FINRA vs. the NARs- Round 3; Same Old Nonsense


A simple question: If a “bad” stockbroker rips you off, can a “bad” lawyer help you recover your losses? The answer should be obvious; but for some people, especially some lawyers, it is not.

For the third time in the last 20 years FINRA has asked the SEC to allow it to restrict an aggrieved customer’s right to have the representative of their choice at FINRA sponsored arbitration.  The previous two attempts were dead on arrival because there was no compelling reason to enact that limitation. The same is true this time. Let’s hope that the Commission staff is not asleep.

The issue is whether or not you must be an attorney to represent a party in a non-judicial arbitration proceeding. There have always been non-attorneys (NARs) representing parties in securities industry arbitration. Member firms would often send branch office managers into arbitration to collect a margin debt from a recalcitrant customer or to defend against a customer claim. Non-attorney representatives in securities arbitration was never an issue until the lawyers realized that they could make a lot of money for a lot less effort than they would put into resolving the same disputes in Court.

In the early 1990s, as real estate took a dip in various parts of the country and the value of real estate backed securities fell, a lot of people who were promised appreciation and steady income from these investments wanted their money back.  It was shown that Prudential Securities and other firms had sold billions of dollars’ worth of questionable real estate backed securities to 10s of thousands of investors around the US. 

The number of arbitration claims skyrocketed.  A lot of attorneys and others saw an opportunity to represent these investors on a contingency basis and an industry of customer representatives, both lawyers and non-lawyers was born. 

As these claims wound their way through the arbitration system the number of new claims began to slow down.  Appalled that they might make less money because there were fewer claims to file, the lawyers started a turf war with the NARs, seeking to get the latter barred for an ever-changing number of reasons.

At that time, the vast bulk of labor arbitrations around the country were being handled by shop stewards because they knew the shop floor rules.  Other state and federal government agencies permitted non-attorney representation in their arbitration forums. The trend was to leave the courtrooms to the attorneys and view arbitration as an alternative system where disputes could be resolved quickly and efficiently with or without lawyers.

Notwithstanding, the lawyers claimed that by representing customers in an alternative dispute resolution system, the non-attorney representatives were engaged in the un-authorized practice of law.  This was absurd on its face, especially since they did not think that true if a non-lawyer represented a member firm.

Admission to practice law is governed state by state.  Out of state lawyers need permission to appear in local courts and then usually with a local lawyer beside them. The same lawyers who claim that you must be a lawyer to represent a party in FINRA arbitration do not seem to care if you are not a lawyer in the state where the customer lives or where the arbitration is being held.  There are many lawyers who specialize in securities arbitration who are admitted in one or two states, but who have a national practice.  If NARs are practicing law in states where they are not admitted to practice law then so are these lawyers.

The lawyers also know that the large wirehouses often send inhouse lawyers to defend these claims and the wirehouses do not have lawyers licensed in every state on staff.  So not being admitted to practice law in the state where the customer resides has never been an issue to either the customers’ lawyers or the industry, unless they are referring to NARs.

The current iteration of the proposed rule allows non-attorneys to continue to represent customers in smaller cases. That is like saying: okay, you can be a little pregnant, because it is not the un-authorized practice of law if you only handle the smaller claims. The “unauthorized practice of law” argument, which never made any sense in the first place, seems dead.

Because of the continuing complaints by lawyers, in 1994 the NASD commissioned a study of its arbitration system chaired by former SEC Chair David Ruder. The report specifically looked at non-attorney representatives and left them in place. It called for more study on the subject and called the complaints against the non-attorney representatives “anecdotal”.  The actual complaints against the non-attorneys were never disclosed and more than one person at the time questioned if those “anecdotal complaints” had any substance.

The Ruder Commission Report did express its concern that “the increasingly litigious nature of securities arbitration has gradually eroded the advantages of SRO arbitration.”  FINRA has always advertised arbitration as a quick, inexpensive way to resolve a dispute with your stockbroker.  When I started doing arbitrations in the 1970s, a dispute could usually be resolved with one day of testimony or less. Now they often take weeks because lawyers have complicated a system that should be easy.   

There was another study and a similar request to limit NARs in 2007. The SEC staff asked FINRA to withdraw that request because the Commission staff thought it not in the customers’ best interest.  That reality has not changed.  

Over the years there were a lots of problems in the arbitration system specifically caused by lawyers. After the “tech wreck” claims went through the system in the early 2000s a significant number of the member firms were sanctioned for repeated violations of the arbitration rules specifically because they intentionally hid documents that the customers sought. Several of the member firms were fined $250,000 and FINRA noted that the practice of hiding documents occurred in multiple claims. 

In virtually every claim where a FINRA firm had been sanctioned for discovery violations the firm had been represented by an attorney. It was attorneys who time and again stood before different panels of arbitrators stating, falsely, that their client had no more documents to produce.  Were any of these lawyers sanctioned for lying to arbitrators? (No). Were any attorneys barred from representing parties again? (No.) Are the “anecdotal” problems with NARs worse than this? (Not by a long shot.)

I think that the SEC staff would be appalled to read the pleadings and briefs that a lot of attorneys present to FINRA arbitrators. Many will cite case law that is not applicable and often out of context. FINRA does not provide arbitrators with law clerks or even a law library. Briefing can be a useless exercise that often obfuscates more than it clarifies.    

Arbitrators are fact finders, not judges. They should examine the actions and utterances of the brokers and compare them to industry rules and regulations.  In many claims the panel is examining a transaction that began with an order to purchase a particular security.  In industry parlance, the question that the arbitrators consider is often the same: is this a “good” order? Did the order comply with the industry rules? Was the broker correct in submitting this order and was the supervisor correct in approving the order for execution?

Industry rules can be nuanced and complex. But every day, in every brokerage office, managers, supervisors and compliance personnel review and approve orders written by stockbrokers and ask and answer that question.  If you have a dispute with your broker because you believe your broker broke those rules, why should you not be allowed to be represented by a retired branch office manager or someone else who has worked with those rules and who can explain them to a panel of arbitrators better than most lawyers?  

It is comical that anyone would think that just because you went to law school you can competently represent a party in securities arbitration.  I have lectured at one of the law school securities arbitration clinics.  Students get taught the arbitration procedures but not what they need to know about the investments or the transactions that are at issue.   

Over the years I worked with a number of attorneys who represented public customers and with several of the large and small NAR firms. The simple truth is that you either know how the securities industry works or you don’t.The best arbitration lawyers often started their careers in house at one of the large brokerage firms where they learned how the firms operate and why.  

Over the years NARs have successfully handled thousands of claims. If the NARS were so bad you would think that there would be stacks and stacks of complaints from their clients about them but there aren’t.

I know that there are arbitrators and industry lawyers who have referred their family and friends to NARs. I know that there are professional traders, fiduciaries, sophisticated investors, lawyers and government officials who have sought out and hired NARs to represent them at FINRA arbitration. They do so specifically because the NARs understand how the rules are actually applied and how firms and brokers are supposed to act.

The lawyers’ current beef with NARs is that the NARs charge investors too much which is a sick joke coming from lawyers. No one really knows what NARs charge because no one asked.  And I suspect that the lawyers would object to disclosing their fees for a meaningful comparison.

When the Ruder Report came out suggesting further study of the NARs, there was some hope that the research would tell the investors what they really wanted to know: which representatives get the best results for their clients. That never happened.

FINRA could break down that data so that consumers might also see which representatives have handled more claims involving annuities or options and what percentage of the amount of the claim was actually returned to the investors through awards or settlements.  We live in a time of almost too much data. Why not collect the data and let the consumers decide?

This issue has come up again because the rising market has substantially reduced the number of claims that are being filed. There were over 10,000 claims being filed in the years after the 2008-2009 crash. I expect the number of claims filed in 2018 will be closer to 4000.  That is the only reason that anyone is talking about banning NARs from arbitration, again. The lawyers do not want any more competition.

I do know that this time out,several of the NARs are thinking about litigating any restrictions that the SEC approves.  That should provide fodder for a lot more articles going forward.

More On Internet Stock Manipulations; SEC v. Lebed (2000), revisited


I was reminded recently of the story of Jonathan Lebed, a 14 year old kid from New Jersey who was investigated by the SEC for stock manipulation using the internet back in 2000.  This case was a big deal at the time, garnishing a segment on 60 Minutes and some interesting discussions in the financial and legal press.

Even though he was underage, with the help of his parents, Lebed had managed to open an account at one or two of the discount brokerage firms. He was apparently trading his accounts in low price stocks when the SEC came knocking on his parents’ door. 

It seems that in the course of trading Lebed liked to post positive comments about what he was buying on various websites, bulletin boards and chat rooms where people who might be interested in purchasing these stocks would see them.  This was in 2000 when the chat rooms were not sophisticated and the web reached a fraction of the people it reaches today. 

