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- Outliers and Oddities in Alternative Investment Documents
Institutional investors and other limited partners are often told they must accept certain terms and provisions in alternative investment fund documents because such terms “are market.” Who is responsible for creating these market terms and what can investors do to prevent undesirable deal terms from becoming the market standard? In this episode of Pensions, Benefits & Investments Briefings (formerly Public Pensions & Investments Briefings), Courtney Krause discusses unusual provisions in alternative fund documents, including limited partnership agreements, side letters and subscription documents. Courtney explores how market terms are created, provides examples of non-standard terms and discusses how investors can work to keep these seemingly one-off provisions from becoming market standard in the future.
Transcript: Outliers and Oddities in Alternative Investment Documents
0:00:01.4 Courtney Krause: Today we are going to talk about Outliers and Oddities in Alternative Investment documents. We're going to explore some unusual provisions that we have seen in limited partnership agreements, side letters, and subscription booklets. While they have not yet become market standard, and in some cases we hope they do not, we wanted to provide early insight on potential shifts in the market. This podcast is meant to assist institutional investors and their legal teams to spot issues before they become tomorrow's market standard.
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0:00:38.1 Speaker 2: Welcome to Public Pensions & Investments Briefings. Nossaman's podcast exploring the legal issues impacting public pension systems and their boards.
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0:01:01.0 CK: Welcome back to Public Pensions & Investments briefings. I'm today's host, Courtney Krause and I'm a partner in Nossaman, San Francisco office. I represent institutional investors across all alternative investment asset classes and in all investment types, including commingled funds, co-investment vehicles, continuation vehicles, and funds of one. And we plan to have more podcasts later this year discussing some of those investment vehicles. So be on the lookout for those. One of the most commonly asked questions I get is, what trends are you seeing in fund documents? And this is a very valid question, but it doesn't always warn about icebergs that may be lying ahead. So on today's podcast I wanted to talk about outliers and oddities that I've seen in some fund documents because today's one-off provisions could become tomorrow's market standard. I think we've all been there. The deadlines to close these deals are really tight and sometimes you just give in on provisions that you might not have been really happy to give in on.
0:01:57.8 CK: For example, most of the time from the date we received fund documents to closing the fund, it was about a month. That timeline has shrank significantly and sometimes we have only two weeks, sometimes less to close a deal. So I understand the need for clients and investors to give in on certain terms. The problem there is that if you agree to a one-off term right now, it may come back to haunt you later. For example, a lot of the general partner law firms that we encounter keep records of past deals. So they will have side letters that they've entered into with some of our clients and they can go pull up those side letters and say, Hey, you agreed to that term over here in connection to this other funds. You have to agree here as well. So just be wary that when you are agreeing to those one-off terms, you don't want that to live on in perpetuity. So one of the things that, just as an example as, yesterday's one-off provision that has become today's market standard is conference and networking expenses. So if you pull out an LPA and flip over to the definition of partnership expenses, you're going to find two to four pages listing out every single expense that's going to be charged to the fund and therefore charge the LPs.
0:03:17.8 CK: If you look at funds from a couple years back, the LPA didn't have any language in there describing the cost of attending conferences, but in recent years that's become a standard expense that's listed in fund documentations. And when that started appearing, investors and their council started pushing back on those costs. But there was really limited success in removing those terms from the documents. And now it's become market standard that LPs and the fund are expected to pay for the GPs cost of attending conferences. But those costs have started to expand. So now we're seeing the cost of attending conferences, hosting conferences, sponsoring conferences and networking events. And it's very hard to say what exactly all of this entails. So for example, if you are a GP or a manager and you're going to host a conference, that's a pretty significant expense. You're going to rent the space, you're going to pay speakers, you're going to have attendees by allowing it to become a market standard that gives the GP room to kind of push it even further and include more costs sort of tangential to the cost that's become a market standard. So that's just an example of something that I've seen creep into the documents and then become the gold standard over time. So this leads to the question of, who sets these market standards?
0:04:42.9 CK: And I don't think this is a case of GPs getting together in a dark and smoky room and coming up with nefarious terms that they could foist upon LPs. This is really an issue of law firms setting the terms for these deals. And one of the trends we've seen in the market is a consolidation of law firms. So again, in the past there were a large number of law firms that represented general partners and drafted the fund document, and now we're seeing fewer and fewer law firms that provide this service because a lot of the lawyers are going to the same limited partnership agreement for all clients regardless of size, and regardless of whether or not the provisions in those form limited partnership agreements really make sense. So just by way of example, one law firm has standard language in its form that allows the GP to advance expenses for the benefit of the fund. So for example, the GPs found this hot new investment, they need to put the money in right away. There's not time to call capital from the LPs. And so the GP fronts the money and then the fund will pay the GP back. But while that money is outstanding, it will accrue interest which then must be paid by the funds and the LPs. So one of the things that I don't like about this provision is that there's no time requirement for the fund to repay the GP.
0:06:09.9 CK: For example, if the GP makes this advance, the interest is charging charging away. If there's no requirement for the GP to call capital right away, there's a small incentive for the GP to let it ride because they keep getting interest on that money. It'd be much better if the fund was required to issue a capital call within say 60 days of that advance to cut off the interest payments from accruing. And when we've raised this issue with council and when clients have talked to the GP's business teams, a lot of the business teams come back and say, this is not something we're ever expecting to do. It's just part of the form and it's there, but don't worry, we're not going to use it. So that's just an example of some of these law firms using their form LPAs in a way that doesn't necessarily make sense for all of their clients because there's GPs out there that aren't intending to use these provisions, they're just part of that particular law firm's forms. And there they are. We also see these same form limited partnership agreements being used for small funds, new funds, novel funds, and these are terms that may be acceptable for a much larger, more established fund. For example, a fund that they're raising fund 10, they're seeking to get $15 billion.
0:07:23.2 CK: These big marquee funds can have very aggressive terms because, you know, they've earned that right. Whereas some of these new managers, the risk is much higher and the term should be more LP friendly to reflect that risk. And I think a lot of times, certainly when we are on the phone with opposing council, the council for the GP, you know, council will tell us that's too bad, these are the provisions, this is market. But I think really the question that should be raised both by outside council and investors is, is this really market for this type of asset in this type of manager? Because sometimes it's not. When I started off speaking, I had discussed that, you know, today's one-off provision becomes tomorrow's market standard. So I thought it'd be interesting to go through a couple of sort of one-off things or oddities we've seen here at Nossaman in the last couple of months. And whether or not they become trends, I don't know, but I think there were very interesting issues and there's certainly things that investors and their council should be looking out for when reviewing fund documents. So I'm going to cover some things I've seen in limited partnership agreements, subscription booklets, and then talk finally about side letters and most favored nation, election rights.
0:08:42.7 CK: We see these things creep in across all of the fund documents and certainly you should be keeping an eye out on all of them. So to begin, I'm going to talk about a trend I've seen in limited partnership agreements, and unfortunately this is something I've seen in more than one limited partnership agreement. So it's possible that this may become a trend. Typically, if you see it once or twice likely isn't something you're going to see a lot, but once you kind of see it that third time, fourth time, definitely you should keep your eyes peeled because that's a sign of a one-off provision becoming a trend in the market. So the provisions I want to discuss today revolve around the LPA cure provisions. When you're reviewing limited partnership agreements, you typically are looking for exit rights. You know, what rights to the LPs have to exit the fund if something goes wrong? Most funds will have a for-cause removal provision or for-cause termination provision. Some funds also have a no-cause removal or a no-cause termination provision, but I'm not going to focus on that. So in connection with the for-cause removal of a GP or a for-cause termination, typically the GP has some right to cure and the cure generally involves terminating the employee at the GP that's engaged in this bad activity.
0:10:07.8 CK: And then the GP makes the fund whole for its economic losses. So just for an example, say the GP has a rogue employee, the employee has committed fraud, that would fall under the banner of a for-cause action. If the GP terminates that employee and then pays the fund back for any economic damages, it would be deemed cured and the LPs would not have the right to remove the GP or terminate the fund. I'm starting to see LPAs where that final piece, the requirement to make the fund whole for its economic losses has started to disappear from documents. It's not there and it's already a pretty high bar to meet the for-cause standard in most cases to trigger a for-cause removal or for-cause termination, there has to be a final non-appealable judicial determination. So that means you've gone through the entire trial process, all the appeals process and there's no more avenues that the GP could prove that it didn't do this thing. It's a very high bar and a lot of funds you see the cure provisions arise once that bar has been met. So that means the GP wouldn't have to terminate that employee that committed fraud until it's been legally determined that they did those things.
0:11:24.4 CK: I suspect that if there's an employee engaging in fraud, the GPs probably going to terminate them right away and you're not going to even get to this point. But it is disturbing that they've started carving out this requirement to make the fund whole for economic losses. And like I said, I've seen this in a handful of LPAs, it's too soon to say if it's a trend, but certainly something to keep your eye on, I usually argue. And we've been pretty successful in pushing back on the elimination of the cure procedure. So now I'm going to shift gears and talk about some trends we've seen in subscription booklets. So subscription booklets typically contain two discreet sections. The first section of the subscription booklet is usually 10-20 pages and it contains a written agreement, most of which contains representations and warranties and sort of standard legal language regarding the investor's enrollment in the fund. And then the second half of the subscription booklet has the questionnaire portion and that's where you write in your name, your contact information and check a lot of boxes regarding your status.
0:12:29.6 CK: In late 2021, we started to see a few managers roll out these online subscription agreements. And typically, what's involved in the online subscription agreement is, you are sent a link, you click on the link and then you create a username and password and log into a portal to complete the subscription agreements. And this seemed like a real novelty the first couple times we saw it. We saw different providers using this, different managers using this. There wasn't a lot of consistency. And the initial rounds where we saw this, it was somewhat optional because for a lot of the clients we interact with they're large institutional investors and they have a lot of internal procedures around how subscription booklets are drafted. And everyone takes a different approach to this. Some investors draft them themselves and have council review, some investors have council draft and then they review before it's sent to the other side. And in the online digital format, the procedures don't necessarily work because everyone needs to have a login to get into the document and it tends to be a little bit clumsy if the procedure involves multiple eyes and drafters to be involved.
0:13:45.6 CK: So when we first started seeing this, it seemed like a little bit of a one-off thing, but early last year in the first and second quarter of 2022, we started to see a surge of the online subscription booklets and we started to see a change where the managers and law firms were using one or two providers of these online portals. And so it seemed like this might be a big trend in 2022 where managers and law firms are going to start using these online subscription booklets, which for somewhat problematic for some of our clients. But it seems like that was a trend that started up and it kind of died down. We still do see these online subscription agreements. There was a period of time where when clients pushed back on using them, they were told no unless they really kept pushing and pushing saying no, like this does not work, we cannot use this document. There seems to be more flexibility now. I don't think they're going away, but I don't think this was the fire sale that we thought it was going to be where it was just going to take off. And if you want more information on online subscription booklets, kind of the pros and cons and things that we've seen. I wrote an article last year for the NAPA report, it's the April, 2022 NAPA report and we discussed online subscription agreements and what you can do as an investor to kind of tackle that format.
0:15:06.9 CK: A second trend in subscription booklets I've seen is a change in some of the language in the agreement portion. And the agreement portion, like I said before, is the first 10-20 pages that has all the reps and warranties. And the vast majority of subscription booklets typically have language in them requiring the investor to directly indemnify the fund and the manager, if the investor breaches its representations of warranties, that's become fairly common. Some clients can't provide indemnity so that will get captured in the side letter. Some clients ask to have the indemnification obligation capped at the size of their commitment. That can be documented in the side letter as well. And just to point out, this indemnification obligation in the subscription booklet is separate from the indemnification obligations that you see in the limited partnership agreement. In the limited partnership agreement, it's the fund indemnifying, the GP, manager, fund, etcetera. And in the subscription booklet it's the investor itself indemnifying the fund, GP or manager. So like I said, it's pretty common to see these indemnification provisions. Where we're starting to see the shift is where there's a requirement for indemnification expenses to be advanced to the GP manager or the fund.
0:16:26.9 CK: So that would mean if there's litigation involved between your client and the GP or manager, the client may need to advance all of the GP or manager's legal expenses to the GP or manager. But the subscription booklets don't have a requirement for the advance to be repaid if the LP is successful and the manager is not, I think that's very problematic. I think if you are in litigation and you're required to pay the other side legal expenses and then the other side loses, then they should have to pay for those legal expenses themselves because they've not been successful. And again, I've only seen this in a handful of subscription booklets and I think a lot of times investors, again, when they're rushing to close, overlook reviewing the agreement portion of the subscription booklet in detail and don't pick up on some of these things. So be sure to read those indemnification provisions and to the extent they're not favorable or not something that you can agree to, ask for it to be changed in your side letter of all the fund documentation subscription booklets tend to be more set in stone and aren't heavily negotiated. So the best place to modify the terms there's in your side letter.
