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Friday, September 09, 2005 | Former Mayor Dick Murphy introduced Paul Maco to San Diego on Feb. 12, 2004 with a simple, one-paragraph press release. Remarkable in only its vagueness, the statement announced Maco’s hiring as a financial disclosure expert.
The bare statement was appropriate, as questions of clarity and purpose would accompany the attorney through his controversial year and a half of legal representation for the city of San Diego.
Without listing the name of Maco’s law firm – Vinson & Elkins, which represented Enron in some of its controversial dealings – the release explained that the former Securities and Exchange Commission official would conduct a review of the city’s questioned financial disclosure practices.
The city was simply doing its due diligence, Murphy told reporters. Maco would be paid $150,000 for two months of work.
Only days later on Feb. 14, the news broke: the SEC and the U.S. Attorney’s Office had launched investigations into city finances and politics.
Maco inked his contract with the city on Feb. 18. But the contract he quietly autographed assigned him a duty that was altogether different than what was presented to the public on his first day of official employ. He was to represent the city in front of the SEC, and perhaps the U.S. Attorney’s Office, in addition to conducting an internal review into its disclosure practices.
More than 18 months later, Maco’s firm has exited from San Diego’s sordid plot after collecting nearly $6 million in fees. Its job is incomplete. Hired to be a narrator of San Diego’s problems, Maco and his Washington-based firm instead became primary characters in the tale of a city mired in a financial crisis, myriad investigations and mounting legal and consulting bills.
The two independent investigative reports prepared by the firm, at a cost of nearly $4 million alone, have been cast aside by the city’s outside auditor and the SEC for their lack of independence, according to memos and public statements from auditors.
The rejection of the reports carries real consequences for the city of San Diego and its residents. A year-and-a-half after Maco’s hiring, the city remains stranded without a credit rating and without access to capital markets to do the things that cities do: fix roads, replace sewers and build fire stations. KPMG, the city’s auditor, won’t bless its stalled 2003 financial statements until it sees an independent investigation into allegations of wrongdoing.
To be sure, the lack of an independent report isn’t the only hitch in the audit plans. Until last week, investigators had been denied access to key pension documents by the system’s board of administration. Likewise, a recent memo from KPMG touched on the fact that city staff is still updating its 2003 figures to bring them into compliance with generally accepted standards.
But when taken together, the delays are costing the city at least $1 million a month in missed opportunities and additional legal and consulting bills.
For example, for every month that the city sits on the market sidelines it cannot refinance the rates on the ballpark bonds it had planned to rework at a savings of more than $280,000 a month in debt payments. KPMG, which originally estimated it would charge the city $800,000 for the audit, has billed for $2.6 million during the prolonged struggle and anticipates charging $121,000 a month until its resolution.
Two other batches of consultants and attorneys have been called in to pick up Vinson & Elkins’ slack. An audit committee, headed by former SEC chief Arthur Levitt, bills $800,000 a month to perform the independent investigation originally assigned to Vinson & Elkins.
Last week, the city officially ended Maco’s tenure. It hired Morgan, Lewis & Bockius to handle the second piece of Vinson & Elkins’ original duties: represent the city in connection with the SEC’s and, if necessary, U.S. Attorney’s investigations. Maco had informed the City Council in August that the firm would be extracting itself from the San Diego job.
In total, the city has spent more than $15 million in the last 18 months on consultants and lawyers related to its disclosure and pension issues, while it has at the same time been forced to shrink the basic city services that are the reason for its existence.
The delays could have already done damage with the SEC, which uses an entity’s cooperation level as a key benchmark in choosing the fines and sanctions it levies against entities. Prior case law show that those who follow the SEC’s cooperation guidelines are spared and those who don’t are fined heavily.
The SEC recently told city representatives that it looked favorably upon entities that had conducted independent investigations.
San Diego’s attempt to do that failed.
“The Vinson & Elkins report was not regarded as independent by the staff and therefore would not receive the same favorable consideration,” said Benito Romano, an attorney for the audit committee and the former U.S. Attorney for the New York City area, during the Aug. 9 City Council hearing.
