Crowdfunding – Impractical Business Plans

There seems to be an overriding attitude in the crowdfunding industry that it exists solely to provide access to capital to small entrepreneurs who have previously been denied access by the evil barons of Wall Street.  Many people in the industry are amazed when I tell them that under the regulatory scheme in the US, the owner of an equity crowdfunding platform or portal is in the business of selling securities and every sale that they do is highly regulated.

The regulations include provisions that are firmly rooted in the idea of investor protection. The regulators will never accept the idea that investors in the crowd can be left to fend for themselves or that proper disclosures do not have to be made. Equity crowdfunding is not a caveat emptor marketplace.

Small investors are being hyped with the idea that crowdfunding portals are offering opportunities for them to invest in the next Facebook or Amazon that will turn their modest investments into huge profits. Investors are actually being offered shares in breweries, distilleries and a lot of small companies with dubious products and often inexperienced managers.

In the mainstream financial market, virtually all of the brokerage firms are members of FINRA so the rules are uniform one firm to the next. In the crowdfunding marketplace only those Title III portals that sell offerings to small investors under Reg. A or Reg. CF need to apply for FINRA membership.  That was intended to provide an extra level of protection for smaller investors.

Unfortunately, some of the portals do not seem to understand their responsibilities as FINRA members.  Several have no personnel on staff with any experience in any aspect of selling securities, let alone compliance with the regulations.

When FINRA expelled crowdfunding portal UFP (uFundingPortal) late last year, in part for listing companies with “impractical business plans”, I expected to see some articles or at least comments from some members of the crowdfunding community about impractical business plans.  The silence from the industry and industry experts has been deafening.

So what, exactly, does FINRA mean when it is telling crowdfunding portals not to list a company that has an “impractical” business plan? It starts with what the company that is raising money is trying to accomplish and whether or not the business plan has a reasonable chance of getting them there.

Everyone would agree that a company that is raising $100,000 and promising that it will be enough money to build a skyscraper in Manhattan or to develop a drug that will cure all cancers has an impractical business plan.  The same would be true if the skyscraper was not designed by an architect or the drug was intended to be sold without FDA approval.

A business plan that suggests that the company will sell one million units of its product using social media would be impractical if the company did not have some way of backing-up that assertion.  FINRA has a consistent policy that requires that there be a reasonable basis for all sales and revenue projections.

As the regulators move forward they will likely find that a company that intends to market a product that infringes on another company’s patent has an impractical business plan. It is also impractical to raise funds to operate a business that is illegal, like a brothel. But not every case will be as clear cut.

The FINRA regulations governing these portals are in addition to the regulations that stem from the federal securities laws. They require additional work and additional skills. Being able to identify and eliminate impractical business plans is one of those skills.

This will make it more expensive to operate a Title III portal than a Title II platform.  Potentially, it is also far more lucrative to be able to accept investments from a larger group of smaller investors.  If you are operating a FINRA portal but you do not have people on staff or as advisors who have experience working at FINRA firms and a clear understanding of what is expected, then I suspect that FINRA will tell you that it is your business plan is “impractical” and put your portal out of business.

In the mainstream markets, FINRA and the SEC have begun enforcement actions signaling that they intend to hold the compliance directors at the brokerage firms personally liable for unlawful transactions that took place on their watch.  I would wager that at least a few of the compliance directors at the 2 dozen or so crowdfunding portals already have regulatory targets on their backs.

I just completed the paperwork for a client who is making an offering through one of the better crowdfunding firms. The offering documents, risk factors, and advertising materials were all reviewed by the firm and the comments demonstrated to me that the reviewers were knowledgeable, competent and well-versed in the rules and requirements. It is not all that hard to comply with the rules if you know what you are doing.  The portals who follow the rules are generally the ones who hire people with some relevant experience.

At the same time, it is very easy for anyone to find crowdfunding portals that are actively inviting small investors to invest in companies that are, for want of a better word, crap.  A portal that lists even one company that would garner this distinction is not doing its job. To my mind, it makes every other offering listed on the portal suspect.  If you cannot make that distinction, you should not be investing at a crowdfunding portal and you certainly should not be operating one.

Please do not push back and tell me that it does not really matter because most start-ups will fail anyway or that investors in these companies know that they are really gambling.  Even casinos are regulated and are expected to operate correctly and in accordance with the rules.

This issue is not that most start-ups fail. The issue is that any start-up funding on a crowdfunding portal should have at least a legitimate chance of success.  They should know how much money they will need and how they will spend it. There is nothing wrong with raising funds to conduct research and development for a new product as long as there is a demonstrable market for the product and the company has people on staff or on hand to conduct the research.

