Fiduciary Fundamentals for Public Retirement System Trustees Presentation to the SACRS Educational Symposium Sacramento Convention Center March 20, 2009 Ashley K. Dunning Manatt, Phelps & Phillips, LLP

2 Overview of Topics Fiduciary Duty of care Fiduciary Duty of loyalty Legal standards used to review Boards’ actions Processes to demonstrate fiduciary compliance

3 Fiduciary Duty of Care Prudent Expert Rule “The members of the retirement board... shall discharge their duties with respect to the system with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.” Cal. Const., art. XVI, § 17(c) (emphasis added).

4 Fiduciary Duty of Care (cont.) Duty to Assure Competency of Retirement System Assets “The retirement board of a retirement system... consistent with the exclusive fiduciary responsibilities vested in it, shall have the sole and exclusive power to provide for actuarial services in order to assure the competency of the assets of the... retirement system.” Cal. Const., art. XVI, § 17(e) (emphasis added).

5 Fiduciary Duty of Care (cont.) Duty to Monitor The duty to monitor and to take corrective action when reasonably appropriate is fundamental to a trustee’s exercise of the duty of care. Rest. 3d Trusts, § 227, p. 14 (1992), comment d (“The duty of care requires the trustee to exercise reasonable effort and diligence in making and monitoring investments for the trust, with attention to the trust’s objectives”).

6 Fiduciary Duty of Care (cont.) Duty to Monitor (cont.) In Public Service Co. of Colorado v. Chase Manhattan Bank, 577 F.Supp. 92 (S.D.N.Y. 1983), the trustee bank was held liable for a loss to the trust from a multi-million dollar mortgage on a large apartment complex because the court found that the trustee made inadequate efforts to monitor the investment and should have known of information that would have revealed that the investment had become imprudent such that it should have disposed of the mortgage. In Citizens and Southern National Bank v. Haskins, 254 Ga. 131, 327 S.E.2d 192, 197 (1985), the court noted that a trustee’s duty to analyze investments “is a continuing one and although it does not require a trustee to ‘watch the ticker as a speculator would’ it does require review and the exercise of the necessary care and skill.”

7 Fiduciary Duty of Care (cont.) Duty to Consult with Experts “To the extent necessary or appropriate to the making of informed investment judgments by the particular trustee, care also involves securing and considering the advice of others [such as legal, actuarial and investment counsel] on a reasonable basis.” Rest. 3d Trusts, supra, § 227, p. 15, comment d. The implicit corollary to that proposition is that if a fiduciary fails to follow the advice of its professional consultants, it must demonstrate an informed, reasonable, and prudent rationale for failing to do so.

8 Fiduciary Duty of Care (cont.) Duty of care = Duty of prudence Prudence requires asking questions and understanding rationale for actions before taking them Prudence requires analyzing advice and recommendations received from experts, not acting as a “rubber stamp” Prudence requires following the Plan Document and other applicable law governing the retirement system

9 Fiduciary Duty of Loyalty Exclusive Benefit Rule “The retirement board of a... retirement system shall have the sole and exclusive fiduciary responsibility over the assets of the... retirement system... to administer the system in a manner that will assure prompt delivery of benefits and related services to the participants and their beneficiaries. The assets of the... retirement system are trust funds and shall be held for the exclusive purposes of providing benefits to participants in the... retirement system and their beneficiaries and defraying reasonable expenses of administering the system.” Cal. Const., art. XVI, § 17(a) (emphasis added).

10 Fiduciary Duty of Loyalty (cont.) Primary Duty Rule “The members of the retirement board... shall discharge their duties with respect to the system solely in the interest of, and for the exclusive purposes of providing benefits to, participants and their beneficiaries, minimizing employer contributions thereto, and defraying reasonable expenses of administering the system. A retirement board’s duty to the system’s participants and their beneficiaries shall take precedence over any other duty.” Cal. Const., art. XVI, § 17(b) (emphasis added).

