ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds Avoiding the Pitfalls of Alternative Investments for Institutional Investors and Fund Managers

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TUESDAY, MAY 30, 2012

Presenting a live 90-minute webinar with interactive Q&A

Susan Mangiero, Managing Director, FTI Consulting, New York

Alexandra Poe, Partner, Reed Smith, New York

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ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds

May 30, 2012

Dr. Susan Mangiero, Managing Director, FTI Consulting Alexandra Poe, Partner, Global Private Funds Practice, Reed Smith

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AGENDA I. Why Now?: Contextual Drivers for this Seminar

II. How Fiduciary Duty is Implicated in Allocating to Alternative Assets

III. Lessons Learned from Recent Litigation

IV. Potential Consequences of Non-Compliance with New Rules

V. What Plan Fiduciaries and Asset Managers Can Do

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I. Why Now? Contextual Drivers for this Seminar Global Alternatives Survey and Pensions &

Investments’ Annual Survey notes pension funds are increasing their allocation to alternatives

After crisis, many pension plans are underfunded or have identified some asset/liability mismatch

Many pension plans experienced negative surprises on risks, especially liquidity risk, during crises

Best practices/recommendations from GAO study and others suggest a path forward for plan fiduciaries if they are willing to do the hard work

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II. How Fiduciary Duty is Implicated in Allocations to Alternative Investments Fiduciary Duty is comprised of the duty of care and

the duty of loyalty

Care: A heightened standard for ERISA fiduciaries to exercise care reasonably expected of a prudent expert

Loyalty: A duty to act in the plan’s (or client’s) best interest and to avoid self-interested conduct with higher standard in many cases set by prohibited transaction rules

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II. How Fiduciary Duty is Implicated in Allocations to Alternative Investments How Do You Fulfill These Duties?

“Right Conduct”

Record of “Right Conduct”

Careful selection and oversight of any delegates, including investment advisers, pension consultants, banks and funds of funds

Rigorous assessment of fees, risk management, valuation, trading policies, leverage, key person risk, internal controls and continuity/succession preparations, etc.

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II. How Fiduciary Duty is Implicated in Allocations to Alternative Investments “Right Conduct” Examples

Due diligence

Analyze party-in-interest relationships

Negotiate degree of transparency and accountability

Assess soundness of valuation and operations

Assure compliance with plan documents

Monitor investment and adviser

Have a “sell discipline”

Verify proper treatment of conflicts and prohibitions

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III. Lessons Learned from Recent Litigation Hennessee (Bayou) Investor alleged Hennessee, the consultant who led

them to Bayou, violated federal securities laws and breached its fiduciary duty by recommending hedge funds that were operated as fraudulent Ponzi scheme.

The Hennessee Investor Presentation outlined its minimum requirements, Five Level due diligence process, and ongoing monitoring and reporting services.

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III. Lessons Learned from Recent Litigation Hennessee (Bayou) (cont’d) In order to hide losses, in 1998, Bayou fired its hedge fund

auditor, Hertz Herson & Co. (“HHCO”) and replaced it with “a fake, but purportedly independent, accounting firm, Richmond, Fairfield & Associates (“Richmond-Fairfield”).” (Id.)

Even though HHCO stopped auditing Bayou in 1998 and never audited any of the Bayou Family Funds established in 2003, Hennessee Group represented to Plaintiff in February 2003 that Bayou Accredited was audited by HHCO.

Hennessee sent monitoring reports to Plaintiff for 2+ years. Just before the Bayou fraud was discovered, Hennessee reported to Plaintiff that its $1.15 million investment had appreciated to approximately $1.5 million.

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III. Lessons Learned from Recent Litigation

Hennessee (Bayou) (cont’d) Required state of mind for establishing securities fraud claim is

intent to deceive, manipulate, or defraud, or reckless conduct.

Conclusory allegations that defendant knew or was reckless in not knowing true facts will not satisfy. “Even an egregious failure to gather information will not establish 10b-5 liability as long as the defendants did not deliberately shut their eyes to the facts.”

Breach of fiduciary duty claims were preempted by New York’s Martin Act. Recent changes have created greater room for private right of action.

No private right of action under the Advisers Act.

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III. Lessons Learned from Recent Litigation Amaranth A single trader was making large natural gas trades, prices

moved against the fund and they were unable to raise cash by selling enough of their positions.

Risk management oversight did not prevent an undue concentration of trades nor did it correctly point to the problems that could arise under dire price conditions.

Policies related to discretionary trading were violated. Yellow flag: the energy trader was located in Canada, when

the rest of Amaranth’s operations were located in Connecticut.

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III. Lessons Learned from Recent Litigation Franklin v. First Union Former participants in Signet Bank’s 401(k) plan, which was merged

into First Union’s plan upon acquisition, filed class action.