The fundamental flaw in the relationship between the city and Vinson & Elkins had come full circle. The firm couldn’t be relied on to defend the city and produce an independent investigation. The result: the reports appeared to be the advocacy work of a defense attorney, not an objective observer.
For critics, it was the final stroke in the whitewash masterpiece they claim the firm was hired to paint in order to shield city officials from their wayward actions. To others, it simply punctuated poor decisions made by officials who faced unprecedented challenges.
A review of contracts, correspondence and comments by officials shows that the firm was essentially set up to fail from the first contract that called on it to juggle the dual roles. In its 18 months on the job, the firm was asked to perform tasks it wasn’t hired to do and wasn’t given the proper accounting expertise to do them. In total, the firm was restrained by city guidelines from doing the very things KPMG needed it to do, such as determine whether individual city officials had broken laws in connection with the pension system and the financial reporting process.
And, because the firm had previously worked with city officials on other projects and reported directly to high-ranking city officials at a time when the entire City Hall establishment was under question, it was unable to shake the impression that its work wasn’t independent.
“There are a number of things that we should have done differently,” said City Manager Lamont Ewell. “We should have separated the role of the law firm representing the city and the investigator. That’s point No. 1. Point No. 2 would have been early on to bring in someone who had experience in understanding what an independent audit would have required.”
On Thursday afternoon, the credibility of Vinson & Elkins’ work took another hit when it was announced that 57,000 of the 160,000 documents the firm was supposed to be reviewing as part of its second investigation weren’t viewed because of an apparent glitch in its computer database.
Ewell announced he was withholding the final $1 million payment owed to the firm pending resolution of the issue.
A month later, KPMG was brought in to audit the fiscal year 2003 financial disclosure the city was set to release when questions arose regarding the accuracy of its fiscal report to the world. KPMG, in its original contract, looked to Vinson & Elkins to clean up the legal questions surrounding the alleged wrongdoing through an independent investigation.
“We will not issue our auditors’ report on the City’s basic financial statements until such investigation is complete,” KPMG’s April 13, 2004 engagement letter states.
To this date, KPMG has not blessed the city’s financial statements for a number of reasons, one of which is the lack of a reliable investigation. Meanwhile, the city’s credit rating is suspended and it cannot issue bonds.
On May 7, less than a month after being hired, KPMG officials first voiced their concerns to city officials and Vinson & Elkins regarding the sufficiency of its investigation.
They would put those concerns in writing with a memo to Assistant City Attorney Les Girard on Aug. 9, asking that the Vinson & Elkins investigation specifically address seven unresolved questions.
Namely, the Big Four accounting firm needed to know if the city’s financial statements were intentionally misleading, and if they could trust the people who took part in those decisions; if heavily-scrutinized pension deals between the city and the pension board broke laws; if a pension reserve that was paying extra benefits outside of the standard pension plan was illegal; and if the pension actuary was pressured to change accounting methods in order to understate the pension system’s debt.
The demands exposed a glaring flaw between what KPMG desired and what was within the scope of what the city hired Vinson & Elkins to do.
The City Attorney’s Office under former City Attorney Casey Gwinn controlled the contract with Vinson & Elkins and, therefore, the scope of the ongoing investigation.
A later memo from KPMG partner Steve DeVetter recalled an Aug. 27 meeting between the city, Vinson & Elkins and KPMG officials: “Both the city and V&E have made it clear to KPMG that V&E was not retained to investigate issues relating to intent or whether any individual’s conduct violated any law, rule or regulation, and that the scope of its investigative efforts were not designed to do so.
At that meeting, we informed the city that, in the absence of conclusions on such issues, KPMG anticipated advising the city that additional investigative procedures may be necessary.”
City officials had been warned. The audit the city so desperately needed faced the possibility of delays because the Vinson & Elkins investigation wasn’t designed to answer the auditor’s questions. Still, they plugged ahead with the same plan.
