Why All The Angst About Public Solicitation?

Written By: Phil Feigin

Without much fanfare, Mary Jo White’s reign as chairman of the Securities and Exchange Commission has begun in earnest. The first regulatory Gordian knot, of the sort that stymied Mary Schapiro’s Commission into an administration with all the innovation of Herbert Hoover’s presidency, has been untied. Ms. White’s SEC proposed new rules to govern money market funds. It well might be argued that the seeds of these consensus proposals were sown a year earlier, when Ms. Schapiro championed bold reform efforts in the face of ardent opposition.

The Commissioners’ consensus and unanimous vote on the money market fund proposals beg the questions:  how many more regulatory logjams at the SEC will be broken, and when? Will the JOBS Act initiatives be next? Will it be crowd funding (the purist in me still precludes me from treating it as one word), the populist and ill-conceived notion for bringing capital formation to the common man—a financial version of the hula hoop and pet rocks (about as useful but much more dangerous)? I doubt it.

Or will it be the change called for in the JOBS Act that the professionals are waiting for, the Congressionally mandated SEC amendments to Rule 506 to allow public solicitation to verified accredited investors? While crowd funding drew a lot of consternation from regulators and consumer protection activists, it is the prospect of public solicitation of Rule 506 deals that is of greatest concern. This is where the real fraud and harm will be centered.

Entrepreneurs and their counsel view the regulatory resistance to public solicitation as some troglodyte, Neanderthal, mindless, Flat Earther reaction to innovation and positive change. Allow me to peel some layers off the onion to explain my concerns (my law partners will never accuse me of having left my regulatory roots far behind). Perhaps these concerns are representative of those of my former colleagues in the investor protection trenches.

First and foremost, regulators only see the worst of the worst private placements. They see them in investigations and enforcement cases. Without any scientifically validated evidence to support the conclusion, any enforcement guy will tell you there is an uncanny correlation between private placements that are being publicly solicited illegally and those rife with abuse and fraud. QED—show them an unregistered deal being publicly solicited and you show them a fraud. That connection has been hard-wired into the enforcement DNA for more than 100 years.

Second, anyone can make a private placement offering. Anyone can pull down a PPM from the Net and edit it to fit their deal. They do not need the resources necessary to register an offering, to deal with the lawyers, accountants and broker-dealers and the regulators. All they need is a computer and an Internet connection. As a result, in addition to fraudsters, shaky private placement offerings can also be made by starry-eyed entrepreneurs who have no hope of succeeding in anything except perhaps convincing some other unsophisticated people they can turn their dream into profitable reality. Whether to a bungling amateur or a slick con man, lost life savings can be just as harmful to unsuspecting victim investors. Enforcement personnel have to deal with all too many errant dreamers who publicly solicit too.

Setting those very real, experience-based factors aside, the real core issue is that the long-standing limitation imposed on private placement issuers allowing them to solicit only those persons with whom they have a pre-existing business or personal relationship carries with it a sense of issuer maturity, of seasoning. Only those issuers who have developed a loyal following of persons over years, people who know them, whose trust they have earned, and are willing and able to support their capital needs based on their history of success and accomplishment, are those issuers who ought to be raising money through private placements. That’s the way it’s supposed to work.

On the other side of the coin are the entrepreneurs, particularly those less established entrepreneurs, who believe to the last fiber of their being that they will succeed in raising the capital they need if only given the chance to publicly solicit. Nature of the beast. They believe that, given the opportunity to share their ideas with others, these strangers will be convinced of the prospects as well, and will support the entrepreneur’s efforts. Sure, the entrepreneurs are willing to make disclosures about their ideas, just as long as they don’t have to pay lawyers to put together a private placement memorandum no one reads anyway. But a prohibition on reaching out to people who might want to share in the dream is downright un-American. But for the prohibition, their dream could become reality and all involved would benefit. [1]

I have long supported Internet-based matching services where potential issuers can post their ideas for vetted angels to peruse undisturbed at their leisure. Those who wish to pursue investing may contact the issuer directly. That should not constitute “public solicitation” for Rule 506 purposes and the website hosts should not be classified as broker-dealers when they take an equity stake in the funded companies. The JOBS Act pretty much mandated implementation of both ideas, and those changes are long overdue.

