Implications For Canada Of SEC Consultant Probe
By: Lawrence E. Ritchie & Derek Leschinsky
The U.S. Securities and Exchange Commission has released its report on the relationship between pension consultants and money managers. Lawrence E. Ritchie and Derek Leschinsky, of Osler, Hoskin & Harcourt LLP, look at the potential fallout of that report on Canada.
In a move that may have implications for Canada, the U.S. Securities and Exchange Commission (SEC) released, on May 16, 2005, its longawaited ‘Staff Report Concerning Examinations of Select Pension Consultants.’The report examines the relationship between pension investment consultants in the United States and the money managers they recommend to pension plans. In particular, it focuses on the potential for conflicts of interest created by compensation arrangements in the pension consulting industry.
The report comes amidst concern in the United States that pension investment consultants may be acting as ‘gatekeepers’ to a system that requires money managers to ‘pay-to-play’ in order to gain access to pension plan clients. It concludes that relationships between pension investment consultants and money managers give rise to serious potential conflicts of interest that should be disclosed to, and monitored by, pension plans.
The report, and the recommendations made as a result, may help improve transparency and improve confidence in the management of plan assets which have been under increased scrutiny as a result of insolvencies by plan sponsors. Insolvencies, including the high profile bankruptcy of United Airlines, are placing a heavy strain on the Pension Benefit Guaranty Corporation, the U.S. agency charged with ensuring payment of basic pension benefits for private sector plans in the United States.
Pension investment consultants play an important role in the pension industry, especially for smaller plans which cannot support the cost of in-house investment advisors. Consultants advise plans about investment objectives, asset allocation strategies, the selection of money managers, specific investments, and the selection of other service providers such as money managers, custodians, and broker-dealers. Pension investment consultants may also provide ongoing services to pension plans including the monitoring of fund assets.
In investigating the risk for conflicts of interest, the SEC report focused on 24 of the 1,742 SEC-registered investment advisors that provide pension consulting services. Approximately half of the firms examined were among the largest pension consulting firms in the United States.
The SEC’s Findings
The report made a number of critical observations with respect to the consultants surveyed:
- More than half of consultants, or their affiliates, provided products and services to both pension plan clients and money managers on an ongoing basis.
- Most consultants were affiliated with brokerdealers or had e s t a b l i s h e d relationships with unaffiliated broker-dealers.
- Although the SEC could not ascertain, based on the information provided, whether pension investment consultants ‘skewed’ their recommendations to favour certain money managers, it saw some correlation between compensation received from money managers and increased incidence of referrals by consultants.
- Many consultants had affiliates providing services to pension plans, creating disclosure and conflict of interest issues the that organizations had not adequately addressed.
- Of the organizations that provided additional services beyond pension investment consulting to pension plans, 84 per cent of consultants provided limited disclosure of the relationship and 16 per cent provided no disclosure.
- Many consultants did not consider themselves to be ‘fiduciaries,’ a position that the SEC vigorously rejects.
- Many consultants did not maintain policies and procedures that were tailored to their business.
- Money managers appeared to have relationships with multiple consultants, appeared to purchase overlapping products from these consultants, and were recommended by those consultants to plan sponsors.
The Contentious Forms Of Compensation
The report focuses on two types of compensation received by consultants: ancillary and directed compensation arrangements.
Ancillary compensation involves compensation paid to consultants from indirect sources such as conferences where a consultant ’s pension plan clients attend free of charge, but where money managers attend for a fee. Alternatively, consultants may derive benefit from selling software programs that analyze the performance of clients’ accounts. The report notes, for some consulting firms, compensation from these sources comprised a significant portion of their annual revenue.
Directed compensation is an arrangement through which a consultant directs pension assets to a money manager and the money manager remits all or a portion of the consultant’s fees on behalf of the pension fund. The report finds that directed compensation arrangements are “not well documented and raise many issues, including the extent to which plan assets may not be receiving ‘best execution’ because their trades are directed to the broker that provides these rebates.” The SEC also expresses concern that there may be no cap to the total amount of fees a money manager remits to a consultant and that these arrangements may create incentives to recommend an active trading strategy that will increase returns for a consultant.
