The reaction to the Frank-Dodd financial reform bill recently signed into U.S. law received mixed reviews, with many saying it was a cave-in to the lobbyists. But one aspect of it appears to be quite bold in terms of addressing abuses within the industry: the whistle-blowing provision now in effect that offers large cash rewards to those who report fraud and other wrongdoing at publicly traded corporations and investment banks.

Under the applicable sections, anyone whose whistle blowing leads to a successful SEC prosecution will be able to collect between 10% and 30% of the amount recovered (for cases above $1 million). With past settlements over the $50 million mark, the pay-offs could be huge, well into the millions of dollars. And with such an incentive, it would not be surprising to see a lot of people picking up the phone. And who knows, maybe there could in coming years be a series of news reports on the skullduggery uncovered.

The Frank-Dodd bill also protects whistleblowers against retaliation. If they are fired, demoted or otherwise harassed, they can file an action in the U.S. District Court to get their job back with double back pay and legal costs covered. In addition, the reporting process is not limited to company employees; academics, private investors and even journalists/securities analysts whose research uncovers fraud could collect awards.

So, could Canada benefit from a similar whistleblower law? Would it even have a chance of being enacted?

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I have been asked to be a trustee and executor of a Henson Trust, so I’ve been reading up a bit on what they are about. It is a type of trust designed to benefit disabled persons by allowing them to receive an inheritance without having to give up government benefits, such as the Ontario Disability Support Program (ODSP).

The trust, also known as an absolute discretionary trust, can perform this role because the trustee has “absolute discretion” in determining how to use the trust assets. The assets do not vest with the beneficiary and cannot be used to deny means-tested government benefits.

The trust can also provide income tax relief, shield assets from matrimonial division in event the beneficiary divorces, and offer immunity in most instances to creditor claims on the beneficiary. Some lawyers specialize in setting up these trusts and should be consulted.

WhereDoesAllMyMoneyGo.com did a post on Henson trusts in early 2008. He notes that they may be contested or denied in some provinces. Those that allow them appear to be: Ontario, BC, Saskatchewan, Manitoba, New Brunswick, Nova Scotia, and PEI.

The trustees and executors have several functions to perform.

First, they need to make funeral arrangements and carry out the rest of the tasks an executor performs such as locating the Will, identifying and protecting assets and contacting beneficiaries.

Second, the executor transfers the share for the beneficiary of the Henson trust to the Trustee. The latter must ensure the disabled person never has an amount in their account that would disqualify them for government benefits, paying for what’s required by making payments to the seller directly. An income tax return has to be filed for the trust each year.

Third, Section 27 of the Trustee Act requires the trustee to invest the trust monies in a manner that shows “ordinary care, skill and prudence,” to act as he or she would in their own affairs. The trustee needs to consider the following criteria in planning investments:

a) General economic conditions.

b) The possible effect of inflation or deflation.

c) The expected tax consequences of investment decisions or strategies.

d) The role that each investment or course of action plays with the overall trust portfolio.

e) The expected total return from income and the appreciation of capital.

f) Needs for liquidity, regularity of income, and preservation or appreciation of capital.

g) An asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.

h) A trustee must diversify the investment of trust property to an extent that is appropriate to do: i) the requirements of the trust; and ii) general economic and investment market conditions.

Interesting. I’m not too sure if followers of the passive school of investing would feel comfortable with some of those requirements. In particular, the first two would seem to require the trustee to anticipate macroeconomic trends. The other conditions, though, make sense. Of note, part d) appears to require taking correlations amoung investments into consideration and part h) talks about diversification.

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A new book, Buying at the Point of Maximum Pessimism: Six Value Investing Trends from China to Oil to Agriculture (2010), examines six socio-economic trends and recommends buying into them whenever moments of maximum pessimism arise. The author is Scott Phillips, principal and portfolio manager at Lauren Templeton Capital Management LLC.

The book gets off to a good start with a foreword about preparing for market downturns, written by Lauren Templeton, founder of the aforementioned investment firm, niece to Sir John Templeton and spouse to Phillips.

Following the foreword, Phillips discusses — with an ample sprinkling of charts and data tables — the financial turmoil of the past three years and six big-picture themes that should be on value investors’ watch lists. Three of the themes may be familiar to most investors:

• growth potential of companies participating in the rise of consumerism within China and other emerging countries.

• favourable positioning of fertilizer, farm-equipment and Brazilian agribusiness companies catering to the demand for higher protein diets made possible by rising income in developing countries

• secular rise in demand for crude oil against a back-drop of costlier supply, and consequent spillover into alternative sources of energy such as the oil sands.

Perhaps the more interesting part is the three less well-known themes. It may also be the more useful part: the themes don’t seem to be crowded trades to the same extent as the three above and may thus be closer to being prospecting grounds for value investors.

