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Brookfield’s Looking-Glass World

Illustration: Edel Rodriguez
Illustration: Edel Rodriguez

A wry investor might be forgiven for concluding that peering at Toronto-based Brookfield Asset Management’s filings is akin to Lewis Carroll’s Alice peeking behind the mirror and finding a universe in reverse.

Consider the third-quarter earnings just released by the real estate management, energy and infrastructure conglomerate, disclosing a handsome $813 million in net income for those three months, walloping the $334 million the public company reported for the same period last year. But instead of popping corks, investors who read the filing will probably want to reach for a bottle of aspirin.

The reality is that a combination of legally permissible accounting maneuvers and Brookfield Asset Management’s singular definition of profit allowed it to script a victory.

Pulling the numbers apart, one can find a $77 million fair value gain, representing Brookfield Asset Management’s assessment of the appreciation of its assets. While asset values do rise and fall, and corporate managements do have to note such things, at Brookfield an increase in asset values lands in the income statement. Even though this makes the bottom line look better, a smart investor knows to discount every penny of it since this adds no cash to the business.

Also noteworthy is how a $525 million one-time gain booked from a litigation settlement became the quarter’s profit driver. This is where the accounting profession goes down the proverbial rabbit hole: Brookfield’s filings seem to follow the reasoning of a character in Lewis Carroll’s “Through the Looking-Glass”: “When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”

The backstory of the litigation settlement is interesting on its own merits. It begins in 1990 when a relatively unknown unit of the AIG insurance colossus called AIG Financial Products struck a 25-year interest rate swap with Brookfield Asset Management’s predecessor, Edper, as Edper fell into serious financial trouble. From the start, it appears that much of the AIG Financial Products-Edper relationship was star-crossed. And in 2008 when AIG collapsed (before a $137 billion U.S. government rescue), Brookfield decided to terminate the agreement, arguing that this amounted to a default under the terms of their agreement, according to Brookfield Asset Management’s 2011 annual report.

Carried on Brookfield Asset Management’s books as a $1.4 billion prospective liability in the second quarter of this year — a spike from the $988 million reported at the end of 2011, the number served as the management team’s best estimate of what it would eventually have to shell out to square away the matter.

Ultimately Brookfield paid AIG $905 million to settle the suit.

What some investors might find slightly surreal is how, using established accounting rules, a company can settle a liability for less than its previously declared amount (for example, by buying back bonds below their face amount) and consider the transaction a profit. So even though $905 million in cash was sent out the door, Brookfield Asset Management claimed a “profit” of $525 million and flowed the figure through its income statement.

This speaks to the larger issue of Brookfield Asset Management’s quality of earnings, a matter discussed in detail in the Southern Investigative Reporting Foundation’s March 11 story on the company. Paper gains on an income statement contribute nothing to the growth of corporate value: Because there is no cash, the company can’t use these “earnings” to make timely investments, increase dividends or buy back shares.

Brookfield Asset Management is hardly the first company to benefit from paper gains: Big banks and securities brokers have perfected the gambit. But Brookfield Asset Management uses them to great effect.

Many of Brookfield Asset Management’s investors and investment bankers dismiss concerns about such issues because a higher income level (usually) serves as ballast to command a higher stock price. But there is a reason that Brookfield seems to have gone to great lengths to keep its share price higher: Partners Limited.

Amounting to what is in effect an old-line Wall Street partnership built into a publicly traded company, Partners Limited consists of a group of about 45 current and former corporate officers of Brookfield Asset Management who privately control 20 percent of its shares — and given Brookfield Asset Management’s dual-share structure, its operations and governance, Partners Limited is an oasis of concentrated corporate wealth. Considering Partner Limited’s big stake in Brookfield Asset Management and its other subsidiaries, and the widespread cross ownership of shares by Brookfield Asset Management and its subsidiaries, there is plenty of incentive for the managers of Brookfield Asset Management to use every last loophole to boost earnings.

With Partners Limited’s current worth exceeding $5 billion, no one has benefitted more from its public-private hybrid model than Brookfield Asset Management’s chief executive, Bruce Flatt. His stake in Partners Limited is now worth more than $713 million.

This is a far cry from the $77 million Brookfield Asset Management disclosed as his aggregate compensation for serving as its CEO from 2002 to 2004 elsewhere in the management information circular.

Regulatory concerns

Investors brave enough to wade through Brookfield’s opaque public filings might take solace in knowing that they aren’t the only ones with a laundry list of questions and concerns.

Recently the Securities and Exchange Commission has been peppering Brookfield with a series of increasingly probing queries and, in its own, stilted bureaucratic language, demanding some serious changes to how Brookfield and its subsidiaries disclose details about their operations to investors.

Brookfield Property Partners, a publicly traded limited partnership spun out of Brookfield Asset Management to hold its commercial real estate operations, has been an object of fascination for the SEC’s accounting mavens. Their communications, in a series of letters and responses carrying on for several months from 2012 to this year, represent an unusually bold turn for the SEC, an agency whose track record is anything but aggressive when it comes to parsing corporate filings to find looming investor headaches.

Using the 2011 annual report as a springboard, the SEC last year sent a series of letters to Brookfield Property demanding clarification of its valuation policy, which, as laid out in footnotes, states in part, “All properties are externally valued on a three-year rotation plan.”

To an investor reading the above, the implications appear both rational and plain: Brookfield Property — poised to be one of world’s leading real estate managers — calculates the fair value of its assets using a combination of its own (internal) assessments and, for a third of the properties each year, the input of qualified and independent consultants.

Except it doesn’t.

The SEC’s sustained questioning of Brookfield Property Partners last year about property valuation process eventually forced Brookfield Property Partners, in a written September 2012 reply, that it does not use “external valuations” to value its investment property. So investors can now see that Brookfield Property Partners describes the worth of its portfolio, much in the manner of Humpty Dumpty; the words selected mean whatever it says they are.

(Furthermore, while Brookfield Asset Management and Brookfield Property Partners are legally distinct entities, with separate investors, filings and boards of directors, Brookfield Asset Management directs all of Brookfield Property’s operations and consolidates its earnings and assets as its own—as it does for all its subsidiaries. Brookfield Asset Management insists that the boards of its subsidiaries are independent. Yet although the board of one subsidiary, Brookfield Infrastructure Partners, meets the legal definition of independent, as the Southern Investigative Reporting Foundation described in March, five of its eight members have deep economic ties to parent company Brookfield Asset Management.)

But what about all that fancy legal wording describing “internal and external appraisal,” which was prominently displayed and repeated throughout the filings of Brookfield Asset Management and its subsidiaries? It seems that this was primarily used for financing purposes. The goal was to give investors and lenders the distinct impression that Brookfield Property Partners relies on a rigorous arm’s-length process to value its portfolio when the reality was the opposite.

All seems to be fair in value

Plus there are big ramifications to some clever wording buried in the footnotes of Brookfield Property’s annual report.

Last year more than $1.3 billion in fair value changes were flowed into Brookfield Property Partners $2.7 billion in net income, according to its 2012 annual report. In other words, nearly 50 percent of its profits were attributed to accounting entries — existing only on paper — that had nothing to do with leasing or selling properties at a profit.

So here’s where a set of truly independent set of eyes reviewing Brookfield Property’s portfolio could mean something beyond an abstract legal concept, perhaps a check and balance. Indeed an independent review could result in a different opinion of the value of Brookfield Property’s billions of dollars of assets and perhaps a substantial change to its bottom line.

After all, if Brookfield Properties excluded fair value changes from its filing and reported earnings of $1.4 billion, the subsidiary might have warranted a sharply different stock price.

And Brookfield Asset Management seems to be quite mindful of its own stock price of late: After the Southern Investigative Reporting Foundation’s March article, Brookfield Asset Management launched an expensive share-buyback program. In putting up the company’s cash, a share buyback can serve to increase (or stabilize) a company’s stock price by removing the amount of shares publicly available — with the result of establishing a temporary floor for the share’s value. It is a popular practice, if rarely as successful as anticipated. (See a chart of Brookfield Asset Management’s buybacks.)

An obscure company called MS451 Inc.

Even though some investors might find it promising that the SEC has recently tried to prompt Brookfield Asset Management to be more transparent, a previous attempt by the SEC to elicit more disclosure in 2009 ended up with the agency backing off.

While few companies have financial filings as opaque as Brookfield Asset Management and its subsidiaries, occasionally the veil surrounding their operations can be pierced. And a diligent detective can piece together the lengths to which Brookfield Asset Management has gone to generate even the thinnest claim to income.

A 2008 related-party transaction by another Brookfield Asset Management subsidiary, its residential property developer Brookfield Homes, thatprompted the SEC to write an epic 2009 letter with a seemingly endless parade of disclosure-oriented questions.

One of the issues that caught the SEC’s attention was a deal struck late in the disastrous real estate year of 2008, when Brookfield Homes sold 451 land plots in the Morningside Ranch residential development outside of San Diego to a Brookfield Asset Management-affiliated related party. This was Brookfield Homes’ only land sale in the region for that year. Brookfield Asset Management revealed the stark terms of the deal in its 2008 annual report: On a $18.5 million sale, Brookfield Homes lost $15 million, suggesting that the land’s true value was $33.5 million.

In its letter in 2009, the SEC demanded more details about related-party aspects of the deal. But in a departure from the typical response of a public company to the U.S. regulatory body, Brookfield Homes refused to elaborate, saying that Brookfield Asset Management’s ownership stake in the entity purchasing the lots was less than 10 percent.

The SEC’s response a month later was unambiguous: The agency demanded full disclosure, arguing that regardless of the size of Brookfield Asset Management’s equity position, it had “a significant financial interest” in the related party.

Brookfield Homes’ subsequent reply was conciliatory: “The Company notes the Staff’s comment and will provide the requested disclosure in its next Definitive Proxy Statement.”

Yet Brookfield Homes’ next proxy statement (known in Canada as a management information circular), in 2010, did not contain the information requested nor did subsequent filings, despite the company’s assurances.

In 2011 Brookfield Homes was renamed Brookfield Residential Properties after an internal reorganization of its operations.

To date, there appears to be no record of the company ever providing the expanded disclosure. And a Brookfield Asset Management spokesman, who assured the Southern Investigative Reporting Foundation the company had indeed disclosed the information, declined to provide a link to a filing with it.

Fast-forward to the first quarter of 2013: The very same Morningside Ranch parcels at the heart of Brookfield Homes’ 2008 transaction suddenly pop up in the company’s corporate disclosures.

Tucked in the back of Brookfield Residential Properties’ filing for the first quarter of 2013 is a mention about an unnamed $29 million residential lot in California being purchased from Brookfield Asset Management during the three-month period.

In a departure from the typical corporate language for such transactions, the filing describes the payment as “measured at an exchange value of $29 million.” This suggests that cash may not have been used in the transaction.

Using public records, the Southern Investigative Reporting Foundation determined that the Morningside Ranch lots sold by Brookfield Homes in December 2008 were bought by an entity called MS451 Inc., and that by March 2013 MS451 Inc. had sold those lots to Brookfield Residential Properties.

According to California corporate documents, a Brookfield Homes executive named Stephen P. Doyle signed papers for both MS451 Inc. and Brookfield Homes during the late December 2008 transaction, as did Larry Cortes, then the chief financial officer of Brookfield Homes’ San Diego area operations and also CFO for MS451 Inc. At least four other Brookfield Homes executives had roles in MS451 Inc., according to these documents.

The Southern Investigative Reporting Foundation’s initial efforts to learn more about MS451 Inc. and its owners has led to still more questions. Dissolved in late March 2013 after the California lot deal closed, MS451 Inc. appears to have had three owners: Brookfield Asset Management, with a stake of less than 10 percent, and two brothers, real estate developers James and Charles Schmid, who are the chief executive and president, respectively, of Chelsea Investment Corp.

