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

January 23, 2019January 23, 2019 Capital Markets, Investors, Issuers, Law Globallization of capital market, Internet stock scams, self-directed investors, Stock fraud

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

December 17, 2018December 17, 2018 Capital Markets, Investors, Issuers, Law Aphria, Cannabis stocks, Pump and Dump, Short sellers, Stock fraud, Stock scams

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 stockbrokers) frequently 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

November 6, 2018 Capital Markets, Investors, Law asset allocation, brokerage industry, fiduciary responsibility, FINRA arbitration, registered investment advisers, robo-investment advisers, stock brokers

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.

BrightCOIN- The Legally Compliant ICO?

September 4, 2018 Capital Markets, Issuers, Law crowdfunding platforms, Crypto-currency, due diligence, ICOs, Reg. D

I recently read an article citing a study that concluded that as many as 81% of initial coin offerings (ICOs) are scams. Several people contested that number but it cannot be too far off. If you have more than a cursory interest in crypto currency and ICOs it is hard to miss all of the discussion about ICO scams and what to do about them.

There is a general consensus among many in the ICO community that the ICOs need to stop kidding themselves that they are not securities and begin to seriously comply with US securities laws. In crypto industry parlance, there is an expectation that ICOs have begun to evolve into STOs (securities token offerings).

A company issuing a securities token will need to register the offering with the SEC or seek an exemption from registration such as Regulation D. Most STOs will be sold under Reg. D,in part because the SEC has yet to approve a registered offering and does not seem to be in any hurry to do so. US securities laws require that investors be given full disclosure of the facts that they need to make an intelligent decision whether or not to invest.

Around the same time, I came across a discussion on LinkedIn about an ICO for a company called BrightCOIN. The company is raising between $1 and $40 million to expand its tech platform which enables companies to launch their ICO in a “legally compliant” manner.

I read the white paper which is anything but legally complaint and I said so on LinkedIn. This got some brush back by the company’s CEO who commented, among other things that the company had a great lawyer who had helped prepare the white paper. The CEO claims to be a Y Combinator alumnus with several successful start-ups under his belt. So, of course, he should have an excellent lawyer.

I offered to explain why I thought that lawyer needed to go back to law school and the CEO scheduled two appointments with me so the lawyer could tell me that he was right and I was wrong. They cancelled both appointments at the last minute.

The ICO for BrightCOIN is intended to be a Reg. D offering. I would have thought that since it was selling a service and a platform where other companies can make “legally compliant” offerings, BrightCOIN would have taken pains to make its own offering “legally complaint”. They missed by a mile.

The BrightCOIN offering document is in what is now being called a “white paper format”. If you look at a lot of ICOs, a great many use this format. I do not know where it originated, but it does not generally make the disclosures that are required for a Reg. D offering in the format that the SEC expects. Using this format is an invitation to the SEC, state regulators and class action lawyers to come after you.

A Reg.D offering is also called a private placement and the offering document is called a private placement memorandum (PPM). There is a reason that most PPMs look alike. Back in the 1980s and 1990s regulators in several states required hands on review of every offering. I personally spent hours on the phone with the staff at these various state agencies going over specific language in Reg. D offerings. They usually wanted additional disclaimers; more risk disclosures; the words “this is a speculative investment” in the cover page in bold.

Congress eventually took away the states’ ability to comment on these offerings; but a lot of lawyers, including me, appreciate that much of what they wanted amounted to good practice. Disclosures are made for the benefit of the company that is raising the money. They are a prophylactic against legal action claiming fraud and misrepresentation.

BrightCOIN calls itself the Kickstarter for ICOs. It is essentially a crowdfunding platform for ICOs including those private placements offered under Reg. D and registered offerings filed under Reg. A+. BrightCOIN charges no upfront fees and will provide everything that a company needs to prepare and launch an ICO including “audited documentation”.

Of course Kickstarter does not handle any securities offerings. They operate in the world of “rewards based crowdfunding”, not securities crowdfunding, so the comparison to Kickstarter that BrightCOIN makes in its ICO white paper is meaningless.

Elsewhere BrightCOIN claims that it will become the “next Goldman Sachs” and compares itself to Goldman, Merrill Lynch and JP Morgan. The white paper included the logos for those companies, all of which I suspect are trademarked.

