Fiduciaries must drill down on Expenses

Investment managers and service providers to qualified retirement plans must disclose the fees they charges to the plan fiduciaries of the investing plans.  The Department of Labor launched a huge project many years ago focusing on these fee disclosures which culminated in a Final Regulation being issued in 2012.

ERISA lawyers, plan sponsors and services providers have devoted endless hours to compliance with the 408(b)(2) requirements.

Where have the Private Equity firms been?   And, where have the fiduciaries been?

Gretchen Morgenson reported yesterday, Pension Funds Can Only Guess at Private Equity’s Cost, that with respect to “rates of return and hidden costs”, private equity funds are as “impenetrable as a lockbox”.

Why are plan fiduciaries still guessing?

Many private equity funds implement restrictions with respect to the character of their investors so as to avoid certain requirements of ERISA.  Notwithstanding these limits, however, many ERISA qualified funds, as well as public retirement funds, do in fact, invest in private equity funds.   The fiduciaries of these plans have a statutory duty to determine that compensation paid to service providers is reasonable.   The disclosure regulations are designed to facilitate this determination.

According to Morgenson a few public investors, namely the Treasurer of the State of South Carolina, and a member of CalPERS, have tried to obtain data and information to assess whether the fees paid to private equity firms constitute reasonable compensation.   But, obtaining this data can be a challenge.

Furthermore, the relevant accounting rules are not clear.

Despite the opacity surrounding these fees, Morgenson reports that consultants and business academics have begun challenging the accuracy of the fee disclosures.  Morgenson links to a recently released study by CEM Benchmarking,  based in Toronto which addresses many of the complexities and deficiency with respect to recent fee disclosures.

All ERISA fiduciaries are on Notice.  It is your obligation to dig deep to understand the fees associated with a private equity investment.  Any fiduciary who does not have the expertise to make these determinations, should hire an expert for assistance.  Failure to do so could be a breach of fiduciary duty.

Given the resistance by Private Equity firms to these disclosures, the requests must be persistent, consistent and demanded by all investor fiduciaries.  Plan participants deserve as much.

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Our Time Has Come

At the next cocktail party, trying mentioning that your firm does “fiduciary work” for qualified retirement plans.  Immediately, people’s eyes glaze over, they bolt to re-fill their drinks, and those who remain simply give a quizzical nod desperately trying to be polite.

Fiduciaries, fear not!  Our moment in the spotlight has arrived.

Yesterday’s New York Times editorial, Successful Investing for the Long Haul, highlights a long simmering regulatory battle between Washington and Wall Street.  Shortly after the financial crisis of ’08-’09, the Department of Labor issued proposed new regulations pertaining to the definition of fiduciary under ERISA.

Wall Street fought back hard, and the regulation wallowed in the backwater of rule making.

Until late February, that is, when President Obama, with Senator Elizabeth Warren (my Senator) at his side, announced in a speech made at the national headquarters of AARP, that he wanted the DOL to move forward with the fiduciary regulation project.

Subjecting brokers and financial advisers to a fiduciary standard captured the headlines.   Brokers must put client interests first — not simply as an advertising tagline, but rather in reality.

Digging beneath the headlines, however, uncovers a potential massive re-structuring of Wall Street firms.  $24 trillion of retirement assets (as reported in the ICI 2014 Annual Report) currently flow through the financial system and Wall Street .  10 basis points here, 10 basis point there, suddenly becomes a lot of money.  These financial firms have a lot at stake.

Once brokers are “deemed” fiduciaries, all related revenue streams will have to be examined and analyzed to determine if there are prohibited transactions or conflicts of interest.  Financial firms are going to have to under take a through review of their business models.

Wall Street will not look the same afterward.  Stay tuned.

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Fiduciaries, Can You Pick the Best Ones

Calpers’s announcement that it is liquidating its hedge fund investments continues to attract widespread attention.  Hedge Funds Lose Calpers, and More as reported by James B. Stewart in the New York Times.

“Foremost were fees”.   In light of the middling performance of Calpers’ allocation to hedge funds, the fees could not be justified.  One of Calpers’s “core beliefs” as stated on its website, “Costs matter and need to be effectively managed.”

ERISA takes this concept a step further.  Right in the statute, it provides that fiduciaries are required to “defray expenses”.  How the Department of Labor continues to permit the investment of plan assets in hedge funds is perplexing.

