Never in history have US markets failed to resiliently rebound from a bear market, but, during a bear market, unrecoverable losses typically result from negligent advice, breaches of fiduciary duties, undisclosed conflicts of interest, and fraudulent activity. Warren Buffet is fond of saying, “Only when the tide goes out do you discover who’s been swimming naked.” Let’s look at who has been swimming naked, and the nature of investment losses that are result of financial advisors’ actionable improprieties.
1. Ponzi Schemes. A Ponzi scheme is a fraud that involves inducing one to “invest” in a nonexistent enterprise promising enticing rates of returns. The returns and requests for the redemption of the investment are funded by the money contributed to the scheme by duped investors, and the perpetrator generously helps itself to support a dreamt of lifestyle. Once there is no longer enough money to meet the demands to pay returns and redemptions, the scheme collapses.
While a Ponzi scheme may collapse at any given time, it is more likely to collapse during a bear market. For instance, the Bernie Madoff Ponzi scheme lasted over 20 years, but collapsed during the late 2008 bear market. Ponzi schemes are more likely to collapse during a bear market, because a) investors, who have suffered substantial market losses in legitimate investments, seek liquidity through redemptions; b) there is a paucity of people with available new money to invest; and c) the perpetrator may have lost the stolen money in the market.
In assessing potential avenues of recovery available to the Ponzi Scheme victim, one should not only consider the remaining assets of the perpetrator, but also consider the potential liability of others for aiding and abetting the fraudulent scheme.
2. High-Yield Investments, Leveraged Products and Structured Notes. For well over a decade, safe income investments, such as treasury bills, investment grade municipal and corporate bonds and certificates of deposit, have been paying very modest interest rates. This environment has caused retirees and others requiring streams of income to take greater risk to attempt to meet their cash flow needs. If high interest instruments or junk bonds are recommended, the financial advisor must both understand and clearly disclose the inherent risks of such an investment to make certain that those risks are suitable for the client. In a recession, issuers, which are burdened with debt and impaired by weakened market conditions, may default, attempt to restructure the debt, or go into bankruptcy, causing loss of both the income stream and the value of the debt instruments.
This issue is compounded by products that attempt to increase yield using leverage. During the Credit Crisis, municipal bond funds that increased yield by borrowing against their portfolios to purchase more municipal bonds suffered substantial losses when the municipal bond market collapsed resulting in margin liquidations in a thinly traded declining market Today, closed end bond funds, including business development company (“BDC”) debt funds, which typically use leverage to enhance return, are experiencing losses well in excess of the risk that was suitable for clients expecting safety and income.
Master Limited Partnerships (“MLP”) are publicly traded limited partnership interests in energy focused ventures marketed as an investment that will produce a steady stream of high-yield dividends. Many of the MLPs are burdened with a heavy debt load. When energy prices fall, their financial condition deteriorates, and their continued financial viability and dividend stream are at risk. Closed end MLP funds enhance this risk by using leverage to invest in a basket of MLPs, recently resulting in dramatic declines far greater than the markets at large. The risks of MLPs and MLP closed end funds are rarely fully and adequate disclosed to the investor.
Structured notes are debt instruments that require the issuer upon the expiration date to pay the investor a return based upon a defined formula. These notes result in high commissions and underwriting fees to the securities industry. They are marketed to clients as an opportunity to participate in market gains in a bull market while limiting losses in a bear market. The formulas for the calculation of the value of the structured notes may be complicated, and the characteristics and risk of these products must be carefully understood by the financial advisor and explained to the client. The overriding risk of the structured note is that the issuer lacks the ability to pay the amount due upon its expiration, as was the case with the Lehman notes which collapsed during the Credit Crisis.
If bonds, funds invested in bonds, BDCs, other debt instruments, MLPs or closed end MLP funds are incurring losses greater than would have been expected from investments sold as suitable for an investment objective of income with safety of principal, consider whether the risks of these investments were understood and accurately and fully disclosed by the financial advisor.
3. Suitability, Margin Exposure, and Transactional Costs. Broker-dealers handling non-discretionary accounts are required to make investment recommendations consistent with a client’s circumstances, investment objectives and risk tolerance, to thoroughly research their recommendations to assure that they are suitable, and to fully disclose the nature, risks and fees associated with investment recommendations. In addition to those duties, broker-dealers handling discretionary accounts and registered investment advisors have a fiduciary duty to their clients to act in their best interest.
When the market turns sour, asset allocations not suitable for a client’s objective and risk tolerance become evident. For example, if an elderly retiree had been invested 100% in technology stocks between 1995 and 1999, the returns would have been outstanding, but when the tide turned in mid-2000, it became obvious that the concentration of the portfolio involved far too great a risk and was not suitable for the client’s financial circumstances.
