Good Risk Governance Pays

Good Risk Governance Pays

Investment Best Practices | Risk Management | Valuation

Trust, Ted and Norb Vonnegut

Posted in Ethics, FINRA, Key Person, Regulation

Trust icon

Having just signed up for a forthcoming webinar about the U.S. Department of Labor fiduciary proposal, trust is on my mind. Due to a recent introduction of like-minded advocates for good process, I had a chance to watch a TED Talk with Mr. Norb Vonnegut. (For those who have not had the pleasure, there is a large volume of interesting videos, courtesy of the Technology, Entertainment and Design nonprofit organization that began in 1984. Click to read about TED.)

During his talk entitled “How Do You Know You Can Trust Somebody With Your Money?“, Mr. Vonnegut asserts that individuals should be wary of relying too heavily on a financial organization’s brand. Even if a regulator like FINRA or the U.S. Securities and Exchange Commission has the purview to oversee a financial advisor or other type of intermediary, budgetary resources do not allow for examinations of everyone they regulate.

Mr. Vonnegut illustrates his cautionary tale for investors with a scary snapshot of a neighbor gone bad – someone who was running a Ponzi scheme and was eventually arrested and jailed. He urges investors to avoid wealth management “helpers” who appear conflicted or boast a troubled background, adding that one can handily visit as a first stop.

Given his many years as a senior financial advisor and now a successful author and journalist, Mr. Vonnegut recommends that investors download the Fiduciary Oath from his website and then do plenty of homework rather than relying blindly on name or where someone went to college.

Insights on Economic Analysis of Fiduciary Monitoring Disputes

Posted in ERISA, Fiduciary Liability, Investment Management, Litigation, Regulation, Susan Mangiero

Lee Heavner_Susan Mangiero

While I typically avoid republishing posts from my other blog, Pension Risk Matters, there are numerous topics that are important to all types of investment industry professionals and not just those who work with retirement plan sponsors and participants. One such topic looks at investment monitoring and the fiduciary responsibilities to oversee and make changes, as needed. Recently, the U.S. Supreme Court applied its judicial experience in opining about the relevance of how long to monitor investments for a trust fund such as an ERISA plan.

While there has been no shortage of informative write-ups by attorneys about this headline-ripping case, little had been written by any forensic experts until now. To fill this void, I wrote “An Economist’s Perspective of Fiduciary Monitoring of Investments” (Pensions & Benefits Daily, May 26, 2015). The interest in the topic of damages and the complexities of when and how to monitor led to a second article.

According to a recent Business Wire press release about these follow-on insights, “Economic Analysis in Fiduciary Monitoring Disputes Following the Supreme Court’s ‘Tibble’ Ruling” (Pensions & Benefits Daily, June 24, 2015), Dr. Lee Heavner (Analysis Group Managing Principal) and Dr. Susan Mangiero (Fiduciary Leadership, LLC Managing Director) explain that what constitutes a reasonable monitoring process may be influenced by plan- and investment-specific factors, as well as by the expected benefits and costs of different monitoring activities. They are quoted as saying that “The monitoring of investments is a broad and complex topic. There is no uniform process that is appropriate in every situation. To the contrary, the list of potentially relevant risk factors is long and subject to revision as circumstances change.” These two economists (both of whom have worked as expert witnesses) also discuss how complexities arise when calculating economic damages due to the wide array of alternative actions and the substantial variation in timing that may be consistent with a prudent monitoring process.

Click to read the U.S. Supreme Court May 18, 2015 Tibble opinion. Jurists emphasize the significance of the topic of investment monitoring for both buyers and sellers of financial products and services.

