Reference no: EM132395245

Case Study: Leger-Acme Quantitative Portfolio

Etienne Leger is a legendary pioneer in the field of quantitative portfolio management. He founded a firm early in his career offering reporting and analytic tools based on his research and academic work. In 1999, a large global investment firm, Acme Financial Services, purchased a significant share of Leger's firm which was renamed Acme-Leger. This new firm was headed up by a group president appointed by Acme, while Leger remained the senior scientist. Leger retained no formal title or responsibilities however continued to call the shots from a research perspective. In this capacity, he enjoyed virtual autonomy vis-a-vis Acme management. His former head of technology, Jeffery Shearer, was made executive director reporting to the executive committee and the group president.

This new firm began to offer a global equity mutual fund whose investment process was based entirely upon Leger's analytic work. 

The essence of the process, which was summarized in the fund's prospectus, consisted of three software programs:

• A valuation engine that took in fundamental data about thousands of individual equities and generated a single Value Factor for each;
• A risk engine that combined fundamental, historic and macroeconomic data to generate a single Risk Factor for each equity; and,
• An optimization engine that would combine these two factors to generate a portfolio of 120 stocks optimizing the risk-reward tradeoffs according to the investment parameters of the portfolio. These parameters were also disclosed in the prospectus.

The optimizer would provide automatic trade recommendations to maintain the live portfolio in synch with the output of the model. These trades would go straight to the trade blotter to be executed with a minimum of human review or intervention.

The fund was rolled out in 2000 as registered investment company available only to institutional and high net worth investors. The minimum initial investment was $3 MM. The fund enjoyed very strong performance from the beginning and accumulated assets of $1.5 billion. This success led to the creation of several institutional portfolios managed by the same process. Many of the new clients were existing Acme wealth management clients enticed into the new product. By the end of 2009, this investment process was managing over $68 billion in total assets.

Early in 2007, the Acme board voted to follow Leger's recommendation that the risk model be adjusted to allow the assumption of greater risk. In the course of making this adjustment, a software error was introduced into the code. Within three months, the west coast office of Acme began questioning the returns of the fund which seemed to be lagging past performance. Meanwhile market volatility had increased. Due to the long and successful record to date, A-L management dismissed these concerns as merely temporary impacts from increasing market volatility. The deterioration of the product's performance continued. Questions from the west coast and other offices became increasingly exigent, and they became openly skeptical of the continued insistence that the issue was market volatility.

In June of 2009, a software engineer, Emily O'Donnahue, was tasked with a relatively small and routine upgrade to one of the modules in the risk engine. She discovered the error introduced back in 2007. Both the valuation and risk engine were designed to deliver their factor results as percentages ranging from 0 - 100%. However, in 2007 the engineer working on the risk engine made an error which caused it to send its factors as floating point numbers - that is as 0.00 - 1.00. Hence the impact of the risk process on the optimization process was reduced by a factor of 100.

Emily O'Donnahue brought this issue immediately to the attention of her most senior manager, Jeffery Shearer, who informed Leger and the portfolio manager in charge of the quantitative product. Leger made the decision to not tell the group president, the board or the compliance department of the error. Shearer told the engineer to keep the information to herself and the error would be fixed in the next scheduled round of software upgrades.

By late August all the affected portfolios were showing increasingly negative results and the questions coming out of the support offices were becoming increasingly frantic. The response of the investment management team continued to be that the unexpected poor performance was the result of unusual market volatility and would be temporary. Hearing rumors about this from amongst the product management people, Emily became alarmed that nothing seemed to be getting done and approached Shearer again at only to be reprimanded verbally and told to mind her own business: the situation was being handled.

The error was fixed in the September 2009 scheduled release, but the same explanations as to underperformance were being retailed to the sales and client service teams.

Angry about her reprimand and concerned about the possible implications, Emily O'Donnahue approached senior management of the Acme via the firm's whistleblower program in November of 2009. Acme took this revelation very seriously and immediately initiated an internal review. The group president was finally informed of the full story at this time and the board launched a full investigation. By December, all of the material facts of the case were known to Acme including the fact that the software issue had not been addressed for two years and that its existence had been kept a closely guarded secret by a handful of senior people in the Leger group.

Shortly after ACME completed its internal investigation, they received a call from the SEC announcing that the regulators would be performing a routine examination beginning in February.

Please review and comment upon the facts and if appropriate what follow up actions you would recommend. Also, to the extent you believe that the decisions of some of the actors were flawed, please discuss what you believe would have been a more appropriate response.

1. Identify the principal actors

2. Identify the stakeholders

3. Determine if there have been ethical or regulatory breaches and what principles have been violated. 

4. Determine if there has been material harm to any stakeholder and what steps are required to mitigate or correct it.

5. Given the facts on the ground as of December 20, 2009, what is the best course of action for Acme on receipt of the SEC's routine announcement?

6. Assuming that the SEC does become involved, does the disclosure language in the prospectus of the Mutual Fund mitigate or worsen Acme's situation?

7. Discuss any other issues of ethics, compliance or good governance that extend beyond the immediate details of this case.