Better safe than sorry, trustees say

A court ruling in California has public pension fund trustees in that state — and across the country — walking out of board votes rather than risk being charged with conflicts of interest.

A state appeals court ruling created the confusion. That ruling — by the California Court of Appeal, Fourth District, San Diego, in Lexin vs. Superior Court — found that trustees, who often are participants in the retirement systems on whose boards they serve, can be criminally liable if they approve a contract that tangentially provides them a personal benefit.

Some observers are concerned the ruling could affect a board of trustees’ ability to adopt rates of return and other assumptions underlying plans’ actuarial valuations.

The appellate ruling let stand criminal indictments of former board members of the $4.8 billion San Diego City Employees’ Retirement System on charges that they reaped personal gain by allowing the city to underpay its contributions to the pension fund, resulting in a massive deficit. But the opinion also eliminated a “safe harbor” that exempted public board members in California from most conflict-of-interest situations, in effect extending the criminal liability to less extreme circumstances than occurred in San Diego, according to lawyers and public pension system officials.

The case now is awaiting review by the California Supreme Court.

In the meantime, nervous board members are declining to participate on some votes and walking out of meetings while the votes are being cast.

“People have been recusing themselves and they have a heightened sense of disclosure. I’ve seen half of the board members have to leave a meeting,” Harvey Leiderman, San Francisco-based partner for law firm Reed Smith LLP.

The ruling has had a ripple effect across the country, said Robert Klausner, general counsel of the National Conference on Public Employee Retirement Systems, Washington. He said he’s been at pension board meetings outside of California — including in Louisiana and Florida — in which board members declined to vote on an issue because of the Lexin opinion.

In California, board members have been contacting their attorneys about potential conflicts before voting. Some are declining to vote.

For example, four of the 11 members present at the San Diego City board’s Nov. 16 meeting recused themselves and left a closed session before a vote on whether to retain the formula used for participants to purchase additional service credits and to continue to amortize the pension fund’s shortfall through the existing unfunded actuarial liability. The four all are plan participants.

When they do vote, trustees are putting lengthy disclosures of possible conflicts into meeting documents, hoping the disclosures will protect them. For example, meeting agendas for the San Diego City Employees Retirement System’s board for the last several months included almost a full page of disclosures.

Four of the seven members of the $11.1 billion Los Angeles City Employees’ Retirement System’s board are either current or former employees and could be affected by the Lexin opinion, said Robert Aguallo Jr., general manager. So far, they have not had to walk out on a vote, he said, but that could change in the coming months when the board is asked to approve cost-of-living adjustment rates for next year.

“The (Los Angeles) city attorney has advised us and the Los Angeles Fire and Police board to be more cautious and be aware that this decision could have an affect on their abilities to make decisions,” Mr. Aguallo said.

A group of 17 California public pension systems — including the $244.8 billion California Public Employees’ Retirement System and the $173.7 billion California State Teachers’ Retirement System, both based in Sacramento — are preparing a friend-of-the-court brief favoring reversal of the appellate decision. NCPERS is expected to file a similar brief.

“Trustees have to be free to make decisions without fear that some of them participate in the plan and it would leave them exposed to criminal liability,” said Mr. Klausner of NCPERS. “We think the court got it wrong.”

The case is being watched nationally. The Louisiana Legislature, for one, is wrestling with similar issues as its members debate amending the state constitution to strip pensions from board members for conflicts of interest.

California, like other states, requires public retirement systems to include employees or retirees on their boards, explained Ashley K. Dunning, partner at San Francisco-based law firm Manatt, Phelps & Phillips LLP, who is representing the 17 pension systems. Roughly half of the members of public boards in California are or were public employees. Therefore, about half of the members of every public fund board in California as well as the retirement system’s entire executive staff, could benefit from most decisions made by the board for the benefit of plan participants and therefore, risk running afoul of criminal conflict of interest laws, even if the benefits are provided on precisely the same terms and conditions as if they were not board members or staff, Ms. Dunning explained.

Most states impose civil penalties, not criminal ones, Mr. Klausner noted.

If allowed to stand, the Lexin decision could make board members second-guess investment decisions, Mr. Klausner said. Board members could worry that decisions affecting returns could affect contributions, tangentially benefiting the board member.

“These public pension boards have baked into their makeup potential conflicts of interest because, by law, they include people who are members,” he said.

In the San Diego case, former board members including Cathy Lexin, former city human resources director, were charged in 2005 with violating their fiduciary responsibilities and, in some cases, engaging in felony conflicts of interest, by repeatedly allowing the city to underpay its contribution to the city’s pension plan. The plan had $3.2 billion in assets and an unfunded liability of at least $1.1 billion as of June 30, 2004. The system still has a $1.2 billion unfunded liability, according to the June 30 valuation updated last week.

Making matters worse is a state Supreme Court ruling in another case that said legal advice doesn’t protect board members from potential criminal liability.

“As a result of Lexin, board members have been asking whether they can participate in votes; but if they can’t rely on what their attorney tells them, they are in quite a quandary,” said Mr. Leiderman, who is fiduciary counsel for a number of public pension plans including the $8 billion Orange County Public Employees Retirement System, Santa Ana, Calif.

“If every time board members do their normal job they expose themselves to criminal prosecution, you won’t be able to find anybody who wants the job.”

“If you take Lexin to its extreme, you could bring the day-to-day operations of a system to a halt,” he said.

At least one union is questioning whether its members should continue to sit on pension boards. For many years, at least one full and one alternate member of the $8.4 billion San Diego County Employees Retirement Association board come from the ranks of the Sheriff’s Department. (In all, six of the nine board members are plan participants.)

These members “now find themselves at risk of felony prosecution for performing the very duties and responsibilities they were elected to perform,” wrote Fern M. Steiner, partner at Tosdal, Smith, Steiner & Wax, attorneys for the Sheriff’s Association of San Diego County, in a letter asking the Supreme Court to review the Lexin case. “As we explain the Lexin decision to our members, it becomes clear that deputy sheriffs and other employees of the county should decline to run for or sit on the SDCERA Board, since doing so exposes them to the risk of a devastating, life-altering felony prosecution,” Ms. Steiner wrote.