Updated with correction
Nearly a decade after the Securities and Exchange Commission targeted investment consulting firms in a sweeping examination of their practices, compensation arrangements and disclosure, the landscape appears to be more transparent.
This is not to say, however, that there isn't room for improvement, or that there aren't those within the sector who think things have actually gotten worse.
“You may be the first phone call about pay-to-play I've received in about eight years,” said Donald B. Trone, founder and CEO of 3ethos, Mystic, Conn., a company that trains investment advisers on being responsible investment stewards. “So it's clearly not the same problem it was in the 1990s.”
In December 2003, the SEC sent letters to several consultants, informing them of a broad fact-finding review, trying to get to the bottom of several allegations of excessive fees and pay-to-play schemes in which recommendations by investment consultants of money managers and investment strategies are based on financial incentives rather than performance.
Following the SEC's investigation, a number of consulting firms (and institutional investors) faced serious scrutiny and litigation. In 2005, the city of San Diego filed suit against San Francisco-based Callan Associates, alleging Callan was negligent in advising the then-$4.6 billion San Diego City Employees' Retirement System. The two parties ultimately settled out of court the following year, with Callan agreeing to pay the pension fund $4.5 million. (At the time of the settlement, Callan spokeswoman Nancy Malinowski said the city acknowledged it “found no evidence that Callan engaged in pay-to-play or any other unfair business practices in connection with the hiring of money managers.”)
As a result of the SEC's inquiry, some consulting firms increased their level of transparency to clients. Julia K. Bonafede, president of the consulting unit of Wilshire Associates Inc., Santa Monica, Calif., e-mailed Pensions & Investments the following statement: “As a result of the SEC's review of industry practices, we further enhanced our disclosures to clients as well as our internal policies and procedures. To this day, we remain committed to those enhanced disclosure requirements.”
“Some firms exited the businesses that were questionable,” said Barry Dennis, co-founder, managing director and chairman of Strategic Investment Solutions, San Francisco, referring to such businesses as money manager-sponsored conferences and the selling of analytical data. “The others probably improved their disclosure.”
Although Mr. Dennis noted disclosure has improved within the consulting industry since the SEC letters, he said he believes the uptick in consultants getting involved in the outsourced CIO business in the past five years “creates a whole new set of conflicts of interest.”
"No smoking gun'
Stephen L. Nesbitt, CEO of the alternatives investment consultant Cliffwater LLC, Marina del Rey, Calif., said he didn't think pay-to-play schemes were rampant or pandemic among the industry back when the SEC began its probe. That said, he does think “a few things have changed as a result, even though there was no smoking gun.”
“Ultimately, the agency wanted to make sure consultants were acting independently, that they didn't not did not violate their fiduciary responsibility and that they weren't receiving a benefit for recommending a specific manager,” he said.
Mr. Nesbitt did note that he no longer sees one questionable practice from a decade ago — that of consulting firms setting up educational institutes and taking money from managers who want to be part of these institutes. At the time, there was some worry that money managers participating in the institutes were getting preferential treatment from the sponsoring consulting firm.
The SEC also was worried about consultants being paid in soft dollars — a practice Mr. Nesbitt said he hardly sees anymore these days. According to P&I's 2004 consultants survey, 13 firms reported getting paid (at least partially) in soft dollars; in the current survey, four firms reported receiving soft-dollar compensation.
Some consultants who work with 401(k) plans, however, are not as optimistic about investment consulting firms being more transparent. Richard D. Glass, president of Investment Horizons Inc., a Pittsburg-based firm that develops communications materials for defined contribution plans, Pittsburgh, said he believes the SEC's actions in 2004 were purely “saber rattling.”
“The consulting business is the same thing it was 10 years ago,” Mr. Glass added. “People are trying to sell a lot of fluff without much value.”
Meanwhile, Mr. Trone of 3ethos believes the investment consulting environment “has been hugely improved,” with pension funds far less vulnerable to pay-to-play schemes and consulting firms more transparent about their practices.
However, he thinks that's less due to the SEC's involvement than other factors.
“The Department of Labor was interested in pay-to-play at least eight years ahead of the SEC,” said Mr. Trone, pointing out that in 1996 the ERISA Advisory Council (of which he was a member from May 2003 to May 2004) was advising the Labor secretary that the DOL should be looking into such schemes.
Another factor that Mr. Trone believes has helped mitigate pay-to-play is fee disclosure regulations for defined contribution plans. With that regulation, service providers are required to notify plan sponsors about fees and expenses associated with a plan, including compensation.
Although some question what value consultants bring to institutional investors (P&I, Sept. 30), and a number of industry executives think the danger of pay-to-play schemes will never be eliminated, many believe investors' vulnerability to such schemes has been mitigated substantially thanks to consultants being more transparent about their business practices and revenue sources.
“Consulting firms are very careful about transparency. If there is any relationship with an asset manager, everything is fully disclosed,” said Mr. Nesbitt. “I've seen a couple changes, but in my thinking it wasn't a major problem nine, 10 years ago.”
Andrew J. Bowden, director of the SEC's Office of Compliance Inspections and Examinations, declined to comment.
This article originally appeared in the November 25, 2013 print issue as, "Industry seeing greater transparency".