PERFORMANCE AUDIT REPORT

Kansas Public Employees Retirement System: Examining the Investment in the Ward Parkway Shopping Center

A Report to the Legislative Post Audit Committee By the Legislative Division of Post Audit State of Kansas March 1992 92-42 Legislative Post Audit Committee Legislative Division of Post Audit

THE LEGISLATIVE POST Audit Committee and its committees should make their requests for perform­ audit agency, the Legislative Division of Post Audit, ance audits through the Chairman or any other are the audit arm of Kansas government. The pro­ member of the Committee. Copies of all completed grams and activities of State government now cost performance audits are available from the Division's about $6 billion a year. As legislators and adminis­ office. trators try increasingly to allocate tax dollars effec­ tively and make government work more efficiently, they need information to evaluate the work of gov­ LEGISLATIVE POST AUDIT COMMITTEE ernmental agencies. The audit work performed by Legislative Post Audit helps provide that information. Senator Ben E. Vidricksen., Chair We conduct our audit work in accordance with Senator August "Gus" Bogina, P.E. applicable government auditing standards set forth Senator Norma L. Daniels by the U.S. General Accounting Office. These stan­ Senator Nancy Parrish dards pertain to the auditor's professional qualifica­ Senator Wint Winter, Jr. tions, the quality of the audit work, and the charac­ teristics of professional and meaningful reports. The Representative William R. Roy, Jr., Vice-Chair standards also have been endorsed by the American Representative Tom Bishop Institute ·of Certified Public Accountants and adopted Representative Duane A. Goossen by the Legislative Post Audit Committee. Representative Ed McKechnie The Legislative Post Audit Committee is a bi­ Representative Kerry Patrick partisan committee comprising five senators and five representatives. Of the Senate members, three are LEGISLATIVE DIVISION OF POST AUDIT appointed by the President of the Senate and two are appOinted by the Senate Minority Leader. Of the 1200 Merchants Bank Tower Representatives, three are appointed by the 8th & Jackson Speaker of the House and two are appointed by the Topeka,Kansas 66612-2212 Minority Leader. Telephone (913) 296-3792 Audits are performed at the direction of the FAX (913) 296-4482 Legislative Post Audit Committee. Legislators or PERFORMANCE AUDIT REPORT

KANSAS PUBLIC EMPLOYEES RETIREMENT SYSTEM: EXAMINING THE INVESTMENT IN THE WARD PARKWAY SHOPPING CENTER

OBT AINING AUDIT INFORMATION

This audit was conducted by Ron Green and Jim Davis, Senior Auditors, and Randall Reeves, Auditor, of the Division's staff. If you need any additional informa­ tion about the audit's findings, please contact Mr. Green at the Division's office. TABLE OF CONTENTS

SUMMARY OF AUDIT FINDINGS

KANSAS PUBLIC EMPLOYEES RETIREMENT SYSTEM: EXAMINING THE INVESTMENT IN THE WARD PARKWAY SHOPPING CENTER

From Whom Did the Retirement System Purchase an Interest in the Shopping Center, and Were There Any Changes in the Center's Ownership Before the Retirement System's Initial Investment? ...... 3

Recommendations ...... 8

How Much Did the Retirement System Initially Invest in the Property, and Who Received Money from the Proceeds? ...... 9

How Much Additional Money Has the Retirement System Invested In the Shopping Center, and Who Has Received Money from Renovation of the Center? ...... 13

How Much Has the Investment Manager Been Paid To Manage This Investment? ...... 16

Conclusion ...... 19

Recommendations ...... 19

APPENDIX A: Major Events Concerning the Retirement System's Investment in the Ward Parkway Shopping Center...... 21

APPENDIX B: Summary of Individuals and Firms that Received Funds From the Renovation of Ward Parkway Shopping Center...... 27

APPENDIX C: Agency Response ...... 31 Kansas Public Employees Retirement System: Examining the Investment in the Ward Parkway Shopping Center

Summary of Legislative Post Audit's Findings

O'Connor Realty Advisors, a real estate investment manager hired by the Re­ tirement System in 1985, fIrst invested Retirement System moneys in Ward Parkway Shopping Center in December 1987.

From whom did the Retirement System purchase an interest in the Shop­ ping Center, and were there any changes in the center's ownership before the System's initial investment? The Retirement System acquired its interest in the Shopping Center from Ward Parkway Associates, a Missouri partnership, as part of a refInancing. Ward Parkway Associates had owned the Center since 1981. Kroh Brothers Development Company, one of the partners in Ward Parkway Associates, was also property manager of the Shopping Center. Mter Kroh Brothers Develop­ ment Company stopped paying the Shopping Center's bills, a new corporation be­ came a general partner in Ward Parkway Associates in December 1986. None of the ownership changes appeared to have any adverse affect on the Retirement System's investment in the Shopping Center.

How much did the Retirement System initially invest in the property, and who received money from the proceeds? In December 1987, O'Connor Realty Ad­ visors invested more than $28 million in the Ward Parkway Shopping Center, which was subject to an existing first mortgage of about $16 million. The initial investment was used to make past-due payments on the fIrst mortgage and to payoff all other creditors. More than half the cash invested went to retire the second mortgage on the property held by a Kansas City real estate investor, who used some of the moneys to payoff a loan he had gotten from Metro North State Bank when he purchased the sec­ ond mortgage.

How much additional money has the Retirement System invested in the Shopping Center, and who has received money from renovation of the center? Through January 1992, nearly $31 million has been added to the original $28 million cash investment. About $29.5 million of that has been spent to renovate and rede­ velop the mall. Most of the money went to pay contractors and subcontractors who worked on the redevelopment project, but about $6.8 million went to pay tenant al­ lowances and operating defIcits during the project. The project appears to be about $5.8 million over the original budget, in part because some major expenditures were not included in the original plan. How much has the investment manager been paid to manage this investment? Through December 1991, the Retirement System paid O'Connor Realty Advisors nearly $1.4 million for managing the Ward Parkway investment. In addi­ tion, another O'Connor subsidiary received more than $1.5 million for managing and developing the Shopping Center. While reviewing these fees, we found that O'Con­ nor had apparently underbilled the Retirement System by about $80,000 for invest­ ment management fees since the end of 1987. We also noted that the Morgan and Dreiseszun families of Kansas City had ownership interests amounting to about 2.5 percent of the parent O'Connor company.

This report includes several recommendations for ensuring that fee payments and other requirements are handled in accordance with written contracts and with Re­ tirement System investment policies. We would be happy to discuss these recommen­ dations with any legislative committees, individual legislators, and other State offi­ cials.

Legislative Post Auditor Kansas Public Employees Retirement System: Examining the Investment in the Ward Parkway Shopping Center

Since 1985, O'Connor Realty Advisors, Inc., has been a real estate investment manager for the Kansas Public Employees Retirement System. O'Connor Realty Advisors has an office in Overland Park and is a subsidiary of J. W. O'Connor and Company, which is headquartered in New York City. At the end of 1991, O'Connor Realty Advisors had invested about $267 million of Retirement System moneys in a portfolio of 13 specific investment properties. One of those properties is Ward Park­ way Shopping Center, a 779,000 square-foot mall located in Kansas City, Missouri. The mall is located between 85th Street Terrace and 89th Street, bounded on the west by State Line Road and on the east by Ward Parkway.

O'Connor Realty Advisors first invested Retirement System moneys in Ward Parkway Shopping Center in December 1987, as part of a refinancing package. The Retirement System obtained a 49 percent interest in a partnership that took ownership of the Shopping Center, and gained complete control over operation and management of the mall. The December 1987 refinancing was actually a deferred purchase on be­ half of the Retirement System; the purchase can be completed if the Retirement Sys­ tem makes an additional payment to the fonner owners in December 1994 or thereaf­ ter.

O'Connor Realty Advisors has committed the Retirement System to a total in­ vestment of about $78 million in Ward Parkway Shopping Center, including about $33 million in renovation and redevelopment costs. The renovation project was sub­ stantially completed in 1991. Thus far, the Retirement System has received no return on this investment. However, O'Connor Realty Advisors has projected a net return of about $1.2 million for 1992.

Recently, a number of legislative concerns have been raised about possible changes in the ownership of the Shopping Center before the December 1987 refi­ nancing, the distribution of the proceeds from that initial investment, the status and cost of the renovation of the Shopping Center, and the amount of fees paid to the in­ vestment manager. This audit addresses the following questions:

1. From whom did the Retirement System purchase an interest in the Shop­ ping Center, and were there any changes in the center's ownership before the System's initial investment?

