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

Life in asset management land will never be the same again. According to "The Future of Asset Management" by Maha Khan Phillips (CFA Institute Magazine, Jan/Feb 2013), operating margins are under pressure, asset growth is anemic, investors are moving away from equity around the world and competitive pressures are not going away. This is bad news to some but great news to those who recognize that tumult gives birth to profitable opportunities. Expanding on this notion of a lucrative brave new world, Ms. Phillips cites target date funds, asset allocation strategies and customized solutions as promising areas for further commercialization.

Ms. Phillips includes a section about the growing fiduciary management marketplace, adding that "fiduciary managers are posting significant gains in assets." As we know too well, some investors do not have the requisite size or skill (or both) to address increasingly complex issues, especially as the regulatory whirlpool is getting dangerously more active and likely to drown those who are unable to swim. Professional Pensions reporter Rachel Dalton cites KPMG's measurement of the UK fiduciary management market as having grown by 40% in 2012 or "the equivalent of 2.4%" of total retirement plan assets under management for 174 schemes. They estimate this annual increase equates to 23 billion GBP "under full fiduciary management" and an additional 30 billion GBP in "partially delegated" arrangements. See "Fiduciary management on the rise," December 13, 2012. Click to access the "2012 KPMG UK Fiduciary Management Market Survey," November 2012.

In "Regulatory Forecast Bodes Change" (onwallstreet, February 1 2013), Kenneth Corbin writes that financial professionals and their clients could be asked to deal with a flurry of new initiatives, including but not limited to, the following: 

• Dodd-Frank and its many provisions;
• Expanded fiduciary duty as per the U.S. Department of Labor;
• Formal Self Regulatory Organization ("SRO") oversight by the Financial Industry Regulatory Authority ("FINRA") should it change its mind and decide to pursue this course of action again;
• Development of a uniform fiduciary standard by the U.S. Securities and Exchange Commission that imposes similar responsibilities for broker-dealers and advisers alike; and
• Commodity Futures Trading Commission ("CFTC") mandated guidelines and limits for users of derivatives, many of which are fiduciaries. 

Hot off the press, one consulting firm affirms others' predictions with its call for a "growth in fiduciary management appointments" and "increased attention to risk and risk management" in 2013. Based on its study of retirement plans in 13 countries with a combined $29.75 trillion in assets, they further predict "sponsor-fiduciary tension" and "focus on risk management and governance of DC [defined contribution] arrangements." See "Global Pension Asset Study 2013," Towers Watson, January 2013.

Based on copious litigation and enforcement research and analysis I have conducted as a financial expert, it is clear that there is increased tension between investors and their asset managers and advisers. There are numerous legal actions being brought against investment management organizations and their leaders, many of which allege fiduciary breach and "excessive" risk-taking and/or insufficient oversight. Most attorneys with whom I have spoken expect to see more action in the dispute resolution area. Product development is fast occurring in the legal arena to exploit this trend. Witness the surge of third-party litigation financing firms and brokers such as BlackRobe Capital and Advanced Legal Capital.

The bottom line is that the global investment management industry of $120+ trillion in assets is experiencing an unprecedented upheaval of the status quo. For those executives who can connect the dots and have an appetite for innovation, start mining the gold. For those that are expecting a return to halcyon days of yore, strap yourself in for a bumpy ride.

In this timely and informative webinar hosted by FTI Consulting, legal and compliance experts will provide critical information about the Qualified Professional Asset Manager ("QPAM") exemption and related compliance audit requirement that applies to numerous financial institutions that manage or want to manage ERISA pension money. Speakers will likewise address the merits of managing money for captive ERISA benefit plans and what it means to be an In House Asset Manager ("INHAM").

Getting the right team to conduct the required audit is one important way to mitigate litigation and enforcement risk and to attract and retain institutional dollars. Having a proper audit conducted and using the information to correct deficiencies is another critical step for anyone who understands that non-compliance can be costly.

This timely and informative webinar will address issues that include the following:

• Background information about the new ERISA rule for a Qualified Professional Asset Manager (“QPAM”) audit;
• What it means to be a Qualified Professional Asset Manager or In-House Asset Manager ("INHAM");
• Who must comply and in what timeframe;
• Who can carry out a QPAM /INHAM audit;
• What a QPAM audit entails in terms of information-gathering and scheduling;
• Case study discussion; and 
• How the results of a QPAM audit can be used to improve operations and client relationships.

