General H. Norman Schwarzkopf once said: “The truth of the matter is that you always know the right thing to do. The hard part is doing it.” While this may be true in many circles of life, knowing what to do in the investment world is becoming increasingly complex, rendering decision-making – and training people how to make ethical decisions – difficult. Because this challenge is especially prevalent in the hedge fund management industry due to the rapidly changing regulatory environment and often-times conflicting motivational forces, hedge fund managers must seek a new model or risk losing investor confidence due to legal or reputational failure. That model, it is arguable, can be found in a military theory.
In “The Strategic Corporal: Leadership in the Three Block War,” which was published in the January 1999 edition of Marines Magazine, General Charles C. Krulak, then commandant of the US Marine Corps, argued that a critical factor in the success of future military operations would rest on preparing soldiers to be strategic thinkers. Gen. Krulak wrote: “Success or failure will rest, increasingly, with the rifleman and with his ability to make the right decision at the right time at the point of contact.” Accordingly, Gen. Krulak stated that the military must ensure that young soldiers are prepared and equipped to lead wherever they may be in the chain of command by a proactive mentoring, otherwise known as “power down,” that eschews micro-managing of soldiers’ activities. Gen. Krulak’s thesis, if followed by hedge fund managers, could have a profound application to the hedge fund industry.
In his article, Gen. Krulak describes a fictional humanitarian mission in central Africa that would require soldiers to make decisions that would “potentially influence not only the immediate tactical situation, but the operational and strategic levels as well,” and thus, “directly impact the outcome of the larger operation.” The day’s operation began with a squad protecting a security checkpoint, but quickly deteriorated as crowds at the checkpoint became agitated while two rival warlords appeared to assemble nearby. The situation became increasingly complex when a helicopter was shot down near the checkpoint just before one of the warlord’s men – trailed by a cable news crew – rushed through the crowd and right up to the checkpoint barricade. The crowd began to throw rocks and a Molotov cocktail at which point the humanitarian mission reached a critical juncture where the wrong decision by the soldiers on the ground could not only have cost lives and caused the overall mission to fail, but also have resulted in far-reaching political fallout. The corporal had to process the situation, make a decision and act, all within a matter of minutes. First, he assessed what he knew and what he did not know. Then he acted in a way that resulted in the situation being diffused almost as quickly as it arose. Gen. Krulak states in his conclusion that the corporal, “firmly grounded in [the Marine Corps] ethos, thoroughly schooled and trained, outfitted with the finest equipment obtainable, infinitely agile and, above all else, a leader in the tradition of the Marines of old… made the right decision.”
This fictional scenario represents what is referred to as a “three block war,” which is “a contingency in which the Marines may be confronted by the entire spectrum of tactical challenges in the span of a few hours and within the space of three contiguous city blocks.” Similarly, employees at hedge fund management firms are routinely bombarded with information that they must quickly digest and determine whether or not to act, including where those actions or inactions involve a zero sum game as among their firm, their client and the financial markets at large. As a result, and in light of an increasingly complex legal and regulatory environment in which they do business, hedge fund managers can glean lessons from “The Strategic Corporal”.
Without question, managing investments on behalf of others is not equivalent to maintaining peace or waging war. Although investment advisers are fiduciaries and serve an important role in the global economy, it is hard to imagine how an employee’s decision on a hedge fund trading floor, for example, could result in saved or lost lives. Such decisions could, however, result in strategic consequences, such as bad investments or missed opportunities, or worse yet, ruin careers and erode public confidence in the integrity of the financial system. One only needs to read the latest headlines to find evidence of bad decisions jeopardising a firm’s very existence.
Gen. Krulak provided three steps for how to prepare Marines for the “complex, high-stakes and asymmetrical battlefield of the three block war.” First, moral character – defined by the “honor, courage and commitment” ethos – must be the foundation upon which Marines are built because many issues faced by Marines are moral quandaries. Second, there must be an institutional commitment to lifelong professional development that aggressively cultivates the “growth of integrity, courage, initiative, decisiveness, mental agility and personal accountability”, so that Marines are capable of addressing tasks they confront. Third, junior leaders must be equipped to lead and provided the “freedom to fail.” With respect to the third step, Gen. Krulak states, “Micro-management must become a thing of the past and supervision – that double-edged sword – must be complemented by proactive mentoring.”
