Howard Marks on Corporate Governance

As I asked in a memo in September, is it a good idea for nations to try to repeal or resist the laws of economics in an effort to make it otherwise? The Bottom Line I consider the tariff developments thus far to be what soccer fans call an “own goal” – a goal scored for the other side when a defender accidentally puts the ball into his own team’s net. In this way, they’re highly analogous to Brexit, and we know how that turned out. Brexit cost the British mightily in terms of GDP, morale, and alliances, and it harmed their reputation for governance and stability. All of this damage was self-inflicted. I like the way things have gone during my lifetime, which conveniently spans 99% of the post-war period I’ve been discussing. Some of our government expenditures have certainly been misspent, both at home and abroad, and our national debt is nothing to celebrate. But I’ve enjoyed living in a peaceful, prosperous, and increasingly healthy world, and I’m not eager to see that change. Just a couple of months ago, the U.S. economy was performing well, the outlook was positive, the stock market was at an all-time high, and there was much talk about American exceptionalism. Now, if Trump’s tariffs are put into effect, the U.S. economy is likely to experience a recession sooner than otherwise would have been the case, higher inflation, and extensive dislocation.

As part of our response to the situation, we further ramped up our efforts to increase the presence of under-represented group members at the highest levels. Thus, we sought and found the ideal person to become Oaktree’s first board member of color. As previously announced, we were privileged last month to be able to attract Depelsha McGruder to join our board. Howard University, Harvard MBA, 17 years as an executive at Viacom and presently COO and Treasurer of the Ford Foundation – this is an ideal background, especially given her role at Ford in managing global operations and vetting investment strategies to preserve and grow the $14+ billion endowment. We are excited to welcome Depelsha to our board and look forward to her contributions. Environmental, Social and Governance – One of the biggest changes we’ve seen in the investment community in recent years is the increased attention to environmental, social and governance (ESG) considerations. Each year, more and more investors are increasing their emphasis on these matters and doing more about them by requiring investment managers to demonstrate their commitment. This has very much been reflected in the evolution of Oaktree’s processes. While we’ve long taken ESG considerations into account as part of our investment process, a decade ago we made little effort to document our ESG assessments. Moreover, each of our investment teams had its own ESG approach.

