FRANKFORT — A new report accuses the state pension system of improperly using $700,000 of its medical insurance money on an "ill-advised" real-estate deal, one that involved improper mingling of funds, a lack of basic investment research and internal conflicts of interest.
The Kentucky Retirement Systems in 2006 bought a 1.9-acre property next to its Frankfort offices for $752,000, three months after a local veterinarian paid $450,000 for it. KRS sold the land this year to the Kentucky State Police for $325,000.
In a July 6 report, the state Finance and Administration Cabinet's Office of Policy and Audit says the deal was bungled from start to finish, raising questions about an agency that manages more than $15 billion in assets for state and county employees.
"The purchase was not a sound business decision that benefited the KRS members," auditors wrote. They forwarded the report to Kentucky State Police — which has examined the deal once before — and State Auditor Crit Luallen for further review.
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On Tuesday, KRS executive director Mike Burnside said he agrees that the pension system could have acted more wisely, but he considers the matter closed.
All systemic weaknesses cited by the auditors were corrected, Burnside said. The officials behind the deal — Gordon "Don" Mullis Jr., chief operating officer, and John Krimmel, chief investment officer — resigned soon afterward. Then-executive director William Hanes retired the next year.
"We have done everything we need to do to wrap this up," Burnside said.
Still, a member of the KRS board of trustees said the botched deal may be indicative of larger problems at the pension system.
If KRS can't handle a simple land deal next to its headquarters, how confident should the public be in its more complicated investments, asked Christopher Tobe, a Louisville-based investment adviser to other pension funds and a former investment specialist at the state auditor's office.
"I literally think that our financial statements in this fiasco have been works of fiction," Tobe said. "I'm a trustee, and I have very little confidence in this system and its management."
Tobe said he was frustrated to find at least 14 documents cited by the auditors — mostly e-mail exchanges between KRS officials — that he didn't know existed, despite his requests to review records related to the property purchase.
"Even on the board, we get stonewalled when we ask for information," Tobe said.
Board Chairman Randy Overstreet disagreed and said relevant documents are available to trustees.
It would be unfair to tarnish the pension system because of "a one-of-a-kind issue," Overstreet added.
"We've vetted this issue thoroughly," he said. "These were two of our highly trained senior staff who made some basic mistakes that you or I would not have made if we were simply purchasing a house. It still amazes me. But they no longer work here."
Krimmel, now an investment adviser with Callan Associates in Atlanta, declined to comment. Mullis could not be reached for comment.
Deal gone wrong
The auditors focused on four lapses:
■ Failure to do research
In 2005, the KRS board discussed whether to buy the church property next door, either as an investment or for its own use. A veterinarian bought the property ahead of KRS for $450,000 in December 2005. When she couldn't get a zoning change to allow outdoor dog kennels, she sold the property to KRS in February 2006 for $752,000, a 67 percent markup in three months. The veterinarian died last year.
KRS didn't inspect the property or get an appraisal before paying that sum. After the sale it got an appraisal estimating the property's value at $135,000 to $290,000. This year, it sold the land for about half what it paid.
KRS filed an insurance claim to recover the money it lost in the deal, alleging that Mullis and Krimmel breached their fiduciary duties. But the claim has lingered for three years. The auditors noted that KRS has had difficulty getting the insurance company to return phone calls.
■ Misuse of funds
To pay for the deal, KRS took $700,000 from an insurance fund, a separate account restricted to cover medical expenses for retirees. It's not allowed to be tapped for investments or agency expenses.
KRS classified the $700,000 on its books as an unsecured loan to Perimeter Park West, the subsidiary of KRS that owns its offices and bought the adjacent land. Most of the loan was forgiven four months later, although Perimeter Park West had the assets to repay the loan.
■ Mingling of funds
KRS merged insurance and pension funds to buy the land, in violation of tax laws that treat such funds differently and require them to be kept separate, auditors wrote.
■ Conflicts of interest
KRS paid $28,012 in fees to Summit Realty Group for representing it in the deal. Frankfort developer Bill Crumbaugh, who is paid as KRS' property manager, recommended Summit, where his son Will Crumbaugh is an agent. Auditors said the relationship was not disclosed to relevant KRS officials.
"The undisclosed involvement of (the Crumbaughs) with the purchase does appear to be a conflict of interest," auditors wrote. "Also, it is possible that this conflict of interest affected the negotiation of the real estate commission related to the purchase, or at a minimum could be perceived by the public as having an effect."
On Tuesday, Bill Crumbaugh denied a conflict of interest. He said he recommended his son's firm because another agent there was a friend of the veterinarian who owned the land, which he thought could benefit KRS.
Burnside, KRS executive director, said he would not comment on the conflict of interest allegation, other than to note that KRS is putting Crumbaugh's property manager contract out for bidding for the first time in years.
'Kudos to you'
In the past, KRS blamed the land deal squarely on Mullis and Krimmel.
But after interviewing past and present employees and reviewing e-mail and board meeting minutes, the auditors determined that KRS leaders knew about and even encouraged the deal. E-mail to then-executive director Hanes before the land was purchased show that KRS was prepared to spend as much as $700,000.
"Although the two former officers exceeded the authority granted unto them, insufficient management oversight and a weakened internal control structure also helped contribute to allowing this transaction to occur," auditors wrote.
Auditors cited a Dec. 27, 2005, e-mail in which Hanes praised Mullis for continuing to pursue the property after the veterinarian bought it.
"I'm convinced that our purchase, even at a higher than anticipated amount, will serve the significant needs of KRS into the future," Hanes wrote to Mullis. "Kudos to you."
Hanes, who moved to Palm Beach, Fla., said he does not remember writing that e-mail.
"I think it's very clear that I was not participating with Don Mullis or John Krimmel on these activities," Hanes said. "They were communicating exclusively between themselves."
Tobe, the skeptical KRS trustee, said he long suspected that Mullis and Krimmel were turned into scapegoats once details of the deal leaked out and embarrassed KRS.
"It seems extremely unlikely that this is the one bad deal we've ever made, doesn't it?" Tobe said.