Pensions and Bankruptcy Claimants

The tug of war continues between pension plan participants and outside creditors. As a result, doing business with troubled municipalities may end up costing creditors time, money and headaches. Just a few days ago, Judge Christopher Klein with the United States Bankruptcy Court for the Eastern District of California ruled against Franklin Templeton Investments. By doing so, this asset manager will not be able to recoup the $32 million it sought from the City of Stockton as the municipality seeks to exit bankruptcy. Instead, as Reuters journalist Robin Respaut writes in "Holdout creditor in Stockton bankruptcy denied higher claim" (December 10, 2014) the city's plan would give Franklin "just over $4 million of the $36 million it said it is owed." This follows an October thumbs-up from the Court to reduce the payout to bond investors in order to maintain retirement and health care benefits and thereby (hopefully) prevent an exodus of badly needed city workers. 

A topic not actively discussed but critically important to ignore is that once-burnt lenders are unlikely to come knocking again. If they do, they will charge a higher cost of capital and demand tighter collateral safeguards to reflect the bigger risk associated with exposure to struggling borrowers. After all, lenders are accountable to their customers. As Bond Buyer's Keeley Webster describes, investors in Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund will suffer as the result of a low recovery rate in the neighborhood of twelve percent for loans made to Stockton. 

As Attorney B. Summer Chandler discusses in "Is It 'Fair' to Discriminate in Favor of Pensioners in a chapter 9 Plan?" (American Bankruptcy Institute Journal, December 2014) putting pensioners ahead of other unsecured creditors may not seem right to some but could be supported by "limited case law assessing chapter 9 plans..." taking into account "the unique nature of a municipality, its relationship to its citizens (including pensioners and current employees) and the purposes of chapter 9..."

To reiterate, customer risk is real for organizations such as Franklin Templeton. Unless its higher costs can be passed along to customers, expect some lenders and suppliers to say "never mind" and look elsewhere for business. This would logically reduce the supply of capital and services and could mean higher costs for all municipalities, not just those seeking bankruptcy protection. As my co-authors and I discuss in "Muni Bonds, Pension Liabilities and Investment Due Diligence" by Dr. Susan Mangiero, Dr. Israel Shaked and Mr. Brad Orelowitz (American Bankruptcy Institute Journal, July 2014), the evolution of decision-making can reduce uncertainty. We add that "...legal, economic and political skirmishes associated with municipal bond distress now being played out are helping to set the stage for future clarity." We assert that future bond buyers may still lend to a municipality if they "are comfortable in their belief that large unfunded post-employment obligations can be compromised as part of a distressed-debt workout..." and that "fresh capital can be a lifeline for a municipality that has fallen on hard times, even if it comes with a higher service cost.'

The best outcome is that pension-plagued municipalities seeking to exit from bankruptcy get their financial house in order as quickly as possible. While retirement plan participants have received a reprieve in some situations such as what happened with Stockton, the overall funding crisis is likely to reverberate in ways that could lead to future skirmishes. Witness what is happening right now, courtesy of the U.S. Congress. According to "Pension Bill Seen as Model for Further Cuts" (December 14, 2014), Wall Street Journal reporter John D. McKinnon portends future diminutions in employee benefit payouts if such action is deemed to prevent the "failure of just a few" plans being able to destroy "the federal pension safety net" (i.e. the Pension Benefit Guaranty Corporation). While the focus of lawmakers right now is on corporate union plans, it is not much of a stretch to imagine certain reductions being allowed throughout the United States and in other countries, postured as protection for the "greater good."

Retail Investors and Derivatives Trading

During a catch-up conversation, a now-retired colleague told me how much money he was making by trading options. Based on several recent articles, it seems that he is not alone in looking to Wall Street instruments in hopes of an income boost or a way to hedge uncertainty. In "Retail Investors Flock to Derivatives for Income and Safety" (TheStreet.com, October 31, 2014), senior reporter Dan Freed describes a growing trend in trading options and futures, with growth rates that exceed the level of purchases and sales of stock. On November 3, 2014, the Options Clearing Corporation reported a 22.32 percent rise in total equity and index option volume in October 2014 from one year earlier, "the second highest monthly volume on record behind the August 2011 record volume of 554,842,463 contracts" or a year-to-date volume of 3,673,768,194 contracts.

