Fidelity’s Folly- Part II

bitcoin

I stopped writing about Bitcoin (BTC) in October 2020 because by then most people realized that, as an investment, BTC is foolish at best. My last article on the subject was about Fidelity Investments which was an outlier because it was a cheerleader for cryptocurrency.

At that time Fidelity was proposing to allow its brokerage customers to keep their BTC in Fidelity’s custodial “vault” and see their holdings valued on their Fidelity statement.  I suggested then that by just taking custody of its customers’ BTC, Fidelity might be considered a “facilitator” of its purchase.  Adding crypto holdings to the statement of mainstream investments might give people the idea that BTC is a mainstream investment, which it is not. 

Predictions

By October 2020 most of the predictions made by BTC self-styled experts in 2016-2018 had failed to come to pass. Banks had not been disrupted.  The US dollar and other fiat currencies were still accepted virtually everywhere. There was not a BTC ATM on every street corner.  No real change in the world banking system was on the horizon. Much of the hype in 2020 came from the same people who had been hyping BTC since 2016 and earlier.

My article was in response to a report published by Fidelity’s Director of Research that suggested that BTC was a “potentially useful” asset for “uncorrelated return-seeking investors”. The report said that “in a world where benchmark interest rates globally are near, at, or below zero, the opportunity cost of not allocating to bitcoin is higher.”   

Stock brokerage firms that merely execute their customers’ orders to buy and sell owe very little duty toward those customers. They are expected to handle the execution and bookkeeping by industry rules and practice, but little more.  Consequently, these “discount” brokerage firms have little liability if a customer loses money because they invested incorrectly. 

The report from Fidelity’s Director of Research in 2020 further suggested that bitcoin’s market capitalization “is a drop in the bucket compared with markets bitcoin could disrupt.” As I noted at the time, that report certainly sounded to me like a “buy” recommendation for BTC.

When a stock brokerage firm issues a recommendation more rules come into play. There must be a “reasonable basis” underlying the recommendation.  The rules governing research reports require more than a crystal ball look into the future.

Get Rich Quick?

Then as now, there is no real data about BTC for anyone to research. You cannot analyze BTC in any traditional way. They are merely a few lines of computer code, generated by a computer.  You can plug in and get rich but that is not going to disrupt the global banking system. 

Fidelity’s Director of Research based his recommendation to buy BTC, not on facts, data, or any traditional analysis, but rather on his speculation that BTC would result in a titanic disruption in the global financial system.  And that is what BTC is, not an investment but speculation. 

That fact is important because last week Fidelity announced that beginning mid-year it will permit financial advisors managing 401(k) retirement plans to invest in BTC as well.  Fidelity has about 23,000 of these advisors on its platform. If only 10% of those purchase BTC in the amount of 10% of the funds they are managing, the price of BTC is likely to sky-rocket.

Congress created 401(k) plans under the Employee Retirement Income Security Act of 1974 (ERISA).  Managers of ERISA plans are held to a fiduciary standard and are expected to invest the funds entrusted to them as a “prudent” person would. No one considers speculation in a retirement account to be “prudent”.

DOL Says NO

Congress assigned regulation of these retirement plans to the Department of Labor (DOL). There are about 800,000 different private pension plans in the US covering about 140 million people. Total assets held by these plans exceed $10 trillion, so it is pretty easy to understand that this is a big business. 

Fidelity has been planning this move for some time. It has been inching up to accepting crypto in 401(k) accounts for at least 2 years.  What is interesting here is that just about one month before its announcement, the DOL essentially told Fidelity, and all ERISA account advisors, not to purchase crypto in 401(k) accounts.

On March 10, the DOL issued Compliance Assistance Release No. 2022-01(CAR) on the subject of “401(k) Plan Investments in “Cryptocurrencies”.  The DOL is aware that firms were marketing investments in cryptocurrencies to 401(k) plans as potential investment options for plan participants.  The CAR lays out the DOL’s reasoning why cryptocurrencies do not belong in retirement plans.

The first reason the CAR lists is because an investment in cryptocurrencies is highly speculative. Highly speculative investments are never prudent for a 401(k) retirement plan.

No one asked Fidelity to respond to the CAR, but they did.  In this case, we get a rare glimpse of Fidelity’s rationale supporting this bold move to offer BTC to ERISA accounts and account managers. 

While Fidelity says that it understands that the CAR “effectively deems the selection of cryptocurrencies for investment in a 401(k) plan to be imprudent” it suggests that the DOL can’t possibly mean ALL cryptocurrencies. Fidelity suggests further study and guidance for the DOL as to which cryptos may be OK for 401(k) plans and which are not.

Notwithstanding its request for more clarity and its request that the CAR is withdrawn, Fidelity’s response can only be read as an admission that it understands the DOL means that crypto of any kind does not belong in a 401(k) or any retirement plan.

Fidelity also argues that it is not specifically designating BTC or any crypto as investments that they are offering to these plans. If a plan manager wants to add some BTC to the portfolio, Fidelity will guide the manager to a different landing page, where the purchase will be made through a different Fidelity company, not the ERISA plan funnel.

That argument is unlikely to hold water as what the DOL was complaining about in the first place, was people marketing crypto to these retirement plans. However Fidelity books these trades, it is still Fidelity’s cheer-leading for BTC that is causing those trades to occur.

To be clear, even though the primary regulator of these 401(k) plans has said no, Fidelity has gone ahead and decided that it will facilitate the purchase of BTC in these accounts. The lawyers and compliance officers who gave Fidelity the green light, need to stand up and explain themselves.  

In its most recent research, (April 2022) Fidelity asserts that BTC is an “aspirational store of value”. Fidelity’s argument for BTC is specious at best, but that does not matter. In that report, Fidelity specifically acknowledges that BTC is a speculative investment. Notwithstanding, Fidelity continues to target retirement fund administrators with positive commentary about BTC.

I would suspect that the DOL was addressing Fidelity when it issued the CAR.  As any lawyer will tell you, Fidelity is essentially telling the regulator to shove it. Fidelity knows that the CAR has not been withdrawn.  In my experience, regulators hate to be ignored. 

I also suspect that the DOL has a contingency plan for this. It has already gotten support from the AFL-CIO which has specifically and publicly supported the issuance of the CAR. The CAR alone will dissuade some of the fund administrators Fidelity is targeting, but Fidelity apparently intends to offer crypto to any retirement account that wants it.

The DOL also has the benefit of several US Supreme Court decisions that support the idea that ERISA accounts require “prudent” investments and that plan fiduciaries need to help eliminate “imprudent” investments.  As Fidelity can be shown to be trying to influence plan administrators to purchase imprudent investments, some courts might just agree that Fidelity has stepped into a fiduciary relationship with the plan investors.     

I suspect that any court that looked at the facts presented here might support a cease-and-desist order against Fidelity. I would not be surprised if it came from the securities regulators in Fidelity’s home state of Massachusetts.   

I cannot for the life of me figure out how Fidelity got itself into this mess. Fidelity enjoyed a reputation as a company that sold mutual funds to mom-and-pop investors. There are more than 25 million people in the 401(k) plans that Fidelity services. Why would Fidelity go against the DOL for the right to sell highly speculative investments that most of those people would never want in their retirement plan?

Sooner or later, I suspect someone will write a book about Fidelity’s attempt to put lipstick on the pig that is BTC and pawn it off on retirees.  The SEC has been threatening to hold compliance directors responsible for allowing practices that harm investors. If Fidelity moves ahead, as I suspect this would be an ideal opportunity for the SEC to make a statement and demonstrate that they are serious and ask the compliance director at Fidelity to explain himself.

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

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What the Women’s Movement can learn from Cesar Chavez

What the Women’s Movement can learn from Cesar Chavez

I got into an interesting discussion with a businesswoman who had posted on LinkedIn about the difficulties that women have in the workplace. Among other things, she commented that women are significantly under-represented in the executive suites and on the boards of directors of most large companies. I certainly agree.

Any intelligent person in the workforce today can see that women have more difficulty getting hired and promoted, are penalized for resume gaps when they take time off to have children, and overall, still get less pay for doing the same jobs as men. Women are too often exposed to toxic work environments, off-color jokes, inappropriate comments, and sexual overtures. That women face this type of discrimination in the workplace is a fact.

Some people approach the treatment of women in the workplace from the standpoint that this is a “gender’ issue. They assert that this conduct by men is our problem. Male business owners already know better than to discriminate against women. The simple truth is that men pay women less because they can get away with it.