Brookfield Homes, Chelsea and MS451 Inc. have a few things in common: Two Brookfield Homes alumni (listed in filings as officers of MS451 Inc.) now work for Chelsea: The aforementioned Larry Cortes is currently a Chelsea project manager, and Liz Zepeda works for Chelsea as a risk analyst (the same role she played at Brookfield Homes).

The purpose of the Schmids’ involvement in the deal remains unclear. In deal documents, they are listed as individuals not corporate officers of Chelsea. Several phone calls made to James Schmid’s office requesting comment were not returned nor was a call to Charles Schmid’s home.

MS451 Inc.’s reasons for involvement with the property are not immediately apparent. And why did the property’s prepared lots stay undeveloped during the past half decade of record low interest rates?

Moreover, the 2008 transaction seems to have been conducted with MS451 Inc. receiving some very favorable terms. During a time of major financial stress for Brookfield Homes, the subsidiary accepted bonds as payment from MS451 Inc. — a company with no assets or operations — and not cash. (In 2008 Brookfield Asset Management provided a waiver when Brookfield Homes could not comply with its net debt to capitalization and minimum equity covenants, an issue the SEC had been quite curious about in its aforementioned 2009 letter.)

At least on paper, the owners of MS451 Inc. did well for themselves, realizing a profit of $10.5 million on the deal. And because of the related-party nature of the transaction, Brookfield Asset Management claimed the full amount of profit as its own. That’s the case even though Brookfield Asset Management directly earned only about $1 million from the deal, from its less than 10 percent stake.

While $10.5 million in consolidated earnings is immaterial when considering an income statement the size of Brookfield Asset Management’s, it does suggest a further question: How much of the company’s earnings come from related-party accounting maneuvers like this one involving MS451 Inc.? Indeed, as the Southern Investigative Reporting Foundation showed in March, Brookfield Asset Management regularly generates hundreds of millions in profit through complex related-party dealings.

In response to reporter questions, Andrew Willis, a Brookfield Asset Management spokesman, sent responses but failed to make any of this any clearer: Concerning the Brookfield Homes-Brookfield Residential Properties disclosure above, he said, “[Brookfield Residential Properties] disclosed the related party nature and valuation basis for both transactions.” He declined to elaborate further when asked follow-up questions.

Brookfield’s Brazilian headache

On Friday when Brookfield Asset Management released its third quarter results, it revealed an interesting development in another whole line of business in another corner of world – one involving potential fraud.

It revealed in the “Risks” section a new disclosure that the SEC and U.S. Department of Justice are investigating allegations that a Brazilian private equity unit had bribed local officials to approve certain real estate transactions. A public prosecutor in São Paulo has filed charges against three Brookfield Asset Management executives and seven municipal officials under the country’s anti-bribery statutes.

Long a key component of the Brookfield Asset Management empire, the Brazilian operations manage or own more than $13 billion worth of utilities and real estate. Indeed prior to becoming Brookfield Asset Management, the company was called Edper-Brascan, with Bras being short for Brazil.

The recent charges emerged following Brookfield Asset Management’s April 2010 dismissal of Daniela Spinola Gonzalez, the former chief financial officer of a Brookfield-managed real estate fund in São Paulo.

Reached by the Southern Investigative Reporting Foundation, Gonzalez said that in the spring of 2009 she uncovered a series of payments to São Paulo municipal officials aimed at obtaining approval of expansion projects at four different malls. Specifically she alleges they were designed to cover up the real estate fund’s lack of compliance with a series of pre-expansion mandates from the São Paulo building approval department designed to address a potential increase in traffic flow. When she discovered requests to approve large payments to holding companies she had never heard of, she investigated further and found municipal officials had set up entities to receive payments from the real estate fund.

Gonzalez alleges that when confronted her unit and corporate supervisors, including Steven J. Douglas, then the head of the Brookfield Asset Management’s international property portfolio, with news she felt sure would outrage them, she was told repeatedly, “This is the way of doing business in Brazil.” The angriest they got about the bribes, according to her, was when they chastised her for discussing sensitive fund business in an email. (In reporting on the claims of Gonzalez, the Southern Investigative Reporting Foundation examined a series of emails between Gonzalez and her supervisors, other internal Brookfield documents and a letter written to the SEC by her lawyers.)

Dismissed in April 2010, Gonzalez filed a labor grievance shortly thereafter in São Paulo. Brookfield Asset Management filed a lawsuit against her in 2011, alleging she had engaged in embezzlement; she says the charges are nothing more than “a complete fabrication to make me seem like a criminal.”

Asked about Gonzalez and her charges, Brookfield Asset Management spokesman Andrew Willis said, among other statements, “Notwithstanding the suspect source of the allegations, Brookfield conducted an investigation into these matters. The investigation found no evidence of wrongdoing by Brookfield or any of its employees.”

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The Paper World of Brookfield Asset Management

Enter the name of Toronto-based public company Brookfield Asset Management into a search engine and it delivers more than 1 million results. The global conglomerate, whose annual sales exceed $18 billion, controls ports in England, owns Manhattan’s prestigious World Financial Center and sells Chicago a fair measure of its electricity. Yet the massive enterprise is better known for what it owns than how it operates.

The Southern Investigative Reporting Foundation began a full-time investigation into Brookfield’s far-flung operations in late fall. This reporting and research uncovered a series of earnings quality problems, the presence of a mostly hidden ownership group that effectively controls Brookfield’s governance and corporate structure, and a business model that involves heavy reliance on related-party transactions with its subsidiaries.

Few companies bear a structure as complex as Brookfield’s: Analyzing the company’s organizational tree and its web of entities, stakes, partnerships and operating companies is to behold the work of gifted accountants and lawyers. Similarly, Brookfield’s financial filings are mind-boggling in their complexity.

A brief glance at a stock chart, which shows that Brookfield’s share price has been on a fairly steady climb from a low of $11 in 2009 to almost $40 in recent months, might give credence to the argument that the labyrinthine structure works.

No one doubts that Brookfield’s share price performance has pleased investors, but how it is achieved should matter.

Control without risk

Brookfield bears a pyramidal control structure, a design that U.S. regulators have frowned on since the 1930s. Simply stated, this type of structure lets a small group of shareholders exercise control of a business without putting a proportionate amount of capital at risk.

(This kind of corporate structure is often depicted by a pyramid; hence the name. It is legal and to varying degrees common in Europe, Asia and Canada. But it should not be confused with a pyramid scheme.)

As has been deeply parsed in academic literature, pyramidal control structures are either tremendously efficient or very worrisome, depending on one’s vantage point. Indeed, legendary investor Benjamin Graham devoted an entire chapter of his still influential 1934 book “Security Analysis” to their risks.

Those in the founding group can leverage their capital to effectively control a broad network of assets or investments; often members of this group do so by creating a holding company with the right to appoint half or more of the board of directors of the parent company.

In turn, these directors can oversee a series of acquisitions using the company’s capital, most of which belongs to other people.

For the shareholders outside of the control group — even if their capital is doing most of the buying — their influence upon the board of directors is perpetually limited, no matter how much they have invested.

Brookfield’s formula

Here’s how Brookfield’s pyramidal control structure works: Partners Limited, a private holding company with 45 equity holders (a mix of current and former Brookfield officers, with just eight publicly named) owns slightly more than 20 percent of Brookfield’s Class A shares via a combination of trusts and direct holdings valued at more than $4.7 billion. Partners Limited also owns 100 percent of Brookfield’s 85,120 Class B shares, allowing it to elect 50 percent of Brookfield’s board of directors. Owning just 20 percent of the Class A shares but electing half of Brookfield’s board, those who run the almost invisible Partners Limited end up with effective control over all Brookfield’s operations and governance, and anyone else who happens to be a Brookfield shareholder with a gripe cannot do much but grin and bear it.

Should an enterprising Brookfield shareholder summon the nerve to put forth a measure for a vote, its adoption requires approval from two-thirds of both the Class A and Class B shareholders alike. In other words, if the 45 Partners Limited shareholders who own Class B stakes believe a measure goes against their interests, the motion is dead even if 80 percent of the Class A holders approve it. Ultimately this creates a public-private hybrid: a corporation that has ready access to public capital but whose governance can be a private matter.

The use of A and B classes of shares is almost universally panned by governance advocates for its allegedly unfair treatment of minority shareholders. But Brookfield is hardly the only company with what is known as a dual-class share structure. The roster of companies with such a structure includes Google, Berkshire Hathaway and The New York Times Co. Whatever their merits, dual-class share structures are designed to keep the company’s operating assets in the hands of founders. When Berkshire Hathaway’s Warren Buffett likes another company, he does not use his publicly traded corporation as a springboard to build a string of downstream corporate investments via minority stakes; he generally buys all of it.

Want to know more about Partners Limited, its history and how it goes about business? Apart from mentions in Brookfield’s management information circular (equivalent to a U.S. corporate proxy statement), the entity is rarely mentioned in the filings of Brookfield and its subsidiaries. Examining public filings, the Southern Investigative Reporting Foundation came up with a list of 40 of the 45 current and former Partners Limited equity holders; a sizable number of them were instrumental to the rise and fall of Brookfield Asset Management’s high-profile predecessor, the Edper Group.

[module align=”left” width=”half” type=”aside”] See the Southern Investigative Reporting Foundation’s exclusive list identifying 40 Partners Limited equity holders — those who really call the shots at Brookfield Asset Management.[/module]

In response to a U.S. Securities and Enforcement Commission comment, Brookfield recently came close to acknowledging that it has a pyramidal control structure in the “Risk Factors” section of a prelaunch filing for its Brookfield Property Partners unit: “The company at the top of the chain may control the company at the bottom of the chain even if its effective equity position in the bottom company is less than such controlling interest,” the document states.

(With its shares traded on the Toronto and New York exchanges, Canada-based Brookfield submits filings to the SEC but does so as a foreign issuer, which allows it to legally bypass some U.S. laws.)

No matter how little Brookfield Asset Management controls economically of Brookfield Property Partners, Brookfield Asset Management will retain control of Brookfield Property Partners’ board.

All this fine print has paid off handsomely for Partners Limited.

Consider just this one, commercial real estate branch of the Brookfield Asset Management ownership tree: Partners Limited, with a stake worth $4.7 billion, is able to control Brookfield Asset Management, whose market capitalization is $23.8 billion. One of Brookfield Asset Management’s investments is its 50 percent stake in Brookfield Office Properties, a commercial real estate developer with $8.5 billion in market capitalization, that in turn owns 73 percent of Australian real estate investment trust Brookfield Prime Property Fund. With what ultimately amounts to a 7.3 percent blended equity stake in these three entities, the 45 people in Partners Limited exert managerial control over many billions of dollars’ worth of commercial real estate around the world.

Asked about the role Partners Limited plays in Brookfield Asset Management, Andy Willis, a company spokesman replied, in part, with the following:

“We believe [Partners Limited] creates a significant alignment of interests with our shareholders that sets us apart from other companies and is valued by shareholders and our clients alike. We believe that Partners’ participation in the ownership of Brookfield will result in greater long‐term value creation for all shareholders.”

The U.S. regulatory distaste for pyramidal control structures can be traced to the presidency of Franklin Delano Roosevelt. Then Federal Trade Commission analysts fervently argued that a series of collapses in the 1930s by pyramidal control structure companies (primarily utilities) had deepened the Great Depression. The FTC analysts seized on three things: real and potential abuses by “minority” shareholders (resulting in investors who did not exert control over corporate affairs), the prospects for one-sided related-party transactions — and most important — weak accounting controls that led to the inflation of asset values.

What the numbers really say

Investors in Brookfield have remained loyal to the corporation despite such governance issues perhaps because it has grown assets and earned billions of dollars annually. With Brookfield’s shares widely held in Canada and finding increasing favor among American money managers over the past few years, members of Partners Limited and the rest of Brookfield’s senior management likely are optimistic about prospects.

But a sunny outlook might not be what comes to mind after close scrutiny of Brookfield’s financial filings and an analysis of how the company interacts with several of its subsidiaries.

Despite its profits, Brookfield is not doing as well as investors might suppose.