2. How much did the Retirement System initially invest in the property, and who received money from the proceeds?

3. How much additional money has the Retirement System invested in the Shopping Center, and who has received money from renovation of the center?

1. 4. How much has the investment manager been paid to manage this invest­ ment?

To answer these questions, we reviewed documentation obtained from the Re­ tirement System and its custodian bank:, Commerce Bank: and Trust of Topeka. We reviewed correspondence and other documents provided by J. W. O'Connor and Company and its affiliates. We interviewed a number of people who were involved with the initial investment in Ward Parkway Shopping Center. We also obtained documents from the bankruptcy court in Kansas City, Missouri. Finally, we reviewed all aspects of the Ward Parkway investment for compliance with applicable contracts and Retirement System investment policies.

In conducting this audit, we followed all applicable government auditing stan­ dards set forth by the U. S. General Accounting Office. One of those standards states that individual auditors should be free from impairments to independence, and should maintain an independent attitude and appearance. Although all members of the Divi­ sion's staff are members of the Retirement System, and the Executive Secretary of the Retirement System was formerly employed by our agency, we are confident that no impairment to independence occurred. We also made every possible effort to provide for and maintain an independent attitude and appearance while conducting this audit.

In general, we found that the Retirement System acquired an interest in the Shopping Center from Ward Parkway Associates, a Missouri partnership, in Decem­ ber 1987. O'Connor Realty Advisors initially invested about $28 million in Retire­ ment System moneys, and the property (with an existing mortgage of about $15.9 million) was transferred to a new partnership. All the money invested in December 1987 was used to payoff creditors of the Shopping Center. From 1988 through the January 1992, O'Connor Realty Advisors has invested another $30.8 million in cash, most of which has been spent to renovate and redevelop the Shopping Center. Fi­ nally, we found that affiliates of J. W. O'Connor and Company have received nearly $3 million for managing the investment and for managing the daily operation and de­ velopment of Ward Parkway Shopping Center.

2. From Whom Did the Retirement System Purchase an Interest in the Shopping Center, and Were There Any Changes in the Center's Ownership Before the Retirement System's Initial Investment?

Before the Retirement System's initial investment in Ward Parkway Shopping Center, the Center was owned by a Missouri partnership called Ward Parkway Asso­ ciates. Ward Parkway Associates had acquired title to the Shopping Center in 1981 from Ward Parkway Shops, Inc., a corporation owned by the Kroh family of Kansas City. We saw no evidence of any change in ownership that adversely affected the in­ vestment made on behalf of the Retirement System in 1987. These findings are dis­ cussed more fully in the sections that follow.

The Retirement System Acquired an Interest in the Shopping Center from Ward Parkway Associates, A Missouri Limited Partnership, in December 1987

Ward Parkway Shopping Center was built in 1959. Until 1981, it was owned by Ward Parkway Shops, Inc. Ward Parkway Shops was owned primarily by a Kroh family trust formed in 1962, and minor interests were held by John Kroh, Sr., Roger Hunt, and Elinor Kroh Tourtellot.

By 1987, when O'Connor Realty Advisors was considering an investment of Retirement System moneys in Ward Parkway Shopping Center, the property was owned by Ward Parkway Associates. The chart on the following page shows the ownership structure of Ward Parkway Associates before the initial investment.

Ward Parkway Associates became the owner of the Shopping Center in October 1981, as part of a refinancing. At that time, the general partners of Ward Parkway Associates were Roger Hunt and Kroh Brothers Development Company, and the limited partners were Star Associates (a Texas limited partnership), Elinor Kroh Tounellot, John Kroh, Jr., and George Kroh. A major factor in the 1981 refi­ nancing was the injection of funds by Star Associates, which resulted in Star Associ­ ates getting most of the equity ownership of the Shopping Center. Kroh Brothers De­ velopment Company was also the manager of the Shopping Center, under a contract with Ward Parkway Associates.

While Ward Parkway Associates was the owner of the Shopping Center, sev­ eral other entities held mortgages and other debts as encumbrances on the property. In July 1982, the 1962 Kroh Trust became the holder of a note issued in the 1981 refi­ nancing. In May 1984, New England Mutual Life loaned $16 million to Ward Park­ way Associates, and received a first mortgage on the Shopping Center. In July 1984, Mercantile Bank loaned $3.1 million to Kroh Brothers Development Company, and that note was secured in part by the Company's interest in the Shopping Center. In July 1985, Blue Valley Federal Savings and Loan loaned $4.5 million to Ward Park­ way Associates and $10 million to the 1962 Kroh Trust, and received a second mort­ gage on the Shopping Center.

3. November 1987 Ownership Stucture of the Ward Parkway Shopping Center Before the Retirement System's Initial Investment

Ward Parkway Associates, A Missouri Limited Partnership Owned title to the Shopping Center I I General Partners Limited Partners • Star Associates, Ltd. • Equity Partnerships Corporation General Partners Officers and Directors -Barton Cohen, Pres. & Dir. -A. Baron Cass, III -Robert Shapiro, Vice-Pres. & Dir. -SANDS -Patrick Healy, Sec. & Dir. -Charies M. Herman -William Shapiro, Asst. Sec. -Robert L. Swisher -Charies M. Herman, Dir. Limited Partners -Byron Cohen, Dir. -Anna Lee Chance Trust -A. Baron Cass, III, Dir. ~esse L. Carroll, Jr. -Robert L. Swisher, Dir. -A. Baron Cass, III • Roger Hunt ~ohn H. Chance • Kroh Brothers Development Co. (a) -Phil Chance Officers and Directors -Herbert and Harriet Gross -Donald W. Jones, Pres. & Dir. ~ohn A. Philbin ~ames E. Harpool, Vice-Pres. -Paul E. Massad -Gregory M. Galvin, Secretary -Robert L. Swisher, Jr. -Gus Saettele -Michael K. Tourtellot, Dir. -William M. Siegel ~ohn A. Kroh, Jr., Dir. -Edwin M. Herman -George P. Kroh, Dir. -Ward Midwest Associates, c/o David Smith • George P. Kroh • John A. Kroh, Jr. • Elinor Kroh Tourtellot

(a) According to an Assignment and Release Agreement dated December I, 1987, Kroh Brothers Development Company assigned all its interest as a general partner in Ward Parkway Associates back to Ward Parkway Associates.

Ward Parkway Shopping Center, being overburdened with debt, continually operated at a loss. Beginning in October 1986, Kroh Brothers Development Com­ pany stopped paying all bills associated with the Shopping Center. In February 1987, Kroh Brothers Development Company filed a petition for bankruptcy. Appendix A contains a chronological summary of the key events in the Retirement System's in­ vestment in Ward Parkway Shopping Center, including actions taken in the bank­ ruptcy court.

In December 1986, Equity Partnerships Corporation was admitted as a co­ managing general partner in Ward Parkway Associates. Equity Partnerships Cor­ poration was formed to take over as managing general partner to protect the interests

4. of Ward Parkway Associates' partners, after Kroh Brothers Development Company stopped paying the Shopping Center's bills. Equity Partnerships, a Missouri corpora­ tion, included some of the same investors who were partners in Star Associates.

In December 1987, Ward Parkway Associates transferred ownership of the Shopping Center to a new limited partnership, Ward Parkway Shopping Center Company, controlled by the Retirement System. O'Connor Realty Advi­ sors became interested in investing in Ward Parkway early in 1987, when the Kroh's financial problems had already become known. O'Connor Realty Advisors made a preliminary loan offer in March, and a formal bid in June 1987. O'Connor's bid to refmance the Shopping Center was accepted in late June 1987.

The refinancing of Ward Parkway Shopping Center (which closed Decem­ ber 21, 1987) was conditioned upon approval of the bankruptcy court for Kroh Broth­ ers Development Company to liquidate its interests in Ward Parkway Associates. Af­ ter a hearing on November 10, 1987, the bankruptcy court approved Kroh Brothers Development Company's application for approval of a settlement agreement which called for Kroh Brothers Development Company to transfer its interests in Ward Parkway Associates to Equity Partnerships Corporation.

The chart below shows the ownership structure of Ward Parkway Shopping Center Company, L. P., immediately after the Retirement System made its initial in­ vestment.

