Hard to Value Assets, Hedge Funds and Investment Fiduciaries

As I have pointed out on multiple occasions, valuation is an integral part of investment risk management for several reasons. First, fees paid to asset managers are frequently linked to performance and performance calculations depend on reported values. If values are artificially inflated, returns are likely to be inflated as well. Second, imprecise values can skew asset allocation decisions, lead to hedges being too big (or too small) and possibly cause an investor to breach trading limits that are part of an Investment Policy Statement. It's no surprise then that valuation process questions about who does what, when and how continue to surface.

According to a May 9 Wall Street Journal article, the U.S. Securities and Exchange Commission ("SEC") is investigating "the way hedge funds value their thinly traded holdings and how they respond when investors ask for their money back." The SEC has been vocal about its concerns regarding asset valuations for awhile. In December 2012, Bruce Karpati, then Chief of the Asset Management Unit of the SEC Enforcement Division (and now in private industry), talked about a focus "on detecting fraudulent or weak valuation practices - including lax valuation committees and the use of side pockets to conceal losing illiquid positions - and the failure to follow a fund's stated valuation procedures." Click to read "Enforcement Priorities in the Alternative Space." (As an aside, some hedge funds buy and sell actively traded securities for which there is a ready market and full price transparency.)

The U.S. Department of Labor ("DOL") regularly broadcasts its concerns about "hard to value" assets, including financially engineered products that show up in certain defined benefit and defined contribution retirement plans. In September of 2008, I spoke before the ERISA Advisory Council, by invitation, to address valuation issues from the perspective of a trained appraiser and fiduciary best practices expert. Click to read "Testimonial Remarks Presented by Dr. Susan Mangiero." I talked at length about valuation questions to ask of service providers and procedural prudence considerations for institutional investors.

A few weeks ago, senior attorney Fred Reish addressed monitoring and uncertainty in his April 19, 2016 newsletter. He directed readers to Fiduciary Rule preamble text that urges an advisor and his financial institution to install an adequate monitoring process before recommending "investments that possess unusual complexity and risk, and that are likely to require further guidance to protect the investor's interests." Click to read "Interesting Angles on the DOL's Fiduciary Rule #1." It doesn't take a rocket scientist to conclude that a "complex" and "risky" investment could be hard to value and not particularly liquid. (I have purposely not defined the terms in quotes herein as they are often related to facts and circumstances for a particular investor.)

Expect to read more about this important topic of valuation, especially as applied to those investors in search of higher returns. In a "no free lunch" world, risk and return go hand in hand. It's not necessarily a bad thing to take on greater risk as long as there is an understanding at the outset as to what gives rise to uncertainty and how risks are being mitigated.

Financial Technology and the Fiduciary Rule

Whether the proposed U.S. Department of Labor so-called fiduciary rule becomes law this year remains to be seen. Many in the industry think its passage is nigh. Critics hope for a reprieve, asserting that costs are likely to outweigh benefits.

One oft-repeated concern is that small savers will be harmed if financial service companies decide to jettison accounts that fall below target asset levels. The Securities Industry and Financial Markets Association ("SIFMA") explains "Because they cannot afford a fiduciary investment advisory fee, they will instead be forced to solely rely on a computer algorithm known as a 'robo-advisor.'"

Financial technology enthusiasts will counter that a more automated approach to retirement planning is a good thing for big and small savers alike. Certainly the topic merits review for at least two reasons.

  • The use of machines has exploded in recent years. In her November 9, 2015 speech about technology, innovation and competition, U.S. Securities and Exchange ("SEC") Commissioner Kara Stein foretells buoyant growth with an expected $2 trillion in assets under management by robotized advisors by 2020.
  • There are central questions about the fiduciary obligations of a company that concentrates on algorithmic advising and money management. Besides seeking to contain model risk, there is a need, at a minimum, for a vendor to regularly review client objectives and constraints. Click here to access a white paper on this topic by National Regulatory Services.

A few weeks ago, a handful of venture capitalists and prominent angels announced a $3.5 million capital round for a financial technology company called Captain401. Its stated goal is to help small businesses streamline the creation and administration of 401(k) plans that the founders argue would be too expensive to offer without automation. A cursory review of the company website makes it impossible to know much about its business model, technology safeguards or compliance infrastructure. Nevertheless, the funding of this and other "Fin Tech" organizations augurs favorably for added growth in this area.

As the global retirement marketplace adapts to regulatory and economic realities, it will be interesting to watch (or perhaps lead) what unfolds in terms of innovation, service provider competitiveness, cost tiers and other outcomes that impact savers and those who have already retired.

Derivatives, De-Risking and Disclosures

According to survey results provided in "Pension Plan De-Risking, North America 2015" (published by Clear Path Analysis and sponsored by Prudential Retirement), "pension risk management remains a principal concern for many plan sponsors." This should come as no surprise. Low interest rates, longer lifespans and anemic funding levels are a few of the concerns cited by the fifty-one senior professionals who answered questions. Half of the respondents agree that implementing a risk management strategy sooner than later makes sense, with one out of four individuals indicating an intent to transfer risk to an outside insurance company in 2015. Three out of four survey-takers "believe that movement in interest rates will impact their decisions to implement a liability driven investment strategy, or to execute a bulk annuity transaction." When asked about the use of alternatives such as hedge funds, fourteen percent replied that they currently use and seek to increase. One third currently allocates to alternatives and two percent look to introduce. Assuming that a respondent can only answer this question once and that there is one survey-taker per pension fund, this means that there is roughly a fifty-fifty split when it comes to including alternatives as part of a defined benefit plan investment portfolio.

If true that lower interest rates may discourage some plan sponsors from fully transferring risk to a third party insurer via a buy-out but they nevertheless seek to more actively manage pension risks, one could logically expect a greater use of a strategy such as Liability-Driven Investing ("LDI"). To the extent that LDI frequently entails the use of derivatives, those plan sponsors in favor of LDI may want to take note of a recent move by the U.S. Securities and Exchange Commission ("SEC"). As I just posted to my investment risk governance blog, certain registered funds could soon be asked to publish a considerable bounty of data about how they price securities, characteristics of trading counterparties and the specific use of derivative instruments. See "SEC and Asset Manager Disclosures About Use of Derivatives" (May 21, 2015). Sometimes an LDI strategy can include an allocation to alternatives. Post Dodd-Frank, lots of alternative fund managers are registering with the SEC. Connecting the dots, plan sponsors that use LDI and/or invest in alternatives are likely to benefit from enhanced disclosures made by asset managers.

Even those sponsors that decide on a risk transfer of some type other than LDI will soon be impacted by reporting mandates. In "Employers must disclose pension de-risking efforts to PBGC," Business Insurance contributor Jerry Geisel explains that data regarding lump sump arrangements will have to include answers to questions such as those listed below:

  • How many plan participants "not in pay status" were offered a chance to switch from a monthly annuity to the lump sum payout?
  • How many plan participants "in pay status" were given a choice?
  • What was the number of participants who made the choice to take a lump sum?

In its filing with the Office of Management and Budget ("OMB"), the Pension Benefit Guaranty Corporation ("PBGC") writes that "de-risking" or "risk transfer" events "deserve PBGC's attention because (among other things) they lower the participant count and thus reduce the flat-rate premium and potentially the variable rate premium." Fewer dollars being paid for this last-resort insurance "have the potential to degrade PBGC's ability to carry out its mandate..."

Given the complexities of managing pension risks and the regulatory changes underway, you may want to attend the May 27, 2015 educational webinar entitled "Pension De-Risking for Employee Benefit Sponsors: Avoiding Litigation and Enforcement Action." I hope you can join us for a lively and topical event.

