Alleged Schemers Passed GIPS Compliance Audit Article published on March 5, 2009 By Scott Johnson Westridge Capital Management, accused by federal authorities last week of committing “egregious” securities fraud, passed independent audits of its performance reporting that industry observers say should have uncovered inconsistencies in the firm’s investment process. The firm claimed it was compliant with the CFA Institute’s Global Investment Performance Standards (GIPS) and even gained the endorsement of Ashland Partners, one of the largest providers of third-party GIPS verification. Ashland’s competitors say the way in which Westridge reported its performance should have thrown up obvious red flags to outside parties. But the case may also expose some limitations of GIPS as a voluntary standards regime. “As the GIPS standards exist today, they are not designed to detect fraud,” says Ashland’s Kimberly Cash, a partner with the firm. “The standards focus on fair presentation of results, calculated in accordance with stated objectives. The standards are not designed to employ forensic accounting procedures on the underlying securities managers invest in for their clients.” A complaint filed by the U.S. Securities and Exchange Commission last week accuses Westridge owners Paul Greenwood and Stephen Walsh of using an affiliated entity, WG Trading Investors, as “their personal piggy bank to furnish lavish and luxurious lifestyles.” The court filing is available here [PDF]. Several institutional investors, including clients of the consultancies Mercer and Wilshire Associates, have emerged as victims of the alleged Westridge fraud. A Wilshire spokeswoman said earlier this week that Westridge’s enhanced index investment strategy, which is under scrutiny, had been reviewed for GIPS compliance since 1996 by a third-party firm. GIPS compliance, while voluntary, has become a de facto requirement of doing business in the institutional space. Most asset managers choose to have an independent firm verify their process for calculating and reporting performance. In fact, a proposed 2010 revision of GIPS would require managers to disclose whether or not their claim to compliance has been verified. Ashland confirms that it verified Westridge’s GIPS compliance, as it has for many of the largest firms in the industry. A client list from October 2007, available here [PDF], names hundreds of asset managers in the U.S. that received services from Ashland in GIPS verification, compliance and performance measurement. None of the other managers has been accused of unethical activity, although a previous Ashland client, whose business collapsed in 2006, was convicted of fraud in May 2008. Westridge itself, as a separate affiliate of Greenwood and Walsh’s other entities, may indeed have been technically in-line with GIPS. Ashland’s Cash says “the firm had the policies and systems in place to be compliant with the GIPS standards.” But there is disagreement over whether the verification process can be used to root out criminal activity, even if the process isn’t designed for that purpose. “Verification is not and has never been intended to be a method to detect fraud,” says Jonathan Boersma, executive director of GIPS for the CFA Institute. “I think you could conceive of a fraud that’s elaborate enough that all of [a firm’s] backup documents tie out. They’ve got detailed policies and procedures in place, yet none of it is real. It’s possible that a verification might not catch that.” But other verification providers say an analysis of information from sources outside of Westridge would have revealed some evidence of fraud. “One would expect that there would be an opportunity to find whether or not fraud is being committed,” says David Spaulding, president of The Spaulding Group, a consultancy and verification provider. “If you’re only looking at the records of the firm, then you wouldn’t know if they’re cooking the books. You need to be able to look at some external documents, such as brokerage statements, custodial statements, trade tickets. One would expect that there would be at least some random review of [such] documentation.” A different provider, asking to remain anonymous, says Westridge should not have been verified, although a GIPS review may not have detected the scope of the fraud. “Whether we would have uncovered the fraud, I can’t say with certainty without knowing what the documents looked like,” says a representative from that firm. “But I am pretty confident in saying that had we run the due diligence, we would have come up with questions where we probably would have ventured into some type of stalemate situation with the client, where they would have been getting nervous and we would have just had to back away.” Another professional at that firm says the Westridge case is an isolated incident and shouldn’t undermine GIPS verification in general. “When you think about due diligence and GIPS and any mindful regulatory [system], it’s all reputation-based,” says that professional. “What we don’t want is for GIPS to get a bad reputation because of what, at least from our point of view, is a bad seed.” All of the providers interviewed by FundFire say it’s rare for an independent consultant to refuse to issue a client a positive letter of verification for GIPS compliance. More often, they point out deficiencies for that client to correct, or they decline to work with managers with inadequate processes. In June 2007, the SEC released an industry alert after an examination of managers claiming to meet GIPS standards for performance marketing found that a third of them were actually noncompliant. Many more had “inadequate” procedures in place, despite most having had their compliance verified. None of those managers were accused of outright fraud, however. At the time, Arin Stancil, a partner with Ashland, said the news was not surprising, noting that his firm often comes across deficiencies with existing manager clients, but that most issues are easy to correct. Other firms besides Ashland had a look at Westridge’s performance without raising objections. Bloomberg reports that investors received financial statements audited by Deloitte & Touche, along with custodial statements from trustee banks showing Westridge’s trading. And Wilshire and other investment consultants, in placing assets with Westridge, would have conducted their own performance review. Westridge is not the first Ashland client to be accused of fraud. Ashland is named as a defendant in a lawsuit filed in March 2008 by the trustee of hedge fund manager International Management Associates (IMA), whose CEO Kirk Wright was convicted of fraud last May. In the complaint, available here [PDF], trustee William Perkins alleges that Ashland and other consultants “failed to meet the relevant professional standards and/or aided and abetted the breach of fiduciary duties, and as a result did not discover and report to the IMA entities, the equity owners of the investment funds, or federal and state regulatory agencies that the performance figures… were substantially incorrect.” Ashland declines to comment on that suit, which is ongoing. The current GIPS guidelines, available here [PDF], outline a recommended process for verification. In the draft of the proposed 2010 revision, available here [PDF] with changes tracked, the Institute appears to be strengthening those recommendations with more specific language. The Institute also offers a certification program in investment performance measurement, which is awarded to both asset management professionals and verifiers