Diane Bucci and her fellow retired Rhode Island schoolteachers were angry about a deal last year to cut their promised retirement benefits. For 28 years, the elementary school teacher devoted between 7 and 9 percent of her paycheck to the state’s pension system. In return, the 72-year-old had been promised a consistent cost-of-living increase to make sure her retirement stipend kept pace with inflation. Now, though, state officials were trimming her check in the name of replenishing the depleted pension fund.

There was, however, a sliver of hope — or so it seemed: If the pension system could generate better investment returns and amass 80 percent of the money needed to pay current and future retirees, the annual cost-of-living increases would return.

“There was a lot of unrest and anger among teachers, but at that point we buckled down and focused on how we could get to solvency,” said Bucci, who is on the board of the 700-member Rhode Island Retired Teachers Association. “So even though we aren’t Wall Street experts, we just started to ask questions about how the pension fund was managed, and what it was invested in. That’s when we realized the fees we’ve been paying to the investment companies were the problem.”

Those levies — which hit $79 million last year — were the product of the state’s recent investment strategy. Following a controversial national trend, Rhode Island pension officials led by then-General Treasurer Gina Raimondo shifted roughly a quarter of the state’s pension portfolio into high-fee hedge funds, private equity firms and other so-called “alternative investments.”

The shift by Raimondo, a Democrat who is now governor, has generated big revenues for Wall Street firms, but only middling returns for a $7.6 billion pension fund on which more than 58,000 current and future retirees rely.

When Bucci and the members of her organization began asking questions about those results, they learned of a federal review showing that roughly half of all private equity firms are charging hidden fees, and they saw a hedge fund industry whose returns have failed to keep pace with the stock market. When they dug deeper, they stumbled onto an even more disturbing revelation. What they found, they say, is evidence that some investors can obtain special rights that may let them secretly siphon money from the state pensioners’ retirement savings.

The retirees are now petitioning federal law enforcement officials to investigate whether the widely used provisions are violating laws designed to make sure all investors are treated fairly. In a letter sent last month to the Securities and Exchange Commission and the FBI, the retirees’ adviser — former SEC investigator Edward Siedle — pointed out that some of the firms managing Rhode Island pension money claim the right to offer different fee rates, inside information and cash-out rights to some investors but not to others.

Read the fine print in SEC forms

12 out of 18 hedge funds in the Rhode Island portfolio have filed documents with the SEC showing they assert the right to give certain investors preferences over other investors. Click on the images of the documents below to read the fine print for each of the 12 firms. Once you've clicked on the document, you can read the firm's key points, which we've highlighted in yellow and which you can skip to by clicking the quotes on the sidebar on the right.

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Siedle and the retiree group he represents say they are concerned the provisions could enable financial managers to boost the returns of sophisticated or well-connected private investors — such as firm executives, their family members, friends and business associates — with cash from the $3 trillion now in public pension systems across the country.

“When money managers disclose that secret investors may be given preferences, state pension officials and pensioners deserve to know whether they are being harmed in the process,” Siedle told International Business Times.

Raimondo did not respond to IBT’s questions about her shift of retirees’ savings into alternative investments or about special preferences for certain investors. Of the pension cuts she pushed for, she recently told the Wall Street Journal: “There’s still a core group that’s angry, and in many ways I understand why they’re angry. I tell them, ‘Don’t be mad at me. Be mad at people who made promises that were unaffordable.’”

‘Flexibility to Negotiate’

Giving special preferences to elite investors is a controversial practice barred in some parts of the financial world, such as mutual funds. In more lightly regulated alternative investments, though, the strictures are less clear.

“An investment manager [in alternatives] owes a fiduciary duty such that he or she treats investors in a similar manner,” said Ron Geffner, a former SEC regulator who is now a private attorney and the vice president of the Hedge Fund Association. “That said, many things may be negotiated in a side letter, giving managers the flexibility to negotiate certain terms with investors.”

According to financial experts who were asked about special investor rights in general (not specifically the Rhode Island deals), financial firms sometimes use side letters to court deep-pocketed investors with access to non-public information, lower fees or special rights to withdraw their money — potentially leaving other investors with losses. The letters are also used to comply with certain clients' special needs — say, a public institution's bylaws requiring it to collect customized data about its investments. Some financial firms say they do not have to notify investors of their side letters with others.

