The Program Review and Investigations Committee met on Thursday, October 8, 2009, at 10:00 AM, in Room 131 of the Capitol Annex. Representative Reginald Meeks, Chair, called the meeting to order, and the secretary called the roll.
Present were:
Members: Senator John Schickel, Co-Chair; Representative Reginald Meeks, Co-Chair; Senators Vernie McGaha, R.J. Palmer II, Joey Pendleton, Dan "Malano" Seum, Brandon Smith, and Katie Kratz Stine; Representatives Leslie Combs, Ruth Ann Palumbo, Rick Rand, and Arnold Simpson.
Guests: Robert Jones, Executive Director, Office of Policy and Audit, Finance and Administration Cabinet. Mike Burnside, Executive Director; William A. Thielen, Chief Operations Officer; Kentucky Retirement Systems.
LRC Staff: Greg Hager, Committee Staff Administrator; Rick Graycarek; Christopher Hall; Colleen Kennedy; Van Knowles; Lora Littleton; Jean Ann Myatt; Rkia Rhrib; Sarah Spaulding; Katherine Thomas; Cindy Upton; Stella Mountain, Committee Assistant.
Upon motion made by Representative Combs and seconded by Senator Palmer, the minutes of the September 10, 2009 meeting were approved by voice vote, without objection.
Robert Jones, Executive Director, Office of Policy and Audit, Finance and Administration Cabinet, said he started his job in December 2007 and soon received a request for an audit of the Holly Hill land purchase. The audit took 12 to 16 months. He began with interviews of Mr. Burnside and the Kentucky Retirement Systems’ (KRS) counsel. All the information he gathered was voluntary. He noted that the chief information officer (CIO) and chief operations officer (COO) at the time of the Holly Hill transaction were not interviewed.
Representative Meeks asked why they were not interviewed.
Mr. Jones said they did not respond to requests for information. He said that Perimeter Park West (PPW) is a corporation set up to acquire and hold land purchases on behalf of KRS. He summarized the background of the purchase, including information that KRS’s property manager and the head of the recommended realty firm were father and son, respectively. He said that the investment committee discussed the transaction in a closed meeting on December 15, 2005, including a memo from the COO and CIO. The memo said the potential cost was $475,000 to $700,000. He said there was no documentation as to whether making the purchase for this amount was approved, but the CIO and COO proceeded as if it were.
Mr. Jones said that Dr. Caroline Bevins-Taylor, a veterinarian, exercised her option to purchase the Holly Hill property. KRS offered her $525,000 for the property, which she rejected. A second offer of $700,000 made a month later was accepted. Checks for $700,000 and $52,502.47 were requested from PPW funds. Only the CIO and COO and the person writing the checks knew that the total amount was over $700,000.
Senator Stine asked for clarification of the payout.
Mr. Jones said the HUD settlement document included $700,000 for the contract sales price, $25,000 for personal property, $28,000 for brokerage fees and settlement charges, and $500 for filing fees.
Senator Stine asked for clarification of the $25,000 for personal property.
Mr. Jones said it is unknown what the personal property could have been.
Senator Stine asked about who the insurance fund covers.
Mr. Jones said the insurance fund is intended for retirement system members and not for alternative investments. He said the money for the Holly Hill purchase should have come from an investment account.
Senator Seum asked if KRS is part of state government.
Mr. Jones said in his opinion yes, but there can be legal arguments about this.
Senator Seum asked if KRS employees are held to executive branch ethics rules.
Mr. Jones said that this was unclear.
Senator Stine asked whether state cabinets purchase property through other state agencies or on their own and how it is determined if a state agency needs more space.
Mr. Jones said it depends on the cabinet. He said that KRS had previously purchased its own property.
Senator Stine asked if KRS could purchase their own vehicles.
Mr. Jones said he did not know.
Representative Meeks asked if a thorough investigation could be completed without testimony from the CIO and COO.
Mr. Jones said he would also include the executive director on that list. He said all three are beyond the reach of the Finance and Administration Cabinet.
Senator Pendleton asked what the reason was for the purchase.
Mr. Jones said KRS wanted more space without giving up existing rental space. The property was conveniently located next door and was thought to be a good investment.
