(December 1, 2001) The Shape of Things to Come |
Turbulence in the financial markets over the past year has exposed many longstanding weaknesses that escaped scrutiny during the long bull market. The financial reporting of many of the nation's leading companies has been called into question, as has the integrity of Wall Street financial analysts' reports. The large investment banks have been accused of scheming to manipulate the price of initial public offerings, as well as obtain commission "kick-backs" from favored clients. (Interestingly the commission"kick-backs" pension consultants solicit from money managers are similar to those received by underwriters in the lawsuits involving IPOs.) Enough time has elapsed since the stock market bubble burst for information to begin to surface as to the causes of the run-up and subsequent collapse. Many financial analysts, investment management and accounting professionals have some explaining to do. It's a great time to be a class action securities lawyer.
While President Bush urges Americans to spend and travel, its unclear where the money is suppose to come from. Are there vast hoards of cash American consumers have been stashing away that are available to fuel an economic recovery? Most investors have accepted that their savings have withered or disappeared and hopes of a quick recovery have faded. The number of personal bankruptcies has soared as those who are have incurred obligations in excess of their now diminished assets have been forced to make some difficult decisions. Due to either denial or eternal optimism, some have flocked to hedge funds that hold out the possibility of stellar returns. No longer exclusively marketed to the wealthy with high minimum investments, hedge funds can and do regularly outperform the market, we are told. Suddenly everyone wants to be a hedge fund manager and anyone can be. A classified advertisement in a recent Wall Street Journal read: "7 Figure Income Opportunity. MANAGE YOUR OWN HEDGE FUND. Leading Investment Research Firm seeks entrepreneurs. Investment required." We have to wonder how many of these managers are included in published data regarding hedge fund performance. Was it just last year that everyone wanted to be a venture capitalist? Here's a few jokes: What's the definition of a hedge fund manager? Answer: A day trader with a private offering memorandum. What's every hedge fund manager's worst nightmare? Answer: Clients demanding audited financials. A venture capitalist's greatest fear: independent valuation of portfolio companies.
Manager and pension shortcomings have become apparent. Many have lost faith in their professional money managers. When investors gained only 13% as the market climbed 15%, they were only mildly disappointed. When investment professionals fail to adequately protect investors from severe market downturns, investors feel betrayed. It is not enough that a manager made money when the market was shooting upward, investors, including the most aggressive, assume that professional management will provide them downside protection.
Disillusionment with pensions is high. Many of the nation's largest defined benefit pensions are heavily weighted in equities and alternative investments such as venture capital, reflecting highly aggressive asset allocation strategies. 70% in equities and 25% in alternatives is not unheard of. In our opinion, such strategies are a disaster waiting to happen. When I opined in a recent interview that hedge funds were inappropriate for pensions, the reporter asked, "What should the investment objective of a pension be?" At first I was taken aback. It had been a long time since I had consciously considered this simple question. Then the answer emerged from my mouth without thinking. Retirement security, of course. A pension's goal is not to maximize return but to provide security. Many pensions seem to have forgotten this. Today modern portfolio theory is used to justify the inclusion of even the riskiest assets in significant percentages. If hedge funds which trade voraciously and without constraints, are permissible investments for retirement funds, why not simply hand money to an experienced gambler and send him to Las Vegas? There certainly would be little correlation between his results and the fund's stock or real estate portfolio.
Participants in defined benefit plans are generally less concerned about and aware of plan performance and asset allocation. As long as the employer is around to honor its obligation to the plan, all's well. Perhaps there haven't been enough large defined benefit plan debacles to cause participant concern. Furthermore, the relationship between employer's financial performance and pension funding is not commonly understood. In a bull market pension performance can contribute to the company's bottomline. In a bear market, funding pension liabilities can drain a company. We've got a long way to go before participants in defined benefit plans grasp how these plans operate. However, as our population ages and the baby-boomers enter retirement, you can be certain they will turn their attention and activism to the management of their retirement funds. Think about it: We will have the largest, most educated retirement class in history.
Defined contribution plan participants, such as 401(k) investors, are far more aware of the deterioration in their retirement savings. There's no employer promising to make up the difference. For many 401(k) investors, retirement plans have been postponed or eliminated as a result of the stock market's performance. Investors whose retirement plan included stock in their employer's company (which plummeted) have suffered worst of all. Many lost their jobs thanks to employer cost-cutting. The Enron case will be remembered as a powerful example of how retirement planning can go awry. Undoubtedly the case will result in further guidance regarding an employer's duties in connection with defined contribution plans.
