Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

In a recent speech, Federal Bureau of Investigation ("FBI") Director Robert S. Mueller, III, warns white collar criminals that agents are busy at work. Citing an alarming increase in fraud (up by "more than 80 percent since 2003"), Mueller provided some interesting facts to attendees of the American Bar Association, Litigation Section Annual Conference.

• The FBI has nearly 2,000 agents working on almost 17,000 white collar cases, "from public corruption and financial fraud to health care and mortgage fraud."
• The FBI has successfully prosecuted more than "490 corporate and securities fraud convictions in 2007" with more than 30 insider trading indictments affecting employees of at least four major banks.
• The FBI is investigating in excess of 1,300 mortgage fraud incidents and has identified "19 corporate fraud matters related to the subprime lending crisis."
• The FBI has its sights on "accounting fraud, insider trading, and deceptive sales practices."

Urging reform to protect shareholders and other relevant parties, this lead G man cites the need for independent (and arguably competent and objective) auditors, outside counsel and independent directors. Conflicts of interest remain a concern.

Click to read the full text of Director Mueller's speech.

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Bayou Group leader, Samuel Israel III, age 48, receives a sentence of 20 years for his part in handing a $400 million loss to investors. (He pled guilty to conspiracy and fraud in late 2005.) A shorter than 30 year sentence reflects his co-operation with the authorities. U.S. Districut Judge Colleen McMahon is quoted as rejecting leniency and instead chastising this hedge fund "mastermind" as a "career criminal" who "ruined lives." In what appears to be a sea change in sentiment towards financial fraudsters, Reuters cites Judge McMahon's upset, referring to white-collar crimes as "every bit as heinous as every other type of crime."

Click to read "Bayou co-founder sentenced to 20 years in prison" (Reuters - April 14, 2008).

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According to State Editor Jay Jochnowitz for timesunion.com, Attorney General Andrew Cuomo is investigating "alleged abuses of the state pension fund" at school district, town and village levels. External contractors may be costing Empire State taxpayers a bundle in the form of "undeserved" retirement benefits. (See "Cuomo expanding pension probe," April 14, 2008.)

Not surprisingly (and assuming facts bear out the presence of fraud), folks are in a major huff. To read a few takes on the fast-changing situation, check out these items.

• "Cuomo: 90 attorneys' pensions potentially fraudulent" by Robert E. Kessler (Newsday.com - April 10, 2008)
• "New York's Pension Scams Must End Now" by James Ostrowski (Free New York - April 14, 2008)

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In what must be an amazing "way to go" moment for any journalist, Milwaukee Journal Sentinel reporter Dave Umhoefer earns the Pulitzer Prize for his detective-like reporting about pension trickery in Milwaukee County. According to "Pension investigation earns reporter Pulitzer: Umhoefer scoured county data for 6 months," Bill Glauber writes that privileged workers were allowed to buoy their benefits by purchasing "service time for seasonal and part-time jobs held decades ago" (Milkwaukee Journal Sentinel, April 7, 2008). Certainly novel, this form of back-dating is said to violate county and IRS rules galore. Congratulations to Mr. Umhoefer for bringing fraud to light on behalf of honest plan participants.

In "Buybacks may figure in pension lawsuit" (Milkwaukee Journal Sentinel, April 12, 2008), reporters Steve Schultze and John Diedrich write that legal documents have the county claiming that "its full costs of the '01 pension perks will reach in excess of $600 million." Alleging failure to give "adequate warning of the potentially steep costs of the lump-sum provision and related benefits while they were under consideration in 2000," the county seeks redress from defendant Mercer Co. The pension consulting firm counters that the county is "seeking to pass the buck for its own failings."

On the topic of fraud, infamous rogue trader Nick Leeson (remember the sale of Barings Bank to ING for a nominal sum?) warns of a "black hole in some markets unless risk-management systems" catch up with the "sophistication of trading desks." Now a "been there, done that" luminary on the speakers' circuit, Leeson apparently corroborates the intended defense of Jerome Kerviel in Rogue Trader v. French Bank. In "Leeson warns of fraud 'black hole' in markets," Financial Times reporter Jeremy Grant (April 9, 2008) writes that corporate negligence will take the stand as Kerviel shouts "J'accuse" and ponders how his jumbo trading could go unchecked for so long.

If HBO found entertainment value in L'Affaire Leeson ("Rogue Trader" starring Ewan McGregor, 1998), can a french film version be too far behind? With so much real-life intrigue, Hollywood writers have little need to imagine.

