City Hall's Rats Run Free

— The national accounting firm of KPMG must feel like the Pied Piper of Hamelin, now tootling around San Diego. KPMG's mission is to rid the town of rats. But in two cases, the firm hasn't received the information it needs to do its job. San Diegans, beware: as the citizens of Hamelin found out, the Pied Piper doesn't like to be hoodwinked.

Peregrine Systems found that out. In early April 2002, it fired its accounting firm, the disgraced Arthur Andersen, and hired KPMG. Less than two months later, KPMG was fired. Peregrine explained that there was a conflict of interest: KPMG was a reseller of its software. KPMG hit the roof. It wrote a blistering letter to the Securities and Exchange Commission, saying that it "could no longer rely on the representations of management." Several times in that letter, it talked about possible fraud at Peregrine. Of course, KPMG was right. Before long, the details of the $500 million fraud, which has led to multiple indictments, came oozing out.

KPMG "wrote a powerful letter in '02 saying, 'We can't do our job unless you are more forthcoming with information,' " says Pat Meyer, an attorney who is pressing one of several civil suits against former Peregrine officers and board members. "KPMG was never allowed to complete its work because Peregrine was not prepared to answer some of those tough questions."

The same is going on with the City of San Diego. In January of this year, the city admitted in an official federal filing that it had been cooking the books and reporting false numbers in its bond prospectuses dating back to 1996. Federal officials launched criminal and civil investigations. In February, the city hired Vinson & Elkins, Enron's former law firm, to do a supposedly objective study of how the city got into its mess and how it could get out. In April, the city hired KPMG to audit city books for the 2003 year. Because San Diego is under investigation for not telling the truth in bond prospectuses, it can't sell bonds until that audit comes out.

Last week, KPMG wrote assistant city attorney Les Girard, saying that it can't do its job until it sees interviews and documents, including e-mails and electronic documents, to see if there has been "a violation of any laws, rules, or regulations having the force of law." It turns out that KPMG has been exchanging letters with the city for several months. It says it can't provide an audit until the city gives assurances that it is trying to find and eradicate the rats in city hall's basement.

In this correspondence, it is clear that all along, Vinson & Elkins was not hired to sniff out rodents, despite the soothing talk from Mayor Dick Murphy and other politicians. In a letter to Girard on October 11, KPMG noted, "At our meeting on August 27, 2004, both the city and Vinson & Elkins made it clear to KPMG that Vinson & Elkins was not retained to investigate issues relating to intent or whether any individual's conduct violated any law, rule, or regulation, and that the scope of its investigative efforts were not designed to do so" (italics mine).

Although Vinson & Elkins was told not to look into individual culpability, it came out with a conclusion that must have helped it earn its $2 million from the city: "It is difficult to attribute the city's failure to fully and accurately ascribe [pension] matters to intentional misconduct on the part of individual employees," Vinson & Elkins said in its report. Huh? Such a comment was beyond the law firm's mandate. KPMG says it can't rely on the statement and needs assurances from the city that it will probe any wrongdoing before it can come out with an audit.

Now hear this. After the Vinson & Elkins contract was announced, civic activist Mel Shapiro tried to get a copy from the city. "I was told it was attorney-client privilege. I couldn't get it," he says. But Shapiro is shrewd; he got it through other means. Here is what Vinson & Elkins pledges to the city in the original contract: "We will of course make our best efforts to achieve a result in this inquiry that is satisfactory to the city." Hmmm. The next sentence hedges a bit, says Shapiro, saying that there are always risks in litigation, and the outcome can't be guaranteed.

In essence, Vinson & Elkins is saying, "We won't be totally honest. Where's my two million bucks?" observes Shapiro. Paul Maco, principal author of the report, did not return phone calls to explain how his firm wandered outside its mandate and whether it delivered on its promise to create a favorable outcome by not looking for illegalities.

"I was misled when I read the Vinson & Elkins report," says Mike Conger, a lawyer who successfully sued the city over its pension dishonesty. "I thought they were looking for intent and didn't find it. I have a lot of evidence of intent, and they never asked to talk to me. There was intent in spades in this case -- the motive of money, staying out of jail, and keeping your job. The only human motive I couldn't find was love."

What about Vinson & Elkins drawing a conclusion about intent when that was not within its mandate? "You shouldn't comment about the Loch Ness monster when you've never been to Scotland," says Conger.

"The problem with the Vinson & Elkins report is that every road they took you down led nowhere," says Diann Shipione, the whistle-blowing member of the city employees' pension board. "No one was responsible. No one was accountable. Everything happened by chance. The KPMG letters confirmed that these images were created artificially. Vinson & Elkins was probably hired to give a whitewash in the first place. Its report does a disservice to the city of San Diego. It's not able to sell more bonds because it is waiting for the auditors." On August 9, KPMG wrote Girard and noted that in September of 2003, Shipione had notified city officials and underwriters of errors and omissions in city financial statements. On September 20, Girard wrote back, "To our knowledge, Ms. Shipione has never alleged any errors in city financial statements," other than in one footnote that he considers immaterial. "Ms. Shipione's criticisms have, in the main, gone not to the city's accounting but its failure to adequately fund [the pension system]."

Girard was clumsily trying to split hairs but wound up shoveling horse manure. What's made underfunding possible is phony accounting, and Shipione has been pointing that out for years. For example, in September of 2003, she told city officials and underwriters that the practice of skimming capital gains out of the pension system to pay for employee health care might be in violation of accounting regulations. She also warned that use of a shaky accounting method permitted the underfunding. She told the city's outside counsel of her concerns, and he shared those misgivings. He then set in motion the actions that culminated in the January 2004 mea culpa.

In April of 2003, councilmember Donna Frye called for an outside audit of the pension system. She was successful. "There is a way to fix this thing," she says. "The first is full disclosure -- getting rid of the culture of secrecy. The second is cooperating with the investigating agencies. We have to assemble a team."

And believe it or not, the city wants to have Vinson & Elkins do an investigation of illegal intent -- the issue it was supposed to avoid the first time around. "I would not hire the same firm, Vinson & Elkins," says Frye.

But San Diego will have to find some firm to get rid of the rats. And then it will have to pay the piper.

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