The Great VC Con Game

The Great VC Con Game

I speak every week with people looking for funds to start or expand their business. With investment crowdfunding, the process has actually become relatively easy and inexpensive. Most people come to me to use crowdfunding as a first choice to fund their business. They appreciate the opportunity to fund their business on their own terms.

Sadly, some report that they spent upwards of $25,000 and more than a year flying around the country attending conferences and pitching to dozens of venture capitalists. If they had called me sooner, I would have told them to save their money.

Pitch Decks

There are a plethora of books and articles and an industry of vendors hawking “pitch decks that work”. Few actually do. When I see a pitch deck I can often tell which “guru” it is trying to follow. 

Unfortunately, most of these experts know nothing about what motivates investors to write a check. One in particular who seems to post on LinkedIn every few hours actually offers the worst advice that I could imagine. 

Logically, investors in your company should really want your company to succeed.  If you want their money, it would seem natural that you would tell potential investors what you intend to do with their money in order to make more money.  Yes, it really can be that simple.

Compare that to the pitch decks that follow the “find a problem and solve it” template. They often minimize the focus on projected revenues and profits. They often leave out the details of how the company will execute its business plan to get there. From an investor’s point of view, return on their investment (ROI) rules.

VCs actually fund a very small number of businesses (in the low 1000’s) every year. Most of the money available for venture capital investment is concentrated into a handful of large funds. Some of the available capital will flow to “serial entrepreneurs” because venture capital is a fairly closed network of people and money.

I was introduced to my first venture capitalist when I made my first visit to Silicon Valley in the mid-1970s. There were a lot more trees and open space on the way to Sand Hill Road back then.

At that time VCs in Silicon Valley were a very small group of very smart people. Many were MBAs or had MBAs on staff to crunch and re-crunch the numbers. This was no small task in the years before VisiCalc.

These VCs were using their own money and the money of a select group of wealthy investors to help small tech companies get their business up and running.  Their goal was to hand these companies over to the investment bankers specifically for a public offering. 

Investment bankers wanted these companies to be profitable before an IPO.  After the offering, research analysts affiliated with the investment bankers were going to project growth in earnings per share. That assured that the IPO investors were almost always going to make a profit from their investment post-offering.  Everybody would win.

San Francisco

I moved to San Francisco in 1984 to work with a law firm that represented a London based VC fund. The fund was making investments in 1980’s era hardware and software companies, companies with cutting edge ideas and those in more traditional businesses as well.  I sat through a lot of pitches. Very few of those companies got funded even though the pitches were well thought out and supported by real facts and research. 

I remember listening to one of the partners in Sequoia Capital being interviewed on TV discussing what they liked about Apple when it was still at the venture capital stage.  I recall that it was more about Steve Jobs’ focus on the design and packaging as it was the tech.  It was more about gross profit than market share.  

Today it seems like “gross profit” is a curse word in the venture capital community.

Investing has always been rooted in mathematics. Today’s VCs have chosen to ignore the traditional math and have created a new math, to line their own pockets, even as the companies in which they are investing continue to fail.

Dotcom

Beginning in the 1990s and especially as the dotcom era heated up, a lot of people who worked in around Silicon Valley, thought that they should become venture capitalists. Some had been founders of the earlier tech companies. Some claimed to have the connections and insight to bring more than money to these portfolio companies. 

The net result was a de-emphasis on the actual, achievable projections of income and how a company might execute to get there. It was replaced with a mindset that said “this is a great idea; millions of people will come to our website and buy our product”. Translated, that means: “Profits? We don’t need no stinking profits?”  

The investment bankers bought into this because it enabled them to make a great deal of money. They took a lot of companies public without real earnings. They then used convoluted reasoning and research to predict share prices in the hundreds of dollars. 

The analysts looking at the dotcom companies created a metric called “growth per share”. I asked one of the prominent tech analysts if they had ever seen that metric in a peer-reviewed journal. Of course they had not.

In the current market bull market post-2008 the VCs have moved the goal posts even further to feather their own nests. Rather than find more and more good companies to fund, they are increasingly conducting multiple rounds of financing on a smaller and smaller group of companies. Most are destined to failure because they cannot operate profitably.

Venture Capitalists

VCs like other money managers get an annual % of the amount of money invested in their fund. The best way to attract new investors is to demonstrate success. If a VC invests in a company at $1 per share and the company goes public at $10 per share then the VC’s success is easy to calculate. If none of the companies in a VC’s portfolio actually go public, the VC’s success is harder to demonstrate.

To solve the problem, VCs have created a metric called “pre-revenue or pre-earnings valuation”.  You will not find it in peer reviewed journals. It is the closest thing finance has to an oxy-moron.

It works like this. Ten VC funds each invest in a seed round of 10 companies. Then some will invest in a Series A round of some of the companies in the other VC’s portfolios, then others will invest in the Series B round, etc. In the end, these VC funds have cross funded each other’s deals at different levels.  Each level is priced higher than the one before.

In the seed round a VC invested $10 million for 10 million shares of the outstanding shares of each company.  By the Series C, D or E round those shares are being sold to the other VCs and now cost $50 each. 

Does that make the original shares purchased in the seed round worth $500 million?  If the company has now issued 200 million shares, is the company worth $10 billion? Not in the real world and especially not if the company is still not profitable.

However the VC can now claim that its original investment is worth much more and use that “fact” to attract more investors into its fund. The VC will receive a % of the amount invested yearly for a decade or more. 

WeWork and the other unicorns will be the subject of business school case studies for at least the next generation. They are the most recent example of what may be the oldest theorem in finance: you can fool some of the people all of the time.  

Capital for new and smaller ventures is essential to the entire system of finance.  Investment crowdfunding is actually a response to the failures of VCs in the dotcom era. The arrogance displayed by VCs in this current market has probably done more to cement the place for investment crowdfunding than anything else. It is up to the crowdfunding platforms and professionals not to make the same mistakes. 

If you’d like to discuss this or anything related, then please contact me directly HERE

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Sex in Economics

sex in economics

When I was teaching Economics back in the 1990s, I was fortunate to have students who had gone to high school in dozens of different countries. These students had different experiences and had functioned in markets that were often driven by local custom and culture. Their questions and comments helped me to understand a lot about the expanding global marketplace.

When I wanted to create an example to illustrate the application of a theory that I was trying to explain, I always tried to create one that everyone would understand regardless of their country of origin. Consequently, I often talked about sex. 

I admit up front that this may have contributed to my being ranked as one of the more popular members of the adjunct faculty at the university. It also seemed to keep the students awake, which, when teaching a subject like Economics can be task number one.

Economics

Classical economics teaches that consumers are rational. It teaches that because most consumers have a limited amount of money to spend each month, they will organize their spending accordingly. First, they will allocate their funds to necessities (rent, food, clothing, and transportation) and then to items that are necessary but which can be put off (dentist, auto repairs). Any funds that are left over can be spent on items that the consumer may want to buy, but could literally live without (sporting events, vacations). 

In order to get the most “bang” from the bucks they have, consumers should be good shoppers.  They should compare the prices of like products and purchase the least expensive ones that suit their needs. In theory, it is a rational process throughout.

Most consumers acknowledge they should allocate some of their monthly earnings to savings, but few will. Most also acknowledge that they should spend no more than they earn each month.  In practice, that effectively went out of style with the advent of the credit card.

Today, the market is awash in consumer debt, a factor that the classical economists could not consider.

I tried to focus the students on the underlying question: “How could they induce consumers to make an irrational decision to buy their product?”  These were, after all, business school students. 

For most products the answer is advertising. The modern “in your face” daily onslaught of ads that encourage people to purchase products were also not considered by the classical economists for obvious reasons.  The textbook I used, followed the classical view, which, to my thinking, might not give students the whole picture.  

The purpose of any advertisement is to make consumers purchase the product. Many ads will stress a product’s “value” which speaks to our rational side.  But even those ads will frequently feature attractive people making the pitch.  Using actors who are “attractive” does not change the message. But it is likely to get more eyeballs on the ad. 

Sex Sells

Indeed much about advertising is rooted in sex. There is a constant, undisputed theme in advertising: “sex sells”.

sex in economics

I could not, in my mind, conjure up a source of more irrational behavior than the human sex drive. It is not “just the things we do for love”. Sex and our desire for it motivates a huge portion of the spending that people do, even if they have limited funds that might rationally be spent elsewhere. 

