SEC Settles 3 RIA Referral Fees Cases

January 11, 2017

The regulation of Wall Street is often a messy undertaking, exacerbated when multiple parties pursue a concerted course of misconduct and take steps to cover up the underlying acts. Consider a recent Securities and Exchange Commission investigation, which produced three separate regulatory settlements. At the core of the charges were an RIA/BD, a President/CEO; a lawyer; and a wealthy widow. How can you not want to read further with that dramatic foreshadowing?

Cast of Characters

Essex Financial Services, Inc., ("Essex") a registered investment adviser ("RIA") and broker-dealer founded in 2003. Since July 2013, Essex has been a wholly-owned subsidiary of Essex Savings Bank.

John W. Rafal, founded Essex and from April 2003 until July 2013 served as its President/CEO, and, thereafter, Vice Chair. From April 2003 to October 2012, Rafal owned 40% of Essex; after which he sold half of his interest and in July 2013, he sold his remaining 20% interest.

Peter D. Hershman, Esq. was licensed to practice law in 1972 and engaged in business and estate planning, and tax law. Hershman was never registered with the SEC and did not hold any securities licenses.

The OIPs

In anticipation of the institution of proceedings by the Securities and Exchange Commission ("SEC") but without admitting or denying the findings, John W. Rafal, Peter D. Hershman, and Essex Financial Services, Inc., each submitted separate Offers of Settlement, which the federal regulator accepted: 

  • In the Matter of John W. Rafal (Order Instituting Administrative and Cease-And-Desist Proceedings and Imposing Remedial Sanctions and a Cease-And-Desist Order; '34 Act Rel. 79755; Invest. Adv. Act Rel. No. 4601; Admin.Proc. File No. 3-17761 / January 9, 2017)
  • In the Matter of Peter Hershman, Esq. (Order Instituting Administrative and Cease-And-Desist Proceedings and Imposing Remedial Sanctions and a Cease-And-Desist Order; '34 Act Rel. 79756; Invest. Adv. Act Rel. No. 4602; Admin.Proc. File No. 3-17761 / January 9, 2017)
  • In the Matter of Essex Financial Services, Inc. (Order Instituting Administrative and Cease-And-Desist Proceedings and Imposing Remedial Sanctions and a Cease-And-Desist Order; U34 Act Rel. 79757; Invest. Adv. Act Rel. No. 4603; Admin.Proc. File No. 3-17762 / January 9, 2017) 
The Fee Arrangement

As noted in the three Orders Instituting Administrative and Cease-and-Desist Proceedings (the "OIPs"), in 2010, Essex, Rafal and Hershman allegedly discussed the latter's referral of an elderly widow, who had over $100 million in her accounts. By Spring 2011, Rafal and Hershman had discussed the payment by Essex of a portion of its asset management fee, and the two eventually agreed on an annual fee of $50,000, paid quarterly. In furtherance of the agreement, Hershman allegedly agreed to become a registered investment adviser agent.

On May 4, 2011, the elderly client signed an Essex Investment Management Agreement but no disclosure of the solicitation fee was provided to her.

Unregistered But Wanting to Get Paid

Although Essex had arranged for Hershman to take the necessary registration examinations, he never did so and Rafal was aware of his ongoing unregistered status. In July 2012, the still unregistered Hershman telephoned Rafal requesting his first payment, which Rafal agreed to have Essex make. Notwithstanding that Rafal purportedly knew that it was improper to pay the fee, he and Hershman agreed that the lawyer would invoice Essex in the form of a bogus bill for legal services. In furtherance of the scheme, the Essex OIP asserts the following:

10. In late July 2012, Hershman emailed Essex a $25,000 invoice for "legal services," representing the first two quarterly payments of 2012 pursuant to the referral arrangement. Rafal asked Hershman to break the bill into two separate $12,500 invoices, and to send quarterly invoices going forward, explaining that the large amount would look bad on Essex's cash flow. Hershman sent a revised invoice to Essex in the amount of $12,500.

11. Rafal forwarded the revised invoice to Essex's bookkeeper, directing her to pay it. On August 20, 2012, Essex sent Hershman a check in the amount of $12,500.

12. In or around November 2012, Rafal asked Hershman to send a more detailed invoice for the first quarter of 2012 stating that Essex "needed something to put in the file for [the] auditors." Hershman complied, sending Rafal a detailed, itemized bill for the first quarter of 2012 that purported to reflect time spent working on matters for various Essex clients.

