JOBS Act

Regulatory Compliance in Crowdfunding

Capital Markets, Issuers, Law , , , ,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

Raining on Crowdfundings’ Parade

Capital Markets, Issuers , ,

If you follow my blog, you know that I am very much in favor of the crowdfunding market place developing and succeeding. However, I need to throw a bucket of cold water over the exuberance that the industry exhibits. I want to inject some much needed reality and perspective into the discussion.  I want to ask some of the hard questions that people do not seem willing to ask. I want to de-bunk some of the major claims that form the foundation of the crowdfunding industry and to set the record straight.

There has been an enormous amount of hype around equity crowdfunding. In mid-May, the last of the JOBS Act sections will take full effect allowing a registration process for equity offering up to $50 million. This section allows mom and pop investors to invest in start-ups and smaller companies, albeit for only a limited amount of money.

Up until now equity crowdfunding (buying shares of stock in small companies and start-ups on crowdfunding websites) has been limited primarily to wealthier, accredited investors.  The equity investments that are being offered on crowdfunding platforms are among the most risky investments available.  Should small investors actually be encouraged to take these risks with their hard-earned money?

The crowdfunding industry expects that these small investors will fund a multitude of new companies and that this new source of capital will greatly boost the industry’s income. It is the income that the industry will earn, not the profits that investors will make that drives the hype.

It is not difficult for a crowdfunding platform to generate a seven-figure annual income for its owners.  Crowdfunding platforms can actually net more profit per dollar raised than a traditional investment bank because they perform a fraction of the work and provide few of the valuable services that a company needs to make a successful offering.

The crowdfunding industry is remarkably cavalier about investors’ money. Nothing about equity crowdfunding respects investors or cares whether investors get a fair shake, let alone a legitimate opportunity to make a profit for the substantial risk that they are taking.  The crowdfunding industry is focused on itself and upon companies that want to raise money. The investors are an afterthought.

What, exactly, does a crowdfunding platform do to help a company seeking funds to succeed? Before the offering not much; after the offering, even less.

Every investor in every market has the same goal; they invest their money to make money. In crowdfunding that has not happened and there is nothing on the horizon that suggests that it will happen.  This is not just about the lack of liquidity for crowdfunded offerings; it is about the fact that most crowdfunded businesses fail.

So let me start with the simple declarative sentence that should counterbalance much of the hype: if you invest in shares of a start-up on a crowdfunding website, it is very, very doubtful that you will ever see your money again.

According to the SEC, the common refrain is that 9 out of 10 start-ups fail, but an equally interesting statistic from one post-mortem analysis is that 70 percent of failed start-ups die within 20 months after their last financing and have raised an average of $11 million.  In other words, not only are these investments highly risky, they also fail quickly.

That statistic is for the larger start-ups funded by institutions and professional venture capital funds.  Smaller start-ups funded on crowdfunding sites cannot expect to do better and most likely will do worse. These are companies that frequently cannot attract venture capital, which is why they come to ordinary investors on crowdfunding websites in the first place.

Unless something is done about this enormous failure rate, equity crowdfunding is not a sustainable model. While this is just my opinion, it is supported by basic math and economics.

If Wall Street brings an IPO to market raising $50 million, the company issuing its shares gets the money that it can use to create new products and new jobs.  Almost immediately, the investors can sell the stock for more or less and re-invest the same money into another IPO.

The same $50 million might fund a handful of smaller businesses on crowdfunding platforms but the great bulk of those funds cannot be recycled into new businesses because the investment are illiquid and most initial businesses will fail.  It is not even fair to say that the crowdfunded offerings create new jobs when the companies and the jobs are usually gone within 2 years.

Assuming that equity crowdfunding grows to where it can raise $500 billion in a given year, the bulk of that money will be lost so another $500 billion in new money will need to enter the market the next year for new companies to get funded.  For how many years is that likely to occur?

This model is unsustainable if for no other reason than investors will not keep going into their pockets again and again if they only lose.  Long term, equity crowdfunding can only be successful if the businesses that it is funding succeed. Right now very few people in the crowdfunding industry are focused on that fact.

