Pictures like this are indeed worth a thousand words. From Item 5d for CalPERS’ Risk and Audit Committee meeting last week.
This misconduct matters ever more than ever because the board wants to reduce its already lax supervision by delegating even more authority to staff.
Despite the whopping number of violations, CalPERS executives orchestrated the Committee meeting to minimize visibility of this disturbing record, and almost succeeded. Since the board played along, failing even to acknowledge the existence of the information in this slide, let alone its seriousness, CalPERS staff isn’t exaggerating by much when it tries to depict its ongoing power grab as a mere formalization of the status quo.
Procedurally, the placement of this item on the “consent calendar” and the Committee’s failure to discuss it (or any part of the Enterprise Compliance Activity report which contains other troubling items, like the number of missing board, employee, and consultant Form 700s) was a calculated effort to hide CalPERS’ dirty laundry.
The use of consent items is intended to be for non-controverial items. CEO Marcie Frost, General Counsel Matt Jacobs and the head of compliance Marlene Timberlake D’Adamo apparently see a 2017% increase in violations as routine, not even worth mentioning or explaining in the agenda item.
In keeping with the “Nothing to see here, move along” pretense, the CalPERS staff did not present the slides describing the personal trading and Form 700 (personal financial disclosure) abuses. The board therefore raised no questions about what they were about, their significance in dollar terms, the seniority of the perps, whether they had broken the rules in the past, and when and how disciplinary measures would be taken. All of this is Supervision 101 yet none of it happened.
How was this embarrassment kept under the radar? Via another abuse, of impermissibly holding whatever actual discussion there was in closed session. This is particularly cheeky because there was no Risk and Audit closed session beforehand; CEO Marcie Frost and her fixer, General Counsel Matt Jacobs, tried treating this as a personnel matter as the justification for relegating what little discussion there was in closed session.
I sent this e-mail to all members of the Risk and Audit Committee:
Dear Members of the Risk and Audit Committee,
Attachment 1 to Item 5d in last week’s Risk and Audit Committee meeting included a chart which showed personal trading violations. Experts say that even one violation a year is a serious matter, yet CalPERS has barely had a month with no violations, let alone the 127 for March.
The placement of this item on the consent calendar and the Committee’s failure to discuss it (or any part of the Enterprise Compliance Activity report which contains other troubling items, like the number of missing board, employee, and consultant Form 700s) looks like a deliberate effort to prioritize CalPERS’ PR objectives by minimizing the visibility of this document, rather than have the board perform its fiduciary duty. The lapse is particularly noteworthy give that many members of the public called out the board the day before for dereliction of duty.
I would appreciate any comment you have on this matter. Thanks.
I did get a reply from Margaret Brown:
I take my role as a Fiduciary seriously and I am not bashful about asking tough questions of staff and consultants.
The Board has been informed that these types of violations are an HR matter. As a result of this information, I did not ask questions in Open Session about the violations.
Brown is defensive because she knows better and despite her protestation here, sat pat. She could easily have queried staff during the open session discussion and chickened out.
For Frost and Jacobs to assert the personnel exemption is bogus. It would apply only to the extent that Frost and Jacobs discussed which employees had engaged in violations. I am highly confident they didn’t because if Frost started that practice, Frost would have to name names of top executives and board members if they were included in the current or future violations.The violators will skew to people with higher net worths, meaning more senior. And what if she or Jacobs or her favored henchman Doug Hoffner or Ben Meng is on the list? How about board members?
And yes, sports fans, this is even worse than it looks. CalPERS, with its footnote “The number of violations in March are uncharacteristic and occurred during a time of significant market volatility” tries to act as if the routine level of violations is acceptable. It isn’t. As we’ll show, even a single violation in a year for a large private sector financial services firm would be seen as a serious lapse.
And keep in mind: this isn’t one rogue employee (or board member or executive). It’s ten in the last quarter alone! That is evidence of a breakdown in supervision.
The number is almost certainly more for the full year, since attributing that number to the entire time period would seem a smidge less bad.
The number of bad actors and impermissible transactions is yet more proof that CalPERS is out of control. Worse, when transgressions this severe arise, we’ve seen again and again that the organization simply tries to sweep them under the rug. Earth to CalPERS: The wider world has not only noticed that that rug is awfully lumpy, they can even see that it’s moving.
And as we’ll discuss, these abuses not only include explicit violations of CalPERS’ regulation on personal trading but also having constructed the regulation to omit the areas where insider trading is most likely to occur. Continuing board negligence rounds out this sorry spectacle.
