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News February 7, 2011 Issue

AXA Rosenberg Stumbles With Secret Formula

Closely guarded investment methodologies are nothing new in the investment management industry.

The SEC just wants to make sure investment firms are not guarding them from – themselves.

Last week, the SEC took institutional asset manager AXA Rosenberg to task for missteps made in the name of "protecting" its proprietary trading secrets. Not only did senior officials conceal a quantitative investment model error from clients, the SEC alleged that the AXA Rosenberg managers kept the error from the CEO and its own compliance staff as well.

"To protect trade secrets, quantitative investment managers often isolate their complex computer models from the firm’s compliance and risk management functions and leave oversight to a few sophisticated programmers," said SEC Enforcement director Robert Khuzami. "The secretive structure and lack of oversight of quantitative investment models, as this case demonstrates, cannot be used to conceal errors and betray investors."

Los Angeles Regional Office director Rosalind Tyson added "[q]uant managers need to ensure that their compliance policies and procedures are tailored to the risks of their model’s strategies, and that compliance personnel are integrated into the development and maintenance of their investment models."

Despite a settlement with the SEC that will return $217 million to investors, a class action lawsuit has already been filed on behalf of Guam’s $1.6 billion pension fund. Guam alleges the repayment is "wholly insufficient to compensate investors for the full amount of their damages." AXA Rosenberg managed a portion of the Guam fund.

In 2007 when the problem began, AXA Rosenberg managed $70 billion in assets. Now it has been alleged that they’re down to $31 billion. The SEC’s order outlined the asset manager’s critical missteps, including the origin of the error itself.

AXA Rosenberg’s quantitative model, developed and maintained by affiliate and registered adviser Barr Rosenberg Research Center [BRRC}, was used as the "exclusive decision-making tool" by registered adviser AXA Rosenberg Investment Management (ARIM) and other affiliated advisers.

In April 2007, said the SEC’s order, BRRC implemented a new version of the model. Primary responsibility for revising the model’s code fell to two programmers. Once the work was completed, the model was tested, but no review of the underlying work was conducted, said the order. As a result, a coding error made during the upgrade went undetected for more than two years.

In June 2009, the model was once again revised. At that time, a BRRC employee "noticed certain unexpected results when comparing the new Risk Model to the existing one." The code error had caused the prior model to omit the scaling of certain risk factors necessary for the model’s performance. The BRRC employee reported up the chain to a senior BRRC official who was also a senior AXA Rosenberg official, and to other BRRC employees as well, recommending an immediate fix of the error.

The senior official determined that the error should be corrected when the new risk model was implemented. Then the senior official instructed the BRRC employees to "keep quiet" about the error, and that AXA Rosenberg’s global chief investment officer should not be informed.

The flawed model’s performance wasn’t so great, as might be expected.

The order alleges that, based on "substantial concerns" expressed by clients about underperformance due to industry overexposure, an AXA Rosenberg team based in London had begun to examine and test the model. "By August 2009, as the U.K. Group began to hone in on the error, the Senior Official’s instruction to keep quiet about the error became increasingly problematic," said the order. Ultimately, in September, BRRC employees acknowledged the error to the U.K. group. At that point, several senior officers with the AXA Rosenberg entities were aware of the problem, "but still failed to disclose the error to AXA Rosenberg’s global CEO or clients."

Throughout mid- to late 2009, AXA Rosenberg’s board held several meetings to discuss the model’s performance in light of client complaints. The senior official and others who knew of the error attended the meetings and participated in the discussions, but still said nothing. In response to a direct question about the model’s underperformance, the senior official said "mistakes if there were any will not be made in the future." He added that "he was ‘not aware of significant’ mistakes in the model," said the order.

Finally, in November 2009, the BRRC employee informed AXA Rosenberg’s global CEO of the problem, and that the error had been corrected. The CEO then launched an internal investigation in December, which concluded in March 2010.

Coincidentally, within days of the internal investigation’s conclusion, the SEC notified AXA Rosenberg it would be arriving in a week to conduct an examination. After a series of board meetings convened during that week prior to the staff’s arrival, AXA Rosenberg informed the staff of the error at the end of the staff’s first day on-site, March 31. On April 15, AXA Rosenberg informed clients of the error.

All that concealment and delay was a breach of fiduciary duty, said the order. "Fundamental" compliance procedures and controls were absent, and "BRRC also failed to conduct any meaningful materiality analysis of the error’s impact."

Once the staff had been alerted, however, AXA Rosenberg’s "remedial acts promptly undertaken," as well as its cooperation with the staff, were given consideration as part of the settlement process.

In addition to establishing and administering a "Compensatory Payment" program for affected clients, the AXA Rosenberg entities also agreed to be responsible for the "tax compliance responsibilities" associated with the Compensatory Payment and not to use Payment funds to meet that obligation.

Through at least 2015, AXA Rosenberg must maintain a Global Compliance and Ethics Oversight Committee [Committee) consisting of senior executives of the AXA Rosenberg entities and senior executives of affiliated advisers as well. The Committee will meet quarterly, and review potential violations of codes of ethics, the entities’ "escalation policy," and general compliance policies and procedures. All violations found will be reported directly to AXA Rosenberg’s CEO and its board of directors.

A reporting system will be implemented whereby employees may report matters on an anonymouse basis directly to the Committee for action.

AXA Rosenberg must also retain an independent compliance consultant experienced in quantitative methods of analysis and "not unacceptable" to the staff and the AXA Rosenberg board. After review of the AXA Rosenberg entities, the consultant will recommend appropriate disclosures about coding of the risk model to investors, the inclusion of compliance personnel, policies and procedures into the error reporting process, and documenting and retaining changes that occur in the code, including error documentation.