A lawsuit filed against Deutsche Bank by two former senior wealth management employees demonstrates a basic problem: even rich people find it difficult to get people to manage their money who won’t take advantage of them. Here, the former employees allege that Deutshce Bank repeatedly pressed account managers to violate their fiduciary duties and stuff discretionary accounts with risky products like start-up hedge funds, even when the customer was clear it wanted only low-risk products.
We’ll discuss lawsuit in some detail for it illustrates a both perverse and troubling trend, that the idea of “fiduciary duty” is becoming a dead letter in the US. Many types of financial relationship, and this was one, impose a fiduciary duty on the service provider. Under the law, a fiduciary duty is the highest standard of care; the professional is supposed to put his client’s interest before his own. Here’s one definition: An individual in whom another has placed the utmost trust and confidence to manage and protect property or money.
Now the increasing difficulties that the wealthy have in hiring honest help may seem a remote concern to Naked Capitalism readers. But this issue exposes a fundamental flaw of the entire neoliberal project: that markets are an efficient and fair way of allocating resources, so the more use of market mechanisms to address social issues, like how to provide for retirement or supply health care, the better. But if the rich, who should be hugely attractive customers with plenty of bargaining power, are abused despite having taken proper precautions, how can the rest of us expect to do any better?
Younger readers, who’ve grown up with predatory capitalism, may think that the notion that fiduciary duty was ever taken seriously is a hoary old myth. Let me give some examples that show how much the world has changed. When I started out in business, financial firms were far more solicitous about client interests even when they were not fiduciaries. For instance, standard fee agreements in mergers and acquisitions indemnify the banker for his actions under the agreement except for cases of bad faith and gross negligence. And M&A professionals are the pit bulls of finance: tell them to get a deal done, and they won’t let go. Yet back in the stone ages of the early 1980s, when Goldman was still a respected institution, I was the junior team member on one client account, a very lucrative, very loyal, and not terribly sophisticated Fortune 100 company. It was hungry to do a medium sized acquisition that on paper met its strategic targets very well. The merger & acquisition department members were tearing their hair because it was a terrible deal: grossly overpriced and the financial statements had red flags on top of that. They felt they had to (and they did) talk the client out of the deal without looking like they were dissing the client’s judgment. The fees they might earn weren’t worth the potential damage to the relationship. Mind you, this was considered to be obvious commercial good sense back then. It had nothing to do with virtue or legal duties.
There are numerous instances where a professional has a fiduciary duty relative to his customer. The most stringent are when the agent is given a great deal of latitude in handling assets. Think, say, of wealthy real estate magnate who sets up a trust to manage his estate on behalf of his schizophrenic son (the building in which I live is in a trust like that), or the classic widow or orphan, who inherits some property and that serves as their source of livelihood and needs to be managed conservatively. Another type is someone who is too busy to manage his assets or believes a professional has more expertise and will do a better job; think of entrepreneurs who prefer to focus on running their business and hire a specialist to manage their retirement accounts.
It’s becoming increasingly apparent that even the rich can’t protect themselves. We’ve mentioned the case of Len Blavatnik, now number 39 on Forbes’ international wealth ranking (Full disclosure: Blavatnik was a client of mine when he was much less rich than he is now). Blavatnik had about $1 billion in cash across all of his operating companies, and thought it could be managed better. His staff went through a disciplined process of selecting a money manager and chose JP Morgan. They wanted only to beat Treasuries by 15 basis points, which before ZIRP was not terribly ambitious. Their agreement with JP Morgan stressed the need for safety and liquidity, and also restricted how much JP Morgan could put in various buckets, like real estate related assets versus loans.
The crisis started and in summer 2007 JP Morgan started using Blavatnik as a stuffee and dumped lots of drecky short-term paper into his account. He lost $100 million on a $1 billion cash account. He sued and recovered roughly half.
