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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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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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“No one can serve two masters.”

Although the tradition is not mine, I can appreciate the rabbinic-like wisdom in the statement. Unfortunately, it appears that ERISA lawyers, on the whole, have not embraced this learning.

The statute, however, clearly is not agnostic on this topic.  Consistent with traditional trust-law concepts, and possibly not unaware of theology, ERISA demands a “duty of loyalty” by a fiduciary to the plan on whose behalf it is acting.

The language of statue is clear.  Dual loyalties are prohibited.  Nonetheless, ERISA lawyers (with the blessing of the courts) still continue to abide by the “two hat” doctrine.

Let me explain.

Two weeks ago, at a national conference of ERISA lawyers, a panel of in-house ERISA lawyers, reviewed a variety of issues that they encounter on a regular basis.  When the discussion shifted to fiduciary practices, one of lawyers explained the care and diligence that she employs when counseling the plan sponsor’s investment committee. This committee, of course, serves as a fiduciary to the retirement plans.  She said that she repeatedly recites or invokes the “two-hat” doctrine.

That is, in the day-to-day exercise of their corporate responsibilities, the officers owe a duty of loyalty to the shareholders of the corporation.  However, in the context of an investment committee meeting, they needed to “remove” their “corporate hat” and replace it with their “fiduciary hat”.  All decisions need to be made “in the best interests of the plan participants.”  They must disregard their duties to the corporation.

Upon recital of the two-hat catechism, every single participant on the panel nodded his or her head in agreement.   An ERISA truth had been proclaimed and knowledgable members of the ERISA bar mustered all of their reverential professionalism and genuflected at this statement of the canon.

Yes, it is commonly accepted that a corporate officer can “wear two hats”.  A chief financial officer, or a director of marketing, can spend his days (and often nights) toiling rigorously on behalf of the corporation (and shareholders), but during certain committee meetings they must shed this hat and instead, make a decision “solely in the interest of the participants and beneficiaries.”

Regularly, in corporations though out America, decisions are made related to $ trillions of retirement assets under this “two hat” theory.

For many years, I too sang from the two-hat hymnal, often a solo, just like the panel member.  However, with a bit of middle-aged experience and having weathered a systemic financial crisis, I have learned at times it can be valuable to question received wisdom, to question the hymnal.  And, sometimes even acknowledge the wisdom of traditions not my own.

For a moment, let’s set aside legal principles, theology, as well as editorial sarcasm, and examine the “real” world.

Another participant on that morning’s panel, explained that the retirement assets of her corporate plan (in excess of $15 billion) are “so important that the CEO personally appoints the members of the fiduciary committee.”

When a CEO handpicks members of a committee, everyone takes notice.   While CEO lieutenants may be adept at various technical and managerial skills, often, intense loyalty to the CEO is a common attribute.  (Dissidents typically do not typically rise to the C-suite).

This loyalty often includes a precise understanding of the CEO’s goals and priorities with respect to corporate strategy and is often rewarded by promotions, committee appointments, raises, bonuses, stock options and other assorted perks.  The senior managers are properly incentivized to advance the vision of the CEO.

Upon assuming a spot on a fiduciary committee, however, these same senior managers are required to shed the very skills that contributed to their corporate rise.  When making decisions on behalf of the plans, they are suppose to set aside any allegiance to the CEO, forget about the stock options they may have patiently accumulated over the years, and make decisions irrespective of an impact on corporate earnings.

The potential for conflicts of interest are real; they are not the abstract musings of lawyers and academics.   Many transactions squarely put the corporation and the plan on opposite sides, with competing goals.

So, can these corporate offices so deftly switch hats as ERISA lawyers assume?   Are fiduciary committee members so professional, so trustworthy, so ethical, that they are immune to the human impulses which gave rise to: “No one can serve two masters.”

Aren’t we all engaged in a collective willing suspension of disbelief as to the artifice of the two-hat theory?  Isn’t it time to say enough?  Let’s bring meaningful independence to the fiduciary oversight of the nation’s retirement plans.  The stakes are way too large not to.