0:17:42.1 CK: So speaking of side letters, bonds would go over a couple of trends I've seen in side letters. The first thing we've seen, and this was truly a one-off, but it is something to keep your eyes open for. Typically, and I think this is true for most investors, but typically our clients are asking the GP and manager for an increased standard of care and for an agreement regarding the fiduciary standards, and that goes into the side letter. And we were recently working on a fund and council gave a very favorable standard of care in the side letter. We were happy, the client was happy, but there was a separate provision of the side letter outside of the provision that related to the standard of care that expressly stated that the side letter did not modify the limited partnership agreement that contained the standard of care. So this gave us pause because the whole purpose of the side letter is to modify the language in the limited partnership agreement, and for them to specifically carve out the standard of care meant that the side letter didn't carry any weight regardless of whether they gave us this really great standard of care language.
0:18:55.7 CK: So we had a lot of back and forth with council where they tried to convince us that no, no, this language really was going to modify the limited partnership agreement, but eventually they took out the carve out, it was a little disturbing that the carve out was completely separated from the language addressing the standard of care in the side letter. So be sure that you're looking for some of these, like smoke and mirrors tactics where one provision gives and the other take it away. And then related to side letters, one thing to look out for also, which may be in the side letter or the LPA are trends in MFN elections. MFN means most favored nations. So these rights give you the opportunity to pick up benefits that were granted to other LPs in their side letters. Typically, there's standard set of carve outs, you can't just have carte blanche to go look at other LP side letters and pick all of their provisions. Typically, the side letter specifically says, you can't pick up this or you can't pick up that. So by way of example, most favored nation provisions usually say, if an investor has been granted a seat on the LP advisory committee, the other investors can't make that election. Or if an LP has received discount or their state specific regulations, those type of carve outs are very standard. And usually that's in the first paragraph of a side letter.
0:20:23.8 CK: Every now and then you'll come across an LPA where the most favored nation provisions are in the LPA rather than the side letter. But it's very important to read those together. So for example, a couple months ago I had a client working on MFN elections and this was for a fund that Nossaman had not represented this client in connection with the fund, but she had called up just for some advice and to bounce some ideas around and she had asked, have I ever seen such severe MFN election carve outs before? And so we opened up the LPA and the LPA's carve outs were much more severe than were standard. For example, it prohibited electing additional notice provisions, representation of warranties and other items that I would say are pretty standard items that get picked up through the MFN election process. And I was very surprised, I thought this was a little sneaky because while I didn't have a red line of the LPA against the prior funds LPA, it seemed to me that this restrictive language kind of got snuck in there and investors hadn't noticed it because while they were negotiating the side letter, they were only looking at the side letter and they weren't also looking at the LPA at the same time. And since the client called and gave me a heads up on this particular issue, I've seen this happen in one other fund.
0:21:44.1 CK: If you're dealing with a side letter where the most favored nation's provision is in the LPA, be sure to pick up that LPA and turn to that provision to see what the carve outs are. It's very important if it has stringent carve outs to ask for everything you might possibly need in your first draft of the side letter, because you aren't going to have the opportunity to pick it up during the MFN election process, which is more common when we get to some of these rushed closings, a lot of clients will say, okay, we can give up on this because another investor likely asked for it and we'll try to pick it up during the MFN election process. When you have very severe carve outs that restrict almost everything, you're not going to have the option to pick up those nice to have items during the election process. So certainly, keep that in mind when you're drafting your side letters. So now that I talked about some one-offs and oddities that I've seen in fund documents in the last couple of months, you might be asking yourself, well, what can I do to solve these problems or avoid these pitfalls?
0:22:47.7 CK: So I think the number one thing you can do is push back on these one-off provisions. And when I say push back, you know, call up the business team, ask them what is their rationale for including this provision in the fund document. It might be that the law firm put the term in and it wasn't something the management team asked for, or if it was something the management team asked for, maybe they have a very rational explanation of why it's there and can give you comfort around why that provision is in the document. When you're working on negotiating fund documents, don't always accept the law firm's excuse that this is a market term, like it may not be market for a new manager or a novel product. Again, that's another time, pick up the phone, talk to the business team on the other side. A lot of times we've seen, you know, when the law firms are really setting the terms, if the business teams just speak to each other, they're often able to resolve some of these issues, get the documents adjusted to everyone's liking and everyone leaves happy. Going forward this year in 2023, the market is likely to soften and this might be a time for LPs to push back and take advantage of the down market to push for more favorable terms. I think if the GPs are more desperate for money and investors, they may be willing to get their law firms to back down or they themselves might be willing to back down.
0:24:09.5 CK: And I think it's also really important to remember if you see something, say something, let others know when you're seeing these kind of one-off provisions in documents, 'cause it really helps when reviewing to kind of keep your eye out knowing, hey, you know, somebody else saw this fishy thing in a document, I haven't seen it yet because you might see it and it's helpful to know what others have seen and sort of where they landed on resolving the problem. Thank you to our listeners for joining us for this episode of Public Pensions & Investments Briefings. For additional information on this topic or other public pension issues, please visit our website @nossaman.com. And don't forget to subscribe to Public Pensions & Investments Briefings wherever you listen to podcasts so you don't miss an episode. Until next time.
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0:24:55.5 Speaker 2: Public Pensions & Investments Briefings is presented by Nossaman LLP, and cannot be copied or rebroadcast without consent. Content reflects the personal views and opinions of the participants. The information provided in this podcast is for informational purposes only, is not intended as legal advice and does not create an attorney-client relationship. Listeners should not act solely upon the information without seeking professional legal counsel.
- Managing IP, Data and Privacy Risks of Pension Administration Systems
Ransomware and other cybersecurity attacks have made national headlines during the past 12 months, and public pension systems are as susceptible to these attacks as any other organization. In this episode of Pensions, Benefits & Investments Briefings (formerly Public Pensions & Investments Briefings), Thomas Dover and Ashley Dunning discuss the protections public pension plans can put in place today to ensure these kinds of data privacy attacks are kept at bay. They also discuss other intellectual property issues every public pension plan administrator should be aware of in order to maintain the health of their organization.
Transcript: Managing IP, Data and Privacy Risks of Pension Administration Systems
0:00:00.9 Ashley Dunning: Now, more than ever, cyber criminals have been targeting large organizations in an effort to steal personal, protected information. Today, we’re looking at best practices and improvements to public pension administration systems to protect personal information from potential attacks.
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0:00:27.8 Intro: Welcome to Public Pensions & Investments Briefings, Nossaman’s podcast exploring the legal issues impacting public pension systems and their boards.
0:00:49.9 AD: Welcome to another episode of Nossaman’s Public Pensions & Investments Briefings. I’m Ashley Dunning, co-chair of Nossaman’s Public Pensions & Investments Group, and I’m joined today by my law partner, Thomas Dover, who leads Nossaman’s intellectual property practice and is co-chair of the Privacy/Data Security Group. Good afternoon, Thomas.
0:01:11.9 Thomas Dover: Hello Ashley, I’m happy to be here, I am always happy to talk with you.
0:01:17.6 AD: And I’m glad that we’re going to be able to talk about this interesting topic today because everyone is currently concerned about hacking and ransomware. And the first question I’d like to ask you is, what we can do or what public pension systems can do to protect their pension administration systems and data on those systems.
0:01:39.8 TD: I share the concern, and we see it in the headlines across the internet and newspapers almost on a daily basis, some kind of hacking or ransomware. The issue is really, if we boil it down to two major buckets, we have privacy obligations that pension systems are required to conform to, and we have data security requirements that we should be expecting of ourselves, for the pension system, and for the developer. The struggle then becomes, who is going to be responsible for what, and at what stage? The first calculation that I think we always make is as to the pension administration system structure, historically, you and I know that most of these systems were maintained at a local level, meaning they were on servers that we owned and maintained very often in our offices, in our buildings in that cold room that nobody ever went into.
0:02:39.4 TD: Now, all of this is very much more advanced, and we have cloud-based systems and cloud-based data storage, so the issue then is, how are we structuring the system, and where are the weak points? There, I always say, look to where there’s an interchange of information, when the information is coming from an outside source regarding a member into the system, and then when we transfer it as the pension system to a vendor, is it going to a vendor for printing checks or is it actually going to our pension administration system vendor into a cloud environment? Those are the points where we have to evaluate whether or not we should be responsible, and how, are there data transfer protocols that we want to keep in place? Some of you might be aware of the HIPAA data transfer protocols that are required.
0:03:38.1 TD: It’s the same sort of evaluation, what kind of security do we want when information is, as they say, in transit, and then how are the developers or the pension system, if we post the information locally, how are we maintaining the security of our system? There the questions are, what are your firewalls, and how are they structured? Now, we’re lawyers. We shouldn’t have to get into the weeds of this, but now, not just lawyers, but even our pension administration systems need to be fluent in this conversation, we don’t need to necessarily understand or dive into the weeds of it, but we need to be able to understand what questions to ask. And so this has now become imperative for our administrators and our IT professionals, and I commonly will just sit down with the IT professional and just have an exchange of what their concerns are, and they can hear what my concerns are, and sometimes this really is captured in the agreements in terms of what our confidentiality expectations are.
0:04:50.8 TD: The developer of a pension administration system, particularly those that are legacy, you’re aware of those boilerplate public records provisions that are in every agreement with a public entity, those have limited meaning when it comes to privacy obligations because we’re talking about what is... As a public entity, what we have to maintain as public, you know better than I, The Brown Act, Public Records Act. The other side of that equation is what is required for individual privacy, this might be members, this might actually be employees of a pension system, and what privacy expectations they are entitled to, and how we have to conform to those.
0:05:39.2 AD: That’s interesting because I think in the public retirement sphere, there is certainly a lot of familiarity with Public Records Act, there’s also a familiarity with the concept of confidential member records being maintained confidentially, and yet it sounds like there is yet a further standard that requires certain data, even additional data to be maintained confidentially in the context of this personally protected information and data breaches that you’re referencing.
0:06:10.5 TD: And what it is and what that importance is is to transfer the obligation that the pension system has additionally to each vendor, so to make sure that they have the same obligations to maintain the confidentiality of personal information that the pension system might have, if we use boilerplate public records provisions, that’s generally not captured. So we need to be aware of these issues.
0:06:35.5 AD: Interesting and so complicated. One other thing or another aspect of this that is complicated now are the software and systems themselves and related contracting around them, I’m thinking specifically now about the licenses. What do pension systems need to include in their pension administration system licenses in order to sufficiently protect themselves?
0:07:02.6 TD: Generally, in terms of the pension administration system structure, the structure that we are looking at to protect the data, the... And this comes back to the procurement approach, is this going to be a standard request for a proposal RFP approach, where there’s a draft contract that is being provided or is this going to be something where we are asking more generally for proposals that maybe we don’t anticipate, but then the drawback to that is, we may well get a developer software license that really doesn’t serve a public entity, so it means combining or somehow conforming the two to each other. Best practice, I still think, is to provide a draft contract. The responses that the systems might get might well include a software license that, again, I’ll use the term boilerplate, because even software developers like to go to a drawer and pull out a form from 10 years ago and still use it. None of those really include the kind of data security requirements that are commonplace nowadays and almost none of them will address the kinds of use and license that a pension administration system will need. So for example, we very often get into a procurement where we’re looking at best price versus what we’re getting, and very often we will say, "Okay, well, this is the best price without really looking... "
0:08:36.2 TD: And I hesitate to say it again, you gotta dig into the details of it because the license grant that you’re getting might not actually be everything that the system needs, if you look at some of those terms, this is bedtime reading, but when you look at the license grant in some software development agreements, you’ll see the word "use," that you have the right to use the system, and it doesn’t include anything else. Well, case law in California specifically has addressed that and said that the right to use does not include the right to modify, make derivative works, to update. These are all critical things now, just consider data security alone or antivirus updates, well, you wouldn’t be able to do that if all you had was a right to use, so is this something where we anticipate, for example, a perpetual license and the developer is going to be there to maintain it for us for a while, and then they go away and maybe we get a new vendor, if you’re doing that, you still need all of these rights after the initial vendor goes away, that becomes a complicated process.