For example, sex is at the root of the global fashion and cosmetics industries. These represent trillions of dollars of annual commerce.  And it is not new. Evidence of consumers’ desire for fashion, cosmetics and adornments goes back into pre-history. 

Why would anyone teach that consumer purchases were rational when so much of it was driven by irrational emotions?  And this does not even touch purchases that are made based on other emotional responses such as fear, greed or envy. I thought that perhaps the rational consumer of the textbook who was focused on the price might be a myth. 

I caught up with Richard Posner’s Sex and Reason (1992) a few years after it was published. His well researched and well presented book came to the conclusion that the human sex drive was rooted in our biology and that acting upon it was perfectly rationale behavior.  

I still have difficulty in reconciling the perfectly rational price theory with less than rational human behavior.  Over time I have come to believe that the latter might actually be underestimated as the determining factor for our purchase decisions. In this regards, I think that business school students might need a lot more sex, at least in their curriculum. 

I liked to challenge my students. I asked the class why so many consumers would reach for a fragrance that was priced at $350 per bottle. People buy fragrances to attract a partner for sex. Would not a fragrance that cost $60 get the job done? 

Vegas Baby

I would ask: If a sex worker in Las Vegas charges $500 to perform a sex act when a sex worker in Brazil might charge $20 for the same service, what can you infer from this data? Yes it is about overhead and what the market will bear, but it is also an introduction to globalization. Change sex worker to software developer and you will see what I mean.

sex in economics

Cable television and the internet itself were once brand new technologies that were slowly beginning to find acceptance from the general public.  In both cases each got an early shot in the arm from one source, pornography.

On cable, networks like HBO screened soft core porn after midnight. It is what made the cost of cable acceptable to many new viewers and indeed what attracted many new viewers. Data at the time suggested that a lot of people liked to watch in bed. If you need a reference go to Wikipedia and look up Sylvia Kristel. 

I think that everyone knows that there is a lot of porn on the internet, but not everyone appreciates how large a business it represents. MindGeek, parent of Pornhub, does not report its revenues but measuring them in the billions would not seem inappropriate. It may not be as large in gross sales as Amazon, but MindGeek’s cost of goods is minimal. 

Sex is even prevalent in finance. I wrote an article about crowdfunding back in 2015 when it was still new and I was just beginning to look at it with a critical eye.  Investment crowdfunding was and is about getting people to look at your offering.

I wrote at the time: “If eyeballs are what you need to successfully crowdfund a company, it would seem logical then that the easiest company to crowdfund might be one selling a line of lingerie. No crowdfunding consultant worth his/her fee would likely tell the company not to include its product catalog in its presentation to investors if that catalog had pictures of models wearing lingerie.” About one year later a lingerie company in London started a crowdfunding campaign that followed that advice and raised all of the funds that they were seeking.  

Sex, Drugs and Rock n’ Roll

The music industry certainly uses sex to make sales. I grew up at a time when Elvis Presley appeared on television from the waist up because much of the audience had “issues” with the way in which he moved his hips.  Currently, it’s obvious that much of the music and entertainment industries have seen that portion of the audience as far out of the mainstream. A music video without some sexual reference? Hard to find near the top of the charts.  

A few years back, I caught an interview of Mick Jagger that was being conducted by a business reporter. Jagger has flaunted sex and sexuality throughout a very long career. The Rolling Stones were starting a tour and the topic was the economics of touring.

mick jagger

Jagger suggested that the tour itself would probably net the band over $100 million, not counting the record sales. The reporter asked how the band could achieve that kind of financial success from traveling around and playing music. Let’s face it, very few musical groups have had that kind of sustained success.

Jagger responded that he had just paid attention in school. The response made me smile. He is a graduate of the London School of Economics.    

I hope that my students were paying attention too.

If you’d like to discuss this or anything related, then please contact me directly HERE

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Hey FINRA- Look Over Here

Finra

FINRA, the stockbrokerage industry’s regulator, often does an absolutely atrocious job of policing its members. It was not always so, but in the last few years FINRA has clearly turned a blind eye to some really outrageous conduct that is going on right under its nose.

There are two distinct types of scams that have been prevalent in the stockbrokerage industry for decades. The first involve bad investments that come down to the registered representatives from the corporate level. These scams would never be sold to investors if the firms had conducted an adequate due diligence investigation.

FINRA has a fairly high bar for its member firms when it comes to due diligence on a private placement. It tells its member firms that they may not rely blindly upon the issuer for information concerning a company, nor rely on the information provided by the issuer and its counsel in lieu of conducting its own reasonable investigation.

In the late 1980’s and early 1990’s a company called Towers Financial was selling pools of consumer debt through dozens of FINRA firms. It was ultimately revealed that the company never owned the debt and it was just a Ponzi scheme. About 200,000 investors lost close to $250 million.

The lesson of Towers Financial was that it is virtually impossible to conduct a due diligence investigation on a company claiming to hold large amounts of consumer debt without a full audit of its books.   Most companies of that size would have an audit as a matter of course. Towers was an exception. A lot of people suffered because of it. FINRA (the NASD back then) never suggested (or mandated) that its members should have been concerned about the lack of an audit. 

Fast forward to the mid-2000s. A company called Medical Capital also claimed to have pools of consumer debt which it really did not have. FINRA members helped the company raise over $1 billion from thousands of unsuspecting customers. It too was a Ponzi scheme and it too was unaudited.

FINRA did very little in the way of enforcement and again refused to simply direct its members to require an audit of any pool of consumer paper. An audit is the only way any firm can verify what the issuer is claiming.  Several of the state securities administrators raised the same questions but the brokerage industry refuses to get the point.

Last week I looked at another company for whom about 60 FINRA member firms raised a little over a $1 billion. Was it audited? No. Is it a Ponzi scheme?  No one has said so officially yet, but there are red flags everywhere. I would hope that FINRA would be all over it, but I know that they will not.  FINRA refuses to see these types of scams even when you rub their noses in them. When public customers keep losing a billion here and a billion there the regulator is clearly asleep.

Case on point.

When I was filing claims on behalf of public customers with FINRA for arbitration, it was never my practice to send a copy of the complaint to FINRA’s enforcement division.  I would only do so if I thought the offending conduct on the part of the broker or the firm was particularly obvious, onerous or both. The very last time that I sent a copy of an arbitration claim to FINRA enforcement they bobbled the ball.

The claim was on behalf of an elderly investor who had forked over about $600,000 to purchase interests in a private placement which would own an office building in the mid-West. Within a year the investors discovered that the roof leaked and that they were on the hook to replace it.  The FINRA member firms that sold the offering had not bothered to have the building inspected as part of their due diligence investigation. Most people would never buy a home without an inspection report.

The offering also described the sponsor as a “successful” developer when in fact his only prior development had ended in bankruptcy with many of the sub-contractors unpaid. The sponsor did not even hold a degree from the school listed in the private placement disclosure documents.

I documented all of this in the claim with appropriate exhibits and sent a copy to FINRA’s enforcement department.  The FINRA staffer who responded told me that the due diligence that the firm had conducted was just fine and that he felt no further action against the firm was necessary. 

I composed a response that expressed my feelings that the FINRA staffer was a ****** idiot. My partner at the time correctly decided that he would not allow me to send the letter because, in his words, you can’t fix stupid. 

Another case on point. 

A little more than a year ago I was asked to look at a series of arbitration claims that were being filed at FINRA against a small group of small brokerage firms located in the New York, Long Island and New Jersey metro area.  The attorney who sent them to me wanted my help in preparing the claims for hearing and my testimony as an expert witness (yes, I still do that) regarding the substance of the claims and the supervision of the brokers. What I discovered was conduct that was obviously intentional and truly disgusting on the part of the brokers and the firms.

There are apparently dozens of disparate customers voicing the same complaints against these firms. It was obvious that the brokers were cold-calling older businessmen and retirees in the mid-West. Quite a few listed their occupations as farmers.

The customers were complaining that the brokers had sold them on the idea that they were superior stock pickers who were and who would continue to make substantial returns for their clients.  Yes, I know that most readers of this blog would not fall for that, but apparently hundreds of public customers did.

Once the accounts were opened each customer complained that they had lost money because the brokers had churned their accounts and had made unauthorized trades. Of all of the claims that customers can make against their stockbrokers, these two in particular, excessive and unauthorized trading are the easiest allegations to prove or disprove. 

