Emerging New Fiduciary Trends and Developments: Systems of Mass Deception vs. Systems of Enhanced Diligence
The following material was included in a speech by Edward Siedle, Esq. at a conference sponsored by Sage Advisory Services in Austin, Texas on September 25, 2003.
Benchmark Financial Services conducts investigations on behalf of pensions and others who feel they have been treated poorly by money managers, pensions consultants or brokers. The work is somewhat legal in nature but frequently focuses upon little-known business practices which may be commonplace in the securities or money management industries but are, on occasion, especially harmful. You could say we get involved in cases of exceptional greed versus normal back-scratching.
Here’s some examples of “typical” investigations we conduct. I say “typical” because I want to emphasize that these are not “one-off” situations.
Many people in the industry, including regulators and self-regulators, take issue with my stating that fraud and other forms of malfeasance are commonplace in the institutional marketplace. For reasons I have never fully understood, most industry insiders would like to believe that the vast majority of people in this business, who daily handle millions of other people’s money, do not succumb to temptation and pocket some of it.
“This rarified world of institutional money management, like an exclusive country club, admits no one with impure motives,” many would seem to say. The reality is that this industry as a whole is as fallible as any human. And, like it or not, dishonesty is not unheard of. Rather than think in terms of a few “bad apples,” I believe it’s more realistic to understand that everyone has his “price.” Most people will go along with “harmless” transgressions for a relatively low price but perpetrating or aiding serious wrongdoing may require big money.
Examples:
1. A pension consultant who, in addition to being paid several hundred thousand dollars for providing “objective” advice regarding asset allocation and money manager selection, received millions in brokerage commissions from the managers he selected for the fund.
2. A money manager receiving more than double the average investment advisory fee in return for brokerage and other kick-backs paid to a consultant.
3. A hedge fund hired by a pension representing it had hundreds of millions in assets under management, an extensive track record and numerous institutional clients who, in reality, had none of the above.
4. Mutual fund portfolio managers personally profiting by front-running client orders and thereby diluting fund performance.
We have undertaken investigations involving every asset class, including venture capital, hedge funds, mutual funds, annuities, traditional equity and bond separate account managers and real estate and involving every type of participant in the pension fund “food chain,” including pension consultants, money managers, brokers and fund employees.
There’s a lot of stuff going on in this business that, if and when exposed, most people can agree is wrong.
Then there are a lot of “business practices” which are so commonplace that many insiders need to be reminded cause real harm to investors:
Examples:
Investment research “tainted” by banking conflicts of interest; Allocation of brokerage by mutual funds to compensate brokers selling fund shares; Exorbitant mutual fund investment advisory fees; Do-Nothing Boards of Directors of mutual funds that summarily approve excessive investment advisory fees.
I’m frequently asked what I think of Eliot Spitzer. What Spitzer has done (which is perhaps only remarkable in that he was the first to do it) is:
1. Found insiders willing to talk about industry practices. 2. Found evidence proving such practices-- evidence that was readily available to any regulator, such as e-mails. Can you believe the SEC and NASD never thought to look at e-mails? 3. Gone public with revelations about the industry that have shocked the public but are hardly surprising to industry insiders.
All of which points out that the SEC, NASD, FBI and most state attorneys general have:
1. Gotten too accustomed to accepting industry assurances. 2. Lack a serious commitment to uncovering wrongdoing. 3. Cannot be relied upon to restore investor confidence.
Anyway, enough about wrongdoing. What I’m here to talk about is not bad news or to provide an indictment of the industry I’ve been a part of for over 20 years now. I’m here to talk about emerging new fiduciary trends and developments. What are enquiring fiduciaries learning today that may develop into tomorrow’s standards? This is the creative and intellectually challenging, cutting-edge stuff.
I. The internet has transformed the meaning of due diligence.
At the outset I have to confess I am not very technologically savvy. So when I tell you that the internet and other technological innovations are opening my eyes everyday to new due diligence possibilities, you can only imagine what a gifted technologist could achieve. I try to keep coming up with the right questions and then hire programmers to find the answers from available data. My focus is on assembling and manipulating data that has generally been kept from investors as a result of powerful business interests.
To date, the federal government and industry groups have controlled the information that is disclosed to investors. That is changing. In the future the SEC, NASD, state regulators, ICI, AIMR, FBI, and others will not have the final word on disclosure to investors.