0:09:43.1 AD: Yeah, that’s really interesting because, as you know, public retirement systems really are perpetual in the sense that they’re very long-term entities, they’re not going to be selling the data to anybody or transferring it to anybody, but they do need to be able to maintain the system and to upgrade it over time. Probably long after the entity that they first contracted with has gone out of business, and so as you’ve seen this develop over time, probably impresses upon all of us even more the incredible importance of these transition terms. Do you see contracts that are currently in existence, aren’t expected to expire any time soon be amended to deal with this just because people recognize that’s an issue?
0:10:32.8 TD: Yes, and I think we should do more of that because you’re right, pension systems are perpetual. Some of the software license agreements that I’ve seen, even some that are old or legacy, also contemplate a perpetual license, unfortunately though, it doesn’t include the kind of consideration for what has to happen from a practical perspective. We know what we want the system to do, but we don’t really think through always at the initial stages, what we’re going to require of the developer for the license grant and for these transition services. And so I think, particularly for purposes of data security, these are things that change every day, you and I see notices every day about a new hacking technology, and our IT professionals have to get up to speed, so that often means an upgrade to the system, that’s the greatest explanation to a developer as to why some of these legacy contracts need to be amended, these are things that weren’t contemplated early on, we just simply didn’t think this could be an issue. I have drafted some of those legacy agreements, and we didn’t think it was important or as important, now of course, this is what we lose sleep over.
0:11:50.0 TD: So going to your developer and having a rational conversation about the current needs of the system and attempting to amend the agreement to current standards I think makes sense, and if they’re unwilling to do that, that tells you quite a bit about the developer.
0:12:05.6 AD: Well, that’s probably a good time to do it, when nothing’s going wrong. Speaking of risk management and crises, what are our current approaches to data breach issues and intellectual property infringement liability?
0:12:21.5 TD: And isn’t that the reason that we’ve talked through everything regarding the pension administration structure and how we’re approaching the license grants, because all of this is now critical, we are intimately aware of data security liability and hacking events, so we don’t want to be on the hook for sometimes what is catastrophic in terms of potential damages, there are a lot of things to talk through for indemnification and limitations of liability. I’ll focus on just a few. The first as to... Let’s focus on data breaches, these are generally the acts of third parties, you don’t often have an insider that does these. If it’s a third party, the developer is going to come to you and say they can’t possibly be held responsible for this because this was out of their control. The argument back to them is, "Frankly, we’re paying you millions of dollars to provide the system and provide for the protection of the information that we are entrusting to you, you have some responsibility." Sometimes that will open the conversation to additional data security requirements, sometimes there are data security addendums that are included.
0:13:38.9 TD: The issue with that, of course, is maintaining currency, you want to make sure that all those data security requirements are the then current requirements, unfortunately contracts are static in nature, generally, so how do we provide for that? Sometimes there are creative ways of approaching it, and sometimes you might come to a compromise in terms of the risk management, in some instances, they may not be responsible, but in certain instances, they would be.
0:14:10.6 TD: Some developers are just simply not big enough from a financial perspective to be able to maintain the liability for a data breach. We have to talk about insurance, there has to be some backstop, particularly if they are not capitalized enough to maintain a liability judgment. Insurance, you’ve talked with Jim Vorhees, our partner on insurance, on related issues. I think cybersecurity insurance is the next critical thing that will develop within the insurance industry, it’ll increase in terms of what is excluded, but it may also increase in terms of the value to pension systems, and that also relates to consequential damages because again, the developer’s argument is going to be, "These are acts of third parties, they are not actual damages to the pension system," the reality is, of course, that if there is a data security event, they’re right, there is no actual damage to the pension system, but you’re going to have tens of thousands of consumers, sometimes not just members, but also employees that will be looking to the pension system to be compensated, and it is absolutely something that is predictable, but it is not by definition a direct damage. So we have to account for that, and it has to be an open conversation.
0:15:40.9 TD: A related issue is IP infringement. As we have worked through this, you and I, Ashley, there are a lot of pension administration systems out there, some of which were maintained by small developers that were then swallowed up by others, there is a very finite group of pension administration systems developers that we have confidence in and that have proliferated throughout the industry. Those are the ones that we deal with, that also means that they’re highly competitive, and it wouldn’t be unreasonable to expect the pension systems to be swept up in IP infringement suits as these developers become more aggressive with their competitiveness.
0:16:24.9 TD: That’s not something that the system should be involved with necessarily, but it is the nature of IP infringement and competition. The way to avoid that sometimes is to create some carve-outs in that IP infringement, to make sure that we are insulated some amount. We could talk about limitations of liability, they’ll want to cap their liability generally, I’m not a big fan of that, and if we do it, it has to be heavily researched, and risk management needs to take a huge look at that.
0:17:02.8 AD: So that’s all very interesting, Thomas, and it highlights the fact that in the context of a dispute, you may well have a lot of different parties implicated, whether it’s one developer or two, potential cyber insurance carrier, certainly members if their data has been released, and then possibly the retirement system, so it’s a good idea to think about all of these things as much as possible in advance before there’s any problems that perhaps leads to litigation. On that point, thinking about best practices and lessons learned, Thomas, are there any final comments you could share with the audience, lessons learned that you would be able to impart to us?
0:17:51.5 TD: Sure, and I echo your concern about the pension administration systems generally, I do think that it is worth diving into the weeds of some of this, and I think we are not doing ourselves a favor by expecting the developers to explain it to us. And that really goes into the first major concern for me, and that’s the nature of software licensing, this is not limited to pension administration systems, this is a broader concern. And some of these concerns, I would cut and paste into other industries because they are dealing with it in essentially the same way. So we have to ask ourselves these critical questions, what do we need the system to do, and what rights do we need from a legal licensing perspective to be able to have during the term of the agreement and then afterwards? And then what happens if something goes wrong? You become dissatisfied with the developer. These are things that we now have to ask ourselves in advance because if we get midstream and we go back and look at the contract, we’re going to be very disillusioned.
0:19:01.4 TD: I think the other thing to keep in mind is really the dramatic importance of data security in this day and age, we have to maintain certain privacy obligations for our own members and employees, and at the same time, we need to understand and require our developers to maintain certain data security measures, whether that is at a local level or even in a cloud environment.
0:19:33.7 AD: Well, that was a lot to absorb for the day and for the podcast. I want to thank all of our listeners for joining us for this episode of Public Pensions & Investments Briefings, for additional information on this topic and other public pension issues, please do visit our website at nossaman.com. Also, for those of you who are clients, you’ll be invited to our annual fiduciaries forum, which is scheduled for early December of this year, 2021, and Thomas will be presenting there on some of these very issues that he’s highlighted at a very high level today, he’ll be able to delve into them a little bit more there. Also, don’t forget to subscribe to Public Pensions & Investments Briefings wherever you listen to your podcast, so you don’t miss an episode. Until next time.
0:20:26.4 Outro: Public Pensions & Investments Briefings is presented by Nossaman LLP, and cannot be copied or rebroadcast without consent. Content reflects the personal views and opinions of the participants. The information provided in this podcast is for informational purposes only, is not intended as legal advice, and does not create an attorney-client relationship. Listeners should not act solely upon the information without seeking professional legal counsel.
- Why Pension Systems May Find New Opportunities in P3 Infrastructure Investments
Infrastructure investment, whether through direct investments in specific projects or through commingled funds, is an attractive asset class for public pension systems and other institutional investors. In this episode of Pensions, Benefits & Investments Briefings (formerly Public Pensions & Investments Briefings), Yuliya Oryol, Andrée Blais and Shant Boyajian introduce you to public-private partnerships (P3s) and alternative delivery methods for infrastructure projects. In addition to P3 projects in the U.S., they also discuss other countries, such as Canada, that have a more developed and mature market for investing in infrastructure projects by public pension systems and other institutional investors. Yuliya, Andrée and Shant also discuss the Biden administration’s infrastructure plan, which should open up investment opportunities for institutional investors.
Transcript: Why Pension Systems May Find New Opportunities in P3 Infrastructure Investments
0:00:01.1 Yuliya Oryol: Infrastructure investment, whether it is through direct investments in specific projects or through commingled funds is an attractive asset class for public pension systems and other institutional investors. Today, we will look at infrastructure development in the United States and as compared to more mature markets such as Canada, and also discuss how the Biden administration's infrastructure plan should open up investment opportunities for institutional investors.
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0:00:37.6 Intro: Welcome the Public Pensions & Investments Briefings, Nossaman's podcast exploring the legal issues impacting public pension systems and their boards.
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0:00:58.6 YO: Thank you for joining Nossaman's Public Pensions & Investments Briefings podcast. My name is Yuliya Oryol. I'm a partner at Nossaman and co-chair of Nossaman's public pensions and investments group. Our discussion today will introduce you to direct infrastructure investments for public private partnerships or P3s and other alternative delivery methods for infrastructure projects. In addition to P3 projects in the US, we will also discuss other countries such as Canada that have a more mature market for infrastructure development and investing by public pension systems and other institutional investors. In addition, we will discuss the Biden administration's infrastructure plan, which should open up investment opportunities for institutional investors.
0:01:45.3 YO: I'm joined today by two experienced infrastructure professionals, Andrée Blais is a partner at Nossaman in our firm's nationally recognized infrastructure group, Andrée focuses on delivering major public infrastructure projects through public-private partnerships and other alternative delivery methods. She serves as key member of Nossaman's team, working with public agency clients to advance some of the most complex procurements in transportation and social infrastructure sector, including the Los Angeles County Metropolitan Transportation authorities, Sepulveda Pass Rail Transit Program, the Los Angeles World airports, automated people mover and consolidated rent a car center, she has significant experience in performance-based availability payment P3 projects, Andrée offers the additional benefit of substantial infrastructure experience in Canada.
0:02:38.9 YO: I'm also joined today by Shant Boyajian, who's also a partner in the firm's infrastructure group. Shant advises public agencies on a wide range of innovative methods to procure and deliver the nation's largest most complex infrastructure projects, Shant also has deep experience in the public policies behind infrastructure project delivery. He previously served in the US Senate where he led development of fixing America surface transportation Act, the largest infrastructure bill in the US History. Shant also worked for the House of Representatives on the 2012 transportation bill. Andrée and Shant, thank you so much for joining me today. It's an honor to have this conversation with you, and I appreciate you sharing your expertise with us. Before we discuss the US government's approach to infrastructure in general, and more specifically what is being proposed by the Biden administration, I would like to start with Andrée, since she focuses her legal practice on delivering major public transportation infrastructure projects through P3s and other alternative delivery methods and to explain to us what is meant by a public-private partnership.
0:03:48.4 Andrée Blais: Thank you, Yuliya, for that kind introduction, and thank you for having me on this podcast. Public-private partnership or P3 is an alternative method for public agencies to procure and finance public infrastructure projects. So a P3 is actually not a partnership in the legal sense, instead it's a legally binding contract between the public agency and a private sector entity, requiring that the private party provide design and construction services and deliver an asset, and typically to operate and maintain the asset through a lengthy term, the contractual structure is set up to allocate risks to the party best able to manage each particular risk, so that basically the private party is intended to take on the risks that it can control through construction and operations and financing risks. In a P3 arrangement, the public agency does remain actively involved, so these are not privatization, what we're talking about today, as I said, procurement and financing structures, they're not privatization of typically government-offered services, private sector party is typically responsible for commercial functions such as project design construction finance and long-term operations of the asset.
0:05:07.2 AB: The key element that we want to talk about today is really from the investor perspective, and the fact that P3s include the element of private finance based on project financing principles. So getting into the weeds on this, what we mean by that is that the private entity and not the public agency is financing the design and construction in a P3 transaction, this is contrasted with the more conventional approach where the public agency might issue its own bonds for example, tax exempt bonds to raise the money necessary to do the design and construction. So in a P3 private entity brings together debt and equity to finance the design and construction, and then once the project is up and running, the project will generate a stream of revenues and that stream of revenues is used to pay back the private entity, the stream of revenues can be either availability payments or user fees and tolls.
0:06:09.4 AB: So I want to just say a word or two about these two different types of project revenue streams that can be derived from a P3 deal. Starting with user fees and tolls, which is something that most people know and understand by way of an example, once a P3 toll highway is functioning and up and running, the tolls paid by its many users come together to form a revenue stream that is used to pay back the private entity that pulled together the debt and equity to finance the highway in the first place, paying back what they borrowed so they can pay their lenders, paying them the costs to operate and maintain, and then also including a reasonable profit on their investment.
