Work at the confluence of international affairs, economics, politics and business drew Martin Harrison towards investment but without connections in the City it was not an obvious career path in 1980, during the deepest recession since the Second World War.
Consequently, from business school in the US, Martin went into strategic planning with an oil major. However, he only became more curious to see the bigger picture and understand investment. So, he contacted several stockbrokers and joined a progressive firm led by Nils Taube, a revered investor. His very first job was to have tea with the board of his former employer.
The Stock Exchange rule-book was before the Monopolies Commission, 2% commissions were on the way out and old hands, to whom 1974 was a fresher memory than the recent financial crisis is today, felt that “the jig was up”, but Martin relished the pulse, the ticker and the impact of news. He recalls: “at last, it felt like being ‘in the cockpit’”.
Lawyer Monthly has the pleasure of discussing with Martin his journey in institutional investment management and his role as an expert witness in the $1.2 billion Libyan Investment Authority (LIA) v Goldman Sachs case.
How do you compare the buy and sell sides?
Exhorting clients to buy or sell never held much appeal. At first, I don’t think I understood what it was to be a salesman: how seasoned brokers got orders was a mystery, until I moved to BP Pension Trust.
BP’s research head told me: “we like to do things slowly here, take our time, get our facts straight”. After the hustle of broking, I thought I had died and gone to heaven.
The fact was that we were few and managed the largest private pension fund in the country, “the world beat a path to our door”. It was like broking without the hassle. If we wanted to buy a million Glaxo shares the rejoinder was: “OK, who shall we deal through?” This, of course, is where that timely research note, call or company lunch, that vague feeling of indebtedness to an attentive broker for his morning briefing, paid off. The “scales fell from my eyes”.
I have principally been a buy side denizen. That said, solving client problems drives innovation; new order arises close to the market, from the complexity at the margins of chaos. For me, an asset management firm embodies the perfect compromise; the buy side but with product innovation.
What has changed in investment management from when you began working?
An era that predates the mobile phone and the internet, let alone the personal computer, seems antediluvian now. Technology skills and continuing professional development are two themes that dominate investment careers for good reason. What was largely theory when I started work defines investment today. Technology was the enabler for pillars of modern finance like the capital asset pricing model, Modigliani-Miller theorems and Black-Scholes option theory. If there was a computer at Oxford when I was an undergraduate, I never saw it, but took to computing at business school and have led its use for investment advantage at every opportunity since.
Pre-Big Bang, the City retained a “gentlemen and players” feel; the “back-office” almost used a different door. UK pension fund management grew from the cosy corporate finance relationships of a dozen merchant banks but, like the dwindling ranks of independent domestic broking partnerships before them, these thinned too as the London market opened to competition, embracing stricter regulation and governance.
In a connected world, price, size and timely data prevail. “Back office” logistics are decisive. Investment has come increasingly to resemble its frictionless, efficient-market theory apotheosis. Taking advantage of inside information is illegal; not sought after. Corporate news is quickly disseminated; and, fair benchmarks are hard to beat.
Where do you stand on indexation versus active management?
I have always been and remain an advocate of both. It is absurd to see them in Manichean terms; they are points on a continuum. Without demonstrable skill, the fair gain from doing anything, let alone managing assets, is zero (before costs). One thing any investor should know is their risk appetite and one thing they can control is their costs.
Theory holds that the optimally priced asset-basket for any investor in terms of risk and return is a mix of the market-basket and cash. It follows that, if you have no skill in picking stocks or managers, you should market-weight allocation and selection, do so as cheaply as possible, and balance risk to taste.
It took a long time for “the penny to drop” with investors. Now that it has, I almost think it’s time for a new paradigm. Failing that, a sound plan is to start with indexation and assume active risk only if you can justify it. For likely levels of skill, it takes a long time to distinguish it from luck with any confidence.
Stock returns are skewed: there is sometimes the proverbial “£50 note lying on the pavement”, but unless you habitually set off for lunch empty-handed, expecting to find the means to pay on the way, it’s prudent to index a lot of your pension.
Are you against derivatives?
