Crime and Crypto Currency

Many people seem to think that crypto currency is a legitimate response to the “evils” visited upon the world by banks, Wall Street and other intermediaries.  They see the mainstream world of finance as corrupt and predatory. Many of these same people are confident that a decentralized system of crypto currency will be more transparent and therefore will reduce the bad acts and eliminate the bad actors.

The same old scams that these crypto enthusiasts hate are playing out in the crypto market every day.  It is actually easier to scam people in the crypto market because both the players and the investors are remarkably naïve.

There has always been crime and criminals in the financial markets.  Some of the same scams have played out over and over for more than 100 years.  The perpetrators and the technology change but at their core many of the scams are the same. The scams succeed because the one fact that never changes is that investors can be both greedy and stupid.  But that fact does not excuse anyone who lies to investors or takes advantage of investors’ stupidity.

Regulation came to the capital markets in the first decade of the last century in the form of “blue sky” laws that were passed by various states.  They were called blue sky laws because they sought to put an end to “speculative schemes which have no more basis than so many feet of blue sky”.  Or more succinctly “to stop the sale of stock in fly-by-night concerns, visionary oil wells, distant gold mines and other fraudulent exploitations.”  Those laws still exist today and were enveloped in a series of federal anti-fraud laws in the 1930s.

I invite you to read the white papers for ten Initial Coin offerings (ICOs). Pick any ten at random. What you will find are the same “fly-by-night” companies that claim that they are going to disrupt this or that multibillion-dollar industry without so much as a bookkeeper on staff.   Almost every white paper I read clearly violates both state and federal law because they do not make full and accurate disclosures. That is why US regulators are perpetually busy issuing injunctions to stop ICOs in their tracks.

In many cases the ICOs are trying to convince themselves that they are not offering securities so they do not have to make the required disclosures.  In some of these cases it is because accurate disclosures would sink the offering.  It is hard to find even simple disclosures like “there are other, larger and better financed companies in this market with whom we will have to compete”.

In other cases, the companies claim to be domiciled in other countries and are not subject to US laws.  I get several e-mails a week soliciting my investment in an ICO domiciled in another country.  Of course if you are soliciting investment from US citizens, then US law applies.

The ICO industry does not acknowledge that it needs to play by the rules. It calls the rules old fashioned and out of date for the modern global economy.  But those rules still apply and failure to follow them is often criminal conduct.

An ICO is an off-shoot of equity crowdfunding or direct to investor financing that uses the internet rather than a brokerage firm to reach potential investors.  Equity crowdfunding was billed as an inexpensive way for small companies to have access to investors.

In the mainstream markets a brokerage firm will conduct a due diligence investigation of the company seeking financing.  The purpose of a due diligence investigation is to have a professional verify the information that is being given to potential investors. This protects investors from the most obvious scoundrels.

With a few exceptions the crowdfunding industry never bought into the idea of due diligence and many of the worst crowdfunding platforms and crowdfunding “advisors” make no serious attempt to verify whether any of the information given to investors is in fact true. The worst of the crowdfunding platforms and advisors have seamlessly moved into the ICO market.

The ICO community suggests that investors conduct their own due diligence investigations.  How, exactly, does a small investor thinking about investing in an IC0 which claims to have a new complex technology and a management team spread over 5 countries “investigate” the offering? Did the management actually graduate from the schools they claim and work at the companies they list? Are the advisors that are listed actually participating? Does the tech violate someone else’s patent? Is the potential market really as big as they say it is? Who are the competitors and how are they positioned in the market?

The ICO market is a market where telling investors the truth is the exception rather than the rule.  In my thinking, every person who sells tokens in an ICO without telling investors all the material facts is a criminal.  And that describes the bulk of the ICO market and ICO advisors.

After the tech market collapsed in 2001 it was revealed that many of the research analysts at the large Wall Street firms had conflicts of interest. Keeping the large tech companies happy meant a lot of investment banking fees for the firms. That is just what the analysts did; they said nice things about the long term growth prospects of companies that were a step away from bankruptcy.  This type of behavior is also clearly illegal.

It is absurdly easy to purchase a good rating for an ICO. Advisors on one of the largest ICO rating platforms, ICO Bench, sell good ratings to any ICO that wants to pay for one.  A pay-for-play rating violates many laws.  Many people in the ICO industry are aware of the practice and keep their mouths shut. In my mind, any rating by ICO Bench is a scam and ICOs that use an advisor affiliated with ICO Bench should be avoided at all costs.

I recently read an article by Jordan Belfort whose antics were portrayed as the Wolf of Wall Street.  Belfort is no fan of crypto currency but he is an expert on pump and dump schemes. What he sees when he looks at an ICO is a lot of insiders and advisors getting a lot of cheap tokens before the public gets any. The insiders then loudly hype the company and dump their tokens on the unsuspecting public. It is exactly the same method that Belfort used and he landed in jail for doing it.

If you follow the Bitcoin trading market it is impossible to avoid repeated allegations of market manipulation. Crypto enthusiasts are always writing articles claiming that the price moved up or down because some “whale” took a large position or dumped one.  No one knows for certain because the crypto currency world is anything but transparent. Many of these people write articles claiming that some large investor has “blessed” crypto currency or is making a sizeable investment. They repeat every unsubstantiated positive rumor while ignoring the reality that the rumor they spread last month never came true.

That there is real crime in the crypto world is evidenced by theft and money laundering.  More than $1 billion has apparently been stolen from electronic wallets and crypto exchanges.  Banks spend a small fortune on technology to keep their accounts un-hackable. The crypto world which is based in technology cannot seem to get its act together.

Likewise, governments all over the world are constantly reporting that money laundering by drug cartels, human traffickers and the like are a significant problem. The FBI recently reported that they have 130 active investigations concerning money laundering and crypto currency. Governments in other countries have many more investigations under way.

In response, the crypto world always says that a lot more money is laundered through banks than with crypto. That logic is very similar to saying that you can get food poisoning at any restaurant, so why should we make our employees wash their hands.  Again banks spend a lot of money on anti-money laundering protocols even if they are not perfect.  Most of the crypto exchanges spend little or nothing.

