only condition was that they could only be sold to accredited investors. Advertising of these offerings to accredited investors has exploded.

The JOBS Act was supposed to offer investors the opportunity to invest on-line through websites that did not charge commissions. Eliminating that commission cost should have created better economics and better deals and given the crowdfunders a leg up. Sadly, that has not been true.

Rather than up their game, the crowdfunding industry seems content to list offerings for companies with half-baked ideas, inexperienced management and unpatented products and processes. Add to that a fair amount of out and out fraud because the offerings are un-vetted and it is easy to see why the mainstream brokerage industry has little to fear from the crowdfunders.

What I see in the future is the mainstream stockbrokerage industry establishing crowdfunding sites where potential investors can browse offerings after being solicited by advertisements. Once there, the websites will make the potential investors presence known for licensed registered representatives to follow up and close the sale.

This is not what many of the crowdfunders had in mind when they lobbied for the JOBS Act.  Some believed that the crowd was capable of making intelligent decisions about investing in start-ups and that many people would want to put their money into these small companies.  Neither assertion was ever true.

I am probably alone in suggesting that crowdfunding will make a better adjunct to a traditional brokerage firm than a replacement for it. I suspect that it will not be long before others begin to see what I see and the “contact for more information” button on a crowdfunding site will go to a licensed stockbroker who will close the sale and be paid a commission.

There is a difference between marketing or solicitation and selling. Selling is what the crowdfunding industry needs in order to ultimately be a successful tool for corporate finance.


The Passive Investment Problem

Buy it, hold it and forget it is the idea behind robo-advisors and is the reason that robo-advisors are detrimental to your financial health and well-being.  The hype behind robo-advisors comes from the advisors themselves who are determined to get your money out of the bank and onto their platforms.  When the market turns down, robos are going to have a lot of unhappy customers.

I spent more than 25 years representing investors who had been ripped off in the financial markets. In most cases they knew just enough about investing to get themselves into trouble.

One of the reasons that I write this blog is my desire to point out foolish investments and investment advice.  Much of that advice, because it is repeated over and over by an industry with a massive advertising budget, becomes “common knowledge” even though it is without a solid basis in fact.

Most professional investors use what is called fundamental securities analysis to make a determination of what stocks to buy and at what price they are willing to buy them.  Fundamental analysis was developed by Prof. Benjamin Graham in the late 1940s and his textbook is still used in business schools all over the world.

Fundamental investors analyze a company’s income statements and balance sheet. They look at its management, products, competitors and prospects for the future. The question they are faced with is the same question all investors face: if I buy this stock today, will the price go up in the future?

It is important to understand that this analysis is not an exact science.  What is more, markets are as often as not driven by irrational forces, fear and greed, as anything else.  Even some of the basic macro-economic factors that drive the markets such as interest rates and oil prices are political decisions, not rational ones determined by supply and demand.

But that is not a reason to give up on a rational, analytical approach to investing or stock selection.

The idea of passive investing has gained some traction of late for the wrong reasons.  Passive investing is the idea that you “buy and hold” a stock or a fund no matter what happens.  The theory, at least for investors with a long time horizon, is that the investment will be worth more when you need it, years in the future.

It should not take you long to realize that no one can predict what the market price of any stock will be years in the future. Fundamental analysis looks out a year or so and even that is difficult.

That “no one can predict the future” is one of the reasons that people advocate passive investing.  But their “buy, hold and it will be worth more when you need it” strategy does just that.

Advocates of passive investing will point to a number of academic studies, most from the 1990s that suggest that mutual funds, which are actively managed, failed to beat the market indexes over the long term.  These studies exist but are flawed for a number of reasons.

In the first place, beating the market index should never be the goal of any small investor.  To beat an index means that you will need to take risks that are higher than the index and those risks will often come back to bite you.  That is one of the reasons that mutual funds, the active investors that these academic studies are looking at, do not, on average, perform as well as an index.

The other reason is that mutual funds are not efficient. They are constrained by law, their own advertising and the ebb and flow of funds in and out.  Mutual funds are also subject to advertising costs, sales charges and management fees.  They should always yield less than a theoretical index that is not subject to these charges.

Notwithstanding, the passive investors are quick to repeat that the average investment advisor cannot beat an index.  I do not know why anyone would hire an “average “advisor or why any investment advisor would bother trying to beat an index.

Your goal should always be to have more money in your portfolio this year than last year and more again next year.  The way to accomplish this is to do the one thing those passive investors will never do, sell your positions when the market starts to go down.

How can you know when the markets are starting to go down? Fundamental analysis works both ways; it tells you what to buy and at what price and what to sell and when to sell it. Even if your analysis is wrong, there are ways to protect your portfolio against losses with stop-loss orders that get you out before you have given back all of the profits that you have made.

No one can predict when the market will peak. People can get greedy and fearful that if they get out now, they might miss another year of profits.  Of course, even if the market does go up for another year, two years from now it may be at levels below where it is today.  That means that you will have less money and be two years closer to retirement.

Investing is difficult. Fundamental analysis is a skill that takes time to learn and is time consuming for anyone.  If all you had to do to make money in the stock market was to buy an index ETF and leave it alone, everyone would do it.

Passive investing in general and robos in particular are for people who do not know enough about investing to do it well.  If you consider yourself to be in this group, either hire a competent advisor to do it for you or leave your money in the bank.  Anything else is foolish.


Founders Dating Discussions

Innovation and entrepreneurship are very much a part of the American culture.  In many respects this may be the best time in history to start a new business. In many industries barriers to entry have never been lower. Globalization has reduced the costs of production and opened new markets. The new media has provided inexpensive ways to reach new customers.