On Sept. 1, DeVetter, the KPMG partner, stopped sending his memos directly to Girard and began copying them to City Manager Lamont Ewell and former Assistant Auditor Terri Webster – who was later put on administrative leave for failing to comply with federal subpoenas. She has been charged by the District Attorney’s Office for violating conflict-of-interest laws for her role on the pension board.
Again, the Sept. 1 memo reinforces KPMG’s doubts about the investigation and its potential consequences.
“We think it is fair to say that over [the last few months] we have expressed our concerns about the scope of the investigation as it has been described by us. … However, without in any way prejudging what our reaction to the final report will be, you should be aware that, if following our review of the V&E report we conclude that the V&E report is not sufficient to resolve all of the issues we face in the audit, we may advise you that additional investigative procedures may be necessary before KPMG can complete its work,” the memo states.
However, city officials gave no hint in public of the auditor’s explicit concerns.
Ewell, who had been copied on the Sept. 1 memo, said he never saw the memos and only became aware of KPMG’s concerns later in September through a conversation with a KPMG official.
“Mail comes to this office every day with me being CC’d,” Ewell said. “That does not mean that I see it. I can’t tell you that it even came to this office.”
He sent out a press release Sept. 8 of that year in response to a news article touching on the prospects of bankruptcy for the city of San Diego. It was similar to the public statements being made by Murphy and Ewell at the time.
“The Vinson & Elkins report has not yet been completed, but the city expects it to be completed within the next few weeks. Once KPMG receives the Vinson & Elkins report, it is the City’s expectation that it will take KPMG at least a few weeks to digest the report and its findings in order to complete its audit,” it states.
“It’s classic city of San Diego. What was being said publicly wasn’t what was going on privately,” said Lisa Briggs, president of the San Diego County Taxpayers Association, an organization that monitored the audit’s release closely in fall 2004.
The first Vinson & Elkins report was released Sept. 16 and described by the media at the time as a blistering report that slammed City Hall. It acknowledged pension board whistleblower Diann Shipione’s minority concerns, giving a mainstream credibility to many of the allegations that had long been dismissed as ridiculous and without merit by everyone from pension officials to Ewell himself.
The report officially opened the lid on the decades of tinkering with the pension system that led to a deficit now estimated to be at least $1.37 billion, and the city’s systemic failure to report the true depth of its pension ills to the public and investing world.
Using never-before-seen internal e-mails and extensive interviews, the report admitted, for the first time publicly, that real, engrained problems existed at City Hall.
However damning the report was in the public domain, some – such as Shipione herself – declared it a whitewash. Indeed, it stopped short of placing any blame, instead chalking up the city’s problems to innocent miscues rather than deliberate actions. It would later be said that the report created more questions than it answered.
The much-ballyhooed report also failed to impress KPMG, as its officials had warned, leaving the city’s return to fiscal credibility further stalled.
Girard, in a letter to KPMG’s DeVetter on Sept. 20, told the accounting partner that the report was sufficiently comprehensive for KPMG to meet the needs of the professional code on auditing investigations – known as AU 317, or an illegal acts analysis. It was, therefore, enough to allow KPMG to issue its audit, he argued.
“The report fully satisfies, and indeed exceeds, the requirements of our terms of engagement with counsel,” Girard writes. “We believe the city is the only municipal government to have commissioned an investigative report of its disclosure practices.”
Girard’s memo then attempts to answer the seven questions posed by DeVetter in August, most of them related to accusations made by Shipione.
This time, in his response, DeVetter copied the mayor and entire City Council, adding copies of all previous correspondence with Girard. He reiterated his consistent concerns with the investigation.
“We do not believe the city of San Diego has conducted an adequate investigation in order to conclude that likely illegal acts have not occurred, or that appropriate remedial action has been taken. Such an investigation is necessary,” DeVetter wrote.
