Journal of Financial Planning: September 2019
interview by Carly Schulaka
WHO: Walter Clarke
WHAT: Author, speaker, consultant, former RIA firm owner
WHAT'S ON HIS MIND: “You’re never going to be able to avoid the examination … . What’s avoidable is what happened to me.”
Editor’s note: Walter Clarke reached out to the Journal a few months ago with an article idea—he wanted to share his story of mistakes and redemption with the financial planning community. His rapidly growing RIA firm was examined by the SEC in 2008 and 2009, which led to an enforcement action resulting in what he calls a “massive” fine and two-year ban from the industry. It was all gone: his firm, his reputation, and the life he knew. The process of “owning” his mistakes inspired him to empower others to not make the same mistakes he did. His forthcoming book, Ultra Rich, Ultra Poor, explores how creating wealth and maintaining wealth are different skill sets.
1. You have an important story to share with fellow financial advisers. Let’s start at the beginning. How did you get into the investment business?
My career as an adviser started in 1995 with Merrill Lynch. I soon learned that bigger firms were super restrictive in how they served their clients. There was a heavy push to promote the company’s products.
After a couple years at Merrill Lynch, I moved to a small firm. From there I migrated to a hybrid platform, which was like owning your own firm, but with the support of a bank and a larger organization. My long-term desire was to have my own firm, and I thought that this hybrid platform offered a good balance of small-firm flexibility and large firm support, but it didn’t work. In the economic downturn, the cost model was fixed. I didn’t have the ability to cut expenses and do the things necessary to run the business in the downturn of 2000 to 2002.
2. What inspired you to start your own firm in 2003?
It was twofold. One was the cost structure model at the former firm I was with; it just didn’t work.
The second piece was my educational program that I ran in partnership with universities. It attracted an interesting clientele to my business. Higher net worth clients sought me out because I came from an educational perspective.
The needs of families that have over $5 million are different than families that have $5 million or less. I needed to be able to facilitate and have a conversation around real estate transactions, which, inside the broker-dealer world are incredibly limited and very expensive. More affluent families typically have some component of real estate inside their allocations, and I was always uncomfortable with the high-cost Wall Street products that pay high commission and have high fees. My business was really geared toward more of a multifamily office and my desire to bring institutionally priced products to the high net worth retail investor.
3. Tell us more about this educational program. And, did this focus on education help your firm grow?
It actually happened by accident. Back in 1998, I was having lunch with a gentleman who had owned 11 car dealerships; he had sold them, and he considered his new business to be investing. He knew everything about the car business, but nothing about the investment business. He was frustrated by the language and the terminology. He told me he wished there was a place where he could just learn, where nobody would make any assumptions about what he knew about investing, and they would start out at a basic level and systematically walk him through a process that could educate him so he could have an intelligent conversation with his advisers.
I took that idea and ran with it.
High net worth people don’t want to be sold; they want to be educated. Some advisers see people with a lot of money or who have a liquidity event, and they immediately want to rush out and talk to them about a solution. That’s actually the wrong thing to do. Instead, ask them about their problems, concerns, pain points, and what’s bugging them about the process. They will be very candid with you about what you can do to help them as they transition from a business into their new business of investing. So, that’s really what the class was.
We partnered with a university and we charged for the class. There was no free dinner and no sales presentation. We didn’t tell people you should do that or shouldn’t do that. We just educated them; we showed people how to interact with their advisers.
The single biggest frustration that people in my class had about their advisers was, “He doesn’t listen. He talks over me. He thinks he knows.” So when you provide a service and you answer questions that people don’t even know they have, you build tremendous credibility. And in that environment, people self-select. They will either refer you business or solicit you to help them, given what they’ve learned.
4. You have said that one botched transaction changed the course of your life, business, and career. What happened?
I started my own firm because I had high net worth individuals as clients and we wanted to have the freedom and flexibility to tailor products and alternatives to our clients’ objectives. One thing I discovered is that many investment advisers are wary of illiquid real estate investments. Many advisers just do stocks and bonds, and yet real estate is a massive wealth creation vehicle. To ignore that, I think is wrong. Instead, I embraced it.