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As a result of its investigation of the Retirement System of Alabama ("RSA"), the U.S. Securities & Exchange Commission, Division of Enforcement, issued a March 6, 2008 report "to emphasize the responsibilities of all investment professionals, including large public retirement systems and other public entities, under the federal securities laws and to highlight the risks they undertake when they operate without a compliance program."

At the heart of the matter was an allegation of improper trading of shares in The Liberty Corporation, prior to the public announcement of its acquisition by Raycom Media, Inc. ("Raycom"). While this state agency, with over $30 billion in assets under management, is described as having cooperated with the SEC, pre-event, it had no "program, policy, practice or training to ensure that its investment staff understood and complied with the federal securities laws in general or insider trading laws in particular. RSA also did not have a compliance officer, and the responsibilities of its general counsel did not include oversight of RSA's investment activities."

According to this official report, RSA founded Raycom in 1996 and was its "primary financing source." (Enforcement investigation aside, this begs an interesting question. Why was the Retirement System of Alabama in the business of creating a private business?) A disturbing excerpt from the SEC report is shown below.

<<RSA's purchases of Liberty stock were unusual in at least two respects. First, RSA's CEO directed the trades even though he normally was not involved in equity trading decisions. Second, Liberty's market capitalization at the time was less than $1 billion and did not satisfy the $5 billion market capitalization guidelines RSA generally used for the two funds that purchased the shares.>>

While state pension plans are not subject to the Investment Company Act of 1940 and the Investment Advisers Act, public plans and their employees are subject to anti-fraud provisions of the "federal securities laws and Commission rules thereunder."

The Commission concluded that bad acts could have been avoided if the state pension plan "had adequate policies and procedures to assure compliance with the federal securities laws." The SEC took into account the following - (a) RSA's cooperation (b) remedial action and (c) the fact that no individual gained from said trades.

Click here to read "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The Retirement Systems of Alabama.".

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The news broke on January 24, 2008 that a rogue trader at Societe Generale was allegedly responsible for nearly US $7 billion (4.9 billion euros) in fraudulent transactions. Hours later, Bank of France governor, Christian Noyer, tried to allay fears. Refuting any connection between sub-prime exposure and the situation at hand, Reuters reports Noyer as saying that "nobody could have foreseen the loss" but acknowledged that risk controls should have been a barrier. "Today we have seen there was a glitch in the system that was exploited by someone who I think got around five successive risk control systems." See "Bank of France head reassures after SocGen fraud" (January 24, 2008).

When contacted for comments by www.pensionriskmatters.com, Mr. Tony Turner, principal with Financial Tracking, LLC asks - "Who was watching the store and who was watching the watchers? This highlights the need for automated and consistent monitoring and alerting."

What's interesting (at least based on preliminary public information) is that the identified bad player was supposedly an expert in operations and able to use that knowledge to his advantage. Many questions arise. 

• How should back office, middle office and front office controls change to avoid a repeat occurrence?
• What role do humans play with respect to monitoring computer systems thought to be otherwise safe from attack?
• Who should ultimately bear responsibility for le rogue trader?
• Is this type of fraud a "black swan" event or can we expect more trouble?
• What can pension fund decision-makers do to better vet their banks' risk controls?

This will not be the last time we read about fraud and its potentially devastasting impact on related parties.

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According to "Bonds' Pricing Is Questioned In Email Trail, Former Trader at RBC Alleges Mismarking Of Plain-Vanilla Issues " (October 26, 2007) Wall Street Journal reporter Susan Pulliam describes alleged fraud at one of the large Canadian banks. Whether government and corporate bonds were incorrectly valued to hide losses remains to be seen. However, if true, this is serious stuff.

Pension fiduciaries should be regularly asking external managers about their trading checks and balances. However, in light of recent negative headlines, one wonders (a) whether sufficiently tough questions are being asked (b) who is doing the investigation and (c) whether risk management and valuation best practices are more myth than reality at some organizations.

ERISA and state pension laws make it clear that fiduciaries have a solemn obligation to properly select and review external money mangers. Are breach of duty complaints likely to ensue for those plan sponsors who have selected "troubled" money managers and cannot provide evidence of a disciplined and comprehensive review of their risk management and valuation policies? 

Our forthcoming November 6, 2007 webinar will look at trading controls and the selection and review of external money monagers. Click here for more information.

