Metropolitan Sewer District Examination

8/3/2019 Metropolitan Sewer District Examination

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Examination of Certain Policies, Procedures,Controls, and Financial Activity of

Metropolitan Sewer District

CRIT LUALLENAUDITOR OF PUBLIC ACCOUNTS

www.auditor.ky.gov

209 ST. CLAIR STREETFRANKFORT, KY 40601-1817TELEPHONE (502) 564-5841FACSIMILE (502) 564-2912


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The Auditor Of Public Accounts Ensures That Public Resources AreProtected, Accurately Valued, Properly Accounted For, AndEffectively Employed To Raise The Quality Of Life Of Kentuckians.


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Table of Contents

TRANSMITTAL LETTER

EXECUTIVE SUMMARY............................................................................ i

Chapter 1 Introduction and Background...................................................................... 1

Chapter 2 Findings and Recommendations ................................................................ 23

Exhibits 1. APA Recommendations for Public and Nonprofit Boards ............ 1062. Donations and Contributions Made by MSD By Fiscal Year ....... 112

Metropolitan Sewer District Response ................................................................................................... 114


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December 16, 2011

Arnold J. Celentano, P.E., ChairmanMetropolitan Sewer District Board700 West Liberty StreetLouisville, Kentucky 40203-1911

RE: Examination of Certain Policies, Procedures, Controls, and Financial Activity of MetropolitanSewer District

Dear Chairman Celentano:

We have completed our examination of certain controls and management practices of theMetropolitan Sewer District (MSD). The enclosed report presents, in total, 27 findings and offersapproximately 150 recommendations to strengthen MSD controls and management oversightprocedures.

Examination procedures included interviews with current and former MSD Board members,current and former MSD staff members, MSD special board counsel, MSD co-bond counsels, MSDfinancial advisor, and others. In conjunction with a review of applicable MSD policies andprocedures, a sample of travel voucher reimbursements and purchasing card expenditures wasexamined to determine whether expenditures were appropriate and made in compliance with MSDpolicies.

Our examination also included a review of MSD Board governance, conflicts of interests,ethics policies, procurement policies and activities, investment policies and activities, legal servicespolicies and activities, policies related to internal audit, as well as other selected policies. Ourexamination included records and information for the period July 1, 2008 through June 30, 2011,unless otherwise specified. The objectives developed by the Auditor of Public Accounts for thisexamination include:

Determine whether policies governing contract procurement are adequate,consistently followed, and provide for a transparent process;

Determine whether policies governing the internal audit process are adequate,consistently followed, and provide for timely reporting;

Determine compliance with policies and other requirements associated withincreasing MSD customer rates;


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Chairman CelentanoDecember 16, 2011Page 2

Review and evaluate MSD Board policies using the APAs thirty-tworecommendations developed for public and non-profit boards;

Review certain financial transactions and determine compliance with MSD policiesand reasonableness of the expenses; and,

Determine if conflicts of interest exist.

The purpose of this examination was not to provide an opinion on financial statements oractivities, but to ensure that processes are in place to provide strong oversight of financial activitythrough a review of MSD organizations policies, Board governance, certain internal controls, andother financial transactions.

Due to the nature of certain findings discussed within this report, we are referring theseissues to the Louisville Metro Police Department Public Integrity Unit and to the Internal RevenueService to determine whether further investigation by those offices are warranted.

The Auditor of Public Accounts requests a report from MSD on the implementation of auditrecommendations within (60) days of the completion of the final report. If you wish to discuss thisreport further, please contact Brian Lykins, Executive Director of the Office of Technology andSpecial Audits, or me.

Respectfully submitted,

Crit LuallenAuditor of Public Accounts


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CRITLUALLENAUDITOR OFPUBLICACCOUNTS

Performance and Examination Audits BranchExecutive SummaryDecember 16, 2011

Examination of Certain Policies, Procedures, Controls, and Financial Activit

of Metropolitan Sewer District

Examination ObjectivesOn July 28, 2011, the Auditor of Public Accounts(APA) informed the Executive Director and BoardChair of the Louisville-Jefferson County MetropolitanSewer District (MSD) by letter that due to theLouisville-Jefferson County Metro Government(Louisville Metro) Mayors request for an audit andconcerns expressed to this office regarding certainfinancial and other activities, it would perform a review

of certain issues at MSD. Specifically, the examinationwould include a review of the organizations policies,internal controls, and certain other financialtransactions.

The purpose of this examination was not to provide anopinion on financial statements, duplicate work ofannual financial audits, or evaluate the amount of rateincreases, but to address the following objectives:

Determine whether policies governing contractprocurement are adequate, consistently followed,

and provide for a transparent process;Determine whether policies governing theinternal audit process are adequate, consistentlyfollowed, and provide for timely reporting;

Determine compliance with policies and otherrequirements associated with increasing MSDcustomer rates;

Review and evaluate MSD Board policies usingthe APAs thirty-two recommendationsdeveloped for public and non-profit boards;

Review certain financial transactions anddetermine compliance with MSD policies and

reasonableness of the expenses; and,Determine if conflicts of interest exist.

The scope of this review includes records, activities,and information for the period July 1, 2008 throughJune 30, 2011, unless otherwise specified, as the timeperiod of certain documents reviewed and variousissues discussed with those interviewed may havevaried.

BackgroundCreated in 1946 by the Kentucky General AssemblMSD was formed as a special district to handle sewein Louisville and at that time the unincorporatJefferson County, now known jointly as LouisviMetro. Generally speaking though, the three core areof service that MSD provides include wastewatcollection and treatment, stormwater drainage serviceand flood protection.

MSD operates and maintains 3,200 miles of wastewacollection sewer lines which collect wastewater froover 200,000 homes, businesses, and industrithroughout Louisville Metro. Wastewater flows MSDs 286 pumping stations, six regional water qualtreatment centers, and numerous smaller water qualtreatment centers in the service area.

MSD maintains the stormwater drainage system for tLouisville Metro area. Responsibilities include tconstruction, repair and maintenance of draina

swales, storm sewers, ditches, and drainage channelsmost of Louisville Metro. Areas not served by MSinclude the cities of St. Matthews, Shively, Anchoragand Jeffersontown. Residents and businesses in thomunicipalities are served by their respective cities.

MSD operates and maintains Louisville Metros OhRiver flood protection system. The system includabout 25 miles of earthen levee, 4.5 miles of reinforcconcrete floodwalls, 16 flood pumping stationmoveable and sandbag street closures to seal strepassages in levees and floodwalls, and floodw

service openings and service doors.

As of FY ending 2010, MSD, a component unit of tLouisville Metro government, reported operatirevenues of $171,590,108 with cash and investments $478,603,152. During FY 2010, MSD employed a toof 677 employees.


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Consent DecreeIn August 2005, MSD entered into a court-orderedConsent Decree with the Kentucky Department forEnvironmental Protection, the EPA and the U.S.Department of Justice. The Consent Decree reached inresponse to pending litigation regarding allegedviolations by MSD of the Federal Clean Water Act andKRS 224 concerning sanitary and combined sewer

overflows, required MSD to create an action plan toaddress the following issues:

An aging sewer system that lacked the capacity tohandle the current sewage and stormwatervolume during wet weather;

Sewer overflows that polluted the river andstreams throughout Louisville Metro, whichviolated the Federal Clean Water Act; and,

A responsibility to keep the public informedabout potential health risks, financial impacts,and construction project activity.

To address the challenges of improved water qualityand meet the requirements of the Consent Decree, MSDbegan a comprehensive sewer improvement initiativeknown as Project WIN, or Waterway ImprovementsNow. Project WIN included the implementation ofsewer improvement projects to minimize the impact ofcombined sewer overflows, eliminate sanitary seweroverflows, and rehabilitate the communitys agingsewer system. In addition, involved keeping the publicinformed of potential health risks, financial impacts,and construction project activity. MSD believed that

Project WIN, estimated to cost approximately $850million over a 20 year period, would achieve the seweroverflow abatement objectives outlined in the ConsentDecree by 2024.

Revenue and Other Means of FinancingMSDs revenues primarily come from wastewater andstormwater service fees, charges for extendingwastewater lines and connecting new customers, andsurcharges associated with the federally-mandatedConsent Decree. Known collectively as the Scheduleof Rates, Rentals, and Charges, these fees, charges, and

surcharges may be modified in order to create enoughrevenue to cover expenses. In addition, MSD mayissue negotiable interest-bearing bonds.

