Auditor Of Public Accounts
Audit: Weak contract with Utility Management Group had ‘detrimental impact’ on Mountain Water District

Press Release Date:  Thursday, January 27, 2011  
Contact Information:  Contact: Communications Director
Phone: (502) 573-0050
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An audit of Mountain Water District (MWD), a Pike County water and sewer public works, released today by State Auditor Crit Luallen found that its management contract with Utility Management Group (UMG) had a “detrimental impact” on MWD.

The MWD board entered into its original contract with UMG in 2005 through a questionable procurement process with no public board discussion and no examination of the contract terms – which resulted in costly management fees and conflicts of interest.

The district, which is the largest in Kentucky with a management contract, has paid UMG more than $36 million in fees from 2005 to June 2010.  

The audit found that after contracting with UMG, MWD costs began to escalate at a faster rate, creating increasingly larger losses for the district despite increasing revenue.

The audit notes MWD, at one point, was losing $5.44 each month for certain customers paying the minimum monthly fee and that the financial burden from its original contract with UMG caused the MWD board to authorize the use of most of its reserve funds to meet its bond payments.

The audit is being referred to the Office of the Attorney General and the Public Service Commission for their review.

The audit, which makes 8 findings and numerous recommendations, calls for stronger board oversight, including an analysis of the financial benefit to MWD prior to any future management contracts, the hiring of an employee to report directly to the MWD board and an audit of UMG.

The MWD board voted last week to approve a new five-year contract that pays UMG $7.6 million in annual fees.

UMG was incorporated in February 2005 and selected by MWD three months later for a five-year contract with an initial annual fee of $6.8 million.
In 2009, MWD reduced or removed certain fees from its contract through a renegotiation with UMG but accepted a $500,000 forgivable loan from UMG that must be repaid if the contract is terminated. 

Auditors also found that under contract guidelines, UMG is not obligated to share with MWD its cost to operate the district nor does UMG have an annual audit of its books that could be available to the MWD Board.

A request by the Auditor’s Office for cost information from UMG was denied, making it impossible to determine if the management contract saves MWD money and if its current management fees are excessive.

Kentucky law authorizes the Auditor to access the records it needs to conduct its audits and examinations of public works. Additionally, since UMG derives at least 25 percent of its funds from MWD and the city of Pikeville, the Auditor’s Office considers UMG subject to Kentucky’s Open Records law.

The audit notes MWD received approval for several rate increases through a federal program rather than through the Kentucky Public Service Commission, which requires a review of the actual operating costs of the district. 

The audit also found MWD circumvented procurement requirements, allowing it to pay more than $171,000 for electrical services to a company owned by a state lawmaker who assisted in obtaining coal severance funding for the district that was used to pay for the electrical work.

This finding is being forwarded to the Kentucky Legislative Ethics Commission for further review.  

“When government privatizes such a basic service, it is critical to have strong oversight that requires transparency and accountability from the vendor,” Luallen said. “Our audit lays out numerous recommendations that can strengthen board oversight and better protect the taxpayers.”

Luallen’s office announced its plans to audit MWD after a request by the Pike County Fiscal Court and after issues had been publically raised regarding the district’s management contract.

Auditors examined the policies, procedures, financial activities and controls of MWD and interviewed current and former MWD board members and UMG staff. Auditors reviewed the records of 10 different construction projects from July 1, 2004 to May 2010.

Mountain Water District was established in July 1986 through a merger of three separate water districts serving Pike County and currently all of the unincorporated areas of Pike County – serving 52,456 water customers and 6,800 sewer customers. MWD operations are primarily funded from the usage fees paid by these customers.

The district is overseen by a board of commissioners that is appointed by the Pike County Judge-Executive, who may appoint up to five members on the board.

The decision by the MWD board to begin the process that led to the management contract was made unanimously through a resolution on March 30, 2005 after a “very persuasive” presentation by the MWD superintendent – an employee of the board who subsequently became a part-owner of UMG.

