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Originally published Friday, May 3, 2013 at 2:38 PM

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Seattle city pension investment mired in legal limbo

$20 million deposited by Seattle’s pension fund in an offshore hedge fund is mired in legal limbo, or worse, after getting sucked into one of the nation’s biggest frauds.

Seattle Times business reporter

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Shorn of its complexity, the story reads like a financial soap opera.

A decade ago, the pension system for 16,000 current or retired city of Seattle employees invested $20 million in an offshore hedge fund. The secretive hedge fund’s managers made big loans to a prominent Minnesota businessman at extremely lucrative interest rates. Only one problem — he turned out to be running a huge Ponzi scheme.

Officials overseeing the Seattle City Employees’ Retirement System (SCERS) are still paying lawyers to disentangle the resulting mess.

The money they entrusted to Epsilon Investment Management remains in limbo. And the plan has even become ensnared in litigation by the trustee for the Ponzi scheme’s victims.

While no retirement payments are jeopardized by this single deal gone awry, it is a stark reminder of the trouble pension funds can get into by chasing high returns through untraditional investments.

Pension-plan officials have learned a few lessons, says Tim Burgess, who as head of the City Council’s finance committee, has chaired the system’s board since January 2012.

“Our private-equity investments have been very problematic, and Epsilon is clearly one of those,” Burgess said in an interview. “We need to get a better handle on this part of our portfolio and better understand the risks as well as the rewards.”

Those risks have become quite clear in the nearly 10 years since the city-pension fund first invested millions in the Epsilon fund, run by Florida-based manager Steve Stevanovich.

Alternative investments

Seattle is one of the few local governments in Washington state that runs its own pension fund. It covers all city employees except police and firefighters, and as of January had assets of $2 billion.

Like many public-pension funds facing anemic bond yields and volatile stock markets, Seattle’s plan sought to boost its returns by investing in hedge funds, private equity and other “alternative” investments. These now amount to $166.3 million, or 8.3 percent of its portfolio.

Seattle’s entanglement with Epsilon began in December 2003, when the pension system’s board agreed to invest $10 million in the hedge fund’s Global Asset Value II fund (known as Epsilon II), based in the British Virgin Islands. A year later the pension plan invested another $10 million.

As a federal judge would later point out, Epsilon II “was, by design, shrouded in relative secrecy.”

Epsilon officially described its investment style as “opportunistic,” meaning it could look at everything from relatively safe government bonds to the dicey debt of “distressed or mismanaged companies which may be in default or in bankruptcy.”

Only much later did Seattle pension officials learn that, for more than two years before their initial investment, various Stevanovich-controlled funds, including Epsilon II, had been pouring millions of dollars into paper companies set up by Tom Petters, a Twin Cities entrepreneur whose holdings included Sun Country Airlines, Polaroid and catalog retailer Fingerhut.

Every few weeks, one or another Stevanovich fund would advance a Petters subsidiary several million dollars at high interest rates — typically between 2 percent and 4 percent a month for a six-month loan.

As outlined in later court filings, the Seattle pension system’s money passed through at least three Stevanovich-run funds and two Petters-organized shell companies on its way to Petters.

The loans supposedly were to finance the purchase of consumer electronics at liquidation prices for resale to Costco Wholesale and other big-box retailers.

In fact, there were no electronics. The purchase orders and receipts used to document the deals were faked.

A 120-page report by PricewaterhouseCoopers found that Petters used most of the money raised from Epsilon and other investors to repay earlier investors, buttress his other businesses and support him and his top aides in opulent lifestyles.

‘False profits,’ real problems

All told, some $41 billion flowed in and out of the Petters scheme before it was shut down in 2008, the report concluded. Investors lost a combined $3.8 billion, making Petters’ enterprise one of the biggest Ponzi schemes in U.S. history.

He eventually was convicted of fraud and sentenced to 50 years in federal prison.

But not every investor lost money: Those, like the Epsilon funds, that got out early enough reaped millions in what the trustee calls “false profits.”

According to a lawsuit by the trustee for Petters’ affairs, between 2001 and 2006 eight separate Stevanovich affiliates pumped more than $2.5 billion into Petters’ operation. Some $878 million came from the master fund into which Seattle’s pension money was channeled.

But Epsilon stopped funding Petters in late 2006, nearly two years before he was shut down. By the time of the last interest payment in May 2007, the Epsilon funds had netted a $323 million profit on their dealings with Petters.

Petters, using other investors, kept his scheme going until federal investigators raided his offices in September 2008.

It was around that time that communications from Epsilon to the Seattle pension fund began to dry up. The pension fund got no annual report for 2008, and no clear explanation why.

By January 2010, the pension board decided it wanted out. A confidential memo from strategic adviser Teresa Wells to the Seattle system’s investment committee complained of Epsilon’s “lack of transparency” and was highly skeptical about the “too consistent” returns reported in unaudited monthly-account statements.

