Foreign Corrupt Practices Act and Implications for Institutional Investors

For those who don't know, I am the lead contributor to an investment compliance blog known as Good Risk Governance Pays. I created this second blog as a way to showcase investment issues that had a wider reach than just the pension fund community. While I strive to publish different education-focused analyses on each blog, sometimes there are topics that I believe would be of interest to both sets of readers. A recent article that I co-wrote is one example. Entitled "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel" (The Corporate Counselor, September 2014), Mr. H. David Kotz and Dr. Susan Mangiero explain the basics of the Foreign Corrupt Practice Act. Examples and links to reference materials are included, along with a discussion as to why this topic should be of critical importance to pension funds and other types of institutional investors. Click to download a text version of "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel."

Fiduciary Shortcuts To Valuation Can Be Dangerous

Despite a plethora of information about how to implement shortcuts to enhance workplace productivity, fiduciaries need to ask themselves whether a "jack in the box" approach that equates speed with care and diligence is worth pursuing.

This topic of shortcuts came up recently in a discussion with appraisal colleagues about the dangers of using a "plug and play" model to estimate value. Although New York Times journalist Mark Cohen rightly cites the merits of having a business valuation done, he lists all sorts of new tools such as iPhone valuation apps that some might conclude are valid substitutes for the real thing. Rest assured that punching in a few numbers versus hiring an independent and knowledgeable third party specialist to undertake a thorough assessment of value is a big mistake, especially if the underlying assumptions and algorithms of a "quick fix" solution are unknown to the user. See "Do You Know What Your Business is Worth? You Should," January 30, 2013.

It's bad enough that a small company owner opts for a drive-in appraisal. It's arguably worse when institutional investors do so, especially as their portfolios are increasingly chock a block with "hard to value" holdings. In the event that a valuation incorrectly reflects the extent to which an investment portfolio can decline, all sorts of nasty things can occur. A pension, endowment or foundation could end up overpaying fees to its asset managers. Any attempts to hedge could be thwarted by having too much or too little protection in place due to incorrect valuation numbers. Asset allocation decisions could be distorted which in turn could mean that certain asset management relationships are redundant or insufficient.

Poor valuations also invite litigation or enforcement or both. As I wrote in "Financial Model Mistakes Can Cost Millions of Dollars," Expert Witnesses, American Bar Association, Section of Litigation, May 31, 2011:

"Care must be taken to construct a model and to test it. Underlying assumptions must be revisited on an ongoing basis, preferably by an independent expert who will not receive a raise or bonus tied to flawed results from a bad model. Someone has to kick the proverbial tires to make sure that answers make sense and to minimize the adverse consequences associated with mistakes in a formula, bad assumptions, incorrect use, wild results that bear no resemblance to expected outcomes, difficulty in predicting outputs, and/or undue complexity that makes it hard for others to understand and replicate outputs. Absent fraud or sloppiness, precise model results may be expensive to produce and therefore unrealistic in practice. As a consequence, a “court or other user may find a model acceptable if relaxing some of the assumptions does not dramatically affect the outcome.” Susan Mangiero, “The Risks of Ignoring Model Risk” in Litigation Services Handbook: The Role of the Financial Expert (Roman L. Weil et al, eds., John Wiley & Sons, 3d ed. 2005).

In recent months, it is noteworthy that regulators have pushed valuation process and policies further up the list of enforcement priorities. Indeed, in reading various complaints that allege bad valuation policies and procedures, I have been surprised at the increased level of specificity cited by regulators about what they think should have been done by individuals with fiduciary oversight responsibilities. Besides the focus of the U.S. Department of Labor, the U.S. Securities and Exchange Commission has brought actions against multiple fund managers in the last quarter alone. Consider the valuation requirements of new Dodd-Frank rules (and overseas equivalent regulatory focus) and it is clear that questions about how numbers and models are derived will continue to be asked.