I see this gender pay disparity as a labor issue. It is past the time for women to flex their economic muscles and actively purge this type of discrimination from large companies. If women were properly represented on the boards of directors of more companies, they would be in a far better position to rectify the actual problems of unequal pay and toxic work conditions at each company.

When I started law school my first-year class had 120 students including 12 women, exactly 10% based upon a pre-determined quota. Each of the women had been interviewed at the school before acceptance. None of the men had been required to sit for an interview. From the beginning, it was obvious to me that this small group of women was a little sharper than many of the men. That should have been expected as each of the women faced stiffer competition for each seat in the class.

Last week I saw the picture of a young woman wearing a tee-shirt that said: “I became the lawyer that my mother wanted me to marry.” To me, that one sentence encapsulates a generation of progress for women in the legal profession.

When I was in school it was commonly thought that women could only be trained to become nurses or teachers. Untrained, women might become waitresses, secretaries, or flight attendants. The uniforms of flight attendants were tailored to accentuate their figures and they were often fired as they got older and deemed to no longer be attractive to male passengers.

There is no question that women have broken through the glass ceilings put in their way in a great many industries. Women now work in construction and other traditionally male blue-collar jobs that would have been unthinkable not that long ago. Teachers, nurses, and flight attendants are now covered by union contracts that have raised their pay, improved their working conditions, and provided benefits and job security.

Women manage large numbers of employees within big corporations across all industries. As managers, they make decisions that define the company’s operations and impact its bottom line. Still, it is rare to find a woman as the CEO at a Fortune 500 company and virtually impossible to find a Board of Directors where women make up the majority of the directors.

Women represent one-half of the US population. The impact of women as consumers cannot be overstated. Even companies operating in niche industries deal with vendors, customers, and employees who operate in the much broader markets.

Shouldn’t seats on boards of directors be handed out equally to men and women so that the boards represent not just the perspective of the management, but the broader market that the companies serve and in which they operate?

Greater representation on corporate boards would seem to be an effective way for women to deal with issues regarding equal pay and toxic working conditions. Taking more control at the very top of the corporate governance pyramid would help women to rewrite the workplace rules at all levels.

Labor unions exist specifically to deal with issues like wages and working conditions. Unions representing workers with far worse conditions and far less power have been able to get what they want using a variety of tactics and strategies.

The last great strike, by the United Farm Workers (UFW), took place against the lettuce growers while I was in college and law school. The tactics employed by the union were quite different from those other unions had used in the past. The lettuce strike offers lessons that might help women successfully break into and take over corporate boardrooms.

Farm labor may be the world’s second-oldest profession. Growers have always had all the power and used that power to accumulate more power. Farm laborers had been excluded from the Fair Labor Standards Act and Social Security in the 1930s. Any attempt to organize farm workers was always met with a stacked deck.

In 1970, when the lettuce strike began, the working and living conditions of the lettuce workers were still medieval. Their pay was inadequate and provided only the barest necessities. The farm workers occupied the lowest rung on the ladder of American workers.

The lettuce strike organized by Cesar Chavez and the UFW was truly a David v. Goliath battle. Throughout, the growers used their considerable influence and deep pockets to thwart the workers.

Chavez succeeded because he did more than just throw up a picket line and negotiate as steel and automotive workers had done in the past. He used very different tactics to leverage support from larger groups to provide financial and logistical support.

Most importantly, the UFW successfully enlisted the lettuce consumers to alter their diets to support the strikers. The union effectively delivered a message that said 1) our working conditions are horrific and 2) don’t buy lettuce.

Traditionally unions and management negotiate contracts focused only on the numbers. Each side calculates how much each incremental boost in wages will cost the company. The union calculates the effect of lost wages on its members if there is a strike. Management calculates the effect of a strike on its bottom line.

By addressing lettuce consumers directly Chavez added the impact to the company’s reputation and customer base to the equation. The cost of winning back consumers after these boycotts would now need to be considered.

Chavez had tested out his new tactics during a 4-year strike against the grape growers. In that campaign Chavez, vowing to be non-violent, had tried out tactics adopted from the civil rights movement including long marches, prayer vigils, and a hunger strike. Local rallies in support of the union were scheduled. Media coverage of these events and the sometimes-violent protests by people opposed to the UFW kept the strikers in the public’s eye.

Chavez used the grape strike to garner support from church groups and other decent people who were horrified when exposed to the working conditions in the fields on television. By the time the strike against the lettuce growers began, Chavez already had all these tools in place. People who mattered, especially the media, had already been educated about the critical issues.

Opposition to the lettuce strike came primarily from the Teamsters Union which had negotiated sweet-heart contracts with some of the lettuce growers   The UFW strikers were physically attacked, and rallies and the union offices were firebombed. Chavez, the “pacifist” of the grape strike was much more aggressive. As the tempo and temperature of the strike increased Chavez was arrested for the first time.

Within a few days Ethel Kennedy, widow of Sen. Robert F. Kennedy visited Chavez in jail. As she was leaving a small riot broke out and Mrs. Kennedy needed to be rescued by the local police. It made for great television. Mrs. Kennedy’s appearance at the courthouse had been intended to be a carefully choreographed stop on the campaign trail. The violence ensured that every television station reported on it.

At this time, I was living in Brooklyn which was about as far from the California lettuce fields as one might get. After a while, it seemed that every telephone pole had a simple sign that said “BOYCOTT LETTUCE” stapled to it. That did not happen by accident.

The “BOYCOTT LETTUCE” signs had been stapled to those telephone poles as part of a well-thought-out and well-managed PR campaign. Originally, they appeared in about thirty cities and later in thirty more. Later signs went up urging consumers to boycott two supermarket chains, one east of the Mississippi and one to the west,which bought lettuce from growers not represented by the UFW. The PR campaign was targeted and periodically expanded to ensure that the number of supporters of the strike constantly increased.

Chavez won his strike and he won it not on the picket line. He kept the conditions of the farm workers in front of consumers, daily, for an extended period. Sympathetic consumers boycotted the product, and the growers took a far bigger hit to their bottom line than they would have if they had just paid the workers from the beginning.

It is fair to consider that similar tactics would get more women on the boards of directors of more companies. Women are the dominant consumers making the decisions whether to buy Tide or Cheer,Luvs or Huggies and whether to take the kids to Burger King or McDonald’s and many, many other products as well. Women can certainly utilize their economic power to have themselves appointed to the boards of directors of these companies.

Most consumers have no idea how many women are on the board of directors of the companies that make these products. Very few consumers know whether those companies are taking advantage of women by paying them less. But, as the UFW demonstrated, consumers can be educated, and they can be mobilized. And the UFW was working within the confines of 1970s technology and media.

I can certainly envision an organization seeking to fill many more directorships with women initiating a correspondence that said: “Dear Fortune 500 company: We have noticed that ten of the 11 people that you have nominated for your Board of Directors are male. Please replace five of the men with women. If you are having difficulty finding qualified women, we will be happy to send you the resumes of thousands of women who are more than capable of contributing to your board. If you have not replaced the five male directors with 5 females in 20 days,we will begin a national campaign advising women to boycott your flagship product.” 

I have no illusion that one tweet from Oprah or one of the Kardashians would be enough to sustain a national boycott of any product. I do believe that both could be included in a carefully planned, targeted, and executed campaign that includes a simple message spoken repeatedly by thousands of “influencers.”

I do not see a way for a large company can come out ahead from a public fight with its most important customers about board representation. There is no satisfactory answer to the question: “why can’t more women serve on your board of directors?” 

The success of the UFW and the tactics it employed will be a lesson to the unions when the next big strikes come along. Women have been fighting for equal pay and better working conditions since at least the 1970s. Despite all the progress they have made, I think they may need some new tactics and some “out of the box” thinking to finally get what they deserve.

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

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Seeking “reasonable” people in crowdfunding

First-year law students encounter what is called the “reasonable man” test. It is usually explained as what an average, reasonable person would do in a similar situation. It is applied as a standard of care in cases where the fact finder is trying to assess the conduct of one of the parties. You can find the “reasonable man” test in patterned jury instructions used every day all over the country.   

There are often a lot of precedents that help judges and juries decide what is reasonable and not. Sometimes a jury will be asked to place themselves into the shoes of one of the parties and ask themselves “what would you do”. That is where things can get a little cloudy.

