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Jurisdictional shocks and fraudulent schemes

The impact of the collapse of Lehman Brothers and similar financial institutions on family offices last year was profound. In particular, family offices are reviewing the standards of regulation in jurisdictions where they hold assets. If there are perceived weaknesses in supervision, they are moving their holdings to other, more scrupulous centres.

The publication by the Organisation for Economic Cooperation and Development (OECD) of a series of jurisdictional lists has also been studied by many family office managers. Several lawyers in diverse locations told Campden FO that family offices do not want the hassle of being associated with grey listed jurisdictions. This favours the Channel Islands, the Isle of Man, Ireland,  Bermuda, BVI and the Cayman Islands, which are all white listed.

Michael Eades, a partner at law firm Carey Olsen, says that cash and near-cash assets are his biggest worry. "We dealt with a family office client who had a large amount of cash in a highly respected bank a few months ago. We did some intensive research into the institution concerned and decided that it appeared not to be as strong as it seemed. We immediately shifted the cash to another highly reputable institution which was backed with sovereign debt."

As it happened the original bank has survived and prospered but the story is indicative of the wary mood of family office investors. It is not only the collapses in financial leviathans in Wall Street and the City that have sparked alarm in family offices, a series of political scams in the Caribbean have also touched investors.

The most notorious are the Stanford scandal in Antigua and Barbuda, the collapse of Millennium Bank– a one-time associate to UBS – in St Vincent, and the Caribbean tentacles of the Bernard Madoff case.

Eades says that one of his larger investors was tempted to put all her family money into Stanford International Bank. "A couple of Stanford's more articulate directors came over and gave a highly plausible presentation about the returns which investors had seen. It appeared too good to be true. All the way throughout the presentation there was a consistent sense that this was not what it appeared to be. We were invited to go to Antigua and see the Stanford operation in situ. Fortunately our client shared our reservations and we placed the money elsewhere."

But the saga does not end there. One of the earliest casualties of the economic downturn was the regional financial services group CLICO. The group had operations in several jurisdictions. The extent of the losses suffered by the individual operating companies is still being investigated but all of its businesses have closed – with regulators enforcing closure in some cases.

It is unusual for so many scandals to break at the same time but it does pose the question for family offices with diverse interests how they can assess the political risks of investments and mitigate or hedge against them.

The IMF recently reported on the tidal wave of financial scandals in the region. "In several Caribbean states, unregulated investment schemes (UIS) grew quickly, particularly during 2006–2008, by claiming unusually high monthly returns and through a system of referrals by existing members. Such high returns are usually associated with Ponzi schemes. "The IMF's Ana Carvajal said that investment fraud can plague financial markets regardless of their level of development: "It encompasses all types of actions aimed at obtaining a financial gain from investors based on deception.

"Such fraud can take many different forms from very simple schemes such as outright theft, where none of the investor's money is returned, to more complex schemes such as Ponzi and pyramid schemes. Schemes can be regulated or unregulated entities and can take different legal forms, from joint stock companies to hedge funds or simple pools of assets," she added.

The Caribbean Ponzi schemes appeared to have mainly flourished in the form of UISs. The longer that they operate, the more damage they are able to inflict. Thus, the main policy lesson that can be extracted from countries' experiences with Ponzi schemes is the need for a rapid and early response from financial regulators and law enforcement authorities to identify and stop the schemes and protect investors' interests.

The IMF further commented: "Responding swiftly has proven to be a challenge in many countries. Other policy lessons involve tackling the social dimensions of the phenomenon by means of programmes to enhance financial literacy and personal financial responsibility among members of the public. In the case of Ponzi schemes operated by regulated entities such as offshore banks, the lessons point more simply towards the dangers of weak regulatory frameworks and inadequate supervision.

"The recent Caribbean experience has heightened the awareness of regulators and potential investors to the risks associated with UIS. However, awareness alone will not prevent a recurrence, and the experience shows that fraudulent schemes will emerge on a regular basis even in financial markets with strong regulatory frameworks. Thus, it is necessary that countries work together in enhancing their legal and regulatory frameworks."

As a result of all this activity, a new mood of caution has emerged. Where proper investment analysis has previously been conducted on an ad hoc basis, suddenly new programmes of valuation review have been launched and become commonplace.

In particular, the scandals have shaken up the larger multi-generational family offices, where significant number of assets needed to be managed. "It is true to say that a new era of prudence has occurred in the family office sector. Trust has always been a key factor in family relationships. That remains so but now that is being underlined by regular and thorough valuation of assets," says Eades.

Many of the larger family offices have extensive holdings around the world. Keeping a check on the status of individual assets can be a time consuming and expensive business. Eades says that family offices have engaged professional investment managers who have the technology to monitor and report on the quality and volatility of valuations. These are now feeding through monthly and quarterly reports.

Philip Munro, an associate at Withers law firm in London, says: "Many of the larger family offices have engaged Big Four accountants to provide regular audits of the individual assets and report on any fluctuations in valuations or the increase in risk profile. Some family offices had done this as an example of best practice for many years but many more are doing this as a direct result of the recession.

"Legal advisers have also been instructed to check the integrity of investment-related contracts and convenants to ensure that assets remain sound. We are aware of many family office clients being much more concerned to verify the quality of their investment strategies and they have become more active in changing investment policy – and where appropriate, investment advisers."

Investment advisors Asset Risk Consultants (ARC) says it has seen more attention concentrated on the quality of managers. Sanna-Liisa Valtanen, director of the ARC investment consulting arm, based in Guernsey, says: "After the Bernard Madoff scandal we have seen much more focus on the risk-management process employed by managers. It is important to remember that we came out of a period of low volatility and there was considerable trust in managers. Now, family offices are more sceptical and we are seeing far greater attention paid to the due diligence process rather than pure performance when selecting investment managers."

At Ernst & Young in the UK head of private client practice Andrew Tailby-Faulkes says his clients are conducting business risk reviews in increasing numbers: "They are examining a range of issues including quality of managers, personal security and the integrity of data. Some have found that some offshore managers with outstanding reputations have taken a cavalier attitude with data protection," he said.

With family offices now tightening their procedures, placing greater emphasis on high quality management information and using top tier lawyers and accountants to verify the integrity of their investments, the impact of political shocks and fraudulent schemes will hopefully be vastly reduced.

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