Hamsters , Cyber Security and Retirement Plans

I typically mute the remote during commercials but a recent ad caught my attention. In "Who's sharing your cloud?" the Ogilvy Group adds glam (actor Dominic Cooper), cute (tiny hamster) and a morality tale (video unexpectedly goes viral) to showcase the downside of not having a dedicated cloud server for a business. This short promotion is a great illustration of risk management at its core.

  • Something seemingly benign creates a costly problem.
  • By not being pro-active, an organization incurs a loss.
  • The cause could have been evaluated and addressed ahead of an adverse effect.

While this television spot and similar messages about technology risk are typically geared to the business community at large, retirement plan sponsors should take heed. Sensitive data about participants, in the wrong hands, can be disastrous. According to "Top 10 Cybersecurity Trends for Financial Services in 2015" (Think Advisor, November 25, 2014), concerns about the integrity of third party infrastructure are paramount. The new year is expected to yield "active cyber risk mitigation and monitoring" as a replacement of the "current self-certification process. (The latter technique is thought to be less reliable.) Concentrating on the protection of "high-risk and high-value" data collections is likewise expected to occur instead of a broad and generalized approach.

In a twist of innovation, insurance companies are "racing to actuarially quantify new cyber risks" and offer policies to insure explicit dollar damages as well as indirect losses due to diminished "brand, reputation and goodwill." Click to read "Insurance for Cyber-Related Critical Infrastructure Loss: Key Issues" (Insurance Industry Working Session Readout Report, Department of Homeland Security, July 2014).

In its editorial about the "Challenges of cybersecurity" (August 18, 2014), Pensions & Investments laid out a list of enterprise risk management priorities that should consume those in charge of pensions, endowments, foundations, mutual funds, custodian banks and alternative investment pools. These include, but are not limited to:

  • Preventing access to proprietary data by unauthorized persons;
  • Avoiding the likelihood of leaks by institutional service providers that could "compromise confidential investment details" or make hacking easier;
  • Establishing parameters to block front-running; and
  • Attempting to seal off access to data about beneficiaries and other confidential information from intruders.

A critical task for a plan sponsor is to gather sufficient knowledge about how a candidate asset manager or other type of vendor secures its operations from unwanted hackers. Asking questions as part of an RFP makes sense although responses could be too technical for a member(s) of a plan committee to meaningful interpret. As a result, a plan sponsor could end up having to hire another vendor - an organization to make sense of the replies about cyber security from the first vendor. Moreover, the issuance of an RFP may not occur frequently enough to adequately monitor a retirement plan's exposure to cyber security risks. Kent Costello shares his views in "Automating the Institutional Investing RFP" (June 26, 2014, Information Week: WallStreet & Technology).

Lack of transparency is another issue. In "What investors need to know about cybersecurity: How to evaluate investment risks" (June 2014), authors with PriceWaterhouseCoopers or the IRRCi bemoan the "hidden" sources of cybersecurity threats. They add that prevailing disclosure standards "are not designed to adequately differentiate between companies' relative readiness, nor are they effective at helping predict which companies are likely to suffer negative impacts due to a security shortcoming."

None of these warnings are comforting, especially when one considers the layers of vulnerability. A plan sponsor, at the corporate or government employer level, has a chance of having non-retirement plan data stolen by a cyber thief. At the retirement plan level, a sponsor could see its participant data compromised. As a customer, there is a chance for a technology snafu with one or more of its service providers to trickle down to the plan sponsor. As an investor, regardless of plan design, there is the risk of being exposed to cyber meltdowns experienced by a company or asset manager. A defined benefit plan with an investment in Target or Sony for example could pay for security breaches in the form of lower stock prices. A 401(k) plan sponsor that selected a mutual fund that owns shares in a cyber victim company may have to change its investment line-up.

On November 9, 2011, the ERISA Advisory Council presented its report on "Privacy and Security Issues Affecting Employee Benefit Plans." A handy "Chart of Practices Useful to Certain Plan Administrators to Minimize Security Breaches" is included. As part of its focus on cybersecurity, the U.S. Securities and Exchange Commission ("SEC") released a sampling of questions it plans to ask during regulatory examinations. Refer to the agenda of "OCIE Cybersecurity Initiative," National Exam Program Risk Alert, April 15, 2014.

Happy New Year fiduciaries. More work is on its way.

ACI ERISA Litigation Conference - New York City

I have the pleasure of announcing that Fiduciary Leadership, LLC is one of the sponsors of this recurring educational conference. For a limited time only, I am told that interested parties can register early and receive a discount. Contact Mr. Joseph Gallagher at 212-352-3220, extension 5511, for details.

Besides two full days of interesting and timely presentations, the American Conference Institute conference about ERISA litigation gives attendees a chance to hear different perspectives. Scheduled speakers include investment experts, corporate counsel, defense litigators, plaintiffs' counsel, class action specialists, judges and fiduciary liability insurance executives, respectively.

Click to download the ACI ERISA Litigation Conference agenda or take a peek at the list of topics as shown below:

  • Fifth Third v. Dudenhoeffer and the Impact of the Decision on the Future of Stock Drop Case and Litigation Regarding Plan Investments;
  • ERISA Class Actions Post-Dukes and Comcast: Standing, Commonality, Releases and Arbitration Agreements, Monetary Classes, Issue Certification, Certification of “Class Of Plans”, Class Action Experts and Halliburton, and More;
  • The Affordable Care Act, Health Care Reform and New Claims and Defenses in Workforce Realignment Litigation;
  • 401(k) Fee Cases: Current Litigation Landscape and Recent Decisions, Evolving Defense Strategies, DOL Enforcement Initiatives, Impact of Tussey and Tibble, Excessive Fund Fees, and More;
  • Retiree Health and Welfare Benefits: M&G Polymers USA, LLC v. Tackett and the Yard-Man Presumption;
  • Multiemployer Pension Plan Withdrawal Liability;
  • Independent Fiduciaries: Working with Them to Manage Plan Assets, Handle Administrative Functions and Authorize Transactions; and the Latest Claims Involving Failure to Monitor Independent Fiduciaries and/or Keep Them Informed;
  • ESOP: New and Emerging Trends in Private Company ESOP Litigation, Lessons Learned from Recent Decisions in ESOP Cases, and the Latest on DOL Investigations and Enforcement Priorities;
  • Benefit Claims Litigation: the Latest on ERISA-Specific Case Tracks Aimed at Discovery Disputes, Attorney Fees Post-Hardt, Limitation Periods in Plans, Addressing Requests for Evidence Outside of the Record in “Conflict” Situations, Judicial Review of Claims Decisions and the Battle Over Discretion, and More;
  • Fiduciary Liability Insurance: Assessing Current Coverage and Future Needs & Strategic Litigation and Settlement Considerations;
  • New Trends in Church Plan Litigation;
  • New Trends in Top Hat Plans: The Latest Litigation Risks;
  • Public Pension Developments and Trends; and
  • Ethical Issues That Arise in ERISA Litigation: The Fiduciary Exception to Attorney-Client Privilege, the Question of Who Really Is Your Client.

In April of this year, I presented at the ACI ERISA Litigation conference in Chicago about working effectively with an economic and/or fiduciary expert. Click to access the slides entitled "Expert Coordination: Working With Financial and Fiduciary Experts" by Attorney Joseph M. Callow, Jr. (Keating Muething & Klekamp PLL), Attorney Ronald S. Kravitz (Shepherd, Finkelman, Miller & Shah, LLP) and Dr. Susan Mangiero (Fiduciary Leadership, LLC). For a recap of this session, click to read "ERISA Litigation and Use of Economic and Fiduciary Experts" (May 5, 2014).

