Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

In "Bear's board was busy elsewhere," Financial News reporter Jeff Nash (March 31, 2008) writes that the investment bank's board has been busy, with three individuals doing work for "at least four other public companies" and two "of those three extremely busy directors" doing double duty as members of the risk committee. Corporate governance pundits add that outside distractions do little to help business fiduciaries carry out critical risk oversight duties.

Wall Street Journal reporter George Anders likewise addresses the question of where the buck stops, or if it arrived at all. In "Wall Street Housecleaning May Bypass Boardroom," the executive director of the $12 billion Illinois State Board of Investment, William R. Atwood puzzles over the involvement of directors as relates to sub-prime losses, wondering if "directors at big banks and Wall Street firms share some responsibility for what has gone wrong." Others quoted in the April 2, 2008 article counter that it may be ill-advised to unseat veteran directors. New appointees face a steep learning curve that exposes a company to risk of another kind.

The courts will surely play a prominent role in determining who pays (if at all) as shareholders and pension plan participants file lawsuits aplenty.

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Sunday was no day of rest for the Board of Governors of the Federal Reserve System.  A unanimous vote to "create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets" accompanied approval to decrease the discount rate by 25 basis points, to 3 1/4 percent. A third initiative was the approval of a deal for JPMorgan Chase & Co. to buy The Bear Stearns Companies Inc. (ticker symbol BSC).

An announced acquisition price of $2 per share (or $236 million in aggregate) is an economic fall from grace by most counts. Bear common last closed at $30 and traded as high as $159 and change over the last year. Click for BSC information. While good news for some, others are reeling from the precipitous drop in stock price. According to "Bear execs lack golden parachutes as stock plan crunched" (Reuters, March 17, 2008), journalist Joseph A. Giannone writes that executives will have little to celebrate since "shares held by the top handful of executive officers plunged in value from about $1.8 billion 14 months ago to just $22 million today." Employees are likely to fare no better with 30 percent of company stock in their various benefit plans (profit sharing, options and so on).

Litigation is underway with Pittsburgh law firm, Stember Feinstein Doyle & Payne, LLC, announcing "possible illegal conduct relating to the Bear Stearns Companies Inc. Employee Stock Ownership Plan, Profit Sharing Plan and Deferred Compensation Plan." According to the March 14, 2008 press relelase, the firm is investigating whether identified plan fiduciaries "knew or should have known that Bear Stearns was concealing its large exposure to highly risky Collateralized Debt Obligations, subprime mortgages, and other poor-quality securities, which has rendered Bear Stearns common stock and certain funds that it manages and offers as a risky investment for Plan participants."

Editor's Note: Does anyone know if BearMeasurisk, LLC is likewise sold to JPMorgan? The BSC web page for institutional investors currently links to a description about this web-enabled product for pensions as follows.

<< Our plan sponsor offering addresses Corporate, Public and Taft Hartley Funds with defined benefit and defined contribution plans. We provide Value at Risk (VaR) analysis at all levels of your fund, including security level, asset class, country, account and total fund. We also provide marginal VaR (contribution of risk), Relative VaR (risk versus benchmark) and risk of the total fund as compared to a policy portfolio. >>

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Following on the heels of our March 15 post about emotions and retirement planning, another just published article addresses the role of the brain with respect to risk proclivity. In "The Science of Risk-Taking," TIME reporter Kate Stinchfield writes that thrill-seeking has a chemical payoff. Research suggests that higher risk tolerance relates to the reabsorption of dopamine, a neurotransmitter. Serotonin is a factor as well. Normal levels prevent erratic behavior. Testosterone is yet another consideration, with lower (higher) amounts linked to risk aversion (taking). Stinchfield quotes Professor Marvin Zuckerman (University of Delaware) as saying that "high-sensation seekers tend to underestimate the risk."

So does this mean that current excesses of financial risk-taking are tied to unusual brain activity? Can "bad" body chemistry interfere with the prudent process of implementing and monitoring risk controls?

"Sorry your honor, my chemical levels made me take wild, zany risks with other people's money." This sounds like the financial equivalent of the Twinkie Defense.

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On February 20, 2008, the U.S. Supreme Court released an opinion heard round Corporate America. In LaRue v. DeWolff, Boberg & Associates, Inc., these nine top justices held that ERISA does "authorize recovery for fiduciary breaches that impair the value of plan assets in a participant's individual account" and allows for lawsuits to enforce "liability-creating provisions" that involve fiduciary breach of duty. This is big news indeed, opening the door for individual participants in 401(k) plans to seek legal redress when their investment directives are ignored or incorrectly processed. In "Top Court Allows Suit Over 401(k)," New York Times legal reporter Linda Greenhouse describes this as "one of the most important rulings in years." It clarifies an otherwise somewhat ambiguous element of ERISA (Employee Retirement Income Security Act of 1974) as to whether fiduciary duty relates to the financial health of the plan versus that of an individual participant.

Click to read our November 28, 2007 post entitled "LaRue, Corporate Governance and the Next Pension Enron."

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There will be no hearts and flowers for Yahoo from a Michigan pension fund. In "Yahoo Rejection of Microsoft Bid Draws First Shareholder Suit," Information Week reporter Antone Gonsalves writes that the Wayne County Employees' Retirement System of Michigan is taking Yahoo to court. Alleging failure to "meet its obligation to shareholders in evaluating the offer," Wayne County is asking Yahoo directors to thoroughly vet the computing giant's offer, especially given the bid price compared to where Yahoo common stock is currently trading ($31 versus roughly $19).

