99999-2764/LEGAL17951840.2

American Bar Association

Business Law Section

Spring Meeting, Denver Colorado

April 23, 2010

Institutional Investors Committee

Transition Management: Legal Risks and Traps for the Unwary

Hypothetical Portfolio Transition

The State of Columbia Pension Fund has approximately $70 billion of assets under management, $60 billion of which is allocated to long-only liquid securities. The Fund has traditionally followed a 60/40 asset allocation strategy for its traded securities, with 60% of those assets invested in equities, and 40% in fixed income securities. Eighty percent of the equity portfolio is in US equities (80% large cap; 10% mid-cap; 10% small cap) with a clear tilt toward growth-oriented managers. Eighty percent of its non-US equity portfolio is in developed market securities (60% Eurozone; 30% Pacific; 10% other) and 20% is in emerging market securities. The fixed income portfolio is invested principally in US government (60%) and US corporate (40%) bonds. The remaining $10 billion in assets are allocated to alternative investments (hedge funds, private equity funds, real estate and commodities). The Fund manages 10% of its US large cap equities and all of its fixed income securities in house, and uses 24 independent investment managers for the remainder of its equity portfolio, 15 of whom are located in the United States, five in London, two in Tokyo and one each in Singapore and Sydney.

Recently the Fund received a report from its consultant that in light of its immediate cash needs to address the impact of the recent financial crisis, the low interest rate environment and the prospect of rising future interest rates, the asset allocation strategy should be changed to a more aggressive one, with 70% devoted to equities, with a greater percentage invested in small and mid-cap domestic securities and in developed and emerging non-US markets. In addition the Fund has been disappointed in the performance of several of its equity managers, and changes have been recommended by its consultant. No changes have been recommended for the Fund's assets that are invested in alternatives.

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The Fund has decided to transition $6 billion of its internally-managed existing fixed income portfolio to fulfill the new asset allocation strategy. Half of those assets will be managed internally in a large cap strategy, 30% will be managed by existing large cap equity managers, and 10% will be managed by each of two new equity mid-cap value and small cap value managers. In addition, the Fund has decided to reposition its equity portfolio to be more aggressive by moving $5 billion of assets from existing US large cap equity mangers. This will require moving $3 billion from four of its US large cap equity managers (three of which will be terminated completely and one of which will have a reduced mandate) to three new mid and small cap equity managers, and $2 billion from the same US large cap mangers to three international mangers, one of whom is an existing manager in London, one a new Pacific Basin manager in Singapore and another new emerging markets manager in London.

When the transition is complete the asset allocation will be as follows:

Before Transition After Transition

Dollars (bns) Allocation Dollars (bns) Allocation

US large cap: $23.040 38.40% $22.840 38.07%

Internal: $2.304 3.84% $5.304 8.84%

External: $20.736 34.56% $17.536 29.23%

US mid-cap: $2.880 4.80% $5.480 9.13%

US small-cap: $2.880 4.80% $4.480 7.47%

Eurozone: $3.456 5.76% $4.456 7.43%

Pac Basin: $1.728 2.88% $2.228 3.71%

Other developed: $0.576 0.96% $0.576 0.96%

Emerging markets: $1.440 2.40% $1.940 3.23%

Total Equity $36.00 60.00% $42.00 70.00%

Fixed Income:

Internal: $24.00 40.00% $18.00 30.00%

The Fund wishes to engage a firm experienced in transition management to effect the transition of the portfolio in a manner that minimizes costs and captures market movements as the funds are being transitioned.

Transition Management: Legal Risks and Traps for the Unwary

Emily A. ReidIllinois State Board of InvestmentAmerican Bar Association, Business Law SectionInstitutional Investor CommitteeSpring Meeting, Denver ColoradoApril 23, 2010

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“In point of fact, other than asset allocation and selection of investment managers, portfolio transitions represent the single biggest area where decisions by plan sponsors directly impact the costs (and thereby returns) enjoyed by their plans.”Steven Glass & Norman Goldberg, Unbundling Transition Decision-Making from Execution: A “Best Practices”Fiduciary Paradigm, Institutional Investor, Summer 2003, at 42.

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As transition management has evolved, institutional investors’ scrutiny of transition management relationships has increased.

