Year: 2016

Suing Your 401(k) Plan

Law ,

Let me begin by saying that I appreciate that class action suits have a role in the general scheme of commerce. Class actions have helped to compensate many people who were injured by asbestos, tobacco, many medications and medical devices. Defective products can injure a large and diverse group of people. Class actions can also provide a remedial action that protects consumers and the markets going forward.

Over the years I worked briefly on one class action and on another quasi-class action suit, what was then called a private attorney general action under California law.  In both cases the defendant was in the financial services industry which, after all, is my area of expertise.

If I learned anything about class actions, it is that they can be lucrative for lawyers. They are frequently long, drawn out litigations that can be costly to defend. The plaintiff’s lawyers often put in many thousands of hours, on the come, as it were. If they win or settle, they can apply to the court for payment of their bill sometimes with a multiplier awarded by the court for their efforts on behalf of the class.

There have been many class actions brought by employees of companies over issues of wages and working conditions. More recently, there has been a spate of litigation by employees concerning the operation of their corporate 401(k) plans.

Several suits by employees of financial firms who are claiming that they have been damaged because the financial firm included its own mutual funds in the employees’ plan caught my eye.   These particular suits illustrate how foolish suing your 401(k) plan can be.

The administrators of a pension or 401(k) plan, that is those people who work for the company and who either invest the plan assets on behalf of the employees or who select the investments in which the employees can invest are fiduciaries. That has been true for at least 40 years. These new lawsuits are suggesting that these administrators have been doing it all wrong for all of that time.

Fiduciaries have special duties and are held to a high standard of commercial conduct. They are always expected to put the interests of the employees first; they are always expected to protect plan assets; they are always expected to invest plan assets prudently.

I have reviewed more than a few of the employee vs. plan administrator lawsuits.  Allow me to break down the most common allegations in the sub-set of those suits brought by employees of mutual funds and financial services companies.  In theory at least, people who work for these companies should have a pretty clear idea of what the company is doing wrong.

First, there is the allegation that the firm is self-dealing; that is the company is offering its own mutual funds for the employees to purchase. That, of course, is exactly what is occurring.  In what universe would a company be expected to direct employees to purchase a competitor’s product?  Companies are not prohibited from investing the plan’s assets in their own stock, nor should they be. A company that is in the business of managing mutual funds that are available to the general public should always be expected to offer those funds to their own employees.

Second, and most common, is the allegation that the mutual funds are too expensive; specifically that other funds that were not offered charged less.  Actually, there is no requirement for a 401(k) plan to offer only the least expensive funds.

The US Supreme Court looked at this specific issue just about a year ago and said that it was never appropriate for plan administrators to “waste” plan assets. Given that paying internal management fees cuts into the fund’s return to investors there is an argument that higher fees waste the investors’ money.

I would argue that this may be true in some, but not all cases.  If a plan offers an index mutual fund, for example, the argument can be made that all index funds from all mutual fund providers are strikingly similar and all will contain virtually the same securities, those that make up the index.  So the least expensive index mutual fund might be appropriate.

It is also true that an index ETF will usually have a lower internal management fee than an index mutual fund. An ETF is not really managed and will just track the index. If a passive investment is what you want, then an index ETF is made to order.

Most of the 401(k) plans that were defendants in the various suits offered the participants the opportunity to invest in several ETFs. No one put a gun to anyone’s head to purchase the company’s mutual funds.

If you follow the argument that the least expensive investments are the only ones that should be offered to 401(k) plan participants, then reason suggests that no index mutual fund will ever be suitable for any plan. Index ETFs are almost always less expensive and provide a very similar investment.

No court has adopted this idea, yet, but much of the discussion about what is and is not appropriate for plan participants is centered on the idea that fees and only fees matter. Someone should throw a bucket of cold water on that idea before some judge unknowingly sends the mutual fund industry to the scrap heap.

If you do want a managed fund, the question becomes, or rather should be, is the manager of the fund worth what it is getting paid? More precisely, are lower fee funds better just because they charge less?

Vanguard Funds were put up as examples in several of the cases. Vanguard has a low fee structure and a long track record with many happy and loyal investors.  There is nothing suspect about the portfolio managers or securities analysts that Vanguard employs and nothing to suggest that they are not competent professionals.

Assume for the sake of argument that JP Morgan has more analysts than Vanguard and pays them more. JP Morgan also has people on the ground doing business in every major money center in the world, every day. There is an added value to working in the market rather than just analyzing it. JP Morgan charges a higher fee to manage its mutual funds than does Vanguard.  Who is to say that JP Morgan is not worth a higher fee?

In a previous article I suggested that if I were asked to serve in a fiduciary capacity on the investment committee of a pension plan or charity, I would not hesitate to recommend mutual funds managed by Dimensional Fund Advisors.  Dimensional was founded by Eugene Fama, the 2012 Nobel Prize winner in Economics. It should cost more to have a Nobel Prize winner manage your mutual fund.

Is it a waste of the fund participant’s money to offer more expensive mutual funds if there is a demonstrable reason why the fund charges more?  Would not the fund administrator be doing the fund participants a disservice by recommending only the least expensive funds as the plaintiffs’ suggest?

Third, there is the allegation that the mutual funds lost money. Against the backdrop of a rising market, this would seem to be a problem. But in the context of these particular lawsuits the results that the investors receive is probably not relevant.

The argument here is that the fund administrator should not have selected the mutual fund in the first place. There may have been good and valid reasons to have selected the fund five or six years ago, even if the subsequent results were lousy.

A fund manager or investment advisor is expected to predict the future. That is not always easy to do.  Investment advisors and fund managers are professionals. In other fields we do not judge a professional’s competency based on their overall results.

I know that when two lawyers enter a courtroom, one of those lawyers will come out the loser, every time. That does not make the lawyer who loses a bad lawyer. It is often not a question of the lawyer’s skill. There are a great many intangibles in any case that are difficult to predict or evaluate.

Underlying all of this is the idea that investment advisers are not truly professional; that they are overpaid hacks, the majority of whom fail to manage their funds up to the level of the benchmark to which their fund is pegged.  Some of that is caused by the ebb and flow of money in and out of the fund.  Just because a lot of people invest in the fund at the end of a quarter, does not mean that there are attractive stocks on that date for the fund to buy.

Assuming one of these class actions moves forward to trial, it is probable that the fund advisor will be able to point to research done by other firms that suggested that the stocks that the fund was buying were rated as “buys” by other analysts at the same time.  So how would the fact that the fund lost money be actionable against the plan administrator?

If any of the law firms try to suggest that the plan administrator should be liable for the fund’s losses, then going forward, the only way for an administrator to protect themselves is to allow only the purchase of US Treasury bonds.  Any other investment that the plan offers the employees has a risk of loss and even US Treasury bonds may be up or down when you decide to purchase or when you reach the dates mandated for your distributions.

Most 401(k) investors lose money not because they bought the wrong investment or fund but because they failed to sell that fund when the market began to turn against them. As far as I know, none of the 401(k) plans that are the subject of these class actions offer the participants individualized advice. If the investors are never advised to sell, then the investors are guaranteed to see their portfolios decline when the market declines.

