The Billionaire vs. The Bank

Published on 15 October 2010 by Mitchell Shames in Uncategorized

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Too Tough Too Call

For Joe Nocera, of the NY Times, it’s an easy one.  He’s rooting for the billionaire — even if the billionaire is not “someone for whom one’s heart instinctively bleeds”.

According to Mr. Nocera’s most recent column, A Billionaire Army of One vs. a Bank, Mr. Blavatnik, a Russian born American citizen, gave JP Morgan $1 billion to manage in a short-term cash portfolio.  A sizable portion of the portfolio was invested in tranches of mortgage-backed securities, as well as securities backed by home equity loans. This was all in the spring of 2006, flash forward to July 2007 and the securities begin loosing value.  All in, by April 2008, Mr. Blavatnik lost $100 million.

Mr. Blavatnik naturally sues JP Morgan.

Mr. Nocera admits in his conclusion that he is “looking for ways for banks to pay for their sins”.  This quest for retribution, however, quite possibly glosses over some complicating facts or questions — which in my mind makes this case too close to call.  Admittedly, my perspective is informed (or maybe clouded) by the fact that I am a lawyer, and I worked for a financial institution which reported that it settled similar types of claims with institutional investors.

My position in short:  there’s more than enough blame to go around.  It’s not so clear that the Billionaire comes to this dispute without bearing some significant responsibility for his own actions.  We must leave it to the judge to determine how much.

In 2006, interest rates were low, very low — “miniscule” — according to Mr. Nocera. At that time, Mr. Blavatnik along with scores of investors (major institutions: pension funds, endowments, and super high net worth individuals) were looking to increase their yields.  In other words, they wanted above average yields.  Specifically, Mr. Blavatnik wanted “just a quarter of a percent more than a typical money market fund”.  While Mr. Nocera downplays this stretch for yeild, by referencing an expert who suggests that this investment goal was “unambitious”, 25 basis points, in an environment when yields are “miniscule”, might not be so unambitious.

With these unambitious investment goals in mind, and supposedly directing JP Morgan that the account had to be “no-risk”, Mr. Blavatnik nonetheless signed investment guidelines (negotiated by “Mr. Blavatnik’s executives”) which authorized an allocation of 20% of the portfolio to mortgage-backed securities and 20% to asset-backed securities.

What?  Wait a second — here’s the rub — if Mr. Blavatnik was truly risk adverse, why would he have agreed to allocate 40% of his portfolio to non-traditional, or alternative assets.  I’m merely a lawyer, but that is not an unambitious allocation of assets.

Furthermore, who were these “executives” who negotiated on behalf of Mr. Blavatnik? Were they investment professionals?  Were they experts in alternative asset classes? What questions did they ask?

Mr. Nocera dismisses the “sophisticated investor” defense rather summarily with a reference to the Goldman Abacus lawsuit and auction rate securities sold by banks.  But, it’s important to be very clear that this situation is not analogous to the auction rate securities where retail investors lost money in no-risk accounts.  Mr. Blavatnik’s executives negotiated very specific and detailed investment guidelines.  With a net worth of supposedly $7.5 billion, the JP Morgan account executives would have made themselves available to answer every single one of his questions.

And, what about the monthly reports which were provided to Mr. Blavatnik, did he read them?  Did he understand them?  If he didn’t understand them did he ask any questions?  Again, what about his experts?  What was their analysis of the monthly reports?

I am not an apologist for the banks.  Far from it. No doubt if JP Morgan breached the investment guidelines, that is very problematic.  Also, no doubt the JP Morgan account executives where deep in a sales mode when presenting this strategy to Mr. Blatnick.  It is critical to understand the representations which were made in assessing responsibility.  Furthermore, I am equally troubled by the fact that a client who purported to be risk-adverse, was nonetheless presented with a set of investment guidelines which allocated 40% of the portfolio to alternatives.  I’d like to hear an unbiased expert on this.

