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Topical Study

Topical Study. Corporate Governance. Generalities. Corporate governance can be generally defined as the system by which corporations are directed and controlled

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Topical Study

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  1. Topical Study Corporate Governance

  2. Generalities • Corporate governance can be generally defined as the system by which corporations are directed and controlled • Common stocks shareholders may influence management by voting rights; not exercising these rights ignores a valuable ownership right that could be managed for the benefit of the portfolio

  3. Generalities (cont’d) • Shareholders frequently delegate their votes (proxy voting) to the investment managers • To meet their fiduciary duties, managers must adopt procedures to ensure that proxy issues are noted, analyzed and considered

  4. Proxy Voting • Basic elements of a proxy voting policy: • Creation of a proxy policy • Administration of the policy • Creation of a proxy policy: • Designate a policy-making body or an individual to recommend proxy policy and monitor implementation • Identify major proxy issues by particular account

  5. Proxy Voting (cont’d) • Administration of the policy: • define responsibility for proxy voting • develop a system to monitor any delegation of proxy voting responsibility to others • Provide for record keeping • Provide for a process to monitor performance of a custodian to ensure timely receipt of proxies • Avoid or minimize conflicts of interest • Educate and train staff

  6. Topical Study Client Brokerage - Soft Dollars

  7. Definitions • Brokerage refers to the amount given to a broker as payment for execution services • Soft dollar practices involve the use of client brokerage by an investment manager to obtain certain products and services to aid the manager in its decision-making process • Soft dollar arrangement refers to the research and benefits given back to the client or the client’s manager by the broker for directing the trade to the broker

  8. AIMR Soft Dollar Standards • AIMR Soft Dollar Standards (AIMR-SDS) are consistent with and complement the AIMR Standards of Professional Conduct (AIMR-SPC) • Purpose of AIMR-SDS: • define “soft dollars” • identify “allowable” research • establish standards for soft dollar use • create model disclosure guidelines • provide guidance for client-directed brokerage arrangements

  9. AIMR Soft Dollar Standards (cont’d) • AIMR-SDS are voluntary and are divided in mandatory and recommended standards (to claim compliance mandatory standards must be followed) • Compliance with AIMR-SDS does not supplant the responsibility to comply with applicable law

  10. AIMR Soft Dollar Standards (cont’d) • Fundamental principles of AIMR-SDS: • Manager must disclose any benefit receives through client’s brokerage (fiduciary duty) • Proprietary and third party research are to be treated the same • Research must directly assists the manager in its investment decision-making process (not in the management of the firm)

  11. Comparison with Current Practices • Research includes proprietary (generated by the broker) as well as third-party research (purchased by the broker) • Soft dollar arrangements include transactions conducted on an agency or principal basis • Enhanced disclosure (more than under the current law)

  12. Comparison with Current Practices (cont’d) • Research requires that the primary use of the soft dollar product or service to directly assist the investment manager in its investment decision-making process and not in the management of the firm • Compliance statement (only to the client that the compliance statement relates)

  13. AIMR-SDS - General • Brokerage is the property of client • Manager has duty to ensure quality of transactions including: • seeking to obtain best execution • minimizing transaction costs • using client’s brokerage to benefit clients • Manager must act in the best interest of client • Manager may not allocate client’s brokerage based on referral fees

  14. AIMR-SDS - Relationship with Clients • Manager must inform client that he or she may engage in soft dollar arrangements before doing so

  15. AIMR-SDS - Selection of Broker • Selecting a broker is a key component of the manager’s ability to add value • Manager must consider the capabilities of the broker to provide the best execution

  16. AIMR-SDS - Evaluation of Research • Criteria to use client brokerage to pay research: • must meet the definition of research • directly benefit the client • can be documented • not precluded under fiduciary regulations (e.g. ERISA) • If research does not meet the criteria, do not use client brokerage to buy it

  17. AIMR-SDS - Evaluation of Research • In determining the portion of Mixed-use research to be paid with client brokerage, manager must: • make a reasonable allocation of cost of research vs expected usage • pay with brokerage only the portion use in decision-making process • reevaluate the allocation at least annually

  18. AIMR-SDS - Client Directed Brokerage • Brokerage is an asset of the client • Manager must not use Brokerage from another client account to pay for research purchased under the Client-Directed Brokerage Arrangement

