A Brief History of Securities Arbitration

The US Supreme Court enforced the arbitration clauses that were boilerplate in the account agreements of most stock brokerage firms and sent almost all disputes that a customer may have with their stockbroker or brokerage firm to arbitration in 1987. Shearson/American Express Inc. v. McMahon, 482 U. S. 220 (1987).

The McMahon case did not find its way to the Supreme Court by accident. Some people in the securities industry were looking for a case to walk up the appellate ladder to get the issue of mandatory arbitration before the Court as early as the mid-1970s.

At that time, the industry had been hit by several large punitive damage awards assessed by juries in cases involving customer losses. Many people in the industry wanted nothing to do with juries. Many states did not then permit arbitrators to award punitive damages.

Certainly the industry believed that it could home court customers and their lawyers. To some extent the industry was able to weed out arbitrators who had the audacity to make a large award against a member firm.

The wire houses handled many of the claims with in-house lawyers because as they were self insured. Where there was a separate insurance carrier law firms around the country were enlisted in the industry’s defense. Throughout, defense lawyers have constantly assisted each other and have consistently acted to further their clients and the industry’s interests by shaping the rules and the forum.

I think that the industry would have been happy to keep arbitration simple. Events in the late 1980s and early 1990s conspired against it.

Customers do not file arbitration claims against their stockbrokers unless they lose money. Many customers lost money when the market crashed in 1987. Shortly thereafter, junk bonds began to default. Real estate limited partnerships were failing and a lot of those had been sold to seniors and retirees.

One firm, Prudential Securities, spawned thousands of claims which were resolved individually in arbitration or mediation. Claims against Prudential and other firms selling similar products caused a lot of lawyers from around the country to begin to take on customer disputes.

Up until that point, most claims involved the alleged misconduct of individual representatives such as churning or unsuitable recommendations. Now there were claims involving financial products where every customer who purchased them had been defrauded.

Prudential and the other firms put forward a number of aggressive defenses. The customers’ lawyers began to share information with each other. Eventually some of those lawyers formed the Public Investors Arbitration Bar Association, PIABA. There was now a formal industry of  customer representatives which substantially leveled the playing field.

At that time I would have said that these arbitration claims were easier to defend than to prosecute. The industry always had access to the information, people and documents that it needed to defend the claims. Customers were often limited to those documents that the panel ordered to be produced at the discovery hearing. Basic discovery in arbitration was not simplified and made uniform until 1999.

Tens of thousands of customer claims were resolved in arbitration after losses stemming from the 2001 “tech wreck” and the 2008 “credit meltdown”. The vast majority of the claims settled just like they would have if the claims had been filed in any court.

There have been tweaks to the arbitration rules over time but the basic system is the same. Arbitration still promises a resolution of a customer’s claim in less time and for less money than a resolution of the same claim in most courthouses.

Efficiency has always been a hallmark of arbitration. When I started (in the 1970s) most claims were resolved with a single day of live testimony. The customer and the broker would each tell their story to the panel. Few panels needed experts to explain the rules or the transactions to them.

The issues in these claims are rarely complex. The brokerage industry and the claimants’ lawyers share the blame for adding complexity where none was needed.

FINRA arbitration is far from perfect. I have elsewhere documented that in one case only one FINRA arbitration panel out of 35 thought customers who were sold a particular Ponzi scheme should get their money back. FINRA Arbitration – How investors actually fare.

Some commentators have attributed results like this to arbitrators who are biased or anti-consumer. Some have argued that arbitrators who worked for the industry will not make a substantial award against it. Others have argued that, because it is run by the industry, FINRA arbitration in inherently biased. This has resulted in more neutral panels and panel selection.

Personally, I do not believe that arbitrators should have to be educated by the customers’ attorneys to the fact that selling shares in a Ponzi scheme to any customer is beneath the standards of the industry. There is a difference between an arbitrator who is neutral and one who has no experience with investments or investing.

Unlike many lawyers representing customers who want arbitrators who are neutral, I frequently hope to get a retired branch office manager or compliance professional on the panel. I believe that customers frequently get a better result when the arbitrators are well informed and personally experienced in proper industry practices.

Too many people who comment about the perceived inequities of arbitration fail to consider that there are often legitimate defenses to these claims. Brokerage customers are generally a wealthier and more educated sub-set of the general population. They frequently approve the offending transactions, sign forms that acknowledge that they have read all of the disclosures and receive monthly statements which they are expected to read.

Arbitrators will often apportion the blame for the losses sustained by the customer between the parties. They will frequently consider a customer’s failure to mitigate their losses when assessing damages.

Arbitrators will also consider how the customer would have fared if they had not purchased the offending investments. If the general market was down during the time period of the claim, industry lawyers will frequently assert that the customer would have sustained losses even if they had gone to a different broker who had sold them something else.

The best cure for any perceived ills in the arbitration process will always be loss prevention. It starts with better educated investors but includes better compliance at the firms as well.