There is no penalty for employees who are prepared to say that their company makes a great product but has a lousy 401(k) plan. The penalty for employees who work at a company whose products are the same investments that are in their 401(k) plan should be obvious.

What will be the collateral effect to the mutual fund if the employees are adjudged to be correct; that the advisors to the mutual funds for whom they work are greedy and stupid.  Obviously, the mutual fund company will suffer because administrators of other 410(k) plans will stay away. Employees will be laid off and in some cases the company may merge out of business. Also the costs of the litigation and any award against the 401(k) administrators will reduce the value of the 401(k) plan. How did this win help you?

It certainly begs the question of whether the lawyers who are bringing these class actions have their client’s best interests fully in view.

 

 

Blogging for Fun and Profit

Capital Markets ,

Why blog?  For many people the answer would seem to be that they blog to bring attention to themselves and their business; they blog with the idea that it will help them to make money.

I started blogging just about a year ago. It began at the suggestion of the editor of my book.  She advised me to start a blog to help get my name out there and sell the book. Blogging is free, she told me, and I had no budget to promote the book.  I receive nothing from the proceeds of the book, all of which go to cancer research.

She also advised me to publish the blog on Linked-in, rather than Facebook where she thought more “serious” people would see it. At the time, I knew very little about either writing or publishing and I willingly took her advice. If I am doing something that I have never done before, I always hire someone who knows what they are doing or seems to know.

The blog follows the basic theme of the book. Its avowed purpose is to call out “foolishness” in the mainstream capital markets. There is certainly enough foolishness to go around. Much of what I write is a reaction to what I see or read elsewhere.  Many of the articles were inspired by conversations that I have with friends or strangers.

Because I write about foolishness in the financial markets, several articles have gravitated to two subjects, Robo-advisors and Crowdfunding.  Both are championed by fools who put a lot of bad information into the marketplace.  I try to counter that bad information with reason.

Robo-investing is foolish because it cannot work.  If you invest with a Robo program you are guaranteed to lose money when the market turns down.  Automated trading programs have been around in the commodity markets for a long time and are universally rejected by regulators and people who understand that a computer program cannot predict the markets.  If you are not investing to make money and are happy to lose, then in my mind, you are foolish.

Robos-advisory programs have become big because they eliminate the most expensive part of the investment transaction, the human advisor, which leaves much more profit for the firm that is offering the program.  A theme of the book, which carries over to Robos is that if the financial industry offers a product it is more likely than not designed to make money for the industry not the investor.

I get a little pushback from the Robo industry when I write negative articles about it. A number of people who contacted me after one article in particular, told me that whatever I thought about Robos, human advisors were terrible. In my experience not all investment advisors are terrible. I responded by inviting people to contact me for the name of my advisor who is very intelligent, competent and hard working and who gets good results for his advisory clients because of it. A few people took me up on my offer and seem to be happy to be working with him.

I get a lot more pushback when I write negative articles about Crowdfunding. I personally think that Crowdfunding has a lot to offer for the companies in need of funding. Unfortunately the Crowdfunding industry is populated by many people with zero experience raising money for small companies. Much of the activity in Crowdfunding is people giving seminars to other people teaching useless information and patting each other on the back.

Pointing out that fact makes those people very angry but it does not change the fact the Crowdfunding industry is remarkably unsuccessful at raising money. It takes money to raise money. The Crowdfunding industry is busy telling people just the opposite; that an inexpensive  social media campaign is all a company needs to successfully attract investors.

Many companies who try Crowdfunding do not get the funds they want. That is a shame because it really is not that difficult for a good investment to attract investors.

There is a very small group of Crowdfunding platforms that close every offering that they list. The people who run those platforms don’t give seminars because they are too busy being successful.  Several are run by people who came out of the mainstream financial industry and understand what works and what doesn’t.

One of the reasons Crowdfunding is failing is because not every company that wants to be funded is a good investment.  Early on I offered to read any company’s pitch deck and make comments for free. That has brought me into contact with a fair number of entrepreneurs, most of who I have found to be quite interesting and appreciative.

I also write about the markets themselves, especially regulations of the markets, FINRA and FINRA arbitration.  If I write fewer articles about these subjects it is because there are a great many lawyers and others who put out good information. The mainstream securities industry is usually careful to stay within the regulatory white lines.

So has blogging been good for my business?  Yes, but in unexpected ways.

Blogging has certainly gotten my name “out there”.  When I started the blog I had about 200 Linked-in connections, mostly friends, colleagues and former clients.  I add new connections with every article and the number has increased 8 fold and continues to increase weekly with each new article.

My articles on the investment industry got me the opportunity to write articles for a mainstream digital publication serving the investment advisor market. Some of those articles reach thousands of readers. I am still very much at the Jimmie Olsen, cub reporter stage but the editors there have been very patient and supportive.

The articles on Crowdfunding, especially the negative ones, put me in touch with a several groups that want to do Crowdfunding correctly, with due consideration to what investors want and deserve.  I have been helping these Crowdfunding platforms move from the planning to the implementation stage. Each shares a goal of funding every company that it lists. I expect that other groups seeking to start Crowdfunding platforms or make existing platforms more successful will seek me out as well.

The articles on arbitration and market regulation have resulted in a few expert witness gigs in FINRA arbitrations and a consulting assignment for one of the larger Wall Street investment banks. I suspect that more will come.

The best part of blogging has been that it has put me in touch with a large number of people with whom I would not otherwise have been in contact.  I speak to 2 or 3 people every week. Some of those conversations go on for an hour or more.

During most of the conversations I find myself laughing over a good joke or comment.  For me it is these personal connections that are the best thing that comes from blogging.  A good laugh in the middle of the business day seems harder and harder to find.

 

 

 

Tax Policy and Economics

Economics ,

When a politician tells you that they will bring good paying jobs back to their district you should know that they are lying.  And while it should surprise no one that politicians lie; this lie is particularly insidious because it is something that could easily be accomplished. Politicians lie about job creation because many have themselves swallowed a lie called “trickle down economics” hook, line and sinker.

The idea of paying taxes to fund government operations goes back to the early Chinese emperors. Taxes can be broad based, like the tax on tea that precipitated the American Revolution. Historically governments appreciated that if they wanted to raise a lot of money, they needed to impose taxes on the wealthier people in the system.

The US federal income tax, beginning in 1919, was always progressive. It taxed people who earned higher income at higher rates.  For most of the time between 1919 and 1970, the highest tax rate on people who earned the most was 70%.  That amount seems confiscatory and it was, but for most of that time it applied to a very small portion of the total population.

The highest period of job growth in the US was during the post-WWII era, roughly 1945-1975.  During that time, the US federal government paid for two wars, Korea and Vietnam (which was very expensive), the US interstate highway system, the cold war military buildup (intercontinental ballistic missiles, battleships and aircraft carriers) and the space program.

All of these were very expensive outlays of funds that originated with taxpayers. At the same time, virtually all of these funds were spent within the US, the great bulk of it on salaries of workers who were building the highways and the hardware that the government was purchasing.

In the mid-1970s the US economy was battered with high inflation caused in large part because oil production was taken over by a cartel (OPEC). That raised the cost of everything in the US that moved by truck which was just about everything.

