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Topics, Issues, and Controversies in Corporate Governance and Leadership

S T A N F O R D C L O S E R L O O K S E R I E S

stanford closer look series 1

Risk Management Breakdown atAXA Rosenberg: The Curious Case of a

Quant 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 the

managers o the company. Because managers are

agents (and not sole owners themselves), they do

not always have incentive to act in the best inter-

est o shareholders. Instead, they can take actions

to improve their own situation, even when there is

a cost to those actions that is borne by sharehold-

ers. o rectiy 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 challenges

o diuse ownership (which makes monitoring di-

cult) and the need to work through a board o

directors. In the case o companies with dual class

shares, shareholders must overcome the challenge

o having inerior 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 considerableinuence over the organization and its culture, and

third-party investors have been brought in to share

ownership. In order to be successul, the governance

system must balance deerenceto the expertise and

knowledge o the ounder with objective oversight

that allows the board o directors to intervene with

the ounders decisions when necessary. Lacking

this balance, a companys governance system can

By dv f. l B ty

My 30, 2013

invite problems that signicantly increase the pos

sibility o organizational ailure.

governance at aXa rosenberg

Rosenberg Institutional Equity Management was

private investment management rm ounded b

Barr Rosenberg in 1985. Barr, a ormer nance pro

essor at the University o Caliornia at Berkeley, i

widely renowned or his pioneering work on ris

actors that inuence stock value that is still in us

today in portolio risk assessment and perormanc

attribution. Trough his rm, Barr employed

quantitative strategy based on undamental analysi

to identiy and rank companies that were underval

ued relative to peers. He set an ambitious target o

achieving 2 to 4 percent alpha (or outperormance

relative to benchmarks, and or the most part wasuccessul in meeting this goal over a 15 year pe

riod. With his track record, Rosenberg attracted

investors in the U.S., Europe, and Asia and by th

late 1990s managed $10 billion in assets.

In 1999, French insurance company AXA, look

ing to diversiy and expand its investment manage

ment business, acquired a stake in Barrs investmen

rm. Under the agreement, AXA purchased a 50

percent ownership position and received an option

to buy an additional 25 percent. Barr remained

a signicant investor and chairman o the rmwhich was renamed AXA Rosenberg. Under thei

agreement, AXA had the right to appoint 50 per

cent o the board o directors, with Barr appointin

the remaining 50 percent.1 O note, this structur

was to remain in place in perpetuity, meaning tha

AXAs board representation would not change eve

when AXA exercised its option to increase its own

ership position to 75 percent.


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Risk ManageMent BReakdown at aXa RosenBeRg: the CuRious Case of a Quant ManageR tRusted too MuCh

Despite his prominent position as ounder and

chairman, 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 portolio 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 centers activities on the ex-

ecutive committee.2 As a result, Barr had no or-

mal management title and no ormal management

responsibilities, despite exerting considerable inu-

ence over the rm.

Although unusual by the standards o a public

corporation, there is some precedent or this type

o governance structure in the asset management

industry. Strategic buyers (such as nancial and

insurance companies) oten have difculty retain-

ing and motivating investor talent ater signing

joint venture agreements with boutique investment

rms. o preserve the environments that allowed

these rms to be successul in the rst place, they

are willing to aord 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 original

investment team ull discretion to make investment

decisions without intererence, although the seller

must typically abide by a code o ethics and submit

to 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 was

given little visibility into the details o the research

process. Barr did not report to the group CEO,and the management team o AXA Rosenberg did

not 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 not

always interview candidates who applied to work

there. Furthermore, although Barr retained the title

o chairman, he routinely delegated the acilitation

o board meetings to ellow board members that

he had appointed. Barr attended the meetings, bu

oten by telephone rather than in person. Finally

even though Barr was not majority owner and wa

only one member o the board, he had eectiv

control over many organizational decisions. I Bar

opposed a change avored by othersor example

a decision to adjust the prot-sharing programi

was typical that the board and the executive com

mittee would deer to his position. Barr also sat on

a specially created governing board that acted a

a 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 signicantly. In 2002, they doubled rom

$10 billion to $20 billion, owing largely to an inu

sion o cash rom AXA and the clients o its wealth

management division. By 2005, assets exceeded

$69 billion and by 2007 reached $135 billion. T

investors in AXA Rosenberg were primarily insti

tutional investors, pension unds (both oreign

and domestic), sovereign wealth unds, and retai

investors. Also during this time, AXA exercised it

option and increased its ownership position to 75

percent.

governance breakdown

Te governance breakdown that led to the unraveling o AXA Rosenberg had its roots in a technolog

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 centers models rom its origina

programming language o FORRAN to an ob

ject-oriented language called Eiel. 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. Par

o the problem was the way the project was managed; rather than upgrade the model in its totality

all at once, the model was upgraded piecemeal. A

the research center was constantly rewriting cod

to optimize its investment strategy and to keep up

with rapid growth and new product development

the migration was unable to keep pace with th

continuous revisions. Another problem was due to

the choice o programming language. While Eie


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is considered a high-quality language, it is also very

obscure. Te PhDs hired into the research center

were oten not experienced working with it and re-

quired a steep learning curve, and the AXA audit

teams could not eectively audit the technology

transer. Finally, because Barr closely guarded access

to the model, a small set o programmers had to

balance 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 research

center was spending too much time on reprogram-

ming and not enough on innovation and under-

standing market dynamics. Te CEO arranged or

a successul technology leader to be seconded to

the research center to support the project manage-

ment o the migration to Eiel; however, he and

the board were unable to enorce accountability or

meeting 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 assume

more risk and improve returns, which had been

lackluster in the low volatility market ollowing the

bursting o the technology bubble. Unbeknownst

to the board, as the changes to the risk model wereimplemented, an error was introduced. A program-

mer incorrectly programmed the risk model so that

some o its calculated risk elements were too small

by a actor oten thousand. As a result, the model

sometimes grossly undercalculated the riskiness o

the rms investment decisions. Even though the re-

search center had quality control measures in place

to check the code revisions, these measures did not

detect 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 yearsbeore it was detected.

