This content is from: Corner Office

Pension Pay To Play Casts Shadow Nationwide

Regulators are looking to crack down on the practice of political patronage in public funds.

It's good to have friends in high places. In 2003 then New York State comptroller Alan Hevesi was a rising star within the Democratic Party — just the kind of friend that Elliott Broidy, the politically connected boss of private equity firm Markstone Capital Group, liked.

Hevesi showed what a good friend he was when the New York State Common Retirement Fund — for which he was sole fiduciary — made a whopping $250 million commitment to the small Los Angeles–based firm, which was launching a fund dedicated to making investments in Israeli old-economy companies. But Hevesi took friendship a step further. According to sources, he approached officials with influence over other public funds about investing with Markstone.

Those efforts seem to have paid off. The California Public Employees’ Retirement System, the U.S.’s largest public pension fund, allocated $50 million to Markstone, with the first installment coming just months after that state’s comptroller met with Hevesi and Broidy at CalPERS’s Sacramento, California, offices.

A “Bush Ranger” known for hosting Republican fundraisers at his mansion in the wealthy Los Angeles neighborhood of Holmby Hills, Broidy never donated directly to Hevesi’s comptroller campaigns. Instead, his wife did. Her largesse extended beyond New York to other states where publicly elected officials also have a major influence on how public funds are invested: California, Hawaii, Nevada and New Mexico.

This May, Broidy resigned from the board of the $12.5 billion Los Angeles Fire and Police Pension fund, where he had served as a commissioner, after receiving an informal inquiry from the Securities and Exchange Commission requesting information as part of its investigation into pay-to-play at public funds. Paul Weber, president of the Los Angeles Police Protective League, is among those who want to know more about who has been watching over their retirement.

“We don’t want our money to become a slush fund for politicians,” says Weber.

The Hevesi-Broidy relationship falls deep into the shadowy world of backroom deals that all too often define how decisions are made at public pension funds, especially when hedge fund and private equity managers are involved. A six-month-long investigation by Institutional Investor has discovered that the troubles in New York are, in fact, part of a much broader problem at public funds across the U.S. Elected officials responsible for overseeing public funds need money to stay in power; alternative-asset managers, hungry to grow their business, want mandates, especially from the so-called sticky dollars that pension funds represent. This darkly symbiotic relationship can lead to a crooked system where everyone must pay to play.

Alan Hevesi: The Politico

“As long as you have anyone who is publicly elected and the recipient of campaign contributions, almost by definition the process is tainted,” says Arthur Levitt Jr., who sought to reform pay-to-play during his tenure as chairman of the SEC, from 1993 to 2001.

“When people are solely selling access, it is a problem,” adds William Donaldson, who was chairman of the SEC from 2003 to 2005.

Investments made during Hevesi’s watch at the now–$116.5 billion New York Common fund are at the center of a more than two-year probe by New York Attorney General Andrew Cuomo. Caught in the glare of the New York State scandal are a host of private equity and hedge funds and their bosses. Carlyle Group, the world’s second-largest private equity firm, has already paid $20 million to settle with Cuomo over its role in the alleged improper payments received by placement agent Henry (Hank) Morris for business won by Carlyle from New York Common. Steven Rattner, co-founder of $6 billion New York–based private equity firm Quadrangle Group and a well-known Democratic fundraiser, resigned as President Barack Obama’s car czar only four months into the job amid questions about Quadrangle’s dealings with New York State’s public fund, including investing in an obscure film whose title is the Italian word for “jackass.”

Pay-to-play casts its shadow nationwide. In New Mexico, Governor Bill Richardson, a former presidential candidate and a cabinet member in Bill Clinton’s administration, is embroiled in a civil suit that accuses him of having stacked the board at the state’s $8.5 billion education retirement fund. In Ohio, Terrence Gasper, the former CFO of that state’s $19 billion Bureau of Workers’ Compensation, languishes in jail after pleading guilty to accepting bribes in return for allocating investment business. As many as a dozen public funds from Connecticut to Missouri recently dropped Dallas-based private equity investment and advisory firm Aldus Equity after one of its founders, Saul Meyer, was indicted as a result of the Cuomo investigation. And questions abound about campaign contributions made to current New York City comptroller William Thompson Jr., who is running for mayor of the Big Apple, by managers doing business with its retirement funds.