Claims included breach of fiduciary duty because First Union replaced investment options including non-Signet funds with access solely to First Union’s affiliated funds.

Case was settled without any judicial ruling on this fiduciary claim.

While final judgment may have favored plan sponsor’s discretion to amend and merge the Signet plan in this fashion, it highlights continued exposure of plan fiduciaries in making such determinations.

$26 million settlement, of which $10 million benefited former Signet employees and $16 million benefited First Union’s own participants.

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III. Lessons Learned from Recent Litigation Mehling v. New York Life In March 2008, NY Life agreed to a $14M settlement

of an ERISA class action lawsuit • Suit alleged NY Life and other fiduciaries of

NY Life-sponsored pension and 401(k) plans violated ERISA • Improperly investing NY Life pension/401(k) plan

assets into NY Life investment funds in order to build NY Life product lines and boost NY Life profits — to the detriment of plan participants

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III. Lessons Learned from Recent Litigation Mehling v. New York Life (cont’d) NY Life created the MainStay Funds in 1990

Over $400M in pension and 401(k) plan assets transferred into the MainStay Funds in the 1990s

Plan participants sued alleging transfers violated ERISA • Fiduciary breach – failure to adequately determine

investments were prudent • Fiduciary self-dealing – transfers done in an attempt

to grow MainStay Funds • Fiduciary conflict of interest – transfers with NY Life on

both sides of the transaction

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III. Lessons Learned from Recent Litigation Mehling v. New York Life (cont’d) ERISA requires plan fiduciaries discharge duties

prudently and for the sole benefit of participants

ERISA prohibits transactions involving fiduciary conflict of interest and self-dealing • Dealing with plan assets in its own interest or for its

own account • Receiving consideration from a party dealing with the

plan relating to a transaction involving plan assets • Acting on both sides of a transaction involving the plan

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III. Lessons Learned from Recent Litigation Mehling v. New York Life (cont’d) NY Life argued no ERISA fiduciary breach or

prohibited transactions • MainStay Funds were prudently selected under ERISA • Investing plan assets in MainStay Funds were exempt

from ERISA’s prohibition transaction rules • PTE 77-3 permits investment of plan assets in a plan

sponsor's mutual funds, if the plan does not: • pay investment management, advisory or similar fee

(although fund may pay those fees); • pay redemption fees other than to the fund; • pay sales commissions; and • have dealings with the funds on terms less favorable

than other shareholders.

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IV. Potential Consequences of Non-Compliance with New Fee Rules

Overview of New Fee Disclosure Rules ERISA § 408(b)(2) requires a contract or an

arrangement between plan and party in interest be: • “Reasonable” • Necessary for establishment or operation of plan • For no more than “reasonable compensation”

“Party in interest” includes plan service providers

“Reasonableness” determination made by plan fiduciaries selecting service providers

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IV. Potential Consequences of Non-Compliance with New Fee Rules Overview of New Fee Disclosure Rules

(cont’d) New ERISA § 408(b)(2) regulation

• Requires advance disclosure of certain types of information regarding conflicts of interest and service provider’s fees — to determine “reasonableness” • Applies to “covered plans”

• ERISA-governed pension plans (DC & DB plans) • Govt’l plans, Keoghs, IRAs & SEPs excluded

• Limited to “covered service providers,” including • Fiduciaries under ERISA or Investment Advisers

Act of 1940

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IV. Potential Consequences of Non-Compliance with New Fee Rules Overview of New Fee Disclosure Rules (cont’d) Required Disclosures under contract/arrangement

• Services - describe services to be provided • Status - state whether providing services as a

(a) fiduciary directly to a plan, (b) fiduciary to a plan asset entity, or (c) registered investment adviser

• Compensation - describe direct & indirect compensation • Direct - received directly from covered plan • Indirect - received from other than plan or plan sponsor

• identify services and payer, and describe arrangement pursuant to which the indirect compensation is paid

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IV. Potential Consequences of Non-Compliance With New Rules Penalties for Non-Compliance Prohibited transaction under ERISA if covered

service provider fails to make required disclosure • Plan fiduciary must report service provider to DOL in

order for fiduciary to avoid prohibited transaction liability

No violation if service provider makes good faith error or omission, if correct information is disclosed as soon as possible, but no later than 30 days from discovery

Prohibited transaction liability for service provider • Return compensation received under contract to plan • 15% excise tax on amount of compensation

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V. What Plan Fiduciaries and Asset Managers Can Do Policies and Procedures

Maintain written polices and procedures

Clear but not so detailed as to constrain exercise of judgment

Recordkeeping – a good defensive habit

Make sure that persons who are authorized to change policies and procedures are not being enriched by doing so