Start-ups have access to incubators, accelerators and many other support systems that did not exist a generation ago.  There are more books, classes, conferences, coaches and success stories to emulate than ever before.  Unfortunately many offer conflicting and sometimes foolish advice.

Start-ups also have access to far more capital than ever before. There is more money in venture capital and angel investor funds. There are government programs like the SBA which will guarantee loans and other programs that provide grants for new ventures.

This convergence of knowledge and capital is important because both are needed for any business to succeed.  A good business without capital is likely to go nowhere. What I find amazing is the need to explain this to a great many people who want to be entrepreneurs.

I frequently speak with two or three entrepreneurs a week.  I meet many through Founders Dating.  Founders Dating is a website where entrepreneurs can ask each other questions that are relevant to the start-up experience.

Conceptually, Founders Dating is an excellent idea. Entrepreneurs frequently face similar problems and unfamiliar situations. There are many seasoned executives who are willing to offer them advice.  However, some of the questions and many of the answers highlight substantial problems.

Some of the questions reveal that some of the entrepreneurs do not have a clue about the real world.  Many of the answers are shallow and reflect a “gut response” to complicated issues.

On more than one occasion, someone has asked for the best book to read to help make them a successful businessperson or to teach them how to successfully market their product.  There seems to be an attitude, especially among the younger entrepreneurs, that they can learn all they need to learn without a business school education or any practical experience.

As it should be, many of the entrepreneurs are younger millennials and many of the advisors are older baby-boomers, like me.  I am surprised how many times that the advice offered by these older executives is “pooh-poohed”.  There is an obvious attitude that baby-boomers do not understand technology or the “new” financial markets.  Nothing could be more foolish.

Baby-boomers after all created both Apple and Microsoft, were the first users of their products and invested in their IPOs.  Similarly, when Genentech did its IPO in the mid-1980s baby-boomers did not have much difficulty understanding “genetically engineered pharmaceuticals” even though they were a cutting edge concept at the time.

At the same time the idea that the financial markets have fundamentally changed is just wrong. If you are looking for funding for your start-up you are probably not going to ask millennials for money because they do not seem to have a lot of it.  Baby-boomers, on the other hand, poured billions into tech stocks in the 1990s and still do.

There are actually a few angel investors on Founders Dating who are happy to tell entrepreneurs what they are looking for in a start-up and how they think a start-up should structure its pitch to investors.    You would think that the entrepreneurs who are looking for funds would value the advice of people with money to invest, but it is not apparent that they do.

Again, there are people who have read one or two books on the subject who claim to know better.  They are telling the entrepreneurs what they want to hear, not what they need to know.

Many inquirers seek specific advice about legal or tax issues.  I always advise them to seek their own legal counsel.  General answers to general legal questions rarely apply in all cases. In many cases questioners are referred to forms or templates which may or may not get the job done.

In one case, a questioner asked about the tax ramifications of using independent contractors as opposed to employees.  It was not a foolish question but it elicited a foolish and dangerous response.

I am not a tax specialist but I do know that the IRS has a specific guideline for determining who is an employee and who is an independent contractor. The guideline contains a list of about 20 things the IRS considers and will apply should you get audited.  I told the questioner to consult his accountant and follow the IRS guideline.

Almost immediately, another person chimed in to tell me that I was an idiot to follow the IRS guidelines or to recommend that anyone should. That person had apparently done so, hired a slew of independent contractors and the IRS penalized him anyway.

My first thought, of course, was that he had not followed the guideline correctly or that there was more to the story than he was telling.  Whatever the truth, he was adamant in his advice to the questioner that following the IRS guideline was useless.  He was so adamant and made such a compelling argument that I called a tax attorney I know to ask if the IRS had changed its mind or if my advice to follow the guideline was misplaced.  He assured me that any competent tax professional would have given the advice that I did. But how would the person who asked the question know that?

I look at Founders Dating as way of doing pro-bono work. When I am speaking with an entrepreneur I give the same advice for free that I would give to a large established company that was paying my normal hourly rate.

One of the hazards of the information age is that there is so much bad information out there.  Founders Dating is a good idea, but it needs some mechanism to filter the good information from the bad or the recipients of the information will get nothing of value.


Crowdfunding Mailbag

Without investors Crowdfunding will become a footnote in financial history.  The Crowdfunding industry continues to demonstrate that it just does not care about playing by the rules or giving investors a fair shake.

A few weeks ago, I wrote an article about Med-X, the first equity Crowdfunding campaign that the SEC stopped mid-offering. It was only the second time that the SEC’s Enforcement Division had gotten involved in a Crowdfunded offering and I thought it was worthy of an article.

Among other things, Med-X was raising money to research and sell products derived from cannabis. One of the larger cannabis websites re-printed the article and I got e-mails from a lot a people in the cannabis industry.

Several people suggested that the SEC’s action was part of a larger government effort to hold back the cannabis industry by denying it funding. They suggested that some Crowdfunding sites would not accept cannabis related offerings before the Med-X action. They thought that this enforcement action would have a chilling effect on their efforts to raise capital.

Frankly, I doubt this is the case. The SEC originally approved Med-X to sell its shares and there are a number of public companies in the cannabis industry. The SEC cares more about disclosure issues than it does about drug enforcement.

My article was also re-printed on a financial website. I got e-mails from several securities lawyers and people in the mainstream financial markets, many of whom, like myself, marvel  about the fact that the Crowdfunding industry offers securities to investors seemingly thinking that the body of law surrounding the sale of securities does not apply to it. The JOBS Act gives some relief from the registration provisions of the securities laws. The anti-fraud provisions of the securities laws still apply.

My real issue with the Med-X action was with the Crowdfunding portal that offered it, StartEngine. Med-X had failed to file financial information that it was required to file, meaning that investors were not getting information that they were required to get.  StartEngine is registered with FINRA as a Crowdfunding portal.  FINRA’s rules certainly impose a duty on its members to disclose all material information whenever they offer securities to the public.

