The Brookfield analysis, published on March 11, was written by Roderick Boyd, a SIRF director and a former staffer for Fortune and the New York Post. He is also the author of Fatal Risk, a book about the near-collapse of insurance giant AIG in 2008.
In his report, Mr. Boyd raises questions about Brookfield's "pyramidal control structure" that he says enables a small group of shareholders to run the business without putting a proportionate amount of capital at risk. He also expresses concern about the financial reporting of the company and its spin-offs such as Brookfield Infrastructure Limited Partnership (TSX:BIP.UN)(NYSE:BIP) and Brookfield Renewable Energy Partners (TSX:BEP.UN)(BRPFF), both of which are recommendations of our companion Income Investor newsletter.
Mr. Boyd does not accuse the company of illegal activity but he raises questions about their accounting methods. For example, he notes that in 2010 Brookfield Infrastructure began reporting its financials in accordance with International Financial Reporting Standards (IFRS) instead of U.S. Generally Accepted Accounting Principles (GAAP) "after Canadian law mandated the switch". As a result, he said, the LP's 2009 assets skyrocketed in value from US$1.074 billion to US$6.046 billion.
"Nothing save the accounting system had changed; it was the same company through and through, except one with a much larger balance sheet," he writes.
He also says Brookfield Asset Management paid out more in $272 million more in dividends than it received in cash flow from operations from the start of 2010 to the third quarter of 2012, relying on new financing to make up the difference. He also criticizes the number of non-arm's length transactions on the company's books.
The report can be read in its entirety at http://sirf-online.org/2013/03/11/paper-world-of-brookfield-asset-management/.
I asked contributing editor Tom Slee to read the report and offer his thoughts. Tom does not follow Brookfield closely but his accounting background enables him to assess the validity of the claims from a professional perspective. Here are his views:
"Looking at some of the criticisms, there is no doubt that tightly controlled voting power is always a problem. Brookfield is structured as a pyramid so that the directors exercise total discretion through Brookfield Partners but that may be the only way to run an international empire. There are bound to be conflicts. However, there is nothing illegal about controlled voting stock and we have lived with that at Magna and Canadian Tire. SIRF seems to think that it's ominous but that is not necessarily so.
"The comments about booking profit through mark to market property value adjustments and non-arm's length transactions are far more serious. We ran into this sort of thing at Enron. There is also the on-going problem of marking to market when properties with no real market quotes are involved.
"My feeling is that we have to depend on company auditor Deloitte & Touche, presumably chastened after what happened at Enron, and the SEC (Brookfield is listed in New York) to make sure that the values are reasonable. Hopefully we can also rely to some extent on the directors' integrity.
"It's interesting to note that SIRF is concerned about Brookfield Partners yet negotiations are underway with the SEC to have this company listed. The necessary audits will certainly shine a searchlight on dealings with hedge funds and other transactions. It would suggest that the directors are comfortable with their dealings.
"One more thing. I had a quick look at Brookfield's coverage and none of the analysts have serious reservations. In fact they are bullish. On the other hand, this is a very difficult company to dissect."
Mr. Boyd says that he tried to get reaction from the company and that a Brookfield spokesman answered some questions but then refused to participate further and referred the matter to legal counsel. He added that the law firm subsequently informed SIRF that Brookfield was considering legal action.
It's important to remember that Brookfield and its predecessor company, Brascan, have been accused of opaque accounting and reporting practices for many years so in that sense this is not new. However, I have not seen this level of detail in an analysis before.
Although it was not widely reported in the mainstream media, the analysis was posted on some Wall Street websites and clearly triggered enough concern among investors to prompt a mild sell-off in the shares of Brookfield and the partnerships. Whether this will accelerate will depend on how much traction the report receives and whether it prompts any action by regulators.
This is clearly not another Sino-Forest situation. Brookfield's assets are real but one of the key issues raised by Mr. Boyd is how they are valued. The report may cause some investors to think twice before buying or to take profits on their holdings. The stock closed on Friday at C$37.89, US$37.20. It was down 4.4% on the week in Canadian dollar terms.
We are changing are guidance to Hold and I will monitor the situation.