Pension Usage of Swaps

I have been writing, training and consulting about the use of derivatives by pension plans for many years. There is no shortage of topics, especially in the aftermath of the Dodd-Frank Wall Street Reform and Consumer Protection ("Dodd-Frank") and the fact that pension investing and derivatives trading are significant elements of the capital markets. The OECD estimates the size of the private pension system in 2012 at $32.1 trillion. The Bank for International Settlements estimates the June 2013 global derivatives market size at $692.9 trillion.  

Given the importance of the topic of pension risk management and the evolving regulatory landscape, it was a pleasure to have a chance to recently speak with Patrick S. Menasco. A partner with Steptoe Johnson, Attorney Menasco assists plan investors, investment advisers and broker-dealers as they seek to navigate the laws relating to hedging, swaps clearing and much more. Here are a few of the take-away points from that discussion.

Question: Do the swaps provisions embedded in the Dodd-Frank legislation contradict the netting rules that are part of U.S. bankruptcy law?

Answer: No, the netting provisions of the Bankruptcy Code remain intact and should be taken into account in negotiating swap agreements. To the extent feasible, a performing counterparty wants to be able to net obligations in the event of a counterparty insolvency and default.

Question: Your firm obtained Advisory Opinion 2013-01A from the U.S. Department of Labor ("DOL") on February 7, 2013 regarding swaps clearing, plan assets and ERISA fiduciary duties. Explain the importance of identifying plan assets in the clearing context.

Answer: ERISA, including its prohibited transaction rules, governs "plan assets." Thus, it is critical to determine whether margin posted by a plan in connection with swaps clearing and the swap positions held in the plan's account are considered "plan assets" for ERISA purposes. Among other things, Advisory Opinion 2013-01A gives comfort that (1) margin posted by the investor to the clearing agent generally will not be considered a plan asset for ERISA purposes and (2) clearing agents will be able to unilaterally exercise agreed-upon close-out rights on the plan's default without being deemed a fiduciary to the plan, notwithstanding that the positions are plan assets.

Question: The headlines are replete with news articles about swap transactions with pension plans that could be potentially unwound in the event of bankruptcy. Detroit comes to mind. Should non-pension plan counterparties be worried about a possible unwinding in the event of pension plan counterparty distress?

Answer: Yes and no. The case in Detroit (which is currently on appeal) illustrates the risk that, notwithstanding state or local law to the contrary, federal bankruptcy judges may disregard the legal separation between municipal governments and the pension trusts they sponsor, treating those trusts as part of the estate. This may present certain credit and legal risks to the trusts' swap counterparties, although the Bankruptcy Code's swap netting provisions may mitigate some of those risks. I doubt that we will see anything similar to Detroit in the corporate pension plan arena because ERISA not only recognizes, as a matter of federal law, the separate legal existence of such plans, but also affirmatively prohibits the use of plan assets for the benefit of the sponsor. Separately, many broker-dealers negotiate rights to terminate existing swaps upon certain credit events, including the plan sponsor filing for bankruptcy or ceasing to make plan contributions.

Question: How does Dodd-Frank impact the transacting of swaps between an ERISA plan and non-pension plan counterparties such as banks, asset managers or insurance companies?

Answer: Dodd-Frank does a number of things. For one, it adds a layer of protection for ERISA and government plans (and others), through certain "External Business Conduct" standards. Generally, these standards seek to ensure the suitability of the swaps entered into by the investors. Invariably, swap dealers will comply by availing themselves of multiple safe harbors from "trading advisor" status, which triggers various obligations relating to ensuring suitability. Very generally, these safe harbors seek to ensure that the investor is represented by a qualified decision-maker that is independent of, and not reliant upon, the swap dealer. Under protocol documents developed by the International Swaps & Derivatives Association ("ISDA"), the safe harbors are largely ensured through representations and disclosures of the plan, decision-maker and swap dealer (as well as underlying policies and procedures).

Question: Dodd-Frank has a far reach. Would you comment on other relevant requirements?

