Can Lawyers Trust Their Clients?

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

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

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

“Never happened” my client told me.

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

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

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

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

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

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

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

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

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

The example went something like this:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


FINRA Arbitration- Where Winning Is Not Everything

The Public Investors Arbitration Bar Association (PIABA) has issued a troubling report to the effect that customers who receive monetary awards in FINRA arbitration forums frequently cannot collect.

Using data from 2013, PIABA demonstrated that more than $62 million in awards made to public customers by FINRA arbitrators in that year went unpaid. That amounts to 1 out of 3 cases where investors went through the arbitration process and won, or nearly $1 of every $4 awarded to investors in all of the arbitration hearings that took place that year.

This is a problem that has been ongoing for many years. FINRA has done little over that time to keep track of unpaid awards and has been reluctant to take any remedial steps. In theory, an award made to a customer by a FINRA panel is due within 30 days. After that it becomes a charge against the firm’s net capital and may lead to disciplinary charges and the firm’s expulsion from FINRA. The latter, of course, hinders collection rather than helping it.

Obviously it is the larger awards rather than the smaller ones that do not get paid. Just as obviously, if the customer dealt with one of the larger firms such as, Merrill Lynch, Morgan Stanley or Charles Schwab, even a large arbitration award is rarely going to be a problem.

Because it is the smaller firms that often opt to go out of business rather than pay a substantial award, PIABA has offered a number of potential solutions including an increase in the minimum requirement for net capital, mandatory liability insurance, broadened SIPC coverage and an industry-wide pool to cover unpaid awards.

I cannot see Merrill Lynch and the larger firms agreeing to fund a pool to cover customers at other firms that they would just as soon have as their own.  And just to be clear, most error and omissions policies carried by FINRA firms specifically exclude actions based upon fraud.

The $62 million in unpaid awards for 2013 is skewed by a single $19 million award that went unpaid and which illustrates the actual problem. The firm that did not pay the award, Western Financial Planning (WFP) actually had insurance, just not enough for its business model.

WFP did not decide to close up shop after the large arbitration award or because of it. It was put out of business by the SEC. A receiver was appointed and assets were managed and sold. Not enough was recovered to pay general creditors like the recipients of the arbitration awards (there were more than a few).

The record does however reflect that WFP sold private placements almost exclusively. Several of the private placements were large Ponzi schemes that resulted in billions of dollars of customer losses causing dozens of small FINRA member firms to close their doors. The only reason that these Ponzi schemes were sold to anyone is that the FINRA firms who sold them did not even attempt to conduct legitimate due diligence investigations to detect the fraud.

Years ago I worked for a law firm that was preparing both public and private real estate offerings. We carried professional liability insurance. The cost was scaled to the dollar amount of offerings that we prepared each year. The more money raised by offerings we prepared, the greater amount of coverage we needed and the premium we were charged went up.

The insurance company sent a representative to our offices. He handed out a multi-page detailed list of documents. “We hope you never have to call upon us to defend you”, he said, “but if you do, this is list of documents about the issue that we would hope to find in your files.” Anyone who thinks that a due diligence investigation is anything other than a way for the issuers, lawyers and brokers to CYA does not understand it.

FINRA has a realistic requirement for due diligence investigations of private offerings that requires member firms to independently verify all of the representations being given to investors.  I had several due diligence officers from smaller firms on the witness stand after the 2008 real estate crash. Almost all just took what the issuer was telling them as gospel. None conducted an independent investigation. You could rarely find a title report or title insurance in their files. None had attended the closing for the property where adjustments are frequently made.

The next crash will assuredly result in arbitrations based upon losses from oil and gas private placements. Where the argument can be made that an office building is an office building, due diligence in the oil and gas industry is very different.

Over the years, I worked on offerings for shallow oil wells in Pennsylvania, deep wells in West Texas, gas wells in Louisiana and at least one shale oil project in Colorado. The due diligence investigation required to verify the facts can differ project by project and state by state. One of the few things that they have in common is they can require multiple experts to conduct an adequate investigation which can obviously run up the cost.

