ShiftPixy – A Reg. A+ Question Mark?

 I frequently get into discussions with proponents of Regulation A+ who believe small investors should be encouraged to invest in start-ups.  The proponents argue that small investors are being deprived of the opportunity to invest in new companies that may turn into the next Facebook.  Why, these proponents ask, should these “opportunities” only be available to Wall Street fat cats and the wealthiest 1% of the population?

The proponents of Reg. A+ shine the spotlight on those companies that have made successful offerings. That is a function of the sales and marketing effort. They fail to discuss the fact that just because an offering is successful does not mean that the company itself is a good investment.

Proponents of Reg. A+ and especially those who suggest that start-ups are suitable investments for small investors have convinced themselves that these small investors have the skills necessary to evaluate investments.  They constantly tell me that small investors can judge a company and separate the good investments from the not-so-good ones.

In the mainstream markets the task of judging the potential for success of a private company that is about to go public is left to very highly paid investment bankers and research analysts.  It takes a great many hours of hard work and in the end these highly paid professionals do not always get it right.

Simply put, evaluating a new company as an investment is a lot like sizing up a doughnut.  You are attracted to the sweet frosting which is the reward, but you really need to focus on the hole. The hole is what is left out. No company can succeed if key components are absent.

Whenever you evaluate a start-up as an investment the essential question is always the same; given the information presented, can the management make it happen?  Can they execute their business plan with the talent on their team and the money that they are going to raise?

This brings us to a company called ShiftPixy, Inc. which is currently making a Reg. A+ offering of 2 million shares that will be priced at between $6 and $8 per share.  Although the company is only 2 years old, it shows sales of $65 million in the last six months and may have gross sales of $125 million in 2017. There is even a research report from Zacks which suggests that the shares could be worth $12.60 in 2018. Not bad for a start-up. There is a lot of tasty frosting on this doughnut.

According to the registration statement the company is “a leading provider of employment law compliance solutions for businesses and workers in an environment in which shift or other part-time/temporary positions, commonly called ‘gigs’ are performed.”

Essentially, the company provides shift workers, currently in the restaurant and hospitality industries.  Customers move their workers over to be employed by ShiftPixy which then acts as a staffing agency for the customer. By pooling the employees of many smaller companies, ShiftPixy can administrate the human resource management function with economies of scale.

“In return for providing insurance, payroll processing, benefits, and compliance services these enterprises pay ShiftPixy a fee based on their payroll that is much less than the cost of doing these functions in house.”

The registration statement says: “A significant problem for employers in the Gig Economy involves compliance with regulations imposed by federal, state and local governments, including requirements associated with worker’s compensation insurance, and other traditional employment compliance issues, including the employer mandate provisions of the Affordable Care Act.”

I agree that this is a significant problem and any company that can solve a significant problem is worthy of attention.  Government regulations and the attendant paperwork can be expensive and strict compliance is a requirement at every level. A company that can provide employees to other companies while retaining the burden of benefits and paperwork would seem to have a good chance of success.

But can they?  The move to the “gig” economy is being fueled by the employer’s desire to reduce the cost of employees.  According the financial reports in the registration statement, ShiftPixy had deployed fewer than 1800 employees to other companies through the end of February 2017.  How much of an extra fee per employee do they charge?  How much of an extra fee will employers be willing to pay?

The financial reports in the registration statement are not audited. This is not a requirement for a Tier 1 Reg. A+ offering and it is one of my pet peeves.  I have seen too many questionable financial statements over the years.  Proponents of selling Reg. A+ shares to smaller investors necessarily assume that those investors are adept at reading and analyzing a financial statement even as accounting and MBA students struggle to learn how to do it properly.

How does ShiftPixy’s gross margin of compare with competing firms?  Do the smaller investors in this offering know enough to ask that question? Do they know how to find the answer?

For this offering, let’s stick with the more simplistic: can the management make it happen?

In this case the company has two founders; Scott Absher and J. Stephen Holmes. Mr. Absher is the current CEO. The only other executive officer is a newly appointed CFO.  There is a single outside director from another industry.  Since February 2010 Mr. Absher has also been President of Struxurety, a business insurance advisory company.  Neither Mr. Absher, the CFO, outside director or anyone else at the company seems to have any connection to the staffing industry.

There are several well known staffing companies from whom an executive or two might have been acquired. That does not seem to be a priority and it is the primary reason why I have trouble answering the question “can management make it happen?” in the affirmative.

The other founder, Mr. Holmes is not an officer or employee of the company. He is an independent contractor focusing upon building a sales network and providing consulting in relation to worker’s compensation programs as well as Affordable Care Act health insurance programs that the company will offer.  The registration statement notes that he is not involved in any part of the accounting or taxpaying and IRS return filing areas of ShiftPixy’s operations.

I suspect the reason for that disclosure is Mr. Holmes was convicted “for acts related to making false statements in relation to two quarterly IRS Form 941 Employer Federal Quarterly tax returns, one in 1996 and the second 1997, for a company for which he was an officer at the time.” That disclosure is in the registration statement. It does not disclose that Mr. Holmes was sentenced to 15 months of incarceration and apparently served at least part of it.

In order to find out the actual disposition of the case, I had to do some additional research. If you are evaluating any investment, you always need to look at facts outside of the offering paperwork in order to give what you are reading proper context.  That is what is meant by looking at the hole in the doughnut.

I am not here to sling mud. I, for one, think everyone who serves their time is entitled to a second chance. Mr. Holmes, because he owns over 12 million shares of the company will remain a “control person” of the company. He is going to be building up the sales force, not dealing with the paperwork involving taxes or employees. Being able to do that paperwork is this company’s critical task.

That brings us back to Mr. Absher, the CEO, who apparently has also had some issues with government required paperwork.  The registration statement discloses that: “On June 25, 2013, the Alabama Securities Commission issued a Cease and Desist Order (the “Order”) against Scott W. Absher and other named persons and entities, requiring that they cease and desist from further offers or sales of any security in the State of Alabama. The Order asserts, regarding Mr. Absher, that he was the president of a Company that issued unregistered securities to certain Alabama residents, that he was the owner of a company that was seeking investments, and that in March 2011 he spoke to an Alabama resident who was an investor in one of the named entities. The Order concludes that Mr. Absher and others caused the offer or sale of unregistered securities through unregistered agents.

Per the registration statement: “While Mr. Absher disputes many of the factual statements and specifically that he was an owner or officer of any of the entities involved in the sale of the unregistered securities to Alabama residents or that he authorized any person to solicit investments for his company, in the interest of allowing the matter to become resolved, he did not provide a response.”

If Mr. Absher was not an owner or officer of the company in question, he likely could have contested it by filing an affidavit with the State of Alabama.  In my experience, intentionally taking a default, usually indicates that the allegations are true and not worth the effort of fighting. By allowing this order to be entered these facts are deemed to be true.  Saying that he disputes them now has no legal effect and, to me, raises a “red flag”.

There is no prohibition against selling unregistered securities in Alabama (or anywhere else) as long as you file a form with the state, pay the filing fee and make the proper disclosures.  Given that the state of Alabama says that some of that did not happen, it seems difficult for me to imagine that Mr. Absher is well suited for the difficult world of employment law compliance.

I claim no expertise in employment law. I do know that it can be complex and that some aspects of it vary location to location. San Francisco, for example, prohibits employment discrimination and harassment based on the employee’s height and weight. That cannot be the law everywhere.

I would have expected to find an experienced employment lawyer, or more than one on the payroll of this company.  They do not disclose that they have one, nor do they seem intent on hiring one after the offering although “employment law compliance solutions” is what they sell.

