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. Last Updated: 07/27/2016

Investing, Pentagon-Style

They had millions of dollars and a mandate from Washington: Help demilitarize the Russian economy, and feel free to get rich along the way if you can. But six years later, a former employee has accused them of frittering away the money, and the Pentagon is conducting a criminal investigation. The program's backers concede some mistakes, but argue the jury is still out on the Defense Enterprise Fund.

Matthew Maly is passionately holding forth in his kitchen about everything wrong with U.S. foreign aid to Russia. It's a field in which he has worked for the past few years, and he spins tales of greed and incompetence: of a failed scheme to coax gold out of trash; of a bungled telecom investment that sucked the American and Russian governments into a little-known spat; of a book published by USAID and then bought back and shredded by USAID.

Maly's harshest stories involve the U.S. Defense Enterprise Fund, an organization given $67 million by Congress and told to shepherd Russian military scientists and factories into civilian work. Maly worked at the DEF from 1996 to 1999, right up until management laid off the last 16 employees of what had once been a 48-person staff. Struggling to communicate his exasperation with his time there, he launches into what seems a long digression:

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In 1985, Maly was a recent emigr? to the United States and a graduate student at Columbia University. One day, a fellow countryman is steered to Maly's New York doorstep by relatives back in Moscow. This man, Vladimir Furman, introduces himself as a brilliant inventor who has developed a vague sort of water heater that will be able to cheaply satisfy the energy needs of the entire planet known as Earth. All he needs is some money.

"He says, 'Introduce me to George Bush,'" Maly said. "I tell him I don't know George Bush. He says, 'Then introduce me to some millionaires.' I don't know any millionaires, I'm a poor grad student.

'Who do you know?'

'I know my geography professor.'

'OK, let's go meet your geography professor.'"

They go. Furman waxes eloquent about his miracle heater and tells the professor he could sell the technology to him for $2 billion. Perhaps the professor should get some investors together?

"Later, we are all three walking down the street in New York, and Furman stops and stares up at this skyscraper. We say, 'What are you doing?' and he says, 'I'm contemplating buying this building after I sell my technology.'"

Thirteen years later, Maly was working in Moscow at the DEF, and growing ever more frustrated with the fund's management. One day his boss told him he had just met a Russian scientist Ч a Vladimir Furman Ч and the DEF was going to invest in some of his ventures.

It was the same Furman. Maly says he immediately told his boss, DEF senior vice president Richard Nordin, that Furman was crazy.

Nordin Ч a 47-year-old burly former U.S. military paratrooper who runs the DEF's Moscow operations Ч confirmed that in an interview.

"Matthew claimed he knew Furman and that he was crazy," Nordin said.

Maly's cautions aside, the DEF and Furman went into business. Nordin said the DEF invested $110,000 into a project brought to them by Furman to commercialize a lubricant to make machinery less abrasive.

Nordin said the science belonged to another man, and the DEF's technology experts judged it sufficiently promising to flirt with. Therefore Furman himself, Nordin said, "was not all that critical to the deal." Among other things, the $110,000 investment let the DEF test-run the lubricant on the equipment of AvtoVAZ, Russia's largest car manufacturer. DEF officials concluded the lubricant did not work well enough to justify pursuing it commercially.

Another consideration was that Furman Ч who could not be found for this article Ч was apparently a pain in the neck. "Mr. Furman was doing ever increasing amounts of screaming and shouting, and we just cut him off," Nordin said.

A 'Missing' $41 Million?

Over the years the DEF has spent $67 million on obtaining and managing stakes in businesses in Russia, Ukraine and Kazakhstan. The businesses all must somehow qualify as "conversion" Ч as somehow moving an institution or its personnel out of the Soviet military past and into a free-market future.

Early on, the DEF indulged itself in six offices in four nations (including offices in Richmond, Virginia, and Washington), and managers were asserting that business was too good to handle Ч that they would have to set up a second, private fund to deal with it all.

That never happened. Instead, the DEF managers have spent lots of time over the years trying to extract themselves from bad situations.