I realize that insisting on “practical business plans” will eliminate a fair amount of the companies that are currently trying to get funded on the crowdfunding portals. That is exactly the point. The JOBS Act was supposed to help companies that could provide sustainable jobs.  Funding companies that are here today and gone tomorrow was never anyone’s idea of what this legislation was intended to do.

The capital  markets, like all markets, work best when they are efficient.  Funding companies that are not likely to succeed is never efficient.  Efficiency results when the companies that have the best chance of success  get funded and those with little or no chance of success do not.

People in the crowdfunding industry tell me that the problem is that the industry is new and just finding its way.  They want to be excused from regulatory compliance until they figure out what to do.

Except that what the crowdfunding portals are doing is not new. People have been selling securities to investors for a long time. The only reason some of the portals are not following the rules is that they do not want to spend the money to do it right.  If they do not believe me, they can explain it to FINRA and the SEC, who are not likely to give them the fair warning that I keep trying to offer.

 

FINRA Expels a Crowdfunding Portal

FINRA has expelled its first crowdfunding portal. The firm, UFP (uFundingPortal) of Herndon, Virginia has only been active since May 2016. In five months it apparently listed 16 offerings which FINRA found to be questionable. UFP signed a consent order agreeing to allow FINRA to expel it from membership. The settlement illustrates how FINRA expects crowdfunding portals to operate.

A central allegation in FINRA’s action against UFP was that the portal knew that none of the 16 issuers had made the filings with the SEC that the issuers were required to make. It is as straightforward as an enforcement action can get; either the required filings were made or they were not. If the portal had asked for copies of these filings it would have known that the filings had not been made and, presumably, declined to list the offerings which is clearly what it should have done.

This is the third regulatory action against crowdfunded offerings and the first against a portal.  The organized crowdfunding industry has greeted this action with a yawn as it did the first two.  The industry has its head buried in the sand because it is populated by a lot of people who have never worked in finance and who keep telling each other that they know what they are doing when they clearly do not.

The first regulatory action against a crowdfunded offering, filed by the SEC in October 2015, was against a company called Ascenergy which raised money from investors on four crowdfunding websites. Ascenergy claimed it was going to drill for oil on land where it had no rights to drill. The principals of the company essentially stole the investors’ money. The SEC did not name the websites in the action. If the websites had conducted appropriate due diligence on the offering investors would not have been defrauded.

I wrote, at the time, about the SEC action against Ascenergy and suggested that it was only a matter of time until the regulators would sanction one of the crowdfunding sites. The crowdfunding industry ignored it. Now it has happened and the industry still does not understand that it is a target for regulators and what to do about it.

In October 2016, the SEC filed its second action against a crowdfunding offering. It halted the Regulation A offering of a company called Med-X. The allegation was that Med-X had not made its required filings to the SEC about its financial condition. The Med-X case is ongoing and an action by FINRA or the SEC against the portal may still be filed. Again, if the portal had merely asked for a copy of the filing, it would have known that the filing had not been made.

The FINRA action against UFP paints a pretty clear picture of what FINRA expects from a funding portal.  FINRA said that it expects “a funding-portal intermediary such as UFP to, among other things, deny access to its platform if the intermediary has a reasonable basis for believing that the relevant issuer or offering presents the potential for fraud or otherwise raises concerns about investor protection.”

Thirteen of the 16 issuers listed by UFP did not have any assets or history of operations and each claimed an unrealistic and unwarranted $5 million equity valuation. FINRA was concerned because these companies had “an impracticable business model, oversimplified and overly-optimistic financial forecasts and other warning signs.”

Obviously, the portal cannot know if it should be concerned about fraud if it does not look.  Federal and state law is crystal clear that the portal or other intermediary is liable for a fraudulent securities offerings if they do not investigate the offering with “due diligence.” Most of the portals do not have a full time due diligence department and there seems to be a lack of understanding across the crowdfunding industry as to what is really required.

When FINRA highlights the fact that the issuers offered by UFP had no assets or history of operations, it is reminiscent of the actions that the SEC brought against so-called “penny stocks” back in the late 1970s.  I represented one of the brokerage firms offering penny stocks back then and the SEC was all over them for taking companies public that were not ready to go public. Nothing in the JOBS Act changed that.

The same is true for financial projections. FINRA requires that there be a reasonable basis for the projections given to investors. If the company has yet to make a sale, what basis is there to project the sale of 2 million units in the first two years?  It is usually wise to conduct a test marketing campaign or prepare a good marketing study before an offering is made. Those are few and far between for crowdfunded offerings.  But if you do not have a reasonable basis to make a projection, you should not make it.