Keep a separation between trading actions and cash management

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Due Diligence

More than a checklist

Understand underlying reasons for items on checklist

Procedure for yellow/red flag follow up

Hire outside experts with the ability to kick the tires on pricing models, review vendor contracts, ensure that internal controls are in place, monitor quality and quantity of collateral related to derivatives trading and structured finance investments

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Ask to meet with the Chief Risk Officer to better

understand whether that person is truly managing risks

Review financial statements to assess whether they reflect expected returns for a given strategy and whether they comport with industry best practices for reporting

Ask about the existence of side pockets, side letters, restrictions on liquidating assets, ownership of voting rights as relates to the fund’s ability to restructure if needed

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V. What Plan Fiduciaries and Asset Managers Can Do Conflicts of Interest

Prepare and update a party-in-interest schedule with each investment

Communicate to the asset manager and other service providers

Make sure they know the rules about dealing with parties-in-interest

Consult counsel when in doubt

Document utilization of conflicts process

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) New Asset Classes

As with any new development, consider how adding new asset classes will affect compliance policies and procedures as well as the expected risk-return tradeoff of the pension plan portfolio or 401(k) investment menu

Consider an independent risk consultant to validate your risk/reward analysis and asset allocation mix

Monitor whether new allocation meets expectations of how it was meant to behave in your overall portfolio and whether it is prudent

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Pension Consultants

Understand the scope of services/limitations

Monitor execution of what was promised

Ask about how the pension consultant is compensated for his or her recommendation of a particular fund

Inquire as to whether the pension consultant is assessing operational risk and the use of leverage

Ask whether the consultant is planning to act as a fiduciary to the ERISA plan(s)

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Asset-Liability Analysis

Somewhat maligned term returns

Know your plan goals and demographics

Communicate your goals to the asset manager

Consider managers who understand asset-liability approach

Identify prohibited transactions and other problem area and ask whether the fund manager is a QPAM or INHAM

Ask whether the fund manager is using equity derivatives to effect ownership

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Affiliated Funds

Get counsel if plan is to invest in funds managed by the plan sponsor or its affiliates

Creates enhanced focus on fiduciary duty of care

Ask whether a fund is or intends to be a VCOC or similar exempted entity for fiduciary purposes

Ask about cross-ownership and who has the authority to make critical decisions – Is the same person overseeing himself or herself?

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Gifts and Entertainment

Create a policy that comports with Form 5500 reporting that specifies acceptable gifts

Communicate your limits and expectations to managers and other service providers

Communicate expectation to notify if any plan representatives seek out inappropriate gifts and entertainment

Public plans: Check local law. Consider fiduciary policies that go beyond statutory requirements that fall short of protecting plan.

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Plan Administrators

Know your administrator’s sources or revenue

Is your administrator getting fees or reimbursement from funds on its platform

Ask if the plan administrator has established processes to evaluate the fair market value of “hard to value” assets owned by the ERISA plan(s) or offered to defined contribution plan participants

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Negotiation of Terms

Large commitments with long horizons can often negotiate better terms

Ask what others have obtained – managers may have undertaken to provide similar terms upon request

Key Items: liquidity, reporting, pricing, notice

Inquire about traders’ latitude to drift away from a publicized investment strategy

Ask about the use of derivatives and whether hedging will be done

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Valuation

Understand manager’s valuation practices

Distinguish between market valued portfolios and assets that mostly require fair valuation

Request reports of manager’s evaluations of its valuation process (if the manager doesn’t evaluate the efficacy of its valuation process, that’s a red flag)

If you don’t have internal resources to assess the adequacy, consider hiring an expert who has the training and experience to independently value “hard to value” assets

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Compliance with Plan Documents

Create an investment policy statement that is specific to alternative investments

Make sure that investment committee members understand how alternative investment fund structures can differ from other types of investments

Decide the basis on which allocations to alternatives will be determined and modified over time as needed

Regularly audit compliance with established policies and procedures

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) QPAM/INHAM Audits

Ask to review communication with the U.S. Department of Labor regarding the nature of the exemptions

Ask to see the results of an audit to assess the existence of and compliance with a QPAM/INHAM audit

Ask for an identification of all parties in interest and the extent to which each party has a controlling influence over the outcome of the ERISA plan(s)’s financial health

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V. What Plan Fiduciaries and Asset Managers Can Do (cont’d) Recordkeeping

Think “defense”

Good habit to keep policies on track

Make sure that adequate technology resources are in place to track compliance with policies and procedures, measurement of risk/return for various alternative funds vis-à-vis peer products and the strategic asset allocation targets

Make sure that internal and external auditors, plan counsel and other advisors are part of the review of records on a regular basis

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Alexandra (Sandra) Poe, Partner Sandra is a leader of the private fund formation and counseling practice in the firm's Business & Finance department. Sandra has over 25 years experience in investment management practice counseling managers of hedge funds, private equity funds, institutional accounts, mutual funds and broker-dealer advised programs.