On October 28, 2014, I will be part of a panel about public pension fund issues. I will be joined by Attorney Elaine C. Greenberg (Orrick, Herrington & Sutcliffe LLP) and Attorney H. Douglas Hinson (Alston & Bird LLP). Topics we plan to cover are shown below:

  • Overview of Public Pension Market - Scope, Size and Funding Levels;
  • Government Plan Hot Button Issues;
  • Pension Reform:
  • Pension Obligations and Bankruptcy, With Discussion of Detroit;
  • SEC Enforcement Actions, With Discussion About the State of Illinois;
  • New Accounting and Financial Reporting Standards;
  • Use of Derivatives by Municipal Pension Plans;
  • Fiduciary Breaches as They Relate to Due Diligence; and
  • Suggestions for Risk Mitigation and Best Practices.

I hope to see you in the Big Apple in a few months!

New GAO Study Addresses Performance Audit Reports

Courtesy of the U.S. Government Accountability Office, a new study looks at performance audits for different types of pension plans. The report is entitled "Oversight of the National Railroad Retirement Investment Trust" (May 2014) and responds to requests from members of the U.S. Congress for information about this $25 billion retirement plan. Based on countless interviews with regulators, private fiduciary experts (and yes, I did answer some questions about benchmarking) and pension fund executives, the authors put forth the idea that performance audits could be mandated to occur more often. Interestingly, GAO researchers point out that "the frequency with which the Trust has commissioned performance audits is comparable to or exceeds most state efforts," adding that "...nine state plans are audited at least once every 2 or 3 years" with interviewees from 19 states pointing out that retirement plans "were subject to audits at longer set intervals that varied from state to state or were not reviewed according to any established time frame."

Pension fund accounting and performance benchmarking is certainly getting its share of attention. U.S. Securities and Exchange Commissioner Daniel Gallagher recently decried what he believes is an under-reporting of "trillions of dollars in liabilities. In his May 29, 2014 speech before attendees of the Municipal Securities Rulemaking Board's 1st Annual Municipal Securities Regulator Summit, Commissioner Gallagher talks about pension and OPEB liabilities as a serious threat and warned that "...it is imperative that bondholders know with precision the size of the potential pension liabilities of the entities in which they are investing. And yet, they do not." He adds that the "threat has been hidden from investors." As Lisa Lambert and Lisa Shumaker describe, government officials say that these sharp remarks sting and will scare people into thinking that a systemic problem exists. Read "Pension groups strike back at SEC commissioner's criticism" (Reuters, June 16, 2014). In its Q1-2014 update, the National Association of State Retirement Administrators ("NASRA") show that public pension fund assets have grown to $3.66 trillion, up slightly from the year-end 2013 level of $3.65 trillion.

On the rule-making front, the Governmental Accounting Standards Board ("GASB") just published an update to its pension accounting standards and posted a pair of brand new proposals to "improve financial reporting by state and local governments of other post-employment benefits, such as retiree health insurance." See "GASB Publishes Proposed Accounting Standards for Government Post-Employment Benefits" by the editor of AccountingToday.com, Michael Cohn. You can download the three documents by visiting the GASB website. Click to access GASB's microsite about Other Postemployment Benefits ("OPEB").

The good news, as I have said all along, is that initiatives for heightened transparency are underway. For more difficult situations, don't be surprised if litigation about disclosures continues to occur. In case you missed the February 24, 2014 Practising Law Institute ("PLI") CLE webinar, you can purchase the slides and audio recording of "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends." I co-presented with Orrick, Herrington & Sutcliffe LLP partner, Elaine Greenberg. My focus was on risk management, valuation, performance and investment decision-making.

Pension Usage of Swaps

I have been writing, training and consulting about the use of derivatives by pension plans for many years. There is no shortage of topics, especially in the aftermath of the Dodd-Frank Wall Street Reform and Consumer Protection ("Dodd-Frank") and the fact that pension investing and derivatives trading are significant elements of the capital markets. The OECD estimates the size of the private pension system in 2012 at $32.1 trillion. The Bank for International Settlements estimates the June 2013 global derivatives market size at $692.9 trillion.  

Given the importance of the topic of pension risk management and the evolving regulatory landscape, it was a pleasure to have a chance to recently speak with Patrick S. Menasco. A partner with Steptoe Johnson, Attorney Menasco assists plan investors, investment advisers and broker-dealers as they seek to navigate the laws relating to hedging, swaps clearing and much more. Here are a few of the take-away points from that discussion.

Question: Do the swaps provisions embedded in the Dodd-Frank legislation contradict the netting rules that are part of U.S. bankruptcy law?

Answer: No, the netting provisions of the Bankruptcy Code remain intact and should be taken into account in negotiating swap agreements. To the extent feasible, a performing counterparty wants to be able to net obligations in the event of a counterparty insolvency and default.

Question: Your firm obtained Advisory Opinion 2013-01A from the U.S. Department of Labor ("DOL") on February 7, 2013 regarding swaps clearing, plan assets and ERISA fiduciary duties. Explain the importance of identifying plan assets in the clearing context.

Answer: ERISA, including its prohibited transaction rules, governs "plan assets." Thus, it is critical to determine whether margin posted by a plan in connection with swaps clearing and the swap positions held in the plan's account are considered "plan assets" for ERISA purposes. Among other things, Advisory Opinion 2013-01A gives comfort that (1) margin posted by the investor to the clearing agent generally will not be considered a plan asset for ERISA purposes and (2) clearing agents will be able to unilaterally exercise agreed-upon close-out rights on the plan's default without being deemed a fiduciary to the plan, notwithstanding that the positions are plan assets.

Question: The headlines are replete with news articles about swap transactions with pension plans that could be potentially unwound in the event of bankruptcy. Detroit comes to mind. Should non-pension plan counterparties be worried about a possible unwinding in the event of pension plan counterparty distress?

Answer: Yes and no. The case in Detroit (which is currently on appeal) illustrates the risk that, notwithstanding state or local law to the contrary, federal bankruptcy judges may disregard the legal separation between municipal governments and the pension trusts they sponsor, treating those trusts as part of the estate. This may present certain credit and legal risks to the trusts' swap counterparties, although the Bankruptcy Code's swap netting provisions may mitigate some of those risks. I doubt that we will see anything similar to Detroit in the corporate pension plan arena because ERISA not only recognizes, as a matter of federal law, the separate legal existence of such plans, but also affirmatively prohibits the use of plan assets for the benefit of the sponsor. Separately, many broker-dealers negotiate rights to terminate existing swaps upon certain credit events, including the plan sponsor filing for bankruptcy or ceasing to make plan contributions.

Question: How does Dodd-Frank impact the transacting of swaps between an ERISA plan and non-pension plan counterparties such as banks, asset managers or insurance companies?

Answer: Dodd-Frank does a number of things. For one, it adds a layer of protection for ERISA and government plans (and others), through certain "External Business Conduct" standards. Generally, these standards seek to ensure the suitability of the swaps entered into by the investors. Invariably, swap dealers will comply by availing themselves of multiple safe harbors from "trading advisor" status, which triggers various obligations relating to ensuring suitability. Very generally, these safe harbors seek to ensure that the investor is represented by a qualified decision-maker that is independent of, and not reliant upon, the swap dealer. Under protocol documents developed by the International Swaps & Derivatives Association ("ISDA"), the safe harbors are largely ensured through representations and disclosures of the plan, decision-maker and swap dealer (as well as underlying policies and procedures).

Question: Dodd-Frank has a far reach. Would you comment on other relevant requirements?