Answer: Separately, Dodd-Frank imposes various execution and clearing requirements on certain swaps. These requirements raise a number of issues under the prohibited transaction rules of ERISA and Section 4975 of the Internal Revenue Code. Exemptions from those rules will be needed for (1) the swap itself (unless blind) (2) the execution and clearing services (3) the guarantee of the trade by the clearing agent and (4) close-out transactions in the event of a plan default. This last point presents perhaps the thorniest issue, particularly for ERISA plan investors that direct their own trade swaps and thus cannot avail themselves of the Qualified Professional Asset Manager ("QPAM"), In-House Asset Manager ("INHAM") or other "utility" or "investor-based" class exemptions. The DOL expressly blesses the use of the QPAM and INHAM exemptions in the aforementioned Advisory Opinion 2013-01A, under certain conditions. Senior U.S. Department of Labor staff members have informally confirmed that the DOL saw no need to discuss the other utility exemptions (including Prohibited Transaction Class Exemption ("PTCE") 90-1, 91-38 and 95-6) for close-out trades because they assumed they could apply, if their conditions were met.

Question: Is there a solution for those ERISA plans that direct their own swap trading?

Answer: It is unclear. There are only two exemptions, at least currently, that could even conceivably apply: ERISA Section 408(b)(2) and Section 408(b)(17), also known as the Service Provider Exemption. The first covers only services, such as clearing, and the DOL has given no indication that it views close-out trades as so ancillary to the clearing function as to be covered under the exemption. In contrast, the Service Provider Exemption covers all transactions other than services. But it also requires that a fiduciary makes a good faith determination that the subject transaction is for "adequate consideration." If the close-out trades are viewed as the subject transaction, who is the fiduciary making that determination? The DOL's Advisory Opinion 2013-01A says that it isn't the clearing agent. Thus, to make the Service Provider Exemption work, you have to tie the close-out trades back to the original decision by the plan fiduciary to engage the clearing agent and exchange rights and obligations, including close-out rights. That argument has not been well received by the DOL, at least so far.

Many thanks to Patrick S. Menasco, a partner with Steptoe & Johnson LLP, for taking time to share his insights with PensionRiskMatters.com readers. If you would like more information about pension risk management, click to email Dr. Susan Mangiero.

Pensions, Politics and the ERISA Fiduciary Standard

Thanks to the folks at the Mutual Fund Directors Forum for disseminating a January 13, 2014 letter from members of the New Democrat Coalition to the Honorable Thomas Perez, Secretary of the U.S. Department of Labor ("DOL"). The gist of the four-page communication is that these members of the current U.S. Congress would like to see regulatory coordination in order to "protect investors while reducing confusion." They add that they are still concerned that a new version of the fiduciary standard, when proposed anew, might discourage plan participant literacy and disclosures. The worry seems to be that individuals with low or middle incomes as well as small businesses could be adversely impacted, depending on the ultimate version.

According to the Securities Industry and Financial Markets Association ("SIFMA") website, Republicans have likewise communicated their concerns to the U.S. Department of Labor as well as the Office of Management and Budget. These ranged from "the impact on an individuals' choice of provider to potential unintended consequences limiting access to education for millions of individuals saving for retirement." Click to access SIFMA's DOL Fiduciary Standard Resource Center.

On October 29, 2013, the Retail Investor Protection Act (H.R. 2374), sponsored by U.S. Congresswoman Ann Wagner (Republican, 2nd District of Missouri), was approved by the United States House of Representatives in a vote of 254 to 166. According to the Gov Track website, U.S. Congressman Patrick Murphy (Democrat, 18th District of Florida) joined as a co-sponsor on September 19, 2013. The stated legislative intent is to preclude the "Secretary of Labor from prescribing any regulation under the Employee Retirement Income Security Act of 1974 (ERISA) defining the circumstances under which an individual is considered a fiduciary until 60 days after the Securities and Exchange Commission (SEC) issues a final rule governing standards of conduct for brokers and dealers under specified law." It further prevents the SEC from implementing a rule "establishing an investment advisor standard of conduct as the standard of conduct of brokers and dealers" prior to assessing the likely impact on retail investors. Click to read more about the Retail Investor Protection Act. Click to read the mission of the United States Department of Labor which states "To foster, promote, and develop the welfare of the wage earners, job seekers, and retirees of the United States; improve working conditions; advance opportunities for profitable employment; and assure work-related benefits and rights."

As I have repeatedly predicted in this pension blog and elsewhere, the retirement crisis, not just in the United States but around the world, is increasingly showing up as a political hot button issue. No one wants to lose votes from retirees who are struggling and employees who cannot afford to stop working any time soon. In his State of the Union address, U.S. President Obama described a new type of retirement account, i.e. "myRA," that is meant to help millions of individuals whose companies do not offer retirement plans. See "What you need to know about Obama's 'myRA' retirement accounts" by Melanie Hicken (CNN Money, January 29, 2014). More details will no doubt follow.

