Risk Rap

Rapping About a World at Risk

Leaking Visions of a New World Order

Every once a while an event happens that shifts the prevailing scheme of things. Julian Assange’s dump and release of US State Department cables (CableGate) for global distribution on WikiLeaks is such an event. It radically alters existing convention and the public’s general perception of normalcy, acceptability and protocol.  It brings into question the motives and interests of nations and their leaders. It squarely plops an 800 pound gorilla on the sofa in everyone’s living room and provokes questions that naggingly insist answers.   Asking leaders about duplicity, conflicts of interest, distortions, fabrications, fibs and outright lies all done in the national interest.  It is how a new Weltanschauung is cast and forged to conform to the needs a new world order.  The sun has set on the American Century.  Blessedly, America’s days as a self righteous post Cold War marauding superpower are coming to a close.  The WikiLeaks disclosures gives us some insights into the thinking and banter world leaders engage as they move the Chess pieces across the board on the great global game  of new world order.

There are moral considerations and ethical arguments to be made on each side of Mr. Assange’s incendiary action.  CableGate raises complex multidimensional issues of national security, informed citizenry, the protection of information, its public disclosure and citizens right to know.  The natural tension between  the simultaneous need for confidentiality and transparency is a reality of our complex and interconnected world.  The management of these issues have escalated to become a preeminent dilemma of our time.  This raises significant  challenges to democratic societies and the governance structures of both public and private institutions.  It threatens institutional sustainability and undermines institutional capability to function in highly interdependent stakeholder ecosystems.  The risk of seeking pathways to safely navigate the virtual minefields of a digitized global world is great and continues to grow.

The most impassioned issue raised by CableGate is the ethical violation of stolen property.  The cables were not Mr. Assange’s property and what gives him the right to publish and violate diplomats right to confidentiality and privacy? His actions could endanger diplomatic relationships, compromise government initiatives or derail delicate negotiations.  Do governments have a right to privacy?  If so, what information needs to be classified as secret and confidential?  If all documents are secret then the designation is meaningless and government nothing more then a ruthless leviathan lording over a clueless citizenry.

Another critical question CableGate raises is who is served by the publication of these cables? Certainly American citizens in whose interest the State Department purportedly acts benefits from the added transparency.  US citizens must admit there is a certain level of comfort in being able to track the satchel of an Afghanistan Vice President stuffed $52 million of taxpayers money through the U.A.E. Customs.

Detractors of CableGate assert that the leaks are a danger to America and its citizens.  If so why is the public aggrieved and who exactly is the “aggrieved public”?  Soldiers and servicemen fighting in Afghanistan?  Does State Department Cables provide tactical and strategic information on troop deployments?  Highly doubtful.  More likely it is the special interests enriching themselves at the public troughs by cutting deals to shamelessly engorge themselves as insidious war profiteers.  Better to ask why our country has placed our young servicemen and woman at risk in wars that makes little sense and accomplishes nothing.

Another set of critical questions CableGate raises are “Do citizens have a right to truth?  Is access to information meaningful?  Does the information help citizens of democratic societies understand the actions and motivations of their government?  Why do diplomats pursue certain course of action and who is profiting from the course of action pursued?  These are critical tenants citizens require to make informed decisions in a democratic society and CableGate certainly supports the notion of information empowerment for citizens.

Arguing the contrary one must ask “is it better to be mislead and be lied too in the name of propriety and protocol then to be victimized by the truth?  I’ll take conviction in a court of truth and pray for a life sentence every time.

If you believe that the public can’t handle the truth or needs protection from it; imagine yourself living near a nuclear power plant and it was leaking radiation into your drinking water.  Would you like to know about it?  What if disclosure led to wide spread panic?  I believe that truth and transparency always serves to discover and determine the best course of action to pursue.

CableGate has also shed damaging light on the power exercised by private corporations and the commercial control and open access and free availability of information.  Amazon’s cloud computing service had no silver lining for WikiLeaks.  After the WikiLeak dump it shut down access to the cables due to the unacceptable risk posed by denial of service attacks mounted by computer hackers.   This was followed by PayPal’s closure of WikiLeaks donation solicitation account.  Was PayPal’s motive purely patriotic?  Where they just pissed at WikiLeaks or were they at risk of  aiding and abetting a subversive organization that risked prosecution under certain provisions of  THE USA PATRIOT ACT?

Academic freedom also seems to have taken a blow due to CableGate.  This weekend, Columbia University warned its students not to download or distribute WikiLeak cables because it may affect future employment opportunities with the State Department. Government employees were also warned not to read or access the cables because they had no security clearance to do so.  If they were caught accessing the leaked cables it could cost them their jobs.  Even though the cables are published in great detail everyday by newspapers throughout the world, government employees must be careful not to notice for risk of losing their employment.  This is truly a Kafkaesque dilemma for some, a divine comedy for others and a growing political drama for everyone.