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An Independent Fiduciary Protects All Parties

With rising interest rates and CEO’s tired of pension-related balance sheet surprises, the volume and size of annuity transactions is bound to explode.

Experience teaches that exuberance in financial markets and products can lead to some very painful losses.  The Department of Labor is concerned.  It has seen this movie more than once.

Multiple factors go into the corporate decision to “de-risk” the balance sheet by purchasing annuity contracts.  Months of work go into this decision.  One key factor is the cost of the annuity, as well as the cost of executing the transaction.  While these transactions can be expensive to execute, senior corporate managers are also incentivized, and have a duty of loyalty to the company, to minimize these expenses.  Lower expenses enhance earnings.

However, annuity pricing is efficiently correlated to the credit quality of the issuer of the annuity.   In other words, lower credit-quality issuers charge less for their products.  The corollary is also true; higher credit-quality annuities are more expensive.

Left to their own devices, corporate managers are incentivized to purchase the cheapest annuity available even if it reduces the credit quality of the issuer.  This pressure is very strong.

Plan fiduciaries and participants, however, have a different view.  They are interested in the strongest credit quality issuer available, price be damned.  Remember, prior to the annuity purchase, the pension plan is funded by a diversified pool of assets, thereby mitigating investment risk.

An annuity purchase,however, substitutes a single issuer for this diversified pool.   The pensions of thousands of plan participants are dependent on this single issuer.  The issuer goes bankrupt, the pensions are lost… forever.

The conflicts for senior managers (some of whom are plan fiduciaries) in executing these transactions are real.  Should they pay up for higher credit quality; or, should they sacrifice credit to enhance earnings.

ERISA provides a single answer.  Fiduciaries must act in the interests of participants.

In the early 1990’s the bankruptcy of Executive Life Insurance Co. provided a huge wake-up call.   Many plans were invested in Exec Life products and they absorbed huge losses.

In response,  the DOL issued guidelines in IB 95-1 setting forth numerous requirements regarding the purchase of annuity contracts.  Post-Executive Life,  the DOL requires that a plan purchases the “safest available annuity”.   In reaching this determination, the DOL requires that 6 six factors be analyzed, price of the annuity is not one of the factors.

Recognizing the potential conflicts of interest and the competing pressures of corporate managers, these IB 95-1 suggests that an independent fiduciary be hired to make the the “safest available annuity” determination.

Unfortunately, plan sponsors don’t like hiring Independent Fiduciaries. They don’t like paying the fees and they don’t like a second set of eyes reviewing their judgments.  If corporate managers want to purchase an annuity from XYZ Insurance Co, they don’t want a third party telling them that they should purchase the annuity from DEF Insurance Co.  And, they really don’t like that an Independent Fiduciary will retain its own lawyers and advisors for the transaction.

Ironically,  the intensity of the resistance by senior managers to hiring an Independent Fiduciary actually illustrates and proves the very conflicts of interest outlined above.

Corporate managers who forgo an Independent Fiduciary might one day be in the position of having to prove to the Department of Labor that they transcended these conflicts and acted in the interests of plan participants.  In the context of large losses (possibly $ billions) That will be a hard argument to make.  The DOL will be very suspicious.  Remember, there is personal liability for breaches of fiduciary duty.

In the end, an Independent Fiduciary will make decisions in the interest of the plan participants.  However, the corporate managers can take great comfort from knowing that the conflict of interest is significantly mitigated by the hiring of the Independent Fiduciary.  Whether they understand it or not, the Independent Fiduciary provider significant protections to the corporate managers.

Corporate managers should focus on executing their corporate strategies.  Let the Independent Fiduciaries wrestle with the complexities of purchasing annuity contracts.

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Is Still a Conflict

JP Morgan sold credit default insurance and a mutual fund managed by JP Morgan’s Asset Management Group bought the insurance.   That’s a conflict of interest.  No way around it. See, As One JPMorgan Trader Sold Risky Contracts, And One Bought Them.