These days, Nordin manages the portfolio out of the offices of Russia Partners, a Moscow-based fund manager. It's a far cry from the 50-person DEF team of 1998, which Nordin said some years cost as much as $7 million to run. Managing the modern-day DEF is so low-key that last year Nordin had time to take on an extended stint as acting president of another Russia Partners property, MTV Russia.

On busier days, when Nordin needs help on a DEF project he can mobilize a dozen or so Russia Partners employees. But instead of scouting for the next big thing, the job now is unraveling old problems, recovering long-lost money and planning for the day when the DEF's modest portfolio Ч stakes in six companies worth about $26 million Ч can be "harvested" for cash. (More fun is planning what to do with that cash. Nordin said the Pentagon's Defense Threat Reduction Agency Ч the DEF's main supervisor Ч would put the money back into conversion in Russia, this time probably as a grant of some sort.)

How did the DEF turn $67 million into a handful of investments worth less than half that? Where did the other $41 million or so go?

There are many ways to tell that story. One way would be to reject the premise: The figure of $26 million can be reached by updating a Pentagon report issued last August that said the DEF portfolio included seven companies valued at $31 million. (One company valued at $5 million has since dropped out). But Nordin said it was he who gave the Pentagon that figure, and he characterized it as a back-of-the-envelop guess. He also argued against trying to put a value on the DEF portfolio before it is harvested.

But it is Maly's version of events Ч angry, impassioned, at times unapologetically speculative Ч that has launched a series of official investigations in Washington.

About $20 million, according to Nordin, was spent just running the DEF for six years Ч on the rent, the staff compensation, the legal and consulting fees. That might raise some questions about costs, and indeed an internal DEF study rapped the American managers for running an expensive shop.

It would also leave another $21 million or so to account for. At least some of those "missing" millions can be chalked up to Furman's super lubricant and other investment misadventures. For Maly, 42, this has always been the story: bad investments, bad management. In July 1999, as he and others were laid off, he was furious to think DEF's managers might consign talk of mismanagement to the fires of the ruble devaluation.

That month he wrote a six-page letter to William Taylor, a top State Department official in Washington who then oversaw assistance to the former Soviet bloc, asking him to look into "a catastrophic situation with the DEF's investments." Maly wrote that the DEF's troubles were caused by "serious wrongdoing" on the part of its managers, and he singled out Nordin by name. He said DEF managers failed to do proper due diligence before investing, failed to keep control over money once invested, hired incompetent staff, did not avail themselves of enough legal advice and were generally sloppy and free with the money in their care.

The managers of Enterprise Funds like the DEF (see related article) are allowed to set up their own venture capital funds and start beating the bushes for private cash. But this is hard to justify unless they are well on their way to having fully invested their public monies. Maly and other DEF employees say there was a constant urgency to invest rapidly, and Maly argued in his letter that DEF managers were in a rush because they had their eyes on the prize of their own fund.

"The DEF rule was: Never, ever do any due diligence lest it interfere with the speed of investment," Maly says.

Maly also wrote that DEF management "may have violated U.S. law," although in that letter he was vague as to how. Later Maly made clear he was referring to payments the DEF made to a former deputy prime minister, Valery Serov, for lobbying work. Maly suggested the DEF's 1998 payments to Serov Ч who at that time was out of office and who today is a vice president of the natural gas company Itera Ч were cash delivered in brown envelops, and so may have been bribes.

That's a serious allegation, and it's worth noting it's based on hearsay: Maly claims no direct knowledge of dollar-stuffed envelops, he only says he was told of them. (He has named his sources to investigators, but those people could not be reached for this article.)

Serov in a telephone interview dismissed talk of being paid in cash as "complete delirium." Nordin is equally testy on this point. He refuses to comment on the size of Serov's payments Ч Maly, again citing office colleagues, has put them at $20,000 a month Ч but he said flatly Serov did not get paid in cash "in brown envelopes, or in any other color envelopes."