MSDs rates must generate enough income to cover itsprojected operation and maintenance expenses, debtservice expenses, and cash funded capital expenditures.In addition, MSDs debt service coverage must be atleast 110 percent and the working capital target is $25million. This is equivalent to what is currently two

months of operating expense, which would give MSenough time to get a bond issued.

If the projected budgets result in the need for raincreases due to the requirements from the 19Resolution not being met, then the MSD FinanDirector must determine how the schedule of ratshould be amended to ensure the requirements are m

For the most part, MSD rate increases have beconsistent with the projected increases identified in tConsent Decree financing plan.

A 6.5 percent increase in wastewater and stormwatvolume and service charges, as well as optional anquality charge rates that are assessed to commercial aindustrial wastewater customers, was implemented FY 2008, 2009, 2010, and 2011. Because the proposincrease was not greater than seven percent, MSD dnot have to gain approval from the Metro City Counfor these modifications to their Schedule of Rate

Rentals, and Charges.

Auditors observed through various means documentation, including Board minutecorrespondence, and newspaper clippings, that MSfollowed all of the relevant requirements for modifyiits Schedule of Rates, Rentals, and Charges in FY 2002009, 2010, and 2011.

MSD: The BoardCurrently, the Louisville Metro Mayor appoints, withe approval of the Louisville Metro Council, t

members of MSDs governing Board. The MSD Boais composed of eight members, no more than five which may be affiliated with the same political partStarting in 1977, the members were to be selected aappointed so that no more than one member resides any one state senatorial district.

The Board, which has statutory authority to enter incontracts and agreements for the managemeregulation and financing of MSD, manages its busineand activities. The Board has full statutoresponsibility for approving and revising MSD

budgets, for financing deficits and for disposition surplus funds. KRS 76.060 requires the board to fix tsalaries and compensation of the officers aemployees it engages, which salaries acompensation, however, shall be in line with that paby the city and county for similar services.


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While it is the responsibility of the Louisville MetroMayor to appoint individuals to the positions ofExecutive Director, Secretary-Treasurer, and ChiefEngineer, these individuals are supervised by the MSDBoard. At this time, the Executive Director is servingas Secretary-Treasurer and the Design Manager withinthe Engineering Division is acting as Chief Engineer,due to vacancies in the positions of Chief Engineer and

Engineering Director.

The MSD Board also may employ professional andtechnical advisors, experts, and other employees as itdeems requisite for the performance of its duties.Presently, the MSD Board employs individuals for thefollowing positions: Legal Counsel and Secretary to theBoard. Board Legal Counsel is employed throughMSD's legal services contract, with the Board LegalCounsel reporting to the MSD Board and the MSDLegal Director. The Board Assistant, who performs thefunctions of "Secretary to the Board," is, however, an

employee of MSD who reports to the Board and to theExecutive Directors Assistant.

MSD: The StaffMSD is currently organized into 10 divisions including:Executive Offices, Legal, Human Resources, Finance,Physical Assets, Regulatory Services, Engineering,Infrastructure and Flood Protection, Operations, andInformation and Technology.

The Executive Offices Division is headed by theExecutive Director of MSD. The remaining nine

divisions are headed by at least one director, with theexception being the Operations Division which has twodirectors: 1) Director of Operations and Maintenancefor Morris Foreman Wastewater Treatment Plant; and2) Director of Emergency Response and MetroOperations. All of the division directors report to theExecutive Director. Both the Internal Auditor and theController report directly to the Finance Director andare not specifically identified on the organizationalchart. As of July 11, 2011, 632 of the 656 authorizedpositions at MSD were filled.

Findings and RecommendationsFinding 1: Governance policies for the MSD Boarddid not address several critical responsibilitiesnecessary for proper and effective oversight.Policies applicable to the Board governance of MSDdid not exist for several critical areas of responsibilitynecessary for proper and effective oversight of MSD.Auditors found no evidence of policies related to:

Annual or new Board member orientatiregarding fiduciary responsibilities as boamembers;

Documentation of Board review of budget actual expenditures in the meeting minutes;

An independent procedure for reporticomplaints and whistleblower policy;

Independent reporting by the Internal Auditdirectly to the Board;

Documentation in the meeting minutes of annuBoard review of MSD compensation policies, aexecutive staff salaries and bonuses; and,

Review and approval of executive staff travel the Board.

Recommendations: We recommend the Boaprovide in their annual orientation training for new areturning Board members a clear understanding MSDs organizational structure and operations, thresponsibilities as Board members, as well as their legand fiduciary roles, and the purpose of the board which they serve. In addition, the orientation shouaddress ethical requirements of Board members astaff and any significant policy changes adopted bMSD during the previous year. We also recommethat the orientation be facilitated by a knowledgeabindependent party, who can participate in and oversthe orientation training.

We recommend that the Budget Committee performregular review of budget to actual expenditures monitor costs in each account and report to the BoarThe name and number of budget categories shouprovide transparency and sufficient detail to alloCommittee members to accurately identify the types expenses attributed to each category. This revieshould be documented in the Board and BudgCommittee meeting minutes. Periodically, the BudgCommittee should receive and review a listing expenditures with sufficient detail to questitransactions as necessary.

We recommend the Board develop a whistleblowreporting policy by creating and documenting independent process whereby employees and/volunteers have the option to directly make the Boaaware of concerns involving matters that specificalneed Board oversight. We recommend the Boaestablish methods that allow for concerns to be reportdirectly to their attention by all staff, includianonymous concerns, and any complaints againexecutive staff. The Board should further developprocess by which concerns are brought to the attentioof the Board and ensure a process exists to analyz


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investigate and resolve issues brought to its attention.The internal audit function could be used to ensure thatconcerns brought to the Board are independentlyinvestigated and findings reported directly to the Board.

We recommend the Board adopt a policy to review andapprove the salary and bonus incentives of theexecutive staff on an annual basis to ensure that the

compensation paid is equitable to the responsibilitiesand duties of each position. We further recommend theBoard annually review MSDs personnel andcompensation policy, including the range of increases,by which salary increases and bonus payments aremade to all staff. The salaries should be reviewedspecifically by the Board to ascertain appropriate use offunds given the mission of MSD, and such reviewshould be documented in the minutes. These actionsshould be documented in the meeting minutes.

We recommend the Board, or a designated committee

of the Board, pre-approve executive staff travel,including estimated costs. The Board meeting minutesshould document the review conducted by the Board.We also recommend the Board require a report of theactual travel expenses of executive staff, with Boardapproval, prior to expense reimbursement. The expensereports should sufficiently detail the expensesassociated with meals, lodging, transportation, andentertainment of each trip, as well as the businesspurpose of each expense item.

Finding 2: Certain policies were not documented or

sufficient to ensure accountability.MSDs policies and procedures related to purchasingcard procedures, reimbursements to MSD, executivestaff reimbursements, reporting lost or stolen financialinformation, and inventory controls of fixed assets werenot sufficiently comprehensive to provide propercontrol and accountability needed for a public agency.Although MSD has implemented various policies andprocedures in an attempt to provide control andoversight of its organization, several of the policieswere limited and did not include necessary criticalprocedures.

Recommendations: We recommend MSD strengthentheir purchasing card procedure by making it a formalpolicy. We recommend the policy include informationrequiring a business purpose be documented andaddress how MSD or the Board will handle expensesthat are considered improper or disallowed expenses.We also recommend the Board review purchasing cardexpenditures of the Executive Director. We furtherrecommend MSD include a procedure concerningreimbursement by an employee when a purchasing cardis used for personal use in a formal policy. A

timeframe when staff is required to reimburse MSD fany personal expenditure that may have been incurrshould also be included in the policy. Currently, MSdoes not use credit cards and therefore has no policbut if credit cards ever become the preferred method payment of goods, then we recommend a strong crecard policy should be developed.

We recommend policies be implemented to ensure ththe Board or a designated committee of the Boareview and approve all executive staff reimbursemenand supporting documentation to ensure treimbursements are for reasonable and necessaexpenditures. Such reviews and approvals also whelp ensure that duplicate payments are not made.

We recommend MSD adopt written policies for tbackup of electronic financial information. Moreovpolicies should include a process to report any lost missing financial information or records.