13. Hershman also sent Essex an itemized bill in the amount of $12,690 for the second quarter of 2012, purporting to reflect time spent doing legal work for Essex related to various clients. Rafal forwarded the second quarterly bill to Essex's bookkeeper, directing her to pay it. Essex paid the invoice for the second quarter of 2012 on November 26, 2012.

14. On March 21, 2013, Hershman sent an invoice to Rafal in the amount of $24,570, representing the last two quarters of 2012, once again purporting to reflect legal work for Essex, itemized by client.

Internal Complaints

Notwithstanding the machinations by Hershman and Rafal, the payment for the final two 2012 quarters did not go out. Further, the Essex OIP explains that:

16. Based on internal complaints at Essex concerning the undisclosed solicitation payments, Essex stopped the process to pay Hershman's invoice for the last two quarters of 2012, and required Rafal to arrange for the return of the previous payments from Hershman.

17. On April 5, 2013, after being directed by Essex not to pay Hershman's invoice for the last two quarters of 2012, Rafal used an account owned by an entity that he controlled to pay Hershman $24,570 - the balance due to Hershman on the invoice Hershman submitted to Essex for the last two quarters of 2012. Rafal concealed the $24,570 payment from Essex.

18. On or about April 17, 2013, at the direction of Essex, Rafal asked Hershman to return the previous payments made to Essex for the first two quarters of 2012-totaling $25,190. Hershman complied. Unbeknownst to Essex, Rafal subsequently paid Hershman $25,190 from an account owned by an entity that Rafal controlled.

19. On or about April 19, 2013, Hershman received a letter from Essex stating that the referral fee payments Essex previously paid to Hershman were prohibited by law, and asking Hershman to return all of the referral fees which he had received to Essex as soon as possible. The letter acknowledged that Hershman had already returned the $25,190. 

20. Neither Rafal nor Essex ever informed the owner of the Referred Accounts that the referral fee payments had occurred, or that there had been an agreement to pay Hershman a fee for the referral of the client's accounts.

21. In or around August 2013, after some former representatives of Essex contacted a representative of the owner of the Referred Accounts to report that Rafal was under investigation, Hershman disclosed to the owner of the Referred Accounts that he had received payments from Essex related to her accounts. At that point, Hershman told the owner of the Referred Accounts that he had received payments from Essex for "legal fees" and that he had subsequently returned those payments. Hershman did not disclose that the true nature of the payments was for his referral of her account to Essex, nor did he disclose that he had received replacement payment from Rafal for the returned payments.

Self Reporting to SEC

The Essex OIP states that in July 2013, Essex reported the referral fee arrangement and payments to the SEC and advised that Rafal was the subject of an internal investigation and had been removed as the firm's President/CEO and relieved of "managerial, compliance, supervisory, or oversight duties." The Essex OIP further asserts that:

24. From May 2013 through March 2014, Rafal sent numerous emails to Essex clients and others that falsely stated, among other things, that the SEC had "fully investigated all matters" and "issued a 'no action' letter completely exonerating [Essex] and [Rafal] from the so called 'securities violation.'"

25. Essex discovered Rafal's false and misleading emails to clients shortly after he sent the bulk of them in March 2014. Essex promptly informed Commission staff of Rafal's misrepresentations. Essex also compelled Rafal to send retractions to recipients of his misleading emails.

26. Essex took further corrective measures by increasing staffing in its compliance department, transferring operations responsibilities away from its Chief Compliance Officer to provide greater compliance focus, improving its account monitoring software, revising its policies relating to employee complaint procedures, and revising its reporting structure so that the Chief Compliance Officer reports directly to the Chair of the Audit Committee of the Board, instead of to the CEO.

27. Essex discharged Rafal in November 2015

Intentionally Mislead

In considering Rafal's above-cited conduct, the Rafal OIP pointedly notes:

Rafal Misleads the Commission Staff During Its Investigation

26. In May 2015, Rafal testified in an investigation being conducted by the Commission staff to determine whether Essex, its officers, directors, employees, partners, subsidiaries and/or affiliates and/or other persons or entities had engaged in violations of the federal securities laws. In May 2015, May 2016, and June 2016, Rafal produced documents to the Commission staff pursuant to subpoenas issued in the staff's investigation.