I got an e-mail from the Compliance Director at StartEngine who told me that the SEC’s action against Med-X was about a missed filing date and the SEC did not mention the word “fraud” in its paperwork. Under the securities laws, fraud is defined as the omission of material facts. The failure to provide required financial information to investors fits that definition like a glove.

The Compliance Director told me that StartEngine was represented by competent counsel which I have no reason to doubt. Regulatory compliance in the securities industry is not something that they teach in law school. You are not likely to become well-versed in day to day compliance issues working for a law firm or regulator. You learn compliance the same way that a surgeon learns surgery; by doing it under the guidance of someone who knows what they are doing.

I was trained in compliance when I worked at two large brokerage firms. I offered to explain the problem that she apparently did not see to the Compliance Director or her counsel, without charge. I told her that I really hated to see someone step in it when this was such an easy problem to fix. She respectfully declined.

There are only about a dozen Crowdfunding portals that have registered with FINRA to conduct Regulation A+ offerings. I have corresponded or been on the telephone with the Compliance Directors of four of those portals. Three of the four had no experience with FINRA compliance.  The one who did have experience stood out like a rose in a garden of weeds.

One correspondent asked me why I brought up Elio Motors, another StartEngine offering in the article as well. Elio has become the poster child for the Regulation A+ offerings because it successfully raised about $17 million from investors. The marketing director from Elio recently spoke at one of the Crowdfunding conferences presumably to regale the attendees with Elio’s fundraising success.

I consider Elio Motors to be a nasty problem that will come back to bite the Crowdfunding industry on its butt. In my opinion Elio is a scam. I am not the only person who thinks so.

I base that opinion on the fact that Elio has been taking deposits and promising to deliver a vehicle to customers since at least 2014. Elio has no vehicles to deliver and is not actually building any. Taking deposits for and promising delivery of a product that you cannot hope to deliver is a deceptive business practice under state and federal laws.

In its Reg. A+ filing Elio disclosed that it was trying to get a loan from the Department of Energy to fund production. To qualify for the loan, Elio would have had to demonstrate that it had a strong balance sheet and that it could reasonably be expected to repay the loan.  Elio is insolvent.

Elio has taken deposits from approximately 65,000 people. I would not bet that these customers will receive delivery of their vehicle in 2017, if ever.

Rather, I would bet that a regulatory action (or a bankruptcy, or both) is going to occur in 2017.  Elio has raised a lot of money from the Reg. A+ offering and the deposits but does not seem have a lot of the cash on hand.  It still needs between $200-$500 million more to deliver on its promises.

Is it possible that a VC fund will make a substantial investment in Elio and bail them out? Yes, but I do not see it. Elio still has not demonstrated that even if developed its vehicle will be street legal.

To me Elio does not pass the smell test. I cannot imagine how a competent due diligence officer gave Elio’s offering a green light.

Another e-mail came from a person who suggested I should not be concerned with Med-X’ failure to make proper disclosures because “everybody” knows that most Crowdfunded businesses will fail and that investors treat Crowdfunding as if they were gambling in Las Vegas.  While I acknowledge that most Crowdfunded businesses will fail, the odds in Las Vegas are actually substantially better that the player will walk away with some of his money.

That person also told me that I do not appreciate that Crowdfunding is intended to “disrupt” the way in which capital is raised. I do appreciate that Crowdfunding is intended to allow companies that would not have access to that market to raise money from investors. I also appreciate that there is a correct, legal way accomplish this.

At the end of the day owning a Crowdfunding portal can be a lucrative business.  All I ever suggested was that every portal needs to play by the rules and offer good investments to investors.

In just one year the SEC has acted twice against issuers who broke those rules. In both cases the issuers were enabled by the Crowdfunding industry “professionals” who were not acting professionally.  If there is any take-away from this article it should be that I offered to set the Compliance Director at StartEngine on a straight path, without charge, and she declined.

There is a lot of promise in Crowdfunding that may be eclipsed by inappropriate behavior. Unless investors are willing to invest, and invest again because it worked for them, Crowdfunding will not fulfill this promise.

The SEC’s Enforcement Division is clearly looking for scam artists who are raising funds in the Crowdfunding market and for legitimate companies that fail to follow often complex rules.  It will keep finding them until the Crowdfunding industry gets serious about its business and makes an effort to protect the investors it cannot survive without.





Any Investor Can Beat an Index

People invest money to make money. That may not seem like a profound statement but a lot of investors think that it is a lot harder than it is and there is an ongoing debate that suggests that most professional investment advisors are not worth what they charge. Personally, I do not buy it.  I would not think of investing any significant sum without a competent advisor.

I know that most large institutional investors still use fundamental analysis and good old fashioned research to select investments.  CALPers, the nation’s largest public employee pension plan has several hundred research analysts on its staff.

The best research analysts are specialists who cover a single industry and have much more than a cursory understanding of the companies that they cover.  It is not unusual to find research analysts with degrees in electrical engineering covering tech companies or doctors who went from medical research to covering drug companies.

When I started on Wall Street the firms would release research reports to their institutional clients first and retail clients a day or two later.  With the advent of discount brokerage firms and DIY investors, a lot of the research available to individual investors has been watered down and is not very insightful.

I am not suggesting that every research analyst is great and there are a great many conflicts that color the reports that some analysts publish. What I am suggesting is that if you cannot read a research report and you do not read several before you make any investment decision, you are shortchanging yourself.

No one has to invest. Leaving your money in the bank where it will currently get you about 1% in interest is better than investing it in the market and losing 10% or more. This is especially true if you have only a minimal amount saved up.  Protect what you have before you start taking market risks.