In addition to fees, however, another challenge looms large.   With over 10,000 hedge funds in the market place, how does a fiduciary pick the “best” fund(s)?   This is the same question the indexers have been asking about active managers for decades.  It is at the very core of Modern Portfolio Theory.

Apparently, even Calpers, with all of its resources and its heft in the marketplace, wasn’t able to crack this nut.

As I first identified just prior to Calpers’ announcement, Hedge Funds: Prudent Investments?, EVERY fiduciary needs to be evaluating the role of hedge funds in the portfolios they oversee.

But, the analysis can’t stop with hedge funds.   In the event that hedge fund investments are liquidated, fiduciaries then need to decide where to allocate the cash proceeds.   The investment environment it tough:

  • record low interest rates
  • record high in US equity markets
  • European debt crisis continues
  • geopolitical risks
  • Federal Reserve’s quantitative easing is about to end.

This might not be the most auspicious time for fiduciaries to be re-visiting their asset allocations in light of hedge fund liquidations.

But, fiduciaries don’t get to choose the investment environment.  They must make prudent decisions in light of the real word risks currently prevailing.

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Maybe the Start of a Trend

The nation’s largest pension fund has announced that it will be liquidating its positions in 24 hedge funds and 6 hedge fund-of-funds.  CalPERS, Nation’s Biggest Pension Fund, to End Hedge Fund Investments reported in today’s New York Times.

Possibly someone read my recent blog post, Hedge Funds: Prudent Investments?

There is little complicated about this decision.  It comes down to fees, risks, and returns.

Not surprisingly, a professional with a hedge fund advisory firm explains, “Hedge Funds are the place to be now because people are expecting a major correction.”

Really? That’s the rationale?

Getting tickets to a Beyonce concert can be justified because it is “the place to be.”  I would suggest that fiduciary decisions to invest plan assets in any asset class would be based on something more than it being “the place to be.”

It bears watching whether plan sponsors begin liquidating positions out of hedge funds.  But, I could be wrong, maybe hedge funds will continue to be the “in” asset class of choice into the future.

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Once Again, Strong Process and Substance Matters

There is not much love lost by the Department of Labor for ESOP transactions.  The skepticism, even antipathy, is somewhat justified.  Some ESOP transactions don’t pass the smell test (see my prior post:  ESOPs: Common Sense Required).

And yet, ESOP transactions continue.  Notwithstanding the bad deals, there are economic benefits to ESOP structured transactions.  Fortunately, however, ESOP fiduciaries now can operate with clearer direction from the Department of Labor.

At the beginning of the summer, the Department entered into a Settlement Agreement in Perez v. GreatBanc Trust Co with respect to an ESOP maintained by the Sierra Aluminum Company.  This Settlement Agreement afforded the DOL the opportunity to issue guidance which has the look and feel of regulations, without having to go through the long process of issuing regulations.

In short, DOL requires that the fiduciary be an active participant in an ESOP transaction.  The fiduciary must determine that financial projections are reasonable, take steps to assess the accuracy of financial data, review the selection and valuation process of the expert appraiser, and generally assure that a prudent process has been followed and documented.  This is far from a passive role.

At Harrison Fiduciary Group we have drafted a set of fiduciary policies and procedures which closely adhere to the terms of the GreatBanc settlement.   In general these procedures focus on the following:

  1. Valuation Advisor — review of qualifications, selection process, no conflicts of interest, analysis of valuation work-product;
  2. Financial Statements — reasonable reliance on financial statements;
  3. Fiduciary Process — written documentation of processes, and reliance upon valuation report; and
  4. Miscellaneous — Preservation of documents, purchase or sale of securities for fair market value (debt not to exceed fair market value of securities), consideration of a claw-back.

In light of the GreatBanc settlement and the general enforcement pressure being brought to bear by the DOL on these transactions, some institutional fiduciaries are exiting the ESOP marketplace.  They are unwilling to assume the risks highlighted by the Department and the Courts. This market disruption might cause concern for some service providers, but at HFG we view this as a significant opportunity.   Our competency and expertise as fiduciaries should give comfort to both plan sponsors and to the Department of Labor.  As is true for each of its fiduciary engagements,  HFG rigorously complies with its own policies and maintains contemporaneous written documentation of its process. ESOP engagements will fare no differently.

