Securities and Exchange Commission

September 2021- Crowdfunding at the Crossroads?

crowdfunding, equity crowdfunding, Issuers , ,
September 2021

The crowdfunding industry is about to announce that more than $1 billion has been raised from investors on the Regulation CF (Reg. CF) funding portals. It is a milestone worth noting for everyone involved in the crowdfunding industry.  

Right now there are approximately 63 Reg. CF funding portals in various stages of the licensing process. Of those, only 27 are operating with 5 or 6 dominating the Reg. CF market. The great bulk of that billion dollars was raised on only a handful of funding portals. 

Also this week the SEC has brought its first case against a Reg. CF funding portal, TruCrowd, headquartered in Chicago.  Among other things, TruCrowd is accused of allowing a company to list its offering on the TruCrowd portal after TruCrowd became aware of some significant “red flags” about one of the people who was associated with the company.

TruCrowd had been alerted to the fact that this person had a criminal past, promised to look into it further, and then did not. TruCrowd apparently allowed the offering to continue, simply ignoring the warning. TruCrowd and its owner have now been accused of participating in the fraudulent offering.

News about TruCrowd’s difficulties with the SEC began to circulate on Monday 9/20.  That same afternoon I got an e-mail from TruCrowd informing me that Shark Tank celebrity Kevin Harrington has endorsed a company raising money on TruCrowd’s funding portal.   

A week earlier Harrington and his partner Mr. Wonderful (Kevin O’Leary) were sued by a group of 20 entrepreneurs claiming that they were defrauded by the pair who had promised to help them get funding but failed to deliver. Mr. Wonderful, of course, shills for StartEngine, one of the largest funding portals. 

The crowdfunding industry is remarkably resourceful. Lacking in funds, many of the participants trade in favors and goodwill. There is a lot of investors’ money splashing around and it is always interesting to see where some of it pops up. 

Last week I published an article about a crowdfunding “rating service” named KingsCrowd that is raising funds from investors using a funding portal named Republic. KingsCrowd, which is little more than a shell, claims a $45 million pre-money valuation.

KingsCrowd’s business is to “rate” companies who are themselves using crowdfunding to raise capital.  All of KingsCrowd’s “value” is tied up in the proprietary algorithm that produces these ratings. 

Yet when asked about KingsCrowd’s own $45 million valuation at a company sponsored Q&A last week, the CEO likened it to values assigned by VCs to other high flying companies. Apparently, he was not asked why he did not seem to trust his own algorithm to rate or value his own company.

The KingsCrowd rating system considers, among other things, an issuer’s management team. Save for the CEO, KingsCrowd has no employees, directors or management team. Is the CEO failing to disclose that his own rating system gave his company a bad score?

The CEO was asked why he was selling his own stock at the same time he was soliciting other people to invest in his company. He apparently disclosed that he needs the funds for personal expenses, including his upcoming wedding. No one asked him why the transaction was structured to put more than $1 million into Republic’s pocket for the company’s Reg, D offering, funds that the company did not need to spend.  

KingsCrowd has been reviewing offerings on Republic’s portal since at least 2020.  Republic has had plenty of time to determine exactly what the algorithm can and cannot do. If Republic has a 3 inch file full of documents that verify that KingsCrowd’s algorithm “works”, then I am certain I will hear about it.

The “notice” of the bad actor’s past, came to TruCrowd from a securities lawyer who was not formally affiliated with the portal. I applaud that effort. It serves no one in the crowdfunding industry, if we let investors invest in scam after scam. Unfortunately, TruCrowd did not listen.

I connected with Republic’s CEO and sent a copy my article suggesting that KingsCrowd’s valuation was way too high.  I am going to punctuate that by offering my opinion, in the words of an old friend, that only “an idiot on acid” could come up with that $45 valuation for KingsCrowd or try to defend it.

The very last thing the crowdfunding industry needs is a corrupt rating system. KingsCrowd’s “independence” from Republic, after this game of “you take a million and I take a million” that KingsCrowd and Republic are playing, is certainly suspect.  If the ratings are not “independent” they have no value at all.

KingsCrowd claims “Wall Street has Morningstar, S&P, and Bloomberg; the equity crowdfunding market has KingsCrowd”. Having followed those services over the years, I think it safe to say that none would place a value of $45 million on KingsCrowd today.

I suspect that the active and retired compliance professionals who follow the blog are all shaking their heads thinking that it is time for Republic to put a halt to both the public and private offerings that KingsCrowd is selling. When a transaction runs up against a regulation, a good compliance officer helps to re-structure the transaction until it complies.

It is certainly time for someone to sit down with KingsCrowd’s CEO and tell him that he needs to be picking out a CFO and Board of Directors at the same time he is selecting his Best Man and ushers. I might suggest taking his algorithm and data over to EY, or similar consulting firm, and see if they will take a look and issue an independent report on what the algorithm does and with what accuracy.

I had no idea that the SEC was about to sanction TruCrowd when I wrote the article about KingsCrowd last week.  Against the backdrop of the TruCrowd complaint, I expect that Republic will halt both offerings unless they do not think that I am waiving a red flag.

To me, this boils down to a question of whether or not Republic will take some amount of ownership for the ridiculous, unnecessary, and misleading valuations featured on its own portal. It would be a signal to other portal operators to do the same.

FINRA has previously expelled two other funding portals, each time questioning the valuations attributed to the companies seeking investors’ funds. The argument can certainly be made that a grossly exaggerated valuation is itself a red flag that the company making the offering lacks substance. 

