Problem
I. Atlanta Vs Hamlin
The year 1994 began with promise for both Hamlin Dewey, Inc. ("Hamlin") and Atlanta Park Medical Center ("Atlanta Park").
Founded in Atlanta, Georgia, in 1894, Hamlin had become one of the nation'spremier full-service investment companies. A brokerage subsidiary, Hamlin Securities, Inc. offered financial services to the public through 87 retail offices in 14 states across the South and Southwestern United States. Hamlin also comprised an investment management subsidiary, Hamlin Asset Management, which managed over $17 billion in mutual funds and private accounts. One of the mutual funds, the Hamlin Dewey Solid Government Fund (HDSG) had just run up returns exceeding 20% in each of the last three years, far outpacing the average 6.4% annual return of the typical government bond fund over this period. At the helm of HDSG was Hamlin's star portfolio manager, a gentleman by the name of Jackson Montgomery. Montgomery was named fixed income portfolio manager of the year 1993 by Capital Magazine, his portfolio having beaten the competition by a sizable margin. Hamlin also had subsidiary units engaged in equity and bond underwriting. Hamlin was a regional powerhouse. Atlantans admired and trusted their hometown investment bank and many would think of doing financial business with no one else.
Atlanta Park was a not-for-profit research and teaching hospital. Since its inception in 1954, the hospital had become a leader in research and clinical programs to combat cancer, asthma, diabetes, and heart disease. They also sponsored a pre-natal counseling program. The organization had 190 employees, an annual budget of $14.3 million, and assets of $21.2 million.
II. What Went Wrong
Over the course of 1994, the HDSG fund and other accounts managed by Montgomery lost 36% of their value. Hamlin lost over $800 million of investors' money. $660 million of the sses were from HDSG. They claimed that they had no idea a bond fund could suffer such large losses. Neither the fund's sales materials nor its prospectus warned of the risk of such a decline. The damage was attributable to investments in volatile derivatives that the claimants argued were not adequately disclosed to investors. The 5.500 HDSG fund investors joined in a class action lawsuit against Hamlin seeking restitution. Some investors brought individual lawsuits. The Georgia Symphony Orchestra, for example, lost $7 million and brought legal action for return of this money. Alamo State University in Texas sued for return of the $15 million it lost. Plaintiffs included all types, running the gamut from private individual investors to corporations, pension funds, non-profit institutions, any municipalities.
The threat to Hamlin extended beyond the damages sought by the bond fund investors. Its image tarnished, Hamlin suffered a drop in its other business lines as well. Assets under management fell from $17 billion to $10.5 billion. Net income in fiscal 1994 was $27.05 million, down 38% from the $43.86 million earned in 1993. As a result of the turmoil. Hamlin's stock price declined from a high of $67.75 per share to $34.63 by the end of 1994. Shareholder equity on the books at the end of fiscal year 1994 (September) stood at $155 million
Hamlin's shareholders also alleged mismanagement and filed lawsuits against the company; such problems did not go unnoticed by regulatory agencies. The National Association of Securities Dealers (NASD), the Securities and Exchange Commission (SEC), and the Georgia Department of Commerce each began investigations into Hamlin' business dealings.
III. History
Prior to September of 1991, Atlanta Park's endowment fund was managed internally by its own executives. Atlanta Park's President, Michael Leone, was a medical doctor and also had an MBA from the University of Chicago. The Executive Vice President received an MBA, with a specialty in finance, from Boston University. Atlanta Park's Treasurer had three years work experience as an equity analyst at Fidelity Investments. Major decisions had to be approved by the hospital's board of trustees.
Atlanta Park's board of trustees was a diverse group, representing the business community, the medical profession, and local government officials.
Many of the trustees were successful business people, and some work specifically in the finance industry.
Endowment funds had been invested in United States Treasury notes and bank certificates of deposits (CDs), which were insured by the federal government. Many of the notes and CDs were coming due in 1991, and executives would soon have to decide how to reinvest the funds. Interest rates had fallen considerably in recent years, and it appeared that the rate of return on endowment investments would subsequently slow. The managers and trustees of Atlanta Park concluded that given the increasing size of the endowment fund and the more challenging nature of the investment environment, a prudent course of action would be to retain professional money management services.
