The Florida Bar

A New Perspective to Investing From an Investor’s Rights Attorney

October 13, 2021

Part Three of a Three-Part Series

By Chris Vernon

Part one of this series, published on January 27, 2021 focused on application of a system to determine whether you (or your clients) need to work with an investment professional and, if so, how to avoid working with an investment professional who is not good (unethical or incompetent or both) or not a good fit for you (or your clients). Part two, published on May 28, 2021, followed a similar path, but focused on the investments (as opposed to the advisor), and a system to help you (and your clients) avoid investments and strategies that are not a good fit for you (or your clients).

This final installment is for those who knowingly want to speculate or take outsized risks in an effort to earn outsized returns. Though I am not advocating speculation or chasing outsized returns, this article focuses on avoiding scams and avoiding investments with unnecessary or uncompensated risks if you or your clients want to take the risks necessary to attempt to hit the proverbial “home run.” Following the speculative investment process outlined in this article will reduce the chances you and your clients will suffer a total loss of your investment due to avoidable risks and increase the chances that you and your clients will not unnecessarily limit your returns. You can also listen to the entire CLE presentation held June 9, 2021, which covers all three articles in this series.

Many good investors conduct thorough due diligence with respect to their core investments, but then ignore doing similar due diligence when they take a “flyer” on a high risk investment. This is a mistake. And, due diligence with respect to speculative investing should include the process of elimination of what you don’t want. As we did in parts one and two, we start with the quote from self-proclaimed “philosopher” and pretty good actor, Matthew McConaughey, who contends: “Process of elimination is the first step to our identity (aka where you are NOT is as important as where you are).”

Based on this due diligence process, that includes avoiding what you don’t want, speculative investing should start with objectively identifying what you (and your clients) want to avoid and, based on that determination, seek out strategies and products that avoid those situations. Specifically, due diligence focused on avoiding scams, unnecessary risks, and uncompensated risks will increase your chances of finding more legitimate speculative investments, limiting the unnecessary risks, and maximizing your participation in the upside of the success of any speculative bet you are making. Set out below are some thoughts on how to conduct this component of due diligence on speculative investments that you or your client are considering.

As mentioned above, many investors like to take flyers on a “great idea” that is pitched by someone they meet and like. However, because they know they are speculating, they often fail to do much of their typical due diligence that they employ in their core investments. If you think about it, rather than ignoring the due diligence protocols, the due diligence should actually be greater in this situation. As a result, I strongly recommend extra due diligence focused on, but not limited to, the following concepts: 1. Whether the speculative investment is actually just a scam disguised as an investment; 2. Whether the speculative investment is the best way to invest in the “great idea” you are being pitched; 3. whether this opportunity will result in the maximum potential return for the risk being taken; and 4. Whether the speculative investment is structured in a way that you have the opportunity to monetize your investment. Each of these due diligence concepts are detailed below.

STEP ONE: AVOIDING OUTRIGHT SCAMS WHEN CONSIDERING A SPECULATIVE INVESTMENT

As an investor rights attorney, it is frustrating to talk to investors after they have lost their life savings investing in a scam. Unfortunately, these scams tend to be more believable in the type of economy we are currently experiencing. The stock market is up and real estate is up, so pitches that promise high returns seem more plausible. Additionally, interest rates are low, so fixed income investors are looking for higher returns without exposing themselves to the risks of the stock market. Sadly, these fixed income investors are often pitched certain types of “alternative investments” as safe products with a steady flow of generous distributions that can be used for living expenses. However, these investments often carry the same massive risks as the flyers that other investors knowingly purchase. When you combine these two groups, the amount of speculative investing occurring today is significant and troubling.

Though these scams can cover a wide variety of investments such as art, real estate, cannabis, crypto, etc., the core pitch is often identical. As a result, regulators have checklists on their websites you can follow (I recommend you do) to protect yourself. These checklists will tell you to make sure the salesperson is licensed, stay away from investment pitches that promise high and consistent returns with low risks, avoid investing in secret strategies, and be wary of sales pitches that create a sense of urgency or exclusivity.

Despite regulatory warnings, many investors still fall prey to investment scams. As a result, based on decades of experience pursuing scam artists on behalf of investors, I would add the following pieces of advice for you to consider before investing in something that is not publicly traded or regulated:

  1. Your due diligence should NOT be dependent on a reference or recommendation from a friend or professional. Suspect investments are often sold by scam artists who spend significant time cultivating relationships with credible people and organizations in the community. Scam artists then leverage those relationships to legitimize themselves and the investment they are promoting. Thus, it is especially important to watch out for people who work their way into prominent social circles with a pitch for a great new investment opportunity; and
  2. Your due diligence should NOT be dependent on the pitch from the promoter or salesperson recommending the investment. Many investors who speak with our office after being ripped off acknowledge they relied almost exclusively on what the seller and/or promoter told them. Your due diligence should be concentrated on what you can independently verify or refute regarding the speculative investment being pitched to you.

STEP TWO: VETTING A SPECULATIVE INVESTMENT THAT DOES NOT APPEAR TO BE A SCAM

Deciding that the investment involves a “great idea” is far from adequate due diligence. Most flyers like this involve an untested strategy or product and, as a result, due diligence is admittedly harder, but also more important than investing in a tested and measured strategy or investment (such as buying a bond or investing in the stock of a company that is publicly traded). In determining whether the investment is the best way to invest in this “great idea”, you should carefully and separately consider all the traditional risks of investing that you can think of, including Management Risks, Funding Risks, Market Risks, Liquidity Risk, Concentration Risk, Credit Risks, Reinvestment Risks, Inflation Risks, Horizon Risks, Longevity Risks, Foreign Investment Risks, etc.