I’m still not sure that Cablegate is what it purports to be.  As the old saying goes and the cables affirm nothing is ever as it seems.  I find it  most improbable that a Private First Class sitting at a PC in Baghdad could download the Iraq War Logs and throw a great superpower into a first class crisis of the new world order.  I liken the leaks  to the past practice  of “special unnamed high placed sources” leaking inside information to the liberal mainstream media outlets.  Its done to float trial balloons about new government directions.  They do it to test the waters of public sentiment to new ideas, or change in policy course or  potentially damaging information to see how the public reacts.  Not one to be of a conspiratorial mindset, I perceive CableGate in this light.  As expected the public reaction thus far  has elevated our collective sense of outrage to a heightened level of ambivalence.

In many respects Iraq War Logs supports the construction of a new narrative about an exit strategy from Iraq and Afghanistan.  The revelations of wastefulness, corruption and back room deal making with a full caste of sordid characters reinforces  the public perception about the uselessness of these wasteful and expensive misadventures.  The cables may prove to be the documentary evidence  of  America’s Waterloo and CableGate  may be seen by future generations as the  historical high watermark of an expired global empire.

As the Iraq and Afghanistan War Logs helped to prepare the public psyche for an exit strategy in Afghanistan and Iraq; CableGate helps construct a narrative surrounding the need to “cut off the head of the snake in Iran”.  These cables implicate Arab States in a desire to undermine the apostate Persians and abrogates Israeli culpability as the driving force behind an attack on Iran.

Iranian President Mahmoud Ahmadinejad called the cables psychological warfare.  I don’t doubt for a second that atomic weapons in the hands of Iran is a dangerous development that needs to be mitigated.  That does not mean that we should employ bombers to destroy Iranian nuclear processing facilities.  This would only create an environmental disaster and political crisis  that further destabilizes the region.  It would secure the enmity of new generations of Muslims and no doubt stoke the escalation of the Crusade against Islam.

In the Far East,China’s growth as a world super power and ascending rival to US dominance makes for compelling reading.  Here its no surprise that cables assess a strengthening China, its growing nationalism and military readiness.  Reading these cables against the backdrop of rising tensions on the Korean peninsula, China’s complicity in helping North Korea ship nuclear materials to Iran and the changing sentiment in the US concerning the largest note holder of government bonds may prove to  carry grave consequences for harmonious US/China relations.   The cable revealing China’s ambivalence toward its North Korean surrogate state is laid bare as long as it can secure preferred trade agreements with a unified Korea.

The revelations offered by Pakistan’s leaders about support for the Taliban and a growing concern about the safety of their nuclear arsenals raised the possibility of a US military move to quarantine or neutralize Pakistani weapon systems.  Though so far India seems to come off unscathed by the cables it must be heartening for India’s leaders to know that its budding friendship with the US may encourage a move to disarm the nuclear capability of its northern antagonist and the worlds sole Islamic atomic state.

These WikiLeaks offer up a brand new narrative for an emerging new world order.  The damaging realization of the spillage of confidential proprietary discussions and dialogs between world governments and the mishandling of those documents diminishes the stature of US federalism.  The undermining of federalism and its suitability as a governance structure for the new millennium foreshadows the growing antagonism of global corporate entities like Google and the nationalistic government of the People’s Republic of China augers an era of  conflict between statism and corporatism.

CableGate is a deliberate attempt to have institutions open up with greater transparency and construct a democratic narrative that force governments to change.  Mr. Assange’s  avowed goal is to, “allow governments and institutions to become more transparent or force them to become more opaque”  Depending on the what side of the fence your sitting on, openness and transparency benefits the public interest.  The struggle for democracy requires the open access and the free flow of information.

In the digital age denial of free, open and equal access to information is tantamount to fascism.  Withheld, it will encourage people to rise up demanding the means to pursue conscious enlightenment.  This may spur political activism that demands institutional accountability,  and the practice of democratic governance based on constitutional principles.  Failing that once free citizens will be forced to accept the meager lies and obfuscations of leaders and power elites whose self interest is the sole interest of government.

So as Secretary of State Hillary Clinton tries to plug the leaks in a failing dike system, we cannot content ourselves to live with our heads buried in the sand,  filling our minds with reality TV reruns of Jack Ass Three and Bristol Palin bustin a move on Dance Fever.  I’ve heard it said that the best way to influence the future is to invent it.  Mr. Assange has given us a world of insights and a basic tool set to start constructing a foundation for a new world order.