January 1988 Ownership Stucture of the Ward Parkway Shopping Center After the Retirement System's Initial Investment

Ward Parkway Shopping Center Company. L.P., A Kansas Limited Partnership Owns title to the Shopping Center

General Partner Limited Partner

WSC Associates Ward Parkway Associates General Partner General Partners • State Line Investors, Inc., • Equity Partnerships Corporation a wholly owned subsidiary • Roger Hunt of O'Connor Management, Inc. Umited Partners Umited Partner • Star Associates, Ltd . • KPERS Realty Holding #18 • George P. Kroh • John A. Kroh, Jr. • Elinor Kroh Tourtellot

5. As the chart shows, the major changes in the ownership structure were as follows: • Kroh Brothers Development Company was no longer a partner in Ward Parkway Associates. • Title to the Shopping Center was transferred to Ward Parkway Shopping Center Company, L. P. • WSC Associates became the general partner of Ward Parkway Shopping Center Company, L. P. • O'Connor Management, Inc., received an ownership interest in WSC Asso­ ciates.

O'Connor Management, Inc., also became the property manager of the Shop­ ping Center after the transaction was closed. The apparent ownership interests of State Line Investors and O'Connor Management, Inc., have no economic signifi­ cance. The property management contract was written so that the only economic benefit that O'Connor could receive was its fees. The Retirement System can buyout the interests of State Line Investors and O'Connor Management, Inc., at any time for $100.

The Retirement System's investment was structured as a refinancing, rather than as a purchase, mainly for tax reasons. One of the main concerns of the Shopping Center owners (Ward Parkway Associates) was to avoid the negative tax conse­ quences that would have occurred if the investment had been structured as an outright sale. To avoid those consequences, Ward Parkway Associates had to retain at least a 51 percent interest in the property. The Retirement System obtained a 49 percent ownership interest, but can buyout Ward Parkway Associates' interest (starting in December 1994) for $1 million to $1.5 million. As a practical matter, O'Connor has set up this option so that the payment will be $1 million.

According to materials provided by O'Connor Realty Advisors, WSC Associ­ ates was created because the Retirement System could not be a partner in Ward Park­ way Shopping Center Company, L. P. (If the Retirement System had been a partner, the loan from the Retirement System would have been between two partners in the same entity, which could have looked like a sham transaction.) Likewise, State Line Investors was created to be the general partner in WSC Associates, because the Re­ tirement System could not be the general partner.

Despite the appearance of the new ownership structure, the Retirement System gained full control over the operation and management of the Shopping Center. The Retirement System also became entitled to receive returns that were designed to con­ sume all net income from operation of the mall. The structure shown in the chart on page five is still in place.

The Retirement System's Board of Trustees Did Not Properly Approve the O'Connor Company's Expanded Involvement in the Shopping Center

Under the contract with the Retirement System, O'Connor Realty Advisors had to have written Board approval if an O'Connor company was to be the property man-

6. ager for any Retirement System investment property. Also, the contract prohibited O'Connor or any of its affiliates from having a direct or indirect interest in any real estate investment made by O'Connor on behalf of the Retirement System. The O'Connor Company made a written request for Board approval on both items for Ward Parkway Shopping Center on December 2, 1987.

Although the Retirement System's former Executive Secretary signed a document approving O'Connor's requests, the Board never gave its approval. O'Connor's letter of December 2, 1987, asked the Retirement System's Executive Secretary to sign the letter as an indication that the Board of Trustees had approved O'Connor's requests. The Executive Secretary signed the letter, even though no offi­ cial Board action ever was taken on either matter. Our review of the Board minutes (including a meeting held on December 12, 1987) showed no reference to O'Con­ nor's requests or to Ward Parkway Shopping Center.

The Executive Secretary did write an internal memorandum that partially ex­ plained his actions in this matter. According to the memorandum, the Executive Sec­ retary told O'Connor officials that he had no authority to sign the letter without offi­ cial Board approval. However, after consultations with Board Chairman Larry Jones - who reportedly approved of O'Connor's requests - the Executive Secretary signed the letter.

O'Connor Realty Advisors Did Not Comply With the Retirement System's Requirements for an Independent Appraisal of the Shopping Center

At the time of the initial investment in December 1987, the Retirement Sys­ tem's investment policies required an independent appraisal of a piece of property, based on the property's value "at or prior to the time of the investment." This re­ quirement apparently was intended to help the Retirement System assign an appropri­ ate value for accounting purposes, rather than to help the investment manager decide how much the property was worth before making the investment. Under its contract with the Retirement System, O'Connor Realty Advisors was a "discretionary man­ ager" that did not need approval from the Retirement System to proceed with a new investment.

O'Connor Realty Advisors did not have the Shopping Center appraised as of December 1987. Despite the requirement in the Retirement System's investment guidelines, O'Connor did not receive an independent appraisal until May 1988. The effective date of the appraisal was April 1, 1988, more than three months after the closing date of the investment. That appraisal estimated the Shopping Center's mar­ ket value at $46 million.

O'Connor has not obtained a more recent independent appraisal of the Shopping Center, as required by Retirement System policy. In August 1990, the Retirement System's Board of Trustees adopted new investment policies that required

7. an independent appraisal "on the third an­ The Townsend Group: Real Estate Oversight Advisor niversary of each investment's acquisition and every three years thereafter." This On December 1, 1991, the Retirement same requirement was applied to all in­ System signed a real estate consulting agree­ vestment property, regardless of whether ment with The Townsend Group of Cleveland, Ohio. The contractual services to be provided the property was under development. The by The Townsend Group were: third anniversary of the Ward Parkway in­ vestment was in December 1990. How­ • a due diligence review of each investment ever, no appraisal has been done since the • a review of the annual budget and projected performance of each investment independent appraisal in April 1988. • a review of the Retail Property Trust (a joint investment managed by O'Connor Realty O'Connor and Retirement System Advisors) • the development of new appraisal policies officials told us they were under the im­ and procedures for review by the Board of pression that no appraisal was required Trustees while the property was in development. • a review and written opinion on the accu­ According to correspondence we re­ racy of the appraisal of each investment property viewed, O'Connor planned to have the Ward Parkway property independently ap­ The agreement required The Townsend praised around the end of 1991, when the Group to work with the Retirement System and O'Connor Realty Advisors to develop a written renovation was substantially completed. appraisal policy and annual appraisal proce­ That appraisal was put on hold, however, dures for the portfolio of individual properties. pending a review by The Townsend Group The agreement also required that The Townsend Group submit written reports and and its recommendations on a new ap­ present the information to the Retirement Sys­ praisal policy. The role of The Townsend tem's Board of Trustees. The Retirement Sys­ Group - the Retirement System's new tem is to pay The Townsend Group $325,000 real estate advisor - is discussed in the for these services. accompanying box.

Recommendations

1. In all future instances, when an investment manager's contract or a Re­ tirement System guideline requires the Board of Trustees' approval for a specific action or exception, the Retirement System should ensure that such approval is properly voted on and documented in Board min­ utes.

2. O'Connor Realty Advisors should follow the Retirement System's in­ vestment policies, including appraisal policies, as required by its con­ tract. If exceptions or waivers are granted to O'Connor, they should be documented in writing.

8. How Much Did the Retirement System Initially Invest in the Property, and Who Received Money from the Proceeds?

In December 1987, O'Connor Realty Advisors invested more than $28 million of Retirement System moneys in the Ward Parkway Shopping Center. In addition, the Shopping Center was subject to an existing first mortgage of about $16 million, bringing the total value of the initial investment to approximately $44 million. The initial cash investment in the Shopping Center was used to make past-due payments on the ftrst mortgage and to payoff other creditors. These ftndings are discussed more fully in the following sections.

The Retirement System' Initial Investment in Ward Parkway Shopping Center Was More Than $28 Million

O'Connor representatives contacted officials in Equity Partnerships Corpora­ tion-a general partner of Ward Parkway Associates, then the owner of the Shopping Center-as early as February 1987. O'Connor Realty Advisors made a preliminary loan offer to Equity Partnerships Corporation in March 1987. In May 1987, Equity sent out a formal request for interested firms to submit sealed bids to provide financ­ ing for the Shopping Center. The written request stated that bids were to be no less than $42 million, less the ftrst mortgage balance of about $16 million.