Use of this “power down” process is how both employees and soldiers gain the skills and judgment to make difficult decisions at the point of contact. In the financial industry, that point of contact has never been more complex due to an historic increase in recent years in rules and regulatory oversight, both nationally and internationally. Currently, aided by a pall of contempt that has fallen on the financial industry due to the Great Recession, mere allegations of impropriety within the industry continue to make headlines in the popular press, further eroding public confidence in global financial markets. In sum, the boundaries created by national and international rules and regulations can be erratic, contradictory, counterintuitive and opaque, and are certainly numerous and evolving. Such a fluid, complex environment demands new thinking and approaches to ensure that those within the broader financial services industry know and abide by the rules, because failing to do so is simply untenable. How, then, can hedge fund managers train, develop and equip employees for their “three block wars”?
First, firms must seek to hire only those candidates who possess a solid moral footing and, thereafter, continuously stress – in both creed and deed – the importance of compliance with applicable law and decision-making based on a stated ethical standard. Grounding decision-making in an ethical framework is particularly important in the financial industry where the law may be unclear, consequences not immediate, or “getting away with it” highly profitable. For this reason, firms should set a clear expectation that not only will the violation of law be punished, but also, unethical behavior will not be tolerated. In other words, firms should turn away from a pure risk versus reward paradigm where decisions are based on a comparison of the risk of getting caught versus the reward for not getting caught. Instead, firms should adopt and promote a firm-wide philosophy that decisions must take into account what is “right” from an ethical perspective so that marginally inappropriate behavior is not disregarded. To be clear, promoting ethical behavior is not a novel concept. To the contrary, it is woven into the very fabric of the fiduciary role of investment advisory firms. However, if they have not already done so, firms should reorient their view of ethics as a pathway to success, not an obstacle preventing it, creating a culture that reflects that shift.
Second, firms should provide progressive training and otherwise afford opportunities for employees to learn new and changing laws, rules and regulations, and how to apply them in a full range of real world situations. The frequency of training, which can be provided by internal personnel or external providers, should be commensurate with the frequency and scope of changes to laws affecting the employee, firm and wider financial industry. With a solid understanding of the law and keeping in mind that what “can be done” may not be the same as what “should be done,” employees “on the ground” should be able to, at a minimum, spot issues for deliberation. After all, in dealing with any issue, one must first be able to recognise it as such. Beyond mere issue spotting though, increasing knowledge and competency should enable employees to anticipate problems before they become crises and result in an unnecessary drain on valuable time and resources. As a corollary, compliance and legal personnel should be expected to stay abreast of business developments and investment opportunities being considered by the firm on behalf of its clients. For example, including legal and compliance personnel in analyst meetings and briefings could help such personnel anticipate legal and compliance issues and, also, better enable them to devise workable resolutions for real world dilemmas.
Third, firms must establish appropriate supervisory roles and responsibilities as required by the Investment Advisers Act of 1940, yet trust that employees are capable of thinking independently and responding to issues appropriately without requiring constant oversight by legal and compliance personnel. This is so because even at the best staffed and equipped firms, such personnel cannot be omnipresent, and many situations simply do not allow enough time for consultation. In addition, employees on the ground may actually be in a better position to develop an appropriate response given their deeper understanding of business issues as compared to legal and compliance personnel. This is not to say that the legal and compliance function can or should be pushed completely down, but rather, it is an acknowledgement of the reality that compliance is not a spectator sport – it is the responsibility of everyone within the firm. And, if a firm hires trustworthy personnel, fosters a culture of compliance, and provides adequate training, powering down will not be a pure leap of faith.
In conclusion, while applying “The Strategic Corporal” to the hedge fund industry may seem like a stretch at first glance, upon closer study, it is the very simplicity of Gen. Krulak’s theory that renders it capable of such a broad application. This does not mean that taking the three steps discussed above will be easy, or without cost. To the contrary, it will require a commitment of time and resources to cultivate ethical behavior and keep employees abreast of changing regulatory regimes so that the right decisions can be made at the right time. However, if the actions during the past decade of overtly bad actors and those who crossed ethical boundaries are any indication, the hedge fund industry must consider fresh approaches and strive to cultivate “strategic employees.”
John Herbert Roth is General Counsel and Chief Compliance Officer at Venor Capital.
Power Down in the Hedge Fund Industry
Military principles and an ethical firm philosophy
JOHN HERBERT ROTH, VENOR CAPITAL
Originally published in the November 2013 issue