In the last few years we formed an ESG Governance Committee to help improve and harmonize the ESG practices of our strategies globally. While we’ve made tremendous advances in ESG, to date we’ve done so without any dedicated resources. Given how fast the landscape is evolving, and because we’ve decided to redouble our commitment, we’ve created the position of full-time Head of ESG, reporting to our CIO and my co-chairman, Bruce Karsh. I am pleased to report that we recently announced the appointment of Priya Prasad Bowe to that position. Priya, who joined Oaktree in 2019 to work on our credit businesses, has been integrally involved in the design and implementation of the ESG framework for our Global Credit strategy, including authoring the beginnings of its climate-change-management strategy. Going forward, Priya will work with all Oaktree investment teams to make certain we’re fully aware and educated regarding emerging ESG risks and opportunities, and she will assist us in bolstering our ESG integration, documentation and engagement practices globally. In addition to Priya, we’re fortunate to have a deep bench of industry experts to provide guidance in this area, including our partners at Brookfield Asset Management. One such expert is Mark Carney, Brookfield’s Vice Chairman and newly appointed head of ESG and Impact Fund Investing. Mark is the © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The Outlook for Democracy There’s a great but little-used word to describe the state of U.S. politics and governance: parlous. Google defines it as “full of danger or uncertainty; precarious.” The country is highly divided in terms of politics, and discourse seems to move further toward the extremes with the passage of time. Part of the blame goes to the media (including social media). The explanation is simple but unfortunate: a few entrepreneurs figured out that there’s money in division. At the birth of television, as I understand it, the people who ran the national networks established the news division as a public service that ran losses. In TV’s early decades (through the 1970s), the main networks did balanced, objective reporting – led by august figures such as Walter Cronkite, Chet Huntley and David Brinkley – and these networks pretty much still do. But over the last 20 years, some media outlets have increased their profits by catering to one side or the other, often in an inflammatory manner. More recently, we’ve heard about social media driving traffic by appealing to highly partisan audiences and disclaiming responsibility for content. The truth is, discord sells (how often does your daily newspaper lead with a positive headline?) The result is very harmful. It’s bad enough that some cable news stations and social media sites deliver only one side of the argument on many issues.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Foundations and universities have rules governing endowment spending, the main purpose of which is to balance the interests of the current generation against those of generations to come. This is a prime fiduciary responsibility of endowed institutions. Likewise, most of today’s parents won’t spend their way to unreasonable credit card balances and saddle their heirs with debt. While the significance of national debt is debatable, as is the question of how much debt is “too much,” it’s hard to argue that recent administrations in Washington have been appropriately balancing the interests of all generations. (And, by the way, today’s generations have been happy to consume an unsustainable share of the earth’s resources to fuel their lifestyles, which is certain to leave future generations with a degraded environment. This is another profound aspect of generational inequity.) In August 2008, on the way to ending my memo What Worries Me, I included a passage from the 2004 book Running on Empty by Pete Peterson (for those who weren’t in the business world in the 20th century, Pete held important positions in government and co-founded Blackstone with Steve Schwarzman): . . . while our problems are not yet intractable, both political parties are increasingly incorrigible. They are not facing our problems, they are running from them.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Growing the Pie A few weeks ago, we were pleased to announce a partnership with Brookfield Asset Management that created an alternative investment manager with one of the broadest slates of strategies and greatest asset totals. And what question did I get? “Will there still be memos?” Well, here’s your answer. * * * One thing I’m not happy being right about is the tenor of the current debate over our economic system. Most of my January memo, Political Reality Meets Economic Reality, was devoted to fretting over the rise of populism from the left and the resulting anti-capitalist sentiment, and it has risen further since. I mentioned legislation that had been introduced to appropriate some of corporations’ cash and governance rights for workers, as well as a proposal for a higher income-tax bracket for top earners. Since then we’ve seen additional suggestions covering a wealth tax, higher estate taxes and, in New York City, a tax on pieds-à-terre. Clearly companies and wealthy individuals are being viewed by some as attractive political targets and good sources of incremental revenue. One of the main reasons behind populism’s ability to stir people is the favorable reception its rhetoric receives. “They have too much.” “We’ve been short-changed.” “The system’s rigged.” “They got where they are by cheating.” “The rich don’t pay their fair share.

 Suppose the fund makes $5 million of investments against an LP’s $10 million commitment – borrowing $5 million on the line – and there’s a financial crisis (or the investments simply turn out to be big losers) and those investments decline in value to $2 million. And suppose the line comes due, the fund calls $5 million from the LP with which to repay it, and the LP – perhaps receiving simultaneous capital calls from a number of similarly affected managers – concludes it’s in its best interest (or its fiduciary duty) to NOT put up $5 million to secure investments now worth $2 million. Instead, it defaults on the capital call, depriving the fund of capital, potentially limiting the fund’s ability to repay the line and/or make further investments, and thereby possibly harming the remaining LPs. (Please note, however, that strategic defaults are an extreme hypothetical, since they would expose LPs to penalties, lawsuits and the forfeiture of their assets in the fund, in addition to the obvious reputational consequences.)  Some funds (although none of Oaktree’s) rely on subscription lines that are due on demand, rather than at the end of a stated term. What would be the effect if a large number of those lines were pulled simultaneously during a financial crisis? Or what if regulators required banks to call in their lines, even those that aren’t callable or whose terms haven’t expired?

As I mentioned in Dare to Be Great II, “agents” who manage money for others can be penalized for investments that look like losers (that is, for both permanent losses and temporary downward fluctuations). Either of these unfortunate experiences can result in headline risk if the resulting losses are big enough to make it into the media, and some careers can’t withstand headline risk. Investors who lack the potential to share commensurately in investment successes face a reward asymmetry that can force them toward the safe end of the risk/return curve. They are likely to think more about the risk of losing money than about the risk of missing opportunities. Thus their portfolios may lean too far toward controlling risk and avoiding embarrassment (and they may not take enough chances to generate returns). There are consequences for these investors, as well as for those who employ them. Event risk is another risk to worry about, something that was created by bond issuers about twenty years ago. Since corporate directors have a fiduciary responsibility to stockholders but not to bondholders, some think they can (and perhaps should) do anything that’s not explicitly prohibited to transfer value from bondholders to stockholders. Bondholders need covenants to shield them from this kind of pro- active plundering, but at times like today it can be hard to obtain strong protective covenants. There are many ways for an investment to be unsuccessful.