The chance of a small FINRA firm doing an adequate due diligence investigation of an oil and gas offering is slim. I am available as a consulting expert witness for both arbitrations and class actions and I expect that I will be busy.

The problem of unpaid arbitration awards is very much centered in the Reg. D private offering market. It is from investments in the Reg. D market that customers take the huge losses that are the subject of many FINRA arbitrations. Many of the largest Ponzi schemes are sold through private offerings for no other reason than crooks do not want government scrutiny on their offerings.

These offerings are most often sold to retail customers by small firms that specialize in private offerings because the commission on each sale may be many times what it would be on a sale of a similar dollar amount of British Petroleum or ExxonMobil. A broker selling $1 million worth of private placements might take home as much as $90,000 in commissions.

In a registered offering, due diligence is performed by the lead underwriter on behalf of the other firms in the selling group. The issuer pays the lead underwriter for the due diligence process up front before the issue comes to market. In the Reg. D market, each member of the selling group frequently performs their own due diligence and is reimbursed after the fact based upon a fixed percentage of the monies that each firm raises.

This business model where the firms do not get paid for due diligence if they reject the offering and then only get paid based upon how much of an offering that they sell is at the root of the problem. For a large firm doing registered offerings due diligence is a profit center with positive cash flow. For small firms in the Reg. D market it can be an out of pocket cost with questionable reimbursement. Therein lays the problem and the solution.

FINRA might consider requiring a lead underwriter for all Reg. D offerings that mimics the investment banking function for registered offerings. As this is a potentially very profitable enterprise, it is reasonable to believe that some firms would be happy to step up. These firms and only these firms would need enhanced insurance coverage which would be folded into their cost of operations and reflected in the fees that they charge the issuers.

Asking each of the small firms selling Reg. D offerings to purchase insurance against offering statement fraud and adding to the cost of what is already an unprofitable part of their business is not going to gain traction at FINRA. A way to shift the risk profitably to a well compensated lead underwriter might do the trick.

The benefit of loss avoidance in the financial markets which is certainly part of FINRA’s charter should take precedence over insuring recovery costs for the few people who deal with the wrong firms.  It should surprise no one that many people in the brokerage industry do not particularly care for lawyers who make their livings filing customer arbitration claims. The PIABA study, while important, is not likely to stir the industry into action.

Arbitration claims based upon the sale of these offerings to unsuitable customers will still occur, but the aggregate losses will be far less and the number of Ponzi schemes foisted upon the public will likely be dramatically reduced. That is good for everyone.

I do have sympathy for the frustration suffered by the PIABA lawyers but the issue of collection is not limited to securities claims or arbitrations. Thousands of people are injured every year by uninsured drunk drivers .I would argue that it would be easier to substantially reduce the number of Ponzi schemes offered through FINRA firms than getting all the drunk drivers off the road.




On the art of being a securities lawyer

One of the benefits of having been a lawyer for so many years is that I have heard a great many jokes about lawyers. Most hinge on the idea that lawyers are not very good people or not very good at what they do.

Overall, there is a general theme that suggests that 80% of lawyers give the other 20% a bad name. I bring this up because there is always a modicum of truth in anything that we find to be funny.

For me two jokes stand out.

The first I heard while I was still in law school. A professor suggested that the A students would go on to become judges and law professors while the B students were destined to spend their careers working for the C students.

The second I heard after I became ill with a cancer from which most people do not recover. One of my doctors cheered me up by suggesting that in his experience it was true that good people die young. He told me that he felt any patient who was a lawyer was good for his batting average.

I am not here to defend lawyers; quite the contrary.

I recently read an article that reported that the hourly rate for the top partners in the best Wall Street law firms had broken through $1500 per hour. The comments (more than 100) were universally disparaging.

Certainly this rate would apply to the best securities lawyers. I was never a partner in a major Wall Street law firm, but I have been the client of more than one.

Right out of law school I went to work as an in-house attorney for one of the larger brokerage firms. Certain trades required approval from the legal department before they could be routed to the trading desk or exchange floor for execution. I was one of the attorneys who gave that approval.

