Lucia spends a minute or so explaining what the charges are (and what they are not) and then takes up the allegation he says is at the root of the charges filed by the U.S. Securities and Exchange Commission: his use of a 3 percent historical inflation rate in his retirement planning strategy.
Lucia notes that the 3 percent historical rate is “universally accepted by among others the AARP and the federal government, including the SEC.”
It’s an excellent strategy no doubt devised by Lucia’s lawyers at Locke Lord in Los Angeles. It puts gets him out quickly with a response that zeros in on the weakest link in the SEC allegations and attemps to spin the allegations as a dispute over statistics.
Of couse, it’s more than a dispute over statistics. Lucia goes out and tells people that his “Buckets of Money” strategy has been proven over time to allow them to retire in comfort. Lucia claims that he has “spent 20 years refinining” his “time-tested” strategy, which follows “science, not art.”
Well, sure that’s what everyone wants to hear. But when the SEC asked for proof, Lucia coughed up nothing more than a pair of two-page Excel spreadsheets put together by one of his employees in 2003.
And it’s the employee spreadsheets that use this hypothetical 3 percent inflation rate. The actual historical inflation rates available here show a wide fluctuation in inflation rates over time. In 1974, the year of the OPEC oil embargo, inflation zoomed to 11 percent. In 1980, after another oil shock and the Iran hostage crisis, it was 13.5 percent.
The SEC notes:
Lucia admittedly knew that using a lower inflation rate for the backtests would make the results look more favorable for the [Buckets of Money] strategy.
This is the heart of the issue: Lucia used the lazy, shorthand of 3 percent because it makes him look better. Those “Buckets of Money” don’t look quite so full when you use the actual (higher) historical inflation numbers. For the same reason, Lucia also didn’t include the massive fees his clients are charged. Apparently, the way to keep your bucket full is to pretend that inflation is less than it really is and ignore the high fees you’re paying.
As a radio host broadcasting his message over many radio stations, Lucia has a huge soapbox. As an SEC registered investment advisor, Lucia has a duty to do the math, to tell his clients the straight truth. So kudos to the SEC for calling his bluff.
This has restored my faith in government…
Washington, D.C., Sept. 5, 2012 – The Securities and Exchange Commission today charged a nationally syndicated radio personality and financial advice author for spreading misleading information about his “Buckets of Money” strategy at a series of investment seminars that he and his company hosted for potential clients.
The SEC’s Division of Enforcement alleges that investment adviser Ray Lucia, Sr. claimed that the wealth management strategy he promoted at the seminars had been empirically “backtested” over actual bear market periods. Backtesting is the process of evaluating a strategy, theory, or model by applying it to historical data and calculating how it would have performed had it actually been used in a prior time period.
“Lucia and RJL left their seminar attendees with a false sense of comfort about the Buckets of Money strategy,” said Michele Wein Layne, Regional Director of the SEC’s Los Angeles Regional Office. “The so-called backtests weren’t really backtests, and the strategy wasn’t proven as they claimed.”
According to the SEC’s order instituting administrative proceedings against Lucia and RJL, they held the seminars highlighting their Buckets of Money strategy in an effort to obtain advisory clients who would be charged fees in return for their advisory services. They promoted the seminars on Lucia’s radio show and on Lucia’s personal and company websites.
According to the SEC’s order, a backtest must utilize actual data from the time period in order to get an accurate result. Lucia and RJL have admitted during the SEC’s investigation that the only testing they actually performed were some calculations that Lucia made in the late 1990s – copies of which no longer exist – and two two-page spreadsheets.
According to the SEC’s order, the two cursory spreadsheets that Lucia claims were backtests used a hypothetical 3 percent inflation rate even though this was lower than actual historical rates. Lucia admittedly knew that using the lower hypothetical inflation rate would make the results look more favorable for the Buckets of Money strategy. These alleged backtests also failed to account for the negative effect that the deduction of advisory fees would have had on the backtesting of their investment strategy, and their “backtesting” did not even allocate in the manner called for by Lucia’s Buckets of Money strategy. The slideshow presentation that Lucia and RJL used during the seminars failed to disclose the flaws in their alleged backtests and was materially misleading.
I was recently contacted by Troy Sapp, a financial professional from Washington state, who had a client that invested in non-traded REITs with Ray Lucia Jr.’s RJL Wealth Management. Troy graciously agreed to do a Q&A to help others in similar straits.