My law professor described it this way. If your spouse is having an affair with your neighbor, they likely feel that their conduct is reasonable at least as they view the surrounding circumstances. You are likely to view their conduct differently. So how you view the situation often depends on your perspective of the conduct at issue which is based upon your own experiences and beliefs.

There is also conduct that is judged against a higher standard of care. Professionals like doctors, because they are specifically trained and licensed, are expected to follow established medical protocols. Others, because of their training or title are expected to perform their tasks as other “reasonable” professionals would if faced with the same facts or situation.   

In securities law, the conduct of those people who are in the business of selling securities to the public (intermediaries) is regulated. Laws passed by Congress and rules adopted and enforced by the SEC and FINRA define the conduct that is reasonable for both mainstream stockbrokers and Regulation CF funding portals.

What do regulators expect from Reg. CF funding portals?

I speak with portal operators and other lawyers working in the Reg. CF market. I get that question a lot, and I cringe whenever someone asks. The answer should be settled by now but it is not. 

Many of the portal operators with whom I have spoken (and some of their lawyers) have very diverse views are regarding the portals’ obligations under the regulatory scheme in which they operate. Some seem to think that a funding portal’s role is primarily passive. They believe that the portals do not need to take steps to see if what investors are being told about the offerings they host is true. 

More than one portal operator told me that they are most often satisfied with the initial representations made by most of the companies that list on their portals after a conversation or two because the managers at these companies sound “credible”. They do not see any “red flags” because they are not looking for them.  

There have always been scam artists in the capital markets. Four decades before the federal securities laws in the 1930s, states were fighting fraud with “blue sky” laws so-named because people were selling stock in companies whose prospects were worth little more than the “blue sky” up into which the price of the stock would surely go. 

Blue sky laws were not a response to a need to protect rich, money center investors. Rather, they were enacted to protect small, Main Street, rural, mom and pop investors. These were people who we now call the “crowd”.  

If you have operated a funding portal for a year or two, a scam artist or two has likely come knocking on your door.  Some portals turn away offerings because the companies cannot provide good answers to the questions the portal asks.

Other portals list any offering that comes along and allow these companies to make any number of false and misleading statements to sell the offering to investors. These portals ask few questions. They cite the SEC’s own statement to support their hands-off approach.

The SEC specifically states that it expects funding portals to take such measures to reduce the risk of fraud. Reg. CF specifically requires a portal to have a “reasonable basis” to believe that each issuer is complying with the law. That should include the laws that require an issuer to make all necessary factual disclosures to investors and to present the offerings in such a way that investors will not be misled.

Unfortunately, the SEC added the following sentence to the regulation: 

“In satisfying this requirement, an intermediary (portal) may rely on the representations of the issuer concerning compliance with these requirements unless the intermediary has reason to question the reliability of those representations”.

Some portals rely upon that statement to support their idea that they can just pass on whatever information the issuers provide to the investors without questioning its content. 

Taken in the context of the regulators’ desire to foster investor protection, the above statement should raise the question; how would an intermediary know if it had reason to question the reliability of the representations made by the issuer unless they dug a little deeper?

FINRA, which regulates both broker-dealers and the Reg. CF funding portals requires broker/dealers to conduct reasonable due diligence investigations of all offerings, especially when an issuer seeks to finance a new speculative venture. In that case, FINRA warns that broker/dealers “must be particularly careful in verifying the issuer’s obviously self-serving statements.”

New, speculative ventures are the meat and potatoes of the Regulation CF marketplace. Aren’t the younger, less sophisticated investors who are being solicited to fund these companies entitled to the same protections as the more sophisticated, accredited investors who might invest in a new venture through a broker/dealer? Are the accredited investors being lured to Reg. CF portals now that the portals have become less restrictive being told that the due diligence they get at the portal is much less than they would get at a BD?

For the record, the SEC originally included that statement about relying on the representations of issuers, in part, because the staff recognized that a true due diligence investigation can be expensive for a company raising only $1 million. As the limit has now been raised to $5 million the Reg. CF funding portals are earning 5x per offering and can certainly conduct a reasonable due diligence investigation of at least these larger offerings. 

Given that 2000 fraudulent ICOS were funded and many just took the money, closed up shop, and crept away, it is easy to imagine a thief posting phony offerings on 4 or 5 portals at the same time raising $25 million and doing the same. Since the regulators cannot catch these offerings in real-time and the portals are not looking, I think that scenario is inevitable.

When is a funding portal compliance director being reasonable?

I trained in broker/dealer compliance while working at a large, national wirehouse. It took me a while to learn the rules and procedures that were already in place. It took longer for me to understand why each of those rules and procedures existed, and how and when they were being applied.

I have consulted with quite a few compliance professionals and departments over the years. The job requires them to make judgment calls and give advice that, if wrong, can be very costly to the firm.  Many of these professionals are guided by their understanding of the rules and a healthy amount of common sense.

Lawsuits and problems with regulators are signs that compliance is sub-standard.  Being ordered to pay investors back $5 million because of a fraudulent offering would hurt any funding portal’s bottom line. Good compliance, and not just trusting the issuers to make representations without verification, would reduce the costs of lawsuits and regulatory problems to zero.

A compliance director at a funding portal must also take into account that the portal must also answer to regulators other than the SEC and FINRA. Remember those pesky blue sky laws? 

State securities laws apply in the state where the portal operates and also any state where any investor in an offering on the portal resides. The Uniform State Securities Act (adopted in more than 30 states) takes a completely different approach towards liability in cases involving a fraudulent offering. 

Under federal law, the person who purchased the security has the burden of proving that they would not have made the purchase but for some important fact that was either omitted, false or presented in such a way that it caused the purchaser to be misled.

Under the state law, the seller must sustain the burden of proof that the seller did not know, and, in the exercise of reasonable care, could not have known of the untruth or omission.  Given that the seller (intermediary) has done no investigation or asked any questions, it is difficult to demonstrate where the investigation would have led if it had been guided by the documents that could have been requested. 

Sooner or later a portal owner will be sitting in front of a state securities administrator who is asking how some purely fraudulent offering got listed on the portal. The portal owner might take out a file of documents that record its investigation of the offering which, while not thoroughly comprehensive, is at least sufficient to sustain a conclusion that “having gotten responsive answers to the questions we asked, and seeing no red flags, we have a reasonable basis to believe the representations being made by the issuer are accurate.”

Other portal operators will pull out a letter from their lawyers advising them because of the SEC’s apparent green light, the portal can list any issuer relying only upon the issuer’s representations and presumed reliability.  (Spoiler alert- state securities administrators really hate that response.)

I write a lot about scams in crowdfunding. A lot of people tell me that the problems I see are just growing pains for this new industry. 

By next summer, if not sooner, thanks to new technology and techniques, 5-million-dollar offerings listed on Reg. CF funding portals will sell out in a matter of hours.  Going forward, a lot of money is going to change hands very quickly with little scrutiny. That should attract more scam artists, not fewer.

The only way to reduce the presence of scam artists and scam offerings from the Reg. CF market is for the portal operators to push back against the idea that a portal can be passive when it comes to investor protection. 

Portal operators need to ask a lot of questions about each offering that is presented to them. They need to be satisfied with the answers they get. It does not need to be an expensive due diligence investigation. A portal just needs to make a reasonable inquiry as judged from the perspective of a professional funding portal compliance officer.

The portals I advise are told to reject offerings when they are not comfortable with the answers they get. If something sounds too good or not quite right, a funding portal compliance officer should be expected to inquire further. The compliance officer should be expected to be satisfied with the veracity of the answers before passing the issuer on to the public.

You will not find words like “comfortable” and “satisfied” in the legal dictionary. Rather they are the result of a feeling of relief that compliance officers get when they have created a paper trail that supports their approval of a questionable offering.

“Comfortable” and “satisfied” are the result of a funding portal compliance officer having taken a practical, not legal approach. Quite often the most practical approach is also the most reasonable. 

What will never be “reasonable”, “practical”, “satisfying” or “comfortable” is the idea that a funding portal could host an offering that did not tell investors the truth or which lure investors with fallacies and fabrications.

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

Or you can book a time to talk with me HERE

KingsCrowd – Again

kingscrowd-again

A few weeks back I wrote an article about KingsCrowd, a company that claims to have an algorithm that can “rate” the offerings that are listed on the Regulation CF funding portals. I called KingsCrowd’s ratings bullshit. In my mind, I was being charitable.  I wanted to call them “scam artists of the first magnitude” but my editor calmed me down.