Did Merrill Lynch give permission for its trademark to be used in this offering? Does Goldman Sachs even know that BrightCOIN exists? Is there any way to read this hyperbole and not consider it to be misleading?

BrightCOIN claims that its tech platform is valuable because an entrepreneur considering launching their own Reg. A+ or Reg. D offering in the form of a token might spend as much as $500,000 to have the tech built. By “tech” it appears to be speaking about the crowdfunding platform that they are offering.

The last time I saw a bid to build a crowdfunding platform from scratch (November 2017) the cost was $50,000 and that had some unique CRM capabilities built in. I made a few calls and to add a token capability to that would cost no more than another $50,000 and probably a lot less. Where BrightCOIN gets that $500,000 number is anyone’s guess.

In any event there is no reason to create the crowdfunding technology from scratch. If you want to open your own crowdfunding platform there are several companies that offer white label products for a small upfront fee and even smaller monthly charge. At least one that I know of comes with AML/KYC capability attached.

For any offering of securities to be “compliant” it must present information in such a way that it is balanced to point that it is not misleading. The BrightCOIN white paper is full of interesting and unsubstantiated hyperbole.

Around the world, it appears that 10% of the funds that have been invested in ICOs have been hacked. BrightCOIN claims its platform is “100% hack proof”. I have spoken with large, mainstream financial institutions that spend a lot of money making their platforms “hack-resistant” but I do not know a single attorney who would put the phrase “100% hack proof” in a securities offering document. The truth is no one knows if a platform is hack proof until it happens.

The white paper discusses how BrightCOIN can be used to “tokenize” assets like real estate making those assets more accessible to small investors who will be able to trade those tokens on a global basis. The white paper notes (in bold type) that there are over $200 trillion worth of assets that can be tokenized. In the context it is presented, that statement is akin to me saying that there are 1 million single women in California implying that I will always have a date on Saturday night.

BrightCOIN claims their platform is fully functional and that they are already in business. Do they disclose how many offerings they have done and how much money those offerings have raised? They do not. They also claim that they offer consulting services to help a company prepare and market its ICO. Do they identify the people who perform these services? No.

BrightCOIN estimates that it may be able to list and sell 20 ICOs per month and might be able to take in $6.5 million per month in “success fees” if it does. The lawyer who they claim prepared this offering and who was supposed to call me and explain it to me should have told them that unless the platform is a licensed broker/dealer “success fees” are forbidden. No where does the white paper suggest that BrightCOIN intends to become a licensed broker/dealer.

People always ask me how is it that I can spot these scams when other people cannot. In most cases, like here, they do not pass the simple “smell test”. The founder, in my opinion, should simply stop this offering until it is actually compliant. If not people at Y Combinator should pull him aside and ask that he stop using their name.

In my opinion, the attorney, if he actually wrote this offering, which I doubt, should go back to chasing ambulances. When you prepare an offering of securities, it is expected that people will call up and ask some questions as part of their due diligence investigation. Any attorney, who agrees to field those questions, cancels two phone calls and makes no attempt to reschedule them, should refund the client’s money.

The entire ICO market has been one con after another. Telling investors the truth is not that difficult but it seems to be the one thing that the ICOs just cannot seem to do.

Crime and Crypto Currency

July 12, 2018 Capital Markets, Investors, Law Crypto-currency, Initial Coin Offerings, securities fraud

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

June 20, 2018 Investors, Law asset allocation, Best interests of investors, DOL fiduciary rule, investment advice, registered investment advisers, robo-investment advisers

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.

Investment Advisor Litigation When the Market Corrects

January 24, 2018 Investors, Law fiduciary responsibility, FINRA arbitration, investment advice, registered investment advisers, robo-investment advisers

When the stock market finally corrects it will be the eighth major correction since I first started working on Wall Street back in the 1970s. It may happen next week or next year but it will certainly happen. When the market does correct investors will certainly experience some losses.

Everyone understands that the stock market goes up and down. That does not mean that investors should expect to lose a significant amount of the money they made during the bull market when the correction does happen.