Systems of Mass Deception (SMD)
I believe that several “Systems of Mass Deception” present a tremendous threat to financial security of Americans.
a. The NASD Public Disclosure Program was developed by an association of brokerages that has historically been allowed to self-regulate the brokerage industry—after much prodding by Congress. This program purports to disclose to investors all customer complaints, arbitrations etc, involving brokerage firms and individual brokers. A Directory we published in 2002, (under threat of litigation from the NASD) which involved downloading all the criminal and disciplinary histories of all the nation’s brokerages, revealed that less than 15% of the criminal and disciplinary histories were properly disclosed. In other words, the NASD’s Public Disclosure Program hugely understates the brokerage industry’s history of misdeeds. Investors are being misled. The SEC has allowed the NASD to maintain this program, control access to the disciplinary data and represent to investors that the information disclosed is complete. IT IS NOT and the NASD and the SEC know it isn’t. In fact, they bought copies of our Directory and never disputed its findings. The SEC should issue a “cease and desist” order to the NASD under the theory that the NASD’s PDP is materially misleading. That’s not likely to happen. When we sued the NASD last year, a federal court actually ruled that the NASD could limit public access to the disciplinary histories of the nation’s brokerages. Which goes to show how out of touch the judiciary is with what’s happening to the nation’s investors and the reach of technology. After publication of the Directory, the NASD added multiple layers of contractual limitations to their PDP website to prevent others from downloading information. That’s how embarrassing full disclosure is to them. As we wrote last year, we doubt whether it is in the public’s best interest to allow the brokerage industry to self-regulate, self-insure and self-adjudicate. Is the brokerage industry so uniquely trustworthy that it should be allowed to self-police when banks, insurance companies and others are not so allowed? I don’t think so. This year, the NYSE has been taking a lot of heat for certain of its dealings. Again, I question whether NYSE should be permitted to serve as a self-regulator. The business of policing the nation’s brokerages is of vital national concern and is far too important to leave to the industry. The conflict of interest inherent in self-regulation is insurmountable.
b. Investment Adviser Public Disclosure (IAPD) Website: While the SEC’s IAPD website indicates this public disclosure system provides investors with money managers’ Forms ADV, only Part I of Form ADV, not the entire Form is disclosed. Part II, the only part of Form ADV managers are required to provide to clients and which includes important information such as fees, is not made available to the public on IAPD. According to SEC staff, Part II is not disclosed on IAPD because of NASD delays in getting the information online. (The SEC entrusted this important project to the NASD.) But it’s not only online investors who lack access to Part IIs. Since managers no longer have to file Part II with the SEC, even the SEC no longer has access to manager Part IIs. The SEC’s IAPD is misleading to investors by not providing complete information that would enable investors to make informed investment decisions, including comparing prices among managers.
c. No public access to deficiency letters and other SEC records regarding managers: As I recently discussed in an article in the New York Times, the SEC inspects money managers generally every three to five years. 95% of inspections end in “deficiency” letters sent by the Commission to the firm, indicating areas in which the firm has failed to comply with applicable regulations. Some of the non-compliance described in the deficiency letter is minor and/or technical, other matters are serious. Only 5% of deficiency letters result in a referral to the SEC’s Division of Enforcement. If the matter is referred to enforcement, it may be disclosed to the public in a litigation release. Deficiency letters, which represent the best due diligence regarding whether managers are complying with the law, are not made public. The Freedom of Information Act doesn’t apply to these files the federal courts have ruled after hearing testimony against public disclosure by the SEC. So the SEC determines which violations the public should know about and which should be kept secret. That’s great if your goal is to maintain public confidence in the money management industry— even if that confidence not based upon a true assessment of the risks involved. If your goal is investor education, then disclosure of all the facts relevant to making an investment decision should be the rule.
Another example of important records available to the SEC but not to investors is mutual fund personal trading violations. The SEC says all mutual funds must keep records of any personal trading violations by their portfolio managers. However, investors are never allowed these files. The SEC protects investors by not allowing them to see unethical or illegal acts committed by the fiduciaries they hire to manage their money!