Consider: JP Morgan decided to trash its relationship with its second largest private client in North America, one who not only has lots of assets to manage, but regularly buys and sells companies, meaning he generates lots of deal fees and financing income. And if this is the sort of behavior that financial firms engage in at the top of the food chain, imagine what the rest of us can expect.
Now to the Deutsche Bank case. Benjamin Pace and Larry Weissman, both former members of Deutsche Bank’s wealth management unit, are suing to have the bank’s non-solicitation policy deemed unenforceable. The plaintiffs were both long-standing Deutsche Bank employees. Pace had been Deutsche’s Chief Investment Officer for wealth management products in the Americas for a decade. Weissman was head of Portfolio Consulting and was Pace’s direct report. I’ve embedded their short and readable filing at the end of the post. This is the guts of their claim:
Both men managed the Discretionary Portfolio Management group, which solicited and managed funds on behalf of high and ultra high net worth individuals. In the overwhelming majority of cases, the clients give Deutsche discretionary authority, meaning they can buy and sell investments without conferring with the customer. That degree of discretion is what produces the fiduciary duty.
The investors were told that Deutsche had an “open architecture” platform, which meant that account manager could choose the products that were the best customer fit, rather than best for Deutsche Bank. But the group was integrated with other asset management business into a new division a few years back, and was increasingly pressured to sell in-house products that were inappropriate for the Portfolio Management (PM) accounts. The filing stresses that many of the PM customers either did not want alternative assets at all or only wanted a limited portion allocated to them, yet Pace and Weissman were pushed to make significant buys of these risky strategies irrespective of suitability or the clearly stated objectives of the account owner.
Some of the dodgy products that the suit alleges Pace and Weissman were pressured to put into client accounts included:
A seed hedge fund. Note that fund managers often incubate lots of funds, and the ones that turn out to have good records are then marketed more broadly. Not only were customers exposed to losses from a potentially losing manager, but even if the fund merely had mediocre performance and was wound up, investors would eat the expenses of the failed fund as well as the cost of liquidating current investments to buy into the fund and then re-establish positions when they exited. Even worse, this particular fund had not even gone through the normal “New Product Approval Process” and internal compliance had not signed off on offering it to PM customers.
A private equity fund by Japan’s Softbank. The PMs were told to sell it not because it was any good but because Anshu Jain, Deutsche’s Co-CEO, was good buddies with the head of Softbank.
Another “seed” fund, this for European equities.
A proprietary private equity fund (Secondary Opportunities Private Equity Fund III) where Pace says he was hectored often for not doing enough to fund it.
Adding various proprietary products to Deutsche model portfolios, which would have led to them being sold into accounts, even though the products did not fit allocation requirements and inclusion of one, a Japanese fund, would have generated adverse tax outcomes.
The suit also describes a series of organizational changes that had taken place and were underway which are depicted as intended to pressure the PM staff to act more like brokers than fiduciaries.
The US seems to be doing a wonderful job of creating not just failed states but failed markets. In wealth management, the big risk used to be too much sleepiness, that overly-risk averse account managers sat in wood-paneled offices and were better at running errands for rich customers than managing their money. But in those days, they knew their limits and stayed with simple products. And truth be told, the most important rule of money management is not to lose principal, so at least they kept their eye on the biggest target.
The Brave New World of modern portfolio theory was supposed to produce a more scientific approach, but in fact, it underestimates market risk in several ways, thus leading customers to take on too much in the way of risky products. It also allows salesmen to bamboozle customers with their supposedly superior knowledge and intimidating jargon. Even so, the industry didn’t have to wind with widespread looting particularly since Pace’s and Weissman’s strenuous resistance of pressure to stuff their accounts shows that even a lot of well-paid Wall Street professionals want to do right by their customers even when their organizations don’t.
Too much of the finance business has become a classic lemon market. And if George Akerlof is right, the end result is that as bad drives out good, more and more customers steer clear of those markets altogether. Financiers are confident that they are invaluable, but we’ve had successful economies with far smaller banking and investment industries. So perversely, if regulation doesn’t reverse financial services industry hypertrophy, the fraud and grifting eventually will.