Brookfield is a creature of the capital markets, relying on financing to fuel its growth and meet its commitments to investors, as the chart below shows. From the start of 2010 to the third quarter of 2012, Brookfield’s distributions — its dividend payments to investors  — were $272 million greater than its cash flow from operations, according to filings. Fortunately for Brookfield, its investors are a truly generous bunch; they helped the company eliminate this deficit and raise almost $1.75 billion more than it paid back out, ensuring that its increasing dividend obligations were met — with cash to spare.


But relying on a constant stream of investor capital has proved a substantial risk for many corporations — the 2008 credit crisis serves as an object lesson — since companies whose business models center on a constant stream of capital market funding hit trouble when the markets seize.

And U.S. tax policy toward dividends is a major stumbling block for companies with pyramidal control structures.  The primary method a pyramidal control structure company has to sustain itself — using preferred stock dividends to shuttle cash from the subsidiaries through the structure to the publicly traded holding company — becomes impractical when both the dividend payer and recipient are being taxed.

Postmodern accounting

Generations of businesspeople have assessed the success of enterprises based on a set of simple criteria: Are they profitable? Do they sell enough goods or services in a given period so that after fixed and variable costs are subtracted and taxes paid, something is left to reinvest, retain for future use or even return to shareholders?

Using net income as a barometer of financial achievement is not without its flaws; any business that requires a substantial investment or a longer time frame for its assets to generate a return is likely to eke out a meager income in the short term. But net income is a rational and understandable measurement of where a business stands.

Brookfield sees things very differently and suggests investors judge its success by relying, as the company does, on a measure called “total return” to accurately capture the growth in asset value and cash flow generation in its units. The company describes this view in its annual report as follows: “We define Total Return to include funds from operations plus the increase or decrease in the value of our assets over a period of time.” (“Funds from operations” consist of the cash flow from its businesses.)

Accordingly, Brookfield’s management says it is not the biggest fan of using net income to define profit because only “fair value” adjustments from its real estate and timber segments can be included but not any from its renewable power and energy businesses. (A company can make fair value adjustments if it decides that the market value of its assets has significantly changed from their book value.)

Whatever the merits of “total return” as a measurement, Brookfield’s investors would need to determine net income to gauge the return on their invested capital in comparison to other investment possibilities.

Management’s linguistic preferences are not the sum total of the drama surrounding Brookfield’s accounting, however. Its income statement has several line items that suggest flaws in the company’s earnings quality. 

A frequently debated subject in the accounting community, earnings quality is usually defined to include, in part, how closely a company’s reported net income tracks its so-called true income (or what it can easily convert to cash).

Those willing to put on the green eyeshade and examine Brookfield Asset Management’s 2011 Consolidated Statement of Operations can find $3.67 billion in net income. It’s an eye-opening number. More interesting, however, is discovering just how much of that figure is generated from accounting entries and not from profits related to business activity.

The problem starts a few rows above the line for net income where one can view the various streams that comprise it. In 2011, almost $1.29 billion, or 35 percent, of Brookfield’s profits came from fair value gains. (This figure, however, is listed as $968 million in the 2012 earnings release; it is not clear why there is a difference between the two filings.) For 2012, according to Brookfield’s most recent earnings release, more than 43 percent — or $1.19 billion — of its net income of $2.74 billion came in fair value changes.

Accounting standards allow for including fair value changes in net income. But any gimlet-eyed investor knows that they are nothing more than paper entries, and in Brookfield’s case, they represent its own assessment of its timber, commercial real estate and agricultural asset values; they have nothing to do with the cash typically associated with profits. Even though company executives may legally term a fair value change as profit, this sum cannot be used to pay dividends, build new plants or be readily tapped for a rainy day. All it represents is that the company thinks an asset has increased in value. As a key driver of the much larger net income figure, however, it certainly appears to have added some heft to Brookfield’s share price in recent times.

Consider a complex line item titled “equity accounted income” in the 2011 annual report’s Consolidated Statement of Operations, representing Brookfield’s share of income from its far-flung investments in entities it controls. Pegged at slightly more than $2.2 billion, this amounts to 60 percent of its total net income of $3.67 billion. Similar to fair value adjustments, equity accounted income is (mostly) noncash. For 2012, it totaled $1.24 billion and equaled more than 45 percent of earnings. (Brookfield released its 2012 earnings in mid-February but not its entire annual report, so details about the components of 2012 earnings are not yet available.)

The primary driver of the “equity accounted income” entry in 2011 was Brookfield’s high-profile 22 percent investment in General Growth Properties, a New York-based commercial real estate developer and manager. (Funds managed by Brookfield own another 18 percent of the stock.) Buried in the back of the annual report, this notation is easy enough to miss, but the carrying value — the value Brookfield assigns to the General Growth Properties position — was $1.17 billion more than its market value: Brookfield valued the highly liquid, New York Stock Exchange-traded shares of General Growth Properties at about 40 percent above the market’s valuation at the end of 2011. All told, about $1.4 billion from this one investment eventually wound up in equity accounted income, but it added only $204 million in cash to the till, according to the annual report. (In 2010, Brookfield reported equity accounted income of $765 million but its only source of actual cash from that input was $374 million in dividend payments from companies it had invested in.)

Thus, accounting entries are making Brookfield look really good. Without including fair value changes and equity accounted income, Brookfield’s earnings sharply decrease.

What does this situation look like numerically speaking? As shown in the chart below of Brookfield’s net income in the last couple of years, after adjusting for fair value changes and equity accounted income, the sum that might be called the “true profits” — the earnings from all the investments and assets Brookfield has the world over — is relatively low.


Investors may accept Brookfield’s desire to be analyzed this way but the SEC has publicly questioned how Brookfield used specific investment terms and its valuation methodology. In one instance in July 2011, the SEC noted its concern that Brookfield’s use of the phrase “cash flow from operations” was outside the standard definition. Despite the unambiguously skeptical tone in the SEC’s correspondence about the phrase, Brookfield held its line for more than five months. The company repeatedly parried the SEC’s concerns in a dispute that played out in a cat-and-mouse series of filings before Brookfield finally consented to change its wording in November. [module align=”right” width=”half” type=”aside”]Find out more about a host of concerns the SEC had in 2009 about another Brookfield subsidiary, Brookfield Homes.[/module]

The real number for Brookfield’s earnings is anyone’s guess. The sheer complexity of its income statement and management’s insistence on nontraditional measurements seem to work in Brookfield’s favor, as virtually no analysts or investors have raised public concerns in this regard.

As Brookfield’s auditor, the accounting giant Deloitte & Touche, notes in an article it wrote in 2002, the prevalence of noncash earnings is an important criteria in assessing earnings quality.

In 2011 Brookfield paid Deloitte $38.7 million for audit work for Brookfield and its subsidiaries. Below, view a chart showing how much Brookfield and other large Canadian corporations compensated their auditing firms.

The curious case of an infrastructure player

As is the case for some icebergs, much of Brookfield Asset Management’s activity is happening below the surface, at the level of its operating subsidiaries and limited partnerships.

Brookfield Asset Management’s approach to navigating the myriad disclosure, accounting and valuation challenges of its pyramidal control structure is perhaps most clearly seen in the filings of Brookfield Infrastructure Partners L.P., a publicly traded affiliate spun off from Brookfield Asset Management in early 2008.

Holding Brookfield Asset Management’s infrastructure investments in commodities like utilities, timber, toll roads and seaports, Brookfield Infrastructure Partners is structured as a publicly traded limited partnership. Though Brookfield Infrastructure Partners is legally autonomous from Brookfield Asset Management and sports brand-name investors like Morgan Stanley Investment Management and Fidelity Investments, there is no apparent practical distinction between the two. Brookfield Asset Management and Partners Limited currently owns about 29 percent of Brookfield Infrastructure Partners’ units (down from 60 percent in 2008) and acts as its general partner, earning a 1.25 percent management fee and incentive fees, which amounted to $53 million in 2011, according to the annual report.

(Using an unusual approach, Brookfield Asset Management calculates its management fee from enterprise value, meaning that the larger Brookfield Infrastructure Partners’ capitalization gets, the bigger the fee. Brookfield Asset Management also receives 25 percent of surplus cash each year from Brookfield Infrastructure Partners if Brookfield Asset Management’s quarterly distribution is more than $.305 per unit; it was $.370 per unit for the most recent quarter. Other limited partnerships have a similar clause for paying out additional dividends with surplus cash but have very strict guidelines about when it applies; in Brookfield Infrastructure Partners’ case, these extra distributions are at the “sole discretion” of the general partner, according to the 2011 annual report.)

For all practical purposes, Brookfield Infrastructure Partners exists solely on paper and has no employees or assets. What Brookfield Infrastructure Partners does have is a series of remote and indirect ownership claims on about 15 assets managed by Brookfield Asset Management employees and held in private-equity partnerships domiciled in Bermuda and controlled by Brookfield Asset Management.

Tracking Brookfield Infrastructure Partners’ cash flow is a fool’s errand: Its filings don’t indicate the cash flow from all its investments. Until recently Brookfield Infrastructure Partners (like Brookfield Asset Management) has had some rough times; it failed to generate enough cash from its operations to cover its distributions to unit holders in 2010 and 2011. This turned around sharply during the first nine months of 2012, when Brookfield Infrastructure Partners booked a surplus of $171 million. But look at the difference between the finances raised and what was invested: Brookfield Infrastructure Partners regularly raised more capital than it needed to finance asset purchases and had some left over.

Like its parent, Brookfield Infrastructure Partners has an earnings quality problem. As the consolidated statement of operations shows, the partnership reported $106 million in net income for 2012 but fair value changes amounted to $200 million of that. In 2011, the $187 million in net income for the partnership was dwarfed by $356 million in fair value changes.

In 2010, Brookfield Infrastructure Partners made a pair of accounting changes (described in Note 7 of its 2010 annual report as a $239 million “remeasurement gain” and a $194 million “bargain purchase gain”); these were related to the purchase of a remaining 60 percent stake in Prime Infrastructure Fund that it didn’t already own. (The fund was founded by Babcock & Brown, an Australian infrastructure finance investment firm that began liquidation in 2009.) The $433 million noncash gain was the majority of the year’s $467 million in net income for Brookfield Infrastruture Partners. In a 15-page response to the SEC’s questions about this gain and other accounting and valuation issues, the partnership offered a host of reasons why the book value of its new assets were markedly above the purchase price; the cited reasons included the appreciation of the Australian stock market from 2009 to 2010, as well as Brookfield Infrastructure Partners’ own unit price.

The conclusion is stark: Noncash accounting entries are saving Brookfield Infrastructure Partners and the market value of its units from some hard times and harder choices.

The charms of consolidation

The balance sheet gets even more convoluted. In 2010, Brookfield Infrastructure Partners began reporting its financials in accordance with International Financial Reporting Standards — as opposed to U.S. Generally Accepted Accounting Principles — after Canadian law mandated the switch. In an attempt to harmonize accounting treatments around the world, IFRS does away with GAAP’s strict definitions, granting financial managers wider latitude to determine the fair value of assets. The end result for Brookfield Infrastructure Partners has been remarkable.

In 2010, Brookfield Infrastructure Partners reported its 2009 balance sheets using both GAAP and IFRS. Under GAAP, Brookfield Infrastructure Partners reported $1.07 billion in assets. Under IFRS, Brookfield Infrastructure Partners’ assets ballooned to slightly more than $6 billion.


Recall that nothing save the accounting system had changed; it was the same company through and through, except one with a much larger balance sheet. And indeed from the spring of 2010 onward, the price of Brookfield Infrastructure Partners’ units have found much more favor in the market.

Brookfield Infrastructure Partners has been able to do this because as it switched to IFRS, it also changed its policy about an accounting concept called consolidation. At its core, consolidation is an easy concept to grasp; it occurs when Company A takes Company B’s financial statements onto its books and presents the combined results to investors. (This usually happens when Company A owns a majority of Company B’s equity, giving it effective control over Company B’s governance and operations.)