A lot of people believe that they can just buy an index mutual fund or index ETF, hold it for the long term and everything will be fine.  The “common knowledge” is that the markets will likely be higher years down the road and that an index fund captures a large diversified basket of companies. Neither is necessarily true.

The markets today are higher than they have ever been. No one can tell where they will be next week, next year and certainly not a decade or two from now when you may need your money.  Whether your portfolio will be worth more or less than it is today when you retire is something that is best worked out with a financial planner.

Most financial planners will caution you about effects of inflation. Even if your portfolio is worth 20 years from now, its buying power may be less.

The idea that an index is diversified is also flawed. An index like the S&P 500 has stocks of the 500 largest companies.  The Dow Jones Industrial Average specifically excludes transportation companies and utilities.

To be diversified a portfolio needs to hold stocks that have a negative correlation to each other.  If you buy a large cap index, a mid cap index, a small cap index and a foreign index with the idea that they are diversified from each other, you are incorrect. Each is likely to hold airlines, telecommunications companies and financial institutions. That is not diversification.

Assuming that you could analyze all 500 stocks in the S&P 500, rank them to identify those which have the best value and create a portfolio of the top 150, you would probably beat the overall S&P 500 index every year.  If you identify the best and eliminate the clunkers, beating the entire index should not be difficult.

By best value, I would suggest that you include those companies whose shares are trading at the low end of their traditional P/E range.  Many market professionals look at the price/earnings ratio of individual stocks that they own and the market in general.  Price/earnings ratios move within a fairly standard range and when they get to the high end of the range they usually pull back and revert to the norm.  Both the current price and the outlook for near and medium term earnings for publically traded companies are readily available.

If you are a DIY investor and it is too much work for you to analyze 500 stocks or you do not need a portfolio with 150 stocks in it, there are easier ways to beat an index. One of the simplest is a strategy called “Dogs of the Dow.”

The Dow Jones Industrial Average is made up of 30 mature, blue chip companies. The earnings of the companies will vary depending on where in their particular business cycle the companies are and their stock price will fluctuate with the earnings. Most, however, have a fairly stable dividend payout policy.

The theory suggests that when a company is at the low end of its cycle and its stock price is low; its dividend yield will be high.  As the company bounces back, its stock price will rise and its dividend yield will return to its mid–range.

To execute the strategy you would purchase equal amounts of the 8 or 10 highest yielding Dow stocks, hold them for one year, sell them and repeat.  The strategy hopes to allow investors to capture both a high dividend and good price appreciation every year.

Understand that this is not asset allocation. Asset allocation is a method of balancing a portfolio with multiple market sectors hoping that the good ones will outweigh the bad.

Dogs of the Dow is a specific stock selection strategy.  You are attempting to select stocks that will appreciate in price faster than the other stocks in the Dow Jones Index.  A fair number of people use this strategy because it is very easy and because it works most of the time.

If you research Dogs of the Dow, you are likely to come across the Hennessey Funds.  The Hennessy Total Return Fund (HDOGX) invests 75% of its assets in the ten highest dividend-yielding Dow Jones Industrial Average stocks (known as the “Dogs of the Dow”) and 25% in U.S. Treasury securities.

Neil Hennessey was the person who first introduced me to this strategy somewhere around 1985.  He was working with it successfully back then and still does.

This strategy is not hard to master.  It shows that you do not have to be a rocket scientist to be a successful investor and in most years you will beat the index.



The SEC Halts a Crowdfunded Cannabis Offering

In the year I have been blogging I have written several articles about the problem that the Crowdfunding industry does not want to address, fraud.  My thesis is simple: if the investors get screwed enough times they will take their money elsewhere.

As stories of Crowdfunding scams begin to proliferate, the industry’s reputation is likely to go down the toilet.  If the investors leave, people will be sitting around in bars saying: “I used to work for a Crowdfunding platform” the same way that people sat around in bars in 2009 saying “I used to be a mortgage broker”.

Back in February when Regulation A+ offerings were just getting underway, I wrote several articles raising some questions about specific offerings. The Crowdfunding industry was very gung-ho about Reg. A+ because these offerings could be sold to smaller investors. The bulk of Crowdfunded offerings are still private placements which can be sold to wealthier accredited investors only.

I wrote a blog article specifically about Med-X, Inc. which was attempting to raise $15 million under Reg. A+ to “research and develop, through state of the art compound identification and extraction techniques,  market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

I questioned the offering, in part, because cannabis is still illegal at the federal level.  But that was not the only reason.

Med-X had acquired an exclusive license from another related company, Pacific Shores Holdings to market NatureCide® herbicide and pesticide products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. As I noted at the time, an exclusive license can be valuable. In this case, because the products are readily available on the value of the “exclusive” license was questionable.  Both Med-X and Pacific Shore holdings were controlled by the same person, Mathew Mills.

To me, Pacific Shores Holdings looked like a classic penny stock. Mr. Mills had been sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors to whom he had no business selling shares. The structure employed here, with one penny stock company acquiring a large block of stock in another pursuant to a licensing agreement is also a classic penny stock tactic.

Last week, September 16 to be exact, the SEC issued a temporary halt to Med-X Reg. A+ offering. The company was required to file an annual report on Form 1-K for the fiscal year 2015. Med-X operates on a fiscal year ending December 31. As such, Med-X was required to file its annual report by April 30, 2016. On September 16, Med-X had still not filed the annual report, so the SEC put a halt to the offering.

The clear message here is that information that investors were entitled to receive, as a matter of law, was not provided to them between May 1 and September 16. Failing to provide material information to investors is the textbook definition of securities fraud.