Organized crime has been active on Wall Street for decades. The NY State Attorney General did a study back in the 1990s that concluded that organized crime was operating smaller brokerage firms that were foisting pump and dump schemes to unsuspecting investors.

A few weeks back someone sent me the prospectus for an ICO that had filed for registration as a Reg. A offering.  The company is just a lawyer who is going to raise $50 million and then hire developers to create Blockchain based projects for this industry or that.

It was a vanilla offering, more akin to a shell than a company; the kind of shell commonly used for pumps and dump schemes. The lawyer has actually represented small brokerage firms that have been accused of pump and dump schemes and also people associated with organized crime families. How do I know?  I “googled” the lawyer’s name and that is what I found.  So why would a lawyer who has ties to organized crime register a shell?  If you do not know the obvious answer, you have no business calling yourself a crypto “expert”.

Everyone I speak with in the crypto world is confident that it will continue to expand and that more and more investors will be drawn to it.  But that will remain a myth unless and until investors are always told the truth about ICOs and their secondary markets. It will remain a myth until the honest people in the industry are prepared to start publishing articles about advisors listed on ICO Bench and other ICO charlatans and stop inviting them to speak at conference after conference.  It will remain a myth until the platforms spend what it takes to become as secure as banks, so that the tokens they hold for investors cannot be stolen and the trading platforms can identify and refuse to deal with the drug dealers and human traffickers.

Do I think any of this will happen? Not a chance. Within hours of the time I publish this article I will begin to get e-mails from people who will tell me that either 1) the regulations or protocols I seek will act to centralize a market that is supposed to be decentralized; or 2) decentralization and Blockchain will fix all these problems; or 3) I am too old to understand modern technology or the “new” world of finance. In the meantime the crypto market will continue to be a cesspool of criminals and criminal acts; the very conduct its backers detest in the mainstream markets.

 

Defining Investors’ Best Interests

In the spring of 2016 the US Department of Labor (DOL) issued new rules which sought to change the landscape for investments held in retirement accounts.  The DOL sought to extend the rules governing how large pension plans and 401(k) accounts were managed to every IRA account held by individuals.

The regulations were a thousand pages long, the result of 6 years of discussion and millions of dollars of lobbying by various players in the financial services industry.  To no one’s surprise that lobbying paid off and the final rule was a watered down version of prior drafts that had actually excluded some of the riskiest investments from all retirement accounts.

The final rules also allowed brokerage firms to create exemptions if the rules did not fit specific individual accounts that were called “best interest of the investor” exemptions. The current administration in Washington and several courts have stopped these rules from being implemented.  The discussion of what investments and investment strategies are in the “best interest of investors” continues.

At no point along the way did the regulators, industry or consumer groups ask investors what they thought would be in the best interest of their retirement accounts. Had anyone done so, they would have been told that investors would be very happy if their retirement account was worth more today than it was a year ago and worth more in one year than it is today.

Before you scream “impossible” I think you should consider that even though no one can win every year, it is important that you at least try.  If you clear your head of all the BS that you hear about the stock market and investment advice and start at the basics, you will see it is not as difficult as many people think.

The primary reason that anyone ever buys a stock is because they believe that the price of that stock will go up.  When the price does go up to where you think it will go no higher you sell the shares.  You may not be right every time but you can certainly be right most of the time and you should be happy with that.

Selecting investments takes time, effort and skill.  The large brokerage firms and investments banks will usually have a fairly large research department and the best ones seek out and hire the best analysts in each industry. In order to “cover the market” a firm may have analysts that will be analyzing companies from 15 different industries if not more.  An analyst with expertise in the automotive industry might not understand the banking industry and neither might be able to understand the value of drugs that the large pharmaceutical companies have in the development pipeline.

The truth is that no one firm has the best analysts in every industry.  That is one reason large institutions frequently deal with multiple firms so they have access to research reports prepared by the analysts they think are the best in each industry.

Beginning in the mid-1990s a lot of stockbrokers began to abandon the traditional business model and the large firms and transformed themselves into self employed Registered Investment Advisors. This was a result of their commission income being under attack from discount brokerage firms that charged much less. It was not unusual for a customer to have an account at one of the wire houses to get access to the research, buy 100 shares through that firm and 900 shares of that stock through their account at a discount firm.

After the tech wreck in 2001 it became clear than many of the “best” analysts covering the tech industry were conflicted.  They were following companies that were grossly overpriced but which were bringing in large underwriting and investment banking fees, so the firms found ways to “value” companies with no revenue claiming it was appropriate for them to do so.

The result is that many of the newly minted investment advisors were willing to leave the research analysts behind. They convinced themselves and their customers that they could be portfolio managers even though they lacked the most basic tools to do so.

This led to the rise of asset allocation using mutual funds and ETFs. The argument was that the losses from the tech crash arose because people had too much of their portfolio in tech stocks. Diversify your portfolio became the new mantra of the market. Buy large baskets of stocks and you will never have to worry again. 

Asset allocation had been around since the 1950s. The purpose of a diversified portfolio is to reduce overall portfolio risk.  If one or two market sectors do poorly, your losses would be balanced by those sectors that would profit.

As applied it is often an attempt to mitigate all risks which it cannot do. If you are trying to manage risk without defining what that risk is, asset allocation will never be the optimal method for any investor.

Asset allocation did not work very well in 2008-2009 as the sectors that were most affected and took the largest losses, banking and real estate touched virtually every other market sector. The losses, especially in the home value portion of investors’ net worth reduced consumer spending, led to increased unemployment and just about all portfolios took some losses.

All of that has apparently been forgotten in the ensuing bull market. Forgotten is the idea that asset allocation does not work in all markets. Forgotten is the idea that loading up a portfolio with mutual funds or ETFs full of stocks is a recipe for disaster unless you have some good reason to believe that market will continue to rise.

Advisors, because they had no good research to support their portfolio selections, told investors that they did not need research.  The rise of robo-investment advisors is indicative of how foolish the investment world has and will become.

Investors are now told that they should invest based upon their age as if an investor’s age had anything to do with how the market will perform.  Younger investors are directed to select portfolios with more stocks because they had the time to could “make up the losses” if losses occurred.