Under U.S. GAAP, consolidation can take place when a company owns 80 percent of another; but with IFRS, a corporation has plenty of freedom to define consolidation.

So Brookfield Infrastructure Partners consolidated the financials of five companies it had invested in even though its stake was less than 80 percent. It seems this move amounted to a deft legal maneuver, whereby Brookfield Asset Management — which managed these investments — ceded to Brookfield Infrastructure Partners the voting rights for these companies, giving the latter the right to select board members and direct corporate actions.

A fair question to ask is, What changed after the voting rights transfer? The answer is apparently not very much. The Brookfield Asset Management executives in charge of Brookfield Infrastructure Partners before this ceding of voting rights were the same executives, in the same roles and with the same incentives, as the ones afterward.

What wasn’t immaterial was Brookfield Infrastructure Partners’ ability to add about $2.4 billion of assets to its 2010 balance sheet from two investments, Longview Timber and Island Timber L.P., even though it had less than a 40 percent equity stakes in each.

The SEC’s Division of Corporate Finance raised specific questions in its previously mentioned Jan. 31, 2012, letter about Brookfield Infrastructure Partners’ consolidation practices.

Consolidation of investments in which Brookfield Infrastructure Partners has a minority stake has not been a one-off occurrence. In 2012 Brookfield Asset Management purchased minority stakes in Warwick Gas Storage and Columbian Regulated Distribution (22 percent and 17 percent, respectively) and then transferred the utilities’ voting rights to Brookfield Infrastructure Partners, which consolidated the companies on its balance sheet.

But finding consistency in Brookfield Infrastructure Partners’ approach to consolidation is difficult, as it has made investments in seven companies (with the equity stake ranging from 10 percent to 50 percent) that did not lead to a consolidation, according to its documents.

The most important aspect of Brookfield Infrastructure Partners’ consolidation policy is the part we know the least about: cash flow. While consolidating select minority stakes certainly improves the appearance of Brookfield Infrastructure Partners’ income statement and balance sheet, this also skews any attempt to figure out just how much cash is flowing into the partnership from these investments.

When it comes to discussing the merits of consolidating its minority stakes, Brookfield says this is done for shareholders and analysts, so they can get a “much clearer depiction of [Brookfield Infrastructure Partners’] underlying investments by showing on a consolidated basis the company’s assets, liabilities and financial performance.”

Asked by email how consolidation makes these metrics clearer, Brookfield’s spokesman refused further comment.

A question of independence

Using the standard interpretation of good corporate governance, an autonomous board of directors is supposed to serve as the investors’ advocate and ensure that senior management is effective in building shareholder value.

Brookfield Infrastructure Partners’ eight-member board of directors includes seven individuals classified as independent. Research shows, however, that five of the eight have clear professional, economic or board ties to Brookfield Asset Management and its subsidiaries.

When pressed on the matter, Brookfield Asset Management disputed the notion that Brookfield Infrastructure Partners’ board of directors lacks autonomy. Responding to questions from the Southern Investigative Reporting Foundation, Brookfield Asset Management stated, The BIP board has eight directors of which seven are independent. The BIP board approves all significant matters involving BIP. BIP also has fully independent audit, compensation and governance committees which are required to approve the matters within their purview.”

[module align=”left” width=”half” type=”aside”]Read about a former Edper executive’s affidavit stating he and his colleagues set up private investment companies that issued preferred shares to investment vehicles controlled by Edper senior managers.[/module]

What exactly constitutes an independent corporate board is certainly the subject of much debate. Following the letter of the law, Brookfield Asset Management can term Trevor Eyton an independent member of its board as long as he has not drawn a paycheck from Brookfield within the prior three years and has no family members working for the company. Yet this ignores the fact that from 1979 to 1997, Eyton (a longtime shareholder in Partners Limited and its predecessors) served variously as chief executive and chairman of Brascan, a key Brookfield subsidiary, and also had been for an extended period one of the most public executives of Brookfield’s predecessor, Edper.

The terrific value of related parties

One area where little doubt remains about Brookfield’s intent is its frequent use of related-party transactions; they happen so often — across so many subsidiaries — that they are clearly part of an overall corporate strategy. The risks inherent with doing a lot of related-party business are apparent: Non-arm’s-length transactions can disproportionately benefit one party’s investors at the expense of the other’s. Such a practice also raises concerns about whether certain deals can be replicated outside of the pyramidal control structure.

One related party transaction stands apart from all others: Buried deep in the rear of Brookfield Renewable Energy’s 2011 annual report are the details surrounding two adjustments to a pair of power purchase agreements with Brookfield Asset Management-controlled parties. Brookfield Renewable Energy, an electricity-generating partnership that’s 68 percent owned by Brookfield Asset Management and that sold 55 percent of its output in 2011 to Brookfield Asset Management-related parties, was able to amend two power purchase agreements with its wholly owned subsidiaries Mississagi Power Trust and Great Lakes Power Limited on remarkably favorable terms.

How favorable? In one instance, the new contract was repriced 50 percent higher; another time it was 20 percent. As far as the Southern Investigative Reporting Foundation can discern, this appears to be an unusual event within the renewable power industry. (Power purchase agreements, typically struck for 10- or 20-year durations, are indeed repriced annually, but only to account for an agreed-upon change in an inflation measure, such as the consumer price index. The delivery price, however, is almost never touched and if it is, it certainly is not augmented 50 percent.)

[module align=”right” width=”half” type=”aside”]Take a closer look at another Brookfield related-party transaction that involved a rights offering with Rouse Properties. [/module]

The results from the changed contracts were indeed significant, amounting to $140 million in additional revenue, 17 percent of Brookfield Renewable Energy’s 2011 earnings before interest, taxes, depreciation and taxes (EBITDA) and 33 percent of its funds from operations. More important to Brookfield Renewable Energy, its annual report discloses that these power purchase agreement revisions were pure profit, contributing an additional $140 million in Ebitda and funds from operations.

Brookfield Asset Management, for its role in the upward revision of the two power purchase agreements, was paid $292.3 million Canadian dollars. The payments kicked off a complex chain of transactions, according to a publicly filed merger document from 2011, resulting in Brookfield Asset Management’s receiving an additional $292.3 million in Brookfield Renewable Energy units.

Getting paid to revise power purchase agreements upward was not always so complex. In 2009, a pair of such revisions netted Brookfield Asset Management a $349 million cash payment, according to Brookfield Renewable Energy’s annual report.

For providing management and “energy marketing services” to Brookfield Renewable Energy, according to its annual report, Brookfield Asset Management was paid a total of $40 million in 2011.

Brookfield’s response

The Southern Investigative Reporting Foundation does its reporting based on publicly available documents and seeks to fully engage with the subjects of its reporting.

So it was when it came to the foundation’s reporting about Brookfield Asset Management.

After the Southern Investigative Reporting Foundation conducted preliminary reporting for many weeks, it submitted detailed questions via email to Brookfield on Feb. 8 and Feb. 11. On Feb. 15 the Southern Investigative Reporting Foundation had a phone conversation with Willis, Brookfield’s media relations chief and a former business journalist. Among other issues, the foundation’s disclosure and trading policies were discussed, and it was reiterated that no one at the foundation has any economic interest in Brookfield’s shares, long or short, and no one outside the reporting foundation sees its work prior to release. Plans were discussed about setting up interviews of some Brookfield executives.

Prior to the call, Brookfield’s Willis also provided the Southern Investigative Reporting Foundation a letter of introduction and the company’s replies to the first two sets of questions.

On Feb. 17 the foundation submitted a third round of questions.

Brookfield’s Willis said on Feb. 19 that the company refused to answer further questions and had referred the matter to its U.S. legal counsel, Kasowitz, Benson, Torres & Friedman LLP; the firm informed the Southern Investigative Reporting Foundation that its client was considering legal action.

While engaged in other reporting assignments, members of the board of the Southern Investigative Reporting Foundation have previously experienced contentious exchanges with Kasowitz, Benson, Torres & Friedman as well as with Michael Sitrick, who is now serving as an outside public relations adviser to Brookfield. (Sitrick has provided media representation to Kasowitz, Benson clients who have unsuccessfully sued short-sellers and analysts, allegedly for conspiring to damage their share prices.)

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The Cost of Standing in the Gap

The Southern Investigative Reporting Foundation needs your help.

After launching the foundation in 2012, the board of directors and I have sought at every step of the way to adhere to the mission statement:

“Our investigative foundation will produce substantive reporting infused with valuable information and a perspective quite distinct from the glossy outlook spun inside Wall Street’s promotion machine. We will mine corporations’ legal and financial documents and perform old fashioned shoe leather reporting to frame investigations that many media organizations are simply no longer equipped to pursue.”

I argue that we are meeting that goal. Moreover, the slate of coming investigations is sure to be the most high-profile work yet. Trust me on that. But a key aspect of our ability to constantly report out and write pieces that afflict the rich and powerful is having comprehensive insurance coverage in place.

That’s getting harder and harder to do.

Over the past several months, as I began to gather quotes prior to renewing our insurance coverage, something became brutally apparent to me: our approach to investigative reporting had scared the living tar out of insurance companies.

Our core insurance coverage has gone to an $8,000 annual premium from under $2,000 — and we are informed that number will increase. The deductible has gone to $50,000 from $10,000.

Consider that out of more than one hundred insurance companies that offer so-called custom liability policies like error and omission — more informally known in the press as “libel coverage” — only three said they would even consider extending a quote to the Southern Investigative Reporting Foundation. (Then and now it struck me that to insurance underwriters, North Korea’s airline and its shipping are acceptable risks, but a small investigative reporting outfit in North Carolina is simply too toxic.)

Ultimately only one company did manage to extend a quote, but only after the Institute for Nonprofit News’ then director Kevin Davis freaked out at its underwriters, threatening (in a truly memorable email thread) to pull several dozen INN member policies at once. When the huge premium increase was quoted, he ordered INN to write the check on the spot to cover it. I asked why he was doing this and he explained, bluntly, “What the fuck do I or INN exist for apart from standing in the gap for those who stand in the gap?”

I am confident that Kevin Davis gets what the Southern Investigative Reporting Foundation is trying to do.

Every Southern Investigative Reporting Foundation story bears the potential for legal threat and a good deal of them eventually result in one. When I worked for large media companies like Euromoney, News Corporation or Time Inc., I didn’t have to pay much attention to the amount of threats and subpoenas I received (and I got more than a few); editors and management seemed to like the fact that a reporter was stirring things up and it was generally perceived as being good for business.

A key requirement of the Southern Investigative Reporting Foundation’s insurance policy is that every legal threat has to be reported, no matter the source or how unlikely they are to ever follow through. Here’s an example of a legal threat that came from our Medbox series; here’s another from our Brookfield investigations. Don’t forget this unpleasant legal interlude last year that emerged from our reporting on inventor, investor and spaceman extraordinaire Anthony Nobles.

The world has changed. Think of the papers and magazines of your youth and then look closely at them now. Growing up in the ’70s and ’80s my parents always had a subscription to Time magazine and I read it religiously, thinking maybe one day I could be one of those reporters on Capital Hill or in places like Lebanon or Taiwan, reporting on the events that drove the world forward.

This is Time today, aggregating news that others reported (who themselves often rely on newswire stringers) on the view that your lingering a few more minutes to watch a funny video or click on a celebrity story can eventually be monetized in some fashion.

Let me ask you a question. Whatever else its attributes, do you think Time magazine’s current management would commit the resources to a yearlong investigation into Scientology that resulted in this article? The five-year legal battle with the Church of Scientology cost Time Inc. many millions of dollars in legal fees and subscriptions but its employees, lawyers and managers (broadly) considered it a badge of honor.

Those men and women are long gone from that building now.

The Southern Investigative Reporting Foundation is designed to have few friends and allies — outsiders and skeptics rarely do — but I’m asking those who value our work to consider using Paypal to make a tax deductible donation to help us meet our insurance premiums so we can continue to generate accountability-oriented investigations.