The above SMD serve to downplay the risks related to investing. The picture investors have of the brokerage and investment management industries is very different from the reality. One has to wonder how many investors would not do business with managers and brokers, or would risk less of their assets, if full disclosure were the rule. What is the impact upon the nation’s wealth of these SMD? If all the risks were known, would investors be more cautious? How many families would be saved from financial ruin?
Today investors get to see only as much information as regulators and self-regulators determine is sufficient, after deliberations behind closed doors in which the industry participates through its powerful lobby groups and the public has no voice.
Ironically today the greatest impediments to full disclosure are the SEC and NASD. All they need to do is just get out of the way of the march of information technology. As perverse as if seems, today mutual fund companies and brokerages are arguing that as long as they meet SEC and NASD limited disclosure mandates, that’s enough—even though far greater is easily achievable.
As a result of systems developed following 9/11 and passage of the USA Patriot Act and the work we’ve done for certain especially curious pensions, institutional investors have access to enhanced due diligence products and services which go far beyond the SMD described earlier. We are entering an age of Systems of Enhanced Disclosure (SED).
In time I believe plan sponsors and money managers who do not take advantage of the enhanced due diligence services emerging will have a difficult time defending themselves when things go wrong. Again, technology is driving this enhanced due diligence capability and control of data is being wrestled from those who have benefited from secrecy. We are entering a period where there will be two classes of investors: those who have access to enhanced due diligence intelligence and those who rely upon traditional avenues of information.
II. The Role of Consultants to Pensions
The role of pension consultants, their proper duties and lack of regulation is of growing concern nationwide.
Pension consultants are unregulated, unlicensed and often unqualified. The subject of conflicts of interest among consultants is of growing concern.
Many consultants, investment and actuarial, either refuse to accept fiduciary status or seek to limit their liability.
It’s really perverse when you think about it that actuaries would seek to limit their liability to pensions that hire them to compute liabilities. Maybe pensions should ask their participants to agree to limitations of liability. Of course that would mean the end of ERISA….
Actuaries are being sued more frequently and when they are sued it’s usually for a lot of money. I think it’s crazy for any pension to agree to a limitation of liability but unfortunately pensions seem to be buying industry arguments that if they don’t go along with such limitations, the whole actuarial industry will dissolve. It’s very similar to the dubious arguments medical doctors have advanced (and the public has bought) regarding the need for medical malpractice limitations.
On the investment consulting side, in Hawaii, Nashville and Chicago public pension funds are waking up to the reality that the price of consulting services is artificially and deceptively low and that surreptitious sources of compensation are significant—dwarfing stated fees. In Chicago the consultant to one pension fund refused to disclose how much brokerage and other compensation it derived from managers it recommended the fund hire. In Hawaii, the State Auditor determined that only managers who “paid to play” were hired by the state employee pension fund. Ironically, in both of these cases the consultant was not terminated. In Nashville, on the other hand, the consultant was terminated and paid in excess of $10 million in damages.
Things have to change because legitimate consultants are forced to compete on the basis of expressly stated fees with corrupt consultants who, due to kick-backs, can offer to provide consulting services “for free.”
Bad advice for free is never a good deal and the harm resulting from consultants providing tainted advice to the nation’s pensions is staggering. I believe that every pension that utilizes a consultant subject to conflicts of interest is being significantly harmed in terms of asset allocation, manager selection and turnover, brokerage costs and portfolio turnover. My firm has quantified the harm in certain cases and it can easily amount to 10% of a fund’s portfolio. Since approximately 75% of the nation’s pensions rely upon conflicted consultants, it is not an overstatement to say that the investment consulting industry is the greatest hidden threat to the health of the nation’s pensions.
If there is any industry that should be terrified at the prospect of massive lawsuits, it’s the investment consulting industry and companies that own investment consulting groups—which includes many of the largest brokerages.
III. The Mystery of the Dearth of “Actual” Fee Data
Moving to another subject, we discovered in connection with our investigations of investment consultants recommending managers who “pay to play” and advising funds as to the fees these managers should be paid, that conflicts of interest in the consulting industry has given rise to a lack of knowledge on the part of pensions regarding “actual” investment advisory fees.
Investment consultants do not want pensions to know the fees managers are actually paid by pensions because such disclosure would inhibit consultants’ ability to reward managers who pay $50,000 or more “to play.” So the rule is to keep pensions in the dark about “actual” fees.
