The Securities Litigation Expert Blog

Jack Duval Quoted on Wells Fargo AWC over Complex Investments

Posted by Jack Duval

Aug 7, 2015 1:26:06 PM


Accelerant Managing Partner Jack Duval was quoted in a Thomson Reuters Regulatory Intelligence article.  The article can be found on the Thomson Reuters Risk website here.  (Behind a paywall.)  For thost without access, the entire article is copied below:



Wells Fargo Fined Over Investment Product Too Complex for Brokers, Clients

Aug 05 2015 Richard Satran, Regulatory Intelligence

The sale of an investment that the U.S. securities industry regulator found too complicated for the amount of training and preparation on the part of Wells Fargo's sales team has generated a long tail of fees and legal costs for the broker dealer.

The Financial Industry Regulatory Authority said Tuesday it had reached an agreement with Wells Fargo on a censure and fine of $500,000 for the broker dealer's failure to educate and train brokers on the risk of the complicated floating-rate loan fund first sold in 2008 by the company's predecessor, Wachovia.

"This is one of those cases where complexity itself is the risk," said Jack Duval, managing partner of Accelerant, a securities litigation consulting firm. "The complexity comes back to bite everybody -- first at the client level and then at the broker level. Many investments have gone wrong because brokers misunderstood what they were selling." 

FINRA already has awarded restitution and assessed fines against Wells Fargo for the selling "unsuitable" investments in the case of the floating rate securities it calls STRATS, an acronym that stands for Structured Repackaged Asset-Backed Trust Securities.

Clients were sold on the STRATS for their safe, enhanced yield by brokers who were not made aware risks of the products, FINRA said in the action announced Tuesday. The STRATS were constructed from bonds whose fixed income interest payments were swapped for floating rate swap agreements. Far from simple, conservative securities, the STRATS were structured products loaded with fees for early termination and a capital security whose value fluctuated in the market.

The brokers "were generally not familiar" with the investments they were selling and the firm did not provide the training and supervision to sell them. In its investigation, FINRA reviewed internal marketing collateral and found that brokers would have "no reasonable basis for recommending the STRATS to retail customers."

The case shows how costly and time consuming a complicated financial offering can become. The broker has paid out some $10 million in fines and restitution for fund sales of only $12 million. While it pales compared with the $5.42 billion Wells reported for its quarterly profit last month the case generated untold legal costs over five years, along with reputational damage. Wells Fargo said it does not comment on FINRA cases.

In the latest action this week, Wells Fargo was still paying out for the complex investments that were initially packaged by Wachovia, a firm it acquired in a government supervised distress sale in 2008. In addition to the half-million dollars in new fines, the new agreement required new restitution of $241,974.34 in 2012 to pay customers for unexpected costs at the final redemption for those who held the securities issued six years ago. FINRA found that holders were not made aware of the risk that they would lose part of the principal on their investment on account of a termination fee.

"At the time of the STRATS termination many customers holding the STRATS received less and in some cases significantly less, than they paid for the STRATS." For Wells Fargo, the costs have also mounted for an ostensibly conservative trading instrument that kept on claiming time and money.


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Topics: Structured Products, Complex Investments, Compliance, Investment Complexity, Complex Investment Expert, Wells Fargo, FINRA Regulation, STRATS, AWC

Manufacturing Investment Complexity - The Wall Street Playbook

Posted by Jack Duval

Dec 16, 2014 6:11:00 AM

This blog post continues my series on complex investments.

If you have followed my work on investment complexity, you might have wondered how investments came to be so complex.

The answer is simple:  complexity is highly profitable. In fact, complex products and strategies have a number of traits that are desirable to Wall Street firms:

  • They require the use of experts to understand them for the client;
  • They are difficult to commoditize;
  • Fees and profit opportunities can be buried in their construction and maintenance.

For Wall Street firms, this is a trifecta. Most broker-dealers have a ready network of licensed salespeople who can sell complex products and strategies to their clients; they can use complex products to blunt the now complete commoditization of their traditional stock and bond trading business; and they have various business units that can all profit from their respective participation in the creation and maintenance of complex products and services.

Given the way complex products and services fit with Wall Street business models, there is a perverse incentive for brokerage firms to increase complexity.

Complexity as a Response to Pricing Pressure

Wall Street firms have faced at least two historical events when the commission-driven business model was challenged. In both instances, they responded by moving away from the threatened area and into an adjacent area with increased complexity.

The first event was the 1975 deregulation of fixed commissions, better known as “Mayday” because it went into effect on May 1, 1975.  In the time leading up to Mayday, brokerage firms had charged fixed fees for executing stock trades. This removed competitive pressure from commissions and the firms enjoyed high profit margins.

After Mayday, Wall Street firms were free to discount their commissions and this introduced competition into commission pricing. It is no accident that the discount brokerage pioneer, Charles Schwab, started his eponymous firm in 1973, and started offering discounted stock trades on May 1, 1975.[i]

The effect of deregulating commissions was significant. As Jerry Markham writes[ii]:

Between 1970 and 1989, commission charges for institutional investors dropped on average from twenty-six to less than five cents per share.  The result was that revenues from commissions for broker-dealers declined from about 65 percent of industry revenues in 1972 to about 40 percent in 1983 and to about 17 percent in 1989.  Commissions made up over 50 percent of Merrill Lynch’s total revenues in 1972 but only 15 percent by 1988.