Good Players Pay For Other People’s Bad Investment Compliance

Posted in Compliance, Financial Crisis, Governance, Investment Management, Municipal Bonds, Pension, Regulation

Tree Lands On House Roof Crushing It

Much to my chagrin, I am told that it is my responsibility to pay for the removal of my neighbor’s tree after it fell in my backyard. Never mind that the tree is old and was left untended for many years until a bad storm destroyed its ability to stand. Ignore the fact that I diligently prune my trees on a regular basis and otherwise provide for their care and maintenance. While my leafy plight is trivial in the grand scheme of things, this notion of paying for the inaction or bad action of others appears likely to stay. Its unhappy companion is the idea that “free” goods and services can magically appear.

There are so many examples in recent news about questionable economics that it is hard to know where to begin. Just tonight, ABC News announced that the City of Chicago has contributed $634 million to its teacher pension plan, thereby forcing a “cut in classroom spending.” According to Mayor Rahm Emanuel, there is an inequity because the State of Illinois “makes the employer contribution to teach pensions for districts outside Chicago.” Elsewhere, it was announced that five million more individuals could be eligible to receive overtime pay, notwithstanding the upset on the part of small business owners who predict layoffs to pay for the mandate.

Then there is the issue of sovereign debt, notably Greece. It is heartbreaking to see the photos of retirees who are desperately seeking reassurance that there will be money to pay them. There is a human face to the creditors as well. Banks, supranational organizations and hedge funds that have lent money to this Hellenic nation, Puerto Rico and other self-declared borrowers in trouble owe an allegiance to their investors to collect. Think about the millions of pensioners and hard-working individuals who will likewise face a diminished checkbook if any of this debt remains unpaid.

At an industry-level, the truism that there is “no free lunch” equally applies. Every action has a consequence and a cost. In an ideal world, interested parties evaluate the risks and expected rewards and decide on a course thereafter. It is not left to governance-focused advocates to pick up the expense. Yet here we are, continuing down the path of often being forced to dive into the deep end when “pushed” by organizations with a lesser focus on good process. How often do we hear regulators address the sins of others as a catalyst for a new rule or regulation? A good example is the current debate about fiduciary standards. If conflicts of interest were less of a concern on the part of some, would the U.S. Department of Labor proposal look as it does now? If organizations with anemic compliance were singularly penalized by the marketplace with no spillover of ill effects on good players, the operating environment would differ from today’s reality. Money spent on risk management and internal controls would exclusively benefit the clients and shareholders of the party that writes the check.

Alas, there is no unfettered free market that purely rewards or impugns. This means that the issue of subsidization is far from trivial since it guides how much money an organization such as an asset manager, bank, advisory firm or insurance company should pay to influence the deeds of industry “peers.” As things currently stand, too much of an isolationist stance could end up plaguing even the most solid of stewards. Said differently, there is an advantage for everyone to strive for integrity in financial dealings, even if it means that some organizations pay more than others, absent a proper price signalling device. It may not seem fair but bad trades, like felled trees, can cost disciplined individuals and businesses real money.

Dinosaurs and Investment Risk Governance

Posted in Compliance, Fees, Governance, Investment Management, Pension

Tyrannosaurus rex

Call me grumpy. I just wasted $10.50 and two hours of my time watching “Jurassic World.” Yes, I know the film is close to raking in a billion dollars (although “Gone With the Wind” is supposedly still number one when revenues are adjusted for inflation). No, I did not count on such excessive product placement or gratuitous violence. That said, my husband enjoyed his popcorn and celluloid raptors as did many others in the audience. If you do buy a ticket, I hope you have fun.

Like multiple movies, this 2015 tale about dinosaurs was predictable enough to know early on who would be gobbled up and who would survive. In the investment world, the ability to forecast the future is not always as straightforward so it is helpful to understand what experts foretell.

In a recent publication entitled “Asset Management 2020: A Brave New World,” PriceWaterhouseCoopers (“PwC”) cites its expectation that pension funds, high net worth individuals and sovereign wealth funds will drive a large rise in assets under management, much of which will remain in the hands of active asset managers. At the same time, PwC chronicles continued pressures on fees earned by asset managers, dovetailed with clarion calls for better transparency. The study makes it clear that cost containment will be a big priority, pointing out that fees and customer care will likely have to differ across market segments. For example, the “mass affluent” will be offered “more self-directed services” as “it will simply be too expensive for many firms to service retail investors.” Simpler products could be offered so that financial advisers can “spend less time explaining strategies.” To the extent that hedge fund and other types of alternative fund managers can reduce fees, there is a chance for them to gain a stronger foothold in the defined contribution plan arena.

