Private investment fund managers are acutely aware of the SEC’s increased efforts over the past few years to target deceptive practices of non-public alternative investments. In particular, the SEC’s Office of Compliance Inspections and Examinations has targeted hidden fees and commissions, the calculation (or miscalculation) of expenses and the application of expense offsets, and has levied fines against some of the major industry players as part of an effort to bring transparency to private equity and hedge funds. While the industry has met this effort with more detailed disclosures to investors in the form of private placement memoranda, at least one state has determined that the SEC’s efforts have not gone far enough.
AB-2833 (the “Bill”) was introduced to the California legislature this year by State Treasurer John Chiang. If passed, the Bill would mandate that all California public retirement systems require each alternative investment fund in which the retirement system invests to make annual disclosures of fees and expenses charged the retirement system, and that the fund publicly disclose such information on an annual basis at an open meeting. The Bill has passed the California Assembly with no opposition and on June 9 was forwarded to the California Senate Public Employment and Retirement Committee for review.
There has been no organized opposition to the Bill thus far, which is surprising given the aggressive stance that private equity and hedge fund managers normally take with respect to increased reporting requirements about their fees. Should the legislation pass, it may decrease the number of alternative investment vehicles available to California pension plans, thereby potentially negatively impacting returns. But, such a result likely would be only a temporary concern, as it will be difficult for investment managers to pass up on offerings to the enormous California public pension market.
AB-2833 requires certain private partnerships in which California public pension plans invest to make the following annual disclosures on forms adopted by the plans:
(1) The fees and expenses that the retirement system pays directly to the alternative investment vehicle, the fund manager, or related parties.
(2) The fees and expenses not included in paragraph (1) that are paid from the alternative investment vehicle, including carried interest, to the fund manager or related parties.
(3) The fees and expenses paid by the portfolio positions held within the alternative investment vehicle to the fund manager or related parties.
(4) The gross and net rate of return of each alternative investment vehicle since inception.
(5) Any additional information described in subdivision (b) of Section 6254.26 (basic information concerning the investment typically disclosed by public plans).
The Bill currently requires such disclosures be made by private equity, venture, hedge and absolute return funds (and since closed-end real estate and a wide variety of other partnerships can be characterized as “private equity,” they too may be required to make the subject disclosures).
Passage of the Bill would create additional administrative burdens for plan investment staff with respect to requesting, analyzing and disclosing the information. One commentator and a former board member of CalPERS reviewing the Bill contends that public plan boards owe fiduciary duties to ensure that investment expenses are in all instances reasonable. Supporting this contention, the reviewer claims that Article XVI, Section 17(b) of the California State Constitution expressly requires an analysis of the reasonableness of such expenses and that that a failure to ascertain what such expenses entail is tantamount to a breach of such fiduciary duty. Section 17(b) of the State Constitution provides as follows:
(b) The members of the retirement board of a public pension or retirement system shall discharge their duties with respect to the system solely in the interest of, and for the exclusive purposes of providing benefits to, participants and their beneficiaries, minimizing employer contributions thereto, and defraying reasonable expenses of administering the system. A retirement board’s duty to its participants and their beneficiaries shall take precedence over any other duty. (Emphasis added.)
While Section 17(b) mandates in part that board members’ duties include defraying reasonable administration expenses, unlike the commentator, we do not view that language in a vacuum. One case in point is Bandt v. Board of Retirement, San Diego County Employees Retirement Association, 136 Cal. App. 4th 140, 38 Cal. Rptr. 3d 544 (2006), which interpreted Section 17(b), supports our contention for a more balanced approach.
Bandt decided whether the board of trustees (“Board”) of the San Diego County Employees Retirement Association (“SDCERA”) violated its fiduciary duties by mandating an interim valuation of unfunded accrued actuarial liability (“UAAL”), which it sought after a voluntary payment by the County of $550 million, which represented the proceeds from the County’s issuance of pension obligation bonds. The Plaintiffs contended that since the Board was not under an obligation to undertake an interim valuation, it should not have done so. The interim valuation had the effect of reducing employer contributions, due to the inflow into the SDCERA’s fund, of the $550 million. Plaintiffs contended that under Section 17(b) the Board was obligated to fund as much as possible for its plan participants and could have relied on the prior valuation’s employer contribution levels and waited to adjust employer contributions until such time as the next annual valuation of UAAL was required.