Lebed would buy a low priced stock and then say something nice about the company in a message that he posted in a chat room. Using multiple e-mail addresses he might get that same, positive message posted in 200 chat rooms.  Some of the people who saw his posts would re-post them again. 

Lebed knew that his simple postings would create significant interest in these shares and that the price would move up.  He commented that posting the messages with key words in all capital letters would actually get even better responses. 

Bringing a lot of attention to a more obscure, low priced stock can, indeed, lift the price. The SEC called it an intentional market manipulation.  Lebed said that he was only doing what the research analysts at the big firms did, publish their opinions about companies whose share price they wanted to go up. 

Lebed did all this out in the open. Several of his classmates and school teachers followed his leads and invested with him. They were willing to take a chance of doubling their money if the share price of one of these companies went from $.30 to $.60. 

Many of these investing neophytes did understand the positive effect that Lebed’s postings and his quasi investor relations campaigns had on these stocks.  They wanted to buy before he posted and get out as the buyers reacting to his posts pushed up the price.  

Lebed was not the only person or group at that time that was using the internet to enhance the price of shares of small public companies.  But he demonstrated that in the year 2000 the power of the internet to sell investments directly to investors was underrated.  In the almost 20 years since, the use of the internet to sell almost anything, including investments, has become much more powerful and pervasive. 

In the regulated financial markets the dissemination of information is encouraged, but it is also controlled.  Regulations require that information be accurate and complete. Public companies are required to report specific information about their business, to present that information in a specific manner and to release that information on a regulated schedule. 

For a licensed stock broker or investment advisor every e-mail, tweet, posting, comment and utterance about any investment is subject to the scrutiny of his/her employer and by regulators. The SEC depends on the market professionals and market participants to play by the rules. There are significant penalties for non-compliance. 

But Lebed was not a market professional. He was an outlier. He was an independent investor, not a licensed participant in the marketplace.  In the end the SEC let Lebed keep most of the money that he made from his trading as long as he promised to stop.  

At the time, no one really questioned the SEC’s jurisdiction over Lebed or what he was doing. Lebed was a US citizen, operating out of New Jersey. His posts were about US companies whose shares traded in the US markets. Many of his posts were made through a US based internet company (Yahoo Finance). 

In the ensuing 20 years, social media and on line platforms, publications and unregulated “experts” have demonstrated that they can easily sell investments directly on line to millions of investors.  Moreover they have demonstrated that they can disseminate information about public companies and new issues without regard to the truth of the information.  And they can do so without regard for regulations or national borders.

In the “direct to investors” investment world, social media “followers” has replaced “assets under management” as a measure of how many investors’ dollars a person can bring to an investment or new offering.  And you can buy people who have a lot of followers.

If I wanted to hype a stock, either a new issue or one that is already trading, I can make a financial arrangement with any number of independent “experts” who have a lot of social media “followers”.  Some may write articles for financial publications, some write books and blogs and many can be found going from conference to conference and podcast to podcast. 

Any financial “expert” can purchase the right to give the keynote speech at a conference and purchase any number of other speaking slots and sponsorships as well.   Anyone can buy interviews on financial websites, blogs and podcasts or pay for the right to create and distribute positive content on these sites.   

If you look at the numbers you can get an idea of how this works.  I can hire a financial “expert” to tout any stock that I wish. The “expert” will send his/her followers a series of e-mails, appear at a series of conferences and write a series of articles about that company. An expert with 1 million followers might reach 2 million other investors who see re-prints and references to it.

If only 10,000 investors of those followers invest an average of $1000 a new issuer can raise $10,000,000. That much new money coming into a thin trading market can often raise the trading price of the shares of a smaller company.  

There is no limit to the number of experts I can hire or the size of the e-mail lists I purchase for their use to augment their own list of followers.  If I hire multiple experts to hype the same stock, other experts who have not been paid may mention the company independently.  And before you say that this type of scheme using paid experts to hype the stock may be questionable under US law, who said that US law applied?   

If you solicit investors in the US for a new issue the offering is subject to US law.  That would require full and fair disclosure to investors in the US and provide for government penalties for non-disclosure.  But what if you donot make the necessary disclosures and you only solicit investors in other countries? 

The capital markets are regulated country to country.  Each country has its own rules which apply to financial transactions involving its citizens and issuers.  Each has rules governing transactions executed on the exchanges domiciled in their country. The laws of the country where the issuer is domiciled, the exchange is located and where the investors reside may all apply to a single transaction.  An overriding question with the direct to investor market is which country has jurisdiction and over what actions and activities.

If an article about a company’s share price or prospects from a European website gets republished or re-distributed in the US is the author subject to US law? What if the author knew the information in the article was false; do US investors have any recourse?  Does it matter if the author got a royalty for the re-print?

Would the answer be different if the false information originated with just one shareholder who bought a large block of shares cheap and now wants to pump up the price?  Does it matter if that person is in a country other than where the shares trade or the articles originate? 

I recall that when the Lebed case was discussed a lot of people thought that the internet would change and globalize the capital markets. It clearly has.  

I think that there is still a lot of discussion that needs to be had and a lot of questions that need to be asked and answered.  In the meantime, it should be obvious that the current international regulatory scheme does not overlap as well as it could.   

The current and expanding global reach of social media create opportunities and but also highlights problems.  The flow of capital and information continue to globalize. At the same time I am certain that it would is a lot easier today for a 14 year old to manage a single successful, global stock manipulation.    

Cannabis Stocks and the Old Pump and Dump

People seem to hate me when I state the simple truth that cannabis  is illegal everywhere in the US. The Obama Administration decided to focus its drug enforcement budget on the cartels and large suppliers and not on small retail dealers.  Deciding not to bust small dealers did not make cannabis legal anywhere in the US.  Just because the federal government will not spend money to send 20 officers to kick down the door of a small dealer, they will still charge you with “intent to sell” if they find a few pounds of cannabis in the trunk of your car.

The former US Attorney General, Jeff Sessions was fairly clear that he wanted to keep cannabis illegal. What the incoming Attorney General will do is anyone’s guess.  The one clear truth is that action by states purporting to make cannabis legal within their borders does not actually make it legal anywhere under federal law.

Notwithstanding,many people seem to believe that there is a “legal” market for cannabis and a lot of people are finding ways to cash in believing that the federal government will continue to look the other way. That has encouraged the flow of a lot of new money into the “new” cannabis marketplace. As these cannabis companies are new, small and somewhat precarious given they often cannot get a bank account,some companies have sought funding in the microcap stock market where small companies can go public.  

Few investors come in contact with “microcap” or “penny stocks”.   Many of the very large brokerage firms will not touch very low priced shares and certainly will not recommend them.  Fewer investors are the victims of the “pump and dump” schemes that plague this portion of the marketplace. Even fewer investors actually understand how a pump and dump works or how to spot one.

The  blueprint for these pump and dump scams is often the same. These scams will often start with a “shell” corporation, a public company with few assets and minimal operations.  In a typical scenario a public “shell” corporation would acquire a private, ongoing business in exchange for stock.  There would be a press release, often several over the first few months that would begin to tell the story that the promoters wanted to tell, especially how this company was going to grow and grow.

The story would be told to thousands of investors through the stockbrokers who would be on the phones, cold calling people around the US with this week’s“tip”.  They would stay at it until enough people bought the stock to make the share price go up. There would often be subsequent acquisitions, subsequent press releases and subsequent hype.  All of the hype caused more people to buy the stock and the price to go further up.  As the price moved up, the insiders who bought for very little when the company  was still a shell could dump their shares.

This can be very lucrative for the people who bought the shares in the shell for pennies a share. It can also be lucrative for the brokers because getting the stock price up and then selling it to unsuspecting members of the public can mean a lot of transactions and a lot of commissions and mark-ups.  It is not unusual for even a small pump and dump scheme to net the promoters and brokers $10-$20 million or more. Consequently, people who pump and dump the shares of one company (often a team of promoters and stockbrokersfrequently do it repeatedly.

Organized crime settled into the stock brokerage industry in a big way by backing or owning a number of small brokerage firms in the 1980s and 1990s. Many of the firms were the quintessential boiler rooms like the ones depicted by Hollywood in The Wolf of Wall Street or BoilerRoom. By the early 1990s these boiler rooms proliferated in lower Manhattan, Long Island, New Jersey and Florida.  By 2000, the SEC was telling Congress that several of these firms were owned by or worked with the Bonanno, Gambino and Genovese crime families.  

A significant amount of regulatory scrutiny and regulatory actions followed,but that did not stop the billions of dollars of profit that was skimmed off by the miscreants.  The SEC closed down a few of those firms, barred a few people from the securities business and put a few of the people in jail.  But the beat goes on. 

Boiler  rooms are still active today and still working out of Manhattan, Long Island, New Jersey and Florida. They are still cold calling unsuspecting retail investors around the country. They are still using press releases and more recently “independent” fake investment newsletters to pump up what are essentially shell companies. 