According to the 2006 Annual Report (most recent document posted on the Wayne County Employees' Retirement System website), their common stock holdings take the form of mutual funds. It's not clear if their reported 13,600 shares of Yahoo are held as part of a pool. An asset allocation pie chart shows equity with a 66 percent sliver. As of September 30, 2006, Wayne County's assets came close to $1 billion. What will be interesting to watch is whether WCER is left in the dust as pension funds with larger stakes compete for a more visible litigation role.

According to the Yahoo company website, its 401(k) plan includes a company match. If that match takes the form of Yahoo stock, a 401(k) stock drop lawsuit may be just around the corner.

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At a time when pensions, endowments and foundations are investing billions of dollars in alternatives such as hedge funds, responsible decision-makers must understand financial and legal risks. If they fail to dig deep or negotiate their interests properly (even when they use a consultant or fund of funds manager), fiduciary breach lawsuits could result. Join Dr. Susan Mangiero, AIFA, AVA, CFA, FRM (President of Pension Governance, LLC); ERISA attorney Noah Weissman (Bryan Cave LLP); and hedge fund attorney Nir Yarden (Bryan Cave LLP) for a mock deposition involving a pension fund’s investment in hedge funds, gone awry. Part of the Fiduciary 360 National Conference, audience members can see what happens during this discovery phase of litigation, watch and hear firsthand what someone in the “hot seat” is likely to experience and learn lessons about proper investment fiduciary process. According to Mangiero, author of "Risk Management for Pensions, Endowments and Foundations" and countless articles about investment risk and valuation, "The challenge is particularly acute when hedge funds invest in 'hard to value' assets or employ complex derivative instrument strategies. Identifying hidden risks can save institutional investors money, reduce stress and avoid harm to reputation."

For more information about this May 7 - 9, 2008 conference, go to www.fi360.com. For more information about pension best practices, visit www.pensiongovernance.com.

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In "Investing in Good Governance: Subprime-Related Losses Stir Up the Conversation," reporter Rachel McMurdie addresses the growing number of lawsuits in pensionland, along with an urgent focus to identify improvements that can and should be made. Interviewing this blog's author and fellow blogger, attorney Stephen Rosenberg, McMurdie describes recent attempts to codify pension governance standards. One initiative, the Clapman Report, is something I analyzed at length when it was published in the summer of 2007.

Click to read the full text of "Investing in Good Governance" (The Institutional Real Estate Letter, January 2008). Click for our take on the Clapman Report. 

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According to Canada.com, NatBank Brokerage will pay $750,000 (assume this is Canadian dollars) to medical doctor, Gilles Dussault. Representing lost income and interest on such, the court-determined fine follows a rough and tumble relationship between the physician and his brokers, a father and daughter team. Advised to short $2 million of savings bonds and then left to make his own decisions when prices rose, Dussault's losses grew until, two and a half years later, his holdings were liquidated to "cover what he owed in 1996." As a result, Dr. Dussault sued, alleging that the "original short sale was contrary to his investment objectives and financial interests." The bank countered, asserting that he knew the risks all along and that his losses would have been smaller had he closed his position sooner than occurred. In a 29-page opinion, Judge Mark Peacock described the plaintiff as "a man alone in a rowboat in a storm in the mid-Atlantic," adding that "The firm had always been his guiding light in the past and now that the waves were towering over him, the beacon was gone." He further characterized the transaction as conflicting with the investor's objectives and lambasted the brokers for not providing adequate information about the riskiness of the short sale. (See "Bitter pill for NatBank brokerage, Canada.com, January 16, 2008 for the full text of the article.)

Thanks to Mr. Carlos Panksep, General Manager of the Centre for Fiduciary Excellence, for pointing out this item. When asked what caught his attention about this news story, Carlos responded as follows. "In reading about this case, I could sense the lack of fiduciary accountability on the part of the advisor, possibly due to her inexperience. However, a firm which promotes a high priority to fiduciary education and sensitivity would have possibly avoided this outcome. I hope this firm will improve its practices as a result rather than bury this incident as unimportant or rare."

On the institutional front, Massachusetts Secretary of State William F. Galvin is asking Merrill Lynch about a $12+ million loss incurred by the City of Springfield. According to The Republican, the Springfield Control Board accuses the brokerage firm of "investing funds in an unsafe manner not permitted by state law." Focus on a collateralized debt obligation ("CDO") known as "Centre Square" ("a fund based in the Cayman Islands and Delaware") will logically examine why a $12.6 million spring 2007 outlay fell to $1.2 million by November. Reporters Peter Goonan and Dan Ring write that Merrill Lynch has declared the city responsible for making "its own investment decisions." (See "State subpoenas Merrill Lynch officials in Springfield investment loss," January 14, 2008). 

Expect more articles along these lines of "he said, she said." Inevitably losses (especially big ones) are going to result in lawsuits. Determining who bears ultimate responsibility is far from trivial and opens the door to other inquiries. Disclosure is a factor. Education is another consideration.

• Suppose a broker (advisor) provides significant information about risk drivers but the investor is unable to digest it properly. Should the broker (advisor) turn down the business even if it means that he (she) might lose his (her) job for not bringing in enough clients? How will he (she) know that a client is ill-equipped to invest in a particular instrument or strategy?
• In the absence of mandatory education and experiential requirements to sit on a city board (or state or company equivalent), what controls should be in place to preclude individuals from being able to inappropriately commit funds? How should the institution better vet the broker (advisor) at the outset and during the investment period?
• What constitutes fraud on the part of the broker (advisor) for not "properly" disclosing risk factors?
• Will the typical broker (advisor) be able to adequately explain the risk trouble spots associated with a complex investment instrument or strategy? If not, why are they promoting such to investors?
• For individuals or institutions, what safeguards (action steps) should kick in as an investment is heading south, if at all? (Value may plummet only to rise again as long as the position is not liquidated before recovery.)
• How should regulators better define and enforce suitability?
• What role should the market play in terms of "lessons learned" by various players? 
• Will attorneys have a different take on suitability than that of brokers (advisors)?