“Now there’s a tableau of corruption on the front pages of newspapers all over the country,” says Robert Plaze, associate director for regulation of the SEC’s division of investment management and a longtime foe of pay-to-play.

Much of the focus by regulators and lawmakers has been on placement agents — the middlemen who introduce investors to managers in return for a fee. One of the most powerful of this group was political consultant and Hevesi adviser Hank Morris, who acted as a placement agent for managers seeking allocations from the New York Common fund. Cuomo says some of the fees that Morris took were illegal kickbacks. In May the attorney general slapped Morris and David Loglisci, the former deputy state comptroller and CIO of New York Common, with a 123-count indictment that included felony charges of money laundering, grand larceny, securities fraud and falsifying business records. Hevesi has not been charged with any wrongdoing by Cuomo, though the former comptroller resigned in December 2006 after an unrelated scandal.

Barrett Wissman: The Go-Between

Cuomo is pushing for a ban on all placement agents. The SEC, whose ability to protect investors was seriously called into question by its failure to uncover Bernard Madoff’s $65 billion Ponzi scheme despite getting tips going back nearly a decade, is also looking to curb pay-to-play. In June chairman Mary Schapiro and the four other SEC commissioners voted unanimously to propose new rules that would ban placement agents, as well as prevent money managers seeking to do business with public pension funds from making campaign donations to political officials with oversight for those funds. Lawmakers in California, Illinois, New Jersey, New Mexico and New York have proposed or adopted similar measures.

Reform has never been more necessary. The $2.2 trillion U.S. public pension system is in crisis, as municipal and state funds are grossly underfunded following the huge investment losses they suffered during the market meltdown from September 2008 through March of this year. In the midst of recession, public funds with $1 billion or more in assets were down, on average, 18.76 percent for the fiscal year ended June 30, 2009, according to Los Angeles–based consulting firm Wilshire Associates’ Trust Universe Comparison Service.

Although it is difficult to prove a direct link between pay-to-play and investment underperformance, the practice undoubtedly represents a very real cost to public funds — and to the tens of millions of people who rely on them. Individual instances tell the real story. In New Mexico, Frank Foy, the former CIO of the state’s Educational Retirement Board, alleges that public funds invested $90 million in a now worthless collateralized debt obligation because of political considerations. In Ohio the BWC only barely got its money back after it invested $50 million in a rare-coin fund run by a big Republican political contributor.

Frank Foy: The Whistle Blower

No one denies the millions of dollars in fees that managers and placement agents can collect doing business with public funds. From fiscal 2004 through 2008, Carlyle collected $30.5 million in fees from New York Common, more than the $20 million that the private equity firm paid to settle with Cuomo. Markstone received $15.2 million in fees from New York Common during the same period. Morris made more than $15 million from his placement dealings with the pension plan, Cuomo and the SEC allege. Mark Correra, a political consultant who acted as a placement agent to public funds in New Mexico, shared in at least $15 million in fees.

The possibility for abuse lies not just with politicians; it exists when board members or investment staff get too cozy with consultants, managers or placement agents, accepting lavish gifts and trips in return for favorable treatment. The funds, their beneficiaries and taxpayers ultimately pay for the placement agent fees, the junkets, the dinners and the other perks for public officials and pension staff. A June 2007 study by the U.S. Government Accountability Office relating to corporate defined-benefit plans found that those using a consultant who failed to disclose conflicts of interest produced returns 1.2 to 1.3 percentage points lower than those of their peers. The bottom line: A less conflicted public fund system would produce better results.

“Restoring a sense of responsibility and integrity is an ongoing priority for me and my office,” says Thomas DiNapoli, who became New York State comptroller in February 2007, two months after Hevesi resigned. “For public pension plans across the country, this is a key need.”

The reforms proposed by Cuomo and the SEC are meant to address the problems and help return integrity to the system. The New York attorney general is encouraging managers to voluntarily sign his “Public Pension Fund Code of Conduct,” which commits them to not using placement agents when seeking business from public funds and bars them from making campaign donations to officials who have influence over public fund investment decisions. The SEC commissioners could vote their similar set of measures into law as early as this month, following a 60-day public comment period.

Forged in the crucible of crisis, some of these new rules will in fact make the job of managing a public pension harder, without actually fixing the underlying problems that still lurk. Most controversial are the efforts to ban placement agents. Without such intermediaries small funds with no marketing budgets and little exposure are unlikely to get a seat at the table. And studies show that investors often do better with smaller, newer funds. In addition, if placement agents are banned, consultants stand to gain influence, and they can be equally vulnerable to conflicts and kickbacks.