The vast majority of the key players and “experts” in the crowdfunding arena have little or no experience in the mainstream financial markets.  Most have no history of dealing with investors even though investors supply the capital upon which the entire crowdfunding market depends.

One of the common excuses that the crowdfunding industry makes is that the current problems are the result of “growing pains” because the industry is still in its infancy. Many people in the crowdfunding industry believe that crowdfunding began with the JOBS Act (2012) and is governed solely by it. Actually, equity crowdfunding has been around for more than 20 years, more than enough time to get its act together.

The first direct to the public stock offering (DPO) done via the internet is generally credited to the Spring Street Brewing Company which successfully raised about $1.5 million in 1995. It was ground breaking at the time, because no underwriter (Wall Street firm and those pesky salespeople) was involved in selling the stock.  No video accompanied the offering as I do not believe that the internet supported video in those days.

The offering was done under the watchful eye of a forward thinking SEC.  Many of the crowdfunding “experts” that you might hire today are not aware of this offering or the serious discussions about DPOs that were engaged in by many regulators and market professionals at the time.  Tell an expert that offerings can be done without a video and they will look at you as if you said the Chicago Cubs just won the World Series.

By 2000, the SEC had already brought a hand full of enforcement actions against other firms that had sold stock via the internet because investors were being defrauded. Wall Street was not interested in DPOs then or now. Scam artists jumped right in. Those scams are the likely reason that the anti-fraud provisions of the federal securities laws are specifically incorporated into every JOBS Act offering.

When an “expert” tells you that the paperwork for a JOBS Act offering is less cumbersome than a regular public offering; they should also tell you that companies still need to disclose all of the material facts to potential investors, no matter what the forms suggest or how cumbersome the disclosures might be.  They should also tell you that the video that accompanies the offering must be in compliance as well.

Every equity offering made on a crowdfunding platform should have the disclosure THIS IS A SPECULATIVE INVESTMENT. INVESTORS CAN EXPECT TO LOSE ALL OF THE MONEY THAT THEY INVEST, in bold, on the first page.  It is the same type of disclosure that is routinely made to accredited investors in the REG. D, private placement market.

The SEC has already brought its first enforcement action against a company funded under the JOBS Act, Ascenergy.  The SEC went out of its way to spell out that the company’s website was a part of the offering. That certainly would apply to any video that accompanied any equity offering.  Most of the people selling videos to the crowdfunding industry are unaware of the Ascenergy case and do not appreciate that the videos they create to support a crowdfunded equity offering need to comply with the law.  That applies to social media campaigns and “tweets” as well.

Many people seem to believe that investors (the crowd) are expected to investigate the offerings themselves. It was never realistic to believe that investors could evaluate a new issue. That is what many people wanted but it is not what the JOBS Act and the SEC regulations delivered.

The JOBS Act places a great deal of the fraud avoidance responsibilities on the crowdfunding platforms. The Ascenergy case called out 4 crowdfunding platforms by name. You would certainly think that these firms have a target on their backs not to repeat their deficient performance.

There is a remarkable absence of trained compliance personnel at the crowdfunding platforms. I spoke with 2 lawyers at one of the larger Crowdfunding platforms a few weeks ago. They were certainly bright attorneys. They had previously worked at law firms and at regulators and had no specific training in investment banking.  There is a big difference between understanding federal securities law and evaluating specific transactions, marketing materials and accompanying social media campaigns for compliance.

I have a particular issue with securities attorneys who are spreading the crowdfunding hype.  Some actually recommend specific platforms and specific offerings. Putting your law firms’ reputation behind a securities offering was always considered a problem.  If you do not believe me, you might want to check with your professional liability carrier.

There are several securities attorneys who are selling technology-based services to the crowdfunding industry.  I started out as a young lawyer with a secretary who took my dictation in shorthand, so nobody has to sell me on the idea that technology can help reduce the costs of practicing law.