Much of the current focus of ShiftPixy is in the restaurant and hospitality industry. Reporting and collecting taxes on tips paid to employees in those industries is another burden.  The IRS requires that an employer must ensure that the total tip income reported by employees during any pay period is, at a minimum, equal to 8% of the total receipts for that period.

ShiftPixy has responsibility to file the paperwork because they are the employer but they have no access to the cash register to see if the information they are reporting is correct or in line with that requirement.  The financial reports also note that there has already been a $280,000 reversal of a charge for workman’s compensation expenses that were “misclassified”. So to me this company has not demonstrated that it can solve the problem that it claims to solve.

ShiftPixy is a staffing/HR company that seems to lack any employees with significant expertise in this often complex field. I would have expected to have seen several people with this expertise in senior management and there is no mention of the need or intent to hire any at the culmination of the offering.

The company sells employment law compliance without employment lawyers and accounting services where everyone important to the company has prior problems with government paperwork.  There are other staffing companies and there is nothing here that screams “we are better.”

Any start-up that is going to compete in an established industry needs to distinguish itself.  To me, this company distinguishes itself by the size of the hole in the doughnut. I think that it specifically lacks the people who can get the job done.

It would seem to have been in Mr. Asher and Mr. Holmes’ best interest to fill this company with knowledgeable employees.  Each of the two founders owns in excess of 12 million shares. If the offering is completed at $7 per share it will increase their net worth by $90 million each. If the share price goes to over $12 in a year as Zacks suggests, by over $150 million each.  With that much on the table I find it surprising that the company seems to be so careless about hiring people with appropriate skills.

Finally, I noted that the attorney who prepared the registration statement was given rights to buy 200,000 founder’s shares at par value $.0001. No other legal fees were charged.

There is nothing illegal about this. Some securities lawyers accept stock in lieu of cash; personally I do not.  I think that it creates the appearance of a conflict of interest.

In a money center like New York or San Francisco, a lawyer preparing a Reg. A+ offering might charge $150,000.  If this lawyer’s gamble pays off and the share value does top $12 per share, he might walk off with more than $2.5 million.  He will be on his yacht while I am still writing blog articles.

Of course if the disclosures later prove to be somehow deficient and a regulator comes in and investigates, an allegation that the lawyer cut corners to get the offering sold may be hard to avoid.

In my opinion what this company lacks is the internal talent to perform the complex tasks that it is selling. It is talent that its more established competitors certainly have and without which I do not think this company can succeed.

The talent at this company is so thin and the payday so concentrated, there is certainly enough here for me to have considered that this offering may be nothing more or less than two people with checkered pasts trying to put one over on unsuspecting investors.  I am more skeptical than most people, but skepticism is what people who evaluate start-ups are supposed to have.

 

 

Regulatory Compliance in Crowdfunding

The more that I blog or comment about the foolishness in the Crowdfunding industry the more people seem to want to shoot the messenger. Of late, several prominent people in the industry have taken umbrage at my comments; a few have gotten personal. Obviously, I have hit a nerve.

I have never been a particular fan of regulation.  I do, however, appreciate that regulations keep the food supply safe, make the air and water cleaner and force people to buckle up their children into their cars that saves many young lives every year.

I also appreciate that the US capital markets are heavily regulated which keeps many of the scoundrels out. It also helps keep investor confidence in the market high and facilitates the formation and intermediation of capital upon which the entire economy relies. Many people see Wall Street as a den of thieves and want more regulation.  The Crowdfunding industry wants less.

The Crowdfunding industry seems to universally hate regulation. A loud cheer went up from the industry when a federal appellate court recently shot down an attempt by state securities regulators to review Crowdfunded offerings.  I doubt a single one of the cheering throng ever had a private placement reviewed by a state regulator. If they had, they might think differently.

Back in the 1980’s many states required private offerings to be reviewed. You would file the offering, pay the fee and usually get back a letter with comments. It was pretty clear from the comments that some knowledgeable attorney working for the state had actually read the document. You could just make the suggested corrections or get that attorney on the phone to discuss them. I never found the process to be adversarial.

To the contrary, I always took some comfort knowing that a seasoned professional had reviewed the document and passed on it. If one of the offerings had later been questioned by an unhappy investor, I would have taken comfort in being able to tell a judge that I had reviewed the offering with regulators in half a dozen states.

At this writing, only ten firms have registered with FINRA to become Crowdfunding portals under Title III of the Jobs Act. A portal will be able to offer Crowdfunded securities to non-accredited investors. It is something that a great many people in the Crowdfunding industry wanted. More firms will certainly take the plunge and register with FINRA to become portals as time goes on.

The Crowdfunding industry sees a need to offer these speculative investments to mom and pop investors. Everyone understands that most Crowdfunded startups will fail. Notwithstanding, the industry continues to stress the “opportunity” for mom and pop to invest in the next Amazon or Facebook.

To be fair, most of the people in the Crowdfunding industry are content to offer investments only to accredited investors on platforms that comply with Title II of the Jobs Act. Many appreciate that hundreds of billions of dollars worth of private placements are successfully sold by the mainstream financial industry every year and follow the well trodden path to success.

Let’s be clear about the fact that owning a Crowdfunding platform or portal can be a lucrative business. Issuers in the mainstream Reg. D private placement market often pay a 10% commission, most of which goes to the individual stock broker who makes the sale. Many Crowdfunding platforms charge a similar listing fee for each offering, all of which goes to the house.

There are a number of people in the Crowdfunding industry who are convinced that regulatory burdens are keeping Crowdfunding from reaching its full potential. They want Congress or the SEC to ease the regulatory scheme for Crowdfunded offerings. The primary concern is that compliance costs too much. The obvious retort is that non-compliance is likely to cost more.

The securities laws, both state and federal, deal primarily with the issuance and trading of securities. They are designed to provide transparency and stability to the capital formation process that is central to our entire economy. If you were to boil all of the laws and regulations down to a single word, that word would be “disclosure”.

FINRA has its own rules which govern the day to day operations of its member firms. A Crowdfunding portal will have no need to concern itself with most of FINRA’s rules. The portal is not trading securities, issuing research reports or handling transactions in options.

Three specific FINRA rules will get the most attention; the rule regarding investor suitability; the rule regarding communications with the public; and the rules regarding the offering and sale of private placements.

FINRA’s suitability rule restricts investment recommendations to those within the customer’s risk tolerance. Every customer who purchases a security on a Crowdfunding portal is buying a speculative investment. Every customer agrees that they understand they can lose every dollar they are investing and that they can afford to sustain the loss. Under the Crowdfunding rules the amount of money that a non-accredited investors can invest is limited. Compliance with the suitability rule is cheap and easy.

FINRA likewise has a fairly comprehensive set of guidelines regarding advertising materials and other communications with the public.  In most cases a portal will use a “tombstone” advertisement which is also cheap and easy.

Other marketing materials for each offering of securities will need to provide accurate information and a balanced presentation of what the investment provides and does not provide.  This applies to the videos with which the Crowdfunding industry seems enamored. If a video is used in conjunction with any offering the video must be accurate, balanced and otherwise comply with the advertising rules.  Again, compliance with these rules is cheap and relatively easy.

The most expensive rules with which a portal or platform will need to comply deals with the sale of private placements. The rules mandate a “reasonable” investigation of private placement offerings. FINRA issued specific guidelines for the offering and sale of private placements in 2010.

Those guidelines (FINRA Notice to Members 10-22) provide: “While BDs are not expected to have the same knowledge as an issuer or its management, firms are required to exercise a “high degree of care” in investigating and “independently” verifying an issuer’s representations and claims. Indeed, when an issuer seeks to finance a new speculative venture, BDs “must be particularly careful in verifying the issuer’s obviously self-serving statements.” The Notice goes on to make suggestions for how due diligence investigations are to be conducted in various circumstances and for various types of offerings.  It highlights the need to identify “red flags” and to resolve them.

