by Robert L. McMahon
7 February 2008
This past week we watched Harry Markopolos sit before Congress and speak truth to power like never before; effectively dismissing the Securities and Exchange Commission as being an ineffective cabal of idiot lawyers who, as Congressman Ackerman so eloquently put it, couldn’t find their ass with both hands if they were standing up.
Mr. Markopolos’s pointed testimony in the Madoff Scandal can also be aligned with what I see on a similar, but much more pervasive scale with regard to ordinary investors and that is the roles of “due diligence” and “fiduciary duty” when other people manage our money.
Much attention has been focused on the lack of due diligence undertaken by the so-called “feeder funds” who were shoveling piles of money into Madoff’s wonderful, but utterly impossible, “split -strike” strategy. In my own world of mutual fund investing a thought came to me then, what sort of due diligence is undertaken by my fund(s) with regard to the suitability of a company (a stock) and its risk profile for being a potential Madoff, Fannie Mae, Lehman Brothers, or Enron? What we all need to recognize with regard to these and other recent corporate failures, is that they were, first and foremost, the result of weak and ineffective corporate governance structures. If that is the root cause, then what is being done by our asset and mutual fund managers, brokers and investment advisers, to assess that risk and make it transparent to us; the folks giving them our retirement futures?
Due diligence is defined as “the process of investigation, performed by investors, into the details of a potential investment, such as an examination of operations and management and the verification of material facts”. This sounds like very serious stuff, but just how much investigating and examining is performed by the firms we give our money to? I tried investigating this via my mutual fund’s website and prospectus materials and found not a word about corporate governance suitability or governance screening. You can read a lot about proxy voting guidelines, that investments can vary in value and that past performance is not to be trusted, but if you want to see the governance profile of the fund’s top ten holdings you’re going to be looking a long time. Simply stated, there’s no readily apparent evidence that my fund actually performs this level of due diligence and if they do, well they’re keeping it a well guarded secret.
The term “fiduciary duty” can be defined as “acting with true faith and confidence in protecting the assets of another person and where there is an obligation to act for another’s benefit and interests”. Well that sounds all very serious and proper as well. It also sounds like the entity with the fiduciary duty must put the interests of him/herself behind that of the person they have the obligation to. In other words, they cannot and should not put their own monetary self-interests before yours in managing your money.
As an illustration of where this can potentially lead, let’s imagine that ABC Small-Cap Growth Fund has been on a stellar run gaining 15% and 20% for several years. Investors in the fund have done amazingly well and the fund manager has been beating his “bogey” by 10% routinely. By all appearances everything is going well and then disaster strikes out of the blue seemingly. Two of the fund’s largest holdings suffer extraordinary setbacks for different reasons; one firm is the spin-off of a well-known and much larger company that was the subject of litigation and a settlement. As part of the settlement the smaller company is obligated to commit up to 15% of the settlement total, effectively erasing 55% of its net income. The other company is in an accounting scandal when the Chairman/CEO dies suddenly and senior executives abruptly resign. It seems the firm was a “controlled company” whereby the founder and CEO (and his family) controlled the company through separate, non-trading Class B shares that had all the voting rights. As things unfolded material accounting irregularities came to light and executives resigned to evade responsibility and culpability.
The question I would have at this point is, “If these risks were known by the fund manager, why weren’t they made available to the investors in the fund?” Certainly if one is a securities analyst and fund manager the risk of contingent litigation against a company would be something very knowable from filings. Likewise, so would the risks of investing in a “controlled company”; just how much transparency would there be for a company that may not offer owners voting-rights, access to a proxy, or even hold regular annual meetings?
And here’s where the rubber meets the perennial road, just like Harry Markopolos uncovered the weaknesses in Madoff’s $50 billion Ponzi-scheme in five minutes, fund managers and securities analysts can deduce whether a company might be party to litigation or that it is a controlled company in about the same timeframe? Now if Madoff’s “feeder funds” can be accused of a lack of due diligence and owing a fiduciary duty to high-net worth investors in a hedge fund, shouldn’t the asset managers of America who oversee some $4 Trillion of equity funds alone exercise an equal amount of due diligence and fiduciary accountability for their much smaller and lower net-worth investors? The continued governance failings we have seen this past year seem to prove otherwise and they should really know better.