0:06:53.5 AB: And availability payment deal. On the other hand, the revenue stream is really generated by periodic payments made by the public agency itself instead of through tolls and user fees paid by multiple users, so it's called an availability payment because the idea is that the public agency will pay the P3 developer to the extent that the asset is available in accordance with performance specifications included in the contract and availability payment P3 structure is generally considered by investors to be less risky than a revenue risk deal or a toll deal, because they're not having to count on long-term use which can be unpredictable. The term of a P3 contract is typically 30 years or more, so from an investor perspective, a good and economic P3 transaction can represent a long-term predictable revenue stream.
0:07:51.9 YO: Shant keeping in mind what Andrée just explain about public-private partnerships and the private aspects of the public-private partnerships. I'm curious if you can explain to us how federal infrastructure programs support P3 projects.
0:08:08.4 Shant Boyajian: Absolutely, and it's a pleasure to be with you both today. Like you said, Yuliya as Andrée mentioned P3s are a unique way to deliver critical infrastructure in that this method of delivery includes private finance, but I think before we get into the appropriate role of the federal government, it's important to mention that I think a lot of people misunderstand what that actually means, and maybe I'm speaking more to lay people than to those in the financial industry, but I think many people, including some policy makers misunderstand P3s to mean that the private sector is somehow paying for the project, almost like free money to the public sector. That's obviously not true.
0:08:52.9 SB: The value in P3 delivery is in the incentives that it creates and the way that it allocates risk to the party that's best able to manage it as Andrée mentioned. However, the public owner will have to repay the private financing, whether it's through a user fee, like a toll or through availability payment structure, as Andrée said. At the end of the day, the public owner still needs to have the funding available to actually pay the private entity, and that can be through local funds, state funds, or through federal funds, and that's really where the federal government comes in, it's fairly uncommon for a major infrastructure project to be funded entirely with non-federal funding, especially for highway and transit projects, there are some airport projects, terminal redevelopments that may be funded through non-federal sources of funding, but by and large, if you're looking at a major infrastructure project in the United States, the chances are good that there is federal funding involved in it.
0:09:53.5 SB: As a result, even if a project is being delivered as a public-private partnership, federal funding is likely going to be required to help pay for that project, and so the more public funding available from the federal side, the more infrastructure projects that are likely to be done and the more public-private partnerships that are likely to be done in addition to the federal funding element of this, an additional point I want to make is that there are federal financing programs that will also help promote the use of P3 delivery, these are the TIFIA program, the RRIF Program, and the use of private activity bonds. These are the three federal financing programs that will help lower the cost of private financing and make the project itself more viable, and we'll talk about some of these later on in the podcast as well.
0:10:44.4 YO: If I hear you correctly, in explaining to us what is meant by public-private partnerships and the federal government's role, it sounds to me like what you're talking about are different opportunities for institutional investors to be invested in the infrastructure asset class through direct investments. Today, many if not the majority of Nossaman's public pension clients invest in infrastructure asset class through commingled private funds, this strategy helps them to enhance returns, mitigate risk and diversify as part of a broader investment portfolio, and at the present time, it appears to be the most accessible method of investing in infrastructure through public pension systems and other institutional investors, especially the smaller ones, which is the endowments and family offices, these investments are typically recommended to the investors through their investment consultants who tend to recommend the same infrastructure funds to their group of clients, and the size of the investments in contrast to direct investment, the size can vary between 10 million to 100 million and still be relatively small as compared to a direct investment that you're talking about and the commitment and size of the investment that that would take.
0:12:01.4 YO: In addition, the fund terms including reporting and transparency are attractive to institutional investors because they're very similar to private fund investments and say infrastructure or other asset class, although I admit the duration of the Infrastructure Funds, given all the extensions are quite long, I mean, you're talking about Andrée, something like 30 years, and it could be more than 30 years as compared to a private equity fund which has a duration of 10, 12 or 15 years, but what it allows the institutional investor to do is to diversify, and it allows them to spread their asset allocation among numerous managers and these investors and some have a history of private fund investing and they're comfortable with this approach to investments. And so given that, I'm very curious to talk with you Andrée, given your expertise in Canada, can you share with us the Canadian model for development of infrastructure projects and investments in those projects, by public pension systems in Canada?
0:13:08.1 AB: Yes, thank you, Yuliya. Let me start with some of the activity that we're seeing among Canadian pensions in Canada. The pension funds that I'm going to mention, are CPP, CDPQ, OMERS and Ontario Teachers pension fund, and also PSP. These large Canadian public pension funds have become very active investors in infrastructure, moving well beyond participating in commingled funds. Several of them do have in-house large and skilled infrastructure investment teams that are finding and evaluating direct investment opportunities that are aligned with the pension funds' goals and long-term strategies, they're looking for stable and predictable returns that line up with their commitments to their pensioners, having a skilled, and in-house team that can do these assessments and evaluations allows these pension funds to not simply be an investor, but they're almost a partner in infrastructure projects and become very engaged in their delivery, execution and Operations, just as one example, OMERS is an active investor in Canada and public schools, long-term care facilities and hospitals, going a step or two further, we see CDPQ almost becoming a developer in infrastructure projects itself through an infrastructure subsidiary that CDPQ owns and runs.
0:14:36.5 AB: It becomes involved in the planning and financing and construction and operation of large infrastructure projects, working together with provincial and federal government. One example is Montreal's REM, which is a large light rail transit project that's currently under construction and a partnership among CDPQ, the province of Quebec and the federal government, so that is a very unique role, I think unique in many respects in the world, what CDPQ is doing becoming very active as an investor and really creating value for its members, and third, I would like to point out, in terms of activity in the P3 marketing Canada pension funds can also be interested in and buy into an infrastructure project after it's designed and constructed and is effectively de-risk because the construction is completed and the project revenues have started to flow and become stable and predictable and have a long-term horizon just as many pensions do, so we see them at times buy positions in the secondary P3 market in Canada.
0:15:48.4 YO: What's interesting about what you're saying is that the Canadian market is so mature that it's really unique in some ways, and what I've seen in the past from commingled fund investments, is having Canadian pension systems as actually the general partner or a sponsor of the fund. What do you think makes them so unique that allows them to take these important roles in infrastructure investment, so not just being investor, but actually the manager of a project and a fund.
0:16:20.8 AB: So you mentioned that when you describe commingled funds, Yuliya, you indicated that that's something that is predictable and comfortable to a lot of pension funds, something that they can fully understand, and I think one of the things about the Canadian P3 market is that it has itself becomes very stable and predictable is very transparent and well understood by institutional investors, and that is in part because there's a fairly long history of using this model among all levels of government in Canada, local, provincial and federal governments, these governments have managed to create a fairly predictable and forward-looking pipeline of projects that allows investors and other market participants to plan in advance and have their resources available, and it makes sense then to develop in-house expertise, if there's sort of a long pipeline of eligible projects, the Canadian procedures, they're based on best practices that have been developed and shared throughout the country, P3 projects really originated in Canada with the provincial governments, but now best practices have been adopted by the federal government and then also municipal governments, and this has created consistent and transparent P3 procurement processes and predictable commercial terms.
0:17:39.3 AB: So again, making investors comfortable and creating some certainty in the market. Also relatively speaking, I guess maybe compared to other jurisdictions, the RFP and procurement process is rapid and very efficient and it lowers bid costs and saves time, and the public agencies that are delivering these projects are considered to be credit worthy and have a very good track record of reaching financial close when they start a project, so I think the key characteristics are stability and certainty transparency that make long-term investors comfortable.
0:18:19.1 YO: So I'm curious, unlike the US, is there a tax-exempt bond market in Canada?
0:18:25.1 AB: No, that's one distinct difference. And that can be an explanation for why institutional investors have developed their private investment strategies so deeply in Canada, we do not have a tax-exempt bond market in Canada offering easy access to low-cost debt for public agencies. That is a very unique US feature. Because there is no tax-exempt bond market in Canada, public agencies have or had an acute need for private financing, and over time that really resulted in the market for private financing that is very diverse. Including this essential role that I've described for pension funds, and another notable characteristic of the Canadian market that makes it attractive and has helped develop in this fashion for institutional investors, is that it has a very stable and more permissive regulatory regime, Canadian jurisdictions, unlike local, state and federal government in the United States have not intensely regulated public procurement and contracting, that's an important distinction, I think between Canada and the United States.
0:19:41.3 AB: This allows investors to more readily understand the regulatory regime in Canada and to have confidence in the Policy Network underpinning their investments, that it's something that they can know and understand and is not likely to change or be inconsistent frequently as between levels of government.
0:20:01.4 YO: Yeah, thank you. So, Shant, now that we've heard from Andrée about what they're doing in Canada, let's talk about the United States. Can you briefly discuss with us the Biden administration's proposed plan for improving US infrastructure?
0:20:17.1 SB: Absolutely. Let's look back to the campaign, and after COVID relief, President Biden's hot priority, even going back to the campaign, like I said, is really dealing with America's infrastructure needs. Back in March, President Biden unveiled his infrastructure plan, which is known as the American jobs plan, and this was roughly $2 trillion that he proposed an additional government funding that included many categories of infrastructure that the federal government currently funds, like highways and transit, as well as many types of infrastructure that the federal government does not typically fund, such as child and elder care facilities and other types of "soft infrastructure," like research and development and workforce development activities.
0:21:04.6 SB: Again, this was the President's plan that he released publicly back in March, but it's up to Congress, the House and the Senate to determine what elements of that they want to actually incorporate in their legislation. And so, the House passed its version of the infrastructure bill in July. This was known as the Invest In America Act, and the Senate passed its version of the infrastructure bill in August, which is known as the Infrastructure Investment And Jobs Act. And right now, in late August 2021, the house is considering kind of the way forward to react to the Senate bill. Let me say that there are some similarities between the House and the Senate bills. Both bills provide over $300 billion in funding over the next five years for highways and bridges, both bills provide nearly $100 billion in funding over the next five years for transit.
0:21:53.3 SB: Now, the Senate bill also deals with other types of infrastructure such as airports, ports, waterways, broadband and power grid infrastructure, which are not addressed in the House bill. And there are always different priorities that are competing for legislative time in the House and the Senate, and right now, there is an incredibly congested schedule in the house between now and the end of September. The house is considering many different bills that are priorities that need to be considered before the end of this fiscal year, including the infrastructure bill. So the house is considering what strategy to take in the way forward on actually getting an infrastructure build at the President's desk. Historically on the two bills that I worked on in 2012 and 2015, the way that this is typically done under regular order, you may read about that, that's talking about the typical procedure in the House and the Senate for actually getting a bill negotiated and to the President for signature.
0:22:51.8 SB: What that would normally look like under regular order is that both House in the Senate after they passed their versions of the bill, they would appoint conferees, which are members of the House and members of the Senate to form a conference committee to negotiate any differences between the two pieces of legislation and ultimately come up with a compromise package that each chamber would then pass again and send to the President, because until both chambers pass an identical piece of legislation, the President can't consider it and sign it. That's the typical way that this would happen, however, given the condensed schedule that we have between now and the end of the fiscal year, what may happen is that the house may actually just pass the Senate Bill verbatim with no changes and send to the President's desk that way, or one other option is that the house would actually make some slight amendments to the Senate bill, or maybe some significant changes to the Senate bill, and then send it back to the Senate for the Senate to then re-pass.
0:23:49.0 SB: Ping ponging it back and forth, but ultimately getting a bill that both the Senate and the House pass verbatim and sending it to the President that way, that would avoid the need of going to conference and the procedural delay that that would have before getting the bill to the President. Now currently, it's looking like that is more and more likely that the house will just consider what the Senate has done, but there are other things that the house is currently looking at, like budget resolution that would set the table for a large "reconciliation" bill, that would deal with other types of infrastructure investment and other priorities of the President. There is voting rights legislation, there is a debt limit that needs to be increased, and so, these types of activities, including the normal just funding of the government, all need to be done before the end of this fiscal year, that's kind of the reason for the condensed schedule right now.
0:24:50.6 SB: The one additional point I want to make is that the Senate bill does provide roughly $1.2 trillion in funding for infrastructure over the next five years, and this is just from the federal government. The state governments and the local governments all by additional funding in addition to this amount and so, it's likely that the final package that Congress ultimately sends to the President is going to be at least this large. As you mentioned earlier, Yuliya, I worked on the largest infrastructure bill in history back in 2015, and I'm hopeful that before too long, I'll have to change my bio and that we'll have a new bill that's much, much larger than that even.
0:25:25.1 YO: Fingers crossed. I mean, it's clear that the Senate and now heads to the House, and assuming it passes, I want to know what your take is on what this will mean for P3 and for opportunities for institutional investors in the infrastructure asset class?