Insufficient time and inadequate information prior to a transition can expose investors to unnecessary risk and increased explicit and implicit transition costs.

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Establish best practices in advance of transitions to ensure prudent decision making and efficient processes.

Plan sponsors can adopt a governing policy for transition management that:

Outlines the plan’s priorities and risk parameters relative to transitionsEstablishes a process for selecting, retaining and evaluating transition managers

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Priorities & Risk ParametersTransition manager standard of care

Prudent expert acting in an agency capacity?Strategy

Minimum qualifications for transition managersReview historical track record of aggregate transition manager activityEvaluate size and expertise of transition teamExamine the business model and business continuity proceduresAssess risk-management capabilities

ConfidentialityProtection against information leakage Separation of transition management from other firm operating areas

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Priorities & Risk ParametersConflicts of interest

Require disclosure document from transition manager detailing actual and potential conflicts of interest and measures taken to manage themDetermine whether trading or other functions are delegated within the firm or outsourced to a third partyEnsure documented work flows and procedures

TransparencyPre-Transition:

Review internal procedures and how revenue is calculatedRequire disclosure of all relationships with expected third partiesEvaluate proposed strategy and cost analysis

Post-Transition:Review a complete accounting of all transition activityRequire disclosure of all revenue derived from the transition by the transition manager, its affiliated companies and/or any third party broker-dealersEvaluate post-trade performance and cost analysis

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Selecting, Retaining and Evaluating Transition Managers

Form a panel of pre-vetted, expert transition managers.

Increases efficiencyPromotes competitive bidding Frees plan sponsors to focus on transition planning and strategy

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Panel Formation: Areas of Focus

Conduct a search for transition managers that:Clearly identifies the plan sponsor’s expectations for the relationshipRequires certification and evidentiary support for minimum qualificationsRequires panelists to agree to be bound by the plan sponsor’s specific policies and “deal breaker”contract provisions

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Panel Formation: Areas of FocusDetermine the appropriate number of panelists.Carefully select panelists to ensure a diverse range of transition specialties.Develop a standard transition agreement, and use the agreement when negotiating a relationship with each panelist.Develop a standard transition bidding notice to distribute to panelists before a transition, and create a standard form for cost estimates, in order to receive “apples to apples” cost comparisons.Bidding panelists should provide a detailed pre-trade analysis and timeline, based on the legacy/target portfolio information and instructions contained in the bidding notice. Request past track records to help assess the efficacy of pre-trade estimates.

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Forming a Panel: Areas of FocusCarefully evaluate explicit and implicit cost projections before selecting a panelist.Create a standard addendum to the transition agreement for each specific transition.Require a post-trade performance and cost analysis and revenue disclosure report.Ensure that the plan sponsor’s professional investment staff provide a transition performance evaluation.

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RESOURCES:S. Glass, A Practitioner’s Guide to Establishing a Prudent Transition Process, Investment Technology Group, Inc., February 2009.Pension Benefit Guarantee Corporation, The PBCG Standard (2008).Steven Glass & Norman Goldberg, Unbundling Transition Decision-Making from Execution: A “Best Practices” Fiduciary Paradigm, Institutional Investor, Summer 2003, at 42.

Transition Management

Brian Golob – Russell Investments

April 24, 2010

Legal Risks and Traps for the Unwary

Important Information

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contain in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

These views are subject to change at any time based upon market or other conditions and are current as of the date of first use. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

Unless otherwise noted, source for the data in this presentation is Russell Investments.

Copyright© Russell Investments 2010. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.

The Russell logo is a trademark and service mark of Russell Investments.

Date of first use: April 2010

THIS MATERIAL WAS CREATED BY RUSSELL AS ANEDUCATIONAL TOOL, AND NOT INTENDED FOR FURTHER DISTRIBUTION

Transition Management

How does it work? Transition management process

Basic documentation

What should you know?Provider’s Business Model

Provider’s Compensation

What should you do?Get the Disclosure…and use it!

How does it work?

Risk-managed implementation

Transition Management Process

Analyze legacy and target portfolios

Identify key differencesin exposures

Estimate total cost of transition (“implementation shortfall”)

Measure performance vs. estimate (T Standard)

Do “post mortem” of event

Watch closely in the early days of the new portfolio

Neutralize largest, most volatile exposures

Begin trading…in many places

Use derivatives to stay invested

Manage currency exposure

Manage communications & operations flow

Pre-transition analysis Post-transition

Several days…or longer

Daily communications among all parties

Focus on overall investment performance.For illustrative purposes only.

