Start-ups, are you buying investors online?

Start-ups, are you buying investors

I have been writing a lot about crowdfunding lately and speaking with other people in the crowdfunding industry.  From our conversations, it is obvious that most do not share my perspective on the entire business.  I see crowdfunding as continuing an evolution of the capital markets already in progress when I started on Wall Street in 1975.

In 1975 the stockbroker was king. People did not buy investments, I was told early on, stockbrokers sell investments.  Good stockbrokers, especially those on their way up, aggressively sold stocks. The sales pitch was often about one particular stock, frequently supported by a report prepared by research analysts.  Analysts were “ranked” every year and firms paid the “1st, 2nd and 3rd All-American teams”, handsomely.

While there were certainly stockbrokers who met their clients for lunch or at the club for golf who came back to the office with orders in hand, much of the “selling” was done over the telephone.  Young brokers were encouraged to stay into the evening and engage in a ritual known as cold calling.

During my training, I spent an evening with a single page from the NYC phone directory, script in hand, dialing for dollars. Most people had those old, heavy rotary phones.  I swear, I could hear the receiver sucking in air as it was being slammed down onto its cradle.

What cold calling teaches us is that some percentage of the calls you make will respond favorably, and buy what you are selling.  If you want to make more sales, you need to make more calls.

I mention this only as a backdrop.  This “sell-side” focus has shifted, significantly. Today, a great many retail stockbrokerage customers, make their own decisions about what to buy and what to sell in their stock or retirement accounts.  These customers are enticed by lower costs. They respond to advertising, and they will rely upon information delivered to them online.  Without these investors, crowdfunding could not exist. 

If I were teaching Law and Economics today, I would look back to 1975 and say that is where it all started.  Changes in the law, a new one enacted and an old one discarded, were the catalysts for enormous changes in the way the capital markets operate. The market responded to those changes by bringing in millions of new people who were affirmatively looking to invest and who brought trillions of new dollars with them.   

ERISA, enacted in 1974 created the tax-deferred Individual retirement account (IRA).  It was intended to incentivize millions of small savers to put their money into a bank or the stock market and to leave it there for the long term. 

In response to this new market of small investors who might start small and add a few thousand dollars every year, John Bogle opened the Vanguard Mutual Funds. Mutual funds provided a simple way for small investors to participate in the market.

Mutual funds had been around for a long time by then.  They were commissioned products sold by many stockbrokers.  And while an IRA account was the perfect vessel for mutual funds, what I would stress to my students would be the shift in the way mutual funds were advertised and sold directly to investors.

Vanguard and the other mutual funds actively advertised for investors seeking to make direct purchases.  Instead of dealing with a stockbroker who would call whenever they had, something that they wanted you to buy or sell, with a mutual fund, an investor could just put their money into a fund and the fund will do it all for you.  Somebody called it “passive investing”. Instead of touting the skill of their analysts to pick winners, these mutual funds sold convenience.

In 1975, both the State of New York and the City of New York were functionally bankrupt. The stock market had tanked and lending had ground to a halt.  The economy was in the midst of abnormal inflation.  People responded to the idea that they take some risk to grow their retirement funds in the stock market rather than save it in a bank so they could keep up with inflation.

Also in 1975, the New York Stock Exchange repealed its long-standing rule that had fixed the commissions that NYSE Members charged for each trade.  Mainframe computers were being installed up and down Wall Street. The costs of everything from executing trades to sending out confirmations and monthly statements were going down.

When commissions were fixed, the customer was charged a commission that reflected both the costs of execution and the “other” services that the brokerage firm provided, most notably, research that would tell the customers what to buy and when to sell. As commission costs became a source of competition, Charles Schwab and others were already talking about “unbundling” the cost of executing a trade from the research component that had always come with it. 

Schwab and its “discount” competitors demonstrated that a great many investors were happy to sit at home and make decisions on what to buy and what to sell, based only on what they read themselves. And while Schwab and other discount brokers now offer research reports, very few customers of discount firms are exposed to the type of research available to institutions. 

The stockbrokers’ response to this unbundling can be encapsulated in their advertising slogans of the time: “Thank you, Paine Webber”; “When EF Hutton talks, people listen” and my personal favorite: “Smith Barney makes its money the old-fashioned way, they earn it”.  The mainstream industry doubleddown; they were selling advice and they were proud of it. 

Without good advertising and a lot of it, the full-service stockbrokers, the discount firms like Schwab, and the entire mutual fund industry would not have grown into the behemoths that they are today.  The result of all of that advertising is a market full of millions of investors who are comfortable making their own investment decisions.  This includes a significant number of baby boomers who still represent a very large pool of capital that is available for investment. 

What does this have to do with crowdfunding in 2021?

If I have learned anything from watching the growth and evolution of this market since 1975, the one thing that stands out is that for companies that are selling investments, good advertising works. There is a cost, certainly, of acquiring investors for any given offering, but if you pay that cost, you will get enough investors to pony up the investment that you seek.

The best people in marketing who are working in crowdfunding understand that it is very much a “numbers game” just like “cold calling”, although now much less expensive and efficient. Modern data mining techniques enable each company that is seeking investors to present its offering to an audience that is more and more specifically targeted. 

I call it “buying investors online”. What do you call it?

I have sat in marketing meetings for various players in the financial services industry many times. Depending upon what these companies are selling and to whom, the marketing and sales strategies differ greatly.

The common denominator of these varied strategies is that they are all measured by the same standard, CAC, the cost of acquiring each customer or investor. The object of any marketing campaign is to attract the most customers (and their ‘orders’) from every dollar spent on any advertising directed at those customers. 

In crowdfunding, while statistics are few, it is obvious that the costs associated with acquiring investors varies greatly, offering to offering. Some offerings fail because investors do not find them attractive, most, I think, because they lacked marketing muscle.  

Personally, I find it painful to watch a company that has hired me to prepare the paperwork for their offering fail to acquire the investors they need.  Often, these company’s campaigns fails because they hire the marketing company that was the lowest bidder.  I try to steer my clients to a marketing company that may not be the least expensive, but gets the job done.   

The Regulation D, private placement market has found enormous success using crowdfunding for investors.  Even now, a sponsor can identify potential investors for the purchase of an office building who can afford to invest, who have an interest in real estate, and who live close enough to the property, to drive by if they want to look at it. And the data mining techniques that created these targeted mailing lists are still in their infancy.

Crowdfunding for capital has become a simple process.

Step one: create an investment that will be attractive to investors

Step two: create advertising copy that can be pre-tested and shown to be effective

Step three: put those ads in front of your pre-targeted lists of prospective investors.

Step four: Repeat step three until you raise the money you need.   

I have written elsewhere that I believe that crowdfunding has reached the point where it will now quickly grow to be a major source of capital for start-ups and small businesses.  A major reason will be that companies seeking funding can now approach crowdfunding with a high degree of certainty that they will get funded. With the proper perspective, those companies can appreciate that they are buying investors online. 

 

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

Or, you can book a time to talk with me HERE

 

Crowdfunding Professional Association – An Open Letter

Crowdfunding Professional Association (CfPA)

To: The Board of Directors

I appreciate that I am a person who no one wants to hear from; a New York lawyer with an attitude and a big mouth.  Fortunately, I have made it work by finding clients who appreciate not only my advice, but the reasoning and experience behind it. Still, I know that people would rather suck an egg than listen to a lawyer.

I worked on Wall Street and helped finance companies for 20 years before I understood finance. That understanding came from teaching finance to college students. There is nothing like going back to the textbooks to create a framework for understanding the nuances of any subject.

I have made no secret of my dislike for the CfPA. I see nothing of value being discussed and certainly nothing of value produced by your organization.

I have been invited to make some practical recommendations to the CfPA Board of Directors. I have no illusions that most of the CfPA Board will simply ignore me. I have been saying many of the same things since 2015. 

To soften the discussion, I think it better that you think of me not as a lawyer but rather a college professor, albeit one who does not give credit for wrong answers. These are my thoughts.

What is best for the investors is best for the crowdfunding industry

There is a great pool of capital available for investment into all kinds of projects and businesses. The job of the crowdfunding industry is to connect companies looking for capital with investors who will provide it.

The JOBS Act was intended to provide capital for small businesses to expand and grow. The Regulation D Title II platforms have demonstrated that investors will invest $25,000-$50,000 or more based largely upon information they learn from a website. Crowdfunding, as a method to source investment capital clearly works. 