The Boston Consulting Group describes the asset management sector as “among the most profitable industries” with steady growth in operating margins in the neighborhood of forty percent. Expanding on the theme of change, its research emphasizes (a) “a tsunami of regulatory tightening and public pressure for change” (b) greater reliance on technology for both portfolio activity as well as operations (c) demand for customized solutions (d) intense global competition with U.S. and UK managers being especially focused on serving non-local customers and (e) a shift away from “traditional active core assets.”

In yet another recent study, Casey Quirk and Evestment spotlight trends that include heightened competition among asset managers, “in particular for traditional mandates,” as well as a “long-term desire of asset owners worldwide to design policy allocations around specific objectives, which differ from investor to investor.” Their take is that successful investment management firms are those that recognize disparate client segments and design products for each of them. Client service and thought leadership could be part of the offerings. The awareness of differences among investors such as corporate defined benefit plans versus public pensions versus defined contribution plans and so on is reflected in the published assessment of key concerns. While rising interest rates are on the agenda for multiple groups, regulations are more stressful for consultants versus end-investors. Somewhat disturbing to me is that risk management and volatility appear to be of less concern to these institutional investor survey-takers than meeting target returns or addressing market corrections. See “A Tailored Approach: Positioning to Outcome-Oriented Global Investors” for detailed graphs and tables.

Business strategists have a lot on their respective plates. Deciding how best to tame the uncertainty beast is no doubt going to be tricky. How does an organization offer a customized and typically expensive product to a coveted client base while keeping fees in check? Over time, technology typically creates efficiencies but can cost a lot upfront to develop. Will technology be a help or a hindrance in search of higher profit-margin customized deliverables to pension funds and other large asset owners? Then there is the challenge of doing “enough” to satisfy clients while being mindful of an increasingly litigious and regulatory environment. Taking shortcuts could destroy customer goodwill and increase an asset management firm’s exposure to being sued and incurring the attendant costs of defense. How will businesses strike the right balance between compliance, good governance and customer hand-holding versus curtailing costs?

The dinosaurs with big scary teeth are showing up everywhere and not just in movies.

Marshmallows and Financial Fraud

Posted in Compliance, Ethics, Fraud, Governance

Portrait of cute joyful boy with a marshmallow

Long deemed to be a seminal assessment of delayed gratification, the Marshmallow Test was designed by then Stanford University psychology professor Walter Mischel (now at Columbia University) and remains popular today. In a typical experiment, youngsters are told that they can have one sweet now or wait awhile and receive two as compensation for their patience. Repeating the experiment in different locations by different researchers has generated results that continue to link childhood discipline with later life accomplishments. While the test has its critics, its architect shared insights in a 2014 interview with The Atlantic‘s Jacoba Urist. Citing from his book entitled The Marshmallow Test: Mastering Self-Control, Dr. Mischel explains that anyone can learn to impose limits on himself but cautions that willpower fatigue can lead to a sense of entitlement or an inability to parse the trade-offs between risk and return. As a result, poor decisions may follow.

Several years ago, New York Times reporter John Tierney wrote a piece about exhaustion and its relationship to compromise, when to change things and why temptation beckons for some but not others. In “Do You Suffer From Decision Fatigue?” (August 17, 2011) readers are told that “Once you’re mentally depleted, you become reluctant to make trade-offs, which involve a particularly advanced and taxing form of decision making.” He credits various behavioral reviews for showing that too many choices can lead to exhaustion and that “once decision fatigue set in, people tended to settle for the recommended option…”

Borrowing from these experiments, numerous questions for the financial service industry arise, a few of which are listed below.

