Investment Management and Public Policy Alert

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1 Investment Management and Public Policy Alert October 2009 Author: Raymond P. Pepe K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit Pennsylvania Adopts Code of Conduct and Pay to Play Restrictions on the Award of Financial Services Contracts by Municipal Pension Funds: Inconsistencies and Omissions in the Code May Pose Significant Problems On September 18, 2009, amendments to the Pennsylvania Municipal Pension Plan Funding Standard and Recovery Act were adopted to improve the financial stability of municipal pension funds. 1 The legislation requires all municipal systems within two years to update information on the value and liability of their funds; establishes new funding requirements for distressed pension funds; and provides significant new sources of revenues to help Philadelphia and Pittsburgh, which operate the state s largest municipal pension funds, deal with unfunded liabilities. 2 The legislation also includes a new set of standards for the award of financial, legal, real estate, consulting and other professional services contracts by all municipal pension funds that have been informally described as a Code of Conduct for the operation of all municipal pension funds. While the primary goal of the legislation is to provide new sources of funds for distressed municipal pension funds, and to ensure the efficient use of the new funding, the Code of Conduct will have a significant impact upon all persons providing professional services to municipal pension funds. Where contracts are not awarded to the lowest bidder, the Code of Conduct requires the use of public and competitive procurement procedures for all new professional services contracts; requires the disclosure of any use of agents and lobbyists by vendors; limits communications between agents and lobbyists with municipal officials; disqualifies persons making political contributions and gifts to municipal officials and employees from being awarded contracts; and imposes sanctions for violations of these requirements. Implementation of the Code of Conduct, which is required by December 17, 2009, will be challenging for both pension fund managers and professional services contractors, both because of the extensive new procurement requirements established, but also because the legislation contains a variety of difficult to reconcile internal inconsistencies and fails to address a number of critical administrative details. Applicability of the Code of Conduct As of December 2008, local governments in Pennsylvania operated 1,064 separate pension funds for police and fire-fighting employees and 2,116 separate pension funds for non-uniformed employees. Together these funds comprise more than 25% of all the local government pension systems in operation in the United States; provide benefits to more than 135,000 employees; and, as of December 31, 2006, held total assets in excess of $18 billion. While the vast majority of these plans are

2 small, 25 of the funds hold assets in excess of $100 million, and two of the funds, both associated with the City of Philadelphia, hold assets in excess of $1 billion. iii Pursuant to cooperative agreements, more than 900 of Pennsylvania s municipal pension funds, with a combined membership of more than 9,300 employees and aggregate assets in excess of $1.19 billion, are administered by a state agency, the Pennsylvania Municipal Retirement System. Pennsylvania also has separate retirement systems for state employees, the Pennsylvania State Employees Retirement System, which has more than 219,000 members and assets in excess of $21 billion, and for public school employees, the Pennsylvania Public School Employees Retirement System, which has more than 425,000 members and assets in excess of $43 billion. The new Code of Conduct applies to all of Pennsylvania s 3,180 municipally operated pension funds, including the Pennsylvania Municipal Retirement System, but does not apply to the Pennsylvania State Retirement System or to the Pennsylvania Public School Employees Retirement System. iv Requirements for the Competitive Procurement of Professional Services Whenever municipal pension funds are not required by law to procure professional services from the lowest bidder, v the Code of Conduct requires funds to establish procedures for the procurement of services from the most qualified person after advertising solicitations for services; accepting applications and disclosure forms from contractors; reviewing the qualifications, experience, expertise and compensation of prospective contractors; adopting policies governing conflicts of interest; and giving notice of the basis for decisions regarding the award of contracts. A. Professional Services Subject to Competitive Procurement Requirements The Code of Conduct applies to all types of professional services, including investment services, legal services, real estate services and other consulting services. Beyond these examples, however, the law gives no guidance regarding how to distinguish professional services from other services; when contracts provide for the procurement of financial products rather than services; and leaves these important issues to be addressed by individual pension systems. Statutory construction principles, however, suggest that the general term professional services should be construed to apply only to items with similar characteristics as those specifically enumerated in the law, i.e., investment, legal, real estate and consulting services. vi Similarly, the competitive procurement requirements of the Code of Conduct do not exclude de minimis initial purchases of professional services regardless of the amount of purchase price. The law appears to allow existing contracts, however, to be amended to increase the cost of services by 10% or $10,000, whichever is greater, without competition, and in greater amounts if written justification for the increase is posted on a municipal website at least seven days prior to the contract amendment. Because these exceptions from competitive procurement may create unreasonable preferences for incumbent vendors, stricter requirements for contract amendments may be imposed by individual pension systems. In addition, municipal solicitors may construe the Code of Conduct in pari materia with other procurement laws so as to provide for de minimis exceptions. B. Advertising The Code of Conduct requires advertising regarding the availability of professional services contracting opportunities to be disseminated in a timely and efficient manner. Advertising must describe and provide specifications for the services to be procured and must set forth the procedures to compete for contracts and describe disclosures required from all vendors. Unfortunately, the Code of Conduct fails to specify how contracting opportunities must be advertised and when advertising must be disseminated. Requirements contained in the Pennsylvania Newspaper Publishing Act designating the publications in which legal advertising shall be published may fill some of these gaps, but issues regarding the timing and frequency of advertising are apparently left to local discretion. vii October

