What’s Happening with the Pension Fund? -- Part 24

by Charles Schwartz, Professor Emeritus, University of California, Berkeley
schwartz@physics.berkeley.edu                         October 17, 2005

>> This series is available on the Internet at   http://ocf.berkeley.edu/~schwrtz

A Conflict of Interest Mess

     The UC Regents have just adopted a policy on Conflict of Interest for the Office of the Treasurer which looks reasonable on the surface; but a peak somewhat deeper shows major flaws.  Here is the policy statement adopted by the Board on September 22, 2005, after approval by the Committee on Investments on August 16.

The Regents have adopted Investment Policy Statements for the University of California Retirement Plan and General Endowment Pool, which assign limited roles and responsibilities to investment fiduciaries, with appropriate checks and balances.

The existing governance process has avoided the potential for and the appearance of conflicts of interest, with respect to the selection of individual investments or investment managers, by maintaining a separation of roles and responsibilities.

The Regents’ Committee on Investments, with advice from the Investment Advisory Committee, is responsible for oversight of the management of investments on behalf of The Regents. This involves the establishment of investment policies and oversight of the management of the assets. These responsibilities include approving an asset allocation policy, performance benchmarks, risk budgets, and investment guidelines.
The Treasurer is responsible for implementing the approved investment policies and the development of investment processes and procedures for asset allocation, risk management, investment manager selection and termination, allocation, monitoring and evaluation, and the identification of management strategies that will improve the investment efficiency of the Fund assets.

In order to maintain the highest fiduciary standards and to continue to comply with institutional investment best practices, this Policy explicitly separates the roles and responsibilities of various UC fiduciaries to ensure the continuance of sound investment practice and the protection against real or perceived conflict of interest, especially with regard to the selection of individual investments or investment managers. By separating the duties of investment policy-making and investment implementation, The Regents’ Committee on Investments has created an institutional framework to uphold the California Political Reform Act of 1974, which provides that public officials shall not make, participate in making or influence a governmental decision in which the official has a financial interest.

     So we see that a formal separation of functions, between the staff of the Treasurer’s Office and the Regents (along with their outside advisors on the Investment Advisory Committee), is supposed to guarantee that there will be no real or perceived conflicts of interest, especially in the sensitive matter of selecting the external managers for UC’s investment billions. Now lets look at an exchange that took place when this policy was considered at the August 16 meeting. (This is transcribed from the Secretary’s tape recording of that teleconference session.)

Interim Treasurer Marie Berggren:  [after presenting the item as written] …
If we ever get, and we have been asked, Has any regent ever had a material impact on any decision made within the Treasurer’s staff?, we can literally say, Absolutely no.  And I think that’s very important and I am sure you have all been reading what’s going on in Illinois.  And this, I feel very strongly about this: to make sure that the roles and responsibilities are maintained.

Regent Richard Blum:  Marie, this is Dick.  I couldn’t agree with you more and I presume when you say that, it is viewed inappropriate for any regent to ever suggest that you look at a given money manager or even a given

Berggren: No. No. Oh, no, no, no. Obviously, I mean, good ideas, I mean this is a wonderful group! I mean, if you know groups and you think that we should be looking at them, absolutely.  I think that that’s important to bring to our attention.  But I want to make sure that we don’t feel the pressure as a result of a regent’s affiliation to do anything that we wouldn’t ordinarily. So, I mean, fine.   We welcome that.  We want to know people

Blum:  OK. Because some people don’t even want that to happen, in other institutions.  But what you’re saying is, whatever decisions you make along these lines, they are made within your staff and that there shouldn’t be any lobbying. Is that fair to say?

Berggren:  Yes. I think. Undue influence on any decision. With respect to a name or a dollar amount allocated to that particular investment.

Blum:  OK. OK, thank you.

Berggren:   Because we want to be able to continue to say this.  So, we are recommending that we approve a policy that describes, which we have here, the responsibilities of each segment within the

Regent Gerald Parsky:  I think it is very important that we go on record with this. I’ll move this item.

     Well, now we see quite a different picture. It is fine for individual regents to “suggest” to the Treasurer or to others on the Treasurer’s staff that some particular money management firm should be looked at for getting a piece of UC’s business, just so long as the regent does not exert “undue influence” on any such decision.  What kind of fairy land are we living in?!