For further reference, interested readers can check out the following items:

U.S. Department of Labor Audits and ERISA Litigation

According to "Attorney, Official Discuss DOL Investigations, Give Recommendations on Avoiding Litigation," by Andrea L. Ben-Yosef (Pension & Benefits Daily, BNA Bloomberg, October 15, 2012), trouble may come in pairs. The same complaints from plan participants, leads from government authorities and/or news about a company's financial distress that trigger U.S. Department of Labor ("DOL") scrutiny could invite plaintiffs' counsel to file a contemporaneous lawsuit.
 
Speakers Mabel Capolongo, Director of Enforcement with the U.S. Department of Labor, Employee Benefits Security Administration ("EBSA") and Attorney R. Bradford Huss with Trucker Huss suggested that persons being examined for possible breach should familiarize themselves with the EBSA enforcement manual and notify their ERISA liability insurance carrier right away. Cited potential areas of investigation include:
  • Fiduciary breach;
  • Co-fiduciary liability;
  • Plan expenses;
  • Plan operations;
  • Plan investing;
  • Prohibited transactions;
  • Company securities in a plan, including Employee Stock Ownership Plan ("ESOP") issues;
  • Real estate holdings;
  • Bonding;
  • Reporting; and
  • Disclosure.

For regulatory information, click to access the EBSA Enforcement Manual.

In a related online interview for the Professional Liability Underwriting Society ("PLUS"), Chartis Executive Vice President Rhonda Prussack cites financial distress (including the filing for bankruptcy protection) as a significant concern for ERISA fiduciary liability. She adds that a troubled plan sponsor may see the value of company-issued securities plummet which in turn could trigger an ERISA "stock drop" case if such securities are part of the mix for a 401(k) or profit-sharing plan. A company seeking to save cash may switch from a defined benefit plan to a cash balance plan which in turn could pave the way for a lawsuit over allegations relating to the change in design. A company in trouble could shut down factories, instigate large-scale layoffs and/or cut back benefits, all of which lead to unhappy individuals who are more likely to sue. Ms. Prussack emphasizes that happy workers are less likely to sue. She further adds that plan participant actions are likely to take the form of putative class actions.

The bottom line is that there is a long list of potential risk exposures for ERISA fiduciaries and a continued need to mitigate liability.

SEC and Revenue Sharing Enforcement

According to its September 6, 2012 press release, the U.S. Securities and Exchange Commission ("SEC") settled with two Portland, Oregon investment advisory firms for $1.1 million. At issue was whether investors were harmed due to the allegedly hidden revenue-sharing arrangements in place that may have resulted in a less than neutral basis for recommending certain funds. Neither party admitted or denied the regulator's charges. See "SEC Charges Oregon-Based Investment Adviser for Failing to Disclose Revenue Sharing Payments," September 6, 2012.

The issue of revenue sharing is unlikely to go away, especially with multiple regulators paying close attention now. The SEC had said that it plans to ask more questions about the independence, or lack thereof, that characterizes the relationship between professionals who give advice and the brokers and/or asset managers they use. Mr. Marc J. Fagel, Director of the SEC's San Francisco Regional Office, states that there will be a continued focus on "enforcement and examination efforts" related to "uncovering arrangements where advisers receive undisclosed compensation and conceal conflicts of interest from investors."

 The U.S. Department of Labor ("DOL") is likewise investigating whether revenue-sharing arrangements are being adequately disclosed. A few months ago, DOL settled with Morgan Keegan and Co. According to published accounts, monies will be returned to nearly a dozen pension plans by Morgan Keegan for having received a fee in exchange for recommendations it made about hedge fund vehicles. Morgan Keegan will also need to disclose whether it is acting as an ERISA fiduciary. See "Morgan Keegan settles with DOL over revenue-sharing accusations" by Darla Mercado (Investment News, April 16, 2012). 

Given recent court activity, more will be said later on by this blogger about when the practice of revenue-sharing could make sense and when there could be problems.

