HD53 - The Virginia Retirement System's Investment in the RF&P Corporation

  • Published: 1994
  • Author: Joint Legislative Audit and Review Commission
  • Enabling Authority: House Joint Resolution 392 (Regular Session, 1993)

Executive Summary:
House Joint Resolution 392 directs the Joint Legislative Audit and Review Commission (JLARC) to study the investment practices of the Virginia Retirement System. A major focus of the study mandate is on the retirement system's investment in the RF&P Corporation. A review of the RF&P investment was of particular interest to the General Assembly because of concerns about the soundness of the investment.

In May of 1990, the Board of Trustees for the Virginia Retirement System (VRS) began the process of acquiring the RF&P Corporation through a transaction in which the company's railroad assets were sold to CSX. With the completion of a complex series of asset and stock purchases and a tender agreement in October of 1991, the State's retirement system became the owner of the RF&P Corporation, whose primary assets were now real estate.

The unique nature of this acquisition has sparked considerable debate and some concern about the retirement system's ownership of RF&P. The concerns and debate about the investment were due, in part, to a lack of information about the acquisition available to the General Assembly. While there is no requirement for VRS to inform the General Assembly of its intent for each individual investment it may consider, the unique nature of the RF&P investment and the General Assembly's ultimate constitutional responsibility for the retirement system should have prompted the VRS to better inform the Legislature of the purpose and long-term benefits of the acquisition.

This report presents the results from JLARC's analysis of the RF&P investment. The JLARC review of RF&P was broadly designed to address three major concerns related to the investment in RF&P: (1) did the Board properly discharge its fiduciary responsibility when making the decision to acquire the company; (2) is RF&P a prudent and sound investment for a public pension fund like VRS; and (3) is the use of a holding company the most appropriate mechanism to safeguard or manage the State's interest in RF&P.

Because of the complexity and scope of this review, two approaches were used to complete the evaluation. First, JLARC staff examined the investment decision-making process that was used by the Board of Trustees over the 18 months in which the investment was evaluated, as well as the internal organization and management of RF&P. Second, in light of the special expertise required when evaluating real estate, corporate tax laws, and corporate structure issues, JLARC procured the services of two groups of consultants with experience in these areas to assist the study team in its review.

The Soundness of the Retirement System's Investment in RF&P

Although the price the Board of Trustees paid to purchase RF&P presently accounts for less than three percent of the total assets of the pension fund, this acquisition represents the largest and most complex single real estate investment which VRS has ever made. Partly as a result of this, concerns have been raised about the quality of the investment, whether the VRS Board of Trustees obtained the necessary professional advice when it acquired the RF&P, and whether the decision to acquire the RF&P was reasonable given the information available to the Board.

Reasonableness of the Acquisition of RF&P by VRS. As trustees for the retirement system, the VRS Board has a legally binding fiduciary duty to protect pension fund assets by exercising the necessary prudence and skill when considering any investment. Given this responsibility, the nature and structure of the RF&P acquisition imposed special demands on the Board of Trustees.

In general, the information reviewed for this study shows that the Board did properly exercise its fiduciary duties associated with evaluating the RF&P investment before the company was acquired. In evaluating the acquisition, the VRS Board spent $3.8 million to procure the services of special legal counsel, several financial and real estate experts, and a firm specializing in environmental liability studies. Based on the advice the trustees received from these advisors, and the given assessed value of RF&P's assets, the Board acted reasonably in deciding to acquire the company.

Completely apart from the question of whether the VRS Board of Trustees hired the appropriate experts to evaluate this acquisition is the issue of whether it was reasonable for the Board to purchase the RF&P. The JLARC consultants estimate the value of the VRS interest in RF&P is $478.6 million. Therefore, the decision by the Board to spend $379 million to acquire the company appears reasonable and prudent.

The Impact of RF&P's Deferred Tax Liabilities. Currently, RF&P has two substantial deferred tax liabilities. One is based on the potential gain associated primarily with the appreciation in its real estate assets. The other potential liability, which RF&P asserts does not exist, is based on a complicated restructuring of the company which occurred in 1988, prior to the VRS acquisition. However, in both cases, these taxes are considered deferred and do not have to be paid unless there is a sale of the assets or a reorganization of certain subsidiaries. Consequently, if VRS were to liquidate RF&P, it would likely be required to pay more than $454 million in federal and State taxes.

It appears that the VRS Board was informed, at the time of the acquisition, of these liabilities and the limitations they posed pertaining to the liquidation of RF&P or the sale of its key assets. The professional advice the Board received supported its plan to hold these assets essentially tax-free for long-term development purposes. While the VRS Board acted prudently based on this advice, some trustees should have pressed their legal counsel for additional, more detailed information.