11 Fiduciary Duty of Loyalty (cont.) Loyalties of Board Members No “dual loyalties,” as would occur if a Board member acted as an “agent” for the party that appointed or elected him or her to the Board. See generally National Labor Relations Board v. Amax Coal Co., 453 U.S. 322, 101 S. Ct. 2789, 69 L. Ed. 2d 672 (1981)

12 Fiduciary Duty of Loyalty (cont.) Loyalties of Board Members (cont.) NLRB v. AMAX incorporated traditional fiduciary duties into the employee benefit trust provision of the pre-ERISA Labor- Management Relations Act (LMRA), holding that although the statute: “requires an equal balance between trustees appointed by the union and those appointed by the employer, nothing in the language of [the provision] reveals any congressional intent that a trustee should or may administer a trust fund in the interest of the party that appointed him, or that an employer may direct or supervise the decisions of a trustee he has appointed.” 453 U.S. at 331 (emphasis added).

13 Fiduciary Duty of Loyalty (cont.) Loyalties of Board Members (cont.) NLRB v. AMAX also noted that the “The management-appointed trustee ‘represents’ the employer only in the sense that he ensures that the union-appointed trustee does not abuse his trust with respect to the funds contributed by the employer. Nowhere in the debates over [the LMRA trust provision regarding board composition] did any Member of either House of Congress suggest that the employer ‘representative’ as a trustee of a benefit fund created under this statute could or should advance the interest of the employer in administering the fund.” 453 U.S. at 330, n.13.

14 Fiduciary Duty of Loyalty (cont.) Loyalties of Board Members (cont.) California law applicable to public pension funds also does not permit trustees to administer the retirement system as an “agent” for the party that appointed, or subgroup of members that elected, that individual to the Board. On the contrary, the California Constitution (Prop. 162) seeks to prevent such political “meddling” or “interference” by others and mandates loyalty to the overall best interest of members and beneficiaries. California cases confirm that many traditional fiduciary duties apply to public retirement system trustees. Hittle v. Santa Barbara County Employees’ Retirement Association, 39 Cal. 3d 374 (1985); Claypool v. Wilson, 4 Cal.App.4th 646, (1992) (stating that Article XVI, Section 17 of the Constitution imports the existing law of trusts).

15 Fiduciary Duty of Loyalty (cont.) Loyalties of Board Members (cont.) California authorities have, however, permitted public retirement system fiduciaries to take actions that result in reduction in employer contributions so long as those actions do not compromise competency of assets of the retirement system to pay promised benefits; no conflict of interest arises in doing so; and the action is in the overall best interest of members and beneficiaries. See generally Bandt v. Board of Retirement (2006) 136 Cal.App.4th 140; see also Claypool v. Wilson (1992) 4 Cal.App.4th 646.

16 Fiduciary Duty of Loyalty (cont.) Collateral interests of Board members? The strict duty of loyalty in trust law ordinarily prohibits the trustee from... investing in a manner that is intended to serve interests other than those of the beneficiaries or the purposes of the settlor. Thus, for example, in managing the investments of a trust, the trustee’s decisions ordinarily must not be motivated by a purpose of advancing or expressing the trustee’s personal views concerning social or political issues or causes. Rest. 3d Trusts, supra, § 227, p. 12, comment c (emphasis added).

17 Fiduciary Duty of Loyalty (cont.) Collateral interests of Board members? (cont.) Common thread in case law and academic publications regarding duty of loyalty with regard to “collateral” interests: social interests may be advanced through investments by fiduciaries only so long as the interests of trust beneficiaries (e.g., risk-adjusted returns provided to members and beneficiaries) are not compromised thereby. See generally DOL Advisory Opinion A regarding proxy voting under ERISA: “as the Department has indicated in other contexts, plan fiduciaries may not increase expenses, sacrifice investment returns, or reduce the security of plan benefits to support or promote goals not directly related to the plan”; and DOL Advisory Opinion 98-04A regarding socially responsible investing: “A decision to make an investment, or to designate an investment alternative, may not be influenced by non-economic factors unless the investment ultimately chosen for the plan, when judged solely on the basis of its economic value, would be equal to or superior to alternate investments.”

18 Fiduciary Duty of Loyalty (cont.) Conflicting interests among members and beneficiaries? Can be complex and crosscutting. Determinations of priorities among members and beneficiaries must serve the overall best interest of members and beneficiaries of the retirement system. Appropriate balance may not be obvious when the interests within the member and beneficiary groups are not the same.