  19. AIMR-SDS - Disclosure, Record Keeping • Manager should disclose soft dollar arrangements to client • Manager must keep all records required by applicable law

  20. Topical Study Fiduciary Duty

  21. Generalities • Generally means to hold someone to a higher standard of loyalty and care than the standard to which most people are held • Extent of a fiduciary’s duty depends on each particular relationship • A fiduciary is charged with having more knowledge than the average person • AIMR members entrusted with assets that belong to others are charged with fiduciary duties

  22. Trust Management • Prudent Man Rule was initially measuring the behavior of trustees: • the fiduciary has an obligation to manage assets entrusted to him with the same care and discretion that a prudent person would; generally, the duty has been defined has avoidance of undue risk, preservation of capital and acting in the best interests of the beneficiaries of the trust • This rule led to legal list statutes limiting managers in choice of investment

  23. Trust Management (cont’d) • Underlying concepts of Prudent Man Rule: • fiduciary expected to be cautious and conservative • fiduciary’s main goal is to protect the principal • speculation is prohibited • fiduciary can be held responsible for a loss of principal • each investment is considered on its own merits • some classes of securities are deemed imprudent (e.g. options, futures, etc.) • delegation of investment authority is forbidden

  24. Trust Management (cont’d) • Modern Portfolio Theory (MPT) (viewing entire portfolio rather than individual investment) has evolved Prudent Man Rule into the Prudent Investor Rule: • requires a trustee to act prudently and with caution, discretion, loyalty and care but does not restrict the assets in which a trustee can invest (diversification) • fiduciary’s central consideration is the trade-off between risk and return • act with prudence in deciding whether and how to delegate authority (PMR: no delegation) • be cost conscious when investing

  25. Trust Management (cont’d) • Underlying concepts of Prudent Investor Rule: • focus on portfolio construction and trade-off between risk and return • no restrictions on classes of securities deemed imprudent under PMR (make sense in a portfolio context) • investment must fit client’s overall portfolio • delegation of investment authority is permitted • process-oriented (not focus on performance but rather on portfolio construction) • dynamic process (review client’s objectives) • duty to diversify (unless the client’s best interest is not to diversify)

  26. Employee Retirement Income Security Act (ERISA) • ERISA governs every qualified private employee benefit plan in the U.S. • Every fiduciary to the plan must be in accordance with: • plan documents • laws governing the plan • ERISA’s definition of fiduciary duty

  27. Employee Retirement Income Security Act (ERISA) (cont’d) • Under ERISA, a person is a fiduciary if: • exercises any discretionary authority or control with the management of the plan or the plan assets • renders investment advice for a fee with respect to plan asset • has discretionary authority or responsibility in the administration of the plan

  28. Employee Retirement Income Security Act (ERISA) (cont’d) • ERISA trustees cannot delegate their fiduciary duties but may delegate investment management responsibilities • ERISA fiduciary needs to be as prudent as the average expert (not simply as the average person)

  29. Employee Retirement Income Security Act (ERISA) (cont’d) • Fiduciaries must discharge their duties with respect to the plan: • solely in the interest of plan beneficiaries • for the exclusive purpose of providing benefits to participants and defraying plan expenses • with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims (Prudent Expert Rule) • by diversifying the investment of the plan to minimize risk of large losses

  30. Employee Retirement Income Security Act (ERISA) (cont’d) • ERISA fiduciaries must adhere to the following procedures: • establish a written investment policy for the plan • diversify plan assets • make investment with skill and care of a prudent expert • monitor investment performance • control investment expenses • avoid prohibited transactions (e.g. conflicts of interest)

  31. Employee Retirement Income Security Act (ERISA) (cont’d) • A person gives investment advice under ERISA if he or she, for a fee or other compensation (interpreted broadly): • gives advice about the value of plan assets or makes investment recommendations • has discretionary authority or control with respect to purchasing plan assets • gives such advice on a regular basis and serves as the primary basis for investment decisions

  32. Others... • Public Pension Plans: • laws follow ERISA but vary widely among jurisdictions • Money Management: • also held to a fiduciary duty • Brokers/Dealers: • held to higher standard of care than average person (shingle theory)