You Tube Music Video: REM, End of the World As We Know It

Risk: diplomacy, international relations, governance

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December 6, 2010 Posted by | Cablegate, corporate governance, corruption, culture, democracy, ethics, government, institutional, Iraq War Logs, legal, nuclear, peace, politics, psychology, reputational risk, terrorism, values, war, WikiLeaks | , , , , , , , , , , , , , , , , , , , | Leave a comment

We Deserve Better (2): The Damnation of the Democrats

A few days after President Obama took office I remember him emerging from a meeting at the Pentagon.  The summit was arranged to brief the Commander In Chief on the progress of the wars and to assure the nation that the new president was in-sync with his generals and admirals charged with running the war.  Emerging from the highly publicized meeting America’s new war time president stated “as long as the generals take care of what they have to do, we’ll take care of what we have to do.”  I found the statement to be unsettling.  It implied that  the new administration would not alter the course set by the previous administration insuring that the inertia of Bush’s policies and strategies would continue unabated.  On another level Obama’s statement also seemed to suggest an abdication.  I get nervous to think that the Commander in Chief  has ceded civilian control of the greatest military force the world has ever known.  The decision to pursue war or enjoy peace is too delicate a matter to be left to the decisions of an entrenched military-industrial bureaucracy.  The abdication of assertive control, weather its born from the desire to get along, build consensus or a deep seated need for acceptance has been a disturbing custom of Obama’s presidency and the prevailing characteristic of the Democratic Party.

Obama’s easy surrender to established protocols, processes, precedents has been a hallmark of his presidency.  It exemplifies the failure of the Democratic Party’s oppositional legacy to Republican rule during the two previous Bush Administrations.  At every turn, the Democrats gave in to the Republican conservative legislative agenda with little or no dissent.  The Patriot Act, the blind march to  two unnecessary wars, the dismantling of government oversight and regulatory controls on business, the slavish submission to Republican led expenditures or tax cuts in service to corporate welfare and the tepid lip service to the struggle for social justice made the democrats complicit accomplices in America’s dramatic conservative swing.

The democrats failure as an oppositional force to counter the reactionary juggernaut of neo-conservatism has emboldened the reactionary impulses of the ruthless power elites.  Threatened by economic distress and disintegration of our political institutions, Americas ruling  plutocracy has spawned a malevolent Tea Party movement to crush any progressive populism that may arise to counteract their social position, economic power and political sovereignty. The democrats adamant refusal to stand firmly against the destructive impulses of xenophobia and virulent nationalism has allowed an ugly chorus of fear to become our new national anthem.  The resentful voices of suspicion, intolerance and  exclusion grows ever louder each day as emboldened Falangists and neo-fascists take center stage on a surreal  commercial production of American political theater.

In defense of President Obama his presidential campaign and his administration have expressed a deep desire to pursue a political consensus.  This sentiment is admirable and the ability to form a consensus is an absolute and critical virtue to the health of a democratic society.  The freedom to express differing opinions, voice dissent, air grievances, petition, ability to listen, interest to hear, converse, change opinions and assimilate these competing impulses to form a consensus to express the common will are what makes democracies imperfect yet the fairest expression of governance.  Mr. Obama has sought to pursue and build consensus with an opposition Republican Party that has been nothing short of obstructionist since the democrats assumed control of the Executive office.  Rush “Country Firster” Limbaugh said it best “I hope he fails” set the tone and sealed the intractability of Republicans and any possibility of bipartisan cooperation to deal with the critical issues confronting the nation.

Last summers spectacle of town meetings designed to initiate a national conversation on Health Care Reform devolved into a partisan shouting match and an opportunity for the formation of the Tea Party galvanized by propaganda about a socialist takeover of the economy, death panels, and the idea that President Obama was a fascist dictator.  At this point President Obama still took the opportunity to sit down with the leadership of the GOP in a televised discussion to initiate a dialog.  The Consensus Builder in Chief was rebuffed again.  The democrats responded by killing single-payer and backing down on universal health coverage.  The watered down health care reform bill accomplished an extension of coverage for more, but not all Americans and eliminated preexisting conditions as a disqualification for coverage while also extending the power of insurance companies by making it mandatory that all tax payers purchase health insurance.

This reform is not a significant ground breaking legislative event.  President Obama and the democrats should have recognized early on the inability to work a compromise with the obstructionists in the Republican Party.  As is the case with Cap and Trade legislation, rescinding  Don’t Ask Don’t Tell, ending the Iraq and Afghanistan war, financial services reform, TARP and the economic stimulus bill;  the GOP, “Party of No” has done everything in its power to derail the efforts of the democratic party to address the deep problems confronting America.  The Democratic Party should have leveraged its control of the legislative and executive branch of the Federal Government to push through a program for a new America.  The pressing circumstances of history required decisive leadership and bold ideas to address the complex problems confronting America.  FDR’s “New Deal” or Johnson’s “Great Society” were ideas accompanied by innovative legislation to solve systemic problems.  The democrats tepid response acquiesced to the conservative demands of the GOP.   The Blue Dog Democrats yelped and barked louder then any rabid GOP hound subverting a robust game changing legislative response to the problems confronting America.