Surprisingly, however, the article by Azam Ahmed implicitly condones, and even praises the transaction.   Rather than finding any criticism of this transaction, Ahmed quotes a researcher at the Brookings Institute who states,  “the lesson is that the asset management firms really do act like different different bodies”.  Apparently this is a good thing.

I disagree.

Conflicts of interest undermine the trust upon which our financial system is built.  Simply put:  one party/individual cannot represent both sides of a transaction.  Or, to put it more colloquially, no one can serve two masters.

In the context of the JP Morgan trade, the credit default swap is a contract.  This contract imposes rights and obligations on each of the parties. These are obligations “with teeth”.  Remember when Goldman and AIG were fighting over collateral which needed to be segregated to support similar derivative-type contracts?.

Suppose similar conflicts arose with respect to the JP Morgan trade.   Would the Asset Management Group, on behalf of the mutual fund and its investors, sue the bank to enforce the credit default swap?   Imagine all of the judgments which would have to be made in this context.   Are the investors in the mutual fund confident that the Asset Management Group would have represented them (the Investors) aggressively against their (the Asset Management Group’s)  employer?

To further highlight this conflict, imagine if the trade had gone the other way.  Assume that JP Morgan Bank earned a huge profit and the mutual fund lost $2 billion on its investments.  In that scenario the Bank would have earned a huge profit at the expense of its clients.  I suspect very different articles and columns would be written.

The most disturbing aspect of the Article, however, is the absolute lack of sensitivity to the conflict issue.  Reflecting the approach of an adolescent kid beseeching her parent “but everyone does it!”, Ahmed explains “That one hand of the bank was selling while another was buying is not uncommon in the dog-eat-dog-world of Wall Street”.  I guess if “everyone does it”, its OK.

The fact of the matter is, it is not OK.  The very foundation of the financial system depends on trust.  One element of this trust is that advisors (or rather agents) will act for exclusively for the benefit of investors (principals), that they will avoid conflicts of interest. While transactions can be structured to meet various legal requirements (and I’ve done tons of “structuring” in my career) and possibly fall within various exemptions or special rules, the reality is that, a conflict is a conflict is a conflict.

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Fiduciary Values

To our Clients, Friends and Supporters –

Thank you for your trust, confidence and support in 2011.  We are looking forward to a strong and robust 2012 and hope to enhance our reputation for integrity and judicious investment decision making.

Over the holidays, I read High Financier, The Lives and Time of Siegmund Warburg, by Niall Ferguson.    Siegmund Warburg was part of the extended Warburg banking family.  After his Hamburg bank was Aryanized by the Nazis in the 1930’s, Warburg moved to London and started his new firm from scratch, S. G. Warburg & Co.  Hewing to traditional values of trust, honor and client service, he built not the largest nor the most profitable merchant bank, but probably one of the most innovative and trusted financial firms.

For Warburg, corporate values were not merely a matter of branding or marketing.  Instead, they were the very organizing principles of his personal and professional life.

The reputation of a banking firm for integrity, generosity and thorough service is its most important asset, more important than any financial item.  Moreover, the reputation of a firm is like a very delicate living organism which can easily be damaged and which has to be taken care of incessantly, being mainly a matter of human behavior and human standards. [SG Warburg's personal papers, Box 64; Ferguson, p. 233]

These words leapt off the page at me.  They capture the essence of my vision and goals for Harrision Fiduciary Group.  Warburg speaks of banking, but in today’s world, banking now includes, trading, private equity, hedge funds and all aspects of investment management.

Simply put, in each of these endeavors, professionals are entrusted with assets properly belonging to others.  It is an honor to be put in such a position of trust.

However, words like Trust, Honor, and Integrity have been excessively diluted in our current culture and financial system.  Either they are scoffed at as relics from a bygone era or they have been turned into cliches by facile marketing campaigns on behalf of firms whose conduct actually belies these very values.

