(Adds quotes from prosecutor and comptroller, further details on case)
By Nate Raymond and David Ingram
NEW YORK, Dec 21 (Reuters) - U.S. prosecutors on Wednesday accused a former portfolio manager at New York state's retirement fund, the third largest in the United States, of steering $2 billion in trades to two brokerage firms in exchange for gifts such as cash, drugs and prostitutes.
Manhattan federal prosecutors announced charges centered on the New York State Common Retirement Fund, which was shaken by another pay-to-play scheme a decade ago that sent the state comptroller to prison and sent shock waves through the pension fund world.
In the latest case, Navnoor Kang, the former director of fixed income at the New York State Common Retirement Fund, was charged in federal court in Manhattan along with Deborah Kelley, a former Sterne Agee Group Inc managing director.
Both face charges that include securities fraud and wire fraud and were also sued by the U.S. Securities and Exchange Commission in a related civil lawsuit.
Kang was arrested on Wednesday morning at his home in Portland, Oregon. Kelley surrendered to authorities in San Francisco, prosecutors said.
Gregg Schonhorn, a broker-dealer at FTN Financial Securities Corp, secretly pleaded guilty to paying bribes on Dec. 15, authorities said. FTN fired him on Wednesday when the firm learned of the allegations, a spokeswoman said.
Prosecutors said that Kelley and Schonhorn lavished Kang with cash, entertainment, luxury gifts, prostitutes and drugs valued at about $100,000 in exchange for fixed-income business.
"This was an age-old and classic tale of quid-pro-quo corruption," Manhattan U.S. Attorney Preet Bharara told reporters.
On weekend trips to Montreal in 2014, Schonhorn paid for cocaine, meals and travel expenses for Kang and another fund employee, according to court papers. They communicated via the WhatsApp smartphone app.
Kelley bought Kang a ticket to a Paul McCartney concert in New Orleans in 2014, and a ski trip to Park City, Utah, for him and a girlfriend in 2015, according to authorities.
In exchange, Kang steered $2 billion in fixed-income business to FTN and Sterne Agee, from which Kelly, Schonhorn and their employers earned millions of dollars in commissions, prosecutors said.
New York state Comptroller Thomas DiNapoli denounced Kang's alleged actions in a statement, saying the fund has "absolutely no tolerance for self-dealing, and we are outraged by Mr. Kang's shocking betrayal of his responsibilities."
Brian McEvoy, Kang's lawyer, declined to comment. Lawyers for Kelley and Schonhorn, who is cooperating with the prosecution, did not respond immediately to requests for comment.
Kang worked at the $184.5 billion fund from January 2014 to February 2016, when the state says he was dismissed, and was responsible for investing over $55 billion in fixed income assets, according to his LinkedIn profile.
He previously worked at Guggenheim Partners Asset Management and Pacific Investment Management Co after beginning his career at Goldman Sachs Group Inc, according to the profile.
Kelley worked as a managing director at Sterne Agee from 2012 to 2015, and left not long after Stifel Financial Corp acquired the company, according to Financial Industry Regulatory Authority records and LinkedIn.
In August 2015, Stifel said that Kelley had been discharged for providing gifts or entertainment to an unnamed portfolio manager at a public pension fund and misrepresenting the nature of expenses she submitted for reimbursement.
FINRA disclosed in September 2015 that it was conducting an inquiry into the matter. Kelley currently works at Seaport Global in San Francisco, according to her LinkedIn profile page.
From 2003 to 2005, former New York state Comptroller Alan Hevesi, who was the sole trustee of the fund, approved a $250 million pension investment in exchange for nearly $1 million in benefits from a California businessman. Hevesi pleaded guilty to corruption charges and went to prison for a year.
The wrongdoing revealed how politics and placement fees resulted in favored treatment by pension funds nationwide, and led to eight people pleading guilty.
The Common Retirement Fund is the investment arm of the New York State and Local Employees' Retirement System and the New York State and Local Police and Fire Retirement System.
The case is U.S. U.S. v. Kang et al, U.S. District Court, Southern District of New York, No. 16-cr-837. (Additional reporting by David Ingram; Editing by Jeffrey Benkoe and Alan Crosby)