by Charles Schwartz, Professor Emeritus,
University of California, Berkeley
firstname.lastname@example.org February 29, 2004
>> This series is available on the Internet
After the Lawsuit & The Case Against Wilshire Associates
With the end of the lawsuit,
we summarize the issues, the arguments, the outcome and ask how the Regents
will behave in the future. With the release of new documents we find a
mounting case against UC's investment advisor, Wilshire Associates; and
in one aspect it may amount to indictable offenses. In the next issue (Part
21) we will report how the new documents flesh out the story of Wilshire's
duplicity as UC's investment consultant over the past several years.
Summary of the Issues in the Lawsuit
The lawsuit, filed in Alameda County Superior Court last April, sought the release of various documents under the state's Public Records Act (PRA), relating to the UC Regents' investment activities. The plaintiffs were: Coalition of University Employees (CUE, UC's clerical workers' union), myself, and San Jose Mercury News; our lawyers were Karl Olson of San Francisco and Judy Alexander of Capitola, both experts on Public Records and Open Meetings law. The defendant, The Regents of the University of California, was represented by five lawyers from the Office of the General Counsel of the Regents, plus two lawyers from the firm of Howard Rice ... , of San Francisco.
After both sides had submitted a pile of papers, Judge James A. Richman held a hearing on June 24, 2003; and one month later he issued a 20-page decision that granted almost all our requests. UC's lawyers then asked, twice, that the judge reconsider his rulings, went twice to the Court of Appeal and twice to the state Supreme Court - all to no avail. Having lost, UC is obliged to pay all of our side's legal fees ($224,116.); I do not know how much their own legal costs were. My personal heroes in this adventure are the leaders of CUE, who had the courage to make the large financial commitment necessary at the outset.
I. One issue was the request that UC make public the performance data for each of its Private Equity investments; these are partnerships in Venture Capital funds and other types of private funds (not traded over public markets like ordinary stocks and bonds.) In the UC Treasurer's latest annual report, dated 6/30/03, one may read that the UC Retirement Plan had a total of $531 million (1.5% of the total portfolio) invested in Private Equities; and this asset class had given an annualized total return of 26.5% over the last ten years (far better than any other part of the portfolio); however, over the past one year the return on Private Equity was a negative 21.5% (far worse than any other part of the portfolio.) This is the aggregated performance data (called IRR = Internal Rate of Return) for all the investments in UC's Private Equity portfolio; we wanted the individual IRR data for each of the individual funds that comprise this portfolio.
We argued that this IRR information was already being released by many other public pension funds across the nation. Our lawyers had just recently won a court case challenging CalPERS, the nation's largest public pension fund, on exactly this issue. UC's lawyers argued against disclosing this information on a variety of legal grounds (trade secrets turned out to be their main argument, and that lost, too.) But the most publicized turn was the argument that if UC was forced by the courts to disclose this "sensitive" data from the private equity partnerships, they would likely be excluded from future participation in what had previously been a very profitable line of investments. This threat was not persuasive to any of the courts, despite the dramatic 11th hour announcement that one prominent venture capital firm (Sequoia Capital) was going to reject UC's participation in its latest fund. In October, after losing its Supreme Court appeal on this issue, UC obeyed the court's ruling and posted on the Treasurer's website a detailed list of its Private Equity investments, showing various informative data on their individual performance.
In November, our lawyer wrote to the regents offering to negotiate towards a reasonable resolution of this potential future controversy. We pointed out that the Private Equity firms' main objection was not so much to the public release of their IRR data as it was to the fear that future disclosure demands would invade the details of their "portfolio companies", that is the several start-up firms that each venture capital fund manages. We declared that we had no intention of demanding that deeper level of public disclosure and were open to assisting UC in defending that "line of demarkation." We also noted that there were other emerging areas of UC's involvement with private investment companies and a uniform policy on disclosure of investment performance should be developed to avoid future lawsuits. (See Proposal ) I am sorry to report that we have received no response whatsoever to this constructive offer.