That said, very few deals at any level are sold on the basis of disclosure information sitting on some website waiting to be perused. There is an old adage that securities are not bought, they are sold. That means brokers, salesmen, guys on the phone pitching, and pitching hard. It is here I predict the private placement enforcement cases of the future will lie:  unregistered brokers and agents and their fraudulent solicitations.

As a general rule, issuers make lousy securities salesmen. It is the track record of the seasoned, successful issuers that attracts their loyal following to their next deal. Any sales effort is minimal. If those issuers had to expand their market to solicit new, unknown prospective investors, their chances of failure to raise capital would soar.

Issuers don’t want to sell their securities, they just want the money. It is natural that they have in the past and will in the future turn to those who are in the business of selling. The JOBS Act did virtually nothing to amend the Securities Exchange Act of 1934 or Rule 3a4-1 in this regard. Those who engage in the business of selling securities are and will continue to be brokers.

The SEC has been uncharacteristically active of late in pursuing unregistered broker cases. Further, and ironically, the opportunities that will be presented by the ability of issuers to publicly solicit for accredited investors coincides with the advent of the most extreme restrictions in decades on registered broker-dealers getting involved with private placements.

In the wake of several recent, highly visible, national private placement frauds, many broker-dealers that were willing to market private placements that (perhaps unwittingly) marketed the fraudulent securities went out of business. Those that continued to market other private placement issues have been faced with intensive regulatory examinations and skepticism. More recently, FINRA has imposed its Rule 5123, requiring much more of broker-dealers that elect to market private placement securities. With the ranks of those firms willing to market private placements thinned by attrition, these new factors are not likely to help replenish the ranks and attract member firms to the private placement market in the future.

That leaves us with the rogues. Private placement issuers that turn to public solicitation in the absence of a ready market for their securities will find out quickly that merely posting the opportunities on websites, or advertising in newspapers, or even via spots during Star Trek or infomercials between late night movies will not attract the investors they need. That is when some will turn to the “placement agents,” “finders” and the like who, through their own websites and other ads, purport to have access to eager accredited investors for private placement issuers. There are far too many of these illicit operations and operators out there today. Their numbers will only increase once the new Rule 506 public solicitation rules are effective.

There is no bright line test to separate those few legitimate, true finders from the far more common illicit, unregistered brokers. It will take a massive diversion of resources for federal and state securities regulators even to make a dent in the hoard of illegal operations and operators who are bound to spring up. Fraudulent private placement issuers will use their own pitchmen. Unsuspecting issuers will retain unregistered firms, and hire unlicensed people to sell their offerings in even greater proportions than they do today. Enforcement efforts will have to be far more “after the fact” than the tripwire that mere public solicitation is today.

Advocates of limited regulation have used the requirement that the SEC conduct a cost-benefit analysis prior to promulgating rules to great advantage in testing and defeating SEC proposals of late (would that legislation enacted by Congress was subject to the same analytic gauntlet.) Contrary to the belief of some entrepreneurs and their market advocates that, but for the ban on public solicitation, they could find investors for their private placement offerings, I fear the lifting of the ban will precipitate far more illicit conduct and investor losses to fraud than any legitimate investing, let alone job creation. Professional investors are not likely to be located by means of ads, cold calls and websites. And make no mistake—there will be a flood of such solicitations. True investors find their investments through networking, through trusted channels of people with whom they have dealt for years. The fraud that will trace its roots to now allowed public solicitation of purported Rule 506 deals will far outweigh any benefit derived from allowing it. The extent of the fraud will boil down to how long public solicitation is allowed before everyone comes to their senses.

[1] However, I note that, in my 34+ years of securities regulation and practice, not once has an investor called and complained to me that they could not find an investment to invest in.