The ball is in Republic’s court. Like I said, this may be one of crowdfundings’ crossroads moments, or not.

If you’d like to discuss this or anything related, then please book a time to talk with me HERE

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

Capital Markets, Investors, Law, Technology
The ICO Is Dead

Rewind to 2018

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

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

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

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

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

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

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

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

Smart Lawyers & Tax Breaks

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

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

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

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

Judgement Day

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

The ICO Is Dead

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

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

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

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

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

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

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

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

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

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

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

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

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

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Crowdfunding after ICOBox

Capital Markets, Investors, Issuers, Law , ,
Crowdfunding after ICOBox

SEC Complaint: ICOBox and Nikolay Evdokimov

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

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

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

SEC Complaint: ICOBox and Nikolay Evdokimov

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

Crowdfunding After ICoBox

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

SEC Complaint: ICOBox and Nikolay Evdokimov

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

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

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

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

Crowdfunding after ICOBox

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Crowdfunding After ICOBox

SEC v. Munchee – Will the crypto-currency community listen?

Capital Markets, Issuers, Law , , , ,

 Just about 2 years ago I wrote a blog article about the first Securities and Exchange Commission (SEC) enforcement action involving equity crowdfunding, SEC. v. Ascenergy.  The SEC action against Ascenergy highlighted the need for the crowdfunding industry to step up and protect the investors from fraud.  That made good common sense because the crowdfunding industry needs investors to survive.

Notwithstanding, most of the crowdfunding industry ignored that enforcement action.  It still largely refuses to carefully vet the offerings that are put on the platforms for investors’ consideration or conduct meaningful due diligence to verify that what the companies are telling investors is true.

Recently the SEC brought what is considered its first action against an Initial Coin Offering (ICO), SEC. v. Munchee Inc.  An ICO is essentially a sub-set of crowdfunding and each offering should be governed by the JOBS Act and the anti-fraud provisions of the securities laws.

A lot of people in the ICO industry will disagree because they believe that they can construct an ICO offering that is not selling securities. The SEC has been clear that it has not seen an ICO that was not a securities offering. Most good securities lawyers agree with the SEC.

Accepting that simple truth would put many people in the ICO industry out of business.  I am referring to the many ICO consultants who charge a lot of money for bad advice. Some of the people who advised Munchee are well known in the crypto industry. Anyone want to bet that they will never mention their participation in the failed, non-compliant and illegal Munchee offering when someone asks about their track record?

On the same day as it announced the Munchee Cease and Desist Order, SEC Commissioner Jay Clayton issued a statement about how the Commission will likely view ICOs. Much of the commentary since has focused on the Commissioner’s statement and not on the enforcement action. That is a mistake.

The Commissioner’s statement covers more ground and speaks in somewhat general terms. It represents the view of the most important regulator in the ICO world, but it is still a statement about generalities that is open to some interpretation.

The enforcement action actually gives more of the “meat” of what the SEC deems illegal conduct. A cease and desist order may become the subject of litigation or appeal. The SEC staff tends to choose its words carefully. It sets forth the facts and the offending conduct, the jurisdictional basis for the action and the reasons why the conduct violates the law.  It is a road map of how not to conduct an ICO offering and everything in it should be scrutinized carefully.

So what, exactly, did Munchee do wrong?

Munchee claimed it was offering “utility” tokens and not securities. It claimed to have performed an analysis of the offering using the test denoted in SEC v. Howey case. I suspect that it did not.  The Munchee white paper lists a dozen officers and advisors not one of whom is an attorney. It provides links to a half dozen PR pieces about the offering but not the attorney’s analysis that these tokens were not securities. The failure to provide a copy of that evaluation was not lost on the SEC staff. They mention that fact specifically in the order.

If an attorney had done the analysis Munchee would set forth the attorney’s name or provided a copy of the evaluation. “Advice of counsel” can be a defense to an SEC action such as this one and Munchee declined to set forth that defense.

A lot of people claim to understand Howey and a lot of articles have been written by people who are not qualified securities lawyers and are claiming to explain it. An evaluation of the offering under the Howey test involves a lot more than just reviewing Howey.

The Order in Munchee refers to Howey and also the SEC’s July 2017 Dao Report.  That report reviews over 30 other cases that have applied the Howey test to various investment offerings. The Order specifically refers to several of those cases which are important to any discussion of this subject.

A lot of people seem to think that if you can use the token for some commercial purpose it is a “utility” token. The Order in Munchee should dispel that idea once and for all.

Purchasers of a Munchee token (MUN) would join a network of people writing reviews of various restaurants. Munchee would pay users in MUN for writing the reviews and would sell both advertising to restaurants and “in app” purchases to app users in exchange for MUN tokens.

Munchee also said it would work with restaurant owners so diners could buy food with MUN tokens and so that restaurant owners could reward app users–perhaps those who visited the restaurant or reviewed their meal in MUN tokens. As a result, MUN tokens would increase in value.

Howey defines a security as an investment premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The argument here might have been that MUN owners might get a profit based upon their own efforts.

But Munchee intended to do much more. It intended to cut off the number of MUN at a fixed amount.  It intended to facilitate a secondary market where people could buy and sell MUN. Because you could buy MUN, not use them or do anything and later sell your MUN for an appreciated price, it should be abundantly clear that your expectation of profits had nothing to do with you and must therefore be derived from the efforts of others.

