CalPERS executives and its board seem determined to implement a private equity scheme which, as our former Sullivan & Cromwell attorney Jerri-Lynn Scofield explained at some length, would have an inherently deficient governance structure. One has to wonder if the reason that CalPERS’ executives and board have latched so hard onto such a bad idea and are refusing to let any independent experts close enough to do due diligence is that they assume that their personal liability is well covered by the insurance policies CalPERS has in place. In fact, CalPERS’ self-insurance policies, created under the regime of the now-imprisoned CEO Fred Buenrosto, are at odds with CalPERS’ governing statute and are being operated out of compliance with the insurance policies themselves as well as state insurance laws.
One example of CalPERS’ staff and board ignoring expert advice and setting themselves up for liability claims if anything goes wrong: the private equity expert that CalPERS brought in to give the board a pep talk, Dr. Ashby Monk, stressed that far and away the most important thing for CalPERS to get right is the governance…something which it clearly has badly wrong. The reason deficient governance matters is that it greatly increases the odds of chicanery. That already exists aplenty in private equity, given the warnings the SEC issued, followed by enforcement actions, about embezzlement and other abuses at major private firms.
What ought to be another huge red flag to the board: CalPERS’ staff has kept the Board’s private equity consultant, Meketa, well away from this plan, when you’d expect them to be an integral player. Similarly, we understand that no one from CalPERS’ private equity staff had been involved in coming up with the private equity “new business model” which explains why it’s such a monstrosity. It’s been cooked up by people with no substantive knowledge, meaning CEO Marcie Frost, departing CIO Ted Eliopoulos, general counsel Matt Jacobs, and Cole, who does not have a background in private equity, with the assistance of hopelessly conflicted Silicon Valley fixer Larry Sonsini.
CalPERS’ refusal to involve or even listen to experts is a grotesque departure from how competent and risk averse organizations operate, and how CalPERS functions in its normal course of business, as opposed to this case. If you’ve watched a typical CalPERS board meeting, you’ll see a parade of hired guns armed with PowerPoint slides. A basic rule of life in the executive suite as well as in investment management is that if you’ve consulted experts, your personal exposure is limited or or you at least have a viable defense.
So why are CalPERS staff and board behaving in such a cavalier manner when they planning to commit large amounts of funds to an utterly unprecedented, in a bad way, program? If they think their insurance will bail them out, they might want to think twice.
Overview of CalPERS’ Fiduciary Liability Insurance Plans and Its Self-Dealing Self-Insurance
Just as it is permitted for companies to buy directors’ and officers’ insurance, so too can CalPERS buy liability insurance for its board members. But the relevant insurance, which is a CalPERS self-insurance policy is so far outside what its own governing statute, the Public Employees Retirement Law (PERL), and state insurance law allows that one lawyer deemed it to be “crazy-town… an absolute joke.” An expert on insurance who regularly serves as an expert witness said that the supposed insurance contract is in fact not insurance due to the lack of reserving and ongoing estimates of what CalPERS’ exposure might be as a result of changes in legislation and precedent, and was a mere contract with board members and employees.
But perhaps the most important problem is that these policies represent a conflict of interest under Government Code § 1090 that rises to the level of a willful violation. That exposes board members as well well as any employees who participate to fines and criminal liability. In addition, the employees who aided and abetted them, meaning at a minimum the CEO Marcie Frost and the General Counsel Matt Jacobs, are subject to separate violation of Government Code § 1090.
We’ve embedded the policies below. We’ll discuss the first, the “Fiduciary Liability Self-Insurance Program.” The second, “The Euclid Vanguard Fiduciary Liability Insurance Policy Certificate” is a policy written by an independent insurer. It covers liability with plans that are overwhelmingly health insurance plans and are thus largely not relevant for this post.
CalPERS’ authority to obtain liability insurance comes from this part of the PERL, the section of the California Government Code that deals with the retirement system:
§ 7511. Liability Insurance: Fiduciaries
Notwithstanding any other provision to the contrary:
(a) A public retirement system may purchase insurance for its fiduciaries or for itself to cover liability or losses occurring by reason of the act or omission of a fiduciary, if the insurance permits recourse by the insurer against the fiduciary in the case of a breach of a fiduciary obligation by the fiduciary.
(b) A fiduciary may purchase insurance to cover liability under this section from and for his or her own account.
(c) An employer or an employee organization may purchase insurance to cover potential liability of one or more persons who serve in a fiduciary capacity with regard to an employee benefit plan.
If you read the statute, CalPERS is allowed to buy insurance for its “fiduciaries” (more on that later) provided that the insurance policy allows for recourse against the individual(s) for breach of fiduciary duty.