Standing in the gap, doing the reporting others can’t or won’t, is not supposed to be easy. There’s no real money in this — here’s our financial filings — and we win no awards and precious little acclaim. Filing a good story about what other didn’t see or didn’t know about is usually enough.

Our payment deadline approaches and we must meet it or we need to go away. The cost of standing in the gap is high and getting higher. It’s almost like someone or something doesn’t want us to do this work.

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Diamond Resorts and Its Perpetual Mortgage Machine

Roddy Boyd-3
Illustration: Edel Rodriguez

Since 2007 the website of Diamond Resorts International has made people think their personal six-night stay in heaven is only a few clicks away.

Online the company’s resorts, full of beaches and golf courses, still beckon. But Diamond is a 21st-century timeshare operation and investors ought to be wary of any company using the controversial vacation concept that has provided decades of fodder for comedy writers while troubling state and federal regulators.

Indeed what Las Vegas-based Diamond is selling is a sleeker, more expensive iteration called a vacation-ownership interest or VOI. And it seems to have proved successful for Diamond, at least thus far.

As is the case with buying a timeshare, customers purchase from Diamond the right to an annual one-week vacation at a resort. There are some important differences, though: Customers aren’t receiving a deeded right to a week’s stay at a specific resort. Rather, they gain the right to stay at a collection of company-owned properties in the United States, South America, Europe or Asia.

They can also buy a membership in a “trust” that allows for stays at other venues: When buying the vacation-ownership interest, they receive “points” that can be redeemed for a week’s stay — even at resorts and on cruises with which Diamond is affiliated but doesn’t own.

The concept of points is key. Think of them as a virtual currency, albeit one for which Diamond is both the dealer and the Federal Reserve. Purchasing more points means that a member has greater latitude to book a vacation, especially during peak seasons. It also means that the customer has spent a good deal of money.

In contrast, having a lower point total may require a member to reserve certain properties as much as 13 months in advance. Determining the price of points is part of the VOI negotiation process when a new member signs up. Thus, a point does not have a fixed dollar value: A chart, with data culled from member lawsuits against Diamond, seems to indicate that over the past three years the dollar value of a point has been trending lower.

Customers can expect to pay about $26,000 for a VOI for one week a year and about $1,460 in annual maintenance fees.

And a VOI is a so-called perpetual use product with a lifetime contract that’s difficult for a member to be extricated from — and there’s no resale market that he or she could tap for cash. The mandatory five- to 10-day cooling off period after a member first signs up is the only chance a customer has for canceling the contract before entering a lasting financial commitment to Diamond. (The company has said it may make some modifications to this policy in the future.)

Diamond faces considerable challenges in selling its main product — the VOI — given the current economics of the travel industry. Travel websites and apps like, and Airbnb frequently let would-be vacationers procure the equivalent of a Diamond resort stay for less than the company’s annual VOI maintenance fees. Many Diamond resorts even allow nonmembers to reserve rooms through consumer travel sites. But when a member relies on Diamond’s financing (banks don’t do VOI financing), this can push the combined annual maintenance fee and loan-payment expense to more than $6,000, a mighty price tag for a week’s stay.

Diamond disagreed with this assessment, arguing at length that focusing solely on cost sacrifices the value of convenience and flexibility.

One fact that Diamond’s management might not dispute is the warm reception investors and brokerage analysts have bestowed thus far. Rare indeed is the brokerage analyst who has not been impressed by Diamond has sustained growth trajectory: The company booked more than $954 million in sales last year, a spike from 2012’s $391 million.

And Diamond’s share price has steadily ticked northward, from $14 during its July 2013 initial public offering to $35 a year ago. This resulted in a $2 billion market capitalization when the company’s shares reached their peak value in February 2015. For the founding management and investment group that still owns more than 35 percent of the shares outstanding, this translated into over a $600 million stake at that time.

Yet in late January, a New York Times investigation showed that some of Diamond’s rapid growth might be due to overly aggressive sales practices. The Times article roundly spooked investors and almost $300 million of market capitalization was lost for more than three weeks before Diamond’s share price recovered. In response, the company issued a press release emphasizing its “zero tolerance” policy toward misleading sales tactics.

The Southern Investigative Reporting Foundation spent two months investigating Diamond’s murky soup of public accounting and disclosures to explore the financial mechanics of the company’s success. This investigation found that the financial statements have a very large red flag.

Simply put, there are a lot of close parallels to how subprime mortgage finance companies rapidly expanded in the last decade. The most obvious similarity lies in the drive to ensure a steady stream of borrowers whose down-payment cash will keep a company operating.

Diamond faces four interconnected problems: The company cannot survive on the amount of cash sales it makes, so it needs to finance sales. Diamond has to securitize those loans to bring cash in the door or run the risk of losing money on every sale. To retain favorable terms for monetizing its debt, the company has to use its own cash to make up shortfalls in the securitization pools. Since the realized value on customers’ loans is less than the amount Diamond has borrowed against them, it needs to monetize new loans faster and faster.

Recent history suggests that the fate of a company like this is not pretty.

(In an effort to provide readers a clearer view of Diamond’s responses, the company’s replies in full to specific questions have been embedded throughout this story. Of special interest are the replies supplied on Feb. 11, Feb. 12, Feb. 16, Feb. 17 and March 4.)


Since 2011 Diamond has experienced a decline in its VOI sales to new members as a percentage of the company’s entire VOI sales (although the percentage did modestly increase last year from 2014). According to the just-filed 10-K annual report for 2015, 21 percent of last year’s VOI unit revenue came from new members. In 2011, that figure was 34 percent. What’s the reason for the broad decline? It’s not immediately clear.

Diamond dismissed a reporter’s recent question about the possibility of a decline in VOI sales to new members, citing the dollar growth of their purchases. (The estimated dollar value of new member sales did increase to about $148.1 million last year from $135 million in 2014.)

By contrast, new members at Diamond’s two biggest rivals, Marriott Vacations Worldwide and Wyndham Worldwide, accounted for 36 percent and 32 percent, respectively, of their companies’ VOI revenues last year.

Common sense would suggest that absent large blocks of new members arriving organically or through a purchase of a rival company, Diamond’s continually pushing current members to upgrade their VOIs will eventually result in diminishing returns.

In addition, the number of “owner families” has decreased in three of the past four years. As owner families drop away from Diamond, the prospect of enticing existing members to upgrade their vacation owner interest becomes threatened. Diamond stopped reporting the number of owner families in the third quarter of 2014 without notice. An archived investor-relations Web page from June 2, 2015, tallied the number of owner families at 490,000, which is a decline to the level in early 2013.

Source: Diamond Resorts SEC filings
Source: Diamond Resorts SEC filings


When asked why the company abruptly stopped disclosing the number of “owner families” in its public documents, Diamond replied that it has stopped providing the number because a large amount of its paying customers are hotel guests or use a so-called timeshare exchange network like RCI or Interval.

CEO David Palmer’s remarks about industry consolidation made during the company’s third-quarter conference call this past fall seemed to indicate that Diamond might be seeking additional acquisitions. When Diamond released its annual earnings report in late February, however, the company disclosed it had retained Centerview Partners to “explore strategic alternatives” — Wall Street shorthand for seeking a buyer.

Selling a company when its revenue grew at almost 12 percent last year and net income more than doubled is an unusual approach for a board of directors to take, especially since the shares nearly 50 percent off their highs. Managers with conviction about company prospects would ordinarily be seeking to add capital and expand the business or to borrow money to take the firm private.

Instead Diamond’s leaders seem to want an exit. What follows below is probably the reason why.

The 2015 10-K shows 82.8 percent of VOI sales had what the company calls “a financing component,” which can be compared with 38.6 percent in 2011.

Figures are expressed in thousands. Source: Diamond Resorts SEC filings
Figures are expressed in thousands.
Source: Diamond Resorts SEC filings

The trend over the second half of last year is even more pronounced: In the third quarter, customers relied on company financing for 84.3 percent of VOI purchases. And in the fourth quarter, 83.4 percent of VOI purchases were financed this way.

Why should shareholders be concerned that almost 83 percent of Diamond’s customers last year borrowed money for their week in the sun? Because the credit crisis of 2008 is evidence that consumers with high fixed-cost debt can, in the aggregate, do grave damage to a company whose sales are reliant on financing.

When one checks numbers culled from Diamond’s November securitization, it takes little imagination to see how a VOI membership can quickly turn into a dangerous burden for a consumer. Consider this: The average loan in this securitization pool is for $24,878. When that amount is coupled with an 14.31 percent interest rate for a 10-year term, this locks a member into a $391 monthly payment. That’s $4,692 annually for the member — with at least another $1,000 in annual maintenance fees. (The 2015 10-K said the average VOI transaction size in last year was $26,007 and the average down payment was 20 percent, or $5,201.)

Diamond told the Southern Investigative Reporting Foundation that these are not regulated loans like mortgages but rather so-called right-to-use contracts it described as a prepaid subscription product without a real estate component.

(It’s worth noting that several paragraphs disclosing potential risks for investors were added to Diamond’s new 10-K about the potential for expanded Consumer Financial Protection Bureau regulation of VOI sales.)

Diamond argued in its filings that other members of the VOI industry offer their customers financing. But unlike Marriott Worldwide Vacation and Wyndham Worldwide, which financed 49 percent and 61 percent of their VOI sales last year, respectively, Diamond’s customer base appears to be dependent on it.

Make no mistake: Offering customers financing of as much as 90 percent of the price of a VOI has enabled Diamond’s rapid sales growth. With the amount of cash sales a paltry 16 percent to 17 percent in the second half of last year, this kind of financing keeps a stream of money from down payments flowing.

So to ensure working capital and manage risk, Diamond set up a securitization program. Chief Financial Officer Alan Bentley explained why securitization is crucial to the company’s needs during a presentation in March 2015, shown on page 21 of the official transcript:

“If I use an example that the customer did a $20,000 transaction with us, they’ve made a 20% down payment, which means we did a $16,000 loan. . . . Well, that 50% is on the $20,000 transaction, right. So you look that and say, ‘Okay, you got — you did $20,000 deal,’ you’ve got $10,000 out of pocket because you’re paying for your marketing costs, you’re paying for your sales commissions, et cetera. So that part’s out-of-pocket. So effectively, you’re upside down. Remember, so you got $4,000 down got $10,000 out-of-pocket. So how do we monetize that and get the cash? During the quarters, what we will do is remonetize that by placing those receivables into a conduit facility. Now that conduit, of course, is we have a $200 million facility and that $200 million conduit facility is we will quarterly place those receivables into that conduit, for which we receive an 88% advance rate, right. So we get that cash back at that 88% level on that — on the conduit.”

Whatever Diamond borrows from the conduit facilities is repaid when it securitizes its receivables.

When one looks from a distance, the program seems to have put Diamond in a virtuous cycle — of issuing high-interest, high-fee loans bringing in interest income and freeing up cash for its sales force to secure additional sales.

Moreover, the bonds that emerge from these securitizations have performed well to date. Then again, they should: Diamond typically has the option to repurchase or substitute in a new loan when a loan defaults (and use its own cash to make up a shortfall). According to the Kroll Bond Rating Agency, “Diamond has historically utilized these options resulting in no defaults on their securitizations.”

These VOI loans do have one truly unusual characteristic, though: Diamond’s members are paying off the loans much faster than their rivals’ customers. Wyndham’s VOI loans are paid off on average in about four years; Diamond members are paying off their loans in about 1.4 years. (In 2011 Diamond’s members retained a loan for about 2.4 years on average.)

But the problem with virtuous cycles is that they can spin the other way, too. If there are broad economic problems, borrowers might start wrestling with job losses or wage pressures and then the speed of prepayment might sharply decline. When that happens, typically the number of loans in arrears increase. If the prepayment speeds stay lower for long enough, Diamond — which has used its own cash and fresh loans in the past to help the loans in the securitization pools avoid defaults — might have to come up with a serious cash injection.