  • Are markets “too complex” and, if so, does that make it harder for persons to decide as to how to measure risks, let alone manage them?
  • Is there too much of a skew towards short-term compensation that encourages “excessive” risk-taking and possible fraud (i.e. opting for a marshmallow now rather than waiting for a longer-term reward)? A May 2015 survey entitled “The Street, The Bull and The Crisis: A Survey of the US & UK Financial Services Industry” laments the need for further reform, post 2008, to ensure good ethics and compliance with prevailing laws.
  • Should key persons be encouraged to take vacations and otherwise embrace work-life balance to ensure that their decisions emanate because of clear thinking and not fatigue?

It is no surprise that behavioral psychology has found a home in the world of finance.

Investment Transparency Now Required in Rhode Island

Posted in Disclosure and Transparency, Fees, Hedge Fund, Investment Management, Pension, Uncategorized

Time for Transparency Clarity Honest Forthright Clock

Just a few days after the U.S. Securities and Exchange Commission (“SEC”) voted to officially propose that certain registered funds provide a lot more information about their operations, the State of Rhode Island has followed suit. In a May 26, 2015 press release, General Treasurer Seth Magaziner describes the Ocean State as a leader in public pension fund transparency, adding that “Rhode Island will only invest with fund managers that agree to public disclosure of performance, fees, expenses and liquidity.” Other initiatives include the creation of a website for public access, the signing of an “Investor Code of Conduct Pledge” by every investment manager and the debut of “full governance reviews of the State Investment Commission and the Retirement Board” by late 2015.

A draft version of the “Transparency in Government Agreement” acknowledges that asset managers may provide some proprietary information that the Employees’ Retirement System of the State of Rhode Island (“ERSRI”) will hold back from the public. However, details about asset managers that allocate to mostly illiquid assets will be disclosed. Facts such as drawdowns, vintage year, management fees, direct expenses and “cumulative net internal rate of return” will be visible with monthly, quarterly or annual reporting requirements, depending on the variable. Visitors to can download data about the various Rhode Island retirement plans and see for themselves how billions of dollars are being allocated. The newest report is based on data from April 29, 2015 and includes a fund-specific breakdown of $1.347 billion in alternative investments.

It is unclear whether this move towards enhanced reporting is related at all to an April 16, 2015 decision by Rhode Island Superior Court Associate Justice Sarah Taft-Carter regarding settlement of a benefits-related lawsuit brought by municipal workers against the Governor. Another motivation could be the repeated headlines about the extent to which Rhode Island pension plans should be invested in alternative investments that include hedge funds. The Providence Journal reported a 14.4% or over $1 billion exposure to hedge funds as of August 2014. See “Raimondo sees no reason to follow California’s lead, exit hedge funds” by Katherine Gregg (September 16, 2014). Things are changing, presumably on an as-needed basis. Earlier this year, Ms. Gregg wrote that the State had terminated one contract with a hedge fund manager. See “Rhode Island dropping stake in low-performing hedge fund” (March 2, 2015).

It remains to be seen whether heightened access to data will garner intense interest and whether a clamor for even more granularity follows. It is hard to see a downside of providing copious amounts of information as long as it is (a) accurate (b) timely (c) representative of the financial well-being (or lack thereof) of any or all of the municipal benefit plans and (d) clear about the process being followed by trustees to arrive at key decisions on behalf of participants.

SEC and Asset Manager Disclosures About Use of Derivatives

Posted in Derivatives, Disclosure and Transparency, Investment Management, Liquidity, Regulation, Valuation

National Vanilla Pudding Day_Small

Notice anything odd about this announcement? Are we to celebrate this creamy dessert on May 21, 22, 23, 24 and 25? If so, why is the event referred to as a “day” celebration? A quick search on the internet informs that National Vanilla Pudding Day is in fact May 22, 2015 and does not span nearly a week of joyous spoons in cups. Unfortunately, we would never know the truth by reading the sign.

