Personal Story on Why We Do This

There is an old joke about three general contractors that die and go to heaven. St. Peter welcomes them and asks for a favor. The pearly gates to heaven are broken could each of them provide an estimate for the repair. The first contractor from the Midwest, looks over the gates thoroughly and tells St. Peter it will cost $300; $200 for parts and $100 for labor and the gates will be just like new. The second contractor is from San Francisco, he spends a couple minutes looking over the project and mentions to St. Peter how busy he is and if he needs it done right away it will cost $3,000; $1,500 for parts and $1,500 for labor. The third contractor is from New York City and without looking at the gates he says $2,300. When asked how he determined the price the NYC contractor responds - $1,000 for you, $1,000 for me and $300 for the guy from the Midwest to do the job. 

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While humorous, the joke essentially describes how much of the investment business works. Many years ago, Wall Street firms figured out if they wanted to grow their business it was more effective to raise the price and bribe the financial advisor to betray their clients rather than do a good job managing investments. Since I've started writing these letters, I have reviewed several reader’s financial plans and have found the same issue over and over. Their advisor charges a fee for financial planning services and then is prescribing high fee products where they receive another large commission. They are supposed to be acting in your best interest, instead, they are double-dipping and padding their bank account instead of yours. A lot of people go to the biggest financial firms thinking they are getting the best and brightest in the industry, when in fact it’s the worst possible place.

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"If you see fraud and do not say fraud, you are the fraud" Nassim Taleb

A few years ago, I was invited by my in-laws to attend a dinner and presentation by their financial advisor.  Their advisor had a new investment opportunity in a real estate company that he wanted to share.  Because I owned a rental house at the time and was looking to purchase another, they thought I too might be interested in their advisor's idea.  Prior to the meeting, I printed off the notes to the company's financial statements (the ultra-boring fine print in the SEC filings), which is where the real information is found.  As an investor, I find digging into footnotes invaluable, and well… almost not boring.  What I discovered in a few minutes of reviewing the footnotes was shocking.  I read aloud some of the details to a co-worker and asked, should I cancel and not attend the meeting?  Or should I go and point out what looks like fraud and possibly save a dozen other families in attendance from a financial disaster?  My co-worker recommended I should go and do my good deed for the day.

 

I arrived early and was greeted enthusiastically by the advisor; we made small talk about this exciting idea he wanted to share.  Once the group had gathered the advisor and a representative from the real estate company began their presentation.  It started with some nonsense industry jargon about the "efficient frontier" and the benefits of "diversification". It was quite clear they were trying to establish credibility on a subject they knew nothing about.  The representative then discussed how his company was going to make everyone lots of money and pay a "6% tax-advantaged dividend."  At that moment the room full of retirees lit up. Desiring safe income in a world with inadequate interest rates, I could see they were all sold.

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But now it was my turn, and by this point I was Samuel L. Jackson in Pulp Fiction quoting-Ezekiel 25:17 angry. I interrupted the advisor and representative and asked for their fee on this "investment." They replied, "12% but we'll make that back for you right away." I pulled out the footnotes and read them aloud to the room.

1. Load fee for initial purchase - 12%
2. Shareholder servicing fee - 1.125%
3. Management fee - 1%
4. Acquisition Expense Fee to Management- 6% of property contract price
5. Acquisition Fee - 2% of the cost of the property
6. Loan Coordination Fee - 0.75% of the loan amount
7. Construction Manager Fee (for oversight of the construction manager) - 6% of the total cost of work
8. Property Management Fee (for oversight of the property manager) - 1% of property management costs
9. Property Disposition Fee - 1.5% of the property price
10. Subordinated Participation Fee - 15% of the net proceeds after return on total investment
11. Listing Incentive Distribution - 15% of total market value upon public listing

I let everyone know this real estate project has been fully occupied for years and has not turned a profit because the managers had their hands in the company till. I then asked the representative since the managers were also the Construction Manager and Property Manager why the shareholders needed to compensate them to supervise themselves. I also inquired as to why they had a cease and desist from soliciting investors in Ohio. The advisor and company rep tried to shut me up by asking to speak privately, but I wasn't finished. I informed everyone in the room the "6% tax-advantaged dividend" is merely them sending a portion of their own money back and we were here  today because they needed an influx of cash to keep this scheme going.  Sometimes the footnotes are juicer than a day-time soap opera.  Sensing I was no longer welcome, I told the advisor that I would be having a chat with FINRA, ordered a steak and two bottles of wine on his tab, and then hit the road.

The real estate company was investigated by FINRA and unfortunately the outcome was not disclosed. The moral of the story: if all the details are in the footnotes its okay to hide behind "buyer beware."

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When my in-laws fired their financial advisor, I became their impromptu investment consultant. In helping them, I uncovered my true calling, and a future business was born.