Sins may have been committed by the Banks and Financial Institutions, but investing money on behalf of a Billionaire (absent misleading statements, etc) is not one of them.  Outside of the ear-shot of attorney’s, I suspect that Mr. Blavatnik

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Pension Plans Must be Overseen by Real Investment Fiduciaries

Jeannie Kaplan, a member of the board of education of the City of Denver, explains that when she reviewed and approved a complicated financial transaction on behalf of the Denver teachers’ pension plan, “I sat there wanting to believe what they (Mssrs Bennet and Boasberg, respecitively, the superintendent and chief operation officer of the school system) were saying”.  This was Ms. Kaplan’s way of addressing a $400 million hole in the pension plan and assessing JP Morgan Chase’s proposed solution.

In retrospect she concludes, “The board probably should have had their own financial consultant.”

This revelation is buried deep in Gretchen Morgenson’s article, Exotic Deals Put Denver Schools Deeper in Debt, on the front page of today’s NY Times.  In great detail, Morgenson outlines the deal which the Denver public school system entered into with JP Morgan in order to address the $400 million dollar underfunding of the system’s pension plan. Not surprisingly the terms of the deal (for Denver) have turned south and are going to be costly.  Again, not surprisingly, it will likely turn out to be a rich deal for JP Morgan Chase.

Ms. Kaplan’s statements reveal a dark secret about the $ trillions held by private and public pension funds.  Many (and I would venture the vast majority) are overseen by people with little investment experience and knowledge.  In all likelihood, a review of the transaction by financial consultants would not have produced a different result.  My suspicion is that Ms. Kaplan and her colleagues would have rubber stamped the recommendations made by a consultant in the same way they rubber stamped the recommendations of Bennet and Boasberg.

Would Ms. Kaplan have asked a consultant penetrating questions about the assumptions, potential conflicts of interest or risks inherent in the transaction?  Probably not.  Because the chances are that Ms. Kaplan wouldn’t even know where to begin in asking these questions.

This is the shocking truth.  Many people serve as pension plan fiduciaries who do not even possess a rudimentary understanding of investment and financial principles.

Quite frankly, the participants in the Denver plan, along with the taxpayers deserve far better.  They deserve real fiduciary experts who understand the complexities of managing and overseeing pension plans.  Experts adept in assessing risk, prudent portfolio construction and monitoring various service providers to the plan.

Wall Street professionals are very smart and creative.  Probably much smarter on financial and investment matters than Ms. Kaplan and her colleagues.  Pension plans need fiduciaries who are an equal match to Wall Street.  I’m not suggesting, at all, that everyone on Wall Street is pedaling a scam transaction.  In fact, many Wall Street innovations have proven beneficial to markets and investors.

Instead, fiduciaries, acting on behalf of plan participants need to assess the risks they are assuming on behalf of the plans and assure that the plans are being properly compensated for these risks.  No doubt, any deal proposed by Wall Street, will be good for Wall Street.   Plan fiduciaries need to make sure that the deal is also good for the plan.

There is nothing to cause me to doubt Ms. Kaplan’s capabilities as an effective school board member.  However, she, and countless others, should recognize the limitations of the their skills and delegate their investment responsibilities to experts.  I’m not suggestion that they simply rely upon and rubber stamp recommendations by consultants, but rather delegate responsibility to those who will stand by the fiduciary decisions which they make on behalf of the plan participants.

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Corporate Officers Reluctant to Serve on Fiduciary Committees

Employee Benefit News, reports that HR managers face challenges in attracting and retaining the best employees to serve on fiduciary committees.  Potential committee members are concerned when they learn that fiduciary responsibilities open them up to personal liability for breaches of conduct.

Simply put, who needs that headache?  Even when indemnification is provided, being a defendant in a lawsuit is not what people what people bargained for when accepting the “honor” of serving on a fiduciary committee.  Years after the settlement of a lawsuit, a Google search will reveal this nugget of a committee members professional history.

These concerns are justified.  However, the hidden and unspoken concern is that many plan sponsors lack the infra-structure to support this fiduciary responsibility.  Without a doubt, the most important component of this infra-structure is the culture of fiduciary integrity.  Does the organization value the fiduciary obligations and the processes required to support these fiduciary roles?

Corporate officers may often feel that they cannot turn down appointment to  these committees — declining such a high profile committee assignment could be career-limiting.  Anyone who feels such pressure should take this as the “canary in the coal mine”, that possibly their organization neither understands nor respects the importance of these roles.