Diamond said its asset-backed bonds are prepaid so quickly because its customers tend to make VOI purchases while on vacation and, upon returning home, quickly pay off the loans.

SIRF’s reporting, laid out in detail below, suggests an entirely different answer.

After weeks of investigation, the Southern Investigative Reporting Foundation came across an obscure accounting rule called Accounting Standards Codification Topic 978, which went into effect in December 2004, that allows Diamond — or any timeshare company — to recognize revenue from upgraded sales even if the member doesn’t put any money down. New-member sales, in contrast, are accounted for only when at least 10 percent of the VOI’s value has been received.

If ASC 978’s logic is counterintuitive to outsiders, for Diamond’s management it is surely heaven sent. On the view that a timeshare purchase is a real estate transaction, an upgrade to a vacation ownership interest is considered a “modification and continuation” of the existing sales contract.

How does this work in real life? Say a new member purchases his or her VOI for $20,000 and puts $4,000 down, a 20 percent equity stake. If six months later that member seeks to upgrade to an expanded membership level that costs $20,000 and signs a sales contract to that effect, Diamond could account for this as a sale even if no money is put down.

That 20 percent equity stake, which is really now 10 percent given the $20,000 additional financed, is all the legal cover the Diamond accountants need since the upgrade is considered a modification and continuation of the initial timeshare purchases contract. Diamond’s computers can now record a new $36,000 loan to pay off the initial $16,000 loan and book $20,000 in new revenue. This appears to be why Diamond has such high prepayment of its loans.

If the whole things seems circular, that’s because it is. A lending facility that Diamond controls loans an existing member $20,000 and it goes on the books as revenue but not a penny of cash has gone into the coffers — yet. Plus, that initial $20,000 loan is now accounted for as fully repaid even if it is not: The member still owes $36,000 plus the hefty interest rate. And it’s completely legal.

So who is responsible for this accounting stroke of genius? None other than the senior accounting staff from the timeshare industry’s leading companies who proposed this new rule in 2003.

At the very minimum, ASC 978 should give investors pause about Diamond’s quality of earnings.

When asked if the new accounting rule had spurred the high prepayment speeds of its loans, Diamond pointed to its customers’ creditworthiness as the cause.


Evidence is beginning to mount that some of Diamond’s borrowers are struggling with their obligations. Less than two weeks ago, Diamond disclosed a 45 percent increase in the amount of its provisions for uncollectible sales revenue in the fourth quarter of 2015 to $24.8 million from $17.1 million a year prior. In the company’s release, the jump was attributed to a change of certain portfolio statistics during the quarter,” suggesting some degree of credit performance woes.

The Southern Investigative Reporting Foundation asked the company to elaborate on the “certain portfolio statistics” that proved nettlesome and in a lengthy answer, it ignored the request to discuss the specific statistics behind the spike in uncollectible sales reserves but merely referenced issues that might have informed its decision.

Nor is that the only data point that suggests looming headaches. The default rate on Diamond’s loan portfolio last year was 7.7 percent, the highest the company ever reported.

Source: Diamond Resorts SEC filings
Source: Diamond Resorts SEC filings


Analyzing the health of Diamond’s loan portfolio is not a cut-and-dried exercise: Its rivals, Marriott Vacation and Wyndham Worldwide, wait 150 days and 90 days, respectively, before they charge off their bad loans; Diamond uses 180 days, a full two months longer.

Asked about why the company waits 180 days, Diamond said it’s a matter of internal policy and that there is no rule governing time frames for charging off bad loans.

The more Diamond’s securitization program has expanded, the deeper underwater the company has become. In 2011 it reported $250.9 million in securitized notes and funding capacity against $270.2 million in receivables. This means that if the company had to pay off its bonds, it had a nearly $20 million surplus of money owed it to draw upon.

As the securitization program doubled in size, however, that surplus evaporated. Last year Diamond borrowed $642.8 million against a net receivables balance of $604.5 million, amounting to a $38 million deficit. In other words, Diamond would have to come up with cash rather than substituting loans to make its bondholders whole. (The Southern Investigative Reporting Foundation excluded adjustments because they were noncash accruals and assumed that receivables that weren’t securitized have a zero net realizable value, otherwise the $38 million deficit would be greater.)

During the same five-year period, the average seasoning of loans (the amount of time that the loans are kept on Diamond’s books before they are placed in a securitization pool) dropped to three months last July from 25 months in an April 2011 offering.

Figures are expressed in thousands. Source: Diamond Resorts SEC filings
Figures are expressed in thousands. Source: Diamond Resorts SEC filings


Editor’s note: When the Southern Investigative Reporting Foundation first approached Diamond for a comment for this story by phone and email on Feb. 5, Sitrick & Co.’s Michael Sitrick responded as the company’s outside public relations adviser on Feb. 13. While his firm has a diverse and high-profile practice, Sitrick is traditionally associated with crisis communications. He also served as the outside spokesman for Brookfield Asset Management when it threatened to sue the Southern Investigative Reporting Foundation in February 2013.

Two Southern Investigative Reporting Foundation board members (while working for previous employers) have written about high-profile Sitrick & Co. clients like Biovail, Fairfax Financial Holdings and Allied Capital.

Correction: A previous version of this story mischaracterized a letter written by the VOI trade association to the Consumer Financial Protection Bureau. The related paragraph has been deleted.

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Who Owns Our Water?

Photo Credit: Rohan Ayinde Smith
Photo Credit: Rohan Ayinde Smith

This story is the result of a collaboration between the Southern Investigative Reporting Foundation and the University of North Carolina’s School of Journalism and Mass Communications’ fall 2014 advanced reporting seminar.

North Carolina is fighting a bruising legal battle against Alcoa over the aluminum giant’s claim to a strip of the Yadkin River that it has long used to generate electricity.

At the center of the dispute are a patchwork of federal and state laws that created a quid pro quo between the two: Alcoa could operate dams to make the electricity as long as whatever they did was “in the public interest.”

The public interest in this case was Alcoa’s aluminum manufacturing operations in rural Stanly County that employed thousands over the decades.

That smelter is now gone. But Alcoa still wants the right to dam the Yadkin’s water for its electricity trading operations. The battle, in other words, stems from North Carolina’s refusal to accept that what the law defines as “in the public interest” has changed. In Stanly County, Alcoa was once a factory that turned rural farmland into a middle-class city. Now, it’s another company that sent its jobs overseas.

Alcoa abandoned Stanly County. But it still wants to use the region’s biggest resource: its water.

Whenever Judge Terrence W. Boyle hands down his decision in his Raleigh courtroom, either the state or Alcoa will have control over an asset that will put a lot of money in someone’s pocket.

A lot of eyes are watching this case. Not all of them call the Tar Heel State home. If Alcoa prevails, corporations around the country litigating similar disputes will have a powerful new federal precedent to wield in the argument over a question that few people ever think to ask: “Who owns our water?”

A high-profile divorce

For several generations, North Carolina and Alcoa had an arrangement benefiting both equally.

A state that had yet to shed its backwoods roots got the jobs and tax dollars that flowed from Alcoa’s smelter in Badin, a rural town in the Piedmont whose economy boomed as demand for aluminum soared. In turn, Badin became a company town that would never have existed if not for Alcoa.

“Alcoa built everything in the town,” said David Summerlin, chairman of the Badin Museum. “They built it all. Every kind of business was there. I mean, it was just a boomtown.”

In exchange, in 1958, the state strongly supported Alcoa’s first bid to operate a series of four dams on the Yadkin, helping convince the Federal Power Commission (now the Federal Energy Regulatory Commission) that the proposal was in the public interest.

When the FPC issued the hydropower license in February of 1958, the concept of public interest was effectively defined as Alcoa’s manufacturing operations: “The operations of  [Alcoa] are a useful contribution to the industrial life of the Yadkin Valley and their continuation is greatly in the public interest.”

The Yadkin was any chief executive’s answered prayer: water — free and bearing little regulatory burden — providing the basis for cheap power to offset the cost of the energy-intensive smelting process; making aluminum is a competitive business and saving millions of dollars in energy costs helped the bottom line of a company that for decades was a mainstay of the American economy.

But the marriage began to crumble in 2002 when Alcoa idled the smelter. In 2007, the factory shut down and in 2010 word came down from corporate headquarters on New York City’s Park Avenue to dismantle it.

Now that Alcoa is seeking a new license to continue operating its dams for another half-century, its longtime ally has switched sides.

‘Why are we poor?’

Like many divorces, what matters is how the judge divides assets and arranges custody, and the real story isn’t found in legal claims and courtroom motions.

In this case, it’s the residents of Stanly County who have the most to say about life after Alcoa and they spin a classic before-and-after tale.

In the early years of the North Carolina-Alcoa relationship, the jobs from the smelter and its supporting industry turned the town of Badin into a regional economic powerhouse.

Workers flocked in and the influx transformed a small farming town into a middle-class community. With the plant running full bore, no one fussed about air and water quality when residents had enough income to buy a second car or send their kids to college in Chapel Hill.

And then, in a plotline many American towns know too well, the allure of lower wages and less regulation elsewhere drew Alcoa to ship jobs overseas in the early 2000s — a move aided by incentives from foreign governments that promised what Raleigh could not. By April 2010, with the plant officially closed aluminum had become to Badin what tobacco was to Winston-Salem.

With only 26 full time Alcoa employees remain and another 14 full- and part-time contractors, the shuttered factory on N.C. 740 became an unplanned memorial to a way of life, something young people would pass on their way out of Badin for good.

“If you’re a young person and your family doesn’t have a business here, you leave,” said Better Badin’s Bill Harwood. “We just don’t have anything going on here.”

So, when Alcoa sells its juice on the wholesale market, turning a multi-million dollar profit using water it doesn’t have to pay for, that rankles some who are living Badin’s woes.

Roger Dick, who grew up in Badin and now owns a chain of community banks in the area, is adamant the dams would benefit the region more in the hands of the state.

“If you sit it an area that is rich in oil resources but it’s poor, wouldn’t you say, ‘What in the hell is going on?’” he said.

“So here we are. We’re rich in water. We’re told it’s the oil of the 21st century. But look at this place. Why are we poor?”

Photo credit: Rohan Ayinde Smith

Turning water into gold

With the smelter gone, the state’s argument is that “the public interest” went with it.

Shortly after the plant was shut, North Carolina began flexing its regulatory muscles in a way that would have been virtually unimaginable a few years earlier. In December 2010, the North Carolina Department of Environment and Natural Resources, during its annual review of Alcoa’s compliance with state water quality laws, revoked a key certificate necessary for relicensing when emails emerged showing Alcoa officials acknowledging frequent, undisclosed difficulties meeting state standards for dissolved oxygen levels. (Alcoa appealed the ruling and was granted the certificate; it currently operates the dams on a yearly license.)

A longstanding cornerstone of central North Carolina’s economy, Alcoa contends that it has done so much for the state — and is continuing to do so. The company argues in legal filings that the riverbed is practically private, pointing out that it has purchased most of the land surrounding its Badin Works facilities.

Alcoa points to a 2008 FERC ruling in defending the public benefit of its relicensing application, including the renewable, low-emission nature of its energy and that the environmental measures then suggested by FERC — if implemented — would provide the public lasting benefit. (Read Alcoa’s full response to the Southern Investigative Reporting Foundation’s question about public interest.)

Nor is Alcoa shy about framing a narrative of a government bent on usurping private property — albeit one in which a demonstrably right-wing, pro-private enterprise governor authorized the litigation.

“I don’t think North Carolina wants to be known as the state that takes private property,” said Alcoa’s relicensing manager, Ray Barham. “If you cave in and roll over because some government wants your property, it sets a dangerous precedent.” (In response  to the Investigative Reporting Foundation’s questions, Alcoa said that it paid more than $1.15 million in local property taxes in 2013 in addition to $163,000 in state taxes.)