Reuters journalist Chris Taylor describes the average options trader as 53 years of age, citing Options Industry Council statistics that put nearly thirty percent of those who trade options at between "the ages of 55 and 64." However, in "New baby boomer hobby: trading options" (July 9, 2013), even retirees with a high net worth are cautioned to educate themselves about the downside of leverage. Mary Savoie, Executive Director of the Options Education Program, talks about the free resources made available by the Options Industry Council.

Critics counter that formal training cannot replace experience and that retirement assets should be invested with a long-term goal in mind, especially for those individuals with a low net worth. What they may not realize is that numerous retirement plans are chockablock with exposure to derivatives in the form of investment funds that trade swaps, options and futures. In mid-September of this year, Bloomberg reporters Miles Weiss and Susanne Walker wrote that then PIMCO senior executive and co-founder of the Pacific Investment Management Company Bill Gross "sold most of the $48 billion of U.S. Treasuries held by his $221.6 billion Pimco Total Return Fund (PTTRX) in the second quarter, replacing them with about $45 billion of futures. In "SEC Preps Mutual Fund Rules," Wall Street Journal reporter Andrew Ackerman (September 7, 2014) cites a concern on the part of the U.S. Securities and Exchange Commission about the use of derivatives by certain mutual funds and could seek "to limit the use of derivatives in mutual funds sold to small investors, including both alternative funds and certain 'leveraged' exchange-traded funds, volatile investments that use derivatives to double or even triple the daily performances of the indexes they track..." 

Over the years, I have traded derivatives, valued derivatives, reviewed financial models, created hedges and stress tested deals for compliance purposes. Throughout that time, the global markets continue to grow, attesting to their popularity. Earlier this summer, the Bank for International Settlements measured the over-the-counter derivatives market as having expanded to outstanding contracts with a value of $710 trillion at yearend 2013, up from $633 trillion in a single year.

Whether singular derivative transactions are appropriate for any one individual plan participant depends on a number of factors. Suffice it to say, derivative instruments are here to stay. It would be incorrect to underestimate the ubiquitous nature of derivatives. Besides asset managers who use derivatives, there are plenty of structured products that layer in derivatives with traditional equity or fixed income securities.

Stay tuned for more from the regulators about the usage of derivatives and asset management. In the aftermath of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, rules about derivatives trading and clearing are changing the operational and technology landscape. Fund directors not already in the know are being urged to pay attention to the economic impact on fund activity when derivatives are used. Click here to download a good risk management checklist. It is part of a November 8, 2007 speech by Gene Gohlke, then Associate Director, Office of Compliance Inspection and Examinations, SEC. Entitled "If I Were a Director of a Fund Investing in Derivatives - Key Areas of Risk on Which I Would Focus," Attorney Gohlke addresses the panoply of due diligence considerations such as custody, pricing and valuation, legal, contractual, settlement, tax, performance calculations, disclosure, investor reporting and compliance. These are important knowledge areas for investors too.

Alternatives and Retail Retirement Account Owners

The prospect of being part of millions of retail retirement plans has some financial advisors and hedge fund managers giddy with excitement. The 401(k) market alone is huge. According to the Investment Company Institute, as of Q3-2012, these defined contribution plans held an estimated $3.5 trillion in assets. In 2011, over fifty million U.S. workers were "active 401(k) participants." This compares favorably to an approximate $2.66 trillion hedge fund market size in 2013, up from $2.3 trillion one year earlier. Private equity, real estate and infrastructure comprise the rest of the alternatives investment sector according to a press release issued by Preqin, a financial research company. See "Alternative Assets Industry Hits $6tn in AUM for First Time" (January 21, 2014).

CNBC contributor Shelly K. Schwartz explains that alternative investment strategies are appearing in the form of 400 plus mutual funds and exchange-traded funds ("ETFs") that employ "complex trading strategies" such as managed futures, long/short trading in stocks and multiple currency exposures. Allocating to leveraged loans, start-up ventures and global real estate are other ways that these relatively new funds seem to be mimicking the approach taken by hedge funds and private equity funds that traditionally have catered to institutional investors and high net worth individuals. Notwithstanding regulatory differences relating to diversification, percentage of "illiquid" investments, redemption, daily pricing and how much debt can be used to lever a portfolio, statistics suggest a growing interest on the part of smaller investors to get in on the action. See "Seeking safe havens? Analysts, advisors point to liquid alternative funds" (November 24, 2013). Also check out "Goldman pushes hedge funds for your 401(k)" (Fortune, May 22, 2013) in which reporter Stephen Gandel describes new funds being offered by various financial institutions, some of which invest in mutual funds that mimic hedge fund investing strategies and others that invest in hedge funds directly.