In the stockbrokerage industry a broker cannot enter a trade in a customer’s account without the customer’s prior approval. In the normal course of business a broker will get permission from the customer to buy or sell a security, hang up the phone and enter the order.  So there should always be a record of the phone call showing the time it began and the time it ended and also a time-stamped record of when the order was entered and when it was executed.

I asked the attorney if the firms had produced records of the phone calls where the brokers and customers had spoken prior to every trade. Not a one.  Obviously the firms and especially the Compliance Directors know that the trades were not authorized.

Churning or excessive trading has been a problem in the brokerage business for at least as long as my tenure in it.   If you are “investing” in a company then you are betting that the share price will move up as the company’s earnings improve. In the normal course it will take until the company’s next quarterly report before you and the market know if you were correct, often longer.

Investors will usually buy a stock and hold it for three or six months or longer. If your portfolio is worth $1 million, then you might turn over (buy and sell) its value two or three times a year. More than that is always suspect.

Traders, on the other hand, buy and sell stocks every day. That is why they gravitate to firms that charge very low commissions per trade. When you see a customer at a full commission firm turning their account over more than once every other month, they are either really foolish or the broker is crooked and taking advantage of them. In the records that I reviewed the customers were paying hundreds of dollars in commissions for each trade.

According to FINRA’s own Brokercheck™ reports there are today ten or so firms in New York, Long Island and New Jersey that have multiple brokers with multiple claims from public customers whose accounts may have been turned over more than 50 times a year, generating millions of dollars in commissions. FINRA tells customers to always look at the Brokercheck™ reports, but apparently its own staff fails to do so.

I see all these scum brokers ripping off unsuspecting customers just by reading the arbitration claims. The Compliance Directors and owners of these small firms certainly see them. The clearing firms are getting paid for every trade so they must see it too. Some of these claims are from 2015 and the brokers are still at their desks churning accounts every day.

Back in the mid-1990s the NY Attorney General published a report on small firms in NYC, Long Island and New Jersey that were churning accounts. The report suggested that several were associated with organized crime. Different firms are involved today, but the ones that allow these brokers to make unauthorized or excessive trades are still stealing money from public customers. They may or may not be “organized” but they are certainly criminals.

What will it take for FINRA to take its head out of the sand and close down these firms and bar these brokers, compliance directors and firm owners from the securities business? FINRA gives a lot of lip service to enforcement. This repugnant conduct calls for action.

(PS- If FINRA enforcement or any state securities administrator would like a list of these miscreant firms and brokers, just let me know). 

If you would like to discuss this or any other related topic, then please book a time with me here

Crowdfunding after ICOBox

Crowdfunding after ICOBox

SEC Complaint: ICOBox and Nikolay Evdokimov

I have been a huge fan of the potential of investment crowdfunding since the SEC’s first experiments in the late 1990’s allowing issuers to use the internet to sell their securities directly to investors.  There was a lot of discussion among issuers, regulators, and the traditional Wall Street firms at the time. However, very few investors were included in those discussions.  There was a clear consensus that investors were entitled to the same “full disclosure” that the purchasers of any new issue would receive. 

The JOBS Act in 2012 codified the use of the internet as a way of offering new issues of securities to the public. Nothing in the Act, or the subsequent regulations suggested that investors who purchased securities on a crowdfunding platform would not be entitled to the same disclosures.  The SEC’s very first enforcement action against an offering done on a crowdfunding platform, SEC. v. Ascenergy, confirmed this. 

The SEC has been doling out sanctions against people associated with the Woodbridge Group of Companies, a high end real estate developer and apparent Ponzi scheme. Woodbridge claimed to have a wealth management company in its group that raised money for mortgages and bridge loans.  The wealth management company hired dozens of highly commissioned salespeople.  Many of these salespeople claimed to operate “financial” firms that looked like legitimate financial firms.  The salespeople were telling investors on their websites that these investments were “safe” and “secure”. 

SEC Complaint: ICOBox and Nikolay Evdokimov

In all, Woodbridge raised more than $1 billion from several thousand individual investors. The SEC noted that one of the salespeople they sanctioned was a self-described “media influencer” who made frequent guest appearances on radio, television and podcasts nationwide touting the safety, security and earning potential of Woodbridge securities to unsuspecting investors. He also touted Woodbridge’s securities on the internet through his own website.

Crowdfunding After ICoBox

The JOBS Act clearly anticipates that securities offerings will be posted on

SEC Complaint: ICOBox and Nikolay Evdokimov

The JOBS Act clearly anticipates that securities offerings will be posted on platforms and websites and investors will be solicited by e-mails. What those postings and e-mails say is regulated. There are things that you can and cannot say to potential investors. There are also things that you must say.

Regulators understand the difference between “posting” and “touting”.  Unfortunately, not everyone in the crowdfunding industry understands this.  Regulators are beginning to take action against the crowdfunding platforms that do not follow the rules. 

This month the securities regulator in Kentucky entered a Cease and Desist Order against a company called Kelcas Corporation which was making false claims about oil wells it was drilling. The Kentucky Order calls out a specific string of e-mails with a representative of the company selling the investment to a potential investor. 

The Order repeatedly notes that the company was using LinkedIn to identify and connect with potential investors. It refers to a post on LinkedIn, specifically seeking investors for an “oil well investment opportunity”. Posts like these are common on LinkedIn and other social media platforms.  No one is suggesting that LinkedIn has any liability for allowing this post or others like it, at least not yet.

Crowdfunding after ICOBox

A day or two after the action in Kentucky against Kelcas, the SEC brought an enforcement action against a crowdfunding platform called ICOBox.  According to the SEC’s complaint, ICOBox raised funds in 2017 to develop a platform for initial coin offerings by selling, in an unregistered offering, roughly $14.6 million of “ICOS” tokens to over 2,000 investors.

The complaint further alleges that ICOBox failed to register as a broker but acted as one by “facilitating” initial coin offerings that raised more than $650 million for about 35 companies that listed their offerings on its platform.

The investors who put up their funds to invest with Woodbridge, Kelcas and ICOBox and the 35 companies listed on ICOBox were sold unregistered securities issued under the same SEC rules. In each case the internet was the primary vehicle by which investors were solicited and the primary vehicle used to provide the fraudulent information to the investors.

What separates LinkedIn from ICOBox or any other website or crowdfunding platform that connects private placements with potential investors? In reality, and as a matter of law, not very much.

It comes down to the SEC’s use of the word “facilitate”.  It does not mean that the facilitator actually sells the securities. Both federal and state statutes govern not just the sale of securities, but specifically how they are offered and to whom they are offered.

In the case of ICOBox the allegations are that the platform was actively involved in marketing of the offerings that they listed.  ICOBox promised to pitch the offerings to their media contacts, develop content for promotional materials and promote the listed companies at conferences.  The SEC included this in the complaint because the SEC thinks these acts constitute “facilitation”.

ICOBox is not the only crowdfunding platform that has helped to promote the offerings it lists. I get e-mails all the time from platforms inviting me to look at specific listings.  A lot of those e-mails and a lot of the offerings they promote make outrageous claims and promises.

The SEC also complained that ICOBox claimed it was “ ensuring the soundness of the business model” of the listed companies. Other crowdfunding platforms claim to “vet” or “investigate” the companies they list.  Many of those platforms have no idea what they are talking about. These platforms are lending their reputation to each offering. That also facilitates the offerings.  

Where does that leave LinkedIn? LinkedIn does not claim to investigate any offerings posted on their site.  It does however sell paid advertising.  Does LinkedIn have a duty to refuse to carry ads for securities offerings that it thinks are fraudulent?  What if LinkedIn ads generated the most sales leads for an offering or if the ads were specifically targeted at people LinkedIn identified as “real estate investors”? 

LinkedIn joined the ban on ICO ads by the major social media platforms in 2018, not because ICO ads caused cancer, but because they were largely fraudulent.  Would LinkedIn refuse to accept an ad from a small real estate syndicator if they had a reasonable belief that the sponsor did not own the property they were selling? 

What would a jury tell the “little old lady” investor who handed a few hundred thousand dollars to a scam like Woodbridge if the investor was introduced to the company on LinkedIn and testified that the company was brought to her attention by a LinkedIn “influencer” whom she followed? 