One wonders if this type of ambiguity and confusion is a motivator for the U.S. Securities and Exchange Commission (“SEC”) in its quest for further disclosures by the $60+ trillion investment industry. According to “SEC Proposes Rules to Modernize and Enhance Information Reported by Investment Companies and Investment Advisers” (May 20, 2015), certain registered funds such as mutual funds and exchange-traded funds (“ETFs”) would have to complete a Form N-PORT each month. If finalized, reporting entities would need to share details about the (a) use of derivatives (b) pricing of securities  (c) information about securities lending, repurchase agreements and counterparty trades as well as (d) “[d]iscrete portfolio level and position level risk measures to better understand fund exposure to changes in market conditions.”

As with any initiative for enhanced transparency, the nature of how information is to be presented will be critical. For example, will derivative transactions that are used to hedge be reported as a separate category and distinguished from any derivative transactions that are used to synthesize asset or sector exposures in anticipation of certain price movements? Will derivative exposures be reported on a net or gross basis? If a derivative transaction has matured prior to month-end, will it be excluded? Will SEC reporting be compatible with Generally Accepted Accounting Principles (“GAAP”) reporting? Regarding valuation, is the goal to share insights with the public about the process used by a registered fund or rather a collection of numbers or both?

Andrew Ackerman with Dow Jones Business Wire explains that worries about a systemic meltdown are driving efforts to reform the capital markets. He adds that investors and asset managers should expect an SEC sequel that mirrors the kinds of stress tests and liquidity assessments that banks are being asked to perform in the aftermath of the 2008 credit crisis. See “SEC Votes to Propose New Mutual Fund Reporting Rules — 2nd Update” (May 20, 2015).

Notable is the implication for retirement plans and the fiduciaries who monitor investment selections for benefit offerings such as 401(k) plans. According to the 2015 Investment Company Fact Book, mutual funds represent $7.3 trillion of Individual Retirement Account (“IRA”) and defined contribution plan assets. That’s a large number. No doubt, both individuals and institutional fiduciaries will welcome any statements that can shed extra light on the risk-return profile of an existing or contemplated investment.

Electronic RFP Process and Fiduciary Duty

Posted in Compliance, Fiduciary Liability, Financial Expert, Investment Management, Pension

Kent Costello

As I have mentioned on other occasions, my work as a forensic economist (and sometimes testifying expert witness) has frequently focused on how service providers were selected and then monitored. Always interested in knowing about industry innovations as they occur, I was intrigued to recently learn about a firm called InHub. Founded in 2014 by two investment advisors, the company’s mission is to apply the power of technology to the Request for Proposal (“RFP”) process and thereby hopefully make it easier for institutional investors to form an educated decision about what advisor, consultant or asset manager to select. Just as important, the goal is to facilitate a centralized repository for documents and communications that could be helpful in demonstrating procedural prudence. After reviewing the website at and requesting a demo, I then asked Mr. Kent Costello (one of the two co-founders) to answer a few questions. The text below is the result of that Question and Answer session.

Q: In your experience, how do institutional investors such as foundations and pension plans currently search for service providers such as consultants and advisors? What are some of the pitfalls associated with these methods?

A: The approach taken by institutional investors to search for consultants varies and often depends on the size of an asset portfolio. Larger organizations with a billion dollars or more typically make their searches public and allow a given amount of time for consultants, managers, and other service providers to indicate interest and/or submit a proposal. In this way, they are essentially crowdsourcing the proposal process and may find firms through this method. A downside of this approach is that respondents are not necessarily pre-qualified. Some vendors are already known to investment committee members and may be referred to their peers. A disadvantage of selecting a vendor on the basis of referrals is that personal relationships may take precedence over the qualifications of a particular firm. It is not uncommon for a consultant to be a friend of a business owner or board member, especially for smaller firms. An advantage of the referral approach, when appropriate, is that it matches an institution in need with a trusted source.

Q: Besides launching a formal public search or connecting with a vendor as the result of a referral, are there other ways that an investment committee or board can identify service providers and then review their qualifications thereafter?