Crowdfunding operates in a unique niche market. It competes with banks and commercial lenders for companies seeking funds. At the same time, crowdfunding competes for investors with the mainstream stockbrokerage industry. Those are huge markets full of tough competitors.

Title II private placements went online and immediately competed with the traditional stockbrokers who sold similar offerings to investors face-to-face. There are Title II platforms and broker/dealers using crowdfunding to raise billions of dollars. At the same time there are Title III funding portals where issuers have difficulty raising $50,000 and where their offerings languish for months. 

In place of stockbrokers, crowdfunding offers increasingly sophisticated digital e-mail marketing campaigns and advertisements aimed at highly targeted lists of potential investors. While I was originally skeptical of this approach, it has been demonstrated that it works.

If the content of the e–mails manage to send some investors to review the offering itself, and some percentage of those become investors, then a company can continue to send out e-mails and advertisements until it attracts all the investors it wants. If some people will invest in an offering based upon what they see on the website, others will invest as well.

Effective marketing will press the right rational or emotional buttons that will result in investors investing. A good campaign will reach out to more potential investors than it needs.

Funding a crowdfunding campaign has become just a simple numbers game. As marketing costs for raising $1 million on any crowdfunding platform or funding portal continue to come down, it has reached the point where any company that can afford a good marketing campaign, can “buy” $1 million in investment or more. 

That conclusion, which I reached after countless hours speaking with campaign marketing specialists, caused me to stop and ponder the consequences for crowdfunding, for banks and for small business. I believe that this crowdfunding marketplace is about to explode with the post-pandemic need for small business capital.  

I covered much of my enthusiasm for crowdfunding in a whitepaper I published last week.I promised some more practical advice and recommendations today. 

Crowdfunding is corporate finance, do the math  

The JOBS Act was specifically intended to operate within the framework of existing federal securities laws and an established universe of corporate financing techniques. The crowdfunding industry can only exist if investors are willing to invest. The crowdfunding industry needs to respect investors. The CfPA needs to lead this effort. 

The industry has foisted scam after scam on the investors it cannot survive without. It consistently offers investments into companies that have no reasonable expectation of success. FINRA requires a certain amount of quality control for the funding portals it regulates. Many of the funding portals just ignore that requirement.

I appeared on a podcast recently. The host made me so comfortable that I blurted out something that I probably would have said differently. I said that one of the main problems with the crowdfunding industry was that too many people in it thought Ben Graham had invented a cracker. 

Graham’s textbook has been the basis for analyzing investments for decades. It has, and continues to be used in business schools around the world. Trillions of dollars are invested every year by decision makers who are trained to apply fundamental analysis to investing and corporate finance transactions.

There are very few MBAs in crowdfunding. I do not think that is a requirement, but I do think that to advise a company seeking financing requires some amount of knowledge and experience. I have helped hundreds of companies raise money over the years and I have taught finance at the university level. Still, I collaborate with two colleagues, one a retired investment banker, the other a retired commercial banker on almost every offering I prepare.   

Financing can be nuanced; terms matter; mistakes can be costly; there are always other companies competing for the same investors. If you accept that crowdfunding is a form of corporate finance, then people experienced in finance are a pre-requisite. If you think crowdfunding is just another form of gambling, you need to be doing something else.

There are clearly crowdfunding platforms that get an A in Finance by helping to structure the offerings they host intelligently. Sadly, most of the industry, especially funding portals, have no clue.

Any investment offered to investors via crowdfunding is a speculative investment. The crowdfunding industry wants investors who understand the risks and who can afford to absorb the loss if the worst happens.

Crowdfunding syndicates risk. Higher risks should yield higher rewards. Risk, if you can get your head around it, is what crowdfunding sells. 

Too often, the risks are buried in the boilerplate. The CfPA should bring the discussion of risk out in the open. It should encourage industry participants to help issuers to mitigate those risks and to adequately compensate the investors willing to take those risks to fund these companies. 

The larger marketplace quantifies risk every day. For example: Pre-pandemic, a small business seeking a loan guaranteed by the SBA, with adequate collateral and a personal guarantee from the business owner, would pay about 8.5% interest on the loan. Today, while the pandemic has raised the risks for all small businesses, there are offerings on funding portals offering investors 6%, without the collateral or guarantee, wondering why they are having difficulty attracting investors.   

The funding portals are in the business of helping issuers get funded. There are way too many issues being offered that make no economic sense. If a company cannot demonstrate that it can execute its business plan with the funds it is seeking, no platform or funding portal should agree to host its offering. The CfPA needs to help its members to step up their game. 

Rather than purchase those skills, some prominent people in the crowdfunding industry have conjured a new type of mathematical masturbation to stroke the egos of the issuers by selling a delusion of value to investors. I have not heard a single word from the CfPA questioning this practice.

A lot of start-ups are still in the late stages of development. They have burned through $500,000 in seed capital. They do not have a final product, so they have no sales to report and at most a limited test of the market they intend to serve. They have no assets and even their IP is not finished or protected. 

This company put an offering on a funding portal offering 5% of the company for $2 million. If successful, they claim that because 5% of the company was worth $2 million, the entire company must be worth $40 million. There is no excuse for this bullshit.  

In addition to the standards for analysis evidenced by Ben Graham there are GAAP accounting rules governing valuations. There are experienced business brokers around the US who help to buy and sell businesses every day who could not place anything close to a $40 million valuation on this business.    

That some VC might adopt this math is not relevant. VCs have a different agenda. They are looking for growth, not the profits that majority of investors who might invest via crowdfunding look for. An offering on a crowdfunding platform or funding portal should not mislead potential investors that a VC valuation is correct. There are no reasonable mathematics to support it.

It is also misleading to suggest “we expect to cash out in 5 years by doing an IPO or selling out to a Fortune 500 company”. That is not a fact, it is wishful thinking.  In many cases, the odds are actually better over the next 5 years that one or more of the top executives will go through a divorce and lose focus and productivity.

The CfPA has been talking about writing best practices for the crowdfunding industry for years and produced nothing. And, no, I do not want to participate in drafting them at this time, but I do have some suggestions on how the CfPA can make itself useful.

Recommendation: It has been suggested to me that the CfPA is considering creating a “test” to certify some individuals as “qualified” to perform certain tasks regarding an offering. I think that a waste of time. There are plenty of qualified people in finance who would come to crowdfunding if properly incentivized. There are qualified consultants available who could offer the issuers and the industry everything it needs. 

The CfPA first needs to define the talents needed.  The reality is a far cry from anything I have seen from the CfPA to date.  I have written about the crowdfunding process. I have offered to allow the CfPA to post or re-print anything that I have written. A more definitive guide telling issuers and investors what to expect should come from the CfPA. 

Shine light on the scams 

The JOBS Act was adopted to facilitate capital formation under the Securities Act of 1933. It specifically incorporates the anti-fraud provisions of the Securities and Exchange Act of 1934. Operators of crowdfunding platforms, funding portals and virtually anyone else involved in the crowdfunding industry should have at least a working knowledge of what can be said about a company offering its securities to investors, what cannot be said, and what must be said to potential investors. The crowdfunding industry simply ignores these requirements.

Several of the crowdfunding marketing companies insist that issuers pay me to review their final offering materials and especially the marketing materials and adsbefore the offering goes live. I have performed this task, reviewing advertising content, for large wire houses. Like these marketing companies, the Wall Street firms want to have their advertisements reviewed by a lawyer, to protect themselves and their clients from regulators and litigation. 

The Reg. A+ market has been a cesspool from the get-go. By now, I suspect that you could fill up a stadium with people who have invested in a Reg. A+ offering.  Ask that crowd for a show of hands from those who have sold their holding at a profit and very few hands will go up, even though we have been in the midst of a raging bull market.

My very first blog article that discussed crowdfunding was about ELIO Motors which was the very first Reg A+ offering.  The company purported to have a 3 wheeled, electric car.  ELIO brought one prototype to a crowdfunding conference and the crowdfunding “professionals” in attendance went into a sugar shock over it.

I read the prospectus thinking I might write something positive about it. I did not believe what I read to be true and made a single phone call to confirm my suspicions. Once I knew that ELIO Motors was a scam, I wrote it up in no uncertain terms. 

I was thinking, foolishly, the honest people working in the crowdfunding industry would do the same and shine light on ELIO and some of the other obvious frauds since then. I should have known better.