The Notice also references several securities anti-fraud statutes, judicial opinions and enforcement actions. There is really nothing new here. I got my training in due diligence in the 1970s and attended my first conference on due diligence in the early 1980s. Not that much has changed.

The small segment of the FINRA brokerage firms that sell private placements to retail investors has a history of conducting due diligence very poorly.  In most cases, it is because they do not want to spend what it costs to do it right even though they may receive a 1% fee, from the sponsor, to do their own and independent due diligence.

Approximately 90 small FINRA firms sold interests in various real estate offerings made by a company called DBSI. DBSI was operated as a classic Ponzi scheme with previous investors being paid from new investment not operations or profits. When the court appointed receiver sued those firms for a return of the commissions that they had illegally obtained, 50 of the firms went out of business.

The Commonwealth of Massachusetts sued Securities America, one of the larger FINRA firms selling private placements over another Ponzi scheme called Medical Capital. Securities America apparently had a due diligence report that raised a number of questions and red flags about Medical Capital and chose to ignore the report. Securities America apparently sold $967 million worth of securities in this Ponzi scheme to retail customers. Medical Capital sold $2.2 billion worth overall. Adequate due diligence would have stopped Medical Capital in its tracks.

Over the years, I have met a number of due diligence professionals who are serious about their job and who do it well. The best bring some judgment and a healthy amount of skepticism to their work. They understand what a “red flag” looks like.

I have also personally cross-examined due diligence officers and industry experts who worked at FINRA firms and outside companies many times.  If they are on the witness stand, it is because I have alleged in the complaint that the loss suffered by the investor could have been avoided. I would argue that if the firm had adequately investigated the offering, they would not have sold it.

Within the first 10 questions I usually ask about their training in due diligence.  Most of the people who do not conduct due diligence investigations correctly were never trained to do so. That fact seems to be true in the Crowdfunding industry as well.

It is also true that due diligence investigations for many offerings are not cheap. That is the primary reason that Crowdfunders do not like to be reminded that they are required to do it. If a company approaches a platform on Monday and the due diligence report is ready on Wednesday, the odds are that the investigation was inadequate.

I wrote a blog article last fall when the SEC brought its first enforcement action against a Crowdfunded company, Ascenergy. The article was reprinted in several Crowdfunding publications. I do not believe that the Crowdfunding industry wants to offer the public fraudulent offerings. I think that most people in the industry unfortunately do not know how to spot one.

I also wrote a blog article about Elio Motors.  I chronicled a number of red flags that I saw when the shares were being offered. Those included the fact that the firm had no patentable product and was raising less money than it needed to deliver one by a factor of 20.  Elio had apparently been taking orders and promising delivery before it made its offering and continues to take orders and deposits even though it has no way to deliver the product.  Notwithstanding, many people in the Crowdfunding industry herald Elio Motors as a success because it was one of the first to raise funds under the new Reg. A+.

The very first call I received about the article was from a class action attorney who saw what I saw.  I suspect that the attorney had someone buy some shares in Elio so that he will be first in line to file a class action when Elio goes under. You can bet that the officers, directors, lawyers and Crowdfunding platforms that participated in the offering will all get sued when the time comes.

Some people in the industry seem to think that if they do not register with FINRA these rules do not apply to them.  Actually, the rules are what is known as a “codification of reasonable conduct” which was a phrase the SEC used to use for rules that were proposed but not finalized. If you sell private offerings on your platform that turn out to be fraudulent, you can explain to the judge why you ignored these simple rules that would have avoided the fraud and protected the investors.

Some people in the Crowdfunding industry despise regulation because they believe that the inherent unfairness of the capital markets that keeps otherwise worthy entrepreneurs from becoming billionaires.  I could glibly remind you that life isn’t fair but the truth is there is no data to support this particular unfairness.

There have always been ways for entrepreneurs and small businesses to get funded.  Before Crowdfunding, entrepreneurs worked two jobs or hustled family and friends for startup cash. The SBA has pumped billions of dollars directly to this market for decades. We managed to get the light bulb, radio and the personal computer into the marketplace before Crowdfunding.  There is far more venture capital money around today than ever before.

There are certainly many professionals in this industry who are doing it right. But there are also many who write blogs, give interviews and put on conferences that do not.  This is the group that keeps chanting, “Regulation is killing Crowdfunding”.  Respectfully, foolish amateurs are killing Crowdfunding with a desire to change the rules rather than play by them. There is much too much hype and much too little substance in this industry.

The fulcrum in the Crowdfunding industry is the desire to fund new businesses. There is an amazing lack of concern for the investors, without whom the industry will wither and die.

As a matter of full disclosure, I am currently counseling people actively involved in the Crowdfunding business. I have been advising a group of realistic executives who want to remove the risk from investors in this market. It is not that difficult. They have spoken to a number of existing platforms about this but have gotten no takers. There does not seem to be a serious interest in protecting the investors at any level of the Crowdfunding industry.

I am also counseling established real estate and business brokers who want to add Crowdfunding to their arsenal of capital raising tools. These are two groups that appreciate the value of raising money efficiently and who are beginning to understand how they can leverage Crowdfunding to make money. To no one’s surprise, most are professionals who have been around the block once or twice. They understand that regulations need to be complied with rather than complained about.

I do not go out of my way to seek out negative aspects of the Crowdfunding industry about which to blog or comment. Many of my negative articles were the result of articles by other bloggers. One lawyer in particular who blogs regularly about Crowdfunding made favorable comments about both Elio Motors and Med-X which in my opinion are scams.

The same blogger spoke highly about two vendors to the Crowdfunding industry who offer a lot for very little but who did not impress me as people who could deliver anything of value when I interviewed them. I would be happy to send my clients to a good vendor if the vendor can supply what the clients need. In both of these particular cases, the vendors were too inexpensive to be able to provide what was actually required. Crowdfunders hate to spend their own money to obtain investors’ money.

I fully intend to continue to call out foolishness in the marketplace whenever and wherever I see it.  I think that is especially fair if I see someone who does not want to play by the rules and who wants your money anyway.

 

 

 

FINRA Arbitration- Where Winning Is Not Everything

The Public Investors Arbitration Bar Association (PIABA) has issued a troubling report to the effect that customers who receive monetary awards in FINRA arbitration forums frequently cannot collect.

Using data from 2013, PIABA demonstrated that more than $62 million in awards made to public customers by FINRA arbitrators in that year went unpaid. That amounts to 1 out of 3 cases where investors went through the arbitration process and won, or nearly $1 of every $4 awarded to investors in all of the arbitration hearings that took place that year.

This is a problem that has been ongoing for many years. FINRA has done little over that time to keep track of unpaid awards and has been reluctant to take any remedial steps. In theory, an award made to a customer by a FINRA panel is due within 30 days. After that it becomes a charge against the firm’s net capital and may lead to disciplinary charges and the firm’s expulsion from FINRA. The latter, of course, hinders collection rather than helping it.

Obviously it is the larger awards rather than the smaller ones that do not get paid. Just as obviously, if the customer dealt with one of the larger firms such as, Merrill Lynch, Morgan Stanley or Charles Schwab, even a large arbitration award is rarely going to be a problem.

Because it is the smaller firms that often opt to go out of business rather than pay a substantial award, PIABA has offered a number of potential solutions including an increase in the minimum requirement for net capital, mandatory liability insurance, broadened SIPC coverage and an industry-wide pool to cover unpaid awards.

I cannot see Merrill Lynch and the larger firms agreeing to fund a pool to cover customers at other firms that they would just as soon have as their own.  And just to be clear, most error and omissions policies carried by FINRA firms specifically exclude actions based upon fraud.

