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Description of the Defense Enterprise Fund Investigation

Matthew Maly (http://www.matthew-maly.ru/)
12 April, 2002

I am a former employee of Defense Enterprise Fund ("DEF"). DEF was established and funded by the U.S. Congress with a mission to create profitable joint ventures with the former Soviet producers of weapons of mass destruction. DEF's stated goal was to convert these producers in order to prevent rogue states and terrorist organizations from getting their hands on the advanced Russian military technology.

DEF was funded with $67M of U.S. government funds and did not have any private money. But DEF was also supposed to prove that venture capital investment in Russia can be a profitable business and to raise a private investment fund, thereby contributing to Russia's economic restructuring.

In July 1999, after my repeated attempts to convince DEF's top management to improve the way the Fund was being run were all rebuffed, I wrote a confidential letter of concern to Ambassador Taylor, Coordinator of U.S. Assistance to the N.I.S. (All documents I mention are available on my website http://www.matthew-maly.ru/index-eng.html#DEF). In this letter, I alleged that during a period of two years about $20M of DEF's money were grossly mismanaged or lost. In particular, I alleged that $3M of U.S. conversion funds went to open a restaurant and $5M was transferred to a French company known to be bankrupt. I also alleged that DEF was paying up to $50K in cash, every month, to a former Russian Vice Prime Minister to lobby for a project DEF had invested in. Here is a figure that puts it all in perspective: prime Russian military scientists require only $2K of salary per year, less than $200 per month - and you get these knowledgeable and skillful engineers working for peaceful ends.

Ambassador Taylor ordered an investigation of my allegations to be conducted by a partner of a lawyer that represented DEF Board. I was concerned about a possible conflict of interest, but Taylor assured me that the investigation would be "thorough and impartial" and urged me to cooperate with it. I came to Washington, DC, and gave a five hour testimony. The investigator did not make an official record of my testimony, but did collect all the relevant documents I had in support of my allegations. The investigation lasted four months and its Report was submitted to Taylor in December, 1999. In February, I was told that DOS and DOD have "concerns" about DEF and "about the Report itself". Attempts to get the Report failed as it was termed "confidential".

On August 15, 2000, DODIG published its Audit of DEF. In it, DEF's management and oversight were seen as "poor" and several million dollars of very questionable losses were described. However, this Audit failed to investigate or even mention my allegations.

On April 4, 2001, the Moscow Times, a Dutch-owned English language newspaper of record in Russia, published a 10,000 page Special Report about DEF, Investing, Pentagon-Style. This Report went through my allegations and essentially confirmed them.

On August 20, 2001, Defense Week published an article on DEF where it repeated the findings of the Moscow Times Report. Defense Week also reported that Defense Criminal Investigative Service was conducting its own investigation of DEF. According to the Defense Week correspondent, this article prompted DODIG to start redoing its Audit of DEF.

On December 31, 2001, the second DODIG Audit of DEF was published. Again, it made no mention of my allegations, but its conclusions were shocking nonetheless. DEF invested about $30M, and the present value of this investment portfolio was estimated at $11M. DEF had just $4M in cash remaining in the $67M program. DEF spent $35M on itself, or 53% of its money, whereas, as the Audit noted, usually venture capital firms spend just "one to two percent" on administration. The Audit also found $2.2M of "unallowable" expenses, such as golf club memberships.

After my letter of concern, the company that managed DEF at the time was fired by DEF Board and another company was found to manage DEF. The new contract calls for $2M yearly management fee and is to run for five years. As present value of DEF investment portfolio was estimated at $11M, a contract to manage this portfolio for a fee totaling $10M seems quite generous.

The new DEF management company rehired only three people from the former management company, my former employer:

  1. a person who, I alleged, deserves most of the blame for DEF's demise. Even though my letter of concern put most of the blame on him, this person was promoted to serve as DEF President (the former DEF President resigned immediately following my letter of concern);
  2. a person who, I alleged, was passing bribes to the former Russian Vice Prime Minister;
  3. a person who, immediately after my letter of concern was received by DEF Board, called a staff meeting to describe my letter as "slanderous".

The Audit noted that the new DEF management company was "destroying documents": it certainly has on its staff the three people best able to do that.

After the second DODIG Audit of DEF, there was a second article in Defense Week and another one in the Moscow Times. These articles reported that all the DEF's money had been spoken for, which means that DEF can no longer conduct its defense conversion and investment activities, and yet, the person responsible for DEF's demise was serving as DEF's President.

I was recently contacted by the Defense Criminal Investigative Service. I was told that now DCIS was conducting an active investigation. But I still do not understand why they failed to contact me for more than a year and did so only after I wrote them a letter.

The second DODIG Audit of DEF reveals an interesting feature of DEF: it was conducting its operations under virtually no supervision. DOS thought that DEF was supposed to be supervised by DOD. DOD assigned supervisory functions to the Defense Threat Reduction Agency. According to the letter of General Bongiovi, DTRA's Deputy Director, DTRA had attempted to discover what were the guidelines and regulations under which DEF was supposed to operate and discovered that there were none.

General Bongiovi's letter, attached to the second DODIG Audit of DEF, argues that since there were no guidelines under which DEF was supposed to operate, nothing in DEF's operations can be considered "unallowable". $100K spent on golf membership, overcharging the US government by more than $150K on housing expenses, losing about $20M on grotesquely misguided or self-serving investments - nothing arouses General Bongiovi's concern. By contrast, I assumed that those who run key U.S. assistance programs are expected to be reasonably competent and honorable.

Why did DEF management invest all its funds in a great rush, essentially over a period of just eighteen months? Why did DEF spend so much on itself? U.S. Congress allowed DEF to raise a private investment fund, to be owned and managed by DEF's management team, and thus, instead of converting former Soviet producers of weapons of mass destruction, DEF's top management essentially used DEF's money as a marketing and advertising budget for the private investment fund they would own and manage. To invest in ten projects that look very good on paper and then raise $200M of private money on the "strength" of this performance - that was the plan. But the projects started failing a bit too soon, and despite DEF's attempt to mislead the potential investors, no money was raised.

DEF investigation also highlighted other unpleasant facts about DEF's top managers:

  • neither of the two top DEF investment managers had any prior venture capital (or business!) experience;
  • one of DEF directors steered $700K of DEF's legal work towards her firm;
  • the Romanian-American Fund complained to President Clinton about a $250K bill submitted by DEF Board's lawyer.

Why did the U.S. Congress give $67M of public funds to two inexperienced and unqualified businessmen to raise the investment fund they would own? This is one generous gift. DEF top managers were earning $150K per annum, had an $150K per annum of housing allowance, spent DEF money on themselves with no limit, flew Concorde, charged family vacations and theater tickets to DEF, paid $100K for golf memberships, etc. But that was not enough for them: they rushed to raise a $200M private fund where their salaries and perks could be limitless.

I hold degrees from Columbia and Yale and am an author of two published books on democratization of Russia. The Globe and Mail called my book, Understanding Russia, "perhaps the best guide to [Russia-s] psychology". I live in Russia and Ukraine and want to find a position having to do with U.S. assistance to the N.I.S. Since I wrote the letter of concern almost three years ago I have not been able to find such a position even though I have filed more than 200 applications. My wife is Ukrainian, and I cannot go back to the States because this would mean a long separation: we have two small children. I currently work as an advisor to Russian and Ukrainian politicians.

There were four investigations of DEF so far (an internal investigation, two DODIG audits, and a DCIS investigation). Almost three years later, after two audits and four newspaper articles - DEF (or whatever remains of it) is still managed by the same person.

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