“There is a legitimate reason for some of these preferences,” said Harvard University’s Jay Youngdahl, an attorney who serves as a trustee for a steelworkers’ pension fund in Ohio. “But there’s also a not-so-legitimate reason for these preferences: If you are a Wall Street money manager, it allows you and your buddies to build a black box and loot retirees’ money.”

Over the last decade, SEC officials have repeatedly warned that such preferences could improperly shield favored investors from expenses that should be shared by all investors. In 2013, the agency brought successful cases against hedge funds over their decision to give certain investors special privileges. Earlier this year, the SEC sanctioned private equity giant KKR for charging fees to investors that it didn’t charge to its own executives in the same investments.

‘The Classic Setup for a Con’

Fears about such schemes are acute for pension funds, which are often controlled not by the retirees, but by public officials. The worry is that with no skin in the game — and with campaign contributions and junkets working to influence their behavior — pension officials may not always prioritize the best interests of retirees. Some analysts use the term “dumb pension money” to describe the issue of pension officials potentially being less rigorous in their decision making — which could make retirees susceptible to being harmed by special privileges given to other investors. Concerns are particularly intense when it comes to pension investments in hedge funds, which generated poor returns for retirees last year but still made headlines spending investors’ money on lavish year-end parties.

Rhode Island’s retiree association appears to be the first to request a criminal probe of whether the preferences are harming taxpayers and government workers. In all, municipal and state pension funds now have roughly $660 billion in alternative investments.

Rhode Island has led the charge into those riskier investments at the behest of Raimondo — a former venture capitalist at a firm that has charged the state pension some of the highest fee rates of any in its portfolio. She won the treasurer’s office in 2010 and quickly pushed to shift roughly $2 billion of retirees’ assets into private financial firms. Raimondo simultaneously proposed cuts to pension benefits in a state where the average retired teacher gets a $45,000 annual stipend.

Photo: Brian Snyder/Reuters

As government workers protested the cuts, a Rhode Island union hired Siedle to evaluate whether the pension fund’s investments were draining the system. When he and Rhode Island’s largest newspaper requested the text of agreements between the state and private financial firms, they were blocked by Raimondo’s office, which at one point justified the decision by noting that Wall Street managers seek “to minimize attention around their own compensation.” Rhode Island, like many states, allows public officials to withhold details of their agreements with private financial firms.

Siedle’s 2013 report concluded that Raimondo’s push into alternative investments such as hedge funds would help financial firms rake in more than $2 billion in new fees. Since 2011, Rhode Island’s $1.2 billion hedge fund portfolio has overall generated $140 million in fees for hedge fund firms while delivering returns that have significantly trailed traditional low-fee stock index funds. Rhode Island’s pension finances have slightly improved in recent years, but the state still faces a $1.8 billion gap between pension assets and liabilities.

Along with warnings about fees, Siedle’s report also cited some of the firms’ own SEC filings in which they assert the right to give unnamed investors special preferences not necessarily afforded to the state.

Michael Flaherman, a former private equity investor now at the University of California, Berkeley's Goldman School of Public Policy, said such preferences are pervasive in the alternative investment world.

“If you look at many of these investment agreements, they have similar provisions giving the financial managers carte blanche to do what they want,” Flaherman said. “Each of the individual investors wants to believe they took something out of the pocket of another institution or investor — and they are encouraged to think that they are on the taker end of these deals and not on the taken end of the deals. But that’s the classic setup for a con — to convince the mark that they are in on the con, even though that may not be the case.”

Some of the provisions are broad: For instance, an SEC filing from Davidson Kempner says situations may arise where clients “could be disadvantaged because of the activities conducted by the adviser for other clients.” Similarly, SEC documents from Ascend Capital say certain investors “may be granted favorable rights not afforded to other” investors, including “special withdrawal rights” and access to “information not provided to other Ascend fund investors.” The firm says it “may enter into such agreements without the consent of or notice to the other investors.”

Davidson Kempner and Ascend together manage nearly $150 million of Rhode Island pension money. Over the last three years, the firms have been paid more than $14 million by the Rhode Island pension system while delivering returns for retirees that have trailed the S&P 500, according to documents from the state pension fund.