Anyone nominated to serve on a fiduciary committee should have an opportunity to ask questions about the role and the opportunity to decline.  Asking questions about a position reflects the very prudence required for the position.  At a minimum, the fiduciary candidate should ask the following questions:

1.  What does the role entail and why have I been selected?

2.  What professional staff will be available to assist and suport the committee?

3.  What training will I receive?

4.  How much time will I need to devote to this and how will it impact my other responsibilities?

5.  Can I review the charter of the committee as well as the fiduciary policies and procedures?

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Compensation expressed as a Percentage of Assets Under Management Needs to be Evaluated

Michael Travaglini  announced his intention to retire as Executive Director of the Massachusetts Pension Reserve Investment Management to join Grosvernor Capital Management.  With remarkable candor, Travaglini explained to the Globe; “it’s an entirely personal (decision) one.  I have a wife and three children and I’m going to provide for them.”

Simply put, it appears that he wants to make more money.  No one can fault a guy for wanting to provide for his family.

Nonetheless, Mr. Travaglini’s career evolution and ambitions raise a significant issue pertaining to compensation and fees in the world of the pension industrial complex.  With $15.6 trillion of assets held by retirement funds (both public and private), everyone wants a slice of this staggeringly huge pie.

Scanning the landscape of various players in the pension market place reveals a common methodology for calculating fees: a percentage of the assets under the control or management of a vendor.  Custodians, record-keepers, administrators, investment managers of all stripes (long-only, private equity, venture capital, real estate, funds of funds and hedge funds), in one way or another, try to tie their fees (whether an annual fee or performance based fee) to the size of the pool of assets they oversee.

In fact, the bonus element of Mr. Travaglini’s compensation arrangement reveals that this culture of compensation tied to the size and performance of an asset pool has even injected itself into government.  Public servants can now expect a performance bonus.  Does that mean that Deval Patrick should get a performance bonus if he increases employment in the Commonwealth?  What about Ben Bernanke and Tim Geithner, should they get a fee based upon the size or growth of GDP?

Admittedly, the examples of Patrick, Geithner and Bernanke are ridiculous.  But, we must ask the question, why is providing Travaglini a performance bonus not equally ridiculous?  For some reason, it appears to be more acceptable that he and his staff be eligible for a bonus.

The standard response is that bonuses are needed to attract talented professionals;  otherwise, the private sector will attract the top talent.  I don’t buy that explanation.  First, even with the bonuses paid to either Travagliani or his staff, the private sector pays many multiples of what is offered by state government.  Second, the likes of Patrick, Geitner and Bernanke, and countless other public servants could all make more money in the private sector.  Nonetheless, they choose public service.

Whether consciously or not, it is now accepted practice that many retirement plan service providers are entitled to bonuses and compensation tied to performance and the size of asset pools.  The great irony, however, is that over the past few decades, many of these services have become commodities.  Practically, everyone is doing the same thing.  There are few secrets in the pension industry.

Custody, record-keeping and administration services are almost identical from bank to bank, consultants hype the same or similar analysis and methodologies, and certainly indexing is the same all over.

In light of these accepted compensation practices, the earnings of many members of the pension industrial complex have sky rocketed beyond belief.  In his best seller from the 1940’s, Fred Schwed asked, “Where are the Customers’ Yachts”.  Today, the yachts seem somewhat quaint, now we can point to private planes, ranches in Montana and vineyards in Sonoma or Burgundy.

While compensation has hit the stratosphere, we need to acknowledge that many retirement funds (both public and private) are experiencing severe underfunding.  Let’s not forget, the service providers are being paid by the retirement plans.  Every dollar paid to a consultant or fund manager is a dollar out of the pocket of a pensioner — especially in times of underfunding.

The system is out of balance.  There is no easy prescription for a quick fix.

At a minimum, those people who have assumed stewardship roles over funds, whether as trustees or fiduciaries, must begin holding service providers more accountable on issues of compensation.  As an industry, we must seriously examine the role of bonus fees and asset-based compensation arrangements.  They must be the exception not the rule.  An overall reassessment of these compensation arrangements will no doubt lead to significant compression of fees.  As John Bogle has proselytized for years, reduced fees over time result in higher investment returns.