There is a saying in the mainstream markets to the effect that “no one hates to see a stockbroker being dragged out of his office in handcuffs more than the honest stockbroker across the street.”  I have not seen anything from the CfPA that even cautions prospective investors. Given the fact that the Reg. A+ market is going “show biz” to reach a wider, uneducated audience, more and more scams, enforcement actions and bad publicity is inevitable.

There is no shortage of scam artists in the Title II and Reg. CF markets either. The platforms and funding portals need to reject every offering where the issuer cannot support the claims it is making. Too many of the platforms and funding portals claim that they thoroughly “vet” each offering they host. Most have no idea what that actually takes.

When the SEC brought the first enforcement action regarding crowdfunding, Ascenergy, I discussed it with an attorney who had reviewed that offering and rejected it. It was the right call; one that I would have expected an experienced SEC attorney to make. But four platforms were mentioned in the Ascenergy order as having listed the offering. That would not have happened if every platform had access to that first attorney’s report or was at least aware of her concerns.

If a scam artist gets rejected by one platform or funding portal, they just move on to the next one. That is what happened in Ascenergy.That could have been avoided, with a little bit of intra-industry communications.

When I was a young lawyer, the compliance officials for the Wall Street firms would have lunch once a month, bring in speakers and schmooze. It was a venue where lawyers at competing firms could get together for the common good.

Recommendation: The CfPA should sponsor a simple bulletin board where lawyers working in crowdfunding and compliance officers at the platforms and funding portals can post questions to each other. Had the due diligence attorney who rejected Ascenergy posted something simple like: “Regarding the offering for Ascenergy. I spotted some red flags that I could not resolve. Call me for details” likely the offering would not have gotten off the ground, investors would not have been burned and four crowdfunding platforms would not have found themselves discussed within the pages of an SEC enforcement action.

The cost to the CfPA for this is nil. The benefit to the platforms, funding portals and crowdfunding industry is immeasurable. Reducing fraud increases investor confidence and the amount of money they will invest which is the crowdfunding industry’s first and common goal. 

Warn investors by telling them the truth

Let me suggest that the very last thing the CfPA needs to do is to form a committee to discuss investor education. Let me offer instead a homework assignment for the CfPA Board of Directors. Create a list of 10 things that an investor who is thinking about making an investment on a crowdfunding platform or funding portal should consider and publicize the hell out of it.

Let me help:

Crowdfunding Investors Beware:

1) Avoid any company that claims a value many times its projected sales, unless supported by an appraisal from a licensed business appraiser. 

2) Avoid any company that claims it will conduct an IPO or be bought out in the future unless it has a letter of intent in hand.

You get the idea. The CfPA Board of Directors should be able to supply the rest. This assignment is due before Labor Day. I will be happy to review your list and make suggestions before you publish it. And remember, I don’t give credit for wrong answers.

Respectfully,

Irwin Stein

Investors: Be Careful Walking Down CrowdStreet

Investors: Be Careful

2016

Back in early 2016, when the first Regulation A + offerings were being made to investors, I wrote a series of articles questioning the veracity of some of the disclosures that were being made. I called out 6 offerings and within a few months, 5 of the 6 had problems with regulators.

Someone suggested to me that I had a talent for spotting scams. It isn’t a talent, it’s a skill, one which I learned when I was a young attorney still working on Wall Street. I was taught how to conduct a due diligence investigation of any company, even when the technology the company was developing was out of my area of expertise.

It is the skill that originally brought me to California in 1980s. I was hired by a law firm to prepare due diligence reports for a venture capital firm that was funding Silicon Valley start-ups.

In the early days of crowdfunding, there was some discussion that the “crowd” of investors could collaborate together and ask the questions on a public platform that investors should ask. That was never true and never really developed. If you want to conduct due diligence on any offering it is always best to hire someone who knows what they are doing.

One of the very early crowdfunding platforms was a company called CrowdStreet which raised $800,000 in seed capital and opened for business in Portland, OR in 2013. It was a Title II platform offering real estate investments to accredited investors. CrowdStreet was one of the few platforms I looked at when I first became interested in crowdfunding. 

Over time, CrowdStreet seemed to quietly grow and succeed. Syndicating real estate is not rocket science and there is no shortage of accredited investors with money to invest.

In 2018, CrowdStreet “partnered” (their word) with a real estate firm in New York City called MG Capital. MG Capital claimed to be “the largest owner-manager of debt-free luxury residential properties in Manhattan”. At that time, MG Capital was offering investors the opportunity to invest in two real estate funds, MG Capital Management Residential Funds III and IV. The principal of MG Capital was a gentleman named Eric Malley.

$500M to $58M?

The private placement memos for these funds touted the success of MG’s two prior funds (Fund I and Fund II) as would have been appropriate. It claimed that MG had raised over $1 billion for the two earlier funds. Based upon their successful raises for Funds I and II, MG projected a successful raise for Fund III of over $500 million. According to the SEC, they actually raised about $58 million, based upon the strength of their prior success with Funds I and II.

Unfortunately, neither Fund I nor Fund II actually existed. On its website, CrowdStreet makes the following claim: “We evaluate the sponsor’s track record, including a review of their quarterly reporting, to confirm they have successfully executed on past deals and can demonstrate stewardship of investor capital. We specifically look for successes in the asset type they are trying to bring to the Marketplace. We want to work with sponsors that value direct relationships with investors and have the infrastructure to support those investors for the duration of the project.”

Forgive me for asking the obvious question but how do you “evaluate” a track record that does not exist?

SEC

According to the SEC, Malley and MG Capital made numerous other misrepresentations in their marketing materials and offering documents, including claiming that investors’ capital was “100% protected from loss” and secured by a non-existent $250 million balance sheet. MG also  claimed that they had partnerships with hundreds of prospective tenants with pre-signed, multi-year lease agreements.

Just the statement “100% protected from loss” is a red flag for any capable due diligence officer. Any private placement is a speculative investment and investors are always advised that they may lose all or part of their investment.

If a company like MG Capital presented a balance sheet claiming $250 million, a good due diligence officer would have asked for an audit. Crowdstreet’s due diligence files should have had a sampling of those leases sufficient to satisfy that MG’s representations were true.

Also according to the SEC, Malley and MG Capital misappropriated more than $7 million in investor assets while using falsified financial reports to conceal huge losses that ultimately forced the two funds into wind-down. At least one early investor sued MG as early as May 2019.

In truth, I don’t follow CrowdStreet, nor did I have any reason to doubt the honesty of its management. I was prepared to give them the benefit of the doubt and assume that they had just been bamboozled by the bad actors at MG Capital.

What actually got my attention was the fact that CrowdStreet is looking for a new President and Chief Compliance Officer. LinkedIn dropped a notice of that job offering into my feed because their algorithm thought it matched my skill set. After 40 plus years syndicating real estate even I thought it was a good match.

I sent in an application last week, in part because the Golden State Warriors were losing (badly), in part because the job was being offered as “remote” which was interesting to me, and in part because if the problem with MG Capital was a one-off, I could probably help them to compartmentalize their exposure.

It took them one day to tell me that my skill set was not what they desired.

Upon further investigation it appears that lawyers who represent investors are lining up to sue CrowdStreet for offerings it hosted that had nothing to do with MG Capital. And let’s be clear, in order for an investor to sue, the investor needs to show that they lost money. In this bull market for real estate, that is hard to do. If CrowdStreet hosted a number of offers where investors were defrauded, in my experience and opinion, the problem at CrowdStreet is a systemic failure.

In addition to a new slate of managers, CrowdStreet is moving from Portland to Austin, Texas. If I had to guess, I suspect that this is the beginning of its winding down process and an attempt to distance the current management from the stench they created.

Multi-Million Dollar Scandal

CrowdStreet may turn out to be a huge, multi-year, multi-million dollar scandal that will turn investors off to the idea of buying shares in a real estate project from a website. That would be a huge black eye for the crowdfunding industry as a whole. 

Notwithstanding, the crowdfunding industry “experts” will, at best, lament this as an aberration. The idea of teaching every platform or portal operator how to conduct a legitimate due diligence investigation is a non-starter. Believe me, I have offered to teach at least one platform that consistently hosts offerings that are BS for free and got turned down.

As I have said before, the crowdfunding industry needs to re-focus on investor protection or the investors the industry cannot live without will continue to stay away.

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

Or you can book a time to talk with me HERE

Remembering the “customer’s man”

customer's man

The 1970’s

Several weeks back I had lunch with a colleague who, like me, had started in the brokerage business in the 1970s. At one point he referred to himself as a “customer’s man”. It was a term used to describe a registered representative that I had not heard in years. It evoked a way of doing business that has largely been lost.