Senator Pendleton said that if it was bought for a revenue stream, he wanted to know why it was eventually sold for $325,000.
Mr. Jones said they found out the property could not be used as intended and the market value was much less than what was paid. They did not get an appraisal at the time of purchase.
Senator McGaha asked why they could not use the property.
Mr. Jones said it was probably related to zoning and asbestos abatement.
Senator McGaha asked if anyone checked the zoning before the purchase.
Mr. Jones said that there was no onsite inspection before purchase.
Representative Simpson asked whether state government is exempt from zoning.
Mr. Jones said he did not know.
Returning to his presentation, Mr. Jones noted that he adopted the findings of the internal audit. The internal audit included concerns regarding the issuance of checks. The person writing the check should not be under direct authority of the buyer. He said only one signature was required; there should have been two, of which at least one should be out of the direct line of authority. The internal audit raised concerns related to letters of direction. A new account was created by the Northern Trust Company by authority of only one person. He said this and the practice of requiring only one signature put KRS at risk. There was a concern about the line of authority; it was unclear what the executive committee had approved.
Mr. Jones said he agreed with the conclusions of the internal audit report, but his report also emphasized lack of sufficient procedures and oversight at KRS. He said the board and investment committee were also responsible for what had happened.
Senator Stine asked about the letters of direction.
Mr. Jones explained that the letters of direction were addressed to the Northern Trust Company to create a new account.
Senator Stine asked if there were other instances in which this had been done.
Mr. Jones said this was the only transaction he looked at, so he was not sure.
Senator Stine asked if KRS management knew that all this was going on.
Mr. Jones said he relied on the internal audit report, which said they did not know all that was happening.
Senator Stine asked if anyone checks on the work of the internal auditor.
Mr. Jones said no, the auditor was not audited.
Senator Stine asked if regular audits of KRS were done and who reviews them.
Mr. Jones said the state auditor does and others may as well.
Senator Stine asked about referrals made to the Kentucky State Police (KSP), the Office of the Attorney General, and the State Auditor.
Mr. Jones said he thinks the State Auditor was contacted at one point. Then, KSP was contacted and took over the investigation. It was not turned over to the attorney general.
Senator Stine asked if KSP bought the building.
Mr. Jones said yes.
Senator McGaha asked when the referral to the state police was made.
Mr. Jones said it was July 5, 2006 according to the chronology provided by KRS.
Senator McGaha asked when KSP bought the building and what it is used for.
Mr. Jones said KSP purchased the building at the end of 2008 or the beginning of 2009. He did not know the use of the building.
Representative Simpson asked about KRS’s insurance claim.
Mr. Jones said his understanding was that the claim was rejected. He did not receive some documents related to this based on the argument of attorney-client privilege.
Representative Simpson asked about any attempt to recoup funds from individuals involved for loss of money in the transaction.
Mr. Jones said none that he knew of.
Senator Stine asked about the findings from the Auditor of Public Accounts on the tax issue related to commingling of funds.
Mr. Jones said he was told by the fiduciary counsel that it was not necessary to report. He made no conclusions about it because there was no documentation presented to him. Mr. Jones said he did not know if this was an issue with the Internal Revenue Service.
Senator Stine asked if PPW board members are members of the KRS board.
Mr. Jones said yes.
Mr. Burnside began his presentation on the Holly Hill Church transaction. He noted that he has been the executive director of KRS since January 2008 and all senior staff are new since the transaction occurred.
Mr. Burnside said the justification for the purchase was for expansion of office space, to replace the existing building with new construction for KRS’s use, or to lease or sell the property. He said KRS purchased the property on February 7, 2006 from Dr. Bevins-Taylor through PPW. He said $700,000 was transferred from the insurance trust, which was improper because the insurance trust is to be used for insurance only. The money was commingled with pension funds.
Mr. Burnside said that in March 2006, the KRS board began an investigation of the purchase. They contacted Ice Miller as outside fiduciary/tax counsel. The internal auditor, the Auditor of Public Accounts, Mountjoy & Bressler (an external auditing firm), and KSP were contacted. They also asked outside litigation counsel Stoll Keenon Ogden whether litigation was in order regarding a fiduciary insurance claim.