A recent article about UK trustees suggests that fiduciaries may acknowledge a problem but not feel comfortable moving towards a solution. In "Trustees ask for help," Global Pensions reporter Heather Dale (January 21, 2008) cites grim statistics from Hewitt Associates. Requests from British plan decision-makers "have doubled over the past 18 months" at the same time that more work, due to increased regulatory scrutiny, adds pressure. Do the math. More work, more complexity, more pressure, more scrutiny = big challenges. Does this mean that trustees must forge an even closer relationship with the fund's broker (advisor)? If so, how will questions of responsibility be impacted?

Caveat emptor will surely be the watchword for months to come. At what point are individuals (institutions) considered "duped" into investing in "excessively risky" assets and on what basis? How should suitability vary by type of institution? How can plan participants, shareholders and taxpayers better inform themselves about the risks being taken by a particular city, state or company pension?

The questions are endless. The answers are important.

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PensionLitigationData.com debuts with over 1,500 retirement plan legal actions, each classified by nearly 100 fields, including court circuit, type of allegation, plaintiff, defendant and date. A joint venture of Pension Governance, LLC and The Michel-Shaked Group, this continuously updated and searchable database reflects the dramatic rise in pension lawsuits. Market volatility, complex investment strategies, new accounting rules, federal regulations and heightened scrutiny of financial decision-making are a few of the many reasons that explain the addition of hundreds more cases each quarter.

This unique web-enabled tool helps attorneys, trustees, board members and policy-makers to better understand the nature of individual pension lawsuits and related litigation trends, thereby encouraging improved practices. “We’re excited to introduce PensionLitigationData.com as a way to stimulate the conversation about fiduciary responsibilities,” said Dr. Susan Mangiero, President and CEO of Pension Governance, LLC. “Litigation is a fact of life now. Regardless of plan type, those in charge need to understand the personal and professional liability. Our hope is that subscribers can learn valuable lessons about what to avoid.” Co-founder of The Michel-Shaked Group, Dr. Israel Shaked urges outside and corporate counsel to pay close attention to ERISA cases, adding “These lawsuits are greater in number, more severe and often accompany securities litigation filings, including class actions.”

A charter annual subscription rate of $695 provides unlimited access to the site, saves decision-makers countless hours of research time and offers otherwise hard-to-find intelligence about pension litigation issues. Users will find cases about a variety of topics such as prudence, duty to monitor, reasonableness of fees and plan design. Circuit commentaries written by and for attorneys are available and cover numerous retirement plan pain points that challenge sitting fiduciaries and their service providers. Assessing statistical patterns, evaluating case precedents, tracking fiduciary hot button issues by circuit, case type and time to settlement are just a few of the information tools you will find here.

For more information, visit www.pensionlitigationdata.com.

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New York Times reporter Vikas Bajaj writes that a State Street Corporation senior executive has been ousted due to sub-prime woes, and that the company has set aside "$618 million to cover legal claims stemming from investments tied to mortgage securities." (See "State Street Corp. Is Sued Over Pension Fund Losses," January 4, 2007.) 

Various other news accounts over the last few months name State Street as defendant in five separate pension-related cases. Plaintiffs' attorneys seek redress under the Employee Retirement Security Act ("ERISA"), citing allegations of fiduciary breach. Critics counter that proving bad faith on the part of investment managers (i.e. not acting "exclusively on behalf of plan participants") will be difficult. They further add that "sophisticated" pension funds should know better.

This blog's author predicts that caveat emptor will pop up in many cases to come. A legal outcome in the matter currently before NY jurists, with San Diego's pension plan going after former hedge fund Amaranath Advisors, goes to this very point (among others).

The stakes for defendants and plaintiffs alike are huge. Whatever happens in several of these big cases will open the door to a flood of similar lawsuits. If defendants are found culpable, it will be open season on service providers. Critical questions abound. Are money managers functional fiduciaries even when they disclaim such status? I wrote about this in my article entitled "Can Pension Clients Be Hazardous to Your Financial Healh?" (Mann on the Street, August 2007 and later reprinted in Journal of Pension Benefits, January 2007).

If defendants claim victory, pension investors will be seriously on the hook for ensuring that they fully understand the nature of their investments. Equally grave will be the need to demonstrate that a retirement plan decision-maker has fully vetted external money managers for risk controls, adequate disclosures and suitability in terms of permitted investment strategies.

Watch for more legal news.

Big Questions - Big Money - Big Consequences!

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In today's edition, New York Times reporter Robert Pear describes a recent action by the Equal Employment Opportunity Commission ("EEOC") that gives employers free rein to cut back benefits for persons 65 and older. (See "Many Retirees May Lose Benefits From Employers.") The rationale seems to be that, once eligible for Medicare, senior workers should transition fully or partially out of private benefit programs because they are otherwise covered. Quoting EEOC Chair, Naomi C. Earp, the goal is to encourage plan sponsors to continue voluntarily providing and maintaining health benefits. Premiums deemed "too high" and the fact that people are living so much longer than ever before is creating havoc with corporate bottom lines. As a result, "many employers refuse to provide retiree health benefits or even to negotiate the issue." In some cases, if they are unable to contain costs for benefits offered to older workers, companies may decide to cut back altogether. This means that younger workers would be exposed - no employer provided coverage, no Medicare.

