Hidden Crimes; Too Many Secrets: How Money Managers Hide Illegalities From Investors
"Major Securities Fraud Bust Nets 120" and "Funds Rocked By Stock Scandal," were both headlines within the last month involving money managers and pension funds. It seems that every week in newspapers around the country, reports about improprieties and illegalities involving money managers and pension funds appear. While isolated incidents are reported, the investing public and the beneficiaries of the nation's pension funds seem unaware of just how widespread the abuses are. The financial press is partially at fault for seldom writing comprehensive stories tying current incidents to similar abuses in the past. But that's not where the bulk of the responsibility lies.
Securities regulators, law enforcement agencies, pension fund executives and the money management industry itself, together, are responsible for the lack of public awareness of the dangers related to the management of the nation's retirement savings. There has been a concerted effort to conceal the wrongdoing from investors by everyone who might be held accountable, including pension trustees and plan administrators, pension staffs and money managers. And the regulators have let it happen.
As the practices of the regulatory agencies have become lax and predictable, the ability of money managers, including mutual fund managers, to manipulate information regarding their operations and performance has grown.
Today the largest money managers have access to powerful law firms, public relations specialists, industry lobby groups (the Investment Company Institute, in particular) and such cozy relations with regulators that they can be assured, except in the most blatantly mismanaged cases, that they can conceal any unethical or illegal practices in which they engage.
The largest money managers can literally control the information the investing public receives.
Sound unbelievable? Let me give you a typical example.
A multi-billion dollar pension fund hires a well-known money manager to manage its assets. A trader employed by the manager discovers the senior portfolio manager handling the pension account has been involved in an illegal brokerage commission kick-back scheme. The trader reports the matter to his firm's director of compliance. The compliance director, a lawyer, patiently explains that as an employee of the manager there is little he can do other than discuss the matter with senior management-a small group which includes the guilty portfolio manager. He further explains that he is bound by the attorney-client privilege from disclosing information about his client to law enforcement. Finally, he reminds the trader that all employees of the manager have signed, as a condition of employment, a restrictive employment contract with heavy financial penalties for employees who say anything derogatory about the firm. He advises the trader to keep silent. The trader, afraid of losing his job and the money he has saved over the years, nevertheless takes the extraordinary step of anonymously reporting the matter to the pension fund. All's well that end's well? Hardly.
The pension fund threatens suit; however, the manager offers to reimburse the fund for "its losses," if the fund agrees to a confidentiality provision as part of a settlement agreement. Pension officials, seeking both to avoid public embarrassment related to hiring the rogue manager and a speedy way to recoup fund losses that are difficult to quantify, agree to the settlement offer and confidentiality provision. The fund is reimbursed for what must be termed "uncertain" losses, because absent a formal investigation it is generally impossible to definitively establish the extent of the harm. Finally, as is often true in these cases, the fund continues to leave its money with the manager so as to avoid questions related to a termination. There is no notification of law enforcement. And when the Securities and Exchange Commission arrives within five years or so for its regularly scheduled inspection of the manager, the trader will either have been fired or learned to keep his mouth shut and any documents related to the incident will be withheld from disclosure to the regulator under the attorney-client privilege. The lawyers have done their job, hopefully the fund hasn't been hurt too badly and the manager and pension executives have all saved face. Unfortunately, the full extent of the loss is never established and any losses related to other illegal practices of the manager are left undiscovered. In other cases, none of the stolen money is ever recovered and the manager is quietly fired. Only in the rarest of cases does the manager both have to reimburse the fund and disclose the wrongdoing.
Under any likely scenario, the beneficiaries of the pension fund never learn they have been robbed and other investors that may have been victimized by the manager are never warned. The manager is free to continue to tout its unblemished reputation.
The problem is, it is in no one's interest that the fraud be publicly addressed, except the beneficiaries, of course.
Welcome to the real world of money management today. It's a world where the laws have been effectively undermined through a concerted effort by the parties to the wrongdoings, where the reality behind "reputable" money managers and "sophisticated" institutional pension fund investors is completely divorced from public perception and where the information the public receives is easily manipulated. As the percentage of the nation's population approaching retirement grows, the numbers that will be turning their eyes toward scrutinizing their retirement accounts will also grow. For many retirement savers it will be a rude awakening when they realize that the fiduciaries they hired or elected did not diligently fulfill their duties over the years.
Today the federal securities laws offer a lessening degree of protection to investors in mutual funds and money management firms and are more misleading to investors than ever.
