Is It CalPERS' Turn to Clean House?

The California Public Employees' Retirement System has long pushed companies to clean up their acts. Now the nation's largest pension fund is getting flak for its own governance practices. But while other pension funds are overhauling their policies on hot-button issues—including campaign contributions and investment middlemen—CalPERS is making only marginal changes.

The worry among shareholder activists is that this new perception may hamper CalPERS' ability to enact change elsewhere. "It's embarrassing for CalPERS," says Charles M. Elson, chair of the John L. Weinberg Center for Corporate Governance at the University of Delaware. "What's the old saying about people who live in glass houses?"

HUGE SUMS AT STAKEThe main concerns center on the pension fund industry's relationship with money managers. CalPERS and the like dole out huge sums of money to financial firms to invest. Some worry that money managers are making campaign donations to elected officials to win lucrative state investment contracts with CalPERS and other pension funds. Others take aim at so-called placement agents, middlemen who get paid for steering those contracts to outside investment firms. As the largest—and one of the most powerful—pension funds, CalPERS is a prime target for critics. CalPERS defends its policies. Chief Investment Officer Joseph Dear says the pension fund takes great care to avoid potential conflicts of interest.

Over the years, the $200 billion pension fund has used its hefty financial clout to push for change at the companies in which it owns shares. It has railed against excessive pay for CEOs, campaigned to eliminate conflicts of interest on Wall Street, and lobbied to give investors a bigger voice at annual meetings. "It's always fun to hear them take companies to the woodshed," says John M.W. Moorlach, a county supervisor in Orange County, Calif. CalPERS called for the ouster of Walt Disney (DIS) Chairman Michael Eisner in 2005 over weak stock returns, as well as New York Stock Exchange (NYX) Chairman Richard Grasso, whose pay the fund called excessive in 2003.

Now CalPERS, which provides retirement and health-care benefits to 1.6 million state workers, is feeling the heat. Prosecutors, regulators, and lawmakers are taking aim at state pension funds for a broad range of ethical issues. For example, New York Attorney General Andrew M. Cuomo earlier this year announced an investigation into pension fund abuses. Other big pension funds are changing their ways in response to the pressure. But CalPERS seems to be resisting.

Consider the issue of campaign contributions. Some money managers with state contracts donate to the campaigns of elected officials, who typically populate the boards of pension funds like CalPERS. The concern is that these contributions could influence how officials award pension fund investment contracts.

The Securities & Exchange Commission is considering a ban on such donations to elected officials. While CalPERS says it supports the SEC's proposal, it has asked in comments to the agency that the ban not apply to political action committees (PACs), political parties, or charities associated with officials, unless the officials are soliciting the contributions. Other states have already implemented these sorts of restrictions. In New Jersey, the donation ban applies to 120 state officials and their PACs. CalPERS says the current disclosure requirements for board members are sufficient.

That may be, but such contributions are raising eyebrows. Former board member Sean Harrigan, for example, solicited large donations from money managers for a union fund while at CalPERS. The longtime union official has been subpoenaed by the SEC and the California attorney general as part of a broader probe into pension fund abuses. "He has absolutely done nothing unethical or illegal," says Harrigan's attorney, Mark Byrne.

Critics say CalPERS' response to the debate over placement agents is even more disappointing. Placement agents, the middlemen who direct state investment contracts to money managers, have been the subject of state and federal probes in recent months. The SEC is considering an outright ban on these players—and several pension funds have preemptively decided to restrict their money managers from using placement agents.

CalPERS hasn't. The California pension fund's official position on the SEC proposal is "neutral." "If the only way you are able to get access is to pay someone to use their connections, then you shouldn't get that business," says Mercer Bullard, a law professor at the University of Mississippi and advocate of pension fund reform. "It's morally wrong."

CalPERS' Dear says placement agents play a useful role in connecting big funds with small money managers, who don't have ample marketing staffs. CalPERS recently hired the law firm Steptoe & Johnson to review its relationship with these middlemen. It also asked investment bank Houlihan Lokey to assess the pension fund's lineup of outside money managers to see if they're doing anything improper or charging too much for their services. "One of the major expenses of running a fund is fees," says Dear. "I'm determined to get a deal for our fund."

These sorts of issues have been dogging CalPERS of late. In October the California pension fund disclosed that Arvco Financial Ventures, a placement agency run by former CalPERS board member Albert Villalobos, had received $50 million in fees for winning state investment contracts on behalf of money manager Apollo Global Management (AINV) over a five-year period. Even Dear said the sum "amazed" him. Villalobos didn't return calls.

WEDDING FAVORSAdding to the controversy, Villalobos hosted a wedding in 2004 at his Nevada mansion for CalPERS then-Chief Executive Fred Buenrostro, according to a Nov. 3 article in The Sacramento Bee. Buenrostro said he didn't have to disclose the wedding under state rules. "It's not whether it is right or wrong, it is the appearance of impropriety," says William J. Pollacek, treasurer for California's Contra Costa County.

Meanwhile, CalPERS' practices seem to be at odds even with its own advice for companies. In recent years the pension has fought hard to get companies to hold annual elections for the entire board so that directors will be held more accountable. That means getting rid of so-called staggered terms in which only a handful of board members come up for a vote each year. At CalPERS' urging, hospital bed maker Hill-Rom Holdings (HRC) announced on Oct. 6 that it would eliminate staggered terms for its board.

CalPERS itself has no such policies. None of its board members sit for an annual election; most serve four-year, staggered terms. CalPERS says its board election process is far more democratic than that of the typical company, where even getting on the ballot can be difficult. Nonetheless, says a CEO at a large company that has been targeted by CalPERS over this issue: "I don't think they have the moral high ground. They have a lot of issues in their shop."

    Before it's here, it's on the Bloomberg Terminal.