24 February 2021
By Gareth Johnson, Strategic Compliance Director, Signature
A long time ago, in a discretionary investment management business far, far, away, I was sitting in a rather nice meeting room listening to a quite brilliant lawyer explain why the firm I had just joined was not a fiduciary. The senior management team of the firm assembled was grappling with that most horrible of situations for a manager: the one where a discretionary investment decision has ‘gone wrong.’
A couple of lawyers in attendance were quite rapt with Senior Counsel’s technical reasoning, but it had not escaped anyone’s attention that the vigorousness of the argument was highly correlated to the size of the firm’s potential liabilities in a complaint about the investment concerned.
We were all contemplating this feat of reasoning when the investment manager who had overseen the investment banged his hand on the table and said, ‘Star Wars.’
It is not that easy to stun a senior management meeting into silence, but that did it.
Look,’ said the investment manager, ‘George Lucas writes terrible dialogue. At a read-through of the script of Star Wars, Harrison Ford turned to him and said, “George, you can write this stuff, but you sure can’t say it.”’
The room contemplated this contribution with a certain amount of eyebrow furrowing and contemplation of midriffs.
What I mean,’ said the manager, ‘is as much as you can construct a clever legal argument to try and help, I know I am fully in charge of my clients’ money, and I know they expect me to stand up and be accountable. So, as Harrison Ford said, you can write that stuff, but I’m sure not going to say it. The bottom line is the investment decision was my fault, and that’s what’s going to cause the damage here.’ His reaction was stand-up and principled; however, he misunderstood the force(s) aligned against us.
The investment decision isn’t the problem,’ I said, which also managed to stop the room in its tracks since we’d been talking about the investment quite a lot. ‘Yes, the investment turned out to be a horror but that’s guaranteed to happen to a manager at some point. You had a process, you followed it, this time it turned out badly. Stuff happens. I’m afraid the reason we are very probably going to have to write a cheque is not that the investment went badly, it’s that we can’t prove you followed your process.’
I am no Obi-Wan, but that day I was right – we wrote the cheque.
The investment manager concerned is a great investor. He is meticulous, cares deeply about his clients, and is captivated by the challenges, pleasures, and pains of picking investments. But we had been unravelled by a simple and fatal mistake that I have seen repeated too many times in the aftermath of the dotcom crash, in the credit crunch, and in less dramatic times too.
He had recorded his buy and sell rationales meticulously, but he hadn’t done the same for his holds. Which is when, as a compliance officer, you mutter, ‘I’ve got a bad feeling about this.’
As is the nature of investments that start losing value progressively, the investment manager had evaluated the position several times over as it continued to head south. He could reconstruct his thinking, he could recite it chapter and verse, he had copious historical data and reams of external research, but what he didn’t have was a contemporaneous written record of his investment decision-making process, which is why we ultimately picked up the bill.
To be clear, as the then Chairman of the FSA, Sir Howard Davies said after a period of volatile markets, performance itself is not a valid basis of a regulatory complaint. Stuff will occasionally happen in every manager’s career and it is inevitable that a fund or other investment will take a very negative turn at some point.
In complex scenarios where things have already ‘gone wrong,’ it is the lack of those objective contemporaneous records that can make a firm’s position indefensible. It is far too easy for ‘alternative facts’ to be suggested as plausible, leading to allegations that the manager was negligent and unskilful in material ways. Especially months or years on from the investment events in question.
In reality, of course, the complexity runs deeper. Records need to have internal coherence and quality throughout: in your research notes model creation process, per account trading implementation, pre- and post-trade investment rule compliance routines, investment committee minutes, those worth-their-weight-in-gold recorded investment decisions to buy and to sell, and most problematically in decisions to hold. As if that wasn’t enough, it is also vital to compare what you are doing within the portfolio to the presentations and pitchbooks that may have been given to clients in market conditions that are very different to those affecting the portfolio today. Are they still consistent with what they said you’d do?
I bet no-one ever told a Jedi that an ounce of prevention is better than a pound of cure, but that’s where compliance professionals who understand how all-consuming chasing that perfect portfolio can be, can bring battle-scarred experience and check for accuracy, quality and internal coherency. We can give the industry best practice advice that saves an investment management team from the terrible loss of productivity, performance, and revenue that complaints so often entail. Unfortunately, in my investment manager colleague’s case, I had only recently joined his firm, and we could only improve going forward.
As Harrison Ford knew, if you don’t write it down well enough, eventually it’s going to bite. Particularly—and I am going to repeat here for emphasis—when it comes to recording decisions to continue to hold positions that subsequently continue to lose value. These are the easiest to ‘overlook’ and the most dangerous. They are also an explicit regulatory requirement which was bolstered in the line-level detail of MiFID II.
We can’t all be Han Solo, but as I’ve told many a young investment padawan at the beginning of their investment management careers: if you keep investment decision making systems and records clear, clean and periodically checked by an objective second pair of eyes, you will be able to focus on what really matters - providing great discretionary services to your clients, uninterrupted by the dark forces of avoidable complaints. Get that right and a much happier investment manager you will be.
Gareth Johnson recently joined the Signature team in the role of Strategic Compliance Director. With more than twenty years’ experience in the field of compliance and operational risk management, he brings a wealth of expertise to the compliance support we provide. Gareth’s key expertise lies in compliance, operational risk, and operational management roles at Rothschild & Co., Morgan Stanley, Flemings, and as a consultant.
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