II. The second issue we raised alleged that the Regents had violated the state's Open Meetings law by holding several important investment policy deliberations in secret. Specifically, we pointed to the meetings in January and March of 2000, when they considered, and finally adopted, the recommendations of the investment consulting firm, Wilshire Associates, to adopt new asset allocation policies and guidelines (which ended in the resignation of former UC Treasurer Patricia Small and the shift of 30% of UC's stockholdings to an externally managed index fund); and also to the meetings in October and November of 2002, when they fired the entire domestic equity investment staff and planned for the distribution of those billions of pension assets into the hands of external stock managers. This was the subject of many of my earlier papers in this series, where many questions have been raised about the legitimacy of those regental decisions. Let me reiterate that it is not the wisdom of those investment choices that I question, but rather the many indications that the Regents were being sold those choices on the basis of erroneous, if not fraudulent, analyses by their hired experts - Wilshire Associates and the new UC Treasurer, David Russ. [See forthcoming Part 21.]
In court, we argued that the law's exemption allowing closed meetings for "investment matters" was limited to consideration of specific investment choices and did not apply to broad issues of investment policy and strategy. We provided legislative history in support of this interpretation of the Open Meetings law; and the judge agreed with us. We asked that UC release the Minutes and tape records and other documents related to those particular closed meetings, in 2000 and in 2002. UC's lawyers argued against this on various grounds. One was that the meetings in question were properly closed because the policy changes being discussed would imply the sale of many large stockholdings, and if word of those plans were prematurely exposed, the market (or various market players) would be able to disadvantage UC in getting the best price for its trades. We produced evidence that this was a phony excuse, since the regents had publicly disclosed the results of their closed meetings and their intentions to make changes in their investment portfolio well before those transactions were implemented.
UC's lawyers also argued that even if those meetings had been improperly closed, the Minutes and tapes should not be released to the public, even after any transactions had been completed. This argument was also rejected by the court. Finally, they said that the Minutes and tapes from closed meetings contained "personnel" data, which should be protected from public disclosure; but the judge, after in camera study of the documents, overruled most of their redactions. Overall, the case law on Open Meetings and Public Records says that these statutes should be broadly interpreted in favor of openness and the exemptions should be narrowly construed, again favoring public disclosure. UC's lawyers failed in their repeated attempt to get the judge's rulings overturned in the Court of Appeal and in the California Supreme Court. Whether the Regents have learned anything from this experience that will change their behavior in the future is an open question. We see the possibility of returning to court if they continue their previous illegal excesses of secrecy.
Side Note. In
these legal proceedings, evidence and testimony are submitted to the court
in the form of Declarations, written and attested to by knowledgeable parties,
under guidance of the lawyers. UC Treasurer David Russ was the most prolific
declarer throughout this matter; and I have chosen a few of his more outrageous
statements for viewing in the separate file, "Russ'
Whoppers," which is posted on my website.
Wilshire Exposed in Recent Investment Industry Scandals
In the midst of recent public revelations about multiple scandals in the nation's mutual funds industry, there was a singular story that focused on Wilshire Associates, and this now has great relevance to their role as UC's investment consultant. It was reported in MONEY magazine, October 2003, that Wilshire engaged in a particular form of "fast-trading" activity, with the permission of a number of (unnamed) mutual funds, which netted enormous profits. Wilshire, according to the story, admitted this activity had gone on for a number of years but said that there was nothing illegal about it. Subsequent news stories report that this whole subject is under ongoing investigation by the S.E.C.
While many questions about Wilshire must wait for further information, one issue - the potential for conflict of interest - stands out as a red flag. Here is the key paragraph by writer Jason Zweig in Money magazine:
Wilshire would not respond to my inquiries in further detail, but disturbing questions remain. Was it a conflict of interest for fund companies - who knew that Wilshire might (or might not) recommend them when its clients searched for money managers - to let Wilshire yank $10 million a day in and out of their funds?
