FIDUCIARY AND ETHICAL RESPONSIBILITIES
OF
MUNICIPAL RETIREMENT BOARDS

Bruce B. Barth
Connecticut Public
Pension Forum
March 22, 2000

I.          ERISA

Governmental plans are not subject to the provisions of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  Therefore, such plans are not subject to the rules governing fiduciary conduct contained in ERISA Sections 401 et seq..

II.         Internal Revenue Code

Governmental plans are subject to the provisions of Section 401 of the Internal Revenue Code of 1986, as amended (“Code”).  These rules avoid current taxation of participants on benefits under the governmental plan until such benefits are actually paid to the participant.  The IRS has interpreted the "exclusive benefit rule" of Section 401(a)(2) as requiring the exercise of prudence in the investment of plan assets.  In light of the legislative history of ERISA, it appears that satisfaction of the ERISA rules would be sufficient to satisfy the Code  requirements.

A.         See, e.g., Rev. Rul. 69-494, 1969-2 C.B. 88 and Rev. Rul. 73-380, 1973-2 C.B. 124 (investment consistent with exclusive benefit rule if the safeguards and diversity that a prudent investor would adhere to are present).

B.  Section 404 of ERISA contains the following duties:

a.  Duty of loyalty – act solely in the interest of plan participants and beneficiaries

b.  Duty of prudence – act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise with like character and with like claims.

c.  Duty to diversify investments to minimize the risk of large losses unless clearly prudent not to do so.

d.  Duty to follow plan documents and governing law.

III.            Connecticut Laws

Plan fiduciaries are also subject to the requirements of state law that contain standards for regulating trust investments.  These standards vary widely from state to state.

          A.          Statutory Investment Rules

There are four primary provisions in the Connecticut General Statutes which govern the investment of monies.  None of these provisions deal specifically with the investment of pension or retirement funds.

                   1.       §7-400

                             The treasurer of any municipality, as defined in section 7-359, upon approval by the budget-making authority, as defined in said section, of any metropolitan district, of any regional school district, of any district as defined in section 7-324, and of any other municipal corporation or authority authorized to issue bonds, notes or other obligations under provisions of the general statutes or any special act may invest, the proceeds received from the sale of bonds, notes or other obligations, or other funds, including the general fund, as hereinafter provided:

                      a. In (A) the obligations of the United States of America, including the joint and several obligations of the Federal Home Loan Mortgage Association, the Federal National Mortgage Association, the Government National Mortgage Association, the Federal Savings and Loan Insurance Corporation, obligations of the United States Postal Service, all the federal home loan banks, all the federal land banks, all the federal intermediate credit banks, the Central Bank for Cooperatives, the Tennessee Valley Authority, or any other agency of the United States government, or (B) shares or other interests in any custodial arrangement, pool or no-load, open-end management-type investment company or investment trust registered or exempt under the Investment Company Act of 1940, 15 USC Section 80a-1 et seq. as from time to time amended, provided:

                           (i) the portfolio of such custodial arrangement, pool investment company or investment trust is limited to obligations described in subparagraph (A) of this subdivision and repurchase agreements fully collaterized by any such obligations;

                          (ii) such custodial arrangement, pool investment company or investment trust takes delivery of such collateral either directly or through an authorized custodian;

                         (iii) such custodial arrangement or pool is managed to maintain its shares at a constant net asset value or such investment company or investment trust is rated within one of the top two credit rating categories and, for any investment company or investment trust not managed to maintain its shares at a constant net asset value, within one of the top two risk rating categories of any nationally recognized rating service or of any rating service recognized by the commissioner of banking; and

                        (iv) the municipal corporation or authority only purchases and redeems shares or other interests in such investment company or investment trust through the use of, or the custodian of such custodial arrangement or pool is, a bank, as defined in section 36a-2, or an out-of-state bank, as defined in said section, having one or more branches in this state.

                   b. In the obligations of any state of the United States or of any political subdivision, authority or agency thereof, provided that at the time of investment such obligations are rated within one of the top two rating categories of any nationally recognized rating service or of any rating service recognized by the state commissioner of banking.

                   c. In the obligations of the state of Connecticut, or any regional school district, town, city, borough or metropolitan district in the state of Connecticut, provided that at the time of investment the obligations of such government entity are rated within one of the top three rating categories of any nationally recognized rating service or of any rating service recognized by the state commissioner of banking.