The OPEC oil embargo caused shortages which resulted in people waiting in long lines to get gasoline.  It also caused home heating oil prices to soar causing difficulties and dissatisfaction during the winter months.  Those of you who remember President Gerald Ford on television with a WIN (whip inflation now) button can relate. That dissatisfaction led to the election of President Reagan in 1980.

It is actually a 1978 article that is credited with the birth of “trickle down” economics and the “Laffer curve”. The article related the events that had occurred at a dinner attended by Dick Cheney and Donald Rumsfeld, both of whom worked for Pres. Ford. At this working dinner Prof. Arthur Laffer, then at the University of Chicago, sketched a curve on a napkin as an illustration of the tradeoff between tax rates and tax revenues.

Laffer suggested that tax revenues would increase as rates decreased because the untaxed funds would be used efficiently to create businesses and jobs and hence additional revenue which could be taxed.

For his part, Laffer claims that the restaurant had cloth napkins and he would never have used one for the illustration.  He also is quick to point out that the idea that cutting tax rates increases tax revenues goes back to the 14th Century.

Economics is a science that is very much based in mathematics. At its core is the idea that people will spend money in ways that satisfy their own best interest. The primary interest is getting the same or similar goods or utility at the cheapest price, so that you can get more goods and services with the money that you have.

There are mega gigabytes of data covering income, spending, taxes and a great many formulas and equations to explain and extrapolate that data.  If you took algebra in high school you know that when you change the variables in an equation, you get different results which you can then plot on a graph.

The Laffer curve is a graph that has no equation or data supporting it.  Most economists never accepted the Laffer curve but “cutting tax rates will make the country better off, create more jobs and result in higher tax collections” is an argument that has needs little factual or statistical support. It is a bastardization of a slogan we used to have in the 1960s: “if it feels good, do it.”

The Laffer curve is the basis of the Reagan era tax cuts on the wealthiest Americans and subsequent tax cuts at the state levels that continue to this day. The sales presentation for these tax cuts was that these wealthy individuals would invest the money that they saved creating new businesses and new jobs as the money “trickled down” into the economy.

It never happened.  Several states, (Louisiana and Kansas) continue to cut state taxes and have increasing difficulty funding schools and essential services. But the slogan: “I’m going to cut your taxes so you will have more money in your pocket” wins elections.

There seems to be an abiding desire to return to the “good old days” when there were many good paying jobs in the US.  As we learned with the New Deal and in the post-war prosperity, government can create those jobs. But it also needs to pay for them.

In round numbers, if your adjusted gross income is more than $375,000 per year you are in the top 1% of US taxpayers. The average overall federal tax rate for this group is just about 25%.  This includes some business owners, some doctors, some lawyers, all NBA rookies, many entertainers and hedge fund managers. Not all create that many jobs for others.

If the tax rate for this group were raised by 5% there would be more than enough money to create 1 million good paying jobs in the US; fixing highways, highway bridges, airports, ports and other infrastructure projects that just about everyone agrees need to be fixed. Fixing the highways would also reduce commute times, gasoline consumption, air pollution and the cost of everything that moves by truck.

These workers would pay taxes on their earnings which would fund other government programs and expenditures. They would also buy homes, cars, hamburgers, movie tickets and just about everything else people buy. It is money that would truly trickle down to other businesses. These types of construction jobs usually come with medical benefits as well.

Understand that even these workers will buy products like clothing and iPhones that are manufactured overseas. Overseas workers charge substantially less per hour for their time and Apple does not repatriate the profits it earns overseas or pay US taxes on them.

That is part of the problem with the current tax system and with the current “trickle down” theory. Left to their own devices business owners will use the money that they save from tax cuts to create jobs overseas.

I appreciate that there is a certain amount of “down with the top 1%” in this but I am not advocating a mass redistribution of wealth.  If anything, it is the tax cuts in the last 30 years that have caused the current disparity between rich and poor. Swinging the pendulum back the other way for a decade or two would seem to be a good way to promote growth and overall economic stability.

 

 

 

 

 

Can Lawyers Trust Their Clients?

Issuers, Law ,

It was a simple case and a simple request. The case involved an older gentleman whose stockbroker had over concentrated his portfolio in real estate securities. When the 2008 real estate crash came the portfolio tanked. I was retained to recover his losses.

I drafted the claim and sent it to the client for his comments. I included simple instructions, “review it carefully and tell me if I have set out the facts correctly. At the hearing you will be asked to swear that this is true”.

One of the facts included in the claim was something the gentleman had told me at our first meeting; that he had never invested in real estate securities before.  This became important when the stockbroker being sued filed his answer. He said that the client had told him that he had previously invested in real estate securities and had lost money and therefore understood the transactions and the risk.

“Never happened” my client told me.

Sure enough, on cross examination, the defense attorney reminded my client that when he first became this broker’s client, years earlier, it was because the previous broker had recommended that he invest in securities that were very similar to the ones he was now complaining about.  Apparently, he had deposited a small check that he had received from a class action over a defunct real estate deal into the account early on.

The next question: “if you lost money in this type of securities before, why did you accept the broker’s recommendation to buy them again?” effectively dooming the case because the client did not have a good answer. I had not prepared him to answer the question that I never thought he would be asked.

I could attribute this to the client’s bad memory but that does not factor into every situation.

In another case, a different client revealed for the first time during cross examination that he had been accused by his wife during their divorce proceeding of molesting his own children. There was apparently enough truth to the allegation that he had been formally charged and sentenced to probation.

I always ask about past lawsuits and criminal matters at my first meeting with any client who is likely to take the witness stand. I believe that a lot of lawyers do so as well. This client did not think that it was important to tell me the truth. We did not win that case, either.

These client omissions resulted in lost cases and a fair amount of lost time.  Most lawyers do not lose too much sleep over it. There are a lot of things that can go wrong with any case. Every time two lawyers go into a courtroom, someone loses. Trial lawyers develop a thick skin.

Corporate lawyers with untrustworthy clients can get into more significant trouble. Lawyers who prepare the offering documents for the sale of securities take on a considerable amount of personal liability. Most of the big law firms that write the prospectuses for IPOs carry substantial liability insurance policies. And these firms usually do a pretty good job of getting the facts straight.

Still, if the offering is deficient and the investment fails anyone connected with the offering, including the lawyers are likely to get sued.

When I was a young lawyer learning how to prepare offering documents I attended a few seminars. One instructor offered an example of an attorney who had failed to do what he should have done and had gotten into a lot of legal difficulty.

The example went something like this:

An older gentleman who owned about $100 million worth of commercial real estate, mostly small office buildings with street level retail storefronts, wanted to retire and sell out. His son, who had no cash, wanted to continue to receive lucrative management fees and arranged a private placement to buy out his father.

Many of the tenants had been there for years and the father gave many of them long term lease extensions as he was preparing to sell. The leases were collected and reviewed by the lawyer who was preparing the private placement. These were reduced to a schedule which showed the current and projected rent roll for the buildings that was included in the private placement memorandum (PPM).

What was not disclosed was the fact that the father had also provided side letters to many of the tenants who he considered to be his friends allowing them to terminate their leases on short notice if market conditions deteriorated, which of course they did a few years later. Several tenants vacated and several more asked for rent reductions threatening to vacate based upon the side letters that had never been disclosed.