At every correction investors who lose more money than they anticipated bring claims for compensation against their stockbrokers and advisors. For a stockbroker registered at FINRA most of the claims will be handled by FINRA in an arbitration proceeding. As soon as the claim is filed it shows up on the stockbroker’s Brokercheck report.

Many of the investment advisors who are registered with the SEC or with a state agency but not FINRA also have arbitration clauses in their customer agreements. They too are supposed to amend their disclosure filings to report customer claims, but few do. I know of investment advisors who have had multiple customer claims but still show a clean record.

Investment advisors are always considered to be fiduciaries to their clients. As such they required to fulfill all of the duties of a fiduciary. A fiduciary’s first duty is to protect the assets that are entrusted to them.

You cannot protect the assets in an investment portfolio unless you are prepared to sell them when the market turns down. For advisors who are paid based upon the amount of money in the portfolio this creates a conflict of interest that no one wants to talk about.

Too much cash in the portfolio invites the customer to withdraw the cash and invest in something else, like real estate. Good advisors will offer a large variety of investments so that they can always find one poised to increase in value or provide a steady income.

This will be the first market downturn where a significant amount of assets are being held by robo-investment advisors. When the next correction comes, robo-investment advisors are going to be likely and easy targets for the plaintiff’s bar. Robo-investment advisors are not programmed to sell positions when the market begins to turn down and are likely to stay invested while losses pile up.

Robo- investment advisors select their portfolios using algorithms that are fed with historical market data. Everyone knows that past performance is no indicator of future results but the SEC allows this sham to continue. For a robo-investment advisor to have any value it would need to be able to assess what is happening in the real world economy and what is likely to happen as a result.

Robo-investment advisors claim to use asset allocation to select their portfolios and to protect their customers from losses. The simple truth is that most robo-advisors (and many human investment advisors) have no idea how asset allocation is done correctly.

The idea behind asset allocation is that you can create a portfolio of non-correlated assets that will reduce the risk if some macro-economic event rocks the markets. Most robo-investment advisors give lip service to the idea of a diverse portfolio but few actually construct their portfolios correctly.

Many human and robo-investment advisors construct portfolios with asset classes such as “large cap stocks”, “mid-cap stocks” “small cap stocks” and “international stocks”. As regards most macro-economic events such as a spike in the price of oil or an increase in interest rates, these asset classes are perfectly correlated with each other, not the opposite as they should be.

Asset allocation is designed to deal with the constant yin-yang between stocks and bonds triggered by interest rate fluctuations. For a long term portfolio, you would accumulate bonds at par when interest rates were high. As interest rates peak and began to come down, you would expect stocks to begin to appreciate, so you would sell bonds at a premium and begin buying good stocks in different, non-correlated industries.

Asset allocation works because its portfolio re-balancing system is based upon the premise that you will buy-low and sell-high. Robo-investment advisors re-balance their portfolio based upon a pre-determined formula that simply ignores what is likely to go up and what is likely to come down. Many human advisors do not do the kind of research necessary to intelligently re-balance a portfolio either.

I worked on a lot of claims against stockbrokers and investment advisors after the market crashes in 2001 and 2008. They always put up the same, weak defenses.

First, they argue that no one can predict the top of the market. That is absolutely true and totally irrelevant. The great bulk of intelligent, prudent investors only invest in stocks that they think will appreciate in value. If your robo (or human) investment advisor told you to buy APPL or a mutual fund or ETF of “international stocks” it is fair that assume that they did so after some analysis that concluded the position would appreciate. Otherwise the advisor brings no value to the relationship.

If the advisor is actually doing that analysis and it includes more than just consulting a Ouija board, sooner or later that analysis will say “sell” or at least indicate that the share price will not appreciate much more. The most common indicator is price/earnings ratio which economists tell us will usually fluctuate within an established range. When prices get out of the range on the high side, they will usually decline and revert to established norms.

Next, brokers and advisors defend these claims by arguing that clients should stay fully invested at all times because the market always comes back. That is another insipid defense. It is akin to suggesting that you should keep your hand on a hot stove because it will eventually cool down.

As we approach the end of this long bull market every investor should be happy with the gains that they made in their portfolio. The Dow Jones Industrial Average has more than doubled since the end of 2008. Even if your portfolio had a smaller gain, why would anyone want to give those gains back when the market declines?