3 C. Disclosures and Conflicts of Interest Prior to entering into professional services contracts, the Code of Conduct requires contractors to identify each individual, advisor or subcontractor that will be providing services to a municipal pension fund; describe the services each individual will provide; and disclose whether any of these individuals are current or former officials or employees of the municipality procuring services or are registered federal or state lobbyists. The legislation fails to clarify, however, whether these disclosures are required of all persons submitting proposals to provide professional services, or only to the offerors determined to be most qualified. To determine how to utilize the information provided in disclosure forms, the Code of Conduct requires municipal pension systems to adopt policies regarding conflicts of interest that at a minimum impose a one-year restriction upon the participation of former officials or employees of the pension system in the submission of applications to provide professional services and upon the participation of former employees of a contractor in the review of proposals and the negotiation of the terms of services contracts. In addition, a professional services contractor may not have a direct financial, commercial or business relationship with any official of the municipal pension system or the municipality which controls the municipal pension system, unless the pension system consents in writing to the relationship following full disclosure. Unfortunately, the Code of Conduct provides no guidance regarding what constitutes direct financial, commercial or business relationships. The Code of Conduct also applies the restrictions upon direct financial, commercial or business relationships only to relationships with municipal officials rather than municipal employees, and fails to clarify whether these restrictions also apply to officers, directors, employees and owners of entities entering into professional services contracts. As a result, this is a further area in which individual pension systems may adopt supplemental requirements to remedy inconsistencies and omissions in the state legislation. D. Awards Upon the award of any professional services contract by a municipal pension system, the relevant factors that resulted in the award must be summarized in a written statement provided within ten days to any unsuccessful applicants and posted on the municipal webpage at least seven days prior to the execution of a contract. Following the award of contracts, the Code of Conduct also requires all applications and disclosure forms submitted to pension plans, except for proprietary information or other information protected by law, to be treated as public records subject to disclosure. While the Code of Conduct fails to clarify what constitutes proprietary information, the Pennsylvania Right to Know Law defines confidential proprietary information as confidential or privileged information the disclosure of which will cause substantial harm to the competitive position of a person. The Right to Know Law also prohibits the disclosure of internal, pre-decisional deliberations of agencies and financial information of persons responding to requests for proposals used to demonstrate a person s economic capability. viii Restrictions on the Use of Agents and Lobbyists The Code of Conduct requires any person that enters into a professional services contract or intends to enter into a contract to disclose the employment or compensation of any third party intermediary, agent or lobbyist used to directly or indirectly communicate with a municipal pension system or municipal official or employee in connection with any transaction or investment involving the contractor. These requirements do not apply to officials or employees of investment firms engaged in their standard professional duties on behalf of the firm, but do apply to any affiliated entity of the contractor or prospective contractor. The Code of Conduct, however, provides a narrow definition of the term affiliated entity that is limited to a subsidiary or holding company of a lobbying firm; a business owned in whole or in part by a lobbying firm; or a nonprofit organization established by a lobbying firm, lobbyist or another affiliated entity. In what constitutes a significant inconsistency in the Code of Conduct, officials and employees of investment firms need not disclose their role in communicating with pension systems and municipalities, but no such exemption is provided to October