In the 1990s the companies were “exciting” because they were going to capitalize in some way on the internet, a new and exciting technology that a lot of people believed could make a lot of money. People were happy to invest in every “internet” company that came along.Today, the pump and dumps have found cannabis stocks as a perfect substitute.   Which brings us to Aphria (NYSE:APHA). 

Aphria is a Canadian cannabis company that is trying to rapidly stake out its territory in new foreign cannabis markets. It traded over the counter in the US until November when it up listed to the NYSE.   The stock price has moved up as the company made a series of acquisitions and announcements in the last year. 

Last week it was the subject of a fairly scathing report by a research company and short seller that questioned whether the company had grossly overvalued some of those acquisitions.  Aphria has retorted that the company’s acquisitions were fine and properly valued and essentially that short sellers cannot be trusted.

Personally I thought that the research report was well written and seemed to have been well researched. There were photos of the headquarters and operations of some of the acquired companies that left a lot to be desired. There were copies of documents that supported the idea that insiders may be guilty of undisclosed self dealing. I thought that the valuations are clearly questionable and that alone was a big red flag. 

What got my interest and what troubled me the most was the discussion of who was involved with Aphria.The report goes out of its way to set out the facts and affiliations surrounding Andrew DeFrancesco who was apparently a founding investor and strategic advisor to Aphria. The report ties Mr. DeFrancesco to  several pump and dump schemes and affiliations with several pump and dump schemers.

These schemers include Paul Honig, John Stetson and John O’Rourke. The SEC brought an action against these three in September specifically charging them with operating pump and dump schemes in the shares of three companies.  I suspect there were other companies whose shares were manipulated by this group as well.  The report points out that in at least one company DeFrancesco’s wife was an early holder of cheap stock.

The report also ties DeFrancesco with a gentleman named Robert Genovese. In 2017,the SEC charged Genovese with operating a separate pump and dump scheme.  So if Aphria’s founding investor has connections with 2 separate pump and dump operators,, and has set himself up to benefit handsomely if Aphria’s stock price should be pumped up, what inferenc e would you make? 

The research report was published by a company called Hindenburg Investment Research. I have no affiliation with them whatsoever and I have never traded shares of Aphria either long or short.  Not surprisingly, a lot of market “experts” refuse to accept any information put into the market by any short seller.  That would be a mistake.

In addition to providing liquidity for the markets, short sellers provide a valuable service because the investment world is grossly overpopulated by“longs”.  The prospects for every company cannot always be rosy. If standard analysis can tell us when the price of a stock is likely to go up, that same analysis can tell us when the price is likely to come down. 

Short sellers truly love to spot scams. If this report is correct about Aphria and the company has grossly overvalued its acquisitions and is being pumped up only to have the insider’s shares dumped into the market, then sooner or later the stock may go to zero or very close to it. That is a win for any short seller.

There is more than enough information in the research report for any small investor who wants to invest in a cannabis company to make an intelligent decision not to invest in Aphria. But please do not think that Aphria is the only cannabis stock whose price may be the pumped up not because its prospects are actually good,but because someone has a lot of stock to dump into the market. As I was researching this article I saw at least a half dozen cannabis related microcap stocks that did not pass the smell test. There are undoubtedly more.

Suing Your Broker After the Crash

When the stock market corrects again it will be the seventh or eighth time that it has since I began working on Wall Street in the mid-1970s. Corrections are always studied and talked about after they occur.  Corrections really need to be identified before they occur because they  always result in losses in accounts of smaller, retail investors. And they always result in a spike in litigation by those customers who wish to blame their brokers for their losses.

One of the reasons that the number of customer claims will go up is that in a rising market customers have fewer losses. That does not mean that the broker’s conduct was correct, just that it did not cost the customers money or that they could not see the losses or bad conduct until the market went down.

In the normal course, customers that have disputes with their stockbroker do not end up in court. Almost all of the cases are resolved by a panel of arbitrators at FINRA. It is a lot quicker and cheaper and in the vast majority of the cases, the customer walks away with a check for at least a portion of the amount lost.

Securities arbitration was the one consistent part of my professional practice. I worked on my first claim while still in law school. I represented mostly the brokerage industry for the first 15 years that I was in practice and mostly customers for the last 25 years. In all I represented a party or served as an arbitrator in almost 1500 cases. Some were unique and interesting; most were fairly mundane.

There are a few hundred lawyers around the country who specialize in securities arbitration representing customers.  Arbitration is intended to be simple enough that any customer can file and prosecute a claim themselves. But in every case the brokerage firm is going to be represented by a good lawyer and put on a competent defense. Even if you have the most mundane claim you need proper representation.

I have worked closely with about 2 dozen customer representatives over the years and like any other profession, some were better than others.  The best have all spent some time working in house for large brokerage firms.  They understand how the firms operate, what records the firms need to keep, how brokers are actually supervised and what defenses the firms are likely to have.

Do not be afraid to hire a representative that is not an attorney.  My fellow lawyers refuse to acknowledge that a retired branch office manager can often question the conduct of a broker better than anyone else.  For most of the claims that I handled I worked with a team that included both a lawyer and a non-lawyer who had worked in the industry for many years.  The latter was invaluable to every successful outcome.

Many lawyers think that securities arbitration is about the law, which it is not, nor has it ever been.  Arbitrators are not judges. They are not required to know the law, follow the law or to read legal briefs. Arbitrators are fact finders. They want to know who did what and why.  Too many lawyers approach securities arbitration as if they are presenting the case in court. It is the single biggest mistake and the single biggest reason why customers lose these claims.

Beginning in the late 1980s there began to be a lot of product related claims where the investment was itself defective.  Prudential Securities for example put out several billion dollars worth of public and private limited partnerships. Some were defective because the disclosures were not accurate or the due diligence was shoddy; others because the advertising and representations minimized the risks or projected returns that were unsupportable.

Over the years I have seen real estate funds where one appraisal of the property was sent to the bank and a second, higher appraisal went to the investors. I have seen “North American” bond funds full of bonds issued by South American companies and funds and ETFs full of derivatives that no investor could understand. Those claims are relatively easy to win. But it does help if you have a clear understanding of what the proper disclosures should have been.

There are always claims that stem from an individual broker’s bad conduct. Sometimes a broker will place an order without calling the customer for permission first. That is clearly against the rules and a customer is entitled to be compensated for any loss that occurs. If it happens it is easy to prove as the telephone records and the order are both time-stamped. Either the phone call preceded the order or it did not.

Sometimes a broker will help a customer trade an account or recommend a lot of buys and sells in a short period of time. Trading is not the same thing as investing.  Most traders, because they are making a lot of trades are concerned about how much commission they are paying on each one. That is why most traders gravitate to one of the low commission discount firms.  When you see a trader paying high commissions per trade and making a lot of trades it is usually a problem.

When the market comes down again, some of the losses will be the result of bad products and bad brokers.  However, most of the losses that the customers will suffer will be the result of staying in the market too long.  They will not be the victims of fraud but of simple negligence, as the claims will be based upon violations of the brokerage industry’s suitability rule.

The suitability rule is something that stockbrokers and their supervisors deal with every day. Notwithstanding, lawyers representing customers seem to have a hard time explaining it and how it is violated to arbitration panels.

Simply stated the suitability rule requires that a broker have a reasonable basis every time they make a recommendation to a customer to either, buy, sell or hold onto a security.   As it is written the rule sets forth a course of conduct for stockbrokers and requires them to get pertinent information about the client’s financial situation and tolerance for risk.

The typical defense is that the customer checked the box on the new account form that said he was willing to accept some risk or was willing to accept something other than conservative, income producing investments. This customer-centric view gives defense lawyers a lot of latitude to confuse arbitrators and will befuddle a lot of claimants when they file claims after the next crash. The proper way to view the suitability rule is to focus on the investment and the recommendation, not the customer.

In the normal course the only reason for a broker to recommend that a customer purchase any security is because the broker believes that the price of that security will appreciate in value. When they think the price will appreciate no further, they should recommend that the customer sell the position and move on to something else. The broker does not have to be correct, but he must have a reasonable basis for his belief.

Brokers and investors all over the world have for decades used the same methods to determine which securities will appreciate and which will not. It is called fundamental securities analysis and it is taught in every major business school.  Most of the large firms have cadres of analysts who write research reports based upon this type of analysis. Most of those reports set forth the analysts’ opinion of a target price for the security they are reviewing.

Deviating from that analysis will always get the brokerage firms in trouble.

That is what happened in the aftermath of the crash in 2000-2001.  Many of the claims from that era were the result of conflicted research reports. The firms were competing to fund tech companies and were funding companies that had few assets other than intellectual property and fewer customers if any.

I had several prominent research analysts on the witness stand who basically explained to arbitrators that they had to make up new ways of analysis because the internet was so new. That was BS, of course, and those “new” formulas were never disclosed to the investors or for that matter, never the subject of an article in any peer-reviewed journal.

