Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

Back from a somewhat relaxing weekend (I had to work part of the time), I opened my mail to find two publications, each with a front page article about 401(k) "stock drop" cases. Is it coincidental or a harbinger of next season's hottest trend in litigation?

According to "401(k) fee suits not soon to retire" by Amanda Bronstad (The National Law Journal, May 28, 2007), earlier filed cases focus on undisclosed fees levied by mutual funds. In contrast, more recent lawsuits look at fees charged for annuities while "others challenge the prudence of employers that invest in funds that charge high fees - even if they're fully disclosed to employees."

In "Stock-drop suits hitch 401(k) ride," writer Susan Kelly describes a resurgence in ERISA lawsuits (Financial Week, May 28, 2007) with companies of all sizes now vulnerable to allegations that stock in the 401(k) plan is a no-no.

Outcomes remain unknown at this time with federal judges in three cases having refused to dismiss (Kraft, Boing, Bechtel). Not all cases are home runs for the plaintiffs. As the National Law Journal article details, the federal judge in a case against Exelon Corp. "dismissed claims that excessive fees in a 401(k) plan caused investor losses." In the Northrup Grumman case, some of the defendants, "including the board of directors," were dismissed.

Along these lines, we think our forthcoming June 4 webinar on the topic of 401(k) plan governance is timely. Click here  to get more details and/or to register. We'll start at noon and end at 1:15 p.m. EST. The webinar is free to Pensiongovernance.com subscribers. The cost to non-subscribers is $125. Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs. This program is eligible for 1.5 PD credit hours as granted by CFA Institute.

Topics to be discussed include the following:

• Description of fiduciary duties under ERISA
• Discussion of procedural prudence as relates to 401(k) plan selection of fiduciary advisors
• Overview of safe harbor and selection of fiduciary advisor pursuant to the Pension Protection Act of 2006
• Litigation trends in the area of investment fiduciary breach as relates to plan sponsors and service providers such as consultants
• Fiduciary investment process for assessing 401(k) provider fees
• Role of fiduciary advisor in providing financial education
• Governance considerations with respect to selection of default investment 
• Structural changes in money management industry in response to material shift away from defined benefit plans
• Fiduciary advisor “red flag” practices such as soft dollar questions, revenue-sharing, limited disclosure.
  

Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM, president of Pension Governance, LLC will moderate an expert group of panelists to include:

• Mr. Blaine F. Aikin, AIF®, CFA, CFP® - Managing Partner, Fiduciary360
• Mr. David J. Bauer - Partner, Casey, Quirk & Associates LLC
• Mr. David Vriesenga - Chief Rating Officer, Cefex - Centre for Fiduciary Excellence, LLC.
  

We hope you can join us for what is sure to be an informative and lively discussion!

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Memorial Day fireworks will be extra special for two airlines - American and Continental. In a pre-holiday move, Congress and the White House okayed the use of an 8.25% rate to determine the estimated DB liability, attempting to create parity for solvent airlines. (Higher discount rates lower the projected net unfunded liability for a defined benefit plan.) According to reporter John Crawley ("US Congress weighs new pension relief for airlines," May 24, 2007), this is "still below Northwest and Delta but more generous than the tougher formula required by lawmakers last year." Click here to read the article.

In response, the Allied Pilots Association (APA), "representing the 12,000 pilots of American Airlines (NYSE: AMR)" cautioned management not to use new rules as an an excuse to reduce funding. APA president , Captain Ralph Hunter, reiterated the unions' agreement to annual concessions of more than $600 million, motivated in part by the recognition of being "at risk in bankruptcy court." Click here to read the full text of the May 25, 2007 press release.

This is not the first, nor the last time, that discount rate discussions will take center stage. Questions about appropriate assumptions linger. (According to the H-15 Statistical Release, 20-year U.S. treasury bond yields as of May 21, 2007 were reported as approximately 5.02%.)

In a December 11, 2006 speech to CPAs, SEC Fellow Joseph B. Ucuzoglu cites an important element of the Pension Protection Act of 2006, taken together with the Financial Reporting Release No. 72. Registrants "should provide transparent disclosure in Management's Discussion & Analysis of the Act's anticipated impact on the company's liquidity and capital resources. Although in some circumstances it will be difficult to forecast precise funding requirements due to the annual recomputation required by the Act, it will often be possible to provide disclosure of the magnitude of cash commitments for future annual periods assuming present market conditions remain constant."