Mr. Markopolos’s pointed testimony in the Madoff Scandal can also be aligned with what I see on a similar, but much more pervasive scale with regard to ordinary investors and that is the roles of “due diligence” and “fiduciary duty” when other people manage our money.
Much attention has been focused on the lack of due diligence undertaken by the so-called “feeder funds” who were shoveling piles of money into Madoff’s wonderful, but utterly impossible, “split -strike” strategy. In my own world of mutual fund investing a thought came to me then, what sort of due diligence is undertaken by my fund(s) with regard to the suitability of a company (a stock) and its risk profile for being a potential Madoff, Fannie Mae, Lehman Brothers, or Enron? What we all need to recognize with regard to these and other recent corporate failures, is that they were, first and foremost, the result of weak and ineffective corporate governance structures. If that is the root cause, then what is being done by our asset and mutual fund managers, brokers and investment advisers, to assess that risk and make it transparent to us; the folks giving them our retirement futures?
Due diligence is defined as “the process of investigation, performed by investors, into the details of a potential investment, such as an examination of operations and management and the verification of material facts”. This sounds like very serious stuff, but just how much investigating and examining is performed by the firms we give our money to? I tried investigating this via my mutual fund’s website and prospectus materials and found not a word about corporate governance suitability or governance screening. You can read a lot about proxy voting guidelines, that investments can vary in value and that past performance is not to be trusted, but if you want to see the governance profile of the fund’s top ten holdings you’re going to be looking a long time. Simply stated, there’s no readily apparent evidence that my fund actually performs this level of due diligence and if they do, well they’re keeping it a well guarded secret.
The term “fiduciary duty” can be defined as “acting with true faith and confidence in protecting the assets of another person and where there is an obligation to act for another’s benefit and interests”. Well that sounds all very serious and proper as well. It also sounds like the entity with the fiduciary duty must put the interests of him/herself behind that of the person they have the obligation to. In other words, they cannot and should not put their own monetary self-interests before yours in managing your money.
As an illustration of where this can potentially lead, let’s imagine that ABC Small-Cap Growth Fund has been on a stellar run gaining 15% and 20% for several years. Investors in the fund have done amazingly well and the fund manager has been beating his “bogey” by 10% routinely. By all appearances everything is going well and then disaster strikes out of the blue seemingly. Two of the fund’s largest holdings suffer extraordinary setbacks for different reasons; one firm is the spin-off of a well-known and much larger company that was the subject of litigation and a settlement. As part of the settlement the smaller company is obligated to commit up to 15% of the settlement total, effectively erasing 55% of its net income. The other company is in an accounting scandal when the Chairman/CEO dies suddenly and senior executives abruptly resign. It seems the firm was a “controlled company” whereby the founder and CEO (and his family) controlled the company through separate, non-trading Class B shares that had all the voting rights. As things unfolded material accounting irregularities came to light and executives resigned to evade responsibility and culpability.
The question I would have at this point is, “If these risks were known by the fund manager, why weren’t they made available to the investors in the fund?” Certainly if one is a securities analyst and fund manager the risk of contingent litigation against a company would be something very knowable from filings. Likewise, so would the risks of investing in a “controlled company”; just how much transparency would there be for a company that may not offer owners voting-rights, access to a proxy, or even hold regular annual meetings?
And here’s where the rubber meets the perennial road, just like Harry Markopolos uncovered the weaknesses in Madoff’s $50 billion Ponzi-scheme in five minutes, fund managers and securities analysts can deduce whether a company might be party to litigation or that it is a controlled company in about the same timeframe? Now if Madoff’s “feeder funds” can be accused of a lack of due diligence and owing a fiduciary duty to high-net worth investors in a hedge fund, shouldn’t the asset managers of America who oversee some $4 Trillion of equity funds alone exercise an equal amount of due diligence and fiduciary accountability for their much smaller and lower net-worth investors? The continued governance failings we have seen this past year seem to prove otherwise and they should really know better.
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