Q. Hi, Mr. Sapp. Thanks for joining us. Tell us about your background.
A: I am a fee-only certified financial planner and CPA with the National Association of Personal Financial Advisors. I’ve been helping clients with tax, estate, investment, education, retirement, and insurance planning and compliance for over 16 years. For many years I also performed accounting, tax, and reporting compliance work for mutual funds, foundations, private equity partnerships, trusts, and corporations. As a side job I now also provide expert witness services in cases where financial advisors have potentially led their clients to make unsuitable investments, so in the past couple years I’ve become quite familiar with nontraded real estate investment trusts (REITs) and other complex property investment vehicles like Tenants-in-Common (TIC).
Q. How did you find out about this website?
A. I was poking around the Internet after I took on a client who used to be with RJL Wealth Management, headed by Ray Lucia, Jr., that purports to follow Ray Lucia, Sr.’s “bucket approach.” When I took on the former RJL client I noticed she had purchased three nontraded REITs. This client of mine is 75 years of age. For the life of me I can’t see how a 10-15 year “bucket” filed with nontraded REITs would have been suitable for her, but I digress.
At that time, my client’s REITs had yet to provide valuations other than the $10 per share purchase price. I informed my client of the high fees as well as the fact that the vast majority of her distributions to date were actually a return of capital, so the likelihood of the investments’ true value being anything close to $10 per share was slim. At any rate, two-thirds of her nontraded REITs have now provided updated valuations. One valuation is came in slightly higher than $10 per share (which is very tenuous even by the sponsors’ own admissions) and the other came in at $7.47 per share.
Q. Let’s back up a bit. Can you explain how a nontraded REIT differs from a traded REIT?
A. REITs traded on U.S. exchanges are governed by the rules of the Securities Exchange Act of 1934 (and the Securities Act of 1933 when initially issued) which helps insure efficient price discovery. That is, among other things, these rules help insure adequate disclosure and fair play so that the marketplace can properly assess a company’s true intrinsic value based on all information that has been made public. Once the market digests all the information which has been made public, the market collectively determines a “fair value” which is adjusted virtually each second that the market for the security is open. The massive number of market participants all digesting information simultaneously does a remarkable job of properly valuing the securities in which it trades.
Nontraded REITs, on the other hand, are not traded on the open market and thus they are not subject to the same level of efficient price discovery. Instead, the shares are generally carried at $10 each until the subscription period closes even though the actual value will be more or less than $10. Once the subscription period closes, the Financial Industry Regulatory Authority dictates that the sponsor of the nontraded REIT must provide an updated valuation within 18 months.
Q. So, these nontraded REITs provide their own share prices? That sounds fishy.
A. As with all private equity investments, this is necessarily the case since the investment is not traded on an open exchange. The internal valuations are made using numerous measures, and then a third party auditor approves the methodology as well as the disclosures associated with the valuation. This second part should not be underestimated as valuations can be highly sensitive to inputs. These disclosures are stated within the REIT’s SEC filings and should not be overlooked. To date, though, I’ve yet to meet one investor that actually understands much less reads the valuation disclosures, but I suppose they’re out there.
Q. How high are the fees associated with them?
A. This is a difficult question. The fees of all nontraded REITs I’ve looked at are all structured somewhat differently, but they tend to include upfront fees, management fees, deal fees, high water mark fees, lease signing fees, etc. At the end of the day, all nontraded REITs I’ve looked at extract fees at every possible turn.
Just looking at front-loads, though, the ones my client invested in charged 15%. This would mean that for every $10 she invested only $8.50 would be put to work. By my math, it would seem that her $10 investment was actually worth $8.50 the minute she wrote the check. Simply earning back that initial 15% fee is a very high threshold when one considers they could have purchased a basket of more transparent public REITs without incurring the 15% fee.
Q. You mentioned that these nontraded REITs have only provided your client a return of capital (ROC)? What do you mean? That sounds like a Ponzi scheme.
A. It’s not that nontraded REITs only provide a ROC; it’s that the vast majority of the distributions in the initial years tend to be. To back up, when a REIT distributes dividends to investors, they can do so out of net earnings, capital gains, and/or investor capital. When companies distribute an investor’s capital back to them, they are simply returning the original amount that they invested. Receiving your own capital back is basically like giving yourself a blood transfusion from one arm to the other while spilling 15% of your own blood in the process.
