Tracking the Recession: Iowa, N.D. Victims of Investment Fraud

The letter from a Connecticut investment firm arrived shortly after New York financier Bernard Madoff was arrested in December on charges of swindling billions of dollars from investors.

“Why WG Trading is NOT Bernard Madoff,” the letter informed Iowa’s public pension fund managers.

WG Trading was trying to assure the Iowa officials that the $339 million the state had trusted WG to manage was safe from the kind of pyramid scheme shenanigans that landed Madoff in jail.

“Our holdings are totally transparent,” the letter said. “Our auditor… confirms the balance sheet, the income statement and all cash flows. As a result, the returns are real.”

It turns out Iowa had plenty to worry about. WG’s owners were arrested Feb. 25 on securities and wire fraud charges, accused of stealing tens of millions of dollars from Iowa, North Dakota and other investors to buy horses, Steiff teddy bears , rare books, Manhattan apartments and other personal items. The owners, Paul Greenwood and Stephen Walsh, treated investor money “as their own piggy bank to lavish themselves with expensive gifts” said Stephen Obie, acting director of enforcement for the Commodity Futures Trading Commission.

The $553 million theft is the latest blow in a turbulent period for state retiree pension funds. The median loss for the state funds last year was 25 percent, most of which came after the Wall Street meltdown in September. The steep decline has caused many pension fund managers and state lawmakers to rebalance investments, reduce monthly payments to retirees, increase contributions and enact reforms. Some states, such as California, have replaced their investment officers and others, such as Wyoming, have restructured their retirement boards.

Wisconsin has reduced monthly payments to retirees for the first time. New York Gov. David Paterson (D) recently proposed a pension reform plan calling for reduced benefits for newly hired public employees. Nevada Gov. Jim Gibbons (R), facing a $2.3 billion budget gap, has also called for trimming retiree benefits.

Kentucky is considering cutting the amount of money that the state and local governments contribute to their public pension funds to help cover budget shortfalls. Indiana lawmakers are weighing a proposal to merge the state employee and teacher pension funds and raise contributions. New Mexico lawmakers recently learned they may have to boost contribution rates if the economy does not rebound soon.

The recession also has led to financial fraud. Iowa and North Dakota were the only two states victimized by WG and another company Greenwood and Walsh owned called Westridge Capital Management of Santa Barbara, Calif. Pennsylvania’s public school employee retirement system pulled back from investing with Greenwood and Walsh after learning auditors were reviewing the companies. But several institutional investors, including the University of Pittsburgh, Carnegie Mellon University, San Diego County and Sacramento County, were stung by the fraud.

The investment scam illustrates how vulnerable state pension funds can be to companies promising high returns even though they appear to be solid– on paper at least. The same thing happened in the 1990s, when institutional investors flocked to dot.com companies, only to get burned when the dot.com bubble burst.

“We’ve seen this movie before, and we know it’s not a happy ending,” said Evan Stewart , a New York attorney and Fordham law school professor whose expertise includes regulatory enforcement and securities litigation.

Until the case is resolved, Iowa and North Dakota pension officials are not sure how much money the retiree funds could lose. If WG and Westridge file for bankruptcy protection, as expected, the states would be among the creditors seeking whatever they can get. For now, federal authorities have frozen the companies’ assets.

The $339 million in state pension money Iowa gave Westridge to invest represents about 2 percent of the Iowa Public Employees’ Retirement System’s assets, which means there is plenty of money to pay retirees despite the fraud. The fund, which fluctuates depending on the market, had $18 billion in assets at the end of 2008, down from $22 billion in June. The system pays benefits to 87,490 retirees, who include state and local government, public school and city and county hospital employees.

North Dakota had $161 million tied up with Westridge but recovered $23 million since demanding Westridge Capital return its money last month. The remaining $138 million represents less than 3 percent of the state retirement office’s portfolio. The office manages pension and workers compensation funds for state employees, public school teachers and city workers in Bismarck and Fargo. About 13,000 retirees receive checks from the funds.

Steve Cochrane, director of North Dakota’s Retirement and Investment Office, estimated the loss to the pension fund at about $14 million, but said the number could change.

“I definitely think, unless you bury the money in the backyard with armed guards, the chances of fraud being committed exists,” he said. “It’s a risk of doing investing.”

Cochrane and his counterpart in Iowa, Karl Koch, have defended their decision to retain Westridge, which ran an “enhanced index equity fund,” in which the investment managers attempt to slightly outperform the Standard & Poors group of 500 stocks. Before a pension fund places money with an investment adviser, the manager generally researches the integrity and performance of the fund, a process called due diligence.

Koch recently told state lawmakers that Iowa officials believed they had “covered the bases” but that “obviously, something went wrong.” He and Cochrane, in an interview, said that there was no apparent problem with Westridge that would raise concerns. Numerous government regulatory agencies had audited the company and the venerable Deloitte and Touche firm was Westridge’s auditor. The company’s investment returns did not raise suspicion because it generally followed market trends: it gained and lost money when the rest of the market did.

A report from consultant Callan Associates to North Dakota officials before the state retained WG concluded that federal oversight of WG Trading “provides comfort that there is very little probability of large losses resulting from fraud or malfeasance.”

Cochrane concluded, “This was simply stealing. It happens.”

Iowa officials say they will re-examine their due diligence procedures to avoid a repeat of the Westridge debacle. “A lot of people will probably weigh in on what should be done differently,” said Julie Economaki, a spokeswoman for the Iowa Public Employees Retirement System.

Stewart said his advice to state pension officials is simple: Don’t go with an investment adviser who promises big returns.

“Do what your father told you. If it’s too good to be true, it probably is,” he said.