Not everyone is an ardent fan. In "FINRA warns investors on alternative mutual funds," Reuters reporter Trevor Hunnicutt (June 11, 2013) describes regulators' concerns that "not all advisers and investors understand the risks involved," especially with respect to whether a retail-oriented fund is truly liquid. In its "Alternative Funds Are Not Your Typical Mutual Fund" publication, the Financial Industry Regulatory Authority ("FINRA") cautions investors to assess investment structure, strategy risk, investment objectives, operating expenses, the background of a particular fund manager and performance history.

Given the ongoing search for the next big thing, we are likely to see a lot more activity in the alternative investments marketplace - for both institutional and high net worth clients as well as for individuals with modest wealth levels. PensionRiskMatters.com will return to this topic in future posts. There is much to write about with respect to fiduciary implications, risk management and valuation.

In the meantime, I want to thank ERISA attorney David C. Olstein with Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates for apprising me of a 2012 U.S. Department of Labor grant of individual exemption for Renaissance Technologies, LLC ("Renaissance").  Described as a "private hedge fund investment company based in New York with over $15 billion under management" by HedgeCo.net (September 26, 2013), Renaissance holds a large number of equity positions in stocks issued by household name companies. Click to see a recent list of their transactions. The "Grant of Individual Exemption Involving Renaissance Technologies, LLC," published in the Federal Register on April 20, 2012 makes for interesting reading for several reasons. First, it describes policies relating to important topics such as valuation, redemption and disclosures for "privately offered collective investment vehicles managed by Renaissance, comprised almost exclusively of proprietary funds" and the impact on retirement accounts in the name of Renaissance employees, some of its owners and spouses of both employees and owners. Second, as far as I know, there are not a lot of publicly available documents about proprietary investment products that find their way into the retirement portfolios of asset management firm employees and shareholders. Third, as earlier described, there is evidence of a growing interest on the part of the financial community in bringing hedge funds or hedge fund "look alike" products to the retirement "masses."

Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends

Mark your calendars to attend "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends."

At a time when unfunded pension and health care obligations are accelerating the budgetary crisis for some municipalities, experts fear that current problems are the tip of the iceberg. A new focus on accounting rules, the quality of disclosure to muni bond investors and the due diligence practices of underwriters, portfolio managers and advisers could mean heightened liability exposure for anyone involved in the nearly $4 trillion public finance marketplace. Add the history-making Detroit bankruptcy decision to the mix and attorneys have the makings of a perfect storm as they attempt to navigate these unchartered waters. The U.S. Securities and Exchange Commission has made no secret of its priority to sue fraudulent players in the public finance market. Insurance companies are reluctant to underwrite policies for high-risk government entities at the same time that municipal fiduciaries are more exposed to personal liability than ever before, especially as the protection of sovereign immunity is being challenged in court. Litigation that involves how much monitoring of risk factors took place is on the rise.

Public finance and securities litigation counsel, both in-house and external, can play a vital role in advising municipal bond market clients as to how best to mitigate litigation and enforcement risk or, in the event that an enforcement action has already been filed, how best to defend such litigation. Please join Orrick, Herrington & Sutcliffe LLP partner, Elaine C. Greenberg, and retirement plan fiduciary expert, Dr. Susan Mangiero, for an educational and pro-active program about the complex compliance and litigation landscape for municipal bond issuers, underwriters, asset managers and advisers. Topics of discussion include the following:

  • Description of the current regulatory environment and why we are likely to see much more emphasis on the disclosure activities of public finance issuers and the due diligence practices of underwriters and advisers;
  • Overview of hot button items that impact a bond issuer’s liability exposure, to include valuation of underlying collateral, rights to rescind benefit programs in bankruptcy and the use of derivatives as part of a financing transaction;
  • Explanation of GASB accounting rules for pension plans and likely impact on regulatory oversight of securities disclosure compliance and related enforcement exposures;
  • Discussion about trends in municipal bond litigation – who is getting sued and on what basis; and
  • Description of pro-active steps that governments and other market participants can take to mitigate their legal, economic and fiduciary risk exposures.