Med-X did file its Form 1-K within days of the SEC order halting its offering. What that filing discloses about what Med-X is doing with the money it has raised so far validates my earlier suspicions.

Back in February, Med-X reported that it had received $3.6 million in reservations from over 1100 prospective investors for their Reg. A+ campaign on StartEngine, a Crowdfunding portal.  Those reservations were apparently meaningless.

As of June 17, 2016 the Company had sold 1,124,038 common shares. The Company received net proceeds of $430,430 from this offering. Med-X has committed to spend $150,000 of that money with a company based in London to develop a mobile platform for its marijuana media site among other things.  How it will pay for the research it promised is anyone’s guess.

Next month the SEC will conduct a hearing to determine whether or not it will allow Med-X to resume its offering.  Since the Form 1-K has now been filed, they may let it proceed. If the SEC has other concerns about the company, it may keep the halt in place while it investigates further.

The SEC has a long history of leveraging its budget for enforcement actions by going after small companies like Med-X where the facts are clear-cut, where it is not likely to find a high-powered law firm defending and where it can make big headlines. With this action, it is likely to make bigger headlines in the cannabis industry than with the Crowdfunders.

An enforcement action against Med-X would send a message to the cannabis industry which should want to seek Crowdfunded financing as banks are generally closed to them as a source of capital.  Despite what you may think about cannabis as a legal industry, the federal government’s policy is to wipe it out.

I have spoken with several people involved with the cannabis industry who report that the Crowdfunding industry, at least in the US, is already skittish.  Given the publicity surrounding cannabis and its thirst for capital, you would expect to see many cannabis related businesses raising funds on Crowdfunding sites but you don’t.

The SEC specifically cautioned brokers, dealers, shareholders and prospective purchasers that they should carefully consider Med-X’s failure to file its annual report on a timely basis along with all other currently available information and any information subsequently issued by the company. Let me translate.

This is the second enforcement action that SEC has brought against a Crowdfunded offering. The first action, SEC v. Ascenergy, was based on the fact that the company was raising money to drill for oil on land where it did not have the rights to drill.  The SEC called out the four Crowdfunding platforms on which offerings took place by name but did not sanction them in any way.

I wrote a blog article about SEC v. Ascenergy which was reprinted on several Crowdfunding media sites. What I wrote was that this was the SEC’s way of telling the Crowdfunding industry to get its ducks in order. I believed and I still believe that sooner or later the SEC will sanction a Crowdfunding platform or portal that lists a fraudulent offering. For the most part the industry looked at the Ascenergy case with a yawn and declared it to be an isolated instance of fraud.

StartEngine has gone to the trouble to become registered with FINRA specifically to be able to offer Reg. A+ offerings to mom and pop investors. They are required to follow FINRA’s rules when listing offerings and that includes the requirement for a significant amount of due diligence. In my mind the Med-X offering raised a number of red flags, not the least of which was the NatureCide® licensing agreement.

More directly, FINRA and the SEC have every reason to expect StartEngine or any other registered Crowdfunding portal to have known that regulations required Med-X to have filed its annual report by April 30 and that it was late. The SEC may justifiably ask StartEngine why it did not close the Med-X offering down instead of forcing the SEC to use taxpayer funds to do it.

It is not always possible to determine what a government agency will do next. In the SEC’s mind the matter may simply be over or they may take action only against Med-X and Mr. Mills. He has, after all, already been sanctioned by two state regulators and has apparently not learned his lesson.

The SEC may give StartEngine a pass or it may not. It may leave the matter to FINRA which also has a history of going after smaller firms while its largest members often get away with fraudulent offerings that impact thousands of people for large amounts of money.

One thing is clear; the standard for the SEC would be to plead that StartEngine “knew, should have known or was reckless in not knowing” that Med-X did not file its annual report in a timely manner.  I do not see that StartEngine has a cognizable defense.

StartEngine did list another offering, Elio Motors which I also questioned in another blog post. My issue with Elio was that it was taking deposits from and promising delivery to consumers for a product that did not exist and which it could not hope to deliver with the funds it had on hand or which it was likely to raise. I am pretty certain that taking deposits and promising delivery of a product that does not exist and is not very likely to exist violates some regulation under the Federal Trade Commission Act or a similar statute.

The Crowdfunding industry has hailed Elio as a success because it raised $17 million from investors.  The people who helped raise the funds speak at various industry conferences to an audience of Crowdfunding participants who want to know how it is done.  (Spoiler alert: In Elio’s case it was done by making promises that they were not likely to keep but that is not what you will hear at the conferences.)

No one invites me to speak at any of the ever present Crowdfunding conferences because the Crowdfunding industry does not want to hear what I have to say.  If I were thin skinned, I would be concerned that the Crowdfunding industry really does not like me.  I’m not.

In all fairness to the Crowdfunding industry, I was solicited a few weeks back by one of the larger platforms. They wanted me to write a series of articles and an occasional white paper for them. When I spoke with the Director of Marketing, the firm’s Compliance Director was on the call. He knew that he would have final approval of anything that I wrote.  I was not surprised to learn that he had learned compliance at a mainstream brokerage firm.  It is not that difficult to stay complaint with the rules if you know what you are doing.

If the SEC or FINRA come calling to any Crowdfunding portal or platform, including P2P lenders, the first thing they will ask for is the firm’s written procedure manual.  There should be written standards and procedures for listing companies. There should be standards and procedures for reviewing the videos and marketing materials that accompany many of the offerings. Far too many of those videos are not compliant with the rules for anyone to think that the industry is serious about the business in which it is engaged; selling securities.

What is likely to happen at the hands of regulators is the industry’s own doing. They are too busy telling themselves that they are being “disruptive” to actually take notice that investors are being ripped-off.  Fraudulent offerings are not going to stop until the industry takes steps to make them stop. The SEC is not going to wait forever.

