THE INSTITUTIONAL
REAL ESTATE LETTER
GOVERNANCE by Rachel McMurdie
Investing in Good Governance
Subprime-Related Losses Stir Up the Conversation
W hen the Florida State
Board of Administration
invested about $2 billion
in structured investment vehicles
(SIVs) and other debt instruments
Executive Summary
◆ The subprime mortgage
crisis has renewed the
While some who are defending
companies and plans against litiga-
tion will likely brush off these as
“me too” suits, the reality is that a lot
of them are going to be settled for a
on behalf of its local government topics of pension fund lot of money, says Rosenberg.
investment pool, the board, which prudence and good “I don’t think they’re all going
also oversees the $138 billion governance. to disappear,” he says. “There’s a lot
Florida Retirement System Pension of smoke there, so I think they’re
Plan, thought it was investing in ◆ Pension funds could seeing a lot more exposure on [the
a relatively safe account, one that face increasing pension fund] side. And the reality
happened to pay a little more inter- litigation from is that the class-action bar is target-
est than a bank would. But when beneficiaries. ing that side now, so that puts it
the mortgage crisis and downgrades on pension funds’ plates as a major
of asset-backed debt held in the ◆ The adoption of best issue they have to stay in front of.”
portfolio began to drain funds from practices could help
the bottom line, it became appar- AN ENRON-LIKE
pension funds steer
ent that the investments were far PENSION COLLAPSE
from risk-free. The lower credit rat- clear of legal troubles. News of increased pension fund liti-
ings and the looming prospects of gations comes at a time when insti-
loan defaults produced a run on tutional investors are increasingly
the Florida fund that totaled $13 them that there’s equal exposure under scrutiny for their investment
billion of redemptions in November on the pension fund side through decisions. New accounting standards
and reduced the size of the invest- ERISA,” says Stephen Rosenberg, an are likewise keeping pension inves-
ment pool by more than half. And ERISA attorney with Boston-based tors on their toes. Add to that the
Florida is not alone, as many other The McCormack Firm. “They’re subprime mortgage debacle and you
state-run funds also have incurred realizing it’s the same exposure have yourself a perfect storm, condi-
losses from subprime-tainted SIVs. they’ve been facing on the front tions ripe for an Enron-like pension
Assignments of blame, in the end through good, old-fashioned fund collapse, some experts warn.
form of lawsuits, have followed securities lawsuits.” “Everybody agrees that the tip-
the downturn. Pension funds might Already a number of litigations ping point is near,” says Mangiero.
see themselves on the receiving are unfolding, says Susan Mangiero, “It won’t be pretty for those who
end of lawsuits as much as on the president of Pension Governance, realize large losses. People must pay
giving end. Under ERISA rules, as an independent research and anal- closer attention to the proper iden-
interpreted by the American Insti- ysis company that tracks pension tification, measurement and man-
tute of Certified Public Accoun- litigation and investment best prac- agement of investment risks. That
tants, fund trustees and executives, tices. The recently launched web- includes making inquiries about how
not their consultants or managers, site, www.pensionlitigationdata. their fund managers deal with risk,
are responsible for the contents of com, a partnership with The Michel- how they value thinly traded secu-
their portfolios. Shaked Group, includes more than rities and the extent to which they
Furthermore, a recent Supreme 1,500 lawsuits, many of which reflect employ leverage.”
Court case, LaRue v. DeWolff, if complaints against third parties such With a new awareness of risk,
won by the defendant, would allow as consultants, asset managers and the conversation on good gover-
individuals to sue pension funds actuaries. “The number of new fil- nance has changed dramatically, says
and open pension funds to even ings is clearly on the rise. We are Rosenberg. “The subprime problem
more liability. adding 300 to 400 new cases each in particular has brought it home for
“Every single day investors read quarter,” says Mangiero. “More than people,” he says.
about another case or class-action 90 percent of these cases allege fidu-
lawsuit of a firm going after a com- ciary breach, meaning that decision WHAT CAN BE DONE?
pany over investment or stock issues, makers are accused of not doing Most investors would agree that
and it’s really becoming very clear to their job properly.” more needs to be done to promote
January 2008 ■ THE LETTER ■ www.irei.com 41
THE INSTITUTIONAL
REAL ESTATE LETTER
transparency, inhibit conflicts of Already faced with tougher “Their real obligations are to act
interest and bring light to opaque accounting requirements under as if they are investing their own
accounting practices, but regulators FAS 157, public pension funds money,” Rosenberg says of pension
and executives that oversee funds are may feel overwhelmed by addi-
divided over how to best proceed. tional regulations.