         

                             2.       §7-402

                a. Any public official of any municipality may deposit any public funds received, held or controlled by him and belonging to such municipality, or otherwise held by him as such official or as a custodian or trustee on behalf of such municipality, (1) in any qualified public depository or (2) in an amount not exceeding the federal deposit insurance corporation insurance limit, in any out-of-state bank which is not a qualified public depository, designated by such public official; provided such deposit shall only be made in his name as such official, custodian or trustee or in the name of the municipality to which the money belongs.  The interest or other pecuniary consideration such depository allows for or upon such deposit of public funds shall belong to and accrue to the benefit of such municipality.

                   In no case shall the deposit by such official in any one such depository exceed in the aggregate at any one time seventy-five percent of the total capital of such depository, as determined in accordance with applicable federal regulations and regulations adopted by the commissioner of banking under Section 36a-322.

                   Any qualified public depository receiving deposits of public funds pursuant to this section is required to disclose such information relating to public deposits as the commissioner of banking may require by regulations which he shall adopt in accordance with the provisions of Chapter 54.  The regulations shall include, but not be limited to disclosure of the most current quarterly statements of condition and statement of income.  Nothing in this section shall affect additional restrictions on the deposit of public funds imposed by the provisions of the charter of any municipal corporation.

                   b. Any person, other than a public official, who receives, has control of, or is the custodian or trustee of, public funds promptly following the receipt or other acceptance of such public funds shall request the authority specified in this subsection to designate one or more depositories permitted under subsection (a) of this section as a depository for the whole or any part of such funds.  The authority shall be (1) the board of selectmen, if the funds belong to a town that does not have a charter, special act or home rule ordinance relating to its government, (2) the first selectman, mayor or other chief executive officer described in a charter, special act or home rule ordinance relating to the government of a city, consolidated town and city, consolidated town and borough or a town having a charter, special act or home rule ordinance relating to its government, if the funds belong to such an entity, (3) the regional board of education, if the funds belong to a regional school district, (4) the warden, if the funds belong to a borough or (5) the chairman of the executive committee or other chief executive officer, if the funds belong to a district, metropolitan district or other municipal corporation.  Such authority, upon the receipt of such request, may, in writing, designate one or more depositories and may, within the limitations of this section, specify the public fund or funds and the maximum amount thereof which may be deposited in each of such depositories.  The instrument designating such depository or depositories shall be filed in the office of the town clerk in the case of a town and with the clerk of any other municipality.  Such authority may, at any time, in writing, revoke such designation and may designate one or more other depositories.  Prior to the designation by such authority of a depository, the person making such request may, within the limitations of this section, deposit public funds in any depository permitted under subsection (a) of this section.  All deposits of public funds shall be in the name of the municipality or in the official name of the fund, person or trustee.  The interest or pecuniary consideration such depository allows for or upon such deposit of public funds shall belong to and accrue to the benefit of the municipality or to the corpus of the fund held in trust.

                    c. If the laws of this state have, in all other respects, been complied with, any person acting in behalf of, or as custodian or trustee for, any municipality, who deposits public funds in any depository shall, because of failure, insolvency, receivership, forced closing or restricted operation of such depository, or a bank holiday or banking emergency proclaimed under the provisions of the laws of the United Sates or of this state, be relieved of personal responsibility for public funds so deposited and the surety or sureties upon the bond of such person shall be likewise relieved to the same extent as such person.  The provisions of this section shall not be construed to relieve any such person or his surety or sureties from the obligation to account for the whole or such part of public funds so deposited as and when the same may be obtained by him from such depository.