The SEC’s Comments
The report emphasizes that, notwithstanding attempts by consultants to insulate themselves under the ‘Employment Retirement Security Act,’ pension investment consultants are fiduciaries under the ‘Advisors’ Act.’ As such, they should enhance their compliance policies and procedures to ensure that all fiduciary obligations are observed. This may include establishing policies to
- insulate a firm’s advisory activities from its business activities
- make disclosure to prospective and existing advisory clients
- prevent conflicts from arising and to disclose them if they do arise
Following the report’s release, the U.S. Department of Labor and the SEC issued a joint statement on June 1 providing ‘tips’ to assist fiduciaries in reviewing their pension investment consultants. The joint release encourages trustees and plan administrators to request copies of all statutory disclosures from consultants and to inquire about any relationships that a consultant has with a money manager that it recommends, considers, or otherwise mentions. In cases where a consultant or a related company receives payment from a money manager, it recommends these payments be disclosed as a portion of the consultant’s total income.
Moreover, the report advises pension plans to inquire about any arrangements whereby their consultant or a related company receives a benefit if a money manager places a trade with a particular brokerdealer. Similarly, pension plans are urged to require consultants to disclose what percentage of their pension plan clients utilize money managers, investment funds, brokerage services, or other service providers from whom they receive commissions.
The joint release recommends that trustees and plan administrators require consultants to provide copies of their policies and procedures that address conflicts of interest and to explain how they prevent existing relationships with money managers and/or payments from having an impact on their advice to pension plans.
With respect to directed compensation, the joint release indicates that if consulting fees are paid using the plan’s brokerage commissions, trustees and administrators should inquire about how these commissions are monitored. Specific queries should include whether the plan is notified when consulting fees have been paid in full and how a plan ensures it does not over-pay for consulting services. It suggests that plans may wish to avoid compensation arrangements without such constraints, given the potential for over-payment.
Overall costs may increase depending upon how brokerage orders are executed. Accordingly, if the plan pays consulting fees through its brokerage commissions, trustees and administrators should ask consultants about the steps they take to ensure the plan receives the best execution for its securities trades.
Trustees and administrators are encouraged to require their consultants to acknowledge – in writing – that they have fiduciary obligations as investment advisors and under ERISA.
Implications For Canada
Canadian pension plans, pension investment consultants, and money managers would be wise to take stock of developments in the United States, as similar attention may be focused on the pension consulting industry in Canada.
Although Canadian standards are less specific than those in the United States, trends in that country often have an impact in Canada. Consultants who administer or advise on the management of pension funds may have wide discretionary powers that they may exercise without beneficiary input and may, in certain circumstances, be found to owe fiduciary duties.
How can pension funds and their advisors avoid allegations of conflicts of interest similar to those under investigation by the SEC in the United States?
For pension investment consultants, a first obvious step for reducing risk is to ensure that potential conflicts of interest are adequately disclosed to pension funds, plan administrators, and trustees. Beyond this, consultants should not pressure money managers to participate in revenue generating arrangements to gain access to the business of their clients. Litigation risk will surely increase when either money managers or pension funds believe that money managers are being required to ‘pay-to-play.’
Pension fund trustees and plan administrators, for their part, would be wise to make pointed inquiries of their consultants over what compensation consultants are receiving and from whom. As a matter of course, such inquires should be documented so that adequate due diligence can be demonstrated should a pension consulting relationship ever come into question. Plan trustees who identify and quantify compensation arrangements where their consulting firms receive money from various sources will be in a better position to evaluate the total costs of consulting. If a pension investment consultant declines to disclose compensation received from other sources, it should be looked at as a red flag for administrators and trustees that should trigger closer scrutiny of the relationship with that consultant.
To safeguard their interests, plans could pursue a number of options. They could adopt a formal tendering process to select pension investment consultants, requiring full disclosure and review of compensation from other sources. The approach developed for retaining consultants could then be used to review and monitor a consultant periodically during the term of the consulting relationship.
Large pension funds may also consider the benefits associated with developing inhouse investment expertise.
In addition, pension funds may benefit from appointing trustees with investment or consulting experience.
Consideration of issues raised by the SEC report and joint release may better prepare Canadian pension plans, trustees, administrators, investment consultants, and money managers to anticipate and respond to the legal and regulatory landscape as it evolves in the United States and Canada.
Lawrence E. Ritchie is a partner and Derek Leschinsky is an associate with the law firm of Osler, Hoskin & Harcourt LLP in Toronto.
The ‘Staff Report Concerning Examinations of Select Pension Consultants’ is available online at: http://www.sec.gov. The Joint Release of the Department of Labor and the Securities and Exchange Commission, ‘Selecting and Monitoring Pension Consultants: Tips for Plan Fiduciaries,’ can be found online at: http://www.sec.gov.
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