Who Should Attend:

• Chief Compliance Officers of asset managers
• Business development executives for asset managers
• Internal legal counsel for asset managers and other financial firms
• ERISA consultants and investment advisors

Please join Timothy Brennan, Assistant General Counsel at The Hartford; Howard Pianko, Partner, Seyfarth Shaw LLP; and Susan Mangiero, Managing Director, FTI Forensic & Litigation Consulting as they address these issues and your questions. To attend this free webcast scheduled for Tuesday, October 23, at 1:00 pm Eastern, please click to register for "Managing ERISA Pension Money - QPAM and INHAM 101."

For further information, click to read "Amendment to Prohibited Transaction Exemption (PTE) 84-14 for Plan Asset Transactions Determined by Independent Qualified Professional Asset Managers," Federal Register, July 6, 2010.

A new study published by the Corporate Board Member and FTI Consulting, Inc. and entitled "Legal Risks on the Radar" suggests that cyber security, operations and corporate reputation are top concerns for U.S. directors and general counsel.

In this 12th annual Law and the Boardroom Study, researchers with the Corporate Board Member and FTI Consulting, Inc. attribute globalization of U.S. businesses and an increased reliance on the internet for product delivery as driving forces behind what some describe as a more uncertain world.

Fifty-five percent of 1,957 general counsel respondents cited poor data security as their top fear, in contrast to only 23 percent of general counsels who were interviewed in 2008.  Of 11,340 directors who were queried, 48 percent of them agreed that data security is an important issue for companies.

Coming in second was a concern on the part of directors and general counsel with nearly half of respondents commenting that preparations were in place or underway to address corruption and regulatory investigations.

Directors put slightly more emphais on managing a company's reputation than general counsel but the numbers were relatively close at 40% and 35% of the respondents respectively. With almost instantaneous distribution of news via Twitter and other social media tools, a big jump in the ranking of headline risk is not surprising.

Another finding from the research is that transparency about how much executives are paid is seen as a high priority, along with a duty for the board to "develop long-term incentive plans that pass muster with shareholders and governance watchdogs" while properly motivating those at the top.

When asked to look ahead, directors expressed an intent to focus on the following areas:

• Strategic planning (88%);
• Executive compensation arrangements (48%);
• Relationship between the board and management (41%);
• Enterprise risk management (36%); and
• Investor relations (33%).

Click to download the full version of "Legal Risks on the Radar."

Inside Counsel likewise emphasized the greater focus on risk management by general counsel. In "7 Risk and Compliance Threats" by Melissa Maleske (July 2012), concerns include:

• Inadequate compliance with the Foreign Corrupt Practices Act ("FCPA");
• Being victimized by company hackers;
• Losing company secrets to insider trading attacks;
• Having to defend against a consumer boycott and/or class action that is related to supply chain problems;
• Whistle blowers whose actions could lead to government enforcement; and/or
• Large economic settlements related to economic sanctions.

The best defense is a good offense, especially as it relates to having a "customized compliance program [that] complements the existing business operations." Providing ongoing training to employees is another touted prescription.

My assessment is that the era of risk management is only just beginning. This is good for shareholders and creditors alike. Moreover, there is mounting evidence that general counsel will continue working with board members to ensure that adequate controls are in place.

Click to read "7 Risk and Compliance Threats ... and 10 tips for implementing and maintaining a successful corporate compliance program."

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...

Investors rely on the net asset values ("NAVs") provided to them as a way to make all sorts of financial decisions such as asset allocation, rebalancing, hedging and possibly exiting a particular money pool.

In a recent case, the bear invaded the tent, eventually denying investors for several funds any illusion about security related to being able to use "good" valuation numbers. According to a June 22, 2011 cease and desist order against Morgan Asset Management, Inc. and other respondents, the way that valuation numbers were assembled for purposes of providing daily NAVs "inaccurately inflated the prices of certain securities, contrary to the Funds' valuation procedures." In addition, several accounting professionals failed to "document justifications for such pricing adjustments."

At stake with any of these valuation cases is a legitimate desire on the part of the investing public to understand how the numbers come to be. In this particular case, Morgan funds held subprime mortgages that had to be "fair valued" with market quotations not always readily available. When broker-dealer confirmations were available, they were not always used and sometimes discarded.