0:25:40.7 SB: As I mentioned before, Yuliya, I'm hopeful that if this does pass and become enacted, that the mere fact that it's going to provide so much additional funding from the federal government for infrastructure projects, that, that on its own will mean that many more P3s are delivered and that many more public agencies consider P3 delivery for their projects. But there are three different provisions from the Senate Bill in particular that I want to talk about briefly, that I think what will have a particular benefit to the P3 market in the United States. The first is a provision that would raise the cap on private activity bonds for highway and freight transfer facilities. We mentioned private activity bonds earlier, this tool, the tool of using productivity bonds, gets to the issue that Andrée mentioned about the Canadian market and the lack of public tax-exempt bond market in Canada, and that being a reason for use of P3s in Canada, because of the parity between private and public financing options.
0:26:47.2 SB: In the United States, we do have a tax-exempt market for public bonds, and the private activity bonds are a tool that the federal government has established to try to allow additional parity between public and private activities, and public and private entities in accessing the bond market. PABs allow private entities to benefit from tax-exempt bond treatment to finance certain Public Works improvements such as highway and freight transfer facilities. However, the current cap in law of $15 billion, which is allocated to these types of PABs has been exhausted. Essentially eliminating the ability of private entities to access tax-exempt bonds for these projects. The Senate provision that would increase the cap from $15 billion to $30 billion would address the current demand and lower the cost of private financing on future P3 projects for highways and freight transfer facilities.
0:27:41.4 SB: The second provision from the Senate bill that I want to talk about is really interesting in that it would provide $100 million in direct grants to public agencies that are sponsoring projects for technical assistance with their P3 procurements. This may seem a little bit esoteric, but it's very challenging, especially for public agencies that have limited institutional abilities, given their constrained budgets to actually consider P3 delivery for its project delivery needs. And so, this provision from the Senate bill would provide $100 million in direct grants that would not need to be repaid to public sponsors of these infrastructure projects to actually go out and get the kind of technical support, whether it's engineering or financial or legal support to actually consider whether P3 delivery makes sense for their project and then actually use a P3 delivery model to deliver those projects.
0:28:36.9 SB: This kind of funding for Technical Support will actually provide a great benefit for some of these agencies that have not been able to access the P3 market before, and result in an increased market for public-private partnerships and for institutional investors in those projects. The final provision I want to mention would actually get at the TIFIA and RRIF programs. I mentioned these before, but these are federal programs that would provide credit assistance for certain types of projects and for any project seeking assistance under TIFIA and RRIF that has estimated capital costs of $750 million or more, this provision from the Senate bill would require that the public sponsor conducts a value for money analysis, to actually evaluate the benefit of P3 delivery for those projects.
0:29:23.7 SB: And the way that this would work is that it wouldn't require that the project seeking credit assistance under TIFIA or RRIF actually use P3 delivery, but what it would do is it would force the sponsor to consider the long-term life cycle of the asset and the project costs over that life cycle and consider whether a public private partnership delivery method would actually be more efficient for the public than a conventional delivery such as design bid build or design build. And so, I think what this would do, again, it wouldn't necessarily force a project sponsor to consider or use P3 delivery, but it would require them to think about the benefits that P3-delivery could provide for a certain type of project. And again, these three provisions are all in the Senate bill, and if enacted, I think they would help expand the market for public-private partnerships in this country, in addition to the general increase that I think we will see just by nature of the increased investment from the Federal Government.
0:30:22.3 YO: Thank you both for joining me today, we could talk for hours and still only scratch the surface of this fascinating topic. I really appreciate each of you sharing your time and expertise with us. I hope to have the opportunity to continue our discussion at a future time. And thank you to our listeners for joining us for this episode of Public Pensions and Investments Briefings. For additional information on this topic and other public pension topics, please visit our website at nossaman.com, and don't forget to subscribe to Public Pensions and Investments Briefings, wherever you listen to podcasts, so you don't miss an episode. Until next time.
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0:31:01.8 S2: Public Pensions and Investments Briefings is presented by Nossaman, an LLP, and cannot be copied or re-broadcast without consent. Content reflects the personal views and opinions of the participants. The information provided in this podcast is for informational purposes only, it is not intended as legal advice, and does not create an attorney-client relationship. Listeners should not act solely upon the information without seeking professional legal counsel.
- Getting the Most Out of Your Public Pension Plan Insurance Coverage
All public pension plans need a well-crafted fiduciary liability insurance policy. This should include ample coverage, including protection against the risk of impending litigation. The recent ruling by the U.S. Court of Appeals for the Ninth Circuit in favor of the San Joaquin County Employees’ Retirement Association (“SJCERA”) in its case against Travelers Casualty and Surety Company of America (“Travelers”) highlights the importance of understanding what to include in your insurance policy. The court found that Travelers had been in breach of contract and granted declaratory relief arising out of Travelers' denial of coverage under the duty-to-defend clause in SJCERA’s fiduciary liability insurance policy. In this episode of Pensions, Benefits & Investments Briefings (formerly Public Pensions & Investments Briefings), Ashley Dunning and Jim Vorhis review this significant decision and explore what lessons may be drawn from that litigation as public retirement systems consider how to get the most out of their fiduciary liability and other insurance policies going forward.
Transcript: Getting the Most Out of Your Public Pension Plan Insurance Coverage
0:00:00.0 Ashely Dunning (AD): Fiduciary liability and other insurance policies have become a norm for many public retirement systems throughout the United States. By understanding the key issues in the recent San Joaquin County employees retirement association versus Travelers case, trustees, executive staff, investment officers and in-house counsel of public pension systems will better understand what to include in their policies and what level of protection they can expect from them.
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0:00:40.9 Speaker 2: Welcome to Public Pensions and Investments Briefings. Nossaman's podcast exploring the legal issues impacting public pension systems and their boards.
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0:01:02.6 AD: My name is Ashley Dunning, I'm a partner at Nossaman and co-chair of the Public Pensions and Investments Group. Our practice is devoted to representing public pension plans across the country in a wide variety of matters, these include plan administration, benefits, actuarial matters, fiduciary duties, investments and litigation, and of course, insurance coverage, which is the topic of our podcast today. My guest today is Jim Vorhis, also a partner at Nossaman. Jim co-chairs our Insurance Recovery and Counseling group. He counsels numerous public pension boards in obtaining insurance and represents those boards in the claims process with respect to insurers and in litigation. Welcome, Jim.
0:01:48.7 Jim Vorhis: Thank you, Ashley. I really appreciate the opportunity of speaking with you today.
0:01:53.0 AD: Today, we are going to start our discussion by focusing on a piece of litigation, the SJCERA versus Travelers case that you handled for SJCERA, and could we start out please by you identifying the provisions of the policy that Travelers relied upon when denying SJCERA coverage initially?
0:02:17.2 JV: Absolutely. Ashley, let me give you just a little bit of context about the lawsuit itself, and then I'll get to the coverage provisions. And so, this lawsuit, which was between SJCERA and Travelers related to a coverage disagreement after SJCERA had been sued by a group of retired members in 2017. Travelers relied upon one exclusion, which was a prior and pending litigation exclusion, and it said that the 2017 litigation was barred because it arose out of litigation that post-dated the Ventura ruling in 1997. So basically, Travelers was taking a piece of litigation in 2017 and said, Well, you know, back in 1998, there was a piece of litigation that arose out of this Ventura decision, which everyone in the public pension world knows, and because it wouldn't have existed, but for that litigation, it should be barred by this prior and pending litigation exclusion.
0:03:16.4 JV: And the second exclusion was an inadequate funding exclusion, and that was an exclusion that was put in the policy to preclude coverage for claims when the entire retirement system was underfunded. And I think the idea behind that from Travelers or any other fiduciary insurer is, they don't want to ensure losses when a public pension system is going through a funding crisis, because those types of claims are significant, lengthy, expensive, and will burn through just about any policy limit that you have.
0:03:44.4 AD: Are those two exclusions that you've just described common in fiduciary insurance that's proposed to public retirement systems?
0:03:53.1 JV: They are common. One you'll find in every policy, one is in most policies, so let me take each one in turn. The prior pending litigation exclusion is, as I noted, it is an exclusion that insurance companies will put in policies to preclude coverage for existing risk, and it makes sense. So, if there had been a lawsuit filed five years ago about a specific topic, and then an insurance policy is issued in that same topic, ends up being the subject of a lawsuit, the insurance company basically doesn't want to pay for that risk again, and the idea is, the insurance company doesn't want to pay for a burning building basically, once it's already happened. Prior and pending litigation exclusions are common, they're in just about every type of policy, fiduciary policy or otherwise.
0:04:41.2 JV: The Second exclusion, which is this inadequate funding exclusion, while it's common in the fiduciary context, because obviously the funding level of a public pension system is really important, you won't actually find that in every policy, so I think it's also not worded the same in every policy, and so, I think it will be very important for any public pension system that is obtaining a fiduciary insurance policy to look and see if there's this type of exclusion, because not every policy will have it.
0:05:08.3 AD: It's interesting, you mentioned on the prior and pending litigation exclusion, reminds me of a circumstance that we looked at years and years ago, where a proposed exclusion was to any litigation that arose out of the Ventura litigation, which was really quite broad and really swallowed the benefit or potentially would have swallowed the benefit of that policy, because so many disputes arise out of the definition of compensation article and how it's applied in various different circumstances, which arguably all relates back to the Ventura decision of the California Supreme Court, so that type of exclusion seems to me at least not something that we would ever want to include in a policy for a public retirement system in California, at least.
0:06:02.2 JV: Yeah, exactly, and that was part of the problem that we had in this case with Travelers. When Travelers was trying to look back to this post-Ventura litigation, SJCERA was not the only civil system that was involved in litigation after Ventura. But SJCERA was sued as part of a class action and ultimately reached a settlement agreement that put into play the operations for the payment of retirement benefits for all retired members, current members, future members at that time. It basically covered every member of the system, so the idea that Travelers might look back to that litigation as the prior litigation that would bar future coverage, it was kind of absurd, because it's just like you're saying, it would swallow the coverage. And so, I think that's one thing that we're talking about sort of general advice for anyone listening to this podcast is, read the policy.
0:06:57.7 JV: I recall, you and I were looking at a recent renewal where there was an exclusion put into play about litigation related to the Alameda decision that just came out. And while there might be ways to put language in place that could have some type of exclusion in that scenario, you have to be really careful about what it is that you're agreeing to. I think that there are types of policies out there where the renewal process is pretty straightforward, and a lot of times you just take what your broker says and you sometimes don't need to read the policy, you should always read the policy, but there are definitely, there are types of forms out there that are so standard that it's probably less important. Fiduciary policies are not that type of policy, you really need to dig in, look at the endorsements and see what they say, because you can end up in some certain scenarios where they're trying to add an exclusion that precludes coverage for all benefits-related litigation.
0:07:47.0 AD: So say you had a prior impending litigation exclusion, do you have to be as concerned if you've had the same carrier all along, or does it only matter if you've changed carriers, so the original carrier... The new carrier is claiming they shouldn't be on the hook for something that arose under the prior carrier?
0:08:05.0 JV: That is an excellent question, and we saw a specific situation come up in this Travelers litigation I'll talk about in a second. Generally speaking, I would say you can be less concerned about that type of situation where you have a carrier on the risk for a long time. So let's pretend Travelers had been insuring SJCERA back to 1995. It was insuring SJCERA during the course of when Ventura was decided, it was there when the litigation was filed against SJCERA. After the Ventura decision, it stayed on the risk, because it was the carrier at that time, it should be well aware of all of the developments that were going on with its client and what were relevant to it. If you have a new carrier though that's changing over, I think it becomes really important because then you have to start thinking about what was disclosed in an application or how might a new carrier look at a situation when it wasn't evaluating the risk before it ever came on and issued policies to your client?
0:09:05.9 JV: The situation that I'm thinking about in Travelers is this, when we were looking at the discovery in this case, we found that Travelers for about the first five years had insured SJCERA from 2005, maybe seven years to 2012-2013 included a specific endorsement that said it wouldn't cover losses related to funding problems with a specific type of benefit that was included in that settlement agreement but it didn't include a similar exclusion for the type of benefit that was an issue in the 2017 litigation. I think that's important, because what it showed to me was Travelers understood, it could look at how SJCERA operated, it understood the benefits it paid, it saw one particular type of benefit and said, Well, this might be a problem when it comes to the funding of that benefit if it doesn't get paid to the recipients, so we're just going to exclude that entirely, but we're not going to do it for this type of benefit, that tells me the Travelers affirmatively decided it wasn't going to exclude that type of loss.