Mr. Burnside said the investigation continued through July 2007. There were numerous KRS board and committee meetings. Ice Miller issued reports in May and August 2006, Stoll Keenon Ogden reported in August 2006, and Mountjoy & Bressler, on behalf of Auditor of Public Accounts, reported in December 2006. The internal audit report was completed in April 2007.
Representative Meeks asked about the KSP investigation.
Mr. Burnside said his information is that KSP did not have evidence for criminal action and, therefore, did not submit a report.
Mr. Burnside summarized the audit findings of Mountjoy & Bressler: KRS staff circumvented existing internal control policies and procedures, KRS staff failed to perform adequate due diligence, the commingling of funds between insurance and pension trusts was a violation of the Internal Revenue Code and the KRS Plan Document, and the circumstances were an isolated incident.
Mr. Burnside said the internal auditor recommended that the PPW operating account should require two authorizing signatures; that the business operations of PPW should be under the oversight of the chief of operations; that checks issued from PPW should require a formal check request document and all supporting documentation; and that general counsel should provide training to PPW agents on the bylaws, conflicts of interest, and their fiduciary obligation. He said all recommendations have been fully implemented. He added that the bylaws have been modified to require quarterly meetings of the PPW board and that the board makes regular reports to the board of trustees. He said the KRS board recently added a third member to the PPW board of directors.
He noted that there was a previous question about KRS being bound by the executive branch code of ethics. He said that it was.
Mr. Burnside said that the internal auditor recommended that KRS PPW should re-evaluate its contractual relationship with the Crumbaugh Companies. He said that KRS staff knew about the familial relationship between the PPW property manager and the Summit Realty agent. There was no evidence that this was known by the board. He said Mr. Crumbaugh, the property manager, was not covered by the executive branch code of ethics based on a letter requesting determination. He said that a request for proposals had been issued for property management services. The Crumbaugh Companies, which had been hired under a sole-sourced contract, got the new contract because it was the best evaluated bid.
Mr. Burnside said another recommendation of the auditor was that the PPW board of directors should require evidential matter for all assets acquired. This has been fully implemented by KRS. He noted there was no real estate contract or other documentation for the $25,000 personal property.
Mr. Burnside said that the internal auditor recommended that $52,502.47 should be reimbursed to the PPW operating account; all employees, particularly those in the Division of Investments, should comply with KRS’ Statement of Investment Policy; formal documentation of check/expenditure requests should be formulated to strengthen internal controls; and that all letters of direction should be reviewed, approved, and signed by the CIO, the executive director, and/or the COO. All four items have been implemented by KRS. Mr. Burnside said the internal auditor also noted that KRS is prohibited from commingling funds from the insurance and pension funds. He said this is fully implemented. The matter was taken up by Ice Miller, which is to report to the board of trustees. He said handling of this will be covered in the annual financial report.
Mr. Burnside said the internal auditor recommended that the CIO should have dual reporting responsibilities to the investment committee and to the executive director, which would require a change to policies. He said bylaws had been changed so that the CIO reports to the executive director and the investment committee.
He said as the audits were being conducted, KRS contacted the Finance and Administration Cabinet about the marketing of the Holly Hill Church and Building B properties. He said KSP eventually agreed to purchase Building B and the church property for $3.2 million.
Mr. Burnside noted that, after the completion of the audit by the Finance and Administration Cabinet auditor, he asked the Auditor of Public Accounts if further audits were needed. He said that the state auditor had sent a letter saying that no further action from that office was needed at this time.
Mr. Burnside said that the Finance and Administration Cabinet auditor recommended that KRS should use the Holly Hill proceeds to reimburse the KRS Insurance Fund for an amount no less than $135,000 and to follow the recommendation of the KRS Internal Auditor to reimburse PPW for $52,502.47. He said the board of trustees has voted to reimburse the account with $700,000 plus interest.
Mr. Burnside said that the Finance and Administration Cabinet auditor recommended that KRS should clearly disclose the decision to self-correct the commingling of assets related to Holly Hill and the subsequent loan write-down in the notes to the KRS and PPW financial statements. Mr. Burnside said that KRS staff has drafted and the audit committee has approved language for the 2009 Comprehensive Annual Financial Report to fully comply with this recommendation.