What are the implications?

1. New legislation allows additional airline carriers to use an estimated discount rate that is, by some accounts, "too high."

2. If the result is an artificially low estimated liability number, SEC filings could reflect an overly optimistic assessment of a company's liquidity situation and related ability to pay.

3. Plan participants may therefore want to take a tour "behind the numbers." After all, cash is required to pay benefits, irregardless of discount rate assumptions.

4. Don't stop with airlines. Compare reported discount rate assumptions with economic reality for a given plan. Does the number comport with current capital market conditions? Is it sustainable? If not, what is the likely TRUE impact on benefit plan payouts and the funding needs of the plan sponsor and isn't that important information to have?

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In a May 23 meeting, open to the public as a byproduct of the Government in the Sunshine Act, the SEC will address a host of issues, not the least of which is a possible relaxation of the Sarbanes Oxley Act. Long awaited relief could help companies with what many cite as "burdensome" and costly compliance requirements. Financial Times reporter Jeremy Grant writes that "Wednesday’s likely approval of a set of guidelines originally proposed in December will provide executives with a clearer idea of how the SEC intends corporate America – and foreign companies listed in the US - to implement Section 404 of Sarbox." (See "SEC set to approve guidance on Sarbox," Financial Times, May 23, 2007.)

Ironically, at a time when regulatory muscle may be giving way to paunch, questions abound regarding transparency. In "Side Deals in a Gray Area," New York Times reporter Jenny Anderson describes a practice known as “big-boy letters” as "typically used when an investor has confidential information about a stock or bond and wants to sell those securities. By signing the letter, the buyer effectively recognizes that the seller has better information but promises not to sue the seller, much like a homebuyer who agrees to buy a house in 'as is' condition."

In "Big Boy Letters: Playing It Safe After O’Hagan," attorneys Wendell H. Adair Jr. and Brett Lawrence write that "big boy letters are designed to limit an insider’s liability under both securities laws and common law" and that a "trader in a company’s debt typically does not assume any fiduciary duty to the company or other security holders, assuming the person is not a member of an official committee or the board of directors and does not hold a similar insider position" unless he or she has signed a non-disclosure agreement.. Click here to read their analysis of U.S. v. O’Hagan, a "seminal case" that implied that a trader in possession of material, nonpublic information could avoid liability under misappropriation theory by disclosing his intention to trade to the information provider without actually disclosing to the trading counterparty the nonpublic information."

While attorneys seem to disagree on the legal exposure attached to big boy letters, the issue may soon be resolved in court. In the aforementioned New York Times article, Anderson describes "a lawsuit set to go to trial next month" in which "a Texas hedge fund contends that it was on the losing end of such a letter in 2001, when Salomon Smith Barney, now Smith Barney, sold more than $20 million worth of World Access bonds to the Jefferies Group, the investment bank, using a big-boy letter."

Not being an attorney (and so relying on the legal expertise of others), institutional investors like pension funds may want to add big-boy letters to the laundry list of "must know" items when evaluating trading practice risk as part of their selection of outside professionals. It is no stretch to see that challenges to statutory requirements all around (SOX, 13F, FASB, to name a few) could impede the flow of information to investors. (A discussion of regulation and information economics is outside the scope of this post.) This in turn could make it more difficult for pension fiduciaries to carry out their duties as informed decision-makers. Of course, mandatory rules can be replaced with industry self-regulation (something most free market economists advocate, including myself). Money managers who volunteer details about their trading practices to existing and prospective pension fund clients should win brownie points for candor.

Until then, one wonders - Are we opening the window to let in more sunshine or introducing darkness?

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In a May 16 interview with investment banker John Whitehead, Bloomberg journalist Christine Harper clearly pushed a button when she asked about Wall Street compensation. Said the former chairman of Goldman Sachs "I am appalled" and then described current levels as "shocking." Click here to read the interview.

On May 3, EFinancialCareers.com summarized an Alpha Magazine piece about the top twenty-five beneficiaries of the hedge fund boom, noting that disproportionate goodies that accrue to the fund's leaders encourage turnover. Hedge fund analysts have little incentive to remain beyond a few years, driving up costs and creating a drag on performance. Click here to read "Hedge Fund Compensation: Too Top-Heavy?"

