The Texas Securities Commissioner recently entered into a consent order with an investment adviser representative (also referred to as an “IAR”) related to his performance fee arrangement and trading practices.

Background Facts

The investment adviser representative allegedly recommended a high-risk options trading strategy to clients who lacked knowledge and sophistication in options. The Texas Securities Commissioner asserted that the clients agreed to place a portion of their assets in the options strategy because the investment adviser representative stated, “I only make money when you make money.” For this option strategy, the investment adviser representative purportedly charged initially a performance fee equal to 25% of the monthly trading profits after a hurdle rate but without a high-water mark.

According to the consent order, after clients expressed concern about the high fees that the clients had incurred, the investment adviser representative told the clients that the investment adviser representative wouldn’t charge a monthly fee unless the net asset value of the account exceeded a high-water mark; however, the investment adviser representative allegedly miscalculated the initial high water mark and then misapplied or ignored it all together. The Texas Securities Commissioner claimed that the investment adviser representative’s failure to utilize properly the high-water mark allowed the investment adviser representative to make money while the clients continued to lose money.

The Texas Securities Commissioner also alleges that the investment adviser representative could have reduced the clients’ trading costs by 30% if the investment adviser representative would have engaged in block trading instead of broker-assisted trading at the discount brokerage firm holding the clients’ accounts. The Texas Securities Commissioner noted that the firm’s Form ADV Part 2A disclosed that the investment adviser representative had discretion to select the discount brokerage firm but failed to disclose that the investment adviser representative would utilize broker-assisted trading which would result in higher trading costs than other available options.

Conclusions of Law & Order

The Texas Securities Commissioner concluded that (a) the investment adviser representative’s alleged statement that he would only make money if the client makes money was misleading and breach of fiduciary duty due to the lack of high-water mark, (b) the investment adviser representative’s alleged failure to establish the promised high-water mark for client accounts constitutes a breach of fiduciary duty, (c) the investment adviser representative’s failure to disclose the additional commissions the clients would be paying due to the use of broker-assisted trading was a failure to disclose a material fact and constitutes a breach of the fiduciary duty, and (d) the investment adviser representative’s use of broker-assisted trading for his own benefit, without any added value to the clients and their consent, constitutes a breach of the fiduciary duty to seek best execution. The Texas Securities Commissioner ordered the investment adviser representative’s registration revoked.

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