Many who worked at the DEF or had dealings with it Ч including some who, like Maly, believe the fund was poorly managed Ч recoiled when told of Maly's suggestion Nordin paid bribes.

Consider Paul Thomas, an American who runs the Ukrainian auditing and assets appraisal company IRE. Thomas has worked with both Maly and Nordin on a DEF project in Kiev, he has been in business in the former Soviet Union for more than eight years, and Maly lists him as one of his character references. Thomas was surprised to hear that, in addition to slamming the DEF as poorly run, Maly had suggested Nordin might have knowingly paid bribes.

"Rich Nordin is a Boy Scout!" Thomas exclaimed indignantly. "He makes George Bush Sr. look like a pickpocket! It's incomprehensible that this guy, who fought for God and country in [the 1989 invasion of] Panama, is somehow giving bribes to enrich himself. Matthew [Maly] is really grabbing at straws on that one Ч it's not good for him and patently unfair to other people."

(Nordin actually helped invade Grenada, not Panama, but point taken.)

Maly counters that he never pretended knowledge he did not have, and only suggested the State Department examine the matter. And he points out that no action was taken for 13 months after he wrote his letter: Only last August did the Pentagon's Defense Criminal Investigative Service open up a probe.

Nordin said the Pentagon is obliged to investigate any such accusation, no matter how well or poorly documented. He and other DEF managers say they expect to be exonerated. "Every so often [the Pentagon investigators] will call and ask for something," said Robert Odle, a lawyer representing the DEF board. "We've prided ourselves on trying to reply instantly."

'A Shitty Job' Investing

If they firmly reject suggestions they somehow violated U.S. law, the DEF's managers are more willing to concede the fund was not a triumph of management. In fact, Nordin himself in a September 1999 e-mail put it more bluntly and succinctly than Maly ever has:

"I think you will be the cause of a report that accomplishes what I assume you set out to do Ч which is to show that a small number of people did a shitty job of investing a fund and that it did not have to be that way. This being Washington, the impact on me will be predictable," Nordin wrote to Maly, who provided a copy of the e-mail.

John Nowell, the DEF's chief executive officer, also declined to argue the point. "As for 'the DEF could have been better managed,' I can't say much," Nowell wrote in an e-mail reply to written questions. "I suppose Winston Churchill could have been a better peacetime prime minister, and maybe Joan of Arc could have been more virtuous. I know I could have done a better job managing the DEF. I apologize."

Nowell added that he believed everyone working for the DEF had "done their best in a continuously tough environment." "If you think it didn't work out, then it's my fault," he wrote. "The successes belong to [the DEF's Moscow team]. The failures and shortcomings belong to me."

Yet even while offering their mea culpas, the DEF managers say Maly is wrong on details. They insist they did do due diligence, use lawyers and handle money with care. And they explain their fund's poor performance by pointing out that it was in bad shape when they got it, and by arguing that similar investors in the unfriendly environment of late 1990s Russia have done as bad or worse.

'A Very Rough Start'

A tendentious early history of the U.S. Defense Enterprise Fund might go like this:

The DEF set aside $2.9 million to invest in OrbitSoft, a startup designed to farm out the services of Russian computer programmers. But the DEF decided not to go forward and OrbitSoft was shut down. It put $800,000 into RAIES International, a venture that was going to use the expertise of nuclear labs to zap timber with radiation to sterilize it before export. That too was abandoned. The DEF put $2.5 million into KK Interconnect, a venture with Kazakhstan's National Nuclear Center to make consumer electronic devices Ч and KKI even came up with the World Connect, a universal modem adapter that made its way into the pages of the swank Sharper Image catalogs for $49.95. But KKI's isolated factory was hundreds of kilometers from the nearest airport, making shipping costs prohibitive. So the World Connect was another bust. "Essentially KKI has had to reinvent itself," says the DEF's 1998 annual report. KKI's process of self-discovery has been an expensive one for U.S. taxpayers: In addition to the $2.5 million it got from the DEF, KKI got another $3.9 million directly from the Pentagon arm that oversees the DEF, the Defense Threat Reduction Agency. What's more, Oleg Gapanovich, a St. Petersburg-based DEF official, described visiting KKI with a colleague, Karen Westergaard, in 1998, and finding that "half of the money [the DEF had invested] was lost" because it had been used to pay a second company's debts. (Westergaard could not be reached.) These days, KKI is, among other things, assembling Samsung televisions for the Kazakh market.