Finally, as for Mr. Travaglini, while he might not be satisfied with the long term prospects of his current compensation package, he must have realized that the non-financial compensation he has received from the Commonwealth has been invaluable.  Under the current system, he will leverage his years of public service, including the many contacts that he made at public funds across the country, into a lucrative career selling the services of Grosvenor Capital Management.  Compensation is a broad concept.  Not everything can be reduced to dollars and cents.

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Don’t Just Blame the Rating Agencies

The Financial Stability Act of 2010 includes various provisions relating to Nationally Recognized Statistical Rating Organizations (NRSRO) — Rating Agencies — ranging from Senators LeMieux and Cantwell’s laissez faire elimination of NRSROS to Senator Franken’s governmental assignment of NRSRO’s to specific bond offerings. While the extremes are covered, a middle of the road approach is missing.

Fortunately, we have been through this dance with the role of Rating Agencies once before, and the SEC came out with a prudent solution.

Every mutual fund lawyer knows that advisors to money market funds cannot blindly rely upon the the Ratings Agencies’ assessment of a debt instrument. Instead, money market fund advisors must do their own credit homework in analyzing debt instruments.  They may take into account a Rating Agency’s rating as one factor in their own analysis, but the rating can not be a substitute for their own analysis.

This issue was firmly put to bed in the early 1990′s.

A little background.  Money Market Funds are allowed to keep their share prices valued at $1.00 per share (irrespective of slight movements of net asset value of the fund) provided they abide by certain credit and diversification rules. (Set forth in Rule 2a-7).  In other words, money market funds are exempt from the basic rule that the share price of a mutual fund must fluctuate and reflect the net asset value of the assets held by the fund.

One of the core provisions of Rule 2a-7, is that a money market fund must “limit its portfolio investments … to instruments which … present minimal credit risks”. After a series of commercial paper defaults in the late 1980′s, the SEC substantially modified Rule 2a-7 in 1991.  Among other changes, the SEC, for the first time amended the “minimal credit risk” requirement, by adding the following parenthetical; “(which determination must be based on factors pertaining to credit quality in addition to the rating assigned to such instruments by a NRSRO)”.  The Commission explained that the language was designed to emphasize that:

Possession of a certain rating by a NRSRO is not a “safe harbor.” Where the security is rated, having the requisite NRSRO rating is a necessary but not sufficient condition for investing in the security and cannot be the sole factor in determining whether a security has minimal credit risks.

This simple amendment transformed the management of money market funds. For over 15 years, money market fund advisers have had to undertake their own credit analysis.  Rather than relying on the Rating Agencies, investment firms had to develop their own staff of credit analysts.

Investors burned by investments in mortgage-backed-securities and CDO’s cannot place all of the blame on the Rating Agencies for the investment losses that they incurred.  I am hardly an apologist for the Rating Agencies given the various allegations of collusion between the Rating Agencies and Wall Street firms, as well as the conflict of interest inherent in their business model in which the issuers of securities pay the fees of the Rating Agencies.  Nonetheless, investors must take some responsibility for their investment decisions.

The unanswered question in the subprime financial crisis is whether investors did their own credit analysis with respect to the various mortgage-related instruements.  Those who did, not only likely sidestepped the crashing market for these instruments, but  some made fortunes on their bets against these instruments.

Michael Burry, Steve Eisman and Robert Rodriguez, profiled in Michael Lewis’s, The Big Short and Roger Lowenstein’s, The End of Wall Street, are examples of investment professionals who did their homework and did not blindly rely upon the pronouncement or ratings of Wall Street’s standard bearers.

In my mind, the lesson is simple, particularly for investing fiduciaries.  Do your homework.  In the constellation of jobs within the financial services industry, credit analysis is neither glamorous nor high paying.  Everyone would rather be a deal-maker or a hedge fund maestro.  But with complicated investment products and volatile global markets, I want to stick with the guy who does his credit homework.  Rigorous credit analysis can never be a bad thing.  Whereas as blaming the other guy — such as the Rating Agencies — seems, shall we say … a bit unfiduciary-like.  Instead, we need fiduciaries who will raise their hands and say, “I did my homework and I take responsibility for my decisions.”

