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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.)