These declining commissions were doubly significant because they were most pronounced for institutional investors.  Institutions not only had the most negotiating power, but their share of trading volume was growing dramatically over the same time period.  This was a one-two punch to broker-dealer commission revenue.

The response from Wall Street firms was to take the asset facing pricing pressure, equities, and package them into more complex investments, mutual funds.  The mutual funds carried high fees of four to six percent and also paid annual “trailers” of one-quarter of a percent or more. 

Furthermore, mutual funds fit right in with the typical Wall Street business model.  Firms could hire portfolio managers to run the funds, use their trading desks to execute the trades, and have their sales force sell the funds to their clients. At Wall Street firms, many beaks could get wet at the mutual fund troth.

In addition, mutual funds provided consistent revenues for issuing firms.  The internal management and 12(b)1 fees were typically from 1.5 to 2.5 percent per annum and were deducted quarterly.  These consistent revenue streams smoothed out broker-dealer revenues and were much less volatile than transaction commissions, which ebbed and flowed with the markets.

While mutual funds seem relatively simple by today’s standards, they represented a leap in complexity that was an order of magnitude higher than simply buying stocks.  Investors had to navigate dense prospectuses that covered a wide variety of issues, including:

  • Fee structures;
  • Investment strategy and discipline;
  • Pooled investment structure;
  • Tax considerations;
  • Liquidity constraints;

Importantly, all the issues listed above are unique to the mutual fund vehicle itself and do not include any of the traditional economic and financial issues that are part of any equity investment.

The shift in focus from equities to mutual funds was instantaneous and sustained and the fund business grew from a small niche investment vehicle to the default in about a decade.

Indeed, in the wake of Mayday, mutual fund AUM enjoyed their highest five-year compound annual growth rates (“CAGR”) on record, notching gains of:  24.1, 26.3, 43.4, 39.3, and 31.4 percent from 1980 to 1985, respectively. [iii]   In the 10-year period from 1975 to 1985, mutual fund AUM grew from $45.87 billion to $495.39 billion, an increase of 9.8x, for a 10-year CAGR of 26.9 percent.[iv]

For higher resolution charts, click here.

Chart 1:  Mutual Fund Assets Under Management and Five-Year Rolling CAGRMutual_Fund_AUM


Driving the dramatic increase in AUM were new sales in mutual funds, which also expanded at their highest  growth rates in the years immediately following the 1975 Mayday deregulation.

Chart 2:  Mutual Fund Annual Sales and Five-Year Rolling CAGR


A new page had been added to the Wall Street playbook:  if a revenue stream became commoditized, take that product and use it to create a new (and more complex) product, to protect the firm's profit margin.  In my next post, I will examine how this page of the playbook was used again 27 years later in the fixed income markets.


Learn more about complex investment expert Jack Duval.

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[i]       Charles Schwab Company History; Available at; Accessed December 2, 2014.

[ii]      Jerry W. Markham, A Financial History of the United States, Volume II, (New York, Routledge, 2001), 182.

[iii]     Investment Company Institute, 2014 Investment Company Fact Book; Available at:; Accessed December 11, 2014.

[iv]      Id.



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Topics: Complex Investments, Investment Complexity, Complex Investment Expert

Complex Investments and the Curse of Knowledge

Posted by Jack Duval

Nov 20, 2014 8:11:00 PM

This blog post continues our series on complex investments.


Image: Bertrand Russell

“To a mind of sufficient intellectual power, the whole of mathematics would appear trivial, as trivial as the statement that a four-footed animal is an animal.”[1]

                                                                                                - Bertrand Russell

People naturally believe other people know what they know.  This is known as “the curse of knowledge”, and was originally observed by psychologists and then economists who noticed that individuals in transactions often didn’t take full advantage of their private knowledge.

 In 1990, Elizabeth Newton, then a Ph.D. student in psychology at Stanford, designed a simple experiment that brilliantly demonstrated the curse of knowledge.[2] The experiment involved two subjects: one designated a “tapper”; the other a “listener.”  The tapper would tap out the rhythm of well-known songs on a table.  Some of the songs included “Happy Birthday” and other instantly recognizable tunes.  The listener would try to guess what song was being tapped out.

The listeners were only able to discern 2.5 percent of the songs.  However, before the experiment began, the tappers predicted the listeners would be able to guess 50 percent of the songs being tapped out.  The tappers were off by a factor of 20.

The reason for the 20x disparity is that the song being tapped out seems so obvious to the tapper.  They can hear the melody in their head as they tap it out and assume the listener can also hear it.  This is the curse of knowledge.  However, the listener doesn’t hear the melody, they only hear the unconnected taps. Without the melody, the taps have no context and were shown to be meaningless 97.5 percent of the time.

This phenomenon is on proud display in investment disclosure documents.  In these, securities lawyers have drafted them by writing out melodies they know by heart from being immersed in their singing for decades.  Meanwhile, their readers, who are untrained in the stylized incantations of securities law, hear nothing but discordant notes.