What CalPERS has done instead is set up an contract that is whose terms resemble those of insurance policies. To make it look insurance-like, CalPERS employees and board members purchase a waiver from CalPERS for personal recourse, meaning the having the insurer come after individuals’ assets to recoup some of the cost of the insurance payouts made on their behalf if the insurer.
The self-insurance plan has no retention (deductible), and so covers the first dollar to $40 million of total liability. CalPERS set the price of the waiver for individual recourse under its self-insurance plan (which covers pension plan) at $25 in 2003 and $4 for the individual recourse under the third party plan (the one written by Euclid Vanguard).
Why the “Self-Insurance Plan” Is Illegal
There are numerous problems with the self-insurance plan:
Violates Government Code § 1090 prohibitions against self-dealing. Specifically:
ARTICLE 4. Prohibitions Applicable to Specified Officers
1090. (a) Members of the Legislature, state, county, district, judicial district, and city officers or employees shall not be financially interested in any contract made by them in their official capacity, or by any body or board of which they are members. Nor shall state, county, district, judicial district, and city officers or employees be purchasers at any sale or vendors at any purchase made by them in their official capacity.
(b) An individual shall not aid or abet a Member of the Legislature or a state, county, district, judicial district, or city officer or employee in violating subdivision (a).
(c) As used in this article, “district” means any agency of the state formed pursuant to general law or special act, for the local performance of governmental or proprietary functions within limited boundaries.
As one trustee put it, “Board and staff buy waivers because of and only because of knowledge of financial interest.”
Even if (a) is deemed not to include employees, section (b) would pick up those employees who were involved in or responsible for aiding the board members, who are also officers of the state government who aided and abetted them in entering into contracts that enriched them personally. That would at a minimum include Marcie Frost, Matt Jacobs, and the party that sent the memorandum offering coverage to board members and employees, which has in recent years been the Chief Financial Officer.
Moreover, from a document on the Attorney General’s website, Conflicts of Interest. First, from the checklist on the first text page:
Does a board member have a direct or indirect financial interest in a contract being made either by the board or by any agency under the board’s jurisdiction?
If so, and the contract is made, the member may be subject to criminal sanctions and the contract may be void and any private gain received by the official under the contract may have to be returned.
And the detail(emphasis ours)
Who is is the individual with the potential conflict of interest?
Section 1090 applies to virtually all state and local officers, employees, and multi-member bodies, whether elected or appointed, at both the state and local level. It also applies to certain consultants and independent contractors…
A Contract Made in Violation of Section 1090 is Void and Unenforceable….
Willful violations by officials are subject to fines and imprisonment.
A willful violation of any of the provisions of section 1090 et seq. is punishable by a fine of not more than $1,000 or imprisonment in state prison. (§ 1097.) For an official to act “willfully,” his or her actions concerning the contract must be purposeful and with knowledge of his or her financial interest in the contract. (People v. Honig (1996) 48 Cal.App.4th 289, 334- 339.) The statute of limitations for section 1090 prosecutions is three years after discovery of the violation. (Id. at p. 304, fn. 1; Penal Code, §§ 801, 803, subd. (c).) Additionally, such an individual is forever disqualified from holding any office in this state. (§ 1097.) When a state or local government agency is informed by affidavit that a board member or employee has violated section 1090, the agency may withhold payment of funds under the contract pending adjudication of the violation. (§ 1096.)
The attorney general’s paper includes this section:
Officials who rely upon advice from a government lawyer (such as a city attorney) that a proposed transaction does not violate section 1090, may not avoid prosecution based upon the defense of entrapment by estoppel.
Translation: Board members and employees can’t get out of trouble by claiming “Matt Jacobs said to was OK.”1
Failure to take steps for this benefit to the board and employees to be considered to be insurance.. The PERL does not authorize CalPERS to self-insure for fiduciaries’ liability, but even if we take “may purchase” to include that, CalPERS in fact has not purchased insurance. As our insurance expert put it, “You don’t have an insurance plan. What you have here is an agreement.”
We put in a Public Records Act request, #3786, which among other things, asked for records showing how CalPERS determined the price of its fiduciary insurance. For instance, the use of “purchased” in the PERL would seem to require that CalPERS that CalPERS would show a premium cost in its annual profit and loss statements, as well as have a reserve account in its balance sheet.
We asked in some detail about how CalPERS determined the price of its policy as well as for information provided to its accountants so that income statement and balance sheet impact of the fiduciary self-insurance was properly reflected in its Comprehensive Annual Financial Report. We got nothing of the sort back.
We e-mailed CalPERS head of media relations, Brad Pacheco, pointing out that we had received no records in response to these sorts of questions and explained the implication. Unless and until CalPERS produces records that show otherwise, CalPERS cannot claim it has “purchased” the insurance pursuant to the PERL.
