P.O. Box 942701
Sacramento, CA 94229-2707\1
Telecommunications Device for the Deaf - (916) 326-3240
(916) 326-3825, FAX (916) 326-3641
November 1, 1999
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549
Also filed via email@example.com
Re: Proposed Rule on Political Contributions by Certain Investment Advisers
File No. S7-19-99
Dear Mr. Katz:
On behalf of the Board of Administration ("Board") of the California Public Employees' Retirement System ("CalPERS"), I am pleased to submit this letter in response to the Commission's request for comments on a proposed new rule ("Proposed Rule") addressing "pay to play" practices in the investment adviser industry.1 The Proposed Rule is set forth in Release No. IA-1812 (August 4, 1999) ("the Release").
As the Commission acknowledged in the Release, the CalPERS Board has taken strong and assertive steps to end any perception that political contributions play a part in the decisions made by our fiduciaries2. CalPERS' efforts have addressed not only the effect of contributions on investment advisory relationships, but also the award of contracts to attorneys, accountants, auditors and other professional services required to administer a $150 billion pension fund. The CalPERS Board supports and welcomes the Commission's efforts to address "pay to play" in the investment adviser industry from a national perspective. However, given the experience that the CalPERS Board has gained during the 1-1/2 years in which it has struggled with this very complex issue - and given the Board's 45+ years' experience as fiduciaries - we offer several comments and suggestions that we believe will both strengthen and ease the administration of the Proposed Rule.Background
CalPERS is the largest public pension system in the country, with assets currently valued in excess of $150 billion. These assets, which provide retirement benefits to over 1 million of California's government employees and their families, are invested in both the public and private markets.
The Board consists of 13 members.3 This composition is fixed by the California Constitution, and can only be altered by a statewide vote of the electorate.4 The various participant groups within CalPERS' membership elect six Board members.5 They serve staggered four-year terms. Two members serve on the Board by virtue of their elected office (i.e., the State Treasurer and State Controller). Two members are appointed by the Governor6, and one jointly by the Legislature7; these members also serve staggered four-year terms. One member is appointed by the State Personnel Board ("SPB"), and serves at the pleasure of SPB.8 Lastly, one member serves by virtue of his/her position as the Director of Personnel Administration.9 Each of these Board members, as well as any designate serving on the Board in their stead, are fiduciaries to CalPERS' participants. Their behavior must conform to the highest legal standards of loyalty and prudence.
In managing the pension fund's assets, CalPERS' Board uses the services of investment advisers in two ways: (1) to provide investment consulting (i.e., non-discretionary) advice; and (2) to exercise investment discretion, within defined parameters. The discretionary investment advisory services are provided either under (a) professional services contracts, or (b) joint venture structures (typically either a limited partnership or limited liability company ["LLC"]). As is more fully discussed in our Comments, below, these differing types of relationships have several key distinctions:
· Professional service contracts (both discretionary and non-discretionary) are generally awarded after a competitive bidding process. Conversely, the decision to invest assets in a joint venture structure is made based upon a comprehensive due diligence process that focuses on the potential returns to be generated from the venture; although other potential uses for the capital are considered, there is no per se "competition" between venture managers.
· Fees paid under the professional services consulting contracts are typically fixed rates (e.g., monthly or annual retainer for defined services, plus negotiated fees for special projects). The manner in which investment advisers participating in the joint venture structures are "compensated" is both highly variable and complex.10
· Except in rare circumstances, CalPERS does not permit its advisers, under a discretionary professional service contract, to participate in "pooled" funds. In contrast, nearly all of the joint venture structures - in which CalPERS is a limited partner or non-managing LLC member - contain many other investors.
· Termination provisions under the different types of contracts are very different. Professional service contracts (both discretionary and non-discretionary) are generally terminable immediately for cause11, and within a defined notice period (30, 60 or 90 days) without cause. Partnership and LLC remedies are much more limited, and typically require at least the consideration (if not active support) of other investors.
Given this background and experience, CalPERS offers five comments to the Proposed Rule.
Comment 1. The Proposed Rule Should Not Prohibit Political Contributions to Elected Officials Who Appoint CalPERS' Fiduciaries, But Who Have No Legal Authority to Influence the Fiduciaries' Decisions.
As drafted, the Proposed Rule would apply to contributions to government officials who have the legal obligation to appoint CalPERS Board members, but who have no legal power to influence Board member decisions. This, the Board strongly feels, is overly broad.