A review of a typical sentence from an auction rate security disclosure document is instructive:[3]

The Issuer and ALL Student Credit may, upon receipt of a Credit Confirmation and in the case of ALL Student Credit the consent of all the Holders of the Senior Series IV-A-6 Bonds and the Series IV-A-13 Bonds, issue Additional Bonds in the future on a parity with Senior Bonds, Senior Subordinate Bonds (if any), Subordinate Bonds or Junior Subordinate Bonds then Outstanding.

Remarkably, this sentence uses 12 defined terms. If the reader does not have command of all 12 terms, she won’t understand the sentence.  The Term Supplement and the Offering Memorandum from which this sentence originates is 184 pages long.  In order to understand this lone sentence, much, if not all, of those 184 pages would have to be mastered.

The writer, however, does have command of all 12 defined terms.  In fact, from the writer’s perspective this sentence is fairly simple and self-evident. These terms (both the defined terms and the deal terms) are common in auction rate security structures.

The lawyer who drafted this sentence is Bertrand Russell’s “mind of sufficient intellectual power”, and to that lawyer, understanding the sentence is trivial.  The problem is that when writing the disclosure document, all their hard won intellectual power and facility with these terms of art become a curse.

They write sentences like the above because to them, there are no defined terms.  All the terms are self-evident, like cat or tree.  Indeed, they may take pride in the artful construction of such sentences.

Thus the curse of knowledge, which starts out as a curse on the writer becomes a curse on the reader.  The writer’s unconscious assumption that everyone shares her knowledge becomes a very real curse on readers that makes them unable to understand what has been written.  This would be a good setup for a sitcom if investment disclosure documents weren’t one of the ways investors are supposed to be protected.


Learn more about complex investment expert Jack Duval.

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[1]                 Samuel K. K. Blankson; “The Einstein Theory of Space-time Without Mathematics”, (Lulu Enterprises, UK) 2005; 38.

[2]                 Chip Heath and Dan Heath; “The Curse of Knowledge”; Harvard Business Review; December 2006; Available at:; Accessed on November 19, 2014.

[3]                 Access to Loans for Learning Student Loan Corporation, Student Loan Program Revenue Bonds, Term Supplement to Attached Offering Memorandum; CUSIP 00433TAA1; October 11, 2007; TS-5; Available at:; Accessed on November 19, 2014.


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Topics: Complex Investments, Investment Complexity, Complex Investment Expert

Complex Investments: Evidence from 10-K Filings

Posted by Jack Duval

Oct 6, 2014 7:20:00 AM

This blog post continues our series on complex investments.

There is a large and growing literature on the amount of complexity in public company filings.  Over the past 14 years, research has show a correlation between statement length, high readability grade levels, and certain word patterns with a number of bad outcomes, including: 

  • Accounting fraud;[i]
  • Restating financial reports;[ii]
  • Stock price crashes;[iii]
  • Higher loan rates;[iv]
  • Poor and less persistent profits;[v]
  • Higher stock price volatility, and;[vi]
  • Negative earnings surprises.[vii]

Phrases of Fraud

Researchers have also identified a number of phrases that appear in the Management Discussion and Analysis section of 10-K filings that are correlated to fraud.  These phrases, called “lexical bundles”, can be searched for using Natural Language Processing techniques, which analyze the text of company filings.

One report compared the frequency of phrases in known fraudulent 10-K filings to non-fraudulent filings. This analysis identified a number of phrases that occurred much more frequently in the fraudulent filings. Some of them included the following phrases (percent difference of appearance in fraudulent filings to non-fraudulent filings in parentheses):[viii]

  • “In the year ended,” (213%);
  • “Process research and development,” (160%);
  • “Could have a material,” (146%);
  • “Have a material adverse,” (50%);
  • “The fair value of,” (50%);
  • “Be no assurance that,” (17%);

The SEC's "Robocop" Regressions

The search of 10-Ks for known phrases has been taken up by the SEC using what they call their Accounting Quality Model (“AQM”).   This initiative is part of the SECs Center for Risk and Quantitative Analytics.  In addition to searching 10-K filings for known phrases, the AQM runs regressions on the accounting numbers reported, focusing on discretionary accrual factors and off-balance sheet items.[ix]

The AQM (which has been dubbed “Robocop” by the industry) regressions produce a score for each filing that gives a probability for it containing fraud.[x]

Taken together, the research on the complexity of 10-K filings shows that longer and more complex filings lead to bad outcomes for investors.  It requires no stretch of the imagination to understand that longer and more complex explanations of company results and operations allow management teams to hide bad news, poor performance, growing debt, and other problems.

Commensurate with this, the use of certain phrases occurs more frequently in 10-K filings where the obfuscation of bad news has risen to the level of fraud.

S&P 500 Component Company 10-K Filing Length and Readability Analysis

The increasing complexity of public companies can be seen in an analysis of the S&P 500 component companies 2013 10-K filings. Some simple statistics are illustrative of the complexity in these 10-K’s:

  • 79.4 percent were written at the Ph.D level;
  • 19.0 percent were written at the graduate level, and;
  • 1.6 percent were written at the undergraduate level.

Furthermore, 86.4 percent of all S&P 500 component companies had 2013 10-K’s of 100 pages or more.

For higher resolution versions of the charts below and additional analyses, see this.