• the bright future for aquaculture (fish farming) arising from the “tragedy of the commons” playing out in the overexploitation of ocean fish stocks along with rising demand for fish protein from emerging nations

• growth prospects for educational firms providing online/computer-based training, prep courses, tutoring books, etc. to students in China and other emerging countries, where the value of education is deeply embedded in the culture

• rising demand for rare-earth elements, driven by growth in high-end consumer and green technologies and supplied mostly by China.

Phillips doesn’t mention too many companies to invest in. An exception relates to the theme of educational firms meeting needs in emerging countries. His list includes ATA Inc., China Distance Education Holdings Ltd., Aptech Ltd. and MegaStudy Co. Ltd.

I personally found the foreword and the less-known trends the more rewarding parts of the book. They offered fresh perspectives and new material for me. The rest of the book was not as rewarding because it was mostly material I had encountered in publications elsewhere.

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Canadian Capitalist has a post on Scotiabank’s Let the Savings Begin program, which gives consumers an incentive of up to $150 to use Scotiabank’s credit/debit cards and bank accounts. I left a comment on the Canadian Capitalist website, but it was dashed off rather quickly and may be a bit jumbled. Maybe I can rephrase it better here in a post.

This offer could be a good deal for existing Scotiabank customers as Canadian Capitalist says. But I do have reservations that it is worthwhile for customers at other banks to switch to Scotiabank’s credit/debit cards and accounts.

Why respond to a special offer with only temporary benefits? After the program is over, thousands will have signed up for a service for which there is a cost in time/effort to switch out of. This hassle of switching gives the institution some leeway to pluck a few feathers off the chicken. Over the longer run, things could average out – – and perhaps in favour of the service supplier.

In my opinion, it may be better to wait for offers with permanent or longer-term benefits before responding. In the meantime, it may pay to stay put with your existing institution and wait for them to introduce their incentive plan. 

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The U.S. Congress passed this week sweeping financial-reform legislation, the Wall Street Reform and Consumer Protection Act.  The 2,300-page bill creates several new regulatory agencies and hands off to new and existing agencies the discretion to create regulations for the financial sector. Here are some of the main features:

• Creation of the Office of Credit Ratings within the SEC to monitor credit-rating agencies (which assigned AAA grades to mortgage debt that blew up during the financial crisis). Investors can sue the agencies.

• Creation of the Bureau of Consumer Financial Protection within the Federal Reserve to formulate rules for consumer-finance products (to guard against abuses such as “liar” and other exotic mortgages).

• The Government Accountability Office can audit emergency Fed actions. Fed banned from lending to individual companies and required to disclose details of certain loans (with lag).

• To deal with “moral hazard” and protect the American taxpayer from further bailouts, regulators can seize and carry out an orderly liquidation of “too big to fail” financial firms (whose uncontrolled demise would otherwise threaten the financial system).

• Trading of many derivatives to be moved to clearing houses and exchanges. Hedge funds need to register with SEC. Sellers of products like mortgage-backed securities need to retain an interest in the products.

• Higher capital requirements sought for banks. Latter also prohibited from trading own capital and from engaging in some derivatives trading.

• Establishment of Financial Stability Oversight Council to coordinate activity among the “fragmented” regulatory system. Office of Finance Research to track issues and problems.

• SEC may impose fiduciary standards on brokers and grant authority to shareholders to participate in nominating directors at financial firms. Financial executives’ incentives to pursue risky strategies somewhat tempered by giving shareholders the right to non-binding votes on pay and golden parachutes.

Reaction to the bill has been mixed. One problem is that a lot of critical detail has been left to regulatory bodies to flesh out and the final shape of the new regulatory environment may not be known for over a year. And it is still an open question whether the regulators – many who were around when the financial crisis unfolded — will exercise their powers judiciously and effectively.

The bill did not deal with all the issues, particularly the role of Fannie Mae and Freddie Mac. Some of these issues may be addressed later on.

Many commentators are of the view the bill has been diluted down by concessions to lobbyists. PIMCO’s founder and co-CIO, Bill Gross, for example, thinks “Wall Street still owns Washington.” He would rather have seen former Federal Reserve Chairman Paul Volcker appointed “Dictator-In-Chief” than the bill that will now be signed into law by the President

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Plenty of books have been published on the wild gyrations in financial markets since 2007. John Authers, a Financial Times of London editor and columnist, has written another in the genre, entitled The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How To Prevent Them in the Future (2010).

But his book is an easy-to-read exposition of basic and more advanced aspects. This makes it a useful offering for people who don’t scour the business pages every day or regularly imbibe financial books — yet are still curious to know why the world almost had a financial breakdown in 2008 and what can be done to avoid another encounter.

