Gerard Quirke looks at some of the issues investment trust boards should be addressing as the level of scrutiny of corporate governance increases.

When former RBS chairman Sir Tom McKillop told MPs that his bank had dealt in instruments he did not understand, it sounded like another ‘Ratner moment’. However, in 1991, when Gerald Ratner told the world that his firm’s products were ‘total crap’, those words consigned a successful high street name to the waste bin.

In the case of RBS, by the time McKillop made his comment, the damage had already been done. The admission has shocked many people and has now been seized upon as the reason for the failures of RBS. In reality, had he made the comment when the bank was at the top of its game and a stock market darling, the reaction might have been very different. Along the lines of ‘He’s a busy man; he must have loads of clever people worrying about that sort of thing.’

The benefits of hindsight
The problem for all company directors is that the world gets to judge with the benefit of 20/20 hindsight, and commentators are keen to seize on ‘the reason’ and even keener to find someone to blame. As a consequence, it is more important than ever for directors, especially in financial services, to do the right thing, but also to be seen to be doing it. As we lurch from one scandal to another, it is crucial that boards seek to eliminate conflicts wherever possible and to maximise the level of independent scrutiny applied to the businesses for which they are responsible.

In many ways, the investment management industry seems to be ahead of the game. Fund trustees all but duplicate the work of the administrator to root out pricing errors and rule breaches. Investment trusts have led the way with independent boards, which can be the scourge of errant fund managers, and the increased use of outsourced administration provides further third-party scrutiny.

Nonetheless, now is clearly the time for boards to re-examine their relationships with service providers. Administrators, in particular, must be chosen because of the quality of service they offer, not because they are a low-cost part of a broader service offering. As the hedge fund industry grew, the prime brokerage model was the norm. Fund managers received a broad range of services from one provider.

While this was clearly convenient, it could be argued that it did not offer the range of checks and balances that was really necessary. The industry is now rightly questioning whether this bundling of services is appropriate. Boards would be well advised to ensure that they understand the ‘value chain’ of the services they receive, and that they choose the best independent provider for each.

Independent administration
Union Bancaire Privée (UBP) has taken a particular stance on this which has implications for many fund businesses. It recently stated that it would not buy any fund product that was ‘self-administered’. This is the clearest expression yet of the belief that an independent check on the daily activities of a fund manager is a source of considerable comfort for investors.

Unfortunately, the act of outsourcing to an independent administrator will not be enough on its own. Boards must also satisfy themselves about the key components of the service being offered, and the more complex the fund, the more involved that must be.

The watchword in the industry for the past decade has been risk, but the sub-prime crisis and ‘Madoff’ shows that there are many who have just paid lip service to this issue. Boards have no choice but to ensure that their business has been dissected to identify where things can go wrong and the cost if they do.

I actually sympathise with Tom McKillop when he says that he did not understand the intricacies of every product his company had developed. In truth, that is not his job. The more interesting question is whether the board had ensured that there were processes and policies for identifying, quantifying and reporting these risks.

A question of priorities
In an investment fund, it is relatively easy to identify these risks and the board should focus its attention on the key ones. If the fund is a FTSE index tracker, directors can take comfort if an independent administrator is valuing every instrument daily. If it is a fund that is invested in complex derivatives, the board has to work a little harder. At Phoenix, we seek to be involved in a company’s own pricing committee to ensure that there are clear methodologies and standard practices for the valuation of complex instruments.

Where subjectivity is involved, a range of prices might ‘seem reasonable’. There is no substitute for a standard that is agreed in advance for the pricing of each complex instrument. Any dispute over valuation then has a basis in objectivity and the board or audit committee simply has to ensure that there is a mechanism for making it aware of any issues.

The subject of conflicts is also critical to the argument. The collapse of Arthur Andersen offers the best example. A so-called independent auditor could not bring itself to pick a fight with the board of Enron because of the fees it was receiving for advising on, and setting up, the entities that were the root of the company’s maladministration. Again it is incumbent on the board to examine its relationships and ensure that where it thinks it is getting independent verification, it really is.

When administration is offered as part of a much broader range of services, it may be harder for the board to view the function as truly independent. When there is a broader relationship at stake, the voice of a concerned administrator may not be heard. At the very least, in a world where we are judged with 20/20 hindsight, if something does go wrong it may be seized upon as the source of the problem. If you are in any doubt about this, just ask Tom McKillop.

Defining the services
At Phoenix, we approach the issue of conflict in the most straightforward way. Unlike many of our competitors, we are not offering administration services as a route to attract other business. Administration is the core service. We still help our clients to source the best custody, foreign exchange, stock lending and financing solutions available, but Phoenix receives no incentives to recommend a particular provider. The only challenge with this approach is that it means that the core service has to be outstanding in its own right. We are comfortable that we rise to this challenge and watch with interest how many other providers will follow this route.

It is a little trite, given the events of recent months, to say that the challenges facing boards are greater than ever. The media spotlight on investment professionals is
more glaring now than ever before, and the regulator is certain to be on its guard to an even greater extent. However, it is not feasible to expect a board to understand the intricacies of every activity. Its role is to set the agenda, ensuring maximum practical independent scrutiny of investment activities, as few conflicts as possible and appropriate methods for concerns to be raised.

Those methods did not seem to exist at HBOS, where the group risk officer, Paul Moore, claims he was sacked for raising issues with James Crosby, his CEO. A well-run board will ensure that employees have several means of raising issues without fear of reprisal from autocratic management. Clear service level agreements and reporting from your independent administrator will also ensure that issues are reported to the appropriate level of the organisation.

Now is unlikely to be the time for firms to be aggressive in the search for new products to launch or new people to hire. But it is a great time to sort out some of those other issues that had previously never reached the top of the priority list. Businesses that come through the turmoil we are currently experiencing will already have proved something. If they can also take the opportunity to ensure that they have addressed any issues in their support services then they will be extremely well positioned for when the market turns and the good times start to roll again.

Finally, you will probably want to know when that upturn will begin. Let me see – I’m sure I wrote it down somewhere!

Gerard Quirke is director of Phoenix Fund Services