Ohio yesterday sued MDL Capital Management, alleging fraud, breach of contract and other violations were behind the loss of nearly two-thirds of the $355 million the Downtown firm was managing for a state agency.

MDL Capital Chairman Mark Lay, who had been silent most of the week as the fire storm around him and his business grew, fired back, saying everything his firm did was done with the full knowledge and approval of the agency -- the Ohio Bureau of Workers' Compensation.

"It is highly unfortunate, unfair and damaging to MDL Capital that inaccurate reporting and political interests in Ohio are promoting misinformation and painting MDL's successful track record in a false light,'' Lay said in a statement distributed by his legal team, led by high-powered New York attorney Barry Slotnick, of the Pittsburgh firm Buchanan Ingersoll.

In a later interview with the Post-Gazette, Lay questioned why Ohio was making these charges now when the hedge fund that caused the losses was closed last September, leaving his firm to continue to manage more than $130 million for the workers' compensation bureau.

"If in fact they thought we were doing all of these really bad things nine months ago when we closed down the [hedge fund],'' Lay wondered, "why did we continue to manage their money?

"Obviously, it comes down to politics."

For his part, Ohio Attorney General Petro said MDL Capital far exceeded borrowing limits outlined in the agreement with the workers' compensation bureau, then lied about it to the bureau.

"By the time the bureau discovered the defendant's irresponsible activities, the bureau's investment had been substantially depleted," Petro said.

The suit, which names MDL Capital and other subsidiaries, Lay and other officers and a Bermuda firm used to provide transaction services, is seeking recovery of the funds and a jury trial for further damages.

The back-and-forth came as the stakes rose over revelations that the hedge fund run by MDL Capital, which took sizable short positions in a bet that long-term interest rates would rise, lost $215 million of $355 million the firm was managing for the workers' compensation bureau.

News of the loss -- revealed this week amid an investigation by the Post-Gazette's sister paper in Ohio, The Blade of Toledo, into the investment activities of the workers' compensation bureau -- was followed by the decision of the Allegheny Retirement Board to drop MDL Capital as one of its pension fund managers and pledges by others to review its performance.

But others yesterday came to the defense of the embattled firm, which has seen its portfolio shrink from a high of $4.42 billion in 2002 to $2.81 billion at the end of last year, not including the latest defections.

"They've been making money for us," said Robert Gentzel, spokesman for the Pennsylvania State Employees Retirement System, for which MDL Capital manages $91 million of the nearly $27 billion portfolio.

At the state employee pension system, MDL Capital is one of 13 fixed-income portfolio managers. Since it started in December 2000, the annualized return on its portfolio has been 4.5 percent -- "a couple of points" below the system's index, but still in the black, Gentzel said.

MDL Capital also manages $500 million for the Pennsylvania State Workers Insurance Fund, which insures employers that cannot find coverage elsewhere, and has "not lost money this past year," said Shannon Powers, spokeswoman for state Labor Secretary Stephen M. Schmerin, who chairs a three-member board that oversees the fund.

The fund's investments are spread among 20 managers whose transactions are closely monitored and required by law to be primarily in lower-risk vehicles such as bonds, Powers noted.

"They're prohibited from investing in hedge funds," she said. "Apparently, we have a lot more safeguards in place than Ohio."

Much of MDL Capital's work is in the public arena, as manager for various state and county retirement and related funds. It is a business that relies almost as much on perception as performance, and on connections and political contributions.

For example, records show that Lay contributed $10,000 to the 2004 campaign committee of House Minority Leader Bill DeWeese, the Greene County Democrat who last year nominated Lay to a position on the state's new Commonwealth Financing Authority and this week has been outspoken in his defense of Lay.

Former Pennsylvania Treasurer Barbara Hafer -- who in 2003 fired MDL Capital when the firm was put on a watch list and subsequently failed to elevate its returns -- received contributions from Lay totaling $9,000 in 2000, when she was running for and won a close race for treasurer, records show.

Other acquaintances yesterday also spoke up in defense of Lay.

Esther Bush, president and chief executive of the Urban League of Pittsburgh, one of numerous organizations that claim Lay as a board member, said the story "raises no questions for me around MDL, but it raises questions around the government and administrators in Ohio."

"It sounds like, as far as MDL is concerned, there's a lot of [self-protecting] going on in Ohio,'' Bush said. "They have to point the finger at somebody and MDL seems to be the obvious target."

Greg Spencer, executive director for the Manchester Youth Development Center, said he has worked with Lay through the center and through NEED, or Negro Educational Emergency Drive, which assists young black students with college.

"He is a former NEED recipient himself" who became a trustee because he wanted to give something back to the program that had helped him, Spencer said.