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News September 18, 2006 Issue

A Tale of ERISA Woe From Former Advisory Firm President

Q: What do you get when you mix a newly-minted MBA, an advisory firm where 75 percent of the firmís clients are Taft-Hartley plans, and virtually no ERISA-specific knowledge or training?

A: The largest pension fraud in U.S. history.

Thatís how Senator Michael Enzi (R-WY), chair of the Senate Health, Education, Labor, and Pensions committee, described the tale of Capital Consultants at a hearing last summer. At its peak, the now-defunct Portland, Oregon adviser had over $1 billion under management, which it invested in privately-originating loans and investments.

In 1998, one of the firmís borrowers defaulted. Instead of disclosing the loss to its advisory clients and devaluing the loan, the firm allegedly kept the value of the loan steady and attempted to engage in a "work-out" of the loan. To the DOL and SEC, that "work-out" looked suspiciously like a ponzi scheme. In 2000, the regulators brought enforcement actions, shut down the firm, and placed the firmís assets in receivership.

Last summer, Barclay Grayson, the firmís former advisory president, testified before the Senate HELP committee in an effort to explain why things went wrong. Grayson, who received his MBA in 1996, was appointed president of the advisory firm just three years later by the firmís founder, who happened to be his dad.

His testimony is quite interesting.

First, Grayson explained, he did not understand ERISA. He noted that in connection with obtaining his Series 7 and Series 63 licenses, he received extensive education and training about the securities laws. However, there was "little, if any, mention of there being any separate laws or requirements associated with the management and administration of ERISA-related funds."

And, despite the fact that most of his firmís clients were Taft-Hartley plans, he did not receive any on-the-job training about the laws pertaining to the management of ERISA money. "I absolutely do not believe that I had adequate knowledge or training about ERISA requirements . . . relating to fiduciary responsibilities associated with the management of ERISA-regulated funds." And, he added, "few salesmen and management personnel in the registered investment advisory community have the legal training or knowledge required to properly manage and invest ERISA-regulated funds."

Grayson pointed out that common sense does not always suffice when managing ERISA money. Most advisers, he noted, tend to follow a general rule of acting prudently. "However, being a prudent fiduciary is in many cases not enough when it comes to managing ERISA-regulated funds, as some behavior that would normally be acceptable is prohibited." For example, he noted that in the investment management industry, as in most other industries, entertaining prospective clients is a common practice. Under ERISA, however, an adviser is generally prohibited from providing an ERISA trustee with anything of value. Specifically, Section 406(b)(3) flatly prohibits plan fiduciaries (such as plan trustees) from receiving any consideration for their own personal account from any party dealing with such plan (such as the planís investment manager) in connection with a transaction involving the assets of the plan. Thereís no de minimis, so theoretically, even a cup of coffee is prohibited. (However, weíre told, DOL has long exercised a rule of reasonableness in this regard.)

Grayson testified that prior to being placed in recievership, his firm had attempted to clarify whether entertainment of trustees overseeing ERISA funds was prohibited. His firmís attorneys, he said, specialized in ERISA. But it was "only after extensive research" that the firm learned "exactly what type of behavior was prohibited," he said. "As it turned out, Capital had improperly entertained clients, along with most of the investment advisory industry as far as I can tell, for the last 30 years. This is but one of several areas in which the industry currently does not follow ERISA law primarily as a result of a lack of education and training," he said. "The fact of the matter is that the industry as a whole is largely not following current ERISA law in several areas given the lack of guidance from the Department of Labor and a general lack of mandatory ERISA training and education."

Of course, DOL is not going to bring enforcement actions for every cup of coffee, sandwich, and working dinner provided to a plan trustee. But, as Grayson testified, the gifts and entertainment provided by his firm to plan trustees went quite a bit above that.

The firmís annual travel and entertainment budget of $500,000, he said, "was exhausted each year."

Specifically, the gifts and gratuities provided by his firmís principals to the union trustees included dinners and golf trips, club memberships, "lavish" parties (including transportation and travel expenses for trustees and their families), sporting events, "very expensive" fishing and hunting trips, and funding of foundations.

In addition, Grayson said that his firm hired relatives of union members, made donations to trusteesí causes, and purchased raffle tickets from trustees and their family members. Moreover, the firm directed investments in a way that would benefit the trustees, such as labor-only investments, and in investments that involved their relatives and friends. Lastly, the firm made loans to trustees and their family members.

"The use of gifts and gratuities is very prevalent in this industry," added Grayson. "It is known as the wine-and-dine industry. Ö Unfortunately, it is to the point where it is almost expected." He described the expensive dinners and trips as "regular events" at his firm, and emphasized that such lavish entertainment goes on industry-wide. "I know that it was going on in most of our competitors associated with the trustees. In our industry, it is viewed that you have to maintain your relationship with trustees, and therefore, wining and dining is part of that."

Grayson added that there are exceptions to the rule. "Obviously, not everybody does this." Some firms, he said, "rest entirely on their performance alone."

Meanwhile, in other ERISA gift news, IM Insightís heard that employees of DOLís Employee Benefits Security Administration have said in private meetings that they plan to examine data submitted to DOLís Office of Labor-Management Standards on Form LM-10s.