The democrats would again demonstrate their timidity in how they responded to the Gulf Oil Spill.  If the free falling economy was the equivalent of economic Armageddon the Horizon Deep Water catastrophic oil spill was its environmental equivalent.  In each case President Obama fashioned piece meal responses designed not to offend “free market evangelists” for fear of being accused of over reaching.  Both instances provided opportunities to mobilize the nation and its significant resources in these titanic tests of national resolve.  In both instances the cojones challenged donkeys failed to seize the reins of state to wield its power.  I am still shocked by images of Jamie Dimon and Lloyd Blankfein pulling the strings on Timothy Geithner like a marionette to exact concessions during the banking crisis.  Or consider the high profile of BP CEO,  Tony “I want my life back” Hayward mounting a $50 million PR campaign to quell any concerns that the benevolence of corporate capitalism will eventually “set things right.”    The Republicans turned this into President Obama’s Katrina with Bobby “don’t spend no stim in Louisiana” Jindal taking the EPA to court for declaring a moratorium on deep water drilling.  And the fattest of fat cats Republican Mississippi Governor Haley “rebuild the casinos first” Barbour shaming Obama to spend a portion of his non- Martha Vineyard family vacation swimming in the pristine waters of the Gulf of Mexico.  It was a PR disaster for President Obama because he failed to act with the resolve or manner of a strong decisive leader.

But now as the midterms approach the democrats must answer to a crumbling alliance of constituencies that they have taken for granted and failed to help.  They are unable to see  constituents as anything other then a demographic voting block devoid of a face, personality or soul.  The democrats see stereotypes not people.  Labor unions are blue collar voters that now approximate 7% of registered voters.  This year the democratic controlled legislature failed to act on Card Check legislation that would protect the right of labor unions to vote and organize non-union companies.  Another important constituency of the Democratic Party is the LGBT community.  The military said it would comply with the decision of a California District Court  that overturned Don’t Ask, Don’t Tell.  Incredibly, President Obama’s Attorney General appealed the decision and asked the court to reinstate Don’t Ask, Don’t Tell.  Teacher unions are also big supporters of the Democratic Party, but many democrats support school vouchers and Charter Schools and seem unconcerned that financial and institutional support of public schools continues to erode.  Working class families and woman  are under severe distress as unemployment rates approach 10%, home foreclosures rise , spiraling cost of living increases spike, the cost of sending kids to college slip out of reach and a marked erosion in quality of life and expectations for a secure future and comfortable retirement evaporate.    The democrats did little to solve these pressing problems save the offer of cheap lip service that they understand their pain.  Charlie Rangel secure in the refuge of his four rent controlled apartments will not feel the cold experienced by a homeless mother and her children this winter;  nor will Hillary Clinton lose any sleep worrying about  deploying Chelsea to fight an incomprehensible war in Afghanistan.

This mid term election democratic candidates are running away from their unpopular president.  They will run on a platform of tax cuts and appear as local election district manifestations of gun toting patriotic Christophanies.  The poverty of a party with no conviction of principle is made plain.  Having no principles, Democrats have not offered a true alternative to reactionary Republicanism.  Nearsightedness has robbed them of a vision for a new republic.  They offer no demarcation with the broken policies that preceded their rule.  The hallmark of their governance has been the complete compromise with an recalcitrant opposition; content to administer a broken and corrupt apparatus rather then chart a new path.  The democrats remain shining examples of self serving politicians retuning to office  on mythical inertia to secure rent controlled apartments while public housing remains an endangered and dear want for many.  They believe themselves to be righteously led by the presiding shame of a president made possible by an epic civil rights struggle who cannot muster the fortitude or conviction to extend the equal right of marriage for one of his liberal constituencies.

We deserve better.

You tube Music Video: Les McCann, Eddie Harris, Compared to What

Risk: democracy, two party political system, liberalism

 

October 28, 2010 Posted by | Bush, conservatism, culture, democracy, democrats, environment, labor, LGBT, Obama, politics, recession, republicans, social justice, TARP, taxation, Tea Party, unemployment | , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , | 1 Comment

Healing the Breach: An Essay on Sound Practices for Fund Managers

…“the “money-management business” (with its plethora of mutual funds, investment counseling firms, and hedge funds) has so many practitioners who’ve grown up in an era where it’s all been about marketing and not risk management,…” “If 2004 goes bad, it will go really bad “ Bill Fleckenstein Contrarian Chronicle

This candid remark is an astonishing observation. The assertion that money management is more about marketing then risk management is a bit disconcerting. The most recent Security Exchange Commission’s (SEC) announcement concerning its investigations of brokerage firms for receiving commission payment premium’s by asset management firms for directing investors into purchases of preferred mutual funds is the latest example of how this statement is a tragic reality for investment product consumers.