Since corporate directors have a fiduciary responsibility to stockholders but not to bondholders, some think they can (and perhaps should) do anything that’s not explicitly prohibited to transfer value from bondholders to stockholders. Bondholders need covenants to shield them from this kind of pro- active plundering, but at times like today it can be hard to obtain strong protective covenants. There are many ways for an investment to be unsuccessful. The two main ones are fundamental risk (relating to how a company or asset performs in the real world) and valuation risk (relating to how the market prices that performance). For years investors, fiduciaries and rule-makers acted on the belief that it’s safe to buy high-quality assets and risky to buy low-quality assets. But between 1968 and 1973, many investors in the “Nifty Fifty” (the stocks of the fifty fastest-growing and best companies in America) lost 80-90% of their money. Attitudes have evolved since then, and today there’s less of an assumption that high quality prevents fundamental risk, and much less preoccupation with quality for its own sake. On the other hand, investors are more sensitive to the pivotal role played by price. At bottom, the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that’s irrationally low (ditto). A low price provides a “margin of safety,” and that’s what risk-controlled investing is all about.

 Won’t voters demand isolationism in the richer nations and relief from the pain of austerity in the poorer nations? Won’t elected leaders offering anything else be ousted?  Will the highly restrictive regulations and labor laws be eased so as to enable Europe to compete on an equal footing with the rest of the world?  Longer term, will the nations of Europe give a central body the control over economies and financial institutions required for an effective economic union?  Will UK voters vote in the coming referendum to stay in the European Union or leave?  Will the EU remain intact? Is a political union in which actions require unanimous support practical? Can governance and coordination be improved? Regarding Leadership:  Are there leaders – anywhere in the world – of the caliber we need to see us through these uncertain times?  Can officials who seek re-election first and foremost rise to the occasion and make the tough decisions needed to apply unpopular solutions to problems, rather than palliative Band-Aids?  Will the successors to Geithner and Bernanke prove up to the task of continuing the recovery while weaning the economy from ultra-low interest rates?  Is it conceivable that America’s elected leaders will create an environment in which uncertainty over taxation, regulation and healthcare costs no longer discourages businesses from investing in plant and personnel? © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

 Can America’s elected officials possibly reach agreement on long-term solutions to the problems of deficits and debt? Or will the national debt expand unchecked?  Will Europe improve in terms of GDP growth, competitiveness and fiscal governance? Will its leaders be able to reconcile the various nations’ opposing priorities?  Can Abenomics transform Japan’s economy from lethargy to dynamism? The policies appear on paper to be the right ones, but will they work? © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. particular problems of the peripherals. But they have problems of their own, since they took the capital piled up by their strong economies and lent it to the profligate borrowers. Thus the direct problems in the strong nations relate not to unpayable debts, but to questionable receivables: their banks and other providers of capital are owed large sums lent to the governments and institutions of the peripheral nations. All member countries are impacted by the general uncertainty present. As in the U.S., the divided, fractious nature of Europe’s governing bodies will complicate the process of problem solving. Will the governance structure of the European Union permit a solution to be reached? What can be done about the weaker members? How much of the relief will the strong nations be expected to provide? Will the untested, loose confederation of the monetary union hold together or, alternatively, have to provide for the exit of the weaker links? Will voters in the strong nations allow their elected officials to use resources to support the weak ones? The basic problems are similar to those in the U.S. in terms of scale, novelty, and the difficulty of identifying solutions. How will the transition be handled from the easy- money environment of the past to the more restrictive one of today? Who will bear the burdens of excessive debt and shoulder the losses?