Arguments notwithstanding, spending a few minutes in Alcoa’s public filings show why this fight is going to get bitter: Whoever holds the license to convert the Yadkin’s water into hydroelectric power has a small fortune in their back pocket.

According to filings from 2008 to 2010, Alcoa’s Yadkin Project is remarkably profitable, sporting a 26 percent net margin in those years. For context, Alcoa’s earnings during the same period carried a 1.2 percent net margin. Moreover, when the paper (or non-cash) expenses of depreciation and amortization are added back to net income, a truer sense of the Yadkin Project’s cash generating power emerges. In 2010, for example, almost $11.5 million in cash was created from just over $31 million in sales. Alcoa declined SIRF’s request to provide updated annual operating figures for Alcoa Power Generating Inc. but said its “recent operating costs and profits are consistent with the information released in 2008-2010.”

Handsome short-term profits aren’t Alcoa’s only option, however. Should it get a new license, it could sell it (and the dams) to the highest bidder, perhaps fetching upwards of $700 million. That’s precisely what Alcoa did in 2012 when it took in $600 million from the sale of a series of similar dams in western North Carolina and eastern Tennessee to Brookfield Asset Management. Asked for comment about possibly selling APGI and its license, Alcoa declined to comment, stating it won’t “speculate on potential asset sales.”

(Brookfield Asset Management has also been a subject of the Southern Investigative Reporting Foundation’s reporting.)

According to Alcoa, about 54 percent of the electricity generated from the Yadkin stays in North Carolina, including sales to Duke Energy. Based on references buried in various filings, it appears the majority of the rest of the production is sold into the Pennsylvania-New Jersey-Maryland power pool because it tends to get higher prices. (Selling into the PJM pool is attractive for Alcoa because it can also sell renewable energy credits associated with the Yadkin’s hydropower production in some of those state’s programs.)

Better Badin’s Harwood – -a supporter of Alcoa’s bid — says he feels the company’s ownership of that section of the Yadkin is already a reality.

“I’m a citizen of North Carolina, and I don’t feel like I own any of it,” he said. “Alcoa bought it, Alcoa paid for it.”

The head of Badin’s museum, David Summerlin, added, “I already know when they get their license they’ll sell the dams. That’s the opinion of everyone that’s here.”

The recapture battle

One of those out-of-staters watching the Raleigh courtroom and its blizzard of legal filings closely is a lawyer named Curt Whittaker, who says Alcoa’s strategy is clear enough to see.

“Allowing Alcoa to relicense means that an asset designed for the public interest is now close to being used or sold at the expense of the public’s interest,” said Whittaker, general counsel for New Energy Capital Partners LLC, a New Hampshire-based private-equity firm that takes equity stakes in renewable energy projects.

Whittaker and his colleagues have petitioned the Federal Energy Regulatory Commission to reopen the bidding process for the Yadkin Project assets in the hopes of eventually operating the dams themselves. (The fund’s initial petition was rejected but they have filed an appeal.)

“Whether [Alcoa] holds or sells [the license], I’m not sure it really matters since it’s clear that apart from small payments or commitments here or there, the state of North Carolina is getting nowhere near fair value for public assets,” said Whittaker. “The profits go directly to the private sector, which is entirely apart from the law’s intent.”

The law Whittaker cites is the Federal Water Power Act of 1920. While it has been amended repeatedly, its essential nature remains unchanged: to regulate and encourage the development of hydroelectric power. The law — now known as FPA Part I — argues that since hydropower uses water from rivers and lakes, a public asset overseen by state governments, a hydropower project must maximize its return to the public.

Given the considerable outlays involved in building dams, licenses are awarded for 40- and 50-year terms to allow the holders time to profit from their investments.

This is not the first time that Alcoa has labored mightily to obtain a recertification to operate dams. In its 2004 bid to relicense the Tapoco hydropower project in eastern Tennessee and western North Carolina, Alcoa argued in filings that, over the 40-year term of the license, it would spend upwards of $100 million in improvements for a project that it estimated created $400 million in economic value for the Knoxville, Tennessee, area and was an important component of Alcoa’s corporate plans.

But by 2010 the smelter was shut and in 2012 Alcoa sold the Tapoco hydropower project. The project’s four generating stations and dams had become “non-core assets,” according to its press release announcing the sale.

In other words, Alcoa is fighting mighty hard to keep the type of asset it has told shareholders is not integral to its long term plans.

Proof that both sides are playing for keeps was seen in a November courtroom hearing when lawyers for both sides took a deep dive into long forgotten statutes, yellowing deeds and bills of sale from the 19th century to support positions on the Yadkin’s navigability and, ultimately, riverbed ownership. The two concepts are intertwined: Should that section of the Yadkin be found navigable, as the state asserts, then Alcoa’s claims are in trouble. Alternately, under North Carolina law, non-navigable rivers can be subject to private ownership.

(In November, Judge Boyle denied Alcoa’s motion for summary judgement, noting there were “genuine issue of material fact” about the Yadkin’s navigability; he also denied several motions by the state. A trial date hasn’t been set.)

Ground zero of the debate is likely to center on interpretations of the Federal Power Act’s recapture provisions, a section of the law that has never been used to reclaim control over a water resource. The rules may be musty but they read plainly enough: When the federal government first granted hydropower access to Alcoa, it clearly delineated its authority to take those rights back after the license expired.

“Under Section 14 of the Act, any project may be ‘recaptured’ at the expiration of the license term,” the Federal Power Commission’s brief reads. “In formulating its plans, therefore, the management of [Alcoa] could not rely upon any assured source of power supply after the expiration of its license for the Yadkin Project.”

To one veteran Republican state senator, Cabarrus’ Fletcher Hartsell, recapturing the Yadkin raised concerns that the state might be overstepping its powers. In an exchange of letters in June 2010 with the state’s Department of Justice, Hartsell expressed concerns about avoiding an infringement of Alcoa’s Fifth Amendment rights. At the same time, however, he also wanted to make sure the state would not be paying through the nose for rights to the river.

The state’s Justice Department issued a swift reply:

“The recapture of the Project by the United States Government would not constitute a taking of the Project licensee’s private property,” the state’s response read. “Following the recapture of the Project . . . the state will not be liable to pay the current Project licensee for the profits that it would have or might have earned on the operation of the Project in the future if the Project had not been recaptured.”

An environmental law analyst said the process of recapture is not so cut and dry as the state is making it out to be.

Heather Payne, a research fellow at the Center for Law, Environment, Adaptation and Resources at the University of North Carolina School of Law, said it will be a long and costly process for the state to take the license because it will have to prove eminent domain — the idea that the state has the power to take private property for public use.

It also won’t be cheap. Eminent domain requires the government to justly compensate the owner of the private property, meaning North Carolina will have to appraise the dams and their surrounding land to pay Alcoa. In 2006, as part of a requirement for its relicensing bid, Alcoa disclosed that the then fair value of the project was just under $137.5 million, representing the amount the federal government would have to pay the company “upon expiration of its license.”

Payne said the state will also have to demonstrate that it could operate the dams better than Alcoa.

Local heroes

In Badin, Roger Dick’s views skeptical of Alcoa and its promises are in the minority, angering some of his neighbors so much he said he’s been called a Communist.

Not shy about couching this as a David vs. Goliath fight, Dick said, “We’re no longer barefooted. We’re no longer yeoman farmers. We can read. [Alcoa has] divided this community by telling [its] retirees and a lot of friends that we’re taking your private property. We’ve got a public document that we can show you and the world, that you know that’s not true. You know that’s not true.”

He wasn’t completely alone, at least initially.

At first, Stanly County’s Board of Commissioners vocally opposed Alcoa renewing its water quality certificate with the N.C. Department of Environment and Natural Resources — a required step for Alcoa’s relicensing efforts. But in May 2013, county leaders backpedaled with the Commissioners voting 3-2 to approve a settlement with the company. What changed? Alcoa made it worth their while. By agreeing to support the company’s bid, Stanly County was given $3 million in cash, access to 30 million gallons of water per day and 20 acres of land for a water treatment plant.

One of the two dissenting commissioners, Lindsey Dunevant, read a statement before the vote that recounted Stanly County’s “long, hard, uphill battle” to reclaim “what legally belongs to the people,” according to minutes of the May 6, 2013 meeting.

Dick’s assertion that North Carolina could benefit from controlling the Yadkin is not unfounded, according to Michael Shuman, an economist hired by Central Park NC, an environmental advocacy organization that participated in relicensing settlement agreement negotiations with but ultimately refused to sign off on it.

Shuman examined the prospective economic benefits of recapturing the water rights to the Yadkin, concluding the state stood to gain a potential $1.2 billion in additional revenues and between 14,000 and 75,000 jobs if it received the standard 50-year license to operate Alcoa’s hydroelectric facilities.

Alcoa is hardly back on its heels, however.

To win hearts and minds, the company went straight to the grassroots, making a multi-year effort to sway local communities to their side, getting counties, state regulators, a business group, a local realtors association and some 20 other stakeholders to sign a settlement agreement. As part of the deal, in exchange for the coalition’s support for a new license, Alcoa promised to implement measures aimed at protecting land and habitat, improving water quality and enhancing recreational opportunities along the river.

Badin, too, is slated to receive some benefits if Alcoa wins another license. The company has promised the town 14 acres along the Badin Lake waterfront, land that its leaders hope to turn into a public park.

Many in Badin project a deep-seated loyalty toward Alcoa, and ex-workers still call themselves “Alcoans.” Some of this is because of a skepticism of government activism ingrained in a politically conservative area. But it’s also because Badin is Alcoa for most residents over the age of 40.

“If the truth comes out, they’ll get the license, and they’ll get it for 40 or 50 years, and we’ll get on about business,” said Badin Mayor Jim Harrison. “They’ve been good stewards of the land; they’ve fixed every complaint that anybody’s had.”

Alcoa has long pumped money into local charities and donated the house that now serves as the Badin Museum. Since the plant closing, Alcoa has expanded these efforts to include joining forces with its old foe Stanly County to recruit industry and spent $15 million turning the site of its old plant into 700,000 square feet of prime industrial space.

The city of Albemarle, seven miles south of Badin, reached its own deal. City Manager Raymond Allen said the town will receive access to water as a back-up to the region’s local drinking supply, a promise from Alcoa to install expensive water filtration technology on its dams and a donation of land from Alcoa to both Morrow Mountain State Park in Albemarle and the Land Trust of Central North Carolina.

Photo credit: Rohan Ayinde Smith

Allen said climate change and harsh droughts are areas of concern for his city.

“So, basically, they have protected our ability to supply drinking water to our customers in this region during periods of extreme drought,” Allen said. (Albemarle has paid Alcoa roughly $15,000 annually for water.)

The access to water is especially important, Allen said, because Albemarle is concerned about being able to meet water demand as the effects from climate change set in.

One of the big concerns about private control of the water is that the license holder could regulate water flows. Alcoa’s relicensing manager Ray Barham acknowledged the fears exist, but said federal regulators can require Alcoa to provide water access.

“There’s not a lot of facts to the argument that we can restrict water,” he said. “It resonates fears with people.”

David Moreau, a research professor at the University of North Carolina at Chapel Hill’s Department of City and Regional Planning, takes a middle route, saying the Yadkin could become an important source of water if the Piedmont population grows as expected.

But he also said that it does not matter whether the river is in public or private hands, as long as the license allows the water to be reallocated to public use once demand rises.

“As long as there are provisions in the FERC [license] that permit the ready transfer of water from hydropower to the urban water supply, then I don’t have much problem with Alcoa continuing to own the system,” he said.

Long-buried problems surface again

The possible environmental repercussions of 50 years of aluminum smelting on Badin’s soil and water, perhaps one of the least debated components of Alcoa’s presence, may prove to be the most lasting of all.

At the center of the issue is how decades worth of so-called spent pot linings from aluminum pots were disposed in and around Badin. In 1988, the Environmental Protection Agency classified spent pot lining as toxic.

(Aluminum is smelted, or extracted, from alumina in pots. During the process, which takes several years, toxic fluoride and cyanide contaminates the used pot linings.)