Some main factors behind the 2008 financial crisis:

Much of the book examines factors that led up to the perilous brush with financial Armageddon. Authers has quite a few of them. Here are some of the main ones. A list in the appendix has more.

• Increasing institutionalization of investing (growth in mutual funds, pensions funds, hedge funds etc.) led to an ever greater wedge between principal and agent, resulting in less care and prudence in the management of investments
• Herding behaviour among money managers
• Pervasive “regulatory arbitrage” (circumventing regulations for profit) that eroded the banking system and led to a shadow banking system without deposit insurance, reserve requirements and other safety nets
• Securitization of mortgages, etc. (took risk off the balance sheets of the banks originating the mortgages, giving them incentives to relax lending standards)
• Deregulation (e.g. repeal of Glass Steagall act) and mergers creating banks too big to fail
• Growth in publicly owned investment banks (financed through overnight markets)
• Hedge funds’ incentives, risk taking, leverage and exposure to redemption runs
• “Greenspan Put” (Federal Reserve cut rates too much whenever markets became unsettled — starting with LTCM hedge fund in 1998 — triggering a sequence of interconnected bubbles and busts (dot-com and housing)
• Escalating “moral hazard” (a feeling that risk takers would always be bailed out thanks to the “Greenspan Put”
• Financial theories that generated a false sense of security, such as the notion portfolio safety can be assured through uncorrelated assets

Solutions:

The book also provides suggestions for avoiding another plunge toward financial and economic chaos. They include:

Measures need to be taken to keep moral hazard and risk-taking from becoming excessive in financial markets; a “safe place” to start would be to tightly regulate “to-big-to-fail” banks — or else make them smaller (raising reserve requirements would force them to sell off asset, Authers suggests). 

The constituents of the shadow banking system must be regulated as if they were banks. This will put them on the same level playing field as the banks and remove the pressure on the latter to stay in business by venturing into new and riskier fields.

The investment industry requires a culture shift and change in incentives to treat other people’s money as their own. Publicly traded investment banks might return to the partnership mode so that the money on the line would be the partners and not the shareholders. In securitization, loan originators should be required to hold a significant interest in the loan portfolio they sell to others.

The herd mentality of current money managers needs to be reined in. Closet indexing by mutual funds should be discouraged by requiring actively managed funds to publish their “active share” (how much portfolio deviates from the index). And paying managers a fixed fee instead of a percentage of assets would help take away some the incentive to hug the index and become a big (but unwieldy) fund.

Hedge fund investors should refuse to abide by the fee structure that encourages managers to lever up and go for broke. Instead, they should pay fixed annual fees and base any performance fees on periods longer than a year.

Investors also need to rethink diversification, i.e. avoid thinking in terms of asset classes and historic correlations between them. Instead they should think about leaving a margin for error, i.e. go with more conservative assets.

Appendix: Other factors behind the 2008 financial crisis

• Rise of (market-cap) index funds and the pressure on them to buy overvalued stocks
• Growth in money market funds (deposits not government-insured)
• Too much creation of fiat currency and easy credit (lack of monetary anchor)
• New financial products made it easier to invest in new areas (e.g. emerging-market funds)
• Carry trade a source of funds for investing/speculation
• Baby boomers increasingly participating in financial markets
• Distortions produced by Fannie Mae and Freddie Mac in housing market
• Bonus systems in financial sector encouraged taking risks
• Use by banks of off-balance-sheet entities, such as structured investment vehicles (SIVs) for lending long term and borrowing short term
• Rosy ratings from the debt-rating agencies
• Rush into BRIC markets and commodities, aided by index funds and exchange-traded funds (ETFs)
• Speculation in credit default swaps can make it harder for an indebted company to borrow to the point where insolvency becomes a risk

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The 2009 Annual Report of the Ombudsman for Banking Services and Investments (OBSI) just came out and it reports a staggering jump in complaints about services provided by banking and investment firms. “In 2009, OBSI reviewed more complaints than ever before in its history,” writes Ombudsman Douglas Melville.

Complaints were up 48% over 2008. Breaking out the complaints, there was a 21% increase relating to banking services and a 73% increase relating to investment services. OBSI attributes the increases to sharp declines in the stock market and greater awareness of the OBSI as a complaint-resolution forum (thanks largely to referrals from regulators and financial firms).

OSBI closed 787 files in 2009. Of these, OBSI recommended compensation for 222 (all accepted). Seven files were withdrawn by clients and the rest were upheld in favour of the firm. The most common complaints involved:

• increased interest rates on lines of credit
• failure to fulfill “know your client” obligation
• failure to properly disclose risks in complex investment products
• margin calls and transaction errors from discount brokers
• surprise over the size of mortgage prepayment penalties
• surprise over deferred sales charges on mutual funds

Hat tip to Ken Kivenko

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