          3.          §7-403

                   Allows any municipality which has accepted, assumed or received, holds, or manages any trust fund under the provisions of Section 7-148 (general powers) to deposit such funds in a custodian account with the trust department of any qualified public depository and prescribe by ordinance the method of supervision of the investment or reinvestment of such fund.  Such action shall be by vote of (1) the board of selectman in a town that does not have a charter, special act or home rule ordinance relating to its government; (2) the council, board of alderman, representative town meeting, board of selectmen or other elected legislative body described in a charter, special act or home rule ordinance relating to the government in a city, consolidated town and city, consolidated town and borough or a town having a charter, special act or home rule ordinance relating to its government; (3) the regional board of education in a regional school district; (4) the board of burgesses or other elected legislative body in a borough or (5) the district, committee or other elected legislative body in a district, metropolitan district or other municipal corporation.

4.                  §7-403a

              This section applies to retiree health and life benefits but not to pension or retirement benefits.

              The budget-making authority may, from time to time, direct the treasurer to invest such portion of such reserve fund as in its opinion is advisable, provided:

                      (i) not more than 31% of the total amount invested shall be invested in equity securities; and

                      (ii) not less than 50% of the total amount invested shall be invested in U. S. government obligations, United States agency obligations, United States postal service obligations, certificates of deposit, commercial paper, savings accounts and bank acceptances.

B.            Prudent Man Standard

A majority of states, including Connecticut, impose a "prudent man" standard for investments.  Under this standard, a fiduciary is required to exercise "the judgment and  care under the circumstances then prevailing, which men of prudence,  discretion and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of  their funds, considering the probable income as well as the probable safety  of their capital."

C.            Prudent Expert Standards

A growing number of states impose a stricter "prudent expert" standard. Under one form of this standard, the fiduciary must discharge his duties with "the judgment and care, under the circumstances then prevailing which an institutional investor of ordinary prudence, discretion, and intelligence exercises in the management of large investments entrusted to it, not in regard to speculation but in regard to  the permanent disposition of funds, considering the probable safety of  capital as well as probable  income."  Still other states have adopted a "prudent expert" standard that is similar to that set out in ERISA Section 404(a)(1).  Under this standard, the propriety of a particular investment or investment course of action depends on whether the fiduciary has given appropriate consideration as to: (1)  whether it furthers the purposes of the plan, taking into account the risks  of loss and opportunity for gain; and (2) the effect it will have on the  portfolio as a whole with respect to such factors as composition, liquidity,  return on investment, and cash flow.

D.   Restrictions on Investing Imposed by State Laws

In most instances, the prudent man or prudent expert standard is combined with other guidelines or restrictions on the manner in which trust funds may  be invested.  For example, many states have a statutory list of permissible  investments.  Some states may limit the percentage of  fund assets that may be invested in a particular type of  investment.  Others may prohibit certain investments or mandate others.

(i)  For example, assets of the Public School Retirement System of Missouri may be invested in bonds with sufficient security, state, county  or school district bonds, accounts of savings and loans associations, and  investments generally permitted to life insurance companies.  See Mo. Rev.  Stat. Section 169.040 (1987).

(ii)  Ohio, for example, limits investment in real estate to no more than 25% of plan assets, equities to no more than 35%, Canadian obligations to no more than 15%, and venture capital to no more than 5%.  See  Ohio Rev. Code Section 3307.15 (1987).

(iii)   A number of other states, including Connecticut, prohibit the investment of public pension funds in companies that do business with the Republic of South Africa. See Conn. Gen. Stat.  Section 3-13f (1987).

(iv)  California, for example, requires that 25% of new public pension funds available be invested in California residential mortgages.  See Cal. Ed. Code Section 22223 (1988).  However, the mandate of certain  investments may raise constitutional questions.  See, e.g., Sgaglione v. Levitt, 37 N.Y.2d 507 (1975) (statute  mandating that New York Comptroller purchase New York City Municipal  Assistance Corporation bonds from state retirement system funds held to  violate provision of state constitution prohibiting impairment of benefits;  prohibition on impairment held to apply to "source" of benefits).

E.            Legal Lists

Some states do not impose a prudence requirement, but instead provide a "legal list" that restricts not only the types of investments that may be  made by the trust, but also the percentage of fund assets that may be  invested in any particular type of  investment.  Thus, there is little, if  any, fiduciary discretion; an investment is either per se proper or improper.

(i)    States that limit investments to those on the legal list include Delaware, Georgia, Hawaii, New Hampshire, New York, North Carolina,  and North Dakota.  Three of these states (New York, New Hampshire, and Hawaii)  permit a small portion of plan assets to be invested under the prudent man  standard.