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Banks fight to maintain $22.6 Billion in Derivatives Trading Revenues

The New York Times reports today that bank lobbyists are fighting desperately to save the trading revenues from their derivatives desks.  http://nyti.ms/aaGgen.   Considering 5 banks (Bank of America, Morgan Stanley, JP Morgan, Goldman Sachs, Citigroup) dominate the derivatives business, that’s $4.5 billion per bank.  I’d also fight like hell to save those revenues.

According to the Article, “the financial industry says that derivatives are a valuable product used by more than 95 percent of Fortune 1000 companies to hedge against risks, including price changes.”  However, the issue is not whether Fortune 1000 companies view derivatives as a valuable risk management tool, but whether banks which benefit from federal safeguards should provide these products.

Yes, derivatives are a core banking product.  And yes, they provide significant profits to banks.  The question is:  Should this continue?

As I wrote in a prior post, Goldman’s Clients — Caveat Emptor, the largest banks rely upon a significant conflict of interest within their basic business model.  No where is this more evident than with trading derivatives.  And as the above numbers reflect, huge bucks depend on this.

First, we must be mindful of the fact that derivatives come in all shapes and sizes, from the most simple to the most esoteric.  And, as always, when we speak in generalities we must be careful.  Nonetheless, it is safe to assume that derivatives are risk reducing tools.  These tools can be used to assist clients with managing their own risks, and they can be used among the banks themselves (and other financial institutions) to apportion risk.   I am more focused on the former than the later.

As my prior post outlined in greater detail, Goldman explains that its risk business (e.g. derivatives business) grows out of its investment banking relationships with clients.  In other words, once Goldman has secured a relationship as an advisor to a client, it then introduces the client to various derivatives strategies.

Upon entering into a derivatives contract with Goldman, the client has evolved from an advisory relationship to an adversarial one.  Counter-parties to a contract, by definition are adversaries.   If Goldman continues to cultivate the advisory relationship (which of course it will), while at the same time maintains and cultivates additional counter-party relationships with the same client, it has entered into significant conflicts with this client.

On the one hand, where the derivatives are plain vanilla interest rate swaps, there are fewer concerns.  That is, many Fortune 1000 companies have expertise within their own treasury departments to make informed decisions about entering into a derivatives contract.  However, quite frankly, the banks don’t make a lot of money of these transactions. Instead, it is in the highly “bespoke” arrangements where the banks both earn the most money and undoubtedly where the clients rely upon the bank’s advice the most.  This is precisely where the greatest conflicts lie.

Again, I don’t mean to pick on Goldman, this is rampant throughout the industry. Not only is it rampant, but these very conflicts help to turn on the lights every day.  For instance, JP Morgan Chase reported $3.3 billion in earnings for Q1 2010 on revenues of $8.3 Billion.  Therefore its $4.5 billion share of derivatives revenue, constitutes about 12% of its revenues (assuming Q1 revenue numbers are annualized).   We are not talking about insignificant numbers, here.  This is worth fighting for.

The other point is that in light of Goldman’s recent challenges concerning the ABACUS deal, many people think of complicated synthetic mortgage backed instruments when the topic of derivatives is raised.  However, the term derivatives encompasses many types of instruments which are sprinkled throughout corporate America.  They are not some isolated, esoteric, rarely used instrument.  They have become a bedrock of the financial industry.   That is why the battle is so heated.

Whether the banking lobbyists are successful in retaining the derivatives trading desks within the banks, or whether the desks get pushed out into affiliated entities, in my mind, the most insidious aspects of derivatives trading will continue — the fact that the bank serves both as advisor and counter-party.

Clients, commentators, policy makers, advisors and bankers themselves need to be aware of these conflicts.   As Justice Brandeis once said, “sunlight is the best disinfectant”.

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Let me see if I get this.

Lehman takes the position that the repo transactions it entered into in order to reduce the size of its balance sheet, constituted a sale transaction rather than a loan.  (See, Floyd Norris, NY Times, April 2, 2010, Demystify the Lehman Shell Game). The argument is that since the value of the securities exchanged by Lehman were greater than the amount of cash it received in the transaction, it would never purchase these securities for the same price.  In other words, it would never “overpay” for these assets, therefore, the transaction had to be a sale.