New documents, just released by UC in response to our lawyer's PRA request throw significant light on this issue. Relevant excerpts follow.
a) From a 9/25/03 letter by Stephen L. Nesbitt, Wilshire's Senior Managing Director, to David H. Russ, UC Treasurer:
The purpose of this letter is to provide you with additional perspective on an article that appeared on September 22, 2003 in the online version of Money Magazine. The article describes one of Wilshire's past investment management practices and is, in our opinion, spurious and rife with misleading suggestions and negative innuendo. In the following paragraphs, I will spell out facts that completely refute the implications of the article.
Management of Conflicts of Interest
A key question raised in the article is whether Wilshire's use of selected mutual funds in its index arbitrage business influenced its advice to institutions on the selection of investment managers. Wilshire has always managed diligently all potential conflicts of interest, and did so in this case through the use of a double "Chinese Wall". In short, there was, by design, a complete separation between the manager research/selection and the index arbitrage funds selection activities. Wilshire consultants had no knowledge of mutual funds used by the Assert Management Division for index arbitrage, and investment management personnel making mutual fund selections for index arbitrage had no knowledge of Wilshire's manager search activities for the firm's institutional clients. To share knowledge would be contrary to our firm's culture of maintaining a conflict-free environment. ...
It is instructive to note that Steve Nesbitt resigned from Wilshire Associates very recently and here is one news report (dated February 11, 2004):
HEADLINE:Nesbitt Leaves Wilshire Associates
BYLINE: Paul Barr, Managing Editor
SANTA MONICA, Calif. (HedgeWorld.com) - Stephen Nesbitt, senior managing director of Wilshire Associates Inc., left the pension consulting and investment management firm after declining a reduction in responsibilities, according to a Wilshire statement. ...
Wilshire's board decided to separate its funds management and consulting divisions, as well as the management of those divisions in light of the SEC's recent focus on consulting firms and in order to strengthen the ethical walls and eliminate the possible appearance of conflicts of interest, according to the statement from Wilshire.
Mr. Nesbitt couldn't be reached for comment. He will be replaced on the consulting side by Julia Bonafede, a senior managing director, and on the investment side by Michael J. Napoli, a managing director. ...
Thus, we learn that Nesbitt himself was in charge of the two divisions at Wilshire that his touted "double Chinese Wall" was supposed to keep incommunicado.
b) From a 10/31/03 letter by Dennis A. Tito, Wilshire's Chief Executive Officer, to Russ.
...Although we believe that both our former investment strategy and its implementation were lawful, we nevertheless initiated a comprehensive review of the investment strategy earlier this month. The law firm of Kirkpatrick & Lockhart (K&L), which has expertise in this area, is doing the review. ...
c) From a 10/15/03 letter by K&L to Tito.
...we can report to you that we have found no evidence to date indicating that there was, at any time, in connection with the investment strategy:
(1) any unlawful late trading ...;
(2) the use of any confidential client information ...; or
(3) any form of special treatment from any mutual fund sought or obtained by any Wilshire officer or employee. ...
d) From a 10/28/03 letter by K&L to Tito:
... our own continuing review of Wilshire books and records has to date not produced any evidence of unlawful market timing activities, breach of fiduciary duties owed to clients or unlawful preferential treatment by mutual funds ... [emphasis added]We note, first, that the qualifying word "unlawful" did not appear in the earlier letter from K&L, where they said that they had found no evidence of "any form of special treatment." This strongly suggests that something else (improper, but perhaps not unlawful) was uncovered by those lawyers in the interim.
We note, second,
that the 10/31 letter from Tito does not even contain the phrase conflict
of interest, although he did mention this briefly in an earlier letter
to Russ; and the two K&L letters mention this topic only once, in reporting
what some SEC staff had said about their investigations. In other words,
the denials about any potential for conflict of interest - given earlier
and with great emphasis by Nesbitt - have disappeared completely in later
letters from Tito and his lawyers.
In addition to Wilshire's fast-trading scheme, which the SEC is still looking into, a second area of investigation - targeted at several major investment consulting firms - was revealed in early January. This involves a variety of questionable payments from investment management companies to the consulting firms who are likely to recommend them (or not) to their big institutional clients. This is described as a "pay-to-play" arrangement; and readers may find further discussion of this at the website www.fi360.com/press/pdfs/paytoplay.pdf
Among the documents recently released by UC is one from Wilshire, titled "Client Statement - NYSE Settlement October 29, 2003", which explains a recent disciplinary action against the company. The following paragraph is especially interesting.
