Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

My comments on April 3 about investment fraud and risk governance struck a chord. As a co-presenter for "Going Beyond the Essential Background Checks: Accessing Crucial Information About the Management Team, Board of Directors, the Economics for the Team and the Succession of the Investment Staff," 4th Annual Due Diligence & On-Going Monitoring of Alternative Investments Summit, Financial Research Associates, LLC, I talked about the numerous reasons why a typical background check is necessary but insufficient.

Send an email to Dr. Susan Mangiero if you would like more information about investment fraud thought leadership under way.

In the meantime, some hot button items that should be considered by institutional investors and asset managers that want to be green lighted by pensions, endowments, foundations, family offices and sovereign wealth funds include, but are not limited to, the following:

• Legal Ownership Structure - Ask for information about who owns what, who has voting rights and whether or when assets can be transferred across legal and tax jurisdictions. If an asset manager cannot or will not provide an organization chart and legal documentation that explains an often complex ownership structure, think twice about taking next steps. I resigned from an assigment to value a U.S. hedge fund limited liability partnership ("LLP") when the CEO and the company's attorney begrudgingly provided by-laws and an organization chart that illustrated firsthand a hard-to-understand web of cross-ownership (offshore and onshore). Should trouble occur, it is imperative to understand how economic rights are distributed and on what basis.
• Job Descriptions - A titular executive is not the same thing as having an experienced and knowledgeable person fill a critical function. As an expert witness, I wrote a report that pointed out, among other things, that the Chief Risk Officer was in name only. The actual person who bore that title was anything but a risk management professional.
• Internal Controls - Entire books have been written about the importance of vetting operational risks and internal controls. Suffice it to say, make sure that important tasks such as trading and approving wire transfers are each carried out by different individuals. Transactions should be verified on a regular basis by independent parties. Checks and balances should be in place to avoid breach for items such as surpassing trade size, making a material change to investment reports and/or modifying the approval process for moving money.
• Complexity and Model Risk - As I discussed in "Model Risk and A $242 Million Overlay" (February 3, 2011), models can be nested so that mistakes made at one level can be catastrophic if not caught early and corrected. That is exactly what happened in a matter relating to AXA Rosenberg, costing the firm nearly $250 million. Someone has to kick the tires on a regular basis. Model audits should be conducted by individuals who are not going to be compensated on the basis of a model's outcome(s).  When trading strategies are complex, it is sometimes tough to identify problem areas. I remember the words of one of my doctoral professors vividly because they still ring true today. "If you can't explain a trading strategy or make-up of a model, you don't know enough to make important decisions."
• Key Person Risk - Marquee name traders may be a draw for institutional and high net worth investors but proceed with caution. First of all, banking on a name trader does not guarantee that good processes are in place. Second, it is critical to know if key person insurance is in place to address the early exit of a trader or executive and the exact nature of the coverage. Also inquire about what happens if a key person gets a divorce and an ownership stake in the asset management firm becomes part of the settlement. Investigate whether the firm has a succession plan, a non-compete contract for departing executives and/or buy-sell agreement to guide how partners leave or join the firm.
• Intellectual Property - Ask about ownership of a patent, trademark, proprietary technology and/or marketing/sales collateral. In one situation, there was a real concern that the head of sales would have carte blanche to use the client list on behalf of a competitor. Depending on the costs to acquire each client, use of a list elsewhere could deal a crushing blow to a firm and by extension, destroy value for limited partners and/or investors in a particular fund or fund family.
• Governance and Committee Structure - A board of advisors can serve as a line of defense for investors in a fund as long as its members do their job well. I recall being interviewed to serve as an expert for a large hedge fund litigation. After having read the initial documents, I told the attorneys that the existence of a pricing committee and a risk management committee was impressive and asked to see the meeting minutes. The response was that neither committee had ever met. Of course a committee could meet on a regular basis but never address critical issues and thereby be ineffective, offering no safeguard for an investor(s).
• Vendor Contracts - Unless someone is doing a comprehensive review of service provider contracts, an investor is likely to encounter a coverage gap. In the matter of hard-to-value investing for example, many times an independent verification of prices is left undone when fund of funds managers, prime brokers, custodian banks and/or consultants accept numbers from hedge fund and private equity funds "as is" as part of their respective contracts.
  