There are fewer than two dozen Title III portals registered with FINRA and I have spoken or corresponded with management, compliance officers or lawyers for a few of them. Some are up to the task and some clearly are not.

The lawyer for one of the portals told me that he saw a gap in the regulators’ thinking. He said: “on one hand (the portal) was not supposed to ‘discriminate’, whatever that means, at the same time they were supposed to reject fraudulent offerings.”

I do not see a gap or a problem. If the offering is questionable or has an “impractical business plan” you do not put it on your website, period. The overriding regulation for the crowdfunding industry is not to allow fraudulent offerings to reach the public. No platform should believe that the SEC would sanction them if they refused to list an offering that they thought was going to be a fraud. Just the opposite is true.

The compliance director at another portal told me that their FINRA registration applied only to the Reg. CF (Title III) offerings it listed. “With respect to Regulation A offerings” she told me, we are “solely a technology platform established to host those offerings. Our FINRA membership has nothing to do with Reg. A offerings and imposes no diligence obligations result from such hosting.”

When I asked if she had a letter confirming that FINRA saw it the same way, she failed to respond.  It was a rhetorical question because FINRA was very unlikely to issue that opinion.

When a firm agrees to join FINRA as a Title III portal, it agrees to abide by all of the rules that are authorized by FINRA’s by-laws. Those rules include a requirement that the firm conduct all of its business in accordance with just and equitable principals of trade and not to commit or “aid and abet” securities fraud in regards to any aspect of its business. A registered representative can be expelled from FINRA for a DUI. The idea that FINRA is only concerned with a firm’s Reg. CF offerings is preposterous.

What, exactly does FINRA expect from crowdfunding portals? Three things. FINRA wants to know that each firm 1) has systems in place and written procedures to foster compliance; 2) has trained compliance personnel in place to carry out those procedures and 3) is vetting the offerings to make certain that what they tell investors is true, reasonable and represents a real business with at least a chance of success.

At the same time, there is no excuse for a Title II platform which is not a FINRA member not to adopt the same procedures and to take the same care that they do not list a fraudulent offering.  These procedures are expenses and few platforms want to pay what it takes implement them correctly.

There is some fraud and the potential for more throughout the crowdfunding industry on both Title II platforms and Title III portals.  I see it. Other people see it and the regulators see it. More than one “knowledgeable” person in the crowdfunding industry has told me that fraud is minimal because the regulators have brought only these three actions. That, too, is preposterous because fraud is fraud whether the regulators catch it or not.

The industry for the most part is in denial because it does not want to see fraud.  In many cases people in the industry would not know a fraudulent offering if they did see one. I am certain that the crowdfunding industry is not interested in eliminating offerings with “impractical business plans” because that describes a great many offerings that appear on both Title II and Title III sites.

Only about 30% of the equity offerings that list on crowdfunding sites actually achieve their funding goals. Issuers incur many costs to list these offerings. The crowdfunding sites are doing no one a favor by listing offerings that investors should not want to consider in the first place.

If crowdfunding platforms exercised some judgment and discouraged companies from raising funds until they were ready to do so, it would help the industry raise that percentage of funded offers. There would be fewer offers but each would stand a better chance of fulfilling the promise of crowdfunding for small businesses and the jobs and opportunities they create.

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 Reports on Robo-Advisors

A year ago FINRA and the SEC issued a joint investor alert regarding robo-investment advisors and other automated tools that offer advice to investors. The alert clearly suggested that investors should be wary because an automated tool may rely on incorrect economic assumptions.

That warning has dissuaded just about no one. Robo-advisors are a fad that is growing exponentially.  Mainstream brokerage firms have acquired existing robo-advisor firms and launched their own robo-platforms.

I have written several articles where I explained why robo-advisors cannot work. In addition to the fact that they may rely on incorrect assumptions, they are also not connected to the real world in any way.  While most investors are concerned with slowing growth in China, the changing price of oil and the continuing rise in interest rates, robo-advisors concern themselves with none of these.  Robo-advisors do not look at what is happening in the broad economy or what is likely to happen.

FINRA has just published a new report on digital investment advice that demonstrates just how poorly robo-advisors perform.  The report asks a great many important questions about the use of robo-investment advisors but answers none.

You can view the report here.  https://www.finra.org/sites/default/files/digital-investment-advice-report.pdf .

