oversight

City of Covington Hotline Complaints Covington, Kentucky

Published by the Department of Housing and Urban Development, Office of Inspector General on 1998-09-03.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                                                     U.S. Department of Housing and Urban Development
                                                     District Office of the Inspector General
                                                     Office of Audit
                                                     Richard B. Russell Federal Building
                                                     75 Spring Street, SW, Room 330
                                                     Atlanta, GA 30303-3388
                                                     (404) 331-3369




September 3, 1998                                                         No. 98-AT-245/255-1811


MEMORANDUM FOR:              Ben Cook, Director, Community Planning and Development,
                             Louisville, Kentucky, 4ID


FROM:         Nancy H. Cooper
              District Inspector General for Audit, Southeast/Caribbean, 4AGA

SUBJECT:      City of Covington
              Hotline Complaints
              Covington, Kentucky

In response to citizen complaints, we surveyed aspects of Covington’s Community Planning and
Development activities. The purpose of our survey was to review the complainants’ allegations
and determine whether further audit work was necessary.

We interviewed HUD Kentucky State Office Community Planning and Development staff and
reviewed their files. We visited the City and interviewed City staff, reviewed loan files, and
performed on-site physical inspections. We also interviewed the complainants, program
participants and other local citizens. We reviewed a judgmentally selected sample of 21 loans and
3 property acquisitions/dispositions.

Our review generally covered the period January 1, 1992, through December 31, 1997. The
review was extended to other periods when appropriate.

                                       BACKGROUND

In September 1997, we received two complaints from Covington citizens through our hotline.
The complainants expressed concern regarding Covington’s operation of the HUD-funded Urban
Reclamation and Investor Rehabilitation Loan Programs. The City-designed programs are funded
with Community Development Block Grant and HOME funds, plus program income from the
Rental Rehabilitation Program. The City annually receives about $2.2 million in block grant
funds, a half million dollars in HOME funds, and $200,000 in program income.

The complaints were wide ranging, but the overall theme was that the City’s Housing
Development Director used his position to give favored treatment to a friend, Covington
developer Esther Johnson. The complaints also alleged the City had not implemented HUD
recommended improvements and lacked procedures or guidelines for some programs.
Through the Investor Rehabilitation Loan Program, the City awards low interest loans as gap
financing to developers rehabilitating dilapidated residential and commercial property. During our
review period, the City awarded 56 such loans totaling $3.3 million. The City’s Housing Director
recommended loans to the City Manager who recommended them to City Commission for
approval. All loans recommended by the Housing Director were approved.

Under the Urban Reclamation Program, the City acquires vacant or blighted properties, then sells
them to developers or other citizens, often for rehabilitation, thereby improving the City’s tax
base. Since the program’s inception in 1977 through approximately August 1997, the City
acquired about 225 such properties. According to City staff, 95 percent of the purchases were
through foreclosure or tax sales. In the 11 years ended April 1998, the City sold approximately
156 properties, including 59 for one dollar each.

During 1997, allegations appeared in local newspaper and television reports that the Housing
Director and Johnson were friends, and he favored Johnson’s participation in the programs while
denying the participation of other developers. The City claimed no one had ever been denied a
loan. A local television station reported that the Director and his wife, Johnson, and others
traveled to Europe together. The Director and Johnson acknowledged the relationship, which is
not a violation of either HUD or City policies, but contributed to the allegations of favoritism.

In an effort to address the allegations, the City hired its auditors, Rankin, Rankin & Company, to
(1) determine the number of total sales and the number of sales to Johnson, (2) test
documentation of loans to Johnson and to others to determine differences, (3) determine if any
loans were denied, and (4) test developer compliance with development agreements. The
auditors’ report in March 1998 stated the number of sales, disclosed one instance of non-
compliance with a development agreement, and concluded no material difference in loan terms,
payments, or documentation between Johnson loans and loans of others. They also stated that of
25 questionnaires mailed to program participants, 5 claimed they had been denied loans. Three of
the five complained about lack of written procedures for the program, and characterized it as
being run by “word of mouth,” the “good old boy network,” or “behind closed doors.” Four
respondents claimed that citizens who speak out against the City are punished through selective
code enforcement by City building inspectors.