0:10:09.9 JV: So, getting back to your original question, Ashley, if you are with the same carrier for a long time, I think the one thing you get is this kind of... It's not institutional knowledge, but it's this course of dealing. I think it's fair to say that a carrier that's been working with you for a long time is going to be aware of what you've gone through, what types of litigation and claims have arisen and you're more likely to end up with a favorable scenario. It turns out in this case though, that didn't help SJCERA. Travelers still denied coverage when the second claim came up.
0:10:37.5 AD: So just turning back to that litigation, Jim, what did the Ninth Circuit ultimately conclude as to each of those exclusions?
0:10:45.6 JV: The Ninth Circuit ultimately ruled in favor of SJCERA, which we would both agree was the right result. It pretty quickly dismissed the inadequate funding exclusion argument that Travelers raised. So what Travelers was trying to argue was because a benefit wasn't paid, this benefit was a non-vested supplemental benefit, it wasn't paid to a particular group of retirees, that constituted inadequate funding. The Ninth Circuit looked at the definition of what had to be inadequately funded in the policy, and it was the entire retirement system. And in fact the plaintiffs in this 2017 litigation allege that SJCERA as a whole was funded adequately enough to be able to pay these benefits, that's what they were trying to have happen through that litigation. And so, Travelers was kind of taking the opposite approach of saying this was inadequate, this was a lawsuit arising from inadequately funded system, it was the exact opposite argument that the plaintiffs raised.
0:11:45.7 JV: The second thing that the Ninth Circuit noted was when it came to the prior impending litigation exclusion, it identified that Travelers was really relying on the wrong language and the exclusion, and so the exclusion precluded coverage for loss that was based upon or arose out of facts, underlying or alleged in prior litigation. What does that mean? That means you have a second piece of litigation, it will be barred if it is the same as the facts that were underlying the first piece of litigation, not something that happened after that litigation happened. So in our case. Everything that travelers was pointed to were these benefits from the 2001 settlement agreement of the 1998 litigation. I know it's a mouthful, but basically, the Ninth Circuit said, Look, this is what the 2017 litigation is about. Let's go back and look at what the 1998 litigation was about after Ventura, it was about, how do you pay retirement benefits, was it applied retroactively?
0:12:45.5 JV: And what travelers was focused on were events that happened after the litigation, and the Ninth Circuit said, You can't do that, there's the underlying or alleged in that necessarily means what you have to look at in the context of this exclusion is what happened before the first lawsuit was filed. And so they were able to dismiss Travelers arguments in that regard and reversed it and obviously decided that there was a duty to defend, which was fantastic.
0:13:10.3 AD: It was a great result. Congratulations. Have there been other provisions of the Travelers policy that have become pertinent in this litigation or in its aftermath that would be useful for other public pension systems to know about as they think about their own policies?
0:13:30.5 JV: Yes, absolutely, and this is probably a broader discussion beyond just this Travelers litigation, although it's come into play there, what is most important to take out of this and what is sort of a universal... It's a universal take-away for people is the importance of retention and the importance of negotiating attorney rates before you execute the policy, and here's the reason why, retention or a deductible is the amount that you have to pay before the insurance will kick in, so you may have a retention of $25,000 or you may have a retention of $50,000 or $100,000, that's how much you will have to pay out of pocket before the insurance company will pay anything. So the lower the retention figure, obviously the better for the client when it comes to the reimbursement of attorney's fees. However, part of the things that then determines how quickly you get through that retention is what is the reimbursement rate from the insurance company. So one of the things that you and I have been very successful at when negotiating with insurance companies is pre-approval for particular insurance rates or firms.
0:14:37.5 JV: So pre-approval endorsements to say, You can use this attorney and here are the rates that we are going to reimburse the partners, associates, paralegals, whatever categorization of attorney that you want to put there. Now, the importance of that, of course, is the higher those reimbursement rates are, the quicker you get through the retention, the quicker the insurance will kick in. If you don't have that type of situation where you have a pre-approval for particular attorney rates, what's going to happen inevitably is that an insurance company is going to say, You know what, this is not a complicated case. We're going to kick this to a panel counsel, and that panel counsel who we work with all the time, charges us partner rates of $230 an hour and associates at $180 an hour, or $150 an hour, it's going to be something out of 1985, and that's really not appropriate in this context, there are certainly types of law and cases out there where that is fine, if you have a personal injury case, there are thousands of attorneys that do personal injury cases, but this is a real niche space, there are only a few people that do it and do it well.
0:15:45.0 JV: And so I think this is one of those places where you have the leverage to be able to work with your fiduciary carrier to say, Look, you want to work with this attorney, here's what their rates are, and you're going to find I think on balance that fiduciary carriers are willing to do that. So long story short, I think a take away is try to negotiate those rates, you want to get through the retention as quick as possible if you end up winning the claim.
0:16:09.9 AD: Yeah, what I was hearing you say is, well, you may not necessarily know exactly who you want to retain on a given matter, you want to be able to retain the right to choose the appropriate counsel, so if you retain that right, then the most important thing is the reimbursement rate, so if it's at $500 or $550 or $600 an hour, even if the counsel's rates are something slightly different from that, you're going to get that minimum amount for an hour of that partner's time. Is that fair, Jim?
0:16:41.5 JV: That is exactly right. If you have a $50,000 retention, you would rather have your attorneys reimburse the $500 an hour, than $250 an hour, so a lot of times when you're in that situation, you can negotiate with your carrier to use the attorney you want, but they're only going to do it if you're at the panel rates, which may be half of what your attorney charges, and this is something that you can, with a little bit of planning, get out in front of and solve a problem before it ever exists.
0:17:11.3 AD: So on that point, what should Retirement Systems consider when they assess a proposed retention amount or reimbursement rate, or even the policy limits within their fiduciary insurance policy?
0:17:26.5 JV: It's a good question. I think the important thing to say on this point, is it's a very individualized decision, I work with a lot of clients and they view insurance very differently, there are some people that look at it like, this is catastrophic insurance, we want to be covered if the worst case scenario happens, so we're going to get a fiduciary insurance policy and we're going to have $20 million in limits, and we don't care if the retention is high, which will bring the premium down, but the idea is basically, look, if the big one comes in, we want a lot of coverage, that is a reasonable way to handle your risk analysis, and if the big one ever comes, you feel you have a lot more comfort about, Hey, look, we're covered. There are other clients though that would prefer to buy that retention down and pay a bit more in premium, so that these sort of more common claims end up getting into the reimbursement of the defense fees, so if you have a retention figure of $250,000, it's going to take a pretty big case to get up to that point.
0:18:25.4 JV: Some of that would get handled on a demurrer, it would never even get close to $250,000. If you have a $25,000 retention, it may be more expensive on the premium, but the reality is you're going to have more situations where the carrier is actually paying you back for your attorney's fees. So there are a lot of different ways to look at this, but those are the types of things that the public pension system should be looking at, what do you really want? Is it here for protecting from the catastrophic loss or is this, I want it to actually come into play more frequently when the claims are filed? Either way is fine to go, it's just that's the type of thought process you should be going through with this.
0:19:05.1 AD: So just thinking about the context where you have a $20 million policy limit, these policies aren't paying for things like investment losses or benefits that haven't been paid, and they're not going to actually pay the benefit or pay the loss of investment earnings. Correct?
0:19:26.7 JV: Correct. And I think that is one really critical thing to look at, there are a number of policies, and the fiduciary policies are similar to directors and officers policies or employment practices liability policies, they pay defense fees. Maybe you'll have a carrier that will contribute to a settlement just to get something done, but there's no obligation to indemnify for benefits, so I've had this question come up a lot. Okay, our pension system grew, now we went from $5 billion to $7 billion, does that mean that we should increase the limits? And my response is always, is the litigation going to be more expensive? 'Cause that's ultimately what matters. I'm not sure that the litigation is going to... If you have some big piece of litigation, it's going to change your attorney’s fees one bit, but that's what you need to be looking at. Because you're not paying benefits, what you need to think about is the risk and the exposure when it comes to attorney’s fees.
0:20:19.7 AD: Yeah, and possibly also the number of lawsuits you expect to receive because the policy limit, would that be a policy limit per piece of litigation or per the life to the policy or for the year? How do they work typically?
0:20:36.0 JV: They're usually annual policies, and they'll have an aggregate. So if it's a $10 million policy, we'll pay out $10 million. I'm accustomed to seeing an individual per claim and aggregate limit the same, basically meaning you got a $10 million policy, if you have a claim comes in, you pay $10 million and attorney’s fees will cover it all. Not all policies are structured that way, some of them will have differences, so that you might have $5 million per claim but a $10 million aggregate. In this case, it's all kind of lumped in. I think one thing though that is interesting about these policies, I know we've talked about this a lot over the past couple of months actually, is they also have a lot of other sort of bells and whistles that come with it, there are a lot of sub-limits in coverage. And so one of the things we've seen is Voluntary Compliance Program Coverage. Another thing you're talking about, benefits are not covered, but there's always, with some of these carriers, a small benefit overpayment coverage.
0:21:31.5 JV: It's only maybe $100,000, but if you can't recover this benefit overpayment, at least you can recover something back, and so I think it's really important as you're looking at your policy to ask the question, "Well, what else can I get here?" Because a lot of people don't actually go through that process, they get their proposal from the broker and they just take it for, "Well, that's all that's there." And sometimes there's more there, just ask the question, the worst they can say is no, that's it.
0:21:57.1 AD: Yeah, that's a great observation because I wonder when a plan has a benefit overpayment situation that doesn't necessarily lead to litigation, how many would think that the policy that the system has might actually cover that situation, that's a really, really interesting observation. So what other factors in a fiduciary insurance policy should a public retirement system focus on, in addition to the ones you've talked about?
0:22:27.5 JV: So I think two things, one I touched on a little bit, I called it the bells and whistles, but a lot of these policies structurally will have some things other than your traditional fiduciary coverage, and so I think it's important, look for the scope. What is the scope of the coverage? What are the scope of the exclusions. On the coverage side, because you have these different sub-limits and you've got coverage for voluntary compliance program situations, maybe you have a benefit overpayment coverage, you also have situations we've seen where they're packaging a little bit of cyber coverage here or there, there might be a package policy with an employment practices liability coverage. I think that understanding what is there from a coverage perspective is really important, and understanding that insurers have been willing to go outside of the norm to try to add on a little bit and incentivize using their policies.
0:23:17.8 JV: I think the second thing I would say is, look at the endorsements. The public pension systems should be looking at what is and is not covered, and you and I have seen some situations pop up in the last couple of years, you brought up that Ventura exclusion, we saw an exclusion on Alameda, we recently saw a carrier that tried to parse out, so there was different coverage parameters, whether there was a class action or a smaller benefit-related piece of litigation. Those are unique, I mean carriers... Because these are not common policies, fiduciary policies are very specific, you see some unusual things that will pop up, and it really is important for you to read the endorsements.
0:23:58.8 AD: Yeah, one of the things that I thought about in connection with the class action language that you noted, Jim, is the more of those provisions that are included in the policy, such as you get one thing if it's a class action and a different thing if it's not, and then there's a question, okay, when does it become a class action, is it when the pleading's filed that says it's filed on behalf of an individual and everyone else who is similarly situated, or is it when the class is certified or some other point? That's just creating a fight within a fight.
0:24:37.1 AD: Why would one do that, when you could simplify your policy and just agree at the outset, okay, here's the policy that applies, regardless of what type of litigation is filed? Yeah, another thing you mentioned, the nuances of the language used in the policy, and it reminds me of another situation we dealt with, which was a system that was contemplating whether to go to the IRS on a voluntary compliance program or to seek a closing agreement, based on the tax issue involved. And one question was, well, does the policy, the insurance coverage policy distinguish between the two? Fortunately, the language was broad enough, so that it really didn't matter, the system could choose to go whatever approach was the most appropriate, but having to parse through that sort of coverage analysis, I thought was interesting, and sort of a cautionary note not to have your language to be too specific.
0:25:39.1 JV: Yeah, it's a good reason to look at. I know we've had a number of situations where that comes up, and it reminded me of we saw that other policy that had DCP coverage, but it didn't cover situations with the state, it was only the IRS, and that doesn't make any sense, why you would have some coverage in place for an IRS filing but not for a state. So it is important to really review that language closely.
0:26:03.2 AD: So turning now, in the last four minutes or so we have of our podcast, to some other types of insurance that public retirement systems may be purchasing, what types of policies have you seen that provide the greatest value to public retirement systems?