CalPERS Insider Trading, Erm, Personal Trading Policy
CalPERS’ personal trading regulation, which includes its insider trading policy1, covers Board members, executives, member of the Investment, Enterprise Compliance, and Enterprise Risk Management, offices, and other CalPERS employees who have access to CalPERS’ pre-trading information. These rules are designed to prevent violations of SEC insider trading rules as well prevent CalPERS board members and staffers from profiting by front-running CalPERS’ trades.
Before we discuss the types of abuses, let us reiterate that there is no excuse for these unheard-of high numbers.
We spoke with Keith P. Bishop, a partner at Allen Matkins Leck Gamble Mallory & Natsis LLP, who has written several articles for the National Law Review questioning CalPERS’ insider trading policy. His reaction:
That’s a very large number of violations. Even one violation in a year is very concerning. This would be extremely atypical in the private sector.
Needless to say, the big spike in misconduct in March from a level that was already pretty bad (hardly a month with no violations) suggests that at least some CalPERS staffers were more fixated on their personal balance sheets than their day jobs.
On top of that, notice that ten people engaged in verboten transactions in the past quarter. It’s not as if CalPERS could pin this sorry picture on a hyperactive newbie. Eyeballing CalPERS’ staffing levels (for instance, 344 in the Investment Office), 500 is a high estimate of how many are subject to the personal trading policy. There’s no prettying up having 10 of CalPERS supposed best and brightest thumbing their noses at it.
If you read the personal trading regulation, the theory of how it is works is all Covered Persons submit proposed trades of covered public securities (which includes stocks, ETFs and ETNs but not thing like mutual funds and government securities) though an approved designated broker that is connected to CalPERS on-line platform to get pre-trade clearance. The investor will receive “immediate” notification if the transaction has been approved, and if not, will be given the reason for rejection.
The never-made presentation shows the types of violations for Covered Persons:
Blackout Period. If CalPERS trades a Covered Security, it’s off limits for the three days spanning the day before to the day after the transaction
Restricted List. This is a list of securities that are off limits because CalPERS insiders may have material non-public information about the company.
Holding Period. CalPERS requires at least a 30 calendar days between buying and selling, or alternatively, selling and re-purchasing, of a Covered Security. This is more a policy to discourage speculation generally than to bar abuse of internal-to-CalPERS information.
Missing Pre-Clearance. Not getting the required pre-clearance per above.
The biggest category of violations in March is in pre-clearance, which is also the biggest and most regularly abused type over the year. If CalPERS employees really are trading through the on-line platform, are they simply ignoring denials of trades? That makes the misconduct willful.2 One would normally wonder if these violations are twofers (someone violated pre-clearance to circumvent the blackout period) but knowing CalPERS, it’s a likely guess that the violations were catalogued in such a way as to minimize the total count.
Admittedly, brokerage firm employees will point out pre-clearance violations are not that uncommon, but the fact that they keep happening at meaningful levels relative to what is almost certainly a small population that actually trades stocks and ETFs and CalPERS (many with the liquid assets won’t want the hassle) indicates the violations aren’t being addressed in a serious manner.
Next is running roughshod over the blackout period. Recall that this restriction is meant to stop employees from front-running CalPERS.3
Now some might point to the lack of restricted list abuses as a sign that at least one part of CalPERS personal trading policy is working. It is, but not in the way you think.
Remember that the restricted list flags companies where CalPERS board members and employees might have material non-public information.
But as Keith Bishop pointed out in California Corporate Law many years ago, CalPERS is highly unlikely to be on the receiving end of corporate inside information. Big companies don’t talk to CalPERS about their businesses. Not only are the issuers not allowed to disseminate information to favored external parties, there’s also no incentive. In equities, CalPERS is an indexer; its active investing is through outside managers and CalPERS has been severely thinning their ranks.4
That formulation misses where CalPERS is most likely to have inside information, which is government securities. From Bishop:
CalPERS is an agency of an issuer (the State of California). Thus, it is possible that CalPERS’ board members and employees could, like the employees of any other issuer, become privy to material, non-public information about the state. In this way, CalPERS’ board members and employees are in no different position than the employees of any publicly traded company. Remarkably, however, the proposed rules specifically exclude debt securities issued by state and municipal governments from the definition of “covered securities”.
Mind you, it’s not just the State of California. CalPERS runs over 2200 pension plans, some of them for cities that issue their own debt. CalPERS employees are in a position to hear a lot of intel about the pain their contribution increases are causing, even more so than ever due to Covid-19. In other words, CalPERS is in a particularly advantaged position to know which entities are in acute distress, particularly which might wind up filing for bankruptcy. That insight like has market value.
