Month: September 2016

The SEC Halts a Crowdfunded Cannabis Offering

Capital Markets, Issuers, Law , , , ,

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 Amazon.com 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

Economics

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

Investors ,

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.