Pay-to-Play in America, Part 1

While politicos and pundits, conservatives and liberals froth at the mouth about Bill Clinton's apparent pay-for-pardons policy, the quiet burial of a rule designed to end the practice of paying for contracts to manage public funds has gone virtually unnoticed.

Pay-to-Play in America, Part 1

Pay-to-Play in America, Part 2: The Subtle Side of the Game

Pay-to-Play in America, Part 3: 'Money Rarely Raises Its Voice'

Pay-to-Play in America, Part 4: The SEC's Proposal for Regulating Pay-to-Play

In August 1999, the Securities and Exchange Commission proposed to ban "pay-to-play," where money managers routinely finance the campaigns of state and local treasurers, who in turn give the money managers contracts to manage billions.

Unable to weather petty -- but highly placed -- criticism, the rule expired with the Commission's decision that, in deference to President Bush, it would not seek to adopt any controversial rules until a new SEC chairman was appointed. This four-part series explores the ins and outs of pay-to-play abuse, and what you can do to put an end to it.

Evidence Worthy of a Prince

The most common criticism of the rule has been that the SEC failed to make the case that pay-to-play exists. This claim is contradicted, however, by a three-volume file at SEC headquarters containing dozens of examples of legal bribery that would be suitable appendices to Machiavelli's The Prince.

If you enjoy sordid political corruption stories and can't make it to Washington, an abridged version of the SEC pay-to-play files is available at Fund Democracy's Web site. For a smaller, more digestible dose, read on.

You Scratch My Back . . .

One of the most frequently criticized recipients of pay-to-play money is California State Controller Kathleen Connell. She serves on the boards of two of the three largest pension funds in the world, the $165 billion California Public Employees' Retirement System (CalPERS) and the $110 billion California State Teachers' Retirement System (CalSTRS).

From 1995 to 1997, Connell received over $250,000 in campaign donations from firms doing business with CalPERS and CalSTRS while she served as a board member.

About $24,000 of that amount came from TCW Realty Investors. TCW ranked 11th of 13 firms managing real estate for CalPERS, producing a meager 3.2% annual return from 1990 to 1995. When an independent CalPERS consultant recommended firing the firm, Connell leapt to its defense. TCW kept CalPERS business and continued to collect millions in annual fees.

Abbott Capital Management, CalSTRS' longstanding alternative investments adviser, had the support of CalSTRS chief investment officer and was considered a shoe-in for the CalSTRS contract.

But Abbott was replaced by Pathway Capital Management in 1997 just a few months after Pathway principal Douglas Le Bon contributed $10,000 to Connell's campaign. Le Bon also contributed $5,000 in 1994 and $5,000 in 1995 to Connell, who was an outspoken critic of Abbott Capital.

In 1995, CalSTRS invested $150 million in a real estate investment fund arranged by Colony Capital, executives of which contributed $20,000 to Connell between 1994 and 1996. During the same period, the executives also contributed $9,500 to CalSTRS board member and California State Treasurer Matt Fong.

Fong, like Connell, was a CalSTRS and CalPERS board member, and relied heavily for campaign contributions on firms doing business with the pension funds. Fong collected more than $9.4 million between 1990 and 1998, with $1.5 million coming from financial services firms.

Fong contributors did well by CalPERS. Lombard Investments contributed $32,000 to Fong campaigns and landed a $225 million investment from CalPERS. After three Hellman & Friedman partners and one employee contributed a total of $9,400 to Fong's campaign in 1996, the firm received a $100 million investment from CalPERS.

Connell's and Fong's questionable fund-raising practices triggered an FBI investigation and hearings before a California Senate committee. They also prompted CalPERS board members to adopt a rule over Connell's objections banning campaign contributions to board members by firms seeking to do business with the pension fund.

Connell struck back, challenging the rule on procedural grounds. While her suit was pending, she continued to collect contributions from firms to which CalPERS had awarded business, including $10,000 from Thomas Lee, the head of a Boston-based buy-out firm, and $7,000 from partners and executives of Apollo Advisors.

"She sued so she could buy time to build her war chest," Jim Knox, the director of California Common Cause, told Institutional Investor's Barry Rehfeld.

Absolute Power Corrupts Absolutely

New York State Comptroller H. Carl McCall has been particularly successful at raising money from firms who look to him for business, in part due to the unique power of his position. While most public pension funds in other states are run by committees, as are CalPERS and CalSTRS, New York law grants the comptroller complete control over the $127 billion public employees' pension fund.

From 1995 to 1998, McCall raised $5.2 million in campaign donations, with $1.8 million, or 35%, coming from firms and their associates that have been awarded business by the Comptroller's office. Payments were often made to McCall's campaign around the time contributors made deals with the pension fund.

About a month after Clarion Partners executives contributed $25,000 to McCall's campaign, the firm was selected to manage part of the pension fund's real estate portfolio. A few weeks after Paul Milstein contributed $28,000 to McCall's campaign, the Comptroller's office lowered the interest rate on a $130-million mortgage on a building co-owned by a Milstein company.

Three months after the Comptroller's office decided to invest $75 million with Colony Capital, the firm's chairman, Thomas Barrack, donated $10,000 to McCall's campaign. Barrack and others associated with Colony contributed another $39,000 over the next two years, which apparently paid off in the form of an additional investment of $100 million with the firm.

Donors connected to Olympus Real Estate contributed $38,000, much of it around the time that the New York pension fund invested $100 million with Olympus.

Close to the time that four firms were selected to manage pension fund money, the firms and their executives donated $53,000 to McCall's campaign. They have since contributed $185,000 more to McCall.

There's Plenty for Everyone

Connell's and McCall's fund-raising records are far from exceptional, as similar stories have been told about dozens of other state, county and local officials.

The SEC pay-to-play files relate pay-to-play practices in 17 states, and that covers only the states where the press has picked up the story. Tracking campaign contributors through mounds of public filings, identifying firms awarded public pension business, and then matching up contributors and contracts is painstaking work.

But the results epitomize investigative journalism at its best. Pay-to-play thrives on anonymity. As I'll discuss in part two of this series, journalists who have reported on the breadth and depth of pay-to-play in America deserve much of the credit for bringing the SEC to the brink of banning the practice altogether.

Part 2: Other More Subtle Ways That Pay-To-Play Operates