Markets never go straight up for as long as this one has without a correction. I think that a lot of people seriously believe that a market correction or a crash is coming sooner rather than later. It may happen next week, next month or next year but it will happen.  I can say that because there is a lot of empirical data to support that position.

For example: 1) price/earnings ratios of many large cap stocks are at the high end of their ranges and when that happens prices come down until they are closer to the middle of the range; 2) employment is very high meaning wages should go up impacting the profits of many companies; 3) interest rates are rising which will cause people to take the profits that they have made in stocks over the last few years and convert them to safer, interest paying instruments; 4) rising interest rates also curtail borrowing, spending and growth; 5) an international tariff/trade war came on the markets suddenly and its impact has yet to be shown; 6) the global economy is not that good which should decrease consumption and prices; 7) oil prices keep rising and gas prices along with it because of international political uncertainty which adds to the cost of everything that moves by truck, which is virtually everything; 8) there is a lot of bad debt in the marketplace (again) including student debt, sub-prime auto loans and no-income verification HELOCs; 9) real estate prices are very high in a lot of markets and in many markets the “time on the market” for home sales is getting longer; and, 10) the increased volatility of late is itself never a good sign for the market because investors like certainty and stability.

None of this means that the market will necessarily go down but all of it needs to be considered. And that is really the point.  Many so-called market professionals urge people to just stay in the market no matter what. They claim that they cannot be expected to call the top of the market. They argue that the market will always come back, so what does it matter if you take some losses now.

Any investor who has made money during this long bull market should want to protect those gains. Any broker who is smart enough to advise clients when to buy a security, should be smart enough to tell them when to sell it.  Any advisor who keeps their clients fully invested when there are indications that a correction may be imminent is going to get sued and frankly deserves it.

The brokerage industry has always had a prejudice that suggests that customer should always be fully invested.  Brokers who work on a commission basis are always instructed that any customer with cash to invest should invest. Likewise, as the industry has morphed away from commissioned brokers to fee-based investment advisors, those advisors want to justify those fees by having a portfolio to manage not just an account holding a lot of cash.

Registered investment advisors are likely to be especially targeted by customers seeking to recover losses they suffer for a number of reasons. Many are small shops that do not employ a large stable of research analysts.  Many advisors just buy funds and ETFs and allocate them in a haphazard way because they really do not understand how asset allocation actually works. This is especially true of robo-advisors that are not programmed to do any analysis at all or to ever hold a significant amount of cash in their customers’ accounts.

All investment advisors including robo-advisors are held to the highest standard of care, that of a fiduciary. Any fiduciary’s first duty is to protect the assets that have been entrusted to their care. Any customer of a stockbroker or investment advisor should have a reasonable expectation that the profits they have earned will be protected.

I am posting this article on the evening before the US mid-term elections and on the day that the US re-imposed economic sanctions on Iran. Both may have significant effects on what will happen in the stock market in the next few months and beyond. Analysts may differ on what they believe those effects will be. But that is not an excuse to do no analysis at all.

The markets are driven by numbers and any broker or advisor who believes that they can offer advice without looking at those numbers has no business calling themselves a professional.  To the contrary, any advisor who tells you to stay in the market because no one can know when it will stop going up or that it will come back if it goes down is just playing you for a fool.

 

 

DreamFunded – Crowdfunding the Dream – Poorly

One of my pet peeves about the crowdfunding industry is that the so-called professionals take Pollyanna views of bad acts and bad actors. They ignore felons and felonies. When someone screws over investors, they make excuses or worse, simply ignore it.

When the SEC brought its very first action against a crowdfunded offering, Ascenergy, I wrote an article about it. I called out how the lack of due diligence would be a problem for the industry. That was in 2015.  A lot of people told me then that the crowdfunding industry would get its act together.

In 2016 when FINRA brought its first action closing down crowdfunding portal UFunding, I wrote an article pointing out the need for better compliance for crowdfunding portals. The crowdfunding industry gave a concerted yawn.

I have written several articles about companies that were raising money on crowdfunding platforms that looked and smelled like scams.  No one else seems willing to do so. The idea of protecting investors from scams and scam artists seems to be an anathema to the crowdfunding industry.

So I really was not that surprised when someone sent me a disciplinary complaint that FINRA had lodged against one of the better known Reg. CF crowdfunding portals last April.  Even though the industry publications had published every press release and puff piece about this portal while it was operating, I could not find even a mention of the FINRA complaint in the crowdfunding media, let alone a serious discussion about what this platform had done wrong. Perhaps I missed it.

It is not like FINRA’s complaint was not noteworthy. The portal, DreamFunded, was owned by Manny Fernandez a serial angel investor, CNBC celebrity, White House invitee and noted author who has appeared on many TV shows and podcasts and in article after article about crowdfunding. If you are going to run any business having a celebrity out front is usually an asset.  But that does not mean that a celebrity can run the business.

Mr. Fernandez was able to assemble a large group of well credentialed advisors for his portal, some of whom were angels and VCs, but all of whom apparently lacked experience in the business that the portal was set up to do, sell securities to investors.  No competent securities attorney was involved even though selling securities is a highly regulated business.

The crowdfunding industry is supposed to follow those regulations but quite often does not.  FINRA’s complaint against DreamFunded and Mr. Fernandez lays out a road map exactly on how not to run a crowdfunding portal. And, again, the industry has ignored it.

At the heart of the complaint is the fact that companies that were selling securities on the platform were lying to investors or making unsupported claims about their business. That is securities fraud, plain and simple.  Every crowdfunding platform or portal is supposed to take steps to see that it does not happen.  DreamFunded listed fraudulent offerings on its portal even when the fraud was obvious. And worse, Fernandez affirmatively told lies to investors himself to help at least one of those companies scam investors.

DreamFunded operated as a funding portal beginning in July 2016, shortly after Reg. CF became effective, until November 2017 when FINRA apparently began to ask questions about its operation. During that time, it managed to list only 15 companies. How many of those offerings actually raised the funds they were seeking is not disclosed. FINRA takes specific issue with three of the offerings.

The first was a social networking company that had no assets, revenue, or operating history.  Notwithstanding, it claimed a $1 million valuation without providing any support or basis for that valuation. Valuation of pre-revenue start-ups is a significant problem in crowdfunding but you will not find a discussion about it at any of the industry conferences.

The company also claimed that it was in a “$9B market,” that it could achieve a “$900MM+ market cap” and that it projected 100 million active users by its fifth year of operation.  The company claimed that its exit strategy was to be acquired at a sales target of $500 million, which would provide a significant return to investors. The company then listed numerous well-established internet and technology companies as potential “strategic acquisition partners” with no basis or support for doing so.

The company closed its offering early without notifying investors as it was required to do.   “DreamFunded, through Fernandez, transferred the investor funds raised through DreamFunded’s portal to the personal checking account of the company’s CEO. Communications from the CEO available to DreamFunded and Fernandez at that time indicated that the relevant checking account had a negative account balance and was being charged overdraft fees.” No competent securities lawyer would have allowed that to happen but apparently consulting with an attorney who understood this business was not in Mr. Fernandez’ playbook.

The second of those offerings involved a health and wellness company, which claimed assets of less than $5,000 and prior-year (2016) revenue of $12,250. Elsewhere it also claimed assets of $2.3 million, which it attributed almost entirely to an online content library, though it provided no support or basis for this valuation.

Moreover, the company’s “business plan” projected 2017 revenue of $500,000 and 2018 revenue of $2 million but provided no basis or support for these projections.  According to FINRA, the company made unrealistic comparisons between itself and established companies and falsely implied that it was endorsed by a leading entertainment and lifestyle celebrity.

DreamFunded stated on its website that it followed the Angel Capital Association’s “strict due diligence guidelines,” the purpose of which was to “mitigate investment risk by gaining an understanding of a company and its market.” DreamFunded also claimed that the firm’s “due diligence and deal flow screening team screened each company that applied to be featured on the DreamFunded platform.”

DreamFunded and Fernandez did not follow the Angel Capital Association’s due diligence guidelines. Likewise, DreamFunded did not have a due diligence and deal flow screening team. Its claims of due diligence and deal flow screening were false and unwarranted and were designed to mislead investors into a false sense of security regarding the level of due diligence conducted with respect to the offerings featured on the DreamFunded portal.

There is a horrible lack of real due diligence in the crowdfunding industry but that is really not the problem here.  In plain English, the problem here, in my opinion, is Mr. Fernandez’ lack of honesty and integrity. The problem is that Mr. Fernandez apparently has a problem telling investors the truth.

Fernandez was a guest on a cable television network program that purported to match inventors with investors. On the program, Fernandez claimed to have invested $1 million for 30 percent ownership in a third company which subsequently conducted an offering through DreamFunded’s funding portal. Fernandez had not, in fact, made any investment in the company. His statement that he had made an investment was a lie and it seems that it was intended to help that company successfully complete its offering on the platform.