Chart 1:  2013 S&P 500 Component 10-K Page Length and Readability Levels[xi]


A comparison of average page 2013 10-K page length by sector and industry group shows that most industry groups average well over 100 pages in their 10-Ks.

Chart 2: 2013 S&P 500 10-K Average Page Length by Sector and Industry[xii]


As we have discusseed here, 10-K page lengths have more than doubled over the past 17 years.

The increasing page lengths and Automated Readability Index levels have made understanding what individual firms do and how they do it increasingly difficult.  This is important, because understanding individual firms is, in theory, easier than understanding investment vehicles that invested in individual firms.


The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.

   Get Updates on Complex Investments



[i]        Sean, Humpherys, Kevin Moffitt, Mary Burns, Judee Burgoon, and William Felix; “Identification of fraudulent financial statements using linguistic credibility analysis”; Decision Support Systems (585-594), August 19, 2010. Available at; Accessed October 2, 2014.

[ii]       Rani Hoitash and Udi Hoitash, “Measuring Accounting Complexity with XBRL”; SSRN Working Paper; August 26, 2014; Available at;  Accessed October 2, 2014.

[iii]      Mine Ertugrul, Jiaping Qiu, and Chi Wan, “Annual Report Readability, Crash Risk, and the Cost of Borrowing”,  SSRN Working Paper;  Available at; Accessed October 2, 2014.

[iv]       Id. at 17.

[v]        Feng Li, “Annual report readability, current earnings, and earnings persistence”; Journal of Accounting & Economics, March 4, 2008, 221-247; Available at; Accessed October 2, 2014.

[vi]       Tim Loughran and Bill McDonald, “Measuring Readability in Financial Disclosures”,  Journal of Finance, July 16, 2013;  Available at;  Accessed October 3, 2014.

[vii]      Id. at 21-22.

[viii]     Kevin Moffitt, “Using Lexical Bundles to Discriminate between Fraudulent and Non-fraudulent Financial Reports”; Rutgers Accounting Seminar, February 4, 2011;  Available at; Accessed October 3, 2014.

[ix]       John Carney and Francesca Harker, “How SEC’s New RoboCop Profiles Companies for Accounting Fraud, Forbes, August 9, 2013;  Available at; Accessed October 6, 2014.

[x]        Id.

[xi]       2013 S&P 500 component company 10-K page length and Automated Readability Index level obtained from analysis of company filings.

[xii]      Id.

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Topics: Complex Investments, Investment Complexity, Complex Investment Expert

The SEC's War on Jargon in Complex Investment Filings

Posted by Jack Duval

Sep 16, 2014 6:44:00 AM

This blog post continues our expert analysis of complex investments.



As we have discussed in a previous post, the SEC has been promoting "Plain English" writing in corporate filings since 1998.  A recent article by The Wall Street Journal highlighted the ongoing efforts by the SEC's 350-member Corporate Finance division to increase the readability of corporate filings.  Author Theo Francis writes:[1]

Corporate securities filings are plagued by some of the world’s most impenetrable prose, bit it isn’t for lack of effort… Last year alone, the securities industry’s style police sent nearly 8,800 letters to more than 4,600 companies… most seeking fuller disclosure or better adherence to accounting rules.  But many would have been right at home in freshman English.

Many of the SEC’s plain English efforts seek to eliminate (or at least clarify) industry jargon.  One bracing example from the article, included an excerpt from a filing by Technology Applications International Corp.:[2]

“rotatable perfused time varying electromagnetic force bioreactor.”  After being flagged by the SEC, it was altered to read:  “In use, the rotatable perfused time varying electromagnetic force bioreactor supplies a time varying electromagnetic force to the rotatable perfusable culture chamber of the rotatable perfused time varying electromagnetic force bioreactor to expand cells contained herein.”

Unsurprisingly, this revision was flagged again and was revised a third time.  What the filing was trying to say was that the company had a device that would grow more natural cell cultures.

Despite the SECs efforts, corporate financial filings remain legal documents that are replete with business, economic, accounting, and legal terms of art.  They are legal documents written by highly specialized practitioners and remain impenetrable to the vast majority of readers, including many industry practioners.


The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.

   Get Updates on Complex Investments



                 Theo Francis, The Wall Street Journal, “To Be Clear, SEC Reviewers Want Filings in Plain English, Period”; Available at; Accessed September 16, 2014.

[2]                 Id.

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Topics: Complex Investments, Complex Investment Expert

CalPERS Looking to Reduce Investment Complexity

Posted by Jack Duval

Aug 28, 2014 7:52:00 AM

This blog post continues our expert analysis of complex investments.

The Wall Street Journal recently reported that the California Public Employees’ Retirement System (CalPERS) is looking to simplify its portfolio. This move is significant because CalPERS led the charge into complex investments in the early 2000’s. Furthermore, because of its size, CalPERS is a bell-weather and other pensions and large asset managers tend to follow its lead.

The move to simplify began last fall when the pension released a set of investment principals that included, “(the fund) will take risk only where we have a strong belief we will be rewarded for it.”[1]

The implications of this are profound.  CalPERS, the largest pension fund in America, with over $295 billion in assets and a staff of 2,727,[2] is saying it has many investments that are too complex to know if they are being compensated for the risks in them.  Conversely, it may be that they can’t evaluate the risks in these complex investments.  Either way, CalPERS is saying they can’t come to a “strong belief” about these investments because of their complexity.