CalPERS has not set up reserves for the self-insurance policy. The self-insurance policy states that:
CalPERS’ total obligation to defend and pay under this Coverage Memorandum for all Loss because of claims first made against the Covered Parties during the Coverage Period shall not exceed $40 million….which amount shall be held as a separate line item in the Reserve Against Deficiencies Account.
Again, we asked in PRA ##3786 for records showing how CalPERS set its reserves and what information it had given to its accountant about them. We got nothing back. There is no item in CalPERS’ Comprehensive Annual Financial Report showing a Reserve Against Deficiencies or any other reserve for fiduciary self insurance. And its mystery bucket, “Contingent Liabilities” has a $58 million deficit!
The lack of a reserve has dire implications for the legality of any payments under this plan. It means if there were significant outlays, CalPERS would have to find the money from somewhere. Would it misappropriate funds from its annual budget? Raid the assets of pension funds? As an attorney put it:
It’s also quite basic that self-insurance without lawful and adequate reserves is invalid. It would be a gift or theft of public funds to pay a claim for violation of fiduciary duty by a board member.
Lack of authority in the PERL for fiduciaries to buy only a waiver of recourse for fiduciary duty violations. If you read § 7511 from the PERL above, (a) allows for a retirement system, meaning CalPERS, to buy a policy for its fiduciaries to cover liability for their acts and omissions if it provides for recourse to them for breaches of fiduciary obligation. (b) allows for an individual to purchase insurance for himself, by himself, to cover acts and omissions. If they buy that policy themselves, it is not required to allow for recourse in the case of a breach of fiduciary duty. The Government Code § 1090 prohibition against conflicted self-dealing descried earlier is the reson the reason § 7511(b) requires that insurance be obtained by a fiduciary board member “…from and for his or her own account.”2
Individuals acting as fiduciaries for CalPERS buying only the personal recourse waiver for fiduciary duty breaches is not contemplated in (a) or (b) and therefore not legal under the PERL. 3
Self-insurance policy impermissibly covers employers and third party plan administrators. On page 1, under (2) Covered Parties:
(b) The following persons or organizations, while acting in connection with the Employee Benefit Plans:
(i) any sponsoring employer,
(ii) any plan administrator,
Wrong wrong wrong! Per the PERL, “an employer or employee organization may purchase insurance”. CalPERS can’t give it to them. The employers need to pay CalPERS for it. Given that CalPERS doesn’t have any records showing that it has the foggiest idea of what this policy ought to cost, and given that the PRA results I received indicated that no one outside CalPERS had been sent a copy of this policy, what do you think the odds are employers even know this plan exists?
Moreover, extending this coverage to employers willy-nilly the way CalPERS has done without underwriting the risk and collecting premiums exposes CalPERS to potentially huge losses. Imagine a large government employer in California that participates in CalPERS illegally excluded a large category of its employees who were supposed to be enrolled from CalPERS membership, and did so for decades. The potential loss that CalPERS would have insured against could potentially be in the billions of dollars. That one claim would exceed CalPERS’ policy limit, leaving no coverage for other claims. While the policy allows the board to increase the policy limits, it would take time for that to move though the approval process, particularly if proper underwriting were done.
Self-Dealing Already Taking Place: The Bargain Basement Recourse Waiver
We can already see that even before you get to the mess of handling a claim, that CalPERS is visibly self-dealing via the absurdly low price it has set on the personal recourse waiver, even assuming it were legal. As a regular insurance expert witness said:
As to the $25 waiver cost, it is obviously nominal and couldn’t possibly fund the risk borne by CalPERS to provide first dollar protection.
Even employees know the pricing isn’t kosher. As one said:
The short answer is every year…CalPERS staff receive the same email with the offer to purchase the insurance coverage for $25. Generally speaking the staff is largely ignorant of the terms of the insurance policy and the coverage it provides. Almost everyone I know pays the $25 without really understanding why…other than that it is a benefit provided by the organization and no one wants to be the only person without the insurance protection if/when a lawsuit is brought which claims certain CalPERS employees violated their fiduciary responsibilities to the fund/pensioners.
To your point the $25 is a de minimis amount. And it would appear given the size of the policy and the protections it provides — the organization must be primarily shouldering the financial burden of making the policy available. It is unclear to me why the organization provides the benefit to its staff. Frankly if individuals have violated their fiduciary duties to the fund/pensioners it would seem logical that they should not be protected by the organization.
Going back to the insurance expert, he also said the fact that the price never changed was also a sign that the $25 was a token charge and not a bona fide price:
You are correct that the pricing of Fiduciary Liability coverage varies over the years, based upon loss experience, changes in laws and regulations and economic conditions. There have been tremendous changes in the environment for directors’ and officers’ policies over the years.