No robo-advisor suggests that it would be better to not take the losses in the first place.  None suggests that the basic tenets of the “investment pyramid” which would have younger investors build a solid base of more conservative investments first might be more appropriate.

Most importantly no robo-advisor seems to think it is important to tell investors when they should sell.  That advice is as important as any advice to buy anything because no stock and certainly no market can go up forever.

At the end of the day, the discussion about what is in the “best interests of investors” boiled down to a discussion of cost.  Investment advice has become commoditized and therefore the argument goes, consumers should be charged the cheapest price.  This is one of the largest crocks of BS that has ever been foisted on investors.

Goldman Sachs, JP Morgan, the largest pension plans, endowments and serious professional investors all rely upon research and analysis to make investment decisions.  The best analysts earn 7- figure salaries because they are the best.  All that smart money pays dearly for advice. At the same time, regulators and others are telling individual investors that it is their best interest to get the cheapest advice or none at all.

If the person offering you investment advice is suggesting stocks, bonds,mutual funds or ETFs without some reasoned opinion about what those investments will be worth in 90 or 180 days, that advice is useless and you should not pay anything for it.  If they tell you that they construct portfolios that use an algorithm, ask them if the algorithm is aware that the US government is imposing new tariffs on imports or that the Federal Reserve is raising interest rates.

The SEC, DOL and other regulators would do investors a favor if they required those giving investment advice to always share with their customers why they bought and why they sold every position.   A little transparency is always in investors’ best interests.

When I was diagnosed with cancer I wanted the best doctors, not the cheapest. When a neighbor or friend called me in search of a lawyer because their kid was picked up on a DUI, I declined to handle the representation because it was not my field of law and they really needed a specialist. And guess what, specialists cost more.

People need investment advice because bad investment advice or no advice will severely impact their retirement and they should be willing to pay more not less for good advice.  Good investment advice will always be in the investors’ best interest. The discussion really needs to stop with that.

 

Annuities and Senior Citizens

Given that I write a lot about foolish investments and investment scams, several colleagues questioned why I have never written about variable annuities. I know a little more about annuities than a lot of people.  When I was a young lawyer I worked at EF Hutton at the time it was first bringing “universal life insurance” to market. Universal life or “investment life insurance” was the precursor to modern annuity contracts.

There is already quite a lot that has been written by regulators and consumer groups about what is wrong with selling variable annuities to senior citizens. Variable annuities are intended to be long-term investments, usually 10 to 15 years or more. They have a lot of up-front fees that can take a long time to re-coup.  Selling investments that take a long time to break-even to senior citizens is always a problem.

At the same time, variable annuity sales to seniors are growing every year. The reason for this is that a variable annuity sale will pay the salesperson a very high commission; higher than the commission on almost any other financial product.

The commission on a variable annuity contract may be 7% or 10% or more of the amount that you invest. If you buy a million-dollar policy, the salesperson who sells it to you may earn a commission of $70,000 or more. For comparison if you invest $1,000,000 into a series of no-load mutual funds or ETFs at a discount brokerage firm the total commission may be less than $100.

Variable annuities are the only kind of investment which requires the salesperson to have both a license to sell insurance and a license to sell securities. Theoretically that should mean that they are better trained than many brokers. That does not necessarily mean that they are supervised more carefully.

A variable annuity salesperson is often licensed by a brokerage firm owned and operated by an insurance company. The intent is often to facilitate the sales, not provide an extra layer of compliance. Insurance companies rarely lose money and variable annuities are some of the most profitable products they sell.

Variable annuities are often complicated and difficult to compare. No two annuity contracts are exactly alike. Even annuity contracts with the same name offered by the same company can contain different riders that substantially change the terms and benefits.

The salesperson with whom you speak will only be able to sell you an annuity contract issued by one of the few companies with whom they are licensed. If you want to shop around for an annuity you may need to contact several different salespeople.

With a variable annuity your money will be invested in a series of mutual funds or sub-accounts that are managed by the insurance company.  The insurance company may offer a range of investment options. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments or some combination of the three. The track record of the fund managers is not always easy to find or evaluate.

The value of your investment as a variable annuity owner will vary depending on the performance of the investment options that you choose. If your intention is to allocate and re-balance your portfolio within the annuity you should understand that it will be difficult to do so properly. The funds will not necessarily correlate well with each other and may not balance against each other in such a way as to substantially reduce market risks.  The person who sells you the annuity might not be able to offer you good advice on how to allocate the portfolio now or when to re-balance it.

You will pay a management fee for each mutual fund. As with all mutual funds, fees will reduce returns. The “expense ratio” of each fund should be disclosed to you. Over 10 or 20 years those fees can add up to a substantial amount of money. Your portfolio will need to earn that much more than the market every year for you to match the market’s performance.

The insurance company will also offer to sell you various guarantees which may provide for a minimum return every year even if the market goes down. You will pay for every rider and option that you select. If you add all of the annual fees you will see that variable annuities are a very expensive way to invest.

A common feature of variable annuities is the death benefit. Often the rider will provide that if you die, a person you select as a beneficiary (such as your spouse or child) will receive the greater of: (i) all the money in your account, or (ii) some guaranteed minimum (such as all purchase payments minus prior withdrawals). Other features may include long-term care insurance which pays for home health care or nursing home care if you become seriously ill.

Most variable annuity contracts include an annual mortality and expense (M&E) fee. This charge is equal to a certain percentage of your account value, typically in the range of 1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract. Profit from the mortality and expense risk charge is sometimes used to pay the insurer’s costs of selling the variable annuity, such as a commission paid to your financial professional for selling the variable annuity to you. The company may include the fees for any guarantees that you buy or may charge you separately for them.

If you withdraw money from a variable annuity within a certain period after a purchase payment (typically within six to eight years, but sometimes as long as ten years), the insurance company usually will assess a “surrender” charge, which is a type of sales charge. Generally, the surrender charge is a percentage of the amount withdrawn, and declines gradually over a period of several years, known as the “surrender period.”

For example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the eighth year, when the surrender charge no longer applies. Often, contracts will allow you to withdraw part of your account value each year – 10% or 15% of your account value, for example – without paying a surrender charge.

