In the News: Recent Developments

Wednesday, February 7, 1996


By LESLIE EATON ( Special Report )

A special report – Public Money Foots the Bills For ‘Privatized’ Foreign Aid

Business does it better. That is the rallying cry on Capitol Hill and in statehouses across the country, where legislators are turning over to private companies traditional government functions ranging from running jails to exploring outer space.

But an experiment in “privatizing” foreign aid has shown that the private sector does not offer a guaranteed cure for problems that critics say have plagued traditional foreign assistance programs: mismanagement, ineffectiveness, political infighting and conflicts of interest.

All these have cropped up at the Czech and Slovak American Enterprise Fund, part of a program that now involves more than $1 billion of taxpayers’ money and some of Wall Street’s biggest names. Similar funds have suffered from some of the same — though less severe — problems.

Congress started the enterprise funds in 1989 to foster capitalism in Poland and Hungary, and the program soon spread to other formerly Communist countries. The funds were to invest in Eastern European companies, much as Wall Street’s venture-capital funds finance start-up or struggling businesses. There was one big difference: taxpayers, not investors, put up the money.

And it is the taxpayers who face the losses in the Czech and Slovak fund. Government documents obtained by The New York Times under the Freedom of Information Act and from both critics and supporters of the program — as well as interviews with United States officials, former fund employees and American executives familiar with the program — draw a picture of failure at the fund:

  • Bad investments appear to have eaten up a third to two-thirds of its$26 million investment portfolio.
  • The costs of running the fund are surging, to $3 million last year.
  • The fund has made few loans to small businesses.
  • It has not developed and trained local people.
  • It has had little, if any, effect on government policies in either the Czech Republic or Slovakia.

The fund “is failing to achieve either commercial success or developmental impact,” according to an independent evaluation done last year by Development Alternatives Inc. of Bethesda, Md., for the United States Agency for International Development, which provides the money for the program. “The investments are suffering major losses, and are generally marginal both in market and in development terms,” the evaluation said.

Furthermore, the fund’s longtime chairman was ousted from its board in November after a Federal investigation involving procurement problems and accusations of conflicts of interest. The United States Attorney’s office in Washington says it is considering whether to bring charges in the matter, at the heart of which is the former chairman’s personal relationship with his assistant and payments for computer work that the fund made to a third person who is part of their household.

Also, a key member of the fund’s volunteer board, who pushed to remove the chairman and improve the fund’s performance, was himself forced out in December by directors loyal to the old chairman — and a second board member quit in protest. The Clinton Administration is expected to decide in the next few weeks if the fund can be salvaged or should be closed.

The Czech and Slovak fund’s experience, critics say, shows that trying to meld business practices and government policies can lead to the worst of both worlds: a program that is vulnerable to political meddling, but lacks the accountability that businesses have to their investors as well as the rules and regulations that government uses to keep its employees in line and programs on track.

The problems at the fund have emerged at a time when the program as a whole is growing rapidly in size and importance, even as traditional foreign assistance falls victim to tight Federal budgets and doubts about its effectiveness. And the program is expanding to some countries that have almost no experience with capitalism.

Today there are 10 funds with total capital of $1.3 billion that can invest in more than a dozen countries, including Albania, Belarus, Estonia, Latvia, Lithuania, Moldova, Romania, Russia, Ukraine and Uzbekistan. And more are probably on the way: Croatia and Macedonia are lobbying for funds of their own, for example.

Doing business in these countries is clearly difficult, which obviously accounts for some of the funds’ troubles. And venture-capital investing always involves a lot of risk.

To be sure, many of the funds are too new to have track records, and at least one, in Poland, is widely regarded as a big success.

But some people who have investigated the funds say that problems stem from the very nature of the program. “I think you can say there is potential for abuse,” said Robert R. Chapman, an assistant United States attorney in Washington.

Because the funds would be venturing into terra incognita, the so-called SEED Act of 1989 (SEED stands for Support for Eastern European Democracy) did not specify any targets for them to meet. Instead, it set two broad mandates: to help develop the private sector and to promote policies and practices necessary for capitalism. What would happen if the funds lost all their money — or even made a profit — was left unclear.

To insure that they have enough flexibility to do their work, the funds are subject to little control from Washington. Instead, each is run by an unpaid board originally picked by the President. The boards vote to approve new members suggested by the White House, and can vote out current members, making the boards almost completely autonomous.

The boards have included some of the best-known names on Wall Street and in Washington: E. Gerald Corrigan, former president of the Federal Reserve Bank of New York; W. Michael Blumenthal, former Secretary of the Treasury; John C. Whitehead, former co-chairman of Goldman, Sachs & Company; John Train, the investment adviser and author, and John P. Birkelund, chairman of Dillon, Read & Company.

But as the number of funds has grown, finding and keeping strong directors has become more difficult. “There are not enough good people,” said one longtime Congressional aide who insisted on anonymity.