What Every Fiduciary Needs to Know About How to Mitigate Investment Fraud Risk

Economic growth may be anemic but fraud continues to find a life of its own. According to the Financial Fraud Research Center, at least 30 million people are impacted by fraud each year with an annual cost of $100 billion for retail fraud alone.  In a 2011 speech, the head of the U.S. Securities and Exchange Commission discussed how key offices and divisions are working together in all areas of its anti-fraud efforts and how the SEC is collaborating more frequently with state regulators, criminal prosecutors or local nonprofits in an effort to weave these initiatives into an increasingly fine-meshed net that is focused on fighting fraud. While the U.S. Department of Labor is not exclusively focused on fraud, enforcement teams have been busy with a closure of nearly 3,500 civil cases and 302 criminal cases, monetary results of $1.39 billion and 129 indictments.

Surprisingly, there is little information available to institutional and individual investors alike as to how to mitigate the risk of losing money to fraudsters. The goal of this webcast is to empower investors to better protect themselves with knowledge of situations to avoid whenever possible. Attendees will hear experts talk about:

  • Common causes of investment fraud;
  • Enforcement and litigation trends relating to investment misdeeds;
  • Lessons learned from financial scandals of the last decade;
  • Role of the investment fiduciary in vetting service providers;
  • Red flags to detect poor internal controls that could lead to fraud; and
  • Regulatory action to stem financial fraud and preserve the integrity of the capital markets.

Speakers for this 75-minute event include:

  • Dr. Susan Mangiero, CFA, FRM – Managing Director, FTI Consulting
  • Jonathan Morris, Esq. – Day Pitney LLP / former General Counsel of Barclays Wealth
  • Brian Ong – Senior Managing Director, FTI Consulting
  • Karen Tyler, North Dakota Securities Commissioner and former president of the North American Securities

To attend this webcast scheduled for Wednesday, June 13, at 1 pm Eastern and sponsored by FTI Consulting, please visit the investment fraud webinar page at http://www.securitiesdocket.com/2012/05/18/june-13-webcast-what-every-fiduciary-needs-to-know-about-how-to-mitigate-investment-fraud-risk/.

The Oops Factor and a Crackdown on Retirement Plan Advisors

In recent discussions with asset managers, pension trustees and consultants, investment fraud continues to attract attention. It is no surprise that people want to know more about what constitutes bad practice versus crossing the line, especially in the aftermath of a devastating few years of economic losses. New disclosure regulations are another catalyst for learning more about how to avoid trouble. Email your request if you want more information about what can be done to detect fraud and/or would like to receive research and thought leadership on the topic of investment fraud.

Impending changes to fiduciary standards and allegations of fiduciary breach likewise continue to create a stir.

In "The EBSA Cracks Down on Retirement Plan Advisors," AdvisorOne's Melanie Waddell (March 26, 2012) describes a material increase in enforcement actions brought by the U.S. Department of Labor ("DOL"), Employee Benefits Security Administration ("EBSA"). Besides effecting nearly 3,500 civil cases in 2011, EBSA closed 302 criminal cases with "129 individuals being indicted," "75 cases being closed with guilty pleas or convictions" and an excess of $1.3 billion in monetary damages collected. Quoting Andy Larson with the Retirement Learning Center, the article mentions fiduciary negligence as a key concern of regulation and a driving force behind a proposed expansion of ERISA fiduciary duties to numerous professionals who work with retirement plans in an advisory capacity.

ERISA Attorney David Pickle points out that fraud and embezzlement of 401(k) plan money have been investigated for years by the DOL and U.S. Department of Justice ("DOJ") but recent investigations are being done now as part of the formal Contributory Plans Criminal Project ("CPCP"). He observes that "the DOL is conducting an increasing number of investigations of financial service providers, including registered advisers, banks and trust companies (both as trustees or custodians but also as asset managers), and consultants. For other insights about ERISA pain points, read "An Excerpt From: K&L Global Government Solutions (R) 2012: Annual Outlook."

