State Securities Regulators and Law Enforcement Intensify Scrutiny of Pensions
(This article is adapted from a speech entitled “Pension Fraud: The Perfect Crime (Huge Gains, No One Complains)” presented at the Florida Department of Financial Regulation/North American State Securities Administrators Annual Broker-Dealer Training Conference in June 2005. Portions of the speech related to specific recommendations to state securities regulators and law enforcement have been omitted.)
Wrongdoing involving investment consultants, money managers, securities firms and others providing services to pensions has been longstanding and pervasive and costs the nation’s pension plans billions annually.
Due to complex political, regulatory, investment and legal issues, pension wrongdoing has not received adequate attention from federal and state regulators or law enforcement. It is encouraging to learn that state securities regulators are interested in increasing scrutiny of pensions at this time and thank you for the invitation to speak before this group today. We recently received similar indications of interest from law enforcement. Hopefully, state regulators and law enforcement will make protecting pensions a top priority going forward.
Why has pension wrongdoing been neglected for so long?
Corporate plans: The Department of Labor, the agency charged with regulating corporate pensions, generally lacks knowledge of the money management and securities industries, has offered little meaningful guidance to corporate sponsors on these issues and has been even less effective in investigating wrongdoing and enforcing the laws. (See Global Pensions article below.) On the other hand, the Securities and Exchange Commission is highly knowledgeable about money management and securities but is subject to political pressures and has seldom ventured into pension matters. State securities regulators, I believe, have to some extent presumed that corporate pensions were adequately regulated on the federal level. I believe law enforcement may also have operated under the same presumption. Finally, of course, these cases often involve complex financial dealings that are difficult for even seasoned pension professionals to fully comprehend.
Public Pensions: Investigations of public pensions, neither governed by ERISA nor regulated by the DOL can raise additional sensitive political issues.
The political dimension of these cases may explain federal and state regulator reluctance in investigating public pension matters. Law enforcement investigations of these matters have, on occasion, resulted in public embarrassment.
What are the political dimensions of these cases? In a case filed in Lucerne County, Pennsylvania, it has been alleged that there may have been a pay-to-play scheme involving vendors to the pension making political contributions to elected pension board members in return for pension contracts. Alternatively, vendors may hire politically connected intermediaries, as opposed to paying elected board members themselves, to secure public pension contracts. That is, in the former case elected officials serving on public fund boards may accept bribes and in the latter, public pension investment decision-making may be tainted by political influence peddling.
Another example, which is common here in Florida, is public pension board members who may have personal accounts with the pension consultant’s brokerage firm or other money manager vendors to the fund. Investment opportunities, such as “hot issues,” that rightfully belong to the pension may instead be allocated to influential public pension board members for their personal profit. (Of course, this conduct may also occur at corporate pensions.)
Public pension scandals emerging in San Diego, Illinois, Ohio and Pennsylvania all involve serious political issues. Public pensions are a political minefield and before aggressively pursuing these cases it is understandable that regulators and law enforcement might choose to proceed with the utmost of caution, or not at all.
“Pre-Spitzer” versus “Post-Spitzer” thinking
However, we are in the midst of a period of radical change in thinking about the securities, money management and now finally, pension industries.
As a result of Eliot Spitzer’s initiatives, the nation recently was made aware that the nation’s largest securities firms have been scamming investors with tainted investment research. Also, Spitzer has drawn attention to the fact that the mutual fund industry has been skimming from investors’ accounts for decades.
While I have investigated mutual fund illegalities since the 1980s, I can assure you from personal experience that “pre-Spitzer” you couldn’t convince state or federal regulators or law enforcement that mutual fund managers could do wrong. Thankfully today there is growing awareness that professional, registered money managers and securities firms often engage in wrongdoing. The untold story is just how much money manager and securities industry scamming has undermined the retirement security of the nation’s investors. As I testified to the Banking Committee of the U.S. Senate, trillions have been skimmed from the accounts of the nation’s workers into the accounts of investment executives over the past 25 years.
Many of the same parties involved in retail wrongdoing have also been scamming pensions.