Let me offer a simple example: You can purchase a membership in COSTCO. The membership allows you to shop in their stores and buy goods in bulk at a discount. You also get free snacks and inexpensive hot dogs. The membership is recorded on the company’s records and you get an ID card with your picture that is checked every time you enter the store so it cannot be transferred to anyone else.  No one would think that a COSTCO membership is a security. But the SEC has declared some other memberships to be securities.

If COSTCO decided to cut off the number of memberships and allow them to be transferred, it might be fair to assume that the price would appreciate. That alone might make them into securities. Transferability, or the lack of it, is not itself the only indicator. A lot of unregistered securities cannot be freely transferred. But once your token can be transferred at a potentially appreciated price, you should certainly consider that you have crossed the line.

The other big issue raised by the SEC staff in the Munchee Order was the way in which the MUN were sold. Munchee posted information about the offering and the MUN White Paper through posts on the Munchee Website, and on a blog, Facebook, Twitter, and Bitcoin Talk.

This type of general solicitation is specifically permitted by the JOBS Act and is the type of marketing that is needed when a company is trying to raise $15 million without a brokerage firm selling the securities for them. If Munchee had accepted the fact that these were securities, this would not have mattered as long as they did not exaggerate the facts or the potential return.

At the same time, Munchee did not advertise the offering of MUN tokens in restaurant industry media to reach restaurant owners and promote how MUN tokens might let them advertise in the future which is what you might expect if the tokens were being sold for their “utility”. The SEC staff picked up on that fact.

Instead, Munchee and its agents promoted the MUN token offering in forums aimed at people interested in investing in Bitcoin and other digital assets. Munchee made public statements or endorsed other people’s public statements that touted the opportunity to profit, not necessarily the opportunity to use the MUN.

The Order states: “MUN tokens were to be available for purchase by individuals in the United States and worldwide.”  It notes that Munchee intended to use “10% of the offering proceeds ($1.5 million) to make sure Munchee is compliant in all countries.” While that sounds fairly innocuous, as I said, the SEC staff chooses the language it puts into these orders carefully.

There are countries where no crypto-currency or tokens can be sold, so saying it can be sold “worldwide” indicates that the offering is a scam. In a securities offering, it is common for the offering materials to set forth the countries where the offering is being made.  Most telling is the fact that you need to be certain that you are “compliant” before you make the offering, not after. The Howey test does not apply anywhere except the US.

The simple truth is that I would have been happy to help this company raise $15 million for a lot less than $1.5 million in full compliance with securities laws. I would have advised them to sell stock in the company and then memberships separately. They would have had a successful offering and money to market and sell memberships at a lower, more reasonable price where many more people might have joined.

The lesson here should be obvious. If you are claiming to offer a utility token, demonstrate its utility and sell it to people who may want to use it. If you are seeking investors, then stop telling yourself you are not selling a security. Hire lawyers and comply with the rules.

The time, effort and expense that the founders of Munchee expended developing their app and their business, went nowhere.  With the JOBS Act the opportunity for funding a small business has never been greater. If you want money from investors, stay between the white lines.

Ziyen Inc- Another Reg. A+ Question Mark

Investors, Issuers, Law , , ,

I have written several articles about specific Reg. A+ offerings. These offerings are targeted at small investors who are ill-equipped to judge their value as an investment, let alone, the accuracy of the disclosures.

I recently got a call from a colleague who works at a reputable brokerage firm.  He suggested that I look at the Reg. A+ offering of a company called Ziyen Inc.  He thought that it might be the grist for a blog article. He was not wrong.

Ziyen Inc. was incorporated in April 2016 to provide a suite of “cutting edge digital business intelligence, marketing and software services.”  By business intelligence it means information about available government procurement contracts, initially in Iraq and eventually globally.

The offering circular states: “Ziyen currently operates the B2B Procurement Portals “Rebuilding Iraq.net” and “Cable Contracts.net”.  “Rebuilding Iraq is our first B2B Procurement Portal, and the flagship service for the company. We are currently the number one international source for information on tenders, contracts, news and marketing services in Iraq.”

As far as I can tell, Rebuilding Iraq.net lists tenders for contracts that might be found elsewhere and does not charge for the information. It claims that 200,000 people visit the site every month.  When I checked Cable Contracts.net, which does charge for usage on a monthly subscription basis, I did not find any tenders listed. According to the financial statements in the offering circular the company has no revenue and roughly $7000 in the bank.

The company is selling up to 64,000,000 shares at $.25 per share. It is self-underwriting, meaning that there is no brokerage firm involved or even an established crowdfunding platform.  The offering circular mentions two crowdfunding platforms by name and the subscription agreement mentions a third, but I could not find this offering on any of them.

It appears that shares are being sold directly from the company website. The website actually uses shopping carts into which you can put a bundle of shares and check out using a credit card. And before you say that the shares are only $.25 a piece, the bundles go up to $25,000 so this is a serious offering of securities.

The subscription agreement also mentions an escrow agent where investors can deposit their funds, except that no escrow agent is being used.  According to the offering circular, “Subscription amounts received by the Company will be deposited in the Company’s general bank account, and upon acceptance of the subscription by the Company, the funds will be available for the Company’s use.”

No competent securities attorney would permit these types of inconsistencies. In truth, it appears that no competent securities attorney was involved in the preparation of this offering.  None is disclosed and no funds are allocated to pay an attorney to prepare the offering or deal with the Securities and Exchange Commission’s Division of Corporate Finance which reviewed it.