Based on the tax findings presented in this report, it would be imprudent for VRS to liquidate its interest in the RF&P. If such a liquidation did occur, deferred tax liabilities which can be minimized over time through careful planning will be triggered. Rather than liquidate the company, the consultants retained by JLARC for this study conclude that it would be more beneficial to pursue business strategies which minimize RF&P's tax liabilities and offer the benefit of an enhanced income stream from the company's key assets. This is consistent with RF&P's plans for the management of its assets.

The Investment Value of the RF&P Corporation. Judgments about the value or quality of RF&P as an investment for the State's pension system must consider the diversity of the RF&P's assets and the Board's purpose in acquiring the company. Although RF&P's assets include valuable, income-producing commercial real estate, the company also owns a substantial amount of undeveloped land. Presently, the most valuable parcels of land produce no capital return, an insignificant amount of real estate income, and are unlikely to experience appreciation in the near future. Consequently, as a short term investment RF&P is unsatisfactory.

However, due to the value of the undeveloped properties, the potential for developing a substantial and steady income stream for the pension fund is strong. Also, it is likely that these properties will experience a considerable amount of capital appreciation in the future. Based on this, the real estate consultants for this study concluded that the RF&P is a reasonable long-term investment for the pension fund.

If the long-term potential of this investment is to be realized, RF&P staff will have to successfully manage the risks associated with this project. This includes the need to negotiate favorable zoning terms for its raw land at Potomac Yard, work out satisfactory agreements with the National Park Service and local officials on infrastructure issues, and keep development costs at a reasonable level.

Oversight and Accountability for VRS' Investment in RF&P

The acquisition of the RF&P Corporation by the Virginia Retirement System represents the merging of two distinctly different organizational cultures. The first is the culture of State government, a large, highly structured, bureaucratic organization with explicit laws, policies, and operational procedures to govern the decision-making process and ensure accountability in the expenditure of State resources.

The other, is the culture of a private corporation, the RF&P, which is a 156-year old company, presently experiencing internal shifts in its mission and basic responsibilities. While the RF&P was once a highly structured railroad which owned quality real estate, it is now a real estate company with the sale mission of generating competitive yields for its only shareholder, the State of Virginia. In light of this, important legal, organizational, and corporate governance issues are raised for both VRS and the RF&P.

SHI Could Provide Oversight and Accountability. In 1991, the independent legal counsel for the retirement system recommended that the VRS Board begin using single-purpose corporations to reduce its liability risks associated with its ownership of real estate. Although this recommendation appears unrelated to VRS' subsequent purchase of the RF&P, the Board used changes in the Code of Virginia authorizing the use of the corporations to form System Holdings, Inc. (SHI), and granted it the authority to purchase the stock of RF&P.

The mere existence of this holding corporation adds little to the protection from liability that already exists between VRS and RF&P. However, with the current structure of RF&P, SHI should be retained because it serves important governance functions for the VRS. Given the other demands on the Board's time and attention, it is prudent to delegate the initial oversight responsibility to an independent board of directors. Therefore, as long as VRS continues to own the entire equity interest in RF&P as it is now constituted, it should do so indirectly through SHI.

To facilitate proper oversight, SHI should establish a more formal standard reporting format for RF&P that requires the company to provide quarter1y reports on the company's investment performance, real estate acquisition program, business plan, fiscal management, and personnel issues.

Recommendation (1). The board of directors for Systems Holding Incorporated should establish a formal quarterly reporting requirement for RF&P which uses a standard reporting format to oversee the company's performance. This format should request information on RF&P's cash flow including partnership distributions, its real estate acquisition program, a progress report on the status of the business plan, and a report on the company's budget and actual expenditures.

Coordination of VRS and RF&P Real Estate Acquisitions. As a private real estate company, RF&P has its own real estate acquisition program that will be implemented apart from the activities of VRS' Real Estate Advisory Committee. This situation raises important governance questions related to VRS management of the RF&P asset. As fiduciaries for the pension fund, VRS clearly has the responsibility to expect that its policy views regarding investment decision-making be reflected in the investment activities of its real estate managers.

The most effective method to ensure that RF&P's senior management is consistently apprised of the goals and objectives of VRS' real estate program is to place one member of the VRS Real Estate Advisory Committee on the RF&P board of directors. As one of two VRS representatives on the RF&P board, this member could articulate the real estate investment views of VRS to RF&P staff as they consider various acquisitions.

Recommendation (2). The SHI board of directors should appoint a real estate professional or other qualified member of the VRS Real Estate Advisory Committee to one of the two seats reserved for VRS on the board of directors for RF&P. This member should have a full understanding of and be able to articulate VRS' real estate investment strategy.

Performance Standards for the RF&P. While RF&P should not be subject to additional external restrictions, both the board of directors and senior management must recognize that the company has a special responsibility to operate in a prudent and efficient manner. Though not a government agency, the company needs to be sensitive to public perceptions and expectations regarding its decision-making and operations.