The leading investment consulting firms only provide clients (and only clients who ask) with “published” fee data or the “sticker prices” managers put on their services. As we all know- no one pays sticker price—except suckers. Institutional investors typically pay 10-15% less than “published” fees. Believe it or not, many pensions, endowments and foundations do not negotiate fees or even receive “multiple account” discounts from their managers.
We have recently released a report on the “actual” fees paid by 100 pensions and a 13-page narrative describing our findings. The report discusses conflicts of interest in the consulting industry and their impact upon fees; the distinctions between “published” and “actual” fees; the illusory protection afforded by “most favored nation’s” clauses; impact of manager cash solicitation agreements on fees; procedures for monitoring and negotiating fees, use of “soft dollars” by managers and manager portfolio turnover rates.
We observed that with respect to investment advisory fees, endowments and foundations pay 40% more than public funds and corporate funds pay 10-15% more.
There are huge disparities in the pricing of investment advisory services—some funds are paying 2-4 times for the same services—sometimes from the very same manager. There is no reason for these disparities and it’s time funds and individuals began rationally scrutinizing the fees they pay.
When the market is up 10% or more, perhaps fees and other costs are not so important. But today reducing investment advisory fees may be an immediate way for funds to improve returns.
IV. Fiduciary Duties of Money Managers Regarding Fees
Question: Do managers have a fiduciary duty to charge clients a “reasonable” fee or may managers charge whatever fee the client is willing to pay?
We all agree that managers are fiduciaries. The only question is when does a manager violate that fiduciary duty by charging too high a fee? Does the fee have to be outrageous or merely higher than customary? What about money managers who conspire with consultants or fund employees to get paid a higher, in return for brokerage or other kick-backs? What if the fee the consultant recommends (and the pension agrees to) is higher than even the manager’s “published” rates? Or two times the average?
I think you can see how easy it is to paint a very ugly picture in these cases when you reference “actual” fee averages and quantify surreptitious forms of compensation.
Managers should think long and hard about the pricing of their services. We are not convinced that managers who charge excessive fees and even disclose to clients that their fees are higher-than-necessary, are free of litigation risk. The bottom-line is that managers are fiduciaries and “caveat emptor” may not be an adequate defense.
The mutual fund industry arguably has the most to lose as fees come under scrutiny because there simply is no reason why retail investors should pay 5-10 times what institutions pay for the same services from the same managers. Inevitably fees will come down as investors become more sophisticated regarding the pricing of investment advisory services.
V. Commission Rates, Directed Brokerage and “Soft Dollars”
Finally, on the brokerage front, it appears that investigations into mutual fund marketing practices, such as directing commissions to brokers that sell fund shares, may have an impact upon institutional commission rates. We estimate that as much as 75% of mutual fund commissions are utilized for marketing; compensating brokers for marketing is the main reason rates have stayed so high.
It may well be that in the next couple years managers will have a very hard time justifying paying six-cents-a-share commissions. “Soft dollar” and “commission recapture” service providers may also suffer as investors scrutinize commissions and other costs more carefully.
It’s pretty clear to all but the most naïve that institutions do not have to pay six cents a share to trade. An investigation we recently completed found that commission rates dropped by 50%, resulting in millions in annual savings, once the investment consultant the fund had hired (and who set commissions rates for the fund) was fired. The savings were immediate and substantial. The brokerage industry will have to find other sources of income as commission rates rapidly slide downwards.
VI. Conclusion
In summary, the veil is being lifted regarding many industry practices. Regulation and self-regulation of the brokerage and money management industries is coming into question as more information is getting to investors than ever before. The failure of self-regulation is apparent and investors are calling for diligent, unconflicted regulators. Control of data is shifting from industry and government to investors. Systems of Mass Deception are being replaced by Systems of Enhanced Diligence.
We are rapidly evolving into a country with the largest, best-educated retiree investor population in the world. They are the first generation to have grown up with professional asset management. Since I doubt they will be passive in retirement, I believe we are in for exciting times ahead.
Our research publication, "Examining Active Investment Advisory Fees: 2003 "Actual " Fee Survey of 100 Pensions," is now available for purchase. The report provides guidance to plan sponsors for negotiating fees with managers and may be useful to managers in pricing their services. Please call Ted Siedle at (954) 360-0557 if you are interested.