Sometimes The Regulated Obey More While The Regulators Could Care Less

Written By: Phil Feigin

After spending 20 years in state securities regulation and enforcement, I would have supported a law making the sale of a security a felony. In 20 years, no citizen had ever called me to report they had made money investing. Everyone lost. In call after call, letter after letter, one investor after another complained of investment deception, fraud and abuse, at the hands of a brokerage industry that was nothing more than a band of corrupt swindlers. Losses incurred in private placements—especially Reg. D, Rule 506 deals—showed they were the work of the devil. From my perspective, the lawyers who represented these guys were all crooked aiders and abettors. Abject cynicism and universal suspicion borne of all this were hard siren songs to resist.

Helping me temper those extremes and gain some balance was my experience as a state regulators’ liaison to the State Regulation Committee of the Business Law Section of the ABA for several years. Attending ABA meetings and otherwise interacting with committee members gave me a broader perspective on regulation and the professions we were charged with overseeing. The state securities law practitioners who participated on the State Reg. Committee were from some of the most highly respected and sophisticated firms, dealing (for the most part) with legitimate and worthy clients. Not quite the “clientele” I dealt with back home.

The experience opened my otherwise myopic eyes to the possibility that, every once in a while, it was the regulators who were screwing up and not the regulated. I dare say that my participation and that of the state colleagues who attended meetings with me opened some private sector eyes as well to problems confronting state regulation. It is unfortunate that, generally speaking, NASAA (the North American Securities Administrators Association), state administrators and others have not attended the State Reg. meetings in recent years. In my view, both the state regulators and the Bar and the public we serve would benefit greatly from the interaction.

State regulators may not realize the extent to which the legitimate private sector goes to comply with laws and rules, even some laws and rules that the regulators themselves might not view with much priority. I find it ironic that the industry is often much more worried about complying with some regulations than are the regulators themselves. I’ll cite three examples.

Form D.  Before enactment of the National Securities Markets Improvement Act (“NSMIA”) in 1996, I think most regulators made sure the filing fee check that came with Form D cleared, and then threw the forms in some dark room, never to be seen, let alone referenced, again. More attention to the Form has been paid since 1996, but at least in most states, not all that much more. Yet many an associate and paralegal have sweated bullets trying to get the darn things filed correctly and on time. Maybe I’m speaking out of school, but with the exception of a few states, Form D remains more of a pain to states and the SEC than of any significant regulatory benefit. The Recession may have changed that a bit from a state revenue perspective, and it will change even more substantively after the JOBS Act Rule 506 changes kick in, but generally speaking, I think the Bar takes compliance with Form D filing requirements a lot more seriously than most state regulators and the SEC take them. For the regulators, it has been more of a pain than it’s worth.

The Model State Commodity Code.  I have written on this subject elsewhere so I will not belabor the point. Suffice to say that the 19 states with the Code in one form or another have all but forgotten it exists, while precious metals companies around the globe struggle still to comply with its outdated restrictions. This is another case where the private sector spends much more time and energy complying with regulations than do the regulators enforcing them.

Brokerage Registration and Licensing Requirements.  Show me a Merrill Lynch or UBS broker who is detected doing business with clients in a state where he/she is not registered or licensed, and BLAM, the regulators will come down on him, his supervisors and his firm like a ton of bricks, with demands of refund of commissions, perhaps adoption of enhanced supervision, a consent order, and maybe even a fine to boot. However, show me an unlicensed “finder” who makes a living brokering private placements and hedge funds on commission or locating merger/acquisition partners and helping to negotiate the deal for a “success” fee, and, absent fraud, the regulators are nowhere to be found, even if the brokers advertise. Meanwhile, issuer counsel tears his/her hair out trying to convince otherwise lawful issuer clients that these unlicensed people are far more than “Paul Anka” finders, are acting in clear violation of the law, and, in many states, it is also illegal for the issuers to hire them.