According to the ERISA enforcement manual, civil violations include:

  • Failure to operate a plan prudently and for the exclusive benefit of participants
  • Use of plan assets to benefit the plan administrator, sponsor and other related parties
  • Failure to properly value plan assets at the current fair market value
  • Failure to adhere to the terms of a plan (assuming that those terms are compatible with ERISA)
  • Failure to properly select and monitor service providers
  • Unlawfully taking action against a plan participant who seeks to exercise his or her rights.

Criminal violations include:

  • Embezzlement of monies
  • Accepting kickbacks
  • Making false statements.

The "oops - I didn't know" strategy is unlikely to serve those who work with or for pension plans. The spotlight continues to focus on ways to improve the management of $17+ trillion U.S. retirement system and rightly so. There is so much at stake for millions of people.

George Washington said that "In executing the duties of my present important station, I can promise nothing but purity of intentions, and, in carrying these into effect, fidelity and diligence.

ERISA and public pension trustees are likewise tasked to be faithful and diligent, among other things. For those who choose a different path, the outcome can be dire indeed. Jail time and stiff penalties as well as legal costs are a few of the potential costs associated with a fraud conviction, not to mention shame and the loss of income.

Louisiana Pension Funds and Hedge Fund Redemption Concerns

As I've written many times herein, understanding transferability restrictions is a "must do" for institutional investors who allocate monies to asset managers. While a pension, endowment, foundation or family office may decide to invest part of its portfolio in illiquid securities for strategic reasons, it is still necessary to understand how to exit if necessary. In "Hedge Fund Lock Ups and Pension Inflows" (July 4, 2011), the point is made that investors who want to redeem but are barred from doing so may seek redress in a court of law. Regulators are paying close attention too.

According to recent news accounts, several Louisiana pension funds that sought to withdraw some of their money from a New York hedge fund were given promissory notes with assurances that it could get cash in several years. Moreover, it may be that the hedge fund in question has counted assets under management more than once due to a feeder fund organizational structure that boasts over a dozen smaller vehicles which cross trade with one another.

In a joint statement dated July 11, 2011, the Firefighters' Retirement System ("FRS"), New Orleans Firefighters' Retirement System and the Municipal Employees' Retirement System ("MERS") describe how attempts by FRS and MERS "to capture some of the profits that had been earned in an investment known as the FIA Leveraged Fund" initially met with resistance on the part of the fund manager to provide cash right away. Instead, the two requesting institutions were told to expect paper IOUs while certain assets were to be liquidated in an orderly manner over a period of up to two years. The statement goes on to say that the pension plans had each been promised a return of at least 12 percent per annum and that if the "collateral supporting the preferred return declines to a level that is 20% above the systems' collective account values, there is a trigger mechanism requiring a mandatory redemption of the systems' investment" with the 20% cushion" designed to protect the systems' accounts against any loss in value."

Getting a promissory note has not made for happy campers who now worry about the liquidity of the FIA fund and "the accuracy of the financial statements issued by the two renowned independent auditors." The statement goes on to say that the hedge fund manager has been apprised that the pension plans intend to "closely examine" performance records by putting together a team that consists of their board members, internal auditors and investment consultant. A forensic economist may be added to the team.

Click to read the July 11, 2011 joint statement from these Louisiana pension plans about hedge fund liquidity concerns for this particular manager.

Having just checked the SEC website, this blogger does not yet see the formal inquiry statement. Speaking from experience, complexity is never a good thing. Someone somewhere has to understand what risks might give rise to material problems. Moreover, proper due diligence of funds that invest in "hard to value" instruments has to take into account how they are modeled and who is vetting the integrity of the model numbers. Regarding organizational structures that encompass multiple money pools, it is imperative to understand who exactly has a claim to assets in a worst case situation of forced liquidation.