Annuities are most often sold as a way of funding your retirement. They do have tax benefits similar to an IRA account so they are rarely purchased with IRA funds.  If you have a large amount of money put away for your retirement outside an IRA, you should consider that the amount you might actually receive annually from a portfolio of dividend paying stocks and bonds might compare favorably once you consider the higher risk that you will have to make up for the annuities annual expenses.

The very first thing I learned about insurance in general (way back at EF Hutton) is that people do not buy insurance, people sell it. Annuities are a high commission item. If you are considering them, get advice from a fee based financial planner first and consider all of your alternatives.

Bitcoins, BS and Banking

I do not believe in Bitcoins because the whole idea behind them smacks of alchemy. For centuries, going back to classical Greece, people believed they could turn lead into gold. A great many, otherwise intelligent people spent a lot of time in this pursuit from the Middle Ages into the 20th Century.

In the latter half of the 19th Century people believed that the new Industrial Age would come up with a mechanical contraption to solve every problem. There were people peddling mechanical contraptions which claimed that you could put a lead bar in one end and a gold bar would come out the other. The process or internal workings of the machine were not disclosed and they became known generically as “black boxes”.

Today, thanks to new technology, you can buy a machine, plug it in and every so often it will send a few lines of computer code to an electronic wallet. You can then exchange that code for a lot of cold hard cash.  That is exactly what a Bitcoin is, just computer code that can be replicated by a machine. They may have value today; but sooner or later those lines of computer code are more likely than not, to become worthless.

For these lines of code to retain value people must be willing to buy them after they are manufactured. As the price increases, more and more people will likely start manufacturing them especially if the next generation of machines are more efficient or cost less.  Sooner or later there will be more code in the market than the market wants and the price will drop. That of course is just basic economics.

Basic economics is something that is often absent from any discussion about crypto-currency. It seems that many people who support crypto-currency, who are passionate about it and who are absolutely certain that it will prevail and disrupt the world are people who have technical backgrounds.  Some of those who are most adamant in the defense of crypto-currency have backgrounds in totally unrelated fields. They gained their insight into finance by having a credit card or reading economic theory in magazine or blog articles.

Most economists, including a Nobel Prize winner or two and most people who have worked in finance or banking dismiss crypto-currency as a fad.  On more than one occasion, a negative pronouncement by someone with stature in economics or finance has led to the crypto-enthusiasts mocking economics, economists and anyone who has worked in finance.  More than one has suggested that I and others are just too old to understand the new Blockchain technology that forms the underlying platform for crypto-currency.

Blockchain is essentially a decentralized ledger. It is a method of bookkeeping where each participant to a transaction creates a record of the transaction which is matched and verified with the other participants to the transaction.

When I wanted to learn about Blockchain I spoke with people who are working in Blockchain at large companies and universities in the US and around the world.  What they told me is that we may see Blockchain coming into various industries in the next few years. Initially they expect that it will be used in supply chain and logistics applications.

What I do not hear from these same people is a lot of enthusiasm for Blockchain in the financial sector.  FINRA assembled a panel of Blockchain experts in 2016 that looked at various functions in the financial markets that might be made more efficient by Blockchain. The overall conclusion was that Blockchain development still had a way to go.

There will certainly be decentralized ledgers within various financial companies and for some financial tasks. The entire world of finance is based upon checks and balances, supervision of employees, and repeated audits. Some of that has been automated since the 1970s.

The financial markets need to keep the bad actors out. Decentralization does not do that. If anything it is the opposite.  Blockchain verifies the transactions but not the people behind them.

A decentralized system prides itself on anonymity and anonymity invites bad actors.  If you read what the regulators of the banking and financial markets around the world have published, they continually share two main concerns about crypto-currency; money-laundering and tax avoidance.

Crypto-defenders will argue that far more money is laundered through banks. Banks spend a lot of money trying to curtail money laundering. The crypto-industry spends virtually nothing. The fact that there are other ways to launder money is no excuse for the creation of a new system that makes money laundering easier.

In the past few months banks, bankers, stockbrokers and serious investors have all given the thumbs down to crypto-currency. Recently the large credit card companies announced that their credit cards can no longer be used to purchase crypto-currencies. The largest stock brokerage firms will not purchase crypto-currency as an investment for their customers. Most professional investment advisors realize that they cannot purchase crypto-currency for their clients and satisfy their obligations as fiduciaries.

Part of the reason is that the crypto-currency industry itself cannot decide if crypto-currency is a security, commodity, currency or a whole new asset class. There is so much divergent opinion within the crypto-community that anyone who reads a few dozen articles on the subject is likely to be confused rather than enlightened.

Much of that divergent opinion is caused by the fact that these are legal definitions being interpreted by non-lawyers. I will not apologize for thinking an opinion written by a non-lawyer with a technical background living in Europe, Asia or Australia about how something should be defined under US law should carry little weight.

That does not stop the crypto-community from hanging on the word of every hack with a keyboard who holds himself out as a crypto-expert.  For an industry barely 2 years old, there are enough people holding themselves out as “crypto-experts” to fill Yankee Stadium at least once, perhaps more.

If all was well in crypto-land I would never have heard about Tether. Tether is a crypto-currency that is exchangeable into US currency at a fixed rate.  It claims to have a cash reserve of $2 billion to back up each and every Tether coin that has been issued.  People have questioned whether the owners of Tether really have secured $2 billion and the owners have repeatedly refused to respond with simple proof that the $2 billion is there. In any legitimate industry this question would never have to be asked more than once.

Theft and fraud are rampant in the crypto-currency world.  Electronic wallets are routinely hacked. Estimates run as high as 10% of the money sent to ICOs may have been hacked from the ICO’s wallet and hundreds of millions of dollars have been stolen from the various secondary market exchanges where the crypto-currency is traded.

Fund raising using crypto-currency (ICOs) has reached a fever pitch and has attracted a significant amount of scoundrels. Very few ICOs fund projects that are worthwhile ventures and most cannot be considered worthwhile investments by any stretch of the imagination. Telling the whole truth about the venture being financed is becoming the exception rather than the rule. Following existing laws regarding investment offerings is an anathema to the crypto-industry.