Investment crowdfunding is still in its nascent stages. As I have written before, all of the mechanics are in place for any issuer to use crowdfunding to raise capital.  With an adequate budget, some professional assistance, and a little common sense, every crowdfunding campaign should successfully raise the funds that it seeks.

KingsCrowd’s ratings do little more than stroke the egos of the founders who bask in their artificial light.  They support the absurd claims of many founders that because they spent a year staying awake all night writing code they will be able to turn that code into a profitable business that will disrupt this or that industry.

Over the years, I have helped quite a few professional chefs raise funds for a restaurant. Several of those chefs had egos that would make Elon Musk blush.

Year in and year out, restaurants have the highest failure rate of any small business. Good food and good reviews will get people in the door. Chefs are frequently proud of their signature dish. The number of beverages, appetizers, and desserts they sell will actually dictate their profitability.  I would tell the chefs that profit margins are not on the menu but that is where their focus needs to be. Some get it, some do not.

These are some of the things that people brought to my attention about my last article. These are the issues that they raised and these are my thoughts:

1) You cannot fund a start-up without some type of valuation.

I have helped all kinds of companies raise capital from investors for over 4 decades. Only the large bond offerings were rated by Standard and Poor’s and Moody. Investors in both the public and private (Regulation D) market have never had a problem parting with their funds to invest in a company that was not “rated”. A rating would, in fact, be an anomaly.

Investors are universally concerned with one metric and one metric only, the return that they can expect on their investment (ROI). One of the true benefits of crowdfunding is that it allows a company great latitude and creativity when it prepares its offering. If the investors’ funds will help a company generate revenue, then the company can share that revenue with the investors.

Again, using crowdfunding, every campaign can be successful, every time. It starts with structuring an offering that investors will find attractive and then putting that offering in front of as many investors as it takes to obtain the funds the issuer needs. You do not need to lie about your company’s prospects, fantasize that it will disrupt an established industry, or come up with a phony rating. End of story.

2) There are no other metrics to value a start-up or small business. 

The SEC mandated that all but the smallest issuers using Reg. CF funding portals have their financial information audited so investors get the facts about the company’s finances.  Those financial reports are presented using what are called Generally Accepted Accounting Principles (GAAP). There are GAAP rules that cover valuations of a myriad of balance sheet items and they apply to all companies.

At the same time, there are business brokers all over the US who help people value, buy and sell businesses every day.  Over the years I have heard many of those business brokers say that a good business is “worth” roughly 3 times next year’s projected earnings. Many of the highest-paid research analysts at the largest investment banks use a similar formula when projecting the future price of a publicly-traded security.

Suddenly all those professionals are wrong and KingsCrowd’s new method of valuation is right? That does not hold water. 

3) KingsCrowd’s ratings are patterned after what VC’s do

I moved to San Francisco in 1984 to join a small boutique law firm that represented a European-based VC fund. The fund was actively investing in some cutting-edge Silicon Valley tech companies and some more run-of-the-mill consumer product companies as well.

I sat in on a lot of pitches that were made by a lot of really interesting and intelligent people. The Managing Director of the VC fund told me that he liked to include me because I asked a lot of questions that cut to the bottom line. I still do.

VCs have been playing a game with each other to reach the insipid valuations that they claim for the companies they hold in their portfolio. VC No. 1 buys 1,000,000 shares in a start-up for $10 per share in the seed round.  His good buddy VC No. 2 invests in the next round buying shares for $20 per share. VC No. 1 can now claim that the “value” of his investment has doubled, even though in many cases the value has been diluted.  

Their good buddy VC No. 3 buys into the next round at $30 per share making the first two VCs look like geniuses by claiming the value of their holdings in the first two rounds have gone up. The roles of these VCs reverse in the next deal that comes down the pike and people rain praise on the VCs for their “vision”.

There is no liquidity in this market. Those “valuations” are meaningless. Once I understood the game, it was pretty easy to spot. Peel back the VC funding for WeWork and similar scams and you will see what I mean.  I call it “frat-boy finance”.

Worse, companies funded this way claim to be “unicorns” a cynical description that too often means the valuation is a fantasy. It creates a false reality in the minds of the people the VCs will screw when they ultimately take the company public.    

4) Normal valuations do not apply to tech firms like Microsoft.

If you develop an essential software package, license it to IBM for $100 a box, and put the sales power of IBM behind you, you may be right. Professional analysts who follow MSFT, of course, use the same metrics as all securities analysts everywhere, using the same methods and formulas taught in all business schools.

If your background is in tech, I promise to never, ever comment about your ability to write code. This article is about finance. Please consider that I have the home-court advantage.  

More importantly, I have the ears of the investors you want, angel and accredited investors, family offices, etc. I can get your company in front of those investors, but they will place their own value on your company no matter what KingsCrowd says. 

5) The new generation of investors needs new methods of valuation

From the beginning of investment crowdfunding, people suggested that the crowd can evaluate the offerings listed on a funding portal. That was never true.

If we learned anything from the Robinhood fiasco it is that young investors are motivated by the same thing that motivates all investors, they invest money to make money.

In the mainstream markets, most small investors do not even try to analyze a company’s financial reports or attempt to determine its true value.  Smaller investors most often buy mutual funds or work with a stockbroker or investment advisor.  I am not suggesting that these professional advisors necessarily know what they are doing. I am suggesting that most small investors realize that they need help.

Why do I even care? 

Working in the crowdfunding industry it has been my pleasure to work with some extremely bright and hardworking people. Day in and day out they roll up their sleeves to help start-ups and businesses of all sizes get the funds they need to grow and prosper. I consider these people to be the unsung heroes of modern capitalism.

Every week I take calls from business owners and entrepreneurs who want to raise a few million or more based upon a “valuation” they computed based upon some article they read, a conference they attended, or a company like KingsCrowd. In many cases, people seeking capital through crowdfunding do so because traditional sources of capital are unavailable to them.

If you can qualify for an SBA loan you will take it. If not, investment crowdfunding is a viable alternative to get the capital that you need. Just send me an e-mail or fill in the form on my blog.

When someone calls and tells me that their pre-revenue start-up, with no assets, patents, or customers should be “valued” at $10 or $20 million I think “yeah and my you-know-what” is 12” long. (Yes, my editor revised my original number.) I am not trying to be inappropriate.  I am just looking for an analogy that will drive my point home.

What is to be done about these fraudulent and misleading valuations?

These false claims about valuations proliferate right out in the open and the primary regulator, FINRA, does nothing.  FINRA (and I choose my words carefully) often has its head up its ass.     

Some scams are difficult to spot. Enron was sophisticated accounting fraud. To uncover it required knowledge of specific inside information. 

Elio Motors, a Reg.A offering hosted by StartEngine a few years back was easy to spot with a modicum of due diligence because its claims could easily be investigated and debunked.

Phony valuations like the ones issued by KingsCrowd are just false advertising right out in the open that anyone at FINRA could easily spot. FINRA does have specific advertising rules that funding portals are expected to follow. The compliance director of any portal that signs off on KingsCrowd’s valuations should be banned from the industry.

Case in point:

StartEngine, which itself has never shown a profit, perpetually raises capital to fund its operations. It needs to pay its spokesperson, Mr. Wonderful, (who was recently accused of defrauding the founders of multiple start-ups) several hundred thousand dollars per year.

This year, as part of one of its several fundraising campaigns, StartEngine claimed a valuation of over $780 million based upon KingsCrowd’s algorithm.  Someone suggested to me at the time that valuation would make Warren Buffet puke.

I did some shopping and found that you could buy a fully licensed and operational broker/dealer for about $200,000, perhaps $2 million if the firm had a few stockbrokers who would agree to stay on with new management.

It is not like StartEngine has a stable of stockbrokers to sell investors other products. I suspect that very few of the people who have invested once on StartEngine’s funding portal have come back and invested twice.

Both StartEngine and Republic that use KingsCrowd ratings are conflicted. Each has benefited from its relationship with KingsCrowd. These ratings, even if they were valid are not independent and no disclosure of that fact is made anywhere.

At the heart of this problem is that in terms of dollars raised, StartEngine and Republic dominate the Reg. CF portion of the crowdfunding industry. I consider these valuations to be a cancer on the crowdfunding community. They scare away serious investors that the crowdfunding industry desperately needs. They unfairly compete with the many hardworking people in the crowdfunding industry who are trying to help companies raise capital honestly. 