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A Practical View From the Trenches

After the drama of a Supreme Court argument, multiple amicus briefs, and voluminous commentary, the role of a fiduciary (from the perspective of a fiduciary) after Fifth Third Bancorp v. Dudenhoeffer , in the end, looks very similar to the role of a fiduciary before Dudenhoeffer.  But, while the role may be the same, the biggest difference is that attention, directed by no less an authority than the Supreme Court, has now been focused on the responsibilities and potential liabilities  assumed by fiduciaries.

Simply put, post Dudenhoeffer, fiduciaries must determine that an investment of plan assets in company stock is prudent.  Sound familiar?

Even before Dudenhoeffer eliminated the Moench presumption, leading fiduciaries recognized that oversight of a company stock account required traditional fiduciary monitoring and analytics of the investment of plan assets in company stock.  This oversight would be judged against a prudent expert standard.  Neither the responsibility nor the standard has changed.

To meet this responsibility, at Harrison Fiduciary Group, we have established a disciplined practice with respect to company stock accounts which includes regular monitoring of

  • contributions/redemptions,
  • cash balances,
  • market price, and
  • public disclosures.

Although the Supreme Court acknowledged that fiduciaries can rely upon the market price of a security (effectively adopting a modern portfolio theory of pricing), we have established a research competency which takes into account:

  • SEC public filings,
  • Financial news reports,
  • Stock analyst ratings and reports,
  • Credit ratings, and
  • Price/volatility of options or credit default swaps (where available).

In other words, every time we purchase shares of company stock, we are in effect, making the determination that the investment is a prudent one.   Similarly, we also recognize that in the event that we determine that an investment in company stock is no longer prudent, then we would be obligated to begin selling the stock.

To repeat for emphasis, however, notwithstanding the Dudenhoeffer decision, none of this is really new.

What is new post-Dudenhoeffer, however, is the recognition that company stock fiduciaries have substantive roles to play and that there is real risk and liability for failure to discharge these responsibilities prudently.  Fiduciaries of company stock accounts are not mere recordkeepers, nor do they merely “rubber stamp” the decisions of others. The Dudenhoeffer decision makes this clear.

At Harrison Fiduciary Group we not only understand these responsibilities and maintain expertise in these fiduciary skills, but we will be accountable for all fiduciary decisions that we make.

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Fiduciaries Should Ask This Very Question

An esteemed ERISA litigation lawyer e-mail me the other day with a question, as follows: “Mitch, would you advise an ERISA plan NOT to invest in a hedge fund which uses an “expert network”, in light of the controversies surrounding network experts?”

My reply, “I have lots of issues with hedge funds, though the use of experts is low on my list.”

In my judgment, the overwhelming concern with hedge funds is whether the fees paid to the hedge fund managers are reasonable.

On the whole, hedge fund performance is somewhat average, mediocre.   Just what would be expected in light of the vast number of hedge funds. Paying the standard “2 and 20” management fee for mediocre performance is hard to justify as prudent. (Check out out, https://www.hedgefundresearch.com, for data on hedge fund performance.)

Sure, some hedge funds have outperformed the market significantly.  But, this assessment, as is always the case, is in retrospect.  Just like selecting active managers, the question is whether the managers can be identified beforehand.

Choosing an out performing hedge fund (thereby justifying high management fees) is further exacerbated by the fact the US equities market has been on an upward trajectory since 2009.   The S&P 500 is up 150% (dividends reinvested) with an annualized return in excess of 18%.

Outperforming, where it occurs, in an overwhelmingly up market is not an impressive accomplishment.  Effectively assessing a manager’s investment skill requires investment performance over an entire market cycle, up as well as down markets.

My prediction is that when the market eventually reverses itself, and over time it certainly will, the class action lawyers are going to catch wind of this issue.  Private litigation will eventually explode in this arena.

Hopefully, fiduciaries will have done their homework.

As for expert networks?  Fiduciaries must undertake their due diligence of the compliance processes employed my hedge fund managers.  Its enough to say, “Please, no insider trading.”  Instead, assure yourself that compliance processes are sophisticated and reflect best practices.

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Dark pools remind me of revenue sharing.  Not much good can come from business practices or products with descriptive titles of this nature.

Whereas an avalanche of class action litigation has shed light on the practice known as revenue-sharing, New York Attorney General Eric Schneiderman, Barclays Faces New York Lawsuit Over Dark Pool and High-Frequency Trading, has focused the spot light on dark pools by filing a law suit against Barclays over its private stock trading platform… otherwise known as dark pools.