From the pension fiduciary perspective, how does this news square in Peoria? Are investment committee members, trustees and/or board members on the hook for having selected money managers who are deemed to make "too much?"

Let me quickly add that what constitutes "too much" requires a systematic and thorough analysis of benefits netted against costs and that performance-linked pay is far from a bad thing under certain circumstances. For those fund professionals who are delivering "excess" returns (and that evaluation likewise requires care and diligence), current compensation may look like a bargain.

What's important is the process in determining how managers' compensation reconciles with projected risk-adjusted performance, at the outset when a selection is made and on an regular basis thereafter.

As a plan sponsor (regardless of plan type), how much attention do you give to this issue and how comfortable are you in explaining your decisions to plan beneficiaries?

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In his May 16 testimony to Congress, Mr. Douglas Lowenstein, head of the Private Equity Council, extolled the virtues of non-public investments. With over $110 billion invested in private equity by twenty large public pension funds, Lowenstein cites relatively higher historical returns that have helped plan sponsors pay the bills. Click here to read his testimony.

A few months earlier, a survey conducted by the State Street Bank describes escalating interest in hedge funds. At the same time, half of respondents expressed "a need for additional reporting and analysis on the part of hedge fund managers and more rigorous due diligence practices," adding that "they find it difficult to gain a portfolio-wide view of risk, and that aggregating risk statistics provided by all hedge funds in their portfolio was problematic. The same number also agreed that obtaining an accurate valuation of hedge fund holdings can be problematic." Click here to read the executive summary of the survey.

As with any investment, there is no "perfect" choice. Selection depends on a wide variety of factors.( A discussion about optimal asset allocation and security/fund selection is outside the scope of this blog post.) However, a few points are in order.

1. Risk management and valuation concerns are not created equal. They vary across type of asset and fund. Private equity funds tend to trade less frequently than hedge funds. Even within an asset class (assuming you agree that hedge funds constitute a separate asset class), the risk-return tradeoff varies by strategy, management and much more. For example, the use of derivatives by a market neutral hedge fund can differ dramatically from that of a macro oriented fund.

2. The use of a side pocket may reduce the need for frequent valuations. However, institutional investors need to understand if a side pocket is to be used, what will go inside the side pocket and the impact on reported performance as a result of its use.

3. Knowing that a manager employs derivatives is not enough. Understanding instrument and strategy choice is likewise important (though still not sufficient).

4. Valuation numbers provided by traders or anyone else who stands to benefit by reporting high numbers should be discarded and replaced with those provided by an independent party.

If you are interested in knowing about other red flags, email us in confidence.

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In case you missed it, here is the link to a video of my appearance on CNBC's Morning Call.  While I concede that it's impossible to have an in-depth conversation in only a few minutes, several things are worth mentioning as a result of the May 17 chat with host Mr. Mark Haines.

1. Not all institutional investors have a large staff to vet different investment ideas. Moreover, large does not always mean better. Witness Fannie Mae and Amaranth Advisors. "Thorough" is the watch word.

2. If considering a hedge fund, ask if the fund has a functional risk manager who monitors, tests and reviews policies for financial and operational trouble spots. Does that person have independence and authority to effect meaningful change?

3. I believe the other speaker in this segment said that private equity avoids having to deal with the daily volatility of being invested in public equities. Caution - The absence of a ready trading market does not necessarily mean that there is less risk. Some could easily assert the opposite. Private equity deals, because they are private, entail valuation challenges, difficulty in liquidating ownership interests and so on.

4. The use of correlation (a measure of linear association) to gauge diversification benefits depends on having good data for all relevant time periods. If using an inappropriately long calendar period (example: last ten years), output may reflect a smoothing out effect which therefore underestimates "true" volatility.

5. There is much more to say on the topics of risk management and valuation!

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As we've said before and will continue to say, the link between corporate governance and pension governance is strong and growing. We welcome the ISS (Institutional Shareholder Services) Corporate Governance Blog to our Links.

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At a time when pension funds explore new ways to buoy funding, billions of dollars are being allocated to hedge funds and fund of funds. Either direct or part of a portable alpha strategy, alternative investments offer potential benefits but often bring new challenges in the form of multi-tiered fees, valuation, leverage, transparency, short-selling, illiquidity and operational risk. Add to the mix the mandates of the Pension Protection Act of 2006 and one thing is clear. Pension fiduciaries are on the hook to demonstrate a solid understanding of the structural and financial characteristics of hedge funds and fund of funds and what could potentially cause problems if left unchecked.