When CalPERS considered its own political contribution prohibition, there was extensive debate over the issue of whether to apply the ban to "appointing authorities." During this debate, the Board determined that, in fact, these "appointing authorities" had never sought to influence the appointed Board member(s) as to the selection of an investment adviser. Moreover, the Board - based upon advice from independent fiduciary counsel - concluded that (a) these officials are not fiduciaries to CalPERS, and (b) any appointed Board member who allowed him/herself to be influenced in this regard by an appointing authority risked breaching his/her duty of exclusive loyalty to plan participants. Lastly, the Board determined that any acceptance of the possibility that "appointing authorities" are permitted to seek to influence their appointees in the exercise of their fiduciary duties would be inimical to the very concept of "fiduciary." CalPERS has a long history of vigorously opposing all efforts - in all contexts and under all administrations - to threaten the independence of CalPERS' fiduciaries. The Board fears that the Proposed Rule could be used by "appointing authorities" as evidence of some right to intrude into the affairs of this System.
The Board understands the Commission's desire to make the Proposed Rule parallel to existing rule G-37. However, we respectfully suggest that this parallel treatment will only survive constitutional challenge to the extent that the record supporting the Proposed Rule is consistent with the record supporting G-37. We see nothing in the Release that would support extending the political contribution ban to all appointing authorities. Thus, we fear that such an overly broad application places the Proposed Rule - which CalPERS conceptually supports - at risk. We suggest that the Commission's goal can be achieved in a more narrow fashion. Specifically, we recommend that the definition of "official" [as proposed in sec. 275.206(4)-5(e)(4)(ii)] be revised substantially as follows:
(4) "Official" mean any person (including an election committee for the person) who was, at the time of the contribution, an incumbent, candidate or successful candidate:
(i) . . .
(ii) For any elective office of a government entity, if the office has the authority to appoint and influence any person who is directly or indirectly responsible for, or can influence the outcome of, the use of an investment adviser by a government entity.
Advisory comments accompanying the Proposed Rule should, in our view, clarify that the "authority to ... influence" is demonstrated by the level of authority to remove the fiduciary from office. If the appointing authority has no ability to remove the fiduciary from office, we suggest there is no nexus between the authority's acceptance of political contributions and the fiduciary's selection of an investment adviser.
Comment 2. The Proposed Rule Must Recognize the Complexities of "Compensation" Arrangements for Advisers to Private Investment Companies, and Give the Pension Fund Fiduciaries Flexibility in Dealing with Contribution Violations.
CalPERS generally supports including "private investment companies" within the parameters of the Proposed Rules' prohibition. However, as described in the Background discussion above, the contractual relationships between pension funds and these "private investment companies" are very different from contractual relationships with other types of advisers. The Proposed Rule attempts to apply a single enforcement standard for all advisers: i.e., non-compliance results in the loss of the ability of the adviser to receive "compensation," although the adviser may be contractually obligated to continue to perform services for some period of time.12 This single approach is not feasible in the private investment company context.
The fee structure of a private investment agreement is heavily negotiated and extremely complex. The final fee structure in a typical agreement is a combination of a management and other fees and a share of carried interest. The management fee may be computed as a percentage of the total committed capital or it may be determined as a percentage of the budgeted annual operating expenses of the fund, which may have to be presented to an advisory board or the limited partners for approval. The management fees may be on a sliding fee scale. In addition to other fees charged against the limited partners, there may be transaction fees that can be earned by the fund and that may be shared by the limited partners. Normally, these funds are used to offset the management fees. Carried interest is the share of the partnership's profits received by the general partner. However, computing this interest is in itself complicated (CalPERS alone uses at least three different methods) and subject to certain contractual provisions intended to guarantee a minimum return to the limited partners before the general partner. For example, all agreements have "clawback" or look-back provisions that allow for a review of total profit distribution from the partnership at the end of the term. In addition, most contracts have a hurdle rate which requires that the investment achieve a minimum rate of return before the general partnership receives its carried interest. Finally, while the summary above is of a "typical" CalPERS agreement, variations within the market are enormous. Given this wide degree of variation, we cannot see how a flat "violating-advisers-cannot-be-compensated" rule can possibly be administered.