We recommend MSD adopt and implement properand inventory control policies and procedures identify and account for all furniture, equipment, other items valued over a certain specified dollamount, with the specific dollar amount included policy. Such policies and procedures should inclurecording of the name of individual in receipt furniture/equipment; description furniture/equipment; vendor name; model and sernumbers; acquisition date; and, acquisition cost. Wfurther recommend such inventory policies a

procedures include an annual, or periodic, physicinventory of all fixed assets. Dispositions of propeshould also be reflected in inventory accounting. Tproperty inventory and control policy should be maavailable to all employees who have responsibility fproperty assets and should include sufficient detail ensure accurate and appropriate accounting for properinventory. MSD should include its inventory aproperty control policies in its Policy Manual.

Finding 3: MSD lacked management oversight aenforcement of established policies.

MSD management has not consistently followed, nhas it required its staff to follow, policies aprocedures established by the Board and managemeto provide fairness in its business practices, to manarisks, and to hold itself accountable to ratepayePolicies and procedures are only effective if personnare informed that such exist, are trained in how


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implement the policies, are required to follow thepolicies, and are held accountable by managementwhen violations of policy occur. Further, and perhapsmost critical, management must lead by example anddemonstrate significant respect for the establishedorganizational policies and procedures. We identifiednoncompliance in the following policy areas:

Procurement of professional services;Procurement of computers;

Reimbursements of employees educationexpenses; and,

Reimbursements of employees travel andtraining expenses.

Recommendations: We recommend the MSD Boarddiscuss with its executive management the need forproper oversight and governance of its operations.Although it is not the Boards responsibility to overseeday-to-day business operations of the organization, theMSD Board is responsible to ensure strong leadershipis in place and is working within the boundaries theBoard has established. We also recommend the MSDBoard require supervisory personnel to be re-trained onkey organizational policies. The trainings should occurin-house at MSD facilities and could be conducted byMSDs own Human Resource Department staff or itsLegal Department staff. Employee attendance for thetraining should be required and documented. Uponcompletion of training, MSD personnel should berequired to sign an affidavit stating that they have beentrained and understand their responsibilities as an MSDemployee to abide by the policies and procedures of the

organization. The statement should furtheracknowledge that the employee understands theconsequences of not following the different policies.We further recommend MSD hold its personnelaccountable to the policies. If a violation of policyoccurs, such as an employee not submitting areimbursement request in a timely manner theemployee should understand that a reimbursement willnot be made. All levels of MSD management shouldconsistently follow and enforce adopted policies.Finally, we recommend the Board evaluate the currentMSD Education Assistance Program to ensure it is

structured to provide the best benefit to the organizationand the ratepayers.

Finding 4: MSD ethics policies for Board members,appointed executive staff members, and employeeswere not sufficient to address conflicts.MSD revised its ethical policies for Board members,appointed executive staff, and employees during theAPAs period of review with an intent forimprovement, but such policies still lack some

significant provisions pertaining to certain ethicissues. The lack of strong, enforceable ethics policiallowed the potential for, as well as actual, conflicts interest by certain MSD Board members, executistaff, and other employees. Although sanctions exfor employee violations of the ethics policies, policies for investigating unethical activity employees exist. Further, there are no policies detaili

the investigation of unethical activity or criteria impose sanctions or disciplinary procedures fviolations by Board members, the Executive Directoor the Chief Engineer. Finally, no ethical policies exfor reporting improprieties directly to the Board.Recommendations: To remain independent in thdecision-making regarding entities doing business wMSD, or seeking to do business with MSD, Boamembers, executive staff, and other employees shouavoid any situations that are actual conflicts betwetheir private interests and their duties on behalf MSD, or that have the potential to present conflic

Neither should they accept gifts and gratuities thcompromise the impartiality of their decision-makion behalf of MSD, or that give the appearance thMSD actions are based on personal benefit, favors, relationships, rather than objective decision-makinWe recommend the Board establish a comprehensicode of ethics, applicable to Board members, appointexecutive staff members, and all employees. MSD mwant to consider having someone skilled in establishiethical standards for public employees and boamembers assist in the drafting of such policy standardUpon adoption by the Board, the code of ethics shou

be incorporated into the two Policies and BenefManuals for employees (unit and non-unit), as well any manual given to Board members during orientatioWe recommend MSD provide initial training for Boamembers, appointed executive staff and employees the code of ethics, as well as a review annually. establishing a financial disclosure policy, wrecommend the MSD Board members, as well as executive team members, annually file with appropriate committee of the Board, and by a specifidate, a statement detailing financial interests heRequired information should be prescribed by

appropriate committee of the Board. The policy shoufurther require an affirmative statement by the filer thhe or she has no interest that would cause a conflwith his or her official duties. Sanction fnoncompliance with the filing requirements also shoube detailed in the policy. To ensure compliance wthe code of ethics adopted, MSD should develop aimplement policies, procedures, and responsibiliti


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regarding reporting, investigation, and resolution ofallegations of ethical misconduct as detailed in therecommendations of Finding 1 regarding awhistleblower policy.

Finding 5: Several conflicts of interest existed thatgave the appearance of improprieties by certainMSD Board and staff members.

MSDs Policies and Benefits Manuals for employeesand MSDs Conflict of Interest Policy for Boardmembers and appointed executive staff, were noteffective in preventing conflicts of interest for Boardmembers, executive staff, and other employees.Several instances of specific conflict of interestsituations were identified that may have contributed tounfair business practices. It is impossible to determineif the vendors/contractors MSD used provided the bestservices at the best cost when relationships allowed thepotential for favoritism and influence of independentdecision-making.

Recommendations: We recommend the MSD Board,within its comprehensive code of ethics, providestandards of conduct for conflicts of interest thatprohibit Board members, appointed executive staff, andemployees from the following:

Having a primary contract, subcontract, oragreement with MSD, either directly, by a familymember, or through a business which is at leastfive percent owned;

Representing a person of business privatelybefore MSD;

Using his or her position to obtain a financialgain, a benefit, or an advantage for oneself, afamily member, or others;

Using confidential information acquired duringhis or her tenure to further his or her owneconomic interest or that of another person;

Holding outside employment with, or acceptingcompensation from, any person or business withwhich he or she has involvement as part of his orher official position for MSD; and,

Involvement in discussions and decisionspertaining to the areas in which there is a conflictof interest.

Board members, appointed executive staff, and otheremployees who abstain from involvement indiscussions and decisions as recommended aboveshould not be present during such discussions, and suchabstention should be documented in writing and placedin the employees personnel file or recorded in theminutes of a Board meeting. To ensure compliancewith the conflict of interest policies adopted, MSD

should develop and implement policies, procedures aresponsibilities found in Finding 1 regarding reportiand resolution of complaints. Finally, we reiteraMSDs Policy and Benefits Manuals that state: Apublic servants, employees must display a histandard of ethical behavior that ensures the public themployees do not use their positions to provide specprivileges to themselves, to other individuals

organizations.

Finding 6: MSDs primary legal services contra

has been with the same attorneys firm since 19

while never being competitively negotiated advertised.MSD has not competitively negotiated or advertistheir primary contract to provide legal services to tMSD Board, Legal Director, Executive Director, aact as Bond Counsel as needed. Since 1984, tsame attorney has acted as the MSD Board LegCounsel and that same attorneys law firm (Firm) h

received MSDs contract to provide multiple types legal services for an average annual amount paid to tFirm of $1 million over the past three fiscal years. Athe MSD Board Legal Counsel, this attorney reviewand approves all matters prior to their submittal to tMSD Board for action, along with all of the othoutside legal services requested by MSD. Therefothe attorneys relationship with the MSD Board couimpair the Boards objectivity and independence relatto advertising this contract to other law firms. Evthough MSD Procurement Regulations give the Boathe authority to waive any procurement requirement

it is in the best interest of MSD, a decision continually authorize this contract with no request fproposals, competitive negotiations, or advertising not a responsible action by the board of a public entiWithout advertising this contract, public confidence the entity may be diminished and a concern exists thMSD is overpaying for legal services.Recommendations: We recommend that MSdesignate this contract as an applicable professionservices contract that should be periodically advertisand competitively negotiated to ensure MSDs beinterests are met. Due to the multiple types of leg

services that can be assigned to this Firm and attornethe contract should be separated based on the type legal services needed. An analysis should be performto determine the need for outside legal services. Bason the results of the analysis, a separate request fproposals should be developed for advertising each tyof service and an evaluation committee should created to evaluate the responses using specific criter


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The evaluation committee should consist of staffmembers that are informed and knowledgeableregarding the services needed by MSD. Werecommend the Board consider whether Board LegalCounsel should be independent of all other legalservices.