The cost of preparing a securities offering or running a crowdfunding platform is important, but should never be the driving issue. Qualified and experienced securities lawyers are still essential to the process of selling equity. Offering securities to public investors incorrectly can be very, very expensive to all concerned.

A few of the crowdfunding platforms carefully vet each offering before they list them.  These platforms reject more offerings than they accept which has to cost them a lot of money.  It is against these platforms that the rest of the industry will be ultimately judged by investors, regulators and class action juries.

Small businesses were funded before crowdfunding. Many entrepreneurs saved up or worked two jobs to get their nest egg to open the business of their dreams.  Others tapped family and friends for seed capital. The Small Business Administration has funded millions of businesses and continues to do so.  Angel investor funds are often made up of groups of smaller investors and are more prolific than ever before.

A good business could often find capital if the entrepreneur tried hard enough and surrounded himself with the right advisors. Better mousetraps get funded and will continue to get funded with or without crowdfunding.  There is nothing “essential” about this new industry.

I spend a lot of my time reviewing pitch books and speaking with founders of companies who are seeking investors. A great many start-ups are not worthy of funding. A great business idea is not the same as a great business.  A great many people with good ideas do not understand what it takes to run a successful business.

Most small equity crowdfunding campaigns fail to raise the minimum amount of capital that they seek.  This inefficiency also suggests that equity crowdfunding is not a sustainable model. In part it is because the owners read a book or two or listen to crowdfunding experts who have no actual expertise. It is also because many entrepreneurs do not want to spend what it takes to do it right.

Traditional underwriters raise the amount of money that they set out to raise virtually every time.  That is the Holy Grail of equity crowdfunding which the industry does not come close to achieving. It is usually because the company raising the money is not willing to spend what it takes to sell their offering to investors.  They fantasize that if they just put the offering onto a platform and send out a few e-mails or tweets, investors will come running with checks.

While no one can guarantee success of a crowdfunded offering that is raising equity for a start-up or small business, there is one group that I have watched that clearly understands how to bring a significant amount of investors’ to each offering that they present.  I suspect that they charge a little more because they obviously do a better job.

I have already had this discussion with several people who are preeminent in the crowdfunding industry and whose best response has been, sadly, that the crowdfunding industry will eventually work things out.  In the meantime, the industry is working things out using money from many thousands of small investors.  The industry is tooting its own horn over its success in being able to separate those investors from their money knowing that the vast majority of those investors will get nothing in return.

The simple truth is that if you have a few hundred extra dollars in your pocket and would like to help a small business succeed, you can go to a local restaurant, order a meal and a bottle of wine and know that the owner will be very happy to have your patronage.  The odds are that the owner stands on his/her feet for many hours a day for 6 and maybe even 7 days a week.

If you are not hungry and have a few extra dollars you know that there is a food bank not far from you no matter where in the US you are that will appreciate your money as much any crowdfunding entrepreneur, probably more so.  I would argue that a food bank donation gives an excellent return on your money in the form of inner satisfaction.

I expect some blow-back from this article, especially that last paragraph.  If anyone would like to debate me on this subject, publicly, I would be happy to appear at any conference. I would expect the topic of the discussion to be “what is the financial benefit of crowdfunding for the crowdfunding investors?”  I know that it is a buzz kill but that is the point.

I have been criticized, repeatedly, because of my negativity toward crowdfunding.  I am not negative about crowdfunding. I just get angry and frustrated by the experts who think they know what they are doing but don’t.  If you do not want me to call out your foolish behavior, stop acting like fools.

Several dozen crowdfunding portals have lined-up to become FINRA members and offer equity offerings to ordinary investors. I am not particularly looking for a job, but I would be happy to sit down with any crowdfunding platform that is actually interested in only offering good investments to investors. I would think that it is the least that they should want to do.

In the next few years a lot of people will be lured into crowdfunding by the hype and will lose their money. It does not usually happen with offerings made by Wall Street firms. It does not need to happen on crowdfunding platforms either.