According to the December 26,2007 Federal Register, the new policy protects plan sponsors from legal threats of age discrimination in the event that they create a two-class benefits program. The "Appendix to Sec. 1625.32--Questions and Answers Regarding Coordination of Retiree Health Benefits With Medicare and State Health Benefits" provides additional information. The upshot is that employers now enjoy flexibility to (a) provide retiree healthcare benefits “only to those retirees who are not yet eligible for Medicare" (b) modify, reduce or eliminate benefits upon an employee's 65th birthday and (c) decrease or eliminate health benefits for the spouse or children of a retiree of a certain age.  

How many companies rush to the door remains to be seen. As employers struggle to attract and retain good workers, including those with a bit of gray, providing or reinstating diminished benefits may come to pass. Only time will tell.

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In "Pension Fund Litigation Could Slow Investments," New York Sun journalist Liz Peek quotes yours truly on the surge in pension lawsuits, notably those alleging breach of fiduciary duty. Attorney Stephen Rosenberg, and creator of a popular ERISA law blog, is likewise quoted as citing the Herculean challenge faced by plan sponsors. Charged with a bevy of everyday tasks, now added to the list is the need to familiarize themselves with increasingly complex instruments and investment strategies. The article suggests that "increased accountability could dampen institutional enthusiasm for alternative investments."

In contrast, a survey just released by Russell Investments finds a worldwide trend on the part of endowments, foundations and pensions towards continued allocation of monies to alternatives such as hedge funds and private equity funds. With increases expected by 2009 in most countries, the twin issues of risk management and valuation will become arguably even more important (though they have never been unimportant).

The next several years promise to be interesting ones, to say the least.

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In response to my query about Justice Roberts and his comment about a plan's SPD, ERISA attorney Stephen Rosenberg wrote "Susan Mangiero was taken by the discussion in the oral argument of what powers may or may not have been identified in the summary plan description appended to LaRue’s complaint. I took this discussion by the Justices to be part of an inquiry into what are the constraining parameters of a claim such as the one brought by LaRue." Go to Boston ERISA & Insurance Litigation Blog for additional discussion.

The Wall Street Journal's Law Blog had an interesting post on LaRue. (I included the link a few days ago and am including it here again.) Several folks commented in response, including this blog's author. See below for my response (with a bit of editing).

<< I concur with the Nov. 27 post by the ERISA Consultant. Pension governance is serious business for millions of individuals who are impacted by the decisions made by plan fiduciaries. Hopefully, the LaRue case (regardless of outcome) will prompt a vigorous debate about fiduciary issues - who has responsibilities for what tasks and how retirees are impacted if breach occurs. Shareholders should be paying attention to LaRue as well. Poor governance of retirement plans can have a material adverse impact on earnings. >>

As I have said many times and will no doubt say many more times, pension governance (broadly defined as best practices, applied to all retirement plan types) is an integral part of corporate governance. While this message is gaining currency, most experts in the fiduciary space assert that there is vast room for improvement. If you agree (and not everyone does), a critical question comes to mind.

What will it take for pension governance to be viewed as equally important as mainstream corporate governance issues such as (a) proxy voting (b) executive compensation (c) financial statement certification (d) internal controls and (e) agency conflicts between managers and shareholders?

Negative headlines about Enron and other troubled companies forced shareholders and lawmakers to pay attention. Do we need a pension meltdown a la Enron to force change in the retirement industry?

We would love to get your feedback on what you think will force pension governance to quickly climb the "high priority" list for organizations not already concentrating on such. Click here to drop us a line.

 

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Inside the hallowed halls of the U.S. Supreme Court, pension history may be in the making. On November 26, 2007, justices heard the case of LaRue v. DeWolff, Boberg & Associates Inc. The long awaited outcome could put employers in the ERISA litigation spotlight as never before by allowing individuals to sue, one person at a time.

By way of background, Mr. James LaRue sought to have his employer switch his 401(k) monies from one mutual fund to another, in his attempt to migrate to "safer" investments. The plan administrator failed to make the change, allegedly costing LaRue an estimated $150,000 in lost profits. In August 1996, the United States Court of Appeals for the Fourth Circuit, in Richmond, Virginia denied LaRue an opportunity to seek redress, claiming that ERISA emphasizes harm to a plan in aggregate. The opinion reads:

<< In ERISA, Congress sought to provide fair and generous remedies for plan participants without imposing ruinous personal liability on plan fiduciaries. That balance pervades the statute, and it is not for us to readjust it. With respect, we think the Secretary’s view does recalibrate the balance, and we do not possess authority to modify plain statutory text, several Supreme Court decisions, and the corpus of circuit law on the subject. If the Department believes fiduciaries should face personal liability for every wrong alleged by individual beneficiaries, even in the absence of personal profit or misuse of plan assets, it will have to seek a forum other than this court. >>

This begs the question then as to how an individual plan participant can hold administrators and relevant parties accountable for mistakes. The import of this issue is huge. At a time when countless companies are terminating defined benefit plans and opting to offer 401(k) plans in their stead, anything that makes that strategy more expensive and/or troublesome could create pushback. If this occurs, employees are going to be under even more pressure to save for their retirement on their own. Add Social Security and Medicare woes, along with what some predict is an imminent recession, and Joe Everyman is likely to truly feel the pinch in a major way. On the other hand, employers fear an honest mistake that arguably opens the floodgates to costly litigation.