One of the risks that I think you should pay special attention to is management risk when taking a flyer on a speculative investment. Management skill, integrity, and experience is especially important because the investment is often not an existing operation with revenues, production, or profits. I see this play out often when the promoter of the great idea really does not have the verifiable skill set, education, experience or historically demonstrated ability to convert a “great idea” to a profitable operation (and sometimes has a questionable background in terms of honesty, ethics, and integrity). Many promoters who I see pitching “great ideas” are great salespeople and may even claim to have the relevant expertise, but you need to do your best to independently verify whether they actually have the skills and expertise to convert the great idea into a profitable venture. Sadly, studies show that instincts are not reliable in the investment world. Virtually every good salesperson appeals to your instincts; they are charming, appear successful, and have an honest face. They are easy to trust. Nonetheless, these personality and physical traits have virtually nothing to do with actual honesty, integrity, competency, or intelligence. Here is the bottom line: Unless the management team can convert the idea to a profitable entity, then you will likely lose all of your money. The best way to determine whether the management team has the potential to turn a profit is to independently investigate their education, experience, track record with other ventures, and ethics. Unless the flyer being pitched to you has a solid and independently verifiable management team, then you should avoid the investment.

Another risk that I think should receive special attention is the risk that the speculative investment will not have enough money to carry out its plan or execute on its strategy. Because many of these flyers are not existing operations with revenues, production, or profits, the ability to fund the operation to the point of profitability or sale is crucial, regardless of good management, good ethics, and a good idea. So many times, I see investors buy into a flyer that has given little thought to how much money will be needed and how that money will be accessed. This is similar to and, arguably even part of, the management skills you want to look for in the team who will be carrying out the flyer idea. Many business experts will tell you that cash flow is the number one determinant of success or failure. As a result, if your flyer runs out of money before it succeeds, then your flyer is highly likely to fail. Unless the speculative investment being pitched to you has a solid and independently verifiable plan for funding to the point of success, then you should avoid the investment.

Although not technically under the category of a specific risks, such as the risks identified above, I strongly recommend you also explore and research alternative ways to invest in this “great idea” separate from the promoter who is pitching you the idea. Though you may be pitched the “great idea” as something totally unique, true independent due diligence usually reveals that there are multiple investment opportunities out there pursuing the same or similar “great idea”. It is pretty rare that no other group or entity is exploring how to capitalize on a “new idea” (e.g. Blockchain, Cryptocurrency, alternative energy, etc.) no matter how innovative it may seem. By looking at the funding, management, liquidity and alternative ways to invest in this “new idea”, you will get a better sense of the best way to maximize the potential upside and minimize the potential downside of making this speculative investment. And, if you find that there are better ways to invest in this “new idea”, do not let the original promoter guilt you into believing you have some obligation to invest with him or her because they first told you about it. You have no such obligation and, oftentimes, this attempt to guilt you into working with them is a big red flag that they are not legitimate or qualified. It is your money and they are not entitled to it based on a claim that they made the first sales pitch to you on this “new idea.”

STEP THREE: VERIFYING THE SPECULATIVE INVESTMENT PROVIDES YOU WITH THE OPPORTUNITY TO BE FULLY COMPENSATED FOR THE RISKS YOU ARE UNDERTAKING

In addition to avoiding unnecessary risks (as well as scams) in making a speculative investment, you should also carefully look at the potential returns to you of investing. Unfortunately, many flyers are designed and structured to primarily benefit the promoters and, in doing so, leave the investor with risk for which they will not fully be compensated even if the investment is a success. As a result, I strongly recommend you carefully analyze what returns or profits will come to you in the event that the “great idea” turns into a great success. For example, is the proposed investment actually just a “loan” you are making and, if so, does that mean that your upside is limited to the interest on the loan and repayment of principal? If so, then you are speculating in a way that your upside is very limited. And, to follow through on this example, is your “loan” collateralized in such a way that you might have some downside protection. Unfortunately, I have seen situations in which the investment is actually an uncollateralized loan in which a promoter is simply using an investors money to try to hit a home run for himself or herself rather than the investor, with virtually no protection for the investor. This is just an example of what I call uncompensated risk wherein the investor is taking significant risks to be part of a “great idea”, but the opportunity to participate in the potential upside of the investment is either limited or, in some cases, non-existent.

STEP FOUR: VERIFY THAT YOU CAN MONETIZE THE UPSIDE OF THE SPECULATIVE INVESTMENT

We often refer to this as avoiding the Hotel California effect, wherein you can check into the investment (invest your money), but can never seem to check out of the investment (get your money and your upside out of the investment). In other words, even if you will be fully compensated for the risk you are taking, you need to conduct due diligence on the “how” and “when” you might be able to monetize the investment in a flyer. Most of these types of speculative investments are very illiquid and cannot be sold whenever you want (like a publicly traded stock). As a result, you need to be provided with (and independently investigate) the plan for converting your investment into return of capital, profits/dividends, and capital gains. To state the obvious, there is a big difference between realized and unrealized gains and the difference can result in extraordinarily different outcomes if your investment is completely illiquid.

Conclusion

By avoiding unnecessary risks and doing your best to make sure you are being fully compensated for the remaining risks, you (and your clients) will reduce the risk of having your financial security being undermined during the latter half of your life.

Remember, whatever it is, let’s make sure our money is working for us and not for somebody else.


About the Author

Chris Vernon is a Naples-based financial litigator who represents investors in financial disputes throughout the United States. He holds an AV rating by Martindale-Hubbell, has been recognized by Florida Super Lawyers and The Best Lawyers in America every year for the past decade. He is also licensed as a Registered Investment Advisor and has testified as an expert on both investment matters and FINRA arbitration matters.