The $62 million in unpaid awards for 2013 is skewed by a single $19 million award that went unpaid and which illustrates the actual problem. The firm that did not pay the award, Western Financial Planning (WFP) actually had insurance, just not enough for its business model.

WFP did not decide to close up shop after the large arbitration award or because of it. It was put out of business by the SEC. A receiver was appointed and assets were managed and sold. Not enough was recovered to pay general creditors like the recipients of the arbitration awards (there were more than a few).

The record does however reflect that WFP sold private placements almost exclusively. Several of the private placements were large Ponzi schemes that resulted in billions of dollars of customer losses causing dozens of small FINRA member firms to close their doors. The only reason that these Ponzi schemes were sold to anyone is that the FINRA firms who sold them did not even attempt to conduct legitimate due diligence investigations to detect the fraud.

Years ago I worked for a law firm that was preparing both public and private real estate offerings. We carried professional liability insurance. The cost was scaled to the dollar amount of offerings that we prepared each year. The more money raised by offerings we prepared, the greater amount of coverage we needed and the premium we were charged went up.

The insurance company sent a representative to our offices. He handed out a multi-page detailed list of documents. “We hope you never have to call upon us to defend you”, he said, “but if you do, this is list of documents about the issue that we would hope to find in your files.” Anyone who thinks that a due diligence investigation is anything other than a way for the issuers, lawyers and brokers to CYA does not understand it.

FINRA has a realistic requirement for due diligence investigations of private offerings that requires member firms to independently verify all of the representations being given to investors.  I had several due diligence officers from smaller firms on the witness stand after the 2008 real estate crash. Almost all just took what the issuer was telling them as gospel. None conducted an independent investigation. You could rarely find a title report or title insurance in their files. None had attended the closing for the property where adjustments are frequently made.

The next crash will assuredly result in arbitrations based upon losses from oil and gas private placements. Where the argument can be made that an office building is an office building, due diligence in the oil and gas industry is very different.

Over the years, I worked on offerings for shallow oil wells in Pennsylvania, deep wells in West Texas, gas wells in Louisiana and at least one shale oil project in Colorado. The due diligence investigation required to verify the facts can differ project by project and state by state. One of the few things that they have in common is they can require multiple experts to conduct an adequate investigation which can obviously run up the cost.

The chance of a small FINRA firm doing an adequate due diligence investigation of an oil and gas offering is slim. I am available as a consulting expert witness for both arbitrations and class actions and I expect that I will be busy.

The problem of unpaid arbitration awards is very much centered in the Reg. D private offering market. It is from investments in the Reg. D market that customers take the huge losses that are the subject of many FINRA arbitrations. Many of the largest Ponzi schemes are sold through private offerings for no other reason than crooks do not want government scrutiny on their offerings.

These offerings are most often sold to retail customers by small firms that specialize in private offerings because the commission on each sale may be many times what it would be on a sale of a similar dollar amount of British Petroleum or ExxonMobil. A broker selling $1 million worth of private placements might take home as much as $90,000 in commissions.

In a registered offering, due diligence is performed by the lead underwriter on behalf of the other firms in the selling group. The issuer pays the lead underwriter for the due diligence process up front before the issue comes to market. In the Reg. D market, each member of the selling group frequently performs their own due diligence and is reimbursed after the fact based upon a fixed percentage of the monies that each firm raises.

This business model where the firms do not get paid for due diligence if they reject the offering and then only get paid based upon how much of an offering that they sell is at the root of the problem. For a large firm doing registered offerings due diligence is a profit center with positive cash flow. For small firms in the Reg. D market it can be an out of pocket cost with questionable reimbursement. Therein lays the problem and the solution.

FINRA might consider requiring a lead underwriter for all Reg. D offerings that mimics the investment banking function for registered offerings. As this is a potentially very profitable enterprise, it is reasonable to believe that some firms would be happy to step up. These firms and only these firms would need enhanced insurance coverage which would be folded into their cost of operations and reflected in the fees that they charge the issuers.

Asking each of the small firms selling Reg. D offerings to purchase insurance against offering statement fraud and adding to the cost of what is already an unprofitable part of their business is not going to gain traction at FINRA. A way to shift the risk profitably to a well compensated lead underwriter might do the trick.

The benefit of loss avoidance in the financial markets which is certainly part of FINRA’s charter should take precedence over insuring recovery costs for the few people who deal with the wrong firms.  It should surprise no one that many people in the brokerage industry do not particularly care for lawyers who make their livings filing customer arbitration claims. The PIABA study, while important, is not likely to stir the industry into action.

Arbitration claims based upon the sale of these offerings to unsuitable customers will still occur, but the aggregate losses will be far less and the number of Ponzi schemes foisted upon the public will likely be dramatically reduced. That is good for everyone.

I do have sympathy for the frustration suffered by the PIABA lawyers but the issue of collection is not limited to securities claims or arbitrations. Thousands of people are injured every year by uninsured drunk drivers .I would argue that it would be easier to substantially reduce the number of Ponzi schemes offered through FINRA firms than getting all the drunk drivers off the road.

 

 

 

Med-X – Crowdfunding, cannabis and chicanery

As a college student during the 1960s, I was exposed to marijuana and had friends who were out and out stoners. As a young lawyer I represented a wholesale head shop company that Time Magazine referred to as “the Dunhill of the industry”. Through them I met many entrepreneurs who had profited in the wholesale and retail paraphernalia industry.

Being a cancer patient I am familiar with medical marijuana. I have read the literature and discussed it with my doctors. I know many people who have used marijuana as part of their recovery from cancer and other illness.

This article is not about the pros and cons of legalizing pot. It is about Crowdfunding, the cannabis industry and a questionable investment.

Sales of marijuana in states where it is legal are expected to top $5 billion this year. Still, I cannot see the loan committee of a major bank or any Wall Street firm step up to finance the cannabis industry in any major way. Even though its use is legal in an increasing number of states, the cultivation, distribution or sale of marijuana is still a federal crime and banks and brokerage firms are regulated by federal agencies.

It is not surprising then, that the cannabis industry has found Crowdfunding to be a source of new capital to fund its growth. Rewards based Crowdfunding campaigns for new vaporizers and similar products are easy to find.

What surprised me was that the Securities and Exchange Commission (SEC) has recently approved a $15 million offering for a cannabis related company under the new Reg A +. The offering for a Southern California based company, Med-X, became effective in early February.

The company has no sales or current business to speak of. The company states that it will use the money from investors to: “research and develop, through state of the art compound identification and extraction techniques, and market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

The Company’s planned compound identification and extraction research and development operation will be conducted primarily at the Company’s existing 600 square foot indoor cultivation center in Chatsworth, California, where controlled quantities of high quality cannabis are being grown, harvested and stored for research and medical use to the extent permitted by California law.

The company has several physicians on its Board of Directors. However, none has disclosed any published research paper on cannabis and none, apparently, works fulltime at the company’s 20’x30’ cultivation center to direct that research. Cannabis is apparently being grown, although the equipment needed to conduct the promised research will not be purchased until the offering is funded. In any event, the research is for future products.

In the meantime the company will use some of the investors’ money “to acquire, create and publish high quality cannabis industry media content through the Company’s media platform, (a website) to generate revenue from advertisers as well as through the sale of industry related products.”

If this were styled as a media company I would not question it. But the website is only a few months old, has no revenue and again the company lacks personnel with a media background to run it.

The company’s other revenue generator will be sales of a product called NatureCide® to cannabis cultivators throughout the world. NatureCide® is an insecticide and pest repellant. This product is owned, manufactured and distributed by a company called Pacific Shore Holdings, Inc. an affiliated company that is controlled by the same person who controls Med-X, Mathew Mills.

Med-X acquired an exclusive license from Pacific Shores Holdings to market NatureCide® products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. An exclusive license can be valuable, however, in this case the products are readily available on Amazon.com making the value of the exclusive license questionable.

