MELLOW SEEKS RECOVERY OF $130 MILLION IN STATE FUNDS

            HARRISBURG, May 27 – State Senate Democratic Leader Robert J. Mellow today sent a letter to Pennsylvania State Treasurer Rob McCord asking for a full inquiry that includes possible legal action to recover more than $130 million in state funds lost as a result of a securities lending arrangement gone awry.           

Pennsylvania lost $133 million as a result of Mellon Bank N.A. exposing taxpayer funds to asset-backed securities issued by Sigma Finance.  Sigma Finance—an investment company managed by a London-based manager—collapsed last September amid the credit crisis. 

“A complete and thorough review is necessary to determine if other Pennsylvania securities are now exposed or in future jeopardy; whether the General Assembly should act to put more safeguards in place; and if we are able to recover the $130 million that was lost as a result of this investment scheme,” said Mellow (D-Lackawanna/Luzerne/Monroe).  “In addition, this examination may conclude that civil action is warranted against Mellon, Sigma Finance or the rating agencies in order to recover taxpayer dollars.” 

Mellow said the loss of these funds has had a deep and significant impact on key investment funds.  Millions of dollars have been lost from the State Worker’s Insurance Fund (SWIF) that benefits businesses, the tuition account program for college students, as well as the Tobacco Settlement Fund that pays for numerous health care initiatives.  Plus, millions of public pension dollars and other important state investment funds are affected.  As a result, he said a significant imbalance between assets and liabilities now exists. 

In a May 22 letter, state Treasurer Robert M. McCord notified the governor and legislative leaders of the “significant and unusual loss” and the steps that he has taken to address the problem. 

Mellow said McCord’s letter raised the potential that there were “questionable and seemingly unregulated practices involving the investment of state funds and the exposure of taxpayer dollars.  These practices include arms-length agreements between the custodians of Commonwealth funds, third party borrowers of securities and investments by the custodian that are not accountable to state officials.” 

Mellon Bank N.A. was able to access taxpayer funds as a result of a Securities Lending Agreement that it had with the state Treasury Department.  The securities lending program has been used to generate revenues and has successfully raised over $400 million in revenues since 1998.  However, as a result of Wall Street’s demise in September, the program experienced significant losses creating taxpayer liabilities. 

The securities lending program enables fund custodians—in this case Mellon Bank, N.A.—to lend Pennsylvania securities to other investment firms and earn a profit on revenues generated.  It also receives a commission to operate the program. 

“Apparently, these arms-length transactions do not directly involve officials from Pennsylvania and there is no accountability chain if the investments fail—except that the taxpayer or the annuitant of a large pension fund gets the bill,” Mellow said.   “While the securities lending program was lucrative in good times, what we may find is that we need to strengthen taxpayer investment safeguards to prevent this huge loss from happening again in the future. 

“We also need to take a good, long and hard look at whether we should initiate a civil action to recover the lost money,” Mellow said. 

Mellow asked that the State Treasurer provide a full inquiry into these investment practices and to use the authority of his office to pursue any use legal remedies with the Attorney General or Office of General Counsel, if the facts warrant civil action and report back to the General Assembly. 

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EDITOR’S NOTE: FOLLOWING IS THE TEXT OF SENATOR MELLOW’S LETTER TO TREASURER McCORD: 

Dear Treasurer McCord: 

On Tuesday, May 26, 2009, I received a copy of your letter to Governor Edward Rendell detailing the significant and exceptionally large loss of over $130 million in state funds as a result of the investment practices of Mellon Bank, N.A. 

This letter is very troubling because it reveals a loss of state funds that will drain millions of dollars from the State Worker’s Insurance Fund (SWIF) that benefits business; the tuition account program for college students, and the Tobacco Settlement Fund that provides for numerous health care initiatives.  In addition, millions of public pension dollars and other important state investment funds were lost. 

Your letter to Governor Rendell points out a number of questionable and seemingly unregulated practices involving the investment of state funds and the exposure of taxpayer dollars.  These practices include arms-length agreements between the custodians of Commonwealth funds, third party borrowers of securities and investments by the custodian that are not accountable to state officials. 

In addition, it is clear that there is the potential—in these custodial arrangements—for the  amassing of huge profits built on the backs of taxpayers that result from commissions, fees and compensation paid to intermediaries with little or no investment transparency.

While your letter identified a specific instance where taxpayer funds are at risk, the reality is that this may be only a small part of a larger problem.  As you may know, Mellon Bank was able to access state funds as a result of a 1998 Securities Lending Agreement between the bank and the Treasury.  As a result of the investment scheme it developed, and the decisions it made, Mellon exposed taxpayer funding to asset-backed securities issued by Sigma Finance.  Amid last September’s credit crisis, Sigma could not sustain itself and collapsed. 

While the securities lending arrangement with Mellon and others generated revenues for the Commonwealth over the years, it appears that some of these investments may have been risky. Almost certainly, third party transactions involving Commonwealth securities were unregulated -- thereby raising issues involving a potential breach of fiduciary duty. 

As troubling, it appears that Mellon Bank in its role as the intermediary, assumed very little risk on either end of the investment string and was fortified against loss simply by assigning risk to either the taxpayer or the third party. 

Your letter illustrates the significant loss Pennsylvania taxpayers now face as a result of the decision by Mellon to lend securities to Sigma Finance, Inc. that were then used to finance its operations.   To make up for the lost revenue from the investment debacle, either taxpayers will be required to dig deeper or additional budget cuts will have to be made. 

As Treasurer, you should be credited with opening up the investment chains to scrutiny and providing legislative leaders with a full accounting of Commonwealth funds involved in this arrangement.  However, identifying the problem is just the first step.  To get to the facts, we need a full inquiry concerning what happened to the hundreds of millions of state funds that have been lost—including an investigation into the investment practices of state funds by custodians of taxpayer dollars. 

Based on this inquiry, we will be able to understand if other taxpayer or annuitant funding is exposed in similar arrangements to a similar type of loss.  Further, this assessment will provide lawmakers with necessary information to make an informed judgment about whether the legislature needs to move quickly in adopting laws to prevent this from happening again.  And, a complete and thorough inquiry will enable you to assess whether a civil action seeking recovery of the loss should be initiated by the Attorney General on behalf of the Commonwealth or the Office of General Counsel, against Mellon Bank, Sigma and perhaps the rating systems themselves. 

An appropriate full inquiry into these investments and possible legal action for recovery of these lost funds should be the first step toward putting the necessary safeguards in place to protect taxpayer and annuitant funds. 

As the Democratic Leader of the Senate of Pennsylvania, I am looking to you to provide additional information on this matter to the legislative leaders and to contact the Attorney General on the possibility of seeking legal recourse on behalf of the citizens of Pennsylvania. 

Sincerely, 

Robert J. Mellow
Senate Democratic Leader

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