For Chesapeake and Dartmouth, are conflicts of interest really worth it?

Issues related to governance and conflicts of interest surprisingly continue to pop up in the news. Two recent notable examples include Chesapeake Energy Corp. and Dartmouth College.

The Chesapeake case had an alarming number of conflicts of interest in place, including the fact that the firm's CEO, Aubrey McClendon, co-owned and actively invested in a hedge fund which invested in commodities produced by his firm. But before getting too worked up, I'm sure any conflicts were appropriately managed by Chesapeake's board — wouldn't they be?

It was also reported that Mr. McClendon arranged for personal loans from investment firms that just so happened to be providing capital for investments in Chesapeake's subsidiaries. Once again, something the board likely had its eye on — didn't they?

Long story short, Mr. McClendon has been stripped of his responsibilities as chairman and four board members are being replaced. Situations such as the Chesapeake case are stark reminders of the severe consequences of not managing conflicts of interest. It teaches us two important lessons:

• Conflicts of interest travel in packs, they are like roaches. Where there is one, there are usually more, and they might not all be out in plain sight.


• If it doesn't seem right it probably isn't. Putting aside the legal technicalities of any violations, which the SEC and the IRS are now investigating in Chesapeake's case, common sense should say that if it doesn't smell right, it probably isn't ethical.

Conflict of interest charges also were made in the endowment world with the recent allegations of self-dealing by trustees and the investment committee of Dartmouth College. A letter from Dartmouth faculty, university employees and alumni sent to the New Hampshire attorney general alleges that trustees "enriched themselves" by diverting business to private equity and hedge fund firms with which they were affiliated.

On its surface, the concept of preventing conflicts of interest at university endowments would seem deceptively simple to implement — if members of the board or the investment committee have an interest in something, they should not use their positions as stewards of capital to otherwise benefit themselves or their friends — period. Unfortunately, it seems this is a lesson that continually needs to be relearned.

In dealing with conflicts of interest there are two general approaches. The first approach is a mechanical application of the letter of the law. Under this approach if the law is not violated, then there is no conflict. A second approach is to take a more conservative view and focus not on the letter of the law but the spirit of the law. That is to say, while allocating capital to an affiliated fund manager may not be a technical violation, even the perception of a conflict surrounding such an arrangement is not worth it.

In Dartmouth's case, it has been reported that the endowment went above the technical requirements of state law by putting the proposed affiliated investments through a "full due-diligence review," including peer analysis, before any approval.

When institutions include peer analysis comparisons in their due diligence reviews, there are a number of potential problems, including the following considerations:

• Different funds may be investing in different opportunity sets which do not facilitate an apples-to-apples comparison;
• Different fee structures may be in place across funds;
• How are more qualitative factors such as length of manager track record or quality of personnel compared?

With such subjectivity involved in peer comparison, it is easy to see how an endowment could be swayed to lean in the direction of investing in funds with ties to board members or investment committee members. Similarly, a series of less than cut-and-dried issues may come about as a result of the design of a manager due diligence process including:

• Is the due diligence process subject to input from or review of the affiliated board members or investment committee members?
• What about elements of discretion in the due diligence process - how does the board or investment committee ensure that at a minimum a consistent process is applied to all funds including affiliated ones?
• Does the due diligence review incorporate aspects other than investment-related concerns such as operational risk, which may encompass a deeper review of the compensation of affiliated members from fund management companies?

Fund manager due diligence and peer comparisons are well and good but by themselves they do not remove the potential for conflicts of interest. Endowment trustees and investment committee members should insist that any potential investments in affiliate funds should be subjected to enhanced independent scrutiny. Even better, keep it simple and avoid any such conflicts all together. It will keep the investment portfolio free of allegations, and your endowment out of the headlines.

Jason A. Scharfman is managing partner of Corgentum Consulting LLC, a Jersey City, N.J.-based operational due diligence consulting firm for the alternative investment industry.