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Basic Documentation

Transition Management AgreementPanel agreement - “evergreen” with form instruction letters for eventsFee Disclosure Duties & Standard of CareConfidentialityPlain English, never more important

Derivatives DocumentationListed futures – risk disclosures & representations…long!“Standard” ISDAs for Swaps – two-way credit agreementsCurrency forwards – all shapes and sizesPower of attorney for Provider

Emerging Markets…Wild west, and EastAccount opening to settlement…Broker indemnification???

What Should you Know?

Know your Provider’s business model

FiduciaryCaveat EmptorIn Latin…

For the benefit of client- Prudent expert standard- Disclosure- Loyalty – Clients first

Fair dealing- Know your customer- Suitability- FINRA, Exchange rules

Legal Duties

Investment benchmarks (“Implementation Shortfall”)

Trade metrics (VWAP, TWAP)

Measuring performance

Overall investment results (CFA Institute)

Best priceBest execution

Investment strategiesTransactionsExpertise

Client advocateFacilitatorRoleInvestment AdviserBroker-Dealer

Know how your Provider gets paid

Disclosed Revenue SourcesAdvisory fees – rare, typically for longer term “interim” assignmentsCommissions & Markups – coming down

“Other” Revenue SourcesProprietary trading – undisclosed gains“Pre-hedging”- a.k.a. front runningCrossing & “Sales Trading” – with provider’s other clientsFixed income to equities – dealer markets with undisclosed spreadsInternational trades – “marking” and undisclosed affiliate compensationForeign Currency – undisclosed everything

So how BIG of a deal?

“If transition managers make $640 million in explicit revenue from transitions, it may represent 25% OR LESS of their total revenue.”

According to a TowerGroup study…

$640 million in explicitrevenue sources

$1,960 million in other revenue sources

Bid/ask spread in fixed income

Commissions on the other side

Proprietary trading & “pre-hedging”

Foreign currencyspreads/margins

Commissions

Source: Portfolio Transition Management: Where Asset Management Meets Extreme Sports, February 2004, TowerGroup.Dollar amounts are based on TowerGroup’s analysis of the revenue models of transition providers and its estimate of the total size of the transition market. Estimated cost range for foreign currency trading based on research by Russell investments.For illustrative purposes only.

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So how much could you pay for $1B in FX trading? $100,000…or $10,000,000!

What should you do?

Get the Disclosure

Require full disclosure of CompensationAll forms, all services, all asset classes

All affiliates

Restrict undisclosed compensation

Watch for generalitiesContractual disclosure obligations not always all they seem

May not cover all forms, affiliates, incentives

Watch for “direction” to cross, trade with affiliates

But don’t stop there…

Is sunlight always the best disinfectant?Disclosure doesn’t guarantee good behavior

“Moral License” - Research shows disclosure may actually increase advisor bias…and client reliance*“Sophisticated investor” exceptions - Many providers – and regulators - expect institutional clients to fend for themselves

Contract for Fiduciary DutiesWatch for additions to legal lexicon – “Trading Fiduciary?”

Discuss, understand, evaluate the Provider’s plan and business model

*Source: Daylian Cain (RSS), George Loewenstein (RSS), Don Moore (RSS) (2005) The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest. The Journal of Legal Studies (Volume 34) (RSS)

Appendix

Derivatives Overview

Benefits - More tools for more efficient managementOverlay unused cash

Hedge unintended bets, buy time to trade illiquid positions

Interim management during new manager searches

Could cost the fund $1.5M per hour if even a small percentage of the fund is out of the market

RisksLeverage: Derivatives and borrowing can be used to magnify gains…and losses! Rare in TM, if only used for hedging, not for speculation

“Basis Risk”: Some derivatives are not a perfect match for the investment you want

Collateral and margin requirements: Some require daily cash transfers to cover May need cash at the WORST possible time

Communications/Operations…Errors can be BIG and grow FAST

Discuss strategy with Provider, include clear restrictions in guidelines…and MONITOR