Several committees of the ABA have been working to get the SEC and the states to adopt a system of “merger broker” and “private placement broker” regulation for years, but without much success. I think the lack of action from the regulators is due, at least in part, to:

(1)     many other and higher regulatory priorities;

(2)     a general lack of complaints of fraud; and

(3)     the realization that if the regulators adopt such a new regulatory regime, they will be forced to come down hard on those who fail to comply thereafter, which circles back to Point 2 and an unwillingness to devote scarce enforcement resources to pure licensing/registration cases.

Now comes the JOBS Act and crowdfunding, or more accurately, the prospects of securities crowdfunding and funding portal regulation that will be part of the rules once promulgated. Investment crowdfunding hopefuls all over the country are chomping at the bit to get started, clamoring to be the first with the most. However, for better or worse, JOBS Act-style crowdfunding is currently, entirely and undeniably illegal, as is serving as a portal.

Here I am advising clients, people who want to be legitimate players in the crowdfunding marketplace, to hold their water until the rules are finalized and effective and they are in full compliance with them. The SEC and state regulators both have warned those who want to crowdfund against gun-jumping because crowdfunding isn’t legal yet. Even so, the number of Internet sites whose sponsors appear to be serving as funding portals facilitating crowdfunding of offerings NOW, as we speak, brings to mind those early kinetoscopes of the Cimarron Strip land rush. These sites and companies appear to be openly ignoring the law and the warnings, yet there’s nary an injunctive action or cease and desist order anywhere to be found. Again, most in this embryonic market sector are dutifully obeying the law and biding their time, even though it seems the regulators could care less, seemingly occupied elsewhere.

Unregistered private placement and merger brokers have proliferated to such an extent that they have all but achieved an air of legitimacy through regulatory neglect. The regulators need only peruse the Yellow Pages or Yahoo to find a career’s worth of unlicensed miscreants. Now, it’s happening all over again with investment crowdfunding. It’s getting harder and harder to convince clients it is the wrong way to go.

Bachus Bunkum

Written by: Phil Feigin

It’s August, and that means football is back! We have had but one pre-season game to date, the Hall of Fame game, but it was from the halls of Congress, not the gridiron, that we saw the launch of the first “Hail Mary” pass of the year. The op-ed piece written by Chairman Spencer Bachus (R-Al) in yesterday’s Wall Street Journal, “Financial Advisers, Police Yourselves” made this loyal Broncos fan yearn for the days of Tim Tebow. Even Tebow’s passes were more accurate than the good Congressman’s desperation heave to revive his moribund investment adviser SRO bill.

I could hardly believe what I was reading. Rather than lift his voice and assert his Chairman’s authority to support enhanced, targeted funding for more SEC investment adviser inspections, at no expense to taxpayers, Bachus urges the profession to cough up millions more in fees to “police itself,” to create its own self-regulatory organization, or, more plainly stated, line FINRA’s shrinking pockets with a newfound membership base.

Bachus and his ilk would rather we rely on a private club of overpaid mercenaries than fulfill the government’s responsibility to provide basic protections for its citizens. On that logic, let’s cut funding to the EPA. After all, the Gulf spill happened on their watch, didn’t it? We should let the petroleum industry police itself. And the FDA and phen-fen, and the FBI and 9-11. His argument is simply ridiculous.

In support of his misguided proposal, he and his supporters wave the “bloody shirts” of Bernie Madoff and Alan Stanford. Bit it was the NASD/FINRA that last inspected Madoff. And don’t give me that tripe about FINRA lacking the authority to look at the adviser side of Madoff’s operation. Ask any broker with his own IA in a FINRA exam how much information he is required to provide to them about his RIA business. (Think colonoscopy.)

And as for Stanford, yes, the SEC could have acted sooner, but it wasn’t all out of lethargy and not caring. The Congressionally mandated barrier to the SEC getting involved in the activities of banks (at the urging of the banking lobby) must account for at least some of the SEC’s reluctance to pursue the matter earlier and more aggressively. And oh, didn’t Stanford operate a FINRA member brokerage firm?