Pacific Shores Holdings is a classic penny stock. Mr. Mills was sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors he had no business selling shares to. The structure employed here, with one penny stock company acquiring a large block of stock in another pursuant to a licensing agreement is also a classic penny stock tactic.

Like any Crowdfunded offering, shares of Med-X are being sold by the company directly to the public. In theory investors should be able to make an informed evaluation of the company before they invest their money. But most investors cannot.

I expect that many people will line up to send their money to invest in this company’s shares. It certainly will not be because this company represents a good investment.

More likely, if you will forgive the pun, the buzz about this offering will be about its asserted link to the cannabis industry. The minimum investment is $420. (No kidding).

Stop to consider that its main product, NatureCide®, was pre-existing. Its only connection to the cannabis industry is the statement that it can be used by cannabis growers in the same way that people growing virtually anything else can use it.

Mr. Mills was apparently content to sell shares of Pacific Shores Holdings without adequate advice from a securities lawyer. He now proposes to conduct cannabis research without a cannabis researcher on staff and publish a website without an experienced website publisher.

Remember, I want the Crowdfunding industry to succeed. To do so it will need to offer investors the opportunity to invest in companies that at least have a likelihood of success. I do not believe that investors will find that here.

Instead, Med-X is poised to give both the evolving Crowdfunding and cannabis industries a black eye and to leave many investors holding the bag. The cannabis industry will survive.

If Med-X turns out to be a $15 million scam, (and there are others) investors may begin to realize that there are better places to invest their money than a Crowdfunding portal.

FINRA looks at Wall Street’s Corporate Culture – It should look at its own.

The Financial Industry Regulatory Authority (FINRA) has announced that as part of its 2016 member firm audits it will look into what it calls the firm’s culture of compliance and supervision. The idea is laudable until you put it into context.

Registered representatives (stockbrokers) are routinely incentivized to open more accounts, bring in more money and make more trades. Many successful stockbrokers gain their clients’ trust by presenting themselves as financial advisers when they are not. They are salespeople not analysts or advisers.

That is the culture of the industry. It is demonstrable without an audit.

As someone who has brought arbitration claims against hundreds of stockbrokers, I can tell you that the miscreants among registered representatives are a small minority. Most stockbrokers do not get out of bed thinking “who can I screw today”. More frequently problems arise from advice they are not qualified to give or even more often from financial products that should not be sold in the first place.

The most conflicted advice that is routinely given by FINRA Broker/Dealer firms is for customers to stay in the market no matter what. If the market crashes, which it periodically does, registered representatives routinely tell customers that they did not see it coming and then “don’t worry, the market always comes back.”

Ask yourself: if your stockbroker did not see the market crash coming, how do they know that the market will come back?

My own adviser (an independent Registered Investment Advisor) has been bearish since last summer. After a long bull market he called the collapse of oil prices a “shot across the bow” for the markets and started selling positions and accumulating cash. He has raised more cash of late because he uses stop losses. He believes that protecting a client’s portfolio is part of his job. If your adviser thinks differently or does not use stop losses, send me an e-mail and I will gladly refer you to mine. (I receive no fee for any referral).

A FINRA audit is often performed by an inexperienced auditor (not a CPA) who is thinking about spending a few years at FINRA and then getting a more lucrative job in the industry. Rarely, if ever, do FINRA auditors ask the hard questions.

Trillions of dollars worth of transactions are placed by FINRA firms every year that are perfectly legitimate and need little scrutiny. FINRA would do better to spend time and energy reviewing those transactions that yield the most problems.

Hundreds of FINRA firms and thousands of registered representatives specialize in selling private placements to non-institutional customers. Private placements pay higher commissions than most other financial products and are therefore always a concern for potential abuse. Private placement losses are a multi-hundred billion dollar problem that affects many seniors and retirees, many of whom should never have been offered these investments in the first place.

FINRA has explicit rules about how firms should perform due diligence on private offerings. Failure to conduct a due diligence investigation on private offerings has been a leading cause of investor losses and the reason that a significant number of FINRA firms went out of business when the market corrected in 2008.

Private placements are sold with shiny marketing brochures that are supposed to be reviewed by compliance departments but frequently are not. Do FINRA auditors routinely review the marketing materials for private placements at the firms that they audit to see if they are appropriately reviewed and not misleading? They do not.

FINRA would do well to examine its own culture.

It has never been my practice to file complaints with FINRA’s enforcement branch, in part because they are consistently ineffectual. Some time back, I did file a complaint on behalf of an 80 year old client who had been sold a particularly ugly private placement for a building in the mid-West.

The sponsor, who was also the master tenant responsible to make payments to the investors claimed to be a college graduate who had previously owned a seat on one of commodity exchanges. He also claimed to have been a successful real estate developer.

In fact, the sponsor had never graduated from college, never owned a seat on any commodity exchange and his only prior development had filed for bankruptcy protection leaving many sub-contractors unpaid. I submit that no competent due diligence officer who actually investigated this offering would have approved it. That did not stop dozens of FINRA firms from selling this and other private placements offered by the same sponsor.

The investors ultimately lost the building to foreclosure because the roof leaked badly and needed expensive repairs. The due diligence officer at the FINRA firms that sold this private placement had never seen an inspection report on the building and it is doubtful that a building inspection was performed before it was syndicated to investors. The sales brochure that every investor received described this as a great building and a great investment.

The FINRA enforcement officer that looked into the complaint had never performed a due diligence investigation himself nor was he trained in any way as to what a reasonable due diligence investigation might entail. I know this because I spoke with him more than once. He pronounced the due diligence investigation on this offering to have been fine and on his recommendation FINRA took no action against the member firm.

I took the claim to arbitration and the panel rescinded the transaction giving the customer all of his money back with interest. It certainly helped that the registered representative who had sold the offering to the customer testified that he would not have made the sale if he had known that the firms’ due diligence had been so minimal. If the arbitrators and the registered representative could see that the due diligence was inadequate, why could FINRA’s own enforcement staff not see the obvious?

In another case involving a complex, highly leveraged derivative I asked the branch office manager who had approved the trade to explain the investment to the arbitration panel. After he had embarrassed himself with a clearly incorrect explanation the claim settled. I doubt that many FINRA auditors could have adequately understood this particular financial product well enough to ask questions about it.

Regulatory compliance in the financial services industry is not rocket science. Every supervisor should be able to spot a bad trade if it hits their desk. Compliance does take time and can be expensive.

If the firm has one compliance officer for thousands of salespeople or one due diligence officer reviewing dozens of offerings every month FINRA does not need to delve into the corporate culture. It is a safe bet that adequate compliance is not happening.

I know that more than a few regulators and compliance professionals read my blog. I would appreciate your thoughts and comments.

Elio Motors- A Crowdfunding Clunker?

A colleague asked me to look into the securities offering of Elio Motors in Phoenix, Arizona. The company is one of the first to register shares to be sold under the new Regulation A.

Reg. A allows smaller companies to raise up to $50 million without the use of an underwriter. Elio is selling its shares directly to investors through a Crowdfunding platform called StartEngine.

Elio is attempting to raise $25 million making it one of the largest direct to investor financings to date. Many people in and around the Crowdfunding industry are anticipating the offering’s success.

Elio claims to be a designer, developer and manufacturer of highly efficient, low cost automobiles. The company intends to offer a 3 wheeled, gas powered vehicle that will get 84 MPG and cost roughly $6800.

It certainly sounds good and from the pictures that accompany the offering the vehicles look pretty good as well. The company says that it hopes to be delivering its vehicles to consumers by the end of this year.