The board, however, did not formally or openly discuss or document the anticipated benefits expected from privatizing the water and sewer operations of the district or conduct an analysis to determine what impact the contract would have on the financial stability of MWD.

Former board members who approved the management agreement told auditors that the contract was expected to provide financial savings for MWD.

Auditors found numerous irregularities in the initial MWD contract for operations, management and maintenance and the established contract bid process.

Auditors are questioning the process followed to initiate the management contract with UMG. The audit notes that the board, due in part to the expedited contract process to hire UMG, failed to properly oversee the contract bid request and the final contract.

Board minutes do not indicate that the contract bid request was ever reviewed by board members before it was advertised or who authored the bid request.

In examining the draft contract provided by UMG, auditors found a date on the contract indicating UMG may have already been aware of the proposal at least two months prior to the MWD superintendent making a presentation to the board to discuss new management.

The contract with UMG transferred all MWD personnel to UMG, including the superintendent who became the UMG project manager and continued to perform his old job duties as he had previously for MWD.

The audit notes the board relied heavily on this person as he served in both capacities. He was released as UMG project manager in 2009. 

The audit found that due to the former superintendent’s ownership interest in UMG, a conflict of interest may have existed because of the opportunity for him to personally benefit financially from MWD entering into contract with UMG.

In addition to the former superintendent, all other staff members who were transferred from MWD to UMG continued to perform regular duties; however, just as with the former superintendent, all employees were now to report to UMG rather than the district.

The contract requires UMG employees to receive MWD invoices, to write checks from MWD accounts, including checks to UMG, and to present checks to the board for approval and signature. The contract did not require UMG employees to follow all internal control policies established by MWD.

In reviewing board minutes, auditors note that the MWD board acknowledged in late 2006 the need for an administrative position to report directly to the board, independent of UMG. The board, however, never filled that position due to a lack of funds. 

The audit recommends the board fill that position, as well as create a finance committee to monitor the district’s finances. The audit also recommends the board require an annual audit of UMG.

Stronger board review and oversight of the original contract with UMG could have prevented MWD from paying more than $1.6 million in extra fees from 2006-2009, according to the audit.

Auditors found that contract language was added after the board agreed to award the contract to UMG requiring MWD to pay extra fees for every new customer over 1,000. 

The audit notes that this provision appears to have been added to the contract to allow UMG to receive additional payments to offset an increase in operational costs from an increase in the customer base. 

In total, invoices show that MWD paid UMG an additional $1.34 million between September 2006 and April 2009 due to the increase in MWD’s new customer base.

Another fee with a detrimental impact not sufficiently considered by the board during the contract process required MWD to pay more than $295,000 from 2006-2009 due to increases in the Consumer Price Index (CPI).

The combined fees resulting from additional customers and the CPI adjustments increased the total payments to UMG by $1.6 million between 2006 and 2009.

The board’s renegotiation with UMG in April 2009 removed the contract provision to pay UMG for each new water and sewer customer and the CPI adjustment, reduced its annual fee by $46,000 a month, and offered forgiveness of $30,940 in repair and maintenance costs owed to UMG.

The renegotiated contract also included a $500,000 five-year forgivable loan by UMG to MWD, which must be repaid if the contract is terminated. 

The audit also notes that procurement requirements appear to have been circumvented, resulting in more than $171,000 for services provided with no contract.

Auditors found that a company provided electrical work for homes connecting to a new sewer line project with MWD. The company did not have a contract and did not participate in two bidding processes for the work.

Auditors note the electrical company is owned by a Kentucky lawmaker, who assisted in obtaining coal severance funds for MWD to pay for the new sewer lines and the electrical work.

The electrical company owner told auditors that the former MWD superintendent instructed him to submit invoices that would not exceed $20,000, which is the small purchase authority limit above which competitive bidding and a contract are required. But the audit notes all the payments are related to the same project, making the aggregate total more than $171,000.

The audit recommends MWD use a competitive bidding process for all projects totaling more than $20,000 and that the board formally adopt a format to track construction project payment and funding information to ensure better recordkeeping and reporting.

The audit, including MWD’s response, can be viewed at