The investors sued and won. The state securities commissioner alleged fraud and the attorney was lucky to settle the case and retain his license to practice.

Attorneys who participate in the issuance of securities are obligated to conduct a reasonable investigation of the facts to make certain that what they disclose is accurate and complete.  This lawyer just accepted what his client told him at face value and suffered the consequences. That was the lesson that was being taught. Lawyers cannot trust their clients.

A few months ago I was approached by a small company that needed a private placement memorandum in order to crowdfund about $600,000. The company had already spent about $250,000 developing its product and was now getting ready to buy inventory and kick–off the business.

They did not want me to write the document. They had prepared it themselves using a software package that asked a lot of questions and spit out a private placement memo. All they wanted from me was to review the document and to “bless it”.  They had budgeted $1500 a legal review because they reasoned it could not take an attorney that long to read the document.

They told me that the software package was recommended as the best by several prominent bloggers and websites.  The software package was popular so they were confident that the resulting document would be fine.

Software templates for private placement memos have been around for a long time. There are dozens available today. For an attorney working without a secretary or paralegal, they certainly might have some utility.

Allowing a company to use a software template to write its own PPM without an attorney is like handing a child a loaded gun. Someone is going to get hurt. In most cases, it is probably going to be the investors.

I told the company what I would charge to review the document, make changes as needed and conduct a reasonable investigation to make certain that the facts were properly disclosed. It was more than $1500. They chose to find what they wanted elsewhere.

Several weeks later I came across the offering on one of the less expensive crowdfunding platforms.  I accessed the documents and saw that the PPM was mediocre at best. It just did not read very well.

They had removed some of the standard risk factors that I would have included for any startup. The prior work histories of the key executives were uneven. Some went back 10 years; others 5 years. There apparently was no marketing study and no discussion of the competition.  The PPM stressed how successful the company was going to be without a realistic discussion of what might go wrong.

The sales and profit projections were questionable.  They were projecting explosive growth in short order even though the company had not yet made its first sale. The company had nothing to support that projection except its own hopes and dreams.

I assume that some lawyer took their $1500 and signed off on the PPM as they presented it.  Some of the crowdfunding platforms require an attorney to review the PPM; some do not.

Most of the lawyers that I have met or corresponded with in the crowdfunding arena and the mainstream financial markets would insist on a reasonable investigation of the facts in any offering that they prepared. In most cases, you cannot do an investigation for a startup correctly for $1500.

I think it fair to question why the founders of a startup who are planning to get rich cannot budget more for a competent attorney than they do for pizza. I appreciate that lawyers have a bad reputation, but at the very least there should be some agreement that we are a necessary evil if the company is going to seek funding from investors.

The investigation is done partially to protect the lawyers from their own clients. It may not be what the entrepreneurs want to hear, but lawyers are not expected to trust their clients and the markets are safer and more efficient for it.

 

Feminism in Finance

Capital Markets, Investors, Issuers ,

This article is a response to a discussion on Founders Dating.  A female entrepreneur who was seeking funding for her business had discovered that she was pregnant. She wanted to know if the Founders Dating community thought that it was necessary for her to disclose that fact to prospective investors.

Almost universally, the men who responded thought that she must. They would not trust her, they said, if she had asked them to invest in her company without disclosing the pregnancy to them up front. I thought this response bordered on absurdity and I said so.

If the female entrepreneur had asked my advice, I might have asked if she thought the pregnancy or childbirth would materially impact the business. If she said no, I would have advised her not to disclose it. That is what I posted and virtually all the men and a few of the women took the contrary view.

If I was preparing the prospectus for an IPO of the same company, I would be obligated to do some due diligence about each of the key executives in the company to make certain that their disclosures were accurate. I would never think to ask anyone if they or their spouse was expecting a child. It is not an event that would normally be disclosed. The SEC would certainly not punish anyone for failing to disclose it.

If the issue is that the pregnancy might take this executive away from the business for a period of time, distract her or impede her ability to do her job then I would be obligated to ask every key executive at the company: Do you have a special needs child or elderly parents?  Are you healthy? How often do you drink alcohol? Do you have a prescription for oxycodone?

You can see where this goes. Any of these would potentially have a greater impact on the executive’s time and performance than an average pregnancy and birth.

No one would suggest that a male executive disclose his wife’s pregnancy even if the company had a policy that would give him extended parental leave after the birth. That is the salient point. This is a prejudice against women. It really has nothing to do with a clear business decision.

If anything, it is easier to plan for the “disruption” that a birth might have with the timeline the company is forecasting. Every schedule needs some slack. Once a pregnancy is known, the business can plan for it.

Much of the discussion seemed focused on the fact that the investors, mostly angels rather than professional VC’s, were concerned that the entrepreneur had divided her attention away from the business. They were concerned that she would not be giving 100% of her attention to the business that they were funding.

This kind of thinking is archaic, inappropriate and demonstrates how poorly these angel investors approach the task of evaluating a business that they are considering funding. To me they were signaling their own ineptitude and a foolish approach to investing their own money.

What these angel investors are saying is that they are not confident the business has a team in place sufficient to deal with the absence of a key player. That might be true if this were a concert tour and the primary artist became pregnant. For almost every other business it should never be an issue. With a CEO or senior executive, if childbirth truly impacts their productivity then that loss in productivity can be picked up by another member of the executive team.

Underlying the desire of these angel investors to have disclosure of this pregnancy was a knee-jerk opinion that women do not make good judgments. Underlying was the attitude: why did she get pregnant when she was trying to start a business? Respectfully, it is none of your business, even if it is your money.

Whether you attend business school at Harvard or at a state university, students are generally taught that the CEO and management team should have 3 types of vision; 1) vision on the product (costs and quality); 2) vision on the market (customers and competition) and 3) vision on the bottom line (overhead and cash flow).  It is a good, simple approach that investors can evaluate. It is a standard that does not care if the entrepreneur is male or female.

The implication is that a woman could not have this requisite vision if she also had vision on her infant. That makes no sense. I could not find a reputable study that supported this, nor would I expect to find one. A lot of women have children and return to work.

I graduated for an all male college in 1971. When I started law school that fall, my law school class of 120 students included exactly 12 women, because there was a 10% quota for women.  When I started working on Wall Street after graduation women were mostly secretaries. A handful of women were in middle management, but none were in upper management. The firm had a few thousand stockbrokers; probably less than 20 were women because people did not think women knew a lot about investments and managing money. Throughout the business world the glass ceiling was very real.

It was not unusual to hear what would now be considered inappropriate remarks about women at any time. It was not inappropriate to ask a woman to bring you a cup of coffee, no matter what her job title or expect her to straighten up the conference room after a meeting. A lot of people, including a lot of women, thought that women joined the workforce to find husbands.

Women were treated as second class citizens in the business world. In many respects they still are.  The Founders Dating discussion highlighted how this problem still exists.

Today approximately one-half of college graduates are women and it seems reasonable that one-half of the venture capital would be directed to companies that women own or control. But that is not the case. It is not going to happen unless and until these archaic attitudes about women’s ability and judgment are dispelled.

The problem needs to be approached from both directions.

