As Trump is about to be sworn in, the press and pundits are agog about his and his fellow Cabinet members’ deep and extensive conflicts of interest, and how dangerous they is for democracy.1 But the hue and cry about conflicts of interest is late in coming. They’ve been tolerated more and more over time even as they’d had visibly corrosive effects on the behavior of professionals and on government and corporate checks and balances.
I plan to write about how neolibearlism corrupted experts, but due to how news is breaking this month, we’ll use public pension funds as a case study of corruption in the professional classes, meaning the Democratic party base that is the most agitated about Trump’s conduct. Mind you, these failings do not justify Trump’s lapses, but they do show these protests are disingenuous by revealing the long-standing failure to call out other abuses.
Regular readers may remember Robert Klausner, the scandal-ridden lawyer that CalPERS nevertheless retained for the sensitive role of fiduciary counsel. Klausner resigned last year under a cloud at least in part due to our coverage.
Klausner was uniquely tainted by virtue of his multi-decade dodgy conduct, such as deep involvement in pay-to-play schemes with his public pension fund clients and setting up hidden and indefensibly lucrative special pension funds for client executives that looked an awful lot like bribes. However, there are other ways that Klausner’s conduct and advice was corrupt that are sadly all too typical among public pension fund fiduciary counsels.
Pension funds play a socially critical role. A key legal protection is that the staff and boards that oversee them are are fiduciaries, which means they are held to the highest standard of care under the law. Yet there is a yawning gap between theory and practice.
Public pension funds in particular, due to the magnitude of fees and expenses paid to the outside fund managers that all but the very biggest hire, far too often have an outsized portion of their monies allocated to high fee alternative investments managers. Finance-savvy readers will know well the message of John Bogle: that even seemingly modest differences in fee levels makes a very large difference in investor returns over the 20+ year time horizon of retirement investing. Needless to say, the lofty charges that hedge and private equity funds suck out of investor commitments is a huge drag on potential returns compared to what it costs to run index funds.
Perversely, public pension funds make extensive use of experts, yet corruption remains widespread. Worse, none of these hired guns appear to focus more intensely on board and staff responsibilty to beneficiaries and taxpayers even though underfunding is widespread and public pension funds are under attack.
It’s hardly a secret, despite elaborate accountability theater, that investment decisions at public pension funds too often are based on political clout or even worse, soft or overt kickbacks. David Sirota has followed the money in North Carolina, New Jersey, Illinois, and other states, documenting again and again unduly cozy relationships between public pension fund officials and some of the fund managers who received allocations on their watch.
With CalPERS, these sales tactics have included the most overt sort of corruption, that of cash (and poker chips) paid to the former CEO, Fred Buenrostro, who is now in prison.
The Big Lie about the procedures at public pension funds is that the goal is to satisfy the various officials’ fiduciary duties, which means above all putting the beneficiaries and taxpayers interests first.
That is not what happens. The primary objective is for the staff and trustees at the funds to shield themselves from liability. Thus the rituals of hiring experts and having a paper trial to show that decisions were made in a deliberate-looking manner, too often take precedence over making sure the content of these decisions is good.
The proof is how easy it is to find experts not only pointedly avoiding doing the right thing, but actively undermining individuals who are fighting abuses and costly neglect at their funds.
Fiduciary Counsels: The dogs that rarely bark and try to silence other watchgdogs. Fiduciary counsels have a fundamentally conflicted relationship as too often takes place with experts nominally hired by and accountable to public and private boards.
An analogy is how compensation experts work for public company boards. They nominally report to the board. But they are pre-screened by the human resources department, which means that only candidates that management approves of will be on the short list. It should therefore come as no surprise that executive comp consultants have succeeded in institutionalizing the norm that CEO pay is always targeted to be in the top 50% of his peer group, and often in the top 33% or 20%. As we first described 2008, that guarantees ever escalating pay. Everyone wins: the comp consultants, who almost without exception sit in headhunting firm whose search fees are set as a percentage of expected first year pay; the executives; and the directors, since board director pay is set in a rough relationship to executive compensation. The losers are the shareholders who this process is superficially designed to protect.
As with compensation consultants for public companies, the fiduciary counsel at a public pension fund nominally has the members of the board as his client. But this relationship is hopeless by design.