Featured Speakers:

Ms. Elaine C. Greenberg, a partner in Orrick, Herrington & Sutcliffe LLP’s Washington, D.C., office, is a member of the Securities Litigation & Regulatory Enforcement Group. Ms. Greenberg’s practice focuses on securities and regulatory enforcement actions, securities litigation, and public finance. Ms. Greenberg is nationally recognized for producing high-impact enforcement actions, bringing cases of first impression and negotiating precedent-setting settlements, she possesses deep institutional knowledge of SEC policies, practices, and procedures. Ms. Greenberg brings more than 25 years of securities law experience, and as a Senior Officer in the SEC's Enforcement Division, she served in dual roles as Associate Director and as National Chief of a Specialized Unit. As Associate Director of Enforcement for the SEC's Philadelphia Regional Office, she oversaw the SEC's enforcement program for the Mid-Atlantic region and provided overall management direction to her staff in the areas of investigation, litigation and internal controls. In 2010, she was appointed the first Chief of the Enforcement Division's Specialized Unit for Municipal Securities and Public Pensions, responsible for building and maintaining a nation-wide unit, and tasked with overseeing and managing the SEC's enforcement efforts in the U.S.’s $4 trillion municipal securities and $3 trillion public pension marketplaces. Ms. Greenberg recently gave a speech entitled “Address on Pension Reform” at The Bond Buyer’s California Public Finance Conference in Los Angeles on September 26, 2013.

Dr. Susan Mangiero is a CFA charterholder, certified Financial Risk Manager and Accredited Investment Fiduciary Analyst™. She offers independent risk management and valuation consulting and training. She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors. Dr. Mangiero has served as an expert witness as well as offering behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary on matters that include distressed debt, valuation, investment risk governance, financial risk management, financial statement disclosures and performance reporting. She has been actively researching and blogging about municipal issuer related retirement issues for the last decade. She has over twenty years of experience in capital markets, global treasury, asset-liability management, portfolio management, economic and investment analysis, derivatives, financial risk control and valuation, including work on trading desks for several global banks, in the areas of fixed income, foreign exchange, interest rate and currency swaps, futures and options. Dr. Mangiero has provided advice about risk management for a wide variety of consulting clients and employers including General Electric, PriceWaterhouseCoopers, Mesirow Financial, Bankers Trust, Bank of America, Chilean pension supervisory, World Bank, Pension Benefit Guaranty Corporation, RiskMetrics, U.S. Department of Labor, Northern Trust Company and the U.S. Securities and Exchange Commission. Dr. Mangiero is the author of Risk Management for Pensions, Endowments and Foundations  (John Wiley & Sons, 2005), a primer on risk and valuation issues, with an emphasis on fiduciary responsibility and best practices. Her articles have appeared in Expert Alert (American Bar Association, Section of Litigation), Hedge Fund Review, Investment Lawyer, Valuation Strategies, RISK Magazine, Financial Services Review, Journal of Indexes, Family Foundation Advisor, Hedgeco.net, Expert Evidence Report, Bankers Magazine and the Journal of Compensation and Benefits. Dr. Mangiero has written chapters for several books, including the Litigation Services Handbook and The Handbook of Interest Rate Risk Management.

ERISA Assets: QPAM and INHAM Audit Legal Requirements and Best Practices

I am happy to announce that I will be joined by esteemed colleagues Howard Pianko, Esquire (Seyfarth Shaw) and Virginia Bartlett (Bartlett O'Neill Consulting) on September 10, 2013 from 1:00 to 2:30 pm EST to talk about QPAM and INHAM compliance audits. See below for more information. Click to register for this forthcoming educational event about ERISA requirements. (Note: I am given a few complimentary guest passes. Contact me if you are interested and they are still available.)

This CLE webinar will prepare counsel to advise asset manager clients regarding Qualified Professional Asset Manager (QPAM) and in-house asset manager (INHAM) audits as required by the Department of Labor. The panel will review the new exemption rules, who can conduct an audit, what the process entails, and how to showcase good practices with existing and prospective plan sponsors.

Continue Reading...