On the contrary, I became enchanted with them early and have introduced and used them widely. Even prior to the 1987 Crash, I sold large stocks like BP across my clients’ portfolios at Schroders and bought traded call options. I later learned that these were the largest stock substitution trades ever in the UK market. For a small loss of premium, my funds were spared a big market fall, earning trustee plaudits.
Derivatives are immensely useful tools but, like any sharp instrument, demand skill and care. Options can articulate exquisitely precise investment views, but this comes at a cost. In contrast to stocks, bonds and other derivatives, like futures and forwards, which are volatile, options alone price volatility; they almost conjure value out of the air. The issuing house’s cost is the need to hedge them; unless it or some other party wants to take the other side, in which case the premium(s) may represent almost pure profit.
You don’t pay for volatility or time-value when you buy a stock, ownership and dividend rights are open-ended, but a call option is like rent; it’s a wasting asset. It doesn’t make sense to rent for longer, or go for a bigger or more elaborate contract, than you need. You must also think about liquidity, exercise rights, counterparty risk, price transparency, administration, and leverage – a particular “red-line” for most funds.
What is a Sovereign Wealth Fund (SWF) and are SWFs receptive to change?
The International Monetary Fund (IMF) defines five categories of SWF: reserve, pension reserve, stabilisation, development and fiscal savings. Of these, intergenerational fiscal savings SWFs are paramount.
Once domestic fiscal resources exceed foreseeable budget needs there is a twofold rationale to create a long-term savings fund: the first is to better accumulate and manage assets and the second is to invest overseas to avert “Dutch Disease”- inflationary and currency pressures that might stifle economic activity.
Several first-generation funds grew on the back of the 1970s energy shocks, when there was an additional imperative to recycle OPEC surpluses. However, SWFs are not confined to energy resources; Asian funds reinvest general trade surpluses and, believe it or not, one of the earliest funds, in Kiribati, derives its wealth from phosphate-rich deposits of bird guano.
Creating and preserving a national “cookie-jar” demands providence and power. Savings SWFs manage assets for generations yet unborn, but it is hard to accumulate and manage assets for the longest term in the full glare of public scrutiny, and harder still to keep “hands out of the jar”. Perhaps this explains why the UK has no SWF.
I have never witnessed change like that in the Middle East and Asia. Some may sneer but SWFs assist in avoiding “African” problems. They are integral to nation-building and progenitors of change. The question is whether they always have sufficient competence and governance for their ambitions.
What got you into working with SWFs and how is managing SWF money different?
Having restructured a multibillion dollar business and led it from Bankers Trust to Invesco, completed back-to-back, part-time Master’s degrees and started a family, I was at a crossroads. UK Pension funds of the day talked a lot but cleaved to their peer averages; I craved a bigger canvas. When a joint move came up in 1996 it was “now or never”. My wife and I each became senior investment advisers at different UAE SWFs. Abu Dhabi Investment Authority’s MD’s office afforded incomparable perspective and the region still fascinates me. We enjoyed quality time and I researched a part-time PhD, supervised by a Cambridge don.
I have worked for three more SWFs since, in Singapore, Qatar and back in the UAE. Each was different and evolving. They had a common imperative to raise their game, either because they were nascent funds or because external events demanded change.
Scale is one big difference: these are the proverbial investment “supertankers”. Horizon is another: the longest of any investment endeavour. Allocation moves take time: you must hope to look “wrong” and carry on; for instance, selling into a rising market. It’s the hardest thing in asset management. SWFs are often also in young, devout, multicultural societies: managing money is not their only end; SWFs perform crucial roles in nurturing a commercial “hinterland” and educating and training nationals.
How did you come to be an Expert Witness in the LIA vs. Goldman Sachs case?
Senior experience at four SWFs was key but, as well as consulting and board advisory roles, I had managed conventional and quantitative portfolios for over fifty global pension funds, including AT&T, Cargill, DEC, DuPont, Ford, Burmah-Castrol, IBM, John Lewis Partnership, De Beers, Mercedes-Benz, Price Waterhouse, Leyland, Kimberley-Clark, Honeywell, Hackney Council, Rolls-Royce, San Diego County and Hong Kong Hospital Authority.