It appears the offering was prepared by the company’s principal, Alastair Caithness, a Scottish-American businessman.  You can tell he wrote the offering circular because he refers to himself in the first person – “I was Head of Sales in a company in the UK” although he never discloses the name of that company.

The offering circular also obliquely refers to other employees and a Board of Directors, none of whom are named. The Company does business in Iraq and for all you know the Company might have people on its Board of Directors whom the US government might not look upon favorably.

I did find six other Board members on the Company’s website, but their backgrounds were short on the type of detail I would have expected to see in an offering circular. The disclosures give incomplete employment histories and several fail to disclose where they were educated.  Nothing negative was disclosed about any of them and I am not suggesting that there was anything negative to disclose. I am only questioning whether Mr. Caithness would have known what disclosures the rules required.

For a little perspective, back in the late 1970s when I was writing registration statements I took some flak from the Division of Corporate Finance because one of the executives at an issuer had claimed to have a Bachelor’s degree and did not. It seems he got his draft notice right before his senior year final exams and decided that graduating was not that important. When he took the job at the company years later his resume said that he had graduated and no one had ever checked. The Division of Corporate Finance told me at the time that was a misstatement of a material fact.

I must have missed the memo where they subsequently decided that not disclosing the names of the members of the Board of Directors in an offering circular was not an omission of a material fact.  Nowhere in the offering circular does it suggest that investors should review every page of the company’s website or every subsequent press release.

The offering circular is dated mid-October of 2016. In mid-April 2017, the Company announced separately that it had established a “new investment division in the company to focus on financing unfunded construction projects in Iraq”.  It claimed to have “the capabilities to provide the finance for long-term projects.”  Financing for long-term projects?  According to the offering circular the company has $7000 in cash in the bank.

In June 2017, the Company announced that Ziyen Energy, a division of Ziyen Inc., had just secured over $36 million dollars of oil reserves in Indiana in the United States.  The deal includes 7 existing oil producing wells worth over $6 million dollars of proven reserves along with a support water injection well and a water producing well for injection purposes with a further potential for 20 new oil producers on undeveloped reserves on the site worth over $30 million.

That would certainly be big news, except the offering circular does not mention Ziyen Energy nor any intention to be in the oil production business, much less in the oil production business in the US. If you were to download and review the offering circular today you would have no idea you were investing in an oil company. Even if you tracked down the press release, it does not disclose how much the company paid for these reserves, whether they were financed, how much the wells are producing or if contracts are in place to sell the production.

As I was researching this article I was prepared to give Mr. Caithness the benefit of the doubt. I thought he was just a businessman trying to raise some money for his own company on the cheap, i.e. without hiring a competent securities attorney.

Then I found this offering on a crowdfunding platform that specializes in Reg. A+ offerings called Wall Street Capital Investment. It is owned by Mr. Caithness who holds himself as an expert and offers to help raise money for others.

Ziyen Inc. is actually the second offering on that platform. The first is a company called Novea Inc. which shares the same address in Cheyenne, Wyoming as Ziyen. (Mr. Caithness is actually in California and presumably operates Ziyen from there. I have no reason to believe that Novea is actually in Cheyenne either.) The offering circulars for the two are remarkably similar and no attorney was apparently paid to prepare the Novea offering either.

Novea Inc. also has neither revenue nor cash in the bank and is in the business of offering warranties that “disrupt” the warranty industry.  One of its largest shareholders is Mr. Carlos Arreola who is Mr. Caithness’ partner in Wall Street Capital Investment. As an aside, the advertising for both companies feature the same actor and the marketing plan and press releases are also very similar.

I also suspect that this is about more than just saving some money on legal fees. Had Mr. Caithness come to me I would have suggested that he raise his funds through a Reg. D offering to accredited investors. He would have spent about the same as he anticipated (the offering budgets $20,000 for crowdfunding and related expenses) whereas the average cost of a Reg. A+ offering is in the neighborhood of $150,000 and much of that is for the lawyers.

Personally I think this offering might have been difficult to sell to accredited investors given that its business plan is weak. But if its Rebuilding Iraq.net website gets 200,000 views per month there would be a steady stream of non-accredited potential investors who are pre-disposed to the idea that Iraq needs rebuilding and might put a few shares in their shopping cart, even though they would actually be investing in a US domestic oil producer.

And that is really the point. Since there is neither a competent securities attorney nor broker/ dealer involved with this offering it is up to the individual investors to investigate this offering and make their own decision. No one has vetted this offering and no one can say whether every material fact is disclosed or accurate. The crowdfunding industry needs to stop deluding itself into thinking that small investors can actually perform due diligence.

Given the internal inconsistencies and inaccuracies, the failure to disclose the names of the Board of Directors and the fact that this was a DIY Reg. A+ offering I would have expected a little more scrutiny by the SEC’s Division of Corporate Finance before it was approved. But that no longer matters.

I know that about two dozen senior staffers at the SEC receive this blog through Linked-in, as do people at FINRA and the offices of state securities administrators in more than a dozen states. I know that people in a few Congressional offices that have oversight on the SEC and crowdfunding receive it as well. This one is a no-brainer.

From the company’s own press releases it is obvious that the information being disseminated to prospective investors in the offering circular does not reflect the current state of the company’s affairs. If a cease, desist and disclose order is not appropriate here, I cannot imagine that it will ever be appropriate anywhere.