If the manager of a branch office wanted approval for a customer to buy or sell 10,000 shares of any stock, they would call the legal department. I would ask for the details and make a decision to allow the trade or not. If I delayed and the stock price moved even ¼ of a point while I was thinking about it, it could cost the customer $2500.

Once in a while I needed help. If I could not get it from one of the other in-house lawyers, I could put the manager on hold and speed-dial a partner at one of the top law firms who was on retainer. If I told his secretary that a trade was pending, he would take my call immediately and help me make a decision.

The experience taught me that to be successful as a lawyer I needed to know what I was doing and not just in a superficial way. It taught me that when I did not have the answer at my fingertips, to admit it and find someone who did.

What makes any lawyer valuable to a client is having the right answer to the questions that the client is asking. Sometimes you need to tell the client what questions they should ask and you have to know why those questions are important.

Last week I spoke to a businessman who had a complicated and fairly unique securities law issue. He was quoted thousands of dollars by other lawyers to research his problem. None had ever encountered it before and none could tell him what he should do.

I told him that I had seen another lawyer solve the same problem back in the 1980s by restructuring the transaction so that the regulation that he was struggling with would not come into play. It was the right answer for him and I was pleased to send him off without charge.

Not one of the commentators on the article about lawyers charging more than $1500 per hour stopped to calculate the enormous value of problems avoided by consulting the right lawyer before you act. Problem avoidance is probably the greatest value that any lawyer can give to their clients.

Perhaps the most valuable answer any lawyer can give to a client is “I don’t know.” It is an answer too many lawyers are reluctant to give.

Good clients often have questions about taxes, patents, immigration and frequently, matrimonial law. I have only a cursory knowledge about any of these subjects. But, I know whom to ask. Part of the value of any good lawyer is their professional contacts, both inside and outside their specialty.

Where even good lawyers get into trouble is by taking on matters that they do not fully understand.

In my own practice I know that the US Supreme Court validated and enforced the arbitration clauses that brokerage firms include in their customer agreements in 1987. Notwithstanding, over the years since then, I have run into lawyers who are prepared to file their clients’ claims in court, confident that the court will let them proceed. It does not happen.

They file in court, spend time, effort and some amount of their client’s money on what is essentially a fool’s errand. A trial court judge is going to go with the Supreme Court every time, if for no other reason than they are themselves overworked and moving a case off their calendar and back to FINRA is a no brainer.

The reason that these lawyers do not want to proceed with FINRA arbitration is because they are not familiar with the forum. FINRA does not permit pre-hearing depositions which can freak out even the best litigators.

Many lawyers do not believe that they can effectively question the stockbroker at the hearing without a deposition beforehand. Having worked in the industry, defended more than a few stockbrokers and having participated in a great many FINRA arbitration claims, I am confident that I know how a broker is likely to testify without a deposition.

Even though I was never a $1500 per hour partner at a Wall Street law firm, I could still give the same advice to my clients. There were always treatises and articles written by lawyers who worked in those firms that addressed my clients‘ issues. Lawyers have always valued scholarship and there has always been enough top-flight literature to keep me educated and up to date.

Equity Crowdfunding is a marginal practice for mainstream securities lawyers. These are smaller issues that do not usually generate enough fees to attract the top law firms. But Equity Crowdfunding is still the issuance of securities. The Equity Crowdfunding portals should have experienced securities attorneys on staff. Many do not. The result is a lack of compliance that can only result in problems in a highly regulated industry.

One of the benefits of blogging is that I read the blogs of others. I learn a lot. Some of the blogs written by lawyers who practice in this area are excellent. Some are mediocre. A few are dangerous because the authors are way out of their element.

There is no excuse for practitioners in this or any area of the law to publish advice that is substantially different than would be published by the top firms. Reading and writing about the law is one thing; offering practical advice without having a fair amount of practical experience quite another.

For all the discussion about how expensive some lawyers have become, and all the jokes, I would invite those lawyers who read my blog to start a discussion about how mediocre many practitioners in our profession have become. How using technology to cut costs has replaced hard work and good judgment. How there is so much careless blogging that we are confusing consumers and others with bad advice.