O'Connor Realty Advisors submitted its bid in June 1987, based on its judgment of the value of the Shopping Center. The O'Connor bid was for $44 mil­ lion - just over $28 million in cash, plus the ftrst mortgage. O'Connor officials said their bid was based on their own internal valuation of the Shopping Center, using a cost-per-square-foot analysis. As noted in question one, at the time the bid was sub­ mitted, O'Connor had not obtained an independent appraisal of the Shopping Center. However, the other three bids that were submitted were all within $1.5 million of O'Connor's bid, in terms of cash to be paid at closing. The ftrms and bid amounts are shown below.

Bids Submitted in June 1987 for Refinancing Ward Parkway Shopping Center

Firm Name and Location Amount of Bids (before subtracting the first mortgage) O'Connor Realty Advisors $44.0 million - New York, N.Y. Aldrich, Eastman, and Waltch, Inc. $43.85 million - Boston, Mass. CIGNA Investments, Inc. $43.0 million - Hartford, Ct. Federal Realty Investment Trust $42.5 million - Bethesda, Md.

9. By the time bids were submitted, Gage and Tucker, the law firm representing the 1962 Kroh Trust, had taken charge of the bid process. By the end of June 1987, the bid submitted by O'Connor Realty Advisors was formally accepted. The parties agreed to a revised commitment letter in November 1987. The revised letter set the loan at $44.4 million, less the first mortgage balance.

The Retirement System's "loan" to refinance Ward Parkway Shopping Center closed December 21, 1987. The Retirement System paid a little more than $28 million in cash at the closing, and committed another $500,000 that was held in reserve for working capital purposes. The property also was subject to a first mort­ gage in favor of New England Mutual Life, which had a balance of $15.9 million.

The loan by the Retirement System was secured by a second mortgage on the Shopping Center. Under the terms of this loan, the Retirement System was to receive basic interest of 14 percent and additional interest of 25 percent of percentage rents. (Percentage rents are based on a tenant's gross receipts; some tenants pay percentage rents, while other tenants rent on a square-footage basis.) Both the basic interest and additional interest were to be paid only from available cash flow generated by the Shopping Center. If the Shopping Center does not generate positive cash flow, the unpaid interest is accrued for payment from future cash flow. These repayment pro­ visions were designed to consume all the profit generated by the Shopping Center and direct it to the Retirement System, with nothing left over for distribution to Ward Parkway Associates.

The tenns of the investment also allowed the Retirement System to buyout the interests of Ward Parkway Associates for $1 million; this buy-out option begins in December 1994.

All the Money Invested by the Retirement System Was Used to Pay Off Creditors of the Shopping Center

The following table shows who received money from the proceeds of the Re­ tirement System's initial investment in the Shopping Center.

Distribution of Cash from the Retirement System's Initial Investment in the Shopping center

Recipient Amount

First Mortgage-New England Mutual Life $ 2,187,575 Second Mortgage-Arvin Gottlieb (a Kansas City real estate developer and investor) 16,724,133 Kroh Brothers Development Company 2,000,000 Mercantile Bank of Kansas City 330,000 Other Creditors- 1,166,408 Various mechanic's liens Non-lien creditors Real Estate & Other Taxes and Penalties 1,673,794 Miscellaneous Fees and Expenses 266,076 Remainder-1962 Kroh Family Trust 3 16991617

Total $ 28,047,603

10. As the table shows, most of the money invested by the Retirement System was used to payoff the second mortgage on the property and to make past-due payments on the first mortgage. All other debts and liens were resolved as part of a settlement agreement approved by the court that handled the Kroh Brothers Development Com­ pany's bankruptcy case. The settlement agreement was reached prior to the closing of the initial investment transaction. No money went to the partnership that owned the Shopping Center (Ward Parkway Associates), to Equity Partnerships Corporation (the managing general partner of Ward Parkway Associates), or to Star Associates (a limited partner in Ward Parkway Associates).

The majority of the cash invested by the Retirement System went to pay off a second mortgage held by a Kansas City real estate developer. Mr. Arvin Gottlieb had purchased the $14.5 million mortgage from Blue Valley Federal Savings and Loan in March 1987, and paid most of the past-due interest, using funds bor­ rowed from Metro North State Bank. Mr. Gottlieb said he purchased the loan origi­ nally with the thought that he might be able to acquire controlling ownership of the Shopping Center, and also because he saw the opportunity to make a profit. Mr. Got­ tlieb also stated that he used (at least part of) the funds he received from the refi­ nancing to payoff the loan he got from Metro North State Bank.

After all other creditors of the Shopping Center were paid according to the settlement agreement, the remainder-$3.7 million-went to the 1962 Kroh Trust. The 1962 Trust was a major creditor of the Shopping Center, having invested more than $8 million in the Shopping Center and Kroh Brothers Development Com­ pany. According to documents on file at the bankruptcy court, Kroh Brothers Devel­ opment Company owed $8 million to the 1962 Trust. The settlement agreement ap­ proved by the court settled all disputes between Kroh Brothers Development Com­ pany and the 1962 Trust.

It appears that O'Connor Realty Advisors' main goal was to get the title to the Shopping Center cleared of all claims other than the existing first mortgage. The loan made by the Retirement System in the amount of about $28.5 million became a new second mortgage on the property.

11. Several Individuals and Entities Involved with The Ward Parkway Shopping Center Investment Also Were Involved with Other Retirement System Investments

As part of this audit, we were asked to try to identify relationships between people in­ volved in the Ward Parkway investment and people involved in the Retirement System's di­ rect placement investments. We found the following relationships between this investment and other Retirement System investments:

• Kansas City real estate developer Arvin Gottlieb purchased an existing $14.5 mil­ lion mortgage on the Shopping Center from Blue Valley Federal Savings and Loan in March 1987. Mr. Gottlieb purchased the mortgage, and paid past due interest, with funds borrowed from Metro North State Bank-an institution controlled by Frank Morgan. Mr. Gottlieb stated that he used (at least part of) the funds he re­ ceived from the refinancing to payoff the Metro North loan.

• J.W. O'Connor and Company, Inc., the parent company of O'Connor Realty Advi­ sors, Inc., is a privately held corporation whose stockholders include a partnership called Prairie Investment Company. Prairie Investment Company is owned mainly by people associated with the real estate firm Copaken, White, & Blitt and by Morgan-Dreiseszun interests-Kansas City area real estate developers and inves­ tors whose names have been mentioned in relation to other Retirement System in­ vestments. Prairie Investment Company holds an 8.4 percent ownership interest in J.W. O'Connor and Company, Inc.

• Meyerdirk Title Company, the title and escrow firm used for the Retirement Sys­ tem's initial investment in the Ward Parkway Shopping Center, also was used for the Retirement System's investment in the Kansas City Merchandise Mart.

• According to an attorney who represented Equity Partnerships Corporation, Star Associates, and Ward Parkway Associates, a number of Kroh Brothers Develop­ ment Company projects may have been financed with funds borrowed from finan­ cial institutions controlled by Frank Morgan. However, Ward Parkway Shopping Center was not indebted to any Morgan financial institution.

• In early 1987, Kroh Brothers Development Company (and other Kroh companies) filed for Chapter 11 bankruptcy. According to the reorganization plan approved by the bankruptcy court in February 1988-.atm!: the closing date of the Retirement System's initial investment in Ward Parkway Shopping Center-Kroh Brothers' businesses would be continued by an operating partnership consisting of the debt­ ors and an entity known as the Ozar Partnership. The partners in the Ozar Part­ nership were 1.1. Ozar (as managing agent), Frank Morgan, and Sherman Dreis­ eszun. The operating partnership was to continue the debtors' business operations for the purpose of executing an orderly liquidation of assets. The Ozar Partnership was to fund the costs and expenses of the operating partnership, with proceeds from the sale of assets being distributed according to the court-approved plan.

12. How Much Additional Money Has the Retirement System Invested in the Shopping Center, and Who Has Received Money from Renovation of the Center?

Through January 1992, approximately $30.8 million has been added to the original $28 million investment in Ward Parkway, for a total of $58.8 million in cash. About $29.5 million - nearly all of the new investment - has been spent to reno­ vate and redevelop the Shopping Center. Most of the money has gone to pay contrac­ tors and other companies that have worked on the project, but significant amounts have gone to pay tenant allowances and operating deficits. These and other findings are discussed in the following sections.

The Retirement System Spent About $1.3 Million in 1988, Before the Renovation Began

Between the time of the initial transaction and the start of the renovation, the Retirement System spent about $1.3 million to pay investment acquisition fees, clos­ ing costs, and other capital expenses. The largest expense - about $555,000 - was acquisition fees paid to O'Connor Realty Advisors. (Acquisition fees are the only in­ vestment management fee that the Retirement System counts as part of its cash in­ vestment. All other types of fees paid to O'Connor are not included in the investment and are not discussed under this question. The types of fees paid to the O'Connor companies are shown later in this report.)