A read of the June 19, 2006 and August 8, 2006 LaRue opinions is instructive, as are the salient documents presented to the U.S. Supreme Court. Click here to download relevant files. Click here to read an informative overview provided by law professor Paul Secunda (who predicts a 6-3 victory for LaRue). One item in Secunda's text that struck me as notable is the line of inquiry by Chief Justice Roberts wherein he "points out that the SPD does not say administrators have to follow the investment directions of participants."  Reading these words catches one's breath. Is the honorable jurist suggesting that the Summary Plan Description ( a guiding document as regards the administration of the plan) preclude an asset allocation change? If so, how are employees to deal with market volatility or altered circumstances that mandate a different investment risk-return tradeoff? I await feedback from ERISA attorneys on this and other points.

Pay close attention when this opinion is rendered. It will make a difference! 

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As of November 15, 2007, those organizations who did not adopt FAS 157 early on will be obliged to disclose much more information about their "hard to value" assets and liabilities. Despite industry's attempts to forestall compliance for another year, the Financial Accounting Standards Board reiterated its intent to force implementation for financial assets and liabilities. Read "FASB Rejects Deferral of Statement 157 for Financial Assets and Liabilities" (November 14, 2007 FASB press release).

For those seeking a user friendly version of this new accounting rule, check out "A FAS 157 Primer" by Mark Gongloff (Wall Street Journal, November 15, 2007). Also check out "A Summary of Statement No. 157" on the FASB website. One important element of FAS 157 is the requirement that items be categorized as belonging to Level 1, 2 or 3 in order of ease of valuation with respect to observable prices (or lack thereof). Predictions abound that FAS 157 will force larger asset write-downs, creating jitters for pensions, endowments and foundations who invest in Level 2 and Level 3 sensitive funds. In a November 15, 2007 CNBC video, economist Nouriel Roubini warns of an impending global recession and a financial meltdown that could roil financial markets for months to come. He is not alone.

In "Why FAS 157 strikes dread into bankers - Just when we hoped the worst was over," William Rees-Mogg (The Times, November 12, 2007) cites research by financial analyst Martin Hutchinson. Financial giants such as Bear Stearns, Lehman  and J.P. Morgan Chase account for more than $100 bilion of FAS 157 Level 3 assets, requiring mark to model information not heretofore provided. The author adds "Even these figures may be understated, since the banks have themselves decided whether assets belong to level three or the more acceptable level two, and they have an interest in placing as little in level three and as much in level two as they reasonably can." Noteworthy is Hutchinson's analysis that Goldman Sachs has disclosed $72 billion of Level 3 assets. That number is relatively big or small, depending on the point of comparison - a $900 billion asset base but capital of $36 billion.

Lest pension decision-makers think they are immune from valuation issues, nothing could be further from the truth. Decision-makers for both 401(k) and defined benefit plans are squarely on the hook for vetting external money managers. This absolutely includes asking copious questions about managers' valuation policies and procedures. A poor job, or ignoring the issue altogether, is going to keep the plaintiff's bar busy indeed.

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We are seekng two or three additional beta testers, preferably attorneys. Please email us if you have an interest in learning more.

We plan to launch in just a few weeks. Click here to be notified of our official launch!

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Attorney Francis Pileggi, creator of the Delaware Corporate and Commercial Litigation blog, has an interesting post about a recent pension lawsuit. In Louisiana Municipal Police Employees' Retirement System v. Countrywide Financial Corporation, 2007 WL 2896540 (Del. Ch., Oct. 2, 2007), statistics played a central role in an option backdating case brought by the Louisiana Municipal Police Employees' Retirement System ("LAMPERS"). 

The court, citing the "close call" nature of the statistical evidence, nonetheless concluded in favor of the plaintiff. Pursuant to Section 220 of the Delaware General Corporation Law, LAMPERS will have some access to the financial records of Countrywide.

Click here to read this interesting October 10, 2007 post.

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Attorney Stephen Rosenberg, creator of the Boston ERISA & Insurance Litigation Blog, provides some interesting thoughts about legal trends. Citing yours truly about the surge in pension lawsuits, Rosenberg offers that courts will struggle with "new issues, or old issues under new fact patterns" with sheer numbers urging the judiciary to clarify. He adds that a pronounced switch from defined benefit plans to 401(k) offerings is likely to drive complaints, with plan participants demanding to know more about those individuals in charge of design and investment selection. Click here to read  "ERISA Number of Suits + Questionable Practices = X" (posted on October 10, 2007) and other analyses by this prolific writer.

 

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This blog's author recently had the pleasure of addressing an audience of hedge fund compliance officers and auditors about valuation issues - a topic near and dear to my heart. As an accredited appraiser, a certified financial risk manager and someone who has worked with models and trades, I am fully aware (and in fact often tout) the inextricable relationship between risk analysis and valuation. Simply put, effective financial risk management does not occur in a vacuum but rather depends on reliable valuation numbers. GIGO (Garbage In, Garbage Out). If a fund manager relies on faulty information, the inevitable result is flawed process, including (but not limited to) inaccurate hedge size (if hedging occurs), imprecise performance reports, possible asset allocation or portfolio re-balancing mistakes, trading limit utilization problems and so on. 