On more than one occasion an ICO has listed someone as an advisor who has never heard of the company or never agreed to be an advisor. I know this to be true because a few months back someone alerted me that my picture had been included in an ICO offering even though I had not given permission for the company to include it. This actually happens way too often.

There was actually one ICO that was so brazen that the people behind it raised a few million dollars and then took down their website leaving only the picture of a phallic symbol. The people who invested in this ICO got the shaft in more ways than one.

What I find most ridiculous about crypto-currency advocates is their overwhelming dislike for banks and their absolute but incorrect belief that crypto-currency and Blockchain will replace banks and send them to the rubbish heap of history.

Some of these people are European based Socialists who have always hated banks, which is their prerogative. But they have unsuccessfully been trying to supplant banks since the French Revolution. Blockchain is not going to help them.

Other people hate banks because they assert, incorrectly, that banks were the cause of the stock market crash in 2008.  I do not know of a single instance of a bank putting a gun to someone’s head and making them take out a loan that they could not afford to repay. The real estate bubble that preceded the crash might better be laid at the feet of the thousands of real estate brokers who encouraged people to buy homes with the foolish notion that real estate always goes up in value.

The most vocal group of bank haters seems to be millennials who have very little experience dealing with banks, but who constantly tell me that they do not trust them. They tell me that banks charge too much and that the world needs better platforms to make payments.

A payment platform like PayPal works quite well and is a big step up from the way banking worked 20 years ago. All it actually does is move money from my bank to a vendor’s bank quickly. Blockchain may make these payments systems better and faster.

I think these advocates will be disappointed to find that banks will ultimately take the best Blockchain has to offer and utilize it in such a way as to fire significant numbers of employees and make more money. Blockchain may actually strengthen the banking industry rather than displace it.

The problem with the idea that crypto-currencies will replace banks is that banks do a lot more than just facilitate payments. The primary function of banks is to aggregate and intermediate capital.  Banks take deposits from a lot of people and use the funds to make loans to small businesses and to make mortgage loans to homeowners.  The consumer side of these transactions can be done with a peer-to-peer approach and an app. You can apply for a small loan or a mortgage from your smart phone, but you are still borrowing from a pool of money held at a bank.

Banks also make large loans. On any given day General Motors or Dow Chemical may float a bond issue to borrow a few hundred million dollars. On the same day the State of New York may float a bond issue to fund a highway or bridge project or new university dormitory. There may be a hundred or more of these large loans and bond financings taking place around the world every day.

It is not likely that these large complicated financings will ever be done with an app on a smart phone.  These bonds are sold to syndicates of commercial banks. This requires that capital be pooled and that large entities have control over those pools of capital. Bank depositors do not decide how the bank invests the money they deposit.

This is the antithesis of the decentralized world envisioned by crypto-enthusiasts. In their world, the crypto-currency is held in electronic wallets over which only the owner has control.  No banks or centralized entity has access to those crypto-funds. There are no banks or similar entities to pool those funds and make the large loans upon which the global economy depends.

Crypto-enthusiasts have no answer to how these large loans might be made in a decentralized financial world. They do not care that banks evolved to where they are because of the need for large loans to fund large companies and large projects.

The US capital market is not a stodgy outdated system screaming for reform. It is a large, dynamic system that handles trillions of dollars of transactions every day. Virtually every transaction settles with every party happy.

It is way past time for the Blockchain industry to leave crypto-currency and the bank-haters behind and to focus on the applications for Blockchain in existing financial institutions and other industries.

 

 

 

 

Conning the Crowd

Equity crowdfunding allows companies to sell their stock or debt offerings directly to investors by placing the offerings on a website platform. No stockbroker or stockbrokerage firm is needed.

An industry of crowdfunding platforms, experts and attorneys has emerged to help these companies raise the capital they seek.  Some do it better than others.  There are several that I would recommend without reservation.  But at the same time, some people do it so poorly that they make a mockery of the whole idea.

Some of those who do it poorly are now suggesting that that equity crowdfunding is a failure.  In reality, those people were never equipped to do it correctly in the first place and never really understood what selling stock to investors entails.

The one idea that these people and others in the crowdfunding industry never embraced was that “no one wins unless the investors win”.  There will never be a shortage of companies looking for capital.  Connecting those companies with people willing to invest takes more than the passive approach that many of the crowdfunding platforms have adopted. If a platform says “we list any company” I would recommend that you find another platform.

There are a small number of platforms that are licensed brokerage firms or run by people who have experience in the mainstream brokerage industry. They seem to appreciate what it takes to make equity crowdfunding work. These platforms offer demonstrably better investments.

The better platforms take the time to carefully consider each company that comes to them seeking capital.  They will not just allow any company to list their offering on their website.  Funding only companies that have a chance of success and providing investors with a return on their investment is the key to success for any crowdfunding platform.

One of the assumptions that people who lobbied for the JOBS Act put forward was the idea that a crowd of investors has the ability to review the offering materials being put out by a new company, evaluate that information and make intelligent decisions about which companies to invest in and which to pass on by.  The crowd never had that ability. Unless you have a working knowledge of accounting, analyzing the balance sheet and income statements of any investment will always be difficult.

When I first looked at crowdfunding I wrote two separate articles about Reg. A+ offerings that I thought were deficient in a number of ways. My primary argument in each case was that the numbers just did not add up. I thought that each company was promising more than it likely could deliver to the investors.  If I owned the platform where these two offerings were listed, I would not have allowed either to list because if they smell like they may be scamming investors, they probably are.

Both of those companies, Elio Motors and Med-X were subsequently the defendants in regulatory actions.  There have not been that many Reg. A+ offerings to date and the fact that there have been several other regulatory actions concerning Reg. A+ offerings should raise the eyebrows of any serious people in the crowdfunding industry.  I have looked at a few other offerings that were clearly suspect as well, but which the regulators have not yet publicly questioned. For the most part, many in the crowdfunding industry just do not care if investors get a fair shake.

A great many people who own and operate crowdfunding platforms simply do not know what they are doing.  If the platforms do not reject these scams, how will they ever build the long term trust of the investors that the industry cannot live without?