“If you ask public pension staff around the country, most would tend to want placement agents to exist,” says Orin Kramer, chairman of the division of investments at the New Jersey State Investment Council, which oversees $66.7 billion in pension assets. Kramer helped draft a rule passed by the council in 2004 banning managers and advisers seeking contracts from the state pension system from making political donations.

Pay-To-Play has a long and sometimes sordid history. In the 1950s the New Jersey legislature passed a law bringing the management of its pension system in-house after discovering that a municipal bond dealer had made more than $230,000 by overcharging the state on trades. The governor at the time had recommended the firm, where the son of the state treasurer worked as a salesman.

In the 1980s, California State Teachers’ Retirement System chairman Gilbert Chilton was found guilty of taking kickbacks on an investment deal. Chilton abandoned his wife and daughter and went on the run with his then–24-year-old girlfriend, Chickie, a former Las Vegas hat checker, turning himself in four years later. As a result, CalSTRS, which now manages $124 billion in assets, increased the size of its investment board from three to 12 members.

But the corruption, like a virus, simply migrated. In 1998, Thomas Flanigan, the former CIO of CalSTRS, says that then–California comptroller Kathleen Connell was “aggressively soliciting” campaign donations from vendors seeking contracts from CalPERS. In response, CalPERS and CalSTRS each imposed a policy banning campaign donations from managers to those in a position to influence investment decisions. But Connell was successful in getting the bans overturned in court. A decade later, Flanigan, who sits on the board of the Orange County Employees Retirement System, is still incensed by how the system can be abused.

“The money managers that are legitimate from the standpoint of performance do not require political influence to be considered or obtain the business,” says Flanigan, who is president of Thomas E. Flanigan Inc., a California-based investment advisory firm. Most legitimate managers, he adds, fear that not making contributions might preclude them from the possibility of doing business going forward. Those managers that may not qualify on their merits — Flanigan calls them “clangers” — usually would make contributions, “and most would almost always let you know it.”

During his flap with Connell, Flanigan wrote to then–SEC chairman Levitt charging that politicians who oversee state retirement funds often pressure pension staffers to make decisions for political reasons, and he urged reform. Levitt, who had recently implemented restrictions on campaign contributions in the municipal bond market, was well aware of the potential for abuse. The SEC chairman went on to propose similar rules related to pension funds, but he left office before he could push through the reforms.

Certain events this decade would add to the potential for corruption in the dark underworld of the public pension system. Two developments in particular exacerbated the problem: the move by public funds into alternatives and the rising cost of campaigning for state office.

Through the 1990s most public funds invested in traditional equities and bonds. They believed this comparatively simple and easy strategy would let them participate in equity market gains while protecting them from dramatic losses.

It didn’t. In March 2000 the dot-com bubble burst, sending equity markets around the world into a downward spiral that would last more than two years and see some stocks drop by more than 80 percent. Although most public funds lost lots of money, several big endowments and foundations saw their investments rise by as much as 20 percent. These funds had invested in alternatives like hedge funds and private equity. Public funds witnessed this and rushed headlong into this high-fee and, they hoped, high-return world.

The problem: Public funds often lacked the expertise, experience and contacts to pick the right funds and rarely had the resources necessary to oversee these new sprawling portfolios. “Alternatives got so complicated,” says Marc Dann, a former Ohio attorney general who investigated fraud at the BWC. “There was no industry standard to compare them to and a thousand managers to choose between.”

Marc Dann: The Flawed Reformer

Coupled with this confusion was the fact that many public pension fund officials were elected — or beholden to people who were elected — during a period that saw campaign expenses skyrocket. In New York, for example, the cost of becoming governor increased eightfold from 1990 to 2006, according to a report by Washington think tank Common Cause.

The rise of hedge fund and private equity firms created a whole generation of wealthy investment professionals who could fill the money gap. Some wanted a piece of the billions that pension funds were offering, and the politically savvy among them were well aware that most states didn’t prohibit asset managers from making large campaign contributions to state officials who oversee the process.

“It’s hard for the public to have faith in the system when the campaign limits are beyond high and well into absurd,” says New York’s DiNapoli.