0:26:20.3 JV: Well, I have reviewed all sorts of policies for public pension systems. I've looked at entire policy portfolios, you have to have CGL coverage, commercial general liability coverage, and you have to have property for any property you own, and all that, and that's fine, but those are all like pretty standard coverage forms. I think the thing that I have done more advisory work on than anything other than the fiduciary coverage is cyber. All you have to do is go on any news network, and you're going to hear about ransomware this, and hackers that, and it's true.
0:26:55.3 JV: Five years ago, the world was in a very different place, 10 years ago it was in a very different place, but when we were looking at this landscape five years ago, the cyber market was increasing, but it was still fairly small, the policy forms were very like unique, everyone had different types of coverage in different language, and that's all kind of started to normalize a little bit. I think the most important thing is when you're looking at cyber coverage is to look at what is actually there. There are some types of coverage that are probably going to be in any cyber form you're going to find. You're going to have coverage for lawsuits from data breaches, you're going to have all of your expenses covered, likely if there's a disaster scenario, you're probably going to have breach notification or public relations coverage. Those things are pretty standard.
0:27:38.4 JV: The types of things that are not standard would be business interruption coverage, and most specifically from a law we'll be seeing recently, ransomware. And that's really important to know is if you're purchasing a cyber policy, if you're expecting coverage, when you have a ransomware situation, whether it's for the ransom itself, whether it's for the tech needs that happen to try to rectify the problem, you have to know that doesn't come with every policy. And the one other thing that I did want to bring up here is one of the most common types of cyber crime these days is social engineering fraud, where people are basically duping other folks and organizations. So it'd be someone that was trying to pretend that they were, for example, our managing partner. And what happens is they spoof his email address, they send it to someone in accounting, and they say, "Hey, you need to wire $1 million to this account 'cause this client is really mad." And etcetera, etcetera.
0:28:28.5 JV: It's really easy to combat that type of situation if you just have the right internal controls, but it happens, and it happens a fair amount. And one of the things that's developed through case law over... And language changes in these two types of policies, the cyber policy and the crime policy is that coverage for that type of loss can fall in one or the other of the policies, but it's not always standard about how the language is worded because in those types of situations, you have a voluntary transaction from someone in the Accounting Department. It wasn't like they were coerced, it wasn't that they were hacked, I mean, they just looked at something, and they thought it was real, and they sent it. So one of the things I have been telling more and more people, you just need to be really clear, where does that type of problem fall, does it fall on your cyber policy, does it fall on your crime policy? Both carriers will offer it in some form, but you just need to make sure it's there. You don't want to have that gap.
0:29:24.4 AD: It sounds like a great topic for yet another podcast or maybe a presentation on some other forum, Jim, 'cause cyber security certainly is a hot topic of the moment. Thank you again, Jim, for being with me today to talk about this important issue of fiduciary insurance policies for public retirement systems. I very much appreciate your time.
0:29:47.4 JV: Thank you, Ashley.
0:29:48.9 AD: Thank you to our listeners for joining us for this episode of Public Pensions & Investments Briefings. For additional information on this topic, or other public pension issues, please visit our website at nossaman.com, and don't forget to subscribe to Public Pensions & Investments Briefings wherever you listen to podcasts, so you don't miss an episode. Until next time.
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0:30:13.8 S2: Public Pensions & Investments Briefings is presented by Nossaman LLP, and cannot be copied, or rebroadcast without consent. Content reflects the personal views and opinions of the participants. The information provided in this podcast is for informational purposes only. It is not intended as legal advice and does not create an attorney-client relationship. Listeners should not act solely upon the information without seeking professional legal counsel.
- How Will the Biden Administration Impact Public Pension Investments?
In this episode of Pensions, Benefits & Investments Briefings (formerly Public Pensions & Investments Briefings), Nossaman Pensions, Benefits & Investments Group Partner Peter Mixon and Institutional Limited Partners Association Senior Policy Counsel Chris Hayes discuss what impact the Biden administration could have on public pensions. They explore how the new administration may alter investment regulations to align with their key policy initiatives, and how public pension plan investors should approach investing to ensure compliance.
Transcript: How Will the Biden Administration Impact Public Pension Investments?
0:00:01.3 Peter Mixon: In this episode of Public Pensions and Investments Briefings, we will discuss how the Biden Administration may alter investment regulations to align with their key policy initiatives, and how public pension plan investors should approach investing in this new environment.
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0:00:27.9 Speaker 2: Welcome to Public Pensions and Investments Briefings, Nossaman's podcast exploring the legal issues impacting public pension systems and their boards.
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0:00:49.0 PM: My name is Peter Mixon. I'm a partner at Nossaman and a member of the Public Pensions and Investments Group. Our practice is devoted to representing public pension plans across the country and a wide variety of different matters, these include investments, plan administration, plan funding, fiduciary duties and litigation. My guest this morning is Chris Hayes. Chris is the Senior Policy Counsel of the Institutional Limited Partners Association, also known as ILPA, and leads their global advocacy efforts in the US and in Europe. ILPA is a professional association of over 550 institutional investors investing in private funds with an emphasis on private equity. Its members include insurers, endowments, foundations, corporate pensions, sovereign funds, family offices, and of course, public pensions. Its membership collectively manages well over $2 trillion in private equity assets across the globe.
0:01:46.9 PM: Chris has led a number of important ILPA projects around private fund terms, including the ILPA Model Limited Partnership Agreement, and more recently, the Model Non-Disclosure Agreement. Welcome, Chris.
0:02:00.8 Chris Hayes: Thanks, Peter, really appreciate the opportunity to speak with you today and some of your listeners, and we also really appreciate massive support on many of those fund terms projects you mentioned. You guys have been an invaluable supporter of us and we really appreciate it and look forward to speaking more about the Biden Administration today.
0:02:18.5 PM: First off, I want to ask you about the changes in Washington. Obviously, we have a new president and a new administration, as well as a changeover of control in the Senate. This means new policies and new faces, as well as a completely different tone in federal government. Focusing on institutional investors, what are some of the high-level policy changes that we can expect to see in the first year or so of the new administration?
0:02:45.0 CH: It's a great question, Peter. I think there's a few main items that the administration is going to focus on this year, core among those are climate change, diversity and inclusion, and infrastructure, as among the, I would say the main three issues that this administration will be working on in 2021. To talk a little bit more about climate change, President Biden during the campaign pledged that publicly traded companies will be required to disclose climate risk and emission levels in their operations and in their supply chains. We had had a number of discussions with the Biden transition, which unlike in previous administrations, it's really the first time that we've seen a strong focus on addressing climate change, particularly in the financial system. And so we expect this to feature quite heavily at the SEC this year, at the Department of Labor, as well as particular action in Congress. In particular in Congress, we do expect there to be some additional items added on climate change as part of an upcoming tax and infrastructure package that we would expect to see later this year.
0:03:47.9 CH: In Congress, we've already had some hearings on climate. Just last week, there was a hearing in the House Financial Services Committee on climate change reporting for public companies, so there's been a big focus on this in the public market. The new SEC Chairman Gary Gensler had his hearing in the Senate Banking Committee, and he was specifically asked about climate reporting as well, and disclosures to investors. I think there's definitely some interest in doing something here. Less has been done in the private markets, which is an area that obviously we at ILPA focus on, but we do expect that there could be some efforts to integrate ESG criteria into the investment process and fiduciary duties of both private fund managers as well as ERISA plan administrator requirements at the Department of Labor.
0:04:32.1 CH: I think it remains to be seen whether these sort of requirements on the investment process side are implemented, but also whether reporting and disclosure type requirements are also implemented, and whether that is a voluntary kind of standard, so say if you marketed a funded CSG or climate change-specific, if there would be certain guidelines for those that opt into that type of regime when marketing an investment product versus obligatory ESG framework and reporting requirements across the industry.
0:05:02.7 PM: Speaking of the, or returning to the SEC, they obviously have an acting interim chair, Allison Lee, and I believe she recently issued a statement on climate change, what was that about? And is that something that's likely to influence the new administration going forward?
0:05:20.3 CH: Yeah, I think that's a good point. Just a few weeks ago, Acting Chair Allison Lee at the SEC issued the statement indicating that climate review would be a focus of the SEC when looking at public company disclosures and they will be enforcing and updating some guidance that was released on climate disclosure by the SEC back in 2010. Furthermore, over the past few years, this committee at the SEC, the Asset Management Advisory Committee, which ILPA has been following during that time, issued draft recommendations around ESG, and that included adoption of standards for disclosure of material ESG risks which are consistent with other financial disclosures with the goal towards pushing standardization in the asset management industry. I think it's interesting how you've seen a holistic approach, and I think generally support for more standardization and clarification around these issues, both from the asset manager, fund manager perspective as well as the institutional investor community who are looking potentially for more of that information.
0:06:21.4 CH: But I think it's interesting also to see where members are, where public pensions or institutional investors are in what we would call their ESG journey. We've had a variety of conversations with our members because we would like to be more engaged on these issues and assist our members with them, and some are very far along. Our European members in particular are some of the larger pension plans in Democratic-leaning states have been very upfront in terms of integration of ESG into their investment process, as well as moving towards more reporting from the managers they invest with, including key performance indicators on the underlying portfolio companies. And in California in particular, obviously the two largest, CalPERS and CalSTRS have also taken some action on that issue. We've also seen some university endowments do more on that as well. And we are looking at how we can better assist our members in incorporating ESG into their due diligence process, or starting to think about what sort of reporting standards are helpful from product fund managers, and then we will have a better sense to share with policy makers about what is actually useful for investors.
0:07:28.4 CH: I think ILPA intends to engage in this climate disclosure debate around private funds, at least in terms of understanding what's useful for our members. And even if those members don't care about that climate reporting, it may be required anyway, so they might as well have something that's useful and effective for the cost since they will ultimately be paying for it if it's going to be regulated anyway. And we want to be part of that discussion to make sure that any kind of reporting requirement is shaped that it's beneficial for investors. And over the next year, we're going to be looking at a variety of standards in the marketplace, from SASB to TCFD to the PRI standards, to try and figure out from our members who are real deep and further along in their ESG journey, how and what standards are the best ones to use, and then be sharing that with our members so they can be thinking about that. Because many of these members are actually on the cusp of going a little bit further towards requiring reporting beyond early stages where they're talking to their managers about ESG or trying to better understand the ESG policies of their managers, to moving towards proactive tracking and reporting across their portfolio. And so that's something that we're going to be looking at.
0:08:37.9 PM: Yes, I think it's safe to say that ESG has gone from perhaps not part of the mainstream to definitely front and center for both private market and public market investors. Next I want to talk to you about action on diversity, equity and inclusion. What can we expect on this front from the Biden Administration?
0:09:00.9 CH: Well, I think the administration, as we've seen in the campaign and obviously now in power, as well as Democrats in Congress have been very vocal about trying to address economic justice issues, lack of diversity and access to capital by underserved communities in the US economy. And we've already seen legislation, both in the private market and in the public market to encourage and track diversity around public company boards, for example, or around private funds managers and who they're hiring. Just recently, and this actually came up at the hearing of the SEC Chairman, there was a real big movement forward with the exchange in New York, essentially issuing a rule proposal that would require all listed issuers on the NASDAQ exchange to have one woman and one underrepresented minority on their board or to have to explain why they weren't able to do so. And ILPA actually submitted a comment letter in support of this proposal, but I think it's illustrative of where the industry is moving towards trying to encourage proactively, aggressively greater diversity on corporate boards, both in the public markets to start, and I think we'll see that move over to the private markets as well.
0:10:16.6 CH: In the private markets, ILPA has been really proactive through our Diversity in Action Initiative, and I would obviously encourage some of the listeners to this podcast to take a look at it where we are actually trying to galvanize the private fund industry, we've seen significant uptake from both private equity managers, as well as institutional investors signing on to the Diversity in Action Initiative would actually requires you to do at least four items which are really around making sure that folks you invest with are racially diverse, or tracking the diversity of the folks that you invest with, if you're an institutional investor. If you're a manager, it's about your hiring practices, how you're increasing the pipeline of diverse candidates into your firm, as well as where you're directing your capital. And as part of that initiative, we think that we can move the private fund industry in a positive direction because ultimately, in our view, and many others, diversity leads to better investment outcomes for ultimately institutional investors and their beneficiaries.
0:11:18.2 PM: Yep. Absolutely. And the next topic I wanted to broach with you is the concept of stakeholder capitalism. On the campaign trail, Joe Biden memorably said that it's time to put an end to the idea of "shareholder capitalism". Instead, he suggested corporations should also have a responsibility to their workers, their community and to their country. What does stakeholder capitalism mean? And how is Joe Biden's view going to affect institutional investors in the administration?