Claren Road’s SEC forms say “its affiliates and its personnel may give advice or take action for their own accounts that may differ from, conflict with or be adverse to advice given or action taken for Clients.” The hedge fund is an affiliate of the Carlyle Group , whose own SEC forms say it may cement side agreements with certain “investors in a manner more favorable to such investors than those applicable to other investors.” The firm says that such privileges may include special “withdrawal rights.”

After Rhode Island faced losses on its $50 million investment in Claren Road, state officials moved to divest the pension’s remaining $43 million from the firm — but Rhode Island is now facing a delay in getting its money back after other investors also demanded withdrawals. Rhode Island has paid Claren Road nearly $2 million in fees. Claren Road’s SEC forms say the firm “has established policies and procedures to monitor and resolve conflicts with respect to investment opportunities in a manner it deems fair and equitable.”

Photo: Joshua Roberts/Reuters

SEC forms from Och-Ziff, a hedge fund that manages $106 million of Rhode Island pension money, say the firm “typically” prevents investors from withdrawing their money for a certain time period — but that when “partners, principals, employees and their respective family members (and those of our affiliates) also own interests in Funds, they will generally be permitted to withdraw from the Funds at more frequent intervals than other investors.” The firm says that if one of its funds is “required to liquidate holdings to satisfy these withdrawal requests” from the privileged investors, “additional costs and expenses will be incurred and will be borne primarily by the remaining investors.”

Since 2011, Och-Ziff has been paid more than $14 million in fees by the Rhode Island pension fund and has generated returns that have fallen short of a low-fee S&P 500 index fund, according to state documents.

“A lot of these investments have a ‘roach motel’ quality: the ability to get in but not get out,” pension consultant Chris Tobe said. “When there’s a secret door for privileged people to get out of the roach motel, that can help them and hurt everyone else who is still stuck in there.”

In all, 12 out of the 18 firms in Rhode Island’s hedge fund portfolio include language in their SEC forms that outline potential preferences for certain investors. The preferences do not affect just Rhode Island: Those 12 firms currently have roughly $214 billion of total assets under management, according to their SEC filings. In the public sector, the 12 firms oversee money for 85 public pensions and public university endowments in 36 states, according to data compiled by the research firm Preqin.

Private equity firms also employ such language. For instance, SEC filings by Providence Equity Partners — which has received $115 million of investment commitments from Rhode Island and been paid nearly $2 million in fees in the last three years — say the company’s “principals and employees or their family members and related vehicles” are permitted to own shares of investments and to have their fees “substantially reduced or waived entirely.”

Similarly, private equity giant GTCR (which does not manage Rhode Island money) says "family members, certain business associates, other ‘friends of the firm’ or other persons may invest alongside funds” it runs for regular investors. GTCR notes that it “might have an incentive to improve the performance of one fund by selling underperforming assets to another fund in order, for example, to earn fees.” The firm, whose most famous stakeholder is Illinois Republican Gov. Bruce Rauner, says it may withhold some information from certain investors “that are subject to Freedom of Information Act or similar requirements” — meaning governments.

Many of the firms downplayed the provisions, telling IBT that the language about preferences is standard in the industry. None of them would respond on the record to IBT’s questions.

‘Disclosure Doesn’t Make it Legal’

Whether these ubiquitous provisions are legal remains an open question.

Experts interviewed by IBT said a 1963 Supreme Court case, SEC vs. Capital Gains Research Bureau, is generally seen as requiring financial firms to treat investors fairly and tell them about any conflicts of interests.

“The basic theory is that if you are a money manager and you are providing benefits to some clients over another, it could be detrimental to the other clients — and at minimum, the clients facing the detrimental effects have a right to know that,” said Barry Barbash of the law firm Willkie Farr & Gallagher.

But the definition of fairness and adequate disclosure is vague because Congress never passed a detailed regulatory statute.

“If an investment adviser tells its clients they have made certain deals with other investors that it hasn’t made with all investors, is it in breach of its fiduciary duty? The answer is, no one really knows for sure,” said Yasho Lahiri, an attorney at Sutherland Asbill & Brennan.