The next largest expense - about $407,000 - was for closing costs associated with the original investment. Closing costs and acquisition fees were paid in early 1988. Later in 1988, nearly $350,000 in Retirement System moneys were spent for other capital expenses at the Shopping Center. The funds used for capital expenses came out of the $500,000 held in reserve at the time of the initial investment.

Through January 1992, the Retirement System Has Spent Approximately $29.5 Million To Renovate and Redevelop the Shopping Center

Even before the Retirement System's initial investment in December 1987, of­ ficials of O'Connor Realty Advisors indicated that they planned to renovate and re­ model the Shopping Center. The Retirement System made a $28.5 million construc­ tion loan in September 1989 for the renovation project. Construction work began in January 1990 and was expected to be completed in late 1990. However, because of the economic recession (which slowed the re-Ieasing of the mall) and delays in the theatre construction, the renovation fell behind schedule by about 12 months. Major aspects of the project included the renovation of mall common areas and entries, the relocation and expansion of the food court, the conversion of the Woolworth area to small store space, and the addition of a new 12-screen theatre. Nearly all the renova­ tion work was completed in 1991, although some of the costs were not billed to the Retirement System by the end of the year.

13. Most of the money spent to renovate Ward Parkway Shopping Center was paid to contractors. In response to our request, O'Connor Management provided us with a list showing all payments made for the renovation project through January 1992. The following table contains a breakdown of how the renovation funds were spent.

Spending Summary Through January 1992 For Renovation and Redevelopment

Construction Companies and Other Firms (a) $19,829,410 Tenant Allowances (b) 4,240,917 Ward Parkway Operating Deficit (c) 2,564,038 Woolworth Lease Buyout 1,200,000 O'Connor Management, Inc. (d) 1,081,674 Law Firms 210,989 City Treasurer - Real Estate Taxes 196,906 Individuals 43,097 Others (e) 101,565

Total $29,468,596

(a) This line only includes businesses that received $10,000 or more. (b) Tenant allowances are payments made to existing mall businesses to help pay their moving costs or to reimburse them for renovations they have made. Tenant allowances also include payments made to attract new tenants to the Shopping Center. (c) Operating deficits are amounts paid by the Retirement System to cover expenses that could not be paid out of operating revenues of the Shopping Center. (d) Payments to O'Connor Management included development fees, leasing fees, and expenses reimbursed by the Retirement System. (e) Others include miscellaneous professional services firms and contractors that received amounts of less than $10,000 during the project.

As the table shows, of the $29.5 million spent, $19.8 million, or about 67 per­ cent, went to the major contractors and sub-contractors that provided materials or services directly related to the renovation.

The remaining $9.7 million went to pay tenant allowances, operating deficits, development and leasing fees to O'Connor Management, and other costs. Some of these items - such as the operating deficits and the Woolworth lease buyout - were not included in the original project budget. O'Connor officials told us it was a normal practice to use construction loan moneys to cover operating deficits during a renova­ tion project.

We also looked specifically for payments made to law firms and individuals. We found that law firms received a total of $211,000, with the largest portion - $123,000 - going to the firm of Ross and Cohen. About $50,000 went to the firm of Lewis, Rice, and Fingersh. Most of the law firms' services dealt with tenant issues resulting from the renovation.

We also looked at payments listed to named individuals who provided special­ ized services. Those payments went to nine different people and totaled only about

14. $43,000. For a listing of the individuals O'Connor Realty Advisors Kept the and firms who received money from the Retirement System Informed About the renovation, see Appendix B. Ward Parkway Investment

In the list of payments sent to us by O'Connor Realty Advisors was required by contract to submit quarterly, semi-annual, and O'Connor, we did not see any payments to annual reports to the Retirement System re­ persons or companies that were connected garding the status and progress of the real es­ (as far as we knew) to any of the key tate portfolio. We found that this requirement had been met. people that have been publicly identified Representatives of O'Connor Realty Advi­ with the Retirement System's direct place­ sors made semi-annual presentations to the ment investments. Board, reviewing the real estate portfolio in general, plans for investment acquisitions and property renovation, and the performance of The redevelopment project ap­ individual investments. pears to be about $5.8 million over the We also reviewed the correspondence ob­ original budget. O'Connor's original tained from files at O'Connor Realty Advisors and the Retirement System. The correspon­ budget for the renovation and redevelop­ dence showed that O'Connor kept the Retire­ ment project included interest charged on ment System informed of both the original in­ the construction loan. In late 1991, vestment and the additional investment. In ad­ dition, O'Connor has attempted to addressed O'Connor removed the interest from the any issues that arose concerning the invest­ original base budget and from its revised ment structure and the renovation progress. budget. This resulted in a base budget of For example, the Retirement System's Board of Trustees has raised a number of questions approximately $27 million. As of January about why the renovation has taken longer and 1992, O'Connor's revised budget was cost more than planned. about $32.8 million, which is $5.8 million Our review of O'Connor's written reports more than the base budget. In response to and the Retirement System's correspondence files showed that O'Connor Realty Advisors at­ questions raised by the Retirement Sys­ tempted to keep the Retirement System in­ tem, O'Connor officials reported that the formed about the real estate portfolio and the construction overages were caused by "ei­ Ward Parkway investment. ther increases in the scope of work or ad­ ditional costs which resulted from field conditions which were not reasonably fore­ seeable when the original budget was established."

It is clear from O'Connor's financial reports that the project went over its budget because of major items that were not included in the original budget. Those items included operating deficits, the Woolworth buyout, and various capital im­ provements such as a roof replacement, an energy management system, asbestos re­ moval, and repair of parking lots and decks.

Through January 1992, the Retirement System had supplied about $29.5 mil­ lion for the renovation and redevelopment project. If O'Connor's $32.8 million re­ vised budget is correct, that would mean another $3.3 million in expenditures for the Retirement System. The total cash investment would then be at least $62 million, and the total value of the investment including the first mortgate would be about $78 mil­ lion.

15. How Much Has the Investment Manager Been Paid To Manage This Investment?

O'Connor Realty Advisors has been real estate investment manager for the Re­ tirement System since 1985. O'Connor Management, Inc., has been the property manager at Ward Parkway Shopping Center since December 1987. Both companies are wholly-owned subsidiaries of J.W. O'Connor and Company. Through the end of 1991, we found that O'Connor Realty Advisors has received nearly $1.4 million for managing the Ward Parkway investment, and O'Connor Management, Inc., has re­ ceived more than $1.5 million for managing and developing the Shopping Center. Together, the O'Connor firms have received nearly $3 million since 1987. These fmdings are discussed more fully in the sections to follow.

O'Connor Realty Advisors Has Received Nearly $1.4 Million for Acquiring and Managing the Ward Parkway Investment

As the Retirement System's real estate portfolio investment manager, O'Con­ nor Realty Advisors is eligible to receive the five different types of fees shown in the accompanying box. For the Ward Parkway investment, O'Connor Realty Advisors has received two types of fees - acquisition fees and portfolio management fees. Both of these fees were paid directly by the Retirement System, under its contract with O'Connor Realty Advisors. O'Connor Realty Advisors re­ Compensation Opponunities for ceived more than $555,000 in acquisi­ O'Connor Realty Advisors tion fees for the Ward Parkway Shop­ ping Center investment. According to According to the contract between O'Con­ nor Realty Advisors and the Retirement Sys­ the contract, the Retirement System was tem, five categories of compensation are pay­ required to pay O'Connor Realty Advisors able to O'Connor Realty Advisors: 1.25 percent of the total amount paid (in­ 1. The Acgujsjtion Fee is 1.25 percent of the cluding assumed debt) by the Retirement total value of the newly acquired investment, System in connection with the acquisition including debt assumed. of a real estate investment. The purpose of 2. The Financing/Disposnion Fee is 1.0 per­ the acquisition fee was to compensate the cent of any financing or refinancing (excluding financing included in the computation of any portfolio manager for the work involved in Acquisition Fee), or 1.0 percent of the gross making new real estate investments. The sales price of any real estate investment. amount of the initial Ward Parkway trans­ 3. The Base Management Fee is a two-tier fee based on the total value of the real estate action (including third-party debt) was ap­ portfolio at the end of each quarter. proximately $44.4 million, which was the 4. The Income Incentive Fee is 10 percent of basis of the $555,000 in acquisition fees. the adjusted net income from all real estate in­ vestments after the Retirement System has re­ ceived a target return of 10 percent on the port­ Our review showed that the amount folio. of acquisition fees paid was in compliance 5. The Gains Incentive Fee is 10 percent of with the contract. A few erroneous realized gains from any sale of a real estate in­ vestment. charges were made, but they were cor-

16. rected promptly. No acquisition fees have been paid for the renovation and redevel­ opment project.