Finding 7: Board Legal Counsel given approval

authority in MSD Board process.Through authority granted by the MSD Board, theBoard Legal Counsel could potentially hinder theBoards control and intervene in the managerialprocess. A MSD Board resolution issued in 1984provides the Board Legal Counsel an approval andoversight role over all matters coming before the Board.Specifically, the resolution states that Board LegalCounsel, shall review and approve all mattersincluding resolutions, agenda items, and all otherdocuments prior to their submittal to the MSD Boardfor action. This approval authority over all matters

prior to their submission to the Board could be used tosubvert Board control and keep certain items or issuesfrom being brought before the Board if the Board LegalCounsel refused to approve such items for the agenda.This could include the review of the Board LegalCounsels contract, which is identified as a potentialconflict in Finding 6. This would limit both theBoards authority to determine items they wanted toreview and discuss, and managements ability topresent items to the Board seeking approval or input.The preemptive review process also limits the ability ofthe Board and MSD management to control the costs of

the services provided by the Board Legal Counsel andduplicates work performed by internal staff.Recommendations: We recommend the MSD Boardrescind the 1984 resolution that requires a review andapproval of all matters by the Board Legal Counselprior to presentation to the Board. Secondary reviewsby Board Legal Counsel of issues or documentspresented to the Board should be performed only uponrequest by the Board, Executive Director, or LegalDirector and only for the specific incidence of therequest. We recommend the Board not make a blanketrequest of the Board Legal Counsel to review all

documents or issues of a certain type.

Finding 8: Legal services contract lacks centralizedoversight.The MSD internal Legal Director does not haveappropriate levels of control and monitoring authorityover the primary outside legal service contract.Currently, the contracted law firm acts as Board LegalCounsel, MSDs litigation representation, EPA ConsentDecree representation, and co-bond counsel. Each ofthese four services has a separate oversight authority

within MSD that is responsible for reviewing invoicand approving the expenses. This removes the legexperience and expertise of the Legal Director from tprocess of reviewing all aspects of outside legservices. It has also allowed for the influence of othreviewing authorities to potentially interfere with tauthority of the Legal Director. This has resulted weakening the authority of the Legal Director, who

employed to provide internal legal expertise and directly responsible for ensuring the legal compliancand defenses of MSD.Recommendations: MSD should ensure that tinternal Legal Director is responsible for legal contracompliance and reviewing all invoices associated wilegal service contracts. The MSD Legal Directshould regularly report on legal service expenditurand any related issues to the Board. Final approvauthority for Board Legal Counsel services shouremain with the Board to ensure an independecounsel, but all other legal services may have fin

approval by the Legal Director. Due to departmenbudgetary oversight, other MSD authorities may stneed to retain final payment approval. MSD shoualso develop a formal procedure for vendors to protesdenial of certain expenses and request in writing additional review of those expenses by a secondaauthority. For legal service contracts, such a secondareview may be conducted by the Executive Directthe Board, or a designated Board committee. The findecision of the secondary review should be documentin writing with an explanation as to the final decisioIndividual Board members should refrain fro

attempting to influence the management process MSD in a unilateral manner. Requests for changes management should be made during Board meetings meetings of Board committees and have the support a majority of the members.

Finding 9: MSDs legal services contract terms a

not well defined and are silent as to settlemeprocedures and conflict of interest disclosures.MSDs legal services contract terms are not wdefined and could result in MSD not maintainisufficient control over the amount spent for contract

legal services. Aggravating this issue is that multiptypes of legal work are included within one contrawhich is discussed further in Finding 6. While tcontracted firm (Firm) is relied on to abide by the ethiof the legal profession, the contract is silent as MSDs expectations regarding legal settlements and tdisclosure as to whether the Firm represents any clien


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with a potential conflict of interest with MSD. Acontract with an outside entity should be clear in itsexpectations, designate a point of contact to oversee theterms of the contract, and include controls to govern theamounts allowed to be billed. Without these criteria,MSD cannot effectively and efficiently control the costsand use of this contract.Recommendations: We recommend that MSD amend

its contract for legal services to ensure that MSDadequately controls the costs and responsibilities of theoutside legal firm. Revisions should address thefollowing areas:

Specifically, define the experience requirementsfor billing at the partner or associate rates. Thecontract should require a justification if thepartner rate is used by more than one attorney onthe case. For optimal monitoring by MSD, thecontract should require a written determinationfor each assigned case as to the expected number

of attorney partners, associates, and paralegals,etc. This determination should also include a not-to-exceed amount to be paid to the Firm for theassigned case. The Firm must obtain writtenprior approval to exceed the maximum amountspecified.

Separate the types of legal work into individualcontracts to improve monitoring efforts.

Designate the MSD Legal Director to assigncontracted legal work as needed.

Require prior approval of any costs other than fortime spent on a case by a Firm attorney from the

Legal Director. This includes any costs related totravel, meals, expert witnesses, mock juries, andother costs incurred not related to the Firms timecosts.

Include a term that specifies the settlementprocess that should be followed by the Firm.

Include a term that requires the Firm to discloseany actual or potential conflict of interestbetween MSD and any of the Firms other clients.

Finding 10: MSD spent $2.1 million for co-bondcounsel services with no documented justification.Between June 4, 2009 and August 24, 2011, MSD paidits bond counsels a total of $2.1 million for legalservices to issue bonds with a total par value of $1.75billion. The legal fees for each bond transaction werepaid in equal amounts to two firms, each of which hasserved MSD as bond counsel consistently since 1997.MSD officials, including its former Finance Director,could not provide a clear understanding as to the dutiesperformed by each bond counsel, the need for co-bond

counsel, and the process through which the financteam, including the co-bond counsel, were selected.Recommendations: We recommend the MSD Boaformally adopt a policy to select bond counsel andfinancial advisor through a competitive selectiprocess using either a RFP or RFQ. This competitiprocess should assist in determining those moqualified to perform the services, while also provide

opportunity to control the costs of issuing bonds. If cbond counsel is desired, justification for co-bocounsel should be provided to the Board for its revieand approval. The RFP or RFQ should state tservices desired, the length of the engagement, tevaluation method, the selection process, and a coproposal to provide services. If co-bond counsel being engaged the RFP, RFQ, or engagement letshould specify the roles and responsibilities and tasassigned to each firm to minimize potential duplicatiof work and costs. MSD should ensure propoversight of legal counsel to ensure work is progressi

and coordinated as required by the RFP, RFQ, engagement letter. We further recommend the MSBoard be fully apprised of the RFP, RFQ, aengagement letter for procuring services, the methused to select bond counsel and financial advisor, ttasks to be performed by counsel and financial advisotheir fees and other bond issue costs.

Finding 11: The lack of a policy developmeprocess results in duplication of work anpotentially unnecessary legal fees.MSD lacks a defined process for the initiation a

development of policies, which has resulted duplicative work and potentially unnecessary legal feePolicies at MSD may be created or revised throughvariety of avenues. The MSD Board or the ExecutiDirector may request that MSD staff develop or revipolicies. Staff may also begin this process internaand bring new or revised policies to management fdiscussion and to determine whether if it should brought to the Board. Further, the Board or ExecutiDirector may also request the MSD Board LegCounsel to produce policies. There is no specificatifor which of these methods should be, or may b

employed in the policy development process. This callow for certain individuals, including staff or tBoard Legal Counsel, to work toward developing tsame policy at the same time, without the knowledge the other parties work.Recommendations: MSD should develop a policy process by which policies are to be initiated adeveloped and subsequently brought before the BoarThis should include who has the authority to initia


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policy development and who has the authority toauthorize the expense of Board Legal Counsel to assistin the process. When making an initial request for anew or revised policy, use of internal staff should beconsidered first, when possible, to ensure the most costeffective methods of policy development are used. Adetermination for the need of outside legal expertiseshould be made in consultation with the internal legal

staff.

Finding 12: The Louisville Green Corporationbylaws specify by name the President and thespecial legal counsel.The bylaws drafted for the Louisville GreenCorporation in 2005 by the MSD Board Legal Counsel,specify by name who will be the President and who willbe employed as special legal counsel. Instead ofreferring to a position title or including a provision thatthe corporation may employ or contract for independentcounsel, the actual names of MSDs Executive Director

and the MSD Board Legal Counsel are used in thisdocument. To avoid the need to amend bylaws, thisdocument should not contain individuals names andshould only include fundamental items that will notchange. Specificity related to a position or detailedduties should be accomplished through policy manualsor board resolutions. By specifying the actual names ofindividuals, an appearance exists that the attorney wasensuring that his personal interests were representedand not those of his clients when he drafted thesebylaws. Further, this circumvented a transparent,competitive process to select the legal counsel for

Louisville Green.Recommendations: We recommend the LouisvilleGreen Board amend its bylaws to remove specificnames of individuals. The Louisville Green bylawsshould be free of any redundant or unnecessary termsthat may complicate the governance of this corporation.Further, we recommend the Louisville Green Boardselect a legal counsel through a transparent, competitiveprocess as similarly recommended in Finding 6.