Leading City solicitors, Enyo Law, instructed me early in 2015, but had to resign due to the Libyan civil war. It looked over. I saw enough, though, to conclude that SWF investment management best practices were not sufficiently well-elaborated. So, I set aside a book project on the subject and applied to research a part-time DPhil at the University of Oxford.
By November 2015, the LIA’s contending factions had appointed BDO as joint receiver. The case resumed and I was reappointed. It was the sort of dispute that I had seen before from both sides. I was familiar with Goldman Sachs as a counterparty and knew of the LIA, though we never had a dialogue.
As a member since 1981 of what is now the Chartered Financial Analysts Institute, which represents 130,000 global asset management professionals, the case was especially thought-provoking in terms of the active debate over professional standards, fiduciary responsibilities, investment suitability and financial regulation.
Can you explain your involvement in the case?
My testimony centred on the investment suitability for a nascent intergenerational savings SWF like the LIA of their nine call option trades made with Goldman Sachs between January and May 2008.
The question of the disputed trades’ investment suitability arose in respect of both the LIA’s allegation of undue influence and unconscionable bargain, the two principal causes of action.
These elements were intertwined: the trades might be so unsuitable that it would be unconscionable for Goldman to sell them, demonstrating actual undue influence; equally, a presumption of undue influence might arise because the LIA bought them despite them being unsuitable.
In contrast to the LIA action against Société Générale, settled on 4 May for £815 million, no corrupt collusion was alleged. I was not instructed as a witness of fact and was asked to assume that the LIA was a nascent fund whose objectives were purely those set out in its founding decree.
I described a model set up for an SWF with this mandate, adduced criteria for investment suitability and analysed the LIA’s transactions. To corroborate my own opinion, I employed the contemporaneous promulgation of the 2008 “Santiago” SWF principles in tandem with a rigorous evaluation of LIA competence and a recently published technique for appraising instrument sophistication.
The LIA was a very large state fund; couldn’t it look out for itself? What should similar state funds look out for?
The original impetus behind the Generally Accepted Principles and Practices (GAPP) agreed at Santiago was certainly not disquiet about SWF’s vulnerability so much as their ungoverned power.
Nevertheless, SWFs do not spring up fully-fledged. There are degrees of development associated with increasing competence over time, embracing progressively riskier and more complex instruments, which facilitate more efficient portfolios.
It’s feasible to categorise investor competence and instrument sophistication along definitive, functional lines, like those I developed for this case. I believe that it would be constructive to do so more generally.
Regulatory regimes exhort financial vendors to know their clients. Others encourage customers to enter contracts “with their eyes open”. Under its Code of Ethics and Standards of Professional Conduct the CFA Institute imposes individual observance of fiduciary and investment suitability obligations on members. Such principles are now broadly accepted but common, coherent, objective criteria are often lacking.
Importantly, no such regulations applied in this case. English law is loath to detract from certainty of contract. An LIA win on undue influence would have been the first in a commercial setting for over 40 years.
It’s hard to draw conclusions because the circumstances were so unusual. However, SWF stakeholders should combat agency and intermediation problems by employing independent board advisers and consultants. They should also require proper investment committee oversight and use qualified, independent, fiduciary “gatekeepers” for all direct transactions.
What led the LIA to plead breach of trust and unconscionable bargain?
Numerous fiduciaries might have managed cheap, segregated portfolios for the LIA. Instead, between 2007 and 2008 it made costly deals in alternatives and structured notes, followed by direct equity trades, without independent asset allocation advice.
Amidst this, the disputed trades were the LIA’s sole direct option transactions and, reportedly, the largest single-stock volatility trades made by Goldman Sachs. They comprised nine over-the-counter, cash-settled call options covering $5.2 billion worth of six stocks, at a premium of $1.2 billion over a three-year term. Similar in principle to my 1987 substitution trades, they differed in almost every material respect and were far from “option money”.
No ISDA Master Agreement was signed and subsequently almost everybody at the LIA swore blind they had bought stock. Available records show this is what the LIA’s board members were told, too.