First, as with the compensation consultant, the candidates are all selected and screened by the general counsel’s office. And board members are passive in this process. Last year, we saw at CalPERS, when staff failed to provide information that the board had gotten in the past, a few members grumbled but they went on with their approval process. A decision-making body with any guts would not have tolerated this sort of insubordination. It would have demanded the missing data as necessary to selecting a candidate.
But even worse is that the fiduciary counsel is also counsel to staff. It’s hard to fathom how anyone can see this arrangement as making sense. A board has to maintain a healthy degree of skepticism about staff or else it cannot do a proper job of oversight. It also therefore needs to be able to get its own advice. Having the board have no independent counsel, and worse, having its only legal advisor be selected by and have its primary legal advisor see staff as its real client is a prescription for getting maneuvered to go easy on staff. We’ll describe in more detail tomorrow how this plays out at CalPERS.
Silencing Other Watchdogs: Using the duboius “co-fiduciary duty” theory to stymie reformers. Fiduciary counsels have increasingly relied on their invention of a “co-fiduciary” duty to cow diligent board members. We discussed this notion when CalPERS’ last fiduciary counsel, the afore-mentioned Robert Klausner, endorsed the dubious claim that board member JJ Jelnicic had violated his fiduciary duty when forced to use the Public Records Act (FOIA) to obtain records staff refused to provide. From our post:
It is a recognized principle under U.S. trust law that, regardless of whether a trustee supported (i.e., voted for) a decision of the board that results in a breach of fiduciary duty, that trustee can be held personally liable for that decision (i.e., jointly and severally liable) if he does not take steps to try to prevent or cure the breach. That risk similarly argues for the necessity of being able to obtain further information if the trustee is concerned about a possible breach and needs to investigate further to determine if action is warranted. Clearly, getting records from CalPERS is a reasonable step to take in that context.
Here is a discussion of relevant law:
Subsection (b) is based on Restatement (Second) of Trusts Section 258 (1959). Cotrustees are jointly and severally liable for a breach of trust if there was joint participation in the breach. Joint and several liability also is imposed on a nonparticipating cotrustee who, as provided in Section 703(g), failed to exercise reasonable care (1) to prevent a cotrustee from committing a serious breach of trust, or (2) to compel a cotrustee to redress a serious breach of trust. Joint and several liability normally carries with it a right in any trustee to seek contribution from a cotrustee to the extent the trustee has paid more than the trustee’s proportionate share of the liability. Subsection (b), consistent with Restatement (Second) of Trusts Section 258 (1959), creates an exception. A trustee who was substantially more at fault or committed the breach of trust in bad faith or with reckless indifference to the purposes of the trust or the interests of the beneficiaries is not entitled to contribution from the other trustees.
A board member of an apparently better functioning board indicated that this information is consistent with his memory of the issue from the fiduciary training he received, that board members are liable for breaches of fiduciary duty of their fellow board members if they failed to take steps to try to remedy the breach. That includes opposing board decisions they believe to be a breach of fiduciary duty. It is thus contrary to law to demand that board members all go lemming-like over the cliff together when they are concerned that their fellow board members are engaged in a breach of trust.
Yet we’ll see board and the tainted lawyer Klaunser pump for fealty over the proper execution of fiduciary duty, while trying to wrap it in the fiduciary flag.
No attorney we consulted agreed with Klaunser, including two law professors. In fact, one deemed Klausner’s argument to be “ludicrous”.
Yet fiduciary counsels, and their close cousins, “fiduciary auditors” have been trying to silence reform-minded board members with this “ludicrous” reading of the law.
A reader e-mailed me after I wrote about how the South Carolina GOP was trying to remove State Treasurer Curt Loftis from the pension fund board, after he had done a heroic job of reform. The state’s fund had been in the bottom 10% performance for large public pension funds. And that was due to an excessively large allocation to underperforming alternative investment funds.
Not only did Loftis pressure staff to cut its allocation to dodgy, high fee fund managers, but he has been a leader in getting better disclosure of fees and costs. Industry standard-setter CEM Benchmarking, in a seminal paper in 2015, cited South Carolina as one of the two public pension funds that had gone furthest in obtaining information on fees and costs, and their work revealed that most other funds were only reporting only about half their fees. That is shocking lapse, particularly given that ERISA, which public pension funds comply with even though they are not formally subject to ERISA, requires that pension fund trustees evaluate the cost of an investment strategy in deciding how to commit funds.