Perhaps FINRA will eventually step in and put an end to KingsCrowd’s ratings.  FINRA has previously expelled only 2 funding portals, uFundingPortal and DreamFunded. In both cases FINRA questioned valuations that were much, much lower than KingsCrowd spits out. 

This is the third article I have written about KingsCrowd in short order. I have no intention of going away. Hopefully, FINRA will intercede before I need to pick apart individual offerings that advertise these ratings that they do not need to raise capital in the first place.  Hope springs eternal.


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

 

KingsCrowd- selling ratings for fun and profit

kingscrowd

The thing about crowdfunding is that it attracts people who are paid to introduce investors to companies that have little to offer. The worst, of course, are those who know that the companies have little chance of success and hype the hell out of them anyway.

So I was particularly interested in a Reg. A+ offering filed by KingsCrowd, a publication that covers the Reg. CF marketplace and companies that are seeking funds.  KingsCrowd has a “patent-pending AI-driven startup rating algorithm” from which it intends to rate the various offerings on the Reg. CF funding portals.  

In its own words, KingsCrowd will “empower individual investors to make intelligent startup investment decisions on platforms like Republic, Wefunder, SeedInvest, Netcapital, etc., by providing institutional-grade research tools for assessing the thousands of investment opportunities available to investors at any one time.”

Given that 90% of start-ups will inevitably fail, any algorithm that can sort likely winners from likely losers would be welcome.  Even if unable to identify the 10% that will succeed, eliminating the bottom 10% or more that have no chance at success would benefit investors as well. 

KingsCrowd already tracks and rates “every Reg. CF investment opportunity in the United States.” It has a system to research and rate Reg. CF issuers. The only question is does their algorithm work?  How good is their research? What constitutes “institutional-grade” research anyway?

CalPERS, the largest public employee’s pension fund manages a multi-billion dollar portfolio.  It employs several hundred research analysts to oversee that portfolio and to make specific buy/sell recommendations. Other funds and money managers around the globe use much the same data and much the same methods to analyze that data.  Generally accepted methods of securities analysis are taught in business schools and have been for decades.

If that is “institutional-grade” research and analysis then I needed no more proof that KingsCrowd does not provide it than the fact that it gave itself a “pre-money” valuation of $45 million.  There is no way that analysis that produced that valuation can be called “institutional-grade”. The numbers just do not add up.

KingsCrowd says that it collects “more than 150 data points on each issuer, including information relating to its team, its market, financial statements, traction with consumers, and competitors. Our investment research team collects data from multiple sources such as the issuers’ pitch decks, capital raise pages on all of the funding portals (including all Reg CF funding portals such as Wefunder, Republic, Netcapital, SeedInvest), news articles and announcements, social media, founder profiles and resumes, recruitment websites, the SEC filings, growth data provided by the companies and information derived from alternative data sources.” 

I do not think that I need tell you that data in “pitch decks” and “growth data provided by companies” is often exaggerated. Information on the funding portals is often unverified.  What I was hoping for was for KingsCrowd to bring some amount of real financial analysis to this marketplace.  To even begin the process it would be necessary for the data used on Reg. CF funding portals to be accurate.  It isn’t.

KingCrowds’ “algorithm uses a comparative modeling approach to rank and score all companies actively raising capital from the markets across the various key dimensions deemed notable in the rating algorithm and traditionally utilized by venture investors to make informed investment decisions.” 

Forget for a minute that the phrase that ties “venture investors” with “informed investment decisions” is itself an oxymoron.  I worked for VC funds and I have dealt with them as a representative of a company being funded, repeatedly, beginning in the 1970s. Funding has always been more about who you know than what you were selling. The days of an MBA as a requirement to be a “venture capitalist” are a receding memory.

I would think that if KingsCrowd’s algorithm really identified better investments, one of the VC funds would have scooped it up.  When you break down what they do, you can see that it is more smoke and mirrors than mathematics.

At the end of the day, KingsCrowd’s patent-pending AI-driven startup rating algorithm yields a rating that is a number between 1 (lowest score) and 5 (highest score) for every aspect of the issuer, including price, market, differentiation, performance, team, and risk, as well as an overall score for the issuer at a specific funding round.

Given that many of the start-ups being funded have neither income nor profits, the metrics of “performance” may be more subjective than one might expect. KingsCrowd seems to intimate that what they are identifying are companies that had a successful capital raise, not successful companies.  If that is true, they are on a fool’s errand. And, while I always help clients structure their offering to present an investment that will be attractive to investors, success in crowdfunding is often about how you market the offering and how much money you put into your marketing campaign.

Giving a numerical score to a “team” also seems quite subjective. KingsCrowd itself has only 3 employees and a “team” of outside advisors. Christopher Lustrino is a founder of the Company, Chief Executive Officer, President, Chief Financial Officer, Treasurer, and also a member of the Board of Directors. If these positions had been filled with qualified people would the “pre-revenue” valuation have been $60 million? More?

Some VCs and angel investors like a founder to have some skin in the game and invest their own money. Lustrino is selling $1 million worth of his stock in KingsCrowd as is one of the early investors. The fact Lustrino needed to sell his shares costs the company an equal amount.

KingsCrowd is also concurrently offering the same shares to investors in a private placement offering under Regulation D. They are raising a total of $15 million which, if the company had something to offer, would have been cheaper and easier to accomplish using only the private placement.

Under current law, however, Lustrino cannot sell his shares or those of the early investor, using Regulation D. To sell his shares, Lustrino needed to have the company prepare and file the offering using Regulation A+.

In the normal course, the shares being sold under Reg. A+ would be the subject of a commission, here 7%.  Shares sold on a crowdfunding platform using Reg. D do not pay a commission unless the platform is a licensed broker/dealer.

Lustrino arranged to have this offering placed with a broker/dealer affiliated with one of the Reg. CF funding portals, Republic. He has agreed to pay that broker/dealer 7% of the entire $15 million or more than $1 million. That is the fee the company will pay to liberate 2,000,000 shares being sold by Lustrino and his partner.     

The issue is more than the fact that KingsCrowd is spending money that it did not need to spend. The funds would certainly be better spent hiring a CFO to watch over the investors’ money.

KingsCrowd is essentially giving $1 million to a company whose offerings it will rate. This kind of conflict of interest would, in my opinion, negate any rating KingsCrowd issues on a company listed on Republic and likely its competitors as well. As importantly, by selling his shares, Lustrino gives the impression that he has one foot out the door, ready to ditch the algorithm with little utility and ready to fund his next company.

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

Start-ups, are you buying investors online?

Start-ups, are you buying investors

I have been writing a lot about crowdfunding lately and speaking with other people in the crowdfunding industry.  From our conversations, it is obvious that most do not share my perspective on the entire business.  I see crowdfunding as continuing an evolution of the capital markets already in progress when I started on Wall Street in 1975.

In 1975 the stockbroker was king. People did not buy investments, I was told early on, stockbrokers sell investments.  Good stockbrokers, especially those on their way up, aggressively sold stocks. The sales pitch was often about one particular stock, frequently supported by a report prepared by research analysts.  Analysts were “ranked” every year and firms paid the “1st, 2nd and 3rd All-American teams”, handsomely.

While there were certainly stockbrokers who met their clients for lunch or at the club for golf who came back to the office with orders in hand, much of the “selling” was done over the telephone.  Young brokers were encouraged to stay into the evening and engage in a ritual known as cold calling.

During my training, I spent an evening with a single page from the NYC phone directory, script in hand, dialing for dollars. Most people had those old, heavy rotary phones.  I swear, I could hear the receiver sucking in air as it was being slammed down onto its cradle.

What cold calling teaches us is that some percentage of the calls you make will respond favorably, and buy what you are selling.  If you want to make more sales, you need to make more calls.

I mention this only as a backdrop.  This “sell-side” focus has shifted, significantly. Today, a great many retail stockbrokerage customers, make their own decisions about what to buy and what to sell in their stock or retirement accounts.  These customers are enticed by lower costs. They respond to advertising, and they will rely upon information delivered to them online.  Without these investors, crowdfunding could not exist. 

If I were teaching Law and Economics today, I would look back to 1975 and say that is where it all started.  Changes in the law, a new one enacted and an old one discarded, were the catalysts for enormous changes in the way the capital markets operate. The market responded to those changes by bringing in millions of new people who were affirmatively looking to invest and who brought trillions of new dollars with them.   

ERISA, enacted in 1974 created the tax-deferred Individual retirement account (IRA).  It was intended to incentivize millions of small savers to put their money into a bank or the stock market and to leave it there for the long term. 