A: Yes. General meetings and website searches come to mind. Many times the committee (or board) will collect and maintain information from consultants who have called on them in the past or whom they have met at a seminar or conference. The obvious pitfall here is that a strong sales team or large marketing budget does not automatically guarantee that a particular vendor is qualified and can deliver services on a cost-effective basis. Critics can argue that firms that are sales-focused are not spending as much time as they should on servicing their existing clients or that a firm that is doing a good job does not need an active sales force because its organic growth is the result of a solid reputation. That said, I think the offering of an educational seminar to both clients and prospects by an advisory firm is a positive sign that the vendor is willing to take time to share new ideas and find ways to add value to their clients. With respect to a Google search, this could be a good first start although there is no way for an investment committee to know if it is missing experienced vendors by relying on the internet alone as a way to decide what firms to interview.

Q: Describe some of the limitations of the existing RFP process for the buyer.

A: As just discussed, investment committees searching for consultants and even consultants conducting manager searches should pre-qualify candidates based on initial criteria. This can be challenging in the absence of some sort of screening process. It can be difficult for investment committees to put together a list of questions that will help them to effectively compare firms and service offerings, especially for small and mid-sized committees. Poorly crafted, irrelevant, or repetitive questions will lead to a weak due diligence process and leave the committee confused and frustrated. Worse yet, it could mean the selection of an inadequate vendor. Then there is the issue of having to sort through mountains of data. RFP submissions are frequently submitted in hard copy form. The nature of the replies could preclude making an “apples to apples” comparison of each vendor’s capabilities. In sum, differences in the way replies are proffered and the sheer volume of submitted pages make it hard for multiple decision-makers to review information, let alone comment and ask questions in an interactive manner.

Q: Describe some of the limitations of the existing RFP process for the seller.

A: Given the proliferation of independent advisory firms, it can be challenging for even the largest and most established of companies to achieve industry-wide recognition and thereby ensure that they are considered for opportunities for which they would be a strong candidate. Firms responding to RFPs struggle to weigh the benefits, given the low likelihood of winning the business, against the significant amount of time and resources that are required to deliver a quality proposal. While there are often similarities among RFP questionnaires written by buyers, the differences can be significant enough that a vendor frequently has to spend time and money to modify its answers (i.e. reinvent the wheel) so that each proposal qualifies for further review.

Q: Are some RFPs easier to carry out than others? If so, please explain your answer.

A: Yes, some RFPs are easier to complete. As stated earlier, RFP consistencies do not always exist throughout the entire, and often lengthy, questionnaire. Then there is the issue of the number of people who are tasked with selecting an advisor, consultant, asset manager or other type of service provider. Where you may see three to seven committee members involved in an RFP for a corporate 401(k) plan, you may see north of twenty people involved in the review process of a large non-profit organization or other institution that is governed by a board. This creates challenges in a number of areas. Organizing communications with the would-be buyer, agreeing on the scope of services, addressing conflicts and negotiating a final contract are a few challenges that immediately come to mind. Sometimes a board or committee may hold a strong view and seek to sway others from voting in favor of a given vendor. Public organizations must adhere to certain rules such as “pay to play” prohibitions. Bureaucracy can extend the timetable before a decision to hire a firm is made. An advantage that larger institutions and public organizations can have over smaller investors is the ability to rely on staff members (if they exist) who are knowledgeable about investment management. This is especially important when conducting an RFP for a specific investment strategy that requires the ability to comprehend technical language. However, even bigger institutional investors can be confronted with information that is less than transparent. For example, some vendors may bundle services and charge accordingly. Others break down services (and related fees). It is critical for the buyer to understand exactly what services they need, what they will likely receive and how much things will cost in “true” economic terms.

Q: What do you believe are the characteristics associated with using an electronic platform for RFP initiation and completion?