27. During Rafal's May 2015 testimony, in response to direct questions concerning the Referral Fee Arrangement, Rafal stated, "We asked for the money back, which he sent back," among other statements by which Rafal intentionally misled the Commission staff to believe that Hershman was no longer in possession of any money or compensation for Hershman's referral of the Referred Accounts to Essex. In testifying about the Referral Fee Arrangement, Rafal concealed from the staff that he had in fact personally arranged to make two payments to Hershman in April 2013 totaling $49,760 in satisfaction of the Referral Fee Arrangement from accounts owned by entities Rafal controlled.

 Violations

The SEC found that the following:

Rafal willfully violated Sections 206(1) and 206(2) of the Advisers Act, which prohibit investment advisers from directly or indirectly employing any device, scheme, or artifice to defraud any client or prospective client, or engaging in any transaction, practice, or course of business which operates as a fraud or deceit on any client or prospective client. As a result of the conduct described above, Rafal willfully aided and abetted and caused Essex's violations of Section 206(4) of the Advisers Act and Rule 206(4)-3, thereunder, which makes unlawful the payment, directly or indirectly, of a cash fee by an investment adviser required to be registered pursuant to Section 203 of the Advisers Act to a solicitor with respect to solicitation activities unless the disclosure and other requirements of the Rule are met.

Hershman willfully aided and abetted Essex's and Rafal's violations of Section 206(1) of the Advisers Act, which prohibits investment advisers from directly or indirectly employing any device, scheme, or artifice to defraud any client or prospective client. As a result of the conduct described above, Hershman willfully aided and abetted Essex's violations of Section 206(4) of the Advisers Act and Rule 206(4)- promulgated thereunder, which makes unlawful the payment, directly or indirectly, of a cash fee by an investment adviser required to be registered pursuant to Section 203 of the Advisers Act to a solicitor with respect to solicitation activities unless the disclosure and other requirements of the Rule are met

Essex willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-3 thereunder, which makes unlawful the payment, directly or indirectly, of a cash fee by an investment adviser required to be registered pursuant to Section 203 of the Advisers Act to a solicitor with respect to solicitation activities unless the disclosure and other requirements of the Rule are met.

Sanctions

In accordance with the Offers of Settlement and having considered the public interest when imposing sanctions, the SEC ordered that: 

  • Rafal, Hershman, and Essex cease-and-desist from further violations of the Adviser Act;
  • Rafal and Hershman were each denied the privilege of appearing or practicing before the Commission as an attorney.

SIDE BAR: There is no indication in the Rafal OIP that he is or was an attorney, although such status is clearly noted for Hershman.

  • Rafal and Hershman are each:

    • barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization;
    • prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter; and
    • barred from participating in any offering of a penny stock, including: acting as a promoter, finder, consultant, agent or other person who engages in activities with a broker, dealer or issuer for purposes of the issuance or trading in any penny stock, or inducing or attempting to induce the purchase or sale of any penny stock

  • Rafal will pay $275,00 disgorgement with $27,297.72 prejudgment interest; and a $275,000 civil money penalty.
  • Hershman will pay $49,760 disgorgement with $4,923.57 prejudgment interest; and a $37,500 civil money penalty.
  • Essex pay $170,00 disgorgement with $13,181.31 prejudgment interest. In consideration of Essex's prompt remedial acts and the firm's cooperation with SEC Staff, the federal regulator did not impose a civil monetary penalty. Essex also agreed to provide a copy of the Essex OIP to each of its advisory clients and to any client referred by Hershmann during the applicable period.
Bill Singer's Comment

Compliments to the SEC for a comprehensive and compelling set of three OIPs.

If the industry is being honest, we would all agree, albeit sotto voce, that a lot of cash gets paid under the table for lots of reasons, not the least of which are pursuant to these so-called referral fee arrangements. In truth, there are many folks, among which I count myself, who argue that there is nothing wrong with finder's or referral fees and in many cases, such payments foster business. Alas, the Devil is in the details. True, in theory the practice of paying for a referral should be a cost of doing business. In reality, however, the best of practices is easily tarnished and turned to the Dark Side when folks engage in some of the fabrications, pretenses, and fraud cited in the three OIPs.

If it were simpler to acquire new business via an incentive payment to the source, would we be confronted with so many of these schemes? Probably not but we are all consigned to live in the world that we inhabit and if something is wrong, simply complaining about it doesn't make it right. Perhaps it's time to re-visit the statutory framework for a host of incentive payments and see if we can better tune the machinery so as to deter folks from taking illegal shortcuts. What must remain in any statutory scheme is the exaltation of investor protection and a commitment to avoiding non-compliance behavior in order to justify a dubious payment.