From the investors' perspective, the trickle down effect can be costly. Any "issues" at the asset manager level directly impact fees paid by pension funds, their own asset allocation decisions, not to mention cash flow and funding status breach as possible forms of "valuation fall-out." Valuation is the proverbial four-letter word in investment risk management. Cause for consternation, valuation issues are often complex and demand rigor with respect to policy creation, implementation and review.

Being somewhat impolitic, yet wanting to convey an important message to an important audience of hedge fund professionals, I cited chapter and verse about valuation pitfalls from a pension fiduciary's perspective. Including the need to get private placement memorandums that address what and how the fund manager intends to assess the portfolio on a regular basis, I explained the rationale for use of an independent third party to either render opinions of value, or at the very least, conduct a valuation process check. Even when a hedge fund does not exceed the twenty-five percent ERISA money limit (pursuant to the Pension Protection Act of 2006), best practices abound for both the fund manager and the pension investors alike. Interviewing traders, along with the asset manager's Chief Risk Officer, about valuation policies and procedures is another good idea. If a fund has no functional risk manager, ask why. Interestingly, one person responded to my comments by declaring success at drafting sufficiently obtuse documents that would likely keep investor accusations at bay.

In today's Wall Street Journal, reporter Eleanor Laise tells readers that it's not just hedge funds caught in the valuation cross-hairs. Mutual funds have their own issues. For example, when a security is not frequently traded, multiple methods might generate disparate "fair value" estimates. Quotation quality runs the gamut from the use of stale prices to "accommodation quotes" offered by "friendly brokers." Time-of-day selection is another conundrum, especially in the case of non-U.S. securities or instruments such as highly customized derivatives. Laise adds that "valuation policies can vary substantially from fund to fund." In some situations, an independent outside firm provides prices. Elsewhere, internal models or broker-dealer quotes are used. (See "Funds Struggle with Pricing Pitfalls," Wall Street Journal, September 17, 2007.)

As I've written (and presented) many times before, plan sponsors who sit silently by, without grilling asset managers about their valuation policies and procedures, are asking for trouble. Pension fiduciaries have a duty to oversee external fund manager performance as relates to the stated risk tolerance and return goals. This includes a weighty discussion about price quotes, marking to market (or model) and provider quality. (Not being an attorney, plan sponsors should seek counsel for a precise assessment of their responsibilities.)

With new accounting rules on their way and a variety of significant valuation unknowns, subprime loan-related losses may look like a walk in the park. What we don't know can hurt!

Editor's Note:

Pension Governance, LLC has partnered with the National Association of Certified Valuation Analysts to develop a technical workshop on hedge fund valuation. Click here for a course description. Other programs are in the works. Click here to read more about our June 28, 2007 webinar about hedge fund valuation. (The recording and program materials are available for a modest fee.) If you want additional information about valuation training for your board, risk analysis or process checks, click here to drop us a line.

 

 

 

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Voices of San Diego reporter Evan McLaughlin writes that the Fourth District Court of Appeal "upheld the district attorney's prosecution of six former pension board members." After several years of wending its way through the court system, allegations that trustees violated California's "conflict-of-interest law" will be heard. Charges emphasize "an agreement in 2002 that boosted the future pension pay of the defendants and thousands of other city employees in exchange for allowing the city to underfund the pension trust that year." Click here to read "DA's Pension Case Moves Forward" (September 7, 2007). Click here to read the ruling.

Regardless of the outcome, and acknowleging a presumption of innocence until proven guilty, a key take-away is that pension fiduciaries are absolutely on the hook. Not to be taken lightly, the job of retirement steward is a serious one. Civil and criminal penalties in the event of proven wrong-doing are possibilities. It's no surprise then that liability underwriters are fielding frequent calls for greater and more comprehensive coverage.

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The following is an excerpt from an article written by Dr. Susan M. Mangiero and published in Mann on Wall Street (August 2007 issue). If you would like to receive a copy of the full text article, click here to send an email request.

<<Despite a recent study that all is okay in corporate pension land, changes are taking place to indicate otherwise. Preparing for lots of pension buy-out business, investment banks hire actuaries in droves. Swap trading desks similarly staff, anticipating a surge in liability-driven investing. CPA firms scurry to find qualified professionals who can handle the alphabet soup of new accounting rules. Even those who breathed a sigh of relief with the final enactment of the Pension Protection Act of 2006 (“the suspense is over”) acknowledge the beginning of the end of “the way things were.” Board members, CEOs and CFOs wait for the other shoe to drop, assuming that the sequel to FAS 158 will compel wide swings in earnings. Congress and regulatory agencies busy themselves with a flurry of investigations. On top of everything else, longevity is forcing plan sponsors to rethink how to cut costs without alienating productive workers. The only constant is change. For traders who embrace volatility, life is good. For those in search of stability, hang onto your hats.

With all of this tumult underway, a little noticed trend seems to be emerging that could make pension clients high risk for service providers - asset managers, brokers, bankers, administrators, custodians, advisors, consultants, auditors and ERISA counsel. At its simplest, there is a real question as to who has investment fiduciary responsibilities other than the plan sponsor. Some organizations wear the hat of “fiduciary” but charge steep fees to compensate for added liability exposure. Others disavow the role, going so far as to include text to that effect in their engagement letter. However, real questions remain. Will judges uphold the legitimacy of this stance or instead classify a service provider as a functional fiduciary against their will, thereby opening the door to claims of breach? If that occurs, asset managers, consultants and other persons peripheral to a plan sponsor get the worst possible outcome – increased liability exposure without compensation.>>

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Alleging breach of fiduciary duty, plaintiff South Cherry Street, LLC cited failure of consulting firm Hennessee Group to do proper due diligence of the now defunct hedge fund, Bayou Group. In response, federal judge Colleen McMahon "granted a defense motion to dismiss the case, finding that Hennessee wasn't alone in being duped by Bayou." (Click here to read the August 3, 2007 Reuters article.)