I read the ICOBox case as a clear warning from the SEC to the crowdfunding platforms to get their act together.  If the platform stays within the regulatory white lines, then regulators should leave it alone.

Unfortunately, it is apparent that many crowdfunding platforms have no idea what the rules require. They are setting themselves up to be defendants in enforcement actions by regulators or civil actions by disgruntled investors. Platforms that do not have a securities lawyer on staff or on retainer will be easy targets.

If you would like to discuss any of this article further with me then please contact me directly here

Crowdfunding After ICOBox

The Troubling Tale of Tether

the troubling tale of tether

I had intended to stop writing about crypto currency.  Despite the massive buzz in 2016 and 2017, crypto has largely shown itself to be irrelevant to any serious discussion about finance or economics.  

The same people who were screaming back then that bitcoins would be trading at $100,000 each are still “certain” that it will happen “soon”.  The promised institutional investors never materialized and probably never will.  The bitcoin ATMs promised for every street corner must still be on order. 

The “un-hackable” online wallets and accounts still get hacked.  People who invested good old fiat currency in more than 1000 “alt-coins” saw those coins disappear into thin air. 

There were and still are people who favor crypto currency because they hate banks. Many have moved on to other battles against the establishment.  Some, having fattened their own wallets as crypto currency consultants, now have very high limit American Express cards. 

There are still people who defend crypto currency despite the fact that there have been so many scams and losses. A common argument is that the losses in crypto are not significant compared to consumer losses caused by banks.  That follows the same logic as the sentence “Ted Bundy killed more than 30 people and I only killed one”.

Perhaps the most disappointed people in the crypto world will be the many who favor crypto currency because of what they see as a lack of transparency and over-concentration in the traditional banking system.  I cannot imagine how they must feel when they realize that the future of crypto currency may be in the hands of Facebook. 

Lawyers no longer have to lecture on the Howey test or lament that they cannot do what they do without more guidance from the government. The best lawyers work with the regulators to “tokenize” this project or that, even when those projects could likely raise money without tokens.

Whatever becomes of the crypto or token market it is a lot cleaner than it was because regulators became more and more active, not because crypto investors have gotten any smarter.  But there is still a lot of crypto-trash to clean up.

The enforcement action of the month involves an action by the New York State Attorney General (NYAG) against iFinex Inc. which operates of the Bitfinex trading platform and Tether Limited, issuer of “Tether” a self–styled crypto currency.  Both, apparently, are controlled by the same people.

Tether bills itself as a “stable coin”.  Its original white paper claimed that “each issued into circulation will be backed in a one to one ratio with the equivalent amount of corresponding fiat currency held in reserves by Hong Kong based Tether Limited.”

On its website the company still claims “Every Tether is always 100% backed by our reserves, which include traditional currency and cash equivalents” and “Every Tether is also 1-to-1 pegged to the dollar, so 1 USD₮ is always valued by Tether Ltd. at 1 USD.”

IFinex Inc. says it issued more than $1 billion worth of Tether.  The New York State Attorney General believes that the reserves may be short by $700 or $800 million or more and wants to see the books. 

People have actually been questioning the accuracy of the reserve figure for some time.  The company promised and then refused to provide any kind of audited financial information.  

The original white paper notes that Tether, Ltd. “as the custodian of the backing asset we are acting as a trusted third party responsible for that asset. This risk is mitigated by a simple implementation that collectively reduces the complexity of conducting both fiat and crypto audits while increasing the security, provability, and transparency of these audits.”

It should be cheap and easy to prepare a certified audit because the company should be able to easily demonstrate how many coins it issued. The reserves are all held at banks and should be easy to prove.  Instead of an audit the company offers a letter from their law firm that says that it looked at some account statements and it seems that there are adequate reserves.  The letter did not satisfy the New York Attorney General.

The idea behind stable coins was intended to fix a problem created by other crypto currency like bitcoins which were susceptible to volatile shifts in their exchange rate with US dollars.  Given that bitcoins were a intended to be “currency”, merchants take on a substantial risk every time transactions were denominated in bitcoins, instead of dollars.  It is a problem best solved by eliminating the bitcoins rather than adding the Tether to the transactions.

Actually the only thing new about stable coins is the name. The financial markets already have a class of securities that are pegged one-to-one to the US dollar and backed by cash or cash equivalents. We call them money market funds. 

Money market funds are registered with the SEC under the Investment Company Act and subject to specific disclosure and custody rules like other mutual funds. Issuing a stable coin on a blockchain is remarkably similar to buying a money market fund from a mutual fund company using a book entry system. Mutual funds are required to provide timely, accurate information to the public.  The management at Tether does not believe that they should be required to do the same.  

Bitfinex and Tether have had problems in the past. In early 2017, Bitfinex accounts were thrown out of Wells Fargo Bank.  At the time, many people in crypto saw this as “retaliation” by a legacy bank against the brave new world of crypto currency. The bank no doubt looked at it as a refusal to assist or participate in an obvious scam. 

In late 2017, Bitfinex announced that hackers had stolen $31 million worth of Tether from its own wallet.  No investigation was ever reported. Management did not even raise a fuss.

Jordan Belfort, the infamous Wolf of Wall Street called Tether a massive scam.  His comment got some press at the time. Most people in crypto just refused to see anything related to crypto as a scam in 2017.  That is largely still true and unfortunate.

IFinex and the other defendants argued that the Judge should refuse to let the NYAG look at their books because they never did any business in the State of New York.  The NYAG has presented the court with evidence that they did. Sooner or later the Judge will question everything the defendants tell her.  

In the meantime, Bitfinex claims to have raised another $1 billion by selling a new crypto currency token called the LEO.  As I said the best securities lawyers are now working with the regulators when they want to issue anything that purports to be a crypto currency.  It does not seem that any regulator, anywhere, reviewed the LEO paperwork.  The NYAG told the court that LEO offering “has every indicia of a securities issuance subject to the Martin Act, and there is reason to believe that the issuance is related to the matters under investigation.”

Sooner or later the Judge will want to see the records that prove that the reserves are indeed in the bank. No one, and I mean no one, should seriously expect that the reserves will be there unless the proceeds from the sale of the LEOs are meant to replenish them.  That will not solve the problem because the people who bought the LEOs were not told the reserves were missing or that their funds would replenish them.

Over the years I have read thousands of prospectuses and other documents that are given to investors when they purchase any new security. Among other things, the documents disclose specific risks that may adversely affect the investors’ returns.  I have seen those “risk factors” go on for pages and pages.

Still there is one “risk factor” disclosed in the original Tether white paper that I cannot recall ever having seen before.  Management at Tether Ltd. deemed it necessary to disclose to the initial buyers of Tether stable coins that: “We could abscond with the reserve assets.” Perhaps they were already thinking about it.

I have written about investment scams before, and as I said, I really do not think crypto is worth writing about. What makes Tether interesting is the potential magnitude of the loss. 

The NYAG says that as much as $850 million may be missing from the reserve account.  After that money was allegedly already gone, the company may have raised another $1 billion with the LEOs.  It is more than possible that a year from now the crypto industry will be staring at a $2 billion loss because the management of Tether just absconded with all of it. 

I actually wonder if the crypto zealots will consider that to be a “significant” loss.  

Want to discuss further? You can contact me directly on Linkedin or right here

 The Troubling Tale of Tether 

Globalization in the Era of Amazon.com

Western capitalists have always had a love/hate relationship with globalization.  When they are exploiting resources in under-developed markets they love it. When capitalists in those markets produce finished goods that are very competitive and sell across borders they hate it. 

Trade routes have been “global” going back into antiquity. They existed and flourished because goods that a merchant could bring back to his home market that were scarce or novel would often sell at a premium.  From the beginning global trade epitomized the capitalist mantra: “buy low, sell high”. 

Carrying gold to far away markets or bringing goods home always entailed a certain amount of risk. Over the centuries commercial banks evolved to handle long distance payment processing. Insurance syndicates evolved to assume the risk of loss during transport.

With every cargo container that is off-loaded in any port, there is a need to settle the bill for those goods.  There is today, a large, interconnected global system of cross-border finance that perpetually creates accounts and instruments that need to be funded and then funds them.  

The international network of commercial and investment banks provide the capital needed for commerce and trade. They do so by identifying, quantifying and syndicating risks. The investors who are ultimately providing the funding for all of these transactions want to eliminate as many risks as they can and be well compensated for the risks that they take. 

