Memorandum. Recommendation. Background/Discussion. Fraud at New York State Common Retirement Fund

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1 Memorandum DATE: June 9, 2017 TO: Members of the Audit Committee FROM: David James, Director of Internal Audit SUBJECT: NEW YORK STATE COMMON RETIREMENT FUND S SCANDAL AND OCERS POLICIES Recommendation Receive and file. Background/Discussion Recent press accounts and a Securities and Exchange Commission Complaint have described how a former Director of Fixed Income at New York State Common Retirement Fund (NYSCRF) allegedly steered approximately $3.38 billion in fixed income trades to two broker-dealers in exchange for various gifts he solicited that were equivalent to about $180,000. Several internal control failures occurred that may have prevented this fraud. We review the details of the fraud that occurred at NYSCRF, recommendations to the Fund by a consultant in their 2013 and 2016 Fiduciary and Conflict of Interest Reviews, implementation of recommendations and improved internal controls by the Fund, and OCERS policies to address the risks of this type of fraud. Fraud at New York State Common Retirement Fund In early 2014, NYSCRF hired Navnoor Kang as Director of Fixed Income. In the hiring process, NYSCRF allegedly did not call Kang s former employer, Guggenheim Partners, to ask about his job performance. Kang had been terminated from his former employer for soliciting and receiving gifts from representatives of broker-dealers in exchange for directing trades to those broker-dealers. In his job interview with NYSCRF, Kang did not give the true reason he left Guggenheim. The investigation at Guggenheim determined that Kang failed to report at least 55 instances where he received benefits and gifts. Kang was terminated from Guggenheim in January 2013 for violation of Guggenheim s compliance and ethics policies. One of the references Kang used was a representative of a broker-dealer who had given him gifts. NYSCRF hired Korn Ferry International for the search process. Korn Ferry s vetting failed to give NYSCRF the reason for Kang s leaving Guggenheim or reason for concern. Kang received training on NYSCRF s polices and codes, and certified his understanding to prohibitions regarding receipts of gifts, meals, travel, and entertainment. However, as soon as Kang arrived at NYSCRF, he solicited and received items of value from two different representatives of broker-dealers. He received the equivalent of $160,000 from one and $20,000 from the other. When Kang arrived at NYSCRF, a small number of brokers were approved to execute fixed income trades directly for the Fund. In June 2014, at Kang s direction, NYSCRF initiated a fixed income broker search. Interested E. New York State Common Retirement Fund s Scandal and OCERS Policies 1 of 5 Audit Committee Meeting

