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San Diego: A Great Case Study in Conflicts of Interest
Wednesday, August 9th, 2006
Reading the newspapers, you might not realize that behind all the fraud, non-disclosure, and "reckless mismanagement" that former S.E.C. Chair Arthur Levitt found in San Diego's pension and wastewater systems were serious conflicts of interest. The sort of conflicts of interest that most people consider "just doing business."
The August 8 New York Times article does refer to these conflicts, recognizing that pension plans "are governed by boards that often include municipal labor leaders, whose duty to represent their workers' interests can easily conflict with their fiduciary duty to represent the plan itself. And even the most exemplary pension boards can be overruled, in many cases, by politicians whose priorities may be incompatible with sound financial management." But various articles about the Levitt Report make no mention of conflicts.
Of course, the whole thing started with self-serving incompetence: a conceptual error regarding what pension "surplus earnings" are and how they can or cannot be used. The self-serving part is that most city governments will use anything that sounds like a surplus to fix whatever problem it most wants to fix, no matter how unrelated. When the money is part of a pension plan, there are fiduciary duties that must be breached to make the surplus available. And breaching fiduciary duties means a great deal of non-disclosure, fudging numbers, and covering up.
Why would a pension board let the city do something like this? Well, as the New York Times article suggests, when city and labor leaders agree on a plan, their representatives on the pension board are going to do what they can to make sure the plan goes through. They are in a classic conflict of interest position, only it's not about their personal finances (although the City Manager's second plan did include a special pension deal for union presidents), it's about doing their jobs, satisfying their bosses.
The pension board job requires looking out for both the pension plan's future beneficiaries and for the taxpayers who will be funding the pensions. This means making the plan solid and making sure that taxpayers don't have to pay more than they should. But the pension board apparently did not even argue that they were acting in the interests of their members.
The city and the unions decided to enhance pension benefits and, at the same time, to reduce contributions, and their contract was contingent on the pension board's approval. Everyone knows this means trouble, but the stock market was doing well at the time of the first plan, so everyone thought they could get away with it. When the second plan came around, a City Council member, Diann Shipione, blew the whistle, pointing out, among other things, the "ethically questionable" nature of the conflicts of certain pension board members, but the rest of the Council ignored her warning. For her trouble, she was charged by the city's ethics commission with disclosure of confidential information (she was cleared of the charges).
There were other conflicts involved. A big law firm, Vinson & Elkins, hired by the City Council to investigate, also represented the city in the related S.E.C. investigation (a conflict raised by the City Attorney but then ignored). Not surprisingly, its report said nothing about violations of the law or personal culpability. Then a new City Attorney was asked by the city to investigate, but like the law firm, the City Attorney was representing the city at the same time it was investigating the city (a typical conflict few municipalities seem to consider).
In another, related scandal, San Diego did not comply with state laws regarding waste disposal, because that would have meant lowering residential rates and increasing the rates businesses paid. By not complying, municipal officials jeopardized the state grants and loans the city accepted, which were contingent upon compliance. They also failed to disclose noncompliance to investors in new sewer revenue bond issues. According to the Levitt report, many of the people who knew about the noncompliance were directly responsible for preparing or ensuring the accuracy of the public disclosures.
There were similar disclosure problems regarding the pension plans. The publication of one damaging fiscal report was delayed until after the offering of bonds for a new stadium. Also, the report was doctored so that it hardly made mention of the City Manager's first pension plan.
Due to the many conflicts of interest, and with the full knowledge and acquiescence of nearly all of the parties, fiduciary duties and financial obligations were ignored, warnings were suppressed, disclosures were inaccurate, current obligations were placed on future taxpayers, businesses were given preference over residents, state and municipal laws were broken, and San Diego was brought to its knees, unable to issue bonds. According to the Levitt Report, officials "came to view the law as an impediment to be circumvented through artful manipulation."
The Report detailed wrongdoing by twenty-six city and pension officials, most of whom no longer work for San Diego, but only six elected officials were accused of having violated laws. Fifty-three officials declined to be interviewed by Levitt's aides. And according to many people, especially the City Attorney, the Report was weak, clearing officials of security fraud and asserting that the added pension benefits would likely survive legal challenge. This view was underlined by the leader of the city's largest government union, who called the Report "a validation of everything we've been saying publicly and privately to our members --'that their benefits are legal." As if nothing else matters. Some Council members said they did nothing wrong, but relied on professionals for advice.
The Levitt Report suggests several ways of ensuring this sort of thing does not happen again. Since the corruption of financial management in San Diego is so similar to that of companies such as Enron, the suggestions are similar to what Sarbanes-Oxley requires of corporations. Recommendations come under four categories: enhanced accountability, greater transparency, increased fiscal responsibility, and independent oversight. The recommendations include a permanent, independent Audit Committee and Auditor General; whistle-blower laws; personal certification of financial reports by senior officials; enhanced information systems; clear lines of authority supervising finances; an audit of internal controls; annual management reports; a Disclosure Practices Working Group that reports to the Audit Committee; selection of independent auditors who have no conflicts; changes in the pension board; sufficient time for City Council to provide oversight regarding financial disclosures; and a City Monitor, subject to S.E.C. approval, to oversee this remediation process.
These recommendations will likely have an important effect on other cities, whether or not they have similar financial and ethical problems. But the most important thing to take from this scandal is how damaging it is to ignore conflicts of interest, to see them as just doing business. When people take on fiduciary duties -- whether regarding pensions, disclosure, or whatever -- they should have no interests or incentives that in any way undermine those duties. If unions, businesses, and politicians don't like being left out, they can cry about it all they like with each other.
Another thing to take from this scandal is a weakness of the Council-Manager form of government. Council oversight over an executive it does not control may be stronger (even if often overly politicized) than that over a city manager. But here it seems that almost everyone was on board, and that even a strong mayor would likely not have opposed what occurred, given the city's ethical environment (a city manager should, at least theoretically, have risen above it). In any event, the city's residents changed the form of government to a Strong Mayor form.
San Diego's motto is Semper Vigilans, "always vigilant." This is a good motto not only to have, but to follow.