Understanding Globalization

When I was teaching economics back in the mid-1990s globalization had not yet made its way into the textbooks in any significant way.  Golden Gate University had a very international student body. Some of the students, who had come from other countries, intended to graduate and stay in the US; some intended to return to their home country.

The basics of economics can be applied to any marketplace, but I often found myself making references to specific American companies or advertising campaigns that were not recognized by everyone. Rather than approach the topic from a US perspective, I tried to find more universal examples in order to explain to the students how the competitive business world was likely to be trending during the first 20 years of their working lives.

The one business model, with which every student was familiar, regardless of their country of origin, was a sweatshop. The image of a group of people huddled over sewing machines in less than ideal working conditions is a universal experience.

Sweat shops are in almost every country. When I gave this lecture in the mid-1990s there were sweat shops within walking distance of the San Francisco financial district where the GGU campus was located.

Sweat shop workers typically get paid by the piece, as opposed to an hourly wage. They get no benefits and if they get ill or injured or fail to produce a sufficient amount of goods, they have no job security whatsoever.  In many countries they are willing to work for a ridiculously small amount because the job is the only thing keeping their families from hunger.

The very first requirement for teaching economics is finding a way to keep the students awake.   I focused the lecture on a fictional pair of entrepreneurs. I told the class that these characters had formally been GGU students that had made a lot of money based upon what they had learned in class. That got the students attention.

The two fictional protagonists were Jane who had studied marketing and was working as a buyer for a small chain of stores selling casual wear in Seattle and Eduardo who had grown up in Manila, studied management and returned home after graduation. Eduardo worked in a factory that made shirts and slacks. The business that they founded together I called JESSE, Inc. (Jane and Eduardo’s Sweat Shop Emporium).

The product that brought them together was unremarkable, except for its price. It was a short- sleeved men’s pull over sport shirt made of woven cotton. Generically they were called “tennis” shirts.  At the time they were very popular with two brands in particular dominating the market.

One of the dominant brands was European; the other American. Neither shirt had a breast pocket; each had their firm’s distinctive logo embroidered on the left side. The European firm had an alligator; the American firm had a polo pony.

Both firms had been around for a while and the shirts were somewhat of a staple among those who played tennis or polo which traditionally had been wealthier people.  Wearing one of these shirts conveyed a certain wealth or status.  They were sold only in upscale retail stores and the retail price at the time was around $60 per shirt. To be fair, the shirts were made from high quality, thick woven cotton.  They were well made and lasted for a very long time.

There were a lot of cheaper shirts on the market that were similar but they were made of thinner cotton or a cheaper cotton/polyester blend. Those shirts were available in less than high-end stores and had an average retail price of $20.

Eduardo worked as a manager in the factory outside of Manila where one of the better shirts was made.  The factory was not a sweat shop. It was clean and well lit. The workers were paid an hourly wage and worked an 8 hour day. The factory was able to deliver a shipping container full of shirts to the company’s distributor in Los Angeles for about $12 per shirt.

The US based distributor paid for an expensive advertising campaign and paid sales people to reach out to buyers representing high-end chain stores and shops. The wholesale price to the retail stores was about $30 per shirt which permitted the stores a 100% mark-up from their cost.  The US distributor was able to derive a nice profit after its costs and paid US taxes on those profits.

Jane approached Eduardo with the idea of producing a similar shirt, different from the cheap knock-offs because it would use the more expensive high quality woven cotton. Except for the distinctive logos the shirt would have the same look and feel of the higher priced shirts because the cloth was the same.

Eduardo initially arranged to buy a single bolt of the material from his boss. He took it to a local sweatshop, along with finished shirts in 4 sizes which were used for patterns. Jane designed her own logo, a palm tree, and created a story about Jesse, a beachcomber who didn’t wear shoes but still wanted to look good. The story would be printed on the outside of the plastic bags that each shirt came in.

Using the sweatshop labor, Eduardo was able to deliver shirts to Jane in Seattle for $8 apiece and still retain a handsome profit.  Jane took a suitcase full of the shirts to a buyers’ convention where she gave them away to other buyers in attendance and began writing orders.

Because she was running a lean operation without a national advertising program, she was able to sell the shirts at a wholesale price of $15. The retail stores could offer them to customers at $30.   Consumers got a product that looked a lot like the shirts that cost twice as much and significantly better than the $20 knock-offs that these same stores had been offering.

As you might imagine, the business took off; new products were added and both partners made a lot of money.  Jane was paying more and more taxes on the profits that she was making.

After a while Eduardo wanted to expand and offered Jane a simple solution to both of their problems. Eduardo raised the price that he was charging Jane to $10 per shirt.  He used the extra $2 to allow Jane to buy into his manufacturing company to fund his expansion.  Jane made a smaller profit and paid less US taxes. She now owned a portion of a Philippine company that was taxed at a far lesser rate.

When I first gave this lecture the internet did not have the bandwidth for moving pictures. Jane was a necessary part of the story because someone had to be the conduit to the US retailers who interacted with the ultimate purchasers.  In the modern internet era, Jane and the retailers are no longer necessary.  Eduardo can have an entire catalog of products on his website. DHL or FedEx will deliver the product directly to the consumer’s door regardless of where in the world that consumer lives.

Eduardo was happy to sell his shirts wholesale for$8-$10 each. He can now sell the same shirts, factory direct to consumer for $25- $30.  Advertising costs using social media and targeted digital ads have never been lower.

When I was young, New York City had a thriving garment center. Much of the labor was unionized. Those jobs are gone because a union shop in the US can never compete with a sweatshop elsewhere. It is not even the cost of the labor that was the determining event in this transition. It was the overnight package delivery which did not become a part of the system until the mid-1970s.

