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CGRP33 -- Risk Management Breakdown at AXA Rosenberg: The Curious Case of a Quant Manager Trusted Too Much

CGRP33 -- Risk Management Breakdown at AXA Rosenberg: The Curious Case of a Quant Manager Trusted Too Much

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All companies face challenges designing a governance system that works best for their particular situation and structure. Even the owners of privately held companies sometimes struggle with issues of separation and control. The challenges can be particularly acute when a company founder has considerable influence over the organization and its culture, and third-party investors have been brought in to share ownership.

We examine the interesting case of AXA Rosenberg, a joint venture investment management firm founded and run by legendary finance professor Barr Rosenberg. Although successful for a time, the firm eventually collapsed due to a failure in risk management.

We examine the governance structure, unique personalities, and series of events that led to the breakdown of the firm and the SEC investigation that resulted in Barr Rosenberg’s lifetime ban from the securities industry.

We ask:
• Is it possible for a board to monitor a renowned executive with extremely specialized knowledge?
• How can the board satisfy itself that risks are appropriately known and monitored?
• How does an executive’s personality affect a company’s risk management practices?


All companies face challenges designing a governance system that works best for their particular situation and structure. Even the owners of privately held companies sometimes struggle with issues of separation and control. The challenges can be particularly acute when a company founder has considerable influence over the organization and its culture, and third-party investors have been brought in to share ownership.

We examine the interesting case of AXA Rosenberg, a joint venture investment management firm founded and run by legendary finance professor Barr Rosenberg. Although successful for a time, the firm eventually collapsed due to a failure in risk management.

We examine the governance structure, unique personalities, and series of events that led to the breakdown of the firm and the SEC investigation that resulted in Barr Rosenberg’s lifetime ban from the securities industry.

We ask:
• Is it possible for a board to monitor a renowned executive with extremely specialized knowledge?
• How can the board satisfy itself that risks are appropriately known and monitored?
• How does an executive’s personality affect a company’s risk management practices?


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06/26/2014

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Topics, Issues, and Controversies in Corporate Governance and Leadership
STANFORD CLOSER LOOK SERIES
stanford closer look series 1
Risk Management Breakdown atAXA Rosenberg: The Curious Case of aQuant Manager Trusted Too Much
introduction
Te need or corporate governance systems is driv-en by problems that can occur when there is a sepa-ration between the owners o a company and themanagers o the company. Because managers areagents (and not sole owners themselves), they donot always have incentive to act in the best inter-est o shareholders. Instead, they can take actionsto improve their own situation, even when there isa cost to those actions that is borne by sharehold-ers. o rectiy this problem (known as the “agency problem”), organizations adopt incentive and con-trol systems that better align the interests o man-agers and owners and improve the ability o share-holders to monitor executive behavior.Each company aces challenges in designing a governance system that works best or its particularsituation and structure. In the case o public com-panies, shareholders must overcome the challengeso diuse ownership (which makes monitoring di-cult) and the need to work through a board o directors. In the case o companies with dual classshares, shareholders must overcome the challengeo having inerior voting rights relative to insid-ers. Even in the case o privately held companies,owners sometimes struggle with issues o separa-tion and control. Te challenges can be particularly acute when a company ounder has considerableinuence over the organization and its culture, andthird-party investors have been brought in to shareownership. In order to be successul, the governancesystem must balance
deerence 
to the expertise andknowledge o the ounder with objective
oversight 
that allows the board o directors to intervene withthe ounder’s decisions when necessary. Lacking this balance, a company’s governance system can
By dv f. l  B tyMy 30, 2013
invite problems that signicantly increase the pos-sibility o organizational ailure.
governance at aXa rosenberg
Rosenberg Institutional Equity Management was a private investment management rm ounded by Barr Rosenberg in 1985. Barr, a ormer nance pro-essor at the University o Caliornia at Berkeley, is widely renowned or his pioneering work on risk actors that inuence stock value that is still in usetoday in portolio risk assessment and perormanceattribution. Trough his rm, Barr employed a quantitative strategy based on undamental analysisto identiy and rank companies that were underval-ued relative to peers. He set an ambitious target o achieving 2 to 4 percent alpha (or outperormance)relative to benchmarks, and or the most part wassuccessul in meeting this goal over a 15 year pe-riod. With his track record, Rosenberg attractedinvestors in the U.S., Europe, and Asia and by thelate 1990s managed $10 billion in assets.In 1999, French insurance company AXA, look-ing to diversiy and expand its investment manage-ment business, acquired a stake in Barr’s investmentrm. Under the agreement, AXA purchased a 50percent ownership position and received an optionto buy an additional 25 percent. Barr remaineda signicant investor and chairman o the rm, which was renamed AXA Rosenberg. Under theiragreement, AXA had the right to appoint 50 per-cent o the board o directors, with Barr appointing the remaining 50 percent.
1
O note, this structure was to remain in place
in perpetuity 
, meaning that AXAs board representation would not change even when AXA exercised its option to increase its own-ership position to 75 percent.
 