And let us not forget the stellar work of the National Futures Association, another broker-dominated SRO, in uncovering MF Global and Peregrine before any harm could befall their customers.

Further, Chairman Bachus cites to the Madoff and Stanford disasters rather than the thousands of scams-in-the-making uncovered by state and SEC adviser inspections over the last 72 plus years, and without an SRO.

It may be a dirty little regulatory secret, but inspections are not the be-all and end-all of regulation. They help detect problems, but they are not foolproof. Brokerage firms are required to inspect branch locations regularly, with searching for evidence brokers are selling away from the firm high on the priority list. Protection of the firm’s own checkbooks are on the line. Even so, dozens if not hundreds of selling away cases come to light every year.

Inspections are regulatory tools with an enforcement side effect. Inspections, exit meetings and follow-up deficiency letters are designed to help industry professionals better comply with statutes and rules. Sometimes you get lucky and uncover a fraud, but that’s not common. Crooks are crooks, and are very good at doing what they do, at least for a time. Once in a rare while, they can pull it off for years. A crook’s success is often due in greater part to weakness in the statutory and regulatory system, not the lassitude of regulators.

Instead of adding another SRO, the debate ought to be whether we need any SROs in today’s market. FINRA has evolved into nothing more than a private police force. Give the same authority and even half its resources and personnel to the SEC and state securities regulators, and brokerage and advisor misconduct would be pulverized.

If the lake is flooding over the dam into the valley, you don’t tell the villagers to hold a bake sale and buy their own bricks. The town council finds the funds to build up the dam for the benefit of all. I don’t want some private security service trying to protect me and my loved ones, I want real police, well staffed, trained and funded. So should everyone. So should Spencer Bachus.

So What Was I Supposed To Do?

Written by: Phil Feigin

A precious metals dealer client of mine called me late Monday afternoon, July 9, 2012, all in a tizzy. He had just received word that all accounts at PFGBest, the futures broker his company uses, had been frozen, and he needed advice on what to do. He added that he had just gone through a similar experience with their last broker, MF Global. I got as much of a handle on things as I could and advised him there wasn’t much for him to do at this point but wait for word from someone in charge, along with all the other PFGBest account holders.

Another fraud and scandal.

This week’s version is the PFG story, as we witness the previously microscopic Cedar Falls, Iowa, life of Russell Wasendorf Sr. being blown up exponentially on the financial world’s big screen. Along with it, we see the typical frustration inherent in the hunger for instantaneous information and clarity where there is none to be found. There are far more questions than answers, a scrambling for hard facts, and in their absence, innuendo, suspicions, and potential conspiracy and intrigue, and inevitably, but in this case a bit ahead of schedule, the recriminations, finger pointing, and harangues of regulatory failure.

What we know as of this morning is that a relatively prominent veteran of the futures industry lies in a coma in a University of Iowa hospital after what appears to be an attempted suicide. PFG’s accounts at U.S. Bank, the custodian for his firm’s client funds, are about $215 million south of what they are supposed to be holding. It is pretty clear Mr. Wasendorf Sr. fiddled with financial holdings reports and U.S. Bank account statements sent to the National Futures Association (NFA). Fueling contempt for regulators, there is some tantalizing indication that in early 2011 the NFA received word that PFG accounts at U.S. Bank held around $10 million—hundreds of millions less than was supposed to be there. However, when the NFA asked for clarification, they received a fax purported to be from the bank verifying the higher holdings. There is now suspicion the fax came from Mr. Wasendorf, not the bank. A bank employee is under investigation for potential complicity.

My client may well ask me, “So, what was I supposed to do?” He was not dealing with some unregistered outfit in Fort Lauderdale or Newport Beach he found on Yahoo. MF Global, and now PFG, were fully registered, regulated, long-established companies run by pillars of the industry. The law decrees that client funds must be segregated from firm money, held in trust, supposedly at independent, third-party custodian financial institutions. Everything was supposed to be overseen and audited by self-regulatory organizations (either the exchanges or the NFA) and the Commodity Futures Trading Commission. What more can you do or ask for?