Prior to the 1950s, common stocks were viewed as a speculative, inferior (i.e., junior) asset class. For that reason, stocks had to pay higher yields than bonds in order to attract buyers; of course a riskier asset should yield more. In fact, most states had laws restricting holdings of stocks in fiduciary portfolios. This attitude toward stocks largely traced from the speculative stock bubble in the 1920s – featuring high-margin buying, bucket shops and shoe shine boys sharing stock tips – which collapsed in the Crash of ’29. Poor economic and market performance stretching from 1929 to the end of World War II further contributed to the skepticism toward stocks. It was only after WW II that economic performance began to support optimism. Brokerage firms led by Merrill, Lynch, Pierce, Fenner and Smith trumpeted the merits of stocks. Equity investing became widespread, and “customers’ men” in local brokerage offices delivered stock investing to a great many households: I remember my mother buying 10 shares of Columbia Gas and 15 shares of Chock Full of Nuts around 1959. I also remember a brochure on “growth stock investing” that Merrill put out in the mid-1960s, touting the desirability of rapid earnings growth and the strength of companies like IBM, Xerox, Avon, Coke, Texas Instruments and Johnson & Johnson. This idea grew into “nifty-fifty” investing, a true mania adopted by many of the large banks, among others.

© Oaktree Capital Management, L.P. All Rights Reserved One of the concepts that governed my early years, but about which I’ve heard little in recent years, is “fiduciary duty.” Fiduciary duty is the obligation to look out for the welfare of others, as opposed to maximizing for yourself. It can be driven by ethics or by fear of legal consequences; either way, it tends to cause caution to be emphasized. When considering a course of action, we should ask, “Is it right?” Not necessarily the cleverest practice or the most profitable, but the right thing? The people I think of perverting the mortgage securitization process never wondered whether they were getting an appropriate rating, but whether it was the highest possible. Not whether they were doing the right thing for clients or society, but whether they were wringing maximum proceeds out of a pile of mortgage collateral and thus maximizing profits for their employers and bonuses for themselves. A lot of misdeeds have been blamed on excessive emphasis on short-term results in setting compensation. The more compensation stresses the long run, the more it creates big-picture benefits. Long-term profits do more good – for companies, for business overall and for society – than does short-term self-interest. Focusing on the Wrong Risk The more I’ve thought about it over the last few months, the more I’ve concluded that investors face two main risks: (1) the risk of losing money and (2) the risk of missing opportunity.

Companies are rewarded for short-term success and penalized for short- term failure, whereas few people ask about the long term. The only thing that matters is “What have you done for me lately?” A lot of this emanates from stockholders. In a memo several years ago, I listed a few phrases that have sunk into obscurity over the course of my career. They included “fiduciary duty,” “preservation of capital” and “dividend yield.” Another is “long-term investor.” Most investment managers are measured against a benchmark every quarter and expected to add value. Some clients have their fingers on the trigger, ready to axe a manager who underperforms for a year or two. For this reason, managers sit with their own fingers on the trigger, ready to dump a stock or bond whose short-term performance lags. And company CEOs whose securities are laggards are likewise on the hot-seat, with boards that rarely support executives who disappoint Wall Street. Too many people think of the long run as nothing but a series of short runs. The way to have the best five-year investment record, they think, is by sequentially assembling the twenty portfolios that will produce the best performance in each of the next twenty quarters. No one wants to invest in a company that may lag until long-term investments pay off down the road. They’ll just sell its stock today, assuming they’ll be able to buy it back later.

” If the amount raised in 2005 was triple the 2002 level, as I believe was the case, that means private equity funds deployed capital in 2005 roughly nine times as fast as they had in 2002. No one of these is evidence of misfeasance or terminal laxness by itself. But together they describe a market where a desire for quantity and speed has taken over from an insistence on quality and caution. And with that insistence goes the margin of safety that Warren Buffett urges investors to demand. UThe Amazing Disappearing Covenant Evaluating and negotiating covenants is an important part of the high yield bond investor’s job. The law says a company’s board of directors has a fiduciary duty to its shareholders, but generally speaking there is no analogous duty to creditors such as banks and bondholders. In fact, some companies behave as if they feel a responsibility to actively take value from creditors and transfer it to the shareholders. Because companies can do anything to creditors that isn’t prohibited by law or the bond indenture, covenants are a key component in creditor safety. It’s important to bondholders, for example, that the companies to which they lend money remain as little changed as possible. They want the creditworthiness they lend against to still be there years down the road, and strong covenants can do a lot to ensure that’s the case. Bondholders can’t prevent problems in the economy, the company’s markets, its products’ competitiveness or its executive suite.a