The CalPERS Investment Office has also been focusing on reducing complexity. In a March 12, 2013 presentation entitled “Performance and Cost Effectiveness", complexity is identified as a cost driver.[3]

Reducing portfolio construction and implementation complexity across all asset classes is identified as a priority.

Chart 1.  INVO Cost Drivers: Reducing Complexity[4]



This move to reduce complexity was reiterated in the CalPERS 2014 Beliefs, which stated, “We will also seek to reduce cost, risk and complexity related to manager selection and oversight.”[5]

If CalPERS, with a staff of 2,727 is looking to reduce the complexity of its investments, individuals with staffs of zero should do the same.



Get Updates on Complex Investments


The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.


[1]           Dan Fitzpatrick, “Calpers Rethinks Its Risky Investments”, The Wall Street Journal, August 10, 2014; Available at; Accessed August 27, 2014.

[2]           CalPERS Facts at a Glance, August 2014; Available at; Accessed August 28, 2014.

[3]           CalPERS Investment Office, “Performance and Cost Effectiveness”, Janine Guillot, COIO, March 12, 2012; Available at; Accessed August 27, 2014.

[4]           Id. at 5.

[5]           CalPERS Beliefs: Thought leadership for generations to come, May 2014, 9; Available at; Accessed August 27, 2014.





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Topics: Complex Investments, Investment Complexity, Complex Investment Expert, CalPERS

CDS ETFs: Reaching New Highs (Lows?) in Complex Investments

Posted by Jack Duval

Jul 24, 2014 2:37:00 PM

This blog post continues our expert analysis of complex investments.

ETF issuer ProShares has filed an N1-A statement to release a series of "hedge strategies" ETFs which will invest in credit default swaps ("CDS") on various high yield and investment grade fixed income IIndices.[1]

The ETFs in the N1-A are:

  •   ProShares CDS North American HY Credit ETF
  •   ProShares CDS Short North American HY Credit ETF
  •   ProShares CDS North American IG Credit ETF
  •   ProShares CDS Short North American IG Credit ETF
  •   ProShares CDS European HY Credit ETF
  •   ProShares CDS Short European HY Credit ETF
  •   ProShares CDS European IG Credit ETF
  •   ProShares CDS Short European IG Credit ETF

Understanding Credit Default Swaps

A CDS is simply a contract where one party pays the other a fixed rate and receives back a variable rate. The variable rate received back is typically based upon how some underlying (refrence) security performs or the occurance of a certain event.

Most adults have a CDS, they just don't realize it.  It is life insurance.  You (the CDS buyer) pay the insurance carrier a fixed amount (your annual premiums) and receive back a variable amount (the face value of the policy) based upon a event (your death).  If you are alive, the variable payment is zero, if you are dead, the varialbe amount is the face value of the policy.

Below is a chart of a these cash flows for a CDS on a bond.

Chart 1.  Plain Vanilla Credit Default Swap




ProShares CDS North American HY Credit ETF (“NAHYC ETF”) Analysis

The Fund’s Investment Objective is “to provide long exposure to the credit of North American high yield debt issuers by selecting a broadly diversified, liquid credit derivative portfolio.”[2]  Like the people in Plato’s cave, owners of the NAHYC ETF will be three times removed from reality, in this case, the economic returns of North American high yield debt.

This thrice removal can be understood by realizing that investors in the NAHYC ETF will be purchasing an ETF that then purchases CDS based upon the economic returns of North American high yield bonds.

The Fund intends to primarily invest in centrally cleared, index-based CDS.

Selling credit protection is equivalent to being "long" credit.  Because the Fund seeks to provide long exposure to credit, it will generally be a net seller of credit protection with respect to North American high yield debt issuers."[3]

Simply put, this means you will be guaranteeing other people's investments in speculative high yield bonds.

You Can Lose More Than You Invest

"Because derivatives often require limited initial investment, the use of derivatives also may expose the Fund to losses in excess of those amounts initially invested."[4]

However, what is strange is that this disclosure seems to contradict what was published in Federal Register Release No. 34-72099 regarding the listing the ProShares CDS ETFs on the BATS Exchange.  To wit:

"The Funds will seek to obtain only non-leveraged long or short credit exposure, as applicable (i.e. exposure equivalent to Fund assets).”[6]

It's not clear how this can be if a Fund is 80 percent invested in CDS guaranteed full notional amounts of bonds far in excess of the swap payments it receives.

Positions Will Be Sold Out When They Move Against You

"With respect to the use of swap agreements, if the North American high yield CDS market has a dramatic intra day move that causes a material decline in the Fund's net assets, the terms of a swap agreement between the Fund and its counterparty may permit the counterpart to immediately close out the transaction with the fund...  This, in turn, may prevent the Fund from achieving its investment objective, even if the CDS market reverses all or a portion of its intraday move by the end of the day."[5]

In plain English, this means the swap counterparty can and will sell you out at the bottom on extremely volatile days.  This virtually guarantees losses if the market swings hard against you because they will sell you out at an intraday loss and you won't recover when and if the market rallies.  (This gives the CDS counterparties an unfair advantage, they can close out the position when it moves in their favor, but not vice versa).  It is similar to the constant leverage trap (which we discussed in detail in our Leveraged and Inverse ETF white paper), but worse.