From my client’s standpoint, my answer has to be, “Not much.” It’s tragic and appalling when time-tested, systemic protections collapse. Reactions are predictable. The regulators and those who believe in and support strong regulation will assert the regulators did all they could. The guy was a clever crook, it was a conspiracy, and there was no reasonable way to discover it earlier than they did. The system did work, in that the fraud was uncovered before he could do more harm than he had already done. Perhaps if they had stronger laws and more resources, they could have discovered the fraud sooner.

The detractors of regulation will assert the laws are fine as they are and the regulators have plenty of resources; they were just incompetent and dropped the ball. At the same time the fraud at PFG was being perpetrated, there were hundreds of thousands of transactions conducted at thousands of commodity brokerage firms across the country in a perfectly lawful manner. Those firms and all the honest professionals who work at them should not be tarnished and made to suffer more unnecessary regulations because of one crook in Iowa and regulatory shortcomings in detecting his fraud.

There will be the hearings, reports will be demanded, some sordid details will come out, the trustee in bankruptcy, trustee’s counsel and forensic accountants will make lots of money, anyone who received back more than they deposited will face clawback suits, account holders will get back X on the dollar, and we will eventually move on when the next catastrophic financial scam surfaces.

As I see it, there is some validity to all of these reactions. My client did his homework and did business with the kind of firm with which he was supposed to trade. Fraud and conspiracy to commit it are pernicious, underhanded crimes. You can only do so much to protect yourself from some things, like having your home burglarized, being hit by a drunk driver, being mugged on a busy street, or losing money to a criminal at a respected institution. Crooks are crooks, and they are the reason we have crimes, prosecutors and prisons.

On the other hand, I was surprised to see how easy it appears to have been to convince the NFA there was money in the bank. In this day and age of instantaneous electronic communication, how hard could it be to require each futures commission merchant (FCM) to report to some regulatory computer their custodial balances electronically, along with the clearing house settlement process after each market close? Wouldn’t it simply be another encoded transmission? Further, FCMs already identify their custodians to regulators. How hard could it be for the regulators to provide confidential codes to custodian banks, and have an electronic report on custodial balances, marked to market, sent to an NFA computer at the close of every business day? The computer would match balances and kick out any discrepancies. A discrepancy north of $100,000 would generate an official inquiry.

I’m not a back office guy, so perhaps what I suggest is already in place, or harder to institute than discovering the Higgs boson. Maybe the NFA proposed doing it, but the industry fought back because it would be too expensive. Maybe some clever computer guy at the bank could figure out a way to game the reporting system.

Maybe pieces of all of that.

I remain firm in my conviction that the surest way of preventing and detecting financial fraud is a two-pronged device. First, an independent, third-party custodian must be positioned between those who are supposed to be investing your money and those who are supposed to be holding it. Second, the custodian must provide reliable reports directly to those with an interest in protecting the sanctity of those custodial assets—either the client, regulators, or both—and those reports must be diligently reviewed, with discrepancies acted upon promptly and effectively, in direct communication with the custodian.

From initial reports, it appears the NFA was in the process of implementing some form of electronic reporting directly with the bank. That triggered the ultimate discovery of fraud at PFG. That’s a good thing, but apparently too late to help my client and his fellow account holders. What seems very, very bad for the NFA is that even when their earlier reporting system succeeded in detecting the gross shortfall at PFG more than a year earlier, in early 2011, the “fire alarm” could be turned off with nothing more than a fax—a form of communication that in this age of so many more forms of direct communication, seems about as reliable as a smoke signal or a whisper around a campfire. How did they know the fax even came from the bank? It could have come from anyone with a sample of U.S. Bank letterhead, word processing, an Internet connection, and a telephone number. Sadly, it appears it did. Someone at the NFA bought it. Perhaps the story will change as more as learned. But if it doesn’t, not good.