Vast sums are continually transferred globally from computer to computer to computer, instantly converting Dollars to Euros to Yen. Information about changing exchange rates and other market information is published constantly and available to all instantaneously. This inexpensive infrastructure allows new capitalists to enter the market.  

Globalization in the last 40 years has moved manufacturing jobs to places where the labor is cheap. Millions of employees in the US and other Western capitalist countries have lost their jobs because of this. Millions of people elsewhere have been raised out of poverty in the past few decades because they will work for a few dollars per day and that is enough to sustain their families. 

In our modern, manufacturing era globalization will always be about cheaper labor, cheaper overhead and cheaper taxes.  When a manufacturer in the Rust Belt packs up and begins to manufacture in Mexico or the Philippines it is about the bottom line and little else. The capitalist view will always be to lower costs, increase margins and provide more profits for the shareholders.

Global shipping has never been quicker, safer or cheaper.  The development of overnight package delivery in the 1970s enabled the “make it here, sell it there” economy to become dominant. The factory to consumer supply chain has never been more efficient than it is today. 

We live in a truly global marketplace.  People all over the world, can and do, directly communicate with each other.  Social media has reduced the cost of global advertising and made it available to even the smallest businesses everywhere. 

A great many of the goods bought by US consumers are manufactured elsewhere. Consumers often do not know where the goods they purchase are manufactured and rarely care.  American consumers should want to purchase whatever they need at the best price possible and indeed most strive to do so.   

Global advertising is cheap; global shipping is cheap and efficient.  Economics teaches that all of this efficiency should bring prices down.  So why aren’t goods sold on-line to US consumers much cheaper?  How much should a US based on-line retailer be able to mark-up the price of goods manufactured elsewhere? 

Let’s assume that a pair of woman’s shoes is manufactured in a country where labor, materials and overhead are cheap. The manufacturer is focused on manufacturing shoes for export to the US for sale to US consumers. This particular pair of shoes is sold by the manufacturer for $15 which includes the manufacturer’s profit. 

In the traditional pricing model, the $15 cost would be marked-up several times by two or three layers of middlemen, aggregators and handlers.  Using “keystone” pricing the retailer might buy the shoes at wholesale price of $40 and sell them to the public for $80. The gross profit covered the retailer’s cost of rent, overhead and employees at its storefront.

Amazon eliminates all that brick and motor expense.  Consequently, people expect to pay less on Amazon than comparable goods at the mall.  But how much less should they pay?  Amazon passes some of that saving on to the consumers in the form of lower prices but not all of it, which is why Amazon makes so much money. 

As the internet makes it easier and easier to purchase goods sourced in other countries and have those goods delivered to your home in the US, the increased competition for each purchase should also drive prices down further. We may be at the cusp of a truly global retail market, the ramifications of which may be disruptive in ways some people will find to be disturbing.

The shoe manufacturer was content with a $15 sales price because it was profitable.  Assume that Amazon is selling the shoes for $55 (30% less than retail at the mall.) The manufacturer can use the internet to sell the same shoes, “factory direct to consumers” in the US for a retail price of $30 where Amazon cannot compete.   

Each unit will be generating substantially more profit to the manufacturer than before. The significantly lower price should result in the sale of many more units. You do not need to be an economist or MBA to see where that is likely to lead.  

That same manufacturer can also aggregate with other manufacturers and offer a website similar to Amazon.  The site might aggregate 10’s of thousands of SKUs of goods that are the same or similar to those already being sold on Amazon.

The logistics are the same. The goods will go to distribution centers in the US where they will be sorted, stored and shipped to consumers.  It is a model Amazon perfected that others can and will adopt. 

Consumers will browse the website, pay by credit card and the goods will be delivered the next day.  These are the same goods from the same factories at much less than the Amazon price because the company infrastructure runs at a fraction of the US cost and because the middleman mark-ups have been eliminated. 

If there are dozens of these cut-rate Amazons available to consumers, they will compare prices and buy some items at one site and some at other sites.  Inevitably, there will be an app that will compare the prices for you, put the best price on top and allow you to buy it with the same click of the button.    Therefore, instead of a delivery from Amazon you might get deliveries from several sites.

As this marketplace develops and other manufacturers and product aggregators compete with Amazon, the price US consumers pay for these goods should come down substantially. This should be good news for US consumers, but perhaps not.

The lower prices and convenience of home delivery offered by Amazon has begun the slow death knell of the local malls and main street storefronts. The exponential growth in online shopping spurred by the cut-rate competitors in the market should hasten the end of brick and mortar retail altogether.  That will put a lot of people out of work.  

Amazon is located in Seattle and employs over 600,000 people, most of who are in the US. Most of those salaries and operational expenses are spent in the US.  If the next generation of Amazon’s competitors operates from Manila, Mumbai or Capetown,that giant sucking sound that you hear will be trillions of dollars leaving the US economy.

I noted in an article I wrote a few weeks back http://laweconomicscapital.com/2019/05/the-job-market-at-mid-century/that new technology is often deflationary because it brings efficiency that lowers costs.  Amazon will fill its warehouses with robots and its trucks will deliver parcels without drivers. Many companies will follow suit.

Tens of millions of jobs will be lost to robotics at the same time globalization will move a lot more jobs out of the US. The salaries earned in other countries represent a lot of the money that US consumers would have spent if they had earned it. This confluence of two broad and sweeping deflationary trends is already evident and potentially very disruptive.

It means that if you buy a home today it may be worth a lot less in 30 years. It means that if you own a shopping mall, it will probably go bankrupt as many already have done. It means that debtors (including the US government) will be paying off their debts with dollars that are more valuable and harder to acquire than the ones they borrowed. It means that the price of gold should be substantially less than it is today.  All of these will disrupt the lives and businesses of a great many people.

At its core, globalization is about competition. All capitalists know that competition is part of the game that keeps everyone on their toes.  Competition and globalization have winners and losers and it is only the losers who hate them.

Investment Crowdfunding Can Offer Better Investments Than Stockbrokers

Someone in the crowdfunding industry should put that sentence on a coffee mug and send me one.

I have been writing about and working in investment crowdfunding for more than 3 years.  I find it interesting to watch this fledgling industry mature.  It is certainly attracting more and more new money every year and is past the point where it can be ignored by any company in search of investors.

I have looked at a great many offerings on a great many crowdfunding platforms.  I read a lot to keep abreast of new offerings and industry developments. I take the time for conversations with platform owners and their lawyers and several of the better investment crowdfunding marketing executives.

I also speak with a lot of companies who are considering investment crowdfunding to raise capital.  Any company that would raise capital in this new DIY crowdfunding marketplace wants to know if it spends the money to list its offering on a crowdfunding platform will enough investors show up and invest?  From the company’s perspective, little else really matters.

The JOBS Act was intended to be a different approach for corporate finance using the internet instead of a stockbroker to reach potential investors. The internet allows companies to reach a lot of prospective investors, very cheaply. Success or failure in investment crowdfunding is more about what you have to say to those potential investors than anything else.  

Selling securities issued by your company to investors is not the same as selling your product or service to potential customers. Investors will have different expectations and will respond to different things.  

People who sell securities for a living will tell you that any new issue of a stock or bond needs two things: good numbers and a good story. Investors want a return on their investment. 

So the best stories are always about how much money the investors will make and what the company will do to provide that return.   

There are two distinct branches of investment crowdfunding. First, there are the private placements sold under Reg. D to institutions and other larger, accredited investors.  This marketplace is healthy and growing rapidly.  Professional money-raisers have caught on that they can use investment crowdfunding, to substantially reduce the cost of capital and use that savings to enhance investor returns.

Reg. D offerings have been sold through stockbrokerage firms since the 1980s.  Most are sold to institutional investors.  Some are sold to individual, accredited investors. Minimum investments of $50-$100K or more per retail investor are common. 

Many of the retail Reg. D offerings will fund some type of real estate (construction or purchase), energy (oil, gas and alternative energy) or entertainment (films, music, and games) project. There are professional sponsors; people who package and syndicate these projects, often being paid to manage the business on behalf of the investors after the funding.

The costs of selling a Reg. D offering through a stockbrokerage firm, including commissions, run 12%-15% of the funds raised. That would be up to $1.5 million for each $10 million raised.. Most Reg. D offerings sold through brokerage firms just raise an additional $1.5 million and dilute the investors’ return.  Using investment crowdfunding a company can raise that same $10 million and not spend more than $100,000 in legal and marketing costs and frequently a lot less. 