Despite the fact that he lied to investors, I am confident that Fernandez could have settled this complaint with FINRA and would have been permitted to continue to operate DreamFunded provided he cleaned up his act. There are larger FINRA member firms which have done far worse that FINRA has fined but whose memberships they have not revoked.  But Mr. Fernandez’ duplicity did not end with lying to investors, it looks like he lied to FINRA as well.

From the FINRA complaint:

“On January 5 and January 19, 2018, DreamFunded and Fernandez provided limited document productions in response to only a subset of the requests contained in the Rule 8210 request. For example, they did not produce financial records, bank account statements and investor agreements responsive to the request. Without such documents, FINRA staff was unable to fully investigate whether Fernandez and/or DreamFunded violated additional rules in connection with their fundraising efforts conducted ostensibly on behalf of DreamFunded. 

The January 19 production was accompanied by a doctor’s note representing that Fernandez was ill and unable to work between January 17 and January 20, 2018. In light of the doctor’s note, FINRA staff granted DreamFunded and Fernandez yet another extension of time, until January 29, 2018, to provide a complete response to the Rule 8210 request.

On January 25, 2018, new counsel informed FINRA staff that he too would no longer be representing DreamFunded or Fernandez. The following day, Fernandez sent FINRA staff a second doctor’s note, this one dated January 23, 2018, which stated that Fernandez would be unable to resume a normal workload until February 5, 2018. The note did not identify any illness that Fernandez was suffering from or otherwise specify the reason for his alleged inability to work. Moreover, during the time period when Fernandez claimed he was incapacitated, his social media posts indicate that he traveled out of town to enjoy, among other things, a film festival in Salt Lake City and a concert in Las Vegas.”

In truth, Mr. Fernandez did not want to maintain his membership in FINRA.  At the first whiff of the investigation he filed the paperwork to withdraw his membership and just walked away.

What he left behind were perhaps thousands of investors who were defrauded and a number of start-ups and small companies that may be sued by those investors.  These are investors who gave crowdfunding a try and who are unlikely to give it a try again. As I said, the crowdfunding industry has refused to condemn this fraud and in my opinion is shooting itself in the foot by ignoring it.

Operating a crowdfunding platform can be a very lucrative business. There is no shortage of small companies looking for funding. Several of the Reg. CF portals charge 7% of the money that a company raises and take a carried interest in the companies which can be very valuable if one actually takes off.  I can tell you from experience that a good portal should be able to raise $2-$3 million a month or more.  Paired with a Reg. D platform side by side, a good team could demonstrate that the JOBS Act can deliver everything it promised.

I have actually worked in the securities industry; this is my home turf.  If I had a backer, I would open a crowdfunding portal tomorrow because a well run portal can make a lot of money. (This is a serious request. I am actually looking for a backer who wants to make more than reasonable ROI. Send me an e-mail if you want to fund a crowdfunding portal run by a serious team of professionals.)

As for Mr. Fernandez, like a lot of people who failed at crowdfunding he has apparently moved on to greener pastures. He currently speaks at crypto currency conferences and undoubtedly holding himself out as a financial “professional”.

The crowdfunding industry is busy lobbying Congress asking it to change the rules to make it easier for more small investors to participate in this marketplace. Perish the thought that they should spend any time or effort cleaning their own house first. Lobbying for more investors without real compliance with the existing rules and protecting the investors they already have is really a waste of time.

Crowdfunding Successfully

Over the last 3 years’ equity crowdfunding has evolved into a fairly easy and inexpensive way to fund a business. More and more businesses, including start-ups, are attracting millions of dollars from investors without having to deal with Wall Street stockbrokers who charge hefty commissions or venture capitalists who want a hefty portion of their company.

I speak with companies every week that are considering crowdfunding as a way of finding investors.  The questions they asked a year ago centered on what crowdfunding is and how does it work. Today the questions are much more practical. They want to know how to get it done and how much it will cost.

One of the great mistakes that people make when they consider seeking outside investors is failing to consider the investment they are offering from an investor’s point of view. Investors expect that you are going to use their money to make more money.  Investors want a return on their investment and they expect some of the money that you make to find its way back into their pockets.

It is very important that you structure your offering to maximize the probability that investors will actually get the return you are promising. It is equally important that you clearly tell them what you are going to do to get there.

Structuring the offering correctly is a balancing act between an investment that will stand out from the pack and be attractive to investors and one that does not promise too much of the company’s profits that would stifle its growth or cause cash-flow difficulties. You can have a great little company with a great product and a huge upside but that does not mean you can attract investors if the offering itself and the return they will get is not attractive to them.

You can use crowdfunding to sell debt or equity in your company.  If you chose debt you get to set the terms and the interest rate. You get to decide whether the debt will be convertible to equity later on and if so when and on what terms. You can also sell common stock, preferred stock, convertible preferred or preferred stock that is callable. In many cases you can keep the financing off of your balance sheet by using a revenue sharing model or licensing your IP.

To structure an offering correctly you need to understand the company’s financial situation, cash flow and anticipated growth both of revenue and expenses.  You also need a good understanding of your competitors and how they approached their financing and the market if you are going to be competitive.

Serious investors look at your spread sheet first. They expect that you will be able to support the projections you are making with real facts and rational assumptions. If you are using investors’ funds to expand your business or introduce a new product into the market, you should have a good idea of what that market looks like, how you intend to reach it and what your competitors are doing.

Unless you have a finance professional on your staff or on your board of directors, you will need someone to help you structure and correctly set the terms of your offering. Very few of the crowdfunding platforms offer this type of advice, but that does not mean that you do not need it. The failure to understand finance is the root cause of the absurd valuations that are everywhere in crowdfunding and are a primary reason that serious investors will not look at your offering.

If you do not have a finance professional to help you, and the platform does not provide this type of advice, by default it is going to come down to the lawyer who is helping you prepare the offering paperwork. I have this discussion with clients almost every time I prepare an offering for crowdfunding.  If you are thinking about using a template to create the legal documents for your offering instead of a lawyer who can give you good advice you are likely to create an offering into which no one wants to invest.

Contrary to what any platform tells you very few platforms have a large audience of loyal investors ready willing and able to write you a check. I work with one platform that caters to institutional investors. Their investors are loyal because the platform is very picky about the companies that it will allow to list. Serious investors want this type of pre-vetting. Serious entrepreneurs want this type of investor.

Some of the worst advice you will get about raising money through crowdfunding is that you can use social media to build a community of potential investors or that crowdfunding for investors is a way to build your brand and solicit new customers at the same time. This actually makes no sense at all.

Customers and investors have divergent interests. Customers want you to sell them your product at the lowest price. They are consumers and think like consumers. Investors on the other hand want you to maximize your profits. They want you to sell your product for as much as the market will bear.

There are a significant number of people in the crowdfunding community who believe that the whole purpose of the JOBS Act is to allow small investors to invest in new companies. Both Regulation A+ and Regulation CF which were promulgated under the JOBS Act specifically allow for small investors.  Both are expensive and cumbersome. In my mind neither is worth the effort.

If you want to raise $1 million using Reg. A+ or Reg. CF you might expect an average investment of $250. That means you will need to reach 4000 investors. To obtain an investment from 4000 investors, your marketing campaign might need to reach 1,000,000 distinct prospects.

If you use Regulation D and make your offering to only accredited investors, you might set your minimum investment at $25,000. That way you need only 40 investors or less to raise the entire $1,000,000 and may need to reach out to only 10,000 prospects to do so.

I have worked with several of the marketing firms that specialize in equity crowdfunding. Some are more expensive than others. I always recommend spending your money on creating a good offering and a good presentation and not spending it on trying to reach 1,000,000 people or more

There are a lot of different crowdfunding platforms. Some specialize in funding real estate, some in solar projects and alternative energy projects. Sometimes a company can benefit by being on one of the larger, national platforms; often a local platform will work just as well.

There is technology available today that allows a company to set up its offering on its own website. You can set it up with what is essentially a drop box where the prospective investors can look at your offering and supporting documents. If an investor wants to invest, it will present the appropriate documents, accept his/her signature, verify the investor’s identity and qualifications and place the funds into an escrow account until the offering is completed.

You lose the advertising that a platform would do but you may gain from the fact that your offering is not competing with a dozen others all looking for investors. The fact that this technology is available has driven down the cost of listing on a platform.

Overall, if you want to raise between $1 and $5 million for your business using equity crowdfunding, legal and marketing costs and platform fees should run in the neighborhood of $50,000 more or less. Legal fees are usually the same but marketing costs increase with the number of investors you are trying to reach. Compared to the 10% fee that a stock brokerage firm would get, you can see why crowdfunding is becoming more and more popular.