O'Connor Realty Advisors received more than $828,000 in portfolio man­ agement fees for the Ward Parkway Shopping Center investment. The portfolio management fee paid by the Retirement System was a two-tier fee, based on the total value of the O'Connor portfolio. The fIrst tier was a quarterly charge of .125 percent on the first $100 million in the portfolio, and the second tier was a quarterly charge of .0938 percent on the amount exceeding $100 million. The contract called for these percentages to be applied to the portfolio balance at the end of each quarter. The con­ tract did not require allocation of the fee to individual investments, but O'Connor at­ tempted to do so for each quarter we reviewed.

Our review showed that O'Connor Realty Advisors made errors in calculating the total portfolio management fee and in allocating the fee to the Ward Parkway in­ vestment. The impact of these errors is discussed in the next section.

O'Connor Realty Advisors apparently has underbilled the Retirement System by about $80,000 in portfolio management fees. The main reason for the underbilling was that O'Connor pro-rated new investments based on the number of days during the quarter that the investment was on the books. According to the con­ tract, O'Connor's portfolio management fee should have been based on the balance at the end of the quarter, regardless of how long the investment was in place.

We found a total of six fee calculation errors, five of which occurred during the first fIve quarters of the Ward Parkway investment. The last error occurred in the fourth quarter of 1989. However, Retirement System offIcials told us that these bills are now checked more closely before they are paid.

We estimated that about $51,000 of the $80,000 should have been allocated to the Ward Parkway investment; if that correction were made, the portfolio manage­ ment fees associated with Ward Parkway would be about $879,000.

In addition to the acquisition fees and the portfolio management fees described above, O'Connor Realty Advisors also receives reimbursement from the Retirement System for its out-of-pocket expenses. According to information provided by the Re­ tirement System, the expenses paid for the Ward Parkway investment totaled about $22,700.

Another O'Connor Subsidiary, O'Connor Management, Inc., Has Received More Than $1.5 Million for Managing and Developing Ward Parkway Shopping Center

In O'Connor Realty Advisors' portfolio of real estate investments made for the Retirement System, Ward Parkway Shopping Center is the only property managed by O'Connor Management, Inc. Ward Parkway is also the only regional shopping mall

17. in that portfolio. O'Connor officials told us that the company's area of expertise was in managing regional shopping centers.

O'Connor Management has received three kinds of fees - property manage­ ment fees, leasing fees, and development fees - under its contract with Ward Park­ way Shopping Center Company, the partnership that owns the Shopping Center. These types of fees are paid out of revenues generated by the Shopping Center, with the Retirement System covering any deficits between total revenues and total ex­ penses.

O'Connor Management has received about $655,000 in property manage­ ment fees for managing Ward Parkway Shopping Center. The property manage­ ment fee is paid to O'Connor Management for managing the mall operations and ac­ tivities. The fee is five percent of rents paid by businesses located in the mall. O'Connor Management officials reported that the fees charged to Ward Parkway are comparable to fees charged to other properties managed by O'Connor.

O'Connor Management has received more than $145,000 in leasing fees for Ward Parkway Shopping Center. O'Connor Management receives a leasing fee for leasing space to new tenants or existing tenants in renovated areas of the Shopping Center. The leasing fee is calculated as a base fee of $2.00 per square foot leased in the redeveloped, renovated, or expanded area, plus an inflation adjustment. In addition, a fee of $100,000 would be paid for any new department store added by the renovation or expansion.

O'Connor Management has received more than $740,000 in development fees for Ward Parkway Shopping Center. Development fees are defined as fees charged for the coordination of the renovation, redevelopment, and expansion of the Shopping Center. Development fees are based on 3.5 percent of construction costs plus reimbursement of all direct and indirect expenses as defined by the contract. O'Connor Management has received more than $740,000 in development fees through December 1991 for the Ward Parkway project, and will receive $166,000 more in 1992.

Our review showed that each of these fees paid to O'Connor Management was in compliance with its agreement with Ward Parkway Shopping Center Company, L. P., the owner of the Shopping Center. While the fees paid to O'Connor Management, Inc., were never officially approved by the Retirement System, they did not appear to be out-of-line. Information provided by O'Connor showed that O'Connor's property management fees were similar to fees received by other management companies. In addition, a consultant hired by the Joint Committee on KPERS Investment Practices testified that the fees paid to O'Connor Management were in-line with what would normally be paid in the marketplace.

18. Conclusion

Through the end of 1991, O'Connor Realty Advisors has received nearly $1.4 million for managing the Ward Parkway investment, and O'Con­ nor Management, Inc., has received more than $1.5 million for managing and developing the shopping center. Together, the O'Connor fIrms have received nearly $3 million since 1987. While reviewing these fees, we found that the Retirement System had been underbilled by about $80,000 in portfolio man­ agement fees since the end of 1987. Most of the errors we noted were in the 1987 -1988 period. In several instances, O'Connor prorated new investments based on the number of days held, rather than calculating its fee based on the portfolio's value at the end of a quarter - as stated in the contract. How­ ever, we did not review the billings for periods before the initial investment in Ward Parkway, nor did we attempt to verify each of the values listed on O'Connor's billing statements.

Recommendations

1. To ensure that past errors in fees are corrected, the Retirement System should conduct a thorough review of all fee payments and expense payments made to the O'Connor companies. When that review is completed, the Retirement System should take appropriate actions to bring the amount paid into compliance with the relevant contracts.

2. If any new real estate investments are made by O'Connor Realty Advi­ sors, the Retirement System should ensure that portfolio management fees and acquisition fees are billed in accordance with contractual pro­ visions. With regard to portfolio management fees, if Retirement Sys­ tem officials want new investments prorated according to the number of days held during a quarterly period, the Retirement System should seek to amend O'Connor Realty Advisors' contract accordingly.

19.

APPENDIX A

Major Events Concerning the Retirement System's Investment in the Ward Parkway Shopping Center

July 25, 1985 The Retirement System entered into a real estate advisor agreement with J. W. O'Connor & Company, Incorporated.

November 1, 1985 1. W. O'Connor & Company assigned its rights and obligations as real estate advisor to O'Connor Realty Advisors Incorporated; a wholly owned subsidiary of J. W. O'Connor & Company. December 18, 1986 In a letter to the Retirement System, officials of J. W. O'Connor & Company listed the names of outside shareholders in J. W. O'Connor & Company, Inc. The list showed that Prairie Investment Co. owned 8.4 percent of the Company, and that Prairie Investment Co. was a partnership controlled by Copaken, White, and Blitt (a Kansas City real estate firm), various interests of Frank Morgan and Sherman Dreiseszun, and Kansas City attorney Jack Fingersh.

February 9, 1987 At J. W. O'Connor & Company's New York office, Ward Parkway Shopping Center was assigned a code number as a possible new investment.

February 13, 1987 Kroh Brothers Development Company (property manager of the Shopping Center, and a partner in the partnership that owned it) med a petition for bankruptcy.

March 6, 1987 O'Connor Realty Advisors sent a preliminary proposal letter to Barton Cohen, a representative of the owners of the Shopping Center. Barton Cohen was President of Equity Partnerships Corporation, one of the general partners in the partnership that owned the Shopping Center. This initial proposal suggested a loan from the Retirement System of about $19.5 million. March 17, 1987 Arvin Gottlieb, a Kansas City real estate developer and investor, purchased a loan from Blue Valley Federal Savings and Loan in the face amount of $14.5 million, plus unpaid interest. In July 1985, Blue Valley had loaned $4.5 million to Ward Parkway Associates and $10 million to the 1962 Kroh Trust. These loans were secured in part by a mortgage on the Shopping Center. May 21, 1987 Equity Partnerships Corporation, representing the owners of Ward Parkway Shopping Center, sent out a request for sealed bids concerning refinancing of the Shopping Center. The letter said no bids would be accepted for an amount less than $42 million, minus the first mortgage balance of about $16 million.