A few years ago, I refused to continue with a valuation engagement of a hedge fund because neither the general partner nor the master fund's attorney could adequately answer my questions about priority of claims for a complex offshore-onshore ownership structure. In several recent matters where I have served as expert witness, concerns about restrictions of transferability and collateral monitoring have taken center stage. Be reminded that in distress, book values often fall seriously short of fire sale or even orderly liquidation (auction) values.

Let's hope that questions can be cleared up in a timely fashion.

Readers may want to check out these articles:

  • "S.E.C. and Pension Systems to Examine Fletcher Fund" by Peter Lattman, New York Times, July 12, 2011; and
  • "Pensions Want Look Into Fund's Records" by Josh Barbanel, Steve Eder and Jean Eaglesham, Wall Street Journal, July 13, 2011.

Financial Model Mistakes Can Cost Millions of Dollars

 

It's been awhile since I've blogged. Work has been busy and then I took off ten days to visit Paris. The City of Lights is amazing indeed. Now that I'm back, I will try to blog more frequently. There is certainly no shortage of topics about risk, governance, litigation, valuation and so on.

For those who don't know, I created a sister blog a few months ago. See GoodRiskGovernancePays.com. Nearly all of the time, the posts on each blog are different. However, I decided to reprint a post from GoodRiskGovernancePays.com here since the topic is hugely important. After all, for those defined benefit and defined contribution plans that are exposed to "hard-to-value" investments, leverage and perhaps higher than expected volatility, model risk could be the hidden alligator that bites if left unchecked. As always, I welcome your comments at contact@fiduciaryleadership.com.

Here is the post that was originally posted on June 2, 2011 by Dr. Susan Mangiero.

In a recently published article about financial models entitled "Financial Model Mistakes Can Cost Millions of Dollars" (American Bar Association, Section of Litigation, Expert Witnesses, May 31, 2011), Dr. Susan Mangiero defines model risk and explains why it is so important. Referencing the recent $242 million enforcement action by the U.S. Securities and Exchange Commission as a result of model mistakes made by a well-known asset management firm, this financial expert cites the heightened regulatory and litigation imperatives with respect to risk and valuation models. She concludes the article by listing some of the ways to mitigate risk. These include, but are not limited to the following:

  • Hire knowledgeable programmers with capital market experience;
  • Create and follow a set of policies and procedures that govern how and who will validate financial models over time and what will trigger revisions in a model(s);
  • Avoid conflicts of interest that would reward managers for ignoring problems and would potentially preclude an independent and objective assessment of problems and related corrective action(s);
  • Test assumptions for validity in stable markets as well as extreme circumstances;
  • Stress a model using a sufficient number of economic scenarios to gauge its predictive power and whether results can be relied upon in both good or bad times;
  • Educate personnel about how a particular model is supposed to work;
  • Establish a response strategy should a problem occur and investors need to be informed before things get out hand;
  • Scrap models that are overly complex and expensive to replicate;
  • Don't be afraid to ask questions about inputs, data quality, results, and concerns; and
  • Invite informed outsiders to offer an independent and regular critique on a confidential basis.

 

U.S. SEC Significantly Steps Up Enforcement

In case you missed it, the U.S. Securities and Exchange Commission announced significant enforcement initiatives on January 13, 2010. These include a focus on due diligence and valuation issues with a particular emphasis on due diligence, investment advisors, investment companies, performance and valuation.

Read "SEC Names New Specialized Unit Chiefs and Head of New Office of Market Intelligence" (U.S. Securities and Exchange Commission, January 13, 2010).

This follows on the heels of our January 7, 2009 blog post wherein we reported that the FBI is hiring over 2,000 professionals with backgrounds in accounting and finance. See "FBI Hiring Spree - More Financial Fraud Expected?" and "Wanted by the FBI: Talented Professionals to Serve the Nation."