     Several months ago I made a formal request, under the California Public Records Act, to inspect various documents related to the Treasurer’s recent selection of a number of external money management firms to take on the active equity investments for our pension fund.  One of the items I requested was “All Due Diligence records compiled/collected by UC in connection with each firm.”  In a formal letter of response from UC’s Office of the General Counsel (dated July 8, 2005), I was informed that many of the documents I had requested were now available for inspection; but they said, “Your request for ”Due Diligence” records is ambiguous in that the University does not maintain any records specifically associated with that term.”  That was a bit surprising; the recently adopted “UCRP Investment Policy Statement” contains the following requirement:

When selecting investment managers, the Treasurer will:
· Follow a due-diligence process to make prudent selections of investment managers.
The due-diligence process will involve analyzing investment manager candidates in terms of [etc.]

     My particular interest in the “due diligence process” was to see what procedures were in place for identifying potential conflict of interest situations. As is well known, several of our regents (and, of course, also the members of the Regents’ Investment Advisory Committee) are prominently involved in the private investment industry.  Apparently, there is no such procedure at the Treasurer’s Office. A routine vetting of any potential or apparent conflicts would seem to me a sensible procedure.

     Here is an actual situation that caught my attention.  One of the firms selected to receive a piece ($432 million) of the Large Cap Domestic Equity investment from UC was Hotchkis & Wiley LLC, in Los Angeles. John Hotchkis has been a member of the Regents’ Investment Advisory Committee since its founding over five years ago. Is there a potential for, or an appearance of, a conflict of interest here?  The Treasurer’s Office, apparently, has no interest in such a question. (Their due-diligence is not very diligent, in this regard.) I did some investigations on my own.  John Hotchkis founded that investment firm in 1980 and later it was sold to Merrill Lynch. More recently the firm was bought back by its own management people, with some external investors; and on its website I saw that John Hotchkis maintained a regular newsletter on investment topics.  But did he have a financial interest in the new firm?  Eventually, I did find out that John Hotchkis has a 1.1% ownership.

     What are the rules, the state law and UC’s own policies, on conflict of interest?  Here is an excerpt from the University’s Conflict of Interest Code.

Financial Interests -- A designated official has a financial interest in a decision within the disqualification requirement of the Political Reform Act and of the Conflict of Interest Code if it is reasonably foreseeable that the decision will have a material financial effect, distinguishable from its effect on the public generally, on the designated official or a member of his or her immediate family, or on:
    (a)    Any business entity in which the public official has a direct or indirect investment worth two thousand dollars ($2,000) or more;

    (d)    Any business entity in which the public official is a director, officer, partner, trustee, employee, or holds any position of management; or …

     John Hotchkis certainly passes those tests for financial interest in that firm. Did he participate in, or influence, the decision for UC to do business with H&W?  I don’t know.  Is there the appearance of a potential conflict of interest situation here? Yes.  Is the Treasurer’s Office failing to provide the sort of investigations and public reports that are needed to maintain public confidence that there are no actual or apparent conflicts of interest in their management of huge amounts of public money?  Yes.

     And here is another failure that I discovered along the way.  Members of the Board of Regents (along with other UC officials) are required to file annual Financial Disclosure Statements, which are available to public inspection.  However, members of the Investment Advisory Committee have not done this. The Conflict of Interest law and the UC Code state that consultants are covered by this requirement; and these people are more firmly seated in influential positions than ordinary consultants.

Another Modest Proposal

     At the August 16 meeting of the Committee on Investments I made the following proposal, which has as yet received no response at all from UC officials.

The present form of Quarterly Investment Reports from the UC Office of the Treasurer, as they are made available to the public, give only aggregate performance data for each asset class.  This is inadequate in view of the recently implemented programs of active investment through a number of external investment managers.

a) Quarterly reports should contain data on Assets held and Performance for each individual external investment manager engaged by the University;
b) Annual reports should also contain data on Management Fees paid to each individual external manager as well as a listing of Commissions paid to all brokers.

This type of information is routinely published by CalPERS (see attached samples, downloaded from their website or copied from their Annual Report.) In the area of Private Equity investments, detailed information of this general sort is already published by the UC Treasurer’s Office; and I can see no reason why this should not be done for external investments in Public Markets. I believe that data of this sort is routinely collected and studied by the Treasurer’s Office; and that it would have to be produced in response to a request under the California Public Records Act.