Med-X – Crowdfunding, cannabis and chicanery

Investors, Issuers, Law , , ,

As a college student during the 1960s, I was exposed to marijuana and had friends who were out and out stoners. As a young lawyer I represented a wholesale head shop company that Time Magazine referred to as “the Dunhill of the industry”. Through them I met many entrepreneurs who had profited in the wholesale and retail paraphernalia industry.

Being a cancer patient I am familiar with medical marijuana. I have read the literature and discussed it with my doctors. I know many people who have used marijuana as part of their recovery from cancer and other illness.

This article is not about the pros and cons of legalizing pot. It is about Crowdfunding, the cannabis industry and a questionable investment.

Sales of marijuana in states where it is legal are expected to top $5 billion this year. Still, I cannot see the loan committee of a major bank or any Wall Street firm step up to finance the cannabis industry in any major way. Even though its use is legal in an increasing number of states, the cultivation, distribution or sale of marijuana is still a federal crime and banks and brokerage firms are regulated by federal agencies.

It is not surprising then, that the cannabis industry has found Crowdfunding to be a source of new capital to fund its growth. Rewards based Crowdfunding campaigns for new vaporizers and similar products are easy to find.

What surprised me was that the Securities and Exchange Commission (SEC) has recently approved a $15 million offering for a cannabis related company under the new Reg A +. The offering for a Southern California based company, Med-X, became effective in early February.

The company has no sales or current business to speak of. The company states that it will use the money from investors to: “research and develop, through state of the art compound identification and extraction techniques, and market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

The Company’s planned compound identification and extraction research and development operation will be conducted primarily at the Company’s existing 600 square foot indoor cultivation center in Chatsworth, California, where controlled quantities of high quality cannabis are being grown, harvested and stored for research and medical use to the extent permitted by California law.

The company has several physicians on its Board of Directors. However, none has disclosed any published research paper on cannabis and none, apparently, works fulltime at the company’s 20’x30’ cultivation center to direct that research. Cannabis is apparently being grown, although the equipment needed to conduct the promised research will not be purchased until the offering is funded. In any event, the research is for future products.

In the meantime the company will use some of the investors’ money “to acquire, create and publish high quality cannabis industry media content through the Company’s media platform, (a website) to generate revenue from advertisers as well as through the sale of industry related products.”

If this were styled as a media company I would not question it. But the website is only a few months old, has no revenue and again the company lacks personnel with a media background to run it.

The company’s other revenue generator will be sales of a product called NatureCide® to cannabis cultivators throughout the world. NatureCide® is an insecticide and pest repellant. This product is owned, manufactured and distributed by a company called Pacific Shore Holdings, Inc. an affiliated company that is controlled by the same person who controls Med-X, Mathew Mills.

Med-X acquired an exclusive license from Pacific Shores Holdings to market NatureCide® products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. An exclusive license can be valuable, however, in this case the products are readily available on Amazon.com making the value of the exclusive license questionable.

Pacific Shores Holdings is a classic penny stock. Mr. Mills was sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors he had no business selling shares to. The structure employed here, with one penny stock company acquiring a large block of stock in another pursuant to a licensing agreement is also a classic penny stock tactic.

Like any Crowdfunded offering, shares of Med-X are being sold by the company directly to the public. In theory investors should be able to make an informed evaluation of the company before they invest their money. But most investors cannot.

I expect that many people will line up to send their money to invest in this company’s shares. It certainly will not be because this company represents a good investment.

More likely, if you will forgive the pun, the buzz about this offering will be about its asserted link to the cannabis industry. The minimum investment is $420. (No kidding).

Stop to consider that its main product, NatureCide®, was pre-existing. Its only connection to the cannabis industry is the statement that it can be used by cannabis growers in the same way that people growing virtually anything else can use it.

Mr. Mills was apparently content to sell shares of Pacific Shores Holdings without adequate advice from a securities lawyer. He now proposes to conduct cannabis research without a cannabis researcher on staff and publish a website without an experienced website publisher.

