Why the SEC charged me with fraud and the three lessons you can learn from my mistakes

The SEC charged me with fraud because they could, and they were justified in doing so

In 2005, I chose to use a hedge fund to manage a portion of my client’s portfolios because I believed they had a process to protect my clients’ principal while still providing upside growth. Today, I know that promises like that are almost always unrealistic and optimistic representations, unless they are guaranteed through an insurance company.

But back then, I didn’t have full clarity of the risks, and as a result, when Thompson Consulting Inc. (the hedge fund manager) collapsed, my clients and I lost $38,000,000. The SEC charged me with fraud because I did not disclose a material conflict of interest to my clients about how I was getting paid on the investment.

I’m here to tell the rest of the story that may get lost by only looking at the surface. It’s in the rest of the story that we learn the key lessons, including how this experience has turned me into one of the best advisors possible for my clients today.

The following Three Lessons are what you can and should learn before you choose your next financial advisor:

#1: Always find out how (and how much) your advisor is getting paid

The reason the SEC charged me with fraud was not because I lost $38M of my clients’ money with a bad allocation to a shady hedge fund company, but instead because I failed to update my “disclosure document” (called ADV Part II) in a timely manner.

Within this disclosure document, I should have notified my clients that the hedge fund managers agreed to pay me a portion of their performance fee. Thompson Consulting, Inc. (TCI) agreed to pay WealthWise, LLC (my investment advisory company), one-eighth of their profit-sharing fees since we were doing 90% of the servicing, communicating, administration, et al, for our clients who invested in their hedge fund.

We did not know how much we would collect in future profit-sharing fees, but to be fair to our clients, we reduced our normal and typical asset management fee from 1.5% down to 1%.

Now here is the irony: Over the time we worked with the hedge fund, our 1% fee along with the profit-sharing fees from the hedge fund, amounted to the same 1.5% we would have been paid under our regular agreement for assets under management with any of our other third party asset managers.

So even though we didn’t earn any more than we would have if we had invested our client funds more traditionally with other third party asset managers, because I did not disclose the structure of the payments from the hedge fund, I unknowingly committed constructive fraud.

And when the hedge fund closed down, taking my clients’ and my money with it, I was prosecuted for fraud because of this lack of disclosure, not because of the poor investment decision.

My learning through this process was to always disclose exactly how and how much I am paid for every service I provide or recommendation I make. You should ask for that from any advisor you are working with, so you are clear where the money is going and how your potential financial advisors are incentivized.

#2. Ask how your advisor will go to bat for you if something goes wrong

When we found out that the hedge fund lost all of our clients’ money, I could have pleaded the fifth, put my head in the sand like an ostrich and hoped that everything would blow over, but that is not who I am.

Instead, I immediately booked a flight to Salt Lake City, Utah to meet with the Principals of TCI. Upon arriving, I met with another advisor from Arizona, who also had clients in the same hedge fund, and we went to TCI’s Corporate office, only to find their door locked and no one there. I called Thompson’s Vice President, David Condie, who said that I could meet him downtown at 2pm, at his attorney’s office.

At the attorney meeting, Condie essentially said that he didn’t know what was going on because he was on a house-boat trip over the prior few weeks and his partner, Kyle Thompson, the President, was at the helm during the fund crash.

Conveniently, Kyle Thompson was not present at that meeting with the excuse that he was too embarrassed to meet with me face to face.

Condie shared a balance sheet with me which showed my clients had about $2M left in the fund and I instructed him to mail out to every investor their respective share of the remaining balance. Verbally, he agreed to do so.

I left after about two hours of attempting to understand what had happened, but without knowing yet how I was going to help my clients’ recover their investment. What I did know is that I would do everything possible to get that money back.

One of my life lessons as an investment advisor was to share with client’s immediately if something had gone wrong so I called my office manager and instructed her to set appointments up with all of my clients over the ensuing 4 days, every hour on the hour. On the 4th day (a Sunday evening) I was meeting with my last client and we called Condie to confirm that he had sent out the remaining $2M of funds equally to all of my clients as he had verbally promised. He then said, “We don’t have any money at all” and denied ever showing me the balance sheet.

At that point, it became very clear that I was being lied to.

The next morning, I called the National SEC Office and blew the whistle on Thompson and their actions and I was passed off to the Utah SEC Office, where I became their number one provider of documentation which helped the SEC to charge Thompson with fraud, embezzlement, and misappropriation of funds. This occurred on March 4, 2008. For a copy of the SEC Complaint, click here. For a copy of the SEC charge, click here.

As a result of my commitment to do everything I could to get my clients’ money back, I was able to directly help them recover $27M of the $38M which was lost, for an average recovery of 72% of their funds. For additional details, read the other articles linked below.

Bottom line: Ask your advisor — how risky are my investments and what actions will you take if the risks turn into losses?

#3. Ensure your advisor understands your risk tolerance and the risks of their recommended investment products or vehicles

When the TCI Principals first presented their process as to how they would protect our client’s principal while still providing for future growth, we didn’t realize it was too good to be true. It seemed to make sense, yet now I realize that hedge funds are not regulated by the SEC in the same manner as publicly traded stocks or mutual funds, who are mandated to provide clear and transparent reporting on a regular basis to the regulatory authorities.

This allowed TCI the freedom to share with us information they wanted us to see, even if it wasn’t the truth. Every client has a different level of risk tolerance and your advisor should clearly understand what yours is and how to appropriately match your comfort level with the various financial solutions and products that are available in the marketplace.

After going through the Thompson debacle, we wanted to have a clear visual which helps clients understand that they are either making “risk investments” or “safe investments.”

The outcome of our goal was creating a visual that we call the Financial Spectrum, which illustrates to clients that when they invest in traditional stocks, bonds, mutual funds, crypto currencies, hedge funds, et al, that there is always a risk of losing some of your principal as well as not receiving the projected earnings and/or returns presented by the promoters. Gains are not guaranteed.

There are only two types of institutions which can use the term ‘guaranteed’ and those are banks and insurance companies.

In the past, these guaranteed options with banks and insurance companies, provided lower growth potential than the more traditional risk based options.

Luckily, times have changed and today, banks are able to offer much higher rates of returns than they did in previous years. You’ve probably noticed this.

The same holds true for the insurance industry. There has been much innovation in the industry and the designs of their annuity and permanent life insurance vehicles are now able to compete head to head with the more traditional risk based investments, while providing the guarantee that you cannot lose money due to market drops. What this means is that you can now get the same types of returns with insurance companies, without the risk.

We have seen that the traditionally trained investment advisors are typically unfamiliar with these vehicles and therefore will either not recommend them or speak incorrectly about how they work, primarily out of lack of education as to how they work.

At the end of the day, your investment advisor should help you to match your risk level with any financial vehicle solution and its inherent risk level. Today, we only help our clients invest in guaranteed vehicles that are backed by the largest and oldest financial institutions in the world: The Insurance Industry.

This is Article #1 of a three-part series. Here are the other two:

Article #2 — What I learned after losing $38 million of my clients money
Article #3 — How I helped my clients recover $27 million dollars