I am older than most of my readers. I was around and litigated matters involving Stratton Oakmont and before them Blinder, Robinson and First Jersey Securities, so I think I have a pretty good idea of what a micro-cap fraud looks like. I was not certain that I was looking at one here until I got to the press release about the potential for 20 new producing oil wells. There have been quite a few micro-cap frauds involving oil stocks over the years. Mr. Caithness and his partner are registering a lot of their own stock. My gut tells me that there will be an enforcement action here sooner or later.

I am not a whistle blower. I know a lot of lawyers and others who are trying to navigate the Reg. A+ waters specifically because they believe that more companies need access to capital and that smaller offerings should be open to smaller investors. Their hard work will go for naught if the investors are drawn into scam after scam.

I am not the world’s biggest fan of government regulators. But if you want the fire department to show up and put out a fire, you need to scream FIRE at the top of your lungs. That is really all that I am trying to do.  I am optimistic that some securities regulator will hear me. There have already been far too many examples of fraudulent Reg. A+ offerings that the crowdfunding industry does not want to talk about.  Here is an opportunity for the SEC to re-enforce the need for compliance with the rules. Investors should be able to look at an offering circular and at the very least get accurate disclosures of all of the facts.

 

Crowdfunding – Letter to the SEC

Capital Markets, Issuers , , ,

The SEC and New York University recently held a dialogue on securities crowdfunding.  SEC Commissioner Kara M. Stein offered closing remarks and asked some questions that need to be answered. https://www.sec.gov/news/statement/stein-closing-remarks-sec-nyu-dialogue.html. These are my thoughts and responses to Commissioner Stein’s remarks.

Dear Commissioner Stein:

By way of background I am a securities attorney with 40 years of experience representing broker/dealers, issuers of securities and large and small investors.  I have also taught economics and finance at a well reputed business school.

My interest in securities offerings that are made directly to investors over the internet goes back to the late 1990s when the first offering was made by the Spring Street Brewery company. I have spent the better part of the last two years studying and writing about crowdfunding under the JOBS Act.

I currently advise clients who are issuers, Title II platforms and Title III portals.  I believe that crowdfunding can work and that it can be a valuable tool in aid of the capital formation process especially for smaller companies.

To this point in time, a large percentage of successful offerings involve various forms of real estate investments. The vast majority are being offered under Regulation D. Several real estate funds have raised $25-$50 million from accredited investors on Title II platforms. Thousands of smaller real estate offerings have also been successful. These offerings are proof that funding is available outside of the traditional broker/dealer sales network.

Small companies and start-ups on the other hand, have had a much more difficult time attracting investors.  Start-ups, of course, are far riskier investments than most real estate offerings.  There are far fewer investors in the market place who are looking for that risk.  Some will take on the risk if they are satisfied with the potential for the company’s success.

There has been a push to offer securities in these companies to smaller investors under Regulations A and CF on Title III portals. The question that you asked in your remarks at the SEC-NYU dialogue: “Are registered portals appropriately considering the companies and offers hosted on their platforms?” is the appropriate question to ask.

There are fewer than 2 dozen registered portals today. I have reviewed offerings on most and have had direct contact with several. The answer to your question is that some of the portals do indeed act appropriately and several clearly do not.

You can easily identify those portals that do not comply with the rules. Most of those do not have a well trained and experienced professional in the role of compliance director.  The compliance director at any Title III portal should, at the very least, have a complete familiarly FINRA’s due diligence and advertising rules.

There are several portals who do not even attempt to conduct a due diligence review. There are also several consulting firms that provide due diligence investigations to the crowdfunding industry that lack the experience or expertise to do it correctly. These consultants get a lot of work from the portals because they charge very little.

You asked whether there should be minimum and uniform standards for vetting companies seeking to be hosted on a portal.  FINRA already has very specific rules for due diligence that require the member firm to verify the facts that the issuer is presenting to investors.  New rules are not needed; just compliance with and the enforcement of the existing rules.

One FINRA member portal in particular that has specialized in Reg. A offerings has listed several issues which are questionable in terms of their disclosures and economic viability. That portal makes no attempt to vet the offerings it lists.  One of these offerings is currently the subject of an SEC enforcement action.  I cannot know if the Commission’s enforcement staff intends to sanction the portal for its participation in that offering.  In my opinion, it should.  This portal unfairly competes with the portals that take their responsibilities seriously.

This portal does not spend money on due diligence. It does not care whether the issues it lists misrepresent their prospects for success to prospective investors.  It has a track record of successful offerings because the issuers are making promises to investors that they are unlikely to keep.

You suggested that some people have registered their concern at what may be a “race to the bottom” as portals compete for offers. That is exactly what is happening.  That same portal is currently offering a one day Reg. CF workshop that provides issuers with accountants, lawyers, copywriters and other vendors to get their campaign to “go live” on the same day as the workshop with no cost.

I cannot imagine that the SEC staff or FINRA would believe that adequate due diligence is being done if the offering is going live on the same day that the portal is first introduced to the issuer. I cannot personally believe that a competent securities attorney would participate in the preparation of these offerings or that the attorney’s professional liability carrier would approve.

Your presentation also noted that FINRA had expelled a portal for listing 16 questionable Reg. CF offerings. Those offerings were essentially done with a “cookie cutter” approach. What besides a cookie cutter approach can be expected when a portal is proposing to create and list multiple offerings on a single day at a workshop?