In the middle of this quagmire were consultants who advised the pension funds and placement agents who helped alternative funds get access to the boards and fiduciaries at pension funds. Many of them, like Los Angeles–based Wetherly Capital Group, were formed during the alternatives boom specifically to act as intermediaries.

The drumbeat of corruption grew louder. In 2005 the longtime chairman of New Hampshire’s state pension fund faced ethics questions over business relationships that his firm, Boston-based Maiden Lane Partners, had with some broker-dealers, hedge fund managers and a placement agent. Some of the same cast of characters showed up in an investigation into abuses at Ohio’s BWC that resulted in a May 2007 64-month prison sentence for CFO Gasper.

There was already evidence something was amiss at New York Common during the Hevesi administration. In 2004 Quadrangle’s Rattner was warned away from doing business with Morris — a warning he chose to ignore, according to a well-connected source.

Around the end of 2003, Wetherly Capital founder Daniel Weinstein hired Morris as a subagent at the suggestion of Wetherly employee Julio Ramirez Jr. Weinstein says Ramirez recommended Morris on the strength of his connections with New York Common. This past May, Ramirez pleaded guilty to securities fraud, admitting to paying kickbacks to Morris in the New York scandal. Weinstein, who says he had no reason to question Ramirez’s dealings with Morris, is now fighting to restore his firm’s reputation.

“I lost my business, I lost my clients over this,” Weinstein says. “I wasn’t some guy working at home in my pajamas and slippers, making a couple of calls. This is a real company of career professionals.”

Within a tainted system honest players get hurt. Foy, the former CIO of the New Mexico Educational Retirement Board, says he was pushed out after he refused to make politically motivated investments. Dallas- and Nashville-based minority-owned Pharos Capital Group was in line to get a $375 million mandate from the New York Common fund until it refused to make a payoff to Morris, according to Cuomo. Morris has pleaded not guilty: “He did nothing wrong and will defend against the charges,” says his attorney, William Schwartz of Cooley Godward Kronish in New York.

Lawmakers and regulators have stepped into the breach. Cuomo’s code of conduct includes a pledge by money managers to swear off using placement agents, an idea echoed in the proposals offered by SEC chairman Schapiro.

Some argue that an outright ban goes too far and that placement agents should play a role in the complicated interface between hedge funds and public plans. “Prohibiting legitimate placement agents is an extreme measure that will reduce our ability to access some of the best managers throughout the world and ultimately result in lower investment returns,” Rick Dahl, CIO of the $6.2 billion Missouri State Employees’ Retirement System, told the commission.

In other ways, however, Schapiro’s proposals don’t go far enough — or fail to address the problem entirely. The SEC’s jurisdiction is limited. It does not, for example, have oversight over law firms or even placement agents directly. “The bottom line is that pay-to-play can be policed only by multiple actors,” says Columbia Law School professor John Coffee. “Change is going to involve the states, the SEC, the justice department and the courts.”

The answer, according to many public fund managers, is not to dismantle the current system but to improve it. “What we need is not an across-the-board ban, but a narrow window with a lot of transparency,” says Richard Ferlauto, director of pension benefits for the American Federation of State County and Municipal Employees. “We need to know if someone is getting paid and how much.”

The SEC and Cuomo would also ban political contributions to those with influence over public funds by vendors such as money managers or their proxies. That idea is endorsed by Wetherly founder Weinstein. “Eliminate the pay so that everyone can play,” says Weinstein, who has been a significant contributor to political campaigns.

But could a ban really prevent payoffs through a third party such as a spouse or lawyer? And would it prevent political favors, such as when Aldus co-founder Saul Meyer allegedly helped one of Hevesi’s sons get a mandate from a New Mexico fund?

Finally, what political races should count? Does giving to the candidacy of the governor or attorney general cross the line? After all, Broidy contributed to Cuomo’s failed 2002 gubernatorial bid.

DiNapoli, who just last month issued an executive order banning the New York Common fund from doing any business for two years with investment advisers who contribute to candidates for his office, also attacks the problem from the other side. He endorses a bill to make campaigns for elected offices, like his own, publicly financed. However, he admits that getting the public to pay for political campaigns is a tough sell.

DiNapoli may be ignoring the elephant in his own room. New York, like Connecticut and North Carolina, has a sole fiduciary for its major public pension fund. “There weren’t a lot of checks and balances in place in New York that would have detected the alleged scheme that went on under Hevesi,” says Heather Stone, a Boston-based partner with law firm Edwards Angell Palmer & Dodge.