Angel investors need to get a little perspective. Investors in large companies do not ask about the executives’ personal lives when they make an investment. A small company is no different.  If you cannot evaluate a business as a business and insist upon knowing the details of the managements’ personal lives, I suggest that you keep your money in your pocket.

Steve Jobs had returned from a commune shortly before he started Apple. Should his personal life have been considered by investors or just his product? And to be sure, Jobs is not an anomaly. Back in the 1970’s men could not get jobs, let alone funding, if their hair was over their collars.

As importantly, women need to call out this foolishness whenever it occurs. At least one woman in the Founders Dating discussion supported the idea that a pregnancy should be disclosed. I would have expected many women to tell the men to get real. Few did.

There are more and more successful women stepping up and providing capital to businesses being started by other women. That is laudable but does not touch on the problem.

I found the fact that not a single woman on Founders Dating raised significant objections to the entire discussion to be an indication of why this type of prejudice continues. Ignoring this problem will not make it go away.

 

 

 

Regulatory Compliance in Crowdfunding

Capital Markets, Issuers, Law , , , ,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

Funding Startups – The Perfect Pitch

Issuers

Funding a new business is one of most perplexing and frustrating challenges that entrepreneurs face.  Like many other things in life funding your business is a process that requires focus.

One of the paradoxes of the information age is that there is so much bad information readily available. If you approach financing your business using the ideas that you read in an entrepreneur’s book or from a guru whose presentation you sat through at a conference, you are not likely to connect with most investors.

I have been involved in various aspects of corporate finance for a long time.  I think I have a pretty good idea of what investors want and expect. My approach is decidedly old school. I approach finance in the way it has been traditionally taught in well respected business schools. I advise companies seeking investors to do what I have seen work time and again.

I especially shun the advice that suggests that you need to set forth the problem that you are solving or that what you are doing is “disruptive” or will change the world for the better.  (Yes, I actually saw that advice in an article in an otherwise well reputed financial publication).  This may describe some businesses, but only a very few. Businesses that are not disruptive also deserve to get funded.

Funding is a business relationship between you, your company and your investors. It certainly helps if you can understand the transaction from the investors’ point of view. Investors will give you money if they believe that you can make money and they will receive an adequate profit for the risk that they are taking. You do not have to be disruptive; just profitable.

Here are 3 things that investors know about any business that approaches them for funding:

1) Most start ups fail. I know that you have heard this before but people who invest in startups need to be convinced that you will beat the odds and have a very good chance of succeeding. Most professional investors get pitched by a lot of companies. You need to convince them that you are the cream of the crop, period.

2) Not every person is cut out to be an entrepreneur. Just because you have a great idea or product does not mean that you understand what it takes to run a successful business.  Most businesses have a lot of moving parts. There are essential tasks, like finance, sales and marketing that cannot be left for you to figure out after you have been funded.

3) Never forget the golden rule of finance: the person who has the gold makes the rules. I am always amazed when an entrepreneur tells me that they will only sell 10 or 20% of their business for the million dollars they need. It is a valuation that they got from listening to the “smart and savvy” crowd. If you need a million dollars to succeed and are not willing to forget your ideas about what your business is worth and hold out for the deal that you want, you are likely to end up owning 100% of nothing.  Investors do not grow on trees.

I look at a lot of pitch decks. There are a great many people who will tell you how to pitch your company to investors. Some will tell you to keep it short. Some will tell you to load your pitch with charts and graphs.  Some people suggest that you cannot pitch your company without a video.  If your product moves and is best presented in operation in a video, then by all means include one. If your video is essentially talking heads, graphs and the product sitting on a table, then I would tell you to save your money.

I personally believe that nothing beats a well thought out and well written business plan.  Most investors feel the same way. It should not be too much to expect a company that is seeking funding to be able to set forth exactly what they propose to do with that money and how they will use the investors’ money to earn a profit.

You should be able to present financial projections of your company’s operations for 3-5 years.  No projection of the future operations of a startup is totally accurate but you should have a reasonable basis for the projections you make.

It is easy to draft a projection that says something like “the company will sell 1 million units in year one, three million units in year two and 5 million units in year three” but you must be able to support that assumption. I always recommend more detail; enough to fill up a comprehensive spreadsheet.

These projections can make or break an investor’s decision to fund you. They should show how your expenses will ramp up and how you will achieve economies of scale. These are important indications of how well you are in command of your business.

Any investor can take their money to the mainstream stock market and buy shares in an established company that will pay them a dividend and the shares are liquid. They will earn a profit if the shares go up and are protected from catastrophic loss if the shares start to go down because they can sell them at a moment’s notice. The investor that puts money into your company takes a much greater risk and expects a much greater reward. That model, income and liquidity, is what you are competing against.

I always caution entrepreneurs not to promise that their company will cash out investors in an IPO or will sell out to a competitor. No one can predict that either will ever happen. Both events are rare.

Investors do expect some idea of how you will get their money back to them and when. You can structure your offering with preferred shares that pay an annual dividend. You can agree to buy the shares back from investors or give them the option of selling them back to you at a profit at some point in the future.

When you make your pitch you must be confident. Self-confidence comes from the knowledge that you know what you are doing.  The message that you want to deliver is that if they give you the funding you seek, you will make it happen.

I always recommend that you bring your product or prototype with you rather than pictures or a video. Let the investors handle it and if possible, operate it. Show them that the design is pleasing; the craftsmanship is good and the functionality excellent.

One presentation that I sat through stands out in my mind. After the group of investors had looked at the product and listened to the entrepreneur describe exactly why it was better than its two established competitors, she went on to say the following:

“We expect our product to sell for $299 retail. The two competitive products retail for $50 and $100 more than our retail price. We intend to source our product from an established manufacturer in the Far East and land it at Long Beach for $95 per unit. That will drop to $85 per unit when we reach a critical monthly volume. We are projecting sales to reach that level within 12 months. We have set the initial wholesale price at $150 per unit.

Our marketing plan was developed by a marketing pro with 20 years experience working in this industry. Our sales manager has 10 years of experience selling similar products to many of the same customers that we intend to reach. The sales manager intends to hire 3 sales professionals who will be highly incentivized to open new accounts. We would be happy if the salespeople were the highest paid employees in the company because that would mean they are opening good accounts at a higher than projected rate.

Both the marketing manager and sales manager are prepared to give their notice to their current employers and join us full time once we are funded. We have taken care of all our packaging, patents and trademarks. We therefore can hit the ground running.

We are offering investors a preferred stock issue that will pay an annual dividend of 8%. We will agree to redeem your shares, at your option, for 200% of face value after 3 years and 300% of face value after 5 years. As you can see from the projections, we will be able to fund those redemptions internally, even if our sales are 25% less than projected or if we need to cut our margins by 25% to boost sales. We hope, however, that you will stay with us for the long term.

We have 3 founders on our Board of Directors and 3 outside advisors who have helped us get to where we presently are. There is a seat on the board for you, if you want it. I issue monthly reports to the board which you will receive in any event.

You should note that we intend to run pretty lean. With our small workforce, we will use a part-time bookkeeper and an outside payroll service. There is no HR or Customer Service department.  If a customer needs service, they can speak with me. It’s my name on the door.  Problems get resolved while the customer is on the line. Any questions? “

The group that I was a part of did not fund this company but it did get funded a few months later. The entrepreneur was self assured, had covered her bases and had that intangible attitude that stuck out from the crowd. Funding your company is a business transaction. This entrepreneur was all business.