Answer: Separately, Dodd-Frank imposes various execution and clearing requirements on certain swaps. These requirements raise a number of issues under the prohibited transaction rules of ERISA and Section 4975 of the Internal Revenue Code. Exemptions from those rules will be needed for (1) the swap itself (unless blind) (2) the execution and clearing services (3) the guarantee of the trade by the clearing agent and (4) close-out transactions in the event of a plan default. This last point presents perhaps the thorniest issue, particularly for ERISA plan investors that direct their own trade swaps and thus cannot avail themselves of the Qualified Professional Asset Manager ("QPAM"), In-House Asset Manager ("INHAM") or other "utility" or "investor-based" class exemptions. The DOL expressly blesses the use of the QPAM and INHAM exemptions in the aforementioned Advisory Opinion 2013-01A, under certain conditions. Senior U.S. Department of Labor staff members have informally confirmed that the DOL saw no need to discuss the other utility exemptions (including Prohibited Transaction Class Exemption ("PTCE") 90-1, 91-38 and 95-6) for close-out trades because they assumed they could apply, if their conditions were met.

Question: Is there a solution for those ERISA plans that direct their own swap trading?

Answer: It is unclear. There are only two exemptions, at least currently, that could even conceivably apply: ERISA Section 408(b)(2) and Section 408(b)(17), also known as the Service Provider Exemption. The first covers only services, such as clearing, and the DOL has given no indication that it views close-out trades as so ancillary to the clearing function as to be covered under the exemption. In contrast, the Service Provider Exemption covers all transactions other than services. But it also requires that a fiduciary makes a good faith determination that the subject transaction is for "adequate consideration." If the close-out trades are viewed as the subject transaction, who is the fiduciary making that determination? The DOL's Advisory Opinion 2013-01A says that it isn't the clearing agent. Thus, to make the Service Provider Exemption work, you have to tie the close-out trades back to the original decision by the plan fiduciary to engage the clearing agent and exchange rights and obligations, including close-out rights. That argument has not been well received by the DOL, at least so far.

Many thanks to Patrick S. Menasco, a partner with Steptoe & Johnson LLP, for taking time to share his insights with PensionRiskMatters.com readers. If you would like more information about pension risk management, click to email Dr. Susan Mangiero.

Pensions, Politics and the ERISA Fiduciary Standard

Thanks to the folks at the Mutual Fund Directors Forum for disseminating a January 13, 2014 letter from members of the New Democrat Coalition to the Honorable Thomas Perez, Secretary of the U.S. Department of Labor ("DOL"). The gist of the four-page communication is that these members of the current U.S. Congress would like to see regulatory coordination in order to "protect investors while reducing confusion." They add that they are still concerned that a new version of the fiduciary standard, when proposed anew, might discourage plan participant literacy and disclosures. The worry seems to be that individuals with low or middle incomes as well as small businesses could be adversely impacted, depending on the ultimate version.

According to the Securities Industry and Financial Markets Association ("SIFMA") website, Republicans have likewise communicated their concerns to the U.S. Department of Labor as well as the Office of Management and Budget. These ranged from "the impact on an individuals' choice of provider to potential unintended consequences limiting access to education for millions of individuals saving for retirement." Click to access SIFMA's DOL Fiduciary Standard Resource Center.

On October 29, 2013, the Retail Investor Protection Act (H.R. 2374), sponsored by U.S. Congresswoman Ann Wagner (Republican, 2nd District of Missouri), was approved by the United States House of Representatives in a vote of 254 to 166. According to the Gov Track website, U.S. Congressman Patrick Murphy (Democrat, 18th District of Florida) joined as a co-sponsor on September 19, 2013. The stated legislative intent is to preclude the "Secretary of Labor from prescribing any regulation under the Employee Retirement Income Security Act of 1974 (ERISA) defining the circumstances under which an individual is considered a fiduciary until 60 days after the Securities and Exchange Commission (SEC) issues a final rule governing standards of conduct for brokers and dealers under specified law." It further prevents the SEC from implementing a rule "establishing an investment advisor standard of conduct as the standard of conduct of brokers and dealers" prior to assessing the likely impact on retail investors. Click to read more about the Retail Investor Protection Act. Click to read the mission of the United States Department of Labor which states "To foster, promote, and develop the welfare of the wage earners, job seekers, and retirees of the United States; improve working conditions; advance opportunities for profitable employment; and assure work-related benefits and rights."

As I have repeatedly predicted in this pension blog and elsewhere, the retirement crisis, not just in the United States but around the world, is increasingly showing up as a political hot button issue. No one wants to lose votes from retirees who are struggling and employees who cannot afford to stop working any time soon. In his State of the Union address, U.S. President Obama described a new type of retirement account, i.e. "myRA," that is meant to help millions of individuals whose companies do not offer retirement plans. See "What you need to know about Obama's 'myRA' retirement accounts" by Melanie Hicken (CNN Money, January 29, 2014). More details will no doubt follow.

There is a lot we don't know about how politics will impede or enhance the state of the global retirement situation. As a free marketeer, I am not particularly optimistic about new rules and regulations that prevent an efficient supply-demand interaction from taking place. However, this is a lengthy topic and the hour is late so I will leave a discussion about the positive and normative aspects of capitalism for another day.

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.

Real Estate Investment Trusts (REITs) and ERISA Plans

According to "REITs By The Numbers," published by the National Association of Real Estate Investment Trusts, Inc. ("NAREIT"), real estate is gaining favor with 401(k) investment committees that decide on asset allocation. They write that the last ten years has seen a rise from 5 percent to 30 percent of 401(k) plans that offer Real Estate Investment Trusts ("REITs") as an investment option. Moreover, the market is large at $1 trillion of real estate held in the form of an investment pool.

If you are a member of a 401(k) investment committee, advisor, consultant or individual participant, you will want to keep up with current guidelines and rules. Some of these are described in "Real Estate Investment Trust Valuation Guidelines Published." This blog post by Susan Mangiero includes FINRA and SEC comments about non-listed REITs as relates to items such as illiquidity, valuation and disclosures.

Fiduciary Shortcuts To Valuation Can Be Dangerous

Despite a plethora of information about how to implement shortcuts to enhance workplace productivity, fiduciaries need to ask themselves whether a "jack in the box" approach that equates speed with care and diligence is worth pursuing.

This topic of shortcuts came up recently in a discussion with appraisal colleagues about the dangers of using a "plug and play" model to estimate value. Although New York Times journalist Mark Cohen rightly cites the merits of having a business valuation done, he lists all sorts of new tools such as iPhone valuation apps that some might conclude are valid substitutes for the real thing. Rest assured that punching in a few numbers versus hiring an independent and knowledgeable third party specialist to undertake a thorough assessment of value is a big mistake, especially if the underlying assumptions and algorithms of a "quick fix" solution are unknown to the user. See "Do You Know What Your Business is Worth? You Should," January 30, 2013.

It's bad enough that a small company owner opts for a drive-in appraisal. It's arguably worse when institutional investors do so, especially as their portfolios are increasingly chock a block with "hard to value" holdings. In the event that a valuation incorrectly reflects the extent to which an investment portfolio can decline, all sorts of nasty things can occur. A pension, endowment or foundation could end up overpaying fees to its asset managers. Any attempts to hedge could be thwarted by having too much or too little protection in place due to incorrect valuation numbers. Asset allocation decisions could be distorted which in turn could mean that certain asset management relationships are redundant or insufficient.