We provided our clients real estate equity investment opportunities, and we also did real estate debt financing. We invested in first trustee deeds secured by real estate. We even started a mortgage brokerage company. I did this to try to improve our clients’ pricing by allowing our investors to go “direct” rather than pay originator markups. Becoming licensed as a mortgage broker would allow us to originate loans within our existing fee structure and pass the wholesale pricing to our customers.
Unknowingly, we entered the danger zone. First, when we entered the mortgage business, we were in a completely different arena—principal transactions. The other real estate investments we did for our clients were agency transactions. Now we were a principal providing a new service to our clients.
But we didn’t do it right. We received what I consider to be poor advice about the risks associated with entering into principal transactions. We didn’t really understand [principal transactions], what the disclosure requirements were, and what the regulatory risk was.
Second, I got carried away and bought a big house in the middle of 2007. I took on way more debt than I was comfortable with. So, I wanted to pay down some of my debt. I looked around, and my business was doing so well that I decided to sell part of my firm to raise some liquidity. Three investors were part of the transaction, including a client of the firm.
Looking back, I should have never done that. Any time you do a transaction that involves a client, it’s going to come under scrutiny. Even though the investment was a small amount in the client’s overall portfolio mix, and there were many reasons to suggest that it was prudent, any principal transaction should be approached with caution and expert advice. My peers need to understand that when you sell your ownership interest to a client, you have a conflict and it doesn’t matter if the transaction makes business sense—it’s a compliance issue.
I didn’t fully appreciate what that meant. At the time, the firm was about five years old, and we’d never had an SEC examination before. I knew that this [sale] would be one of the first things regulators would look at, so I instructed the staff and the attorneys to make sure it was papered correctly. In fact, we were examined in 2008—just months after these transactions—and that examination went really well.
Then, the SEC came back in 2009, at the depth of the recession, and re-examined us.
Our clients had significant real estate investments, and the SEC wanted to make sure we properly marked those real estate assets on our books and could show who held custody. The 2009 examination was very different from the first examination. We could tell that the auditors had an issue with this particular transaction [that involved the client] and it just continued to escalate.
However, I was in “la-la land.” I thought: they examined us in ’08, and it was okay; the client didn’t even make a complaint. These were just compliance details.
I was wrong. We made disclosure mistakes and did not take the extraordinary steps you need to take in a principal transaction. I didn’t get the expert advice I needed, and it cost me my firm, my reputation, and the life I knew.
I don’t fault the regulators. They were doing their job in a very difficult environment. They felt it was a conflict of interest, and disclosures weren’t done properly. In that situation, they’re going to come down on you. They’re going to come down on you hard.
When I look back on it now, I think: things are always meant to be. But at the time, it was the most painful experience of my life.
5. When the SEC confronted you about this transaction, you fought it. Do you regret that?
I regret it completely.
The way the process works is, first, you have an examination. You can kind of tell the path of the examination. The first examination we had lasted four days, and they were gone. They asked for a few follow-up things, then gave us a deficiency letter and asked us to correct a number of things.
The second examination just went on and on, and they kept asking for more and more things. It went on for eight or nine months. Finally, they issued a deficiency letter. But right after that, they launched an investigation. Investigations are not public; there’s no finding of facts or anything like that. There’s no public disclosure while the investigation is happening. So, that would have been my opportunity to make a realistic evaluation of what was happening and propose a settlement to address the regulators’ concerns.
I remember my first deposition with the SEC. I recognized what we had done in our inadequate disclosure and how it had looked. My gut said: talk to your attorney; let’s stop this and make a deal. Whatever the consequences are, the consequences are. If I lose my firm, or I get barred from the business for a period of time, just take responsibility.
But my counsel said, “No, let’s not do that. They’re overreaching.” It’s hard when your life is on the line to not listen to that gut. I really, really regret that.