At that time, commissions and costs were fixed across the industry. Today, we see these costs as an impediment to our ability to maximize investment returns. We have lost sight of the value that a good customer’s man brought to the process.

A good customer’s man got to know you.

The brokerage firms encouraged every customer’s man to get to know every one of his customers and to get to know them well. You would meet in person to share lunch, drinks, dinner or to play squash, tennis or golf. Over time and many conversations you would get to know quite a bit about each others’ lives and families. Your customer’s man would become one of your trusted advisers.

A good customer’s man was a good stock picker.

Customers’ men were always on the look-out for the next stock that was about to make a move. They were selling their ability to pick stocks and to buy them for you at the right price.

Your customer’s man would always tell you which stocks he was following and why he was following them. He would call to tell you when the price had dipped and to recommend that you give him an order to buy a few hundred shares for you. You would not hesitate.

A good customer’s man made money for you.

Customer’s men were judged by how much the stocks that they recommended went up. It was a simple metric that everyone understood. Very few built their book of customers by advertising or seminars. The best built their books by word of mouth. They asked existing customers for referrals. Customers who made money following their broker’s recommendations gave the best referrals.

From the 1970s forward if the firms wanted more customers, it meant having more brokers with bigger and bigger books of customer accounts. The big action was moving established producers around from firm to firm. Front-end bonuses for really big producers became really big. Just about every broker wanted to be a bigger producer.

That attitude was good for the firms and they encouraged it. Brokers became almost exclusively focused on bringing in more customers. No longer were they judged for the stocks that they picked or how much money their customers made. Producers were now judged on how many “assets under management” they have.

The actual management and investing of the customers’ funds was increasingly handled elsewhere. Enticing new customers meant selling the investing and management skills of others.

The 1987 Crash

This was logical as so many of the customers’ men had not seen the 1987 crash coming. If they had, logic suggested that they would have pulled their customers out before it happened.

customer's man

It was time to let the experts manage your investments. Customers were sold many different kinds of managed funds, annuities and other “packaged” financial products. All of these products were expensive from the customers’ standpoint. The firms had built in significant underwriting costs and management fees.

Many of these fund managers drank from the Kool-aid that said that price/earnings ratios of 50 or more were sustainable and likely to go higher. Individual brokers who questioned the wisdom of the high paid fund managers and research analysts were brought into line or shown the door.

When the tech market inevitably crashed, many in the industry argued that “no one had seen it coming.” They said the same when the market crashed again in 2008. It was a phrase that was repeated so often that people started to believe it.

It re-enforced the idea that the average financial adviser can do no better than average. Everyone just started buying the index, certain that no human being who actually works in the markets every day could actually have awareness of what was going on or to help customers profit from it.

The index was much cheaper than a human adviser in any event. Lower costs were more efficient and would increase returns, provided, of course, the market goes up.

A good customer’s man always put the interests of his customers first. It was an era when almost every business adhered to the idea that “the customer was always right.” When is the last time that you heard that phrase or saw it posted in a business or an office?

Today, the industry staunchly opposes any regulation that would require individual brokers to put their customers’ interests first. That should tell you everything that you need to know about the financial services industry today.

The individual registered representative, the back-bone and the public face of the brokerage industry will likely not survive another generation. Their jobs are already foolishly being replaced by computer driven robo-advisers.

The industry will survive and prosper without the customer’s men. It is already oblivious to what it has lost.

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

Or you can book a time to talk with me HERE

Fidelity’s Folly: Bitcoins for All?

Fidelity

Fidelity Investments

People keep asking me what I think about Fidelity Investment’s announcement that it will act as a custodian for bitcoins and other cryptocurrencies. As anyone who follows me knows, I don’t think very much of it at all. 

Fidelity has made it clear that it is “all in” on cryptocurrency. Its website notes that: Fidelity Investments “operates a brokerage firm, manages a large family of mutual funds, provides fund distribution and investment advice, retirement services, Index funds, wealth management, cryptocurrency, securities execution and clearance, and life insurance.” 

Fidelity would certainly wish to expand each of those profit centers. With bitcoins and cryptocurrency there is the potential for enormous growth if Fidelity can turn them into just another “investment”. It can’t, even though it is trying very hard. 

Just last week, Fidelity’ Director of Research published a report that suggested that bitcoin is a “potentially useful” asset for “uncorrelated return-seeking investors”. The report said that “in a world where benchmark interest rates globally are near, at, or below zero, the opportunity cost of not allocating to bitcoin is higher.” 

Please do not be impressed with that gooblygook. There is no real data about bitcoins for the Director of Research to research. You cannot analyze bitcoins in any traditional way. They are merely a few lines of computer code. This report is reminiscent of the type of justification that analysts gave in the dotcom era for supporting stocks, with no income, trading above $100 per share. 

The report further suggests that bitcoin’s current market capitalization “is a drop in the bucket compared with markets bitcoin could disrupt.” That certainly sounds like a “buy” recommendation to me.

The primary markets that bitcoins might disrupt are banks. In truth, bitcoins, when used as payment in commercial transactions, disrupt nothing. Banks and banking are not going away.   

If you consider how many payroll and Social Security payments are already deposited directly to recipients’ accounts and how many of those recipients pay their electric power or insurance company “on-line” it is fairly easy to see that converting the deposit to bitcoins before you make the payments is an extra step not likely to find favor.  

The one thing that will cause the current price of bitcoins to appreciate is a lot more investors willing to buy them and hold on. That is the strategy being pushed by Fidelity with the blessings of “pseudo” market professionals. 

Last month, Fidelity stated that it had polled a number of the “professional” fund managers and investment advisors who are currently its customers.  Apparently enough advisors would consider bitcoins for their advisory clients to warrant Fidelity acting as a bitcoin custodian. 

Some number of advisors who already use a Fidelity platform will certainly purchase some amount of crypto currency for their clients’ accounts.  That “professionals” are buying bitcoins is likely to be used by Fidelity as a reason to advertise them to average, small investors as “what the Pros” are buying. 

In 2 years, Fidelity may have many billions of dollars’ worth of bitcoins held in accounts on its platform. That will not make it the right thing to do.

Law and Economics, which I taught back in the 1990s, studies how our interwoven markets interact with the laws that regulate them. Judges interpret those regulations, often influenced by what they perceive the regulators intended to accomplish.

The regulations that govern our financial markets (equity, debt, currencies and insurance) have evolved over the centuries with the markets that they regulate. The introduction of something as novel as crypto currencies into the financial markets should be expected to suffer some adverse legal consequences. 

As a matter of law, every Registered Investment Advisor (RIA) and anyone investing other people’s money is held to a fiduciary’s standard of care.  Fiduciaries are usually required by law to: 1) act in the best interests of their clients, 2) preserve and protect the assets entrusted to them and, 3) when investing to act as a “prudent” investor would act.

A fiduciary’s duty to its client or beneficiary is a much higher standard of care than in any ordinary commercial transaction. To satisfy that standard often means taking “extra” care to mitigate obvious risks.

Fiduciaries become fiduciaries when people trust them to hold their property or to act on their behalf.  People most often trust fiduciaries because they have specific expertise in the matter at hand. Both fund managers and RIAs fit that description. Both are held to a fiduciary’s standard of care and their conduct is most often judged against that of other experts in their field. Most investment professionals will never purchase any crypto currency for their clients.

Fidelity, the fund managers and RIAs who do purchase bitcoins and store them at Fidelity obviously believe that the price of bitcoins (currently in the range of $10,000 a piece) will appreciate and perhaps double or more.  It is certainly possible this could happen.  Two years from now the price of a bitcoin might have risen to $20,000 each and possibly higher. Many of the bitcoins held at Fidelity will have been purchased at close to that amount.   

Let’s assume that for some reason or another, in a 90-day period, the price drops back to $10,000 each.  That could result in several billion dollars in actualized losses as some will “hold” all the way down in hope of a rebound.  Does Fidelity shoulder any liability for these actualized losses?

The Fund Managers and RIAs certainly do. Unlike most litigation, where the burden of proof is on the plaintiff, in many states, fiduciaries are required to demonstrate the reasons that they made the offending investments.  Much of the case will be dependent upon what the advisors can show were their reasons for buying bitcoins in general and also specifically on the day and at the price that they did. They will also have to demonstrate why they held on as the price deteriorated.