The Housing Director and Johnson sued citizens who made allegations publicly for libel. They
also sued a local television station and newspaper which ran stories containing allegations of
favoritism. Some citizens expressed fear of being sued by the Director or Johnson or of
retaliation by City building inspectors.

                                     SUMMARY

The attached finding describes weaknesses in management controls in the two programs
reviewed. Both programs lacked adequate operational procedures, and property acquisition and
disposition files as well as loan files were inadequately documented. In addition, some loans in
the Investor Rehabilitation Loan Program were disbursed contrary to loan terms. As a result, the
City could not document impartiality and fairness in program operation and was susceptible to
claims of favoritism such as those made.


                                                2
During our review period, Johnson or related entities received Investor Rehabilitation Loans
totaling about $1.1 million, or 32 percent of the loans awarded. We were unable to prove or
disprove favoritism; however, Johnson benefited from the loan program to a greater extent than
any other investor. As a result, there is the appearance of favoritism, and the absence of either
written procedures or documentation made it difficult to refute. The City attributed the high
number of Johnson loans to her willingness to undertake projects no one else would do.

It is unfortunate the public lacks faith in the integrity of local programs supported with Federal
funds and intended to benefit the entire community. The attached recommendation, if adopted by
the City, should improve the public’s confidence in the programs.

We provided you a draft of our report on June 18, 1998, soliciting comments and input into
recommended corrective actions. We received no response. We discussed the deficiencies and
the need for improved controls with the City’s Housing Development Director at an exit
conference on May 15, 1998. We also provided the City a draft of our report on June 18. The
City submitted written comments to us on July 21, 1998, and again on August 6 to replace those
received July 21. The City Manager stated he believed the allegations were unsubstantiated.
However, he pointed out changes the City had implemented as a result of the adverse publicity,
and stated that many of our recommended management control improvements have been
implemented or are in the process of being implemented. We summarized the City Manager’s
comments at the end of the finding and included them as Attachment E. Voluminous attachments
to the comments are not included, but we provided you a copy separately.

Within 60 days, please furnish this office, for the recommendation in the report, a status report on
(1) the corrective action taken, (2) the proposed corrective action and the date to be completed,
or (3) why action is considered unnecessary. Also, please furnish us copies of any
correspondence or directives issued because of the review.

We provided a copy of this memorandum to the City.

If you have any questions, please contact Rudy E. McBee, Assistant District Inspector General
for Audit, at (423) 545-4368.

Attachments:

       A - Finding and Recommendation
       B - Schedule of Loans Reviewed
       C - Loan Disbursements Prior to Note/Mortgage Execution
       D - Loans Disbursed Contrary to Development Agreements
       E - Auditee Comments
       F - Distribution




                                                 3
                                                                                 Attachment A

                           FINDING AND RECOMMENDATION

Finding 1 - Management Controls Need Improvement

Covington needs to improve internal management controls in its Investor Rehabilitation Loan and
Urban Revitalization Programs. Neither had adequate written procedures, and program activity
was inadequately documented. As a result, the City was susceptible to allegations of favoritism
and neither HUD nor the public have adequate assurance the programs were properly run. Two
complaints alleged favoritism, also that the City lacked written loan procedures and had not
responded to prior HUD recommendations to improve its loan underwriting process. We were
unable to verify favoritism, but the allegations regarding process and procedures were valid.

Title 24 Code of Federal Regulations 85.20(b) requires grantees to maintain adequate records and
effective internal control for all grant assets.

Investor Rehabilitation Loan Program

Neither the City Commission nor the Housing Development Department had established written
operational procedures for the Investor Loan Program. Our review found:

    •   disorganized, under-documented loan files, and
    •   loan disbursement deficiencies.