The report defines the investing process in six steps; customer profiling, asset allocation, portfolio selection, trade execution, portfolio re-balancing, tax-loss harvesting and portfolio analysis. I don’t quibble with these steps, however, it is how the robo-advisors execute them that is the problem.

The report notes that there is a wide disparity between the platforms regarding the amount of information that they acquire about a prospective customer.  I wasn’t actually troubled by this. The brokerage industry knows how to open an account and obtain enough information to ascertain a customer’s investment objectives and risk tolerance.  It is a task that the industry performs every day.

Where the report was most enlightening was in its side by side comparison of the portfolios that seven robo-advisors would have constructed for a hypothetical 27 year old who was investing for retirement. The disparities are enormous. The amount of equities purchased ranged from 51% to 90%; the amount of foreign issues from 22% to 48%. One portfolio contained 5% in gold and precious metals; another 14% in commodities. The rest had no investments in either category.

Presumably these allocations would not change over the next 40 years as the customer added to the account every year. The FINRA report defines re-balancing as maintaining the target allocation.  I would assume that risk tolerance declines with age, but the FINRA report makes no mention of how that money would be invested in the future.  Even if the allocations were static, the end result would vary greatly platform to platform.

So what, you say? The end result of a 40-year investment portfolio is going to vary greatly if you compare the portfolios prepared by live advisors as well.  True, but the difference is that live advisors are looking at the real world and absorbing real information.  The algorithm that is at the core of a robo-advisor, once set, may never be modified and never looks at real world events.

I have read a lot of articles about robo-advisors.  Few actually try to evaluate the algorithms of one versus another. The FINRA report suggests that member firms need to effectively govern and supervise the algorithms that they use. An algorithm is a mathematical formula. Exactly how does the investment committee at a brokerage firm supervise it?

The FINRA report gives passing acknowledgement that many of the robo-advisors are based in Modern Portfolio Theory (MPT) and gives a shout-out to Prof. Harry Markowitz who first proposed it and later won the Nobel Prize.  I went back and re-read Prof. Markowitz’ article that was published in 1952.  The math was over my head.

Markowitz was a theoretical mathematician who applied his theory to economics, specifically to investment portfolio construction. He theorized that investors would want to maximize their investment returns while at the same time minimizing their risks.

He accomplishes this by theorizing that a diverse portfolio of non-correlated assets will perform better than a portfolio of concentrated assets.  He creates a series of mathematical formulas (algorithms) to show that it is possible.

As a practical matter it is the idea that the various assets in the portfolio are not correlated to each other that is at the core. As oil prices come down for example, we know that it has a negative effect on the profit of oil companies but a positive effect on the profits of airlines and trucking companies. Higher interest rates are good for banks, but not so good for home builders.

Now go back and look at the categories of equities that make up the robo-advisor portfolios; large, mid sized and small cap domestic securities, developing and emerging foreign markets.  How are these non-correlated?  Haven’t builders, large and small in all countries been helped by low interest rates? Aren’t airlines of all sizes in all countries going to be negatively affected if oil prices shoot back up?

MPT necessarily looks at the effect that interest rates and commodity prices have on portfolio securities. I realize that those 5 categories of equities, large, medium and small cap, developed and emerging markets have become standard in some quarters but in a global economy they are less and less non-correlated.  That correlation is even higher if you use baskets of securities (ETFs) because some number of the securities in every basket will be affected by changes in macro market conditions.

Markowitz’ formulas are based upon what he believed investors should want; good returns with less risk. The “efficient frontier” that evolved from his equations is a point on a graph, not a place on a map.  It is a hypothetical goal.

The algorithms that support the robo-advisors are the same, hypothetical. They do not look at the real world, nor are they concerned with it.  They just tell you, if you do X, Y should happen.  That might be true is the world were stagnant, but it isn’t.

One difference between Markowitz and the new generation of algorithm writers is that Markowitz published his equations in a peer reviewed journal. The robo-advisors will never let anyone see what is behind the curtain.

The fact that FINRA can demonstrate the wide disparity between the portfolios that various algorithms would create makes shopping for a robo-advisor all the more necessary while at the same time demonstrating that it is an impossible task.

If you hire a human investment advisor you can sit down and talk to them first. You can ask them what they know and what they think. You can ask them about the markets and about the future. Chances are because they deal with a lot of people they have heard the same questions before and have had an opportunity to consider their answers.

Robo-advisors are a fad. They are popular because they are cheaper. They are sold by disparaging human investment advisors who some people think cannot do any better than average. That begs the question that I have asked before: why would anyone want to hire an average investment advisor?

 

 

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.