Poor valuations also invite litigation or enforcement or both. As I wrote in "Financial Model Mistakes Can Cost Millions of Dollars," Expert Witnesses, American Bar Association, Section of Litigation, May 31, 2011:

"Care must be taken to construct a model and to test it. Underlying assumptions must be revisited on an ongoing basis, preferably by an independent expert who will not receive a raise or bonus tied to flawed results from a bad model. Someone has to kick the proverbial tires to make sure that answers make sense and to minimize the adverse consequences associated with mistakes in a formula, bad assumptions, incorrect use, wild results that bear no resemblance to expected outcomes, difficulty in predicting outputs, and/or undue complexity that makes it hard for others to understand and replicate outputs. Absent fraud or sloppiness, precise model results may be expensive to produce and therefore unrealistic in practice. As a consequence, a “court or other user may find a model acceptable if relaxing some of the assumptions does not dramatically affect the outcome.” Susan Mangiero, “The Risks of Ignoring Model Risk” in Litigation Services Handbook: The Role of the Financial Expert (Roman L. Weil et al, eds., John Wiley & Sons, 3d ed. 2005).

In recent months, it is noteworthy that regulators have pushed valuation process and policies further up the list of enforcement priorities. Indeed, in reading various complaints that allege bad valuation policies and procedures, I have been surprised at the increased level of specificity cited by regulators about what they think should have been done by individuals with fiduciary oversight responsibilities. Besides the focus of the U.S. Department of Labor, the U.S. Securities and Exchange Commission has brought actions against multiple fund managers in the last quarter alone. Consider the valuation requirements of new Dodd-Frank rules (and overseas equivalent regulatory focus) and it is clear that questions about how numbers and models are derived will continue to be asked.

For further reference, interested readers can check out the following items:

New PCAOB Report Finds Pension Valuation Numbers Wanting

According to a new report just published by the Public Company Accounting Oversight Board ("PCAOB"), valuation of pension plan assets was one of the audit areas with "deficiencies attributable to failures to identify and test controls." Given the importance of having proper pension valuations carried out by knowledgeable and experienced persons, it is no surprise that this oversight organization devoted an entire section of its findings to the topic of valuation of pension plans assets. The problems they found include the following:

  • Insufficient testing of controls over how pension plan assets are valued;
  • Testing of controls that were imprecise and therefore did not allow for an assessment of the risk of material misstatement by plan auditors;
  • Failure to properly test the valuation of pension plan assets; and/or
  • Relying on management or the person(s) who performed the reviews without seeking an independent assessment as to why "variances from other evidential matter" were occurring.

In response to these findings, a prominent ERISA attorney commented that the cited deficiencies were not surprising and that valuation problems will continue to grow for those retirement plans that are allocating more money to "hard to value" funds.

In his 2011 speech before the AICPA National Conference, Jason K. Plourde with the Office of the Chief Accountant, U.S. Securities and Exchange Commission ("SEC"), talked at length about the role of pricing services and how securities that are not actively traded should be valued. He suggested that management "may need to perform different procedures and controls when considering the information from pricing services regarding the fair value of financial instruments..."

Concerns about how best to value pension plan assets and regularly test methodologies and controls related to said valuations took center stage in 2008 when the ERISA Advisory Council working group on "Hard to Value Assets" met to discuss how best to improve things. This blogger - Dr. Susan Mangiero - testified on the topic of "hard to value assets," emphasizing that poor valuations lead to a cascade of problems. For one thing, inflated valuations translate into higher fees paid by ERISA pension plans. Second, incorrect valuations make it difficult to properly review and revise any of the items listed below, each of which are critical to proper fund management such as:

  • Asset allocation;
  • Exposure to a particular sector or fund manager;
  • Fee benchmarking for appropriateness of compensation paid to a manager;
  • Type and size of hedges;
  • Hiring and termination of an asset manager(s);
  • Regulatory funding ratio and related cash financing; and
  • Cost of pension plan de-risking for some or all of current defined benefit plan participants.

If you missed reading Dr. Susan Mangiero's September 11, 2008 testimony before the ERISA Advisory Council Working Group, click to read about "hard to value" assets in the context of ERISA fiduciary duties and pension risk management.

With more pension plans reporting large scale deficits, don't be shocked if further questions are asked about the integrity of asset and liability valuation numbers.

SEC and Revenue Sharing Enforcement

According to its September 6, 2012 press release, the U.S. Securities and Exchange Commission ("SEC") settled with two Portland, Oregon investment advisory firms for $1.1 million. At issue was whether investors were harmed due to the allegedly hidden revenue-sharing arrangements in place that may have resulted in a less than neutral basis for recommending certain funds. Neither party admitted or denied the regulator's charges. See "SEC Charges Oregon-Based Investment Adviser for Failing to Disclose Revenue Sharing Payments," September 6, 2012.

The issue of revenue sharing is unlikely to go away, especially with multiple regulators paying close attention now. The SEC had said that it plans to ask more questions about the independence, or lack thereof, that characterizes the relationship between professionals who give advice and the brokers and/or asset managers they use. Mr. Marc J. Fagel, Director of the SEC's San Francisco Regional Office, states that there will be a continued focus on "enforcement and examination efforts" related to "uncovering arrangements where advisers receive undisclosed compensation and conceal conflicts of interest from investors."

 The U.S. Department of Labor ("DOL") is likewise investigating whether revenue-sharing arrangements are being adequately disclosed. A few months ago, DOL settled with Morgan Keegan and Co. According to published accounts, monies will be returned to nearly a dozen pension plans by Morgan Keegan for having received a fee in exchange for recommendations it made about hedge fund vehicles. Morgan Keegan will also need to disclose whether it is acting as an ERISA fiduciary. See "Morgan Keegan settles with DOL over revenue-sharing accusations" by Darla Mercado (Investment News, April 16, 2012). 

Given recent court activity, more will be said later on by this blogger about when the practice of revenue-sharing could make sense and when there could be problems.

Louisiana Pension Funds and Hedge Fund Redemption Concerns

As I've written many times herein, understanding transferability restrictions is a "must do" for institutional investors who allocate monies to asset managers. While a pension, endowment, foundation or family office may decide to invest part of its portfolio in illiquid securities for strategic reasons, it is still necessary to understand how to exit if necessary. In "Hedge Fund Lock Ups and Pension Inflows" (July 4, 2011), the point is made that investors who want to redeem but are barred from doing so may seek redress in a court of law. Regulators are paying close attention too.

According to recent news accounts, several Louisiana pension funds that sought to withdraw some of their money from a New York hedge fund were given promissory notes with assurances that it could get cash in several years. Moreover, it may be that the hedge fund in question has counted assets under management more than once due to a feeder fund organizational structure that boasts over a dozen smaller vehicles which cross trade with one another.

In a joint statement dated July 11, 2011, the Firefighters' Retirement System ("FRS"), New Orleans Firefighters' Retirement System and the Municipal Employees' Retirement System ("MERS") describe how attempts by FRS and MERS "to capture some of the profits that had been earned in an investment known as the FIA Leveraged Fund" initially met with resistance on the part of the fund manager to provide cash right away. Instead, the two requesting institutions were told to expect paper IOUs while certain assets were to be liquidated in an orderly manner over a period of up to two years. The statement goes on to say that the pension plans had each been promised a return of at least 12 percent per annum and that if the "collateral supporting the preferred return declines to a level that is 20% above the systems' collective account values, there is a trigger mechanism requiring a mandatory redemption of the systems' investment" with the 20% cushion" designed to protect the systems' accounts against any loss in value."

Getting a promissory note has not made for happy campers who now worry about the liquidity of the FIA fund and "the accuracy of the financial statements issued by the two renowned independent auditors." The statement goes on to say that the hedge fund manager has been apprised that the pension plans intend to "closely examine" performance records by putting together a team that consists of their board members, internal auditors and investment consultant. A forensic economist may be added to the team.

Click to read the July 11, 2011 joint statement from these Louisiana pension plans about hedge fund liquidity concerns for this particular manager.