In Alcoa’s case, there has not been a public accounting of where the Badin smelter’s tons of pot lining were disposed of prior to 1988, according to a Yadkin Riverkeeper letter in October to a regional EPA supervisor, asking for a preliminary assessment of Alcoa’s site. The Yadkin Riverkeeper has joined the state in suing Alcoa, arguing that the river is a public trust.

Of particular note are the higher levels of aluminum-related carcinogens and toxins the Riverkeeper’s team claimed they recently found in a drainage area attached to a ball field that Alcoa recently donated to the town. (The EPA, which had a year to respond to the Yadkin Riverkeeper request, responded in 25 days and agreed to start preliminary assessments. Ryke Longest, the Duke Environmental Law Clinic lawyer representing the Yadkin Riverkeeper, said he was stunned by the EPA’s “unusually quick” response.)

That Badin might have extensive contamination is hardly surprising: As far back as 1992, Alcoa was preparing for a major cleanup at Badin when it filed suit against its insurers seeking coverage for the cost of pollution damage, investigation and remediation at its 35 manufacturing sites around the United States. At three of those sites, including Badin, Alcoa had estimated the covered claims would exceed $50 million.

The land and the water around other two sites — in Texas and upstate New York — were designated EPA Superfund sites; Alcoa, per the North Carolina Department of Environmental Regulation, was allowed to conduct its own cleanup. The company didn’t break any speed records in getting a corrective action plan proposal (as mandated under the Resource Conservation and Recovery Act of 1976) to the state, submitting it in 2012, nearly 21 years after the initial investigation uncovered the problem.

The Alcoa plans propose fencing off certain areas and instituting regular monitoring over actual clean up. Asked about this, Alcoa said North Carolina’s Department of Environment and Natural Resources conducted more than “100 studies and reports” into its environmental practices at Badin and determined what was necessary to remediate the site and the company executed these directives. (View Alcoa response to questions from the Southern Investigative Reporting Foundation.)

“As we tested, we found some information that tended to show contamination,” Longest said. “We also found some materials, just visually, that don’t look like they in any way, shape or form belong where they are found,” Longest added.

“Obviously, there’s going to be costs imposed to clean up this water body,” he said. “If the polluter doesn’t pay, then all the rest of us do.”

Alcoa’s Barham said the company has spent more than $12 million on cleanup, a far cry from the $50 million estimated in 1992; conversely, it has spent nearly $23 million on its relicensing bid. He said their costs today are associated with simply monitoring and sampling. Linking cleanup and relicensing is unfair, Alcoa argued in a statement, as the two issues are entirely unrelated. Moreover, according to a statement provided SIRF, the state’s attempt to “take Alcoa’s property” has delayed a planned water quality improvement plan worth up to $80 million.

“We understand where everything is, and it’s being monitored,” Barham said. “There’s this misconception that we’ve got this environmental issue that we have to clean up, but there’s nothing left to do.”

But Barham said he doesn’t think the site meets the requirements to be deemed a Superfund site, arguing that most bodies of water had some level of PCBs or other pollutants and Alcoa couldn’t be blamed for every trace detected.

“If you look at the times we’re below [the state’s dissolved oxygen levels, the minimum standard of which is four parts per liter], most are at 3.99, 3.98,” Barham said. “Does a fish really know the difference between 3.98 and 4.0? It probably doesn’t.”


Officials for government agencies involved in this dispute, such as the North Carolina Department of Administration and FERC, declined comment, citing the ongoing litigation.

Calls for comment to the North Carolina Department of Environment and Natural Resources were not returned.

Fitzpatrick Communications, an outside public relations counsel for Alcoa, provided the responses to the Southern Investigative Reporting Foundation’s questions.

(View all of the questions posed and the responses.)

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Disclosure Diligence

Brookfield Asset Management’s disclosure practices have raised regulatory eyebrows before.

In a nine-page June 10, 2009, letter, the Securities and Exchange Commission raised with Brookfield a laundry list of concerns it had about Brookfield Asset Management’s home building subsidiary Brookfield Homes, requesting more detailed disclosure.

One issue was the Brookfield’s failure to disclose that Craig Laurie, Brookfield Homes’ chief financial officer, had also been serving as the CFO of Crystal River Capital, a company that was then being managed by another Brookfield Asset Management unit.

Brookfield Homes replied two weeks later, and among other things, agreed to disclose Laurie’s dual role. In 2011, Brookfield Homes became Brookfield Residential Properties.


For more coverage of Brookfield Asset Management, read “The Paper World of Brookfield Asset Management.”

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Northern Exposure

Beginning at about 9 a.m. on Jan. 24, 1996, in the offices of the Toronto law firm of Tory Tory DesLauriers & Binnington, a combative former Ontario Securities Commission regulator named Joseph Groia made a small piece of Canadian legal history by deposing a native South African named Jack Lorne Cockwell. Though not a shy man, the 55-year-old Cockwell had thus far achieved astounding career success, due in some measure, to avoiding people like Joe Groia.

Though Cockwell invariably bore impressively nondescript titles like vice chairman and took pains to keep out of the limelight, he had been chief strategist of the Edper Group and the architect of its constellation of nearly 360 separate subsidiaries. He had not been alone; he built a small band of intensely loyal colleagues who shared his singular view of business. Though Edper became many things over the years of its operation from the late 1960s to the mid-1990s, it began as a sleepy holding company for the shareholdings of its two original owners, Edward and Peter Bronfman, the scions of the Seagram’s liquor fortune.

The combination of the Bronfmans’ capital and the ruthless intelligence and vision of Cockwell’s team proved unstoppable and Canada’s business firmament bent before it. By the late 1980s, Edper controlled an empire that included everything from Labatt brewing company, Brazil’s largest utility, huge real estate holdings, the Toronto Blue Jays and mining giant Noranda.

Edper was no ordinary company by any measurement, in any era: At points in the late 1980s, nearly 15 percent of the Toronto Stock Exchange’s daily trading volume involved the shares of its various subsidiaries and more than 110,000 people drew their paycheck from one of its companies.

It had not ended as planned, however. After the debt crisis of 1989, Edper’s spiderweb structure, in which every unit seemingly owned the debt or the preferred shares of another, underwent a sudden rapid shift away from the diversified conglomerate model. By February 1993 its stakes in Labatt and pulp and paper giant MacMillan Bloedel were sold off in a single night in what Canadian business reporters took to calling “the great Edper lawn sale.”

Yet despite losing 90 percent of its market capitalization from 1989 to 1993, Edper survived. Emerging unscathed, Cockwell folded many of the company’s assets into Brascan, an already asset-rich Brazilian subsidiary. After a series of asset transfers, a newer, more streamlined company surfaced in 2005. The company, based in Toronto’s tony Brookfield Plaza, was renamed Brookfield Asset Management.

Groia’s deposition of Cockwell concerned the matter of Lionel Conacher’s case against Hees International Bancorp, which was one of the central components of Edper’s empire. Like all such cases, sharply divergent viewpoints came into play: Lionel Conacher, a Dartmouth College–educated former Citicorp banker, had been hired by Hees International Bancorp as assistant treasurer.

Conacher argued that Hees had failed to honor a key compensation clause and left him with worthless options, and Hees (represented by Cockwell) defended the company’s actions as proper and just. The merits of Conacher’s claim soon became secondary to what was uncovered during discovery: how Edper really worked.

Behind the corporate facade and the track record of success lay Edper’s universe of related-party deals and a nonstop continuum of managerial investments into or out of subsidiaries. Publicly, Cockwell and his colleagues proclaimed the benefits of having managers with a personal stake in their businesses; privately, the reality was often different.

The complexity of the effort is astounding. According to Conacher’s sworn affidavit, he and his Edper colleagues set up private investment companies that issued preferred shares to investment vehicles controlled by senior Edper managers like Cockwell’s brother Ian. Such managers then used the proceeds to buy shares in a subsidiary of a private holding company of Edper, which in turn held a mix of public and private shares in other Edper entities. Depending on the cash needs of management, the publicly held Hees could act as a financial intermediary, buying back shares or providing loans.

At the center of this whirlwind of loans and secret deals was Jack Cockwell and a small group of senior Edper executives. They held shares in Partners Holdings Inc., which Conacher described as a “financial partner with Peter Bronfman in the control of the Edper group.” And there was another layer: Quadco, a company that appeared to hold a controlling interest in Partners Holdings Inc., which was a partnership between the two Cockwell brothers and two other long-serving Edper executives, Tim Price and David Kerr.

The filings also disclosed an August 1993 deal involving Hees subsidiary Great Lakes Holdings and designed to help relieve some of the financial pressure on Hees executives as a result of loans they had assumed to buy stock in Hees or its subsidiaries. That August Hees allowed executives like Conacher to purchase shares at 50 Canadian cents and bought them back six months later in February 1994 at CA$7.04. The loan to purchase the shares came from Cockwell’s private management company and the more than CA$563,000 in proceeds from the Great Lakes trade were used to pay off a bank that wanted back the money it had loaned Conacher.

Roughly 10 million Canadian dollars in shareholder cash were transferred to Hees executives to pay off loans they had taken to participate in various equity investments.

Lurking within the Hees-Great Lakes Holdings deal was the real threat — one posed by the massive web of undisclosed private guarantees to a series of otherwise healthy operating companies, with Hees using public capital to stave off private risk.

After some additional legal wrangling, Conacher reached an out-of-court settlement with his former business associates within the year; the terms were never disclosed. Conacher, reached at his new employer, Roth Capital Markets, declined comment.


For more coverage of Brookfield Asset Management, read “The Paper World of Brookfield Asset Management.”

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A Rousing Relationship

A series of transactions beginning last winter involving Brookfield Asset Management and Rouse Properties (a New York-based mall developer in which Brookfield has a substantial investment) illustrates how complex financial moves with related parties can prove remarkably advantageous.

The backstory: Rouse Properties, a developer of Class B malls (a real estate industry term referring to malls that are nondominant competitors in their region, with sales of less than $400 a square foot), was spun out of General Growth Properties in August 2011.

In February 2012, Rouse conducted an unusual $200 million stock purchase rights offering, whereby existing shareholders were given the opportunity to “subscribe,” or buy, shares at $15 for one month when the shares were trading around $13.75. (Rights offerings are usually offered at a slight discount to the prevailing share price to motivate shareholders to participate without diluting their stake.)

Lasting a month, Rouse’s rights offering never reached the $15 level but instead of the embarrassment of a failed deal — less than 15 percent of Rouse’s non-Brookfield shareholders participated in the offering — Rouse got its money. That’s because Brookfield “backstopped” (or guaranteed) the completion of the deal — for a $6 million fee. After the deal was done in March 2012, Brookfield owned an additional 11.35 million shares, taking its stake in Rouse from 37 percent to 54 percent, giving it effective control over the company. Of note, Brookfield was able to do this without paying a control premium to Rouse’s investors.

Shortly after the rights offering was closed, Brookfield and Rouse engaged in a series of transactions that seem to show how Brookfield obtained a large block of Rouse shares by spending only $13.7 million.

It began January of last year, when $150 million of the cash Rouse raised was transferred to a wholly owned Brookfield subsidiary, Brookfield U.S. Holdings, that pays Rouse an annual floating interest rate of Libor plus 1.05 percent. According to Rouse’s filing, this was structured as a demand deposit due to mature on Feb. 14 of this year. No reason was given in either company’s filings for making the demand deposit at BBB-rated Brookfield as opposed to a traditional bank, like A-rated J.P. Morgan.

At the same time, Rouse opened a $100 million credit line with Brookfield U.S. Holdings that costs Libor plus 8.5 percent, plus a onetime initiation fee of $500,000, and had made $250,000 in interest payments through the third quarter. To date, the credit line does not appear to have been touched.

Visually, the cash transfers look like the list on the chart, below:


For more coverage of Brookfield Asset Management, read “The Paper World of Brookfield Asset Management.”