What has happened in the 20 years since I gave that lecture? APPLE for one manufactures overseas using cheap labor and adjusts the price to leave much of the profit overseas exempt from US taxes. Remember that when you are tweeting about the loss of jobs in the US on your iPhone.




Investing for Millennials

There is an ongoing discussion in the investment advisor industry regarding how to attract millennial investors. I have read several articles that suggest that a great many millennials have minimal savings.  And for those who do, investing for retirement may not be a high priority.

Many millennials are drawn to robo-advisor platforms. I find robo investment advisors to be a sick joke foisted on millennials and others by an industry that makes its money gathering assets.  If for no other reason than robo platforms will never advise investors to sell, the portfolios of many robo investors will suffer losses when the market comes down.

There is nothing wrong with the idea of asset allocation if you have a portfolio of size, are investing for the long term and allocate and re-balance your portfolio correctly.  But most robo platforms do not allocate portfolios correctly. There is a wide variance of portfolio allocations from platform to platform so investors really cannot know with any certainty how the platform they select will perform.

I have seen more than one study that suggested that millennials are attracted to robo investment platforms not just for their convenience and affinity for technology but because a great many millennials distrust the human financial advisors who their parents used.  Trust is important when you select any professional to work for you.

But the wholesale lack of trust in financial advisors is misplaced. I say that as a representative of the generation that coined the phrase: “don’t trust anyone over 30.” The truth is that the best investment advisors are older, having been seasoned by a market cycle or two. There was a lot to be learned when the market crashed in 1987, 2001 and 2008.  Advisors who were around and learned those lessons should be less likely to let their clients take losses in the next crash when it comes.

There is an annoying debate based upon studies that suggest that the average financial advisor cannot get even average returns, meaning equal to a broad index, year in and year out. The debate tips toward the idea that passive investing, just buying the index or sectors within the index, is superior.  Passive index and sector investing is what you get with a robo platform.

For the most part, the large institutions, insurance companies, pension plans and endowments, still invest the old fashioned way; using fundamental securities analysis to purchase investments that will either provide a good continual rate of income or which are likely to appreciate in price. Most stocks and bonds are bought and sold on the basis of research. Robo and passive investing is still a small portion of the overall trading volume.

Most asset allocation models counsel that younger investors can accept more risk and allocate a higher percentage of the portfolio to stocks.  The theory is that younger investors can take more risk because they have more time to make up losses if they occur.  Stocks are usually riskier than bonds.  If you invest a significant portion of your portfolio in stocks or a stock index you are guaranteed to experience losses when the stock market comes down.

Investing in an index, riding it up and then down is foolish. A smart investor gets out of the market before the market turns down. A smart investor takes their profits when their stocks move up and then invests in something else.

There is also an idea that millennials can begin investing with a very small amount of money. In some cases, I have seen firms advertising that you can start with as little as $500 or $1000.  I would certainly encourage any young person to begin saving, but a diversified portfolio of securities on a robo platform is not where you should begin.

If you were to take a reputable course in financial planning one of the first lessons that you will learn is about something called the investment pyramid. If you Google “investment pyramid,” you will find that there are many versions of it but that all are variations on the same basic theme; save first, invest later.

An investment pyramid starts with the idea that before you invest your first dollar you should have some cash in savings.  The standard has always been enough to cover 6 months of living expenses in case you find yourself unemployed because the company downsized or you cannot work due to an accident or illness.

The idea behind any investment pyramid is that you build a sound base for your portfolio of safer, income producing investments, usually bonds, before you buy anything else. The interest from the bonds, together with your annual contributions, will help the portfolio grow.  After you have built a sound foundation you can move up to the next layer of the pyramid.

The second tier of the pyramid also contains income producing investments, usually dividend paying stocks and REITs. At this point the idea is to have a steady income stream from everything in which you invest.  In many cases, the companies in which you invest will have dividend re-investment programs that will allow you to accumulate additional shares without paying commissions.

As you move into stocks you should diversify your portfolio into different sectors, some energy stocks; some pharmaceutical companies; some transportation companies.  It matters less if all the companies pay dividends. In years when one company’s share price is down, the dividend re-investment program will purchase more shares at the lower price. Over time, this will have the effect of lowering the average price per share that you paid and increase the overall dividend yield of the portfolio.

Once you have a solid base and a second tier both of which produce income that will continue to add value to your portfolio, you can add a third tier of growth stocks and a smaller top tier of more speculative investments.  Do not take risks with your money unless and until you have taken care of the business of building a portfolio that will take care of you after you retire.

Let us say that you are fortunate enough to put away $50 -$75 thousand by the time that you are 35 years old. Using an investment pyramid you will likely hold only cash and bonds.  If you use a robo investor platform you are likely to hold mostly stocks which may be worth more or less than the money that you actually put into the account.  This is a lot like the story of the tortoise and the hare; the tortoise usually wins over the long term.

The counter argument, and you will find it everywhere, is that stocks will potentially give you more bang for your buck. Smart people will tell you that you will be sorry if you fail to invest in the next Amazon when it comes along. If you can spot the next Amazon and the one after that and so on, you do not need advice from me.

The importance is that you realize that if you use a robo platform they are more likely than not going to steer you into stocks. If you use the investment pyramid model, you are going to start out with bonds and stay with bonds for a while. Its apples and oranges.


Avoiding Ponzi Schemes

It’s a safe bet there are a number of Ponzi schemes operating right now. Ponzi schemes are actually a lot more common than you might think and are often offered to retirees and other investors who are seeking higher income. Retirees are especially vulnerable to Ponzi schemes that offer the appearance of consistent high interest or dividends because so many retirees are trying to make ends meet.