A battle then ensued as to which of the numerous duties described in Section 17(b) had precedence—whether such duties shared equal priority or whether the duties to participants and beneficiaries took precedence. The Bandt court determined that the constitutional provision was ambiguous as to the manner in which the duties set forth therein must be prioritized (i.e., whether the duties were equal in priority or whether the last sentence made duties to plan beneficiaries paramount). While the analysis of the fiduciary duty of “defraying reasonable expenses” (which is the duty that proponents of AB-2833 contend mandates the new disclosures contained in the Bill) was not at issue in Bandt, the case is still instructive as to the Court’s interpretation of the constitutional provision as a whole.
In interpreting the provision, the Bandt court looked at the Ballot Arguments provided with respect to Proposition 162, passed in 1992, which established Section 17(b). Citing a couple of additional cases construing the provision, the Bandt court determined that the intent of Proposition 162 was to insulate the administration of retirement systems from oversight and control of legislative and executive authorities, and in particular to protect against raids by the legislative and executive branches of government in order to provide for balanced budgets. Based on the foregoing, the Bandt court assumed that the SDCERA Board had a paramount duty to act in the interests of its members and that this duty would be given precedence over the other duties of the Board mandated by Section 17(b). The Bandt court also suggested that one possible standard for determining whether the Board’s action was in the interests of its plan participants might be drawn from the law of corporate governance, which prohibits a court from substituting its business judgment for that of a corporation’s board of directors where the board’s actions are made in good faith, with a view to the best interests of the corporation and its shareholders. The Bandt court held that even assuming the strongest arguments propounded by the Plaintiffs, the SDCERA Board was within its constitutional rights to exercise its judgment as to the time period in which UAAL may be amortized and that no constitutional principle barred its recognition of a voluntary contribution to the pension fund.
The Court’s analysis above is dicta, but it is apparent from the decision that that Bandt court likely would construe Section 17(b) to hold that while the duty to plan participants and their beneficiaries is paramount, a board has wide latitude in decision-making with respect to the exercise of that duty, so long as such decisions are made in good faith with a view to the best interests of the plan participants, beneficiaries and the plan.
We glean from the foregoing that while Article XVI, Section 17(b) of the California Constitution requires trustees to make investment decisions in the interests of plan participants and beneficiaries, and while fees paid in connection with an investment are important factors to determine an investment’s merit, in the absence of AB-2833, we believe the California courts would be reluctant to mandate the sorts of disclosures required by the Bill. However, the passage of AB-2833, which will mandate such inquiry and reporting concerning expenses, may render moot a large part of the controversy arising from whether a fiduciary duty to defray reasonable expenses trumps other fiduciary duties to which a board is obliged to follow. Assuming the Bill’s passage, California boards and their investment staff will be left to determine what to do with the fee and expense information disclosed, as the Bill does not currently mandate any analysis or set any guidelines concerning the reasonableness of expenses disclosed by investment managers. That issue will be left for another day.
With respect to public plans outside of California, the disclosures required by the Bill may be a harbinger for transparency in other jurisdictions. If the Bill becomes law, we anticipate that advocates of tighter scrutiny of public plans will want to enact versions of AB-2833 in their states. Since investment managers will be providing information to California plans, it should not be difficult for them to duplicate such information for use by other investors. Accordingly, even before enactment of clones of AB-2833 in jurisdictions other than California, it may make sense for plans outside of California to demand the disclosures required by AB-2833 in their investment side letters.
If your organization has questions regarding the California Bill AB-2833, the SEC’s efforts in targeting deceptive practices of non-public alternative investments, or other public pension and alternative investment issues, please contact your Kutak Rock attorney, the authors of this article listed below, or other members of our National Pension Practice Group.