Clearly, more needs to be done. Here are our suggestions, based on scores of interviews with federal and state officials, regulators, pension managers and placement agents.

Reform and Police Placement Agents. A bill approved in September by the California state legislature provides a good model. It requires CalPERS and CalSTRS to implement a policy mandating that all managers disclose payments made to placement agents in connection with those systems’ investments. Placement agents who deal with any of the state’s pension system investments also need to file a comprehensive disclosure of campaign contributions or gifts they made to any elected member of the board of CalPERS or CalSTRS. Like all public fund consultants, placement agents should also be required to register.

Restrict Political Contributions. Getting contributions out of the system is key. Only 14 states currently have some kind of ban on campaign donations to investment fund officials from money managers hoping to do business with the states, according to Ki Hong, a Washington-based partner with Skadden, Arps, Slate, Meagher & Flom. The SEC’s proposals, if adopted, would create a national ban. Challenges remain, of course. Courts have overturned extended bans on contributions in the past, citing the First Amendment right to free speech.

Eliminate Sole Fiduciaries and Reform Governance. States with only one person making investment decisions or where the board can be stacked with political appointees have more problems than those with more balanced boards. But local government officials often have a vested interest in keeping the status quo. Public pension fund governance should be reviewed on a national level, best-practice guidelines should be established, and the elimination of the sole fiduciary model should be recommended. Boards should be independent and professional. “An independent board is always going to be less subject to conflicts of interest than one run by a sole official,” says professor Coffee.

Empower Public Fund Investment Staff. Consultants and placement agents don’t need to be shut out of board rooms, but giving more authority to those within the pension system would limit consultants’ and agents’ power. Pension funds should be run by seasoned investment professionals, not political operatives. Investment staff should be able to select managers, with the board acting as policy adviser rather than meddling in specific investments. Staffers should be paid salaries and bonuses for performance, the way they are at most university endowment funds.

Clamp Down on Conflicts. Staff and board members should face the same scrutiny as the people they deal with, disclosing sources of income, investment interests and gifts from fund vendors or prospects. Some of this information is already required, but it should be more readily accessible to the public. If board or staff members have a conflict of interest, they should disclose the information and recuse themselves. Meetings, like the one Hevesi and Broidy had at CalPERS, should be made public. Staff should not be allowed to take jobs that would allow them to influence their former colleagues — as a money manager, consultant or placement agent ­­— for at least one year.

Create a National Disclosure Database. A national system of centralized disclosure should be set up so pension board members, investment staff and others can see the contributions made by managers and placement agents or their proxies. This system should be comprehensive, so that fees for marketers, consultants, lawyers, brokers and others associated with the process of soliciting, obtaining and operating pension business are disclosed regardless of who pays. The challenge will be funding such a project. There is also the question of whether the added disclosure burden will dissuade qualified people from volunteering for public service.

Criminalize Ethics Violations. The fact remains that some politicians and pension officials are not going to disclose conflicts, even if they are mandated to do so by law. Ohio is one of the few states where such violations can be prosecuted as a criminal offense, which gave the Ohio Ethics Commission powerful ammunition in its BWC investigation.

Grant Greater Federal Oversight. Local lawmakers often fail to ask important questions, particularly when fund returns are good, and state politicians may have their own reasons for not wanting to know. State and local investigators are frequently overstretched and hampered by lack of resources. Additional regulatory oversight should occur at the federal level, either through the SEC; the Financial Industry Regulatory Authority, which already regulates brokers; or the Department of Labor, which now monitors corporate defined benefit funds.

Despite the impetus of nationwide investigations, however, reform may be delayed or denied, as it has been in the past. Those who benefit from the existing system are often in a position to block change. In New Mexico, Governor Richardson appoints four members of the State Investment Council, as well as having a seat himself, giving him a majority on the nine-member board of that state’s $11 billion endowment. This year he vetoed a bill, passed overwhelmingly by the legislature, that would have reduced the number of his appointees and increased the board to 13 members.

For former SEC chairman Levitt, the greatest sin would be to allow the current chance for reform to slip through the cracks. “These scandals open up opportunities to correct the system,” he says. “If we don’t take advantage of this, we deserve the system we get.”

Following the steps above would go a long way toward correcting the system.

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