Credit Events

"Upon the occurrence of a credit event (i.e. when you get stuck with a defaulted bond), the Fund will have an obligation to pay the full notional value of a defaulted reference entity less recovery value."[7]

You get put the defaulted bond and have to pay them the notional value of the bond less the recovery value (which will be haircut quite a bit).

If the fund is fully invested (by prospectus about 80 percent), and there is a significant credit event in one reference security, it will most likely be forced to buy back some of the other CDS written to raise cash to make good on the original defaulted bond.   This will almost certainly necessitate realizing losses on positions away from the initial credit event.

This chain of events could lead to a catastrophic decline in the value of the Fund.

Complexity Risk

Most frightening of all the risks inherent in CDS ETFs is ProShares' saying they don't know how the underlying CDS will perform.  And indeed, they say just that:

"Other risks of CDS include... the risk that the CDS utilized by the Fund perform in ways that are not expected."[8]

Warren Buffett has said that risk comes from not knowing what you are doing.  If you make investments without the knowledge of how they will perform, then you don’t know what you’re doing.

The ProShares CDS ETFs will allow individual investors to turn themselves into insurance companies like AIG.  Buyer beware: bailout not included.


   Get Updates on Complex Investments


The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.


[1] ProShares Trust Form N1-A Registration Statement, May 31, 2013;  Available at;  Accessed June 25, 2014.

[2] Id. at 7.

[3] Id. at 9.

[4] Id. at 9.

[5] Id. at 9.

[6] SEC Release No. 34-72099; Self-Regulatory Organizations; BATS Exchange, Inc.; Order Granting Approval of a Proposed Rule Change to List and Trade Shares of Certain Funds of the ProShares Trust; May 6, 2014;  Available at; Accessed July 24, 2014; 3.

[7] See Supra note 1 at 9.

[8] Id. at 9.


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Topics: Complex Investments, Investment Complexity, Complex Investment Expert, ProShares

The "Plain English" Disclosure Documents of Complex Investments

Posted by Jack Duval

May 30, 2014 6:14:00 AM

This blog post continues our expert analysis of complex investments.



Twenty-six years ago the SEC adopted a rule that required securities issuers to write certain section of their disclosure documents in “plain English”. Alas, disclosure documents remain, for the most part, exceedingly hard to decipher.  Indeed, there is evidence that they have become even more complex.

As we have discussed here and here, the typical annual report is replete with legalese, industry jargon, and written at a very high level. In the table below, we have measured the readability of the 2013 annual report risk disclosure sections of all 30 Dow Jones Industrial Average (“DJIA”) component companies.

This is especially pertinent because the SEC Plain English Disclosure rule “requires issuers to write the cover page, summary, and risk factors section of the prospectuses in plain English”.[1] (Emphasis added)


Table 1.  Readability and Other Selected Statistics of DJIA Component Companies[2]


Automated Readability Index - Grade Level

Percent Difficult Sentences

Percent Complex Words

Percent Dale-Chall Unfamiliar Words






AXP American Express Co





T AT&T Inc





BA Boeing Co





CAT Caterpillar Inc





CVX Chevron Corp





CSCO Cisco Systems Inc





DD E I du Pont de Nemours and Co





XOM Exxon Mobil Corp





GE General Electric Co





GS Goldman Sachs Group Inc





HD Home Depot Inc





INTC Intel Corp





IBM International Business Machines Co...





JNJ Johnson & Johnson





JPM JPMorgan Chase and Co





MCD McDonald's Corp





MRK Merck & Co Inc





MSFT Microsoft Corp





NKE Nike Inc





PFE Pfizer Inc





PG Procter & Gamble Co





KO The Coca-Cola Co





TRV Travelers Companies Inc





UTX United Technologies Corp





UNH UnitedHealth Group Inc





VZ Verizon Communications Inc





V Visa Inc





WMT Wal-Mart Stores Inc





DIS Walt Disney Co











The average annual report risk disclosure section was written at slightly under the Ph.D. level, contained a majority of difficult sentences, and a significant number of complex and unfamiliar words.

Needless to say, such documents are not written in “plain English”. In addition, as we have discussed above, annual reports have continued to get longer, with many now in excess of 400 pages.

These facts are disappointing in light of the long time period that filing companies have had to refine their reporting, and the regulatory emphasis on “plain English” writing.

Background of "Plain English" Disclosure

In August 1998, the SECs Office of Investor Education and Assistance issued guidance on how issuers should write disclosure documents. This document was called “A Plain English Handbook:  How to create clear SEC disclosure documents”.[3]

In the Handbook, investor Warren E. Buffett wrote the preface, stating:[4]

For more than forty years, I’ve studied the documents that public companies file. Too often, I’ve been unable to decipher just what is being said or, worse yet, had to conclude that nothing was being said… There are several possible explanations as to why I and others sometimes stumble over an accounting note or indenture description.  Maybe we simply don’t have the technical knowledge to grasp what the writer wishes to convey.  Or perhaps the writer doesn’t understand what he or she is talking about.  In some cases, moreover, I suspect that a less-than-scrupulous issuer doesn’t want us to understand a subject it feels legally obligated to touch upon.  (Emphasis added)

SEC Chairman Arthur Levitt gives the motivation for plain English disclosures:[5]

Investors need to read and understand disclosure documents to benefit fully from the protections offered by our federal securities laws.  Because many investors are neither lawyers, accountants, nor investment bankers, we need to start writing disclosure documents in a language investors can understand: plain English.