Remember, I want the Crowdfunding industry to succeed. To do so it will need to offer investors the opportunity to invest in companies that at least have a likelihood of success. I do not believe that investors will find that here.

Instead, Med-X is poised to give both the evolving Crowdfunding and cannabis industries a black eye and to leave many investors holding the bag. The cannabis industry will survive.

If Med-X turns out to be a $15 million scam, (and there are others) investors may begin to realize that there are better places to invest their money than a Crowdfunding portal.

Elio Motors- A Crowdfunding Clunker?

Capital Markets, Investors, Issuers , , , ,

A colleague asked me to look into the securities offering of Elio Motors in Phoenix, Arizona. The company is one of the first to register shares to be sold under the new Regulation A.

Reg. A allows smaller companies to raise up to $50 million without the use of an underwriter. Elio is selling its shares directly to investors through a Crowdfunding platform called StartEngine.

Elio is attempting to raise $25 million making it one of the largest direct to investor financings to date. Many people in and around the Crowdfunding industry are anticipating the offering’s success.

Elio claims to be a designer, developer and manufacturer of highly efficient, low cost automobiles. The company intends to offer a 3 wheeled, gas powered vehicle that will get 84 MPG and cost roughly $6800.

It certainly sounds good and from the pictures that accompany the offering the vehicles look pretty good as well. The company says that it hopes to be delivering its vehicles to consumers by the end of this year.

Unfortunately, that seems highly unlikely. The company currently has only a few drive-able early prototypes of its vehicles. It does not have a full production prototype, a final design, a built-out manufacturing facility or manufacturing processes. Even with this financing, the company will still need another quarter of a billion dollars to get its manufacturing facility into production.

I reviewed the prospectus and made a note of a number of “red flags” – items that seemed a little off base to me. A number of things caught my eye.

First, the company is insolvent and will continue to be insolvent even after investors put in $25 million. Investors will pay $12 per share and each share will have a negative book value and no liquidity for a long time to come.

Roughly $10 million is owed and due to an affiliate of a large shareholder within the next 6 months. That loan is already over due and subject to a forbearance agreement. If the agreement is not renewed roughly 1/2 of the proceeds of this offering will revert to the lender.

The company hopes to obtain a $165 million loan under a federal government program intended to help existing auto manufacturers expand their businesses. If unsuccessful in obtaining this loan Elio will need to find that much and more, elsewhere.

The government program was intended to help Ford and GM when they were having financial difficulty back in 2008/2009.The program is specifically designed to have low upfront borrowing costs. Elio is paying a lobbyist $1 million to help them to get funding under the program in addition to the lobbyist presently on staff. Perhaps the company does not believe that it could obtain the loan if the government agency judged the company solely on its merits.

There does not appear to be a single dollar of professional venture capital in this company. The company says this is because the venture capital industry moved away from investing in new vehicle startups. Personally, I believe it was because the venture capital industry spotted Elio as a loser or worse, a scam.

There are no patents. Despite years and millions of dollars worth of designs and modifications Elio does not have anything that it deems to be worth patenting. That always begs the question of whether or not their designs infringe on anyone else’s patents.

Perhaps the most disconcerting issue is that the company currently funds itself by taking vehicle deposits from consumers. The company has taken in more than $20 million in deposits from in excess of 45,000 people promising to deliver vehicles for which it does not yet have a final design and still needs up to a quarter of a billion dollars to produce.

The sales projections seem very rich. In order to get its retail price to $6,800 the company is projecting 250,000 units sold annually, meaning sales would be about $1.7 billion. With competition from other larger automotive manufacturers this number even if attainable would seem difficult to sustain.

No one apparently conducted a real due diligence review. StartEngine is not a FINRA firm and cannot be expected to conduct a due diligence review that is up to FINRA standards. The name of the law firm that prepared the offering is not disclosed. Experience suggests that this prospectus is not the product of one of the large Wall Street law firms.