CalPERS recognizes that the Commission may be reluctant to give enforcement discretion to the government entity whose official(s) may have been the beneficiary of contributions made in violation of the new rule. Although CalPERS understands this reluctance, we strongly believe that such flexibility is necessary to protect the interests of the pension trust fund and its participants. Since the protection of these interests is the foundation of our fiduciary duty, we believe that - in the narrow context of private investment company relationships - the fiduciaries themselves (and not the Commission) are in the best position to determine the sanction that appropriately sanctions the investment adviser.
Comment 3. The Proposed Rule Should Expressly Not Apply to Investment Adviser Relationships That Have Been Delegated Fully to Staff.
Two footnotes in the Release suggest that the prohibition will not apply when adviser relationships are fully delegated to staff.13 To avoid any uncertainties, CalPERS recommends that this concept be expressly stated in the new rule. This could be accomplished by adding a definition to section 275.206(4)-5(e):
(7) "Influence" means the exercise of any lawful authority, designed to affect the decision regarding the use of an investment adviser.14
Comment 4. The Commission Should Extend the Transition Period, to Allow Time For Pension Plans to Adopt Appropriate Contractual Remedies.
The Commission specifically requested comment on the length of the transition period.15 For many of the same reasons as discussed in Comment 3, above, CalPERS believes additional time is necessary for public plans to incorporate into their contracts appropriate remedies for violations of the new rule. This time is particularly important if the Commission declines to provide the enforcement flexibility that we suggest is necessary in the private investment company context. To accommodate these contract negotiations and amendments, we suggest a minimum six-month extension of the proposed transition period.
Comment 5. The Commission Should Consider a Shorter "Look-Back" Period.
The Commission also expressly sought comment on the length of the "look-back" period.16 CalPERS respectfully suggests that a one-year period (rather than the proposed two years) is sufficient to prevent circumvention of the new rule.
Thank you again for the opportunity to comment upon this significant proposal. Again, on behalf of the CalPERS Board, I applaud the Commission for undertaking what I know is a controversial and complex issue. CalPERS stands ready to assist you in this effort. If you or any of the Commission's staff would like to discuss these comments in greater depth, please feel free to contact me.
JAMES E. BURTON
Chief Executive Officer
cc: Members, CalPERS Board of Administration
1 CalPERS offers no comments on the proposed amendments to existing rule 204-2 [17 CFR 275.204-2], concerning the record keeping obligations of investment advisers.
2 The Release, at pp. 13-15.
3 Cal. Gov. Code sec. 20090.
4 Cal. Constn. Art. 16, sec. 17(f).
5 One Board member is elected by retirees; one by State employees; one by Classified School employees; one by participating local government employees; and two by all employed and retired members. (Cal. Gov. Code sec. 20090(g).)
6 One appointee must be an official of a life insurance company, and the other must be an elected official from a participating local governmental entity. (Cal. Gov. Code sec. 20090(e).)
7 The Speaker of the Assembly and the Senate Rules Committee jointly make the Legislative appointment. (Cal. Gov. Code 20090(f).)
8 The members of SPB are Governor appointees who serve staggered 10-year terms.
9 The Director of Personnel Administration is a Governor appointment, subject to confirmation by the Legislature.
10 See Comment 3, below.
11 "Cause" typically includes violations of laws.
12 "Investment advisers making contributions covered by the proposed rule would not be prohibited from providing advisory services to a government client, but only from receiving compensation from the client for providing advisory services. This approach is intended to avoid requiring an adviser to abandon a government client after the adviser . . . make(s) a political contribution covered by the rule. An adviser subject to the prohibition would likely be obligated to provide (uncompensated) advisory services until the government client finds a successor." (The Release, p. 22; emphasis original.) "An investment adviser that violates the rule may be required, under its fiduciary duties, to continue providing advisory services to the public fund, for a reasonable period of time, until the fund obtains a new adviser." (The Release, p. 22, fn. 75.)
13 See footnotes 32 (at p. 11) and 78 (at p. 23) ["In some cases, authority to select and terminate an investment adviser is completely delegated to the staff of a public fund, in which case a government official may not be able to influence the selection. . . Under the proposed rule, contributions to the official would not trigger the prohibitions of the rule."].
14 We respectfully suggest that this definition would also apply to our recommended addition of the concept of "influence" as applied to appointing authorities. See Comment 1, above.
15 The Release, at p. 32.
16 The Release, at p. 26-27.