In the Plain English Disclosure rule release, the SEC’s executive summary states:[6]

Full and fair disclosure is one of the cornerstones of investor protection under the federal securities laws. If a prospectus fails to communicate information clearly, investors do not receive that basic protection. Yet, prospectuses today often use complex, legalistic language that is foreign to all but financial or legal experts. The proliferation of complex transactions and securities magnifies this problem.  A major challenge facing the securities industry and its regulators is assuring that financial and business information reaches investors in a form they can read and understand.
In response to this challenge, we undertake today a sweeping revision of how issuers must disclose information to investors. This new package of rules will change the face of every prospectus used in registered public offerings of securities.  Prospectuses will be simpler, clearer, more useful, and we hope, more widely read.
First, the new rules require issuers to write and design the cover page, summary, and risk factors section of their prospectuses in plain English.  Specifically, in these sections, issuers will have to use: short sentences; definite, concrete, everyday language; active voice; tabular presentation of complex information; no legal or business jargon; and no multiple negatives.  Issuers will also have to design these sections to make them inviting to the reader.  In response to comments, the new rules will not require issuers to limit the length of the summary, limit the number of risk factors, or prioritize risk factors.
Second, we are giving guidance to issuers on how to comply with the current rule that requires the entire prospectus to be clear, concise, and understandable.  Our goal is to purge the entire document of legalese and repetition that blur important information investors need to know. (Emphasis added)

On January 22, 1998, the SEC adopted Rule 421(d) – The New Plain English Rule and amended Rule 421(d). Both rules took effect on October 1, 1998.  In staff Legal Bulletin No. 7 (CF), the SEC summarized the new rule and amendments as follows:[7]

Companies filing registration statements are required to:

  • write the forepart of these registration statements in plain English;
  • write the remaining portions of these registration statements in a clear, understandable manner; and
  • design these registration statements to be visually inviting and easy to read.

Since 1998, the “plain English” language has been incorporated into a number of SEC Rules and other laws, including:

  • 2002; The Sarbanes-Oxley Act in Section 409, Real Time Issuer Disclosures.  “Each issuer reporting under section 13(a) or 15(d) shall disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English…”[8]
  • 2006; SEC Proxy Statement Disclosure rules; “We are also adopting a requirement that disclosure under the amended items generally be provided in plain English.”[9]
  • 2010; Amendments to Form ADV. “Investment Advisors are required to provide new and prospective clients with a brochure and brochure supplements written in plain English”.[10]

Somewhat ironically, the SEC itself is subject to the Plain Writing Act (“PWA”) of 2010.[11] The PWA requires the SEC (and other federal agencies) to:[12]

write documents in plain writing, which the Act defines as writing that is “clear, concise, well organized, and follows other best practices appropriate to the subject or field and intended audience.” Plain writing avoids jargon, redundancy, ambiguity, and obscurity.

Investors Are Relying on their Financial Advisors

The state of most investment disclosure documents today is that they are a nexus of “jargon, redundancy, ambiguity, and obscurity.”  This defeats the purpose of disclosure, one of the bedrock principals of investor protection.  If disclosure documents are written in such a way that only a highly trained professional can understand them, then investors won’t even know what questions to ask. In such cases, investors are forced to rely on their advisors.

I believe this is good cause for a uniform fiduciary standard for all registered representatives and investment advisors.


The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.


[1]                 17 CFR Parts 228, 229, 239, and 274, Release Nos. 33-7497 and 34-39593, 1. Available at; Accessed May 28, 2014.

[2]                 DJIA 2013 component company annual reports are available at; All annual reports were accessed on May 28, 2014.  The entire risk disclosure section of each component company’s annual report was used for this analysis.

[3]                 “A Plain English Handbook:  How to create clear SEC disclosure documents”; SEC Office of Investor Education and Assistance; Available at; Accessed May 28, 2014.

[4]                 Id. at 1.

[5]                 Id. at 3.

[6]                 17 CFR Parts 228, 229, 239, and 274, Release Nos. 33-7497 and 34-39593. Available at; Accessed May 28, 2014.

[7]                 Staff Legal Bulletin No. 7 (CF); “Plain English Disclosure”; September 4, 1998; Available at; Accessed May 28, 2014.

[8]                 Sarbanes-Oxley Act of 2002, Section 409, Real Time Issuer Disclosures; (Generally effective after August 29, 2002)  Available at; Accessed May 29, 2014.

[9]             SEC Executive Compensation and Related Person Disclosure; 17 CFR Parts 228, 229, 232, 239, 240, 245, 249, and 274; Release Nos. 33-8732A, 34-54302A, IC-27444A; 191.  (Effective November 7, 2006)  Available at;  Accessed May 29, 2014.