For example, the major wirehouses all have brokers who call themselves pension experts and prey upon unsophisticated pensions, including corporate and public pensions with hundreds of millions and even billions in assets. Here in Florida we have a broker-consultant pension-scamming epidemic. Over 100 Florida public pensions are currently being harmed by corrupt broker-consultants; the conflicted advice these funds are receiving from these pension scammers is costing Florida taxpayers hundreds of millions annually.
Pension scams are far more complex than retail scams.
In the retail context scamming often involves only a single party’s wrongdoing. For example, a broker may churn a customer’s account or recommend an unsuitable investment. Spitzer’s investigations gave the public insight into collusion involving brokers, money managers, research analysts, investment bankers and others. For example, the public learned that mutual fund managers often have hidden financial arrangements with brokerages to recommend investing in managers’ funds. In other words, money managers and brokers may collude to the detriment of retail investors. The investor is not sold the fund that is best for him; rather the brokerage recommends or selects the fund that provides the firm the highest compensation.
A key difference between retail and pension scamming can be the number of parties involved in wrongdoing, as well as the degree of collusion between them.
There are many different hands involved in managing pensions and often more than one party is involved in the unscrupulous conduct. In some cases, participation of multiple parties is required to facilitate the wrongdoing. Collusion between investment consultants, money managers, brokers, custodian banks, actuaries and even pension lawyers is commonplace. I encourage you to read my speech, The Art of Theft, which was written for the Teamsters annual pension trustee training conference earlier this year, for more information regarding the ways in which various parties can steal from pensions. (See Benchmark’s Library of Articles)
Like Enron and Worldcom, pension scams often are not perpetrated by one or two “bad apples.” It may take a team of hired “experts” to commit the wrongdoing, opine that there was no wrongdoing and/or otherwise conceal it.
As we stated in The Art of Theft speech, we are not aware of any pension that has adequate procedures in place to prevent and detect fraud related to all the various parties that have a hand in managing the assets.
Corruption of “gatekeepers.”
Now I would like to direct my comments to a critical concern in pension cases and that is corruption of “gatekeepers.”
Recognizing their lack of investment expertise, most pension boards (over 70%) use investment consultants (who claim to have pension expertise) to advise them on broad issues such as asset allocation, manager selection and performance reporting. These unregulated or poorly regulated investment consultants exert tremendous influence over pension returns. They serve as gatekeepers to funds and purport to offer objective advice. Unfortunately they often have undisclosed financial arrangements with the very money managers they vet and recommend. Often the managers that consultants recommend are those that compensate the consultants for their recommendations.
Our investigations show a corrupt consultant gatekeeper can cost fund 10-15% over time. Given the trillions in pensions, that’s a lot of money.
We have been investigating pension consultant wrongdoing since 1996. Self-dealing and conflicts of interest are at the core of these cases—losses in the cases we have pursued on behalf of smaller funds have ranged from $30 to over $100 million.
But there are hundreds of these cases out there, some involving the largest pensions in the world. We’ve been contacted about investigations from Guam to Bermuda. The fact that few cases alleging pension consultants abuses have been brought is best explained by political considerations. It is in no one’s interest (except for the participants in these funds—and they have little information about, or control over, the fund’s investment operations) that wrongdoing be exposed. Board members fear culpability and parties to the daisy chain of corruption obviously will vigorously oppose the truth coming out. Consultants and money managers have symbiotic relationships—managers praise the consultants who recommend them and vice versa, before the pension client.
The perfect crime
Thus, pension wrongdoing is often the perfect crime: huge gains with no victim that complains!
Imagine stealing vast sums from a financial institution that was too embarrassed to report the crime. That’s exactly what’s been happening to our nation’s pensions. In the past pensions may not have known they were being ripped off but recently, as more information regarding pension wrongdoing has come to light, many funds have determined that remaining silent or actively covering up wrongdoing is the best course.
Swift shift of focus onto pensions
But things are changing quickly. Look at how much has happened in the pension arena in less than 2 years.
In late 2003, both the SEC and DOL asked my firm for assistance in investigating pension matters.
In February 2004, the Chairman, Retirement Committee Louisiana House of Representatives asked us for guidance in drafting a law to prevent pension wrongdoing.