 

 

 

The Purely Passive Permanent Portfolio

Capital Markets, Economics, Investors ,

My nephew recently asked me to recommend a good book on investing for someone who was just starting to make contributions to his retirement plan.  Somewhat reflexively, I recommended Prof. Malkiel’s “A Random Walk Down Wall Street” as a good place to start.

I first read “Random Walk” in the 1980s and it was an eye-opener for me at the time. I was and continue to be a dyed in the wool Graham and Dodd fundamentalist. I had met and followed quite a few research analysts when I worked on Wall Street. Their opinions were coveted by institutional investors. The brokerage firms were justifiably proud if one of their analysts was named to the annual “All-American” institutional research team.

The random walk theory was not original to Prof. Malkiel. He popularized it in layman’s terms. He used a coin flip to create a trading pattern for a fictional stock and then attempted to have an analyst apply technical analysis to the resulting chart.  When the technician told him to buy the fictional stock he concluded that analysts could not accurately predict the future price of a stock, so why bother?

In Malkiel’s view, simple asset allocation with periodic rebalancing will outperform the overall stock market. The standard allocation, 60% stocks and 40% bonds will never increase as much in a bull market as stocks alone, but the bonds will buffer loses in a bad market.  Many people believe that this type of allocation is fine for investors over the long term.

Asset allocation requires the construction of a portfolio with non-correlated assets. The stock portion of the portfolio must be selected carefully or the entire purpose of the allocation will be defeated.  Prof. Malkiel currently shills for one of the large robo-advisors that does not perform asset allocation very well.

Correlation is a tricky concept. The idea is to purchase investments that are affected differently by shifts in macro-economic conditions.  A truly diverse stock portfolio should have stocks from at least 15 non-correlated sectors.  You cannot create a truly diverse portfolio by investing in large cap, small cap and emerging market funds or ETFs. The stocks in these funds are correlated to each other in too many ways.  Capitalization does not define a sector for allocation purposes.

If you buy an index fund or ETF such as the Standard and Poor’s 500 you get the average market return in good years and in bad years. If the market happens decline for the 3 years just before you need your money, such as the 3 years before you retire, your portfolio may be worth the same as it was worth ten years earlier. You may have earned nothing during the last 10 years that you were working.  That is ten years in which you could have easily doubled your portfolio’s value if you were 100% invested in income producing investments.

Many people want a portfolio that will give them “higher than average market returns with lower than average market risks.”  It clearly is something that can be accomplished but it takes work to get there.

You can beat any index or sector fund by identifying the “dogs” that are in it. Some of the stocks in an S&P 500 fund are not expected to do all that well in the next 12-24 months. Certainly if you constructed a portfolio of the 250 stocks most likely to do well and leave out the dogs, you should beat that index every year.

Eliminating the dogs requires analysis. Fundamental analysis works and is still the primary way in which most professional investors make their investment decisions.

The “problem” is that a lot of people do not think that anyone can actually analyze individual stocks and pick the winners over the losers. That, of course, is not true.

There are a great many securities analysts and portfolio managers out there who are more than competent. The problem is that the best investment advisors are mixed in with a lot of advisors who are more adept at sales than analysis.

Rather than take the time and put in the effort to understand investing well enough to choose a good advisor, people have fallen back on the idea that they can buy a few index ETFs, rebalance periodically and all will be well. That is the investment philosophy behind robo-advisors. It is an investment philosophy I call “cheap and stupid.”

This brings us to Harry Browne.  Browne developed what he called the “permanent portfolio” back in the early 1970s.  He introduced it to the world in a well received 1987 book called “Why the Best-Laid Investment Plans Usually Go Wrong”.

I came across this book when I started teaching Law and Economics in the early 1990s.  Much of the literature around Law and Economics at the time came out of the University of Chicago and had a very libertarian bias.  Browne was a Libertarian and later became the Libertarian Party candidate for President.

Browne’s book described the virtues of a diversified portfolio whose composition would stay constant year in and year out — permanent, in other words, except for annual rebalancing. Browne’s idea of diversification into non-correlated assets was different from what you might think and very different from the diversified portfolio that you will get with any robo-advisor.

Browne’s portfolio divided your funds into only four asset classes. The portfolio was equally divided between aggressive growth stocks, which do well in times of prosperity; gold which does well in times of inflation; long-term Treasury bonds which increase in price during times of deflation and Treasury bills which do well in times of tight money/recession.

Browne was a “gold bug”. He recommended that you hold the gold portion of the portfolio in bullion or gold coins. This was fairly common advice at the time.

At the time the book came out, Browne reported that the portfolio had produced an annual return equal to 12% over the preceding 17 years. Much of that return was due to the doubling and re-doubling of the price of gold. Gold was still pegged at $35 per ounce when the portfolio began.  The latter half of the 1970s was a period of high inflation which helped the price of gold to move up.

Browne’s permanent portfolio continued to do quite well in its original form until his death in 2006. A number of books and articles have been written about it and several people have modified it with funds and ETFs.

There is a mutual fund called the Permanent Portfolio fund (NYSE: PRPFX) which uses a modified permanent portfolio including real estate and Swiss Francs. The fund holds about $3 billion in assets. If you are really determined to be a passive investor and appreciate that those robo-advisors are a scam you might take a look at this fund.  You will discover that it has done quite well since 2006, when Browne died, until the present.

As always, I do not know anyone at this fund and no one has offered to compensate me in any way for recommending it.

Browne’s permanent portfolio has apparently produced positive results continually since 1970 through the present. It can do so because growth and recession, inflation and deflation are opposites and assets that perform well in each cycle are non-correlated by definition.

Will Browne’s permanent portfolio continue to do well, year in and year out?  It should. It represents asset allocation and diversification in its purest form.

 

 

 

 

 

 

 

 

 

What is Wrong with FINRA Arbitration? Nothing.

Uncategorized

FINRA arbitration provides a simplified procedure for a customer to resolve any dispute that they may have with their stockbroker or stock brokerage firm. The rules of evidence are relaxed and arbitrators will often ask questions of the parties and witnesses to make certain that they understand what has occurred. That should benefit any skilled litigator representing a customer in this forum.

Notwithstanding, I constantly read articles about how FINRA arbitration is unfair. Lawyers who represent customers claim that the arbitrators favor the industry.  Some complain that arbitrators are not required to follow the law nor give reasons for their decisions. Others argue that they cannot conduct adequate discovery because depositions are not allowed.

Many stockbrokers also think that FINRA arbitration is unfair. More than one stockbroker has referred to the arbitration forum as a “kangaroo court”.

There are a handful of elite lawyers who regularly practice in this forum on both sides of the table. There are many more who are competent (if not inspired) and then there are those who complain because they frankly miss the point. The lawyers who complain the loudest about the arbitrators are the lawyers that cannot put the facts in their proper context.

Many lawyers who practice in this forum, on both sides, have no real understanding of the day to day functioning of a brokerage firm or the actual relationship between a broker and a customer. They often cloud the proceedings with irrelevant information and misguided assertions.