In other words, the lack of restricted trading violations may largely be a function of CalPERS having made sure the areas where abuse is most likely to occur are never up for consideration.
But even if there were any names on the restricted trading list, no one is to know about it! I am not making this up. CalPERS takes the bizarre position that telling employees what was on the restricted list that would be inside information.
Anyone who has worked at a real firm that gets inside information all the time would tell you that’s bonkers. Confirmation comes via the fact that the SEC has no problem with widespread internal dissemination of restricted lists. From a SEC study of practices at broker-dealers:
As one attorney described CalPERS’ position:
What moron came up with this? I can’t even call it a “plan.” It’s Abbott and Costello.
“You can’t trade restricted stocks.” Which stocks are those? “I can’t tell you.” Then how will I know what not to trade? “Just don’t trade on inside information.” But I’m on the inside; everything I know could be deemed inside information. “I can’t tell you not to trade, just don’t trade based on anything that you know.” So I can only trade if I don’t know anything? “How do you know you don’t know anything? That’s inside information.” But will you know what I don’t know? “The SEC will tell me if they don’t like a trade you made. Then I’ll tell them that I didn’t know what you don’t know.” It sounds to me like you don’t know anything! “Exactly. Now get to work.”
CalPERS Toothless Enforcement
One reason the personal trading misconduct is so routine is that enforcement is a joke. The organization has sent the message that the policy is eyewash. At the very end of the regulation:
Violations. In the event of any alleged violation of this section 558.1, Enterprise Compliance shall conduct an investigation, which will include notification of an employee’s direct supervisor. Violations will be treated in accordance with Government Code section 19990, including but not limited to, Government Code section 19572.
Have a look at the CalPERS org chart:
Even though “Enterprise Compliance” is the equivalent of a C-level position, it’s less powerful than any other on that level. It has all of 24 employees. By contrast, Communications and Stakeholder Relations is set to increase to 80 in the next year.
Remember that “Covered Persons” includes all of the board, Marcie Frost, General Counsel Matt Jacobs and his key deputies, and Chief Investment Officer Ben Meng. Do you seriously think the Compliance Office could investigate CalPERS players who are clearly more powerful than they are? And the enforcement clearly does not contemplate how to handle abuse by board members, even though they are included in Covered Persons.
One of our long-standing observations about CalPERS: that it can’t be bothered to obey rules, even its own rules.
Let’s go back to one of the big sins we mentioned at the outset, using the consent calendar to hide serious misconduct. This is one of the mechanisms by which staff strips the board of power and to which the board all too happily acquiesces. Some other recent abuses of the consent calendar, which sets up the board simply to rubber-stamp an item with no discussion whatsoever:
Having the board cede most of its remaining authority over investments to staff (that was withdrawn due to blistering public comments)
Having the Pension, Health and Benefit Committee hand over more authority to staff (also on deck for last week, withdrawn by committee chair at the top meeting, apparently resulting from public comments firestorm the day before)
Having the board cede all of its authority over Treasury Management Policy and Treasury Management Reserve Policy, even over policy-setting to staff (the Finance and Administration Committee did wave that through, but amended at the full Board of Administration session last week)
Enough members of the public appear to be waking up to CalPERS dirty tricks that the board is now getting embarrassed by staff chicanery on a more regular basis, so much so that it is finally starting to penetrate their unwarranted lofty opinion of themselves. Maybe they’ll wake up to the fact that they are on the receiving end of a con job where no matter what, they’ll be the ones holding the bag.
1 See this document, which was incorporated into “Personal Trading Regulation” approved by the Office of Administrative Law in late 2016:
2 I’m at a loss to understand the notion of having what appears to be an honor system, given the toothless sanctions. At most brokerage firms, you have to have your account at the firm and if a security is on a restricted list, you can’t execute the transaction. Brokerage firms also have watch lists, where the usual concern is the appearance of front-running a client transaction. Transactions in those securities are subject to approval by the compliance department.
3 Those trying to minimize the misconduct might argue that CalPERS rebalances its S&P 500 index every day, and thus it’s hard to trade a stock like Microsoft since there will hardly be a day when CalPERS isn’t buying or selling it. The reality is no one was forced to join CalPERS. Its personal trading policy is public and can be read by anyone who might work there. If prospective employees can’t ditch their trading jockey habits and buy mutual funds, maybe this isn’t the right job for them.
4 Bishop did miss one area where CalPERS has occasionally been an insider to company information: on litigation. For instance, CalPERS was privy to the mortgage-backed securities settlement with Morgan Stanley. The amount Morgan Stanley agreed to pay was less than Mr. Market anticipated, so an insider would have made a nice turn if he had bought the stock before the terms were announced.