The Reg. D crowdfunding platforms compete with stock brokerage firms for projects to fund and for investors to fund them.  The same institutions and accredited investors who have been purchasing Reg. D offerings from their stockbrokerage firm for years are catching on to the fact that they can get good offerings and better yields without the need to pay the very high commission.

The other branch of investment crowdfunding is the Reg. CF or regulation crowdfunding. This allows offerings which can help a company raise up to $1 million from smaller, less experienced investors. Reg. CF allows smaller businesses to sell small amounts of debt or equity to small investors.

The Reg. CF market was the SEC’s gift to Main Street American small businesses. There are always a great many small companies that could benefit from a capital infusion of a lot less than $1 million, the Reg. CF upper limit.

To put down a layer of investor protection the SEC required that these portals that are dealing with small investors become members of FINRA. FINRA dutifully set up a crowdfunding portal registration system and has audit and enforcement mechanisms in place.

As a reward for joining FINRA, the SEC allows Reg. CF portals to be compensated by taking a percentage of the amount the company raises which the Reg. D platforms cannot. Several of the portals also take a carried interest in every company in case the company is eventually re-financed or sold.

The SEC looks at Reg. CF as a tool of corporate finance for small business. It provides a mechanism where a great many small businesses should have access to a pool of capital every year, potentially a very large pool. It provides for a market structure for these small offerings and incentivizes the portals help raise that capital. All in all, not too bad for a a government regulation.

Sadly, the Reg. CF industry is still foundering. There are still fewer than 40 registered portals operating and several have closed up shop.  So why are these portals not successful? Because the people who operate them are not listing better investments than stockbrokerage firms.

When I first looked at investment crowdfunding there were a lot of people proclaiming that it would “democratize” capital raising.  They believed that the crowd of investors could discern good investments from bad ones and that the crowd would educate each other as to the pros and cons of each.  That was never true.

The Reg. CF portal websites are full of bad information and consequently, bad investments.   Comments about any offering that lists on a portal, if any, are always overwhelmingly positive.  Investors will not do any due diligence or other investigation of the company because they do not know how.

The Reg. CF portals compete with banks, which are the primary source of funding for small business.  Here too, a Reg. CF portal can have a competitive edge.  When you borrow from a bank you do so on the bank’s terms. On a Reg. CF platform you can set the terms of your financing.  Done correctly, you can get the capital infusion you want for your company without giving up too much equity or pledging your first-born child to the lender.

What the portals should be offering investors are bank-like products that stress the ROI that investors reasonably might expect to receive.  The portals should be telling investors how each company mitigated the risks that the investors might face. Instead, too many portals and too many people in the Reg. CF marketplace are still selling fairy tales and lies.

The big lie, of course, is that by buying equity in any of these companies an investor might hit the proverbial home run.  Suggesting that investors can or should think of themselves as VCs is patently absurd for any company that I have seen on a Reg.CF portal.  I always tell people who ask that if even one valuation on a Reg. CF portal seems very outlandish, then they likely cannot trust that the portal operator knows what they are doing. I would question anything told to investors by any company that lists on that portal.

If a company wants to raise $1 million on a Reg. CF portal, it might end up with 2000 distinct investors each investing an average of $500.  To secure subscriptions from 2000 people, the company might need to put on a marketing campaign that will put its offering in front of hundreds of thousands of investors if not more.  Success or failure of your fundraising campaign will depend on what you say to these people. 

The cost of the marketing campaign is the major upfront cost of the offering. The good news is that marketing seems to be more data- driven and more efficient as time has gone by reducing the cost of the marketing.

Sooner or later these  Reg. CF portals will wise up to the idea that they cannot succeed unless the investors can make money. They, too, could offer better investments than stockbrokers, but do not seem to have bought int the idea.    

Until that happens, I expect more portals to fail and close up shop and the SEC’s “gift” to small business to remain largely unwrapped.

Will Artificial Intelligence Pick Stocks?

I admit that I have always been a fan of science fiction.  I read most of the Sci-fi classics in high school.  When I was a senior in college I created and taught an accredited course called Science Fiction as a Literary Genre

Much of science fiction imagines or predicts the future.  The stories were often set in the future and gave us a sense of how we would get there and what it would be like.  Sometimes that future would be logical and orderly, other times dark or chaotic.

The idea of artificial intelligence (AI) as science fiction dates at least to Capek’s R.U.R (Rossman’s Universal Robots) (1920). Frankenstein’s monster had a human brain. Capek’s robots were machines that could think.  By 1942, Isaac Asimov introduced his “Three Laws of Robotics” based on the premise that if the robots got too intelligent they might do harm to  humans.  When HAL was introduced to a mass audience (1968) everyone seemed to accept that robots would eventually be smarter than people. 

The development of AI is certainly attracting a significant amount of funding and attention. I am starting to see references to it in advertising for various products and services.  There are certainly ethical issues to be explored, but I am a pragmatist.   AI is “real” enough today that I wanted to take it for a theoretical spin.

My first thought was to use AI to predict the future better than humans and to make money doing it. I wanted to consider if AI will eventually be able to pick “winners” in the stock market. 

Predicting the future accurately is something to which we apply human intelligence every day.  Capek predicted “thinking” machines 100 years ago.  Dick Tracy had a two-way radio in his wrist watch in the 1940s.  Anyone who sells anything is trying to predict how consumers will react to the price and advertising.

Humans make predictions using these two broad steps. First we collect and sort through the data that we believe to be relevant, next we analyze that data based upon assumptions often based upon our prior experiences.

Every day at racetracks the odds are fixed in such a way as to allow the track to take its cut and then have enough collected from bets on the horses that did not win to pay off the winners.  The odds and thus the payout are really set by the crowd placing bets. 

Every day at every racetrack there are people reading tout sheets, looking at track conditions, the horse’s and jockey’s prior races and gathering information from track insiders trying to do better by betting smarter.  Each will filter the data they collect using assumptions that come from their individual experiences.

There is a logical argument that says that these racetrack “handicappers” are trying to be better informed and smarter than the crowd, so they should be able to do better than the crowd and pick winners more often. Those who cannot do better will be weeded out.  

The same logic suggests that AI should surpass human intellectual ability if for no other reason than through trial and error it will continue to develop the way in which it collects data and the way it analyzes that data until it can do it better than humans.  It will do so because that is the goal we will set for it. 

A stock market outcome is far more logical and data driven than a horse race. People buy shares in a given company when they believe the price of the shares will go up.  Conversely, people will sell shares of stock when they think the price will rise no further. 

For every order to buy the stock there is someone entering an order to sell the same shares at the same price. Presumably many intelligent humans are looking at the same data and are coming to the opposite conclusion. That should set a pretty low bar for artificial intelligence.     

There have been computerized stock and commodity trading systems around for years. Most were a scam. They would create a “track record” by back testing their software.  These systems never took in a lot of data.  Traders are concerned with trends in a stock’s price and the volume rather than the company’s income or profits and assets and liabilities.  

The long term investors like the large institutions and small middle class households do care about the company’s financial health and that of its customers and competitors.  That requires a lot more data and a lot more analysis.  

In the US there are mandatory disclosures about financial and other information posted publicly about each company. In theory, everyone can look at the same data.  Analysts take that data and use it to predict the future performance of a company and often, its stock price as well.  Even those analysts who do a mediocre job are well paid.

Could AI do better? 

In theory, AI should be able to collect the data and do the analysis to make the comparisons that will tell it to buy the stock of Company A and not the stock of Company B.  If AI can demonstrate that it can do better than humans, then more and more humans will make a decision to let their money be managed by AI.  Eventually AI will decide which data to analyze and how to analyze it to get the best, consistent results.  The best AI stock pickers will rise to the top of the heap and the rest will be left by the wayside.

At some “tipping” point a significant amount of money will be managed by AI. When this occurs and AI decides to buy stock in Company A, the price of the stock will appreciate in response to the buy order alone.  It will be a self-fulfilling prophesy.  Is that stock-picking heaven? 

But if the AI says the share price of Company A will go higher, who is going to sell into this new demand?    A scarcity of sellers will certainly help the price to run up.  But it will also lead to market dysfunction.   If the AI starts to sell off a large position, there may not be enough buyers to prevent the price of those shares from dropping sharply.