I have singled out this portal because its conduct is so egregious that I suspect that the Commission staff has already taken note.  I am not the only person in the crowdfunding industry who would understand if FINRA or the Commission did its job and closed this portal down.  If the crowdfunding industry is to succeed, investors must be able to look to this market with confidence.

You also asked what needed to be done to ensure that crowdfunding opportunities are accessible to everyone from the businesswoman in Missouri to the immigrant in West Virginia.  I have personally been contacted by potential issuers from all over the country. I know that Title II platforms exist in many states and several portals are “under construction” outside of major money centers.

Many of these issuers lack the knowledge and skills to put together an offering that might attract investors.  They lack experienced managers, quality boards of directors and well thought out business plans.  The Small Business Administration (SBA) has an existing mentoring program (SCORE). The Commission would be doing the marketplace a service by partnering with the SBA to make accurate information about crowdfunding available to more potential issuers.

There is currently a lack of good information about crowdfunding in the marketplace and much of the information that is available is inaccurate.  Much of the information about crowdfunding is being disseminated by a remarkably small group of people.  Many of these people have no experience selling securities and treat the process as if they were selling soap powder.

You expressed a desire on behalf of the Commission to improve this marketplace. There are those who are advocating making these very risky investments more accessible to small investors. I urge the Commission to reject that approach.  The risk should be allocated to those investors who can afford to absorb the loss.

As you noted, “portals that are effective at vetting issuers and offers are important as both gatekeepers and facilitators of repeat investment.” Keeping the portals focused on that task is the best thing that the Commission can do for this market.  Investors will come when there are better offerings. Better offerings will come when the portals insist that issuers demonstrate that they have real potential for success.

Respectfully,

 

Irwin G. Stein, Esq.

 

 

 

Crowdfunding Mailbag

Capital Markets, Investors, Law , , , ,

Without investors Crowdfunding will become a footnote in financial history.  The Crowdfunding industry continues to demonstrate that it just does not care about playing by the rules or giving investors a fair shake.

A few weeks ago, I wrote an article about Med-X, the first equity Crowdfunding campaign that the SEC stopped mid-offering. It was only the second time that the SEC’s Enforcement Division had gotten involved in a Crowdfunded offering and I thought it was worthy of an article.

Among other things, Med-X was raising money to research and sell products derived from cannabis. One of the larger cannabis websites re-printed the article and I got e-mails from a lot a people in the cannabis industry.

Several people suggested that the SEC’s action was part of a larger government effort to hold back the cannabis industry by denying it funding. They suggested that some Crowdfunding sites would not accept cannabis related offerings before the Med-X action. They thought that this enforcement action would have a chilling effect on their efforts to raise capital.

Frankly, I doubt this is the case. The SEC originally approved Med-X to sell its shares and there are a number of public companies in the cannabis industry. The SEC cares more about disclosure issues than it does about drug enforcement.

My article was also re-printed on a financial website. I got e-mails from several securities lawyers and people in the mainstream financial markets, many of whom, like myself, marvel  about the fact that the Crowdfunding industry offers securities to investors seemingly thinking that the body of law surrounding the sale of securities does not apply to it. The JOBS Act gives some relief from the registration provisions of the securities laws. The anti-fraud provisions of the securities laws still apply.

My real issue with the Med-X action was with the Crowdfunding portal that offered it, StartEngine. Med-X had failed to file financial information that it was required to file, meaning that investors were not getting information that they were required to get.  StartEngine is registered with FINRA as a Crowdfunding portal.  FINRA’s rules certainly impose a duty on its members to disclose all material information whenever they offer securities to the public.

I got an e-mail from the Compliance Director at StartEngine who told me that the SEC’s action against Med-X was about a missed filing date and the SEC did not mention the word “fraud” in its paperwork. Under the securities laws, fraud is defined as the omission of material facts. The failure to provide required financial information to investors fits that definition like a glove.

The Compliance Director told me that StartEngine was represented by competent counsel which I have no reason to doubt. Regulatory compliance in the securities industry is not something that they teach in law school. You are not likely to become well-versed in day to day compliance issues working for a law firm or regulator. You learn compliance the same way that a surgeon learns surgery; by doing it under the guidance of someone who knows what they are doing.

I was trained in compliance when I worked at two large brokerage firms. I offered to explain the problem that she apparently did not see to the Compliance Director or her counsel, without charge. I told her that I really hated to see someone step in it when this was such an easy problem to fix. She respectfully declined.

There are only about a dozen Crowdfunding portals that have registered with FINRA to conduct Regulation A+ offerings. I have corresponded or been on the telephone with the Compliance Directors of four of those portals. Three of the four had no experience with FINRA compliance.  The one who did have experience stood out like a rose in a garden of weeds.

One correspondent asked me why I brought up Elio Motors, another StartEngine offering in the article as well. Elio has become the poster child for the Regulation A+ offerings because it successfully raised about $17 million from investors. The marketing director from Elio recently spoke at one of the Crowdfunding conferences presumably to regale the attendees with Elio’s fundraising success.

I consider Elio Motors to be a nasty problem that will come back to bite the Crowdfunding industry on its butt. In my opinion Elio is a scam. I am not the only person who thinks so.

I base that opinion on the fact that Elio has been taking deposits and promising to deliver a vehicle to customers since at least 2014. Elio has no vehicles to deliver and is not actually building any. Taking deposits for and promising delivery of a product that you cannot hope to deliver is a deceptive business practice under state and federal laws.