21. Sealed bids were to be submitted no later than June 5 (later revised to June 12).

June 1, 1987 In response to the May 21 letter, O'Connor Realty Advisors sent a proposal letter to the owners of the Shopping Center. This letter set out the basic structure of the initial investment made by the Retirement System. The amount stated in this letter was $44 million, less the principal balance of the first mortgage held by New England Mutual Life. This proposal also included a $2 million option for the Retirement System to buyout the remaining interests of the Shopping Center owners, starting seven years after closing.

June 26, 1987 Barton Cohen sent a letter to O'Connor Realty Advisors, accepting O'Connor's proposal of June 1.

July 8, 1987 A letter from J. W. O'Connor & Company notified the Retirement System that O'Connor was planning to invest about $28 million to refinance the Ward Parkway Shopping Center. The letter also said that O'Connor planned to extensively renovate, expand, and re-merchandise the property over the coming years.

November 10, 1987 A new commitment letter from O'Connor Realty Advisors restated and superseded the earlier agreement accepted on June 26, 1987. According to this letter, the transactions could not be closed until certain title issues were resolved and the proposed transactions were approved by an order of the bankruptcy court administering the estate of Kroh Brothers Development Company. (Kroh Brothers Development Company was a general partner in the partnership that owned the Shopping Center.)

November 10, 1987 A hearing was held in the Bankruptcy Court for the Western District of Missouri, and the court approved Kroh Brothers Development Company's application for approval of the general terms of a settlement agreement for distribution of the proceeds of the refinancing of Ward Parkway Shopping Center. The order documenting the court's approval of the settlement agreement and associated transactions was filed November 19, 1987.

December 2, 1987 O'Connor Realty Advisors sent a letter to the Executive Secretary of the Retirement System, seeking approval from the Retirement System's Board of Trustees (1) for O'Connor Management, Inc. to act as property manager at Ward Parkway Shopping Center, and (2) for an O'Connor affiliate to be a nominal general partner in one of the partnerships formed to carry out the proposed refinancing of Ward Parkway.

December 3, 1987 The law firm of Brown, Koralchik & Fingersh (acting as attorney for O'Connor Realty Advisors and t4e Retirement System) sent a letter to the Executive Secretary of the

22. Retirement System, explaining that the only real economic interest of any O'Connor affiliate would be the right to receive the fees and expenses described in the property management agreement. December 7, 1987 The Executive Secretary of the Retirement System wrote an internal memorandum explaining that he had no authority to give Board approval as requested in O'Connor's letter of December 2, but he would sign the document after receiving assurance that the Board Chairman had verbally approved. December 21, 1987 The Retirement System's investment in Ward Parkway Shopping Center was closed. The Retirement System invested about $28 million in cash. The investment was structured as a refinancing to avoid unfavorable tax consequences for the former owners. A new partnership was formed (Ward Parkway Shopping Center Company, L. P.) to take ownership of the property, subject to an existing mortgage of about $15.9 million. The Retirement System received a 49 percent interest in Ward Parkway Shopping Center, L. P., but gained full control over all operation and management of the Shopping Center. The investment was set up so that, starting in December 1994, the Retirement System could buyout the remaining 51 percent interest retained by the former owners for $1 million.

The following attorneys and law fIrms represented the various parties in the Retirement System's investment in Ward Parkway and related transactions:

Attorneys and Firms Parties Represented

John Hickey (now of Lewis, retained by O'Connor to Rice, & Fingersh; formerly represent the Retirement Brown, Koralchik, & Fingersh) System

William Shapiro (now of Rose, represented Ward Parkway Brouillette, & Shapiro; Associates (fIrm also acted formerly Ryder, Rose, Frensley, as counsel to Equity & Shapiro) Partnerships Corp. and Star Associates, both partners in Ward Parkway Associates)

Thomas A. Higgins, ill (of represented the 1962 Kroh Gage & Tucker) Family Trust

Jacob Bayer (of Shughart, represented Arvin Gottlieb Thomson, & Kilroy)

James A. Polsinelli (of represented Kroh Brothers Polsinelli, White, Vardeman Development Co. & Shalton)

23. Attorneys and Firms (cont'd.) Parties Represented (cont'd.)

David Wells and Linda Goyda represented Mercantile Bank (of Thompson & Mitchell)

February 11, 1988 A hearing was held in the Bankruptcy Court for the Western District of Missouri, and the court approved a reorganization plan submitted by the debtors (various Kroh organizations, including Kroh Brothers Development Company) and the Ozar Partnership. The Ozar Partnership provided the financial backing for the operating partnership that continued the Kroh Brothers businesses under supervision of the bankruptcy court, pending liquidation of assets. The partners in the Ozar Partnership were I. I. Ozar, Frank Morgan, and Sherman Dreiseszun.

February 23, 1988 In response to various concerns and questions, O'Connor Realty Advisors sent a letter to the Retirement System's Executive Secretary, explaining the structure of the Ward Parkway investment and O'Connor's economic an~ysis. The letter says that O'Connor hoped to effect a major redevelopment of the Shopping Center.

March 7, 1988 ' Another letter sent from O'Connor to the Retirement System, explaining the mortgage debt on the property. In this letter, the market value of the property was estimated to be about $50 million. '

March 15, 1988 An O'Connor letter to the Retirement System referred to the Ward Parkway investment and said that O'Connor was "in the process of evaluating expansion and renovation options and , will keep the Board informed of our progress." Documents enclosed with the letter made it clear that the Retirement System's position was "the equivalent of equity ownership," and that the structure of the investment was designed to reduce the seller's tax liability.

March 25, 1988 At a Retirement System Board of Trustees meeting, a representative of O'Connor Realty Advisors summarized the main aspects of the Retirement System's investment in the Ward Parkway Shopping Center.

May 16, 1988 Buss-Shelger Associates, a Los Angeles real estate consultant fIrm, sent a completed appraisal report to J. W. O'Connor & Company in New York City. The appraisal estimated the fair market value of the Shopping Center at $46 million as of April 1, 1988. March 31, 1989 O'Connor's quarterly report to the Retirement System mentioned the selection of a design and architectural fInn for the renovation of the Shopping Center.

September 22, 1989 The Retirement System committed another $28.5 million, in the

24. form of a construction loan, to finance the renovation of the Shopping Center.

January 1990 Renovation and redevelopment work began at the Shopping Center. The major components included renovation of mall common areas and entries, relocation and expansion of the food court, conversion of the Woolworth area to small store space, and addition of a new 12-screen theatre.

January 29, 1991 In response to a question raised by a legislator, O'Connor sent a letter to the Retirement System, explaining that Prairie Investment Company owned 8.4 percent of J. W. O'Connor & Company, and members of Frank Morgan's family owned about 17 percent of Prairie Investment Company.

February 1991 The renovation of the Shopping Center was virtually completed, except that the theatre complex was not finished until November 1991.

June 24, 1991 O'Connor sent a letter to the Chairman of the Retirement System's Board of Trustees, clarifying the Morgan family interests in Prairie Investment Company and J. W. O'Connor & Company, and asserting that this information was provided at the time O'Connor was hired as a real estate investment advisor in 1985. September 26, 1991 O'Connor Realty Advisors submitted to the Retirement System a listing of the internal valuation as of June 30, 1991, for each asset in the real estate portfolio, based on the lower of cost or market value.

November 22, 1991 The Joint Committee on KPERS Investment Practices received a written report from the Mortgage Investment Trust Corporation of Prairie Village. The report estimated the value of Ward Parkway Shopping Center was $50-56 million, before consideration of the first mortgage on the property. The Joint Committee received testimony from Lindsay Olsen of Mortgage Investment Trust Corporation and Ben Gifford of O'Connor Realty Advisors.

December 31, 1991 In its quarterly report, O'Connor Realty Advisors stated that income flowing from the Shopping Center to the Retirement System should be about $1.2 million in 1992, and about $4.6 million in 1993. The Retirement System's total cost was estimated to be $78 million, including $15.5 million of third-party debt and $33 million for the redevelopment.

25.