Loan documentation

Investor loan files were generally disorganized and under-documented, with no written record of
citizen inquiries about participation in the loan program. None of the loan files reviewed
contained evidence of underwriting procedures, and Housing Development staff verified there
was no formal underwriting process. Also, the files did not adequately document the history of
the loan approval process. Related recommendations in a HUD 1994 monitoring report
pertaining to the HOME Program, not implemented by the City, were “...that the City more fully
document the underwriting process it uses to approve multi-family rental projects. This includes
analysis, reasoning, and supporting documentation, such as appraisals and loan closing statements
on acquisition type projects. The basis for approval of each loan should be evident from a review
of the individual project file.” The basis of loan terms and approval was still unclear.

As a result of negative media attention, the City in August 1997 began using a standardized loan
application and named a loan committee to recommend loans for approval. Files for two loans
completed under the new application procedures were much improved, and the City began
keeping a record of persons inquiring about investor loans. The changes were an improvement,
but there were still no written guidelines or procedures to, for example, describe the role the
committee will play in the loan approval process, who will serve on the committee, the




                                               4
methodology the committee will apply as a basis for evaluating loans, and the underwriting
process prior to presentation to the committee. For example, the process should evaluate the
financial condition of the borrower, the soundness of the proposal, the reasonableness of any
assumptions, how the project represents best use of available funds, and how it qualifies under
HUD regulations. The procedures should also require file documentation of compliance with the
process.

Loan disbursement

The City needs to better control the loan disbursement process. In our sample of 21 loans
(Appendix B), the City disbursed loan funds prior to executing a mortgage and/or note in 4 cases,
and disbursed funds contrary to the provisions of respective development agreements in another 4
cases. Seven of the eight incidents involved Johnson loans. Details of the transactions are in
Appendices C and D. Housing Development staff stated some of the payments occurred because
they were unaware the City Attorney put restrictive clauses in the development agreements. In all
cases the developers completed the projects as promised. However, such practices are risky as
contractors may not finish jobs when they get money prematurely. Also, it presents the
appearance of favoritism to the contractors involved. The City should adopt a simple control,
such as a checklist, to assure the loan is eligible for payment.

                                              * * *

During our review period, Johnson, or entities with which she was associated as owner,
developer, or general partner, received 15 of the 56 Investor Rehabilitation Loans awarded by the
City. Her loans totaled about $1.1 million of the $3.3 million awarded (32 percent). We were
unable to prove or disprove favoritism; however, Johnson benefited from the loan program to a
greater extent than any other investor. As a result, there is the appearance of favoritism, and the
absence of either written procedures or historical documentation made it difficult to refute. The
City attributed the high number of Johnson loans to her expertise and the fact she was willing to
undertake difficult projects others would not.

Urban Reclamation Program

The City had inadequate operational procedures for the Urban Reclamation Program, and did not
adequately document its files for property acquired with Federal funds, or for subsequent sales.
As a result, the City lacked evidence the transactions were proper, and left itself open to charges
of favoritism. HUD Handbook 1378, Tenant Assistance, Relocation and Real Property
Acquisition, paragraph 6-3b(4), requires grantees to document compensation for acquired
property.

Documentation of the purchase and sale of all three properties reviewed was almost nonexistent.
There was no documentation in the files as to how the City arrived at the decision to purchase the
properties or how they determined market value. According to City staff, compensation for
property acquired through foreclosure or tax sales was the amount of unpaid taxes not to exceed
two thirds of appraised value, although this policy was not stated in the program’s limited
guidelines. However, the files reviewed were not documented with appraised value.


                                                5
Citizens stated they did not understand how the City determined who it selected to obtain City
property and at what price. Allegations of favoritism were made based on claims developer
Johnson obtained several properties for one dollar. According to records provided by the City
Clerk, Johnson purchased seven properties since 1987, five of those for one dollar each. In
addition, the City sold another four properties for one dollar each to Anawim, Ltd., a non-profit
organization with which Johnson was affiliated as developer and general partner. Most of the 59
one-dollar sales were to non-profit organizations; no other investor received more than one. The
transactions with Johnson may have been proper, but the lack of file documentation related to
purchases and dispositions made propriety impossible to determine.