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Risk The reading materials for a meeting of a corporate board on which I sit – and what turned out to be an eight-hour meeting of the audit committee (thank you, Messrs. Sarbanes and Oxley) – included an article by Rick Funston, a Principal of Deloitte & Touche LLP and its National Practice Leader for Governance and Risk Oversight. The subject of the article was corporate risk, but many of its points were equally applicable to investment risk. It got me thinking. We’re all preoccupied with the quest for excellent investment returns, and most of us understand that risk management has a lot to do with achieving them. From there, investment orthodoxy often takes over, with the discussion turning to the relationship between return and volatility. But I think that tells so little of the story that I’ve decided to devote an entire memo to the subject of risk. 0BUWhy Does Risk Matter? When I joined the investment management industry at the tail end of the 1960s, everyone talked about returns but few people talked about risk-adjusted returns, or the idea that risk matters. I was fortunate, however, to have attended the University of Chicago in the preceding years, during which Capital Market Theory had begun to be discussed. Of course, nothing underlies the Capital Market approach as much as the relationship between risk and return.

The reluctance to make risky investments also meant that they had to be supported by research and analysis performed by skeptical experts.  There was a particular aversion to new, unproven and “alternative” forms of investment. Fiduciary caution was an overarching consideration. With the returns from U.S. equities expected to handily exceed the overall return needs of pension funds and endowments, alternative investments were something of an exotic luxury: tempting but also non-essential and somewhat forbidding.  Because the amounts of capital pursuing alternative investments were limited, investors had negotiating power and were able to insist on, among other things, an incentive system that aligned their interests with those of their money mangers, in which fixed fees merely covered managers’ expenses and incentive fees offered managers the hoped-for brass ring.

We all know what’s implied: shared decision making, diffused responsibility, personal risk minimization, and go- along-to-get-along interaction. All of these things work to discourage unconventionality, and thus to render superior investment results elusive. David Swensen takes direct aim at institutional behavior. In fact, he makes repeated use of the word “institution,” as if invoking a negative mantra. . . . active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel. (my personal favorite, emphasis added) By operating in the institutional mainstream of short-horizon, uncontroversial opportunities, committee members and staff ensure unspectacular results, while missing potentially rewarding longer-term contrarian plays. Creating a governance process that encourages long-term, independent, contrarian investing poses an enormous challenge to endowed institutions. Whether the connotation has to be negative is unclear. But certainly it is true that “idiosyncratic” and “unconventional” seem to go with “unusual investment results,” but probably not with “institutional” and “bureaucratic.” I encourage everyone to examine the © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved commissions. The head of a charity draws a salary that reduces the amount left for the organization’s good work. The doctor collects for his services, and the more he charges, the fewer the people who can afford them. And we investment managers charge management fees, and sometimes a percentage of the profits, that cut into our clients’ net return. We all want to increase our incomes, but it should be possible to stick to the high road while doing so. The tradeoffs present challenges, but they can be overcome. I do not argue that mutual fund executives – or investment managers in general – should be expected to serve in an eleemosynary capacity. Certainly Oaktree doesn’t run on pure altruism. Vanguard comes close to the ideal, as a non-profit organization owned by its fund owners, but Vanguard’s people take compensation, not vows of poverty. The critical question in my mind isn’t whether people make money, or even how much, but what methods they employ to do so, how candid they are about those methods, and how the inevitable conflicts of interest are resolved. U What’s Wrong With a Little Salesmanship? My October memo “The Feeling’s Mutual” argued that late trading wasn’t the worst thing going on in the mutual fund industry. Rather, it pointed to questionable long-term practices relating to governance, marketing and compensation.