 

Crime and Crypto Currency

Many people seem to think that crypto currency is a legitimate response to the “evils” visited upon the world by banks, Wall Street and other intermediaries.  They see the mainstream world of finance as corrupt and predatory. Many of these same people are confident that a decentralized system of crypto currency will be more transparent and therefore will reduce the bad acts and eliminate the bad actors.

The same old scams that these crypto enthusiasts hate are playing out in the crypto market every day.  It is actually easier to scam people in the crypto market because both the players and the investors are remarkably naïve.

There has always been crime and criminals in the financial markets.  Some of the same scams have played out over and over for more than 100 years.  The perpetrators and the technology change but at their core many of the scams are the same. The scams succeed because the one fact that never changes is that investors can be both greedy and stupid.  But that fact does not excuse anyone who lies to investors or takes advantage of investors’ stupidity.

Regulation came to the capital markets in the first decade of the last century in the form of “blue sky” laws that were passed by various states.  They were called blue sky laws because they sought to put an end to “speculative schemes which have no more basis than so many feet of blue sky”.  Or more succinctly “to stop the sale of stock in fly-by-night concerns, visionary oil wells, distant gold mines and other fraudulent exploitations.”  Those laws still exist today and were enveloped in a series of federal anti-fraud laws in the 1930s.

I invite you to read the white papers for ten Initial Coin offerings (ICOs). Pick any ten at random. What you will find are the same “fly-by-night” companies that claim that they are going to disrupt this or that multibillion-dollar industry without so much as a bookkeeper on staff.   Almost every white paper I read clearly violates both state and federal law because they do not make full and accurate disclosures. That is why US regulators are perpetually busy issuing injunctions to stop ICOs in their tracks.

In many cases the ICOs are trying to convince themselves that they are not offering securities so they do not have to make the required disclosures.  In some of these cases it is because accurate disclosures would sink the offering.  It is hard to find even simple disclosures like “there are other, larger and better financed companies in this market with whom we will have to compete”.

In other cases, the companies claim to be domiciled in other countries and are not subject to US laws.  I get several e-mails a week soliciting my investment in an ICO domiciled in another country.  Of course if you are soliciting investment from US citizens, then US law applies.

The ICO industry does not acknowledge that it needs to play by the rules. It calls the rules old fashioned and out of date for the modern global economy.  But those rules still apply and failure to follow them is often criminal conduct.

An ICO is an off-shoot of equity crowdfunding or direct to investor financing that uses the internet rather than a brokerage firm to reach potential investors.  Equity crowdfunding was billed as an inexpensive way for small companies to have access to investors.

In the mainstream markets a brokerage firm will conduct a due diligence investigation of the company seeking financing.  The purpose of a due diligence investigation is to have a professional verify the information that is being given to potential investors. This protects investors from the most obvious scoundrels.

With a few exceptions the crowdfunding industry never bought into the idea of due diligence and many of the worst crowdfunding platforms and crowdfunding “advisors” make no serious attempt to verify whether any of the information given to investors is in fact true. The worst of the crowdfunding platforms and advisors have seamlessly moved into the ICO market.

The ICO community suggests that investors conduct their own due diligence investigations.  How, exactly, does a small investor thinking about investing in an IC0 which claims to have a new complex technology and a management team spread over 5 countries “investigate” the offering? Did the management actually graduate from the schools they claim and work at the companies they list? Are the advisors that are listed actually participating? Does the tech violate someone else’s patent? Is the potential market really as big as they say it is? Who are the competitors and how are they positioned in the market?

The ICO market is a market where telling investors the truth is the exception rather than the rule.  In my thinking, every person who sells tokens in an ICO without telling investors all the material facts is a criminal.  And that describes the bulk of the ICO market and ICO advisors.

After the tech market collapsed in 2001 it was revealed that many of the research analysts at the large Wall Street firms had conflicts of interest. Keeping the large tech companies happy meant a lot of investment banking fees for the firms. That is just what the analysts did; they said nice things about the long term growth prospects of companies that were a step away from bankruptcy.  This type of behavior is also clearly illegal.

It is absurdly easy to purchase a good rating for an ICO. Advisors on one of the largest ICO rating platforms, ICO Bench, sell good ratings to any ICO that wants to pay for one.  A pay-for-play rating violates many laws.  Many people in the ICO industry are aware of the practice and keep their mouths shut. In my mind, any rating by ICO Bench is a scam and ICOs that use an advisor affiliated with ICO Bench should be avoided at all costs.

I recently read an article by Jordan Belfort whose antics were portrayed as the Wolf of Wall Street.  Belfort is no fan of crypto currency but he is an expert on pump and dump schemes. What he sees when he looks at an ICO is a lot of insiders and advisors getting a lot of cheap tokens before the public gets any. The insiders then loudly hype the company and dump their tokens on the unsuspecting public. It is exactly the same method that Belfort used and he landed in jail for doing it.

If you follow the Bitcoin trading market it is impossible to avoid repeated allegations of market manipulation. Crypto enthusiasts are always writing articles claiming that the price moved up or down because some “whale” took a large position or dumped one.  No one knows for certain because the crypto currency world is anything but transparent. Many of these people write articles claiming that some large investor has “blessed” crypto currency or is making a sizeable investment. They repeat every unsubstantiated positive rumor while ignoring the reality that the rumor they spread last month never came true.

That there is real crime in the crypto world is evidenced by theft and money laundering.  More than $1 billion has apparently been stolen from electronic wallets and crypto exchanges.  Banks spend a small fortune on technology to keep their accounts un-hackable. The crypto world which is based in technology cannot seem to get its act together.

Likewise, governments all over the world are constantly reporting that money laundering by drug cartels, human traffickers and the like are a significant problem. The FBI recently reported that they have 130 active investigations concerning money laundering and crypto currency. Governments in other countries have many more investigations under way.

In response, the crypto world always says that a lot more money is laundered through banks than with crypto. That logic is very similar to saying that you can get food poisoning at any restaurant, so why should we make our employees wash their hands.  Again banks spend a lot of money on anti-money laundering protocols even if they are not perfect.  Most of the crypto exchanges spend little or nothing.

Organized crime has been active on Wall Street for decades. The NY State Attorney General did a study back in the 1990s that concluded that organized crime was operating smaller brokerage firms that were foisting pump and dump schemes to unsuspecting investors.

A few weeks back someone sent me the prospectus for an ICO that had filed for registration as a Reg. A offering.  The company is just a lawyer who is going to raise $50 million and then hire developers to create Blockchain based projects for this industry or that.

It was a vanilla offering, more akin to a shell than a company; the kind of shell commonly used for pumps and dump schemes. The lawyer has actually represented small brokerage firms that have been accused of pump and dump schemes and also people associated with organized crime families. How do I know?  I “googled” the lawyer’s name and that is what I found.  So why would a lawyer who has ties to organized crime register a shell?  If you do not know the obvious answer, you have no business calling yourself a crypto “expert”.

Everyone I speak with in the crypto world is confident that it will continue to expand and that more and more investors will be drawn to it.  But that will remain a myth unless and until investors are always told the truth about ICOs and their secondary markets. It will remain a myth until the honest people in the industry are prepared to start publishing articles about advisors listed on ICO Bench and other ICO charlatans and stop inviting them to speak at conference after conference.  It will remain a myth until the platforms spend what it takes to become as secure as banks, so that the tokens they hold for investors cannot be stolen and the trading platforms can identify and refuse to deal with the drug dealers and human traffickers.

Do I think any of this will happen? Not a chance. Within hours of the time I publish this article I will begin to get e-mails from people who will tell me that either 1) the regulations or protocols I seek will act to centralize a market that is supposed to be decentralized; or 2) decentralization and Blockchain will fix all these problems; or 3) I am too old to understand modern technology or the “new” world of finance. In the meantime the crypto market will continue to be a cesspool of criminals and criminal acts; the very conduct its backers detest in the mainstream markets.

 

Defining Investors’ Best Interests

In the spring of 2016 the US Department of Labor (DOL) issued new rules which sought to change the landscape for investments held in retirement accounts.  The DOL sought to extend the rules governing how large pension plans and 401(k) accounts were managed to every IRA account held by individuals.

The regulations were a thousand pages long, the result of 6 years of discussion and millions of dollars of lobbying by various players in the financial services industry.  To no one’s surprise that lobbying paid off and the final rule was a watered down version of prior drafts that had actually excluded some of the riskiest investments from all retirement accounts.

The final rules also allowed brokerage firms to create exemptions if the rules did not fit specific individual accounts that were called “best interest of the investor” exemptions. The current administration in Washington and several courts have stopped these rules from being implemented.  The discussion of what investments and investment strategies are in the “best interest of investors” continues.

At no point along the way did the regulators, industry or consumer groups ask investors what they thought would be in the best interest of their retirement accounts. Had anyone done so, they would have been told that investors would be very happy if their retirement account was worth more today than it was a year ago and worth more in one year than it is today.