Disposition prices varied widely, but the files did not document a description of the property how
best use was determined, or how price was determined. The City advertised each property for
sale once in the newspaper. If the property did not sell, as was often the case, housing staff
negotiated a sales price with anyone interested. However, files reviewed did not document how
they arrived at the price. One citizen who purchased a small adjoining lot for $5,000 claimed to
have no idea how the price was determined. In another case, a citizen claimed attempts to
purchase a property and furnished copies of letters written to the City. However, none of the
letters appeared in the City’s files. The responsible City official stated she did not have time to
document inquiries.

Acquisition/disposition transactions should be better documented to establish their propriety and
impartiality, and that they are in the City’s best interests. We also suggest the City periodically
advertise available properties in local newspapers.

Also, there was no evidence of competition for rehabilitation of City-owned property and no
explanation of how the transaction was in the City’s best interests. For example, in the case of
property at 117 East 8th street, which Johnson restored as Historic View Apartments, at least one
other contractor discussed plans to restore the property with the Housing Director, but reportedly
dropped his plan because $25,000 in assistance offered him was insufficient to make the project
viable. Subsequently, the developer loaned Johnson his plans, Johnson purchased the property for
one dollar, and received City rehabilitation loans totaling $150,000. The Housing Director stated
the developer never submitted a final proposal. City files indicated no evidence anyone other than
Johnson was interested in the property.

The City should institute written procedures requiring retention in the files of all proposals for
purchase and/or rehabilitation of City-owned property and open competition among developers
for rehabilitation projects. Also, as with the loan program, procedures should require
documentation of the decision process in selecting winning proposals.

Auditee Comments

The City Manager pointed out changes made in their loan processing after the City received
adverse publicity generated by complaints in local media. He stated that neither the old nor the
revised process resulted in automatic approval of the Housing Director’s recommendations, as we
implied. He pointed out that the City’s Ethics Board dismissed the local complaints because




                                                6
of a lack of specific dates of alleged infractions. He said the City auditors also concluded they
were unable to prove or disprove favoritism and observed no difference in documentation
between Johnson’s files and the files of others. He said he believed the allegations made locally
were unsubstantiated, and the same complainants apparently called our hotline.

The City Manager said he appreciated our recommendations, and many either have been or are
being implemented. He added, however, that since we did not prove or disprove favoritism, we
should not infer favoritism existed until facts are submitted to prove it.

In an attached memorandum to the City Manager, the Housing Development Director disagreed
with our conclusion that internal controls should be improved, saying nothing requires the City to
have fixed, rigid guidelines for loan processing. He said he could not adequately respond to the
finding because he was unaware of the specific cases we examined, the details of the complaints,
or the deficiencies found. He denied their files were disorganized and under-documented or that
loan funds were disbursed improperly. He also claimed the acquisition regulations we cited do
not apply because the properties were obtained through judicial action. He said our statements
regarding the number of one-dollar properties sold to developers other than Johnson and to non-
profits are incorrect, and the reason for lack of competition for rehabilitation jobs is that few
individuals, developers, or non-profits are willing to undertake such projects. He said he had
preliminary discussions with a contractor, but no developer other than Johnson submitted a final
proposal for 117 East 8th Street.

OIG Evaluation of Auditee Comments

Our report recognized improvements the City made, but additional improvements are needed. We
revised the draft comment that the Housing Director’s recommendations were tantamount to
approval, to say all loans recommended by the Housing Director were approved. The City
auditors drew no conclusion regarding favoritism, nor were they asked to. They expressed no
opinion even on the matters they reviewed, as they were not engaged to perform an audit.
Neither were they asked to evaluate the loan approval process or attendant management control
system, both related to the allegations of favoritism. We agree with their observation of no
material difference between documentation and loan terms for developer Johnson as compared to
other developers. There was little documentation in any of the files.

We did not infer favoritism existed; however, developer Johnson’s high level of program
participation combined with her personal relationship with the Housing Director gave the
appearance of favoritism, and the City’s lack of management controls tended to exacerbate the
problem rather than resolve it.

The City Manager’s comments about implementing our recommendations were positive, but were
inconsistent with the comments of his Housing Development Director, who disagreed with our
conclusions and recommendations. We found no basis in the Director’s comments to change our
central conclusion regarding the need for better internal control, and find his refusal to consider
minor improvements difficult to understand.