In response to this new market of small investors who might start small and add a few thousand dollars every year, John Bogle opened the Vanguard Mutual Funds. Mutual funds provided a simple way for small investors to participate in the market.

Mutual funds had been around for a long time by then.  They were commissioned products sold by many stockbrokers.  And while an IRA account was the perfect vessel for mutual funds, what I would stress to my students would be the shift in the way mutual funds were advertised and sold directly to investors.

Vanguard and the other mutual funds actively advertised for investors seeking to make direct purchases.  Instead of dealing with a stockbroker who would call whenever they had, something that they wanted you to buy or sell, with a mutual fund, an investor could just put their money into a fund and the fund will do it all for you.  Somebody called it “passive investing”. Instead of touting the skill of their analysts to pick winners, these mutual funds sold convenience.

In 1975, both the State of New York and the City of New York were functionally bankrupt. The stock market had tanked and lending had ground to a halt.  The economy was in the midst of abnormal inflation.  People responded to the idea that they take some risk to grow their retirement funds in the stock market rather than save it in a bank so they could keep up with inflation.

Also in 1975, the New York Stock Exchange repealed its long-standing rule that had fixed the commissions that NYSE Members charged for each trade.  Mainframe computers were being installed up and down Wall Street. The costs of everything from executing trades to sending out confirmations and monthly statements were going down.

When commissions were fixed, the customer was charged a commission that reflected both the costs of execution and the “other” services that the brokerage firm provided, most notably, research that would tell the customers what to buy and when to sell. As commission costs became a source of competition, Charles Schwab and others were already talking about “unbundling” the cost of executing a trade from the research component that had always come with it. 

Schwab and its “discount” competitors demonstrated that a great many investors were happy to sit at home and make decisions on what to buy and what to sell, based only on what they read themselves. And while Schwab and other discount brokers now offer research reports, very few customers of discount firms are exposed to the type of research available to institutions. 

The stockbrokers’ response to this unbundling can be encapsulated in their advertising slogans of the time: “Thank you, Paine Webber”; “When EF Hutton talks, people listen” and my personal favorite: “Smith Barney makes its money the old-fashioned way, they earn it”.  The mainstream industry doubleddown; they were selling advice and they were proud of it. 

Without good advertising and a lot of it, the full-service stockbrokers, the discount firms like Schwab, and the entire mutual fund industry would not have grown into the behemoths that they are today.  The result of all of that advertising is a market full of millions of investors who are comfortable making their own investment decisions.  This includes a significant number of baby boomers who still represent a very large pool of capital that is available for investment. 

What does this have to do with crowdfunding in 2021?

If I have learned anything from watching the growth and evolution of this market since 1975, the one thing that stands out is that for companies that are selling investments, good advertising works. There is a cost, certainly, of acquiring investors for any given offering, but if you pay that cost, you will get enough investors to pony up the investment that you seek.

The best people in marketing who are working in crowdfunding understand that it is very much a “numbers game” just like “cold calling”, although now much less expensive and efficient. Modern data mining techniques enable each company that is seeking investors to present its offering to an audience that is more and more specifically targeted. 

I call it “buying investors online”. What do you call it?

I have sat in marketing meetings for various players in the financial services industry many times. Depending upon what these companies are selling and to whom, the marketing and sales strategies differ greatly.

The common denominator of these varied strategies is that they are all measured by the same standard, CAC, the cost of acquiring each customer or investor. The object of any marketing campaign is to attract the most customers (and their ‘orders’) from every dollar spent on any advertising directed at those customers. 

In crowdfunding, while statistics are few, it is obvious that the costs associated with acquiring investors varies greatly, offering to offering. Some offerings fail because investors do not find them attractive, most, I think, because they lacked marketing muscle.  

Personally, I find it painful to watch a company that has hired me to prepare the paperwork for their offering fail to acquire the investors they need.  Often, these company’s campaigns fails because they hire the marketing company that was the lowest bidder.  I try to steer my clients to a marketing company that may not be the least expensive, but gets the job done.   

The Regulation D, private placement market has found enormous success using crowdfunding for investors.  Even now, a sponsor can identify potential investors for the purchase of an office building who can afford to invest, who have an interest in real estate, and who live close enough to the property, to drive by if they want to look at it. And the data mining techniques that created these targeted mailing lists are still in their infancy.

Crowdfunding for capital has become a simple process.

Step one: create an investment that will be attractive to investors

Step two: create advertising copy that can be pre-tested and shown to be effective

Step three: put those ads in front of your pre-targeted lists of prospective investors.

Step four: Repeat step three until you raise the money you need.   

I have written elsewhere that I believe that crowdfunding has reached the point where it will now quickly grow to be a major source of capital for start-ups and small businesses.  A major reason will be that companies seeking funding can now approach crowdfunding with a high degree of certainty that they will get funded. With the proper perspective, those companies can appreciate that they are buying investors online. 

 

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

Or, you can book a time to talk with me HERE

 

Making the New Capitalism Efficient

Making the New Capitalism Efficient

Economic theory teaches us that in a perfect world capital would always be allocated to its best use. The best use is always viewed from the perspective of the person or entity that is deploying the capital. Consequently we normally calculate the best use as the highest rate of return that the capital can reasonably achieve. The object is always to use money to make money.

To further this goal, capital has always been deployed to companies that have had the best chance of success. A due diligence process is employed to separate the best companies from those that the market deems less worthy. While far from perfect, this system has historically worked well enough to create our modern society with few truly innovative ideas left by the wayside, meaning unfunded.

In the last 20 years, some people with capital have been content to deploy it for other, more altruistic reasons. Specifically, they want to make capital available to people who have no access to the mainstream capital markets and others who for a variety of reasons could not get funded.

This new capitalism has taken two innovative forms, micro-lending and crowdfunding. Each has the potential to put capital into the hands of people who otherwise would never have access to it. Both have the potential to be transformative at the lowest tier of the global economic system. Neither is focused on highest rate of return as its primary goal.

In its purest form a micro-loan is very small and will often help a subsistence level individual transform into a capitalist. Micro-loans are frequently used to purchase one sewing machine to create a manufacturer; one shipment of goods at wholesale to create a merchant. Some micro-loans are used by a rural community to purchase one used truck or tractor. The benefits of these loans are obvious.

As originally envisioned, micro-loans were often interest free or loaned at an interest rate low enough to cover only the lender’s overhead and the costs of defaults. Even though no one who gets a micro-loan has a FICO score, statistics show the rate of default worldwide to be very low. As much as 97% of the loans are repaid. As conceived, micro-lending is a model of market efficiency.

Unfortunately, as this industry has developed and matured, there are some places where micro-loan programs are managed by bloated bureaucracies. There are stories of interest rates that would make loan sharks blush, corruption and exploitation in the lending process and misappropriation of funds intended for borrowers.

Crowdfunding

Crowdfunding is a remarkable tool for capital formation. Its successful utilization still eludes too many small businesses who might benefit most from an infusion of capital.

The crowdfunding industry still suffers from “experts’ who have no idea how to raise capital. Fraud remains a problem because no one really vets the companies that seek funding. The process itself can be expensive and is often hit or miss even though it does not need to be.

Investors who buy into the equity of a small company on a crowdfunding platform must understand they may take a total loss. Even if the company is initially successful, there is no liquidity for the equity that investors purchase.

There is, I would think, a way to combine the micro-loans with crowdfunding in a way that would remove much of the inefficiency. I think it would be welcomed in the developing world.

In most developing countries there are universities whose students are themselves often making the transition to the middle class. They should appreciate that strengthening the underclass will provide a greater market for the products and services that they themselves will eventually make and/or sell.

What I would propose is that each university in developing countries create a crowdfunding program to enable students to fund micro-loan programs in their own communities.

Most peer-to peer lending platforms allow companies in need of loans to borrow from multiple individuals, essentially syndicating each loan. I envision the university students creating a single fund from which to make micro-loans to many borrowers.

I would ask the students to fund the program by purchasing shares in the fund with a small yearly tithe for the 4 years that they are students and for a few years after they graduate. Call it a 10 year voluntary commitment to purchase shares.

Additional funds would come from sale of shares to faculty, alumni, local banks, businesses and importantly, each country’s expatriate community. University students in western countries could partner with university students in developing countries. All anyone need do to participate is buy one share.

I have intentionally left out any local government involvement or participation. Direct government participation rarely adds efficiency to anything.