The use of margin is an accelerant, which comes at the cost of paying interest on the funds borrowed to purchase securities. The securities purchased on margin are secured by the value of other securities in the account. If a market decline causes the collateral to be insufficient, the client is required to liquidate securities and/or deposit additional collateral. While the use of margin is intended to increase returns by leveraging equity, in a market decline the margin leverage substantially increases risk. If the use of margin is recommended or encouraged by a financial advisor, it is highly likely that the strategy was unsuitable and should not have been permitted.
Another significant factor that affects portfolio returns is transactional costs, such as commissions, management fees and margin interest paid to the broker-dealer or advisor. Whether an account charges commissions or a management fee, these costs incurred should be reasonable and commensurate with the services provided. The cost-to-equity ratio measures the percentage of the equity in an account consumed by transactional costs. A cost-to-equity ratio of 10%, means than an account’s investments would have to appreciate by 10% before the client would realize a return. Transactional costs substantially benefit the broker-dealer, but as John Bogle noted, maintaining low transactional costs is often the best way to enhance portfolio return.
If an account performance is substantially inconsistent with an appropriate benchmark reflecting the client’s objective and risk tolerance, careful consideration should be given as to whether the discrepancy is the result of the financial advisor’s duty of care.
4. Style Drift. Investment advisors often represent that they employ a certain investment style or strategy. Unless the advisor discloses that its investment style has changed its strategy, it should adhere to the stated strategy. For instance, during the late 1990’s, an investment advisor touting a value style of investment morphed into a growth investment style to increase its performance. Clients who came aboard in early 2000, believing that they would be conservatively invested, suffered Tech Wreck losses.
In the mid-2000’s, an investment advisor represented that it adhered to an investment strategy consistent with the Monte Carlo Simulation looking at statistical long-term market returns. The teaching of this strategy is that, if you panic and get out of the market during declines, you will miss the gains that will follow. In October 2008, the advisor panicked, abandoned its strategy, and liquidated its clients’ accounts. In 2011, the advisor returned its clients to the market after captured the bear market losses and missing the strong bull market rally.
If an advisor veers from its represented investment style and strategy, careful consideration should be given to whether the change in investment style is consistent with the investor’s objectives and reason for selecting the advisor.
5. Private Placements. Some private placements, such as non-traded REITs and promissory notes, are marketed as alternatives to avoid market risk and receive a reliable, predictable stream of interest or dividend payments. In fact, this is materially misleading; they are far riskier than represented. Private placements usually pay high commissions of 5% or more and may involve management and syndication fees of 10% or more. A dollar invested in such a private placement, upon investment, may only be worth 85 cents or less. In a robust economy, over a period of 5 years, the private placement may provide reasonable returns, but when the economy turns south, so does the value of these investments.
Private placements only provide liquidity pursuant to their contractual terms and may require the investor to hold the investment for five years. The ability to liquidate an investment is no greater than the ability of the private placement to fund the requested redemption. To the extent that interest or dividends are promised, oftentimes they are funded from assets of the private placement, rather than earnings. A private placement also may reduce its interest or dividend payments, defeating the reason for the investment. While the price of an interest in a private placement is not set in a publicly reported market, it has inherent value in a secondary market. While you may not see its value decline, its value in fact fluctuates.
If you are holding a private placement, such as a non-traded REIT or a promissory note, look for red flags that the investment is failing, such as the inability to make required payments or honor redemptions or signs of weakness in its financial statements, including the failure to generate sufficient cash flow from operations to meet its obligations.
6. Annuities. In times of market volatility, it is natural that one might think that an annuity offering a fixed monthly payment would be appealing. Annuities, however, have drawbacks which should be considered. Annuities pay high commissions, which often result in high-pressure sales tactics. If an investor needs to liquidate an annuity, the cash surrender value may less than the purchase price. Furthermore, if the annuity is purchased during a period of low interest rates, the annuitized monthly payments may be modest after inflation is taken into effect. Sales tactics may include suggestions to liquidate existing insurance policies with built-up value or securities holdings to purchase an annuity, which may not be in the investor’s best interest.
In the sale of an annuity, careful consideration should be given as to whether the investor fully understood the characteristics of the annuity and whether the annuity meets the investor’s needs and objectives.
If you have questions or concerns about whether your investment losses are actionable or could be remedied, please feel free to contact Glenn S. Gitomer, Esquire (ggitomer@mkbattorneys.com; 610.341.1020), Jean Hanna Bickhart (jbickhart@mkbattorneys.com; 610.341.1019) or Benjamin R. Picker (bpicker@mkbattorneys.com; 610.341.1073) for a no-obligation consultation.