FINRA would do well to remember that for all its efforts to make the arbitration process more neutral, FINRA also has an important enforcement function. The greater certainty of the customers’ ability to recover inappropriate losses, the greater the deterrent to the offending conduct.

SEC v. Ascenergy; Crowdfunding’s First Black Eye

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Due Diligence by Dummies

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Will securities fraud kill crowdfunding?

I have started to get a lot of e-mailed advertisements from crowdfunding platforms established under the JOBS Act. Many people see crowdfunding as a simple way for small companies to raise capital. Companies that are selling their securities can offer their shares or notes on a platform (website) for potential investors to consider.

Each of these offerings is still subject to the anti-fraud provisions of the federal securities laws and also the anti-fraud provisions of the states in which any investor lives. These provisions are not that hard to understand. Purchasers of securities are entitled to receive all of the facts that they would need to know in order to make an intelligent decision whether or not to make the investment. It is up to the people selling the securities to supply that information.

Liability for making a false statement or omitting a material fact falls on anyone who participates in the offering or sale of the securities. This generally includes the company issuing the shares or notes, its officers and directors and the lawyers and accountants who put the offering documents together. Liability will certainly adhere to the platforms that list the securities for sale without making certain that the proper disclosures are being made.

With this in mind, I looked at a number of different offerings on crowdfunding platforms. I was specifically looking for red flags, things that said to me that something might just not be right.

I limited my search to crowdfunding platforms that specialized in real estate offerings. I have seen more than a few fraudulent real estate private placements over the years. They frequently sound good until you look under the hood.

I came across one platform that caught my attention. It is aggressively advertising for investors under the new general solicitation rules for private placements. It is syndicating hard money loans to accredited investors. For reference, let us call the platform the HMLM Co. (Hard Money Loans to the Masses), not its real name.

What caught my attention was the sales pitch. The loans that HMLM is syndicating promise to pay investors double digit returns. The loans are secured by real estate that has been appraised. The loans are short term, usually for a one year term. There are often personal guaranties by at least one principal of the company that is borrowing the money. The website states that none of the people who have invested on the platform have ever lost money.

This is very similar to the sales pitch of a real estate fund that I called the Construction Investment Fund (CIF) in my book (Investment Schemes, Scams and Strategies Retirees Should Avoid ). Investors in that fund lost 80% of their investment ($400 million) in the last market cycle. I believe that people who invest on the HMLM platform are likely to experience a similar fate.

A hard money lender who is making loans at a 50% LTV has a lot of collateral and is usually not concerned where the real estate market might be 12 months down the road when the loan matures. As long as the lender is confident that the market price of the property will not come down by more than 50% they are still well collateralized.

Many of the loans on the HMLM platform were at 70% LTV which can be more of a problem. If you buy a property today, pay 15% interest on 70% of the purchase price for 12 months and then sell it with outgoing real estate commissions of 6% it is easy to see where the purchase price of property would need to appreciate by almost 20% just to break-even.

There are not that many markets in the US where real estate is likely to appreciate that much next year or the year after. If the people who are borrowing the money are likely to have difficulty selling the property down the road, why would any lender make the loan?

Logic suggests that a real estate investor with a string of successful projects, good credit, adequate collateral and a personal guarantee would not be interested in borrowing funds at 15% or more. It is one thing to tell investors that they might lose their money. It is quite another to advertise the security as a good investment when it clearly is not.

The platform describes its borrowers as “seasoned” real estate investors. To me “seasoned” would imply experience in real estate for at least a full 15 year market cycle. If you started in the real estate business in 2009 you might have some experience by now and you have probably been successful. If you started in 2000 and went through the 2009 bust then it is possible that you took some losses but at least you got “seasoned”.

I went to the webpage where the management of the platform disclosed its own business history. Not a lot of “seasoned” real estate people there, either. This platform does not sell toasters. It sells complex financial transactions which it has packaged as investments. Management really needs to understand its products. How else can they be certain that all of the material facts about these investments are being disclosed?

To clarify this point a little further, on some of the loans on this platform the names of the individuals who own the companies that are borrowing the money was redacted. If the platform does not believe that the names of people behind the companies who are borrowing your money is a “material fact” that investors would want to know, it certainly begs the question of what other information they are not disclosing.

No one questions that the platform is selling securities and that the securities are exceedingly speculative. Seniors and retirees are drawn to investments that claim to be secured and promise to pay double digit returns. Will this platform accept investments from seniors or allow people to invest their retirement funds? You bet.

Is the HMLM platform committing fraud when it sells these securities? I will leave that determination to the class action lawyers who will clean up the mess likely to result when the real estate markets inevitably turn down. There certainly are red flags that would warrant further investigation.

I singled out this platform because I found many of its shortcomings to be obvious. They would not be obvious to the average investor. There are many, many other platforms out there which I am certain are equally deficient. It is an issue that the crowdfunding industry and its regulators need to address and need to address quickly. If investors begin to realize that crowdfunding platforms cannot be trusted to tell them what they need toknow about any of their offerings, investors will take their money elsewhere.