APPENDIXB

Summary of Individuals and Firms that Received Funds from the Renovation of Ward Parkway Shopping Center

The following pages show a list of some of the individuals and firms that received money from the renovation of the Ward Parkway Shopping Center through January 1992. The list is categorized as follows:

• Payments to Contractors and Vendors • Payments and Allowances to Tenants • Payments to Law Firms • Payments to Individuals

27. Summary of Payments to Contractors and Vendors Amount Vendor Received 1 Bennett/Kroll - (General Contractor) $ 11,281,802 2 Harris Construction - (Theatre Construction) 2,907,406 3 FCO&A - (Architecture & Engineering) 980,286 4 North American Roofing 798,489 5 Musselman & Hall Contractors 552,182 6 RTKL - (Architecture & Engineering) 451,110 7 B & R Insulation 389,086 8 Midwest Drywall 326,876 9 Lico Steel 233,835 10 Metro Tile 219,758 11 Shaw Electric 162,280 12 Wesnic - (Food Court Furniture) 152,174 13 Mallscapes 105,344 14 Lennox Industries 85,340 15 Northeast Painting 83,429 16 Building Management Consultants 75,743 17 Blue Springs - (Ventilation and Duct Work) 70,979 18 American Fire Sprinkler 66,183 19 Sunbelt Steel 58,362 20 Quality Plumbing 57,251 21 Intercity Mechanical 56,375 22 Acme Sign Co. 53,955 23 All State Mechanical 49,723 24 D&MMasonry 47,759 25 Lintech Limited- (Temperature Control Systems) 42,393 26 GS&B Advertising 41,037 27 General Testing 39,712 28 Montgomery Elevator 32,531 29 A-Cord Electric 29,113 30 Deffenbaugh Disposal Service 28,975 31 Meyerdirk Title Co. 27,644 32 Valentine Roofing 23,478 33 HSGjGould Associates - (Market Studies) 23,200 34 Saladino Plumbing 22,534 35 Commercial Openings 21,831 36 PSI - (Test Boring) 20,987 37 TapanArn - (Inspections) 19,905 38 Livers Brass 19,527 39 Lico Construction 19,000 40 Norton & Schmidt - (Inspections) 18,967 41 Smith & Luebbert Construction 17,390 42 Hammer, Siler, George, & Assoc. - (Market Studies) 16,171 43 Imperial Glass 15,356 44 All State Plumbing 14,375 45 Sol's Glass Co. 14,135 46 Merritt Engineering 11,931 47 Wiss, Jarmey, & Elstner Assoc. 11,464 48 Kansas City Star 11,212 49 Ferrellgas 10,815 50 Gannett Outdoor 10,000 Total $ 19,829,410 28. Summary of Payments and Allowances to Tenants Amount Tenant Received 1 Woolf Brothers $ 1,046,393 2 Lerner 850,000 3 Limited 750,000 4 Woolworth 400,000 5 Function Junction 260,000 6 Everything's a Dollar 130,000 7 HaIper's Fabrics 100,000 8 Mrs. Field's Cookies 77,500 9 B. Dalton 74,413 10 Mr. Bulky 60,000 11 Gloria Jean's 59,600 12 Software Etc. 58,800 13 Nu-Way 56,795 14 JMPorter 55,500 15 Overland Trading 50,000 16 Frankly Fries 43,657 17 Crnze 35,738 18 Hair Care Harmony 25,000 19 Ward Parkway Health Services 23,000 20 Life Unifonn 20,000 21 DePalma Group (Woolf Bros.) 19,580 22 Egg Roll House 15,000 23 Amigo's 10,000 24 Shoe Express 8,000 25 ICBY 6,720 26 Russell Stover Candy 5,000 27 Grainger (Sir Knight) 141 28 Deck The WaIls 80 Total $ 4,240,917

Summary of Payments to Law Firms Amount Eiml R~~ived 1 Ross & Cohen $ 123,652 2 Lewis, Rice, & Fingersh 50,193 3 Law Offices of David Skrilow 28,041 4 Brown, Koralchik, & Fingersh 6,141 5 Shook, Hardy, & Bacon 2,962 Total $ 210,989

Summary of Payments to Individuals Amount Individuals Rec~ived 1 Robert Hunzeker $ 26,667 2 Mike Pusateri 8,930 3 Roy Perry 3,149 4 Dan Alcala 1,466 5 Robert Dizmang 800 6 Mary McKenna 800 7 Joel A. Siegel 575 8 Susan Shank 550 9 Virgil Edmisten 160 Total $ 43,097

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APPENDIXC

Agency Response

On March 6, 1992, we provided copies of the draft audit report to the Kansas Public Employees Retirement System. Its response is included as this Appendix.

31. Kansas Public Employees Retirement System

March 16, 1992

Barbara J. Hinton Legislative Post Auditor Legislative Division of Post Audit 800 S.W. Jackson, suite 1200 Topeka, KS 66612-2212

Dear Ms. Hinton:

We appreciate the opportunity to respond to the draft copy of the completed performance audit report, Examining the Investment in the Ward Parkway Shopping Center. We also appreciate the opportunity to respond to this audi t report today, after last Friday's meeting of the Board of Trustees of the Retirement System.

As you may know, at that meeting, the Board of Trustees took action to implement additional controls and oversight of the Retirement System's real estate portfolio. Specifically, the Board of Trustees instituted a three-party approval process with respect to any restructurings of real estate investments. The new process requires that a recommendation to restructure an investment made by the real estate investment advisor be reviewed and approved by both Retirement System staff and The Townsend Group, acting in its capacity as real estate oversight advisor. Funding of previous commitments and additional investments of $2 million or less will be subj ect to the three-party approval process. Funding of additional investments of greater than $2 million will also require approval by the Board of Trustees.

Additional control and oversight was also implemented by the Board with respect to the funding of draw requests for developmental properties by the O'Connor Group. Retirement System staff will be working with The Townsend Group to retain an engineering consultant to review detailed documentation supporting the draw requests, and to ascertain whether the payments requested are reasonable. The draw requests will have to be approved by Retirement System staff, working with the engineering consultant, prior to funding. The engineering consultant will also be asked to review previous draw requests in order to determine whether the costs incurred were reasonable.

The Board of Trustees also took action to approve, in principle, an annual appraisal process for the Retirement System's real estate investments. A complete narrative appraisal will be conducted for each of the Retirement System's real estate invest-

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Capitol Tower - 2nd Floor - 400 w. 8th - Topeka, Kansas 66603-3911 - Phone (913) 232-6665 KPERS Telephone Facsimile (913) 232-3041 In Kansas, Call Toll Free 1-800-228-0366 Page 2 Barbara J. Hinton March 16, 1992 ments as of the end of the fiscal year, June 30, 1992. Appraisals will be bi-annual thereafter. Interim appraisals might also be conducted upon notice from the advisor of a significant event at the property. The appraiser will be retained by the Retirement System, and will be required to be a certified MAl.

We would like to note that, while O'Connor was a "discretionary manager," as noted on page 7 of your audit report, the statement that they did not need approval from the Retirement system to proceed with a new investment is correct, as long as the investment was within the parameters of the real estate investment guidelines.

with respect to O'Connor's role as property manager of the Ward Parkway Center, the report states that fees paid to O'Connor Management, Inc. were never officially approved by the Retirement System. However, the property management fees were disclosed to the Retirement System in the Management Agreement, which was attached as Exhibit B to the December 2, 1987, letter from O'Connor to the Retirement System.

We concur with the recommendation that, when an investment manager's contract or a Retirement System guideline requires the Board of Trustees' approval for a specific action or exception, the Retirement System should ensure that such approval is properly voted on and documented in Board minutes.

We also agree that O'Connor Realty Advisors (and all other investment advisors employed by the Retirement System) should follow the Retirement System's investment policies, as required by its contract. All exceptions to compliance with investment policies and guidelines will be documented in writing.

Retirement system staff are in the process of reviewing all of the historical transactions for the direct placement and real estate investments in order to verify that transactions were processed correctly, and in order to correct those transactions which were handled incorrectly. That review process will encompass the past fee payments made to O'Connor, and appropriate action will be taken to bring the amount of fees paid into compliance with the contract.

The Board of Trustees has placed a moratorium on additional real estate investments. However, Retirement system staff now have procedures in place which ensure that all fee statements received from investment advisors for the Retirement System are billed in accordance with contractual, provisions.

33. Page 3 Barbara J. Hinton March 16, 1992

The Retirement System's staff and Board of Trustees are committed to aggressive, proactive, and ongoing oversight of the real estate investments. We look forward to discussing this audit and our response with the Legislative Post Audit committee in the near future, and to your presentation of this report to the Board of Trustees at their April 10, 1992, meeting.

Sincerely, W~LJ~ Meredith Williams Executive Secretary

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