The law suit essentially claims that certain high-frequency traders were favored over other participants in the pool and that various practices were not properly disclosed.

Many of the other banks and financial services firms run similar “platforms”, so the entire financial industry has a stake in the litigation.  Schneiderman is not the only regulator involved, the SEC, charged with maintaining integrity in the financial markets, is also a key player.

And so … here goes another financial services industry free-for-all.   Mind you, these dark pools are big revenue producers, so the stakes are high.

The issues are serious and complex for Wall Street, however, I am much more interested in the fiduciary issues at stake.

Make no mistake about it, plan fiduciaries have oversight responsibility for the trading of securities held by the plan.  At a minimum, the trading practices must be reasonable, prudent and, generally, managers are required to seek “best execution.”  And, of course, this analysis must includes a review of trading costs and expenses.

The challenge and tension revolves around the fact that fiduciaries require transparency, whereas the name dark pools suggests the opposite — opacity.

At the outset, Fiduciaries need to determine whether plan assets were traded through these dark pools.  If the answer is yes, then a whole series of questions follow:

Did the plan assets get best execution?

Are other pool participants advantaged over the plan assets?

What fees are charged for trading in the pools?

Are these fees reasonable?

Are the fiduciaries assured that trading via the pools did not constitute a prohibited transaction?

How are pool operators compensated?

Are there any conflicts of interest?

Has the fiduciary been monitoring these trading practices on a regular basis?

This is merely an initial list of questions.  But, posing the questions is the easy part.  Understanding the answers is far more challenging.  In my many years of serving as the General Counsel of a global investment management firm, no area was more confusing or harder to get my arms around than the issues related to the trading desk.  Traders use a lingo and jargon that is all their own.  Sometimes getting satisfactory answers in this area requires the best of prosecutorial skills.  It can be tough going.

If they haven’t already, Fiduciaries are best advised that they begin asking these questions.  If they do not, certainly class action lawyers and the Department of Labor, most certainly will.

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Is it a Good Deal?

Employee Stock Ownership Plans (ESOPs) present an attractive financing tool and ownership structure for both publicly and privately held businesses.

ESOPs can be very complex.  There are many moving parts.

Lawyers, investment bankers, consultants and other advisors love complexity.  In fact, professionals often thrive on complexity.  Somehow complexity conveys an aura of expertise, and of course, expertise demands high fees.

However, the structuring of an ESOP and the decision-making process undertaken by the various stakeholders (plan sponsors, plan fiduciaries, advisors, etc.) should not overlook very simple questions:  “Is this a good deal?”  “Do the economics work?”.

In transactions of this nature, there is lots of pressure to “get the deal done.”  Pressure by selling shareholders and pressure by the bankers can all be significant.  But, it is a fiduciary’s job to ask the simple questions.

In Fish v. GreatBanc, a recent decision by the Seventh Circuit, the Court outlines what amounted to a bad business deal.  Although the precise issue decided by the Court focused on the application of the relevant statute of limitations, the underlying business deal was not pretty.

As noted by the Court, and repeated by other bloggers, Steve Rosenberg, What Happens to Company Owners Who Get Overaggressive When Selling out to an ESOP?, outsider advisors to the independent fiduciaries characterized the transaction as “the most aggressive deal structure in the history of ESOPs.”

Wow.  When an advisor puts that warning in writing it is best to pay attention.  (Remember, it will be part of the record if the deal heads south.)

While many lawyers have commented on the legal issues, I’d like to provide a practical perspective, as an Independent Fiduciary.

At the outset, it is important to note that “aggressive” –taken by itself — is not necessarily a negative or a bad thing.

Many “aggressive” investments may still be prudent. But, in the parlance of modern portfolio theory, an aggressive, or high-risk investment, must be compensated for by a higher rate of return.  High risk.  High Return.

In addition, the risk of an investment must be assessed in the context of the composition of an entire investment portfolio.  High risk investments must be balanced with lower risk investment so that the overall portfolio reflects an appropriate risk level.

ESOPs present a unique challenge when it comes to risk.  That is, the company stock held by the ESOP is the sole asset held by the plan (other than some cash).

In the context of Fish, once the deal was characterized as “aggressive”, it was then the fiduciary’s responsibility to dig in.  What gives rise to the nature of the aggressive nature of the deal?  Are there ways to mitigate the aggressiveness?  Can the plan be adequately compensated for the risk inherent in the transaction?