stanford closer look series 2
Risk ManageMent BReakdown at aXa RosenBeRg: the CuRious Case of a Quant ManageR tRusted too MuCh
Despite his prominent position as ounder andchairman, Barr did not retain ormal leadership o management activities. AXA Rosenberg was led by a group CEO who was appointed by AXA. Tis in-dividual ran the executive committee that oversaw day-to-day operations, including portolio develop-ment, executing and settling trades, client relations,marketing, human relations, and legal and regula-tory compliance work. Although Barr was the
de  acto
head o the research center (where the quan-titative trading models were coded and executed),he ceded the ormal title o director to om Mead, who represented the center’s activities on the ex-ecutive committee.
2
As a result, Barr had no or-mal management title and no ormal managementresponsibilities, despite exerting considerable inu-ence over the rm.Although unusual by the standards o a publiccorporation, there is some precedent or this typeo governance structure in the asset managementindustry. Strategic buyers (such as nancial andinsurance companies) oten have difculty retain-ing and motivating investor talent ater signing  joint venture agreements with boutique investmentrms. o preserve the environments that allowedthese rms to be successul in the rst place, they are willing to aord considerable autonomy to theounding investors. A typical arrangement is or thestrategic buyer to assume responsibility or the sup-port unctions o the rm while giving the originalinvestment team ull discretion to make investmentdecisions without intererence, although the sellermust typically abide by a code o ethics and submitto periodic review by internal compliance ofcers.In the case o AXA Rosenberg, however, the de-gree o autonomy was extreme. Barr not only over-saw all activities in the research center, but AXA wasgiven little visibility into the details o the researchprocess. Barr did not report to the group CEO,and the management team o AXA Rosenberg didnot audit the models that the research team devel-oped. Te group CEO had no authority to hire orre personnel in the research center, and did notalways interview candidates who applied to work there. Furthermore, although Barr retained the titleo chairman, he routinely delegated the acilitationo board meetings to ellow board members thathe had appointed. Barr attended the meetings, butoten by telephone rather than in person. Finally,even though Barr was not majority owner and wasonly one member o the board, he had eectivecontrol over many organizational decisions. I Barropposed a change avored by others—or example,a decision to adjust the prot-sharing program—it was typical that the board and the executive com-mittee would deer to his position. Barr also sat ona specially created governing board that acted asa “tie-breaker” i the AXA Rosenberg board dead-locked on any issue.
3
Following the joint venture agreement, the as-sets under management at AXA Rosenberg in-creased signicantly. In 2002, they doubled rom$10 billion to $20 billion, owing largely to an inu-sion o cash rom AXA and the clients o its wealthmanagement division. By 2005, assets exceeded$69 billion and by 2007 reached $135 billion. Teinvestors in AXA Rosenberg were primarily insti-tutional investors, pension unds (both oreignand domestic), sovereign wealth unds, and retailinvestors. Also during this time, AXA exercised itsoption and increased its ownership position to 75percent.
governance breakdown
Te governance breakdown that led to the unravel-ing o AXA Rosenberg had its roots in a technology migration project spearheaded by Barr and man-aged by research director om Mead. In the mid-1990s, Barr decided to transition the code under-lying the research center’s models rom its originalprogramming language o FORRAN to an ob- ject-oriented language called Eiel. Te migration, which was intended to take no more than a ew years, ended up stretching out over a decade and e-ectively became a continuous work in process. Parto the problem was the way the project was man-aged; rather than upgrade the model in its totality all at once, the model was upgraded piecemeal. Asthe research center was constantly rewriting codeto optimize its investment strategy and to keep up with rapid growth and new product development,the migration was unable to keep pace with thecontinuous revisions. Another problem was due tothe choice o programming language. While Eiel
 
