January 2004

Feature:Misbehaving in Public?

Public pension funds have been a "target-rich" environment for unscrupulous individuals.   Will greater public scrutiny be enough to stop cronyism?

First of a two-part series. The high-profile cases speak for themselves: There was Connecticut State Treasurer (and sole fiduciary) Paul Silvester, who had demanded and received kickbacks from private equity firms doing business with the state fund and finally was sentenced in November, seven years after pleading guilty and agreeing to cooperate with the authorities. Also setting a high-water mark for sleaze was Miriam Santos, the Chicago city treasurer who was convicted of extortion and fraud in connection with solicitation of campaign contributions from firms doing business with the city and blacklisting non-contributors.

The hard fact is that unethical dealings by public pension officials, and particularly by elected officials who serve on pension boards or appoint their members, remain part of the landscape in many states. Misbehavior—or the appearance of it—all too often involves high-profile elected officials, and the size of the assets at stake and the number of workers and retirees affected tend to be too large to ignore.

The fishbowl-like atmosphere in which public funds operate today is clearly a deterrent to criminal behavior. Indeed, most public plans—from large to small—have never been accused of harboring ethical conflicts. Even so, the glass seems half-empty. Patterns of wrongful dealing, from pay-to-play to outright extortion, are still everyday occurrences at some of the largest public pension systems. Securities and Exchange Commission rules that effectively eliminated political giving by municipal bond fund underwriters have, ironically, increased the incentives for elected officials to seek campaign contributions elsewhere, particularly from investment managers and other pension vendors. Indeed, a whole new category of vendor—law firms specializing in investor lawsuits—now appears to be enmeshed in the pay-to-play pattern.

The Santos and Silvester cases, in particular, prompted the SEC to embark on a nationwide study of pay-to-play practices by state and local elected officials in charge of pension assets. The study documented pay-to-play allegations in 17 states and culminated in the drafting of a stringent new rule. This rule would have barred investment managers from receiving any compensation for managing public money for two years after the firm, its executives, or agents made a campaign contribution to an elected official or candidate who could have influenced the money manager's selection.

Not unexpectedly, the commission received a heap of negative comments both from officials of large public funds and from investment firms, mostly arguing that it was too stringent and a restraint on free speech. After SEC chair Arthur Leavitt left office, the momentum for a nationwide rule dissipated. Indications are that, in many places, public fund portfolio management remains a game of patronage.

A recent telling example occurred in Maryland, where money manager Nathan Chapman, an investment manager who ran money for the State Retirement and Pension Systems, was fired early last year for allowing one of his submanagers, Alan Bond, to buy stock in Chapman's own company. The $25.3 billion state pension fund lost some $4 million on its investment in eChapman, an Internet investing start-up. An internal investigation following Chapman's firing revealed that Peter Vaughn, chief executive of the State Retirement Agency that oversees investment of the $25 billion state pension funds, earlier had directed CIO Carol Boykin to halt an inquiry into Chapman's dealings with Bond. Vaughn and Boykin both subsequently left the agency and have declined to discuss matters there.

The plot thickened last summer when federal prosecutors began probing the relationship between Chapman and Debra Humphries, one of the pension system's trustees. At the same time Chapman was indicted for the illegal investments, Humphries was charged with failing to reveal to a grand jury that Chapman had given her $46,000 in money and gifts while they were personally involved. Humphries, a bond manager with Potomac Asset Management, did not recuse herself from board decisions involving Chapman—indeed, she had opposed his firing. It also emerged that Chapman, who chaired the state university system's Board of Regents, had recommended Humphries to then-Governor Parris Glendening for her post as a pension trustee (see "Oh, Maryland!" August 2003). In August, Humphries pled guilty to lying about the cash she had received.

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