Atlanta Park's board and executives interviewed many potential candidates to oversee investment of the endowment. Large and small firms were invited to make presentations, as (were local and distant firms. Atlanta Park emphasized to every candidate that their preference was for conservative investments. Preservation of capital was of paramount concern. The following written guidelines were presented to every candidate:
"The primary objective for investment of Atlanta Park Medical Center endowment funds will be preservation of capital. A secondary objective is sufficient capital appreciation to maintain a growing fund in real terms. Consistent with prudent standards for preservation of capital and maintenance of liquidity, the goal of the Atlanta Park Medical Center is to earn the highest possible total rate of return within the hospital's tolerance for risk with their solid local reputation, Hamlin Dewey was the early favorite. A Hamlin account executive by the name of Nancy Andrews made the sales pitch. Atlanta Park executives and trustees met with Ms. Andrews on numerous occasions. Notes taken during these meetings indicate that Ms. Andrews understood well Atlanta Park's low tolerance for risk. She assured them that Hamlin would use prudent investment principals in selecting, diversifying and managing assets to reduce risk. Hamlin would work closely with Atlanta Park to understand its It's needs.
IV. The Events of 1994
A series of unprecedented and unforeseen events conspired against the bond market in 1994. According to surveys conducted at the end of 1993, economists expected interest rates to remain low throughout 1994. However, on February 4, the Federal Reserve voted to raise interest rates in a preemptive move against possible inflation. Whereas in the past the Federal Reserve would reveal policy changes only after a one or two month delay, this time it broke with tradition and announced that interest rates would immediately be pushed upward. These moves rattled bond traders. Long-maturity as Yell as short-maturity interest rates rose, and bond prices began to fall. From January 31, 1994 to February 28, one-year Treasury bill yields rose from 3.51% to 3.83%. Ten-year rates rose from 5.75% to 5.97%.
Throughout the year, interest rates kept rising. The Federal Reserve raised rates six separate times over the year, an absolutely unprecedented and unexpected occurrence. By December 31, 1994, the one-year Treasury bill rate had hit 7.15%. This rate had more than doubled since January. The ten-year rate rose 206 basis points to 7.81% (note: a basis point is 01% of yield). From January through December, the 3-year rate rose 323 basis points, from 4.48% to 7.71%. The continued rise in interest rates repeatedly surprised the economic pundits. When asked by the Bloomberg Economic Survey in December 1993 what +h ay forecasted the 30-year interest rate would be three months later, leading economists predicted a 6.2% level. The actual rate turned out to be 6.91%. When asked to update their forecast for the following three months, in light of the realized surprise, the experts forecasted a 6.82% rate. They were wrong again as the 30-year rate came in at 7.40%. Their next forecast was for 7.36%, but they were wrong again as the true rate turned out to be 7.71%o. The spike in interest rates caught virtually everybody off guard.
Though all bond prices fell as rates rose in 1994, those bonds that were most sensitive to interest rates were hit the hardest. Collateralized mortgage obligations (CMOs) in particular suffered, and the HDSG fund was invested chiefly in CMOs.
To make matters worse, the infrastructure of the CMO market began to unravel. The Askin Capital Management Granite funds had borrowed heavily to invest in CMOs. When CMO values declined, lenders called in their loans. But Askin did not have liquid funds to pay back the debt. As a result, creditors forced Askin to liquidate its CMO holdings.
This sudden dumping of CMOs on the marketplace pushed prices down further. Institutions panicked and tried to unload their CMO portfolios onto the already stressed marketplace. Soon there were few buyers and an oversupply of sellers.
Atlanta Park stayed in until October 1994. By then, having lost over $3 million since January, they had had enough. They withdrew their investment from Hamlin Dewey, redeeming their HDSG fund shares at $22.80.
A month after Atlanta Park pulled out, the fund began to stabilize and then recover. By August of 1995, the fund's shares stood at a value of $29.16, up 28% from the low. The surge in interest rates subsided in January of 1995. By May of 1995 the one-year Treasury rate had fallen once again below 6%, and by February of 1996 the rate fell below 5%. By December of 1995, the ten-year Treasury rate had returned to the same level observed in January 1994, just before the Fed tightened. As rates fell, CMO prices rebounded. Many investors who bought CMOs at the market bottom booked handsome profits. Liquidity returned to the market, and investors
trickled back.