Given the prevailing financial excesses and market volatility, an understandably cynical view pervades our financial markets and the various players in these markets.  We need to recapture the meaning and behaviors embraced by these values.

Ours is a small firm. Our vision and mission are simple to articulate.  We want to be the industry leaders and set the standard for fiduciary services with respect to Trust, Honor and Integrity.   At HFG we will always put the interests of our clients ahead of our own.  We will never stand on the other side of a transaction from a client.  We will never engage in a conflict of interest, and will never use client information or positions to advance our own.

While these ideals may sound lofty and therefore beyond one’s grasp, they actually are easy to implement.   Like S.G. Warburg & Co, Harrison Fiduciary will neither be the richest nor the largest fiduciary services firm.  However, we hope to be known as a firm which always acts in the best interest of its clients.

We wish all of our clients and friends the best for 2012.

With appreciation.

Mitchell

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BlackRock Solutions Needs to Shed Light on Valuation Methods

Today’s Wall Street Journal, BlackRock’s “Geeky-Guys” Business, focuses a spot light on BlackRocks Solutions — a small business unit tucked away in the bowels of BlackRock, complete with its own elevator entrances, computers and separate office floors.  If nothing else, haven’t we learned from the ’08-’09 financial crisis, that “Geeky-Guys” hidden away from view have the potential to inflict great harm on our financial system.

Let’s give BlackRock Solutions (BRS) the benefit of the doubt — they have some really smart people who work really hard.  And, during the height of the financial crisis BRS assisted with the management of portfolios which held a lot of funky assets.  The system and US government (including the taxpayers) needed BRS.

As the WSJ reports, BRS provides various risk management services, including asset allocation, to major pension plans — both public and private.  As part of these services, BRS also values hard to value assets according to its own proprietary algorithms and processes.  These valuation process are secret — according to the WSJ.

While I obviously am not privy to the contracts between BRS and its clients, I have strong suspicions that BRS is hired as a fiduciary to provide these services.  Furthermore, the people at the pension plans who hire BRS are likely fiduciaries themselves.

Based upon these two assumptions, I have 2 simple questions:

1) If valuation processes are secret, how do the fiduciaries which hire BRS know that they are prudent processes?

2) Are the fees which BRS charge dependent upon these secret valuations?

These are not sophisticated questions.  But, the answers go to the heart of our pension system.

ERISA is very clear.   Plan fiduciaries are able to hire and delegate responsibilities to other fiduciaries.  If they do so, the decision to hire and delegate these responsibilities must be a prudent decision.  Furthermore, the plan fiduciaries must continue to monitor the hired fiduciaries.  How can the decision to hire BRS be prudent if the valuation methods are secret?  Furthermore, how can anyone monitor whether BRS is discharging its responsibilities in the face of secret valuation methods.

Finally, I also strongly suspect that BRS  charges a fee based upon the assets under management.  If this is the case, then the secret valuations placed upon the assets can directly effect BRS’s compensation.  This is a problem under ERISA.

Yes, the professionals at BRS are smart, and we should trust them.  But, that is besides the point.  Assuming that they are fiduciaries, secrets can’t be permitted.

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Outsourced Chief Investment Officer — More Questions Than Answers

Pension investment consultants have found their latest fad …..outsourced CIO services….otherwise known as OCIO.

From benchmarking, to style boxes, every couple of years the investment consultants cook up a new fad to sell to retirement plan fiduciaries.  As a business model, replenishing the product line has served the consulting industry very well.  The question, however, is “how well have the plans performed using their advice?”

And now, the industry is off on its newest fad:  OCIO.  While each firm might tailor their services in a unique manner, the general theme is the same. Rather than offering traditional consulting services, with an OCIO, a plan turns over its entire portfolio to the consultant to be managed.

Presto Change-o!!!!  The lowly consultant morphs into the coveted role of investment manager.  Rather than receiving a fee for consulting services they can now charge fees based upon the assets under management.  And, who knows? If they are lucky, they may even get a performance fee: the holy grail of asset management.