Given that there are no fundamental reasons for purchasing bitcoins I suspect that most will try to defend themselves arguing that bitcoins are a hedge against adverse results in the rest of the portfolio. That argument is likely to fail. 

Bitcoins are, after all, a commodity, and putting aside the fact that most RIAs are not trained or licensed to sell commodities, gold would be a more accepted hedge if that is what the RIA wanted to do. If nothing else gold is unlikely to lose 1/2 its value in a short period of time, which bitcoins have already demonstrated they can do. 

Litigation

Fidelity’s role as a platform or clearing firm might save it in Court but these customer claims are more likely to be heard by arbitrators appointed by FINRA, especially if Fidelity is named as a respondent. I have been an arbitrator and argued many cases in front of others. They are more likely to be older and their view of bitcoins will probably be closer to Beanie Babies, than as a new form of currency that trades in a very opaque market. 

Fidelity

Two recent cases brought by the SEC will not help Fidelity’s defense either. The first is SEC v. ICO Box, where the SEC alleged that the platform “facilitated” the sales of more than 30 different crypto currencies. “Facilitated” is a word that will make defense lawyers crazy. 

By the time that these claims get to a hearing I suspect that complaining customers will be able to present a banker’s box or two of “reports” written by Fidelity that suggest that RIAs purchase bitcoins for their customers. That should certainly be viewed as a “facilitation”.

The other case is called SEC v. Lorenzo.  Lorenzo was charged with copy and pasting an e-mail written by someone else and sending it to prospective investors. The SEC alleged that Lorenzo “disseminated” misleading information in order to make the sale. Given the outrageous claims made by many in the bitcoin world, some Fidelity employee is more likely than not to resend a report or article that Fidelity cannot defend.

The mutual fund industry, Fidelity’s core business, is under great stress to lower the fees it charges investors.  For all the BS that you may hear about how Fidelity’s actions in embracing crypto is “cutting edge” or “visionary”, it makes more sense that Fidelity is touting crypto to make up for revenue lost elsewhere.

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

Or you can book a time to talk with me HERE

Reg. CF – Will Fools Rush In?

Reg. CF – Will Fools Rush In?

I have written a lot of articles about crowdfunding in general and specifically about crowdfunding to accredited investors under Regulation D.  I have largely ignored the much smaller financings that are accomplished under Regulation Crowdfunding (Reg. CF) that accept investments from all comers. The time has come to fill that void.

REG CF

Reg. CF was the last of the regulations issued by the SEC under the JOBS Act.  It embodied much of what proponents of the Act had wanted….a sanctioned method for community funding for start-ups and small businesses. 

The first Reg. CF offerings began in May 2016. Despite a few success stories, the Reg. CF marketplace has yet to mature.  I do not see that coming at any time soon, despite the out-sized need for small business capital.

Reg. CF created a new class of financial intermediary called “portals” which are essentially websites where companies seeking investors are displayed.  But the portals are more than just websites.

The SEC wanted this market to be regulated, in part to protect investors from fraudulent offerings and in part to provide the companies seeking capital with a way to interact with investors in a regulated environment. The SEC required the portals to register with FINRA, the stock brokerage industry’s regulator, and to adhere to FINRA’s regulations.     

Until recently only about 50 portals had been registered with FINRA, a number that had been fairly static for a while. A small handful of the portals handle the bulk of the transactions.  Some of the earlier portals have quietly gone out of business. The rest quietly grind out only a few offerings at a time. 

Top Ten REG CF Portals Ranked By Capital Raised 2020

Reg. CF required that investors be given specified disclosures about each company.  It set baselines for the presentation of financial information and set limits on how much any small investor could invest every year in these very risky ventures.  A required filing gives the SEC specific information about each offering. 

Reg. CF allows companies to raise no more than $1,070,000 in a single year. For reference, the average loan guaranteed by the SBA is closer to $600,000. The SBA guarantees about 40,000 loans per year and rejects a similar amount. There are many thousands of small companies that do not come up to SBA standards.

A great many companies would have their capital needs satisfied with much less than $1,000,000.  These companies should be looking to Reg. CF portals but are not. The portals have not demonstrated that every listing will get funded which is what any company should want.   

A very large percentage of the offerings that list on Reg. CF portals raise very little money.  Still, a great many start-ups and small businesses ask for very little.  Many of the offerings seek less than $100,000. 

Many of those small offerings do not employ a specialized marketing company or even an organized crowdfunding advertising campaign.  Too many of the campaigns rely solely upon the company’s existing social media contacts which are rarely enough to get the company funded. 

Portals

Very, very few of the portals are wildly profitable, if at all, even though the compensation structure is patterned after the wildly profitable mainstream stock brokerage industry.  Most portals charge close to 7% of the funds every company raises. The very best portals raise a total of less than $1 million every week.  This against a backdrop of so many companies in need of capital.

Five new portals were registered this month and the scuttlebutt around the industry is that another dozen portals more or less are in various stages of the registration process. Many anticipate that the SEC will raise the limit to $5 million. That may or may not happen and it will have little import since most of the portals have no idea how to raise even $100,000.

Just in the last few months, I have spoken with several people planning new Reg. CF portals. With one exception, none of these new portal owners knew anything about selling securities which is the business of any portal. None seemed particularly interested or focused on helping the listing companies raise the funds that they seek, even though the portals get paid a percentage of the funds that are raised.

FINRA

FINRA has always been a fairly lax regulator.  Notwithstanding, like many regulators, FINRA can get their teeth into you. They especially like to tangle with smaller firms that would rather settle than fight. 

Reg. CF – Will Fools Rush In?

I expect FINRA to get more involved as it is aware that the investors themselves have little recourse. If an investor invests in a Reg. CF offering that is a total scam no lawyer is going to file a suit against the portal if the loss is only $500.  Even a $1 million Reg. CF offering is likely too small for a class action.

FINRA has its own set of portal rules and an established set of standards and practices.  FINRA views the portals as being in the business of selling securities to public customers and should be expected to act accordingly.

Several people in the crowdfunding industry have suggested to me that crowdfunding platforms and portals have no real liability if an offering they host uses fraudulent or deceptive means to attract investors.  At least with portals, that is categorically not true.

FINRA’s Rules for Portals specifically forbids the portals from engaging in fraudulent conduct with the same language it prohibits the mainstream stock brokers. As the portals do not have trading desks, the only place the portals might engage in fraudulent conduct is regarding the offerings they host.

FINRA expects each of its Members to have some system in place to verify the information that the listing companies provide to the public investors.  FINRA has warned its members to not accept the self-serving statements of the founders of these companies at face value.  In many ways, this is the antithesis of the approach that many portals take, especially with start-ups. 

I have said before: when a portal lists an offering for a pre-revenue company, with negative or minimal book value, and allows the company to claim a “valuation” of tens of millions of dollars it is a fraud.  What some VC might think or say about the company is not regulated in the same way as a firm registered with FINRA.  The lawyers who allow the portals they represent to make a misrepresentation as to the “value” of a company are not doing anyone any favors. 

There are very few lawyers who work with Reg. CF portals. Every one of the lawyers that I have met or spoken with was a very competent professional.  But not all of them could really see Reg. CF offerings from the investor’s point of view which FINRA is likely to adopt as its own.

I recently spoke with an attorney who represents one Reg. CF portal and who is in the process of helping a client set up another.  His new client writes a blog with a lot of followers. The blog features articles about specific start-ups.  His client frequently appears on podcasts that get a significant amount of viewers. The client hopes to leverage his notoriety to help the companies that list their offerings on his new portal.

Rules Are Rules

FINRA expects portal owners to follow its rules regarding communications with the public.  When you are selling securities much of what you can and cannot say is regulated.  There is also a list of things that you must say when talking about an offering where you expect to collect a fee if the offering is successful.

Reg. CF – Will Fools Rush In?

FINRA has already expelled one portal owner for what he said about an offering in an interview away from his portal. There will be others.

I asked the attorney if the portal he was working on had an in-house compliance officer with experience to check all the scripts and the advertising copy for compliance before it is released.  He told me that his client had not even thought about it.

That is the nub of the problem.  Only one of the new portal owners with whom I spoke had a clear idea of how they would find companies to fund or how to make certain that there were always more investors available than securities to sell.  And that is really crucial to the success of this business.

Adding 20 new portals to a market where most of the portals are not profitable is likely to result in a race to the bottom rather than the top.  Adding more portals whose operators lack essential experience and trained compliance officers is not going to get more small businesses funded correctly.

