The Securities and Exchange Commission took a lot of heat from Congress last week over its failure to respond to numerous warnings that Bernard Madoff allegedly was running a giant Ponzi scheme. The failure reportedly cost investors, including some institutions, at least $50 billion.
Conflicts of interest appear to have played a role in the Madoff scandal, with those gatekeepers supposedly identifying and vetting Madoff's firm for investors being paid finders fees by him.
Perhaps as a result of continuing congressional pressure, the SEC will be more alert for fraud and conflicts of interest. One place it could improve its performance is in monitoring, identifying and taking action against abuses regarding conflicts of interest in investment management consulting. While the damage from Madoff's alleged scheme was great, the unseen damage from biased recommendations by consultants in the pension arena could be far greater because pension funds invest trillions of dollars.
Will the SEC step up to help fund executives make decisions on consultant objectivity by enforcing consultant disclosure standards? Or will it drag its collective feet, ignoring the problems of objectivity in consulting that have been evident for years, especially in soft-dollar or directed-commission arrangements.
The most recent case of apparent conflicts of interest pursued by the SEC provides little guidance on how seriously it will follow such cases.
In a case involving Merrill Lynch & Co.'s consulting unit, the SEC alleged clients weren't getting objective advice.
The Merrill Lynch unit was charged by the SEC on Jan. 30 with breaching its fiduciary duty by misleading pension fund clients about its manager selection process, and failing to disclose conflicts of interest. The allegations particularly involve a Merrill Lynch Florida office with almost 100 pension fund clients.
The consulting unit agreed to settle the charges by paying a $1 million penalty. The Merrill Lynch unit neither admitted nor denied any of the charges. (Bank of America Corp. acquired Merrill Lynch & Co. Jan. 1.)
The SEC allegations charged that from at least 2002 through 2005, the Merrill Lynch unit breached its fiduciary duty by failing to disclose “its investment adviser representative might have a financial incentive to recommend that its clients enter into a directed brokerage arrangement.”
Among examples cited in the SEC allegations, one client obligated to pay Merrill Lynch Consulting Services a $7,500 annual hard-dollar fee for its work instead paid by executing trades at Merrill Lynch, generating almost $175,000 for brokerage services, fees shared by MLCS and its investment adviser representatives.
While the SEC finally brought the allegations to the attention of the investment community, it has done far too little and too late to police and effectively enforce its rules about disclosure. These allegations go back at least seven years, and the $1 million penalty would not appear to make up for the possible hidden costs of the actions. The SEC complaint didn't quantify the losses to the pension funds.
Problems of non-disclosure in the consulting industry have been evident for years. In 2005, the SEC released its report critical of the lack of disclosure of conflicts of interest in financial arrangements by many consultants. A 2007 Government Accountability Office study attempted to quantify the cost of consultant non-disclosure abuse.
This is an area where the SEC should put more effort. By focusing on conflicts of interest, it might identify and head off other potential frauds and hence save pension funds and other investors from losing more billions of dollars.