In August 2004, Louisiana became the first state to pass a pension consultant/money manager conflicts disclosure law. This law was amended in 2005 to include financial penalties for collusion involving money managers and consultants. Now the question in Louisiana is whether compliance with the law will be enforced and disclosures verified.
On May 16, 2005, the findings of the SEC’s Investigation of Pension Consultants were released. In summary, the Commission found conflicts of interest were pervasive throughout this industry and disclosure of these conflicts was abysmal.
On June 1, 2005, SEC/DOL issued a Guidance Release that provided pension trustees with a list of questions to ask of their investment consultants.
One of the key conclusions stated in the SEC/DOL findings was that pension consultants are, whether they like it or not, fiduciaries to the pensions they advise. This high duty of care is especially problematic for broker-consultants employed by the major wirehouses. While these brokers (and their employers) want to profit from posing as pension experts and serving as gatekeepers to pensions, their firms’ compliance departments generally are aware that such schemes perpetrated upon pensions can, under a fiduciary duty standard, result in a liability that can vastly exceed the amounts devious broker-consultants can skim from funds.
The June 1, 2005 joint release by the SEC and the DOL regarding pension consultant conflicts of interest may signal the beginning of an era of cooperation between SEC and the DOL. A June 9, 2005 Government Accounting Office release pointed out the need for such a DOL/SEC joint enforcement initiative to combat the nation’s growing pension problems. Hopefully these two agencies will continue to work together to provide guidance and enforcement in pension matters.
In a June 20, 2005 letter from the Aircraft Mechanics Fraternal Association (“AMFA”), a union representing 16,000 airline ground workers, to U.S. Secretary of Labor Elaine Chao and Bradley Belt, executive director of the Pension Benefit Guaranty Corporation (“PBGC”), AMFA requested that the PBGC conduct a forensic audit of the pension plans of bankrupt United, a subsidiary of UAL. While the PBGC has taken over the pension plans of many bankrupt corporations in the past, the April estimated $6.6 billion bailout of the United plans is the largest in history.
To date, as unbelievable as its seems, the Pension Benefit Guaranty Corporation, the government agency that insures private corporations, has never undertaken a forensic investigation aimed at ferreting out wrongdoing involving vendors to any corporate pension it has overtaken. This agency has never investigated possible wrongdoing before using government funds to bail out a corporate pension. That’s great news for firms that may have profited from advising a failed pension (and even contributed to its demise) but horrible news for taxpayers.
Should the PBGC require a forensic audit of any failed pension it overtakes, corporations will think twice before dumping their pension obligations onto taxpayers and vendors to pensions may clean up their acts. PBGC mandated forensic audits would also greatly assist regulators and law enforcement in identifying abusive industry practices, as well as specific instances of wrongdoing. (See Pensions & Investments June 27, 2005 editorial calling for forensic investigations of consultant conflicts; our supporting letter to the editor of P&I and a New York Times editorial dated August 3, 2005 endorsing forensic audits of failed pensions are included below.)
Conclusion
The result of wrongdoing by vendors to pensions is that, with respect to corporate pensions, employee retirement security is being undermined. Many corporations have already and more in the future will fail to honor their obligations to retirees. With respect to public pensions, taxpayers must contribute more and more to fund pensions that are being drained as a result of wrongdoing by parties hired to handle pension assets. That is, taxpayers are paying more to fund public pension obligations than necessary.
In conclusion, these are difficult cases to investigate due to complex political, regulatory, investment and legal dynamics. However, since the retirement security of participants in the nation’s pensions is at risk, I would submit that these cases should be your top priority.
It is becoming increasingly clear that our pensions are generally not providing retirement security for our citizens. “Retirement insecurity” is growing. We must do a better job of policing our pensions. Given the nation’s demographics, we simply cannot afford not to.
Your June 27, 2005 editorial calling for forensic investigations of pension consultant conflicts of interest was right on the money.
Pension consultant conflicts of interest, often involving collusion between money managers and consultants, result in substantial, quantifiable harm. As the only firm that has successfully investigated these conflicts and recovered assets from consultants on behalf of pensions, we know that tainted consultant advice can cost a fund 10-15% over time. While funds may choose to spend $250,000 or more for so-called forward-looking operational reviews, we believe that these reviews provide minimal value and fail to address the fundamental issue. That is, if conflicts cause harm (and we know they do), then an approach that neglects to fully investigate, quantify and recover damages fails to safeguard participant funds.