Having just checked the SEC website, this blogger does not yet see the formal inquiry statement. Speaking from experience, complexity is never a good thing. Someone somewhere has to understand what risks might give rise to material problems. Moreover, proper due diligence of funds that invest in "hard to value" instruments has to take into account how they are modeled and who is vetting the integrity of the model numbers. Regarding organizational structures that encompass multiple money pools, it is imperative to understand who exactly has a claim to assets in a worst case situation of forced liquidation.

A few years ago, I refused to continue with a valuation engagement of a hedge fund because neither the general partner nor the master fund's attorney could adequately answer my questions about priority of claims for a complex offshore-onshore ownership structure. In several recent matters where I have served as expert witness, concerns about restrictions of transferability and collateral monitoring have taken center stage. Be reminded that in distress, book values often fall seriously short of fire sale or even orderly liquidation (auction) values.

Let's hope that questions can be cleared up in a timely fashion.

Readers may want to check out these articles:

  • "S.E.C. and Pension Systems to Examine Fletcher Fund" by Peter Lattman, New York Times, July 12, 2011; and
  • "Pensions Want Look Into Fund's Records" by Josh Barbanel, Steve Eder and Jean Eaglesham, Wall Street Journal, July 13, 2011.

Hedge Fund Lock Ups and Pension Inflows

Various sources tout increasing inflows to hedge funds from public and corporate pension plans.

In "Strong start to hedge fund activity in 2011" (April 1, 2011), Pensions & Investments reporter Christine Williamson writes that "First-quarter institutional hedge fund activity, including net inflows and pending searches, totaled $18 billion - the highest since the intense investment pace of the first quarter 2007, which saw $25 billion in activity." James Armstrong of Traders Magazine describes the billions of dollars going to hedge funds in recent months as a catalyst to "increased trading volumes for the equities trading business." See "Hedge Funds Could Juice Volume" (June 2011). Imogen Rose-Smith of Institutional Investor gives readers a detailed look at the love affair with hedge funds in "Timeline 2000-2011: Public Pensions Invest in Hedge Funds" (June 20, 2011).

Fortune writer Katie Benner says "wait a minute" to what seems to be an upward trajectory in retirement plan allocations to hedge funds with a 51% increase since 2007 and a doubling of the mean allocation to 6.6% (according to a study by Preqin). In "Hedge fund returns won't save public pensions" (March 30, 2011), she cites willful underfunding and a "mish-mash of accounting tricks" as fundamental problems that will not be corrected with more money in alternatives.

In her May 16, 2011 article for Pensions & Investments and entitled "Promises, promises: $100 billion still locked up," Christine Williamson writes that assurances made to institutional investors in 2008 and 2009 about redemptions are not being met by some hedge fund managers. At that time, jittery pension funds, endowments and foundations that wanted out were asked to be patient rather than force hedge funds to unwind hard to value positions at sub-par prices. Quoting Geoff Varga, a senior executive with Kinetic Partners US LLP, a consultancy for asset management firms, there is an estimated $100 billion in "exotic" or non-standard investments that were stuffed into "emergency side pockets." He adds that it is hard to come up with an exact number, especially since managers' valuations of these illiquid positions are not always realistic.

Certainly the issue of side pockets is unlikely to go away any time soon. On October 19, 2010, Emily Chasan reported that the U.S. Securities and Exchange Commission ("SEC") had filed a civil complaint against several hedge fund managers for overvaluing illiquid assets. See "SEC charges hedge fund of inflating 'side pockets'" (Reuters). Click here to read the SEC complaint and October 19, 2010 press release from the SEC. On March 1, 2011, Azam Ahmed with the New York Times Deal Dook described another case in "Manager Accused of Putting $12 Million in Side Pockets."

This blogger, Dr. Susan Mangiero, has written extensively on the topic of hard to value investments and liquidity and served as expert witness on cases involving due diligence allegations. Acknowledging that not all hedge funds invest in hard to value instruments, the following items may be of interest to readers:

U.S. Department of Labor and Definition of Fiduciary

As the U.S. Department of Labor ("DOL") prepares to expand the definition of fiduciary, at the same time that the U.S. Securities and Exchange Commission is doing likewise, the financial industry is girding for some potentialy massive changes.

In response to the DOL's request for comments about an expanded definition of fiduciary as relates to retirement schemes, I warned that the law of unintended consequences could push knowledgeable professionals out of the marketplace. If fears that the liability costs will outweigh the benefits of working with plan sponsors, perhaps materially so, it will be difficult to attract the talent that is so badly needed to assist with implementing pension governance policies and procedures. 

I further wrote that a hefty dose of transparency could do wonders for differentiating "good" fiduciaries from others. This problem is not new. In fact, I wrote in 2006 that trying to identify who serves as a member of a plan's investment committee is like searching for hidden treasure. Click to read my 2006 post about pension fiduciary disclosure.

Click to read my January 20, 2011 letter to the U.S. Department of Labor about their proposed expansion of who should serve as a fiduciary.

Click to read the other letters submitted to the U.S. Department of Labor about this important issue of who properly counts as a fiduciary. Letters I read suggest the need for a universal education standard. As is the case in other countries, the United States could well end up with a mandate for independent fiduciaries to serve on investment committees, after having been properly vetted, licensed or otherwise credentialed.

SIFMA Study Intimates Fiduciary Standard Cracks

Hot off the press, a study commissioned by the Securities Industry and Financial Markets Association ("SIFMA") questions whether a uniform fiduciary standard of care makes sense. Conducted by Oliver Wyman consultants, "Standard of Care Harmonization: Impact Assessment for SEC" (October 2010) suggests that a "one size fits all" approach for fee-based advisors and broker-dealers may force consumers to bear higher costs and/or limit their access to financial products that are distributed through broker-dealers and/or lower access "to the most affordable investment options." The authors assert that only one out of every twenty retail investors rely only on fee-based accounts. Their analysis considers three different types of investors to include "small," "affluent" and "high net worth." Researchers cite the regulatory burden on asset managers due to compliance with Europe's Markets in Financial Instruments Directive as a harbinger of things to come in the United States.

Critics of the study have raised eyebrows about the type of data collected for examination. They add that the Dodd-Frank Act does not require all of a broker-dealer's activities to be subject to an imposed fiduciary standard of care so the emphasis of this new research is misplaced. See "Advisory Industry: SIFMA Fiduciary Study Raises Lots of Questions" by Melanie Waddell, AdvisorOne, November 2, 2010.

At a time when numerous financial professionals are aggressively courting investors who seek to buoy their retirement nest eggs, how fiduciary standard of care rules are finalized will be important in numerous ways and to numerous individuals and organizations.

Venture Capital Allocation and the IPO Drought

On March 1, 2010, Dr. Susan Mangiero, CEO of Investment Governance, Inc. sat down to talk to financial and strategy expert, Mr. Pascal Levensohn. In this ninth question of ten, read what this Investment Governance, Inc. Advisory Board member has to say about IPOs and whether institutional investors should allocate monies to venture capital ("VC") funds right now. Click here to read Mr. Levensohn's impressive bio.

SUSAN: Does an anemic initial public offering ("IPO") market will remain a deterrent to VC investing?

PASCAL: Yes I do. I believe that an entire generation of American innovation is at risk as a result of the lack of IPO’s. The statistics are overwhelming in support of my position, starting with the fact that over 90% of jobs created by VC-backed companies occur AFTER their IPO - and this has been the case for 40 years. What concerns me the most about the IPO vacuum is that it is systemic and is the result of a “one size fits all mentality” when it comes to regulation of the securities industry.  A relatively unknown emerging growth public company with a $500 million market cap has different needs for research and trading support to provide liquidity for investors than IBM. I remain surprised that this seems to be difficult for our policy makers to understand, but I am encouraged that the U.S. Securities and Exchange Commission ("SEC") has recently invited public comments for a 90 day period to address structural problems with the U.S. equity markets.

