Non-Financial Companies Should Not Operate Crowdfunding Portals

I attended a holiday party last month where one of the nameless wheeler-dealer types in attendance bragged that his technology company was planning to launch a crowdfunding portal.  His logic was that developers using his startup's tech could help build their ecosystem by attracting investment partners.  He shrugged his shoulders when I told him that FINRA regulates portals and will probably mandate more formal affiliations.  I was really put off by his nonchalance.  Needless to say, he never followed up with me but eagerly took business cards from suckers in attendance.

That conversation left me wondering whether it is appropriate for a non-financial company to own and operate a crowdfunding portal independent of a broker-dealer.  I totally understand the need for technology companies to develop ecosystems of partners and developers.  That's what enables app stores' success.  The difference is that app stores merely display retail products and don't raise investment capital.  An app store is not a fundraising platform for companies offering ownership of their future revenue.

FINRA is still soliciting interim funding forms from portals.  These animals called "crowdfunding portals" still don't have the SEC's equivalent of a zoological classification.  That allows everyone and their cousin to create their own platforms from white-label technology providers like Launcht with no regulatory supervision.  The first lawsuit from a disgruntled investor who invested through an unregistered crowdfunding portal run by a non-financial company will ruin the operations of every other portal that didn't seek FINRA registration or brokerage affiliation.  The portals that don't take those steps may be ignorant of the auditing and recordkeeping requirements that come with fiduciary duties for investors.

I almost phrased the title of this article as a question:  Should non-financial companies operate crowdfunding portals?  I decided that I had to come down firmly on the "no" side of that question because that's the only way I can think of to protect investors from predators running baloney portals.  It's the Wild West out in crowdfunding land and these tumbleweed towns called portals really need a sheriff.  The SEC proposed a 585-page crowdfunding regulation last October and it is still not finalized.  Portal operators need to read the fine print of this soft law starting right now.  It currently exempts portals from registering as brokers and allows them to collect "success fees" instead of brokerage commissions.  I don't know what the final regulation will say but there's a lot of minutiae buried in those 585 pages that will trip up anyone not paying attention.

The freewheeling dude I met was with a tech startup that does not have the internal risk management and recordkeeping architecture common to financial service providers.  Anyone who thinks companies making software and hardware can run their own portals is in for a rude awakening when financial regulation compliance smacks their company hard.  

IRA Rollovers and 401(k) Problems

FINRA is warning financial advisers in Regulatory Notice 13-45 that they need to remember their fiduciary duties when discussing IRA rollovers with clients.  I have no such fiduciary duties with anyone so I can discuss this subject from all angles.  The regulatory notice reminds advisers that products in a 401(k) may be more appropriate for a client's goals and risk tolerance than products available in an IRA.  I'm reminded of target date funds that automatically adjust portfolios as clients age, and those funds may not be available outside of a 401(k).  Positioning clients to accept comparable arrangements with products in IRAs may harm their best interests if management fees and transaction costs would increase.

FINRA's regulatory workarounds preserve the independence of retirement plan sponsors who offer diverse options within 401(k)s.  The remaining problems for 401(k) investors go beyond the choice of whether to rollover assets into other retirement accounts.  I can think of quite a few problems off the top of my head, based on years of studying finance.

A 401(k) contains a lot of actively managed products.  Actively managed funds carry more fees and tend to underperform passively managed products (i.e., indexed funds).  Even target date funds contain actively managed funds, layering another set of fees on top of the active managers' fees.  This Yale study by Ian Ayres and Quinn Curtis shows how active management and plan fees hurt 401(k) investors.

Multiple 401(k) options confuse investors.  Plan sponsors do not all perform thorough educational roles for their plan participants.  The best education is probably oriented toward construction of simple plans to avoid overwhelming low-information investors with poor choices.  It is unfortunate to see plan sponsors mimic brokerages by stuffing flavor-of-the-year mutual funds into 401(k) choices but that's what they are allowed to do to entice interest from their participating employees.

Investors borrow from 401(k) accounts.  Allowing investors to borrow from their own retirement accounts is IMHO one of the dumbest loopholes in American tax law.  Those loans must be repaid with interest to ensure the investor catches up to where their retirement account balance should be if they had never taken out a loan.  Oh BTW, the interest on a 401(k) loan is NOT entitled to the same tax deductibility as a home mortgage loan, so it's a pretty stupid way to fund a home purchase for people who don't qualify for a mortgage.