At the Czech and Slovak fund, two of the most experienced directors — David O. Maxwell, former president of the mortgage giant known as Fannie Mae, and former Representative Charles A. Vanik, an Ohio Democrat — resigned in 1994 and 1995, respectively, and were replaced with friends of the chairman.

Central Figure A Banker but Not A Venture Expert

From the fund’s inception in 1991, that chairman was John R. Petty, an Assistant Secretary of the Treasury in the Nixon Administration who retired in 1988 as chairman of the Marine Midland Bank of New York.

Mr. Petty is not a venture capitalist, however, and that may partly account for some of the problems with the fund’s investments.

One measure of those problems is the amount of money the fund shows as reserves, basically the amount it expects to lose on its investments. In the year ended September 1995, those reserves more than doubled, to $9.6 million from $4.3 million. The 1995 figure represents 37 percent of its investments.

The two board members who recently left, Joseph S. Fichera and Robert M. Rubin, suggest the level of reserves should be much higher; one investment professional familiar with the portfolio has suggested 65 percent. While the other funds also have reserves, they are far lower; the Polish fund’s expected losses amount to about 8 percent, but that is almost matched by projected gains.

Among the troubled investments of the Czech and Slovak fund are bakeries that went broke, a joint venture with an American company that was supposed to produce fertilizer and cattle feed, and companies that make everything from charcoal briquettes to motorcycles.

“It was the blind leading the blind,” said Harvey M. Schuster, an American who runs the Corus Funds, a mutual fund company in Prague. “The Czechs didn’t know how to manage and the Americans didn’t know how to invest.”

Mr. Petty was interviewed in November and again last week. In a brief telephone interview Thursday from Hawaii, where he was vacationing, Mr. Petty said that the main issue was risk and that the fund’s original board “did not believe Congress created the fund to do transactions that would compete with private funds.” He canceled a longer interview scheduled for Friday and could not be reached for further comment but later provided extensive written material.

Managing Risk Hands-On Way To Run a Fund

In the past, Mr. Petty has said that the fund’s problems date from its early days, when he said it was under pressure from the State Department and the Agency for International Development to make investments more quickly than he would have liked, according to several people with whom he discussed the matter. Executives of other funds have made similar complaints.

While the fund’s investments have performed poorly, the Czech economy has been booming and its entrepreneurs thriving. Indeed, international aid organizations are so confident that the Czech Republic will prosper without further help that they are pulling out of the country.

Not surprisingly, the State Department has suggested that the fund wind down its Czech operations and focus on Slovakia, where the economy is faring poorly.

Despite difficult circumstances, most of the fund’s problems “are related to management,” according to a report by the Institute for East West Studies, a New York research center that is generally a big fan of the fund program.

At the successful Polish fund, the board sees its job as “finding the right people to run it and supporting them,” said the chairman, Mr. Birkelund. “If I tried to run it myself, that would be impossible.”

But Mr. Petty, who is 65, took a different approach. Unlike other fund chairmen, he did not have a substantial job in the private sector. Instead, he had his own office at fund headquarters, in Washington, and was involved in daily operations. At times he also served as chief executive, again in an unpaid capacity. Even after he stepped down as chairman last August, he remained a director and chief executive.

In a memo he wrote last October to the new chairman, Lawrence McQuade, Mr. Petty said that in the beginning he served as a hands-on executive to get the fund up and running quickly, as the State Department had requested. He intervened later when various people did not work out, according to the memo. The fund has gone through several chief executives in its brief history and is now searching for a new one.

But former employees, including Stephen L. Wald, who served as the fund president in Prague in 1992, and Karel Kosman, former head of the Prague office, complained that Mr. Petty’s involvement amounted to interference. Mr. Petty says he was simply trying to enforce accountability. Both men resigned under pressure from Mr. Petty within a year.

Questions Arise Mixing Business And the Personal

Mr. Petty probably could have continued as chairman and chief executive except for two developments. One was the arrival on the board of two Wall Street executives unconnected to him: Mr. Fichera, a former investment banker at Bear, Stearns who is now a fellow at the Woodrow Wilson School of International Studies at Princeton, and Mr. Rubin, executive vice president of the AIG Trading Group, which trades commodities and currencies.

The other development was complaints made in December 1994 by some fund employees in Prague that led to an investigation by the inspector general of the Agency for International Development.

According to a report of the investigation obtained through the Freedom of Information Act, in 1991 Mr. Petty put his longtime assistant on the fund’s payroll, and soon got her a raise of more than 50 percent, to $85,000. They became romantically involved and in October 1992 he moved in with her but did not formally inform the board of this until last March.

The assistant, Alexandra Ossipoff, resigned last July after admitting that in 1991 she had fabricated documents in an effort to get the fund and its sister Hungarian American Enterprise Fund, with which it shared an office, to pay $1,500 for computer consulting work, according to the inspector general’s report. The work was done by another member of her household in McLean, Va., named Judy Shaw.