Next, advisors offer lame excuses as to why they did not hedge the portfolio against a market downturn. There are a number of ways to accomplish this but very few advisers have a system to do so effectively. I have asked many advisors why they do not hedge their portfolios or include stop loss orders to protect against a serious loss. They usually tell me that they were afraid to sell positions because the market would resume its climb and they would miss further gains.

That particular defense only works if the advisor has some research that suggests the market will go higher still. Many of the advisors that I cross-examined over the years had nothing more than their own gut feeling.

Where advisors tend to really screw up is when they get into the habit of adding speculative “alternative” investments to a portfolio to “juice” the returns. This may be acceptable for people who understand the risks and who are willing to accept the losses if things do not turn out as planned. That does not describe a lot of people who are sold these investments thinking that they are hedging against losses in other investments.

Real estate investments are commonplace as an alternative and many advisors will add an exchange traded REIT to a client’s portfolios. These are very different than non-traded REITs which are usually private placements. The risk is much greater if the investment cannot be sold and at least some of the value retained. Non-traded REITS have been the subject of thousands of claims against brokers and advisors in the last 10 years.

At the end of the day most of an advisor’s clients turn over the management of their portfolio because they want the portfolio to grow. That should not be that difficult for any good advisor but like anything else, you have to know what you are doing and you have to put in the hours to do it right.

Giving good professional investment advice takes skill and it takes effort, but it is also a people business. The number one complaint that I heard over and over, year after year, from people who contacted me asking about suing their broker or advisor was always the same, “He stopped returning my phone calls”.

When the market takes a sharp downturn, people want advice. That is another reason why robo-investment advisors are likely to see more litigation when the down-turn comes. They are never going to hold your hand.

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

December 20, 2017 Capital Markets, Issuers, Law Bitcoins, crowdfunding, Crypto-currency, JOBS Act, Securities and Exchange Commission

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

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

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

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

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

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

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

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

So what, exactly, did Munchee do wrong?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Remembering Bre-X- The First Big Internet Stock Scam

December 11, 2017 Issuers, Law Bre-X, Internet stock scams, Stock scams

It has been 20 years since the Bre-X stock scam. It may not be completely accurate to call it the first internet stock manipulation, but it was certainly the largest for its time. The scam was based upon false information that the company originally circulated on the internet. After a while large companies and the mainstream media jumped on the bandwagon. Then large investors followed.

Bre-X was a Canadian penny stock company whose share price went from about $.30 per share in 1993 to over $250 in 1997. The stock was originally traded on the Alberta Stock Exchange and later the Toronto Exchange and then moved to NASDAQ.

At the end, it took only about one month or so for Bre-X to unravel completely. When the stock collapsed, investors had lost somewhere in the neighborhood of $5-$6 billion.

Bre-X has a fairly simple story. The company claimed to have located a huge deposit of gold, perhaps the largest single deposit ever discovered, deep in the jungle on the island of Borneo which is part of Indonesia.

People have been scamming investors with claims of huge gold discoveries for a long time. And as they say “greed is a powerful motivator”.

As far as anyone knows the entire a scam was the product of no more than 3 people. The primary players were David Walsh the founder and largest shareholder of Bre-X, John Felderhof the chief geologist and Michael de Guzman the on-site geologist in Borneo.

Walsh purchased the property located in the middle of a jungle in 1993 on the advice of Felderhof. The on-site geologist, de Guzman, took samples which were assayed. He initially estimated that the deposit was equal to 2 million Troy ounces of gold. The estimate of the site’s size and worth increased over time. In 1995 the estimate was raised to 30 million ounces, in 1996 it was raised to 60 million and finally in 1997 the estimate was 70 million ounces.

There was actually no gold at the site. It was later revealed that de Guzman was “salting” the samples he was sending to be assayed, i.e. he was adding gold shavings to the samples. There is nothing particularly new about this scam. People had salted gold and silver mines to gain investors before. What was new is that the fake information was disseminated over the internet.

The internet in 1994-1997 was very different than it is today. Computer screens still had no color. You could not upload or attach documents. There were no search engines. E-mail was primitive and very few people had an e-mail address. There were 3 primary services that you could use for internet access; America On-Line, Prodigy and CompuServe.