I would much prefer that the US scrap its entire tax-advantaged retirement system and start over from scratch.  The replacement regime should be very simple.  It should NOT at all resemble Theresa Ghilarducci's Guaranteed Retirement Account plan.  I've criticized that idea before because it's just another way of funding persistent federal budget deficits.  Investors forced to accept such a plan will eventually be prohibited from investing in anything other than government bonds.  Those bonds will eventually pay below-market interest rates and will lose purchasing power after inflation.

My preferred solution would resemble Australia's superannuation accounts system.  A simple system would be the best system.  Investors would be able to put as much of their income as they like into one tax-advantaged account with exactly one product:  a target date fund.  The fund would be structured like the federal government's Thrift Savings Plan and contain only index funds to minimize fees.  Limiting the number of fund components to a handful would still allow for allocations to equities, fixed income, and hard assets (and I'll include real estate and infrastructure among hard assets).  Investors would be prohibited from taking out loans from their superannuation account.  My plan has exactly zero chance of ever being enacted in America because it's too easy to understand.  The national political climate favors complicated solutions that are amenable to financial sector lobbying.  The plan would also completely replace Social Security because it could not be used as an entitlement program or as an accounting gimmick to mask deficit spending.  That definitely isn't going to fly in Washington, DC.  We'll just have to watch our government's entitlement programs collapse during hyperinflation before we see real reform.

I was a financial adviser years ago, and I was very circumspect when I discussed the characteristics of an IRA rollover with prospective clients.  I outlined the advantages, disadvantages, and consequences for their particular situations.  That's precisely why no one wanted to entrust an IRA rollover to my care.  Sharing my knowledge and concern really turned people off.  Human beings won't listen to detailed descriptions of consequences.  They prefer the excitement of wish fulfillment and will trust liars who promise the moon.  Financial advisers who "succeed" in obtaining business from investors doing rollovers are likely to ignore details and lie about consequences; they are human and they pitch to humans.  They tend to use action words like "must, should, ought" to manipulate a prospect into thinking there is only one choice.  This is why I have contempt for most financial advisers and most individual investors.  I find manipulation to be disgusting and I believe FINRA would agree with me.

Nota bene:  Nothing I wrote here constitutes investment advice.  I need to state that clearly in case a bunch of idiots claim I give financial or investment advice.  I do no such thing.  I don't give advice because I don't give a hoot what other people do with their money.  

Alfidi Capital Heard Roger Royse at Idea to IPO's Current State of Crowdfuning

I'm always checking out startup action in Silicon Valley.  The JOBS Act of 2012 was supposed to make that easier.  Performing due diligence online is one thing but actually closing an investment round is quite another.  The Idea to IPO Meetup group presented Roger Royse of Royse Law Firm last week down at Menlo College to give us all a rundown of the current state of crowdfunding.

The JOBS Act was intended to further democratize the venture investment playing field so that securities laws could catch up to technology.  Roger mentioned that the cost of fundraising has dropped in recent years and technology has expanded the types of offerings available.   He's published some good info on crowdfunding at his Royse University site.  The complications for startups raising money through crowdfunding portals can be tricky if those portals are open to any investors other than venture capital funds or angel groups.

The JOBS Act was supposed to make venture investing easier for individual investors but the SEC's rule changes so far are intended to apply to accredited investors.  Roger mentioned that Title III of the JOBS Act for retail investors does not yet have the force of law because the SEC has not yet finalized regulations.

Roger noted that venture capital firms have already begun stigmatizing crowdfunded companies as being otherwise unfundable.  Crowdfunded companies may find themselves in a "market for lemons" if they cannot obtain a subsequent funding round, forcing them to focus on an exit strategy.  I've heard VCs on public panels mention crowdfunding as marginally useful in extending the life of a startup that could fail prematurely, but that is probably a minority opinion.