Interestingly, Elio will pay a FINRA firm, FundAmerica Securities, to conduct due diligence on the investors to make certain that they comply with the SEC’s rules regarding how much they can purchase. FundAmerica Securities will receive up to about $950,000 for this service. (For the record, I would have cheerfully performed this administrative task for about ½ the cost).

No similar fee is being paid to anyone to verify the statements in the prospectus and to make certain that all appropriate disclosures have been made. Due diligence can be expensive and the amount spent, if material, would likely be disclosed.

If fully subscribed, this offering will cost Elio about $2.4 million which is about what it would have cost if the offering had been done in the traditional way by a FINRA firm using salespeople. The offering would have been subjected to real due diligence and if it passed more likely than not would have sold out before the end of last year.

I suspect that the “crowd” will buy up all of the shares that Elio is selling, not because the crowd knows what it is doing, but because most people would not know an investment scam if it bit them on the butt.

As I said, a lot of people in the Crowdfunding industry are waiting for Elio to sell its shares as an indication of how the Crowdfunding industry has progressed. The industry would be better served if got behind companies that offered investors a better chance of success.

What The Crowdfunders Forgot ….The Crowd

Capital Markets, Investors, Issuers , ,

My own interest in Crowdfunding goes back only about one year but there are few old timers like me in this now exploding corner of the capital markets. By now I have now read hundreds of articles and studies, spoken and corresponded with people who were instrumental in getting the JOBS Act passed and people who work in the Crowdfunding market every day.

I admit that I am fascinated by Crowdfunding. I see it as especially beneficial to smaller companies who can now raise capital in a regulated environment. Much of the literature focuses on the benefits of that capital to those companies and the benefits of those small companies to the general economy.

Very little seems to have been written on how this market will attract investors. If anything, there seems to be an attitude that suggests that ”if we build it, investors will come”.

Up until now, Crowdfunded offerings could only be purchased by “accredited investors”, wealthier people who are supposedly sophisticated enough to evaluate a private offering themselves and who are presumed to be wealthy enough to accept a loss if the investment tanked.

Before Crowdfunding accredited investors were sought out for private placements offered under Regulation D. Reg. D offerings are generally made through regulated brokerage firms where professional salespeople sell them to investors and are sometimes motivated by high commissions.

Crowdfunding is attempting to compete with these live salespeople using mostly passive portals and social media. It is not the same. Social media is just a tool. What Crowdfunding needs to embrace is a message that these investors want to hear.

A significant number of Reg. D offerings are real estate or oil and gas production syndications. In a great many of these offerings investors are promised a share of the rents or royalties or some other monthly or quarterly income stream. Some of these offerings offer tax benefits that are attractive to wealthy investors.

There are many established sponsors in the Reg. D market. These companies fund project after project through private placements. The larger sponsors can often point to a track record of success. By success I mean that prior investors were able to cash out for more than they invested.

Crowdfunding is too young for any company to post a similar track record. Crowdfunding counts its successes by how many companies get funded. As Crowdfunding matures it needs to judge its success by how many investors make money.

Only a small portion of the people who qualify as accredited investors actually invest in private placements. What exactly is the Crowdfunding industry doing to lure these private placement investors to Crowdfunding websites? The short answer is: not nearly enough.

The Securities and Exchange Commission (SEC) has recently opened Crowdfunding to all investors. Many smaller investors will be restricted to investing no more than $2000 on Crowdfunding portals each year. The SEC understands that with any Crowdfunded offering there is a high risk that the investors will could lose their entire investment.

Since we are speaking of only $2000 of non-essential income, it would seem more logical that people might opt to take that amount money to Las Vegas and put one dollar at a time into a slot machine. Statistically, slot machines pay out about 97% of the money that people put into them. Whether you ultimately win or lose has a lot do with when you stop. If you play a slot machine for long enough the casino is likely to buy you a beverage.

Investing that same $2000 in a small business through a Crowdfunding portal would have a significantly higher risk of loss and demonstrably less entertainment value. I see a lot of ads for Crowdfunded offerings and to date none has included a drink coupon.