There is a lot we don't know about how politics will impede or enhance the state of the global retirement situation. As a free marketeer, I am not particularly optimistic about new rules and regulations that prevent an efficient supply-demand interaction from taking place. However, this is a lengthy topic and the hour is late so I will leave a discussion about the positive and normative aspects of capitalism for another day.

Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends

Mark your calendars to attend "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends."

At a time when unfunded pension and health care obligations are accelerating the budgetary crisis for some municipalities, experts fear that current problems are the tip of the iceberg. A new focus on accounting rules, the quality of disclosure to muni bond investors and the due diligence practices of underwriters, portfolio managers and advisers could mean heightened liability exposure for anyone involved in the nearly $4 trillion public finance marketplace. Add the history-making Detroit bankruptcy decision to the mix and attorneys have the makings of a perfect storm as they attempt to navigate these unchartered waters. The U.S. Securities and Exchange Commission has made no secret of its priority to sue fraudulent players in the public finance market. Insurance companies are reluctant to underwrite policies for high-risk government entities at the same time that municipal fiduciaries are more exposed to personal liability than ever before, especially as the protection of sovereign immunity is being challenged in court. Litigation that involves how much monitoring of risk factors took place is on the rise.

Public finance and securities litigation counsel, both in-house and external, can play a vital role in advising municipal bond market clients as to how best to mitigate litigation and enforcement risk or, in the event that an enforcement action has already been filed, how best to defend such litigation. Please join Orrick, Herrington & Sutcliffe LLP partner, Elaine C. Greenberg, and retirement plan fiduciary expert, Dr. Susan Mangiero, for an educational and pro-active program about the complex compliance and litigation landscape for municipal bond issuers, underwriters, asset managers and advisers. Topics of discussion include the following:

  • Description of the current regulatory environment and why we are likely to see much more emphasis on the disclosure activities of public finance issuers and the due diligence practices of underwriters and advisers;
  • Overview of hot button items that impact a bond issuer’s liability exposure, to include valuation of underlying collateral, rights to rescind benefit programs in bankruptcy and the use of derivatives as part of a financing transaction;
  • Explanation of GASB accounting rules for pension plans and likely impact on regulatory oversight of securities disclosure compliance and related enforcement exposures;
  • Discussion about trends in municipal bond litigation – who is getting sued and on what basis; and
  • Description of pro-active steps that governments and other market participants can take to mitigate their legal, economic and fiduciary risk exposures.

Featured Speakers:

Ms. Elaine C. Greenberg, a partner in Orrick, Herrington & Sutcliffe LLP’s Washington, D.C., office, is a member of the Securities Litigation & Regulatory Enforcement Group. Ms. Greenberg’s practice focuses on securities and regulatory enforcement actions, securities litigation, and public finance. Ms. Greenberg is nationally recognized for producing high-impact enforcement actions, bringing cases of first impression and negotiating precedent-setting settlements, she possesses deep institutional knowledge of SEC policies, practices, and procedures. Ms. Greenberg brings more than 25 years of securities law experience, and as a Senior Officer in the SEC's Enforcement Division, she served in dual roles as Associate Director and as National Chief of a Specialized Unit. As Associate Director of Enforcement for the SEC's Philadelphia Regional Office, she oversaw the SEC's enforcement program for the Mid-Atlantic region and provided overall management direction to her staff in the areas of investigation, litigation and internal controls. In 2010, she was appointed the first Chief of the Enforcement Division's Specialized Unit for Municipal Securities and Public Pensions, responsible for building and maintaining a nation-wide unit, and tasked with overseeing and managing the SEC's enforcement efforts in the U.S.’s $4 trillion municipal securities and $3 trillion public pension marketplaces. Ms. Greenberg recently gave a speech entitled “Address on Pension Reform” at The Bond Buyer’s California Public Finance Conference in Los Angeles on September 26, 2013.