As it went on, I started to convince myself that I hadn’t done anything wrong. The regulators were overreaching, I thought. There were no client complaints and no intention to harm my clients. So I decided to fight. I decided to have my day in court. But that’s not how the process works. I wish somebody had mapped it out for me, because if they had, I would have settled very quickly.
6. How does the process work?
The way the process works is once the SEC concludes its investigation, they issue a Wells Notice. At that time you have an opportunity to respond and basically make your case. Inside that window of time from when you get the Wells Notice and the filing of a formal administrative action, there’s an opportunity to negotiate a resolution. The regulators are tough, but they don’t want to go to court.
In my case, my lawyers felt like we had a good case; the regulators were confident too. So we could never come to an agreement with them. Then, the regulators just went dark for a period of time, and we didn’t really know what was going on. I believe what happens is that the regulators will give you a “last and final” offer—take this deal or else we’re going to litigate. For some reason they didn’t give me that opportunity, or we didn’t realize they had. Instead, they just called one day and said, “We are filing today.”
I’ll never forget that day. I stayed up all night because I wondered if I was going to hit the paper. And at 2 a.m., I saw the article in my local paper: investment adviser accused of fraud. It was in the Wall Street Journal, too.
I rallied and thought, I’ll have my opportunity in court, and I’ll prove my innocence. But two days after the SEC filed, Fidelity Investments, the custodian of many of my clients’ accounts, sent me an email saying they were pulling the plug on my custodial relationship. Then TD Ameritrade did the same. This was early June, and it didn’t matter that my hearing was in October. If you don’t have a custodial relationship, you’re done. I was already out of business.
My big message to the advisory community is: never let it get that far.
My single-biggest mistake at the time of the principal transactions was that the firm was growing so fast and I didn’t have the right expertise in place. If you’re in hyperdrive, and if your business is complex like mine was—you’re doing real estate and some of these other alternatives—your most important employee is your chief compliance officer. And your toughest job is to listen to your chief compliance officer.
People may think, well, I don’t do real estate, so I’m safe. But you could have a rogue employee, and he could plagiarize marketing material. He could misrepresent the company or make performance representations. He could sell products away from you that you don’t know about. There are lots of ways to be in the crosshairs of the regulators, and you need a culture of compliance.
For me, it wasn’t the real estate itself that was an issue; it was the principal transaction. That was the thing that crushed us. We didn’t disclose it in the right way. Frankly, we didn’t even fully understand the nature of the conflict and what all needed to be disclosed. I didn’t know what I didn’t know.
7. What advice do you have for advisers on how to avoid an audit?
You’re never going to be able to avoid the examination; periodic examinations are a part of the business. What’s avoidable is what happened to me in terms of not seeking good compliance advice, having an unrealistic view of the investigation and its potential consequences, and not making the choice to resolve it early.
As the CEO of a firm, you’re either a rainmaker or a systems guy. Very rarely are you both. For me, I’m a marketing innovator; I’m not a detail guy. I didn’t recognize what my deficiency was, and my team wasn’t deep enough in the areas that it needed to be. I don’t think I wanted to be bothered.
Advisers should ask themselves: what am I good at, and what am I not good at? Be honest.
Another thing advisers need to do is review their E&O policies on an ongoing basis. Don’t just take your insurance agent’s word for it. I thought I had a really good E&O policy, and then when I tendered my defense in the SEC action, I was denied coverage. As it turns out, the insurance agent wasn’t an expert in adviser risks and sold me the wrong policy. There was an exclusion in the policy that we didn’t catch; we just didn’t see it. By the time we got the right policy, it was too late.
8. What’s your advice to advisers who get audited and enter the enforcement stage?
If an adviser gets into enforcement, this is my advice: settle fast. The longer you go into the process, the more expensive it is, and the deal gets worse. So whatever deal you get, the sooner you make that deal, the better your deal is. The more resources the government has to spend on your case, the worse the deal gets.
9. As the CEO of a very successful, quickly growing RIA firm, what did you learn from your SEC enforcement experience about how you were running your business?