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A recent news article chronicles another insider trading scam that highlights a dangerous variation of pillow talk. According to a May 11 article, "A husband and wife were arrested and charged yesterday after allegedly netting nearly $600,000 (£300,000) of illicit profits from shares they bought in a takeover target." Times.com journalist Steve Hawkes writes that this joint arrest follows quickly on the heels of another couple's guilty plea for providing material non-public information about pending mergers and acquisitions. Click here to read more.

Does nuptial bliss mean scandal? Prison is now a known commodity to Mr. and Mrs. Fastow of Enron fame. Similar allegations were recently launched against a husband and wife team who worked at a hedge fund and investment bank, respectively, and engaged in questionable "chatting."

Fraud is not uniquely committed by power couples with privileged access. Sometimes it's a family act.  A former New York University student pled guilty last year to bank and wire fraud. His mother "was sentenced in March to two years in prison after she pleaded guilty last year to conspiracy to commit wire fraud in the scheme. The two lived in Pound Ridge before they were arrested in June 2005." Click here to read more.

These cases are yet another reminder that risk comes in many forms. It's simply not enough to look at risk-adjusted return performance (historical, current and projected). Pension fiduciaries must carefully vet money managers (regardless of asset class) on a comprehensive basis. This includes a rigorous assessment of their internal controls that relate to trading, how valuable information is protected and the ethical requirements for anyone on the "production line."

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According to Business Insurance, the former Chief Financial Officer of the Ohio Bureau of Workers' Compensation gets sixty-four months in jail. Involved in a rare coin investment scandal dubbed "Coin Gate,"  he pled guilty to "violating the federal Racketeer Influenced and Corrupt Organizations statute." (See "Former Ohio comp bureau CFO sentenced" by Roberto Ceniceros , May 11, 2007.)

The current Statement of Investment Policy and Guidelines prohibits investments in coins. Click here to access the document.

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The latest news on Hilton heiress Paris is not good. Sentenced to forty-five days time for violating probation over a suspended license, she must report to jail on June 5. Click here for the CNN.com story.

Ordinarily we wouldn't include a story about Paris Hilton except that it gives one pause for the following reason. In the last week, we've been busily focused on gathering news about litigation, enforcement and general stories about fraud in the financial world for www.pensiongovernance.com and www.pensionlitigationdata.com.

Our conclusion? There are a lot of Paris Hilton wannabes out there if you think of her as a role model for "let them eat cake."

One can barely keep up with allegations of wrong doing - securities fraud, option backdating, imprudence of investment selection, lack of oversight, accounting "flexibility," incorrect valuations, conflicts of interest, absence of prudence, excess this, excess that. Many of the cases being filed allege fiduciary breach on the part of pension decision-makers or directors and officers or both.

To be VERY clear, allegations mean little until due process takes place and individuals have their day in court to argue their case. Additionally, we recognize that it's easy to hang our hat on the most egregious events, letting them taint everyone in the business. This too is an injustice for those folks who work diligently to execute best practices.

That said, however, the sheer number of news stories, allegations and complaints about financial bad acts is daunting to say the least. There are some who predict more to come, especially with so many millions of dollars at stake and increased exposure to complex securities and strategies.

We'd like to emphasize the importance of applauding the "good guys and gals." Let's learn lessons from demonstrated bad acts (for the sake of improvement).

For those who find it hard to resist temptation, keep in mind - The "pass the buck" mentality is unseemly and dangerous, especially when innocent bystanders stand to lose.

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According to the SEC website, a complaint has been launched against an economics professor and several funds he controlled. In "SEC v. Albert E. Parish, Jr., Parish Economics LLC and Summerville Hard Assets LLC, Civil Action No. 2:07-cv-00919-DCN" (D. S. C., April 5, 2007), the SEC charges fraud.

Shortly after the filing, in a somewhat sad turn of events, news outlets report a claim of amnesia. See "Fund Manager Offers Memorable Response to SEC's Fraud Charges" by Suzanne M. Schafer (Associated Press), April 7, 2007. Click here to read the article (one of many).

What's ironic is that the professor, apparently oft-cited as an economic forecasting expert, was quoted in May 2006 as happy with the Enron verdict. "It certainly provides a boost of faith." Click here to read the text of "Local businessman, economists pleased by Enron verdict," The Sun News, May 26, 2006.

Everyone should have their proper day in court but it does seem odd that $134 million is allegedly missing and a "smart" man suffers forgetfulness.

Nevertheless, in the spirit of lessons learned, plan sponsors can be reminded (for that matter, all investors should pay heed) that background checks of key players is desirable, nay essential.

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