The intent behind the Investment Company Act of 1940, which regulates mutual funds, and the Investment Advisers Act of 1940, which regulates money managers, was to provide investors with the important information they needed in order to determine whether to invest with a given manager and to judge the ongoing performance of their managers. These statutes are premised upon the notion that full disclosure of information regarding managers, including adverse information, is necessary for investors to make sound decisions regarding their money. In some cases, the laws require that disclosure be made directly to the investor or potential investor. In other instances only disclosure to the securities regulator is required-the public never learns.
For example, mutual fund "codes of ethics," internal policies regarding trading for personal profit by fund managers, while required by statute to be available for SEC review, until recently were not required to be shown to investors. Codes of ethics, required by law for the protection of investors, not required to be shown to investors? It never made any sense. Yet before the SEC changed the law last year, for almost thirty years no mutual fund company would provide a copy of its code to investors when asked. Why would the SEC permit this concealment? Because the SEC struck a compromise with the mutual fund industry to limit attention to the very real dangers personal trading by managers poses to clients.
Today violations of the personal trading rules by portfolio managers, such as front-running, which cause substantial monetary harm to investors, are still not required to be shown to investors. Why wouldn't the SEC require public disclosure of such wrongdoing by money managers? Records of wrongdoing by brokers involving theft, drunken driving, sexual abuse of children, assault, are all publicly available, much to the chagrin of the brokerage community. Why should money managers be treated any differently? Nondisclosure provides no benefit to investors; rather, it is the mutual fund companies themselves who benefit and they have secretly lobbied the SEC to keep the law unchanged. As a result, under current law it is virtually impossible for mutual fund investors to ever learn when their portfolio managers have engaged in such abuses. That is not to say violations of the personal trading rules are rare.
In our opinion, all records and documents money managers and mutual funds are required to keep under the federal securities laws for review by the SEC, should be made available to the public. The SEC should get out of the business of determining what information investors get to see and when.
All-too-often the SEC cooperates with managers to delay damaging disclosures that would cause a "run on the bank." The result is that investors are lulled into a false sense of safety, reassured that any misdeed by their manager was superficial and ancient history, and disreputable managers are permitted to continue fleecing the public.
The first step in providing investors with a more complete picture of money managers is to make public all records required by the federal securities laws. But we can go far beyond closing these "loopholes" in the Investment Company and Advisers Acts that permit illegalities and improprieties to remain concealed.
Today the SEC and the federal securities laws actually stand in the way of investors seeking accurate and complete information about the money managers they hire.
Sound too harsh? Technological advances permit disclosure far beyond what the laws require and have for quite some time. It didn't take the internet to pave the way; the internet only made possible on an hourly or daily basis what previously was possible weekly or monthly. Greater disclosure, if compelled by public outcry, could transform the money management business and prove the undoing of many managers. As a result, the money management industry is now clinging to the federal securities laws to shield it from curious investors. So much for laws that were enacted "for the protection of investors." But weaknesses in the federal securities laws are not solely responsible for the lack of investor awareness of money management illegalities.
Restrictive employment agreements crafted by law firms to protect their money management clients from nasty disclosures, have further undermined the effectiveness of the federal regulatory scheme.
Managers have grown increasingly bold in the scope of activities covered by their employment agreements and the coercive penalty provisions imbedded in them. These employment agreements have gone well beyond their original purposes of preventing portfolio managers from competing against their former employers. (Even the existence of a non-compete should be disclosed to clients because such an agreement may affect a client's ability to retain a portfolio manager upon leaving his firm and may result in substantial unnecessary transaction costs should the client terminate the firm.) Over time the SEC has ignored developments in the use of restrictive employment agreements, despite some well-known legal cases, and has allowed money managers through use of such agreements to undermine the law. These agreements are no longer limited to portfolio managers, but often include all senior management, such as marketers, in-house lawyers and compliance officers. They often prohibit the dissemination of any disparaging information, including information regarding illegal or unethical activity of the manager. Agreements may also prohibit the commission of any act that could be construed by the manager as "harmful" to the manager. Through the establishment of severe financial penalties for poorly defined "offenses," employees can be terrorized into believing that any act of conscience can result in financial ruin, loss of reputation and permanent unemployment.
In our opinion, the SEC should establish standards for the use of restrictive employment agreements by money managers.