A little self criticism will not stop all of the jokes, but it might make us better lawyers. Our goal should be to offer advice that is worth $1500 per hour even if we charge less.

A Brief History of Securities Arbitration

The US Supreme Court enforced the arbitration clauses that were boilerplate in the account agreements of most stock brokerage firms and sent almost all disputes that a customer may have with their stockbroker or brokerage firm to arbitration in 1987. Shearson/American Express Inc. v. McMahon, 482 U. S. 220 (1987).

The McMahon case did not find its way to the Supreme Court by accident. Some people in the securities industry were looking for a case to walk up the appellate ladder to get the issue of mandatory arbitration before the Court as early as the mid-1970s.

At that time, the industry had been hit by several large punitive damage awards assessed by juries in cases involving customer losses. Many people in the industry wanted nothing to do with juries. Many states did not then permit arbitrators to award punitive damages.

Certainly the industry believed that it could home court customers and their lawyers. To some extent the industry was able to weed out arbitrators who had the audacity to make a large award against a member firm.

The wire houses handled many of the claims with in-house lawyers because as they were self insured. Where there was a separate insurance carrier law firms around the country were enlisted in the industry’s defense. Throughout, defense lawyers have constantly assisted each other and have consistently acted to further their clients and the industry’s interests by shaping the rules and the forum.

I think that the industry would have been happy to keep arbitration simple. Events in the late 1980s and early 1990s conspired against it.

Customers do not file arbitration claims against their stockbrokers unless they lose money. Many customers lost money when the market crashed in 1987. Shortly thereafter, junk bonds began to default. Real estate limited partnerships were failing and a lot of those had been sold to seniors and retirees.

One firm, Prudential Securities, spawned thousands of claims which were resolved individually in arbitration or mediation. Claims against Prudential and other firms selling similar products caused a lot of lawyers from around the country to begin to take on customer disputes.

Up until that point, most claims involved the alleged misconduct of individual representatives such as churning or unsuitable recommendations. Now there were claims involving financial products where every customer who purchased them had been defrauded.

Prudential and the other firms put forward a number of aggressive defenses. The customers’ lawyers began to share information with each other. Eventually some of those lawyers formed the Public Investors Arbitration Bar Association, PIABA. There was now a formal industry of  customer representatives which substantially leveled the playing field.

At that time I would have said that these arbitration claims were easier to defend than to prosecute. The industry always had access to the information, people and documents that it needed to defend the claims. Customers were often limited to those documents that the panel ordered to be produced at the discovery hearing. Basic discovery in arbitration was not simplified and made uniform until 1999.

Tens of thousands of customer claims were resolved in arbitration after losses stemming from the 2001 “tech wreck” and the 2008 “credit meltdown”. The vast majority of the claims settled just like they would have if the claims had been filed in any court.

There have been tweaks to the arbitration rules over time but the basic system is the same. Arbitration still promises a resolution of a customer’s claim in less time and for less money than a resolution of the same claim in most courthouses.

Efficiency has always been a hallmark of arbitration. When I started (in the 1970s) most claims were resolved with a single day of live testimony. The customer and the broker would each tell their story to the panel. Few panels needed experts to explain the rules or the transactions to them.

The issues in these claims are rarely complex. The brokerage industry and the claimants’ lawyers share the blame for adding complexity where none was needed.

FINRA arbitration is far from perfect. I have elsewhere documented that in one case only one FINRA arbitration panel out of 35 thought customers who were sold a particular Ponzi scheme should get their money back. FINRA Arbitration – How investors actually fare.

Some commentators have attributed results like this to arbitrators who are biased or anti-consumer. Some have argued that arbitrators who worked for the industry will not make a substantial award against it. Others have argued that, because it is run by the industry, FINRA arbitration in inherently biased. This has resulted in more neutral panels and panel selection.

Personally, I do not believe that arbitrators should have to be educated by the customers’ attorneys to the fact that selling shares in a Ponzi scheme to any customer is beneath the standards of the industry. There is a difference between an arbitrator who is neutral and one who has no experience with investments or investing.