Tibble v. Edison and ERISA Fiduciary Breach Issues

Speedy and insightful as always, ERISA attorney Stephen Rosenberg has commenced a series of blog posts that describes his view of the "hot off the press" conclusions made by the United States Court of Appeals for the Ninth Circuit in Tibble v. Edison. Click to access the March 21, 2013 Tibble v. Edison opinion. This ruling will no doubt receive much attention in the coming days as jurists and ERISA fiduciaries digest its content. Some will view this adjudication as yet another reminder that prudent process must be undertaken and can be demonstrated with respect to a host of issues (although the outcome is mixed in terms of plaintiff versus defendant "wins"). Issues include the selection of investment choices and the fees paid accordingly. Click to access the amicus brief filed by the U.S. Department of Labor in support of the plaintiffs.

In his first post about yesterday's opinion, Attorney Rosenberg points out that the timeline that determines ERISA's six-year statute of limitations was deemed to have started "when a fiduciary breach is committed by choosing and including a particular imprudent plan investment" and did not continue by virtue of the investment mix remaining in the plan. He further asserts that defendants will want the clock to begin on the day an investment option is first introduced and that "any breach of fiduciary duty claims involving that investment that are filed later than six years after that date are untimely."

I will leave court commentary to the legal experts. Click to access the Boston ERISA & Insurance Litigation Blog for his analysis about this case and many more.

Help With Form 5500 Reporting

For those in need of help, click to access the "Troubleshooter's Guide to Filing the ERISA Annual Report" (U.S. Department of Labor, October 2010). This 70-page publication includes a handy reference chart that relates to the Form 5500 and Form 5500-SF (for small firms), along with related attachments. Another helpful resource is "FAQs About The 2009 Form 5500 Schedule C."

School's still out regarding the extent to which plan sponsors will be able to comply with new rules. So far, Schedule C seems to be a sticking point with numerous questions being asked about how to properly report "indirect" versus "direct" compensation to service providers.

As more pension plans allocate monies to mutual funds, hedge funds, private equity funds and funds of funds, they will need to report details about fees paid to these organizations as they too are now deemed service providers.

401(k) Plans, Mutual Funds and Derivatives - Hello SEC

Given that mutual funds are a popular 401(k) plan choice, it's not surprising that further regulatory scrutiny of the use of derivatives by traders is underway.

"SEC Staff Evaluating the Use of Derivatives by Funds" (U.S. Securities and Exchange Commission Release 2010-45, March 25, 2010) talks about a new initiative to review the current practices by pools of capital regulated under the auspices of the Investment Company Act of 1940. Scrutiny will focus on items such as:

  • Leverage, concentration and diversification
  • Existing risk management policies and procedures
  • Oversight of use of derivatives by fund board of directors
  • Rules for proper pricing
  • Prospectus disclosures.

Click here for more information.

Investment Ethics, Balloon Boy and Sizzle

A colleague called me the other day, after attending a recent Connecticut event that addressed "too big to fail" concerns on the part of state regulators. In response to her comment about the large crowd size, I queried her about whether a forum on investment ethics would likely be a similar draw. Somewhat surprising to me she said "no" with nary a hesitation in her voice. Teasing her for more information, she simply declared that the topic of ethics is boring. Is she right?

Is ethics too dry to appeal, even to those tasked with compliance and investment best practices? Should we even compare ethics hounds to those of us who watched the silver spaceship-like balloon, floating above the Colorado countryside a few weeks ago, wondering if Balloon Boy was safely tucked inside? (Go on, admit it. You took at least one peek to hear whether a 6-year old really can fly, unsupervised, 8,000 feet above ground.)

Let's assume for a moment that celebrity and quirky news stories trump discussions about ethics and governance. Should we care? 

I've long maintained that carrying out one's professional duties with integrity does indeed impose a need to pay attention to what is right. Yet recognizing that one should be "ethical" is a necessary but insufficient condition. One can acknowledge the need to act properly yet do nothing about it, exposing ultimate beneficiaries to potential ruin. Then there are those who embrace the mantra but are blind to the gap between "investment best practices" and compliance. One can adhere to the letter of the law and yet fail miserably in terms of improving internal controls (and much more) so that investment risk is mitigated.

Since compensation levels are in the headlines of late, I'd like to repost an article that my colleague Wayne Miller and I wrote several years ago. Though written for retirement plan executives, the issues we discuss in "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?" ring true today and will apply tomorrow. The primary assertion is that individuals behave according to incentives in place. The rewards must be clearly positive and attainable for anyone who rightly walks the extra mile on behalf of beneficiaries (mutual fund investors, retirement plan participants, etc).