Unfortunately, that seems highly unlikely. The company currently has only a few drive-able early prototypes of its vehicles. It does not have a full production prototype, a final design, a built-out manufacturing facility or manufacturing processes. Even with this financing, the company will still need another quarter of a billion dollars to get its manufacturing facility into production.

I reviewed the prospectus and made a note of a number of “red flags” – items that seemed a little off base to me. A number of things caught my eye.

First, the company is insolvent and will continue to be insolvent even after investors put in $25 million. Investors will pay $12 per share and each share will have a negative book value and no liquidity for a long time to come.

Roughly $10 million is owed and due to an affiliate of a large shareholder within the next 6 months. That loan is already over due and subject to a forbearance agreement. If the agreement is not renewed roughly 1/2 of the proceeds of this offering will revert to the lender.

The company hopes to obtain a $165 million loan under a federal government program intended to help existing auto manufacturers expand their businesses. If unsuccessful in obtaining this loan Elio will need to find that much and more, elsewhere.

The government program was intended to help Ford and GM when they were having financial difficulty back in 2008/2009.The program is specifically designed to have low upfront borrowing costs. Elio is paying a lobbyist $1 million to help them to get funding under the program in addition to the lobbyist presently on staff. Perhaps the company does not believe that it could obtain the loan if the government agency judged the company solely on its merits.

There does not appear to be a single dollar of professional venture capital in this company. The company says this is because the venture capital industry moved away from investing in new vehicle startups. Personally, I believe it was because the venture capital industry spotted Elio as a loser or worse, a scam.

There are no patents. Despite years and millions of dollars worth of designs and modifications Elio does not have anything that it deems to be worth patenting. That always begs the question of whether or not their designs infringe on anyone else’s patents.

Perhaps the most disconcerting issue is that the company currently funds itself by taking vehicle deposits from consumers. The company has taken in more than $20 million in deposits from in excess of 45,000 people promising to deliver vehicles for which it does not yet have a final design and still needs up to a quarter of a billion dollars to produce.

The sales projections seem very rich. In order to get its retail price to $6,800 the company is projecting 250,000 units sold annually, meaning sales would be about $1.7 billion. With competition from other larger automotive manufacturers this number even if attainable would seem difficult to sustain.

No one apparently conducted a real due diligence review. StartEngine is not a FINRA firm and cannot be expected to conduct a due diligence review that is up to FINRA standards. The name of the law firm that prepared the offering is not disclosed. Experience suggests that this prospectus is not the product of one of the large Wall Street law firms.

Interestingly, Elio will pay a FINRA firm, FundAmerica Securities, to conduct due diligence on the investors to make certain that they comply with the SEC’s rules regarding how much they can purchase. FundAmerica Securities will receive up to about $950,000 for this service. (For the record, I would have cheerfully performed this administrative task for about ½ the cost).

No similar fee is being paid to anyone to verify the statements in the prospectus and to make certain that all appropriate disclosures have been made. Due diligence can be expensive and the amount spent, if material, would likely be disclosed.

If fully subscribed, this offering will cost Elio about $2.4 million which is about what it would have cost if the offering had been done in the traditional way by a FINRA firm using salespeople. The offering would have been subjected to real due diligence and if it passed more likely than not would have sold out before the end of last year.

I suspect that the “crowd” will buy up all of the shares that Elio is selling, not because the crowd knows what it is doing, but because most people would not know an investment scam if it bit them on the butt.

As I said, a lot of people in the Crowdfunding industry are waiting for Elio to sell its shares as an indication of how the Crowdfunding industry has progressed. The industry would be better served if got behind companies that offered investors a better chance of success.

SEC v. Ascenergy; Crowdfunding’s First Black Eye

The Securities and Exchange Commission (SEC) has brought its first fraud enforcement action that occurred on a Crowdfunding portal  http://Ascenergy LLC et al. (Release No. LR-23394; October 28, 2015).  The Commission alleges that a Texas oil company called Ascenergy raised $5 million from 90 investors on at least four Crowdfunding portals including crowdfunding.com, equitynet.com, fundable.com and angel.com.

Ascenergy claimed to be raising funds to drill oil wells on leases that it had evaluated and secured. The investors were defrauded because Ascenergy had not secured any leases. The person whom the company claimed had evaluated the leases had not done so, did not work for the company and had not agreed to allow his name or resume to be used by Ascenergy to raise money.

Ascenergy used false and misleading facts and omissions to create a false legitimacy which the portals and the public readily accepted. The Commission noted that Ascenergy’s website contained false claims of partnerships or associations with several legitimate companies whose logos appeared on Ascenergy’s website, also without permission.

Investors were told that investing in Ascenergy was “low risk” and that its shares were “liquid” when they were neither. The vast bulk of the money raised was spent on what the SEC calls ”personal expenses” of the person who thought up this scam and who might have gotten away with it.

Scams like this are common in the mainstream Regulation D private placement market. It is more likely that the due diligence process at a Financial Industry Regulatory Authority (FINRA) member firm would not have passed Ascenergy along to investors. No FINRA firm would likely have allowed Ascenergy to call its offering “low risk” or “liquid”.

The SEC’s complaint charges Ascenergy with fraud under the same sections of the federal securities laws that the SEC has been citing for decades. The SEC has made it clear that it expects Crowdfunding portals to actively seek to keep scams off their websites. The SEC has been just as clear that the anti-fraud provisions of the securities laws absolutely apply to Crowdfunding transactions.

The final Crowdfunding rules encourage and almost mandate portals to become members of FINRA. FINRA has established guidelines for due diligence investigations for private placement offerings. The FINRA due diligence standards seem reasonable to adequately keep scam artists away from public investors.

As scams go Ascenergy was not particularly novel or complex. FINRA firms have conducted thousands of due diligence investigations of oil drilling programs over the years. No due diligence investigation properly done by a FINRA member firm would have let Ascenergy claim to have secured leases without verification.

The portals generally do not conduct anything close to this type of due diligence investigation. The investigations can be costly and most portals elect not to spend the money. Very few of the Crowdfunding portals even attempt to conduct a substantive investigation sufficient to catch the “bad actors” let alone the “bad” deals. But do the portals assume the risk?

If you were one of the 90 investors who purchased Ascenergy on one of the four portals listed above, send the portal an e-mail and ask for your money back. Tell them that you have been defrauded because the portal failed to do its homework. Please copy me on the correspondence. I am curious to see how much denial the Crowdfunding industry is in.

Let me predict the future. The next SEC enforcement action will not mention the Crowdfunding portals in passing. The next SEC enforcement action (or the one after that) will find the portals being named as defendants and subjected to significant fines. The SEC has no real budget for Crowdfunding enforcement. In my opinion the SEC’s Enforcement Division is more likely than not to make an example out of an offending portal to send a clear message to the Crowdfunding industry that they must actively attempt to keep fraudulent offerings off their websites. That is, if the industry did not get the message the Enforcement Division delivered in its complaint against Ascenergy.

If any of the portals or their advisers disagrees I would like to hear from them as well. The literature surrounding Crowdfunding is rife with experts who have little or no experience actually preparing securities offerings or raising money from investors. I have seen many articles by “good” lawyers suggesting that a due diligence investigation is an unnecessary cost or that a superficial investigation is sufficient for a small Crowdfunded offering.

The problems that the SEC found with the Ascenergy offerings should not have occurred. Investors should not have had their $5 million stolen. The four portals that facilitated Ascenergy’s fraud owe at least an apology to the investors who got scammed.

Some people in the Crowdfunding industry have already suggested that Ascenergy is an isolated case. As I have written elsewhere, there are a great many portals that are currently offering securities for companies that are obviously not telling investors the whole story. Perhaps it is a little easier for me to spot an investment scam because I have seen so many, but that is exactly the expertise that the portals need and lack.