The DEF also toyed with going into business with an Alabama company, R&G International, to make vacuum tubes on the site of a St. Petersburg defense plant. R&G executives, however, complained about the legal and consulting fees the DEF was racking up on that project Ч a whopping $524,000, including $150,000 to Ernst & Young accountants and more than $250,000 to Steptoe & Johnson, a Washington law firm with one of its partners on the DEF's board of directors. The DEF board killed its $3 million investment into the vacuum tube project. R&G sued, claiming the DEF wanted to punish it for pointing out the large legal and consultancy fees. The DEF's then-CEO, Kevin McDonald, agreed. He resigned, and wrote to the DEF board: "I believe that a decision to stop funding this deal would indeed be a form of punishment against our U.S. partners [R&G] for their 'whistleblower' activities."

This was the picture at the halfway point in the DEF's life span. Three years into its six-year existence, the most remarkable things the fund had to show was its eyebrow-raising legal and consultancy fees. A USAID analysis in 1997 found them larger than all but one of the other 10 Enterprise Funds Ч even though the DEF itself was one of the smallest of those funds. In 1995 and 1996, for example, the DEF paid Steptoe & Johnson $739,000 for legal services.

Some of the above was covered in the Chicago Tribune, which took a long look at the DEF a few months after Congress held hearings on Enterprise Funds in 1997. That Tribune article, however, also held out the hope of a brighter future: Nowell and Nordin had just been brought in as the new brooms. Nowell conceded the DEF had had "a very rough start" and promised change.

"Under Nowell," the Tribune reported, "the fund has moved into telecommunications and scrap metal deals that he says" will turn matters around.

As promised, the DEF did indeed move into telecoms and scrap metals. But among such projects were two of its more egregious missteps. It was a $9.65 million telecommunications venture called MPS-Telekom that dragged the DEF Ч and the U.S. departments of State, Commerce and Defense, and the Russian prime minister Ч into an agonizingly extended feud. And it was an ill-considered scrap metals deal called MZA that saw the DEF lose $5 million by loaning it to a dying French company.

$3 Million to a Restaurant?

More about MPS-Telekom and MZA in a moment; first, consider another up-and-coming project Nowell talked of once upon a time to the Chicago Tribune: RAMEC, a St. Petersburg-based computer manufacturer the DEF has put $6 million into.

More accurately, the DEF put in $3 million for 40 percent of the company Ч but the money evaporated. So the DEF put in a panicky second transfusion of $3 million, this time as a loan, accompanied by a stern finger-wagging. In an interview, Nordin characterized the RAMEC project as "a success, but a very expensive one." The Pentagon's August 2000 report estimated RAMEC's value at a mere $1 million, and stated not enough had been done to figure out what had happened to the other $5 million.

Maly alleged in his letter to the State Department that RAMEC had "reportedly" diverted the first $3 million to build a restaurant in St. Petersburg. Gapanovich, a former member of the Russian parliament who oversaw DEF operations in St. Petersburg, agreed the fate of the first $3 million was a mystery.

"I can't say whether it was diverted to a restaurant, but I can say that from the very beginning the transfers of money were unprofessionally and poorly documented," Gapanovich said in an interview.

Nordin said he knew nothing of any restaurants, but he did volunteer, "We're convinced [the money] wasn't used the way it was supposed to be."

"[The RAMEC managers] are involved in lots of businesses, and they've had a hard time distinguishing between our money and their money," Nordin said in an interview a few months ago. Since then, the DEF and RAMEC have come to an agreement under which RAMEC will pay back the second $3 million loan with a mix of company shares and cash.

Click here for Part 2.