• Investment Reports - Financial statements, audited or otherwise, do not always provide the same information on investment reports. The topic of performance reporting is left for another post as it is both broad and complicated. Suffice it to say however, all investors should be treated equally in terms of information access. With side letters and side pocket arrangements, disclosure may be limited and provided on a selective basis. As an expert on a regulatory enforcement case, I explained what industry standards exist for reporting true economic risks and returns versus statements that may be misleading at best. The hedge fund being investigated had topped off losses for some investors but not others and used some creative ways to report results.
• Borrowing Capacity - In 2008 and 2009, numerous investors were taken by surprise when asset managers were unable to honor redemptions (if allowed in the first place). One indicator (and there were many) of a liquidity crisis was the inability for some asset managers to borrow enough cash to keep going. Even worse, some prime brokers pulled back existing credit lines and/or charged considerably more which in turn depressed potential upside for investors. Ask about the current costs of borrowing and the capacity and sources for an asset manager to borrow more if needed. Depending on the leverage inherent in an asset manager's trading strategy, it may be necessary to ask for a copy of borrowing agreements and to understand what could trigger a margin call(s).

The list of problem areas is long and worthy of close scrutiny, ideally by an independent third party who can work with the internal auditor, external auditor and/or board of directors (assuming that all of these parties are focused on best practices and not contributing to a fund's downfall). Institutional and high-net worth investors alike should monitor these and other risk factors before writing a check.

Background checks are invaluable tools for investors who want to conduct proper due diligence. Importantly however, a background check is simply not going to provide the kind of information described above that can make a difference between investment success and failure.

Insider trading, anti-money laundering, investment fraud techniques and much more are left for future blog posts...

I have the pleasure of moderating a series of in-person and telephonic conferences about ERISA litigation and compliance in the next several months. Formally entitled the "FTI Consulting ERISA Litigation and Compliance Breakfast Series 2012: The $17.5 Trillion Challenge For Corporate Executives and Asset Managers," professionals working for or with pension plans are encouraged to attend these no-charge sessions with experts in New York (April 18, 2012), Chicago (April 26, 2012), Boston (May 3, 2012), Washington, DC (May 9, 2012), Philadelphia (May 15, 2012) and San Francisco (June 5, 2012).

The corporate pension market in the United States is facing unprecedented challenges in the form of massive deficits, new disclosure rules, recapitalizations, complex financial arrangements, turbulent market conditions and a rise in fiduciary breach litigation against C-level decision makers, board members and asset managers. Plan sponsors are being asked to improve governance, better manage risks and acknowledge the enterprise impact of nearly $18 trillion invested in U.S. retirement vehicles such as defined benefit plans and 401(k) plans. The perfect storm of low interest rates, sagging equity returns, mandatory cash infusions, increased longevity, financial volatility, investment complexity and greater regulatory scrutiny is a reality that is here to stay. Being informed and action-oriented is important as never before.

Join leading industry and regulatory experts in a lively discussion about the changing legal and financial landscape for ERISA fiduciaries, counsel and asset managers. Aimed at professionals who work for or with corporate benefit plans, these complimentary breakfast meetings examine the impact of new rules and regulations, lessons learned from the courts and ways to mitigate personal and professional liability at a time when fiduciary litigation is soaring.

Join us in New York, Chicago, Boston, Washington, Philadelphia and/or San Francisco for breakfast and a chance to hear and participate in a moderated panel discussion session about important topics such as pension and 401(k) plan governance, service provider due diligence, fee economics, withdrawal liability, successor liability, bankruptcy restructuring and much more. Stay abreast of breaking news, network with colleagues and earn CLE, if applicable. Call-in arrangements will be made for those who cannot attend in person so you can participate in each and every event.

For more information, including a list of esteemed speakers, visit http://www.fticonsulting.com/email/erisa2/.

In addition to sovereign debt restructuring, European financial market executives have a new mandate - high frequency trading governance. On February 24, 2012, the European Securities and Markets Association ("ESMA") published the final version of "Guidelines on systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities" in all official languages of the European Union ("EU"). As a result, regulatory supervisors must "declare whether they intend to comply with the guidelines or otherwise explain the reasons for non-compliance."

What caught this blogger's attention is the document's emphasis on governance as being "central to compliance with regulatory obligations" and having to address technical, business and operational risks, among other things. The document continues that policies and procedures must be in place to monitor a firm's trading systems and algorithms for adherence with the firm's internal control requirements. Additionally, it is critical for a firm to be able to detect when failures occur.