2 entities were required to submit applications which were reviewed internally by a group led by Kang. In November 2014, Kang sent a memo to the NYSCRF s CIO recommending eight brokers, including the two brokers he used at Guggenheim. The memo said the eight brokers would submit to a full due diligence process, but this never occurred. So the eight brokers were approved solely on the recommendation of Kang s memo. While soliciting and receiving benefits and gifts from these two broker s representatives, Kang steered about $2.38 billion in fixed income securities trades to one first broker and nearly $1 billion to the other. Several internal control failures appear to have occurred. A move from paper tickets to electronic trade confirmations allowed Kang to avoid listing the broker who executed the trades. Under Kang s watch, the pension fund stopped producing weekly trade reports that identified the brokers involved. Unlike his predecessor or his counterpart who managed the Fund s stock investments, Kang himself traded rather than direct his staff to trade. This meant that no one approved his transactions. Kang instructed his brokers to send the electronic confirmations to his subordinates, creating the false impression that most of these transactions were conducted by the investment staff and then approved by him. Kang sidestepped rules requiring a minimum number of broker bids on each trade. Kang was slow to adopt new guidelines as the fund became a more active bond trader. NYSCRF apparently did not do analysis of trades for unusual activity like trades shifting to a brokerdealer or potential unnecessary trades. NYSCRF did not discover the fraud internally, but were notified by the SEC. In February 2016, NYSCRF terminated Kang. In 2006 former Comptroller Alan Hevesi pleaded guilty to a felony involving misuse of State resources and resigned. Subsequent investigations revealed improper payments to politically connected intermediaries in exchange for investments in the Fund. The former Comptroller pleaded guild to accepting nearly $1 million in travel and benefits from a money manager who won $250 million in investments from NYSCRF. Eight individuals, including the CIO, pleaded guilty to crimes related to pay to play. As part of the outcome of this scandal, NYSCRF implemented mandatory ethics training for all staff, including special training for investment staff. NYSCRF also required monthly public disclosure of investment transactions. A compliance officer was appointed to better monitor potential conflicts and ethical behavior. Also a Director of Risk and Reporting was added. The Comptroller introduced initiatives to restore integrity, such as banning placement agent fees, issuing an Executive Order that barred staff from accepting any gifts, created new positions of Inspector General and Special Council for Ethics, expanded internal and external vetting, and review and approval for all investment decisions. Fiduciary and Conflict of Interest Reviews In 2013, consultant Funston Advisory Services issued a Fiduciary and Conflict of Interest Review of NYSCRF. The review covered the investment-related operations of the Fund. The 2013 report did not find issues with investment transactions, transaction approval, and due diligence procedures. The report concluded that investment-related contracts were signed and transactions were closed in substantial compliance with applicable Fund policies and procedures. The report found that NYSCRF s investment-related operational expenses were recorded in a detailed, clear, and logical structure to allow analysis and comparison. The report concluded that the NYSCRF led their benchmark group in the detail of operational expense disclosed. Funston s 2013 report offered recommendations on internal controls related to risks of kickbacks: E - New York State Common Retirement Fund s Scandal and OCERS Policies 2 of 5

3 Employees training of policies and law, fiduciary duty, insider trading, ethics, enhanced training for investment staff. Review policies to provide greater consistency for internal transaction approval report forms. RFP for brokers seeking trading business. Bring in an outside advisor to help vet and select brokers. The 2013 report said, For its internally managed portfolios, the Fund currently uses 35 brokers selected through an RFP process in Staff recognizes that because of the pace at which markets and brokerage firms change, the selection process should be done more frequently. For example, CalPERS uses a continuous online application process managed by an expert consultant, and the Fund reevaluates its broker-dealer list semiannually. In March 2016, NYSCRF signed a contract with Mosaic Global Partners Inc., a broker-vetting consultant, complying with the 2013 review s recommendation. Funston s June 2016 Fiduciary and Conflict of Interest Review said 40 of the 47 recommendations from their 2013 report had been fully implemented or had seen substantial implementation progress. However, most of the recommendations did not address risks regarding illegal gifts to staff. Like the 2013 report, there was an emphasis on growing staff size and compensation levels. The report was intended to provide reasonable but not absolute assurance. The 2016 review found that there were 96 investment transactions that were approved in accordance with Fund policies and legal requirements. Documentation on 96 transactions was reviewed for compliance with investment policies, procedures and requirements. The Comptroller approved all transactions. Descriptions of all transactions which closed are available on the website. The descriptions include the rationale for the changes and other pertinent information. The report said, We did not identify any instances of inappropriate or unethical behavior. None of the external managers or service providers we spoke to identified any inappropriate requests or behavior by any... staff. We found the policies and procedures established by the Inspector General and Special Counsel for Ethics to be effective and a further control and check and balance. The 2016 review did not identify any areas for material improvements to policy or process. The report found the governance of the Fund to be sound, but with opportunities for improvement. The report did not identify any instances of inappropriate conduct. None of the external managers or service providers we spoke to identified any inappropriate requests or behavior by any... staff. The report found the Fund s policies and procedures to be effective. OCERS Policies Addressing Risk of Investment Fraud and Inappropriate Gifts OCERS does not have the same exposure to the type of fraud in the NYSCRF case since no OCERS employee directs trading of any type of investment which would require interaction with a broker-dealer. The same risk for bribery or inappropriate gifts could exist with an OCERS external fixed income or equity money manager, but OCERS has no direct control over this risk. OCERS has policies to help prevent the broader risk of bribery and inappropriate gifts to staff: E - New York State Common Retirement Fund s Scandal and OCERS Policies 3 of 5