In a speech to pension offi- Rosenberg believes regulations
cials in October, Arthur Levitt Jr., won’t get at the root of the prob- “The problem we’re
the longest-serving chairman of lem. “The problem we’re seeing
the Securities and Exchange Com- consistently is that [pension funds] seeing consistently is that
mission, called for a repeal of the don’t do sufficient investigation. [pension funds] don’t do
Tower Amendment, which shel- They don’t bring in sufficient exper-
ters government entities from some tise and they get blind-sided. First
sufficient investigation.
of the accounting standards that it was company stock, then it was They don’t bring in
corporations are held to. He also excessive fees, now it’s subprime,” sufficient expertise and
suggested that, in order to avoid he explained. “If you rely on regu-
inherent conflicts of interest, Con- lation, it seems like you’re always they get blind-sided.”
gress should create an indepen- fixing the last investment problem. — Steve Rosenberg,
dent source of financing to fund I’m not sure you can regulate the
the body that writes the accounting problem out of existence.” attorney
rules for governments — some- But what regulators can do, The McCormick Firm
thing Congress already has done Rosenberg says, is impose tougher
for corporate accounting rule mak- regulations on sellers that would
ers. Though the current SEC chair- make their products more trans-
man, Christopher Cox, has not parent. Investors, for their part, fund executives and trustees. “Basi-
called for its outright repeal, he he says, should take preventative cally, what they need to do is have
also has expressed his doubts over action against lawsuits and pro- due diligence in place for investigat-
the Tower Amendment’s continu- tect themselves by imposing better ing the investments in their pension
ing usefulness. internal practices. fund. They should be bringing in the
outside expertise of people who can
really value their investments and
Cover All Your Bases who can decide whether they are
appropriate and how to diversify.”
I n response to a rising num- have trustees who are Mangiero, whose company also
ber of pension fund scandals, competent in financial and assesses and advises companies on
the committee of the Stanford accounting matters; governance risks, says the key is for
Institutional Investors’ Forum at pension trustees to look beyond the
• Establish clear reporting obvious. “Even if you don’t have a
Stanford Law School, in coop- authority between trustees
eration with the Arthur and Toni really fancy analytics system or a
and staff; and large staff of experts, you can ask
Rembe Rock Center for Corporate
Governance, published last June • Define appropriate traders tough questions about what
a set of best practice principals responsibilities and delegate keeps them up at night, what calam-
for managing pension, endow- duties among fund trustees, ity could bring the fund to its knees
ment and charitable funds. The staff and outside consultants. and whether they have a chief risk
report calls for the adoption of officer who stays on top of things.
“To be sure, the diverse forms Even now, as some pension plans
basic policies aimed at improv-
of institutional investors make realize losses, trustees and their ser-
ing how pension funds govern
it impossible to develop a ‘one- vice providers should be thinking
themselves, with the goal of mak-
size-fits-all’ approach to regulat- about what could have been done
ing plan sponsors more account-
ing fund governance,” writes Peter differently and how risk can be bet-
able to their beneficiaries. The
Clapman, chairman of the com- ter mitigated going forward. Take a
Clapman Report recommends that
mittee on fund governance. “But look at the institutional investors with
pension funds:
in light of today’s current system, robust risk management and valuation
• Clearly define and make which is rife with opportunities policies and procedures. Assess exist-
publicly available their for abuse or mismanagement, our ing risk and valuation best practices.
governance rules; best-practice principles offer a Those who delay making improve-
road map to a more secure sav- ments put themselves in the litigation
• Mandate tough and
ings and investment environment.” crossfire and risk personal and profes-
transparent policies to
The report is available at sional liability.” v
address conflicts of interest;
www.law.stanford.edu/clapman-
• Take steps to ensure funds report. Rachel McMurdie is assistant editor of
The Institutional Real Estate Letter.
42 January 2008 ■ THE LETTER ■ www.irei.com