Insights & Reports > Kroll Global Fraud Report

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David Holley

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Pay-to-play has been the state of play since the earliest days of commerce. A flurry of criminal and civil cases in the United States involving the management of public pension funds, however, has recently raised its profile. Prosecutors and regulators are now clamping down on investment firms and their agents who use ostensibly legal, or outright illegal, means to corrupt public officials.

Illinois: Pension funds, not politics, drove corruption

When the FBI arrested Governor Rod Blagojevich in November 2008, the allegation that received the most attention was that he had tried to sell the U.S. Senate seat made vacant by Barack Obama’s ascent to the presidency. Lost in the coverage was that Blagojevich had conspired, from before taking office in 2003, with a cadre of insiders in a bi-partisan, pay-to-play and kickback scheme to control tens of billions of dollars in state pension funds, road contracts, real estate leases, and valuable state licenses.

Blagojevich is said to have demanded contributions in exchange for control of pension and state contracts. He raised millions for his racketeering enterprise, but its captains and soldiers earned far more. One alleged co-conspirator, a Republican, controlled more than US$1.4 billion in state pension investments and received millions more in fees and lease payments from the Illinois government.

The link between pensions and corruption started early. One of Blagojevich’s first official acts in January 2003 was a critical refinancing of US$10 billion in State of Illinois Pension Bonds. The deal helped replenish the US$30 billion Teachers Retirement Fund, a principal source of money for the pay-to-play criminal conspiracy, but also saw the first in a series of kickbacks. The bond underwriting contract was directed to an investment bank that paid its lobbyist US$800,000, who handed most of this on to Blagojevich’s co-conspirators. Of course, contrary to a 1994 regulation imposed to clean up the bond market, none of these transactions were made public until after the deal closed.

After Blagojevich was ousted from office, the new governor formed a Reform Commission. It determined that large but legal campaign contributions had been “the ‘pay’ in ‘pay-to-play,’” – influencing decisions by state officials even after a campaign bribery scandal had landed Blagojevich’s predecessor in federal prison. The commission is therefore proposing that companies in regulated practices, or those seeking state contracts in excess of US$50,000, be prohibited from making such donations.

New York: Cuomo reprises Spitzer

For more than two years, New York Attorney General Andrew Cuomo, in parallel with the U.S. Securities and Exchange Commission (SEC), has been investigating corruption in the Office of the State Comptroller, which controls America’s second largest retirement fund.

In February 2009, he unsealed the first in a series of criminal indictments. Cuomo alleged the pension fund had been used as a “piggy bank” by the former comptroller’s deputy and chief investment officer, the comptroller’s chief outside political advisor, a state political party chairman, and agents for private equity firms and hedge funds. Cuomo and the SEC, in civil and criminal actions, have alleged that the political advisor – Hank Morris – and his “national network of advisors” were paid more than US$30 million in sham fees in exchange for securing investments from the New York fund.

Similarly to his predecessor, Eliot Spitzer, Cuomo has sought to make an example of some of the largest and best-known private equity firms and their use of intermediaries. Already, one well-known company has agreed to stop using placement agents and to curtail campaign contributions to elected officials who run public pension funds.

The problem is not limited to New York. Money managers have been a primary source of campaign funds of state treasurers, comptrollers, and other local and state officials in all 50 states. Ten years ago, the SEC proposed taking action on pay-to-play, with stiff penalties for money managers if they, their executives, or agents contributed to officials who had trusteeship over a fund. The rule was never enacted.

In May, Cuomo announced that he had formed a task force with 36 other state attorneys general to broaden his investigation across the United States. He intends to share information and prosecute abuses of government pension funds with his fellow state prosecutors. He has also subpoenaed more than a 100 investment firms and their placement agents. The latter are supposed to be registered with a broker-dealer, but Cuomo’s office stated recently that more than 40 percent of those brokering deals with New York public pensions were not. The Attorney General has accordingly subpoenaed 50 investment firms to disclose their relationships to unlicensed agents, why they were hired, how they were used, what they were paid, whether the pension funds knew about the relationships, and what due diligence the investment firms performed on the agents.

Municipal scandals at home and abroad

Several banks have also acknowledged that they are under investigation in the United States and Europe in connection with allegations of bid-rigging, excessive fees, and corruption relating to the sale of interest swaps and derivatives in recent years to local governments. In one case, the mayor of Birmingham, Alabama, is facing federal charges related to a series of transactions taking place when he was president of the county commission. Federal authorities allege that banks paid a close political associate and friend of the mayor millions of dollars to get involved in the sewer refinancing. The banks were not charged in this case, but the SEC is reportedly considering regulatory actions.

In Italy, meanwhile, two newspapers, Il Sole 24 Ore and the International Herald Tribune, reported in late April that the Guardia di Finanza in Milan had seized US$300 million in assets in a case involving four major American and European banks. They stand accused of fraud in connection with a US$2.2 billion Milan municipal bond offering and derivative contracts. Italian prosecutors are investigating former city officials and the agents and consultants involved in the deal. In circumstances mirroring those of derivative scandals in the United States in the 1990s – when Orange County, California, among others, went bankrupt – prosecutors allege that the Milanese government did not understand the risks of the derivatives it entered into.

Back to the future?

What does all this suggest the future might hold? There is a striking similarity in these actions to the recent growth in the number of prosecutions of American and foreign companies under the U.S. Foreign Corrupt Practices Act (FCPA), enacted in the post-Watergate era. First, the cycle of prosecution and regulation of public funds has increased significantly after relative inactivity during the last fifteen 15 years. Second, shifting regulatory standards appear to be redefining the rules of engagement between public officials and the agencies in control of regulated public and private pension funds.

The FCPA experience suggests that highly publicized, pay-for-play scandals will probably lead to increased due diligence responsibilities for money managers and financial institutions similar to those required under the FCPA. In addition, renewed calls for transparency and ethics may affect how the investment community interacts with union or corporate investment and pension funds. The rules of the game look set to change once again.

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David Holley is a senior managing director based in Boston and has been conducting complex investigations for Kroll since 2000. Prior to this he was a senior investigator with the Boston office of an investigative firm and spent six years working in a litigation support capacity with the Environmental Enforcement Section of the U.S. Department of Justice, Environmental Enforcement Section.

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