Mr. Petty, the report said, ordered the chief financial officer of the two funds to pay the $1,500 in a memo that included the fabricated documents, which were supposed to make it look as if the funds had obtained competitive bids on the computer work. The inspector general’s report says that Mr. Petty approved other bills and signed checks to the consultant even after they were living in the same house.

Over all, Ms. Shaw received about $100,000 from the two funds while living with Ms. Ossipoff, according to several people familiar with the transactions. In an interview earlier this week, Ms. Shaw said that while she could not confirm the exact figure, $100,000 was “in the ball park”; she said that it included not just several years’ worth of consulting services, but also hardware she purchased for the funds.

Describing herself as an expert in Eastern European telephone systems and noting that the Czech and Slovak fund’s staff “felt free to call me 24 hours a day,” Ms. Shaw said “they certainly got their money’s worth.” She also said that no one raised concerns about the fact that she shared a house with Ms. Ossipoff or complained to her about the computer system she installed. (Among the grievances expressed by Mr. Wald and Mr. Kosman, the former fund officials, however, were problems with the computer system, according to the inspector general’s report.)

Repeated attempts over the last week to reach Ms. Ossipoff were unsuccessful. There was no response to messages left at her house and with Mr. Petty.

In his memo to Mr. McQuade, Mr. Petty defended Ms. Ossipoff’s salary as proper given her experience, responsibilities and hard work, and said that the fund’s chief executive at the time was aware of their relationship.

He described Ms. Shaw as “an unusually reliable, experienced, favorably priced, first-rate supplier.” He said he did not know at the time that Ms. Ossipoff had fabricated bids, an action he called “stupid and pointless in the extreme,” but stressed that the work was performed at a fair price and that taxpayer money was not misused.

Road to Resignation An Official’s Visit Brings On an Exit

In various letters and documents, Mr. Petty repeatedly said that the inspector general’s report found no evidence of wrongdoing. And he suggested that the Agency for International Development might be looking for problems at the fund to justify the agency’s existence at a time when Congress is considering cutting its budget.

The inspector general’s report said its findings had been discussed with prosecutors, who were described as saying that Federal criminal statutes had not been violated because the fund is not a Government agency. But the United States Attorney’s office said recently that it had not reached a conclusion and that the matter remained open.

The development agency did not see the inspector general’s report as an exoneration of Mr. Petty, Michael D. Sherwin, the agency’s procurement executive, told the fund board’s audit committee at a meeting in October. In a memo he prepared for agency files, Mr. Sherwin said that he explained to the directors that the inspector general did not make recommendations in its investigations and that that fact should not be taken to mean it believed there had been no wrongdoing.

“I went on to tell the committee that had these matters involved Federal employees, these employees would indeed be facing criminal indictments and immediate administrative action to remove them from their jobs,” wrote Mr. Sherwin, who said he attended the meeting at the request of the White House.

He then told the committee that if it did not do something about Mr. Petty, the Government might close the fund, according to his memo.

Mr. Petty, who has denied all wrongdoing, could not be reached for a specific response to Mr. Sherwin’s memo.

In an interview, Mr. Sherwin said that he appeared before the committee, a highly unusual action in the fund program, because of “the nexis of the relationship of the woman doing the phony bids, the woman who got the job and the chairman.” While such links might be acceptable on Wall Street, he added, “these were things we could not tolerate.”

After Mr. Sherwin left the committee meeting, Mr. Petty agreed to resign, although he did not do so for another month.

Change of Command Longtime Ally Steps Into Post

The board’s new chairman, Mr. McQuade, did not press for the resignation. Mr. McQuade, a former Assistant Secretary of State who recently left Prudential Mutual Fund Management, joined the board at Mr. Petty’s request. The two have been friends “since we were Young Turks on Wall Street,” Mr. McQuade said, adding that he was “much more sympathetic to John than some people are; after all, he gave of his life to build the fund and was not getting paid for it.”

Shortly after Mr. Petty left, Mr. Fichera, his chief critic, was voted off the board and Mr. Rubin quit.

Mr. McQuade said that Mr. Fichera’s dismissal had nothing to do with Mr. Petty’s departure; rather, he said, it was because of a personality conflict. But both Mr. Fichera and Mr. Rubin said the dismissal was an attempt to direct blame for the fund’s problems toward the very person who was trying to fix them.

As a result of all this turmoil, the fund’s future is unclear, although the Clinton Administration seems likely to recommend changes and may try to merge the fund with a more successful fund or close it down. A lawyer for the fund’s audit committee, Robert C. Odle of Weil, Gotshal & Manges, said that the issues raised in the inspector general’s report were “examples of the fund’s serious corporate-governance problems.” He said other funds would be able to avoid such problems by separating the chairman and chief executive functions, as the State Department recently suggested.

Nonetheless, the debacle at the Czech and Slovak fund calls into question the autonomy of the funds as a whole, and the power that is vested in their boards.

“The funds should move more into being government-type things or pure private sector — to inject some accountability,” Mr. Rubin said. As it is, he added, “they are neither fish nor fowl.”

Copyright 1996 The New York Times Company

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