In its Reg. A+ filing Elio disclosed that it was trying to get a loan from the Department of Energy to fund production. To qualify for the loan, Elio would have had to demonstrate that it had a strong balance sheet and that it could reasonably be expected to repay the loan.  Elio is insolvent.

Elio has taken deposits from approximately 65,000 people. I would not bet that these customers will receive delivery of their vehicle in 2017, if ever.

Rather, I would bet that a regulatory action (or a bankruptcy, or both) is going to occur in 2017.  Elio has raised a lot of money from the Reg. A+ offering and the deposits but does not seem have a lot of the cash on hand.  It still needs between $200-$500 million more to deliver on its promises.

Is it possible that a VC fund will make a substantial investment in Elio and bail them out? Yes, but I do not see it. Elio still has not demonstrated that even if developed its vehicle will be street legal.

To me Elio does not pass the smell test. I cannot imagine how a competent due diligence officer gave Elio’s offering a green light.

Another e-mail came from a person who suggested I should not be concerned with Med-X’ failure to make proper disclosures because “everybody” knows that most Crowdfunded businesses will fail and that investors treat Crowdfunding as if they were gambling in Las Vegas.  While I acknowledge that most Crowdfunded businesses will fail, the odds in Las Vegas are actually substantially better that the player will walk away with some of his money.

That person also told me that I do not appreciate that Crowdfunding is intended to “disrupt” the way in which capital is raised. I do appreciate that Crowdfunding is intended to allow companies that would not have access to that market to raise money from investors. I also appreciate that there is a correct, legal way accomplish this.

At the end of the day owning a Crowdfunding portal can be a lucrative business.  All I ever suggested was that every portal needs to play by the rules and offer good investments to investors.

In just one year the SEC has acted twice against issuers who broke those rules. In both cases the issuers were enabled by the Crowdfunding industry “professionals” who were not acting professionally.  If there is any take-away from this article it should be that I offered to set the Compliance Director at StartEngine on a straight path, without charge, and she declined.

There is a lot of promise in Crowdfunding that may be eclipsed by inappropriate behavior. Unless investors are willing to invest, and invest again because it worked for them, Crowdfunding will not fulfill this promise.

The SEC’s Enforcement Division is clearly looking for scam artists who are raising funds in the Crowdfunding market and for legitimate companies that fail to follow often complex rules.  It will keep finding them until the Crowdfunding industry gets serious about its business and makes an effort to protect the investors it cannot survive without.

 

 

 

 

The SEC Halts a Crowdfunded Cannabis Offering

Capital Markets, Issuers, Law , , , ,

In the year I have been blogging I have written several articles about the problem that the Crowdfunding industry does not want to address, fraud.  My thesis is simple: if the investors get screwed enough times they will take their money elsewhere.

As stories of Crowdfunding scams begin to proliferate, the industry’s reputation is likely to go down the toilet.  If the investors leave, people will be sitting around in bars saying: “I used to work for a Crowdfunding platform” the same way that people sat around in bars in 2009 saying “I used to be a mortgage broker”.

Back in February when Regulation A+ offerings were just getting underway, I wrote several articles raising some questions about specific offerings. The Crowdfunding industry was very gung-ho about Reg. A+ because these offerings could be sold to smaller investors. The bulk of Crowdfunded offerings are still private placements which can be sold to wealthier accredited investors only.

I wrote a blog article specifically about Med-X, Inc. which was attempting to raise $15 million under Reg. A+ to “research and develop, through state of the art compound identification and extraction techniques,  market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

I questioned the offering, in part, because cannabis is still illegal at the federal level.  But that was not the only reason.

Med-X had acquired an exclusive license from another related company, Pacific Shores Holdings to market NatureCide® herbicide and pesticide products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. As I noted at the time, an exclusive license can be valuable. In this case, because the products are readily available on Amazon.com the value of the “exclusive” license was questionable.  Both Med-X and Pacific Shore holdings were controlled by the same person, Mathew Mills.

To me, Pacific Shores Holdings looked like a classic penny stock. Mr. Mills had been sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors to whom he had no business selling shares. 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.

Last week, September 16 to be exact, the SEC issued a temporary halt to Med-X Reg. A+ offering. The company was required to file an annual report on Form 1-K for the fiscal year 2015. Med-X operates on a fiscal year ending December 31. As such, Med-X was required to file its annual report by April 30, 2016. On September 16, Med-X had still not filed the annual report, so the SEC put a halt to the offering.

The clear message here is that information that investors were entitled to receive, as a matter of law, was not provided to them between May 1 and September 16. Failing to provide material information to investors is the textbook definition of securities fraud.

Med-X did file its Form 1-K within days of the SEC order halting its offering. What that filing discloses about what Med-X is doing with the money it has raised so far validates my earlier suspicions.

Back in February, Med-X reported that it had received $3.6 million in reservations from over 1100 prospective investors for their Reg. A+ campaign on StartEngine, a Crowdfunding portal.  Those reservations were apparently meaningless.

As of June 17, 2016 the Company had sold 1,124,038 common shares. The Company received net proceeds of $430,430 from this offering. Med-X has committed to spend $150,000 of that money with a company based in London to develop a mobile platform for its marijuana media site among other things.  How it will pay for the research it promised is anyone’s guess.