The CalPERS board and staff are naked, from an insurance perspective, when the CEO and staff are pushing the Board to take the biggest and most bone-headed risk in CalPERS’ history. The attorneys leading the case against three hedge fund managers in Kentucky over roughly $1.2 billion in total investments have included every bystander they could identify as defendants in the case, including employees, trustee, the fiduciary counsel, and even the firm that certified the Kentucky Retirement System’s annual reports. The lawyers expect to get a nine-figure judgement or settlement. One motivation for including these parties is to demonstrate the extent of negligence and corruption in handling of beneficiary funds.
If the CalPERS board doesn’t recognize that handing over what will ultimately be on the order of $10 billion to an unprecedented structure with an untested team makes them a monster target for litigation if anything goes wrong, they are smoking something very strong. Recall that the Kentucky suit is over the three hedge fund misrepresenting their risks and returns and greatly undershooting the stock market, not for delivering big losses.
This is yet another demonstration of the incompetence of Matt Jacobs and Marcie Frost. We have long said Jacobs is not qualified to be the general counsel of CalPERS. He has neither been in a general counsel’s office in the private sector, nor has he been a “government attorney” as in working as a counsel on the business of a governmental body. Jacobs punted on doing an intellectual property audit, a basic step any incoming general counsel should take when joining a new organization. That lapse, and his failure to take any interest in obvious ongoing copyright abuses in the form of CalPERS maintaining a database of the full text of news articles for employee use without having obtained the rights to them, led to a massive copyright settlement.
Jacobs is also so inattentive to basic conflict of interest issues that he mis-advised board member Richard Gillihan over the very same § 1090 issue we discuss in this post. Gillihan had been offered the Chief Financial Officer position but was concerned that he had been involved enough as a board member in setting the terms for the position that he might be deemed to have a conflict of interest. Jacobs brushed off the issue. Gillihan accepted the position and CalPERS even issued an announcement of his hiring. But another board member raised concerns about a possible § 1090 abuse, leading CalPERS to seek an independent reading. Gillihan was advised he was exposed and he withdrew his acceptance. That didn’t just result in a public black eye for CalPERS, and set up the hiring of the later-dismissed CFO Charles Asubonten. It also nearly caused Gillihan great personal distress. He had also said he was leaving his position as head of CalHR, and only by virtue of groveling to the governor was he reinstated. Gillihan would otherwise have been unemployed thanks to Jacobs’ cavalier attitude.
Jacobs is responsible for this “self-insurance” fiasco. It is his business to understand whether this “self-insurance” plan was legal. He can’t pretend he didn’t know about it. He would have been on the distribution list for sign-ups and almost certainly has purchased the non-recourse waiver.
Similarly, Frost is guilty, both legally and managerially. She is ultimately responsible for Jacobs as his boss. As we indicated above, under the law, she and Jacobs are liable for the § 1090 abuses not just s direct participants, assuming they both purchased the non-resource waivers, but separately by aiding and abetting the board in doing so.
We warned Frost that Jacobs was a risk to CalPERS and her personally and she should fire him. Our words have been borne out. We also warned the board and public that Frost is a hazard to them by virtue of her history of self-serving misrepresentations going back to her time in Washington, as well as her record of poor performance, which we documented. But this board appears determined to go down with both of them.
1 As part of the reform of the Penal Code, in 2014 the enforcement of Government Code § 1090 was handed off to the Fair Political Practices Commission through the imposition of civil penalties, except in the case of “willful” violations. However, Misappropriation of Public Funds under Penal Code § 424 is still on the books.
2 As an attorney elaborated:
Under subdivision (b) a board member can only insure themselves “from his or her own account.” CalPERS can’t provide the insurance. Otherwise you set up the classic “moral hazard”problem.
The drafting in subdivision (c) is apparently being read with a nonexistent comma. “An employer or an employee organization” means that a board member who represents an “employer organization” or an “employee organization” on a board can have their “own account” insurance under subdivision (b) paid for by the organization that they represent.
This does not mean that CalPERS can self-insure as an “employer” and then waive recourse, as they do not “employ” board members within the meaning of subdivision (c). It also means that a GC 7511 policy only covers fiduciary violations by board members, not wrongdoing by actual employees. Only board members act as fiduciaries. The reading under which the illegal purported self-insurance was created was evidently Fred Buenrostro getting “cute” with corruption on the board.
3 Most but not all of the experts consulted stated that
That does not necessarily preclude CalPERS from buying errors and omissions insurance for its officers and other staffers, but it can’t do so through the ruse of a “fiduciary” policy covering both the board and employees. The minority view was that staff are fiduciaries per their employment arrangements.Fiduciary Liability Self-Insurance Program
17-18 Fiduciary Liability Policy- CalPERS
00 Conflicts of Interest 2010