Companies can advertise on crowdfunding portals for accredited investors now that the SEC has lifted the general solicitation prohibition.  The challenge for startups is that the SEC's rules are still in a state of flux and FINRA is still working on certifying crowdfunding portals that comply with the rules.  The SEC may be considering easing some investor verification requirements.  Roger thinks this environment is why startups need to get more conservative and refrain from discussing their financial status until the SEC finalizes more rules.  Pitchfests in front of investor panels may be considered a general solicitation.

I appreciated Roger's revelation that the SEC now considers a one-time placement fee for locating funding to be a transactional relationship requiring a registered broker.  I used to hear stories from old finance hands about how they earned finder's fees for connecting deal flow to investment banks on a freelance basis.  I had considered doing that myself for a while but I elected not to keep my securities licenses active once I launched into public commentary in 2008.  I was very aware (during my financial advisor days) of the SEC's guidance on public commentary for those who maintained securities licenses and fiduciary relationships.  Assuming a role as public commentator required me to surrender any and all means of maintaining fiduciary relationships or mediating transactions.  There are ways to navigate conflicts of interest but I'd prefer to avoid conflicts entirely.  I don't play games with my career or the law.  All I do now is speak my mind and invest my own money, any way I like.

Roger's talk was awesome and he covered way more legal ground than I can summarize here.  I spoke with him and some other entrepreneurs afterwards on the future usefulness of crowdfunding in such a complex regulatory environment.  I now believe the main advantages of crowdfunding for startups are the reduction of friction in closing deals and the compressed time windows for feedback.  Friction is lower on those portals that have broker/dealer affiliations, because accredited investors can theoretically complete a transaction online.  Feedback times are shorter because a startup can now appear in front of the entire early-stage investor universe simultaneously instead of spending months getting on the meeting calendars of angel groups up and down California.  The speed of feedback from investors, either positive or negative, will help startups pivot earlier if they combine it with feedback from their CustDev efforts.  BTW, I'm still convinced that those portals showing early success in generating deal flow will become acquisition targets for major brokerages.  They will be even more attractive if they add microfinance and P2P lending functions.

I'm already applying some of the insights Roger shared.  I've been attending pitchfest and business plan competitions for years.  I even pitched a tech startup idea myself as an undergrad at the University of Notre Dame in 1995.  I didn't state any disclaimers back then and neither have any of the entrepreneurs I've heard since then.  That is all going to have to change very quickly.  I attended a pitchfest in San Francisco last Friday and noticed that the startups in attendance need to get legal advice, get their paperwork in order with the SEC, and start using legal disclaimers that investors like me will respect.  They also need to be mindful of the FTC's privacy policy guidance if they handle customer data.  Failure to do so can subject them to severe regulatory sanctions.  I care as much about my own portfolio as entrepreneurs do about their startups, which is why early stage founders need to mitigate regulatory risk by keeping top advisers like Roger Royse in their hip pockets.

Full disclosure:  I have received no compensation from Roger Royse, his corporate entities, or the Idea to IPO Meetup organizers for this article.  This article, or anything else published under the auspices of Alfidi Capital, does not constitute legal or financial advice.  

Alfidi Capital in Compliance With First Amendment in Social Media

I'll give my audience another reason why I don't give financial or investment recommendations to investors.  Securities regulators take note of registered representatives' public statements and can use them to resolve complaints against reps.  FINRA issued regulatory notice 10-06 to cover blogs and social networking sites with further guidance in regulatory notice 11-39.  These notices ensure that registered reps do not make public statements that can be construed as investment recommendations lacking in suitability for an investor's specific situation.

These rules don't apply to me for several reasons, as I must enumerate below.

1.  I am not a registered representative, securities firm, broker/dealer, RIA, or any such thing either as a human being or as my business entity Alfidi Capital.  Read my AL-FAQ-DI and Legalistic Disclaimerism if you're confused.

2.  I do not sell securities or investment products of any kind.  

3.  I do not originate or underwrite corporate finance transactions.  

4.  I do not maintain custody of client assets.  I have no clients at all.  

All I do is publish my opinions on financial topics and how those topics affect my own money.  I can speak my mind on finance because the First Amendment protects freedom of speech.  I use social media as much as possible to ensure the whole world has access to my genius.  I have no interest at all in what anyone else on this planet does with their money.  Anyone who does not understand this blog article is a stupid loser.  

The Haiku of Finance for 05/22/12

Regulators look
Facebook debut went poorly
Too many problems