To help pension decision-makers better understand this important area, Pension Governance, LLC has created the Hedge Fund Toolbox^SM – a series of six webinars that focus on hedge fund economics, operations and legal considerations. Webinars are scheduled as follows:

•Hedge Fund Fees, Performance and Transparency (June 14, 2007)
•Hedge Fund Documentation, Background Checks, Enforcement and Litigation (June 19, 2007)
•Role of Consultants and Financial Advisors in Selecting Hedge Funds (June 26, 2007)
•Hedge Fund Valuation, Use of Side Pockets and New Accounting Rules (June 28, 2007)
•Hedge Fund Leverage, Use of Derivatives and Risk Management (July 10, 2007)
•Hedge Fund Operational Risk (July 12, 2007)

Register to attend the entire series or individual webinars. If you miss an event, recordings will be available for a modest fee for non-subscribers. Webinars are free to all Pension Governance subscribers. For more information, go to http://www.pensiongovernance.com/webinars.php?PageId=58&PageSubId=59.

About Pension Governance, LLC:
Pension Governance, LLC (www.pensiongovernance.com) is an independent research and analysis company that focuses on benefit plan related investment risk, corporate strategy, valuation and accounting issues, with the fiduciary perspective in mind. Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs.

Media Sponsors:
Pension Governance, LLC is proud to have Albourne Village (www.albournevillage.com), Hedgeco.net (www.hedgeco.net) and the National Association of Certified Valuation Analysts (www.nacva.com) as media sponsors.

Contacts:
Pension Governance, LLC
Susan M. Mangiero, 203-261-5519
Ph.D., CFA, AIFA, AVA, FRM
PG-Info@pensiongovernance.com

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A recent news article chronicles another insider trading scam that highlights a dangerous variation of pillow talk. According to a May 11 article, "A husband and wife were arrested and charged yesterday after allegedly netting nearly $600,000 (£300,000) of illicit profits from shares they bought in a takeover target." Times.com journalist Steve Hawkes writes that this joint arrest follows quickly on the heels of another couple's guilty plea for providing material non-public information about pending mergers and acquisitions. Click here to read more.

Does nuptial bliss mean scandal? Prison is now a known commodity to Mr. and Mrs. Fastow of Enron fame. Similar allegations were recently launched against a husband and wife team who worked at a hedge fund and investment bank, respectively, and engaged in questionable "chatting."

Fraud is not uniquely committed by power couples with privileged access. Sometimes it's a family act.  A former New York University student pled guilty last year to bank and wire fraud. His mother "was sentenced in March to two years in prison after she pleaded guilty last year to conspiracy to commit wire fraud in the scheme. The two lived in Pound Ridge before they were arrested in June 2005." Click here to read more.

These cases are yet another reminder that risk comes in many forms. It's simply not enough to look at risk-adjusted return performance (historical, current and projected). Pension fiduciaries must carefully vet money managers (regardless of asset class) on a comprehensive basis. This includes a rigorous assessment of their internal controls that relate to trading, how valuable information is protected and the ethical requirements for anyone on the "production line."

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Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs. This program is eligible for 1.5 PD credit hours as granted by CFA Institute.

06/04/2007 : 12:00 pm to 1:15 pm EST

Description:
Join us for a lively discussion about 401(k) investment fiduciary issues in the aftermath of the Pension Protection Act of 2006, emphasizing economic and operational issues.

Who Should Attend:
Money managers, plan sponsors, plan administrators, custodians, pension consultants, pension attorneys or board members with responsibilities for selection of investment fiduciary advisors

Learning Points:
Persons who attend this 75-minute webinar will learn the following:

• Description of fiduciary duties under ERISA
• Discussion of procedural prudence as relates to 401(k) plan selection of fiduciary advisors
• Overview of safe harbor and selection of fiduciary advisor pursuant to the Pension Protection Act of 2006
• Litigation trends in the area of investment fiduciary breach as relates to plan sponsors and service providers such as consultants
• Fiduciary investment process for assessing 401(k) provider fees
• Role of fiduciary advisor in providing financial education
• Governance considerations with respect to selection of default investment 
• Structural changes in money management industry in response to material shift away from defined benefit plans
• Fiduciary advisor “red flag” practices such as soft dollar questions, revenue-sharing, limited disclosure
  

Speakers:

• Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM - Moderator (Pension Governance, LLC)
  
• Mr. Blaine F. Aikin, AIF®, CFA, CFP® - Speaker (Fiduciary36)
  
• Mr. David J. Bauer - Speaker (Casey, Quirk & Associates LLC)
• Mr. David Vriesenga - Speaker (Centre for Fiduciary Excellence, LLC)
  

Note: Subscribers to www.pensiongovernance.com receive free access to this webinar.