Ideally, there would already be 50 portals each supplying $1 million per week or more for start-ups and small businesses.  Another 20 would be welcome, especially now when the need for small business capital is great.

With Reg. CF the SEC offered a truly new and relatively simple method of corporate finance for small business.  FINRA offers a roadmap to compliance and respectability. The road to success will come when the portal owners start acting like they are in the business of selling securities and focus on doing exactly that. Sadly, I do not see that happening any time soon.

If there are any portal owners out there who are ready to give up because they cannot run their portal profitably, I have some clients who would be interested in acquiring your registration to help you to salvage something from your efforts.  Serious inquiries only.

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

Or you can book a time to talk with me HERE

Creative Crowdfunding

Creative crowdfunding

A mentor of mine used to refer to the process of preparing a securities offering for public investors as a “craft”. He would explain to me:“Before you can sit down and write the offering based on your clients’ specifications, you need to be able to see the offering through the eyes of the prospective investors.”

Crowdfunding is creative finance.  Crowdfunding comes with endless possibilities for creating a variety of unique financing transactions. Each company sets the terms that they will offer to investors. Investors get to say “no thank you” to those terms if other investments are more appealing.   

Many people who work in crowdfunding don’t know the first thing about finance. This limits their creativity and often dooms a crowdfunding campaign that should have been successful.

Crowdfunding Experts

When speaking with a company seeking an infusion of capital, many crowdfunding “experts” give cookie-cutter advice. Some companies use templates to create their offering instead of lawyers. Those companies will never know that there is usually a better way to approach their financing that will be more attractive to investors and at the same time save them a lot of money.  

Creating an attractive investment for an audience of targeted investors on a crowdfunding platform involves a series of tasks. Much of it involves a lot of time looking at spreadsheets.  If you don’t, at the very least, do the following while preparing your crowdfunding campaign, you are likely wasting your time and money. 

Before I structure an offering I expect to review the company’s current financial position. Only then can we decide whether the financing should be debt or equity, whether it should be on or off balance sheet and whether the offering should be for more or less.

You need to be able to demonstrate how you will use the investors’ money and how that money will generate revenues. Your revenue projections need to be supported by real world data and real world assumptions. “We’re going to capture 50% of a billion dollar market in 2 years” is fantasy, not finance.

Every financing transaction has a risk of default or sub-standard performance. You need to understand the specific risks of your business and how to mitigate those risks. You will need to estimate how much of a reward it will take to compensate your target investors so that they will accept those risks. 

Crowdfunding overwhelmingly operates in the Regulation D market selling private placements to accredited investors.  A great many of the accredited investors who you are likely to pitch for your offering have more likely than not, already been pitched to purchase a private placement.

Since the 1980’s the mainstream stock brokerage industry has sold private placements to millions of individual accredited investors. Various types of real estate offerings are the most popular, followed by energy (oil, gas, and solar), films, entertainment and events and equipment financing. 

For over 40 years the mainstream brokers have been selling investors on the idea that private placements provide passive income. Accredited investors are also used to being pitched that private placements come with higher returns. Most crowdfunding is directed at these same accredited investors. You need to give them the information and the pitch they expect to hear. 

The vast majority of accredited investors are baby boomers. They still control the bulk of the money in the Reg. D market. They have grown up with new tech and new companies and they are not afraid to invest in either. But new tech is always risky. You have to offer a return commensurate with the risk.

Crowdfunding as we know it today began with a rewards based model. A company would sell its product on a platform like Kickstarter and use the proceeds from the sales to manufacture the product. Much of the time, the product never got delivered. 

Revenue Sharing

During 2016-2017 there was a lot of discussion among Crowdfunders about a financing model called “revenue sharing”.  In its basic form, a company would raise money from a pool of investors, manufacture the product and then share the revenue with the investors.

Revenue sharing is actually a mainstream tool of modern finance. Many oil drilling programs pool investors’ money to cover drilling costs with the investors and land owners, sharing in the revenue if and when it strikes oil. 

Many franchisers use a revenue sharing model with their franchisees. The parent gets a percentage of the franchisee’s gross revenue structured as a franchise fee, rent, or a royalty on intellectual property. The parent often provides advertising support or promotions to help build sales.

Accredited investors that have purchased Reg. D offerings are familiar with this “slice of the revenue pie” structure. They understand that they will earn less if their oil well pumps 10 barrels a day than they will if it yields 100 barrels a day.  

As I have already mentioned, there was for a while a lot of discussion about revenue sharing.  Several platforms were going to come on line to specifically offer revenue sharing programs. Revenue sharing is a natural for a crowdfunding audience.  Unfortunately it never really took off in the way that I would have expected.  

The crowdfunding industry is still focused on the “buy equity in the business” model, It has gone out of its way to create derivatives like SAFEs to complicate what should be simple capital raising projects.

The crowdfunding industry needs to accept the fact that businesses with no sales or assets are not “valued” at hundreds of millions of dollars in the real world. Insane valuations actually hurt the crowdfunding industry because they drive away serious investors.  Many of those same companies could use creative revenue sharing models instead of trying to sell equity.    

I recently spoke with a business owner willing to sell 10% of his business for $2 million. He wanted to syndicate a Reg. D offering and raise the money on a crowdfunding platform.  He was having a good year and wanted to expand.

The company sells an automated HR suite to businesses with at least 100 employees.  Its customers pay monthly, per employee. The company wants to use the $2 million to open more accounts, each with a large number of employees.    

The company knows the cost of account acquisition and expects at least $10 million in additional revenue in the first year from its $2 million expenditure. Those new accounts are likely to stay customers for many years. 

Instead of selling 10% of the company, I suggested that he share the income stream with investors, pay them back quickly with a generous return and move on. It makes perfect sense.

The company might give the investors 60% of the revenue from these new accounts until the investors get distributions equal to $3 million and then cut them off. They can pay the investors more or less and carry the payments into the future, if they prefer. The company should easily be able to attract $2 million with the promise of paying back $3 million in only a few months.

In this case I would advise the company to take the investors into a separate limited partnership or LLC. Investors like this structure for a number of reasons, not the least of which is that can get paid on the gross sales. They are not concerned about executive pay or management issues. How the company spends its 40% the first year is not the investors’ concern. 

The company does not have to deal with investors on its books and all that entails. This relationship operates and terminates by contract.  If the company wants to sell 10% of its stock later, it will get more if the sales have been increased by $10 million per year.  

I have seen many advertising campaigns funded this way. I have seen companies with multiple products fund one product or even one cargo of its product this way. Most of the crowdfunding “experts” have never recommended this type of revenue sharing arrangement because this type of offering rarely shows up on crowdfunding platforms.

This $2 million gets you $3 million model does not work for every company, but there are other “fund the transactions, not the company” models that may.  These are only one alternative to the traditional equity method. There are others.

As I said, crowdfunding offers opportunities for creative finance, but you need to understand finance, in all its forms, before you can really get creative. 


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

Or you can book a time to talk with me HERE

Is Mom Still In The Market?

Is mom still in the market

Millions of retirees are about to get screwed by taking the advice they are getting from their financial “professionals”.  Older investors and retirees are being told to stay invested in the market regardless of the current risks.  It is foolish advice that a lot of foolish retirees will follow.

A lot of people have done quite well in the stock market “buying and holding” during this long bull market. But the time to hold is likely behind us and the time to fold’em is right now. 

Many of these retirees have the same poorly diversified portfolios of stocks they have held for a long time.  It is improbable that the price many of those stocks will continue to appreciate. If anything, the risk that they will continue to go down is greater than the likelihood that they will continue to go up. If they are not going to go up in price, there is no reason to continue to hold them.

Concerned Mother

Last week, I got a call from a friend whose mother was concerned that her account had taken a 6 figure loss in value for the first quarter of this year. His mother is divorced and already retired. Her account is with a large, national brokerage firm. She is concerned that her account balance dropped so much and so fast.

Her broker is telling her not to panic which is always good advice. Investment decisions should be based upon mathematics. It is not very hard today to do the math and realize that holding on to the portfolio you had last year does not add up. 

Her portfolio today is worth less than it was 3 years ago and as I said, down over $100,000 in this last quarter alone.  Her broker told her to “stay the course” because “these corrections happen and the market always comes back”.  

is mom still in the market

As I have said before this current correction is my 7th or 8th and no two were exactly alike.  In the last two, 2001 and 2009 there were clear indications that the market averages were too high and likely unsustainable many months before the bottom. There was plenty of time to sell out and save some money but many brokers then, as now, told their customers to just hang on. 