Finding 13: MSD Board provides inadequateinvestment oversight and lacks sufficient

information.MSD invests hundreds of millions of dollars from bondproceeds in a proprietary investment program through athird-party investment management firm that providesMSD with limited reporting on investment holdings andthe investment process. This lack of investmentinformation provided by the investment managementfirm combined with no known inquiries into the detailsof the investment program by the Board means that thefiduciary body of MSD does not know the level ofinvestment risk and cannot ensure whether investments

are secure through compliance with MSD policies other regulations.Recommendations: MSD should, at a minimufollow current Investment Policy and provide the Boawith detailed semi-annual reports as to the holdings the investment program, investment activities, rilevels of the program, and program strategieHowever, we recommend the policies be updated a

investment reports be provided to the Board, or toBoard investment committee as recommended Finding 16, on a monthly basis. Board members shourequest such information if not provided by staff. MSshould follow the requirements of the curreInvestment Policy and annually solicit Request fProposals for investment services that contain required details of the investment management firm athe services being provided. In the interests transparency, MSD should not enter into a proprietainvestment program that does not disclose all details the program to the Board members.

Finding 14: MSD financial advisor has conflict interest.The financial advisor used by MSD to proviindependent evaluations and recommendations finvestment opportunities also acts as a programanager for the primary MSD investment program areceives substantial fees based on the gains of thoinvestments. Having a management role in tinvestment program and receiving fees based on tprogram profits creates a conflict of interest for tfinancial advisor and calls into question his ability

act in an independent nature on behalf ofMSD.Recommendations: MSD should undergo an opprocurement process on a periodic basis for experienced financial advisor to provide advice aconsultation related to the investment portfolio of MSThis contract should be separate from other financservices such as the issuance of bonds, which may negotiated on a per transaction basis. The contrashould require the financial advisor to be free conflicts with any investment firm doing business wMSD. All fees for an investment consultant aadvisement contract should be a single fee based up

the amount of funds to be invested and the type investments that are expected by MSD.


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Finding 15: MSD does not have financial staff orBoard members with background or specificexperience in the types of investments and otherrelated financial activities undertaken at MSD.MSD does not have staff or Board representation withsufficient financial expertise to adequately understandand analyze the various financial programs andactivities undertaken by MSD at the direction of its

external investment management firm and financialadvisor. Without the expertise and ability to understandand evaluate such programs, MSDs assets may beexposed to unnecessary risk and MSD may not beassured of receiving the most competent, compliant,and economical financial advice.Recommendations: We recommend that MSD ensurethat the finance staff include a person or persons withstrong financial and investment knowledge andexperience to enable investment and financial strategiesto be based on the knowledge and understanding ofsuch activities by MSD staff and not solely on the

advice of third party advisors. We further recommendthat MSD Board membership include at least oneprofessional who is particularly knowledgeable ininvestment and financial management activitiescommensurate with the types of activities in whichMSD may engage. In addition, we recommend theMSD Board create an investment committee whosemembers are responsible for the oversight ofinvestment activity and programs. The committeeshould include, at a minimum, one professional whoparticularly knowledgeable in investment and financialmanagement activities. We recommend the investment

committee receive detailed reporting of MSDsinvestment portfolio, all investment activities,programs, trends, and strategies. The investmentcommittee should have a thorough understanding ofexisting investment policy, and propose additionalpolicies as deemed necessary. The committee shouldquestion staff and financial advisors regardinginvestment activity and programs to evaluatecompliance with investment policies.

Finding 16: MSD has insufficient policies regardinginvestment and other financial activity.

MSD has not updated its Investment Policy since it wasadopted on February 27, 1995. Further, no policy hasbeen developed to address the use of interest rateswaps. An entitys policies should be comprehensiveand define the roles and responsibilities related to majorfinancial activities including the investment of funds orother financial tools. MSD has increased its investmentactivity over the years, and has also entered into anextensive number of interest rate swaps that have had aprofound impact on the liabilities of MSD.

Recommendations: We recommend that MSundertake a comprehensive review of its InvestmePolicy to strengthen Board oversight and to determiwhat changes are needed to ensure this policy fuladdresses the actual investment activities conducted MSD. In addition, these policies should address the uand monitoring of external financial advisors aprovide detailed guidelines related to their use. Furth

we recommend MSD develop policies related interest rate swaps that include the following:

Objectives for the use of interest rate swaps;

Conditions for the use of interest rate swaps;

Guidelines as to the terms and conditions of aMSD swap agreement;

Criteria related to the use of interest rate swcounterparties;

Evaluation and management of interest rate swrisks; and,

Terminating interest rate swaps.

Finding 17: MSD lacks a formal process finitiating, performing, reporting and distribution its internal audits.The MSD internal audit function is governed by Internal Audit Charter, which was formally adopted July 2008. The Charter describes the internal aumission and scope of work, including responsibilities and authority within the organizatioWhile the purpose of this Charter is to establish tbasic groundwork for internal audit, it is not designto provide the details of a formal process to be followby internal audit in accomplishing its mission and scoof work. MSD has not established a formal process finitiating, performing, reporting, and distributiinternal audits.Recommendations: We recommend the MSD AuCommittee develop and approve procedures for tinternal audit function. The adopted procedures shoustate the process for the Internal Auditor to follow initiating an audit, including the process for the AudCommittee to be informed of and approve or authoriany audit requests not already on the annual audit plmade by management or other parties. The adoptprocedures should also state the acceptable time perifor the Internal Auditor to allow management respond to a draft audit report. The adopted procedurshould specify that the Auditor is to inform the AuCommittee if management fails to respond to the drreport within the specified time period and the proceto follow to release an audit report when manageme


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fails to respond. The procedures should require theInternal Auditor to inform the Committee when a draftaudit is completed for the Audit Committee to reviewand approve the draft report prior to forwarding thereport to management for response. Finally, proceduresshould require the Audit Committee, after reviewingand approving internal audit reports, to ensure internalaudit reports are presented to the full MSD Board for

ratification.

Finding 18: Oversight of MSD internal auditfunction primarily performed by executivemanagement; MSD Audit Committee is notsufficiently engaged with Internal Audit.Despite an Internal Audit Charter stating the ChiefInternal Auditor reports functionally to the AuditCommittee and administratively to the Budget andFinance director, MSDs internal audit function is primarily directed and supervised by MSDs executivemanagement. The current structure of MSD and the lack

of engagement by the MSD Audit Committee with itsInternal Auditor indicate the MSD Board failed tosupport an independent internal audit function.Recommendations: We recommend the MSD AuditCommittee perform the annual evaluation of the InternalAuditor. We recommend the MSD Audit Committeeapprove and recommend to the full Board an annualbudget for the Internal Auditor based on the approvedinternal audit work plan. The Internal Auditor shouldrequest directly to the Audit Committee the amount offunds estimated as necessary to conduct those audits.Once approved by the Audit Committee, the annual

budget for the Internal Auditor should be ratified by thefull Board to be included in the MSD budget by theFinance Director. We also recommend the MSD Boardrevise the Audit Committee Charter to include within theCommittees responsibilities the performance of theannual evaluation of the Internal Auditor and thebudgeting for the expenses of the Internal Auditor. Werecommend the MSD Board revise the organizationalchart of MSD to include a direct reporting line from theInternal Auditor to the Audit Committee of the Board.We recommend the MSD Audit Committee consistentlyapprove the annual MSD internal audit work plan as

required under the Internal Audit Charter. Further, theBoard should revise the Audit Committee Charterlanguage to agree with the language in the Internal AuditCharter as the current Committee Charter only states theCommittee is responsible for reviewing the work plan.Additionally, we recommend the MSD Internal Auditorprovide routine status updates on audits to the AuditCommittee. This will foster continued communicationbetween the Internal Auditor and Audit Committeemembers. It will allow the Internal Auditor to discussany problems that may be encountering on an audit with

the Committee in a more timely manner and will althe Committee an opportunity to discuss any concethey may have with the thoroughness of a particuaudit or regarding other areas of the organization tthey may wish to ask her to investigate. Finally, recommend the MSD Audit Committee consider holdquarterly meetings to ensure continued dircommunication with the Internal Auditor.