E-mail: PG-Webinars@pensiongovernance.com

Click here to register.

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According to Business Insurance, the former Chief Financial Officer of the Ohio Bureau of Workers' Compensation gets sixty-four months in jail. Involved in a rare coin investment scandal dubbed "Coin Gate,"  he pled guilty to "violating the federal Racketeer Influenced and Corrupt Organizations statute." (See "Former Ohio comp bureau CFO sentenced" by Roberto Ceniceros , May 11, 2007.)

The current Statement of Investment Policy and Guidelines prohibits investments in coins. Click here to access the document.

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Hedge fund Amaranth Advisors, LLC has settled an SEC complaint regarding violation of Rule 105 of Regulation M  which makes it "unlawful for any person to cover a short sale with offered securities purchased from an underwriter or broker or dealer participating in an offering, if such short sale occurred during the . . . period beginning five business days before the pricing of the offered securities and ending with such pricing.” Click here to read the SEC-Amaranth document.

Zurich Capital Markets Inc. has settled with the SEC on an issue relating to hedge fund trading. According to the order, "ZCM, an entity that provided financing, aided and abetted four hedge funds that were carrying out schemes to defraud mutual funds that prohibited market timing. Specifically, ZCM provided financing to four market-timing hedge funds that employed various deceptive tactics to invest in mutual funds. ZCM and these hedge funds knew that many mutual funds in which they invested imposed restrictions on market timing activity. In order to buy, exchange and redeem shares in these mutual funds, these hedge funds employed deceptive techniques designed to avoid detection by these mutual funds. ZCM came to learn that the hedge funds were utilizing deceptive practices to market time mutual funds, and nonetheless ZCM provided financing to them and took administrative steps that substantially assisted them. By providing assistance to the hedge funds, ZCM aided and abetted the hedge funds’ violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder." Click here to read the SEC-ZCM document.

One takeaway for pension fund investors is that a review of the manager absolutely must include a thorough assessment of trading practices.  Some of the many questions in search of answers include the following:

• What trading controls, by category, exist?
• Who oversees compliance?
• How are violations detected?
  
• What is the penalty for internal policy breach?

A second takeaway is to ask serious questions about the entire chain of command related to trade processing, reporting and who gets paid to do what.

Look for news next week about our hedge fund webinar series for pension fiduciaries. The Hedge Fund Toolbox^SM will cover many important topics such as valuation, risk management, fee structure, disclosure and ERISA considerations.

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According to various press reports, in his conversation with Berkshire Hathaway shareholders, CEO Warren Buffett reiterated his concern about the use of derivatives, "saying that excessive borrowing by traders, investors and corporations will eventually lead to significant dislocation in the financial markets. In fielding a question Saturday about derivatives, which he once referred to as "financial weapons of mass destruction," Mr. Buffett told shareholders that he expects derivatives and borrowing, or leverage, would inevitably end in huge losses for many financial participants." He further added that "The introduction of derivatives has totally made any regulation of margin requirements a joke." (See "World According to Buffett: How Media, Oil -- Among Others -- Matter" by Karen Richardson, Wall Street Journal," May 7, 2007.)

We've written about derivatives many times and will continue to do so. (I've even written an entire book on the topic.)

Derivatives are everywhere in pension land. Defined benefit plans consider liability-driven investing and portable alpha strategies (often entailing the use of derivatives). On the DC side, qualified default investment alternatives sometimes involve futures, options and/or swaps. Hedging company stock in 401(k) plans might rely on the use of derivatives. Many external money managers employ derivatives and pension fiduciaries are responsible for vetting their risk process and procedures.

So the pivotal question is whether derivatives are a hindrance or a help. Certainly a market that topples $400 trillion in global size reflects widespread popularity. Like anything else, however, fiduciaries who don't understand the incremental risks are putting themselves in harm's way.

Much more to come!