For the stock market to fulfill its primary function to facilitate trading it needs to be a liquid market; there must be a lot of participants who are willing to buy and sell at every price level.  The market needs the smart MBAs who work for the institutions that can pay for their services. It also needs the mom and pop investors who get their “tips” from a Jim Cramer.  

For the market to work efficiently every time, someone’s prediction about the future price of a stock that they buy or sell has to be wrong.  Sooner or later I suspect that AI will realize that problem and act accordingly.  I predict that it will act to change the market rather than its methods of evaluating the companies that trade on it.

This is how I predict AI will approach the problem of its own presence in the market where it makes better investment decisions than any human competitor:

Scenario No. 1- AI realizes that its success may cause the trading to become dysfunctional. It concludes that it would be better to buy shares in companies it would want to hold for the long term.  As new money enters the market, if managed by AI, the AI will eventually use that money to buy larger and larger stakes in those companies. Eventually it may purchase enough shares where it can elect the Board of Directors and control company operations.  It could very efficiently direct business relationships between the portfolio companies for their mutual benefit. It could even direct campaign contributions from portfolio companies eventually freeing itself and those companies from many regulations. 

                        –or–

Scenario No. 2- AI realizes that its best long term strategy is to invest where no one else wants to invest. There are currently many places around the globe where an investment of US dollars buys a lot more plant, equipment and labor than anywhere in the US.  The AI might conclude that its best investment opportunities are in underfunded markets where labor is cheap and investment funds expensive.  Funneling large amounts of money into these less developed markets might make a lot of sense to an artificial intelligence that is looking only at the bottom line, not preconceived ideas about race or nationality. 

There are already investment platforms that claim to incorporate AI into their services. I do not want to judge any of them because I do not think any of them are really ready to operate effectively.  My one hope is that as they continue to evolve they do not get too smart for their own good and for ours.

Two Years of Crypto Market Memories

I first looked at bitcoins in the Spring of 2017 because a friend asked me for my thoughts.  The price of a single bitcoin had run up sharply and the ICO craze was proceeding at full speed.   Up until that point I knew very little about either blockchain or cryptocurrency. 

I spoke with people who were actually developing blockchain projects for the big tech companies. I read a lot of articles which they thought would help me and a lot of other articles that I found through my own research. I spoke with traders, regulators, and with a lot of people who thought that they had cryptocurrency all sorted out.  There seemed to be a wide spectrum of thought about cryptocurrency, how it might be regulated (if at all) and whether it would augment or supplant the established financial order.  

I concluded that the bitcoin market was in a classic bubble, the price rising only because of hype, and the new money that hype always attracts. I was not alone in that opinion.  Still some intelligent sounding people were making an argument for continued price appreciation to ridiculous levels.  And that was what a lot of people wanted to hear. 

I wrote an article about my research, my thoughts and predictions for bitcoins.   http://laweconomicscapital.com/2017/06/the-bitcoin-bubble/   The article got the attention of a lot of people who were also trying to understand cryptocurrency and ICOs.

The article ends with an invitation to the securities lawyers who were writing the disclosure documents for ICOs to contact me for a professional conversation.  I would have had difficulty preparing those documents.  I confessed my professional curiosity to any and all that might satisfy it. 

A lot of lawyers and other professionals did contact me.  Many of the lawyers were doing what lawyers are supposed to do, marshaling the facts and applying the law as they saw it.  But it was clear that there was not a unified position as to what the facts regarding any cryptocurrency actually were. 

Some lawyers approached ICOs as if they were issuing securities and some as if they were issuing anything but securities.  Before the SEC issued its DAO Report, (July 2017) I was of the mind that a token offering might be structured so as not to be a security. Once the DAO Report was issued, it was clear to me that the SEC saw tokens as securities and would look at an ICO as the sale of securities with all that entailed.

The DAO Report led to a robust discussion, on line and off, with those same lawyers and professionals and more.  The discussion became somewhat convoluted as many non-lawyers often in other countries felt comfortable discussing the finer points of US securities law. A great many of those commentators had interesting takes on the Howey decision that no competent US lawyer would ever present to a judge.  Many of those “experts” just ignored the dozens of other cases cited by the SEC in the DAO Report and many other cases that should have been germane to the discussion. 

There was an interesting undercurrent of lawlessness in the cryptocurrency world.  It was impossible to search for articles about cryptocurrency without coming across many quoting regulators around the world who were reporting cases of money laundering and fraud.  That has not changed.  Fans of cryptocurrency were often happy to ignore these transgressions even though it was obvious that regulators would not.

By now I have read several hundred white papers for ICOs. Some were written by lawyers; other white papers were written by either monkeys or idiots. Some of the latter were using templates because the thought of actually hiring a lawyer to prepare documents for a multi-million dollar financing did not make sense to them.

These white papers are supposed to tell potential investors what they needed to know so they could make an informed decision whether or not to send their money.  That was rarely the case. I recall one white paper where the principals of the firm refused to disclose their last names. 

People were claiming to have advanced degrees they never completed and to have worked at firms where they were never employed.   Quite often, outrageous claims were made about the size of the market to be served and the profits to be made.  If these same founders had been sued by investors in a prior company for fraud, investors in this new company would never hear about it. 

I had my bio and picture hijacked and included in a white paper. So did many other people.  There was no way for any investors to know if what they were being told was true.  Very often, it wasn’t.

These ICOs were being sold by networks of unregulated, self-validating crypto “experts and advisors”.  They traveled in packs to frequent crypto conferences around the world.  They cross-validated each other in articles on websites that had popped up and which reached many thousands of people around the world. Some crypto “experts” developed 6 and 7 figure lists of social media followers.

An issuer could engage any number of these crypto gurus and just pay them in the tokens to be issued.   The “advisors” would notify their followers about the token sale and urge those followers to cough up real fiat money to buy them.  Along the way the advisors were selling tokens that they had gotten for nothing in exchange for their sales efforts.  

Several otherwise intelligent people tried to convince me that this was not just a dressed up pump and dump scheme playing out over and over again. The results were certainly the same because most people who bought the tokens in these ICOs were left holding the bag.

A significant number of the ICOs were out and out scams which, sadly, many people refused to see.  Fifty million dollars raised here; one hundred million there, all going down the toilet of financial history.  It got so bad that several of the large social media platforms banned ads for ICOs. Several countries banned the sale of ICOs altogether.

Many of the ICOs claimed that they were not selling securities but “utility” tokens instead.  That died down significantly after the SEC published its Cease and Desist v. Munchee toward the end of 2017.  http://laweconomicscapital.com/2017/12/sec-v-munchee-will-the-crypto-currency-community-listen/

Along the way some really bright lawyers thought that ICO offerings might be structured as SAFTS. I saw it as an attempt to solve a valuation problem by promising to set the value down the road.  They were touted as making the ICO market less risky. To me they looked to be a riskier “derivative” and began to write an article that said so. But I never finished that article. 

In short order one of the NYC laws schools published their research and pulled back the curtain on SAFTS. After that most securities lawyers stopped talking about them.  SAFTS were a financial flash in the pan and not a very good one at that.   

I also had conversations with a number of groups that wanted to develop a realistic scheme to regulate ICOs and cryptocurrency trading across borders.  Each failed because most of the participants had never worked at or had dealt with any market regulator.  I wrote e-mail after e-mail trying to explain that transparency is only useful if everyone in the market was honest and that without significant penalties for dishonesty no regulatory scheme can work.  All that fell on deaf ears and each of those groups disbanded.

I also spoke with several people who wanted to create trading platforms for cryptocurrency but most of whom had no idea what a trading platform does or how it operates.  I would ask questions like: What would be the minimum standards for listing on your trading platform?  It was apparent that they had not even worked out that simple, basic and necessary issue. When I asked about market-makers and liquidity I got a series of blank stares.

Today, at least in the US, most lawyers have accepted the fact that any ICO sold here will be the issuance of a security and that US securities laws will have to be followed.  

To sell securities to investors in the US the securities must be registered with the SEC or specifically exempt from the registration requirement.  Registration is an expensive and often lengthy process. By mid-to-late 2017 a number of lawyers were reporting that they were filing registration statements for ICO offerings with the SEC. Apparently, many never got approved.