Before you scream “impossible” I think you should consider that even though no one can win every year, it is important that you at least try.  If you clear your head of all the BS that you hear about the stock market and investment advice and start at the basics, you will see it is not as difficult as many people think.

The primary reason that anyone ever buys a stock is because they believe that the price of that stock will go up.  When the price does go up to where you think it will go no higher you sell the shares.  You may not be right every time but you can certainly be right most of the time and you should be happy with that.

Selecting investments takes time, effort and skill.  The large brokerage firms and investments banks will usually have a fairly large research department and the best ones seek out and hire the best analysts in each industry. In order to “cover the market” a firm may have analysts that will be analyzing companies from 15 different industries if not more.  An analyst with expertise in the automotive industry might not understand the banking industry and neither might be able to understand the value of drugs that the large pharmaceutical companies have in the development pipeline.

The truth is that no one firm has the best analysts in every industry.  That is one reason large institutions frequently deal with multiple firms so they have access to research reports prepared by the analysts they think are the best in each industry.

Beginning in the mid-1990s a lot of stockbrokers began to abandon the traditional business model and the large firms and transformed themselves into self employed Registered Investment Advisors. This was a result of their commission income being under attack from discount brokerage firms that charged much less. It was not unusual for a customer to have an account at one of the wire houses to get access to the research, buy 100 shares through that firm and 900 shares of that stock through their account at a discount firm.

After the tech wreck in 2001 it became clear than many of the “best” analysts covering the tech industry were conflicted.  They were following companies that were grossly overpriced but which were bringing in large underwriting and investment banking fees, so the firms found ways to “value” companies with no revenue claiming it was appropriate for them to do so.

The result is that many of the newly minted investment advisors were willing to leave the research analysts behind. They convinced themselves and their customers that they could be portfolio managers even though they lacked the most basic tools to do so.

This led to the rise of asset allocation using mutual funds and ETFs. The argument was that the losses from the tech crash arose because people had too much of their portfolio in tech stocks. Diversify your portfolio became the new mantra of the market. Buy large baskets of stocks and you will never have to worry again. 

Asset allocation had been around since the 1950s. The purpose of a diversified portfolio is to reduce overall portfolio risk.  If one or two market sectors do poorly, your losses would be balanced by those sectors that would profit.

As applied it is often an attempt to mitigate all risks which it cannot do. If you are trying to manage risk without defining what that risk is, asset allocation will never be the optimal method for any investor.

Asset allocation did not work very well in 2008-2009 as the sectors that were most affected and took the largest losses, banking and real estate touched virtually every other market sector. The losses, especially in the home value portion of investors’ net worth reduced consumer spending, led to increased unemployment and just about all portfolios took some losses.

All of that has apparently been forgotten in the ensuing bull market. Forgotten is the idea that asset allocation does not work in all markets. Forgotten is the idea that loading up a portfolio with mutual funds or ETFs full of stocks is a recipe for disaster unless you have some good reason to believe that market will continue to rise.

Advisors, because they had no good research to support their portfolio selections, told investors that they did not need research.  The rise of robo-investment advisors is indicative of how foolish the investment world has and will become.

Investors are now told that they should invest based upon their age as if an investor’s age had anything to do with how the market will perform.  Younger investors are directed to select portfolios with more stocks because they had the time to could “make up the losses” if losses occurred.

No robo-advisor suggests that it would be better to not take the losses in the first place.  None suggests that the basic tenets of the “investment pyramid” which would have younger investors build a solid base of more conservative investments first might be more appropriate.

Most importantly no robo-advisor seems to think it is important to tell investors when they should sell.  That advice is as important as any advice to buy anything because no stock and certainly no market can go up forever.

At the end of the day, the discussion about what is in the “best interests of investors” boiled down to a discussion of cost.  Investment advice has become commoditized and therefore the argument goes, consumers should be charged the cheapest price.  This is one of the largest crocks of BS that has ever been foisted on investors.

Goldman Sachs, JP Morgan, the largest pension plans, endowments and serious professional investors all rely upon research and analysis to make investment decisions.  The best analysts earn 7- figure salaries because they are the best.  All that smart money pays dearly for advice. At the same time, regulators and others are telling individual investors that it is their best interest to get the cheapest advice or none at all.

If the person offering you investment advice is suggesting stocks, bonds,mutual funds or ETFs without some reasoned opinion about what those investments will be worth in 90 or 180 days, that advice is useless and you should not pay anything for it.  If they tell you that they construct portfolios that use an algorithm, ask them if the algorithm is aware that the US government is imposing new tariffs on imports or that the Federal Reserve is raising interest rates.

The SEC, DOL and other regulators would do investors a favor if they required those giving investment advice to always share with their customers why they bought and why they sold every position.   A little transparency is always in investors’ best interests.

When I was diagnosed with cancer I wanted the best doctors, not the cheapest. When a neighbor or friend called me in search of a lawyer because their kid was picked up on a DUI, I declined to handle the representation because it was not my field of law and they really needed a specialist. And guess what, specialists cost more.

People need investment advice because bad investment advice or no advice will severely impact their retirement and they should be willing to pay more not less for good advice.  Good investment advice will always be in the investors’ best interest. The discussion really needs to stop with that.

 

Annuities and Senior Citizens

Given that I write a lot about foolish investments and investment scams, several colleagues questioned why I have never written about variable annuities. I know a little more about annuities than a lot of people.  When I was a young lawyer I worked at EF Hutton at the time it was first bringing “universal life insurance” to market. Universal life or “investment life insurance” was the precursor to modern annuity contracts.

There is already quite a lot that has been written by regulators and consumer groups about what is wrong with selling variable annuities to senior citizens. Variable annuities are intended to be long-term investments, usually 10 to 15 years or more. They have a lot of up-front fees that can take a long time to re-coup.  Selling investments that take a long time to break-even to senior citizens is always a problem.

At the same time, variable annuity sales to seniors are growing every year. The reason for this is that a variable annuity sale will pay the salesperson a very high commission; higher than the commission on almost any other financial product.

The commission on a variable annuity contract may be 7% or 10% or more of the amount that you invest. If you buy a million-dollar policy, the salesperson who sells it to you may earn a commission of $70,000 or more. For comparison if you invest $1,000,000 into a series of no-load mutual funds or ETFs at a discount brokerage firm the total commission may be less than $100.

Variable annuities are the only kind of investment which requires the salesperson to have both a license to sell insurance and a license to sell securities. Theoretically that should mean that they are better trained than many brokers. That does not necessarily mean that they are supervised more carefully.

A variable annuity salesperson is often licensed by a brokerage firm owned and operated by an insurance company. The intent is often to facilitate the sales, not provide an extra layer of compliance. Insurance companies rarely lose money and variable annuities are some of the most profitable products they sell.

Variable annuities are often complicated and difficult to compare. No two annuity contracts are exactly alike. Even annuity contracts with the same name offered by the same company can contain different riders that substantially change the terms and benefits.

The salesperson with whom you speak will only be able to sell you an annuity contract issued by one of the few companies with whom they are licensed. If you want to shop around for an annuity you may need to contact several different salespeople.

With a variable annuity your money will be invested in a series of mutual funds or sub-accounts that are managed by the insurance company.  The insurance company may offer a range of investment options. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments or some combination of the three. The track record of the fund managers is not always easy to find or evaluate.

The value of your investment as a variable annuity owner will vary depending on the performance of the investment options that you choose. If your intention is to allocate and re-balance your portfolio within the annuity you should understand that it will be difficult to do so properly. The funds will not necessarily correlate well with each other and may not balance against each other in such a way as to substantially reduce market risks.  The person who sells you the annuity might not be able to offer you good advice on how to allocate the portfolio now or when to re-balance it.

You will pay a management fee for each mutual fund. As with all mutual funds, fees will reduce returns. The “expense ratio” of each fund should be disclosed to you. Over 10 or 20 years those fees can add up to a substantial amount of money. Your portfolio will need to earn that much more than the market every year for you to match the market’s performance.

The insurance company will also offer to sell you various guarantees which may provide for a minimum return every year even if the market goes down. You will pay for every rider and option that you select. If you add all of the annual fees you will see that variable annuities are a very expensive way to invest.

A common feature of variable annuities is the death benefit. Often the rider will provide that if you die, a person you select as a beneficiary (such as your spouse or child) will receive the greater of: (i) all the money in your account, or (ii) some guaranteed minimum (such as all purchase payments minus prior withdrawals). Other features may include long-term care insurance which pays for home health care or nursing home care if you become seriously ill.

Most variable annuity contracts include an annual mortality and expense (M&E) fee. This charge is equal to a certain percentage of your account value, typically in the range of 1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract. Profit from the mortality and expense risk charge is sometimes used to pay the insurer’s costs of selling the variable annuity, such as a commission paid to your financial professional for selling the variable annuity to you. The company may include the fees for any guarantees that you buy or may charge you separately for them.