Finally there was an idea that websites would develop where the crowd could share its evaluations of various offerings and where the issuers could respond to comments and clarify what they were offering to investors. A true give and take of information so that investors might make informed decisions.

In most cases this has not really happened.  For all the talk about the wisdom of the crowd, there are people who are so foolish that they will not listen when someone makes a cogent analysis of an offering that would lead anyone with an ounce of common sense to invest in something else.

Case in point.

Both Elio Motors and Med-X were listed on a crowdfunding platform called StartEngine.  As I said, neither should have been allowed to come to market because it was pretty obvious that neither was giving investors the whole story.

StartEngine (SE) is currently offering its own shares to public investors under Reg. A+. I wrote an article about StartEngine’s offering as well. I questioned why it was not making a profit in an industry that should be enormously profitable.  As with all my articles, I asked some hard questions, but I always try to be polite. That cannot be said for everyone.

In the name of transparency, StartEngine posts the comments people make about its offering right on its webpage.  Several people sent me this comment which was posted on the StartEngine offering page which I re-publish here verbatim:

-StartEngine is paying its founders $400k apiece per year. This is INSANITY.
-StartEngine is paying all of its EXECUTIVES over $1,000,000 per year!! This is also insanity.
-Half of that pay was in cash bonuses. This needs to be addressed by their CEO especially as they have not made any profits and are taking investor capital.
-Investors are being offered Common Stock NOT Preferred Stock as they should be offered.
-What does that mean? That means that the founders have significant liquidation preferences over the investors.
-You are asking your investors to assign their voting rights to the CEO. This may not even be completely legal.
-The valuation of the company is unheard of,especially for a company that has continually lost money without any profit.
-There is no road map or path to reaching a revenue breakeven point where you can even sustain operations without SIGNIFICANT additional capital commitments.
-Investors will be HEAVILY diluted after this raise or worse there will VERY likely be a down round.
-The fund raise leaves the company with VERY little cash reserves. Guaranteeing the need for more cash.
-StartEngine has to be in the process of registering as a  full broker dealer for what it needs to accomplish the goals stated.
-The language of the offering circular makes it appear that SE is doing everything it can to shield investors from knowledge of its current and actual future plans as well as prevent them from having any ability to have a voice in the company.
-Over $5,446,367 has been spent to date in deficit without any profits.
-StartEngine does not include any listing or sufficient breakdown on its technology
-There is a significant lack of data and information that you would find in a standard pitch deck of a seed stage startup
-There is no timeframe for the ending of this campaign.
-There is no coverage of an exit strategy or potential for one.
-StartEngine does rolling closings and does not disclose when or how it will go about these, directly in conflict with the traditional “crowdfunding” model of get to your goal or get your  money back.
-StartEngine does not cover much on its competitors or the competing models or market.
                Please address these issues.

Certainly this list includes some issues that the company would do well to address. This commentator is no idiot and he is one person of whom it can be said that there are people who can read and assess a crowdfunded offering. He is exactly the type of investor that the crowdfunding industry needs if it is going to succeed.

So did the company respond with a point by point explanation?  It did not.  This is the company’s response which I also republish verbatim:

Thank you for your comment. We believe our offering describes our business effectively, and clearly shows our goals for the future. In fact, your critique of the offering is only possible because we chose to be so transparent.  If you have a specific question about StartEngine that will help you to decide whether or not to invest, please ask. We’d like to provide all the information we can.

Personally, I never would have let a client of mine publish that response.  It strikes me as arrogant and treats a potential investor who asked intelligent questions as someone who can be ignored. To me it smacks of the Wizard of OZ saying “don’t look behind the curtain.”  I would have counseled a carefully worded point by point response that demonstrated respect for the potential investor.

In truth I would never have suggested that StartEngine prepare a Reg A + offering or seek public investors.  As the anonymous commentator points out for any number of reasons investors are going to have a difficult time making a profit on this investment. This is not a charity. The executives are taking out a substantial amount of money ever year.  Because the company is not profitable, some of the money they are taking home is likely to be the investors’ money.

Despite this, the same web page notes that StartEngine has over 400 new shareholders as a result of this offering.  If an active crowdfunding platform can successfully make this offering despite its flaws, why would it care if any of the offerings that were listing on its platform had any value or could possibly offer a return to the people who are investing in them?

In my mind Elio and Med-X were strikes one and two against StartEngine and this offering is strike three. I would not advise a client to list on their platform and I certainly would not advise a client to invest in any company that does. In my opinion, investors deserve and should demand better.

As I said, this offering and the commentary was sent to me by an acquaintance who has toiled in the crowdfunding industry and the commentary was also mentioned to me by others.  They privately say tsk-tsk but do not want to publicly say what needs to be said.

I look at it this way, not every stockbroker is honest or competent. When they do bad things investors lose money. No one hates to see a stockbroker taken away from his office in handcuffs more than the honest stockbroker working across the street.  Bad actors and stupid people just demean the reputation of the whole industry and make it more difficult for honest people to make a living. That is true in crowdfunding as well.

In the past two years I have spoken with a lot of hard working people in the crowdfunding industry who are trying to help small companies find investors by giving investors a solid chance to make a return commensurate with the risk they are taking. You know who you are. Keep up the good work.

 

 

 

Investment Advisor Litigation When the Market Corrects

When the stock market finally corrects it will be the eighth major correction since I first started working on Wall Street back in the 1970s. It may happen next week or next year but it will certainly happen.  When the market does correct investors will certainly experience some losses.

Everyone understands that the stock market goes up and down. That does not mean that investors should expect to lose a significant amount of the money they made during the bull market when the correction does happen.

At every correction investors who lose more money than they anticipated bring claims for compensation against their stockbrokers and advisors.  For a stockbroker registered at FINRA most of the claims will be handled by FINRA in an arbitration proceeding. As soon as the claim is filed it shows up on the stockbroker’s Brokercheck report.

Many of the investment advisors who are registered with the SEC or with a state agency but not FINRA also have arbitration clauses in their customer agreements. They too are supposed to amend their disclosure filings to report customer claims, but few do.  I know of investment advisors who have had multiple customer claims but still show a clean record.