Securities offerings in the US do not have to be registered if they comply with regulations which provide guidelines for un-registered offerings. Un-registered offerings are generally sold only to institutions and wealthier investors who have no real interest in owning crypto currency.  These unregistered securities are not intended to be traded.

More than one lawyer has reminded me in the last few months that unregistered securities can be transferred after 12 months if the company is putting financial information into the market or if the tokens are listed on a crypto exchange outside the US.  I am not certain that they have thought that idea through.

Investors in an unregistered offering in the US are usually required to attest to the fact that they are making a long term investment and not intending re-sale.  That is why most companies in the US that sell unregistered securities provide those investors with income from dividends or interest.   So if you are selling unregistered securities with the promise of liquidity and re-sale, you are likely to confuse everyone, except perhaps the judge who will ultimately set you straight.

Companies from around the world have always wanted to tap the US for capital investment.  It is often a difficult process for any company and especially for start-ups and smaller companies.  In the ICO market, it became apparent that political borders and local regulations were not considered to be important by the issuers.

Investors who should have seen the shoddy disclosures as a problem seemed happy to invest, convincing themselves that if the offering “complied” with the laws of the country of origin, then protections afforded to them by US law were unnecessary.   A lot of people who were touting blockchain because it was supposed to promote transparency were willing to invest in crypto offerings that provided none. 

Today, people are spending money to “tokenize” real estate, fine art and many other tangible items as if there was a market for those tokens or if it made any sense to create one.  If I can buy 1/10,000,000 of a Picasso, do I get to hang it over my fireplace for 20 minutes? 

If you are selling shares in a building that you call “tokens” and tell me that you believe that all of the laws pertaining to real estate syndications would not apply, I would suggest that you really need to re-think what you are doing.  There are established rules for selling “asset backed” securities in the US.  Not surprisingly, most of the articles I read about “tokenizing” this or that fail to mention those rules and most of the people with who I am now speaking who are preparing to “tokenize” this or that offerings do not seem to be considering them.

Back in 2017 a lot of regulators told me that the ICO boom came upon them suddenly and that they did not have the staff or budget to deal with them.  They do now and there is every indication that the leniency some regulators have exhibited is about to come to a screaming halt.  

More On Internet Stock Manipulations; SEC v. Lebed (2000), revisited


I was reminded recently of the story of Jonathan Lebed, a 14 year old kid from New Jersey who was investigated by the SEC for stock manipulation using the internet back in 2000.  This case was a big deal at the time, garnishing a segment on 60 Minutes and some interesting discussions in the financial and legal press.

Even though he was underage, with the help of his parents, Lebed had managed to open an account at one or two of the discount brokerage firms. He was apparently trading his accounts in low price stocks when the SEC came knocking on his parents’ door. 

It seems that in the course of trading Lebed liked to post positive comments about what he was buying on various websites, bulletin boards and chat rooms where people who might be interested in purchasing these stocks would see them.  This was in 2000 when the chat rooms were not sophisticated and the web reached a fraction of the people it reaches today. 

Lebed would buy a low priced stock and then say something nice about the company in a message that he posted in a chat room. Using multiple e-mail addresses he might get that same, positive message posted in 200 chat rooms.  Some of the people who saw his posts would re-post them again. 

Lebed knew that his simple postings would create significant interest in these shares and that the price would move up.  He commented that posting the messages with key words in all capital letters would actually get even better responses. 

Bringing a lot of attention to a more obscure, low priced stock can, indeed, lift the price. The SEC called it an intentional market manipulation.  Lebed said that he was only doing what the research analysts at the big firms did, publish their opinions about companies whose share price they wanted to go up. 

Lebed did all this out in the open. Several of his classmates and school teachers followed his leads and invested with him. They were willing to take a chance of doubling their money if the share price of one of these companies went from $.30 to $.60. 

Many of these investing neophytes did understand the positive effect that Lebed’s postings and his quasi investor relations campaigns had on these stocks.  They wanted to buy before he posted and get out as the buyers reacting to his posts pushed up the price.  

Lebed was not the only person or group at that time that was using the internet to enhance the price of shares of small public companies.  But he demonstrated that in the year 2000 the power of the internet to sell investments directly to investors was underrated.  In the almost 20 years since, the use of the internet to sell almost anything, including investments, has become much more powerful and pervasive. 

In the regulated financial markets the dissemination of information is encouraged, but it is also controlled.  Regulations require that information be accurate and complete. Public companies are required to report specific information about their business, to present that information in a specific manner and to release that information on a regulated schedule. 

For a licensed stock broker or investment advisor every e-mail, tweet, posting, comment and utterance about any investment is subject to the scrutiny of his/her employer and by regulators. The SEC depends on the market professionals and market participants to play by the rules. There are significant penalties for non-compliance. 

But Lebed was not a market professional. He was an outlier. He was an independent investor, not a licensed participant in the marketplace.  In the end the SEC let Lebed keep most of the money that he made from his trading as long as he promised to stop.  

At the time, no one really questioned the SEC’s jurisdiction over Lebed or what he was doing. Lebed was a US citizen, operating out of New Jersey. His posts were about US companies whose shares traded in the US markets. Many of his posts were made through a US based internet company (Yahoo Finance). 

In the ensuing 20 years, social media and on line platforms, publications and unregulated “experts” have demonstrated that they can easily sell investments directly on line to millions of investors.  Moreover they have demonstrated that they can disseminate information about public companies and new issues without regard to the truth of the information.  And they can do so without regard for regulations or national borders.

In the “direct to investors” investment world, social media “followers” has replaced “assets under management” as a measure of how many investors’ dollars a person can bring to an investment or new offering.  And you can buy people who have a lot of followers.

If I wanted to hype a stock, either a new issue or one that is already trading, I can make a financial arrangement with any number of independent “experts” who have a lot of social media “followers”.  Some may write articles for financial publications, some write books and blogs and many can be found going from conference to conference and podcast to podcast. 

Any financial “expert” can purchase the right to give the keynote speech at a conference and purchase any number of other speaking slots and sponsorships as well.   Anyone can buy interviews on financial websites, blogs and podcasts or pay for the right to create and distribute positive content on these sites.   

If you look at the numbers you can get an idea of how this works.  I can hire a financial “expert” to tout any stock that I wish. The “expert” will send his/her followers a series of e-mails, appear at a series of conferences and write a series of articles about that company. An expert with 1 million followers might reach 2 million other investors who see re-prints and references to it.

If only 10,000 investors of those followers invest an average of $1000 a new issuer can raise $10,000,000. That much new money coming into a thin trading market can often raise the trading price of the shares of a smaller company.  

There is no limit to the number of experts I can hire or the size of the e-mail lists I purchase for their use to augment their own list of followers.  If I hire multiple experts to hype the same stock, other experts who have not been paid may mention the company independently.  And before you say that this type of scheme using paid experts to hype the stock may be questionable under US law, who said that US law applied?   

If you solicit investors in the US for a new issue the offering is subject to US law.  That would require full and fair disclosure to investors in the US and provide for government penalties for non-disclosure.  But what if you donot make the necessary disclosures and you only solicit investors in other countries? 

The capital markets are regulated country to country.  Each country has its own rules which apply to financial transactions involving its citizens and issuers.  Each has rules governing transactions executed on the exchanges domiciled in their country. The laws of the country where the issuer is domiciled, the exchange is located and where the investors reside may all apply to a single transaction.  An overriding question with the direct to investor market is which country has jurisdiction and over what actions and activities.

If an article about a company’s share price or prospects from a European website gets republished or re-distributed in the US is the author subject to US law? What if the author knew the information in the article was false; do US investors have any recourse?  Does it matter if the author got a royalty for the re-print?

Would the answer be different if the false information originated with just one shareholder who bought a large block of shares cheap and now wants to pump up the price?  Does it matter if that person is in a country other than where the shares trade or the articles originate? 

I recall that when the Lebed case was discussed a lot of people thought that the internet would change and globalize the capital markets. It clearly has.  

I think that there is still a lot of discussion that needs to be had and a lot of questions that need to be asked and answered.  In the meantime, it should be obvious that the current international regulatory scheme does not overlap as well as it could.   

The current and expanding global reach of social media create opportunities and but also highlights problems.  The flow of capital and information continue to globalize. At the same time I am certain that it would is a lot easier today for a 14 year old to manage a single successful, global stock manipulation.