A: As a co-founder of an electronic RFP platform, I obviously believe that there are significant advantages of harnessing technology when selecting vendors via an RFP. These include, but are not limited to, the following: (a) speed of preparation (b) ease of collection and reviewing of the proposals (c) centralized communication with committee and candidates and (d) proper documentation of the decision. Preparing a traditional paper RFP can be overwhelming for an average investment committee. If they have never issued an RFP in the past, they often do not know what type of information they should be providing as background, what services they should be requesting and what information they should be providing on their account in the form of a description and addendum documents. In a quality electronic RFP, the system will be laid out in a way that guides the committee through the key steps and even suggests ideas for content or questions to ask, allowing for a much more intuitive process. Instead of sorting through piles of papers, an electronic RFP allows for all proposals to be submitted to one online portal where committee members can log-in and view proposals side-by-side in the same format. When there is more than one decision-maker (which is normally the situation), an electronic RFP platform facilitates ongoing communication among committee members and/or board members. The communications are centralized and create a paper trail for outsiders to examine as needed. That paper trail likewise allows investment fiduciaries to demonstrate that they have individually and collectively adhered to a prudent due diligence process (if indeed they have). Finally, an electronic RFP process will automatically generate a document that includes relevant information associated with the RFP process such as (a) the purpose of the RFP (b) scope of services requested (c) key questions asked (d) committee members involved (e) all firms invited and (f) the voting process.

Q: Are there particular areas of an RFP such as compliance, fees or risk management that institutional investors are including more now than in the past?

A: Yes. Institutional investors are focusing on fiduciary obligations, fee disclosures and operational transparency. I expect to see more of this emphasis as the fiduciary outsourcing business grows. For example, when a consulting firm is engaged as an Outsourced Chief Investment Officer (“OCIO”), one would expect that function to be clearly addressed in the RFP. As fiduciaries can be personally held liable, enlightened committee members know that they must do a good job of selecting a service provider. Regarding fee disclosures, it is safe to say that new regulations are forcing institutional investors and their advisors to focus on fee compensation arrangements and transparency about buyer-seller relationships. More and more institutional investors are asking pointed questions regarding fee transparency and potential conflicts of interests. They are also expecting the consultants to provide services that help them understand the reasonableness of the fees of both other service providers and their own. This has led to a far bigger number of consultants that now employ a direct bill model (either as a flat fee or percentage of assets). Requests for fee benchmarking services and help with the RFP process have increased.

Q: How do you think the RFP process will change as the fiduciary outsourcing business model grows?

A: I do not think that the RFP process will necessarily change with the increase of fiduciary outsourcing but rather will become even more standard in the sense that questions and answers should reflect proper due diligence. Whenever one party seeks to shift responsibility and some liability to another, the act of deciding who will hold the burden of responsibility is an urgent and scrutinized decision. While fiduciaries can never fully abdicate their responsibilities, by outsourcing to a third party, they are seeking to mitigate their liability by granting discretion on key decisions to parties such as advisors, consultants and asset managers. In the event that something were to go wrong, one of the first things that an examiner would inspect is how the third party was vetted by the institutional investor.

Note: Interested readers can check out “Request for Proposal (RFP) Checklist for Retirement Plans” by Sarah E. Downie, Hughes Hubbard & Reed LLP, Practical Law Employee Benefits & Executive Compensation. Other educational resources include “Creating an effective RFP process” (Vanguard, 2014) and “Model RFP” templates (CFA Institute).

FINRA and Financial Fraud Sanctions

Posted in FINRA, Fraud

Crossed fingers

In its just-released “Sanctions Guidelines,” the Financial Industry Regulatory Authority (“FINRA”) makes no secret of its goal to design disciplinary actions “that are meaningful and significant enough to prevent and discourage future misconduct.” Repeat offenders are unlikely to get away with a mere slap of the wrist, particularly if their actions demonstrate “a reckless disregard for regulatory requirements, investor protection, or market integrity.”