Besides the payment of $200 million in disgorgement and civil fines, Morgan Asset Management Inc. and Morgan Keegan & Company agreed to be censured, fully cooperate with the SEC in any other investigations that relate to trading and/or valuing a fund's portfolio or its components and a prohibition against fair valuing any fund portfolio instruments for three years. Click to download the SEC Cease and Desist Order "In the Matter of Morgan Asset Management" et al, June 22, 2011. 

The harm to investors should be clear. For one thing, in bad markets when it became harder to liquidate complex instruments, inflated valuation numbers may have incorrectly dissuaded some investors from redeeming had they known the truth. Additionally, better than real numbers line the pockets of fund personnel when investors end up paying "higher" fees for "artificially" better performance.

Attorney Robert Robertson at Dechert has an interesting article about this case, laying out the facts, the violations and related cases. His conclusion from a review of various SEC cases involving the valuation of fund portfolios is that sound procedures must be adopted and followed. Moreover, he adds that procedures need to be properly documented and that "there should be checks and balances so that one person does not have the ability to circumvent the system." Click to read "Morgan Keegan Settles SEC Fraud Charges Related to Mortgage-Backed Securities Valuations in its Registered Funds," Dechert On Point, July 2011.

The terms of the settlement are far from trivial and may have influenced the decision to find a suitor for the Morgan Keegan enterprise. According to "TARP pressure behind Regions putting Morgan Keegan up for sale" by Ted Carter (Mississipi Business Journal, June 27, 2011), raising capital and regulatory costs are proffered explanations for why Regions Bank (owner of Morgan Keegan) has hired Goldman Sachs to "review 'strategic alternatives' for Morgan Keegan."

The U.S. Department of Labor's ("DOL") proposal to expand the definition of fiduciary is stirring the pot for multiple sectors of the investment world. Investment News journalist Darla Mercado writes that the U.S. Securities and Exchange Commission ("SEC") and the DOL should work together on any initiative that expands the scope of the fiduciary in order to ensure compatiability across regulators. See "B-Ds plead for DOL, SEC to team up on fiduciary rule: Efforts to rewrite regulations produce overlap, angst" (March 3, 2011). In reviewing the comment letters submitted to the U.S. Department of Labor on this matter, I came across a particularly interesting response on behalf of broker-dealers and asked the primary author to elaborate. In the Q&A that follows, Attorney John R. Fahy (with Whitaker Chalk Swindle & Sawyer) predicts big changes ahead.

Q: You represent broker-dealers as a securities attorney and authored the 33-page letter to the Employee Benefit Security Administration ("EBSA") dated January 11, 2011. In that letter, you suggest that certain transactions may no longer be available to ERISA plans should rules change. As things stand today, SEC-licensed securities brokers and dealers who act only as "executor of instructions relating to securities transactions during the ordinary course of its business as a  broker or dealer" are exempted from the definition of ERISA fiduciary. Would you elaborate?

A: It's helpful to consider what broker-dealers are likely to stop doing on behalf of ERISA plans should they be forced to wear the hat of fiduciary. For one thing, if a plan sponsor wants to get a second opinion about something like asset allocation trends or the state of the economy from a broker-dealer with which it has a long-standing relationship, that broker-dealer is almost surely going to say "no" for fear of being seen as giving advice and, by extension, having fiduciary liability. Plan sponsors won't get the benefit of a "give and take." This may not be a huge problem for larger plans that have the budget to hire consultants. It could be a problem for smaller plans and individual investors such as IRA account owners. Blocked communications could impede investment literacy at a time when financial planning education is critical.

Q: ERISA currently defines certain transactions as "prohibited." Should the ERISA fiduciary definition be expanded, how will the universe of services now provided by broker-dealers to ERISA plans change?