I was an early CompuServe user. I say early because my account number had only six digits. I would usually access CompuServe in the evenings via my dial-up modem. It was primarily a collection of forums and primitive chat rooms where users could swap information and discuss various subjects. There was a section dedicated to stocks.

Bre-X was certainly one of the most often talked about stocks during this period. There might only be one or two dozen people who left comments but you knew that many more were silently lurking and reading them. I was reading the comments late in the evening on the West Coast. There were certainly people who were writing comments and other people reading them on the East Coast the next morning. There was a lot of information about Bre-X to post and discuss.

As new assays were supposedly being taken and the estimates about the size of the potential strike went up and up, larger players tried to put their hand into the cookie jar.

First there was a failed take-over attempt by Placer Dome which was a much larger mining company. Next, the government of Indonesia (then a corrupt dictatorship) tried to bring Barrick Gold on board. The government claimed to be concerned that a small company like Bre-X might not be able to handle a large mining operation,

Later, the government brokered a deal whereby Freeport-McMoran a third large mining company, would have a majority interest and run the mine. Members of Indonesian President Suharto’s family and their cronies got a cut of that deal as well.

Once the shares were on the NASDAQ in 1996, Lehman Brothers and other big firms started to follow the stock. There were articles about it in the Wall Street Journal and the mainstream media.

Everyone seemed to think that the gold deposit that had been discovered in the middle of the jungle on Borneo might be larger than expected and that other sites in the jungle might be the next to be explored. The “smart money” seemed to think that it was only a matter of time before more gold was discovered.

Freeport-McMoran began its due diligence by drilling samples in early February 1997. The internet chat rooms were on fire with the speculation that the results might show richer deposits than did previous samples. But it was not to be.

The scam ended abruptly in mid-March when the geologist, de Guzman, supposedly fell (or was pushed) out of a helicopter over the jungle. The body that was recovered days later was badly disfigured and identified through dental records. The body quickly disappeared from the local morgue. People have claimed to have sighted de Guzman in Canada and elsewhere in the years since.

Freeport McMoran reported the results from its test a few weeks later stating that there was little or no gold on the site. There were a few subsequent tests which concluded that the gold in the original samples had come from elsewhere which is how we now know that the early samples were salted.

The stock, of course, collapsed. Trading was suspended in Toronto and on NASDAQ and the company filed for bankruptcy. The bankruptcy revealed that three large Canadian public pension funds had been big investors and hence, big losers.

Walsh claimed innocence of the whole affair, moved to the Bahamas and died of natural causes. Felderhof was charged with insider trading (he had apparently sold millions of dollar’s worth of stock along the way) but was eventually acquitted. Class actions brought on behalf of shareholders returned virtually nothing to them.

Just before the end, Bre-X had blamed the meltdown of the share price on the internet. Walsh claimed that the rumors that the company had no gold had emanated from enemies of the Indonesian government and that the people in the internet chat rooms were short sellers who wanted to see the company fail.

It is certainly correct to argue that the stock would never have run-up if the “news” about the alleged gold discovery had not circulated in the chat rooms. It is certainly fair to assume that the stock price would have gone higher if many more people had visited these chat rooms. As the share price went up, more and more people became convinced that the people saying it will go higher must know what they are talking about.

It is appropriate to consider just how high the price of Bre-X might have gone if there had been as many internet users then as there are now. In the 1990s the internet was just flexing its muscles. Today it can easily move the price of any investment up or down. People who know nothing can sound like geniuses if the the stock price goes up after they say that it should.

Bre-X is actually a model for a modern pump and dump schemes. All you need to do is acquire a lot of shares in a penny stock, set up one or more investment newsletter websites and drive traffic to those sights by sending e-mails to lists of investors. The SEC has closed down internet investment sites that have done just that.

If there is anything that any investor should learn from the Bre-X scam it is that you should only take investment advice from people that you know and trust. A lot of what you hear on the internet is just not real.

Ziyen Inc- Another Reg. A+ Question Mark

July 26, 2017 Investors, Issuers, Law crowdfunding, JOBS Act, Reg. A+, Securities and Exchange Commission

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Law and Economics in Capital Markets

Thoughts and essays by Mr Irwin Stein

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