Derivatives Legal Considerations

Listed futuresComplex documents, time consuming

Daily cash movement for margin calls

Jurisdiction matters – customer protection rules and bankruptcy practices vary considerably

OTC Derivatives – Swaps, FX forwardsCustom arrangements for complex exposures

Dealer market…price discovery limited

ISDA documentation complex, time consumingFinancial disclosure requirements

Sovereign immunity waivers

Termination Triggers…can lose exposure when you need it most

Counterparty exposure managementAgain, jurisdiction matters

Collateral movement…if you want it

Provider can (should) act as agent…but read the documents anyway

Research on Foreign Exchange Trading Costs

Source: Theoretical distribution based upon Russell’s expectation of results.Typical results are for illustrative purposes only; distributions based on actual analyses can differ.

Superior executionInferior execution

Daily range of exchange ratesOutside daily range

Dis

trib

utio

n : N

umbe

r of T

rade

s

Exchange rates should be random

No rate would be more likely than any other rate

The graph below shows the expected distribution of a large number of trades (symmetrical with a broad spread between the best and worst prices of the day)

Execution rates are often negatively skewed

Method of getting to ‘market’ affects execution quality

The graph below shows a typical distribution of a manager who trades with a single counterparty that resulted in uncompetitive pricing

Expected results Typical results

Inferior execution Superior execution

Daily range of exchange rates

Dis

trib

utio

n : N

umbe

r of T

rade

s

Outside daily range

For illustrative purposes only.

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Compensation Disclosure Sample

Compensation agreed in advance“For each transition, Provider’s compensation will be agreed separately by the parties in advance and set forth in the applicable Fund Restructure Notice.”

No other compensation“Except as provided in or authorized by this Agreement or other separate written agreement with the Client, neither Provider nor any of its officers, directors, partners or affiliated companies will receive any additional compensation or fees with respect to the business of the Client.”

Sample disclosure with some wiggle room

“Client hereby directs Provider to market transactions and foreign currency transaction through [Provider’s affiliated securities broker] for execution. Provider’s Affiliate may use external crossing networks. The commission charges on such external crosses will not exceed $xxx per share. Any securities not traded on an external crossing network will be traded at a commission rate of $xxx per share. In addition, Client hereby directs Provider to execute all futures transaction through [Provider’s affiliated futures broker].”

Direction eliminates fiduciary duty to chooseDisclosure doesn’t cover foreign exchange or futuresNeed to learn more about pricing of trades in “Crossing networks,” and who’s clients are on the other side

Transition Management: Legal Risks and Traps for the Unwary

Elizabeth Kemery SipesJanus Capital Group Inc.

American Bar Association, Business Law SectionInstitutional Investor Committee

Spring Meeting, Denver ColoradoApril 23, 2010

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• Asset managers need to consider a variety of operational and legal issues that may arise when clients seek to transition portfolios.

• Communication between the client, asset manager, transition manager and custodian is essential to ensure a smooth transition.

The Asset Manager’s Perspective

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• Internal teams need to be aware of the transition timeline as soon as possible.

• Key dates to consider:– How long will the transition take?– When will portfolio holdings need to be disclosed?– When will the assets settle in the final custodial account? – When will the asset manager take over the portfolio?– When will performance start?

Transition Timeline

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• Asset managers provide the list of target portfolio holdings, the “wish list”, to the transition manager and/or client.– Managers typically enter into a non-disclosure agreement with

the transition manager for each transition.– Holdings may also be disclosed to clients after execution of the

investment management agreement.

• Depending on length of transition, asset managers may need to update the list of target portfolio holdings.

Disclosure of Portfolio Holdings

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• Managers should receive a post-trade list from the transition manager and a certified holdings list from the client’s custodian upon completion of the transition to verify what has settled in the client’s account.

• Key Considerations:– Are the proportions correct or within an acceptable tolerance?– Are there illiquid securities?– Are there any other securities the manager can not or does not

want to hold?

Certification of Final Holdings

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• If the portfolio cannot be transitioned within acceptable tolerances, the asset manager, client and transition manager will work together to determine how to treat any problem securities.– Consider segregating problem securities and contribute

proceeds to account at a later time.– If these securities cannot be segregated into a separate account,

managers need to consider the impact of the securities on the performance of the account.

• How will the composite be affected?• Will there be any impact on performance fees?

Additional Considerations