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The latest news on Hilton heiress Paris is not good. Sentenced to forty-five days time for violating probation over a suspended license, she must report to jail on June 5. Click here for the CNN.com story.

Ordinarily we wouldn't include a story about Paris Hilton except that it gives one pause for the following reason. In the last week, we've been busily focused on gathering news about litigation, enforcement and general stories about fraud in the financial world for www.pensiongovernance.com and www.pensionlitigationdata.com.

Our conclusion? There are a lot of Paris Hilton wannabes out there if you think of her as a role model for "let them eat cake."

One can barely keep up with allegations of wrong doing - securities fraud, option backdating, imprudence of investment selection, lack of oversight, accounting "flexibility," incorrect valuations, conflicts of interest, absence of prudence, excess this, excess that. Many of the cases being filed allege fiduciary breach on the part of pension decision-makers or directors and officers or both.

To be VERY clear, allegations mean little until due process takes place and individuals have their day in court to argue their case. Additionally, we recognize that it's easy to hang our hat on the most egregious events, letting them taint everyone in the business. This too is an injustice for those folks who work diligently to execute best practices.

That said, however, the sheer number of news stories, allegations and complaints about financial bad acts is daunting to say the least. There are some who predict more to come, especially with so many millions of dollars at stake and increased exposure to complex securities and strategies.

We'd like to emphasize the importance of applauding the "good guys and gals." Let's learn lessons from demonstrated bad acts (for the sake of improvement).

For those who find it hard to resist temptation, keep in mind - The "pass the buck" mentality is unseemly and dangerous, especially when innocent bystanders stand to lose.

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We are proud to have our blog picked up by Knowledge Mosaic. If you'll excuse a bit of chest puffing, here is the May 2, 2007 announcement from KM president, Mr. Peter Schwartz. Check out Securities Mosaic and Litigation Mosaic and other members of their virtual family.

<< We are pleased to announce that we are now publishing Susan Mangiero of the Pension Governance website and the Pension Risk Matters blog on our Securities Mosaic and Litigation Mosaic Blogwatches. Susan brings stellar academic credentials and more than twenty years of experience to her thoughtful posts on pension governance, risk management, asset liability, fiduciary obligations, and other matters of interest to asset managers, funds compliance officers, and legal counsel.

Susan's new Pension Governance LLC is published by an independent research and analysis company that focuses fiduciary obligations associated with on benefit planning, investment risk, corporate strategy, valuation, and related accounting issues. Pension Governance LLC works closely with ERISA plan fiduciaries, public plan fiduciaries, fund board members, CFOs, actuaries, attorneys, financial advisers, and money managers.

We are delighted to add Susan's perspective on pension fund and asset management matters not previously addressed in our Blogwatch publications. This is an important area of interest to our customers that we have not previously addressed. In short order, we also plan to add new authors with a special focus on market regulation, broker-dealer governance, and arbitration. >>

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According to the New York Stock Exchange Fact Book, pension ownership now accounts for nearly twenty-five cents of every equity dollar. No surprise then that the governance movement is alive and well and ensuring that forthcoming talks about proxy reform receive wide attention.

Part of the SEC's roundtable discussions about voting reform, various institutional investors, attorneys and governance experts will meet on May 7 to talk about topics such as shareholder rights under state law, whether investors should be able to exert more influence over corporate management and the role of the SEC in overseeing the proxy process. Click here to access the full agenda and list (and bios) of speakers. Subsequent meetings will take place later this month.

At a time when large shareholders crave more power over issues such as executive pay, corporate social responsibility and proper financial disclosure, a meaningful conversation is welcome.

On a related note, the PCAOB (Public Company Accounting Oversight Board) concluded its first International Auditor Regulatory Institute on May 4, 2007. With representatives from over forty countries assembling to discuss how the PCAOB handles Sarbanes-Oxley Act of 2002 compliance, chairman Mark Olson extols the notion of global oversight.

Also in the news, BDO Seidman's "Financial Reporting" letter (dated May 2007) is replete with question lists for shareholders. Organized by topic such as board composition, audit committees, preparation of financial statements, management's strategic plans and business ethics, the publication is easy to understand and serves as a useful guide.  The sub-list on risk management emphasizes company-wide issues, including, but not limited to, topics such as the role of the board in developing a risk management system and the choice of risk management techniques to evaluate "the adequacy and cost effectiveness of insured risks." Questions related to derivatives and financial risk are shown below (excerpted verbatim from the BDO document). Click here for the full text publication.