Supermarkets have no fiduciary duty to their customers, and customers don’t expect supermarkets to provide objective, professional advice regarding which brands to buy. The opposite is true for stockbrokers. Under securities laws, brokers are held to the high standard of trusted financial advisors – not just salespeople – and must either offer objective advice or properly disclose any serious conflicts. . . . “We recognize there is a conflict of interests between the broker and the mutual fund investor,” says Robert Plaze, associate director of the SEC’s Division of Investment Management. “That client needs to understand the recommendation of their broker is being affected by these payments.” (Wall Street Journal, January 9) How would you like to learn that the heart surgeon to whom your general practitioner sent you had paid for the referral? That your banker recommended a trust-and-estate lawyer in exchange for a holiday cruise? Or that the broker who suggested you buy a certain fund was paid to do so? “The deception is that the broker seems to give objective advice,” says Tamar Frankel, a law professor at Boston University who specializes in mutual-fund regulation. “In fact, he is paid more for pushing only certain funds.” (Ibid.) The Los Angeles Times put it another way on January 18: There are two ways to describe such payments, and both smell bad, said Don Phillips, a principal at fund research firm Morningstar, Inc.the

Putnam typically discloses in its prospectuses that it may ‘pay concessions to dealers that satisfy certain criteria established from time to time by Putnam Retail Management relating to increasing net sales of shares of Putnam funds over prior periods, and certain other factors.’” Huh? How many prospectus readers are capable of extracting the significance from that sentence? How many know the meaning of the word “concession” in this context? How many even read the last dozen “boilerplate” pages of a prospectus? First, I think regulators should insist not on disclosure, but on effective disclosure. Things should be expressed in everyday English, such that laymen can grasp their significance. And the things that matter should be separated from the things that don’t. Second, disclosure of the conflicts between fiduciary and client should be made directly by the fiduciary, and should be made clearly. How about, “The fund’s sponsor is paying me extra to recommend this fund to you”? UThe Average Common Denominator As I wrote in “The Feeling’s Mutual,” I think the most significant failing of the mutual fund industry – and the area where the most sweeping changes hopefully will be seen – relates to the governance responsibilities of fund directors.for

only if the directors who vote to approve such implementation or continuation conclude, in the exercise of reasonable business judgment and in light of their fiduciary duties . . . that there is a reasonable likelihood that the plan will benefit the company [i.e., the fund] and its shareholders. As Morningstar puts it, “the latter phrase would seem to require that the fee will result in more assets, and ultimately lower costs – otherwise, there is no benefit to the fund” (or its investors). Of course, fund companies would have a clear conflict: more expense reimbursement for them would translate directly into lower asset values for their investors. The SEC recognized this conflict and stated in the release accompanying the rule that it remained “generally concerned about (1) the conflicts which may exist between the interests of a fund and those of its investment adviser in deciding whether a fund should pay its distribution costs, (2) the likelihood that the fund will benefit from paying such costs, and (3) fairness to existing shareholders.” Thus the SEC required that 12b-1 fees be approved by majorities of the full board, the disinterested (i.e., independent) directors, and the fund’s shares. It went on to state that, “Since rule 12b-1 does not restrict the kinds or amounts of payments which could be made, the role of the disinterested directors in approving such expenditures is crucial.added)

© Oaktree Capital Management, L.P. All Rights Reserved failure of directors to police the executives. The examples are endless: excessive compensation, unwarranted expenditures, phony accounting, and transactions intended only to deceive or obfuscate. In general, executives forgot that they run companies for their owners and instead tried to turn them into personal piggybanks. Or they decided to eschew honest reporting in order to hype results and thus their own economics. Directors of these companies haven’t been accused of wrongdoing, just underachieving. They were too complacent and obliging, and thus asleep at the switch. As Warren Buffett says, “sadly ‘boardroom atmosphere’ almost invariably sedates their fiduciary genes.” The fundamental questions regarding corporate directors and executives are the same as those I proposed earlier regarding mutual funds: How much ends up in the pockets of the company and its owners, and how much in the pockets of the stewards? What means are used to accomplish this “wealth transfer”? How much is disclosed, and how clearly? A number of thought-provoking examples were discussed in the Wall Street Journal of December 29, under the headline “Many Companies Report Transactions With Top Officers; ‘Related Party’ Deals Disclosed By 300 Large Corporations; Potential for Conflict.” The article discussed not the headline-grabbing misdeeds of the scandal era, but matters that are routine at America’s largest corporations.

