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.