Because of its unique relationship with the Commonwealth of Virginia, RF&P's standard of accountability needs to be higher than the norm for other private corporations. For example, regardless of its performance as an investment for the pension fund, expenditures at RF&P will be especially scrutinized. Every dollar that the company spends will be perceived as money which could have been distributed to the pension fund. In light of this, the RF&P board needs to ensure that public accountability becomes an important part of the organizational culture at the RF&P.

Recommendation (3). The RF&P board of directors should consider the development of "accountability guidelines" and "standards of conduct" for the board and staff, recognizing the company's unique relationship with the Commonwealth of Virginia.

Development of RF&P's Business Plan

Since VRS acquired RF&P in 1991, a significant amount of the work of the company has been focused on developing and implementing a business plan designed to make RF&P a cash-yielding vehicle for the pension fund. The business plan outlines RF&P's strategy for developing its raw land, resolving various zoning and environmental clean-up issues, and managing the development costs of Potomac Yard. RF&P's business plan provides a general and conceptual discussion of the company's future plans for minimizing the impact of the taxes on any distributions to the VRS. Basically, the company is in the process of evaluating two approaches. The first would involve the formation of partnerships to develop some of its raw land. The second would involve transforming the RF&P Corporation into a real estate investment trust (REIT).

Based on a review of the work conducted by RF&P staff, the consultants used by JLARC for this study have concluded that the plan is comprehensive, has feasible goals, and can probably be successfully implemented with considerable patience and skill.

Organization and Management of RF&P

Although RF&P appears to have established a sound business strategy for the management of its assets, this plan creates special challenges for the company. In order to execute this plan, both the RF&P board of directors and the company's senior management will have to resolve a number of organizational and management problems within the corporation.

Departments Have Not Adjusted to New Mission. In the new RF&P, each of the company's departments has been redefined to accommodate the corporation's new mission. However, at times RF&P's progress towards fulfilling its new mission has been frustrated by some of the company's tradition-bound employees who have resisted change.

According to most all accounts, none of the major departments within the RF&P -- finance, legal, real estate -- have completely adjusted to the company's new mission or the demands placed upon them by the president. For a number of reasons, the most serious performance problems appear to have occurred in the Finance Department. Nonetheless, there have also been deficiencies in the performance of the Law and Real Estate Departments.

In some cases, the problems experienced by RF& P are to be expected given the disruptive nature of the attempted merger by CSX and the subsequent acquisition of the company by VRS. Still, in other cases, some staff appear to have been resistant to the new mission and direction of the company.

In addition, attempts by the president of RF&P to reorganize the company around its new mission have been blocked by staff employment contracts which sharply limit any changes in the job functions of virtually all of the company's senior Vice-presidents. Based on interviews with RF&P staff, it appears that several of the vice-presidents at the company are either completely or partially underutilized. Given the salaries that the RF&P pays its vice-presidents, this has created special problems in the efficiency of company operations. However, because some of these employees are secured by encumbering employment contracts, a reorganization of the company to address this problem would be costly. If RF&P violates these contracts, it must pay the relevant employees amounts that equal two and one half times their salaries subject to IRS limits.

Management Style Not Accepted by Staff. When the new management was installed at RF&P in 1991, the company lacked internal operating procedures, had an insufficient number of staff, and was faced with the pressing demand to develop a strategic plan for the management of its assets. So as not to be inhibited by the limitations of existing departments and the railroad-related skills of some staff, the president of the company responded by forming teams to complete specific tasks based on the particular needs of individual projects.

In terms of productivity, the strategy used by the president to organize the work has served RF&P quite well. After a slow start on evaluating its tax questions and developing a strategic plan, the company has developed a business plan, presented it to VRS, and is now prepared to submit a ruling request to the IRS that could eliminate one of its large deferred tax liabilities.

These are important accomplishments for a company that is in the process of being reorganized. However, in accomplishing these objectives the president failed to adequately communicate his management style and objectives to key staff members. As a result, many of the RF&P staff members did not understand his motives for circumventing the hierarchy and have expressed disappointment over what they perceive as an attempt by the president "to push some staff" out of the company. Even staff members who understand and agree with his reasons, suggest that the president's management style has caused some problems, in part, because it was not adequately communicated to staff.

Lack of Attention to Administrative Issues. When RF&P was a railroad, its corporate manual consisted of 43 executive orders which established the operating environment of the company. With VRS' acquisition of the company, six of these executive orders were made obsolete and a decision was made to revise the orders by creating a new corporate policy manual. While revisions to the policies were made, they were not adopted by senior management. As a result, a year and a half after the process was initiated, the company has not developed a comprehensive set of policies to establish an operational framework for RF&P and distributed them to staff.