The mainstream stock brokerage industry chose to ignore the same indicators that they used when they predicted that stock prices would go up. It is ignoring the indicators that this current market is still far from its bottom.

I wrote an article just two months ago when the pandemic was still tangential to everyday life.   I did not think that the government’s tepid response in January would be so consequential by April.  

I noted the various conflicts of interest behind the brokerage industry’s desire for investors to stay invested.  Recessions hit Wall Street hard.  Profits and bonuses disappear. A lot of people typically get laid-off.  The idea that people might sell their stocks and put the funds in a CD to sit things out gives Wall Street indigestion.  

Just Do The Math

Investing is governed by mathematics. Large institutions control most of the money that is invested in the stock market. Most use the same method of Fundamental Securities Analysis first described,in 1934, by Ben Graham in his book of the same name. That book is still used in virtually every major business school.  A large investor like CalPERS or an insurance company will have hundreds of analysts on staff.   

At its basic level, the analysts are using one primary metric; earnings both current and projected into the future.  A projection of higher earnings for next year would be an indication that the share price will be higher next year as well. Analysts are always looking at a company’s business to see if its revenues and profits are likely to increase 6 months or a year down the road.

What do these analysts see today?

Right now, it is pretty clear that a great many companies will continue to struggle at least until the end of this year. When these companies report their earnings for 2020 next spring, they will show that earnings, if any, will be down from earnings last year.  Lower earnings should indicate lower stock prices.

Every indication is that the stock market is likely to be lower next year. The risk that people who stay in the market for the next year will lose money is high. So why would any financial professional recommend that their clients should stay invested especially clients who are already retired? How much can retirees afford to lose in a bear market?

Regulators Agree

A lot of people who got the same advice to stay invested no matter what eventually watched their account values decline to the point that they finally realized that their broker was full of shit. They sold their portfolios and realized the losses that they had were a result of risks that they never wanted to take.

I handled many customer claims against their stockbrokers recovering losses from the last two corrections. The stockbrokers always make weak defenses when confronted with losses that their customers never expected and which they could ill afford.

These claims are handled as arbitrations run by FINRA, the brokerage industry regulator. They are fast and cheap. Like most court cases, FINRA arbitration claims usually settle before the hearing. Retirees who lose money in the market can often recover some or most of what they lost.

 When every stock brokerage account is opened, there is a question on the new account form that asks for the customer’s “risk tolerance”.   A typical form might ask investors to identify the account as  “conservative”, “moderate”, “aggressive” and “speculative”.  They represent an ascending willingness to lose money. But a willingness to lose is not the same as a desire to lose.

For retirement accounts, especially as the retiree gets older, there is a consensus that the account should become more conservative.  Once people stop working and are using their retirement funds to pay bills, preserving those accounts becomes the paramount concern.

Diversify

A diverse portfolio of stocks and bonds was always considered to be a “moderate” risk account. And then something unusual happened.  The overall market itself has become riskier and many of those diversified accounts took on the risks of an “aggressive” account. 

There is no justification for a stockbroker to tell a customer looking for a moderate risk account to stay invested when the risks of the portfolio they are holding have gone up past the customer’s level of comfort.  Many retirees have already lost more than they can afford to lose.

A stockbroker is required to have a reasonable basis for every buy, sell, or hold recommendation that they make. When arbitrations over losses in 2001 and 2009, went to a hearing, there was nothing that the brokers could point to in their files that showed they had a reasonable basis to tell people to stay invested.

If your brokerage statement shows losses that you did not want, send your broker an e-mail asking for his/her specific advice as to what you should do now.  Ask them for the research reports that support their recommendations.

If they tell you, “the market has always come back” remind them that past performance is no indication of future results. If they tell you that no one saw the pandemic coming, remind them that price to earnings ratios were way above their normal ranges for months before the virus.

If your losses are too high and you get insipid answers from your broker, just send me an e-mail. I will be happy to refer you to an attorney who will help you recover your losses.


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

Or you can book a time to talk with me HERE

The ICO Is Dead. Did The Lawyers Get The Telegram?

The ICO Is Dead

Rewind to 2018

I spent a good part of 2018 reading the white papers for hundreds of Initial Coin Offerings (ICOs). More than 1,000 ICOs were offered to investors around the world that year.

I admit that I was intrigued. Many of these offerings were targeting US investors from overseas.  This type of cross-border finance has always existed but it has always been on the margin of the US securities market. ICOs seemed to want to bring it into the mainstream.

Big companies outside the US could always deposit their shares with a bank or custodian and issue American Depository Receipt (ADRs) to US investors. Financial advisors often tell their clients to diversify a portion of their portfolio into overseas investments.

Some people thought that the tokens issued by these ICOs were an entirely new asset class. Others, myself included, saw that they were being sold as investments and if they could be traded or re-sold, they were just another security.

As I published a few articles on the subject of cryptocurrency, I started getting calls from lawyers around the country who wanted to hear my thoughts on whether the tokens were a security or not and where the line might be drawn. There is nothing unusual about that. Lawyers seek advice from each other all the time. The discussions about ICOs naturally revolved around the Howey decision.  

During this period there were a lot of articles on crypto websites that re-printed the basics of the Howey test and argued why this or that cryptocurrency did not pass it.  Some people argued that the Supreme Court’s decision from 1946 should not be applicable to the new technology.

There had been several US Supreme Court cases on the same subject subsequent to Howey and opinions from other appellate courts as well.  The ultimate question: “is this financing the sale of a security?”, has been considered time and again.

I researched the question extensively in the 1970s.  At that time the marginal US tax rate on the highest wage earners was 70%. At the same time the tax code was full of special credits and deductions as incentives for various types of activities.

Smart Lawyers & Tax Breaks

There was an industry populated by some of the smartest and best credentialed tax lawyers and CPAs who created transactions that took advantage of those incentives to help high earners get relief from their income tax liabilities.  The “products” were remarkably innovative.

One of the incentives was accelerated depreciation on various types of tangible assets.  Using leverage, you might buy a piece of machinery for $1,000,000, depreciate it to zero in 3 years, and pay it off in 10 years. If you put $100,000 down, you got the benefit of the depreciation on the entire purchase price early and depending on your income, you might reduce you tax liability to zero for 3 years.

Of course if you were a high earning doctor you were not likely to be operating the machinery which was a requirement to obtain the deductions.  Many of these tax shelter programs were packaged as “turnkey” operations which raised the question: “are you buying the machinery which can be depreciated or a business which cannot?”  The latter might mean that the transaction involved the sale of an “investment contract” and thus the question: “is this a security?”

I researched and wrote opinion letters that concluded that particular transactions were not investment contracts. The answer to this question, then and now, centered on the economic realities of the transaction.

Judgement Day

Last week a US District Court Judge in NY looked at that same question regarding the tokens issued in an ICO from a Russian company called Telegram. Telegram claims to have raised $1.7 billion through its ICO world-wide, with only a fraction of the investors located in the US. There was no dispute that Telegram was promising investors that they could profit from re-selling their tokens at a later date.

The ICO Is Dead

The Judge’s decision was well reasoned, hit all the points, and really surprised none of the lawyers that are interested in cryptocurrency or ICOs. The SEC brief was full of cases that it had successfully relied upon for years.

Some of the lawyers with whom I spoke in 2018 were writing the paperwork for ICO offerings. Several of the best were on the phone with the SEC staff discussing each offering because they appreciated that they had an obligation to keep their client within the regulatory white lines. That is something that Telegram, apparently, never wanted,

I read yesterday that Telegram intends to appeal the Judge’s order which is to be expected, but they are also, apparently, thinking about defying it.  The Judge has ordered them not to distribute their new tokens and they may do so any way.

Let’s be clear. Telegram did not need to take money from US investors in the first place. If they wanted to they could have followed the rules and registered the tokens or sold them under an exemption to accredited investors only. They chose not to.

In all probability they could have settled with the SEC early on by simply returning the money to the US investors, but they chose to fight the SEC instead.  Nothing in the Judge’s opinion was new law. The facts in this case were not in dispute.

I would have advised Telegram initially that they were issuing securities, had they asked. I think most securities lawyers would have agreed. The investors were going to profit from the efforts of others. That was the economic reality of the transaction.

Some lawyers apparently disagreed and gave Telegram the green light to make its offering in the US in the first place.  After reading the Judge’s decision I find that troubling. What case law were they reading? Will their opinion letters to Telegram on this subject become public as that case continues?