Unlike many lawyers representing customers who want arbitrators who are neutral, I frequently hope to get a retired branch office manager or compliance professional on the panel. I believe that customers frequently get a better result when the arbitrators are well informed and personally experienced in proper industry practices.

Too many people who comment about the perceived inequities of arbitration fail to consider that there are often legitimate defenses to these claims. Brokerage customers are generally a wealthier and more educated sub-set of the general population. They frequently approve the offending transactions, sign forms that acknowledge that they have read all of the disclosures and receive monthly statements which they are expected to read.

Arbitrators will often apportion the blame for the losses sustained by the customer between the parties. They will frequently consider a customer’s failure to mitigate their losses when assessing damages.

Arbitrators will also consider how the customer would have fared if they had not purchased the offending investments. If the general market was down during the time period of the claim, industry lawyers will frequently assert that the customer would have sustained losses even if they had gone to a different broker who had sold them something else.

The best cure for any perceived ills in the arbitration process will always be loss prevention. It starts with better educated investors but includes better compliance at the firms as well.

FINRA would do well to remember that for all its efforts to make the arbitration process more neutral, FINRA also has an important enforcement function. The greater certainty of the customers’ ability to recover inappropriate losses, the greater the deterrent to the offending conduct.

SEC v. Ascenergy; Crowdfunding’s First Black Eye

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,, and

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,, and 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.

Accredited Investors-Here Comes Direct Solicitation

The JOBS Act required the SEC to permit issuers of certain common private placements to greatly expand their marketing efforts. Issuers using the Reg. D exemption had been prohibited from using any form of “general solicitation” or “general advertising” to market their interests. The SEC has amended its rules to lift that prohibition.

“General solicitation” and “general advertising” were not defined terms, but the rule states that these may include, “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”

A private placement offering is frequently structured to be sold to accredited investors only. This includes banks and insurance companies and retail customers provided the latter have either a $1 million net worth or earn $200,000 per year.

Under the old rule, a stockbroker could not address a stranger with a solicitation for a private placement. There needed to be a pre-existing business relationship between the stockbroker and the potential investor. This was always a chicken and egg problem for the brokerage industry. Many brokerage firms and issuers found interesting ways to comply with the rule and still attract “new” customers.

Under the new rules, accredited investors will likely be bombarded with advertisements for Reg. D offerings of every kind. There will be print and website ads, U-Tube videos and infomercials. Seminars will be less informational and more focused on making sales.

This rule change is likely to launch billions of e-mails. Mailing lists with e-mail addresses for accredited investors are currently available from list brokers. The lists can be sorted geographically and will identify people who previously invested in Reg. D offerings.

If these advertisements emanate from FINRA brokerage firms there is at least a presumption of compliance with the rules that require the advertisements not to be misleading. If the ads emanate from the issuers themselves, there is less oversight.

More likely than not there will be more abuses. In the last cycle, we saw issuers put out glossy brochures offering interests in “Class A” office buildings that were not “Class A” and ads for oil drilling programs with “proven reserves” that were not “proven”.

Some ads will likely target seniors. It is not hard to imagine an advertisement for a Reg. D offering that asks: could you use more monthly income? I should not have to tell you that scam artists will be especially active.

The interests sold in Reg. D offerings are speculative investments. The ideal customer for a Reg. D offering is an accredited investor who is willing to take the risk of these investments and who can afford to take the loss if it occurs. They should be sophisticated enough to understand the offering materials and to make an informed decision whether or not to invest.

General advertising will cast a much wider net. It will undoubtedly bring more investors and more capital into this market. It will also bring more investors into the market who will not understand the offering documents or be able to accurately assess the risks.

Advertising appeals to our emotional nature. Emotions are never a good tool for evaluating risky investments.


Reg. A+ – Exuberance and Reality

The JOBS Act mandated the creation of new rules to help smaller companies obtain funds for development and expansion. One result is the SEC’s new Reg. A+.