Even the CEO seemed shocked to learn that total LIA premiums might be lost. At a “stormy meeting” in July 2008, Goldman staff were so severely “chastised” that they requested emergency evacuation.
Until then, the relationship seemed almost too close for market counterparties. For example, entertainment offered to the LIA CEO’s brother and other forays to Morocco for junior staff during their derivatives training in London breached Goldman’s policy.
Consequently, the LIA contended that the disputed trades cried out for explanation.
How did the case affect your own perceptions?
I believe both sides were shocked at how one-sided the judgement in favour of Goldman Sachs was. It seemed to me to conflict with the norms of the investment industry as I understand them. Scant justice was done to the valour of Catherine McDougall, the Australian lawyer and “whistle-blower” in this case, whose career had suffered unwarrantedly and to whom it added insult to injury.
Having worked at senior level in both banks and SWFs, where I’ve seen a lot of transactions and authored guidelines, ethics, conflicts and risk codes, I was conversant with the potential pitfalls.
My career has straddled the advent of investor protection regimes. Over thirty years ago, I had helped draft derivative sections of the forerunner to the BMBA and later IMRO customer agreements. One inevitable consequence of progress was that firms, which might once have felt obliged to stand behind their clients, now on best advice and for the avoidance of doubt, disclaimed responsibilities.
Among SWFs, though, regulatory regimes have little to say, deal sizes can be large, some financial products carry high margins and best practices cannot always prevail over societal norms.
As a former banker, I also understand the urge to return with the “still-bleeding carcass slung over one’s shoulder”. At a well-governed SWF, frustrated would-be “hunter-gatherers” often asked: “What’s our problem with you guys, Martin?” and I’d respond: “Please understand, my national colleagues don’t wish just to sign your bits of paper; they want to look you in the eye and know that, if things go wrong, you’ll be there for them”.
It was a hurdle in terms of trust and commitment that few banks met.
The Santiago Principles were published in 2008, how have things improved?
It’s hard to tell: GAPP adherence is voluntary and, whilst transparency is the touchstone for outsiders of a Whiggish persuasion, many SWFs are not in pluralistic liberal democracies and prefer discretion; even if they agree the investment principles. This presents a conundrum.
Though the pattern of GAPP compliance is all too predictable, even based on largely self-reported data, opacity is not the same as non-compliance. The converse of best practice has few advocates, but there is little call to advertise: funds struggle to be more transparent than their owners.
As a former SWF insider, I am less concerned about transparency and can attest that this is an instance where absence of evidence is not necessarily evidence of absence.
What could be transformational is a rigorous technical framework linking investment best practice to objective badges of compliance. This would facilitate independent accreditation of an SWF quality “kitemark”, provide assurance to stakeholders and assist SWF planning, implementation and business process improvement.
As discussed, the LIA case prompted me to combine my consulting with part-time DPhil work in this field.
I hope to collaborate with funds and service providers during my doctoral research into these aspects of SWF investment management cybernetics at the University of Oxford, recently ranked the world’s foremost research university by Times Higher Education.
How did you set about defining investment suitability and what for you are the main elements of suitability?
My definition of suitability comprised four criteria present across asset management generally and within SWFs at every level of delegation: from asset allocation, through individual security selection, to investment committee decision-making. They are: a fund’s financial predicament, the provenance of its decision-making, its technical competence and the sophistication of its proposed investments.
Provenance is the least familiar but most important of these concepts. In the context of a strategic asset template derived from a fund’s financial predicament, provenance demonstrates ownership of a continuous, comprehensive chain of diligent investigation, confirming the rationale for and attesting to the fitness of all subsequent transactions.
To convey to a lay audience just how incongruous the LIA’s disputed trades were, even by the standards of its other costly but unlevered security purchases, I analysed fund competence across 25 investment functions in terms of expertise and organisation. Then I mapped these onto a congruent proprietary model of security sophistication in terms of risk and complexity using a common five-point scale.
This reinforced my conclusion that the trades were unsuitable for a nascent fund by demonstrating graphically just how far outside the competence of the LIA their risk and complexity fell.