But wait a second, forget for a moment about the repurchase part of the transaction, doesn’t that mean that Lehman “sold” the securities for less than adequate consideration?  If I’m understanding this correctly, the logic is that it is OK to sell an asset for less than its value, but not OK to overpay for an asset.

This feels like Alice in Wonderland.

If I were a Lehman shareholder or a board member, I’d be very happy that my smart, hard-charging Wall Street financiers were not willing to overpay for assets. But, I’d be distressed that these same investment professionals were willing to sell corporate assets for less than fair value.  Great business franchises are not built upon selling assets for less than fair value.

The convoluted logic put forth by Lehman is likely supported by well articulated legal and accounting documentation.  The problem is that we have a generation of talented, lawyers, accountants and investment professionals who are adroit at mastering complicated concepts and principles for the purposes of erecting extraordinarily complicated and sophisticated legal structures.  All too often, however, these professionals get lost in the brilliance of their creativity and problem solving capability.

This is the proverbial forest and trees issue.  Everyone gets so caught up in the composition and structure of the trees, that they lose sight of the forrest.

How could it ever be acceptable to assume less than adequate consideration upon the sale of an asset and yet refuse to pay more than fair value upon buying the exact same asset.  Lehman is asking us to accept that 1+1=3.

As fiduciaries, it is our responsibility not to loose sight of the forest.  We need to be able to both assess complicated products and structures, but we also to be able to step back and ask a simple question: Does this make sense?  Or, more specifically, using the language of fiduciaries:  Is this prudent?

Ostensible a simple question:  Is this prudent?   However, when certain practices and assumptions become common place throughout an industry and culture, it can be a very difficult question to ask.  However the importance of asking the question, is directly related to the difficulty in raising it.

Our entire retirement industry, and even the global financial markets, require fiduciaries to raise their hands and say, “No, 1+1, does not equal 3.”

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“Financial Innovation Boosts Economic Growth,” an Oxford-style debate — featuring Jeremy Grantham, a doyenne of investment management, and author Richard Bookstaber, author of A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation, opposing the proposition, and Myron Scholes, Noble Prize winner, and Robert Reynolds, CEO of Putnam Investments, in favor of the proposition — is summarized in an Appendix to Grantham’s January 2010 Quarterly Newsletter entitled, “What a Decade!”

In offering stinging criticism about the investment management industry, from which he admits he has profited handsomely, Grantham provides:

Clients can’t easily distinguish talent from luck or risk taking.  It’s an unfair contest [between clients and the investment management industry], nothing like the fair fight assumed by standard Economists.  As we add new products, options, futures, CDO’s, hedge funds, and private equity, aggregate fees per dollar rise.  As the layers of fees and layers of agents increase, so too products become more complicated and opaque, causing clients to need us more.

The ultimate industry insider acknowledges that the game is stacked against the clients in favor of the service providers.  Ironically, however, he includes that the high fees, complexity and opacity, create greater reliance upon the industry itself.

Au Contraire!!  The trifecta of high fees, complexity and opacity cries out for the role of professional fiduciaries to cut through the jargon, smokescreens and hype surrounding the investment of plan assets.

To focus momentarily just on fees, as fiduciaries, with respect to administrative expenses, we clearly have an obligation to “defray reasonable expenses.”  The explosion of fee litigation clearly bears this out.  However, with respect to investment management fees the directive is not as explicit, but nonetheless the obligation to monitor fees is critical.  Certainly there is an obligation to make sure that fees are reasonable, but the exclusive benefit language in ERISA also suggests that where possible, fiduciaries should work to reduce fees wherever possible.  Simply put, any reduction in fees is an increase in the assets available for plan participants and beneficiaries.

The current shock to the financial system, as well as to client portfolios across the board, provides a unique opportunity for fiduciaries to review all of their investment relationships not only with respect to investment performance, but also with respect to fees.  Fiduciaries must ask themselves a hard question; are the fees being charged by private equity, real estate, venture and hedge funds justified by the investment returns being generated and the risks assumed?

The current financial environment levels the playing field between the investment management industry on the one hand, and plan fiduciaries on the other.  Plan fiduciaries must jump at this opportunity to exercise responsibility to strike deals in the best interest of their plans. Negotiate, negotiate, negotiate!