Because many of the firms broadly disclose that they may give certain investors special preferences, some experts say they are in the clear.

“The financial firms don’t have to disclose all the side deals they negotiate — and they shouldn’t have to,” said Herb Meiberger, a finance professor and trustee on the board of the San Francisco Employees Retirement System. “Pensions are told these agreements may occur and they can say yes or no to an investment. If they aren’t comfortable with it, they can take their money elsewhere.”

Siedle, though, noted that, as reported by the Financial Times, two of the funds feeding investors’ money to Bernie Madoff had told customers that an investment manager “could abscond with those assets” — and one of the funds said that “information supplied by the investment adviser may be inaccurate or even fraudulent.”

“That didn’t somehow make what they or Madoff did OK under the law,” Siedle told IBT. “If you and I sign an agreement explicitly saying that I may steal from you, that disclosure doesn’t make it legal.”

Photo: Jim Young/Reuters

Many large pension funds negotiate clauses purporting to guarantee that any preference given to one investor is given to them, said J.J. Jelincic, a board member of California’s $295 billion pension system. However, Jelincic said, “You are left relying on the investment manager saying, ‘Trust me, I wouldn’t rip you off’ — at a time when the SEC is saying half of all private equity firms are secretly ripping people off.”

Rhode Island Treasurer Seth Magaziner, a Democrat, echoed that concern. Once the money is with an investment firm, he told IBT, a lack of transparency means it can be difficult to guarantee that pensioners are not being abused.

“If they lie to us then it might be hard for us to know if they were outright lying, but that’s where the regulators ought to get involved,” Magaziner said. “Certainly if we found out one of our managers was lying to us, we wouldn’t have any patience for that.”

In 2011, the hedge fund Third Point said in its SEC filings it had ceased giving special preferences and noted that such “provisions may have provided a Fund investor with certain advantages over other Fund investors.” But in 2015, the same firm stated that its “practice, however, is not to provide full transparency of a fund’s current portfolio to any shareholder.”

That kind of opacity is where the legal concerns come in, said Hofstra University law professor Daniel Greenwood, who has studied alternative investments.

“There’s nothing illegal about secrecy in and of itself, but when you set up a highly secretive, highly profitable investment scheme and then you allow public officials to direct public money into it, you have to wonder if there are kickbacks and financial favors for insiders — and that does lead to the question of whether these investments fulfill the law’s fiduciary requirements,” Greenwood told IBT. “If you hand someone else’s money to someone and say, ‘I won’t ask what you will do with it,’ you can’t be terribly surprised if one of the people you hand money to is Madoff. You are setting yourself up to be robbed.”

‘Limited Investigatory Power’

That possibility is exactly what Diane Bucci and her fellow retirees have feared in the wake of the 2015 court settlement that cut their pensions. After they learned about the skyrocketing fees, the open records exemptions and the potential for special provisions for unnamed investors, they hoped state officials would intervene with subpoena power to force all the state’s alternative investment portfolio into plain sight.

Bucci told IBT that she and her group don’t expect any help from Gov. Raimondo — who still maintains an ownership stake in a firm that manages Rhode Island pension money. So in June, the retirees’ group contacted Rhode Island Attorney General Peter Kilmartin, a Democrat, asking for an investigation.

That request was denied in letters from Kilmartin’s aides telling the group his office “has limited investigatory power [and] no stand-alone investigatory staff.” Kilmartin’s staff suggested that the retirees contact the state or local police, which they did. Bucci’s colleague, retired music teacher Ann Gardella, said that one local police chief she contacted advised the group to try to get the FBI involved through a private attorney — one from out of state who would not be compromised by Rhode Island’s notoriously insular political culture. That’s when they hired Siedle.

“When we started looking into this, we had no idea that the people we were giving our retirement savings to were allowed to use our money to give special favors to their friends,” Bucci told IBT. “These investments may be fine if it was all just rich people, but they are not appropriate for pensioners. Why are we investing money in funds that don’t even tell us what’s being done with our money? The lack of transparency at best makes it too easy to mismanage our money — and knowing what I know now, I’m afraid something much more diabolical is happening.”

Andrew Perez contributed research and reporting to this story.