If you withdraw money from a variable annuity within a certain period after a purchase payment (typically within six to eight years, but sometimes as long as ten years), the insurance company usually will assess a “surrender” charge, which is a type of sales charge. Generally, the surrender charge is a percentage of the amount withdrawn, and declines gradually over a period of several years, known as the “surrender period.”

For example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the eighth year, when the surrender charge no longer applies. Often, contracts will allow you to withdraw part of your account value each year – 10% or 15% of your account value, for example – without paying a surrender charge.

Annuities are most often sold as a way of funding your retirement. They do have tax benefits similar to an IRA account so they are rarely purchased with IRA funds.  If you have a large amount of money put away for your retirement outside an IRA, you should consider that the amount you might actually receive annually from a portfolio of dividend paying stocks and bonds might compare favorably once you consider the higher risk that you will have to make up for the annuities annual expenses.

The very first thing I learned about insurance in general (way back at EF Hutton) is that people do not buy insurance, people sell it. Annuities are a high commission item. If you are considering them, get advice from a fee based financial planner first and consider all of your alternatives.

Conning the Crowd

Equity crowdfunding allows companies to sell their stock or debt offerings directly to investors by placing the offerings on a website platform. No stockbroker or stockbrokerage firm is needed.

An industry of crowdfunding platforms, experts and attorneys has emerged to help these companies raise the capital they seek.  Some do it better than others.  There are several that I would recommend without reservation.  But at the same time, some people do it so poorly that they make a mockery of the whole idea.

Some of those who do it poorly are now suggesting that that equity crowdfunding is a failure.  In reality, those people were never equipped to do it correctly in the first place and never really understood what selling stock to investors entails.

The one idea that these people and others in the crowdfunding industry never embraced was that “no one wins unless the investors win”.  There will never be a shortage of companies looking for capital.  Connecting those companies with people willing to invest takes more than the passive approach that many of the crowdfunding platforms have adopted. If a platform says “we list any company” I would recommend that you find another platform.

There are a small number of platforms that are licensed brokerage firms or run by people who have experience in the mainstream brokerage industry. They seem to appreciate what it takes to make equity crowdfunding work. These platforms offer demonstrably better investments.

The better platforms take the time to carefully consider each company that comes to them seeking capital.  They will not just allow any company to list their offering on their website.  Funding only companies that have a chance of success and providing investors with a return on their investment is the key to success for any crowdfunding platform.

One of the assumptions that people who lobbied for the JOBS Act put forward was the idea that a crowd of investors has the ability to review the offering materials being put out by a new company, evaluate that information and make intelligent decisions about which companies to invest in and which to pass on by.  The crowd never had that ability. Unless you have a working knowledge of accounting, analyzing the balance sheet and income statements of any investment will always be difficult.

When I first looked at crowdfunding I wrote two separate articles about Reg. A+ offerings that I thought were deficient in a number of ways. My primary argument in each case was that the numbers just did not add up. I thought that each company was promising more than it likely could deliver to the investors.  If I owned the platform where these two offerings were listed, I would not have allowed either to list because if they smell like they may be scamming investors, they probably are.

Both of those companies, Elio Motors and Med-X were subsequently the defendants in regulatory actions.  There have not been that many Reg. A+ offerings to date and the fact that there have been several other regulatory actions concerning Reg. A+ offerings should raise the eyebrows of any serious people in the crowdfunding industry.  I have looked at a few other offerings that were clearly suspect as well, but which the regulators have not yet publicly questioned. For the most part, many in the crowdfunding industry just do not care if investors get a fair shake.

A great many people who own and operate crowdfunding platforms simply do not know what they are doing.  If the platforms do not reject these scams, how will they ever build the long term trust of the investors that the industry cannot live without?

Finally there was an idea that websites would develop where the crowd could share its evaluations of various offerings and where the issuers could respond to comments and clarify what they were offering to investors. A true give and take of information so that investors might make informed decisions.

In most cases this has not really happened.  For all the talk about the wisdom of the crowd, there are people who are so foolish that they will not listen when someone makes a cogent analysis of an offering that would lead anyone with an ounce of common sense to invest in something else.

Case in point.

Both Elio Motors and Med-X were listed on a crowdfunding platform called StartEngine.  As I said, neither should have been allowed to come to market because it was pretty obvious that neither was giving investors the whole story.

StartEngine (SE) is currently offering its own shares to public investors under Reg. A+. I wrote an article about StartEngine’s offering as well. I questioned why it was not making a profit in an industry that should be enormously profitable.  As with all my articles, I asked some hard questions, but I always try to be polite. That cannot be said for everyone.

In the name of transparency, StartEngine posts the comments people make about its offering right on its webpage.  Several people sent me this comment which was posted on the StartEngine offering page which I re-publish here verbatim:

-StartEngine is paying its founders $400k apiece per year. This is INSANITY.
-StartEngine is paying all of its EXECUTIVES over $1,000,000 per year!! This is also insanity.
-Half of that pay was in cash bonuses. This needs to be addressed by their CEO especially as they have not made any profits and are taking investor capital.
-Investors are being offered Common Stock NOT Preferred Stock as they should be offered.
-What does that mean? That means that the founders have significant liquidation preferences over the investors.
-You are asking your investors to assign their voting rights to the CEO. This may not even be completely legal.
-The valuation of the company is unheard of,especially for a company that has continually lost money without any profit.
-There is no road map or path to reaching a revenue breakeven point where you can even sustain operations without SIGNIFICANT additional capital commitments.
-Investors will be HEAVILY diluted after this raise or worse there will VERY likely be a down round.
-The fund raise leaves the company with VERY little cash reserves. Guaranteeing the need for more cash.
-StartEngine has to be in the process of registering as a  full broker dealer for what it needs to accomplish the goals stated.
-The language of the offering circular makes it appear that SE is doing everything it can to shield investors from knowledge of its current and actual future plans as well as prevent them from having any ability to have a voice in the company.
-Over $5,446,367 has been spent to date in deficit without any profits.
-StartEngine does not include any listing or sufficient breakdown on its technology
-There is a significant lack of data and information that you would find in a standard pitch deck of a seed stage startup
-There is no timeframe for the ending of this campaign.
-There is no coverage of an exit strategy or potential for one.
-StartEngine does rolling closings and does not disclose when or how it will go about these, directly in conflict with the traditional “crowdfunding” model of get to your goal or get your  money back.
-StartEngine does not cover much on its competitors or the competing models or market.
                Please address these issues.

Certainly this list includes some issues that the company would do well to address. This commentator is no idiot and he is one person of whom it can be said that there are people who can read and assess a crowdfunded offering. He is exactly the type of investor that the crowdfunding industry needs if it is going to succeed.

So did the company respond with a point by point explanation?  It did not.  This is the company’s response which I also republish verbatim:

Thank you for your comment. We believe our offering describes our business effectively, and clearly shows our goals for the future. In fact, your critique of the offering is only possible because we chose to be so transparent.  If you have a specific question about StartEngine that will help you to decide whether or not to invest, please ask. We’d like to provide all the information we can.

Personally, I never would have let a client of mine publish that response.  It strikes me as arrogant and treats a potential investor who asked intelligent questions as someone who can be ignored. To me it smacks of the Wizard of OZ saying “don’t look behind the curtain.”  I would have counseled a carefully worded point by point response that demonstrated respect for the potential investor.

In truth I would never have suggested that StartEngine prepare a Reg A + offering or seek public investors.  As the anonymous commentator points out for any number of reasons investors are going to have a difficult time making a profit on this investment. This is not a charity. The executives are taking out a substantial amount of money ever year.  Because the company is not profitable, some of the money they are taking home is likely to be the investors’ money.

Despite this, the same web page notes that StartEngine has over 400 new shareholders as a result of this offering.  If an active crowdfunding platform can successfully make this offering despite its flaws, why would it care if any of the offerings that were listing on its platform had any value or could possibly offer a return to the people who are investing in them?

In my mind Elio and Med-X were strikes one and two against StartEngine and this offering is strike three. I would not advise a client to list on their platform and I certainly would not advise a client to invest in any company that does. In my opinion, investors deserve and should demand better.

As I said, this offering and the commentary was sent to me by an acquaintance who has toiled in the crowdfunding industry and the commentary was also mentioned to me by others.  They privately say tsk-tsk but do not want to publicly say what needs to be said.

I look at it this way, not every stockbroker is honest or competent. When they do bad things investors lose money. No one hates to see a stockbroker taken away from his office in handcuffs more than the honest stockbroker working across the street.  Bad actors and stupid people just demean the reputation of the whole industry and make it more difficult for honest people to make a living. That is true in crowdfunding as well.

In the past two years I have spoken with a lot of hard working people in the crowdfunding industry who are trying to help small companies find investors by giving investors a solid chance to make a return commensurate with the risk they are taking. You know who you are. Keep up the good work.