  33. Topical Study Insider Trading

  34. Definitions • Inside information: • generally defined as information about a cie that is both material and nonpublic • Material information: • if investor consider it significant in making an investment decision or if it have an impact on price (dividends, contracts, etc) • Nonpublic information: • if it has not been generally disclosed to the marketplace

  35. Traditional Theory (Chiarella v. U.S) • The mere possession of material nonpublic information does not give rise to a duty to disclose that information • The duty to disclose or abstain from trading arise only when a fiduciary relationship of trust and confidence is involved between parties to a transaction • Liability may extend to “temporary insiders” when those parties obtain access to corporate information by their special relationships with the corporation

  36. Traditional Theory (cont’d) • Liability under the traditional theory was extended to “tippees” (Dirks v. SEC) • “Tippee” is a person who learns material nonpublic information from a corporate insider • Tippee “inherits” the insider’s fiduciary duty when: • insider breach a fiduciary by disclosing information • tippee knows or should know that the insider is acting improperly by disclosing the information

  37. Traditional Theory (cont’d) • A breach of a fiduciary duty occurs if the insider personally benefits from the disclosure (directly or indirectly). Benefits can be: • pecuniary or reputational • through a quid pro quo relationship • a “gift” of information to others • Trading is specifically prohibited on material nonpublic information related to a tender offer (no breach of duty need to occur)

  38. Misappropriation Theory (U.S v. O’Hagan) • A person is liable when misappropriates material nonpublic information in breach of a duty owed to an employer or any other person who is not the securities issuer and uses that information in a securities transaction or communicates it to others (in general also violates Standard V(A))

  39. Defenses to Insider Trading: The Mosaic Theory • May use significant conclusions derived from the analysis of public material and nonmaterial nonpublic information as the basis for investment recommendations and decisions even if those conclusions would have been material inside information had they been communicated directly to the analysis by a cie • Should document all research • Existence of an independent reason for an investment decision does not provide a valid defense against charges of insider trading

  40. Selective Disclosure • When a corporation determines that information is material and should be made public, it must disclose the information to the marketplace generally (not to a chosen few) • Information made available to analysts remains nonpublic until it is made available to investors in general • Cies should develop and follow disclosure policies to disseminate information in a n equitable manner (no blacklist)

  41. Procedures for Compliance • Adopt procedures to prevent misuse of material nonpublic information: • review of employee and proprietary trading • documentation of firm procedures • supervision of interdepartmental communications (Fire Walls) • restricted lists

  42. Procedures for Compliance • Minimum elements of Fire Walls: • substantial control of interdepartmental communications • review of employee trading • documentation of procedures designed to limit the flow of information • heightened review or restriction of proprietary trading while a firm is in possession of material nonpublic information

  43. Obligations under AIMR’s Code and Standards • Members may receive information as a result of their confidential relationship with securities issuers (temporary insiders) • Members may receive information where no confidential relationship exist (must determine if inside information or not)

  44. Topical Study Personal Investing

  45. Fiduciary Responsibilities of Investment Industry Personnel • Members have a duty to put the interests of their clients, firm and profession over and above their own self-interest • Manager can make personal trading profit as long: • client is not disadvantaged by the trade • manager does not benefit personally from trades undertaken for clients • manager complies with applicable regulatory requirements

  46. Task Force Recommendations • AIMR’s Personal Investing Task Force was formed to examine issues related to personal investing of managers • Task Force recommends that firm should adopt certain basic procedures to address the conflict areas created by personal investing: • no participation in equity IPO’s • restriction on private placements • establish blackout periods (restricted periods) • no short-term trading (60 days) • gifts (maintain independence) • Reporting requirements • Disgorgement and disclosure of policies

  47. AIMR Performance Presentation Standards

  48. Goals of AIMR-PPS • Achieve greater uniformity and comparability • Improve the services offered to the clients • Enhance the professionalism of the industry • Bolster the notion of self regulation • Note: intended to be performance presentation, not measurement performance

  49. Parties affected by AIMR-PPS • Firms: • entity registered with the appropriate regulatory authority • an autonomous investment firm • all assets managed to one or more base currencies • AIMR members, CFA Charterholders and CFA Candidates (to remain in compliance with V(A)) • Prospective and current clients

  50. Main Topics of AIMR-PPS • Creation and maintenance of composites • Calculation of returns • Presentation of results • Disclosures

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