                                                7
We added three attachments to address his concern about lack of details, a list of the 21 loans
examined (Attachment B), and details of disbursements prior to mortgage execution and contrary
to development agreements (Attachments C and D). Lack of knowledge of the specifics of the
complaints did not hinder the City in responding to our review. The draft conclusions were not
based on the complaints precipitating the review, but on our review of program operations. The
City’s procedures can and should be improved, without limiting desirable flexibility. The
improvements will provide better accountability to HUD and the public for use of Federal funds,
and a basis for responding to complaints more substantively and timely.

Housing Development staff admitted during the review that loan files were disorganized.
Documents loose in file folders in no particular order made review of files difficult and time
consuming. Under-documentation of files relates to lack of information on the loan underwriting
process, such as determination of loan terms and basis of loan approval. The referenced
acquisition regulations require documentation of compensation paid for either negotiated
acquisitions or properties acquired by judicial action. Similarly, the City must document the
necessity and reasonableness of any cost under OMB Circular A-87 guidelines.

The Housing Director provided no support for his claim that our conclusions regarding the
number of one-dollar property sales were inaccurate. During the review, Housing Development
staff directed us to the City Clerk for sales information because Housing Development had no
historical database of such information. Information in the report is based on City Commission
resolutions approving property sales as provided by the City Clerk.

If the Housing Director is correct about developer Johnson being the only one interested in
rehabilitating certain properties, open and aggressive solicitation of competition, adequately
documented, will provide a basis for rebutting future criticism of favoring certain developers.

Recommendation

1A.    We recommend that you require the City to develop written operational procedures for
the two HUD funded programs, including documentation to demonstrate how future acquisition
and disposition prices for properties acquired with Federal funds were determined and open
competition for City-owned property to be rehabilitated.




                                              8
                                                                 Attachment B


                            SCHEDULE OF LOANS REVIEWED

Owner/Developer              Property Address           Loan Amount

Emery Row, Ltd.              830-848 Scott                 $225,000
Emery Row, Ltd.              830-848 Scott                  225,000
Altevers, D.                 1511 Garrard St.                 8,256
Anawim, Ltd.                 1221 Garrard St.                43,000
Anawim, Ltd.                 1236 Garrard St.                10,000
Anawim, Ltd.                 1236 Garrard St.                 5,000
Anawim, Ltd.                 228 13th St. East, et al       150,000
Classic Properties, Inc.     724 Madison Ave.                 9,095
Classic Properties, Inc.     814 Madison Ave.                24,075
Classic Properties, Inc.     724 Madison Ave.                40,000
Garrard St., LLC             517-519 Garrard St.             95,000
Historic View Apts., Ltd.    117-123 E. 8th St.             110,000
Historic View Apts., Ltd.    117-123 E. 8th St.              40,000
Johnson Properties, Inc.     130 W. 6th St.                  95,000
Johnson Properties, Inc.     201 E. 12th St.                 20,000
Johnson Properties, Inc.     1210 Greenup St.                15,000
Kukla & O’Neil               6 & 8 W. Pike St.               55,000
McMahon, D.                  309 Trevor St.                  15,000
Reliance Properties, LLC     709-713 Garrard St.             60,000
Reliance Properties, LLC     709-713 Garrard St.             60,000
Taylor, E.                   1224 Scott St.                  18,000




                                                9
                                                                           Attachment C


          LOAN DISBURSEMENTS PRIOR TO NOTE/MORTGAGE EXECUTION

                                         Date of       Draw            Check
Borrower/Project Address            Note and Mortgage Approved       Date/Amount

Historic View Apts., Ltd.               04/11/96         04/02/96   04/04/96 $35,000
117-123 E. 8th St.

Classic Properties, Inc.                12/10/921        12/04/92   12/09/92 $25,000
724 Madison Ave.

Johnson Properties, Inc.                10/19/95         10/12/95   10/17/95 $18,000
201 E. 12th St.

Johnson Properties, Inc.                10/19/95         10/12/95   10/17/95 $13,500
1210 Greenup St.