Many people see the new regulation as an opportunity for small companies to gain access to the capital markets. It has created a fair amount of excitement and a plethora of seminars and experts.

There are groups prepared to assist businesses owned by women and minorities to take advantage of new sources of capital. There are bio-tech companies with patents (and those still developing their patents) looking for funds. There are consultants pitching Reg. A+ to the cannabis industry.

The sales pitch for Reg. A+ goes something like this: small investors will help to fund small companies that Wall Street ignores. Reg. A+ is a way for companies that could not get funded elsewhere to raise money from Main Street investors.

Some people seem to suggest that thousands of small companies will be able to take advantage of this new regulation. They seem to believe that there is a vast pool of underutilized capital eager for this type of speculative investment.

Reg. A+ will permit companies to raise a maximum of $50 million. Many of the offerings will be smaller; some a lot smaller. These are unlikely to attract the attention of any of the large investment banks. There will be some brokerage firms that will occupy this space, but they too are likely to be smaller.

The anticipation seems to be that many issuers will try to sell the shares to the public themselves without the help of an underwriter. Direct to the public securities offerings have been around for 20 years. Raising a relatively small amount of money from family, friends, suppliers and customers has always been an option.

The up front costs of a new Reg. A + offering are likely to be high. Lawyers and accountants who take companies public are specialists and frequently expensive ones. How little a Reg. A+ offering raise and still justify those costs has yet to be determined.

Underwriters provide essential services to every offering. Underwriters conduct due diligence about the issuer and the offering. Underwriters participate in preparing the registration statement. They make the important pricing decisions and provide research and aftermarket support. All of these tasks will still need to be performed if the company decides to go it alone.

All of this will fall to the issuers, their attorneys and accountants. Issuers who do not use an underwriter will need to assemble an experienced team from scratch. The attorneys and accountants are not going to be much help in the effort to sell the shares. That is what the underwriters do best.

Liability under the federal anti-fraud statutes will rest with the issuers as well. Insurance companies are already advising management that raising funds from public investors without appropriate coverage is fool-hardy.

Proponents are looking to social media to create interest in these offerings. Reg. A+ has a provision allowing a company to use a preliminary prospectus akin to a red herring to obtain indications of interest before the offering becomes final.

As a practical matter, potential purchasers will likely be directed to a website that will allow them to read the preliminary prospectus and which will likely contain a video about the company. The latter is a modern version of what used to be called the “dog and pony show”.

The lawyers who are moving the registration statement through the SEC are likely to make certain that those videos are toned down. That does not mean that a company cannot generate some real excitement in a video. It means that the videos will need to be compliant with the regulations anbd offer a balanced presentation including the fact that investors could lose all the money that they invest.

Given the reach of social media, the video might be viewed by a great many potential investors. Success of a direct to the public offering may hinge upon how many people are excited enough to direct their friends and contacts to the website. At least with an underwriter the offering is likely to be funded.

Any investor willing to assume the risk will be able to purchase shares offered in a Reg. A+ offering. That is the point. Mom and pop can help fund a small business that might eventually turn out to be big. Investors will further benefit because sales made directly by the company will not be subject to sales commissions.

Institutions and accredited investors (wealthier individuals with $1 million net worth or $200,000 in income) are also expected to invest. Angel investors and professional venture capital funds may invest as well. These investors are currently purchasing offerings being made under Regulation D which frequently have substantial loads and commission costs. Direct from the company offerings that are commission free will certainly appeal to some accredited and professional investors.

Unlike Reg. D, investors in a Reg. A+ offering come away with freely trade-able shares, just like they would in an IPO, but not quite. The Reg. A+ market is brand new. Reg. A+ shares may be legally trade-able but if you wish to sell them the question will be: to whom? It may take a while for a truly liquid secondary market for these shares to develop.

Certainly there will be successful offerings made under Reg. A+ both underwritten and direct from the issuer. How many there will be and how much money they will raise remains to be seen.

One thousand Reg. A+ offerings per year at the maximum of $50 million each would add only $50 billion to this end of the market. I suspect that the actual amount of funds raised under this rule will be less.