We live in the era of radical capitalism. It is characterized by fierce political pronouncements of the sanctity of laissez-faire principles and the ultra aggressive pursuit of free markets, resulting in the increased rationalization of the market mechanism into our culture and daily lives. For many readers this statement is not surprising or profound. Marketing is king, and if you have any doubts about it, try locating a music station in New York City that is not wed to a Top 40 play list or Talk Radio format.

However, as this Milton Friedman vision of utopia continues its inexorable march of rationalization, a strange alchemy is taking place. As businesses damn the torpedoes to pursue markets, ethical business practices and sound corporate governance principles are being sacrificed at the alter of EBITDA, ROE, P/E’s and the Holy of Holies those sacred stock options. The ironic twist to all this is that these aggressive business practices defended on the grounds that they enhance shareholders value are actually seriously eroding the values of brands, profit margins and market capitalizations. Ask a shareholder of Enron, Parmalat or WorldCom about the clever corporate stewardship of these company’s former management teams and you’ll get a resounding thumbs down.

But there is something deeper going on here. When investors entrust their money to an investment manager, they may be attracted to the sizzle (remember past performance is not indicative of anything) but what they want is still the steak. Investors want an investment manager that can understand their investment goals and risk tolerance and provide them with an investment vehicle that can balance that risk tolerance with the capability of realizing an expected return. The act of giving a manager discretionary power over an individuals retirement fund, a union’s pension portfolio, a family office or child’s educational financing vehicle is a tremendous act of faith that requires an extraordinary degree of confidence in the manager’s ability to provide an acceptable return, but to also be a trusted fiduciary that has the requisite operational support and controls in place that will safeguard and honestly seek to grow and protect an investors capital.

Mr. Fleckenstein’s assertion that risk management has taken a back seat to marketing and product placement is unfortunately an accurate assertion. The financial services industry is unique in the sense that it is the loam of all capitalist constructs. Yet as a business, financial services companies are no different from any other economic enterprise. All companies create products and differentiate themselves through the value proposition incorporated into their product. Intrinsic to the product creation process is a determination of the type of materials that will form its composition. A conscious decision is made as to how the product will be positioned and marketed, its performance metrics determined, customer service resources required to support the product as consumers use it and how it will be distributed. Once those variables have been determined, a profit margin is added and a value proposition to potential customers is conveyed. The value proposition that is communicated to consumers comes to be known and identified as the product brand. An investment product is designed to essentially address current and future financing requirements and the risk profile of the consumer are central to the design and purpose of the product. That is why this bifurcation is so dangerous. It undermines the inherent purpose of the investment product and should more truthfully be marketed as a product that enriches the commission merchant that may over a specified period of time garner a return for the investor. Think about all the Enron employees who had their 401k’s invested entirely in Enron stock.

This is probably the most significant point and primal differentiator of companies that manufacture financial products with that of companies that manufacture consumer durables. Financial products facilitate the flow of capital through the markets. It feeds the invisible hand that guides and directs all economic activity. If the flow of financial products is impeded, or abates due to consumers lack of confidence, a consumer driven economy like that of the United States will suffer greatly. Foreign governments and institutions buy US Government bills, bonds and notes because of the well-earned confidence they have in Uncle Sam’s stable currency and it’s ability to pay it’s debt and provide a fair return to all note holders. However if that confidence goes away, Uncle Sam will have to curtail its deficit spending, raise taxes on its people and enter into other messy measures to remain economically viable. Confidence is a lovely thing both for nations and companies and once that confidence is lost it is a difficult, if not an impossible thing to regain. Confidence is the basis of risk management. Credit risk and rates of return, the key variables of risk management, all start with the certainty of confidence.

Yes, from an investment performance point of view 2003 was a terrific year. All major equity indices were up. Thanks in large part to a federal tax rebate program the US economy grew by 8% during the 3rd quarter, prompting Mr. Greenspan to proclaim with a certain degree of confidence that the recession had ended. Yet from corporate governance, business confidence point of view, 2003 business news makes the turn of the century robber barons look like acolytes of Mother Teresa. To restore confidence investment managers need to develop a Sound Practice program that will repair the breech and bridge the bifurcation of marketing and risk management within the investment management enterprise. Lets turn our focus on how and why this bifurcation must be bridged.