On a cash flow basis, however, most of the nontraded REITs are not actually returning the investor’s original capital, but instead use the proceeds from sales to later investors. Recently, this has been made clearer by many nontraded REITs reducing their distributions once funds have been closed to new investors. In my opinion, this does seem like a Ponzi scheme, but legally it’s not since this is all disclosed by the REIT sponsor. In other words, Madoff may not have been running a Ponzi scheme if he adequately disclosed what he was doing. Of course, he would have also been subject to different regulations, and would likely have needed to position himself in the private equity space.
Q. Ha! Are these things regulated? Why haven’t they been shut down?
A. Yes, nontraded REITs are regulated. Private equity is seen as an important part of our capitalistic system. Without risk taking by those with adequate capital to prudently take it on, there would not be the economic and technological advances we’ve seen. Congress recognizes this as well as the fact that heightened regulation causes higher costs which would probably cause less investment in the private equity space. Therefore, current regulations basically say that heightened regulations won’t be imposed if investors meet certain wealth and/or income thresholds.
Q. So there are less safeguards for unsophisticated retirees with a large nest egg to invest. Wouldn’t an advisor who makes these kinds of recommendations for clients be breaking the law?
A. As long as the investor meets minimum wealth and/or income requirements, there is full written disclosure, the advisor does not misrepresent the investment, and the investment is at least suitable; then no, the advisor is likely working within the regulations. This said, for advisors subject to the fiduciary standard, these investments may often be difficult for them to justify. The fiduciary standard means that advisors have to act in the best interests of clients.
The problem I’ve seen is that even if all the issues were properly disclosed in writing, clients generally listen to what their advisors tell them about the investment, and not what’s written in the complex and voluminous offering documents. In the case of nontraded REITs, clients generally hear that they are stable in price and provide a good dividend. These assumptions are flawed at best.
Q. Why so?
A. In my client’s case it’s clear to me that she thought the investments were more profitable, more liquid, less costly, less volatile, and less opaque than they are in actuality. Why would she have thought this if the advisor hadn’t steered her in this direction? Had she had the experience and knowledge necessary to dissect the private placement memorandums, she would not have come to the same understanding.
Q. So what’s the next step for your client?
A. My client is now faced with a difficult choice. She can redeem, but the redemption fees are steep. She can go to arbitration, but that route is both monetarily and emotionally expensive. She can hold onto her REITs, but her heirs will likely be stuck with these stinkers that will in all likelihood not pan out as well as their publicly-traded counterparts. She is at the age where she will likely not see the eventual outcome if she does hold onto them.
Q. What’s your advice for someone who’s considering an investment in nontraded REIT that RJL or some other advisor is strongly recommending?
A. First, remember there are no free lunches. If there is a deal in the private equity space that’s better than available publicly traded options, then investment banks, pension funds, endowments, sovereign wealth funds, hedge funds, and other institutional investors will have beaten you to it. Unfortunately, retail customers are left with the “scraps” that institutional investors leave behind.
I also recommend that they ask the following questions:
- Is the value really stable? How do we know that the value is stable if it isn’t regularly priced by the marketplace?
- How much of my investment will be put to work? That is, what are the front loaded and ongoing fees?
- How does management fund the distributions? What percentage of the distributions are likely to be ROC?
- Why should I invest in a nontraded REIT instead of a public fund with no loads and low ongoing fees? (Note that if the advisor says that nontraded REITs are more stable, then run.)
- What cost will there be if I need to get out early? Have there been any cases where management has frozen redemption requests?
- What are the conflicts of interest? If the fund sponsor is also the property manager and broker of the underlying properties how can I be assured that the best job is being done for the price?
- How have these investments and this particular manager performed in the past compared to publicly traded options? Be careful here, though, as time variance returns can vary greatly. That is, the initial investors could have wildly different returns than the latter ones. There are also issues with measuring private equity returns since their returns are generally calculated using an internal rate of return methodology, so if your due diligence allows you to make it this far, you will need to examine this issue further.
- What other risks are there? At this point ask that the advisor slowly walk you through the risks outlined in the offering documents.