Mr. Burnside said that the Finance and Administration Cabinet auditor recommended that KRS should formalize its real property purchasing process and that KRS and PPW should implement and/or continue the implementation of all internal controls recommended herein and in the KRS Internal Audit Report. KRS has fully implemented both recommendations.
In conclusion, Mr. Burnside said that the KRS executive management team has changed through resignations, transfers, or retirements, and that six of the nine trustees of KRS have changed since the Holly Hill transaction.
Senator Seum asked about investigations by KSP, the attorney general, the Internal Revenue Service, and possible civil action.
Mr. Burnside said there is no investigation that he knows of. The outside litigation counsel has communicated to the board regarding civil action and a decision is forthcoming. The insurance claim is yet to be settled; it is unclear whether there is any final loss to settle.
Senator McGaha asked how selling Building B and the church property is consistent with the initial reason to purchase property for more space.
Mr. Burnside replied KRS was able to modify existing space to meet its needs. No space analysis was originally done.
Senator McGaha asked for clarification of the purchase of the property.
Mr. Burnside said that KSP had purchased both Building B and the church property. A formal appraisal was done before the sell. He said 10% of the purchase price was assigned to the Holly Hill property ($325,000).
Senator McGaha asked about the zoning of the property.
Mr. Burnside said that the property was zoned for governmental use and passed on to KSP as governmental zoning when KSP purchased the property.
Senator McGaha clarified the reimbursement process and asked if that resulted in money still being lost on the deal.
Mr. Burnside said yes.
Senator McGaha asked about Mr. Crumbaugh’s role as property manager.
Mr. Burnside said Mr. Crumbaugh gets a percentage of gross rent to perform property management and maintenance.
Senator McGaha questioned the justification for rehiring Mr. Crumbaugh.
Mr. Burnside said that the father/son relationship was known to KRS staff at the time. He said Mr. Crumbaugh has done an excellent job as property manager. Mr. Burnside said, based on his own experience at the Finance and Administration Cabinet, Mr. Crumbaugh did nothing that would bar him from future state contracts.
Representative Simpson said that current KRS management cannot be responsible for past actions, but the executive director and the board are responsible for pursuing the insurance claim to recoup losses. He said there is a financial loss for the transaction plus the time and money to deal with it. He asked when the insurance claim was filed.
Mr. Burnside said the claim was filed in September or October 2006. He said there had been a series of letters between the insurance company and KRS officials. The claim has not been rejected.
Representative Simpson asked if KRS is still using the same insurance company.
Mr. Thielen said the only state bidder for fiduciary insurance is Chubb, the company that KRS uses now.
Representative Simpson asked if there is any estimate of the total loss.
Mr. Burnside said no.
Representative Simpson asked if the insurance claim would be for an amount above the financial loss.
Mr. Burnside replied that this is up to the board.
Representative Simpson said he would be interested in a supplemental report on what happens with the insurance claim.
Representative Meeks asked for clarification of the loss.
Mr. Burnside said, in overall value, there was a loss. However, since Building B and Holly Hill were sold together, it is difficult to ascribe loss to one particular property.
Senator Stine asked whether the insurance agency could pursue the individuals responsible.
Mr. Burnside said yes, but the individuals are covered by KRS’s insurance. This matter is being discussed by the board.
Senator Stine asked why KRS owns its own buildings and state agencies do not.
Mr. Burnside said KRS is a quasi-governmental organization and not bound by the state procurement code.
Senator Stine said maybe KRS should be. She asked whether PPW board members receive remuneration.
Mr. Burnside said they get per diems and allowances for travel.
Senator Stine said that there should be oversight of KRS by a legislative committee.
Representative Meeks asked for clarification on the insurance claim being filed in 2006 but not being rejected yet. He asked what the plan was to resolve this.
Mr. Burnside said they could not determine the final loss until the property was sold.
Representative Meeks said the co-chairs would explore options for oversight and that input from committee members would be welcome.
Senator Schickel agreed with this.
Representative Meeks directed Mr. Burnside to provide to the committee, in response to Representative Simpson’s request, information on the amount and details of the loss from the Holly Hill transaction.
The meeting was adjourned at 12:25 p.m.