stanford closer look series 3
Risk ManageMent BReakdown at aXa RosenBeRg: the CuRious Case of a Quant ManageR tRusted too MuCh
is considered a high-quality language, it is also very obscure. Te PhDs hired into the research center were oten not experienced working with it and re-quired a steep learning curve, and the AXA auditteams could not eectively audit the technology transer. Finally, because Barr closely guarded accessto the model, a small set o programmers had tobalance model reprogramming with model optimi-zation. As a result, the system migration was long and expensive.Te board o AXA Rosenberg was rustrated with the pace o progress. Tey were particularly concerned that the intellectual talent in the researchcenter was spending too much time on reprogram-ming and not enough on innovation and under-standing market dynamics. Te CEO arranged ora successul technology leader to be seconded tothe research center to support the project manage-ment o the migration to Eiel; however, he andthe board were unable to enorce accountability ormeeting deadlines and completing the migration.In 2007, the board agreed that the research mod-els be adjusted to assume more market risk. Tis was done in response to client requests to assumemore risk and improve returns, which had beenlackluster in the low volatility market ollowing thebursting o the technology bubble. Unbeknownstto the board, as the changes to the risk model wereimplemented, an error was introduced. A program-mer incorrectly programmed the risk model so thatsome o its calculated risk elements were too smallby a actor o 
ten thousand 
. As a result, the modelsometimes grossly undercalculated the riskiness o the rm’s investment decisions. Even though the re-search center had quality control measures in placeto check the code revisions, these measures did notdetect the error because the model was producing higher risk on a simulated basis as the board expect-ed. Te error remained in the code or two yearsbeore it was detected.Starting in 2007 and through 2008, the volatil-ity o the market increased. Most unds that tradedon a quantitative basis perormed poorly during this time. AXA Rosenberg, however, experienceda considerable deterioration in perormance rela-tive to other active quantitative managers. Many o  AXA Rosenberg’s unds slipped into the ourth andth quintiles.In June 2009, a programmer identied the er-ror in the course o updating the risk model. Henotied his boss, om Mead, who in turn inormedBarr. Te chie investment ofcer, who was respon-sible or implementing a portolio strategy basedon the model’s outputs, was also notied. However,Barr made the decision not to inorm the groupCEO, the head o compliance, or the board o directors. Instead, he proposed that his team waitand correct the error during the next round o codeupdates that were scheduled to take place a ew months later. Known to him or not, this decision was in clear violation o SEC regulations which re-quire that an investment company notiy clients i its policies dier materially rom those disclosed inits marketing materials.
4
Although the error was corrected in September2009, the CEO was not notied that the error hadexisted until November 2009. Shortly thereater, theboard launched an internal investigation to evaluatethe matter. Barr and om Mead were recused romthis process. In March, the company inormed theSEC o the error, and the SEC launched a sepa-rate investigation. When clients were inormed o the error and the SEC investigation in April, many demanded the return o their capital. By the timethe investigations were complete nine months later,assets under management had declined to $20 bil-lion.AXA Rosenberg hired Cornerstone Research tocalculate the economic cost o the error. Corner-stone determined that the coding error had aected600 client portolios and caused $217 million inlosses (approximately 22 basis points on average)over the two years it was in place. O note, it oundthat 57 percent o client portolios either had notbeen aected or had beneted rom the increasedrisk taking caused by the error.
5
 In June 2010, AXA agreed to purchase the re-maining 25 percent o AXA Rosenberg that it didnot own. AXA Rosenberg became a wholly ownedsubsidiary o AXA Investment Managers. It con-tinues to exist today and continues to rely on thesame quantitative investment models originally developed by Barr. However, its product ocus hasshited to lower risk investment strategies with

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