Shortly thereafter, Epsilon president Stevanovich told investors in Epsilon II and two related funds that they couldn’t withdraw their money. He blamed the ongoing credit crunch and said the funds’ audits had been delayed because of a nonpublic investigation by the Securities and Exchange Commission (SEC).

When the city’s pension system sued Epsilon to pry loose some account information — such as how much its investment was worth and where the money was invested — U.S. District Judge Richard Jones slapped it down.

“SCERS did not contract for transparency,” the federal judge wrote in May 2010. “Instead, it invested $20 million in a foreign-investment vehicle that by its own terms provided for only minimal transparency.”

The court’s powers, he wrote mordantly, “Do not permit it to transform SCERS’ investment into the investment it perhaps now wishes it had made.”

Winners in losing game

The pension system did learn something significant from the suit: Since other investors had earlier pulled out of Epsilon II, Seattle’s investment represented more than 95 percent of the Epsilon fund’s remaining assets.

That let the pension system take control of the Epsilon II fund in the summer of 2010 through legal action in the British Virgin Islands.

But seizing control didn’t bring the city any more good news about its frozen investment.

What it did bring was a subpoena from the SEC in October 2010 for records related to the agency’s ongoing inquiry, followed by a lawsuit brought by the Petters bankruptcy trustee, Minneapolis attorney Douglas Kelley.

While the Seattle pension fund had been wrangling with Stevanovich, Kelley and his investigators were busy poring through the records of Petters’ far-flung enterprise to unravel the layers of fraud and recover some of the lost billions for the scheme’s victims.

What they found, according to the suit, is that the Epsilon entities collectively were the Petters scheme’s biggest “winners.”

Kelley demanded millions of dollars from Stevanovich, Epsilon II and nearly two dozen affiliates — anywhere from $85.6 million to $3.2 billion. (Kelley declined several interview requests.)

The hedge-fund manager and the Ponzi-scheme trustee have spent most of the past two and a half years fiercely battling over technical issues.

In an emailed statement, an attorney for Stevanovich wrote that “had the [Epsilon] fund been aware that the Petters entities were engaged in a fraud, they would not have done business with those entities.”

Cecelia Carter, who became the Seattle pension fund’s executive director in early 2008, referred all questions to its outside attorney for the Epsilon affair, Brad Thoreson.

In an interview, Thoreson insisted that the pension system was, at most, an indirect beneficiary of the Epsilon-Petters relationship.

But he acknowledged that if Stevanovich and the Epsilon “master” funds he still controls are forced to give back all or part of their Petters-derived profits, what’s left of the Seattle system’s investment also will take a hit.

“If they win at the master level,” Thoreson said, referring to the trustee, “we lose.”

Compounding system’s troubles

For accounting purposes, the pension fund as recently as February valued its Epsilon II investment at just under $24 million, based on statements from the fund’s administrators.

The system’s auditors saw it differently. Since June 2010 auditors at Moss Adams have repeatedly recommended writing off the entire investment. Twice the pension fund ignored the advice, but last year it agreed to set aside $12.85 million — half the reported value of its Epsilon II stake at the time — to cover potential losses in the fund.

Given that Epsilon II represents just 1.2 percent of the Seattle pension system’s total assets, even a total loss would hardly break the pension fund.

But it would compound the system’s other problems. The pension fund’s 10-year average annual return of 6.65 percent is considerably below its assumed rate of 7.75 percent, which it uses to determine how well-funded it is. The plan’s total returns have lagged their benchmarks over the past year, five years and 10 years.

And all that is before the Seattle pension system fully recognizes the large losses its investment portfolio suffered during the recession.

Along with rising pension liabilities, those factors have pushed the plan’s funding level down to about 66 percent, said Burgess, the pension system’s board chair.

The plan’s funding level was 92.4 percent as recently as 2008, but it slid sharply during and after the recession. As a general rule, a plan should be at least 80 percent funded to be considered healthy.

“That has been a sobering reality for us,” he said.

Burgess said the Epsilon affair and issues with other alternative investments have prompted several reforms in the pension system’s investment methods.

The board has become more educated and involved, he said, and staff members have less leeway to make investment decisions on their own. The pension fund’s outside consultant, Pension Consulting Alliance, now provides strategic advice as well as monitoring investment performance.

For nearly two years, a working group within the Seattle pension system has been examining more far-reaching changes.

One option, Burgess said, is having the $72 billion Washington State Investment Board manage the Seattle system’s investments, as it does for nearly all other city and municipal pension funds in the state.

A bill to authorize such a management shift was introduced in the Washington House in February but went nowhere.

Shifting investment responsibility to the state would be “be really complicated, but I’m favorably inclined,” Burgess said.

“They’ve done a better job in terms of returns than we have ourselves.”

Drew DeSilver: business@seattletimes.com

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