I should have invested in my infrastructure—my people, my technology, and my systems. I was in a car that was built to go 60 miles an hour, and I was driving it on the freeway going 120.
As the size of your firm steps up from $100 million to $300 million to $600 million to a billion in assets under management, your systems, process, infrastructure, and people have to change, too. When you’re staffed for a $100 million firm, those people may not be the ones who can help you at the next level, or the one after that. I didn’t recognize that. The people that were with me when I was at zero were with me when the firm had $300 to $400 million under management. It was beyond their experience and expertise; they and our systems broke down. I hadn’t upgraded my staff to be sure they had the skill sets that we needed.
Not that I would have cleaned house, but I would have brought in a much deeper talent pool. I should have recognized that I needed operations people. I needed a COO, and I needed a CCO. Those officers needed to have authority to tell me no—and I needed the discipline to listen.
I wish I would have given my key employees ownership. I think that when key staff are owners, they’re going to look at things differently. With the transaction that caused the issue with the SEC, the fix was relatively simple. If we did a couple easy things and included two paragraphs in the purchase agreement, the SEC wouldn’t have had an issue. But we didn’t.
Nobody caught it. Nobody asked the question. Nobody said, “Hey, let’s get an outside opinion.” We just had “yes” people because I was a hard-charging CEO, and I had followers. I think as a CEO, you shouldn’t want that—you need people who challenge you. You want people who give you the opinion you don’t want to hear.
As your firm grows, you have to build a culture that’s a team. If one guy goes down, the whole team goes down. That’s reality. But I built a dictatorship; I was going too fast to wait for my firm to mature. The thing that I didn’t do that I have a lot of regret about is, I didn’t build community. If you look at any organization that does remarkable things, at the center of their success is community. It’s community of ideas, it’s community of sharing the wealth, it’s community of sharing with each other personally. When you do that, you have a glue and a bond and a commitment.
My employees punched a clock. They didn’t care. I didn’t care that they didn’t care. There was actually resentment, because I was making millions of dollars, and they were making an ordinary office wage. So, I would change that culture. If you change that culture, you won’t have the issues I faced because your team will be looking out for you and will help you solve the problems before they even happen.
Looking back I would have done one thing very differently. There are many firms that provide roll ups and support for independent firms. I had an early conversation with Joe Duran at United Capital and was too arrogant to see the value in what he brought to the table. It would have been a perfect marriage of my marketing genius and his systems. The irony of that is, I went out of business and he was acquired by Goldman Sachs.
Currently, I think Ron Carson’s group is the best at offering advisers solutions and controls. These types of firms provide the best of both worlds—they have the resources to protect your blind spots and the muscle to move you forward. It’s not like Ron’s firm is the only option, but I like how he has combined systems, marketing, and products.
The last piece is to get your E&O policies checked. Enforcement actions within regulators are very expensive. Self-insuring that cost will generally cause you to run out of money at the worst time. It’s easy to spend $1 million or more, just for defense costs.
10. How have you recovered from this?
It took me a while to figure out where I was wrong. But I eventually recognized the mistakes that were made. I don’t blame the attorney or anyone else. The freedom came for me when I finally embraced what we had done wrong.
Afterward, I took a bunch of time off. I was forced to sell my firm. I still dabble inside the real estate world. I finished my book. I’m teaching a class at UCLA on mistakes millionaires make, and it’s been a blast. I’m putting the content from my class online in 10-minute modules. I want to make it available to the community. I’m writing an animated movie about money. I’m writing a kid’s book about money. It’s just going to continue to evolve. This is now my life’s mission. I no longer look at it as I’m the guy that got barred. It’s now, I’m the guy that gets to educate people.
The rebirth is in the vulnerability of what happened to me and educating people on what happens when you acquire wealth. I think it’s a great story that I continue to tell and hopefully help people avoid the same mistakes I made.
My oldest daughter just graduated from college, and we have very candid conversations about my mistakes. Now that she’s embarking on her career, I want her to know how not to do the same things I did.
Anything that happens to you like this can be turned into an incredible experience.