In the wake of accusations regarding a pay-to-play scandal involving a New York State pension fund and influence peddling at the California Public Employees' Retirement System (CalPERS), the California Legislature passed Assembly Bill 1743, which extends the reach of the Political Reform Act of 1974 to “placement agents.” Specifically, AB 1743, which will take effect on January 1, 2011, treats placement agents that act in connection with state pension or retirement funds as “lobbyists,” and thus imposes various registration and reporting requirements and constraints on placement agents. Among other things, lobbyists:
- Must register with the Secretary of State and renew their registration in every even-numbered year
- Must complete an ethics course biennially
- Must file a quarterly activity report, detailing any honoraria, gifts, fees, or other compensation provided to public officials
- Must register and file reports with local government agencies, as may be dictated by municipal ordinance or rule
- May not receive contingent fees paid by investment managers for the defeat, enactment, or outcome of a proposed investment action
- May not make campaign contributions to public officials or candidates for positions related to a state pension or retirement fund
- May not make gifts aggregating more than $10 in any calendar month to any one person
It is important to note that AB 1743 is specifically applicable to California state public retirement systems, which are currently comprised of CalPERS and the California State Teachers' Retirement System (CalSTRS). However, to the extent local government agencies incorporate the provisions of AB 1743, the persons or entities acting as placement agents in connection with the sale of securities, assets, or services of an external manager to local public pension funds or retirement systems also will likely fall under the new definition of lobbyist for purposes of local law.1
Placement Agent as Lobbyist
Following passage of AB 1743, the term lobbyist now includes a placement agent— an individual compensated to act for an external investment manager in connection with securing the investment of a state public pension or retirement system.
However, the Bill carves out two exceptions to the term placement agent:
- “an employee, officer, director, equityholder, partner, member, or trustee of an external manager who spends one-third of his or her annual time managing the assets held by the external manager; and
- any employee, officer, director or affiliate of an external manager, if that external manager is: (a) registered with the SEC or a comparable state securities regulator; (b) selected for investment through a statutorily defined competitive bidding process; and (c) willing to be subject to the fiduciary standard of care applied to the retirement fund board.”
An individual falling under either of these exceptions would not be considered a lobbyist under AB 1743 and, thus, would not be subject to the requirements or restrictions of the Political Reform Act.
While AB 1743 takes effect in 2011, there will be uncertainty about how its requirements are imposed until formal regulations are adopted. In the interim, we recommend that external investment managers maintain independent records of placement agent compliance with AB 1743. Specifically, investment managers should require an annual certification from each of its placement agents stating that the placement agent is registered with the California Secretary of State and is otherwise in compliance with AB 1743.
Additionally, investment managers should have any employee or other individual acting under either of the lobbyist exceptions listed above provide an annual written certification to the Secretary of State detailing satisfaction of the exception's requirements, at least until the application of those exceptions is better established.2
Prohibition of Contingency Fees for Placement Agents
Perhaps the most significant change enacted by AB 1743 involves the payment of contingency fees to placement agents. While the legislation is careful to allow the payment of fees by investment managers to placement agents for services rendered, such fees may not be contingent on “the defeat, enactment or outcome of any” proposed investment action. Despite lobbying by investment managers, no exception to this rule — long applied to lobbyists regarding proposed legislative or administrative action — was included in AB 1743.
A Change in Investment Manager Practices?
AB 1743 may alter the business relationship between external investment managers and placement agents. While there has been general support for greater oversight of placement agents, the ban on contingency fees in AB 1743 raises concerns about the continued use of placement agents by investment managers. Investment managers have long utilized the contingency fee structure to reward placement agent performance while ensuring competitiveness in securing public fund investment and managing internal risk. However, if investment managers lack the ability to make payment dependant upon success, the risk of paying a placement agent with no guarantee of return may be too high. Particularly in the case of smaller investment managers, upfront payment may be cost prohibitive. In addition, placement agents may find the obligation to register to be more burdensome than the benefit of working for non-contingency based payments. In sum, AB 1743 may lead many investment firms to scale-down the use of placement agents in dealings with California pension and retirement funds.3
Another Layer of Regulation
AB 1743, particularly its registration provisions, is largely duplicative of federal law in this area. Pursuant to the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC passed rules governing registration requirements for placement agents. Under that act, placement agents and other “municipal advisers” must register with the SEC, disclosing their lines of business, and any past securities-related infractions and criminal histories. Ultimately, the SEC adopted rules on a temporary and emergency basis to comply with timing guidelines set in the Dodd-Frank Act. The SEC considered, and ultimately rejected, a complete ban on the use of placement agents in the solicitation of public pension and retirement funds (which is in contrast to the City and State of New York, which in 2009 banned the use of placement agents for the solicitation of pension plans). Furthermore, the SEC rules do not include a contingency fee ban as found in AB 1743. The temporary SEC rules are set to expire at the end of 2011, but a permanent set of rules, with possible amendments, will replace them. The possibility that the permanent rules could include more stringent limitations on placement agents may depend on the success or failure of AB 1743 and other state measures.