4 employees engaged in providing legal, real estate, consulting or other types of professional services. Following the advertisement of solicitations for a professional services contract, the Code of Conduct provides that a prospective contractor may not cause or allow a third party to communicate with officials or employees of [a] municipal pension system except for requests for technical clarification. Technical clarifications may also be requested only from a designated employee of the pension system. Prospective contractors may, however, respond to requests for clarification or additional information from a municipal pension system. Because the Code of Conduct bars ex parte contacts by third parties, but not by contractors themselves, and does not distinguish between communications related to the procurement process versus unrelated communications required in the ordinary course of business, it seems likely that individual pension systems may need to adopt policies or rules for the effective implementation of these requirements. Restrictions on Political Contributions and Gifts The Code of Conduct prohibits a person who within the past two years has made a campaign contribution to a municipal official or candidate for municipal office in the municipality which controls the municipal pension system from entering into a professional services contract with the pension system. These restrictions also apply if an affiliated entity has made a contribution within the two-year period, ix but do not apply to political contributions made prior to the effective date of the Code of Conduct, i.e., December 17, Similarly, the Code of Conduct prohibits professional services contractors from offering or making any gift having more than a nominal value to any official, employee or fiduciary of a municipal pension system. The Code of Conduct also prohibits a contractor or prospective contractor from soliciting a contribution to any municipal official or candidate for municipal office in the municipality where the municipal pension system is organized or to the political party or political action committee of that official or candidate. Persons holding professional services contracts with municipal pension funds are also required to update their required disclosures annually, and to report gifts to officers or employees of pension funds and municipalities controlling pension funds. These restrictions also apply to any agent, officer, director or employee of a contractor or prospective contractor. The restrictions on political contributions and gifts established by the Code of Conduct contain a number of inconsistencies and omissions that seem likely to generate substantial confusion that may need to be addressed through the adoption of supplemental requirements by municipal pension systems. For example: While the ban on the solicitation of contributions applies to contractors and their officers, directors and employees, the ban on contributions themselves applies only to contractors. While the ban on contributions made by contractors applies to affiliated entities that are subsidiaries, holding companies, owners, and nonprofit entities created by lobbying firms, the ban does not apply to contributions made by political committees affiliated with contractors, or by parents or subsidiaries of contractors. No time period is specified for application of the prohibition upon soliciting campaign contributions by contractors and prospective contractors, and no guidance is provided to distinguish unlawful solicitation from political speech protected by the First Amendment. The prohibition upon contractors making gifts to municipal officials and employees does not appear to apply to prospective contractors and does not appear to apply prior to the execution of contracts with pension systems. No guidance is provided regarding how to measure the two-year restriction on making contributions and no clarification is provided regarding whether the two-year limitation on contributions applies to agents, officers, directors and employees of contractors and prospective contractors. October

5 While the ban on the solicitation of political contributions applies to political committees and party committees, the ban on contributions themselves does not apply to political committees and party committees. In addition to these inconsistencies and omissions in the legislation, significant constitutional questions exist regarding the validity of an outright ban on contributions for pension system contractors. In DePaul v. Commonwealth, 969 A.2d 536 (Pa. 2009), the Pennsylvania Supreme Court held a total ban on political contributions by persons involved in the casino and horse racing industries to be unconstitutional when the objectives of the Pennsylvania Gaming Law could have been met with more narrowly structured limitations on the amounts of political contributions. The same principle may apply to the ban on contributions provided by the Code of Conduct because its objectives could similarly be achieved by restrictions and limitations on contributions similar to those provided by Rule G-37 of the Municipal Securities Rulemaking Board. x Mandatory Disclosures of Political Contributions and Gifts As a mechanism to enforce the Code of Conduct s restrictions on political contributions and gifts, the legislation requires persons contracting to provide professional services to municipal pension funds, and persons who have applied for, submitted an offer or bid for, responded to a request for proposals, or otherwise solicited a professional services contract, to disclose all political contributions made within the last five years. The reporting requirements apply to contractors; their officers, directors, executive level employees, and affiliated entities; and to any persons with a five percent or greater ownership interest in a contractor or prospective contractor. Reports must disclose contributions made to any municipal candidate for public office or office holder, or the political committee of any municipal candidate or officer holder, if any individual contribution, or the aggregate amount of all contributions, exceeds $500. The reporting requirements of the Code of Conduct supplement, but do not replace, similar less extensive reporting requirements imposed upon all business entities awarded non-bid contracts by state and local agencies by the Pennsylvania Election Code. The Election Code requires the submission of reports by February 15 th of each year concerning all political contributions made during the prior year by officers, directors, associates, partners, limited partners or individual owners, and members of their immediate families, if the total contributions made by all such individuals exceed an aggregate of $1,000, and all employees of a business entity, and members of their immediate families whose contributions exceed $1,000. xi The term executive level employee as used in the reporting requirements for political contributions means an individual who can affect or influence the outcome of [a contractor s, prospective contractor s, or an affiliated entity s] actions, policies or decisions relating to business with a municipality or municipal pension system, or an individual directly involved in the implementation or development of policies relating to the conduct of business with a municipality or municipal pension system. Contractors are also required to report gifts to officials and employees of municipalities and pension systems and all direct financial, commercial or business relationships with officials and employees of municipalities and their pension systems. In the event of any violations of these reporting requirements, or the disclosure requirements associated with the submission of applications to enter into professional services contracts, municipal pension systems are required to void professional services contracts with any person that knowingly makes a material misstatement or omission in a disclosure form and must prohibit the person from entering into a contract for a period of up to three years. As is the case with the restrictions on contributions and gifts included in the Code of Conduct, these reporting requirements also contain a number of inconsistencies and omissions that raise numerous questions that may need to be addressed through the adoption of supplemental requirements by municipal pension systems. For example: The legislation fails to clarify whether the $500 disclosure limit is calculated annually or applies October