Yet soi-disant fiduciary experts, rather than praising Loftis and urging their clients to emulate Loftis, are instead demonizing him. And what is the basis for their criticism? That he is making life hard for South Carolina’s staff.
The venom of the attack reveals the realpoitik we described above: that the fiduciary counsel’s role is to protect his client even when that entails enabling bad behavior, rather than act as an independent expert and tell them what they need to do to serve their beneficiaries and taxpayers properly.
From a reader via e-mail after we ran a post calling on readers to go to bat for Loftis:
I’ve run into Funston Advisors, the firm that did the “fiduciary audit” that Loftis said made the recommendation to kick him off the board.
I made some kind of comment along the lines of, “That guy Loftis has done an incredible job of driving reform and transparency there.” The senior Funston guy then looked me in the eye and said, “You should never praise Loftis to any public pension fund official. The staff at the SC pension system hate him, and in our view, he is very disruptive. The public pension fund staff people around the country all talk to each other, so you are really hurting yourself if you praise Loftis to any public pension fund official.”
I then defended my comment by saying that I thought he was executing his fiduciary duty by speaking out publicly. One of the Funston people then trotted out the argument that Loftis had a “co-fiduciary duty” NOT to speak out in a way that was critical of the pension system. I argued about this with them but they clearly thought that I didn’t know what I was talking about.
As we indicated above, law professors disagree with Funston on its claim that a “co-fiduciary” duty means trustees should all play nice. So if you strip away that bogus objection, what do you have left? That Loftis was making life hard for a poorly-performing and potentially corrupt staff. And what was the position of this “fiduciary” advisor? Effectively, that having life be comfortable for staff was more important than improving performance and cutting fees, and that the only thing that matters is the avoidance of controversy and public embarrassment.
Not Barking: Failure to consider conflicts of interest. We’ve already demonstrated one immediately above, how “fiduciary auditor” Funston Partners clearly sees its job as serving staff, not beneficiaries. So its economic incentives are to slander effective trustees like Loftis and even worse, encourage staff in the patently false view that the sort of misconduct and failure to get as much information about fees and costs is sound.
Here are other sorts of fundamental conflicts that it is a virtual certainty no fiduciary counsel will raise:
Staff members who oversee alternative investment funds are effectively getting bribes at beneficiary/taxpayer expense. It is an ethics violation in high-cost Washington DC for mere Congressional staffers, who do not have decision-making roles, to take a gifts exceeding $25 from a single party in a year. Yet private equity and hedge fund team members as part of their supposed supervision go to dog and pony shows by the fund managers, with the excuse that they are being updated on performance. These events are always in desirable locations, with costly meals and big-ticket entertainment or pricey speakers. As we wrote of private equity fund TPG engaging Elton John to perform for fund staffers at taxpayer expense:
…it’s hard to see lavish entertainment at supposed informational gatherings as anything other than a kickback to private equity investors. As someone who is in the business of consuming and analyzing information, it is vastly more efficient to process written information than speeches or presentations. Lambert and I both greatly prefer transcripts and can barely stand the time cost of listening to Web presentations. Conferences are an even bigger time sink.
In other words, if the objective were to inform investors, these events are clearly not necessary. The limited partners are flattering themselves if they think they can learn anything more by seeing general partner execs or the team from their showcased portfolio companies in the flesh. These are all highly skilled performers and these events are very carefully staged in advance.
So what are the limited partners getting? Aside from getting an excuse to visit New York, London, Phoenix, or other major destinations, and getting wined and dined, the general partners are marketing to them. This is an extended sales pitch to help groom them to invest in the next fund. And secondarily, it’s an opportunity to mix socially with other limited partners…which is questionable as a use of the funds entrusted to them. They can do that just as well at educational conferences, which are also neutral territory.
The consultants who advise on alternative fund managers pretend they can out-select when that’s bogus. The conflict of interest here is that too many people benefit from complexity: the specialist fund consultants, the asset allocators, and the staff. How much can you justify paying for advice to construct and run an asset allocation model for liquid and only somewhat illiquid securities and make those investments on an indexed basis?
