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

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.

• Print
• Comments
• Trackbacks
• Share Link

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?

• Print
• Comments
• Trackbacks
• Share Link

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

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

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

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

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

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

• Print
• Comments
• Trackbacks
• Share Link

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. >>

• Print
• Comments
• Trackbacks
• Share Link

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!

• Print
• Comments
• Trackbacks
• Share Link

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.

• Print
• Comments
• Trackbacks
• Share Link

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.

• Print
• Comments
• Trackbacks
• Share Link

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.

• Print
• Comments
• Trackbacks
• Share Link

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?

• Print
• Comments
• Trackbacks
• Share Link

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.

• Print
• Comments
• Trackbacks
• Share Link