Next month the SEC will conduct a hearing to determine whether or not it will allow Med-X to resume its offering.  Since the Form 1-K has now been filed, they may let it proceed. If the SEC has other concerns about the company, it may keep the halt in place while it investigates further.

The SEC has a long history of leveraging its budget for enforcement actions by going after small companies like Med-X where the facts are clear-cut, where it is not likely to find a high-powered law firm defending and where it can make big headlines. With this action, it is likely to make bigger headlines in the cannabis industry than with the Crowdfunders.

An enforcement action against Med-X would send a message to the cannabis industry which should want to seek Crowdfunded financing as banks are generally closed to them as a source of capital.  Despite what you may think about cannabis as a legal industry, the federal government’s policy is to wipe it out.

I have spoken with several people involved with the cannabis industry who report that the Crowdfunding industry, at least in the US, is already skittish.  Given the publicity surrounding cannabis and its thirst for capital, you would expect to see many cannabis related businesses raising funds on Crowdfunding sites but you don’t.

The SEC specifically cautioned brokers, dealers, shareholders and prospective purchasers that they should carefully consider Med-X’s failure to file its annual report on a timely basis along with all other currently available information and any information subsequently issued by the company. Let me translate.

This is the second enforcement action that SEC has brought against a Crowdfunded offering. The first action, SEC v. Ascenergy, was based on the fact that the company was raising money to drill for oil on land where it did not have the rights to drill.  The SEC called out the four Crowdfunding platforms on which offerings took place by name but did not sanction them in any way.

I wrote a blog article about SEC v. Ascenergy which was reprinted on several Crowdfunding media sites. What I wrote was that this was the SEC’s way of telling the Crowdfunding industry to get its ducks in order. I believed and I still believe that sooner or later the SEC will sanction a Crowdfunding platform or portal that lists a fraudulent offering. For the most part the industry looked at the Ascenergy case with a yawn and declared it to be an isolated instance of fraud.

StartEngine has gone to the trouble to become registered with FINRA specifically to be able to offer Reg. A+ offerings to mom and pop investors. They are required to follow FINRA’s rules when listing offerings and that includes the requirement for a significant amount of due diligence. In my mind the Med-X offering raised a number of red flags, not the least of which was the NatureCide® licensing agreement.

More directly, FINRA and the SEC have every reason to expect StartEngine or any other registered Crowdfunding portal to have known that regulations required Med-X to have filed its annual report by April 30 and that it was late. The SEC may justifiably ask StartEngine why it did not close the Med-X offering down instead of forcing the SEC to use taxpayer funds to do it.

It is not always possible to determine what a government agency will do next. In the SEC’s mind the matter may simply be over or they may take action only against Med-X and Mr. Mills. He has, after all, already been sanctioned by two state regulators and has apparently not learned his lesson.

The SEC may give StartEngine a pass or it may not. It may leave the matter to FINRA which also has a history of going after smaller firms while its largest members often get away with fraudulent offerings that impact thousands of people for large amounts of money.

One thing is clear; the standard for the SEC would be to plead that StartEngine “knew, should have known or was reckless in not knowing” that Med-X did not file its annual report in a timely manner.  I do not see that StartEngine has a cognizable defense.

StartEngine did list another offering, Elio Motors which I also questioned in another blog post. My issue with Elio was that it was taking deposits from and promising delivery to consumers for a product that did not exist and which it could not hope to deliver with the funds it had on hand or which it was likely to raise. I am pretty certain that taking deposits and promising delivery of a product that does not exist and is not very likely to exist violates some regulation under the Federal Trade Commission Act or a similar statute.

The Crowdfunding industry has hailed Elio as a success because it raised $17 million from investors.  The people who helped raise the funds speak at various industry conferences to an audience of Crowdfunding participants who want to know how it is done.  (Spoiler alert: In Elio’s case it was done by making promises that they were not likely to keep but that is not what you will hear at the conferences.)

No one invites me to speak at any of the ever present Crowdfunding conferences because the Crowdfunding industry does not want to hear what I have to say.  If I were thin skinned, I would be concerned that the Crowdfunding industry really does not like me.  I’m not.

In all fairness to the Crowdfunding industry, I was solicited a few weeks back by one of the larger platforms. They wanted me to write a series of articles and an occasional white paper for them. When I spoke with the Director of Marketing, the firm’s Compliance Director was on the call. He knew that he would have final approval of anything that I wrote.  I was not surprised to learn that he had learned compliance at a mainstream brokerage firm.  It is not that difficult to stay complaint with the rules if you know what you are doing.

If the SEC or FINRA come calling to any Crowdfunding portal or platform, including P2P lenders, the first thing they will ask for is the firm’s written procedure manual.  There should be written standards and procedures for listing companies. There should be standards and procedures for reviewing the videos and marketing materials that accompany many of the offerings. Far too many of those videos are not compliant with the rules for anyone to think that the industry is serious about the business in which it is engaged; selling securities.

What is likely to happen at the hands of regulators is the industry’s own doing. They are too busy telling themselves that they are being “disruptive” to actually take notice that investors are being ripped-off.  Fraudulent offerings are not going to stop until the industry takes steps to make them stop. The SEC is not going to wait forever.

SEC v. Ascenergy; Crowdfunding’s First Black Eye

Capital Markets, Investors, Uncategorized , , , , , ,

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.

Reg. A+ Assessing the True Costs

Capital Markets, Issuers , , , , , , , ,

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.