Finding 19: MSD provided compensation benefthat could be considered excessive for a pubentity.MSD executives received bonuses, deferrcompensation, and retirement increases that appeexcessive for a public entity. While these actions mhave been approved by the MSD Board, the pubcould consider these actions to be excessive aunnecessary costs incurred by MSD. The former acurrent executive directors received deferrcompensation trust funds, 180 employees in 1999 a

the current Executive Director in 2003 receivpayments to purchase retirement service credits, asignificant salary increases and bonuses were providto executives and other employees during our audperiod.Recommendations: We recommend that MSD revieits various methods of providing compensation executives and other staff and ensure that compensation structure and programs are fair aequitable to executives and staff and is in the beinterests of the public it serves. Expenses incurred bypublic entity should be scrutinized due to the pub

nature of the business. Alternative measures should evaluated to reduce staffing and a cost-benefit analyof any retirement buyout considered by MSD so that tBoard is aware of the potential costs involved and tgoals that should be achieved by additioncompensation costs. In addition, the policy providisix-month and annual salary increases and bonuses new employees should be reconsidered because thpolicy could provide an excessive increase compensation to an employee that has not been wMSD a complete year. Furthermore, all forms compensation, including performance salary increas

and bonuses, should be considered if MSD wants control or freeze its payroll budget.


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Finding 20: MSD did not comply with procurementguidelines when procuring certain professionalservices.In several cases, MSD contracted for professionalservices without following its own internal procurementrequirements or those in the Model Procurement Code,KRS Chapter 45A, applicable to state agencies for theprocurement of personal services. Furthermore, MSD

policies allowed the MSD Board to waive allrequirements in the regulations if deemed to be in thebest interest of MSD.Recommendations: We recommend MSD implementprocedures to ensure compliance with all procurementpolicies, particularly those pertaining to professionalservices. Employees responsible for procurementshould be sufficiently trained on those policies.Further, we recommend MSD adopt the provisions inthe Model Procurement Code in KRS 45A.740,45A.745, and 45A.750 pertaining to the procurement ofarchitectural and engineering services.

We recommend:

Procurement Method Determination Forms becompleted in a timely manner in accordance withprocurement policies and used to document themethod by which the agency intends to procure aservice. It is a checkpoint to ensure the agency isutilizing the correct procurement method andshould not be overlooked or completed after thecontract is signed or services are provided;

MSD centrally maintain all procurement records;and,

MSD only approve payments that have a signedPurchase Order.

Finally, we recommend that MSDs policy of allowingthe Board to waive any or all requirements related tothe procurement of professional services be repealed.

Finding 21: Employee usage of MSD computerappears to violate policy.While attempting to address a MSD procurement issueinvolving procurements made by the MSDAdministrative Services Manager during the audit

period, auditors found a significant number of personaluser data files stored on the MSD server through ashared network directory designated to theAdministrative Services Managers user profile. Whileincidental and occasional personal use of MSDElectronic Media is permitted for reasonable activities,it must be minimal according to the MSD ElectronicCommunications Media Policy.Recommendations: We recommend MSD provide anupdated training to its staff regarding MSD policies,

including its Electronic Communications Media PolicMSD should require staff to sign-in for the training amaintain the sign-in sheets in accordance with record retention policy. We further recommend MSrequire its personnel to periodically sign acknowledgment to be placed in the employeepersonnel file, when its Electronic CommunicatioMedia Policy is updated.

Finding 22: MSD had no formal records retentipolicies or records retention training for employees.Upon employment, MSD employees were not providinformation and training on records retentirequirements for the public records created at MSNo formal policies on records retention procedures aincluded in the Policies and Benefits manuals for MSemployees. Further, no records retention system formail exists to assure that recorded information MSDs functions, decisions, procedures, and essent

daily transactions, is retained, regardless of format.Recommendations: To ensure MSD retentischedules and related systems and processes are beieffectively carried out, we recommend MSD formaadopt records retention policies to be included in tPolicies and Benefits manuals for employees. Supolicies should detail employee responsibilities ovretaining required books, papers, maps, photographdiscs, software, e-mails, databases, and othelectronically generated records. We furthrecommend an archival policy and system be draftand adopted specifically regarding proper e-m

retainage. Policies should also include trainirequirements. Once such policies are adopted by MSwe recommend that all employees be formally trainon all records retention requirements, including tproper retention of e-mail communications. Upemployment, all new employees should be trained records retention responsibilities to assure propretainage of records. MSD also may want to considhaving employees sign an acknowledgement that thhave read and understand the records managemepolicies.

Finding 23: MSD accounting system coding erroled to misclassified expenditures and failure to iss1099 forms to its contractors.Auditors identified accounting system coding erroboth in the classification of MSD expenditures and vendors. These coding errors led to tmisclassification of certain expenditures betwe


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capital projects, between MSD and Louisville Green,Inc., and led to a failure by MSD to issue any 1099s tocertain vendors prior to 2009. A 1099 is a federal taxform to report non-salaried income.Recommendations: We recommend MSD FinanceDepartment be more diligent in ensuring expendituresare coded to the proper projects and cost categories.Further, because the MSD Finance Department

personnel partially rely on the department managersand directors to assist them in identifying theappropriate codes to use when entering the expendituresinto the accounting system, we recommend the MSDFinance Department review expenditure cost center andclassification information provided by those approvingthe expenditure and question the information that doesnot appear reasonable or appropriate. We recommendthe MSD Finance Department require all necessaryfinancial forms, including W-9s, prior to entering thevendor into the MSD accounting system. Finally, werecommend MSD develop a policy that addresses

financial processing activity involving the reporting ofW-9 information. The policy should be presented tothe MSD Board Policy Committee for approval prior toimplementation. The policy should then be posted anddistributed to all required personnel to ensure completeinstitutional knowledge of the newly created andadopted policy.

Finding 24: MSD has not reviewed the computer-based overhead process used to allocatedepartmental cost to capital projects.MSD uses a mainframe computer-based process to

allocate overhead costs between departments and fromdepartments to maintenance and capital projects.MSDs failure to review the allocation process since itsinception in 1999 raises concerns as to the accuracy andapplicability of the process to the current MSDstructure. Any such misallocation of costs could have asignificant impact on financial statements resulting inthe over or under allocation of costs to capital projects.Per the current MSD Controller, in the three years thatshe has been with MSD there has not been a review ofthe methodology or percentages used in the process.Recommendations: We recommend MSD review the

allocation process on a regular basis and ensure that theprocess is fundamentally sound and complies with thecommonly accepted accounting basis for capitalizedproject cost. We also recommend that MSD review theallocation process annually and document that theprocess has been reviewed and approved by theappropriate administrative and executive staff.

Finding 25: MSD made questionable expenditurfor parties, donations, travel, training, and othitems.A review of MSD financial records lead auditors identify MSD funds spent on various questionabitems, such as a private tribute party, donations various organizations, holiday parties, and othmiscellaneous items. As a public agency, the MS

Board is responsible for ensuring that funds are used the most efficient and effective manner possible alignwith its mission and in the best interest the ratepayethat it serves. As such, the benefit of these types questionable expenditures should be reexamined by tMSD Board and Executive Management.Recommendations: We recommend MSD refrafrom spending funds for activities and items that do nprovide a clear benefit to its ratepayers or help fulfMSDs mission. We recommend MSD managemecarefully evaluate each discretionary expenditure ensure funds are efficiently and effectively used

keeping with its mission. We recommend MSconsider seeking reimbursement of the amount contributed to the private tribute from the MSemployee who authorized the payment with obtainithe appropriate approval from the Executive DirectWe recommend that the MSD Board closely scrutiniits expenditures for contributions and donations. Ifcontribution or donation is being considered, it shouhave a clear and documented connection to MSDmission or must be needed to meet a requirement of EPA Consent Decree. Further, we recommend contributions and donations under consideration

MSD be presented to the full Board for approval ensure Board awareness and managemeaccountability MSD. We recommend MSD no longuse public funds for Holiday parties and celebrationWe recommend MSD closely scrutinize travel aconferences, particularly of out-of-state travel. Wrecommend MSD management also closely scrutinithe number of employees allowed to attend a singconference or meeting. Further, the MSD Board shouapprove out-of-state travel after being provided westimated travel costs. Subsequent to the travel, tactual travel expenses should be reported to the Board

Finding 26: MSD uses the Internal RevenServices (IRS) commuting valuation rule

calculate the taxable value of assigned vehiclregardless of the employees compensation levels.MSD calculates the taxable benefit of an employassigned vehicle using the same method for employees, but this method is not appropriate for employees. According to MSDs Employee Benef


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policies, MSD employees are taxed for the benefit of atake-home vehicle using the IRS Commuting Valuationmethod. However, this method cannot be used todetermine the taxable benefit for certain employees thatmeet the definition ofa control employee per the IRSTaxable Fringe Benefits Guide. Using an inappropriatemethod to calculate this benefit could result in anunderstatement of taxable benefits reported to the IRS.

