Advisory Opinion No. 2003-8

Application Of The Ethics Code To Connecticut Innovations’ Proposal To
Create Small Business Investment Company

Scott Murphy, Esq., whose firm serves as special counsel to Connecticut Innovations, Inc. (CI) has requested an advisory opinion regarding CI’s proposal to form and invest in a Small Business Investment Company (SBIC).

Background

CI is a quasi-public agency with a statutory purpose focused on support, principally in the form of investment capital, for technological innovation and development in Connecticut.

An SBIC is a privately owned and operated equity fund that receives a license from the U.S. Small Business Administration (SBA). The license enables the SBIC to obtain federal funding for investment on favorable terms up to twice the SBIC’s privately raised capital.

The proposed SBIC will be a limited partnership with an expected term of ten years. The entity will have a number of private limited partners and two general partners,

CI and Next Generation Ventures LLC (Next Gen), a private venture capital firm previously established by CI and in which it holds a 49% interest.

Under the Operating Agreement of the General Partner, overall management of the General Partner will be vested in a board of managers (Board of Managers). The Board of Managers will initially consist of five members, three of whom are current CI executives. The Board of Managers in turn is authorized to appoint an administrative committee (Administrative Committee) of two, one of whom is a CI executive, to run the day to day operations of the SBIC.

The General Partner will provide 1% of the SBIC’s private capital. CI will also provide up to 7.5 million dollars as a Limited Partner. The other Limited Partners have committed 14 million dollars in private capital and up to 28.5 million dollars in additional Limited Partner interests will be offered to other private investors. (Under federal rules, less than 33% of the private capital of an SBIC can be contributed by a state-related entity such as CI. Under the plan described above, CI’s contribution would represent 15% of such private capital). If a license is granted by the SBA and a total of 50 million dollars in private capital is invested, the SBIC will qualify for up to 100 million dollars in federal leveraged monies through the SBA; resulting in a total capitalization equal to twenty times CI’s investment as a Limited Partner.

Investment advisory services will be provided to the SBIC, under a contract with the General Partner, by a company formed by CI and Next Gen (Investment Advisor). The services of the Managers and of eight additional investment professionals, including six from CI (Associated Professionals) will be made available on a part-time basis to the Investment Advisor, in order to staff its operations.

Ethical Issues

The application for obtaining an SBIC license requires extensive information regarding the proposed entity’s ownership, capital structure, investment criteria and management. Special attention is given to the investment experience and qualifications of the proposed investment managers. As part of the review of these application materials, two issues were identified by the SBA which CI recognized would have significant implications under The Code Of Ethics For Public Officials.

The first issue relates to the concept of carried interest. Consistent with the practice of private equity funds, the gains from investments made by the SBIC would be distributed 80% to the Limited Partners and 20% to the General Partner. In keeping with its established policy, the SBA expects that the General Partner’s profits (i.e., 20 percentage points of the carried interest) will be used to reward the Managers and, to a lesser extent, Associated Professionals who have achieved the investment results. In fact, the SBA insists on such a distribution, since it aligns the interests of the Investment Managers and the SBA as the principal investor.

Given the various distribution rules established by the proposed SBIC, these carried interest payments will in all likelihood not be finalized until well into the investment term and perhaps not until its end. Nonetheless, CI wishes to have the advance guidance of the Commission regarding the application of the Ethics Code to this proposed profit distribution plan.

The second issue relates to the SBA’s concern regarding state control of the SBIC. As previously noted, an SBIC is by definition a privately controlled entity. As part of its overall concern that the State of Connecticut not exercise control of the SBIC through CI, the SBA has requested assurance that there will be no impediment to the continued availability of CI employee/managers to the SBIC should these individuals be terminated from their CI employment. In order to provide this assurance, CI requests the guidance of the Commission regarding the applicability of the Code’s post-state employment provisions to such individuals.

Proposed Solutions

In addition to providing the foregoing factual background and statement of issues, Attorney Murphy has furnished the Commission with CI’s specific proposals regarding adherence to the Code and attendant legal analysis.