4 OCERS Staff Code of Ethics & Standards of Professional Conduct Policy places the integrity of the investment profession and the interests of plan participants and beneficiaries above staff s personal interests. Staff must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence. Staff may not accept or receive any compensation, consideration, or benefit from or paid to others for the recommendation of an investment manager, products or services. Staff must not accept gifts, benefits, compensation, or consideration that competes with or might reasonably be expected to create a conflict of interest with their employer s interest unless they obtain written consent from all parties involved. Staff must make reasonable efforts to detect and prevent violations of applicable laws, rules, regulations, and the OCERS Code and Standards by anyone subject to their supervision or authority. In addition to those disclosures required under the California Fair Political Practices Commission regulations relating to economic interests, staff must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their duties to the plan, the Board, participants, beneficiaries and employers. Staff must ensure that such disclosures are prominent, timely, are delivered in plain language, and communicate the relevant information effectively. OCERS Procurement and Contracting Policy requires the use of an RFP process to select Named Service Providers such as investment consultants, auditors, and actuaries. Named Service Provider contracts require Board approval prior to execution. Contracts valued at less than $100,000 can be executed by the executive responsible for the budget in from which the contract is paid. Contracts with greater amounts are executed by the CEO. According to the policy, OCERS staff and members of the Board shall not be directly involved in a decision if it will have a material effect on their economic interest. The Board, or a Committee of the Board, will interview candidates recommended for appointment as Named Service Providers. Procurements can also be performed by an Invitation for Bid when procurement needs can be stated specifically, or where services or products are standardized. For small purchases of less than $50,000, at least three quotes from qualified sources must be obtained. In cases where the CEO believes that a competitive alternative to a particular service provider does not exist, the CEO will provide the Board with a report supporting the need for a sole source. According to OCERS Investment Policy Statement, investment managers may be sourced through consultants, a CIO prepared Request For Information, or an Investment Committee approved RFP. OCERS Due Diligence Policy requires initial and ongoing due diligence of investment managers. On-site due diligence is performed at the discretion of the CIO. Also, OCERS has hired audit firms and others to perform due diligence over new and existing managers for proper operational controls to help prevent fraud and other objectives. In addition, OCERS investment attorney crafts phrases in side agreements to prevent unreasonable expenses from investments being charged to OCERS. OCERS Annual Disclosure Policy requires use of Form 700, Statements of Economic Interests. The form requires that OCERS' Board members and executive staff disclose all family and business relationships with, and value received from, any investment manager, placement agent, vendor, consultant, actuary, counsel or other persons providing or actively seeking to provide services or products to, or seeking to influence the deliberations of, E - New York State Common Retirement Fund s Scandal and OCERS Policies 4 of 5

5 OCERS' Board of Retirement. They must disclose any personal financial interests in any contract that OCERS considered or entered into during the disclosure period, an incompatible office, gifts and honoraria, and campaign contributions. OCERS Acceptance and Reporting of Gifts Policy limits gifts that can be received by staff. According to the California Fair Political Practices Commission, state and local officials and employees are prohibited from receiving gifts totaling more than $470 in a calendar year from certain sources. OCERS Travel Policy limits Board Member and staff travel. The California Fair Political Practices Commission regulations limit the ability of OCERS Board Members and designated staff to accept gifts of travel, lodging and meals from third parties. The evaluation of whether the gift can be accepted and the determination of the Commission reporting requirements is made by the CEO in conjunction with general counsel. OCERS Investment Placement Agent Policy requires disclosure of placement agents by investment managers or consultants. The external investment manager is solely responsible for, and OCERS does not pay directly or indirectly, any fees, compensation, or expenses for any placement agent used by an external manager. OCERS also has its Ethics, Compliance, and Fraud Hotline in which suspected illegal acts can be anonymously reported for investigation. Submitted by: David James Director of Internal Audit E - New York State Common Retirement Fund s Scandal and OCERS Policies 5 of 5