© Oaktree Capital Management, L.P. All Rights Reserved  Are these deals negotiated at arm’s length? Are the terms the best the company can get?  Who negotiates on behalf of the shareholders? How vehemently?  Where a deal is proposed by a shareholder or shareholder/director with a dominant ownership position, who stands up for the minority shareholders?  How can we be sure director A won’t simply vote for director B’s excessive deal in exchange for director B returning the favor?  As I mentioned above, there has been no allegation – even in Enron, Tyco and Adelphia – of actual director impropriety. Rather, the questions surround the energy put into governance.  After working together for many years, directors develop congenial relationships with each other and with the executives. How strongly will they then fight to resist questionable transactions between the company and their colleagues?  Directors’ fees can run into the hundreds of thousands, perhaps with stock options and perks in addition. Will a director risk this package to fight for some faceless shareholders?  In short, can a director who serves at the pleasure of the chairman police the chairman and his other handpicked directors and executives? How can directors be guaranteed the independence that shareholders need them to have?

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Learning From Enron The investigation was not completed until June . . . The testimony had brought to light a shocking corruption, . . . a widespread repudiation of widespread standards of honesty and fair dealing . . . and a merciless exploitation of the vicious possibilities of intricate corporate chicanery. The public had been deeply aroused by the spectacle of cynical disregard of fiduciary duty . . . Part of a draft post-mortem for Enron? Could be, but it's not. It's a passage from one of my favorite books, "Wall Street Under Oath." The book was written in 1939 by Ferdinand Pecora, who served as Counsel for the Senate Committee on Banking and Currency investigating the Crash of '29 and went on to become a Justice of the Supreme Court of New York. It recounts the outrageous 1920s conduct of commercial/investment bankers that inspired the creation of the Securities and Exchange Commission and the enactment of securities laws that govern our industry to this day. The bankers' conduct was rife with self-dealing, conflicts of interest and gross dishonesty. In other words, reviewing the 1920s reminds us of history's tendency to repeat. U What Can We Learn From Enron? An article about Enron in the December 5 Wall Street Journal made a big impression on me.

Already companies are scrambling to show they're clean in terms of accounting, governance, and executive compensation.)  Certainly the belief in the inevitability of stock market profits has been dispelled. Who still believes that "stocks can be counted on to beat bonds and cash"? (Okay, nothing has changed regarding the long run, but investors have learned that living through a negative short run isn't that much fun.) And who still believes that the "efficient market" can be relied on to price stocks right? For these reasons, I think millions who were suckered into investing without the necessary expertise or awareness of risk will drop out for a while.  Likewise, the 1999 mantra of buying on dips has been laid to rest. Those who tried it in the last 28 months have paid a high price for investing on autopilot, and they are unlikely to rise up and counter the bears' selling any time soon. Sure, stocks will rise again, but few of the burned investors are worried about missing the first ten percent.  The leaders that people counted on to make them rich in 1998-99 are gone from the scene, and no one's likely to win investors' confidence anytime soon. Alan Greenspan's words no longer have the same soothing effect; now he's blamed for fostering too much liquidity, too great a market bubble, and then too-high interest rates. Likewise, investors have learned painfully that bullish statements from analysts and strategists precede up markets UandU down markets alike.

© Oaktree Capital Management, L.P. All Rights Reserved behalf of the entities with Enron subordinates whose compensation they determined, and (4) profited fabulously. Fastow is famous for having made $30 million from the entities, and Kopper made at least $10 million. Given that the partnerships are generally not believed to have served valid business purposes, those profits represent a direct transfer from Enron's coffers to those of the employees for which Enron received no legitimate quid pro quo. By the way, Enron had an ethics policy, and it probably would have prohibited these things. So the directors voted to waive the policy. But that vote didn't make the actions right. Neither was it a good idea for Ken Lay's sister to be Enron's travel agent, or for Enron to contract with and invest in companies owned by Lay and his son. Each of these might have had a valid business purpose. But it's essential to avoid both conflicts and the appearance of conflicts. We all might like to use employer dollars to benefit our relatives, our friends, and even ourselves, but the temptation must be resisted. If top executives engage in transactions that suggest self-dealing, even if they might be capable of tortuous rationalization, it makes a statement that fiduciary duty and moral behavior are dispensable. What could be worse? In the business world, potential conflicts of interest arise all the time. We can't avoid them, but our goal must be to deal with them honorably.

