Fiduciary Duties, Post Madoff
In "The Post-Madoff Emergence of a Fiduciary Duty of Due Diligence - Recent Regulatory Enforcement Actions and Their Impact on Best Practices for Investment Managers" (Practical Compliance & Risk Management For The Securities Industry, September-October 2009), Attorneys Scott A. Meyers and James G. Martignon describe a renewed scrutiny of the relationship between hedge funds, investment advisers, broker-dealers and their investors. As a follow-up, Chicago-based Attorney Martignon (with Ulmer & Berne LLP) answered additional questions about the investment world in the aftermath of highly publicized financial fallout.
Q: Jim, I came across your interesting article in research for my new book on investment risk governance. You and Attorney Meyers did a terrific job of elaborating on fiduciary duties and the relationship between asset managers and their clients. Thanks for joining me today to talk further about this important topic. Let's start with understanding your motivation to write the article.
A: It's pretty straightforward. Our clients are mostly asset managers and broker-dealers. With so much news about regulatory mandates and the increased number of lawsuits being filed in the last few years, our clients asked for more information about their responsibilities to investors and what they should be doing differently, if anything, to mitigate their risks.
Q: Whom do you think bears the responsibility for compliance at a fund and is good governance seen as a differentiator?
A: Good fund managers care about doing the right thing for their investors. It's always a balancing act between the general counsel and chief compliance officer and the sales team. However, unless a fund is around for the long haul, everyone loses. Business development professionals have a lot to gain by supporting their colleagues in legal and compliance. Importantly, it's not just adhering to the letter of the law. Fiduciary duty means applying common sense as well. I recall hearing the former head of the SEC's Office of Compliance and Investigations and Examinations tell a story that stayed with me. A hedge fund chose not to do something that was legal but didn't quite pass the smell test. The examiners were impressed that the fund was sensitive to going the extra mile.
Q: Is there a difference between vulnerability to litigation for a fund that trades more frequently?
A: Probably. For example, the trigger factors for a hedge fund that actively trades are likely to be different than let's say a private equity fund that can perhaps dedicate more resources to monitor fewer positions. With more active trading (and I'm not even addressing high frequency trading issues here), issues that attract scrutiny include compensation, performance reports, trading across multiple entities and delegation of some work to others (such as a custodial bank or prime broker).
Q: You write extensively about fiduciary duties that include (a) good faith, full and fair disclosure (b) prudence in selecting agents and in making and monitoring investments (c) fulfilling representations made to clients and(d) furnishing information to clients, obtain material information and disclose limitations on inquiry or investigation. Are you saying that these duties are more important now than in the past?
A: No. Discharging one's fiduciary duties have always been important. It's just that so many investors were surprised by situations involving investment fraud as well as those that reflected poor oversight of operational and financial risks. Things go in waves and financial reform is no different. The Madoff scandal revealed chinks in the armor. You had a name fund manager that consistently reported great returns and continued to attract investors. Given the scale of losses, it's no surprise that people took a further look at what went wrong. We've lived through investment fraud before but never had multiple catalysts occurring at the same time. After news broke about Lehman Brothers, Bear Stearns and others, investors clamored for answers about systemic vulnerability. For example, if an investor allocates money to a hedge fund, they have to understand that they are exposed to a wide array of risks, not just the price movement of what's inside the hedge fund's portfolio.
Q: With competing parties seeking to expand fiduciary standards, is there a chance that new rules could conflict with one another?
A: Yes and it is a concern to me. I wrote about fiduciary duties in the context of U.S. trust law and investment management law. ERISA fiduciary duties are not really different so that's a good thing. However, as rules evolve, we'll have to monitor specifically what funds and broker dealers need to do. Keep in mind that not every hedge fund wants ERISA money. The flip side is that not every ERISA pension plan will want to invest in the same hedge fund strategy, let alone the same fund.
Q: You made a distinction between breach of fiduciary duty and fraud - loss causation versus reliance. Please elaborate.
A: The U.S. Supreme Court long ago established that investment advisors are fiduciaries, pursuant to Section 206(2) of the Investment Advisors Act of 1940. Securities regulators are clearly interested in raising the bar with respect to fund manager and adviser duties in the enforcement context in order to address risks to which investors may be exposed. The situation is more complex for private litigants as there is not a private right of action under the Investment Advisers Act. Rather, investors must generally look to securities fraud-based causes of action. These are more complex claims to prosecute, both procedurally and substantively, than a claim for breach of fiduciary duty. This means that in many instances settlements with fund managers and regulator are likely to be faster and potentially larger than those associated with private litigation. What we may also see going forward is a focus on contractual disputes versus allegations of fiduciary breach. Certainly litigation statistics bear this out.
Q: You don't think that private funds in the United States are ready yet to embrace the use of independent board members as is mandated by many offshore jurisdictions. Why not?
A: Let me clarify. Getting an independent take on business and investment decisions is an excellent idea. You can carry out good practices by setting up different committees, modifying the compensation arrangement for managers and traders and much more. Valuation, particularly for illiquid or hard-to-value securities, may be an exception to outsourcing to an independent party that can price positions and thus bring a certain level of independence and disinterested objectivity to the process. At the end of the day, regardless of the mechanisms used, I think the key is for organizations to build strong cultures of compliance and policies and procedures that are attuned to their legal and regulatory duties and to managing risks to which both the fund and its investors may be exposed.
Q: Are you concerned that we will see more investment fraud?
A: Yes and no. Fraud is always a concern but, as the last few years have reminded us, it is not the only source from which risk can emanate. If fund managers, advisors, broker-dealers and investors get back to basics in evaluating and monitoring risk and how to manage it, we'll be in good shape. Even sophisticated investors need to do their own homework, whether they use a fund of funds or consultant or advisor. The last few years have been a good reminder that risk comes from many places and we need to focus on all types of risks and how they are being managed.
Q: Does an institutional investor have to be a certain size in order to invest in hedge funds?
A: Investing is an active process with preservation of capital being a primary goal for many pension funds and endowments. Smaller organizations may have unique challenges in that they may not have the money to hire dedicated resources to select and then monitor asset managers and funds. Importantly, all investors, to the extent they are managing and investing other people's money, have their own duties as fiduciaries to implement robust due diligence processes because investment-related risks continually develop and evolve, sometimes with great speed from many directions. As I mentioned earlier, we need to focus on many different kinds of risks.
Note to Readers: You may also want to download "Exploring Hedge Fund Manager Fiduciary Duties in Light of Recent Proposed Legislative Initiatives" by David W. Porteous and James G. Martignon (Investment Lawyer, March 2010).