Investment advisors are always considered to be fiduciaries to their clients. As such they required to fulfill all of the duties of a fiduciary.  A fiduciary’s first duty is to protect the assets that are entrusted to them.

You cannot protect the assets in an investment portfolio unless you are prepared to sell them when the market turns down.  For advisors who are paid based upon the amount of money in the portfolio this creates a conflict of interest that no one wants to talk about.

Too much cash in the portfolio invites the customer to withdraw the cash and invest in something else, like real estate.  Good advisors will offer a large variety of investments so that they can always find one poised to increase in value or provide a steady income.

This will be the first market downturn where a significant amount of assets are being held by robo-investment advisors.  When the next correction comes, robo-investment advisors are going to be likely and easy targets for the plaintiff’s bar.  Robo-investment advisors are not programmed to sell positions when the market begins to turn down and are likely to stay invested while losses pile up.

Robo- investment advisors select their portfolios using algorithms that are fed with historical market data.  Everyone knows that past performance is no indicator of future results but the SEC allows this sham to continue. For a robo-investment advisor to have any value it would need to be able to assess what is happening in the real world economy and what is likely to happen as a result.

Robo-investment advisors claim to use asset allocation to select their portfolios and to protect their customers from losses. The simple truth is that most robo-advisors (and many human investment advisors) have no idea how asset allocation is done correctly.

The idea behind asset allocation is that you can create a portfolio of non-correlated assets that will reduce the risk if some macro-economic event rocks the markets.  Most robo-investment advisors give lip service to the idea of a diverse portfolio but few actually construct their portfolios correctly.

Many human and robo-investment advisors construct portfolios with asset classes such as “large cap stocks”, “mid-cap stocks” “small cap stocks” and “international stocks”.  As regards most macro-economic events such as a spike in the price of oil or an increase in interest rates, these asset classes are perfectly correlated with each other, not the opposite as they should be.

Asset allocation is designed to deal with the constant yin-yang between stocks and bonds triggered by interest rate fluctuations. For a long term portfolio, you would accumulate bonds at par when interest rates were high. As interest rates peak and began to come down, you would expect stocks to begin to appreciate, so you would sell bonds at a premium and begin buying good stocks in different, non-correlated industries.

Asset allocation works because its portfolio re-balancing system is based upon the premise that you will buy-low and sell-high. Robo-investment advisors re-balance their portfolio based upon a pre-determined formula that simply ignores what is likely to go up and what is likely to come down.  Many human advisors do not do the kind of research necessary to intelligently re-balance a portfolio either.

I worked on a lot of claims against stockbrokers and investment advisors after the market crashes in 2001 and 2008.  They always put up the same, weak defenses.

First, they argue that no one can predict the top of the market.  That is absolutely true and totally irrelevant. The great bulk of intelligent, prudent investors only invest in stocks that they think will appreciate in value. If your robo (or human) investment advisor told you to buy APPL or a mutual fund or ETF of “international stocks” it is fair that assume that they did so after some analysis that concluded the position would appreciate. Otherwise the advisor brings no value to the relationship.

If the advisor is actually doing that analysis and it includes more than just consulting a Ouija board, sooner or later that analysis will say “sell” or at least indicate that the share price will not appreciate much more.  The most common indicator is price/earnings ratio which economists tell us will usually fluctuate within an established range. When prices get out of the range on the high side, they will usually decline and revert to established norms.

Next, brokers and advisors defend these claims by arguing that clients should stay fully invested at all times because the market always comes back. That is another insipid defense.  It is akin to suggesting that you should keep your hand on a hot stove because it will eventually cool down.

As we approach the end of this long bull market every investor should be happy with the gains that they made in their portfolio. The Dow Jones Industrial Average has more than doubled since the end of 2008.  Even if your portfolio had a smaller gain, why would anyone want to give those gains back when the market declines?

Next, advisors offer lame excuses as to why they did not hedge the portfolio against a market downturn. There are a number of ways to accomplish this but very few advisers have a system to do so effectively.  I have asked many advisors why they do not hedge their portfolios or include stop loss orders to protect against a serious loss. They usually tell me that they were afraid to sell positions because the market would resume its climb and they would miss further gains.

That particular defense only works if the advisor has some research that suggests the market will go higher still. Many of the advisors that I cross-examined over the years had nothing more than their own gut feeling.

Where advisors tend to really screw up is when they get into the habit of adding speculative “alternative” investments to a portfolio to “juice” the returns. This may be acceptable for people who understand the risks and who are willing to accept the losses if things do not turn out as planned.  That does not describe a lot of people who are sold these investments thinking that they are hedging against losses in other investments.

Real estate investments are commonplace as an alternative and many advisors will add an exchange traded REIT to a client’s portfolios. These are very different than non-traded REITs which are usually private placements. The risk is much greater if the investment cannot be sold and at least some of the value retained.  Non-traded REITS have been the subject of thousands of claims against brokers and advisors in the last 10 years.

At the end of the day most of an advisor’s clients turn over the management of their portfolio because they want the portfolio to grow. That should not be that difficult for any good advisor but like anything else, you have to know what you are doing and you have to put in the hours to do it right.

Giving good professional investment advice takes skill and it takes effort, but it is also a people business. The number one complaint that I heard over and over, year after year, from people who contacted me asking about suing their broker or advisor was always the same, “He stopped returning my phone calls”.

When the market takes a sharp downturn, people want advice. That is another reason why robo-investment advisors are likely to see more litigation when the down-turn comes. They are never going to hold your hand.

 

Equity Crowdfunding 2018

I received year end 2017 reports from quite a few equity crowdfunding platforms and consultants. All were glowing with their accomplishments.  Several reported the number of offerings that had successfully raised money. None spoke of the offerings that paid the listing fees and failed to get funding.

Overall the equity crowdfunding industry continues to grow and become more popular with both issuers and investors.  Still, no one wants to look at the significant problems that still plague this industry.

There is absolutely no reason why any company that lists on a crowdfunding platform should not raise the money that it seeks.  There is no reason that investors should be offered the opportunity to invest in scams or in businesses that are unlikely to succeed.  The amount of effort that the crowdfunding industry expends to protect investors from scams and losses is virtually nil. The crowdfunding industry cannot expect to succeed if it does not get its act together and begin to address these issues.