In fact, Wilshire is not a brokerage in the traditional sense. The firm has been a member of the NYSE since 1983, principally for the purpose of providing clients -- primarily those purchasing our software analytics products -- a means to pay for Wilshire services through brokerage commissions, also known in the industry as "directed brokerage" or "soft dollars."
Wilshire Violated Conflict of Interest Law
The basic standard of judgment in this area is based upon the phrases "potential conflict of interest" or "appearance of a conflict of interest"; and there seems no doubt that this threshold has been passed in the case of Wilshire's role as investment consultant to UC (and other public pension funds).
California has a strong set of laws on conflict of interest in its public institutions (Government Code Section 81000 et seq. and Section 87100 et seq.); these laws apply to the University of California; and they also apply to independent consultants to state agencies. The basic law is that no one may participate in the making of a governmental decision when he/she has a conflict of interest in the matter. Yet we find, according to plans approved by the UC Board of Regents, that Wilshire Associates is now performing a central role in the (secret) selection of individual investment managers who will receive significant portions of the UCRP funds. This conflict-ridden situation was pointed out in my paper, "What's Happening with the Pension Fund? -- Part 19," and in a followup letter sent to all regents, in which I sought to remind them of their fiduciary duties. No UC official has given any response whatsoever to these alarms.
Moreover, I have found two official documents, previously released in response to PRA requests, wherein Wilshire Associates formally attests that it knows of no potential conflict of interest in connection with providing consulting services to the University, and those services include likely recommendations regarding external investment managers. These appear to be concrete evidence of fraud, in concealment of illicit conduct, and lying about conflicts of interest.
I have written
to California's Attorney General about these matters and I wait for a response.
Anyone else who would like to see a thorough outside investigation is invited
to contact the AG and express their own views.
Where the Regents Sit Now
Early last fall, the UC Treasurer's Office issued a Request for Proposals (RFP) seeking outside investment managers for about $1 Billion to be handed out for Small Cap Domestic Equities (stocks). Wilshire Associates was given a key role in the selection process -- before it was publicly known about their compromised situation, discussed above. It would appear that the only right thing for the Regents to do is to stop that contaminated process, wait until all charges have been investigated and cleared up, before resuming the search for outside managers. I made this recommendation in Part 19, to no avail. Whatever questions of ethics or legality might be involved have been delegated to Treasurer Russ, with absolutely no policy guidance by the Regents. I believe this is a gross breach of their fiduciary responsibilities, and I have written them about this, and they remain silent.
On February 23, UC posted a new RFP, this one for external investment managers in the Large Cap Domestic Equities area, to receive a total of some $5.5 Billion in UC funds. Wilshire is still designated as playing a key role in the selection process. I was able to discern one slight change in the RFP requirements, from the first one to this second one. On page 16 of the Questionnaire, one finds a paragraph (#5) about potential conflicts of interest, which ends with the following instruction: "Also disclose any business relationship with Wilshire Associates and any financial remuneration paid to Wilshire (explain)." The second half of that sentence, starting with "and any ...", is not found in the earlier RFP. This change is clearly in response to the recent published stories about "pay-to-play" schemes. But I must wonder that nobody among the many experts on UC's staff or on its Board of Regents or Investment Advisory Committee had any inkling that such things went on and that UC should concern itself, before the SEC announced it was getting into the act.
contract to be the Regents' investment consultant expires at the end of
March. At their February 11 meeting, the Regents' Committee on Investments
approved the issuing of a new RFP. Formally, all qualified firms are invited
to submit proposals and be judged in some fair competition. It was noted,
however, that both Regents Parsky and Hopkinson, who have chaired the Committee
on Investments during recent years, took this occasion to express their
great appreciation of Wilshire and their admiration for Steve Nesbitt.
My own view is that a prudent Board would postpone any search for a new
consultant until the SEC investigations are concluded.