Restrictive employment agreements should be required to expressly state that no penalties can be applied to an employee who reports unethical or illegal activity of the manager. Investors should also have access to such agreements in order to judge the intentions of the money manager/employer and the likelihood that violations may go unreported as a result of employees entering into the agreements.
However, restrictive employment agreements are not the only devices money managers use to hide their mistakes from investors. Employment agreements only silence employees. Money managers also regularly enter into confidential settlement agreements with institutional clients who have been victims of illegal or unethical manager conduct.
A confidential settlement agreement might involve misrepresentation of the credentials or identity of the portfolio manager, or using an undisclosed affiliated broker for all portfolio trades, or operating a hedge fund to the detriment of clients. Facts or occurrences such as these are important to investors in determining whether to hire a manager and should be disclosed. Yet frequently such violations go unreported because managers persuade their pension fund clients that either little harm has been done or that they can easily reimburse the client for any loss and that the matter is "not serious."
Because they have access to information unavailable to ordinary investors, the staffing to review such information and detect abuses, as well as the financial wherewithal to pursue wrongdoing, pension funds frequently enter into confidential settlements with managers. Once the matter has become the subject of a confidentiality agreement, the money manager will usually withhold it from regulators and law enforcement pursuant to the attorney-client privilege. Pensions entering into these agreements often don't realize the harm they are doing. The violations they have detected may only be the tip of the iceberg. There may be far more serious violations and/or the number of investors harmed may be far greater than the pension imagines. The manager may misrepresent or minimize the extent of the violations, or even be unaware of how widespread within his organization the problems may be.
In our opinion, money managers should be broadly prohibited from concealing in settlement agreements, information which, if disclosed, would be "material" to prospective investors.
Any agreement relating to matters such as compliance violations, misrepresentation, fraud, or an investment loss suffered by a client should be disclosed to the public. The Commission should send a clear message that parties entering into agreements to treat confidential, matters that should be disclosed under the securities laws, are themselves "aiding and abetting" violations of the law.
The SEC has ignored the effects of confidential settlement and restrictive employment agreements upon the money management industry for too long. These private agreements enable the money management industry to maintain the illusion of respectability it enjoys. Reputable managers who have nothing to hide should not oppose disclosure of such agreements and managers who are unwilling to disclose, do not deserve the public's blind trust. However, deep-pocketed managers need not go it alone in their quest to maintain an "illusion of respectability."
Today savvy money managers are using public relations firms to disseminate misleading information to the public-information the managers themselves are prohibited under the federal securities laws from advertising.
Testimonial messages mysteriously appear in online "chat rooms" and supportive "letters to the editor" appear in newspapers nationally whenever certain managers are openly criticized. Is it mere coincidence? Do these managers really have loyal clients strategically dispersed around the country ready to rally in their defense? Many large managers have discovered that they can employ public relations firms to accomplish indirectly what the federal securities laws prohibit them from doing directly, e.g., to misrepresent their investment performance or how they manage money or even to defend them against allegations of unethical conduct or criminal wrongdoing. This disturbing practice has not caught the attention of securities regulators to date. We all know that corporate America employs public relations firms for these purposes; however, public relations firms, when representing money managers subject to the federal securities laws, may cross the line and fraudulently misrepresent the manager to the public. As far as the public relations firm is concerned, all's fair in marketing and war. The conduct of public relations firms in representing money managers and public companies generally needs to be examined, including the instructions they receive from their clients.
This article is just the beginning of an exploration of the devices money managers and pensions use today to conceal illegalities and improprieties from investors and beneficiaries. The statutes governing the money management industry were drafted sixty years ago and always had "loopholes." In addition, despite efforts by regulators to keep pace with developments in the industry, managers have over the years skillfully found ways to circumvent the disclosure provisions of the federal securities laws. When necessary, managers have lobbied the SEC against improved disclosure; the Commission has become accustomed to weighing the interests of managers, including managers' privacy concerns, against those of investors. Whenever a compromise regarding manager disclosure obligations has been struck, investors have been the losers.
At this point in time, the cumulative body of secret information about the money management profession is truly staggering. Our informal survey suggests that all large pension funds and money managers have entered into agreements to conceal information from beneficiaries and investors. The practice of concealment has become routine and uncontroversial. Even the SEC no longer seriously questions its practice of withholding information about manager wrongdoing from investors. When you consider how vast this body of secrets is, you arrive at the conclusion that if all the secrets were told, a very different and far scarier portrait of the money management industry would emerge.
Setting Standards For The Investment Management Industry