Specifically, the SEC wants to know if anyone from the public has thoughts on "whether the current market structure is fundamentally fair to investors and supports capital raising functions for companies of various sizes, and whether intermarket linkages are adequate to provide a cohesive national market system." The Commissioners expressed particular interest in receiving comments from a wide range of market participants. Comments on the Concept Release are due within 90 days after publication in the Federal Register.

Click to read "SEC Issues Concept Release Seeking Comment on Structure of Equity Markets" (January 13, 2010).

I believe that the U.S. equity capital markets must be structured with the goal of promoting the growth of publicly held small businesses in America. America had this structure in place prior to 1997. We should take a hard look at what has changed to render the small company IPO extinct. (Contrary to popular belief, it first became an endangered species before the technology bubble).

Compounding this problem is the fact that, with no IPO options, the consideration paid for companies in trade sales - acquisition by larger companies - has been declining.  Why should venture capitalists take the risks associated with starting up a new company, working through all of the difficulties with multiple financing rounds and executive changes over a six-to-eight or even ten-year period, only to get backed into a corner by a large multinational that dominates the sales channel and can wait them out?

The biggest problem the VC industry has today is that, absent access to public market capital, there are too few VC-backed companies that are self sustaining cashflow generators.  The biggest problem that the U.S. economy has today is unemployment. You would think that maybe the stewards of the U.S. economy, our legislators, could make some structural changes to our small company capital markets regulations to fuel the greatest job creation engine in America - the entrepreneur driving an emerging growth company. This problem goes way beyond venture capital. Consider that 47% of all IPO’s since 1991 were backed by neither VC’s or private equity firms. This is an American problem.

Funds of Funds - What Comes Next?

According to John Gapper, funds of funds ("FOFs") are significant players, accounting for nearly one-half of all hedge fund assets. This Financial Times chief business commentator connects growing institutional interest to a rise in demand for intermediaries who offer due diligence services. Post-Madoff, he paints a grim picture for the industry unless good players are able to differentiate themselves from those who are now being scrutinized.

Whether certain organizations could have detected fraud is unknown at this time though Grabber suggests that "funds of funds need to work harder and show that they actually contribute something valuable." I am quoted as saying “It is not as if this stuff is really complicated. A lot of the risk of fraud can be mitigated by measures that are low-cost and not very time-intensive.”

I certainly agree with Gapper that there is a "role for the good funds of funds." I'd go further to say that it is unfortunate indeed for those funds of funds that exercised care and discipline in researching  financial and operational risks on behalf of pensions, foundations and endowments. They are unfairly being painted with a dirty brush.

For institutional investors, a key question remain. Will pensions, endowments and foundations continue to reach out to funds of funds or decide instead to hire in-house experts? If they have already hired one of the funds of funds that turns out to be tied to large Madoff-related losses, to what extent might investment fiduciaries be asked to explain their FOF choice and subsequent oversight of said FOF? These are important questions, yet to be answered.

Click to read "Funds of funds have to work harder," Financial Times, January 7, 2009. (Access may be limited to subscribers only.)

Editor's Note: Click to read "Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds," published by the U.S. Securities and Exchange Commission. Click to read "Report on Funds of Hedge Funds," published by the International Organization of Securities Commissions, June 2008.

SEC Short Selling Rules - Fallout for 130/30 and Hedge Funds?

Trading today may be wild as Wall Street back office staff and short sellers scramble to comply with new rules, imposed via emergency order by the U.S. Securities and Exchange Commission ("SEC"). By way of background, on July 15, 2008, the SEC issued "Securities Exchange Act of 1934, Release No. 58166/July 15, 2008," prohibiting naked short sales for 19 identified financial company stocks. (The company names and ticker symbols are shown below.)

The official stated goal is to avoid panic selling as a result of outright short trading and discourage false rumors. (A naked short contrasts with the situation whereby an individual borrows shares and then sells them at the prevailing market price. The short can be closed at a profit when the trader buys shares back at a lower price, assuming that prices do eventually fall).

Only a few days later, the SEC issued "Securities Exchange Act of 1934, Release No. 58190/July 18, 2008," amending its earlier emergency order and exempting certain parties such as "registered market makers, block positioners, or other market makers obligated to quote in the over-the-counter market, that are selling short as part of bona fide market making and hedging activities related directly to" the identified securities and related derivative instruments and exchange traded funds. The order is set to terminate at 11:59 p.m. EDT on July 29, 2008 "unless further extended by the Commission."

According to "SEC Short-Sale Rule Gets Negative Reviews," Wall Street Journal reporter Kara Scannell (July 19-20, 2008) reports that certain companies did not make the list but have nevertheless seen their stocks come under recent "selling pressure." Some firms complain that SEC list inclusion will add to jitters and thereby exacerbate woes for existing shareholders, big and small.

Important questions remain unanswered, notably the impact on non-exempted parties and their institutional investors. Take 130/30 managers. By their very nature, they short stocks they deem "over-valued." How will this SEC mandate impact quarterly 130/30 fund performance and beyond, especially if trading costs mount as a result of compliance? What about those pension plans that have allocated monies to 130/30 managers who are adversely impacted by the SEC order? Could their funding status be in jeopardy? The same concerns extend to hedge fund managers whose specified strategy requires short-selling in any or all of the SEC "specified" stocks. Additionally, will the regulatory effect be materially different if shorted shares already represent a large percentage of outstanding common equity?

Will the SEC emergency order solve one problem but create others?

Financial Services Firm Name (Ticker Symbols) Covered by the Order and Amendment:

  • BNP Paribas Securities Corp. (BNPQF or BNPQY)
  • Bank of America Corporation (BAC)
  • Barclays PLC (BCS)
  • Citigroup Inc. (C)
  • Credit Suisse Group (CS)
  • Daiwa Securities Group Inc. (DSECY)
  • Deutsche Bank Group AG (DB)
  • Allianz SE (AZ)
  • Goldman, Sachs Group Inc (GS)
  • Royal Bank ADS (RBS)
  • HSBC Holdings PLC ADS (HBC and HSI)
  • J. P. Morgan Chase & Co. (JPM)
  • Lehman Brothers Holdings Inc. (LEH)
  • Merrill Lynch & Co., Inc. (MER)
  • Mizuho Financial Group, Inc. (MFG)
  • Morgan Stanley (MS)
  • UBS AG (UBS)
  • Freddie Mac (FRE)
  • Fannie Mae (FNM)

SEC Announces Investigation of Hedge Funds' Valuation Methodologies

Reuters.com reporters, Karey Wutkowski and John Poirier, relay the SEC's intention to review valuation methods used by hedge funds.  Testifying before the House Financial Services Committee on June 26, Chairman Christopher Cox said that "We are going to further review, using the SEC staff, the valuation and other issues that managers for these funds have." Apparently, his message to the press, after the hearing, was serious, citing "concern that hedge funds and the investment banks that manage them are not marking assets to their proper value," something that "is of interest to the SEC's examinations and enforcement departments." Click here to read more.

So what does this portend for the plan sponsors knee deep in "hard-to-value" hedge funds? In the event of an asset write-down, fiduciaries are going to be grilled about the extent to which they vetted the valuation policies and procedures of hedge funds in which they invested. Absent any documentation to explain the (hopefully thorough) due diligence process they employed, pension decision-makers will squirm. A pretty picture - NOT!

In some circumstances, the use of an external consultant may provide little refuge, especially if a plan sponsor is unable to demonstrate that the consultant has a good command of valuation principles as applied to hedge funds. Having just co-led a workshop about hedge fund valuation, I was appalled to hear a colleague describe the "not my job" mentality of some service providers who act as pass-throughs for valuation numbers. That begs the question - If the consultant, administrator, prime broker or custodian are accepting traders' marks with no review (however formal), who exactly is overseeing the valuation activity at a particular hedge fund or fund of funds? Moreover, how independent are numbers that are generated by traders whose bonus is almost always tied to reported performance? (We'll talk about valuation standards and best practices in later posts.)