FundFire reports on this industry trend, Consultants Tweak Outsourced CIO Message.  As FundFire explains, however, there is a lot of confusion underlying the OCIO title and the services actually being provided.   This confusion requires the industry to “Tweak”  its message.  In fact, one public plan rejected the shift from traditional consulting to OCIO because of the lack of clarity surrounding these services and this role.

Two points in this article jumped out at me.

First, a critical term is missing. Neither the consultants, nor the article, mention the term “fiduciary”.  This entire model is presented as an asset gathering and fee generating exercise by the consultants.   But where is the fiduciary obligation to the plans and the participants?

Second, the article, in the opening paragraph, references potential “new conflicts of interest” presented by this new arrangement, but does not fully explore these conflicts.  Very often consultants provide multiple services to their clients.  Adding a OCIO role can add to these potential conflicts.

Furthermore, consultants also have significant relationships with other investment managers.   This side of the relationship equation is very murky.  How will the consultant  select managers for its OCIO services?   How will these services be priced?  These are just the start of the questions.

From the perspective of the consultant industry, it is completely understandable that they want to explore new ways to develop their services.  As Shale Lapping, president of IPEX, an independent consulting firm in Plymouth, MI states, “the ability to generate additional revenue is obviously an attractive position …. The margin has always been smaller for consultants (than for managers); that’s not secret in the industry. [Outsourcing] brings in higher margins and makes it easier to retain quality talent.”

This is well and good for the consulting industry.

At Harrison Fiduciary Group, we unequivocally and categorically reject this form of the  OCIO business model as embraced by many consultants.  While it might make sense for the consultants, it doesn’t necessarily makes sense for clients.

On one level, we do support the delegation of investment oversight, monitoring and management to outside, independent experts. In contrast, however, at HFG our business model starts and finishes with our role as a fiduciary for plan assets.  First, we provide a single service to plan sponsors — fiduciary services.  We don’t have multiple services to sell, or rather cross-sell, to a plan sponsor.  We have no ability to increase our fees with a client.  We also do not have affiliates such as broker/dealers which also can give rise to conflicts of interest.  Plain and simple, we pledge:  No Conflicts of Interest.

Importantly — and maybe even heretically in our business — we will charge a flat fee for our services.   We are not engaged in an asset gathering exercise and will not charge a basis point fee for assets under management.  Anwill bed, of course, we will never charge a performance fee. Instead, our flat fee is based upon (i) the complexity of an engagement, (ii) the resources needed to execute the project and (iii) the fiduciary risks which we assume.  Our fees will never increase simply because the value of a particular market increases.

To use a much over used expression; “we are thinking outside of the box”.  We present an alternative business model for the oversight, monitoring and management of retirement assets.  We are competing against traditional big players in our field.  However, we have a principled and new approach which puts the best interest of plan participants at the core of our business model.

We are not embracing a fad by serving as a fiduciary.  The duties of a fiduciary harken back to the 16th century.  At Harrison Fiduciary Group we serve a time honored role.

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No One Seems to Care about Conflicts

A member of the board of trustees of a NY City private school provides information to a prospective parent about the school.  Sounds simple enough, but then the parent pays the trustee for the information.  Say, what?

Apparently, there is a business in this.  The NY Times reports that Aristotle Circle provides these various contacts to otherwise unconnected NYC parents.  Let’s set aside for a moment, the hyper-aspirations of parents and the crazed environment for coveted spots in select pre-schools.  Instead, let’s focus for a moment on the trustee who provided these services.

Serving as a trustee on the board of a non-profit is a fiduciary position.  The trustee owes a fiduciary duty to the Board and the organization.  Receiving a fee from a third party for either access to the school or information about the school is a gross example of self-dealing.  This trustee should be thrown off the board, ASAP.