19 Fiduciary Duty of Loyalty (cont.) Conflicting interests among members and beneficiaries? (cont.) Dissimilar interests among beneficiaries are built into most trusts. Trust law has evolved to grant trustees a fair measure of discretion to balance those competing beneficiary interests. See Rest. 3d Trusts, §§ 50, 183 comment a, and 232; Estate of Bissinger, 212 Cal.App.2d 831, 833 (no liability where trustee bank “acted reasonably, prudently, in good faith and in the exercise of its best judgment... and with the intention of being fair to both the income and remainder beneficiaries”); and IIIA Fratcher, Scott on Trusts, § 232, p. 7 (4th ed. 1988) (“The trustee, however, ordinarily has considerable discretion in preserving the balance between beneficiaries”).

20 Fiduciary Duty of Loyalty (cont.) Conflicting Interests Among Members and Beneficiaries? Examine purposes identified in Plan Document (’37 Act provisions, Bylaws/Regulations and, possibly, certain existing Policies) and determine means to serve those purposes. Consider number of active, deferred and retired members and their beneficiaries affected by Board action. Consider degree of hardship created by potential curtailment or provision of particular benefit. Consider equities as between members/beneficiaries. Consider whether proposed action implicates any vested rights of members/beneficiaries, including, without limitation, actuarial competency of retirement system assets to pay promised benefits.

21 Legal Standards Used to Review Retirement Boards’ Actions Standard of Review and Related Issues Arbitrary and capricious standard for “quasi-legislative” acts Strumsky v. San Diego County Employees Ret. Ass’n (1974) 11 Cal.3d 28, 34 n.2 (different standards of review for quasi-legislative and quasi-adjudicative acts of retirement boards). Deference to administrative discretion In re Retirement Cases (2003) 110 Cal.App.4th 426, 471 (“when a statute imposes upon an administrative body discretion to act under certain circumstances, mandate will not lie to compel the exercise of such discretion in a particular manner”). Op. Att’y Gen. No (December 1, 2006), p. 7 (“As long as an actuarial method is ‘reasonable’ and not ‘arbitrary’ or ‘irrational,’ it may be applied even though other approaches may be equally correct or even ‘more precise’ or ‘better.’”).

22 Legal Standards Used to Review Retirement Boards’ Actions (cont.) Deference to administrative discretion (cont.) Mathews v. Ventura County Employees’ Retirement Association, Ventura County Superior Court Case No (Statement of Decision, February 17, 2005) (appeal abandoned October 4, 2006) (in a non-precedential decision, court concluded that VCERA did not violate Cal. Constitution when it required the County to pay no or reduced employer contributions when the system’s funded ratio was over 100% where “There was no evidence in the record that the County controlled or influenced the actuaries used by VCERA. Instead, the evidence presented in this case was that VCERA’s actuaries were competent, independent and only used accepted actuarial methodologies in determining when and how much, if any, the County was required to contribute to the retirement fund.”).

23 Legal Standards Used to Review Retirement Boards’ Actions (cont.) Evidentiary Issues Legislator’s subjective motives are irrelevant. County of Los Angeles v. Superior Court (1975) 13 Cal.3d 721, (given the general rule that the validity of legislation does not turn on legislative motive, the mental processes of individual legislators become irrelevant and the courts do not peer into these subjective realms). NOTE: Intent may potentially become relevant, however, if conflicts of interest or other crimes are alleged. FURTHER NOTE: Attorney-client privilege is held by the Board, and thus cannot be waived by an individual trustee or staff member. Further, because the Board holds the privilege, no individual trustee or staff member can assert the privilege to prevent Board counsel from communicating anything said to him or her by the individual trustee of staff member to the Board.

24 Processes to Demonstrate Fiduciary Compliance Recognize that although Courts afford Board’s broad discretion in decision-making, “exclusive authority” is not absolute discretion Avoid “abuse of discretion” Process important – make sure record reflects that process: minutes reflecting deliberation, written materials provided by expert consultants Education, inquiry, disclosure of reasons for action, reflecting due consideration to overall best interest of members and beneficiaries Active independent actuarial oversight Active independent investment oversight Legal consultation and compliance with applicable statutes

25 Fiduciary Goal When Addressing Actuarial and Economic Issues In Current Environment A Board of Retirement must use informed judgment and act in the overall best interest of system members/beneficiaries in a manner that is consistent with applicable laws when exercising its plenary authority over actuarial and investment determinations, and its actions in that regard may not be “arbitrary” or “capricious” and must be rationally related to the evidence presented to the Board.

26 QUESTIONS? Ashley K. Dunning manatt | phelps | phillips W. Olympic Blvd., Los Angeles One Embarcadero Center, 30th Fl., San Francisco Direct tel: (415)