Over the years I have seen a local real estate developer (whom everyone loved for his charity work in the community) borrow money to fund his developments by selling promissory notes secured by first trust deeds on real estate. After a while it was discovered that he had sold notes secured by the first position on the same property to dozens of different people and the developer just pocketed the difference.

I have seen real life schemes similar to The Producers where non-existent films and Broadway stage productions were funded. I have seen millions of dollars raised for non-existent new drugs and non-existent gold mines and oil wells. I have seen investors shocked when the young entrepreneur who was building a new business took their money and moved away.

A more typical Ponzi scheme takes some of the investors’ money and gives it back to them, every month, seemingly paying a high dividend. People hear about this great investment or some broker tells them about it and the Ponzi scheme suddenly has millions and millions of dollars. The operation of a Ponzi scheme is all about appearances.

The difference between a high yield investment in the private securities market and an investment into a Ponzi scheme is often the honesty of the people who are running the company into which you are investing. Some people will take your money and really try to make their business work. The operator of a Ponzi scheme is a thief.

The promise of consistent high income is common to all Ponzi schemes. High yield is the bait that snares investors and makes Ponzi schemes profitable for the thieves that operate them. Each scheme always comes with a great story about how the company can earn enough money to pay out 12% or 15% or more to investors and still make a profit.

I cannot remember a Ponzi scheme run by someone who was trying to secure cancer treatments for their impoverished parents. When the forensic accountants add up the swag accumulated by most Ponzi scheme operators there are frequently yachts, expensive jewelry and lavish lifestyles all paid for with the investors’ money.

No one is surprised when the brokers who helped to bring investors into the scheme are also found to have been well compensated. I have witnessed a succession of less than honest operators who paid themselves high front-end fees and who lavished golf trips and big parties on the stock brokers and others who would bring trusting investors to their door.

There was one particular Ponzi scheme that was a little different and which I saw played out twice about 10 years apart. In both cases, the high returns were supposedly generated by medical receivables that were purchased at a discount.

In the 1990s a company called Towers Financial raised hundreds of millions of dollars from investors. The funds were intended to purchase medical receivables from smaller, private hospitals. Investors were told that the medical insurance companies were paying slowly and that buying these receivables helped the cash flow of each small hospital.

Towers Financial allegedly bought the receivables at a discount of 8% and claimed to collect the bulk of them in 90 days as opposed to the 30 days that the hospitals needed. This supposedly allowed Towers to roll investors’ money over 4 times per year generating more than a 30% return; more than enough to pay 18% to investors. The operators never actually bought any receivables and used money from newer investors to pay investors in its older funds.

What I especially remember about Towers is that they employed a group of actors who occupied desks in an office one floor below the corporate offices. When a brokerage firm showed up to investigate Towers, the company executives would walk the party down one flight of stairs to the “bull-pen”. Someone would call ahead and the actors would pretend to be hard at work on the telephones making collections. When the group left, everyone hung up their phone and laughed.

Beginning in 2003, a similar scam was repeated under the name of Medical Capital Holdings which also claimed to be buying receivables from smaller hospitals and health-care facilities. Once it allegedly bought the receivables of those companies, interests in the receivables were sold to investors in the form of private Medical Capital Notes.

Medical Capital Holdings issued more than $2.2 billion of Medical Capital Notes to some 20,000 investors across the country. These notes were sold by stockbrokerage firms in almost every state.

By the time the SEC sued Medical Capital for fraud in July 2009 Medical Capital had almost $550 million in phony receivables on its books and had lost over $300 million on various loans that it did make. Meanwhile, the company had collected over $300 million in fees for managing the money-losing loans. The bankruptcy receiver discovered that Medical Capital spent $4.5 million on a 118-foot yacht and another $18 million on an unreleased movie about a Mexican Little League team.

Despite the fact that Medical Capital was essentially a re-do of the Towers Financial fraud of a decade earlier quite a few brokerage firms sold Medical Capital notes without an adequate investigation.  The individuals who organized and ran Medical Capital had previously had serious problems with insurance industry regulators. These problems were not disclosed to potential investors. That fact alone should have been a red flag to any stockbrokerage firm that had actually conducted a reasonable investigation of Medical Capital.

Ponzi schemes do not spend the money that they raise in the way they promise investors. Who keeps track of the money that a company raises and how it is spent? Auditors. Medical Capital and many of these other questionable investments had none.

Medical Capital refused to hire a reputable accounting firm to audit their books. That reason alone should have been enough for any reputable stockbrokerage firm to have refused to offer Medical Capital securities for sale to its customers.  At least one large brokerage firm, Securities America, apparently questioned the fact that Medical Capital was not audited and allowed it brokers to sell the notes anyway.

Auditors play a crucial role in the public securities markets. They make certain that companies publically report specific financial information about their business and their balance sheets. Auditors provide a transparency and a consistency in our evaluation of the firms who are seeking capital.

Audited financial statements are much rarer in the private securities market. That is partly because regulations governing the private sale of securities do not require audited statements for all private offerings. It is also because there is a presumption in the private markets that participants are more sophisticated and that they can fend for themselves.

If you do invest in a private placement, you know that these are almost always considered to be speculative, high risk investments. You can lose all the money you invest and a lot of people do.  If you cannot afford to lose your money, this market is not for you.

Even in the current very low income investment environment there are still listed companies and funds that pay dividends or interest in the 4%-5% range. There are REITS and real estate funds that pay even more. Too much more and you are buying a speculative investment; a lot more than that and there is a good chance that you are getting scammed.

Staying with listed securities that pay market rate dividends or interest is the best way to avoid losing you money in a Ponzi scheme. If you deal with a major brokerage firm there is less of a chance that they will offer one to you and a greater chance that you will be able to recover your losses if they do.