Sound Practices Builds Confidence

The explosive growth of the global hedge fund industry and the important role it plays in providing market liquidity and as an alternative asset class for high net worth investors and institutions is increasingly placing the industry in the global spotlight and many regulators, interest groups and institutional consumers are demanding greater transparency and advocating increased oversight and government regulation.

The Long Term Capital Management debacle, George Soros’s unilateral assault on and profitable dismantling of the Pre-Euro Exchange Rate Mechanism, numerous hedge fund blow-ups through poor management controls or outright fraud, and the most recent disclosure of the widespread collusion of hedge fund arbitrageurs and mutual fund managers to conduct market timing trading, is seriously eroding investor confidence in financial institutions. This is creating a political climate favorable to enhanced regulation and oversight of financial institutions. The recent investigative actions of New York State Attorney General Elliot Spitzer, and the appointment of William H. Donaldson to head the SEC are clearly political responses to the crisis in corporate governance and regulatory malfeasance.

At last count, there are approximately 20,000 companies engaged in investment management within the United States. Some investment companies are regulated by the SEC, some by the Commodities Futures Trading Commission (CFTC), some by the National Association of Securities Dealers (NASD), some conform to best practices required by custodial counter-parties, and some are guided solely by the good conscience of the fund manager.

In this rapidly expanding market, managers are seeking to differentiate themselves and attract investors assets through slick marketing campaigns, presentations, road shows, and shameless boasts about a mangers progeny, experience and past performance. Attestations of operational readiness and management’s commitment to ethical corporate governance is usually covered with a statement that lists the prime broker, the accounting firm for auditing and the administrator for transfer agency and shareholder communications. The manager believes that by listing the service providers (corporate brands) they convey a message to the investor that they are operationally sound and have the operational controls in place to satisfy all contingencies. Unfortunately, these service providers are retained for a very specific purpose and taken in aggregate do not amount to the implementation of a unified sound risk management program. Indeed, Arthur Anderson was a leading provider of services to the alternative investment management market and reliance on this brand to infer regulatory compliance or adherence to sound operational practices was clearly a miscalculation.

In the day-to-day operation of the business the tension between regulatory compliance and entrepreneurial zeal is usually resolved in favor of doing the transaction. When we asked an executing broker working a large sale transaction for a first time hedge fund customer if the hedge fund identity had been properly documented and verified in conformance with the rules of the USA PATRIOT Act he stated, “They’ll never answer these questions and if we ask they’ll simply go to another broker to work the order. We’ll take the hit to do the deal.” Yes this broker made a calculated decision based on the potential that the hedge fund was not entering into this transaction to launder money through the capital market system or was a front for terrorist financing. He was probably right, and earned his firm a nice commission for working the 100,000-share block at $.05 per share. But what if he was wrong? Was the premium commission rate a fair return for a ruined reputation, a million dollar fine, the revocation of your industry license, a lifelong ban from the industry, or even a prison sentence?

What are Sound Practices?

Sound Practices are a set of standards and operational controls that mitigate numerous risk factors in the investment management enterprise. Sound Practices address the investment process, its decision and operational support functions, capital introduction, compliance requirements, business continuity, fund strategies and investor communications within a set of defined expense ratios.

What’s the difference between Sound Practices and Regulatory Compliance?

If we accept the definition that compliance is a set of externally imposed rules required to insure that counter-parties of a transaction and the rules governing the transaction meet acceptable minimum standards to facilitate an ethical and efficient exchange of value; I think we come pretty close to the meaning and nature of compliance and the purpose of the functions required to support it.

In the United States, depending upon the type of products a financial services firm offers, there may be or may not be a governmental agency or Special Regulatory Organization (SRO) that is charged with compliance oversight and enforcement of its business practices. The Office of the Comptroller of the Currency (OCC) is charged with the responsibility to oversee compliance with regulatory statutes for savings and loans, thrifts and banks. For broker/dealers the NASD is the SRO oversight body. For mutual fund companies and publicly listed companies, the SEC is the regulator. Future Commission Merchants are regulated by the CFTC; and hedge funds, -sometimes referred to as an Unregistered Investment Company (UIC)- at present escape any formalized regulatory oversight body.

Each regulatory body has its own set of compliance rules, guidelines and enforcement mandates. One can imagine the overlap and confusion that occurs when a bank owns a broker dealer, which owns an asset management firm, that offers mutual funds and off shore hedge fund products to institutional, retail and high net worth investors. The maze of regulators and the differing and sometimes contradictory regulatory requirements creates a reactionary and possibly antagonistic response to regulatory examinations and demands. At the very least, compliance is a significant cost of doing business and adds little to the intrinsic value of the product offered by the institution. The added expense of compliance deals with the structural aspects of the market, not the intrinsic value of the product. This is a dangerous bifurcation in its own right. A financial product, (specie for the capital markets) requires a denigration of value to assure a controlled velocity through a regulated market structure.