Stormy days ahead?

If you'd like our insight or want to learn more about the work we do in this area (before the fact, during the investment process or after trouble begins), email us. All inquiries are kept confidential. Also note that we'll be devoting seventy-five (75) minutes to the topic of hedge fund valuation from noon to 1:15 p.m. EST on June 28. Click here for more information.

Insider Trading and Pension Funds

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

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

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

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

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

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

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.

Pension Risk Matters Joins the Knowledge Mosaic Blogwatch Team

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

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

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

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

Eeny, Meeny, Miny, Mo - What Accounting Rules Do You Want?

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

What does this mean for institutional investors?

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

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

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

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

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

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

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

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

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

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

SEC Alleges Insider Trading - Should Pension Investors Care?

Former U.S. Senator Alan Simpson is said to have claimed "If you have integrity, nothing else matters. If you don't have integrity, nothing else matters."

After reading the SEC's March 1 press release about insider trading, these words ring loud and clear.

If you haven't seen it yet, click here for details about charges against fourteen individuals "in connection with two related insider trading schemes in which Wall Street professionals serially traded on material, nonpublic information tipped, in exchange for cash kickbacks."

Efficient markets are crucial for the pension funds which invest over $10 trillion in global assets. Trust, integrity and internal controls are the lifeblood of a system that works.

If there is a silver lining attached to these allegations, it is to remind fiduciaries of the importance of a due diligence process that goes beyond financial risk management. Credit checks, questions about oversight of traders and continued verification of trades are just the beginning.

Options, Pensions and the SEC

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 option backdating.

Option valuation is another topic with considerable import. Relatively new accounting rules in the form of FAS 123R set the stage for a vigorous debate about how to value employee and executive stock options (ESO's). Unlike shorter-term options that actively trade in ready markets, ESO's are more challenging to value for a host of reasons. Though a bit outdated with respect to regulations, readers may nevertheless find my article about option valuation of interest because it highlights the importance of having good inputs and an appropriate model. (Click here to read "Model Risk and Valuation," Valuation Strategies, March/April 2003.)

In a recent decision, the SEC notified Zions Bancorporation that its Employee Stock Option Appreciation Rights Securities (ESOARS) is "sufficiently designed to be used as a market-based approach for valuing employee stock option grants for accounting purposes under Financial Accounting Standards (FAS) No. 123R." According to Zion's press release, it is their intent to assist other public companies in valuing ESOs. I took a quick look at their site and plan to read more. Certainly a mechanism that facilitates marketability is a step in the right direction. After all, the coming together of willing buyers and sellers, under ideal circumstances, permits a flow of information that should result in the "right" price.

Editor's Note:
I am currently writing an article about option backdating as it relates to pension fiduciaries.

New Rules for Soft Dollars - Pension Buyers Beware

In his July 12, 2006 speech, SEC Chairman Christopher Cox describes soft dollars as "inflated brokerage commissions" and urges reform to ensure their use for research only. "Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934," issued a week later, sought to clarify the extent to which money managers could properly purchase research without breaching their fiduciary duties to "seek the best execution for client trades, and limit money managers from using client assets for their own benefit." (Click here to access the 63-page file.)

Attempting to promote better transparency in trading costs, the SEC emphasizes "the statutory requirement that money managers must make a good faith determination that commissions paid are reasonable in relation to the value of the products and services provided by broker-dealers in connection with the managers' responsibilities to the advisory accounts for which the managers exercise investment discretion." Another stated goal is to help money managers with pension fund clients avoid ERISA non-compliance as relates to soft dollars.

At a time when Congress is joining the fray about pension fees, little has been said about the SEC's dictate that "Market participants may continue to rely on the Commission's prior interpretations for six months following the publication of this Release in the Federal Register, that is, until January 24, 2007."

January 24, 2007 has come and gone. Where's the fanfare? A topic as important as this merits discussion.

Second Chance for Pension Fiduciaries Too?

In case you missed it, Donald Trump, co-owner of the Miss USA pageant, just announced that the reigning titleholder will be given a second chance, despite questions about her behavior, post-win.

In stark contrast, former CEO of Pfizer has been forced into early retirement "in part because of investor anger about his rich retirement benefits." Hang on to your hats. It's written that SEC disclosures describe truly golden years for this former executive - an $83 million pension and nearly $78 million in other deferred compensation. No second chance here but with that much in the bank, one might ask who cares. (For additional information about pensions at the top, see "Executive Paywatch.")

Well, reputation and legacy issues are important to some. Then there is the possibility that allegations of excess compensation could result in legal action. According to New York Times reporter Eric Dash, Fannie Mae's primary regulator has filed suit against top executives in an effort to take back more than $200 million in bonus payouts. Notwithstanding questions about recent accounting restatements, the former head received a "pension valued around $25 million." (See "Fannie Mae Ex-Officers Sued by U.S." by Eric Dash, December 19, 2006.)

So what's the takeaway for pension fiduciaries?

Second chances are a gift, allowing those in charge to improve current practices, stave off trouble and be good, or better, stewards on behalf of plan participants. However, not everyone gets a chance to go round again, begging a logical question.

Why not get it right from the outset?

Pension Disclosure and SEC Sanction

According to its website, the SEC sanctioned the City of San Diego "for committing securities fraud by failing to disclose to the investing public important information about its pension and retiree health care obligations in the sale of its municipal bonds in 2002 and 2003."

The SEC-issued Order "finds that the city failed to disclose that the city's unfunded liability to its pension plan was projected to dramatically increase, growing from $284 million at the beginning of fiscal year 2002 to an estimated $2 billion by 2009, and that the city's liability for retiree health care was another estimated $1.1 billion.

According to the Order, the city also failed to disclose that it had been intentionally under-funding its pension obligations so that it could increase pension benefits but defer the costs, and that it would face severe difficulty funding its future pension and retiree health care obligations unless new revenues were obtained, pension and health care benefits were reduced, or city services were cut. The Order further finds that the city knew or was reckless in not knowing that its disclosures were materially misleading."

The Order makes for fascinating reading. For one thing, an eight percent assumed rate of return on investments was used "without regard to its actual historical rate of return." Some increased benefits were treated as contingent liabilities that were not reflected in certain liability calculations.

Some general observations ensue.

1. Assuming no fraud, a plan's actuarial report should be read in conjunction with any other disclosures about a plan. To the extent that there are differences, responsible fiduciaries must ask hard questions in order to reconcile the "tale of two pensions."

2. This is unlikely to be the last event of its kind. Does this put additional pressure on rating agencies and other watchdog groups to identify potential red flags before the fact, to the extent possible?

3. What is the future of public plan pension and health care benefits? Courtesy of Sean McShea, president of Ryan Labs, a recent Economist article about Other Post-Employment Benefits ("OPEB") augurs poorly for taxpayers in states adversely affected by a new government accounting decree. "Going into effect on December 15, the rule requires municipal government employers to "treat their health-care promises to workers the same way they already handle their pension obligations: by reporting on the total size of their future commitment, instead of just this year's cost." (See "The known unknowns, Economist, November 16, 2006)

4. The size of the liability is important as is the rate of growth in the liability, netted against the expected change in asset performance.

5. Plans in crisis will be tempted to reach for higher expected returns. Identifying and evaluating incremental risk is essential. A bad choice could exacerbate an already grave situation.

With Thanksgiving in the U.S. only a few days away, we'll have to think long and hard about why we are grateful in benefits land.