As several related cases make their way through the courts, pay attention to how the judge rules. Some experts suggest that institutions could be asked to assume more responsibility for the investments they make, even after hiring a consultant.

If true, things are likely to change. After all, why hire someone else if ultimate responsibility stays with the plan sponsor? The import is considerable. Trustees and other internal fiduciaries who now look to outside experts will have to become more expert themselves. (We've long advocated for better fiduciary training and selection standards, whether an outside firm is employed or not. Click here to read a recent blog post on the topic.)

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In "Test case looms on backdating" (June 1, 2007), FEI journalists Jeffrey Marshall and Ellen Heffes write that a legal precedent may soon be set in the form of a class action case against builder KB Home. Many managers and board members who participated in backdating decisions and also act as company fiduciaries for the 401(k) plan are named in the lawsuit. Alleging ERISA fiduciary breach due to the backdating of stock options, plan sponsors and their attorneys await the outcome.

"If this case survives summary judgment, plaintiff's attorneys will be emboldened and bring more employees onto the class-action backdating bandwagon," suggests attorney John Gamble, with Fisher & Phillips, a labor and employment law firm. Marshall and Heffes caution that a post-Enron amendment of ERISA  increases punishment. "Individuals who are caught willfully violating ERISA face 10 years in prison and fines up to $100,000."

A few months ago, I predicted an ERISA litigation fallout if companies recommend stock for the 401(k) plan yet do not properly vet the process by which executives receive options. Click here to read "Will Executive Option Issues Drive the Next Wave of Pension Litigation?" by Susan M. Mangiero (Journal of Compensation and Benefits, March/April 2007).

This case is sure to attract attention.

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In his pension blog, ERISA litigator Stephen Rosenberg recently wrote about the forthcoming legal battle between the San Diego County Employees Retirement Association ("SDCERA") and Amaranth Advisors, LLC. In response to an original complaint against the once mighty energy hedge fund, its high-power attorneys countered with a motion to dismiss. Claiming caveat emptor, defendants assert that the plan sponsor understood the risks and went ahead anyhow. Click here to read the original complaint and here to read the motion to dismiss.

How this case will be adjudicated is anyone's guess. Nevertheless, the outcome will be closely watched as it goes to the very heart of investment disputes by asking who bears responsibility.

In our kick-off of the Hedge Fund Toolbox^SM webinar series on June 14, 2007, we heard from former FBI agent Mr. Ken Springer (now president of Corporate Resolutions) and senior attorney and former regulator, Rick Slavin (now partner of law firm Cohen and Wolf P.C.). Both gentlemen vigorously urged pension investors to undertake a background investigation of key principals, check documents and never shy away from asking tough questions. Springer added that "material non-disclosure of critical events in one's career" represents a major concern, along with the need to do additional follow-up to explain discrepancies. Late payment of credit card bills or a faillure to pay child support suggest carelessness with other people's money.

In his overview of case precedent and enforcement actions, Slavin offered that sloppy, obtuse or incomplete paperwork is usually the beginning of trouble. He reiterated that the use of outside parties does not absolve plan sponsors of their fiduciary duties. Oversight obligations remain.

Springer told listeners that Bayou's problems, pre-meltdown, were evident had investors carefully reviewed available facts. "Blatant conflicts of interest, overstating of employees' accomplishments, suits by former employees, suits filed by investors and even suits filed by hedge fund managers" should have caught investors' attention before money changed hands. Slavin suggests that we're in for a bumpy ride. "There is every indication that more litigation and enforcement is on its way."

Rosenberg agrees. "We are currently watching the rise of a pension/401(k) investment plaintiffs bar, clearly modeled after the securities litigation class action bar, ready and waiting to sue pension advisors and anyone else in the line of fire for excessive fees, poor investment choices, and anything else that affects returns in the plans." He adds that, "If the hedge fund’s lawyers are right, then aren’t the plan’s fiduciaries and other advisors potentially liable for breaching their own obligations to the plan and its participants to properly select and monitor plan investments? And if so, then their best defense should the newly forming class action bar come after them for this mess would be that, contrary to what the hedge fund’s lawyers say, they actually did full and complete due diligence, and therefore lived up to their obligations and cannot themselves be liable for the fact that the investment went south."

Wise words to remind us of the importance of good process!

If you are interested in purchasing the recordings of any webinars that have already taken place, click here. (Webinars are listed in chronological order.) Click here to register for any or all of the forthcoming webinars in this exciting new series. Speakers will address the roles of financial advisor and consultant on June 26. Valuation is the topic of the June 28 event.

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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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A recent trend in class action litigation circles is the pension plan opt-out. Choosing not to settle with the rest of the "class," several large institutional investors are getting recompense that reflects multiples of what they could otherwise receive.

Pension Governance contributing editor, attorney Kevin Lacroix talks about this significant shift in class action outcomes, citing a sea change in the cost of litigation. Click here for more information about Kevin's interesting article and here to read more about our first class team of contributing editors.