Q. What do you suggest to those who’ve already purchased a nontraded REIT and are now worried about it?
A. Unfortunately there are few options. The first would be to request a redemption, but this will likely cause a major haircut if redemption requests have not been frozen altogether. Another might be to contact the advisor and ask that they purchase the investment back from you if you believe they were misrepresented and/or not suitable. Good luck with that route, though. A more formal route would be to contact an attorney specializing in securities law. Most provide free consultations and many will work on either an hourly or contingent basis. Again, this route can be both monetarily and emotionally expensive. Finally, the obvious route is to do nothing and chalk it up as an “education expense”. Many investors seem to prefer the do nothing route as they feel overly responsible for the bad investment. Remember, though, that the advisor was the “expert” and this “expertise” was relied upon before making a decision. At the very least, I would recommend the investor speak with a securities lawyer. One lawyer I’ve worked with is Richard Brady, but there are many good securities lawyers out there. If you take this route be sure to interview two or three before deciding on one.
Q. What’s your recommendation for someone who wants to invest in a REIT?
A. Currently, my primary recommendation for US REIT exposure is the Vanguard REIT Index Fund. I currently recommend the ETF class for most of my clients. No loads, expenses are 0.10%/year, very liquid, and underlying holding obviously highly transparent to the marketplace. For those that prefer an active management style, there are over 250 REIT mutual funds to choose from. For a very small annual fee, Morningstar has an excellent screening tool as well as provides excellent commentary and analysis for virtually every publicly traded REIT and REIT fund available.
I should also add that nontraded REITS are not unsuitable for every retail investor, just most of them.
Q. What’s the best way to get in touch with you?
A. My website has my contact info.
Q. Thanks very much for taking the time to explain nontraded REITs.
A. You’re welcome.
I’ve recently been contacted by a few disgruntled Ray Lucia investors who found their way to my website and asked for my help. Short of recommending they file complaints the U.S. Securities and Exchange Commission and FINRA, there was little I could do.
However, since I’m one of the few people writing about Lucia, I’ve become a sort of clearing house for these people. One investor who recently contacted me on behalf of her 75-year-old father wants to organize a meeting and speak to others in the same situation. This person was able to get dad out of one of the non-tradeable REITs that Ray Lucia (senior, not junior) stuck him in and is willing to share with others how to do it themselves.
So, if you’re interested, let me know and I’ll pass along the details.
Ray “Buckets of Money” Lucia, the host of an investment radio talk show, has been going around the country hosting retirement seminars with actor Ben Stein.
The seminars are free to attend, but they’re not free. Someone is paying for them. If you’re considering investing with Lucia, it’s important to understand that the person who may wind up paying is you.
Money for the “Buckets of Money” seminars comes out of the pockets investors in RJL Wealth Management, according to Lucia’s own client disclosure.
In addition to being the main sponsor of Lucia’s seminars, RJL Wealth Management advertises on his radio show. It pays Lucia a fee for referring potential clients. It also pays him hourly consulting fees. The amount of this compensation is not disclosed.
RJL manages more than $300 million in assets in 4,880 accounts, according to its filing with federal regulators.
As I noted in an earlier post on Lucia’s fees, the RJL Wealth Management Program charges staggeringly high fees of as much as 2.9 percent annually.
Lucia’s SEC disclosure states that for his solicitation and consulting, he receives a portion of the fees collected by RJL Wealth Management that “shall not exceed 1 percent” annually. One percent of $300 million is $3 million a year.
You would be forgiven that Lucia is essentially paying himself. In fact, Lucia is being paid by his son, Ray Junior, who runs RJL Wealth Management. Dad is listed as a consultant and member of the advisory board (along with Ben Stein).
The arrangement between the Lucias leads inexorably to a conflict of interest.
Both Lucia junior and senior are SEC registered investment advisers. Registered investment advisers are considered fiduciaries, which means they have a legal duty to put their clients’ interests first. So whose interests come first clients or Lucia father and son?
I think the answer can be found in a complaint against Lucia Senior that was filed with the Financial Industry Regulatory Authority in December.
An unnamed client accused Lucia of breach of fiduciary duty for failure to execute stop loss orders in between June and December 2008 when markets plummeted in the depths of the financial crisis.
The client claimed $24,631 in damages. Lucia settled for $18,000 for “business considerations in order to avoid the cost of arbitration,” according to FINRA.
According to FINRA’s summary of the case:
Mr. Lucia was listed as a joint representative on the account for administrative purposes, but did not interact with the client and made no recommendations or representations, as those alleged or otherwise.
In other words, Lucia really had nothing to do with the account or the client. His name was on the account only “for administrative purposes.”