IV.            Prohibited Transactions

Although the excise tax on prohibited transactions imposed by Section 4975 of the Code does not apply to governmental plans, such plans are subject to the prohibited transaction rules of Section 503 of the Code.  A violation of these rules may result in the  loss of tax-exempt status of the trust associated with the plan and, consequently,  the loss of benefits to participants associated with such status.  The exemption will  be lost only for taxable years after the year in which the trust is notified  by the Secretary of the Treasury that it has engaged in a prohibited  transaction, unless the prohibited transaction involved a substantial part of  the corpus of income of the trust and was intended to divert funds from the  exempt purposes of the trust.  The trust that has lost  its exemption may file a claim for exemption with the Secretary of the Treasury in any year following such loss, and if the Secretary is satisfied  that the trust will not knowingly commit a prohibited transaction, the  exemption will be restored for the year subsequent to the year in which the  claim is filed.

Section 503 of the Code was enacted to require arm's-length dealings between the creator of the trust and the  trustee.  To effectuate this purpose, Section 503 of the Code prohibits transactions that would result in  a substantial diversion of trust income or corpus to the creator of the trust  or of any substantial contributor to the trust.  Among the specific transactions proscribed are:  (1) the lending of any part of the trust income or corpus without the receipt  of adequate security and a reasonable rate of interest to the creator or  contributor; (2) the substantial  purchase of securities or other property for more than adequate consideration  from the creator or contributor; and (3) the sale of a  substantial part of its securities or property for less than adequate consideration to the creator or contributor.  Whether a particular  transaction constitutes a prohibited transaction depends upon the specific facts and circumstances.

Discussion of the application of Section 503 to governmental plans has arisen almost exclusively in the context of trust acquisition of employer obligations. Such an acquisition may be treated as a loan made without adequate security from the trust to the employer and thus could be a  prohibited transaction under Section  503(b)(1).  For example, the concern with respect to the acquisition of New York City  debt obligations by certain city pension plans that prompted the enactment of  P.L. 94-236, mentioned above, centered on whether the New York debt obligation was adequately secured, given that it was backed only by the  credit of the City, which at that time was in poor financial  condition.  The IRS had previously taken the position with respect to private  employers that the pledge of an employer's general assets did not provide  adequate security for purposes of the prohibited transaction  rules.  The IRS  subsequently concluded that the acceptance of city-employer  issued bonds by two employees' trusts as part of a settlement of delinquent  contributions was a loan rather than debt collection, and as such, would be a  prohibited transaction unless structured to fall within the special rules of  Section  503(e).

The purchase of debt obligations issued by the creator of, or substantial contributor to, a trust is considered to be a loan by the trust for purposes of Section   503(b)(1).  See Treas. Regs. Section 1.503(b)-1(b).  However, Section  503(e) provides that such an acquisition will  not be treated as a loan made without receipt of adequate security if it is:  (1) acquired at a price no less favorable than the price paid by persons independent of the issuer; and (2) immediately following the acquisition, not  more than 25% of the outstanding issue is held by the trust and at least 50%  of the outstanding issue is held by persons independent of the issuer.

V.            Proposed Rules

A.    The SEC may enact a “pay-to-play” rule

Under the draft rule, to curb pay-to-play in the $1.5 trillion municipal bond market – fund managers would have to forego two years of compensation from localities whose elected officials accepted contributions from them.  A final rule is expected in the coming months.

B.     Connecticut’s Governor John Rowland and State Treasurer Denise Nappier have recently called for reforms concerning how the State Treasurer invests the state’s pension fund, following the scandal involving former State Treasurer Paul Silvester.

(i)  In September of 1999, Silvester plead guilty to money laundering and racketeering charges stemming from financial schemes he ran from his office. 

VI.     Developing a policy which sets out fiduciary duties and liabilities of fiduciaries in the event of a breach of these duties

A.   Uniform Management of Public Employee Retirement Systems Act (copy attached)

(i)    Draft approved by the National Conference of Commissioners on Uniform State Laws at 1997 Annual Meeting