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Universities and Investment Fraud

Knowledge about operational due diligence and investment performance analysis, with a bit of skepticism as well, can help prevent getting tangled up in investment scandals.
University Business, Mar 2011

Westridge Capital Management, formed in 1996, promised investors enhanced cash returns by trading equity index futures. The firm's performance was so attractive, a host of pensions and endowments invested with it, including Bowling Green State University (Ohio), Carnegie Mellon University (Pa.), Ohio Northern University, and the University of Pittsburgh. In 2009, the Securities and Exchange Commission alleged that staff at Westridge invested very little client money. Instead, the SEC claims, the company's managers "misappropriated the rest to pay for their lavish and luxurious lifestyles."

The SEC filed charges after the National Futures Association, which oversees trading in derivatives, audited Westridge and found irregularities. Company executives refused to cooperate with the investigation. However, they did accept a $21 million deposit from the University of Pittsburgh the day after the NFA began its audit.

The Westridge scandal isn't the only one that has snared colleges. Tufts (Mass.) and Yeshiva (N.Y.) universities both had funds invested with Bernie Madoff, who served on the Yeshiva board of trustees while perpetrating what may be the largest investment fraud ever. Other educational institutions have avoided frauds in their endowments, but were hurt when major donors were victims.

The sales tactics used in fraud pitches were the same as those used in legitimate sales.

"This can happen to anybody. You don't have to be stupid," says Pat Huddleston, a former SEC enforcement branch chief and the CEO of Investor's Watchdog of Kennesaw, Ga., which provides due diligence services. The institutions affected by the Westridge and Madoff scandals had savvy people on board. Likewise, the list of Bernie Madoff victims includes leaders in the venture capital and mutual funds industries, along with experienced business owners and professionals. Another Ponzi scheme was uncovered in 2010. It was operated by a Florida money manager named Wayne McCleod, who stole retirement investments from officers of the FBI, Drug Enforcement Agency, and Immigration and Customs Enforcement - people trained to look for cons.

Although it's important to have smart staffers and sophisticated trustees, that's only a start. Higher ed institutions should have employees and volunteers trained in operational due diligence, investment performance analysis, and the value of a little skepticism about their fellow human beings. It may seem awkward, but it actually fits into the spirit of knowledge and inquiry that is the hallmark of higher education. "There's a lot of thought that goes into everything that happens here," says Bront Jones, treasurer of St. John's College (Md.). St. John's standardized its investment due diligence practices as part of a comprehensive institutional financial plan put into place in early 2008.

No one sets out to be a victim of fraud. Huddleston says he has talked to countless defrauded investors over the years, who had believed that it could never happen to them. This belief "blinds institutional investors as well as individual investors to the possibility of fraud," he says. The first step to preventing fraud, then, is accepting that it is possible.

Along with the anecdotal evidence on the Madoff and Westridge who's who list, research shows sophisticated investors can be taken in. In 2006, the National Association of Securities Dealers (NASD), a predecessor organization to the Financial Industry Regulatory Authority (FINRA), issued a study on investment fraud. Although it examined senior citizens and their behavior as individual investors, it revealed some surprises that may apply to broader groups. Namely, victims of fraud scored higher on tests of financial literacy than people who were not ripped off. They had more education, more income, and were more likely to rely on their own experience and knowledge. The NASD analysts were unsure if those who were defrauded suffered a gap between what they knew and what they did, if they were tangled by their own expertise, or if expertise was simply no protection against the tactics of a confidence artist.

The NASD study also looked at the content of fraud pitches, by analyzing tapes of sales presentations taken by undercover investigators. What they found was that the sales tactics used in fraud pitches were the same as those used in legitimate sales, including building relationships, drawing on social consensus, and creating favorable comparisons. That makes it tough to recognize who's good and who's not.

"The vast majority of people who serve on boards are well-intentioned and come from the best backgrounds in the country," says Ron Hagan, who is president of Roland|Criss, a fiduciary consulting firm in Arlington, Texas, as well as the chairman of the board of the Investment Fiduciary Leadership Council, a voluntary organization that has developed standards for those in fiduciary roles. The problem, Hagan says, is that board members often have no training in how to be a fiduciary.

Due diligence is the basic process of verifying that people are who they say they are and that they follow proper practices to ensure financial integrity. It's a legal requirement that is getting tougher; endowment fiduciaries are usually subject to the Uniform Prudent Management of Institutional Funds Act, which has been enacted as law in 46 states and introduced in two others. It raises due diligence standards on charitable institutions to higher levels than called for in previous laws.

There are four operations aspects to check, says Gianluca Morello, a securities lawyer with Wiand Guerra King in Tampa, Fla., who is serving as the court-appointed receiver in the bankruptcy of Arthur Nadel, who operated a fraudulent hedge fund. The important aspects include who the money's custodian is, whether the fund is audited, the appearance of fund documents, and checking references (see "Four Questions for Due Diligence").