V. Atlanta Park's Complaint
Atlanta Park filed for arbitration before the National Association of Securities Dealers (NASD).
NASD bylaws stated that member firms are bound by the decisions of NASD arbitrators. An NASD hearing followed many of the same rules as a court trial, with a binding decision rendered by a panel of three adjudicators. For all practical purposes, the NASD tribunal would thus serve as the court for Atlanta Park's complaint.
In its statement filed with the NASD, Atlanta Park claimed that Hamlin Dewey breached a fiduciary responsibility. Hamlin invested the Atlanta Park endowment in unsuitable securities. The HDSG fund was far too risky for Atlanta Park, and was completely inconsistent with the investment objectives agreed upon. Moreover, Hamlin had a self-serving reason to place Atlanta Park's funds into the HDSG fund. As managers of the HDSG fund, Hamlin collected an annual management fee from the fund of .5% of the fund's total assets. This compensation was in addition to the .5% fee Atlanta Park directly paid Hamlin to manage the endowment account. Had Hamlin chosen a more appropriate fund, managed by another firm, Hamlin would not have been able to double dip.
Atlanta Park claimed that they were never told of the risks inbedded in the HDSG fund. On the contrary, the fund's sales literature and prospectus implied that the fund was safe and conservative. Hamlin's sale representatives and account executive described the fund as safe. The AAA rating was emphasized. These representations were intentionally deceptive, according to Atlanta Park. Jackson Montgomery knew full well that he was making speculative bets on interest rates. He knew that if rates would rise, the fund would fall.
Atlanta Park alleged that Hamlin Dewey took advantage of its trust. The discretionary account agreement documented that Atlanta Park had put full faith into Hamlin Dewey delegating Hamlin Dewey as a fiduciary to protect Atlanta Park' interests, and find appropriate, conservative, and safe investment vehicles. For these services, and to take this fiduciary responsibility, Atlanta Park paid Hamlin Dewey well.
VI. Hamlin Dewey's Defense
In its response filed with the NASD arbitrators, Hamlin Dewey emphasized that they were not hired to manage Atlanta Park's endowment.
On the contrary, executives of Atlanta
Park managed the endowment, and allocated the funds to two separate firms. Atlanta Park opened an account at Hamlin Dewey, but they also had an account at Kennesaw Associates. The allocation of the Atlanta Park money was made after deliberations with Atlanta Park executives, and with their full consent. Hamlin Dewey was the investment agent for Atlanta Park executives, not their fiduciary portfolio manager.
At least four times each year, Hamlin's account executive met with Atlanta Park's executives to explain how the money was invested. Written reports also detailed the fund allocation, right down to an account of which securities were owned and in what quantities.
Atlanta Park's executives and board of directors are a sophisticated group of business professionals, highly experienced in financial matters. They understood as well as anybody the risks of the HDSG fund. They understood that there is a risk-return tradeoff in the financial marketplace. The fact that the HDSG fund posted unusually high returns between 1991 and For three years, Atlanta Park reaped high returns from the HDSG fund.
Those high returns were compensation for bearing added risk. Atlanta Park understood that there were risks, but they judged the high returns ample compensation. In the last year they lost money.
VII. Atlanta Park's Dilemma
On January 12, 1995, Hamlin Dewey negotiated a settlement with the 5,500 investors who joined together in the class action lawsuit. Hamlin Dewey offered, and the class accepted, a payment of 40 cents for every dollar lost since January 1, 1994.
Legal analysts noted that this was an unusually large offer. Generally, a 15-cent reimbursement was more typical. Atlanta Park was given the opportunity to drop its suit against Hamlin and join the class action.
Atlanta Park now had to decide whether to join the class and receive the 40% reimbursement or, alternatively, to permanently opt out of the class, and pursue an individual lawsuit, seeking treble damages.
• What course of action should Atlanta Park take?
• Will Atlanta Park win the case as an individual lawsuit?