Dr. Susan Mangiero is a CFA charterholder, certified Financial Risk Manager and Accredited Investment Fiduciary Analyst™. She offers independent risk management and valuation consulting and training. She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors. Dr. Mangiero has served as an expert witness as well as offering behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary on matters that include distressed debt, valuation, investment risk governance, financial risk management, financial statement disclosures and performance reporting. She has been actively researching and blogging about municipal issuer related retirement issues for the last decade. She has over twenty years of experience in capital markets, global treasury, asset-liability management, portfolio management, economic and investment analysis, derivatives, financial risk control and valuation, including work on trading desks for several global banks, in the areas of fixed income, foreign exchange, interest rate and currency swaps, futures and options. Dr. Mangiero has provided advice about risk management for a wide variety of consulting clients and employers including General Electric, PriceWaterhouseCoopers, Mesirow Financial, Bankers Trust, Bank of America, Chilean pension supervisory, World Bank, Pension Benefit Guaranty Corporation, RiskMetrics, U.S. Department of Labor, Northern Trust Company and the U.S. Securities and Exchange Commission. Dr. Mangiero is the author of Risk Management for Pensions, Endowments and Foundations  (John Wiley & Sons, 2005), a primer on risk and valuation issues, with an emphasis on fiduciary responsibility and best practices. Her articles have appeared in Expert Alert (American Bar Association, Section of Litigation), Hedge Fund Review, Investment Lawyer, Valuation Strategies, RISK Magazine, Financial Services Review, Journal of Indexes, Family Foundation Advisor, Hedgeco.net, Expert Evidence Report, Bankers Magazine and the Journal of Compensation and Benefits. Dr. Mangiero has written chapters for several books, including the Litigation Services Handbook and The Handbook of Interest Rate Risk Management.

Real Estate Investment Trusts (REITs) and ERISA Plans

According to "REITs By The Numbers," published by the National Association of Real Estate Investment Trusts, Inc. ("NAREIT"), real estate is gaining favor with 401(k) investment committees that decide on asset allocation. They write that the last ten years has seen a rise from 5 percent to 30 percent of 401(k) plans that offer Real Estate Investment Trusts ("REITs") as an investment option. Moreover, the market is large at $1 trillion of real estate held in the form of an investment pool.

If you are a member of a 401(k) investment committee, advisor, consultant or individual participant, you will want to keep up with current guidelines and rules. Some of these are described in "Real Estate Investment Trust Valuation Guidelines Published." This blog post by Susan Mangiero includes FINRA and SEC comments about non-listed REITs as relates to items such as illiquidity, valuation and disclosures.

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:

New PCAOB Report Finds Pension Valuation Numbers Wanting

According to a new report just published by the Public Company Accounting Oversight Board ("PCAOB"), valuation of pension plan assets was one of the audit areas with "deficiencies attributable to failures to identify and test controls." Given the importance of having proper pension valuations carried out by knowledgeable and experienced persons, it is no surprise that this oversight organization devoted an entire section of its findings to the topic of valuation of pension plans assets. The problems they found include the following:

  • Insufficient testing of controls over how pension plan assets are valued;
  • Testing of controls that were imprecise and therefore did not allow for an assessment of the risk of material misstatement by plan auditors;
  • Failure to properly test the valuation of pension plan assets; and/or
  • Relying on management or the person(s) who performed the reviews without seeking an independent assessment as to why "variances from other evidential matter" were occurring.

In response to these findings, a prominent ERISA attorney commented that the cited deficiencies were not surprising and that valuation problems will continue to grow for those retirement plans that are allocating more money to "hard to value" funds.

In his 2011 speech before the AICPA National Conference, Jason K. Plourde with the Office of the Chief Accountant, U.S. Securities and Exchange Commission ("SEC"), talked at length about the role of pricing services and how securities that are not actively traded should be valued. He suggested that management "may need to perform different procedures and controls when considering the information from pricing services regarding the fair value of financial instruments..."

Concerns about how best to value pension plan assets and regularly test methodologies and controls related to said valuations took center stage in 2008 when the ERISA Advisory Council working group on "Hard to Value Assets" met to discuss how best to improve things. This blogger - Dr. Susan Mangiero - testified on the topic of "hard to value assets," emphasizing that poor valuations lead to a cascade of problems. For one thing, inflated valuations translate into higher fees paid by ERISA pension plans. Second, incorrect valuations make it difficult to properly review and revise any of the items listed below, each of which are critical to proper fund management such as:

  • Asset allocation;
  • Exposure to a particular sector or fund manager;
  • Fee benchmarking for appropriateness of compensation paid to a manager;
  • Type and size of hedges;
  • Hiring and termination of an asset manager(s);
  • Regulatory funding ratio and related cash financing; and
  • Cost of pension plan de-risking for some or all of current defined benefit plan participants.