6 to the total five-year period, and from what date the five-year period is measured. The reporting requirements apply to contributions to candidates, office holders, and their political committees, but not to unaffiliated political committees, such as corporatesponsored political action committees, that may in turn make contributions to the same candidates, office holders and political committees. No clarification is provided regarding whether contributions to both state and federal candidate committees must be reported. Gifts and direct financial, commercial or business relationships must be reported by contractors, but not by prospective contractors, or by the officers, directors, executive level employees or owners of either contractors or prospective contractors. No clarification is provided regarding for what period of time gifts and direct financial, commercial or business relationships must be reported. Preemption and the Need for Uniform Rules and Policies Recognizing that the City of Philadelphia previously imposed similar and in many cases stricter requirements, the Code of Conduct expressly provides that it does not preempt codes of ethics adopted by municipalities stricter than those imposed by state law. xii While the absence of preemption on one hand poses the danger that a confusing maze of non-uniform policies to implement the new law may arise, it also affords individual pension systems the ability to craft supplemental requirements to address the numerous inconsistencies and administrative omissions of the new legislation. Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London Los Angeles Miami Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d Alene Taipei Washington, D.C. K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; and a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer K&L Gates LLP. All Rights Reserved. 1 Act (September 18, 2009), House Bill 1728, Printer s No. 2638, 53 P.S et seq. 2 The City of Philadelphia is authorized to collect an additional one percent sales tax for the next five years and defer its pension costs over the next three years; and the City of Pittsburgh is authorized to lease or sell its parking garages and keep 2.5% of its parking tax revenue to pay for pension contributions. iii Pennsylvania Public Employee Retirement Commission, Status Report on Local Government Pension Plans, December iv This omission may have occurred because Pennsylvania has a fairly strict constitutional single-subject rule for legislation which the General Assembly may have concluded made it impractical to address issues relating to state retirement systems in legislation dealing with local retirement funds. Whether the Code of Conduct will be extended to apply to the state retirement funds, however, is uncertain. v Very few types of services, other than printing, are currently subject to competitive bidding requirements. vi McClellan v. Health Maintenance Organization of Pennsylvania, 546 Pa. 463, 686 A.2d 801, 806 (Pa. 1996) ( where general words follow the enumeration of particular classes of persons or things, the general words will be construed as applicable only to persons or things of the same general nature or class as those enumerated. ). October

7 vii 45 Pa.C.S. 101, 302, 307, 308. The Newspaper Publishing Act requires all legal advertising, i.e., all advertising required by law, regulation, ordinance or court order, to be published in newspapers of circulation and local newspapers in the counties in which municipalities are located. Advertising is not required in legal journals for bids for contracts for public work, materials or supplies, or lists of delinquent taxpayers, but no comparable exemption exists for advertising regarding the procurement of services. viii 65 P.S , (b)(10) & (26). ix As noted previously, the law defines the term affiliated entity to mean only a subsidiary or holding company of a lobbying firm; a business owned in whole or in part by a lobbying firm; or a nonprofit organization established by a lobbying firm, lobbyist or another affiliated entity. x Rule G-37 allows contributions of up to $250 provided the contribution is made to a candidate or a candidate s committee for which the contributor is eligible to vote. xi 25 P.S. 3260a; 4 Pa. Code Ch xii The Pennsylvania Public Employees Retirement Commission is authorized to issue rules, regulations, policies and procedures necessary for the effective administration and operation of the Municipal Pension Plan Funding Standard and Recovery Act. The Commission has no plans, however, to develop rules, policies or procedures relating to implementation of the Code of Conduct. October