And the even uglier truth, as we discussed way back in 2014, is public pension funds would have to abandon private equity if they were honest about performance:
When you boil it down, this graph illustrates the ugly truth of investing in private equity: it’s not attractive unless you can outrun most of your peers investing in the asset class.
Rather than question the logic of investing in private equity at all, everyone in the industry has convinced themselves that it is reasonable to believe that they can be the Warren Buffett of private equity. The investment consultants go through the shooting-fish-in-a-barrel exercise of convincing their institutional clients that each of them is prettier, smarter, and more charming than average, and therefore capable of achieving sparking results. Needless to say, flattery is an easy sell….
Fundamentally, this is an intellectually dishonest exercise, and diametrically opposed to the way many public pension funds construct other parts of their investment portfolios. With public equity in particular, it’s almost certain that a significant majority of U.S. pension fund assets are invested in index funds. That’s because pension funds have recognized that, collectively, they cannot do better than average, and that after paying active management fees, actively managed public equity portfolios typically perform worse than the market average.
So it’s not as if these investors are so clueless that they can’t grasp the point that all of them cannot achieve above average results, let alone significantly above average results. Instead, with private equity, there is a desperate desire to be in the asset class for reasons that probably reflect a combination of intellectual capture by the PE managers, political corruption in legislatures that control public fund board appointees, and the need to have a strategy that could conceivably solve the pension underfunding problem over time.
So the only possible way to justify being in private equity would be to invest in managers with lower fees (and there are some), since private equity fees and costs are so large that a minimizing-fee approach could potentially improve performance by 1% to 2% a year, which would make a big difference over time, or bring the strategy in-house and cut out the middleman, which would take years to implement but would yield big benefits.
Insufficient vigilance about self-serving behavior. One shocking example took place with a highly reputable pension fund consultant, Pension Consulting Alliance, with is better than most by virtue of being a pure consultant, as in not being conflicted by having a fund-of-fund management business, which forces other consultants to play nice with far too many fund managers to maintain access to their funds.
As we recounted in 2015, PCA was laying the groundwork at CalPERS and CalSTRS to abandon fundamental precepts of investing and recommend that private equity investments be measured on a absolute return basis rather than based on its returns relative to the greater risks embodied by the strategy.
As we said then, this was utterly indefensible. Had PCA succeeded in getting CalPERS to sign on, they would have become the toast of the pension fund industry. At a minimum, their recommendation would have gotten tons of coverage in the trade press, and they would have had a big leg up in winning new clients. This was patently self-serving, to help provide a continued justification for investing in private equity, meaning preserving their franchise, as well as potentially giving them a competitive advantage.
We orchestrated pushback, the most important of which was an op-ed by private equity experts Eileen Appelbaum and Rosemary Batt in the Sacramento Bee right before the board was set to endorse the general policy framework to legitimate this scheme. Staff backed down at the board meeting and withdrew the recommendation. But this was a very close call that would have done enormous damage to beneficiaries all across America, and the supposed experts were all on board to preserve their bottom lines.
So the experts, staff and the board are all in cahoots in not rocking the boat and making sure that the experts act as a liability shield when they themselves are also not accountable (under the doctrine of secondary liability, only their immediate clients, meant the pension fund staff and trustees can sue them, and not by the beneficiaries that to which they give lip service).
So we have a perfect system for abuse: it generates a lot of fees and motion with no one responsible unless things get so bad the press wakes up and makes noise. And the sophorific nature of pension investing means all the participants know the external checks are so weak that as long as they maintain the veneer of professionalism, they are very unlikely to be caught.
1 As Lambert has pointed out, conflicts of interest are inevitable in oligarchy. While some of the very rich have been able to dismantle their formal business ties, like former Treasury Secretary selling his Goldman stock, we’ve had other billionaires get a free pass. Michael Bloomberg did formally put his Bloomberg shares in blind trust when he became New York major, but his former employees expected him to resume control of his business, as he did when he left office. So how can one pretend that Bloomberg would not continue to make decisions that would serve the interests of his business, particularly given that CEOs of his biggest customers work and often live in New York City? Yes, blind trusts greatly reduce the possibility of overt self-dealing. But they do not remedy the issue that people who have accumulated that much wealth typically have a large network of people who are also rich,. By virtue of experience, acculturation, and not wanting to lose friends and create enemies, they are unlikely to become class traitors.