Arbitrators are fact finders, not judges. Lawyers should explain the dispute to arbitrators in the way arbitrators understand it, rather than complaining that the arbitrators do not understand the claim the way the lawyers want to present it.

I was trained in broker/dealer compliance. Arbitrators are frequently concerned with the same thing that concerns compliance officers; was this a “good trade”? Whether or not Rule 10b-5 was violated is usually irrelevant.  That is why you cannot approach FINRA arbitration in the same way that you would approach a case being filed in court.

When a lawyer drafts a complaint for court, the focus is on the legal causes of action. They make certain that the complaint is legally sufficient because failure to do so will get the complaint dismissed long before the hearing.  FINRA arbitrators rarely dismiss a claim except under limited circumstances, so customers are almost always assured of getting their claim heard.

When I draft a claim for FINRA arbitration I tell the panel what happened in a narrative form.  I focus on what the broker did wrong or why the investment product was defective.  And I tell the arbitrators why those facts caused the loss that the customer suffered.

Many customers want to file claims against their broker because they feel that their trust in the broker has been violated. Trust is hard to prove and often not relevant to the facts at hand.

The securities laws are grounded in the idea of “disclosure”, not trust.  Customers must be told everything they need to know. Like all financial institutions, the brokerage industry has systematized this disclosure into the fine print that is included in the customer agreements, margin agreements, confirmations and monthly statements. All of these disclosures have been approved by the appropriate regulators.

Products like variable annuities and private placements which are the subject of many of the arbitration claims usually require a customer to sign a form declaring that they have received everything they are entitled to receive. With private placements customers sign a form that states that they have read the disclosure documents, had an opportunity to ask questions and were told to review the transaction with their own attorney and tax advisor before they make the purchase.  Obviously, that makes it more difficult for customers to claim that they did not get the disclosures that they should have gotten.

Many claims invoke FINRA’s suitability rule which requires brokers to have a reasonable basis for any investment recommendation that they make.  It rarely comes into play where the customer is self directed using an account at a discount brokerage firm.

You also need to appreciate that a reasonable basis for recommending a stock is that the broker thought that the price would go up.  A recommendation can often be justified by good news or bad news about the company or the market. No broker has a crystal ball.

Brokers are required to only make recommendations in accordance with the customer’s “risk tolerance”.  At the hearing this is going to come down to a simple question that will be asked of both the broker and the customer: “how much money was the customer prepared to lose?”

Once the answer to that question is ascertained, defense counsel will invariably bring out the monthly account statements.  Arbitrators have little sympathy for customers who do not read the monthly statements or who claim not to understand them.

Everyone knows that the stock market goes up and down and sometimes crashes. Customers are often asked: “your account went up 20% from where you started, didn’t it occur to you that it might go down by that much or more?”

Not every customer who has a loss has a cognizable claim. The firm or the broker must do something wrong and the wrong must be the cause of the loss.  A suitability claim is essentially a negligence cause of action and legal defenses to negligence such as “comparative negligence” and “last clear chance” come into play even if they are not expressed as such.

Beginning in the late 1980s, more and more “product” cases began to surface. These were easier to prove because there was always a prospectus or similar disclosure document which either made all of the material disclosures or did not.  But finding facts that were not disclosed takes work.

In the mid-1990s I worked on about 2 dozen claims against a number of firms that had sold notes issued by a large Ponzi scheme. The operators of the scheme had been indicted by a state regulator. At that time court documents were not available on the internet.  I contacted the prosecutor and obtained an affidavit that had been sworn by a Deputy Attorney General that had been submitted to the Court as part of an asset freeze in the criminal case.  It laid out the whole scam in great detail.

I would attach the affidavit to my pre-hearing briefs. Most of the defense lawyers who handled multiple claims for their brokerage firm clients had never seen it before, meaning many of the other customers’ lawyers had not bothered to pick up the phone and contact the prosecutor.

I had a similar experience during the tech wreck/research analyst cases. My partner and I flew back to New York and spent two days in the windowless basement of a mid-town office tower reviewing documents that had been produced in one of the class actions.  We came away with enough to prove what we needed to prove in our arbitration claims but it took time and effort to do so.  I know that a lot of other lawyers representing customers had never bothered to make the effort.

Discovery is the key part of any FINRA arbitration and FINRA has established lists of documents that are presumed to be relevant to different types of claims. These are usually exchanged without incident or discussion although I have seen instances where defense lawyers claim that some of the requests are “vague and ambiguous” even though they have responded to these same requests many times before.

Supplementary discovery requests are permitted but not depositions or interrogatories.  It helps if the customers’ lawyer understands the paper flow and record retention requirements of the brokerage industry.

Every single order (buy or sell) that is entered by a broker on a customer’s behalf is approved by at least one supervisor at the firm and a record of that approval is kept.  Orders that fall outside of pre-established guidelines become the subject of exception reports and are further reviewed by the compliance department.  All marketing materials that a broker hands out and all outgoing correspondence are reviewed and approved as well.

I am frequently amazed how little of a paper trail the industry produces in many cases. The most important documents, such as the broker’s notes setting forth why he told the customer to buy XYZ at $100 per share never seem to find the light of day.

The most outrageous abuse of the arbitration discovery process, in my opinion, was committed by Morgan Stanley which claimed, falsely, to have lost millions of e-mails when its headquarters in the World Trade Center was destroyed on 9/11.  Morgan Stanley was fined and a fund was set up to repay customers whose arbitration claims were tainted when its duplicity was ultimately uncovered.

Product cases often become “battles of the experts”.  FINRA rules require a high level of pre-offering due diligence by the firm. The customer needs to prove that the firm acted below the industry’s standard of care which usually means setting out the facts that were not disclosed or demonstrating how little due diligence was actually done.

There were a great many claims that were the result of losses from real estate private placements after the real estate crash in 2008.  The more successful claims involved private placements or private REITS where the disclosure documents were deficient. But again, you have to prove what is missing. The best experts are people who have written disclosure documents themselves.

Customers’ lawyers have already begun to file claims due to losses on oil and gas offerings as the price of oil has tanked.  As these programs cut dividends or file for bankruptcy fraud and other problems are frequently revealed.

These claims should be easier for customers’ lawyers because a due diligence investigation of an oil and gas investment is more complicated and costly than an investigation of a real estate offering.  In many cases, the smaller FINRA firms that sell these offerings do not want to spend the money to perform a due diligence investigation properly.

One issue that frequently draws negative comments about FINRA arbitration is the subject of damages. Arbitrators will often apportion the loss between the parties. In times of a market decline, they will often consider the fact that if the broker had done everything correctly or purchased different investments the customer might still have lost money.

Have I ever had a bad arbitrator? Yes. I have been in front of arbitrators who fell asleep, were preoccupied with other matters or just did not understand what was going on.  It is rare, but it has also happened with judges.

The organized investors’ bar association has reformed the FINRA arbitration to allow panels to be constituted without any member who has worked for the industry. Personally, I always want someone on the panel who understands how a broker or brokerage firm is supposed to act.

The complaints against FINRA arbitration are part of a larger movement to move many kinds of consumer disputes away from arbitration.  That would send these disputes back to courthouses that are already swamped. In many parts of the country consumers can wait 5 years for their case to be heard and spend tens of thousands of dollars in deposition and other preparation costs.