For many employees, this has raised unnecessary questions about the stability of the company. More importantly, it has at times, produced inconsistencies in management practices. Specifically, at the time of this study, RF&P had yet to articulate the company's organizational structure and reporting relationships to all staff members, there was no formal employee evaluation system, company job descriptions were still not ready for dissemination, and there was no policy on moving expenses or staff expenditure authority.

It appears that the primary reason that these organizational issues have not been addressed in a timely manner is the competing responsibilities of the vice-president of Planning and Administration. Although hired primarily to manage the administrative affairs of the company, the vice-president has spent a considerable amount of his time acquiring and closing real estate deals in Northern Virginia and Richmond.

Future Role for RF&P Staff in the Management of the Company's Assets. One question that has been consistently raised about the RF&P Corporation is whether its assets could be adequately managed through a model similar to that used by VRS' real estate division to manage its assets. In this model, VRS' asset managers hire companies to manage the leases on its buildings. When leases expire, the management company is expected to find replacement tenants.

This would not be a prudent approach for the management of RF&P's assets. First, RF&P owns a substantial amount of undeveloped land. Before this land will be converted to a cash-yielding asset for VRS, a number of zoning and environmental issues will have to be resolved. This requires a staff that has the knowledge and time to devote to these issues, as well as an ongoing relationship with local officials who control zoning rights.

Second, and perhaps most important, if VRS is to receive an adequate return on this investment, RF&P's deferred tax liabilities must be expertly managed and coordinated with the company's overall plan to generate a tax-free yield for the pension fund. Few management companies possess the expertise to deal with the complicated tax questions that RF&P will have to resolve over the next few years.

Interim, Part-Time President Has Created Instability. The current president of RF&P was originally hired by the company's board of directors on a temporary basis to assist in the search for a permanent chief executive officer. In organizing the search process, the board realized that RF&P did not have a clearly defined mission. More importantly, very little attention had been given to how the company would function as a pension fund asset. Consequently, the RF&P board requested that the current president work with the company on an interim, part-time basis to develop a job description for the chief executive officer and a business plan to guide the future direction of the company.

However, at this point, it appears that the company has moved past the stage from which it can further benefit from having a temporary, part-time president. As RF&P moves forward with the implementation of its business plan, the president of the company will be called on a daily basis to address issues related to zoning; commercial and residential real estate development; corporate taxes; real estate acquisitions; real estate finance; and environmental liabilities.

Recommendation (4). The RF&P board of directors should begin the process to recruit and appoint a permanent, full-time president and chief executive officer for the RF&P.

Continuity and Political Neutrality Will Be Important for the RF&P Board. As a private real estate company, wholly owned by the Commonwealth of Virginia, RF&P can anticipate a level of interest and scrutiny of its operations that will be unusual for a private corporation. This will be especially true for the policymaking arm of the company -- the RF&P board of directors.

As stewards for the RF&P, both SHI and the VRS Board of Trustees need to exercise caution and good judgment in situations whenever it exercises the chief prerogative of a shareholder -- the election and removal of board members. If the company is to succeed, it is essential that VRS and SHI attempt to establish continuity in service for RF&P directors and work diligently to keep the appointment process free from the appearance of political interference or influence.

Recommendation (5). The board of directors of System Holdings, Inc. should establish written qualifications for appointments to the RF&P Corporation's board of directors. The criteria for appointment should be based on clearly demonstrated expertise in real estate management, investment, finance, or business management.

The Future of the Pension Fund's Investment in RF&P

As noted in the discussion of RF&P's real estate portfolio, approximately 43 percent of its assets are undeveloped land. Although this land has considerable value and development potential, there is some risk associated with holding such assets for future development. Under the current structure for this investment, the VAS assumes all of this risk because it owns 100 percent of the company. Should the VRS Board of Trustees determine that such an ownership position is inappropriate for the retirement system over the long term, it should be careful to reduce its interest in the company based on sound economic analysis and in ways which protect VRS' remaining investment in the RF&P.

Regardless of the eventual ownership position which VRS may take in the company, the consultants for this study have concluded that VRS should not find it necessary to provide any financing for the development of the RF&P properties. According to the consultants, RF&P should seek necessary financing from conventional lending sources such as contributions from partnerships or borrowing from commercial banks. It would be imprudent for VAS to finance development in any case for which funding cannot be competitively secured from such conventional sources.

Recommendation (6). The Virginia Retirement System should evaluate the appropriateness of its sole ownership of the RF&P Corporation. If some reduction of VRS' interest is considered prudent by the Board, it should carefully evaluate alternatives to ensure that the remaining investment in the RF&P Corporation is not jeopardized.

Recommendation (7). The Virginia Retirement System should, in keeping with current policy, provide no funding for the development of RF&P land holdings. Financing for the development of the properties should be secured only through conventional sources.