For companies that view regulatory compliance as a necessary evil that tempers entrepreneurial pursuits and whose function is an added cost of doing business; these organizations will develop a best practice culture that is inherently restrictive. This type of corporate response to regulatory or best practices initiatives will always be overwhelmingly reactive and places the enterprise at great operational and regulatory risk.

Sound Practices are different. Sound practices are a set of internally (organically) developed operating principles that inform the values of ethical corporate governance, is enforced by internal management and seeks to become invisible as it ingrains itself into the operational and business culture of the firm. Sound practices must be viewed as fundamental to a firm’s value proposition, organically grown and endemic to the corporate culture and proactively conveyed to the market as a premium brand.

The internal development or organic growth of best practices as a central desire and objective of the corporate enterprise is revealed as central to product brand and the value proposition offered in the market. This positions the firm and its products as a premium brand. The business benefits of a sound practice program are enhanced margins, product performance and the attraction of quality clients and vendor relationships. More importantly it differentiates the firm in a crowded market because its quality brand is perceived by the market as endemic to the firm’s corporate culture and as such is inherently superior to something that is externally imposed by some governmental or regulatory body. On a macro-economic level the socialist or state capitalist experiments in highly regulated planned economies are the logical extreme and true antithesis of a sound practice culture.

Within the hedge fund industry in the United States the concept of Sound Practices first surfaced in an industry study entitled Sound Practices for Hedge Funds. The study was an industry response to the Clinton Administration’s request to examine the lessons learned from the Long Term Capital Management implosion and recommend basic guidelines to avoid similar disastrous occurrences in the future. The paper was a breakthrough on a number of fronts, placing the science of risk management and the utilization of risk measurement tools at the center of the investment management enterprise. Though the study was a political response to a catastrophic market event, the real purpose of the study was to temper the drive to regulate the hedge fund industry. In essence, the authors of the study asserted that regulatory oversight is not needed if hedge funds implement and maintain a sound practices program. Sound practices will allow investment companies to remain unregulated and will assure that the industry is fully capable of self-policing through the creation of practice standards. Indeed, any regulation or governmental oversight will further drive the industry offshore to more discreet and tax friendly domiciles and could potentially drain capital and liquidity from the US capital markets.

Operational Risk Mitigation

As previously stated, developing and adhering to a set of best practices principals and guidelines will add intrinsic value to product and corporate brand. The purveyors of Business Performance Management (BPM) solutions routinely boast the claim that publicly listed companies that practice BPM have P/E ratios that trade at a 15% premium to industry peers who have not implemented a BPM strategy. The question whether BPM is a silver bullet to enhance market value or whether BPM practitioners are leading companies dedicated to implementing programs and mechanisms to build shareholder value are irrelevant. What is important is that BPM practitioners are implementing processes and tools to understand and isolate operational risk to create product delivery and decision support mechanisms that build intrinsic product and corporate brand value. Thus at its heart, BPM practitioners seek to heal the bifurcation of marketing and operational risk management and firmly establish and display the synthesis as central to the value proposition a company delivers to its clients.

Operational risk factors in the investment management complex are numerous. They include valuation practices, system infrastructure, business continuity contingencies, vendor and service provider dependencies, risk management tools, risk management function segregation and asset gathering or capital introduction and investment acceptance principles. All of these risk factors are significant and each one on its own could threaten the ongoing viability of the enterprise. Each risk factor must be addressed in detail with a comprehensive programmatic approach to develop and implement processes and controls to enhance best practices to support the function and mitigate the risk factor associated with the business process. The Basel Capital Accord (Basel ll) proposes the introduction of a capital charge related to the operational risks of financial institutions. Basel II defines operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.”

As an example, poor record keeping or an honest miscalculation on a corporate action treatment or security valuation can be forgiven. After all, the restatement of earnings -even during the Sarbanes Oxley Era- in corporate America is common. Laundering money for criminal enterprises, or heaven forbid, financing terrorism goes way past lax controls. In the eyes of the law it is criminal, in the eye’s of regulatory authorities it’s a serious offence, and a heavy fine and asset forfeiture is possible. If this occurs, in the mind of the consumer the fund manager is guilty of two counts of treason. The first count of treason the fund manger is guilty of is against his country. The second count the fund manager is guilty of is the betrayal of a sacred fiduciary duty. A hedge fund manager would probably never recover from this type of avoidable catastrophic risk event.