Fiduciary reviews that do not assign blame for past or on-going malfeasance are an easy sell to pensions unprepared to seriously examine the actions of their vendors, however, they are not in the best interests of participants because the fund is never made whole. We have observed that these superficial reviews seldom result in subsequent civil or criminal proceedings. They are sold as being a painless alternative for sponsors, as opposed to a precursor to a forensic investigation. Participants are the losers when boards choose a cover-up, as opposed to clean up.
Furthermore, only through in-depth investigations of past and ongoing wrongdoing can one competently advise pensions regarding their operations going forward. Absent a thorough forensic investigation, procedures to prevent reoccurrence of problems cannot be established. Put simply, a fund cannot adopt procedures to prevent problems of which it is not fully aware. Our investigations of past and ongoing wrongdoing inevitably provide funds with the guidance they need to correct operations going forward; on the other hand, operational reviews at best provide superficial advice going forward with no resolution of past matters.
We believe it is appropriate to judge firms that seek to advise pensions by the results they deliver. All-too-often superficial operational reviews leave serious wrongdoing untouched. When we examine funds that have undergone such reviews, we often see continuing malfeasance. The operational review has merely provided the board with a possible defense against lawsuits brought by participants or others. The board can claim to have looked into the matter and, on advice of expert counsel, taken (limited) action to address the matter. We are not in the business of providing such relief to those who turn away from wrongdoing under their noses. If you engage this firm to conduct a forensic audit, I promise you will get our best analysis of all potential vendor wrongdoing and nothing less.
Finally, we believe an approach that focuses upon industry best practices is fundamentally flawed. It only ensures compliance with industry standards of today and, as the mutual fund and similar scandals have shown, commonly accepted industry behavior often is corrupt. We focus upon conduct that is harmful to plans, regardless of whether it is commonplace in the industry or not. When we identify such harm, we seek to fashion a legal theory that will address it. We were the only firm talking about illegal mutual fund activity in the 1980s and 1990s and the first to draw attention to pension consultant conflicts of interest in the 1990s. Our efforts, including testifying before the U.S. Senate and the Louisiana House of Representatives, as well as advising the SEC and law enforcement, contributed substantially to bringing these abuses to the forefront. Currently we are advising unions representing participants in defined benefit pensions in requesting forensic audits of any plans taken over by the Pension Benefit Guaranty Corporation. We are committed to continuing to ferret out wrongdoing and bring it to the attention of our clients, regulators, legislators, law enforcement and ultimately investors.
Edward Siedle President Benchmark Financial Services, Inc.
August 3, 2005 NYTimes Editorial www.nytimes.com/2005/08/03/opinion/03wed1.html?
The Imperfect Storm
When trying to explain United Airlines' recent pension default, various analysts and assorted lawmakers often use the phrase "perfect storm," suggesting that an unstoppable combination of impersonal economic forces blindsided the carrier. It's a faulty metaphor. Some of United's problems may have been due to avoidable waste and human greed. Congress should take heed, for the sake of the 44 million American workers who are covered by pensions similar to United's.
A recent report by The Times's Mary Williams Walsh documents the likelihood that the United employees who collectively lost $3.4 billion in benefits in the default weren't simply the victims of a bad stock market and low interest rates. From 1999 through 2003, Labor Department records show, some 30 money managers, consultants and other professionals that handled United's pensions earned at least $125 million, paid out of plan assets. During that same period, a huge gap opened between the value of the pensions' assets and the amount owed to present and future retirees - from a surplus of about $2 billion to a deficit of nearly $7 billion. The record is silent on how individual money managers performed, making it impossible to determine who may have acted in a way that contributed to the pensions' failures.
Even though the federal government is the ultimate insurer for failed pensions, the world of pension investing is largely unregulated. In United's case, that system allowed money managers to make risky bets that included junk bonds, dot-com stocks and, apparently, an Albanian energy venture. A pension auditor told Ms. Walsh that many pension money managers favor actively traded equities, in part because they generate fees and commissions that can be shared with pension consultants who steer business their way. The auditor's observation is supported by a report released last May by the Securities and Exchange Commission. It found that more than half of the consultants who helped pension funds invest their money had outside business relationships that could taint their advice.