What will entice my friend to race to a meeting to learn more ethical behavior, along with hundreds of others? Free wine and cheese or a true belief that comprehensive risk management is simply the only course of action for high-integrity stewards of other people's monies? Alas, she may not soon have a choice. Regulators and politicians will not be handed the next Madoff scandal on their watch.

According to her October 27, 2009 speech to attendees of the SIFMA Annual Conference, the SEC Chairman Mary Schapiro has created a new Division of Risk, Strategy and Financial Innovation and has its sights set on "new products - particularly those related to retirement investing." She emphasizes the need for "simple, clear disclosure" in lieu of "complex fee arrangements or product descriptions...Already on the radar screen are target date funds and securitized life settlements."  Click to read "The Road to Investor Confidence."

Is the SEC focus a faux reward? Comply and stay out of trouble (a carrot of sorts) but not necessarily map actions to best practices (hence one runs into a proverbial brick wall with attendant pain). How will good players be differentiated from bad but lucky investment professionals? Alas, this is a topic for another day.

 

Equity Bye Bye - Asset Allocations Are a Changin'

According to Financial Times reporter Deborah Brewster ("Investors pull out of mutual funds," April 27, 2008), nearly all U.S. mutual fund managers saw a drop in assets in Q1-2008. Sagging returns are a main driver on the retail side. Citing Strategic Insight, Brewster writes that individuals and institutions have pulled $100 billion from American, European and Japanese equity funds.

Money market funds, charging lower fees, seem to be picking up the slack. This suggests an inevitable decline in profitability for the asset management business. In "Has the Financial Industry's Heyday Come and Gone?" (April 28, 2008) Wall Street Journal reporter Justin Lahart writes that "the businesses of borrowing, lending, investing and all of the middlemen in between" are slowing and thereby creating ripples throughout the U.S. economy. With documented job cuts in the financial sector, new regulations and questions about "excess" risk, a discernible shift is underway. A shrinking financial sector and reduced availability of credit hits consumers and corporations hard.

In addition, defined benefit plans are moving assets away from equity to alternatives and fixed income. In "CalPERS to shift $44 billion" (December 24, 2007), Pensions & Investments reporter Raquel Pichardo describes the giant retirement plan's move into international equity, real estate, private equity and a "new inflation-linked asset class." On April 17, 2008, New York Times reporter Mary Williams Walsh offers insight into what some of American's biggest plan sponsors are doing to manage market volatility. Referring to a new study by Evaluation Associates in "Market Turmoil Has Taken a Toll on Big Pension Funds," Walsh writes that General Motors, Ford, Boeing and Deere are a few of the large plans to turn from equities.

The issue is important for many reasons, not the least of which is the impact on statutory funding requirements, cash flow and related share price. In March 2008, money manager Charles Gilbert spoke to a Society of Actuaries audience about the double whammy of falling interest rates (increases the defined benefit liabilty) and unhealthy stock returns (reduces portfolio value).

Hedge Fund Settlements with SEC - Lessons for Pension Plans

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 ToolboxSM will cover many important topics such as valuation, risk management, fee structure, disclosure and ERISA considerations.

Private Equity, Mutual Funds and Valuation


Wall Street Journal reporter, Eleanor Laise recently wrote that an increasing number of mutual funds are "venturing into the risky world of private-equity investments", "because of the prospects for higher returns." While SEC rules limit assets to no more than fifteen percent in illiquid holdings, Ms. Laise describes potential problems. Higher legal expenses for more complex deals, difficulty of unwinding a position and valuing private investments are far from trivial challenges. She cites one SEC investigation of a mutual fund that allegedly undervalued its private company positions to give the impression that it had not breached the fifteen percent limit. "The SEC also has charged funds with inflating the value of illiquid investments. Mutual-fund managers have an incentive to overestimate the value of these holdings because they collect fees that are calculated as a percentage of total assets in the fund." (See "Mutual Funds Delve Into Private Equity" by Eleanor Laise, Wall Street Journal, August 2, 2006.)

Applying a version of the transitive property from mathematics, the implication is clear. Some pension funds have increasing exposure to private equity investments that do not trade in a ready market.

1. Pension funds allocate money to mutual funds.

2. Mutual funds buy private equity.

3. Pension funds are exposed to private equity as an asset class. (This is in addition to any direct allocation by pension funds to private equity.)

The message is clear. For those pension funds investing more money in private equity (indirectly or directly), the valuation issues are real and cannot be overlooked.