During this time there were some lawyers who publicly stated that SEC’s rules regarding the issuance of cryptocurrency were unclear. I tried to throw cold water on them at the time. If you cannot define a security, or know one when you see one, how can you hold yourself out as a securities lawyer?  

As I was writing this story over this weekend I exchanged comments on LinkedIn with a university Professor who is a fan of Telegram and its platform. He told me that Telegram has over 300 million users. He assured me that Telegram does not sell user information. He reminded me that its founder had refused a request from the Russian government for a backdoor into its system.  I asked him why he thought that any of that was true.

I reminded him that Telegram has never disclosed what it did with the $1.7 billion it raised. Telegram has never disclosed any financial information whatsoever. It may have raised more or less, it may sell user data and it may be in bed with the Russian government. Auditors have never seen its books or its operations. Telegram’s self-serving public statements have no more value than did Madoff’s public statements.

The real issue here should be that if Telegram issued securities, then it failed to give US investors any of the information to which they were entitled. That, of course, is fraud.

As I said, this type of cross-border financing intrigues me. Going forward I expect to help more and more companies from around the world successfully reach US investors. Some amount of creativity may be needed to make the “economic realities” of these transactions attractive to US investors. But there is a difference between creativity and fantasy. Good lawyers know the difference. If your client wants to test the boundaries of the system, they should do it with their own money, not funds taken from investors who were never given all the facts.

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Robinhood- Robbing the Not So Rich

Robinhood

There is nothing like a stock market crash to shine a light on the bad actors in the market. Many of the people who will be exposed will be out and out scam artists. Some of those scams will have been sold thorough mainstream brokerage firms that refuse to spend what it take to actually investigate what they sell.

Many more investors will lose money because the mainstream stockbrokerage firms will continue to offer investors conflicted or unsupported advice.  Investors are being told to “stay the course” and stay invested as the market is sliding to an inevitable bottom, perhaps a year away. 

Investors who lose money will file arbitration claims against their brokers to recover those losses, just as they did after the crash in 2001 and 2009. This time around they will be joined by many customers of online firms who lost money because those firms failed to operate properly. This is something that has not happened very much in almost 20 years.

Wall Street

I started on Wall Street in 1975 as the NYSE, Federal Reserve and the brokerage firms were changing over to large mainframe computers from the legacy hand written orders and record keeping.  There was a lot of skepticism at the time as to whether the computers could carry the load.  The SEC mandated that duplicate paper records be kept for several years just in case of an outage. 

The market crash in 1987 was the first significant correction where the market was wholly computerized.  Before you draw similarities between 1987 and what occurred in the markets last week, remember that the internet was still not widely accessible. The vast amount of information that is available today was not available in 1987.

The Black Monday crash was certainly exacerbated if not caused by computerized, program trading.  Program traders were using computers to analyze the data they had faster than others and then use that data to get in and out of the market before other traders caught up. As a result of Black Monday, the NYSE instituted circuit breakers which, until last week, had only been triggered once or twice since 1987.

When the market crashes, customers want to know what is going on and they want to know immediately.  This fact should not surprise anyone! Nor should it surprise anyone that securities industry regulators have always taken notice when the customers could not access their brokers or accounts.

The year 1975 was also the year that Wall Street did away with “fixed” commissions and unbundled its two primary customer services of advice and execution.  This was the birth of the discount stock brokerage firm and the DIY investor.  By 1987, Schwab and the other discount firms had millions of customers.

Stockbroker?

If you still had a stock broker on Black Monday you had someone to talk to. I know many brokers who were returning calls well into the evening on that day. If you used a discount firm, you had to go to their office to access your account and find out what was going on. Many people did just that.

There was a story that went around a day or two after the crash in 1987. When people at one of the discount brokerage houses could not get through on the telephone to place an order, they showed up, en masse at their local office. The story went that there was such a crowd of panicked customers trying to get into one office, that one of the employees was lying on the floor in the break-room in a fetal position. 

When it was all over the SEC recommended that discount firms beef up their call centers to handle the overload as trading volume was steadily increasing.  Today, most of the large discount firms have local offices supported by call centers.  Complaints that “no one picked up” are rare.  

Trading

About 10 years later, as the internet made trading from home possible, a lot of people took up the challenge and became “day traders”.  Discount firms were opening more accounts than they could handle as the computers they had maxed out.  The problem was noticeable.

Robinhood

I went to a conference to hear a representative of the SEC speak to this issue of customer capacity.  He told the crowd that “you can only fit so many people in RFK Stadium”.  His message was clear, if you don’t have the capacity to service the customers, don’t take them on.  No one in the audience was surprised.  Since 2000, complaints about lack of computer capacity have been rare as well. 

Which brings us to Robinhood Financial, a brokerage firm that claims 10 million distinct customers. Many of its customers are younger, first time investors. 

Robinhood

Robinhood’s site crashed multiple times last week, as the market see-sawed and volume grew. Individual customers were locked out of their accounts during several periods of exceptional volatility.   If you cannot access your account you are not going to be able to lock in gains or avoid losses. You are likely to lose money that you did not intend to lose. 

Apparently no one told the owners of Robinhood that this is not supposed to happen.  They were not part of the brokerage industry in 1987 or in the late 1990s as the industry heeded the regulators’ advice and bolstered their systems and capacity. 

In point of fact it appears the owners of Robinhood have no real experience operating a brokerage firm. They are techies by training and experience and apparently not very good ones.

Robinhood’s website boasts the following: “We are a team of engineers and designers, and we hold the products we craft to the highest standard. We believe that exceptionally engineered systems — not marble office buildings on Wall St — are the cornerstones of establishing trust.”  If you want an example of false advertising, there it is.

Robinhood Financial, like all brokerage firms is a member of FINRA.  It says so right in the fine print on the bottom of its website.  With membership in FINRA should come an understanding that all customers will have access and the ability to place trades in their account whenever the market is open. 

Also in the fine print is this disclaimer:  “Investors should be aware that system response, execution price, speed, liquidity, market data, and account access times are affected by many factors, including market volatility, size and type of order, market conditions, system performance, and other factors.”

Being a member of FINRA and disclosing that your system can be “affected” by a variety of extraneous factors should be mutually exclusive.  System failures are not acceptable in the brokerage industry any more than a software glitch would be acceptable in the operating system of a heart/lung machine. 

Robinhood has previously demonstrated that its management does not understand the stockbrokerage business that it operates in. At the end of 2018, Robinhood announced that it would launch “checking and savings account” that would be covered by SIPC insurance, except that it wasn’t.  The account was supposed to pay out substantially more than any bank savings account except it was never disclosed where that extra income would come from.

No professional brokerage industry compliance officer would have allowed that product to get close to launching. Apparently, no professional compliance officer works at Robinhood Financial.

More recently, FINRA fined Robinhood for directing its customers’ orders only to firms that paid Robinhood for the order flow. FINRA allows for the payments, but it requires the firm to direct the orders to those firms that give customers the best execution price.

FINRA noted that Robinhood’s systems were not set up to follow this basic industry wide rule. FINRA fined Robinhood $1.25 million. All of this begs the question, what other basic industry rules don’t they follow.

Robinhood’s claim to fame is that it does not charge any commission to its customers.   Robinhood executes through a clearing firm and there is no indication that that firm is not charging Robinhood for each trade. It is also clear that the clearing firm did not break down last week. All the problems noted were with Robinhood’s system.

Robinhood has taken in over $900 million from VC investors.  That VC funding allows Robinhood to claim a “valuation” of over $7 billion.  I suspect that some of that money is going to pay for clearing those trades.

Seriously, can a stockbrokerage firm be worth over $7 billion if all it has is software and that software does not work up to industry standards? Can it ever be profitable if it charges it customers nothing? Any profit it might have derived from financing margin loans likely vanished last week as most of those loans were certainly called as the market crashed.

Maybe next time Robinhood’s system will be down for a week or longer.  In a fast moving market the losses could be in the billions. Some regulator needs to look behind the curtain here before 10 million angry customers start calling their Congressperson screaming. At that point it can get really ugly. 

Fintech has become a buzz word for technology that makes the customer experience in finance better and cheaper. VCs pumped $900 million into Robinhood and came out with product that is clearly defective. Technology can improve a lot of things, but applying it to a regulated industry you know nothing about is a recipe for failure and a colossal waste of money.  

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

Or you can book a time to talk with me HERE