The bigger issue, however, is how come this trustee is so tone deaf to a blatant conflict of interest?  Did the trustee have any qualms about these actions?  Furthermore, how does Aristotle Circle build a business model on these fee for services, and introductions?

A few weeks ago, Berkshire Hathaway announced that David Sokol had made personal investments in a company in which he then encouraged Warren Buffet to buy.  Neither Buffet, nor his right hand man Charlie Munger, seemed to think that there was anything wrong with these actions.  Sokol tendered his resignation only after pressure was raised by outsiders.

Whether it is the heir apparent of Berkshire Hathaway or an ambitious NY city parent, no one seems to be bothered by these conflicts of interest.

Try as we may to overcome the financial crisis through new rules and regulations.  No meaningful progress can be made until we address this very simple business proposition.  People who hold positions of trust — in any organization — must avoid any appearance of a conflict of interest.

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David Sokol’s Resignation from Berkshire Hathaway Doesn’t Pass the Smell Test

Full disclosure:  I have been a long time shareholder of Berkshire Hathaway.  Therefore, I’m particularly disappointed with the current episode of bush league antics from corporate America.  I expected more from Berkshire, Warren Buffet and Charlie Munger.

I want to set aside the legal analysis of whether Sokol’s action constitute insider trading or a breach of a duty to the corporation, shareholders or anyone else.  No doubt, talented lawyers will line up arguing both sides of these issues.  Irrespective of the final legal assessment, these facts stink.

As reported in yesterday’s New York Times, by Reuters, Sokol learned about Lubrizol  because Citigroup had an investment banking assignment from Berkshire to bring potential acquisition targets to Berkshire’s attention.   In effect, Sokol learned about the Lubrizol opportunity in his capacity as an employee and officer of Berkshire.  He then took that information and used it for his own benefit.

This egregious behavior was then compounded by the fact that he turned around and pitched the Lubrizol deal to Buffet.  He also attended a meeting with Lubrizol’s CEO in the process — no doubt that he scored this meeting because of his position at Berkshire, it was not in his personal capacity as an investor of $10 million in Lubrizol’s stock.  (Although a lot of money, $10 million investments don’t typically afford an investor a one-on-one meeting with a CEO).

Simply put, Sokol abused a position of trust.  Buffet and Munger’s failure to call him out on it only exacerbates these inexcusable actions. In fact, Munger makes the tired excuse: “Few people understand how good he is, how really good he is”.  In other words, he’s so good that he is above the rules. The ultimate rationale of elitism; members of the club can’t possibly do anything wrong.

Corporate governance experts are explaining that Berkshire’s internal policies (Code of Conduct, Insider Trading Policy, Conflict of Interest Policy, etc) need to be reviewed and possibly re-vamped.  As a fiduciary, I am a huge proponent of rigorous policies and procedures.  However, policies and procedures are only as good as the judgment of the people who enforce them.  Nothing replaces strong business ethics.  And, as anyone who has worked at in a large organization knows — a culture of strong business ethics  starts at the top.

Buffet and Munger’s staunch support of Sokol sends a strong message not only through the capital markets, but also throughout the entire Berkshire entity.  Just possibly, there are two sets of rules:  one set for the rank and file and one set for those who are “really good”.  In large organizations everyone sniffs out these double standards and the integrity of the culture begins to erode.

Our financial system has survived a near death experience.  Congress attempted a legislative fix through Dodd-Frank which is now mired in a political and regulatory  morass.  As I have stated before, real reform will never occur until behavior is reformed. We need business leaders with the courage to proclaim that conflicts of interest are intolerable and unacceptable. Failure to do so undermines the integrity of our financial system.

Warren Buffet use to be such a leader.  For decades, he has only taken a minimal salary from Berkshire for the stated reason that he wanted his interests to be aligned with shareholder interests.  A noble and unique position in corporate America.   Somehow David Sokol missed this message.  Maybe he and Buffet should pull out some of the old Berkshire annual reports.  They provide an exemplary primer on corporate ethical behavior.

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