Recommendations: We recommend that MSD complywith IRS guidelines to ensure that the personal benefitof an assigned vehicle is valued appropriately for taxpurposes. The MSD policies should be amended toreflect how controlled employees will be determinedand the method that will be used to calculate the taxablebenefit of assigned vehicles.

Finding 27: The MSD Board allowed a corporationunder its authority to administratively dissolvebefore conveying the corporations property to

MSD.

In the 1990s, MSD agreed to accept responsibility overa local area subdivisions wastewater treatment plantthat, in exchange, conveyed its stock to MSD. TheMSD Board was then named the Board of thisorganization. While MSD still assumes responsibilityfor the facility and surrounding property, the MSDBoard allowed the corporation under its authority toadministratively dissolve before formally conveying thecorporations property to MSD.Recommendations: We recommend the MSD LegalDirector take the necessary actions to address thesituation regarding the dissolved corporation and its

related property. We also recommend the MSD Boardand its Executive Management evaluate its processes toensure tasks undertaken by employees are reasonablyaligned with their job responsibilities. While it is notinappropriate for the former Executive Director to havefiled annual reports on behalf of the Corporation, it ismore reasonable and allows for better continuity for theMSD Legal Department to perform that function.


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Introduction and Background

Page 1

Impetus andObjectives forExamination

On July 28, 2011, the Auditor of Public Accounts (APA) informed the ExecutivDirector and Board Chair of the Louisville-Jefferson County Metropolitan SewDistrict (MSD) by letter that due to the Louisville-Jefferson County MetGovernment (Louisville Metro) Mayors request for an audit and concerexpressed to this office regarding certain financial and other activities, it wouperform a review of certain issues at MSD. Specifically, the examination wouinclude a review of the organizations policies, internal controls, and certain othfinancial transactions.

The purpose of this examination was not to provide an opinion on financistatements, duplicate work of annual financial audits, or evaluate the amount of raincreases, but to address the following objectives:

Determine whether policies governing contract procurement are adequatconsistently followed, and provide for a transparent process;

Determine whether policies governing the internal audit process aadequate, consistently followed, and provide for timely reporting;

Determine compliance with policies and other requirements associated wiincreasing MSD customer rates;

Review and evaluate MSD Board policies using the APAs thirty-twrecommendations developed for public and non-profit boards;

Review certain financial transactions and determine compliance with MSpolicies and reasonableness of the expenses; and,

Determine if conflicts of interest exist.

Scope of andMethodology forExamination

The scope of this review includes records, activities, and information for the perioJuly 1, 2008 through June 30, 2011, unless otherwise specified, as the time perioof certain documents reviewed and various issues discussed with those interviewemay have varied.

To address these objectives, the APA reviewed documents, conducted interviewand tested expenditures. Thousands of documents, including emails, invoicereports, and policies, were supplied by the MSD staff, the MSD Board, anconcerned citizens of the Commonwealth in response to our announcinvolvement in this audit and our request for information. These and othdocuments were analyzed in relation to the objectives of this review. The findingor results, from this review are discussed in detail in Chapter 2.


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The APA reviewed certain MSD organizational policies, procedures, and othgoverning requirements and compared them to the APAs 32 Recommendatiofor Public and Nonprofit Boards regarding financial oversight and internal contrprocesses for board consideration. See Exhibit 1 for a listing of these Recommendations. When performing this comparison, the APA reviewed variodocuments and manuals provided by MSD, as well as other criteria. Whnecessary, we made recommendations to develop new or to further strengthecertain policies, controls, and oversight procedures.

The APA conducted interviews with individuals holding the following positions:

Current and former MSD Board members;

Current and former members of the MSD executive staff;

Current and former MSD staff members;

MSD Special Board Counsel;MSD co-bond counsels; and,

MSD financial advisor.

Auditors judgmentally sampled certain types of expenditures for fiscal years (FY2009, 2010, and 2011 to determine the presence of required documentatioreasonableness of expenditures, and compliance with MSD policies. Theexpenditures included capital project and other contract transactions, travreimbursements, education reimbursements, donations, and purchasing catransactions. The findings from this review are discussed in detail in Chapter 2.

MSD: The Agency Created in 1946 by the Kentucky General Assembly, MSD was formed as a specidistrict to handle sewers in Louisville and at that time the unincorporated JeffersoCounty, now known jointly as Louisville Metro. While wastewater treatment wadded with the construction of the Morris Forman plant in the late 1950s, the basmission remained the same until 1987 when MSD assumed the responsibility providing drainage and flood protection to most areas of Jefferson County.

As of FY ending 2010, MSD, a component unit of the Louisville Metgovernment, reported operating revenues of $171,590,108 with cash aninvestments of $478,603,152. During FY 2010, MSD employed a total of 6employees.

Purpose/Duties According to the MSD Board bylaws, the purpose of MSD is to provide adequaand effective sewer and drainage facilities and services for the benefit of thgeneral public within the district area in accordance with Chapter 76 of thKentucky Revised Statutes (KRS), as may be amended. More specifically, KR76.080 empowers joint metropolitan sewer districts, such as MSD, with thfollowing powers:


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To have jurisdiction, control, possession, and supervision of the existinsewer and drainage system of the city of the first or second class; maintain, operate, reconstruct, and improve the same as a comprehensivsewer and drainage system; to make additions, betterments, and extensiothereto within the district area; and to have all the rights, privileges, an jurisdiction necessary or proper for carrying such powers into executioNo enumeration of powers in KRS 76.010 to 76.210 shall operate to restrithe meaning of this general grant of power or to exclude other powecomprehended within this general grant.

To prepare or cause to be prepared and to be thereafter revised and adopteplans, designs, and estimates of costs, of a system of trunk, interceptinconnecting, lateral, and outlet sewers, storm water drains, pumping anventilating stations, disposal and treatment plants and works, and all othappliances and structures which in the judgment of the board will provide effective and advantageous means for relieving the district area froinadequate sanitary and storm water drainage and from inadequate sanitadisposal and treatment of the sewage thereof, or such sections or parts such system of the district area as the board may from time to time deeproper or convenient to construct, consistent with the plans and purposes KRS 76.010 to 76.210, and may take all steps the board deems proper annecessary to effect the purposes of KRS 76.010 to 76.210.

To construct any additions, betterments and extensions to the facilities the district, within or without the district area, and to construct anconstruction subdistrict facilities or additions, betterments and extensiothereto, within or without the district area, by contract or under, through, by means of its own officers, agents and employees. No construction extensions shall be started within the city of the first or second class untfirstly, the city's director of works, and secondly, its board of aldermen havapproved the plans. No construction or extensions shall be started in acity of the second, third, or fourth class until the governing authorities such city or cities have approved the plans. No construction or extensioshall be started in any other part of the county until the plans have beapproved, firstly, by the county engineer and, secondly, by the fiscal court

To establish, construct, operate, and maintain, as a part of the sewer andrainage system of the district, sewage treatment and disposal plants ansystems and all the appurtenances and appliances thereunto belonging. Tsewage treatment and disposal plants may be located in the city, or beyonthe limits of the city in the county in which the city is located, as the boadeems expedient.

To acquire and hold the personal property the board deems necessary anproper for carrying out the corporate purposes of the district and to dispoof personal property when the district has no further need therefore.


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To acquire by purchase, gift, lease, or by condemnation, real property or aninterest, right, easement, or privilege therein, as the board determinnecessary, proper and convenient for the corporate purposes of the districand to use the same so long as its corporate existence continues, and same necessary or useful for the corporate purposes of the district. Condemnatiproceedings may be instituted in the name of the district pursuant toresolution of the board declaring the necessity for the taking, and tmethod of condemnation shall be the same as provided in the EmineDomain Act of Kentucky. When the board by resolution declares that areal property which it has acquired, or any interest therein, is no longnecessary or useful for the corporate purposes of the district, the reproperty and interest therein may be disposed of.