Business students and volunteer faculty at each university would administer the fund. This would remove much of the costs and corruption. It would give these students valuable experience evaluating business proposals and detailed knowledge about the local economy that will not be found in their textbooks.

Borrowers would pay a fixed interest rate. A rate of 6% might be sufficient to cover the risk of defaults and provide some amount of internal growth. Real growth for the fund will come from new students who will join the program each year as they enter college.

At some point each fund would reach a predetermined principal amount and be closed. In the US and elsewhere a closed-end mutual fund can become registered and be listed and traded in the regulated securities markets. This would provide liquidity to these crowdfunded investments where none exists.

Even after it is closed, a fund can continue to collect payments on existing loans and make new loans year after year. There would be no reason or requirement for it to liquidate.

As the fund grows after it is closed the per-share value will continue to appreciate. Providing for growth and a liquid market would mean that shareholders could expect to make a profit from their investment.

The closing of one fund will be followed by the opening of a new fund to replicate the process. Over time, multiple funds will exist in every country that wants them, sponsored and funded by university students and others who will see both the benefits of the program and the potential for their own modest profit.

Replicated university to university and country to country a program like this would have a demonstrable effect within a decade. On a continuing basis it has the ability to transform communities and economies in the developing world from the bottom up.

It is an opportunity to demonstrate that altruism and capitalism are not mutually exclusive.

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

Or you can book a time to talk with me HERE

Remembering the “customer’s man”

customer's man

The 1970’s

Several weeks back I had lunch with a colleague who, like me, had started in the brokerage business in the 1970s. At one point he referred to himself as a “customer’s man”. It was a term used to describe a registered representative that I had not heard in years. It evoked a way of doing business that has largely been lost.

At that time, commissions and costs were fixed across the industry. Today, we see these costs as an impediment to our ability to maximize investment returns. We have lost sight of the value that a good customer’s man brought to the process.

A good customer’s man got to know you.

The brokerage firms encouraged every customer’s man to get to know every one of his customers and to get to know them well. You would meet in person to share lunch, drinks, dinner or to play squash, tennis or golf. Over time and many conversations you would get to know quite a bit about each others’ lives and families. Your customer’s man would become one of your trusted advisers.

A good customer’s man was a good stock picker.

Customers’ men were always on the look-out for the next stock that was about to make a move. They were selling their ability to pick stocks and to buy them for you at the right price.

Your customer’s man would always tell you which stocks he was following and why he was following them. He would call to tell you when the price had dipped and to recommend that you give him an order to buy a few hundred shares for you. You would not hesitate.

A good customer’s man made money for you.

Customer’s men were judged by how much the stocks that they recommended went up. It was a simple metric that everyone understood. Very few built their book of customers by advertising or seminars. The best built their books by word of mouth. They asked existing customers for referrals. Customers who made money following their broker’s recommendations gave the best referrals.

From the 1970s forward if the firms wanted more customers, it meant having more brokers with bigger and bigger books of customer accounts. The big action was moving established producers around from firm to firm. Front-end bonuses for really big producers became really big. Just about every broker wanted to be a bigger producer.

That attitude was good for the firms and they encouraged it. Brokers became almost exclusively focused on bringing in more customers. No longer were they judged for the stocks that they picked or how much money their customers made. Producers were now judged on how many “assets under management” they have.

The actual management and investing of the customers’ funds was increasingly handled elsewhere. Enticing new customers meant selling the investing and management skills of others.

The 1987 Crash

This was logical as so many of the customers’ men had not seen the 1987 crash coming. If they had, logic suggested that they would have pulled their customers out before it happened.

customer's man

It was time to let the experts manage your investments. Customers were sold many different kinds of managed funds, annuities and other “packaged” financial products. All of these products were expensive from the customers’ standpoint. The firms had built in significant underwriting costs and management fees.

Many of these fund managers drank from the Kool-aid that said that price/earnings ratios of 50 or more were sustainable and likely to go higher. Individual brokers who questioned the wisdom of the high paid fund managers and research analysts were brought into line or shown the door.

When the tech market inevitably crashed, many in the industry argued that “no one had seen it coming.” They said the same when the market crashed again in 2008. It was a phrase that was repeated so often that people started to believe it.

It re-enforced the idea that the average financial adviser can do no better than average. Everyone just started buying the index, certain that no human being who actually works in the markets every day could actually have awareness of what was going on or to help customers profit from it.

The index was much cheaper than a human adviser in any event. Lower costs were more efficient and would increase returns, provided, of course, the market goes up.

A good customer’s man always put the interests of his customers first. It was an era when almost every business adhered to the idea that “the customer was always right.” When is the last time that you heard that phrase or saw it posted in a business or an office?

Today, the industry staunchly opposes any regulation that would require individual brokers to put their customers’ interests first. That should tell you everything that you need to know about the financial services industry today.

The individual registered representative, the back-bone and the public face of the brokerage industry will likely not survive another generation. Their jobs are already foolishly being replaced by computer driven robo-advisers.

The industry will survive and prosper without the customer’s men. It is already oblivious to what it has lost.

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

Or you can book a time to talk with me HERE

What is a dream worth?

What is a dream worth

A long time ago, when I was a young lawyer fresh out of school, I was walking with a friend along a side street in Manhattan, probably in the West 30s. There were brownstones on both sides of the street. We stopped in front of one that had a small shop on the street level.

In the window were two shelves on which were displayed a series of antique dolls, doll clothes and doll carriages and furniture. Many seemed to be from the early 20th Century, if not earlier. The shop was dark and the sign on the door said: Hours by Appt. Only.

“Interesting business” I remarked. My friend responded: “That isn’t a business, it is someone’s dream”.

In some ways, every entrepreneur and small business owner is a dreamer. They try to turn the intangible, an idea, into something tangible, a business. Assigning a value to any business is not an easy task. While the business is still a dream it is virtually impossible.

Valuations

Of all the things that we teach business school students, corporate valuation is given very little time or attention. When a business needs to be valued because it is being bought or sold the task is relegated to accountants. Accountants plug data about earnings and assets into established formulas and come up with a value. 

Accountants can determine the “book value” of a business by subtracting the company’s liabilities from its assets. That rarely tells the whole story. What if there is little or no data? What if the business has no earnings or assets?

Assets are placed on a balance sheet at cost and are then depreciated over time. The true value of the asset is not always represented in the financial reports. Some assets, especially real estate can often appreciate over time to greatly exceed their cost.

We teach that real estate should ultimately be valued at its highest and best use. A developer may see a dilapidated old farm as the site of a shopping mall or residential development. Still, the current owner carries the farm on its books at cost minus depreciation. The value of any parcel of real estate can change dramatically in the time it takes to hold a press conference announcing a new development.

Accountants will often add a line item for the company’s “good will” which is more often than not the accountant’s way of capturing the value of the business as a going concern, including the value of its brand and customer base. This, too, is far from perfect.

I have helped many clients buy or sell a business over the years. If they use a business broker to facilitate the transaction, they are likely to hear that a business is “worth” 3 times next year’s projected earnings.

This may not be a proper method of valuing a small business either. It is modeled after the way that many research analysts predict the future price of publicly traded securities. But with privately held companies, the risk is often higher so the price for which it sells, logically should be lower. 

Yes, I know that this is the antithesis of the view practiced by venture capital firms who are often dealing with companies that have little more than an idea that they want to bring to market. These companies do not have earnings or assets. The values assigned to portfolio companies by venture capital firms have no basis in reality nor are they entitled to be included in any serious discussion of finance.

IP

Intellectual property like patents, copyrights and trademarks are very hard to value at the time they are first obtained. No author knows that they have a best seller on the day their book is published. Few know that their book will be made into a movie or that anyone will pay to see it. So, what is the “value” of any book on the day before the manuscript goes to the publisher?

As an example, I have a friend who is a noted cartoonist. Her characters were originally published in the US for an American audience but have found a huge following in Japan. Was that in her business plan when she sat down to draw those characters for the first time? Hardly.

One of the interesting things about intellectual property such as copyrighted material, is that it can be segmented in myriad ways. A novelist can sell the right to have his book published in the US to one publisher and the rights to publish the book in a dozen other countries, or a dozen other languages to a dozen other publishers. The theatrical rights and film rights to the same novel can also be segmented and sold. In the right circumstances, the rights to produce and sell merchandise that derives from the novel may be the most valuable rights of all.