We were pleased to offer insights and solutions regarding many of the problems that emerged this past year. Following our Alerts regarding pension consultant conflicts of interest and the duty to investigate consultant compensation, Consultant Conceals Manager Brokerage- Asserts Duty to Protect Confidentiality of Brokerage Clients, November 2001 and The Duty to Investigate Pension Consultant Conflicts and Compensation, September 2001, we successfully completed, on behalf of a pension client, what we believe to be the largest investigation of pension consultant abuse ever conducted. This investigation, involving dozens of money managers, confirmed our worst suspicions. Pension consultants are surreptitiously earning ten or even as much as thirty times their stated compensation without disclosure to their clients. For selfish reasons, we hope that the results of our investigation will be publicly available in the future for other plans to consider. Hopefully, other pensions will set any political concerns aside and initiate investigations into pension consultant corruption. Unfortunately, another pension trustee we advised was unsuccessful in persuading his fund's board to insist upon consultant compensation disclosure. In what surely represents one of the most blatant example's of trustee breach of fiduciary duty that we have witnessed, the board accepted the consultant's position that it had a duty to keep confidential which of the fund's managers were paying it commission and conference fee "kick-backs." Furthermore, the board renewed the consultant's contract in the face of this refusal to disclose.
In "Anatomy of a Hedge Fund Fraud," we alerted investors to the prevalence of hedge fund shenanigans and outlined a routine investigation we undertook to ferret out a Ponzi scheme. According to the state regulators to which we referred the matter, that hedge fund manager will be required to provide restitution to the investors he defrauded. More of these hedge fund scams are surfacing as we write.
When we wrote 401(k)s: Far More Dangerous Than IRAs, March 2001, many industry insiders thought we were causing unnecessary alarm. There were no 401(k) problems we were told. "It's a great deal for investors and employers alike," they said. We received many telephone inquiries from individuals with serious 401(k) problems following that Alert, thanks to the "links" provided by other websites such as 401khelpcenter.com and benefitslink.com. Long before the Enron blow-up, we received calls concerning employer stock in 401(k)s. Participants were waking up deficiencies in their plans and asking questions. However, 401(k) problems are complex and multi-layered. Thanks to the lack of an effective regulator, investors are left scratching their heads, unsure of what to do when something seems wrong. We anticipated in that article further litigation regarding mutual fund companies that limited their employee's 401(k) investment options to only the employer's mutual funds. However, we are not aware of any new cases involving mutual fund company 401(k) plans filed in 2001. In 2002, we will endeavor to do a follow-up article on 401(k) problems.
In Financial Analysts: Writing Research That Benefits Their Employers and Themselves, August, 2001, our intention was simply to make the public more aware of the true purpose of Wall Street's so-called investment research. As we said in that piece, if investors understand that proprietary trading brokerages write research in order to create investor demand for stocks in the firm's trading account, then investors will be less likely to rely upon such research. While there has been a great deal of discussion of financial analysts' conflicts of interest in the press, we are confident that Harvey Pitt, the new chairman of the SEC, will continue his "kinder, gentler" approach to regulation and nothing will be done to eliminate the abuses. Pitt evidently is an advocate of "self-regulation," whatever that is. Why is it that when we look for individuals to head crime fighting agencies, we hire former prosecutors, not criminal defense types, yet virtually every SEC Commissioner seems to have a background representing the very firms he is to regulate? Isn't that a conflict of interest? How about Ralph Nader as an SEC Commissioner? Seriously, there is a need for greater investor advocacy at the Commission.
When Money Managers Are "Sanctioned By the SEC: 3 Tips to Protect Funds, January, 2001, explained process whereby information regarding money managers disciplinary problems gradually becomes publicly available and the difficulty this process poses for pensions who may have suspicions about their managers. As we explained, pensions can learn about manager SEC problems years long before they are made public. Unlike individual investors, pensions have the clout to get answers from their managers, if they are willing to ask.
The New Year promises to deliver new challenges to investors. We believe that improvements in technology could produce significant shifts in investor behavior in the near future. Many securities and investment management practices are outdated and have lost their utility. The opportunity exists to provide investors with information and products unlike any we have seen before. Recent incursions by technology savvy entrepreneurs into the securities and investment management industries have been refreshing but winning combinations failed yet to surface. In our opinion, technological innovation could transform these industries rapidly and soon. We are confident that regulatory agencies will not foster and may not even welcome technological innovation. Often regulators seem to believe their primary role is to foster confidence in the financial system, as opposed to exposing weaknesses. Hopefully, regulators will not stand in the way of improvements which our enhanced technological capabilities permit.