Whether these directives have an impact on high frequency trading remains to be seen. Bruce Love does a nice job of explaining the likely impact of ESMA's guidance. See "ESMA's HFT rules widen net, cash shadow over dark pools" (The Trade, January 24, 2012).

Please join me and fellow panelists on January 24, 2012 fro. 4 to 6 pm for a topical discussion about pension risk management and governance. Given that the last few years have posed unprecedented challenges for plan sponsors, both corporate and public, as well as their asset managers and consultants, life in employee benefit land will never be the same again. Market volatility, low interest rates, increased scrutiny about carrying out fiduciary duties, calls for better disclosure and greater complexity keep pension decision-makers busy.

Hear what legal and financial professionals have to say about what keeps plan sponsors and their advisors and asset managers up at night and how they can implement best practices for pension risk management within a fiduciary framework.

The roster of speakers who will address both defined benefit and defined contribution plan best practices and concerns include:

• Mr. William Carey, President, F-Squared Retirement Solutions
• Attorney Gordon Eng, General Counsel and Chief Compliance Officer, SKY Harbor Capital Management, LLC
• Dr. Susan Mangiero, CFA, FRM, Risk and Valuation Consultant and Expert Witness
• Attorney Martin J. Rosenburgh, CFA

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I recently had the pleasure of contributing an article about the importance of risk management and service provider due diligence to The Glass Hammer website. For those who are not familiar with the group, check out www.TheGlassHammer.com to learn about this award-winning blog and online community created for women executives in finance, law, technology and big business. See below or click on "Thought Leaders: Prioritizing Risk Management" to read the full text of this commentary about the benefits of risk mitigation well done and the costly consequences of inattention or sloppy practices.

Full Text:

Thought Leaders: Prioritizing Risk Management, July 14, 2011, 1:00 pm

Contributed by Susan Mangiero, PhD, Investment Risk Governance Consultant and Author

For those financial institutions which have yet to grasp the importance of identifying, measuring, managing, and monitoring risks on a comprehensive basis, time may not be on their side. Regulators and litigators alike are forcing change.

There are countless individuals who want better information from their service providers about risk and are prepared to vote with their feet if they don’t get good answers. After all, these institutional investors themselves are confronted with a bevy of new mandates that require transparency. The good news is that change opens the door to business opportunities. Enlightened organizations that have good processes in place and have nothing to hide can differentiate themselves from competitors. Providing clients with education and data tools offers yet another way for asset managers, consultants, banks, and advisors to forge stronger relationships with their pension, endowment, foundation and family office clients. On the flip side, those who are reluctant to explain how they manage their financial, operational and legal risks may lose clients or worse yet, could end up as defendants in a lawsuit.

Pay to play conflicts, questions about hidden fees, state and federal legislation and new accounting rules are a few of the forces at work to ensure that trillions of institutional dollars are in good hands. Effective investment stewardship is no longer a luxury. Recent surveys confirm that buy side decision-makers continue to emphasize governance and risk management for their organizations as well as providers of products and services. Institutional investors can ill afford to lose money after a tumultuous few years. Investment committee members who give short shrift to fiduciary duties could end up being investigated by regulators or sued. According to federal court data, the number of ERISA lawsuits is going up. Factor in investment arbitrations, enforcement actions and “piggyback” securities litigation allegations and it is clear that unhappy investors are not going to accept the status quo.

1. Fiduciary Focus

Besides efforts underway by the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Labor (DOL) has proposed an expanded definition of who should serve as a fiduciary to ERISA employee benefit plans. If adopted, countless more professionals will be tasked with demonstrating procedural prudence when it comes to the investment of over $30 trillion in money from corporate retirement plan sponsors. States are likewise seeking change in the form of trust law reforms that tighten accountability for the investment of monies held by endowments, foundations and charities. The questions now being addressed by judges and arbitration panels relate to “excessive” risk-taking, insufficient diversification, absence of independent assessments of hard-to-value instruments and oversight failures that have led to large losses that might have been highly preventable.

One asset management firm recently settled with the SEC for $242 million over a mistake with one of its risk management models. Another firm just settled with the SEC for $200 million due to problems in the way subprime securities were marked. A few years ago, a Northeast pension plan was sanctioned by the DOL for not having thoroughly vetted valuation numbers provided by one of its hedge fund managers.

When I testified before the ERISA Advisory Council in 2008, I emphasized that having good valuation policies and procedures is essential because it impacts so many decisions having to do with asset allocation, hedging and fees paid.

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