If you missed reading Dr. Susan Mangiero's September 11, 2008 testimony before the ERISA Advisory Council Working Group, click to read about "hard to value" assets in the context of ERISA fiduciary duties and pension risk management.

With more pension plans reporting large scale deficits, don't be shocked if further questions are asked about the integrity of asset and liability valuation numbers.

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.

Hedge Fund Lock Ups and Pension Inflows

Various sources tout increasing inflows to hedge funds from public and corporate pension plans.

In "Strong start to hedge fund activity in 2011" (April 1, 2011), Pensions & Investments reporter Christine Williamson writes that "First-quarter institutional hedge fund activity, including net inflows and pending searches, totaled $18 billion - the highest since the intense investment pace of the first quarter 2007, which saw $25 billion in activity." James Armstrong of Traders Magazine describes the billions of dollars going to hedge funds in recent months as a catalyst to "increased trading volumes for the equities trading business." See "Hedge Funds Could Juice Volume" (June 2011). Imogen Rose-Smith of Institutional Investor gives readers a detailed look at the love affair with hedge funds in "Timeline 2000-2011: Public Pensions Invest in Hedge Funds" (June 20, 2011).

Fortune writer Katie Benner says "wait a minute" to what seems to be an upward trajectory in retirement plan allocations to hedge funds with a 51% increase since 2007 and a doubling of the mean allocation to 6.6% (according to a study by Preqin). In "Hedge fund returns won't save public pensions" (March 30, 2011), she cites willful underfunding and a "mish-mash of accounting tricks" as fundamental problems that will not be corrected with more money in alternatives.

In her May 16, 2011 article for Pensions & Investments and entitled "Promises, promises: $100 billion still locked up," Christine Williamson writes that assurances made to institutional investors in 2008 and 2009 about redemptions are not being met by some hedge fund managers. At that time, jittery pension funds, endowments and foundations that wanted out were asked to be patient rather than force hedge funds to unwind hard to value positions at sub-par prices. Quoting Geoff Varga, a senior executive with Kinetic Partners US LLP, a consultancy for asset management firms, there is an estimated $100 billion in "exotic" or non-standard investments that were stuffed into "emergency side pockets." He adds that it is hard to come up with an exact number, especially since managers' valuations of these illiquid positions are not always realistic.

Certainly the issue of side pockets is unlikely to go away any time soon. On October 19, 2010, Emily Chasan reported that the U.S. Securities and Exchange Commission ("SEC") had filed a civil complaint against several hedge fund managers for overvaluing illiquid assets. See "SEC charges hedge fund of inflating 'side pockets'" (Reuters). Click here to read the SEC complaint and October 19, 2010 press release from the SEC. On March 1, 2011, Azam Ahmed with the New York Times Deal Dook described another case in "Manager Accused of Putting $12 Million in Side Pockets."

This blogger, Dr. Susan Mangiero, has written extensively on the topic of hard to value investments and liquidity and served as expert witness on cases involving due diligence allegations. Acknowledging that not all hedge funds invest in hard to value instruments, the following items may be of interest to readers:

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.

 

Model Risk Costs One Asset Manager $242 Million

According to a February 3, 2011 document released by the U.S. Securities and Exchange Commission ("SEC"), AXA Rosenberg Group ("AXA") and various related entities have settled a matter relating to model risk for $242 million in economic damages and penalties. In a company letter dated April 15, 2010, several AXA executives describe an error with an investment model as having been "discovered in late June 2009" and "corrected between September and mid-November." While there are issues about the disclosure of said problems, the official message to investors at that time was a continued commitment to risk management.

Investor fallout has occurred nevertheless with various press accounts reporting the withdrawal of monies from AXA by pension plans such as the School Employees' Retirement System of Ohio, Los Angeles Fire and Police Pensions, the City of Fresno Retirement System, Florida State Board of Administration, the Marin County Employees' Retirement Association and the Montana Board of Investments. 

As I've written before, valuation (and by extension, model risk assessment) is a key element of the due diligence of asset managers. For a list of some of the "must ask" questions about model reviews, click to read "Asset Valuation: Not a Trivial Pursuit" by Susan Mangiero, PhD, CFA, FRM (FSA Times, The Institute of Internal Auditors, Q1-2004).

