Governmental Plans

It’s true, ESG is a ‘compliance minefield’

Sometimes, our friends in the press come up with a headline that simply cannot be topped. Yesterday, Ignites published an article called, “Going Green: Shops Work to Navigate ESG Compliance Minefield.” The article opens appropriately, noting that while ESG funds “may be all the rage with investors […] shops that fail to think carefully about their investment methodologies and related disclosures could end up in the SEC’s hot seat.” Indeed, though, the SEC is certainly not the only regulator to keep a close eye on ESG products and mandates. In the United States, the Department of Labor also has ESG on its radar. ESG is also a hot topic for numerous regulators and legislatures globally. What are some of they important compliance challenges?

  1. Are fund descriptions, registration statements and disclosures accurate? If ESG factors are considered as part of the fund’s strategy, do such documents reflect that reality correctly?
  2. If the firm has publicly committed to engage in certain conduct (e.g., shareholder engagement, etc.) by reason of membership in a particular group or alliance (e.g., UN PRI, Climate Action 100+, etc.), is the firm following through on its promises?
  3. Are global legal developments considered, recognizing that Europe, North America and Asia are at different stages of ESG statutory and regulatory promulgation?
  4. Have proxy voting policies been considered in light of SEC and DOL guidance?
  5. Does the investment management agreement explicitly require (or prohibit) the investment manager to vote proxies or exercise other shareholder rights on behalf of an ERISA plan?
  6. Are the investment manager and asset owner on the same page in terms of which ESG strategy will be pursued?
  7. Does the investment policy statement or investment guidelines specify which E, S or G factor is part of the investment mandate?
  8. Has the investment manager considered potential conflicts of interest of proxy adviser firms?
  9. If the client is a governmental plan, has the investment manager diligenced the applicable state statutes and constitutional provisions to confirm that implementation of the mandate complies with applicable law?
  10. Is disclosure in due diligence questionnaires accurate and factually supportable?


Bipastisan bill introduced to block TSP investment in China

What is the FX Global Code?

Foreign exchange (FX) is one of the most obscure asset classes for ERISA and governmental plans (as well as other institutional investors). The FX Global Code is an important development. The FX Global Code is a set of good practice principles for both buy-side and sell-side participants. It is also voluntary in nature. So, why should plan fiduciaries be aware of it? First, plan fiduciaries that invest in international securities will most likely hedge their exposure to that local currency. So while FX is rarely used as a source of alpha for plans, it is often used defensively. Second, FX is the largest market but probably the least understood. It’s long been obscure, I think. So what are some of the key principles?

(A) a clear understanding of whether a market participant acts as a principal or agent in executing a transaction;

(B) a need to handle orders with fairness and transparency, which includes making clear whether the prices quoted are firm or indicative, time stamping policy, etc.;

(C) pre-hedging as a principal only and in a manner that does not disadvantage the customer;

(D) understanding how reference prices are established;

(E) whether a markup is fair and reasonable (e.g., how much is the spread?); and

(F) having an effective compliance framework governing FX activities, including processes designed to identify and eliminate abusive or manipulative practices, escalation procedures once issues are identified, etc.

Not all of the principles in the Code apply equally to participants, but they do reflect a consensus (for the most part). A plan investment committee may wish to ask its investment managers whether it’s a signatory to the FX Global Code and how they intend to comply with it, and whether those managers will engage dealers on applicable principles.

CalPERS/CalSTRS enter into settlement over alleged bad investments

CalPERS declines to divest from private prisons

Staff at the California Public Employees’ Retirement System (CalPERS) are apparently opposed to the divestment of private prisons, according to a recent report. The CalPERS Investment Committee is expected to follow suit. Legislation forced the issue, but in almost all cases it is subject to a determination by the plan fiduciary that following such legislation comports with its fiduciary duties, often enshrined at the constitutional level.

Governmental/public plans – fiduciary due diligence considerations

A common question we field is how investment managers and others can provide services to governmental plans and state entities without running afoul of applicable law. “Governmental plans” refer to employee benefit plans offered to state, county or municipal employees. Texas Teachers and CalPERS are two examples. State treasury assets may also be subject to myriad restrictions. These plans/entities, though not subject to ERISA, present numerous due diligence considerations for service providers.

An immediate challenge is determining what rules apply to a particular plan. Fiduciary duties, prohibited transactions, investment restrictions and other important provisions may be found in the state constitution, numerous statutes, administrative regulations, local ordinances, case law and attorney general advisory letters. Each state, of course, differs in terms of (1) where these rules can be found and (2) how detailed and restrictive they are.

Various (but certainly not all) governmental plans are subject to laws that impose fiduciary duties that are quite similar to those found under ERISA. A minority have ERISA-like prohibited transaction rules, and of those, a scant few seem to offer any apparent analog to ERISA’s prohibited transaction exemptions.

In stark contrast to ERISA, a number of legislatures and regulators have formulated detailed investment restrictions, such as prohibitions on derivatives, investments prohibitions in certain countries, concentration caps, and ESG-related rules. It can be challenging to ensure that a term in draft investment guidelines does not conflict with these nuanced rules.

A number of governmental plans have very detailed disclosure requirements. While this is rarely a deal-breaker for a service provider, these disclosure rules entail special consideration to manage the administrative burden.

There are several other considerations, too, such as whether compliance with the procurement rules are necessary, the extent to which sovereign immunity applies, and ensuring that the applicable pay-to-play rules are satisfied.