1
    Date of promissory note only.
                                                    10
                                                                            Attachment D


       LOANS DISBURSED CONTRARY TO DEVELOPMENT AGREEMENTS


Emery Row, Ltd. The final draw of $24,375 for the $450,000 loan was disbursed by the City in
December 1995. The Development Agreement required the developer to spend $953,000 to
develop the project, $503,000 provided by the developer and $450,000 provided by the City loan.
The agreement stated that City disbursement of the loan was conditioned on proof of expenditure
by the developer of the $503,000. The loan file included no documentation of developer
investment in the project.

Kukla & O’Neil The final draw of $2,000 for the $55,000 loan was disbursed by the City in
September 1997. The Development Agreement required the developer to spend $15,000 for the
site and $97,000 to rehabilitate the structure. The agreement stated that City disbursement of the
loan was conditioned on proof of expenditure by the developer of a minimum of $100,000 prior
to the final draw. The loan file included no documentation of developer investment in the project.

Historic View Apts, Ltd. The final draw of $6,000 for the $150,000 loan was disbursed by the
City in July 1996. The Development Agreement required the developer to spend at least
$500,000 to rehabilitate the structure. The agreement stated that City disbursement of the loan
was conditioned on proof of expenditure by the developer of a minimum of $500,000 prior to the
final draw. The loan file indicated the developer had invested no funds in the project as of the
date of the final draw of the City loan.

Johnson Properties, Inc.(130 W. 6th St.) The final draw of $9,500 for the $95,000 loan was
disbursed by the City in May 1997. The Development Agreement required the developer to spend
at least $511,000 to rehabilitate the structure. The agreement stated that City disbursement of the
loan was conditioned on proof of expenditure of at least $600,000 prior to the final draw. The
loan file indicated the developer had drawn only $33,550 of owner funds, in addition to the
$95,000 City loan, as of the date of the final draw of the City loan. The Housing Director stated
he was not aware the above condition was in the Development Agreement.




                                                11
                        Attachment E
AUDITEE COMMENTS




                   12
13
14
15
                                                                                          Attachment F


                                            DISTRIBUTION

Secretary's Representative, 4AS
State Coordinator, KY State Office 4IS (2)
Director, Office of Community Planning and Development, 4ID (2)
Audit Liaison Officer, 3AFI
Director, Administrative Service Center, 4AA
General Counsel, C (Room 10214)
Associate General Counsel, Office of Assisted Housing and Community Development,
  CD (Room 8162)
Assistant Secretary for Community Planning and Development, D (Room 7100)
Audit Liaison Officer for Community Planning and Development, DG (Room 7214) (3)
Chief Financial Officer, F (Room 10166) (2)
Deputy Chief Financial Officer for Finance, FF (Room 10164) (2)
Director, Office of Budget, FO (Room 3270)
Director, Housing and Community Development Issue Area, U.S. GAO, 441 G Street N.W.,
  Room 2474, Washington DC 20548
Counsel to the IG, GC
Public Affairs Officer, G
HUD OIG Webmaster-Electronic format via Electronic mail-
    Morris_F._Grissom@Hud.Gov
Director, HUD Enforcement Center, 1240 Maryland Avenue, Suite 200, Washington, DC 20024
Assistant to the Deputy Secretary for Field Management, SDF (Room 7106)
Assistant to the Secretary for Labor Relations, SL (Room 7118)
The Honorable John Glenn, Ranking Member, Committee on Governmental Affairs,
  United States Senate, Washington DC 20515-4305
The Honorable Fred Thompson, Chairman, Committee on Governmental Affairs,
  United States Senate, Washington DC 20515-4305
The Honorable Dan Burton, Chairman, Committee on Government Reform and Oversight,
  United States House of Representatives, Washington DC 20515-6143
Mr. Pete Sessions, Government Reform and Oversight Committee, Congress of the United States, House of
Representatives, Washington, DC 20510-6250
Ms. Cindy Sprunger, Subcommittee on General Oversight and Investigations, Room 212,
  O'Neil Office Building, Washington DC 20515
City Manager, City of Covington, 638 Madison Avenue, Covington, KY 41011-2298




                                                   16