The Crowdfunding industry projects $40 billion in Crowdfunded offerings next year. The bulk of these offerings will be executed by buyers, sellers and portals that are mostly novices in an uncharted and unregulated market. If you wanted to commit securities fraud, what better opportunity could you find?

The Crowdfunding industry is justifiably jubilant about its prospects for success. Small companies have good reason to cheer this large infusion of new capital. But are the investors jubilant? Certainly not the 90 people who put up $5 million for the securities sold by Ascenergy.

I would advise crowdfunding.com, equitynet.com, fundable.com and angel.com to carefully consider their position should any defrauded customer correspond or a member of the financial press come knocking. A public pronouncement that due diligence is unnecessary or that a cursory investigation is sufficient will likely be used against you in a court of law.

The crowdfunding industry has very few investors who are loyal to one portal over another. It should be obvious to the industry that exposing investors to scams like this will not build loyalty, but will send investors back to their stockbrokers at mainstream brokerage firms.

Due Diligence by Dummies

Due diligence is one of the most misunderstood concepts in the financial world.

As an attorney, I have examined and cross-examined quite a few due diligence officers and experts employed by FINRA brokerage firms. Even those people who are specially tasked with the job of conducting due diligence investigations often do not know what they are doing or why.

The why is easy. Lawyers and underwriters who prepare securities offerings are required to include all the material facts in the offering documents. To do it properly, the lawyers and underwriters must independently investigate the facts to make certain that the sales materials given to potential investors are accurate, complete and the sales pitch for the security is honest.

The law does not presume that the management of any business will necessarily tell their lawyers or underwriters the whole truth. Management, especially management that is in the process of raising money, will often emphasize the positives about the business and leave the negatives out entirely. A good due diligence investigation is always infused with a healthy amount of skepticism about the managements’ claims for the business.

The large Wall Street investment banks usually do a pretty good job of due diligence. The bankers and lawyers usually charge the issuers at Wall Street billing rates to get the investigation done as part of the underwriting process. They frequently bring in experts with unique knowledge of the industry that the business is in.

A good due diligence investigation is the best way for these bankers and lawyers to protect themselves against investors’ claims of misstatements or omissions in the offering documents down the road. For securities lawyers, a good due diligence investigation is their insurance carrier’s best friend.

The due diligence team needs to have a sense of the business that they are investigating. They need to understand the cash flow, the real risks facing the business and how its competitors are positioned.

Even the best sometimes make mistakes. Those who really do not understand the process and those who focus on cutting costs make mistakes more often. Billions of dollars in offerings for Ponzi schemes that were sold by FINRA firms would not have made it to the market if the FINRA firms conducted real investigations of the facts they were presenting to their customers.

Here are some examples of poor due diligence from actual cases:

1) A few years back one of the larger Wall Street firms raised $60 million for a real estate developer who was planning to build a new high-end residential community in Southern California. The carefully calculated projections that came with the offering documents promised that 300 homes could be built and sold in the first year. Only after the money was raised was it discovered that the County in which the development was located, which had been through several years of drought, was not authorizing that many new residential water hook-ups.

2) In a case where a single office building was being syndicated to investors, no one bothered to have the building inspected by a professional building inspector. If they would have done so, they probably would have discovered that the roof of the building leaked, and leaked badly. Most prudent people would not purchase a home without an inspection. Many lenders insist upon it. The brokerage firm executives, some of whom had partied on the promoter’s yacht, apparently did not think that an inspection was necessary.

3) A prospectus will frequently describe the people behind the company as “successful”. Investors value prior success and many people who are raising money claim that they were successful in prior ventures. One real estate developer was described as successful even though he had put his only prior development into bankruptcy. I have asked a lot of due diligence officers to produce their files on an executive’s participation in the success of prior ventures. Very few could produce one.

4) For example, one real estate promoter who raised hundreds of millions of dollars in Reg. D offerings through FINRA firms was described in the prospectus as having previously been the owner of a successful financial firm. Due diligence officers at each of the FINRA firms that sold the offerings failed to discover that the SEC had determined that the financial firm was actually owned by someone else and that the promoter had lied to the SEC when they asked him about it. The SEC case was a matter of public record.

5) Banks frequently use their own appraisers when making a loan because they are risking their own money. A brokerage firm that is risking only investors’ money will often accept the appraisal that the promoter provides. That is never prudent, nor diligent.

I have seen two appraisals that were issued by the same appraiser on the same day for the same property. The one that went to the brokerage firms estimated that the property was worth 5% more than the amount they gave to the bank. Giving a false appraisal to a bank is a felony which is often prosecuted. Giving a false appraisal to a brokerage firm’s due diligence officer is not. Underwriters need to get appraisals from appraisers that they trust and who they pay for, even if ultimately reimbursed by the issuer for the cost.

6) Several large and respected VC funds and investment banks invested funds to build a $500 million processing plant for a company that claimed to have a new process to produce ethanol from wood scraps. The company claimed that the process was proprietary and ready to go which was why they were seeking funds for construction of a large plant to begin producing ethanol. After the bankruptcy, it was determined that the process did not actually work and had never been patented. None of the firms hired a chemical engineer to review the patents or the process. They saved $5000 by not doing so and wrote –off over $500 million because they did not.

7) An offering for a franchised hotel stated that its occupancy would be largely dependent upon events at a new arena being built just across the freeway. The projections indicated that the arena had sporting events, concerts and other events scheduled 340 days a year. A call to the arena box office confirmed that the arena was largely dark for its first few years of operation and was never projected to be occupied 340 days a year. Had a due diligence officer made the same call at the time the securities were being offered and the correct projections given to investors, there probably would not have been any litigation.

8) The SEC just recently brought actions against 22 banks and brokerage firms for failing to conduct adequate due diligence investigations on municipal bond offerings. You can almost hear the due diligence officers saying: “it is a municipality, why spend the time and money investigating it?”

Economic problems are sometimes best viewed along the margins of the markets. The new crowdfunding industry is certainly on the margin of the capital markets. Although each funding project is relatively small, no one doubts that hundreds of billions of dollars will be raised on these platforms as time goes on. Investors on these platforms are entitled to the same honest disclosures of material facts as are any other investors.

At the same time, because the offerings are small, the crowdfunding industry has loudly denounced the need for audited financial information because of the added expense. The probable result will be a great many small companies who will claim solvency when they are not and who will use investors’ funds to pay off undisclosed debts rather than expanding their business as promised.

The SEC always tells investors to investigate before they invest. Underwriters, attorneys and crowdfunding platforms are equally charged to investigate before they offer securities to the public. It is just common sense.

FINRA Arbitration – How investors actually fare

Arbitration is arguably the most efficient way for public customers to resolve a dispute that they may have with their stockbroker. I have personally been a participant in a great many more securities industry arbitrations than most people.

But the arbitrations themselves have become suspect. Too many customers who have clearly been defrauded by their stockbrokers are walking away uncompensated and shaking their heads. A brief case study will illustrate the point.

I located only 35 awards in the FINRA Arbitration Awards database concerning securities issued by a company called DBSI. DBSI was a national real estate syndicator that filed for bankruptcy protection in 2008 and was shown to have been operating as a Ponzi scheme.

I chose DBSI claims for three reasons:

First, the Examiner working for the DBSI’s Bankruptcy Trustee filed a comprehensive report detailing how DBSI had operated as a Ponzi scheme from at least 2004 at which time DBSI was already insolvent. Like any classic Ponzi scheme, DBSI was using funds collected from new investors to pay obligations to prior investors.

Second, virtually every private placement offering that DBSI made after 2004 (approx. $800 million in total) contained an un-audited balance sheet that stated, falsely, that the company was actually solvent. This was important because with each offering the company was taking on financial obligations to the investors, mostly lease payments for the buildings that it was syndicating.