PG Editor's Note: We have just posted an interesting and complementary item to www.pensiongovernance.com. In "Predicting Corporate Governance Risk: Evidence from the Directors' & Officers' Liability Insurance Market," authors Tom Baker and Sean J. Griffith examine how liability insurance underwriters assess corporate governance behavior - and related expectations of risk - when pricing coverage. The authors also examine whether corporations are deterred by the cost of liability insurance, especially since "virtually all corporations purchase D&O insurance to cover the risk of shareholder litigation, and because virtually all shareholder litigation settles within the D&O insurance limits, the D&O insurance premium represents the insurer’s best guess of the insured’s expected liability costs." The authors conclude that governance factors such as culture and character are taken into account by insurance underwriters. Click here for more information.

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According to money management letter (April 9, 2007 issue), Rocaton Investment Advisors paid $2.75 million to the San Diego County Employees Retirement Association "for recommending Amaranth Advisors." The article also goes on to say that no information is forthcoming about whether Rocaton did anything wrong and whether this money is covered by professional liability insurance.

The reason for citing this article is not to put any one particular firm in the spotlight but rather to suggest that pension fiduciaries check with their appropriate counsel and do sufficient homework internally to make sure that everything that should be done is being done. This includes, but is not limited to, seeking answers to the following questions:

1. How much experience does a particular consultant and/or financial advisor under consideration have with respect to examining hedge funds or fund of funds?

2. Does the consultant and/or financial advisor have an adequate understanding of the hedge fund or fund of funds' use of leverage through short-selling and/or use of derivatives, if relevant? What is their systematic process for examination of leverage? How do they define leverage and does that comport with industry norms?

3. Has the consultant and/or financial advisor identified (and explained to plan sponsors) possible risk factors associated with a given hedge fund or fund of funds? Sector concentration, management style, specific ownership structure of the limited liability company or partnership, availability of risk analytics, stop loss triggers, primary and secondary plans for liquidation, valuation policy, redemption restrictions and use of side pockets are JUST the beginning.

We'll talk much more about the issue of investment risk review in coming days. Why? Plan sponsors are still on the hook for monitoring their monitors. It's simply not as easy as passing along a hot potato regarding due diligence to someone else.

P.S. There is a rumor that another pension consultant has offered recompense in conjunction with this hedge fund case. If true, could this be a trend in going after consultants and/or financial advisors in the event of losses?

 

 

 

 

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Alleging questionable stock option practices at technology giant Apple Inc, the New York City Employees' Retirement System ("NYCERS") will serve as lead plaintiff in a lawsuit filed a few months ago. Citing the Private Securities Litigation Reform Act of 1995 ("PSLRA"), NYCERS claims the largest financial interest in the lawsuit. (Click here to read the original filing and here to read "Recent Developments Under the PSLRA.")

According to Reuters (January 22, 2007), the NY fund's ownership stake is roughly one million shares or about $87 million in current value terms. Its 2006 Comprehensive Annual Financial Report shows $46.34177 billion as plan net assets as of June 30, 2006. While NYCERS equity exposure to Apple is large in absolute terms, it is small compared to the equity interests held by institutional investors such as Fidelity Management & Research (60,316,011 shares as of September 30, 2006) or AllianceBernstein L.P. (48,637,731 shares in second place). Click here to review ownership statistics, courtesy of Thomson Financial (and reprinted by the Wall Street Journal.)

The intent of this post is not to single out any one company nor to imply that the filing of a complaint supports any or all of the allegations. That's for the trier of fact to determine. What is important is to understand that executive compensation practices can (and often do) impact shareholder value. If the market interprets a particular practice as far removed from economic reality and/or regulators start sniffing around, defined benefit and defined contribution participants stand to lose a bundle. In order to reduce the likelihood of an adverse outcome due to investing in company stock, pension fiduciaries must carefully consider relevant risk factors. That includes the percentage of company stock already part of a particular plan (whether self-directed or not). See "Options, Pensions and the SEC" for additional comments about backdating and pension fiduciary duty.

With more than 120 companies being asked questions about their respective option practices, there is surely much more to say on this topic!

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It's hard to pick up a newspaper these days without reading some story about stock options - when they are granted, how often they are repriced, what portion of an executive's total compensation they represent and so on. What has authorities particularly busy is a fast-expanding review of practices such as option backdating and spring loading. As of December 31, 2006, the Wall Street Journal counts 120 companies on their option backdate list. Click here to view the options scorecard and learn about executive departures and various regulatory agency investigations.

The Free Dictionary defines backdating as "dating any document by a date earlier than the one on which the document was originally drawn up." Spring loading can mean either that "a company purposely schedules an option grant ahead of expected good news or delays it until after it discloses business setbacks likely to send shares lower." See "SEC eyes 'springloading'" as published by the New York State Society of Certified Public Accountants. In both cases, the idea is to inflate the value of the executive's stock option. (Experts remind that neither backdating nor spring loading is necessarily illegal per se, a conclusion that is best left to attorneys and regulators.)

These and other practices are important to pension fiduciaries and plan participants alike. Defined benefit plans sometimes invest in company stock. Defined contribution plan participants are often given a similar choice. Any problems with option grants, especially when they result in tax and/or accounting penalties, not to mention regulatory enforcement levies or litigation payouts, can do serious harm to an employee's retirement plan. From a fiduciary perspective, real questions could arise about the ex-ante assessment of company stock as a viable investment vehicle for a sponsored plan(s). Did an adequate due diligence review of risk factors that influence company stock price occur? Did pension fiduciaries sufficiently understand existing practices regarding executive compensation, including option awards? How often did pension fiduciaries assess option grant practices and/or inquire about industry norms, internal controls and likely impact on "shareholder" retirement plan participants?

For interested readers, the D&O Diary, authored by attorney Kevin LaCroix, has an excellent collection of articles about op