Orange County Investments: The Need for Stronger Oversight

The County investment policy prohibits investments in the commercial paper or medium-terrn notes of corporations that are not organized and operating witllin the United States. The policy also prohibits investments in derivatives. Response: Agrees wit11 tltefitding.

Findings pertaining to the revised December, 2008, JI'S are:

Tlle TOC is not functioning as an oversight committee as it was originally intended and as set forth in its bylaws, and as a consequence, is not as effective as it should be. Response: Disngpees who/i'y with tlt e finding. The TOC is functioning exactly as it was originally intended and as set forth in its bylaws. The bylaws refer to the committee's authority as contained in Govcrment Code sections 27 130 through 27 137. It is important to note that there is a direct, one-for-one correspondence between the Government Codes and the bylaws. The general purpose of the TOC is contained in section 271 30: "The Legislature further finds and declares that the creation of county treasury oversight committees will promote the public interest by involving depositors in the management of their funds." This has been accomplished as individually delineated by various Government Code sections. As validated by annual independent audits, the TOC has been in compliance with these sections since its origination: $27 13 1 (TOC Bylaw Rules 4 & 5) Outlines establishment and determinations of size and membership. $2713 2 (TOC Bylaw Rules 6 - 10) Outlines membership and the pool of candidates. $27132.1 (TOC Bylaw Rule 11) Prohibition against members employment by campaign contributors. $27132.2 (TOC Bylaw Rule 12) Prohibition against fundraising by a member for a treasurer. $27132.3 (TOC Bylaw Rule 13) Prohibition against men~bers'e mployment in the financial services industry. $2713 2.4 (TOC Bylaw Rule 2) Adherence to open meeting laws. $2713 3 (TOC Bylaw Rule 27) Review and monitoring of the investment policy prepared by the treasurer. Note that independent daily monitoring of the investment pool had been accomplished for nearly one year by the Auditor- Controller's 111ter11al Audit Section, This was subsequently reduced to ten times monthly on a random basis. $271 34 (TOC Bylaw Rule 28) Periodic audits for compliance with the bylaws. $271 37 (TOC Bylaw Rule 29) No committee interference with the day-to-day operations and decisions of the treasurer. Tllirleen audits of the TOC have been conducted since its inception. None have found the committee to be out of compliance with the Governmnent Code, and by association, none have found it to be out of compliance with its bylaws.

The Treasury Oversigl~Ct ommittee (TOC) has been operating, for the most part, with only three members, all l~oldii~Cgo ul~typ ositions, for most of2007 and 2008. In December, 2008, two n~embersre presenting tlae public were added. The Government Code recommcnds that: the size of this cormnittee be from 3 to 1 I members. Respotzse: Disngrees wlrolly with t/lefirtding. The minutes of the committee show that it had three members present from October 3 I, 2007 through October 15,2008. Prior to October 3 1,2007 there were four to five members. Mr. Jeffrey Thon~asw as listed in the minutes for the January 3 1,2007 and ApriJ 25,2007 meetings and Mr. Ken Henderson, a iifth member, was listed in the minutes for the April 25,2007 and July 25,2007 meetings. Mr. George Jeffries, representative for outside participants was present for the October 3 1,2008 meeting. A fifth member, Dr. Raghu P. Mathur, public member, was appointed by the Board of Supervisors on October 28,2008.