As a forensic economist and someone who has calculated and testified about investment losses, FINRA’s comments about damages are noteworthy. Besides disgorgement, this industry watchdog group warns that “restitution may exceed the amount of the respondent’s ill-gotten gain.” For those seeking recompense, don’t jump for joy too soon. FINRA adds that a respondent’s inability to pay must be considered “with the imposition, reduction or waiver of a fine or restitution.” This could be a serious matter. Even if a victim proves his or her case, a fraudster may have already spent so much money that there is nothing left to distribute. In situations where assets exist, aggrieved investors will benefit from sanctions that are grossed up for inflation.

That said, the monetary sanctions for offenses, listed according to categories and sub-categories, in “Sanctions Guidelines” seem relatively low to me. For example, on page 34 of this new document, “Settling Customer Complaints Away From the Firm” shows a monetary sanction of $2,500 to $73,000. However, a suspension “in any or all capacities for up to two years” or an outright bar in “egregious cases” would seem to have a far more deleterious impact on the bottom line of the perpetrator (if he or she is found appropriately guilty). In today’s environment, the inability to keep relationships warm with constant contact likely makes it impossible to generate investment-related revenue.

With annual fraud-related losses between $40 to $50 billion, deterrence is being hailed as a cornerstone of effective regulatory response. Interested readers can download “Scams, Schemes & Swindles: A Review of Consumer Financial Fraud Research” (Financial Fraud Research Center, 2012) for insights about wrong-doers and characteristics of victims. If the authors are correct that fraud is on the rise, CNBC’s “American Greed” will continue to flourish. Click here to watch full episodes.

Non-Profit Compliance and Size

Posted in Compliance, Non-Profits

Little feet in big shoes

I sometimes hear individuals expressing the view that larger tax-exempt organizations are better managed. The thinking is that more resources allow for the payment of bigger salaries, presumably to attract otherwise unattainable talent. The acquisition of expensive technology systems that can track cash flows and any financial limit violations is another cost that smaller entities may not deem affordable.

Does size matter and if so, how? Do smaller organizations gravitate towards less risk-taking as a cautionary measure to offset fewer compliance resources? Are donors asking sufficient questions about important topics such as internal and external controls, adherence to mission, administrative budget and financial integrity?

The topic of size is referenced in a recent comment by Ms. Maura Pally, acting CEO of the Bill, Hillary & Chelsea Clinton Foundation (with more than $350 million in assets as of year-end 2013). In her April 26, 2015 blog post, she wrote “So yes, we made mistakes, as many organizations of our size do, but we are acting quickly to remedy them, and have taken steps to ensure they don’t happen in the future.” What exactly does she mean?

Regulators and industry associations seldom differentiate by size when it comes to fiduciary duties and adherence to existing statutes.

In “Nonprofits Face Up to More Compliance” (Wall Street Journal, May 17, 2013), Ben Dipietro quotes one executive as acknowledging that smaller organizations do not get a free pass to ignore rules. In “Recommended Best Practices in Managing Foundation Investments” (March 2010), the Council on Foundations makes no size distinction and instead focuses on federal and state fiduciary laws that prohibit self-dealing, investments that “jeopardize the existence of a foundation” and mixing for-profit purposes with charitable goals, inter alia. As part of “A Compliance Checklist for Private Foundations” (Council on Foundations, 2010), its author, Attorney Jane C. Nober, provides a road map for items such as public disclosure responsibilities, the maintenance of board meeting minutes and proper insurance coverage. Size gets a specific mention in the form of guidance about compliance with laws such as what happens when a gift exceeds $250. In “Principles for Good Governance and Ethical Practice” (Independent Sector, 2015), the large or small scale of a non-profit is discussed at the operational level. For example, how many people should serve on the board for optimal effectiveness? What kind of annual audit or review of financial statements should be carried out “in a manner appropriate to the organization’s size and scale of operations[?]”

The take-away is that size should not lessen the need for risk mitigation by any non-profit. Taxpayers and donors subsidize the work of foundations, endowments and charities. They want to know that safeguards are in place and that any problems that do occur are hastily fixed.