He detailed specific faults with the Vinson & Elkins work: it wasn’t conducted as a forensic investigation, didn’t reach clear conclusions of whether securities laws were broken and did not follow up “on evidence that might suggest that certain deficiencies in the financial reporting may have been conscious efforts by one or more persons at the city.”
Two of those faults were a direct function of what Vinson & Elkins was contracted to do.
Maco declined to be interviewed for this story, citing attorney-client confidentiality.
But in testimony before the City Council earlier this year, he said he asked for assistance on the forensic end of the investigation, “since we are not accountants, nor are we auditors.”
“We were not the decision-maker, the city attorney was the decision-maker, advising the city what to do,” said Maco, the former head of the SEC’s municipal securities department. “But we expressed the need for the involvement of some degree of forensic accounting assistance as part of the condition for the city’s hiring of an auditor.”
Maco continued, “That forensic assistance, in terms of conducting our investigation, did not come to pass.”
Neither Gwinn, who now works for the District Attorney’s Office, nor Girard returned phone calls for this story.
And although city officials and Vinson & Elkins were warned at the Aug. 27, 2004 meeting that KPMG needed to know if certain individuals broke the law, the scope of Vinson & Elkins’ investigation didn’t allow them to assess the actions of individual city officials.
“What [the City Attorney’s Office] hired them to do was to look at disclosure practices, not do an investigation into wrongdoing,” Ewell said.
Maco also shifted blame to KPMG. He said when it became clear that he wouldn’t receive the forensic help from KPMG, he asked for the specific guidelines that they needed him to work between. He was told by KPMG that there were no guidelines, Maco said.
KPMG officials have refused to comment to the press during their audit engagement with the city of San Diego.
But by August, the accounting firm had spelled out in specific terms the seven questions it needed answered. In an Oct. 11 memo, DeVetter took what he later called the “somewhat unusual” step of providing the city with copies of the applicable accounting standards under which KPMG’s concerns fell. It also, step-by-step, rebutted Girard’s responses to KPMG’s original concerns.
In that memo, the KPMG partner directly challenges a key statement in the Vinson & Elkins report.
“Based upon what we have been told about the investigation, we do not believe the statement in the report that ‘it is difficult to attribute the City’s failure to fully and accurately describe [pension] matter[s] to intentional misconduct on the part of individual employees’ is one that can be relied upon to resolve the issue of potential illegal acts for purposes of KPMG’s audit because it is not based on an investigation that had a scope and methodology that would provide a reliable basis for making such a conclusion,” according to the Oct. 21 memo.
City officials would continue to fight KPMG on its demands throughout the month of October while publicly disclosing no hint of troubles with the stalled audit.
Throughout October, the disagreement over the sufficiency of the investigation continued to grow, as KPMG and the city and Vinson & Elkins exchanged private letters that grew tenser by the day.
On Oct. 21, 2004, Girard sent an e-mail to KPMG officials proposing that Vinson and Elkins undertake a new investigation. Six days later, KPMG responded with a memo addressed to Girard and copied to the City Council, Murphy, Ewell and Webster, saying that the plan offered by Girard still wouldn’t resolve outstanding issues.
KPMG asked that the city’s new contract with Vinson & Elkins include a clear statement of the expected scope of the investigation and the firm refused to guarantee that it would issue the audit following completion of the new investigation, as it had been asked to do in the newest investigation proposal.
“KPMG cannot accept any limitations on, or conditions for, the performance of our audit,” DeVetter wrote.
It was at this time that bits of KPMG’s correspondence with the city made its way to the press and public. For the first time, it was understood outside a small group in City Hall that the firm was dissatisfied with the Vinson & Elkins investigation. Until then, few had known what was delaying the audit. In response to inquiries, Murphy claimed that, although they had been in his office, he too had never read KPMG’s letters.
The same day KPMG’s terse memo arrived, Ewell fired off a quick fax proposing an immediate meeting between city and KPMG officials to calm both parties.
Ewell told KPMG that city officials believed the new investigation program would be responsive to the firm’s needs, and he pleaded with them to meet face to face. “We do not believe that we can best move forward by writing letters, but rather by meeting to work through issues,” he wrote.
