Scissors and Glue...Cut and Paste
In recent posts, we have touched on the "neverending staircase" where responsibility for the valuation process is passed in a perpetual and unresolved circle between fund, administrator, manager and directors. We have also reviewed the recent AIMA guidance on fund administration, which suggests that "best practice" now involves less, not more administrator oversight over pricing - at least compared to AIMA's earlier admin guidance, first published in 2004.
It is against this background that we consider the FSA's recently published judgment against Simon Treacher, previously a senior portfolio manager at BlueBay, the well known (and publicly traded) alternative asset manager based in London.
Treacher was the manager of the BlueBay Emerging Market Total Return Fund (EMTRF). According to the FSA:
"The third party administrators of the funds managed by Bluebay, including EMTRF and MSF, price the funds for month end valuation. Bluebay would assist with this process, particularly for hard to value securities and these valuations were ordinarily supported by third party evidence, such as broker quotes via email or Bloomberg messages and screenprints.
As a result of a perceived discrepancy with third party evidence provided for the September 2008 month end, Bluebay began an internal investigation in November 2008....
Mr Treacher mis-marked positions in EMTRF and MSF by altering seven documents used in support of the month end valuation for specific assets. He altered the documents by printing legitimate broker quotes valuing the assets, carefully cutting out and pasting different figures onto the relevant valuation line, copying the altered document, and then submitting the altered copied version as the original quote. All the alterations justified a more advantageous price for the assets i.e. higher where the funds were long, and lower where the funds were short."
In terms of outcome, BlueBay, as a deeply resourced money manager, was able to make investors immediately whole, paying some $650,000 to compensate for the net impact of the mismarking (in gross terms, the NAV impact of Treacher's inflated prices, per the FSA, peaked at more than $11 million). Clearly, investors could take thankful comfort that the rogue individual was employed by a manager with the resources and ethics to provide immediate restitution.
However, while the BlueBay case ended without investor loss, the principle it exposes goes to the heart of a critical weakness in current administrator procedures. It is clear from the FSA's narrative that, in this case, the EMTRF's fund administrator priced easy to value positions - where prices are hard if not impossible to fake - but accepted pricing support provided by the Manager for hard to value securities. We hate to say it, but there is not much point guarding the hen coop if you spend all your time looking at the well built fence but don't watch who is coming in and out of the open gate.
As we mentioned in our neverending staircase post, the administrators believe they have washed their hands of this problem by inserting disclaimer language in their admin agreements and PPM disclosures:
Typically, the PPM will state that the administrator is "entitled to rely upon (and shall not be responsible for the accuracy of) financial data provided to them by prime broker, third party pricing services or the investment manager. Moreover, the administrator will state that if the Board or the Investment Manager is involved in the pricing of any of the Fund's securities, the Administrator may accept such prices without any further liability."
Our concern here is very simple. Imagine a situation where a major fund has a 20% NAV drawdown because a portfolio manager has faked pricing support with Adobe Photoshop, and then provided those pricing documents to his firm's back office and onwards to the administrator. The PM deflects any questioning as to the validity of prices by shouting that the back office - and especially the administrator - does not have the "expertise" to price the securities (we have yet to meet a PM who was not supremely confident that their marks were right - especially if they know that they were wrong.) The administrator, relying on the above clause in their admin agreement, makes no attempt to verify the Manager's prices to third party, independent pricing sources.
Mr. Treacher raises the unpleasant possibility that the above scenario is, conceptually at least, a real risk for hedge fund investors. If this could happen at one of the industry's premier, publicly traded asset managers, it could certainly happen at a smaller shop.
What really concerns us, though, is not the financial loss from a single fund with mispriced securities, even if the loss could potentially be very large. The issue is the icy chill to broader investor confidence if all the administrator could say, in the aftermath of a pricing fraud, was that "it was not our responsibility to verify prices under the terms of our administration agreement." Has anyone stopped to think what would happen then?
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