The allure of Crowdfunding to any investor is the chance to cash out big. For the vast majority of Crowdfunded businesses that is very unlikely to happen even if the funded company is successful.

To date, there is no meaningful secondary market for Crowdfunded offerings. An investor who invests in a company that does well may still not get their money back to spend or invest in other offerings.

What will the Crowdfunding portals offer to entice any investor to bring money?

There is a lot in the Crowdfunding literature regarding the use of social media campaigns to sell offerings. This reliance upon social media actually highlights a weakness in the Crowdfunding system.

Investors who are solicited by a single company because they are suppliers or customers of that company or friends of the management have no reason to evaluate any other offering on the same portal or other portals. The portals should not expect these investors to become repeat customers.

If an investor does not get interest or a regular share of the profits, cannot cash out and has worse odds of success than at a slot machine, it is easy to see that the Crowdfunding industry still has will have some work to do. Once the “newness” of Crowdfunding wears off investors will need better deals and better incentives for investors.

 

SEC v. Ascenergy; Crowdfunding’s First Black Eye

Capital Markets, Investors, Uncategorized , , , , , ,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sex and crowdfunding

Economics , , ,

Crowdfunding is very much an exercise in self-funding. The companies that are raising funds on the crowdfunding platforms are often expected to solicit their own customers, suppliers, friends and family to become investors in the business as part of the crowdfunding process.

There is a burgeoning industry of consultants who will help companies that want to raise money on these platforms. These consultants exist because there is still far too little capital available in this market. These consultants specifically help companies compete for that capital, but the crowdfunding process is still largely hit or miss.

It seems to be common knowledge that a good social media campaign should accompany any equity offering on a crowdfunding platform. Like all advertising, a social media campaign is a “numbers” game. Its goal is to bring enough eyeballs to your offering so that all of the shares you are offering will get sold.

If eyeballs are what you need to successfully crowdfund a company, it would seem logical then that the easiest company to crowdfund might be one selling a line of lingerie. No crowdfunding consultant worth his/her fee would likely tell the company not to include its product catalog in its presentation to investors if that catalog had pictures of models wearing lingerie.

Titillation aside, lingerie companies sell products that may be easily and inexpensively sourced and which can often be sold at substantial mark-ups. But that is not what the conversation is likely to be about.

In a perfect economic world, investors would travel to the “efficient frontier” (a great name for a crowdfunding platform, in my opinion) and select investments suited to their taste for a blend of risk and reward. Illiquid shares received by crowdfunding investors will always be speculative, so reducing the risk or increasing the potential reward seems to be the obvious way for the platforms to gain the most customers.

When a crowdfunded business finally monetizes the investors’ “bet” there should be every expectation that the investors will be well compensated. Greed, not sex, should be the emotional basis for any crowdfunding investment.

The crowfunding platforms are filled with companies seeking funding for real estate projects, technology projects, electronics, toys, bio-tech, consumables, films and office applications. A prospective investor visiting a few of the larger platforms would likely find a few hundred very different offerings to consider. As the offerings attempt to distinguish themselves one against the other, there seems to be more showmanship than substance.

The classic business model for offering new securities to the market would have them underwritten by an investment bank or brokerage firm. This model works for the companies that are being funded because they get funded. It is also exceedingly profitable for the investment banks.

Investors in an underwritten offering can expect to get a reasonably investigated, intelligently structured investment into which someone at the investment bank, independent of the company, has given some time, thought and analysis. The value added to a funding transaction by an investment bank is the judgment that they bring to the transaction. Investors who may know nothing about the company seeking funds will invest if they have relied upon the bank’s judgment in the past and made money.

I was only able to find one crowdfunding platform that even attempted to offer this type of assistance to companies that were listing on it. Only one platform that seems to see what everyone else is missing.

I should not have to tell you that many of the companies that are currently seeking funding on the crowdfunding platforms are very weak. Even companies which have a “cool” new product created by a great team of engineers will often employ no one with the experience to effectively get the product to market.