But one day later, a letter written from Maco to Girard – which KPMG claimed was immediately posted to the city Web site – stated that KPMG had failed to “articulate the ‘possible illegal acts’ it believes may have occurred or how the identification and analysis of any such acts should be addressed as audit issues … KPMG’s current position would require counsel to speculate on an unbounded universe of unasserted claims.”
KPMG was not pleased. In a memo the next day, addressed directly to Murphy and Ewell, DeVetter wrote that Maco’s letter “seriously impairs, rather than advances, the prospects for a prompt resolution of the issues that currently stand in the way of KPMG completing its audit.”
He pointed to his previous letter that had provided a “detailed explanation” of auditing standards to justify KPMG’s request for information, and he called such a step “somewhat unusual.”
DeVetter continued, “If the City is prepared to proceed with an appropriate investigation, then we urge you to consider retaining counsel other than V&E to do so” because of its positions and “oppositional tone.”
But as quickly as tempers had flared, a Nov. 1 meeting between KPMG officials and Murphy, Girard, Ewell, Maco and other city consultants appeared to leave officials at ease.
In a memo to the City Council and Murphy sent on Nov. 2, Ewell informed the council that Vinson & Elkins would continue work as investigators not because its work was insufficient in the context of what the city had asked it to do in its original contract, but because a new investigation was necessary in the context of KPMG’s auditing needs.
“City staff has never tried to dissuade KPMG from fulfilling its obligations as an independent auditor; we have been trying to understand the requirements of the City in this context and thus propose an additional scope of work to satisfy the City’s and KPMG’s requirements and obligations,” he wrote, applauding Murphy for his work in convincing KPMG that the city was sincere in its efforts to release the audit.
Thus, more than six months after KPMG’s concerns were first voiced regarding the Vinson & Elkins investigation, new parameters were set and forensic accounting help was provided to the law firm.
The idea of an audit committee was first envisioned in this meeting, Ewell said in an interview, so that a group that could be seen as independent could synthesize the Vinson & Elkins report.
“The reason we continued with V&E at that point is that they now had all the background from completing the first investigation. To start over, it would take a law firm four-to-five months to get up to speed,” Ewell said. “We were trying to get this done as rapidly as possible.”
At this point, the firm had billed the city $1.5 million. It was to complete its investigation by Nov. 19 unless further allegations arose.
As winter turned into spring, and spring into summer, the report still hadn’t been released. The release date kept getting pushed back.
In the meantime, Mike Aguirre took over the City Attorney’s Office from the termed-out Gwinn and undertook his own investigation into the city’s disclosure practices, opining that Murphy and former and current council members had likely broken securities laws when approving bond sales accompanied by misleading financial information.
Now, KPMG and SEC officials had two opposite reports to digest: one that placed blame on nobody and one that placed blame all the way up to the top ranks at City Hall.
Shortly thereafter, the city brought in Levitt and a group of his colleagues to serve as the audit committee in February. The five-man committee charges the city $800,000 a month for its investigation. They quickly grabbed the spotlight and the importance of the second Vinson & Elkins report, once paramount to the city’s problems, faded into the backdrop.
Eventually, Vinson & Elkins would quietly complete a draft of its second investigation months after it was expected to be done.
The report, which became public last month, essentially drew many of the same conclusions and criticism as the first. It was rejected by both the SEC and KPMG due to Vinson & Elkins’ lack of independence.
Upon receiving Vinson & Elkins’ second investigation report last month, SEC officials reportedly wondered how a truly independent investigation could fail to reach tougher conclusions regarding the culpability of city officials.
The rejection closed the book on a tenure Briggs summed up simply as “disappointing and expensive.”
Aguirre was less judicious.
“I think one of the man- and woman-made wonders of all time is why we paid $6 million to V&E,” he said.
Please contact Andrew Donohue directly with your thoughts, ideas, personal stories or tips.