Third, brokerage industry standards require the firms that sell private placements to verify the information that they are handing out in the private placement memorandums s (PPMs). Verifying DBSI’s claim that it was solvent when it was not would not have been possible. Logic and experience suggest that the approximately 100 brokerage firms that sold DBSI securities failed to conduct a reasonable due diligence investigation if they conducted any investigation at all.

So, we have an independent report filed with the Bankruptcy Court that would seem to establish that investors were given false financial information about DBSI at the time the brokerage firms sold the DBSI securities to them. The principal of DBSI was also convicted of fraud, on basically the same facts, at his criminal trial.

We also have aggrieved investors who begin the FINRA arbitration process knowing that the investment that their stockbroker had sold to them was a Ponzi scheme. The public investors should have a reasonable expectation that a securities industry arbitration panel would find that selling interests in a Ponzi scheme to be beneath industry standards and be willing to award the investors adequate compensation.

So how did the complaining investors actually fare?

Of the 35 awards involving DBSI securities that I could locate in the FINRA Arbitration Awards database, the results were as follows:

In 8 of those claims the brokerage firm had either filed for bankruptcy protection or defaulted and failed to appear at the hearing. In two of these claims the brokerage firm was not a named party presumably because it had gone out of business. A substantial number of the brokerage firms that sold DBSI securities did exactly that. Had they not, I would think that there would have been a lot more claims.

The arbitrators made awards in several of these “defaulted” claims where the customers were able to prove up their claim and establish their damages. There is no indication that the defaulting firms actually paid anything to these customers. A brokerage firm that will not defend a claim will generally not pay the award.

In FINRA statistics these count as a win for investors because an award was made, even though the customers did not actually receive compensation for their losses. FINRA does not require its member firms who sell these private placements to have either adequate net capital or adequate insurance. FINRA does not take any steps to enforce an award against the principals of a firm who sell Ponzi schemes and then close up shop.

In 10 of the 15 claims where the brokerage firm was present and represented by counsel the arbitrators dismissed the claim or awarded the investors nothing. One has to wonder why these 10 panels of arbitrators could not be convinced that selling a Ponzi scheme to public customers was conduct for which the customers should be compensated.

In the 5 fully adjudicated claims where the arbitrators did make an award in the customers’ favor, in only one did the panel order the offending DBSI investment rescinded and the customers fully compensated. The rest of the awards were for much less than the amount that the firms’ customers had invested.

In one of the adjudicated claims the panel dismissed the claim for one DBSI investment and made a small award on a second. Both of these offerings contained fraudulent financial information about DBSI. What could these arbitrators have been thinking?

Twelve of the claims brought by customers seeking compensation for DBSI losses were settled for undisclosed amounts. Pre-hearing settlements are often based upon each party’s evaluation of what might be their worst result if the claim is given to the arbitrators to decide. The fact that only one panel deemed it appropriate to rescind the DBSI transactions and fully compensate the customers would certainly impact the brokerage firms’ idea of what might be the worst result that they might suffer if they did not settle.

When you boil this down to the fact that in only one claim in 35 did the customer get all or a substantial award from the FINRA arbitration panel when all were clearly defrauded, it does give one pause to consider than something may just not be right.

Perhaps it might help to look at the expungement phase of some of these hearings. Claims like these are routinely expunged from the record of the individual registered representatives when the claims settle.

After a settlement, the arbitrators conduct a live or telephonic hearing to determine if the claim should be wiped from the representative’s record. The claimants and their representatives do not usually appear at this hearing, nor should they need to appear. Left alone with the arbitrators some industry firms may be taking advantage.

In more than one claim the expungement order noted that the claim (for selling a Ponzi scheme to a public customer) was factually impossible. In others, the panel held that the offering materials (which contained fraudulent financial information) were within industry standards or that the due diligence (which, if done correctly could not have verified that DBSI was solvent as it claimed to be) was adequate and also within industry standards. I personally refuse to believe that industry standards have fallen that low.

These findings by the panels are often supported by “experts” whom the brokerage firms bring to the expungement hearings to educate the panels without cross-examination. If an arbitrator hears this recitation of “industry standards” from an expert or two provided by the industry over several cases, many apparently start to believe it.

It is certainly logical to assume that after many claims involving DBSI and several other large Ponzi schemes that were sold to public customers in the last market cycle (Medical Capital, Provident Royalties, etc.) the arbitrator pool around the country may have been tainted by the patently false “opinions” of these industry “experts”. Arbitrators get no training in securities law or industry standards from FINRA.

Securities industry arbitration has always been considered to be efficient because it costs less than state court litigation. The cost of the forum should be irrelevant if the customers cannot realistically expect to obtain a reasonable recovery of their losses in cases like this. I cannot fathom that a series of 35 juries sitting in civil courts around the country would come up this many defense victories. If I am right then clearly there must be some defect in the FINRA arbitration system.

As importantly, the lack of compensation awarded to these aggrieved investors in FINRA arbitration forums re-enforces a business model where a broker/dealer can be inadequately funded, carry no insurance, affirmatively flaunt the rules, conduct inadequate due diligence and sell millions of dollars of fraudulent investments to thousands of investors. Once exposed, the principals can simply close up shop and open up across the street under a new broker/ dealer and start over.

Either way, if FINRA intends to advocate its forum as fair and equitable to the public investors, it should take steps to see that it really is.

Reg. A+ Assessing the True Costs

From the laptop of Irwin G. Stein, Esq.Many small and mid-sized companies seem to be assessing their option to raise equity capital using the SEC’s new Regulation A+, which was promulgated under the JOBS Act. The regulation allows companies to register up to $50 million worth of their shares with the SEC and then offer them for sale to members of the general public.

Until now, companies seeking equity capital at this low end of the market could only seek funds from wealthy, accredited investors using a different regulation; Reg. D, the private placement rule.

The upfront costs of preparing a private placement offering will always be less than the costs of a Reg. A+ offering. In both cases competent securities attorneys will prepare the prospectus. Reg. A+ requires that the company’s books be audited as well. This is an added expense. The true costs however, will be determined by who sells the offering and how it is sold.

It is not unusual for a private placement being sold under Reg. D to have an upfront load of 15% of the total amount of the offering or more. The issuing company only receives 85% or less of the funds that are raised by the underwriter.

One percent of the load might repay the company’s costs of preparing the offering. Another one percent might cover the underwriter’s marketing and due diligence costs. The rest is the sales commission and other fees that the underwriter is charging for selling the private placement.

Many accredited investors are currently purchasing Reg. D offerings and paying the 15% or more front-end load. There is no incentive for the brokerage industry to charge Reg. A+ issuers any less.

When you purchase shares in a private placement you generally cannot re-sell them. Even if the company does well at first, if it fails in later years, you still lose your money.

With Reg. A+ the shares are supposed to be freely trade-able, except that they are not. The market in which they are supposed to trade is not yet fully developed. It may not develop for quite some time.

How much will the underwriters charge for a fully underwritten Reg. A+ offering? The rule of thumb has always been that commissions go up as the risks go up. Shares issued under both Reg. D and Reg. A+ are speculative investments.

Since both regulations will yield securities that are speculative investments that cannot be re-sold, it is reasonable that underwriters will charge the same for both types of offerings.

Some companies will attempt to sell their shares under Reg. A+ directly to the public without an underwriter. Investors who purchase these shares will get more equity for their investment. That does not necessarily mean that they will get greater value. If many issuers can self-fund without an underwriter it might cause downward pressure on loads and commissions that underwriters can charge.

If commissions on Reg. A+ offerings turn out to be substantially less, many accredited investors may shift to the Reg. A+ market. More likely, some brokerage firms will sell both Reg. D and Reg. A+ offerings side by side. If they do, the commission structure and total load on each should be similar.