A: ERISA has a list of specific prohibited transactions that cover many of the services that broker-dealers provide to plans and plan participants. For example, ERISA prohibits ERISA fiduciaries from loaning money or otherwise providing credit facilities to plan and plan participants. In the broker-dealer context, this would mean no more margin accounts from broker-dealers deemed to be fiduciaries. Margin accounts are required for options. So plan and plan participants would not be able to engage in legitimate option-based hedges of their holdings through such accounts. The broker-dealer industry does have a split between the clearing brokers - those who provide the margin loans - and the introducing broker-dealers that provides the personalized services. An argument could be made that the firm providing the credit facility is not the one that recommends transactions. However, clearing agreements typically allow the clearing firm to pursue the introducing broker-dealer for unpaid customer margin losses. In this sense, the introducing broker(s) would be on the hook for the credit facility. I am not sure what impact that would have as an ERISA prohibited transaction. Additionally, none of the foregoing applies to self-clearing firms that may be in the position of both recommending a transaction and providing the credit facility. These organizations may be deemed to be a fiduciary and forced to shed the margin loan(s) in place. Generally speaking, plans and their participants will have a narrower universe of investment and financing choices. Investment services will cost more and there will be fewer counterparties available. ERISA also prohibits self-dealing transactions. As a result, principal trades would be construed as a prohibited transaction, even if the principal trade settlement could have fulfilled the trade order at a better prices than an agency trade. Firmly underwritten offerings such as IPOs would be off limits as they would be deemed principal trades. To reiterate, ERISA plans and plan participants would see their investment selection pool shrink.

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Whether or not it wins an Oscar, "Social Network" is a fascinating film. How much of it is truth with respect to the creation of Facebook is unknowable to outsiders. What does appear certain however is that regulators have concerns about how private companies, complex securities and derivative instruments are valued. Recent headlines have the U.S. Securities and Exchange Commission investigating secondary equity trading venues over issues relating to transparency, compliance and pricing.

One stock that has been a favorite with organizations such as SecondMarket is Facebook. According to its October 12, 2010 press release, "Nearly three dozen private companies are now traded over SecondMarket..." including the social network juggernaut led by Mark Zuckerberg, along with gaming company Zynga, Zipcar, Pandora and Groupon. Absent an IPO or acquisition, early investors and/or employees have an opportunity to sell their holdings and generate liquidity for themselves. Click to read "Q3 2010 SecondMarket Private Company Report." In the case of Facebook, there is active discussion about whether its size should force an Initial Public Offering ("IPO"). Importantly, the number of investors is only one variable that drives the decision to debut publicly traded stock. Moreover, private companies are not necessarily bad or good investments in the same way that public status does not overcome the reality that some investments are "dogs" and may not be suitable for a particular buyer.

There is a lot to write about valuation. I am hard at work on a book about hard-to-value investing from the perspective of pensions, endowments, foundations and family offices that are held to prudent investment standards. Already, the list of lawsuits over supposedly incorrect pricing is growing long. One can expect a lot more litigation alleging bad process and whether complex, illiquid positions should comprise part of institutional portfolios. This blog, www.goodriskgovernancepays.com, will examine valuation and trading mechanisms in detail over the coming weeks.

In the meantime, interested readers can download my September 11, 2008 testimony before the ERISA Advisory Council on hard to value assets and risk management. Posts about valuation that I've written for www.pensionriskmatters.com likewise shed light on the fiduciary risks associated with hard to value investing when good practices are absent. The archives include:

• "Valuing Positions in Alternatives - New DOL Scrutiny"
• "Hedge Fund Valuation and Performance Reporting"
• "U.S. SEC Significantly Steps Up Enforcement"
• "The View From The Other Side - Regulatory Insight"
• "Return, Liquidity and Valuation."

According to today's news reports, the U.S. Securities and Exchange Commission may soon investigate the California Public Employees' Retirement System ("CalPERS") for its disclosures about inherent risks. If true, this type of inquiry could quickly lead to serious trouble for other public retirement plans as well as ERISA plans. For that matter, any issuer of securities (government or corporate) will be fair game if it's found that the investing public was ill-informed about the ticking time bombs associated with underfunded defined benefit plans, mismanaged 401(k) plans or both.

No public information has yet been made available on the topic of CalPERS and a federal regulatory examination so it is imprudent and inappropriate to speculate.

On a general note, at a time when investors are still reeling from losses in 2008 and 2009 and questions abound regarding the rules of the game, transparency and conflicts of interest, the last thing plan sponsors should do is to gin up their performance numbers. It's better by far to get the bad news out and deal with the aftermath in a legitimate fashion. One constructive approach is to engage a risk management expert to conduct an assessment of current economic vulnerabilities and how those risks are being communicated to bond buyers (and, for corporations, equity investors).

Email Dr. Susan Mangiero, CFA and certified Financial Risk Manager if you would like information about what a risk disclosure assessment entails for your organization or on behalf of a client(s). You may likewise be interested in one of our workshops for directors, trustees and/or members of the investment committee about performance reporting within a fiduciary and financial risk management framework.