There are many start-ups on these platforms that are not yet in business. Someone independent of the company issuing its shares still needs to ask the question: “can you get this to market, on time, sell it and make a profit?” In the crowdfunding marketplace, at least up until now, no one really asks this question because no one considers it their job to do so.

Sooner or later, the platforms will likely realize that they are in the business of selling equity shares to investors and step up. Goldman Sacks is also in that same business and makes a lot of money doing it. As billions of dollars find their way to these platforms in the next few years, there will be a lot of money to be made as the crowdfunding industry matures.

The crowdfunding industry will have matured, in my opinion, when the social media messages change direction. Eventually, the current outgoing “please buy my offering” messages will be replaced by the incoming ”I wonder what the ‘Efficient Frontier’ crowdfunding platform is offering this week?”

Looking back ten years from now, will any of the crowdfunding platforms now operating be able to boast that “97% of the companies funded on our platform in the last 10 years are still operating” or anything close? Certainly the platforms should realize that this type of track record would draw a lot of new investors to their offerings and encourage loyalty from the investors that they already have.

Crowdfunding success or failure should never really be determined by sexy catalogs or the size of your social media campaign. The cream should always rise to the top. The crowdfunding market is new and growing rapidly. All that it needs to succeed is an infusion of a little judgment and some common sense.

Due Diligence by Dummies

Capital Markets, Investors, Issuers, Law , , ,
due diligence
Image by Nick Youngson CC BY-SA 3.0 Pix4free

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Will securities fraud kill crowdfunding?

Capital Markets, Investors , , , ,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Reg. A+ Assessing the True Costs

Capital Markets, Issuers , , , , , , , ,

From the laptop of Irwin G. Stein, Esq.Many small and mid-sized companies seem to be assessing their option to raise equity capital using the SEC’s new Regulation A+, which was promulgated under the JOBS Act. The regulation allows companies to register up to $50 million worth of their shares with the SEC and then offer them for sale to members of the general public.

Until now, companies seeking equity capital at this low end of the market could only seek funds from wealthy, accredited investors using a different regulation; Reg. D, the private placement rule.

The upfront costs of preparing a private placement offering will always be less than the costs of a Reg. A+ offering. In both cases competent securities attorneys will prepare the prospectus. Reg. A+ requires that the company’s books be audited as well. This is an added expense. The true costs however, will be determined by who sells the offering and how it is sold.

It is not unusual for a private placement being sold under Reg. D to have an upfront load of 15% of the total amount of the offering or more. The issuing company only receives 85% or less of the funds that are raised by the underwriter.

One percent of the load might repay the company’s costs of preparing the offering. Another one percent might cover the underwriter’s marketing and due diligence costs. The rest is the sales commission and other fees that the underwriter is charging for selling the private placement.

Many accredited investors are currently purchasing Reg. D offerings and paying the 15% or more front-end load. There is no incentive for the brokerage industry to charge Reg. A+ issuers any less.

When you purchase shares in a private placement you generally cannot re-sell them. Even if the company does well at first, if it fails in later years, you still lose your money.

With Reg. A+ the shares are supposed to be freely trade-able, except that they are not. The market in which they are supposed to trade is not yet fully developed. It may not develop for quite some time.

How much will the underwriters charge for a fully underwritten Reg. A+ offering? The rule of thumb has always been that commissions go up as the risks go up. Shares issued under both Reg. D and Reg. A+ are speculative investments.

Since both regulations will yield securities that are speculative investments that cannot be re-sold, it is reasonable that underwriters will charge the same for both types of offerings.

Some companies will attempt to sell their shares under Reg. A+ directly to the public without an underwriter. Investors who purchase these shares will get more equity for their investment. That does not necessarily mean that they will get greater value. If many issuers can self-fund without an underwriter it might cause downward pressure on loads and commissions that underwriters can charge.

If commissions on Reg. A+ offerings turn out to be substantially less, many accredited investors may shift to the Reg. A+ market. More likely, some brokerage firms will sell both Reg. D and Reg. A+ offerings side by side. If they do, the commission structure and total load on each should be similar.