© Oaktree Capital Management, L.P. All Rights Reserved argue that they had the shareholders' blessing, given that they never let on what they were really doing. Of course, executives defend their actions by invoking the cloak of shareholder governance: that shareholders elect the directors, and it's the directors who choose and direct the CEO. We've seen hundreds of times, however, how hard it is for the company- proposed slate of directors to lose an election or for a dissident proposal to be passed. Acting in the interests of shareholders is just one option for management today, and clearly it wasn't the one chosen at Enron. UAligning Interests About a decade ago, Forbes published a special issue on executive compensation. In it, a sage, experienced director said of managers, "I've given up on getting them to do what I tell them to do; they do what I pay them to do." I've never forgotten that statement. When individual compensation gets into the tens or even hundreds of millions of dollars per year (including stock and options), managers profit as if they owned the company and took the risk. They appropriate a major share of profits for themselves in the good years, even though they lose nothing (other than perhaps potential or previously-accrued profits) in the bad ones. Set up this way, management has lots of incentive to take risk and cut corners. It sure worked that way at Enron.

© Oaktree Capital Management, L.P. All Rights Reserved  we do not have a fact pattern that would look good to the SEC or investors, and  best case: clean up quietly if possible. These quotations certainly suggest a preoccupation with perception. Did Watkins truly worry about right and wrong and choose her mode of expression to make an impact on Lay and company? Did she write to complain about wrongdoing or just to push for damage control? And are they two different things or the same? Unlike the little guys, the top execs are employing what I call the Geneva defense: "I was in Switzerland during the war." Nobody ordered the misdeeds or even knew about them. Either they were out of the room or the lights went off. Control freaks with great memories left things to others or can't remember what happened. And, ultimately, they claim the directors and auditors approved everything. UThe Role of the Auditors Why do companies have auditors? So the owners can be sure that (1) they know what management is doing and (2) the financial statements accurately reflect what's going on. As such, auditors play an absolutely essential role in the corporate governance process. In addition to checking the numbers and opining on the reasonableness of the financial statements, it's their job to tell directors, through the audit committee, when something's amiss. Every audit committee meeting should include some time when no management representatives are present.

© Oaktree Capital Management, L.P. All Rights Reserved  Finally, Andersen served Enron for nineteen years, and maybe things got too comfortable. While SEC rules require that the audit partner be rotated, they don't limit the tenure of the firm. On the other hand, in Andersen's defense:  It's hard for auditors to know more than management will tell them. (It is their job, however, to tell the audit committee when they don't feel they're getting complete information and to check matters independently where they can.) There's just too much evidence to the contrary for anyone to believe that honest auditors will always sniff out dishonest management.  All of the details of the financial statements Andersen certified, and of their engagement at Enron, may have met the letter – if not the spirit – of the rules.  As in any other field, the rotten apple - the dishonest auditor, or even the incompetent one – can do a lot of damage. We don't know yet what the real role of Andersen's David Duncan was in the Enron debacle, but we may find out if he receives immunity as seems to be under discussion. Auditors are one of the shareholders' last bastions of protection. The Enron example shows us two things: their essential nature and their fallibility. We still need more help. USo Who's Left? The shareholders' ultimate protection comes from the board of directors. The directors are the representatives of the shareholders and the bosses of the CEO.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Safety First . . . But Where? Are you from the old school? Do the following terms sound familiar?  fiduciary duty  preservation of capital  risk aversion  dividend yield Although in common use prior to the 1980s, they've been heard less and less since then. For this reason, a score of zero means you are completely modern, two means you're so- so, and four means you are far behind the times. I fall solidly into the last category. That means much of what I heard and read in the late 1990s made absolutely no sense to me. Of course, just as momentum investing eventually gives way to contrarianism (and vice versa), periods when carefree investing is highly rewarded eventually come to an end, as happened in 2000. I am writing to explore the question of where to look for successful investments when sheer aggressiveness stops paying off. "A-B-C," my Uncle Jack used to say when he taught me how to cross the street, "always be careful. Stop and look both ways." Most of us start off that way, but after a period when few cars come and the people who rush headlong get there fastest, caution sometimes is cast aside. Just as standing frozen with fear is no way to move ahead, investors occasionally are issued a reminder that not worrying about danger can be just as foolish. Pursuit of return must be balanced against aversion to risk.