[10]               SEC Amendments to Form ADV; 17 CFR Parts 275 and 279; Relase No. IA-3060; 1; (Effective October 12, 2010) Available at;  Accessed May 29, 2014.

[11]               SEC Plain Writing Initiative; (Effective October 1, 1998)  Available at; Accessed May 29, 2014.

[12]               Report on Implementing the Plain Writing Act of 2010; U.S. Securities and Exchange Commission; April 11, 2014.  Available at; Accessed May 29, 2014.

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Topics: Complex Investments, Complex Investment Expert, Automated Readability Index

Complex Investments Alert: How iShares Made the P/E Ratio Complex

Posted by Jack Duval

May 15, 2014 9:09:00 AM

This blog post continues our expert analysis of complex investments.

One of the most closely watched valuation metrics for equities, equity funds, and indices is the price-to-earnings (“P/E”) ratio.  The higher the price of the investment for a given level of earnings, the higher the P/E ratio, and vice versa.

The P/E ratio gives insight into the price an investor has to pay to buy the earnings of a given investment. It is useful as a metric to make comparisons between different investments and the same investment over time.

iShares Biotechnology ETF (IBB)

However, when investing in the iShares Biotechnology ETF (“IBB”), the reported P/E ratio of 39.62 differs materially compared to the average P/E of its largest holdings.  Amazingly, when calculating the P/E ratio of the IBB, Blackrock does some strange things.  Indeed, the fact sheet states that, “negative earnings are excluded, extraordinary items are excluded, and P/E ratios over 60 are set to 60.”[1]

The table below shows the actual P/E ratios of the top 10 largest holdings in the IBB.

Complexity of iShare ETFs.

 Table 1.  iShares Biotechnology ETF Top 10 Component Analysis[2] 


Thus the actual P/E ratio of the top ten holdings of the IBB is 54.33, not 39.62.  A difference of over 37 percent.  However, the discrepancy is even worse when accounting for all 122 companies in the IBB.  Zerohedge analyzed all 122 IBB component companies and found that 86 of them had negative earnings.[3] They calculated the P/E ratio to be 82.5, or roughly twice the reported P/E ratio.[4]

IBB Price Decline after the Zerohedge Story

As the chart below shows, it appears that investors were unaware of this discrepancy, because after Zerohedge broke the story, the IBB price declined immediately by over one percent.



Hidden Complexity

As we have discussed here, this is another example of how complexity can get baked into an investment in ways that would never occur to an investor (or an advisor) and would be very hard to find in the prospectus.  The P/E ratio is one of the simpler valuation metrics used by financial advisors.  If the IBB has an advertised P/E ratio of 39.62, but its largest constituents have a P/E ratio of 82.5, the investment might behave much differently than expected.


The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.


[1]           iShares Nasdaq Biotechnology ETF; Available at; Accessed May 14, 2014. 

[2]           Source: Google Finance

[3]           Zerohedge; “What Is the PE of the iShares Biotech ETF?  It Depends on Whether You Read the Fine Print”; Available at; Accessed May 15, 2014.

[4]           Id.

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Topics: ETF, Complex Investments, Investment Complexity, Complex Investment Expert, iShares, P/E Ratio

Complex Investments have Complex Disclosure Documents

Posted by Jack Duval

Apr 23, 2014 8:53:00 AM

This blog post continues our expert analysis of complex investments.

Complex Investments - Annual Report

Most in the finance industry would place individual stocks toward the simple end of the complexity spectrum. However, annual reports have become much longer, and more complex, over the past 15 to 20 years.

A study by Deloitte of 130 companies listed on the London Stock Exchange revealed that over the past 17 years the average annual report length has more than doubled, from 45 pages to 107 pages.[1] Furthermore, Deloitte highlights that banks have consistently had the longest reports, and in 2013 had an average 415 pages.[2]

It would seem that the longer documents have discouraged reading.  An IR Web Report cited Google web traffic data showing that investors spend less than five minutes viewing annual meeting materials online.[3] Furthermore, PostRank compiled data that reflected scant investor interest in annual reports as measured by shared links to those reports.[4]

Finally, the International Accounting Standards Board (“IASB”) has recognized the increasing complexity of annual reports and is making an effort to reduce their size.

IASB chairman Hans Hoogervorst stated, “the risk is that annual reports become simply compliance documents, rather than instruments of communication.”[5  The plan is to “ditch disclosures that are not ‘material’, with new guidance to define what is relevant.[6]

As we have discussed here, wading through hundreds of pages of disclosure documents to figure out what is relevant is beyond the abilities of lay investors.


The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.


[1]                 Deloitte LLP.  A new beginning: Annual report insights 2013; 21. Available at; Accessed April 21, 2014.

[2]                 Id. at 22.

[3]                 IR Web Report.  Investors spend just five minutes on annual reports – stats. Dominic Jones; May 12, 2011. Available at; Accessed April 23, 2014.

[4]                 Id.

[5]                 Reuters. Time to declutter annual reports, says accounting rule setter. June 27, 2013. Available at; Accessed April 23, 2014.

[6]                 Id.

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Topics: Complex Investments, Investment Complexity, Complex Investment Expert, Annual Reports

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