0:11:55.2 CH: Well, I think the idea of stakeholder capitalism is something that's been floating around for a while, and ultimately what it is, is taking things into account beyond just the financial performance of the company and its ability to produce the maximum returns for shareholders. And so that means thinking about the impact on communities, the impact on employees, as well as other stakeholders in the company's success. This has first kind of come up as part of an effort to encourage folks to be thinking about the treatment of workers in particular at companies as well as maybe harmful practices that the corporation is doing or companies are doing in various communities as a way to address it. It also kind of fits within the social element of ESG where you're thinking about what we would call human capital management.
0:12:44.2 CH: And this human capital management issue has been a significant one in the private equity space where there has been continual focus on treatment of portfolio company employees, just part of the nature of the capitalist system where sometimes companies fail, sometimes workers lose their job, and those are negative repercussions, and how can we address those or encourage more responsibility from corporations or funds that invest into companies to consider those factors? And so this did come up in our conversations with the Biden transition. It's difficult to maybe fully understand how it'll manifest in terms of the policy changes or how companies do business, but it is something that just a few years ago, the Business Roundtable, which is a group of the largest company CEOs actually issued a statement talking about this, how they're taking account communities, employees and other stakeholders besides shareholders, so it's certainly something that folks have been talking about, and I think part of this ESG discussion.
0:13:42.8 CH: And so potentially you could see some changes if you're considering ESG factors in your investment process, you need to be thinking about other stakeholders in the company and how you should be thinking about that. And obviously, the US maybe doesn't have the strongest safety net as other places where some of the negative impacts of companies failing, workers losing their jobs are more widely felt without that safety net there. And so trying to think about the responsibility that companies have for that.
0:14:11.3 PM: I sense a theme in our discussion here today with ESG investing. Let's explore a little bit more in detail, the potential policy initiatives. We know that President Biden generally supports ESG investing. Do you expect him to actually take policy action either in Congress or at the regulatory level around these types of initiatives?
0:14:38.4 CH: I do. Starting with the Department of Labor, the ERISA plans obviously, top charity plans, union plans or corporate pension plans who are regulated by the Department of Labor. And obviously ERISA also influences us. I don't have to tell you, Peter, the public pension community in terms of their state laws. And for the past 20 years, there's been a variety of informal guidance and bulletins issued by the Department of Labor around fiduciary standards. At the end of the last year, much anticipated rule was released by the Trump Administration at the Department of Labor which sought to limit the ability for ERISA-backed fiduciary, so these types of pensions, to consider ESG factors as part of their investment process. More specifically, the rule required plan fiduciaries to make all investment decisions based on so-called pecuniary factors, i.e., those that are expected to have a material effect on risk or return over appropriate investment horizons.
0:15:36.5 CH: Although this was not a lot different than some of the informal guidance that have been issued previously, the new rule was designed to preclude these fiduciaries from making investments to promote non-financial goals, particularly around ESG. ILPA opposed this rule. A number of other groups, folks, institutional investors and managers who care about these issues also opposed this and thought it was inappropriate for investors that wanted to consider ESG factors as part of their process to do that. I think that ILPA restated their position that it's completely in line with being a fiduciary to consider environmental, social, governance impacts and weigh those as part of the investment process when you're making an investment. That's ultimately in the best interest of the beneficiaries to consider the risk rewards of those particular elements. With the Biden Administration coming in, I think we expect... And they've already indicated this, that this regulation will be "reviewed" before it's enforced, and ultimately, we expect this rule to roll back, but I think it actually would go in the other direction to require consideration of these factors, and we'll have to see what the new Secretary of Labor Marty Walsh, former Mayor of Boston, former union guy, what he thinks about this, but I would expect that to be a high priority of the Department of Labor in the next year or two, although we'll take a little bit of time to roll that rollback.
0:17:00.7 PM: Yes, I agree. I think Department of Labor is going to take a hard look at this new regulation. As you know, they finalized the regulation in December of last year, and actually didn't become effective until, I think maybe 10 days before the end of the Trump Administration. And although the Department of Labor does not have jurisdiction over governmental plans like public pension plans, they often will look at guidance from the Department of Labor, particularly when it comes to fiduciary issues in the investment arena, because there is a lot of guidance, as you mentioned. I think that although the rule itself that was issued was not startling, I think some of the material that was put out by the Department of Labor around adoption of this rule, including the idea of investigating plan fiduciaries for violation of these new rules in the context of ESG investment decision-making certainly gave people pause. Early in March, the Department of Labor made an announcement that the rule regarding "pecuniary factors" in investment decisions will not be enforced. According to the statement, the rule has created a perception that fiduciaries are at risk if they take ESG factors into account and the evaluation of plan investments. The department plans to revisit the rule in the future after taking additional stakeholder comment.
0:18:40.0 PM: I also want to bring up another topic that is infrastructure investing. I'm old enough to remember the infrastructure talk during the Trump presidency, it seemed like every other week was infrastructure week, and after a while became a running joke because the Trump Administration actually never did take any substantive steps in implementing any kind of a plan. Well, everyone, virtually everyone, anyway, agrees that there's a massive need of an overhaul of the nation's infrastructure. There is very little agreement on how to pay for it. There was a lot of discussion during the Trump Administration around PPPs, the public-private partnerships and leveraging private market investments to improve the nation's infrastructure. Some of this discussion actually included the idea of public pension plan participation in PPPs, but as I said, nothing really ever happened. Like former President Trump, President Biden supports a federal infrastructure initiative, and according to his plan anyway, he would like to invest about $2 trillion in federal money over four years to improve the infrastructure. Does Biden's infrastructure plan have any traction? That's my question to you. And if so, what does it mean for institutional investors?
0:20:01.8 CH: Yeah, I think it does. It's funny that you would mention infrastructure week because us here in Washington DC actually agreed, it was a running joke where ultimately there would be some infrastructure week announcement, and then ultimately there'd be some crazy calamity that happened that week that completely took the focus off infrastructure. We remember in the Trump Administration, they released a plan, as you indicated, that was very focused on public-private partnership, and that plan was essentially, I remember there was a lot of hype when it was released and it was ultimately a two-page bulleted suggestion of what infrastructure should look like, which to be honest, wasn't much of a plan, and ultimately, it never moved forward. And I think part of that... And a differentiation between what the Biden Administration's trying to do here is that it wasn't anticipated to be a lot of federal money that would also flow into infrastructure as part of the plan. The idea of the Trump Administration was to really try and incentivize private sector capital into these infrastructure investments, and I had a number of discussions with our member institutional investors who invest in infrastructure, and I think there were a lot of challenges to that plan, from attractiveness to investment to the muni bond market which makes it difficult to earn a return on these types of investments.
0:21:15.8 CH: But I think the Biden Administration is going to really focus on, as you indicated with this $2 trillion dollar price tag, really deploying federal capital into investing in infrastructure as well as trying to also try and encourage private sector investment along with it. But I think potentially there's more substance here than what we saw in the last administration, and I think there's a vehicle to move this later this year. So as folks listening to this podcast may be aware, with a reconciliation bill, which you can only do once per fiscal year, you can pass legislation that is budgetary in nature with only a bare majority through the Senate, which the Democrats have. They're using their first reconciliation package from actual, the last fiscal year, because there was no budget to move this COVID-19 stimulus package, $1.9 trillion package, and then they will be turning to another reconciliation package which we expect to be an infrastructure package, but also packaged together with tax changes.
0:22:16.3 CH: So ultimately with infrastructure, if you're going to do a $2 trillion dollar investment program, you need to generate some money to pay for that. And we would expect some significant tax changes that's indicated by Biden during his campaign to raise the capital gains rates, raise corporate rates, and particularly potentially eliminate the carried interest loophole as well as some other potential tax changes that would help pay for this package. I think some of the challenges to this package just generally are going to be the price tag of the package given the amount of money we would have just spent on COVID relief, and certainly now there's a big shift politically from Republicans to attack the cost and the debt of these programs. And I would expect there to be a similar shift in those sort of talking points. From an institutional investor perspective, I think you want to look at this package in two ways. So first you want to think about the negative impacts which could be through these potential tax changes. Investors need to be thinking about, if there's an inclusion of a financial transaction tax, which could impact them if they're not carved out, and they also need to think about potential carried interest changes that could ultimately come back to them as investors.
0:23:29.1 CH: And while we don't have a position at ILPA on the taxation of carried interest, we do think LP should be reviewing their investment agreements to be prepared to push back on managers who try to shift the economic burden of their increased tax rate onto investors, which we don't think would be appropriate, and investors need to unite as a group and push back on any attempts to do that. Beyond that, obviously, we had looked in the Trump Administration, when they had made tax changes, they absolutely tried to tax public pensions, apply unrelated business income tax to public pensions in their investments. ILPA, CI, some of these other groups, as well as many of the public pensions themselves were really helpful in fighting that proposal and preventing it from happening. But these sort of things need to be monitored from the tax side for an institutional investor perspective, but also there may be opportunities there.
0:24:16.9 CH: There's been a variety of pieces of legislation that floated around to try and incentivize, particularly public pensions to invest in infrastructure in the past. I would expect there to be similar types of programs that attempt to do that this time, and institutional investors should be thinking about and/or public pensions thinking about what sort of program might be attracted to them from an investment perspective that could deliver returns or there's been certain items around pension liabilities where they're able to invest in infrastructure and lessen their pension liabilities to beneficiaries. So those are the things that institutional investors should be thinking about with this upcoming package, which we expect probably to move forward in spring or summer of this year.
0:24:58.7 PM: Talking a little bit more about carried interest and a change in the taxation of carried interest to ordinary income, I agree with you, I think that if that becomes a realistic possibility, I think the fund manager community will definitely go back to their existing fund agreements and take a look and see how they can mitigate their tax liabilities, whether through additional borrowings or changes in the economics, as you suggest, or even other ways. I also think, and this is a question to you, it is a possibility that this community will call on their partners in the public pension plan and other institutional investor community for assistance in lobbying in the Congress on this issue. Do you think that's a realistic possibility?
0:25:45.8 CH: Peter, I do. This is definitely something that institutional investors seem to think about, "Wow, the private equity managers have been very effective over the years in maintaining their carried interest tax treatments." Even during the most recent tax reform in 2017, they essentially just required a three-year hold on companies, to retain that status which they were able to adjust to achieve. We do expect them to be deploying a significant amount of lobbying power on this issue, which is something they have done for decades successfully, and we do expect them to try and encourage LPs to engage for the same reason we just discussed. However, I don't think it's our role to weigh in on their specific tax status. The tax issue around what a manager is paid individually is their issue. It's not an investor issue, but investors need to make sure that they are pushing back with a united voice that it's not okay for them to try and make up that difference if they are taxed more.
0:26:49.3 CH: And we have been asked a number of years for us to come in and weigh in on carried interest, but we don't believe that it's the appropriate place for the investor to do that, particularly folks who are representing first responders and teachers to be advocating for large tax breaks for wealthy individuals at private equity firms. And in that case, I think we need to make sure that if these changes happen, that we're aware of what's in those fund agreements, Peter, as you mentioned, about where the shifts could happen by the manager by choice, make sure that those provisions aren't showing up in newer fund agreements, and if there is an attempt to either invoke those provisions or amend the LPA, that investors push back with united voice to prevent those sort of shifts in economics.
0:27:35.5 CH: And so that's something that we would encourage folks to do. ILPA's going to be looking at that over the next few months and be educating policy makers about that challenge. We aren't sure that there's a policy solution, there may be from a policy solution standpoint, but there's certainly a solution for LPs to push back and prevent that sort of thing from occurring. We do expect there to be an attempt to roll this carried interest back as part of the package. There's a significant amount of capital that could be raised there to deploy towards infrastructure and other needs, but I wouldn't count up the managers and their ability to protect their tax status.
0:28:14.3 PM: Yes, we will just have to see when that battle starts to gear up. So that's all the time we have today. I want to thank Chris for participating in our podcast. Thank you very much, Chris, it's been very interesting, and I'm sure we're going to hear more from the Biden Administration, all of these topics, but your insights are very welcome.
0:28:37.7 CH: Well, thanks, Peter. Thanks for having me today, and I really appreciate the opportunity to share with you and your listeners, and continue to work with the Nossaman team. Thanks for having me today.
0:28:49.2 PM: And thank you to our listeners for joining us for this episode of Public Pensions and Investments Briefings. For additional information on this topic or other public pension issues, please visit our website at nossaman.com. And don't forget to subscribe to Public Pensions and Investments Briefings wherever you listen to podcast, so you don't miss an episode. Until next time.
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