Sandra counsels hedge and private equity fund advisers in all stages of their business, including fund formation, structuring the manager and its affiliates, adviser registration, compliance program development, compliance training and advice, placement arrangements, marketing, client relations, side letter and seeding arrangements, the creation and implementation of liquidity crunch strategies, and day to day trading and operations advice. Sandra has also designed and supervised international law surveys, created vehicles for investment in non-traditional assets such as ships and trade receivables, and advised regarding establishment and restructuring of managed account platforms.

Other representations include advice in connection with investment adviser acquisitions, implementation of compliance following prosecutorial settlement agreements, registered fund governance matters and hedge fund due diligence.

Prior Experience

Sandra has significant prior experience working in-house with a wide variety of asset managers. Sandra was General Counsel at Schroder Capital Management (U.S.) and served as President of the Schroder family of mutual funds and chief legal officer for the Schroders hedge funds and U.S. venture capital businesses. She also served as Assistant General Counsel at U.S. Trust, and Chief Legal Officer for the Excelsior mutual and alternative investment funds, where she advised the initial adoption of fund compliance programs, the implementation of responses to market timing investigations, and the response to fiduciary and auditor independence issues of considerable significance. Finally, Sandra also served as Chief Legal Officer for Managed Accounts and Alternative Investment Strategies at Prudential Financial and as Vice President and investment company counsel for Citibank Global Asset Management.

Education New York University School of Law, 1985, J.D. Cornell University, 1981, B.S.

599 Lexington Avenue 22nd Floor New York, NY 10022 +1.212.549.0388 (Direct Dial) +1 212 521 5450 (Fax)

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Susan Mangiero, PhD, CFA, FRM On January 9, 2012, Dr. Susan Mangiero joined the Forensic and Litigation Consulting Practice as a Managing Director in the New York office. Susan is a CFA charterholder and a certified Financial Risk Manager who will be assisting FTI in further developing investment and financial management dispute related opportunities. She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offering expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, performance, risk and valuation matters. She has over twenty years of experience in capital markets, global treasury, asset-liability management, portfolio management, economic and investment analysis, derivatives, financial risk control and valuation, including work on trading desks for several global banks, in the areas of fixed income, foreign exchange, interest rate and currency swaps, futures and options.

Susan has provided insights about asset allocation, fiduciary duties, risk management, modeling, hedge effectiveness and valuation best practices for consulting clients and employers that include General Electric, PricewaterhouseCoopers, Mesirow Financial, Bankers Trust, Bank of America, Chilean pension regulator, World Bank, Pension Benefit Guaranty Corporation, RiskMetrics, U.S. Department of Labor, Northern Trust Company and the U.S. Securities and Exchange Commission. Susan is the author of Risk Management for Pensions, Endowments and Foundations (John Wiley & Sons, 2005), a primer on risk and valuation issues, with an emphasis on fiduciary responsibility and best practices. Her articles have appeared in Expert Alert (American Bar Association, Section of Litigation), Hedge Fund Review, Investment Lawyer, Valuation Strategies, RISK, Financial Services Review, Journal of Indexes, Family Foundation Advisor, Bankers Magazine, Expert Evidence Report and the Journal of Compensation and Benefits. Her article on CFO liability as relates to pension issues in bankruptcy, M&A and underfunding situations is due out shortly in the Journal of Corporate Treasury Management.

Susan has written chapters for several books, including the Litigation Services Handbook and The Handbook of Interest Rate Risk Management. She is a frequently invited speaker and has keynoted or led workshops for organizations such as the Stable Value Investment Association, Harvard Law School, Florida Public Pension Trustees Association, New York State Department of Insurance, Association of Public Pension Auditors, AICPA - Employee Benefits Section, National Association of Corporate Directors and Financial Executives International.

Education University of Connecticut, PhD - Finance

New York University, MBA - Finance

George Washington University, MA - Finance

Practice Forensic & Litigation Consulting

Certifications CFA Charterholder

Certified Financial Risk Manager

Professional Affiliations American Bar Association

American Society of Appraisers

Association for Financial Professionals

CFA Institute

High Water Women Foundation

New York Hedge Fund Roundtable

Managing Director Forensic & Litigation Consulting 3 Times Square 14th Floor New York, NY 10036 Tel: 646 453 1241 Fax: 212 841 9350 Susan.Mangiero@fticonsulting.com

ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds

May 30, 2012

Dr. Susan Mangiero, Managing Director, FTI Consulting Alexandra Poe, Partner, Global Private Funds Practice, Reed Smith