Congress and the Labor Department, which oversees the federal pension agency, should swiftly investigate the allegations of conflicts of interest and, if warranted, seek redress for bilked workers and retirees. So far, Congress hasn't broached the topic, and the Labor Department has been unresponsive to a written request from one of United's unions, sent in June, for an audit of United's pensions. There's no excuse for foot-dragging. The Pension Benefit Guaranty Corporation, the federal pension insurer, is straining under the weight of $63 billion in liabilities. If it should ever collapse, American taxpayers would be the payers of last resort.
Congress should also impose rules to limit aggressive pension investments and to charge higher pension-insurance premiums to companies that engage in risky investing. Lawmakers have long resisted such interventions, mainly on the grounds that they would distort the free market. That's backward. Government regulation is less distorting than investors' misbehavior, that dreaded "moral hazard" - which is unleashed when investors take undue risks because they are protected by insurance and, in the case of pensions, shielded from having to disclose their performance. And charging higher insurance premiums to high-risk clients is simply common sense.
Rather than a perfect storm, the United pension debacle may be the tip of an iceberg.
July 2005, Global Pensions By Renee Schultes, Editor
The former president of Portland based Capital Consultants, Barclay Grayson, which was involved in a massive case of pension fraud in the US in the late 1990s, has said that federal officials did little to stop the scheme despite spending almost a decade investigating it. At a US Senate Committee on Health, Education, Labor & Pensions hearing on 9 June on protecting America’s pension plans from fraud, Grayson issued a chilling testimony of the failure of regulatory oversight on the part of the Department of Labor to stop fraudulent activities. “Based on my observations the DoL has a limited understanding of private investments and a general lack of accounting skills,” testified Grayson. “This results in the DOL having long “open files” which makes them largely ineffective.”
According to Grayson’s testimony, Capital Consultants managed assets in excess of $1bn at its height, 75% of which were Taft-Hartley regulated funds. Capital invested almost half of its clients’ capital in privately originated loans and investments. One of Capital’s private borrowers was Wilshire Credit Corporation led by Andrew Wiederhorn. Over a period of nine years, Wilshire borrowed over $150m, which it used to acquire high risk, sub-performing loans, that represented nearly 15% of Capital’s total assets. In 1998, Wilshire defaulted on its loans.
Instead of disclosing Wilshire’s default and shutting down the borrower, Capital advised its clients that it was taking a “work-out”, which first involved maximizing what little was left of the Wilshire loans. Through a series of complex transactions, Capital falsely led its clients to believe that the firm’s loans were fully performing, secured and of limited risk. As to why Capital loaned so much money to Wilshire, Grayson said that his father, founder and ex-president of Capital received improper personal loans and Capital received a 3% management fee from clients on promptly invested assets. But as ERISA fiduciaries, why did union officials then invest so much money into Capital’s private investment programme? Grayson cited Capital’s funding of expensive dinners and hunting trips, hiring relatives of union members and the establishment of relationships with service providers associated with recommending which investment advisers are selected for management.
After two DOL investigations, in 1992 and 1997, which in the case of the 1992 probe led to Capital being ordered to pay the Oregon Laborers Trust $2m for an ERISA violation, in 2000 Securities and Exchange Commission forensic accountants descended on Capital to investigate and determined that the initial Wilshire loans were likely worthless, that the loans going forward were highly risky and that the disclosures to clients were insufficient. As a result Capital was placed into court-ordered receivership in September, 2000, and Grayson pleaded guilty to one count of mail fraud and served 14 months in detention. Lebowitz pointed out that well over 70% of the plans’ losses have been recovered through the receivorship. He also added that in April 2002, the DoL entered into consent orders with 10 plans in the District of Oregon, which provided for the resignation of a number of trustees and permanently enjoined others from serving as other ERISA fiduciaries or service providers.
Grayson said that there was a need for the DOL to employ highly trained accountants like the SEC to audit pension investments at least once every two years, as well as the unions themselves to ensure that no conflicts of interests exists.
Setting Standards For The Investment Management Industry