The value of intellectual property can vary greatly based upon how it is used and how it is sold. Young Bill Gates might have sold the operating system he purchased from a third party to IBM for a nice profit and gone on to do something else. Instead, he licensed the software and received a royalty every time IBM sold a PC with the operating system in it. The result was the Microsoft Corporation which made Gates the world’s richest man. We use a lot of royalty or revenue sharing arrangements in crowdfunding because they are clean and simple.

1990’s

Back in the 1990s when there was a new and disruptive technology introduced every day, I would ask my students if they could identify the most valuable intellectual property that was in use in the 20th Century. It had been a century of tremendous innovation, much of which had been superseded by even better innovation. Many very valuable patents and other IP had become worthless.

The object of the exercise was for them to identify a simple idea that had been patented, trademarked or copyrighted, that had become very valuable even though no one could have predicted the magnitude of its success on day one. I wanted to demonstrate just how difficult it was to value things that had never been done before. Two pieces of IP stood out.

The first was the copyrighted image that is Mickey Mouse. The media giant that is Disney today started with an animated short film of a mouse whistling.  Maybe the most recognizable face on the planet, I do not believe that even Walt Disney would have valued the ownership of the copyright at anything close to its true value.

The second was the patented formula for Coca Cola. I have been in a Jeep in the middle of a jungle where the guide said that there was a village up ahead where we could stop and get a Coke. Pour yourself one and try to imagine how many cans and bottles they have sold. How would you have valued that patent on the day it was filed?

I think that I have made the point that placing a value on any business, especially a start-up, is a waste of time and effort. I will encourage any small business owner to dream big, but you just cannot put a number on it. 

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

Or you can book a time to talk with me HERE

Fidelity’s Folly: Bitcoins for All?

Fidelity

Fidelity Investments

People keep asking me what I think about Fidelity Investment’s announcement that it will act as a custodian for bitcoins and other cryptocurrencies. As anyone who follows me knows, I don’t think very much of it at all. 

Fidelity has made it clear that it is “all in” on cryptocurrency. Its website notes that: Fidelity Investments “operates a brokerage firm, manages a large family of mutual funds, provides fund distribution and investment advice, retirement services, Index funds, wealth management, cryptocurrency, securities execution and clearance, and life insurance.” 

Fidelity would certainly wish to expand each of those profit centers. With bitcoins and cryptocurrency there is the potential for enormous growth if Fidelity can turn them into just another “investment”. It can’t, even though it is trying very hard. 

Just last week, Fidelity’ Director of Research published a report that suggested that bitcoin is a “potentially useful” asset for “uncorrelated return-seeking investors”. The report said that “in a world where benchmark interest rates globally are near, at, or below zero, the opportunity cost of not allocating to bitcoin is higher.” 

Please do not be impressed with that gooblygook. There is no real data about bitcoins for the Director of Research to research. You cannot analyze bitcoins in any traditional way. They are merely a few lines of computer code. This report is reminiscent of the type of justification that analysts gave in the dotcom era for supporting stocks, with no income, trading above $100 per share. 

The report further suggests that bitcoin’s current market capitalization “is a drop in the bucket compared with markets bitcoin could disrupt.” That certainly sounds like a “buy” recommendation to me.

The primary markets that bitcoins might disrupt are banks. In truth, bitcoins, when used as payment in commercial transactions, disrupt nothing. Banks and banking are not going away.   

If you consider how many payroll and Social Security payments are already deposited directly to recipients’ accounts and how many of those recipients pay their electric power or insurance company “on-line” it is fairly easy to see that converting the deposit to bitcoins before you make the payments is an extra step not likely to find favor.  

The one thing that will cause the current price of bitcoins to appreciate is a lot more investors willing to buy them and hold on. That is the strategy being pushed by Fidelity with the blessings of “pseudo” market professionals. 

Last month, Fidelity stated that it had polled a number of the “professional” fund managers and investment advisors who are currently its customers.  Apparently enough advisors would consider bitcoins for their advisory clients to warrant Fidelity acting as a bitcoin custodian. 

Some number of advisors who already use a Fidelity platform will certainly purchase some amount of crypto currency for their clients’ accounts.  That “professionals” are buying bitcoins is likely to be used by Fidelity as a reason to advertise them to average, small investors as “what the Pros” are buying. 

In 2 years, Fidelity may have many billions of dollars’ worth of bitcoins held in accounts on its platform. That will not make it the right thing to do.

Law and Economics, which I taught back in the 1990s, studies how our interwoven markets interact with the laws that regulate them. Judges interpret those regulations, often influenced by what they perceive the regulators intended to accomplish.

The regulations that govern our financial markets (equity, debt, currencies and insurance) have evolved over the centuries with the markets that they regulate. The introduction of something as novel as crypto currencies into the financial markets should be expected to suffer some adverse legal consequences. 

As a matter of law, every Registered Investment Advisor (RIA) and anyone investing other people’s money is held to a fiduciary’s standard of care.  Fiduciaries are usually required by law to: 1) act in the best interests of their clients, 2) preserve and protect the assets entrusted to them and, 3) when investing to act as a “prudent” investor would act.

A fiduciary’s duty to its client or beneficiary is a much higher standard of care than in any ordinary commercial transaction. To satisfy that standard often means taking “extra” care to mitigate obvious risks.

Fiduciaries become fiduciaries when people trust them to hold their property or to act on their behalf.  People most often trust fiduciaries because they have specific expertise in the matter at hand. Both fund managers and RIAs fit that description. Both are held to a fiduciary’s standard of care and their conduct is most often judged against that of other experts in their field. Most investment professionals will never purchase any crypto currency for their clients.

Fidelity, the fund managers and RIAs who do purchase bitcoins and store them at Fidelity obviously believe that the price of bitcoins (currently in the range of $10,000 a piece) will appreciate and perhaps double or more.  It is certainly possible this could happen.  Two years from now the price of a bitcoin might have risen to $20,000 each and possibly higher. Many of the bitcoins held at Fidelity will have been purchased at close to that amount.   

Let’s assume that for some reason or another, in a 90-day period, the price drops back to $10,000 each.  That could result in several billion dollars in actualized losses as some will “hold” all the way down in hope of a rebound.  Does Fidelity shoulder any liability for these actualized losses?

The Fund Managers and RIAs certainly do. Unlike most litigation, where the burden of proof is on the plaintiff, in many states, fiduciaries are required to demonstrate the reasons that they made the offending investments.  Much of the case will be dependent upon what the advisors can show were their reasons for buying bitcoins in general and also specifically on the day and at the price that they did. They will also have to demonstrate why they held on as the price deteriorated.

Given that there are no fundamental reasons for purchasing bitcoins I suspect that most will try to defend themselves arguing that bitcoins are a hedge against adverse results in the rest of the portfolio. That argument is likely to fail. 

Bitcoins are, after all, a commodity, and putting aside the fact that most RIAs are not trained or licensed to sell commodities, gold would be a more accepted hedge if that is what the RIA wanted to do. If nothing else gold is unlikely to lose 1/2 its value in a short period of time, which bitcoins have already demonstrated they can do. 

Litigation

Fidelity’s role as a platform or clearing firm might save it in Court but these customer claims are more likely to be heard by arbitrators appointed by FINRA, especially if Fidelity is named as a respondent. I have been an arbitrator and argued many cases in front of others. They are more likely to be older and their view of bitcoins will probably be closer to Beanie Babies, than as a new form of currency that trades in a very opaque market. 

Fidelity

Two recent cases brought by the SEC will not help Fidelity’s defense either. The first is SEC v. ICO Box, where the SEC alleged that the platform “facilitated” the sales of more than 30 different crypto currencies. “Facilitated” is a word that will make defense lawyers crazy. 

By the time that these claims get to a hearing I suspect that complaining customers will be able to present a banker’s box or two of “reports” written by Fidelity that suggest that RIAs purchase bitcoins for their customers. That should certainly be viewed as a “facilitation”.

The other case is called SEC v. Lorenzo.  Lorenzo was charged with copy and pasting an e-mail written by someone else and sending it to prospective investors. The SEC alleged that Lorenzo “disseminated” misleading information in order to make the sale. Given the outrageous claims made by many in the bitcoin world, some Fidelity employee is more likely than not to resend a report or article that Fidelity cannot defend.

The mutual fund industry, Fidelity’s core business, is under great stress to lower the fees it charges investors.  For all the BS that you may hear about how Fidelity’s actions in embracing crypto is “cutting edge” or “visionary”, it makes more sense that Fidelity is touting crypto to make up for revenue lost elsewhere.

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

Or you can book a time to talk with me HERE