Investment cases are difficult to win because investors are not ordinary people who get struck in  by a car in a crosswalk. They know that they can lose money every time that they invest.

Investors are usually given all of the disclosures that they are supposed to get. They certainly know what they are buying, how much they are spending  and how much their account is worth, every month. Does it surprise you that defense lawyers frequently ask: “if you were unhappy with the losses in your account, why didn’t you just tell your broker to sell everything and quit before the losses doubled?”

The fact that many of these cases are difficult to win is not the forum’s fault.

I cannot be the only person who regularly practiced before FINRA arbitrators who believes that the system works well enough to be left alone. Well meaning consumer groups should think twice before they argue that investor claims are better heard in court.  And lawyers representing investors should consider that the arbitrator bias and other problems they keep complaining about may actually not be as prevalent or as harmful as they seem to think.

How Much is One Hour of Your Time Worth?

Economics

More and more people in the service sector of the economy are independent contractors setting their own hourly rate. For many self-employed people, it is one for the most important business decisions that they make.  It is also often one of the most difficult.

I worked as a lawyer for many years and I would periodically adjust my hourly rate upward, usually on the first of the year, to reflect the added expertise I had acquired during the year. Being self-employed allowed me the luxury of setting my own rate.

My hourly rate took into consideration that I had office rent and employees to pay as well as all of the ancillary expenses that come with running a business. However, that does not mean that I reduced my rate when I moved out of a pricey financial district office tower and into a lower rent office in the suburbs.

I was recently contacted by a very large international consulting firm that wanted to add me to their stable of experts. They had a client in need of a consultation about a fairly new regulation that I had written about and they invited me to call in and sign up.

The person with whom I spoke had all of my information from Linked-in and was happy to sign me up and explain their procedures. The assignment was a one hour phone call with an executive at one of the large Wall Street investment banks.

The last question the interviewer wanted to know was the most important; she wanted to know my hourly billing rate. Now that I am semi retired, I have even lower overhead and fewer expenses. I intended to handle this consultation sitting in the shade on my deck.

I asked my interviewer what she thought the right hourly rate would be.  We settled on a rate that she felt was appropriate.  The rate was the same that other experienced lawyers who were still working and paying overhead expenses would charge. I could have charged less because I had no overhead. Because I had written about the regulation I had demonstrated expertise and did not need to charge less.

Three factors will always come into play when setting your hourly rate; how good you are at what you do, your overhead and expenses and what the market will bear. It sounds much easier than it is.

In a perfect world, if you are very good at what you do, you should be able to charge more. That is not always the case.

In a great many cases, the customer is not looking for the best of the best. The customer is looking for someone who is good enough to get the job done.  I call it the good enough economy and there is a lot of it going around.

Basic economics teaches that the one universal factor determining how much you can charge per hour is what your competition charges. Price matters and it is going to throw the old idea about hiring the best people who went to the best schools and then worked at the best companies out the window.

The easiest example of this is code writers. It is an industry full of freelancers and independent contractors.  I live near Silicon Valley where I have heard many people say that the best code writers congregate.  Except those code writers have priced themselves out of the market.

If you have a fair amount of student loan debt because you learned code writing at Stanford or MIT and you live in Silicon Valley where rents are higher than almost anywhere else outside of San Francisco or Manhattan the amount that you need to earn in order to cover your monthly overhead is substantial.

There are excellent code writers living near Seattle or Austin as well as London, Moscow and Mumbai who will get the job done and charge far less because they need a lot less to pay their bills. I appreciate that Silicon Valley is where the action is, but even the big Silicon Valley companies have been outsourcing overseas for years.

This is not limited to tech jobs.

There are radiologists in India and the Philippines who read x-rays for hospitals and insurance companies in the US and Europe. There are teams of lawyers and paralegals in other countries who handle the volume of documents produced in large cases litigated by large Wall Street law firms. These firms have lawyers and paralegals on staff and would be happy to bill them out to accomplish the same tasks. But the clients do not want to pay Wall Street rates for tasks that they can buy cheaper even if they hire the most expensive law firm to represent them.

The simple truth is that a significant amount of student debt may actually be an impediment to making a lot of money as an independent in your chosen field. It may require you to work at a big company for a big salary. It can restrict your ability to take chances, like working with a start-up that could have a big time pay-off.  It can even rob you of the kind of opportunities, like a business convention in Hong Kong, that could really open up doors for your career.

Self worth is an interesting concept. Many independent contractors have difficulty setting their hourly rate because they do not have a good feel for how they stack up against their competition.  If you post a higher hourly rate you are advertising that you are better than your competitors. Of course, you need to back that up by doing a better job if you are hired.

It seems that a better approach would be to charge a little less and deliver a little more.  I have certainly read articles by many experts who would claim that that is the best way for an independent contractor to build his/her reputation and gain valuable referrals.

Never confuse your hourly rate with your advertising budget.  How you present yourself to prospective clients is still essential. If you want to charge more than your competitors you need to convince potential clients that you are worth more. And you need to reach more potential customers through advertising.

I read business plans and pitch books for start-up companies for free.  I will get on the phone with a budding entrepreneur and spend an hour answering specific questions and offer some suggestions or perspective about their business without charge. I have the experience, a fair amount of free time and I enjoy speaking with people who are starting a business. I often learn a lot more from them about what is going on in the marketplace than I do from reading the business or financial press.

Occasionally, a company wants to hire me to do more.  If I want the assignment, then I often have to charge less than I am worth because the company rarely has the cash to pay me what the NY investment bank paid me.  In most cases the company wants my on-going business and legal advice. In those cases, I usually prefer a monthly retainer to hourly billing.  That way, neither the company nor I are watching the clock.

I was recently approached by a very successful businessman who had started and sold three start-ups.  He had a pretty good idea for start-up number four and offered to give me equity in exchange for my expertise and on-going advice.

He was surprised when I declined because he had spent ten minutes explaining how my small share would be worth millions.  I told him to sell the shares he was offering to me to someone else for a deep discount and use the proceeds to just pay me my hourly rate.

For those of you who think that I was foolish for passing up what may have been a great opportunity, I can only tell you that I have been there before.  If you pay for my advice and then don’t take the advice, well okay, every lawyer has clients like that.  If I have equity and you don’t take my advice then I should not have taken you on as a client in the first place.

Do I really think that my advice is that good?  Yes I do, but mostly I know that advice that is not paid for is often disregarded.

Being semi retired and overhead free, I can give or sell my time to whomever I wish at whatever rate I wish to charge. It is truly liberating.  I only take on clients I like and projects that interest me. I can apply myself to only those projects where my experience and skills will add value.

I am not going to be giving seminars on this but I invite any independent contractor to adopt the same mindset, at least as an exercise.  What would you charge a really nice person who really needs your help?  Someone with a project that you could really enjoy sinking your teeth into even though they cannot pay you what you would like to get paid.

I suggest that amount is your base hourly rate. Charge more for mundane projects or difficult clients. There is no Nobel Prize winning economics behind this but I suspect that you will be happier when you are compensated at above your base rate for work that you do not enjoy and clients that you do not like. I suspect that you will probably be more productive, as well.