Starting in 2007 and through 2008, the volatil-

ity o the market increased. Most unds that traded

on a quantitative basis perormed poorly during

this time. AXA Rosenberg, however, experienced

a considerable deterioration in perormance rela-

tive to other active quantitative managers. Many o

AXA Rosenbergs unds slipped into the ourth and

th quintiles.

In June 2009, a programmer identied the er

ror in the course o updating the risk model. H

notied his boss, om Mead, who in turn inormed

Barr. Te chie investment ofcer, who was respon

sible or implementing a portolio strategy based

on the models outputs, was also notied. However

Barr made the decision not to inorm the group

CEO, the head o compliance, or the board o

directors. Instead, he proposed that his team wai

and correct the error during the next round o cod

updates 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 notiy clients i

its policies dier materially rom those disclosed in

its marketing materials.4

Although the error was corrected in Septembe

2009, the CEO was not notied that the error had

existed until November 2009. Shortly thereater, th

board launched an internal investigation to evaluat

the matter. Barr and om Mead were recused rom

this process. In March, the company inormed th

SEC o the error, and the SEC launched a sepa

rate investigation. When clients were inormed o

the error and the SEC investigation in April, man

demanded the return o their capital. By the tim

the investigations were complete nine months laterassets under management had declined to $20 bil

lion.

AXA Rosenberg hired Cornerstone Research to

calculate the economic cost o the error. Corner

stone determined that the coding error had aected

600 client portolios and caused $217 million in

losses (approximately 22 basis points on average

over the two years it was in place. O note, it oun

that 57 percent o client portolios either had no

been aected or had beneted rom the increased

risk taking caused by the error.5

In June 2010, AXA agreed to purchase the re

maining 25 percent o AXA Rosenberg that it did

not own. AXA Rosenberg became a wholly owned

subsidiary o AXA Investment Managers. It con

tinues to exist today and continues to rely on th

same quantitative investment models originally

developed by Barr. However, its product ocus ha

shited to lower risk investment strategies with


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lower targeted alphas.

In July 2010, both Barr Rosenberg and om

Mead resigned rom the company. In February

2011, AXA Rosenberg settled charges o mislead-

ing investors with the SEC and agreed to pay over

$240 million, including $217 million to reimburse

clients or investment losses and $25 million in

penalties. In a press release, SEC Director Robert

Khuzami criticized AXA Rosenberg or an organi-

zational structure that did not allow the companys

executive committee to have clear insight into the

operating activities o the research center:

o protect trade secrets, quantitative investment

managers oten isolate their complex computer

models rom the frms compliance and risk man-

agement unctions and leave oversight to a ew

sophisticated programmers. Te secretive struc-ture and lack o oversight o quantitative invest-

ment models, as this case demonstrates, cannot

be used to conceal errors and betray investors.6

In September 2011, the SEC charged Barr Rosen-

berg with securities raud or ailing to disclose a

signicant error in the companys investment mod-

el. Barr agreed to pay $2.5 million in penalties. As

part o the settlement, Barr was banned rom the

securities industry or lie.7

why this Matters

1. Risk management is a undamental duciary

duty o the board o directors (including the

subsidiary board o AXA Rosenberg). How does

a board satisy itsel that risks are known and ap-

propriately monitored within an organization?

2. Te case o AXA Rosenberg involves a widely

renowned investor with extremely specialized

nancial knowledge. Is it really possible or a

board to monitor such an executive and engage

in rigorous risk management?3. Barr Rosenbergs relation with the board and

the executive committee o AXA Rosenberg was

guarded, and he was not particularly orthcom-

ing with inormation. How does an executives

personality aect the implementation o risk

management by the board?

4. Te joint venture agreement between AXA and

Rosenberg involved several curious eatures.

Could the deal structure have been modied to

mitigate the economic impact on AXA share

holders? I so, how? Would this have improved

the outcomes or all parties?

1 Te board was a subsidiary board, responsible or compliance wit

the rms obligations under the Investment Company Act o 1940Te mutual unds managed by AXA Rosenberg were overseen by separate board o trustees comprised o independent directors.

2 Portolio development activities were separate and distinct rom th

activities o the research center. Te research center calculated anranked the relative value o potential stock investments. Tese wer

then conveyed to the chie investment ofcer whose team created

portolio that was diversied in terms o industry, size, geographyetc. From an organizational perspective, the chie investment ofce

was not a member o the research center. Both the chie investmen

ofcer and the director o research were members o the executiv

committee and the board o directors.3 In the Matter o Barr M. Rosenberg, administrative proceedin

number 3-14559, in the U.S. Securities and Exchange Commission4 SEC, Securities Act o 1933; Investment Advisors Act o 1940.

5 During the period in question, AXA Rosenberg managed an averago $100 billion in assets.

6 SEC, SEC Charges AXA Rosenberg Entities or Concealing Erroin Quantitative Investment Model, (Feb. 3, 2011).

7 SEC, SEC Charges Quant Manager with Fraud, (Sep. 22, 2011)

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