This analysis must be a collaborate effort, undertaken by the fiduciary, the plan sponsor, and the selling shareholders.  The analysis is not intended to kill the deal.  To the contrary, the analysis is designed to enhance the deal, to afford protections to everyone involved, not the least of whom are the plan participants who must get a fair deal.

ESOPs can be very compelling structures for all stakeholders:  owners, plans and plan sponsors.  However, it is the fiduciary’s responsibilities to make sure that the risks and rewards are prudently shared.

As an Independent Fiduciary, it is my job to exercise discretion as a “prudent expert”.  While prudence includes following various processes and procedures, it also demands me to ask, “Is this a good deal for the plan?”   Financial advisors and investment bankers, it is your job to persuade me that, in fact, it is a good deal.

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Seems Like Some Fiduciaries May Be Asleep at the Switch

The SEC is attempting to cast some sunlight on to the tangle of fees charged by private equity firms.  The Deal’s Done. But not the Fees, Gretchen Morgenson.  My question, as if often the case is, “Where are the plan fiduciaries?”

Moregenson points out that in addition to the typical “2 and 20” fee arrangement (2% management fee, 20% performance fee), private equity advisory firms charge investors a host of other fees, many of which are buried deep in disclosure and other documents.

The SEC, apparently, is now hip to these tricks.

Morgenson notes that private equity investments constitute $3.5 trillion of the $64 trillion asset management industry.  The Investment Company Institute reports that as of December, 31, 2013, total US retirement assets were $23 trillion. With respect to these assets, managers must not only abide by the rules of the SEC, but also ERISA (the Employee Retirement Income Security Act of 1974).  Admittedly, many private equity funds are structured in a manner designed to avoid ERISA, however, not all are so structured.

ERISA imposes a regulatory regime which is materially different than the regulatory regime imposed by the securities laws. Whereas the securities laws rely heavily upon the “sunshine” of disclosure, ERISA places affirmative duties on fiduciaries with respect to the investment and monitoring of plan assets.

Therefore, the SEC’s efforts should be supplemented by the Department of Labor.  While the SEC can direct its attention on the advisors, the DOL can focus on plan fiduciaries.

The questions for the plan fiduciaries are simple:

  1. Were they aware of theses intricate fee arrangements?
  2. Did they analyze and review the various fees?
  3. Did they conclude that the fees are reasonable and sign-off on the reasonableness of the fees?

ERISA requires that fees paid out of plan assets must be reasonable.  In fact, a couple of years ago new regulations were issued related to plan expenses.  Mutual funds and various other plan service provides have been jumping through hoops to comply with these new regulations.  What about private equity funds?

Another ERISA concern revealed by Morgenson relates to various relationships which might give rise to conflicts of interest.  Again, ERISA takes a different approach than the securities laws.  Under the securities laws, generally, disclosure is sufficient to “cure” a conflict of interest.  The thinking is that once effectively disclosed, sophisticated investors can consent to these conflicts.

Not so under ERISA.

ERISA contains a set of requirements which preclude a series of transactions known as “Prohibited Transactions”.  The types of transactions are fairly explicit, and, simply put, they are prohibited, not allowed, barred.   It’s really plain english.   Disclosure and consent are not remedies.  Conflicts of interest clearly constitute Prohibited Transactions.

Allowing a plan to engage in a prohibited transaction constitutes a breach of fiduciary duty under ERISA.  Therefore, plan fiduciaries typically are vigilant in detecting these prohibitions.

At a minimum, in light of Morgenson’s article, and the SEC’s questioning, plan fiduciaries need to examine whether in fact a plan’s private equity investments is subject to ERISA.  If it is, then further diligence may be necessary.

These concerns are not intended to disparage private equity investments.  Private equity managers have delivered consistent returns for their investors over the past decades.  But, like any investment, past performance is not a guarantee of future results.  Private equity investments clearly can play a role within a larger portfolio of plan investments.

However, private equity investment structures need to pass the same regulatory scrutiny imposed upon all other advisors and services providers to retirement plans.

Morgenson’s article suggests that possibly plan fiduciaries may have been asleep at the switch.  Her article puts fiduciaries on notice as to where they should be directing some attention.

Any fiduciary not up to the task of demanding information and asking hard questions of private equity advisors should delegate that task to fiduciaries who are prudent experts.  Plan participants and beneficiaries deserve no less.

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