As a starting point, he emphasizes that the envisioned financial arrangements do not involve the kind of separation between one’s official duties and private interests that typically give rise to an impermissible conflict under the Code. Rather, as previously noted, the intent of the profit distribution plan is to align the interests of the Managers with that of the investors, which include CI. As a consequence, he believes that the distribution of carried interest would not create a conflict, and further notes that such payments would be quite similar to performance-based compensation arrangements already in place at CI.

Nonetheless, CI, in keeping with Commission precedent, does not propose that its Manager/employees directly receive private remuneration for their loaned service to the SBIC. See, State Ethics Commission Advisory Opinion No. 2000-7, 61 Conn. L.J. No. 38, p. 7D (3/21/00). Rather, any such carried interest will be paid to CI and, in turn, awarded to the Managers by CI’s Board of Directors in conformance with an established performance-based incentive plan. In a further effort to harmonize this plan with the Commission’s holdings in A.O. No. 2000-7, Attorney Murphy reiterates that the potential conflict addressed in that Ruling, between the employee’s short-term investment interests in a private entity and his long-term state responsibilities, is not present in CI’s current proposal. As a consequence, Attorney Murphy suggests that CI’s performance-based incentive plan is permissible under the Ethics Code.

With regard to the SBA’s concerns regarding involuntarily terminated Managers, Attorney Murphy, on behalf of CI, proposes the following:

• Under §1-84b(f) of the Code no quasi-public agency employee may accept employment with a private entity for one year, if, during their last year of state service, they were personally and substantially involved in awarding that entity a contract valued at $50,000 or more. In order to comply with this provision, if a CI Manager is terminated within the first year after CI’s investment in the SBIC, CI will engage and pay that individual for one year as an independent contractor so that the Manager may continue to work for the SBIC. The payments will be equivalent to the pro rata portion of the individual’s state salary attributable to the time devoted to SBIC duties.

• Under §1-84b(b) of the Code no former quasi-public agency employee may represent any party, other than the State, for compensation before his or her former agency for one year after separation from state service. In order to comply with this provision, Attorney Murphy proposes, consistent with general Commission precedent, that any former CI employee hired by the SBIC not represent that private entity before CI for the proscribed one year.

• Under §1-84b(a) of the Code no former quasi-public agency employee may ever represent any person, other than the State, concerning any particular matter in which he or she participated personally and substantially while in state service and in which the State has a substantial interest. In this instance, Attorney Murphy submits that §1-84b(a) should not be interpreted to prohibit the continued service of a former CI employee as an SBIC Manager or Associated Professional. In essence, Attorney Murphy reasons that the "particular matter" is the initial formation of and CI’s investment in the SBIC. Consequently, as long as the former employee does not participate in any attempt by the SBIC to renegotiate or amend this contractual arrangement, his or her subsequent work on the transaction should, consistent with Commission precedent, qualify as technical implementation of a previous contract which benefits the State and is, therefore, permissible under the Code. See, State Ethics Commission Advisory Opinion No. 88-15, 50 Conn. L.J. No. 15, p. 3D (10/11/88).

• Finally, Attorney Murphy references the Commission’s Ruling in Advisory Opinion No. 97-1, wherein, pursuant to §1-84(c) (the Code’s use of office prohibition) the Commission held that a state employee may not use his official position to create a private employment opportunity and then personally fill that private position. 58 Conn. L.J. No. 35, p. 3E (2/25/97). Again, Attorney Murphy would distinguish CI’s current proposal from this past Opinion. First, since CI is only seeking guidance in regard to involuntarily terminated employees, such individuals cannot be accurately described as affirmatively using their positions to obtain private employment. Second, there is, in reality, no new position created, since the former CI employee will only be continuing his or her service on the same financial terms as initially approved, and in fact required, by the SBA.

Conclusions

The State Ethics Commission wishes to thank Attorney Murphy for his assistance and commend him for his legal analysis. In only one aspect is amended guidance required. With regard to §1-84b(b), the exemption for technical implementation of a pre-existing contract, set forth in A.O. No. 88-15, applies equally to this Code provision. Therefore, provided the former employee strictly avoids any conflict or controversy regarding implementation of the SBIC/CI contract, he or she may represent the SBIC before CI during his or her initial year of post-state service.

With this one amendment, CI’s proposals for compliance with the Ethics Code in this matter are hereby approved.

By order of the Commission,

Rosemary Giuliano
Chairperson