1. Does the company use enterprise risk management?
2. What is the company's attitude towards financial risk?
3. Were there any significant foreign currency exchange gains or losses in 2006 and in interim 2007 operations?
4. What is the company doing to minimize the impact of changes in foreign currency rates?
5. Does the company hedge its foreign currency exposures?
6. What types of financial instruments and derivatives does the company use?
7. What are the major risks from the company's use of financial instruments or derivatives (e.g. options, futures, forwards, caps, collars, interest rate swaps)?
8. Does the company have written guidelines and policies on the use of financial instruments and derivative instruments?
9. Who formulated those policies?
10. Did the board of directors approve those policies?
11. Do management and the board of directors monitor the company's financial instruments and derivatives exposures?
12. Is there a limit system in place (i.e. a system that sets the maximum amount of loss the company would tolerate before liquidating a position)?

PG Editor's Note: We are (and will continue to) address many of these issues online. Visit www.pensiongovernance.com. Also watch for our soon-to-be published newsletter about the use of derivatives, investment fiduciary risk, financial statement analysis and so much more. Pension Risk Alert^SM will examine risk and valuation issues from a "how-to" perspective. Email us if you want to be notified about the availability of this informative newsletter.

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Throughout my career, I've been fortunate to work on multi-disciplinary projects, many of which combined accounting with finance. It is my personal view that the two areas are integral to good business decision-making. Whether I've taught eager MBAs or corporate executives or managed analysts, I've cautioned people to look beyond the numbers, try to ascertain what information is missing and identify whether there are gaps between the accounting representation and potential economic profitability. Citing Columbo and the need to "be a good financial detective," I've suggested that (dare we say it?) accounting numbers can be illusory and therefore require a proper vetting. (By the way, my mention of the venerable television sleuth drew blank stares from the students so I had to switch to CSI characters instead.)

What does this mean for institutional investors?

Anyone committing funds to fixed income, equity or hybrids must have a solid understanding of what financial statements convey, and by extension, what they do not reflect. Assessing the quality of earnings (balance sheet) is often difficult. Rules are complex. Companies can have tremendous latitude in their reporting choices. This puts the onus on the investor to do a good job of comparing reported numbers against industry/company factors as they relate to predicting future expected cash flow or some other measure of economic profitability.

Always challenging, it may become more so now that the SEC has opened the door to foreign companies (and perhaps U.S. firms by extension) being able to choose which standards make sense for them. In his April 25 article, ("SEC to Mull Letting U.S. Companies Use International Accounting Rules"), Wall Street Journal reporter David Reilly writes: "The commission said it will begin soliciting comments this summer on a possible change allowing foreign companies registered with it to file financial results using international financial reporting standards, or IFRS. Currently, foreign companies that file with the SEC must reconcile their results to U.S. GAAP, a costly and time-consuming process that many companies, especially in Europe, want to do away with."

Whatever the choice, financial statement users have a tough job. First of all, analyzing industry peers could require even more attention being paid to HOW numbers are put together. Company X uses U.S. GAAP (Generally Accepted Accounting Principles) and Company Y uses an altogether different approach. You have two sets of numbers. Which one is right in terms of assessing economic potential?

Still a classic (but pay attention to new rules) is Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 2nd edition by Dr. Howard Shilit.  Also check out Michelle Leder's blog, Footnoted.org. Author of Financial Fine Print: Uncovering a Company's True Value," Leder drills down deep into the footnotes that many ignore.

On the pension accounting front, European firms are still reeling from rigorous rules. The adoption of new financial strategies and plan redesign (or perhaps termination) are not uncommon in some countries such as the UK. Stateside, FAS 158 is getting lots of attention with much more to come.

If people ignored accounting numbers and chose instead to focus on economic forecasts alone (i.e. take a fundamental approach to investing that emphasizes competitive structure, operating environment, etc), that would be one thing. However,  there is extensive research that suggests that companies DO behave a certain way in response to accounting rules.

Therefore, as companies get to choose accounting rules by which they will abide, investors must:

1. Understand what the different standards mean in terms of an accounting - economics "gap"

2. Identify whether a reporting entity is perversely changing its behavior to game a particular rule and buoy its numbers

3. Roll up those shirt sleeves and sleuth away. What you see may not be what you get!

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