Email contact@fiduciaryleadership.com if you want to further discuss model review best practices.

U.S. Department of Labor and Definition of Fiduciary

As the U.S. Department of Labor ("DOL") prepares to expand the definition of fiduciary, at the same time that the U.S. Securities and Exchange Commission is doing likewise, the financial industry is girding for some potentialy massive changes.

In response to the DOL's request for comments about an expanded definition of fiduciary as relates to retirement schemes, I warned that the law of unintended consequences could push knowledgeable professionals out of the marketplace. If fears that the liability costs will outweigh the benefits of working with plan sponsors, perhaps materially so, it will be difficult to attract the talent that is so badly needed to assist with implementing pension governance policies and procedures. 

I further wrote that a hefty dose of transparency could do wonders for differentiating "good" fiduciaries from others. This problem is not new. In fact, I wrote in 2006 that trying to identify who serves as a member of a plan's investment committee is like searching for hidden treasure. Click to read my 2006 post about pension fiduciary disclosure.

Click to read my January 20, 2011 letter to the U.S. Department of Labor about their proposed expansion of who should serve as a fiduciary.

Click to read the other letters submitted to the U.S. Department of Labor about this important issue of who properly counts as a fiduciary. Letters I read suggest the need for a universal education standard. As is the case in other countries, the United States could well end up with a mandate for independent fiduciaries to serve on investment committees, after having been properly vetted, licensed or otherwise credentialed.

Venture Capital Allocation and the IPO Drought

On March 1, 2010, Dr. Susan Mangiero, CEO of Investment Governance, Inc. sat down to talk to financial and strategy expert, Mr. Pascal Levensohn. In this ninth question of ten, read what this Investment Governance, Inc. Advisory Board member has to say about IPOs and whether institutional investors should allocate monies to venture capital ("VC") funds right now. Click here to read Mr. Levensohn's impressive bio.

SUSAN: Does an anemic initial public offering ("IPO") market will remain a deterrent to VC investing?

PASCAL: Yes I do. I believe that an entire generation of American innovation is at risk as a result of the lack of IPO’s. The statistics are overwhelming in support of my position, starting with the fact that over 90% of jobs created by VC-backed companies occur AFTER their IPO - and this has been the case for 40 years. What concerns me the most about the IPO vacuum is that it is systemic and is the result of a “one size fits all mentality” when it comes to regulation of the securities industry.  A relatively unknown emerging growth public company with a $500 million market cap has different needs for research and trading support to provide liquidity for investors than IBM. I remain surprised that this seems to be difficult for our policy makers to understand, but I am encouraged that the U.S. Securities and Exchange Commission ("SEC") has recently invited public comments for a 90 day period to address structural problems with the U.S. equity markets.

Specifically, the SEC wants to know if anyone from the public has thoughts on "whether the current market structure is fundamentally fair to investors and supports capital raising functions for companies of various sizes, and whether intermarket linkages are adequate to provide a cohesive national market system." The Commissioners expressed particular interest in receiving comments from a wide range of market participants. Comments on the Concept Release are due within 90 days after publication in the Federal Register.

Click to read "SEC Issues Concept Release Seeking Comment on Structure of Equity Markets" (January 13, 2010).

I believe that the U.S. equity capital markets must be structured with the goal of promoting the growth of publicly held small businesses in America. America had this structure in place prior to 1997. We should take a hard look at what has changed to render the small company IPO extinct. (Contrary to popular belief, it first became an endangered species before the technology bubble).

Compounding this problem is the fact that, with no IPO options, the consideration paid for companies in trade sales - acquisition by larger companies - has been declining.  Why should venture capitalists take the risks associated with starting up a new company, working through all of the difficulties with multiple financing rounds and executive changes over a six-to-eight or even ten-year period, only to get backed into a corner by a large multinational that dominates the sales channel and can wait them out?

The biggest problem the VC industry has today is that, absent access to public market capital, there are too few VC-backed companies that are self sustaining cashflow generators.  The biggest problem that the U.S. economy has today is unemployment. You would think that maybe the stewards of the U.S. economy, our legislators, could make some structural changes to our small company capital markets regulations to fuel the greatest job creation engine in America - the entrepreneur driving an emerging growth company. This problem goes way beyond venture capital. Consider that 47% of all IPO’s since 1991 were backed by neither VC’s or private equity firms. This is an American problem.