PFM Asset Management, a consulting firm, was hired in late 2007 to perform a risk analysis of the County's investment pools. In their report PFM concluded that the County's investments were of high quality and managed in a prudent manner. The firm also offered some suggested changes to the IPS that were later adopted. However, PFM reached a questionable conclusio~a~b out the Whistlejacket SIV by expressing an opinion that "No portfoIio holdings are impaired or in present danger of becoming impaired." Evaluating investment compliance with the IPS was oulside the scope of PFM's ~aeviewP. FM limited its interviews and research to Treasury staff and Treasury documents. Hes~onse:D isngrees partially wif/r f/zef indirrg. PFM issued a report on January 28,2008. Although Whistlejacket had been placed on "credit watch" by the rating agencies on November 30,20107, there was no information in tlie market to reach a conclusion that the asset was either impaired or in present danger of becoming impaired. It was still rated as investment grade, and paying the required interest payments as of January 28. Also on Ja~~ila2ry8 ,2008, Moody's Investors Services issued a Global Credit Research Atinouncement affirniing their "A3 rating of Standard Chartered PLC, with a stable outlook following an announcenlent by the bank that it intends to fund the debt obligations of its Structured Investment Vehicle (SIV) Whistlejacket as they come due." On December 3 1,21007, tlie two assets were priced at 97.701% and 99.138% (of purchase price). It was iiot until a subsequent downgrade of Whistlcjacket on February 12, 2008 followed by a downgrade by Standard and Poor's on February 15,2008 tliat questions concerning the impairment of Whistlejacket stlrfaccd. The Grand Jury Report criticizes PFM for being inco~isistentw ith the internal audit of tlie treasury as of December 3 1,2007 which indicated valuation troubles with Wliistlejackct. This report was not issued until June 11,2008, well after the PFM report. The treasurer wrote down tlie recorded value of Whistlejacket after the Forbes article surfaced indicating problenls with the asset. Had the scope of PFM's review included IPS compliance, it would not have affected their opinion colicerning the impairment of assets. Moreover, including IPS compliance work in the PFM contract would have been an imprudent use of public funds as the Auditor-Controller had been co~iducting daily compliance work of the entire portfoiio. The nature of PFM's work, as indicaled by the title of the report was the "Risk Analysis of the Treasurer's Jnvestnient Pools." It is expected that their review be linljted fo the treasury staff and documents. A review of compliance audits by two outside firnis that later merged (Moreland & Associates and Macias Gini & O'Connell) showed that the audits were limited in scope. Neither audit completely dddresses the sections of Government Code and the IPS regarding prohibited investments. Res~o~zseD:i sagrees ~v/zoYlyto ii/r fhejitttii~~g. The Graiid Jury report infers that the annual audit does not completely address conipliance sections of the IPS related to prohibited investments because lhis specific wording is not included in the report. However, Moreland's audit procedures in Iteni # 14 of their report on the Annual Audit of Treasuly Investment Compliance for the Year Ended 12/3 1/07 stated: "Investments maintained in the pol-tfolios shall comply with investment criteria as stated in IPS Sections IV, V and VI, including the n~axiniuma llowable percentage by type of security, allowable percentage per issuer, lnax term limits and credit rating requirements." Section V of the IPS for the period audited (from the old IPS for 2007) specifically lists the types of investments that are prohibited. This sanie provision is included in the scopc of !he audit as delailed in Moreland's engagement letter. Although the Moreland Audit Report does not specifically state tliat no prohibited investinents were found, it does state that they audited for conipIianlce with Section V. Furlher, they state: "In our opinion, excepit for the noncompliance described in the accoriipanying schedule of findings, recommendations, and responses, management's assertions that the Orange County Treasurer complied with the aforementioned requirements for the year ended December 3 1, 2007, are fairly stated in all material respects." No noncompliance itenis were noted concerning psollibited investments. P.11 'The investnient in SIVs were inip~udenfto r several reasons. Anlong them are: safety and liquidity, the Iiigliest priorities for the County's investments, were not adequately considered; the TOC never reviewed them; and, 56 out of 58 California counties chose not to invest in them. Resy~onse:D istrgrees partia fly with tJrefirtciing. Although it is correct that the TOC did not spe?cifically review them, the TOC reviewed their bond ratings and the coinpliance monitoring reports provided by extertial sources. It is not within the scope of the TOC to make investment decisions or prudence dete~minations.T he only persoii who is given the duty and responsibility of determining prudence is the elected Treasurer.

There is confusion surrounding the purpose of the TAC, its ~neinbership,a nd the advice il gives to tlie Tnasurer's OElce at its quarterly ineclil~gs. Res~onse:D isagrees wltolly witlt tlrefinding. In the past, tlie Treasury Oversight Committee has had little colitact with the Treasury Advisory Committee (TAC). The TOC had not considered the TAC to be part of the cot~trols tructure. Accordingly, the TOG has no basis to evaluate the finding. The PFM report recommended occasional joint meetings with the TAC, and the TOC agreed with the recommendation. Responses to Recommendations: R.2, R.3, R.S(a)(b), R.6(a)(b), R.8, R.9 and R.11