Fund managers need not look at compliance with the USA Patriot Act as another cumbersome compliance requirement that will be expensive to address. The belief that compliance will antagonize or annoy potential clients and may in fact drive them to a competitor whose controls are not as stringent and whose compliance laxity facilitates transactions by making it easier for investors to place assets with the competitor may hold some truth. But shouldn’t a fund manager avoid those types of clients anyway?

Compliance with The USA Patriot Act requires that investment companies conduct due diligence and maintain and administer a Customer Identification Program (CIP). Investment companies should view compliance with the Act as an opportunity to develop a Know Your Customer (KYC) capability that enhances and enriches the client relationship with the firm. When fund managers make KYC the cornerstone of their product development initiatives marketing will then truly serve the risk management requirements of clients.

The process of conducting the KYC due diligence exercise results in a more in-depth understanding of the customer. As managers are verifying customer identification information they will routinely uncover residential, employment and family histories that give them a better perspective on the client’s needs, their appetite for risk, other fiduciary relationships the client has and the source of the clients wealth. The regulatory objective of the KYC process is to verify the clients identity and to make sure they are not a money launderer or terrorist. The sound practice objective of the KYC process is to cover the regulatory requirements and more importantly to gain insights and understandings into their personal and business motivations. Armed with this understanding the manager can design or offer an investment product that will address the client’s risk management requirement. Client’s will appreciate the fact that managers are conducting this due diligence to insure that their funds will not be commingled with money launderers or terrorists, and that the firm is taking appropriate steps to insure that they transact business with reputable clients whose ethical and moral standards are similar to their own high standards.

As clients experience the KYC discovery process, they will begin to understand that the firm is committed to delivering a qualitatively superior value proposition. The client experience will help them to understand that the marketing focus of the firm is to acquire trusted customers and the depth and quality of client relationships are established to understand client needs and requirements. The client will also gain the assurance that regulatory risk and the potential for large fines and asset forfeitures are minimized due to the care the firm has exercised in determining that its clients are the right type of clientele and that the firm’s management has created operational controls and processes to prevent the risk of money laundering within the investment management enterprise.

Furthermore, subscription and redemption releases are facilitated due to proper controls in place with administrators and custodial institutions. This places enhanced liquidity at a fund manager’s disposal allowing the manager to practice effective cash management techniques that position the manager to take advantage of investment opportunities that may arise. This raises the possibility of developing a more effective collateral management capability that will tighten spreads on haircuts and dramatically reduce financing expenses. The credit rating of the firm would improve allowing lenders to further reduce financing rates to capture the funds business in a competitive credit and financing market. The reduction in the cost of capital can dramatically affect investment performance and the marketers can truly boast of a source of alpha that is directly attributable to operational sound practice processes.

Having proper procedures and business processes in place with administrators and custodian institutions will also facilitate the transfer of shareholder data to accountants for tax and audit purposes. This will expedite the delivery of tax and performance information to shareholders, generating savings in preparation fees and lessening the possibility of costly restatements. This will reduce and maintain fund expense ratios to absolute minimums. Marketers can clearly demonstrate that the fund managers are good stewards and are as concerned with minimization of business expenses as well as investment performance and high watermarks.

Increased transparency and the opportunity to dramatically enhance shareholder communications and reporting will be a strong attraction to many investors. Indeed, many institutional investors demand a level of transparency, communication protocols, and reporting tools that would have been unthinkable only a short while ago. As sophisticated institutional participation grows within the industry, the implementation of a sound practice program will be the only way hedge fund products can incorporate the necessary value proposition that addresses their risk management profiles and requirements. Sound practices and the compliance function become significant differentiators and powerful marketing tools. At last, the bifurcation is healed.

James Wolfensohn, President of the World Bank has been quoted as saying, “Corporate governance is about promoting corporate fairness, transparency and accountability.” Sound Practices is a necessary prerequisite for effective and ethical corporate governance. Fund managers must accept it’s precepts and sell side institutions and other industry participants and service providers must demand compliance, disclosure, ethical trading principals, honest research, operational integrity and a full commitment to its implementation and adherence. Effective corporate governance practices will restore the faith of the investing public in the global financial services industry and maintain the rationality of the world’s capital markets. It will also please investors to see realized enhanced returns on investment portfolios and help fund managers to fully participate and enjoy the benefits of a thriving hedge fund practice.

Originally written January 5, 2004, the article is significant because it raises concerns about financial services product marketing practices that still need to be addressed six and half years later.

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Risk: regulatory, consumer confidence, sound practices

June 7, 2010 Posted by | AML, banking, Basel II, credit crisis, hedge funds, investments, marketing, operations, private equity, product, product liability, regulatory, reputational risk, risk management, sound practices | , , , , , , , , , , , , , , , , , , , , | 1 Comment