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I did a double-take.   I had not yet settled down with the paper, but merely glanced at the headline.  Thinking to myself, “no this can’t be true”.  I looked again, “Public Pension Funds Are Adding Risk to Raise Return”.  Ditching my usual morning ritual, I sat down immediately in disbelief and read the lead article of the New York Times on March 8, 2010.  The Article outlines that many state and other governmental pension funds are increasing their exposure to riskier asset classes with the expectation of earning higher investment returns and contrasts this approach with many corporate plans which are taking the opposite approach; that is, decreasing risk in their portfolios.

A former chairman of a state pension review board commented, “In effect, they are going to Las Vegas…..Double up to catch up.”  In other words, if the economy and financial markets aren’t experiencing enough challenges, we now have to deal with high-roller state pension officials gambling with pension assets.

While academics, policy-makers and pundits alike continue to offer explanations into the causes and effects of the financial meltdown of 2007 & 2008, one overriding take-away from this experience is the recognition that financial risk is real.  Yes, riskier assets can deliver higher returns, but they can also deliver bigger loses.  I am not an investment professional, but merely a fiduciary lawyer, but even I know that there are two sides to the risk equation.

As a fiduciary matter, one can only wonder about the processes in place which gave rise to these decisions.  Merely from reading the Article, however, one senses that there were no processes.  Instead, confronted with the reality of investment returns not meeting projections and the potential to have to make increased contributions to the plans, it was simply easier to increase the risk profile of the portfolio.  The fiduciary question is whether it is prudent to do so?

Possibly reasonable minds could come to opposite conclusions on the prudence of this strategy. But the real question is, on whose behalf are the fiduciaries making their decisions.  Or, put another way, to whom do the investment fiduciaries owe a duty of loyalty?  It appears that these decisions were made probably with the States and the taxpayer foremost in the fiduciaries minds; that is, if the over all goal is to decrease the contributions by the state, then dial-up the risk attributes of the portfolio.  But, who is looking out for the best interests of the plan participants and retirees?  I always thought that was the fiduciary’s obligation.

Here’s the nub of the issue:  in times of limited resources it can be easy to lose sight of whose interests a fiduciary represents.   Whether it is a state or a corporation which is funding pension obligations, it is always in the funder’s interest to increase the risk profile of the portfolio.   But is it in the interest of the participants?  There is a healthy tension in this equation.

Unfortunately, many times individuals who are plan fiduciaries are nonetheless beholden to the funder of the plan — whether this is a state employee or an employee of the plan sponsor.  In these contexts, its easy to see how risks get shift onto the plans.  Absent robust policies and transparent decision-making, serious conflicts of interest can arise.  Fiduciaries must be sensitive to these conflicts, and avoid them at all costs.

Next week, “Ruth Madoff launches New Investment Fund”. Stay tuned.

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The Prudent Experts

Published on 22 March 2010 by Mitchell Shames in Thought Leadership

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Welcome to the first post by the Prudent Experts, Mitchell Shames and Sean Flannery.

Our overriding mission at Harrison Fiduciary Group (HFG) is to provide professionalized investment fiduciary services on behalf of retirement plans.  With our combined 50 years of experience in investment and fiduciary matters, we have found all too often that while the term “fiduciary” can be tossed around a great deal, there are few individuals and firms devoted exclusively to providing investment fiduciary experiences.

We are committed to the principle that the role of a fiduciary is professional discipline in its own right.  Serving as a fiduciary is not simply ancillary to providing another service such as providing investment or consulting advice.

This blog will be devoted to identifying current issues confronting investment fiduciaries as well as directing readers to other professionals and organizations which are advancing fiduciary issues.   With Mitch’s background as a fiduciary lawyer, and Sean’s as an investment professional, each of our posts will be focused in our particular areas of expertise.  (For greater details on our backgrounds, please see the About Us tab on our website.)

HFG is proposing a new business model with respect to the management and oversight of retirement plans.  The role of serving as an investment fiduciary has enormous benefits both to plans sponsors as well as to plan participants.  We are firmly convinced that sponsors and participants will derive quantifiable value from our services.

Finally, we look forward to your thoughts, comments and questions pertaining to the issues and concepts which we present.  Please, challenge our assumptions, processes and conclusions.  We welcome the debate.

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