In addition, Huddleston says that many fiduciaries ignore conflict of interest disclosures just because there can be so many of them among a money manager and different service providers. "If your consultant receives a fee from an investment that you could go into, he had a conflict," Huddleston says. "He may try to do the right thing, but he has a bias."

One way to overcome these biases, Huddleston suggests, is reversing the approach to due diligence. Instead of looking to confirm that the investment opportunity is legitimate, he recommends starting with the assumption that the investment is really a well-disguised fraud and looking for ways to confirm that. If you can't prove that a fraud exists, then you're probably safe.

After checking out the names, dates, and places, fraud-fighting fiduciaries need to check out investment performance. This is harder and calls up more biases. For example, the investment with the best performance may not be the best investment. "People become overly concerned about checking the boxes and less concerned about investment understanding," says Eric Alt, managing director at Hall Capital Partners, an institutional investment advisory firm in San Francisco.

"Our investment process is really focused on getting a granular understanding of what portfolio managers are doing," explains Alt. "By knowing what people are doing and by knowing what's happening in the markets, we can see what they should be doing in performance." If there's a difference, he says, there's a potential problem. A fund that outperforms may not be better if its extra return comes from deviating from the agreed-upon investment style or from fraud.

Performance is not a standard under UPMIFA, Hagan says, but it is clearly an important consideration for responsible boards. A hallmark of many frauds is consistently excellent reported investment performance, sometimes in defiance of market conditions. The Investment Fiduciary Leadership Council has proposed an investment standard emphasizing policies for selecting and reviewing managers, limits on compensation, and full disclosure of revenue sharing. The goal: Give board members and others guidelines to best practices rather than a list of regulations from the law. (The standard was being finalized at press time but will be available through the IFLC website.) "Process begets outcomes, not the other way around, in the eyes of UPMIFA," he adds.

Still, fiduciaries need to look at the numbers that funds present to them. "We have found it to be very useful and possible to develop quantifiable fiduciary screens," Hagan says, considering performance against peers working with the same asset class. That comparison, he says, is more useful than stand-alone return data.

The ultimate test draws on a very old adage, says Morello. "If it sounds too good to be true, it's probably not true."

Because endowments have many money managers competing for their business, he says they should be willing to move on to the next candidate if they sense that something isn't quite right. "There's nothing wrong with saying no."

"You have to maintain a healthy sense of skepticism," Alt says, and that's very much key to avoiding frauds. But that's not always easy. Huddleston notes that many problems start out with conflicts of interest involving board members. "If we're nominating our buddies, we can't be objective and say that we've chosen the right guy." One has to be made aware of his or her own biases before acting on them, and training may help.

Huddleston recommends investment committees discuss manager integrity at every meeting. A money manager going through a divorce may be tempted to behave wrongly because of personal stress and financial pressures, he notes as an example. "You aren't a bad person, or evil, or hopelessly cynical to do this analysis." At St. John's, Jones and staff have identified board members in the best position to meet with money managers, and they send them out to talk face-to-face. Then, everyone meets quarterly to document who attended which meeting, to create an internal paper trail.

The work has to be ongoing, Huddleston says, because few financial scammers start out crooked. Many, he says, start out legitimate, and then fudge numbers to avoid posting disappointing results. The money manager hopes to make it up in the future, but that never quite happens; once someone crosses the line, it's hard to come back. "We're talking about human beings and human reactions," he says.

Frauds are rare, but they happen. What happens if a college executive reaches the sickening conclusion that the campus is involved in one? Report it to the Securities and Exchange Commission immediately, Morello says. "You've got to bring it to the attention of the authorities." Then, investors should ask for their money back, but they should not try to negotiate with the suspected firm, as that can cause more trouble.

Investors often want to negotiate instead of report, too. If a fraud has occurred, the regulators have the right to order any investors that took a payout of profits to return them - a process known as claw-back - something that investors want to avoid. After all, it's bad enough to lose money on account, it's even worse to lose funds that were spent years ago. Morello says that a claw-back is an unfortunate reality - and a very bad reason not to file a report.

There's a new silver lining to filing a complaint, Huddleston says, that could lessen or even offset the effects of a claw-back. Endowments may be able to file claims under the whistleblower provisions of the Dodd-Frank Wall Street reform act, which became law in 2010. These allow anyone providing original information about violations of securities and commodities laws to receive up to 30 percent of any sanctions that exceed $1 million. "I'm really excited about that," Huddleston says.

It's good to know, because this story won't go away. Frauds are as old as human nature; careful fiduciary behavior can reduce the risk and limit the damage, but it can't prevent every scam lurking in the investment business. "The next Madoff is in the making right now," says Hagan.

Ann C. Logue is a Chicago-based freelance writer whose former career was in financial analysis.