To make bylaws and agreements for the management and regulation of affairs and for the regulation of the use of property under its control and fthe establishment and collection of sewer rates, rentals and charges, whisewer rates, rentals and charges, applicable within the limits of a city of tfirst or second class, shall be subject to the approval, supervision ancontrol of the legislative body of the city as hereinafter provided.

To make contracts and execute all instruments necessary or convenient the premises.

To borrow money and to issue negotiable bonds and to provide for thrights of the holders thereof.

To fix and collect sewer rates, rentals, and other charges, for servicrendered by the facilities of the district, which sewer rates, rentals, and othcharges, applicable within the limits of a city of the first or second clas

shall be subject to the approval, supervision and control of the legislatibody of such city as hereinafter provided.

To enter on any lands, waters and premises for the purpose of makinsurveys, and soundings and examinations.

To approve or revise the plans and designs of all trunk, interceptinconnecting, lateral and outlet sewers, storm water drains, pumping anventilating stations, disposal and treatment plants and works proposed to constructed, altered or reconstructed by any other person or corporatioprivate or public, in the whole county, in order to ensure that such proposconstruction, alteration or reconstruction shall conform to and be a part ofcomprehensive sewer and drainage system for the said county. No sewe

drains, pumping and ventilating stations, or disposal and treatment plants works shall be constructed, altered or reconstructed without approval by thboard of the district. Any such work shall be subject to inspection asupervision of the district.

Generally speaking though, the three core areas of service that MSD providinclude wastewater collection and treatment, stormwater drainage services, anflood protection.


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MSD operates and maintains 3,200 miles of wastewater collection sewer linwhich collect wastewater from over 200,000 homes, businesses, and industrithroughout Louisville Metro. Wastewater flows to MSDs 286 pumping stationsix regional water quality treatment centers, and numerous smaller water qualitreatment centers in the service area.

MSD maintains the stormwater drainage system for the Louisville Metro areResponsibilities include the construction, repair and maintenance of drainagswales, storm sewers, ditches, and drainage channels in most of Louisville MetrAreas not served by MSD include the cities of St. Matthews, Shively, Anchoragand Jeffersontown. Residents and businesses in those municipalities are served their respective cities.

MSD operates and maintains Louisville Metros Ohio River flood protectiosystem. The system includes about 25 miles of earthen levee, 4.5 miles reinforced concrete floodwalls, 16 flood pumping stations, moveable and sandbstreet closures to seal street passages in levees and floodwalls, and floodwaservice openings and service doors.

History Louisvilles first sewers were built around 1850, routing wastewater to the OhRiver. By the end of the 19

thcentury, a 99-mile network of clay, brick, and timbe

lined sewers moved the wastewater of the 204,000-person community directly the river and streams. In 1946, MSD replaced the second Commissioners Sewerage, an organization formed to design, build, and manage sewer and drainawork in Louisville between 1919 and 1944.

Early Emphasis onWastewaterCollection andTreatment

MSD stopped building combined storm and sanitary sewer lines in the mid-1950A separate drainage fee or drainage property tax had been discussed in the ear1950s, but city government wouldnt allow it. The City of Louisville, which hgiven its old combined sanitary and storm sewer system to MSD when it wformed in 1946, would contend for decades to come that MSD was responsible fdrainage in the city; MSD would counter that its only income, from sanitary sewfees, had to go for much-needed sanitary sewer improvements.

New Sources ofRevenue

In the 1960s, new federal clean-water programs began to provide the financiassistance necessary for sanitary sewer improvements. But with the additionfunds from the federal government came more stringent wastewater standards in t

form of the Water Quality Act of 1965. One of the pressing problems facing MSin 1965 was the industrial waste being discharged into the sewers. For generationmany Louisville businesses and industries had been dumping and flushing thewaste. It mingled in the sewer lines before emerging in Beargrass Creek or tOhio River.


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In 1967, with backing from the Chamber of Commerce, the MSD Board adoptedsewer surcharge based on the amount of solids and grease in industrial wastPlants with a significant amount of waste could reduce their surcharges by prtreating their water to remove waste before discharging it to the sewers.

A 1968 state law made it possible for MSD to expand by assessing property ownea share of the costs of providing them with new sewers. This eliminated the needform sewer sub-districts, a very cumbersome process, and provided an additionsource for revenue.

Previously AssignedResponsibility orUnfunded Services

Due to a reported lack of adequate financing from the beginning, MSD limited istormwater drainage work in the City of Louisville. However, by the mid-1950Jefferson County government contracted with MSD to manage its drainage prograoutside the city limits, with the county agreeing to pay all the costs. By the 1970the county still hired MSD to handle its drainage program in unincorporated areof Jefferson County, but progress depended on county appropriations.

Each new suburban city that incorporated found itself immediately responsible fits own drainage program. Other government agencies were responsible fdrainage on their land: the state highway department, the airport authority, the citcounty parks department, the state parks department. While each governmeagency was responsible for drainage within its own boundaries, no governmeagency had the responsibility, or the authority, to make sure these drainagprograms worked well together.

In 1987, MSD assumed the responsibility of providing drainage and floo

protection to most areas of Jefferson County, including the City of LouisvillMSD also assumed the operation and maintenance of the Ohio River FlooProtection System. Prior to this, public stormwater drainage and flood protectiwas the responsibility of more than 90 government entities.

Another Source ofRevenue

Financing for drainage improvement projects would be handled through a drainauser fee based on the "impervious area" (pavement, roofs, etc.) on a propertSingle-family residences would all be charged the same rate, eventually set at $1.7per month, and commercial and industrial properties would be charged $1.75 pmonth for each 2,500 square feet of impervious area. MSD pledged that the rawould not be increased for five years. The fee would be considered as a pub

utility service charge, similar to sewer, water, gas, electricity and telephone servicharges; government agencies would pay it, as well as schools and non-proforganizations. In mid-2006, MSD began providing free sewer and drainaservices to the Metro government, a service valued at $3.3 million in 2010.


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The urbanized and developing areas of the county would be included, but not tfarmland in the outer reaches. Third and fourth-class cities would be given toption of joining the program, or continuing to handle their own drainage. As tprogram developed, five suburban cities decided to keep their own drainaprograms: Anchorage, Jeffersontown, St. Matthews, Shively, and Prospect. Aothers joined the new program.

Consent Decree The Federal Clean Water Act of 1972 requires the U.S. Environmental ProtectioAgency (EPA) to develop water quality criteria that accurately reflect the latescientific knowledge. The EPA provides guidance to the Commonwealth Kentucky for developing and adopting water quality standards. Criteria adeveloped to protect aquatic life, as well as human health.

In the mid-2000s, portions of Louisville Metros 500 miles of combined sewewere more than 100 years old and improvements to the sewer system were needeto reduce sewer overflows that compromised area water quality. In August 200MSD entered into a court-ordered Consent Decree with the Kentucky Departmefor Environmental Protection, the EPA and the U.S. Department of Justice. TConsent Decree reached in response to pending litigation regarding allegviolations by MSD of the Federal Clean Water Act and KRS 224 concerninsanitary and combined sewer overflows required MSD to create an action plan address the following issues:

An aging sewer system that lacked the capacity to handle the current sewaand stormwater volume during wet weather;

Sewer overflows that polluted the river and streams throughout LouisvilMetro, which violated the Federal Clean Water Act; and,

A responsibility to keep the public informed about potential health riskfinancial impacts, and construction project activity.

To address the challenges of improved water quality and meet the requirements the Consent Decree, MSD began a comprehensive sewer improvement initiatiknown as Project WIN, or Waterway Improvements Now. Project WIN includthe implementation of sewer improvement projects to minimize the impact combined sewer overflows, eliminate sanitary sewer overflows, and rehabilitate thcommunitys aging sewer system. In addition, Project WIN involved keeping tpublic informed of potential health risks, financial impacts, and construction projeactivity. MSD believed that Project WIN, estimated to cost approximately $85million over a 20 year period, would achieve the sewer overflow abatemeobjectives outlined in the Consent Decree by 2024.


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In April 2009, MSD entered into an amended Consent Decree to address sanitasewer overflows and unauthorized discharges from MSDs sanitary sewer systemcombined sewer system, water quality treatment centers, and discharges froMSDs combined sewer overflow locations identified in the Kentucky PollutaDischarge Elimination System permit for the Morris Forman Water QualiTreatment Ce

Documents

Metropolitan Sewer District Examination