Equity crowdfunding allows a company to sell its shares, bonds or notes directly to investors through a website rather than through a licensed stockbroker. That can save a company a lot of money. It also allows start-ups and companies that are too small for most stockbrokers to handle efficiently to raise capital.

A stockbrokerage firm provides two specific and necessary tasks to any stock offering. First it provides investment banking services to the company to assist properly structuring the offering so that it will be accepted by investors.  Second, the brokerage firm provides the sales and marketing efforts that attract the investors, close the sales, and raise the money.  Both tasks are necessary. Offering a new issue of securities without either being done well is like changing a tire without a jack.

The platforms are remarkably passive as regards the structure and sales of any offering. They are content to accept listing fees from any company that wants to list. They do not care if the offering is successful. They do not care if the company is a good investment or if the investors will make a profit.  These are the crowdfunding industry’s biggest mistakes. For the crowdfunding industry to succeed it must reduce the risks to its investors.

The largest beneficiary from equity crowdfunding has certainly been the real estate industry. There are established real estate syndicators in this market offering investors participation in single properties and in public and private REITs.  Several have set up their own proprietary platforms to showcase their own offerings; others use public platforms where their offerings compete with other properties.

Many of these syndicators have always used private placements as a source of equity funding. Crowdfunding has enabled real estate syndicators to save the 10% -15% that stockbrokerage firms charge to fund their projects.  This lower cost usually provides more cash flow for investors.

Most of the platforms are using Regulation D private placements because there is no reason for an income producing property to be “public.”  Real estate is easy for investors to understand. Investors trust real estate not just as an asset class, but as an investment.

Start-ups have a more difficult time raising funds on crowdfunding platforms.  And before you say that is to be expected, when you compare most start-up offerings with real estate offerings it should become obvious that most of the deficiencies with start-ups are correctable.

If you are investing in the equity of a commercial real estate offering there is usually a bank that has done an appraisal of the property and a physical inspection.  With start-ups the valuations are often off the charts. Rarely has anyone actually tested the product to see if it is viable or conducted a patent search to determine if the product infringes on someone else’s patent.

With a commercial real estate offering there is usually a seasoned property manager to handle the day to day business affairs.  With many start-ups the management is often less experienced than it should be.  Asking for investors to fund your business if you have never run a business, or do not have good managers or advisors in place becomes an up-hill fight.

Real estate offerings are most often structured to provide income to investors. Simply stating that the property will be sold after 7-10 years is all the exit strategy most investors need.  Many start-ups would have a much easier time raising funds if they structured the offering as preferred shares or provided income through revenue sharing or royalty payments.

When I advise a start-up seeking to raise capital I always offer my sense of what they should do prior to the offering to strengthen the company. I advise them how they should structure their offering to increase the chance of success.  This is the advice that the crowdfunding platforms should offer to every start-up that is paying for the privilege of listing, but do not.

My hope for 2018 is that the crowdfunding platforms get on board and do the same.  The platforms handling start-ups just need to become more proactive. There is no reason that every offering that lists on a crowdfunding platform should not be funded.

When the JOBS Act was passed there was a lot of discussion about small investors being able to invest. Millennials, especially, were arguing that they were being denied the opportunity to invest in the next Facebook.   So at the end of 2015, the SEC promulgated changes in Regulation A allowing a slimmed down registration process for smaller offerings of up to $50 million.  By any standards Reg. A has been an abject failure.

It takes a lot more money and a lot more time to prepare and complete a Reg. A offering than a Reg. D offering. I will advise any company seeking funding to use the latter instead of the former.  A company that spends an additional 6 months and $200,000 to reach small investors is usually telegraphing that the more sophisticated accredited investors do not want to invest.

Reg. A has been used to raise a fair amount of money, but the issuers themselves have not prospered. Several of the most hyped offerings, such as Elio Motors, have crashed and burned taking the investors with them. The share price of most of the other companies that used Reg. A to raise capital have not been able to maintain the original offering price. And this is in the middle of an historic bull market.

The Reg.A platforms and advisors do not support the price, after the shares have been issued,the way a stockbrokerage firm would.  Again, my hope for 2018 is that they get their act together and provide all the services that a company issuing shares to the public needs, both before and after the offering.

Perhaps the most disappointing aspect of the crowdfunding market has been the lack of attention to the Reg. CF portals. These handle the smallest offerings of up to $1,000,000 that cater start-ups in need of seed capital.  They represent the very essence of what crowdfunding should be about; small investors helping small companies.

Unfortunately, only about 35 Reg. CF portals are operating.  Those that are operating also take a passive role. They fail to assist the companies with the structuring of the offering. They fail to assist with marketing.  The simple fact is that if you are going to raise $1,000,000 by taking one or two hundred dollars from a lot of small investors, then you need to reach out to tens of thousands of investors before you find enough who are willing to invest.  That takes both marketing money and muscle.

It is pretty clear that most start-ups will fail within 24 months and these investors will lose their money. It is these small start-ups that need the most help and these small investors who need the most protection from loss.  But again, the crowdfunding industry has just not provided that help in any meaningful way.

I hope to make a contribution to the crowdfunding industry in 2018.  I am working with a group that wants to provide a measure of protection to small investors that are investing in these small offerings.  They are discussing starting a new Reg. CF portal where small companies can raise $500,000-$1,000,000.

They intend to offer a program to buy back any shares of any offering that lists on their Reg. CF portal if the company fails within 24 months.  You know that they can only do this if they offer only companies that they think will survive and succeed.

This type of vetting is missing in the crowdfunding industry and I am pleased to be part of the team that is putting this together. Besides me the team includes people with years of investment and commercial banking experience and a young, dynamic marketing team.  The goal is to select only the best companies to offer to investors, help those companies get the funding they need and help them succeed thereafter.

Right now, the group is seeking a very small number of investors to help fund the platform itself.  It is using a revenue sharing model so these investors can expect their investment returned quickly with significant return thereafter. If you have an interest in participating with an investment, contact me and I will put you in touch with the CEO.