In the News: Recent Developments

March 16, 2007

SEC Allows Auction-Rate Manipulators With Disclosure

By Darrell Preston, Published in Bloomberg News / BusinessWire

March 16 (Bloomberg) — The Securities and Exchange Commission, after sanctioning Wall Street’s biggest financial institutions for misdeeds in the $260 billion auction-rate market, now lets the same firms manipulate investor purchases as long as they disclose their intentions.

Citigroup Inc., Bank of America Corp. and 13 more investment banks get inside knowledge of bids when they run auctions to set the interest rates on the securities. They can use the information to put in their own bids and influence the outcome, even after paying a $13 million fine to settle SEC claims about the practices last May.

The difference now is banks have to tell investors that they use inside information with a notice like this one by Goldman Sachs Group Inc.: “When we submit an order for our own account, we are likely to have an advantage over other bidders because we will have knowledge of some or all of the other orders placed through us.”

The disclosures have safeguarded $650 million in fees that Thomson Financial data show the industry reaps each year from selling the securities, corporate or municipal debt with interest rates reset periodically through auctions. The control that dealers exercise over the market may force issuers to pay higher yields or leave investors with lower returns.

“You make your point, you collect your money and everyone goes on as they were before,” said Richard Lehmann, a registered investment adviser in Miami Lakes, Florida, and president of Income Securities Advisors Inc., regarding the SEC’s action. “That’s the way a lot of compliance is.”

Speaks for Itself

SEC Chairman Christopher Cox, a former Republican congressman from California appointed by President George W. Bush, declined to respond to several requests for comment. Commissioner Paul Atkins, a Republican, had no comment, according to Hester Peirce, a member of his staff. The three other commissioners — Roel Campos and Annette Nazareth, both Democrats, and Kathleen Casey, a Republican — didn’t respond to telephone and e-mail messages seeking comment.

SEC spokesman John Nester said in an e-mail that the SEC’s decision last year “speaks for itself.”

Citigroup, Goldman and the other brokerages settled claims they broke laws prohibiting omissions or misstatements in the sale of securities. The firms didn’t admit or deny wrongdoing in the settlements.

Bid Advantage

The SEC’s May 31 press release describing its cease-and- desist order says “each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws,” including “allowing customers to submit or change orders after auction deadlines;” “having an express or tacit understanding to provide certain customers with higher returns than the auction clearing rate,” and “providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.”

Nester said in his e-mail that the order “did not find rigging, nor was rigging alleged.”

Paul Kanjorski, a Pennsylvania Democrat who chairs the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, said he plans to bring up the matter with House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat.

“I certainly will look at it, and where it’s possible to have the regulator perform up to standards, I’d certainly rather do that then getting involved legislatively,” Kanjorski said in an interview. “But certainly we have requirements of oversight and it’s an issue that we should take up. We have to see if it constitutes some conflict of interest or violates some law.”

Need to Know

Rates on auction-rate securities are reset every seven, 28 or 35 days via so-called Dutch auctions, at which investors submit the yield they are willing to accept to hold the debt. The lowest yield necessary to place all the bonds becomes the rate on the securities until the next auction.

SEC officials have said the auction-rate securities market is misnamed. “The method by which rates are set for auction- rate securities bears little resemblance to a pure Dutch auction process,” said Martha Haines, the SEC’s head of public finance regulation and the official in charge of market regulation for the municipal bond market. “There is nothing wrong with that so long as it is fully disclosed.”

Dealer Control

Haines, in a speech to a municipal bond industry conference in September, said auction-rate sales shouldn’t be called auctions because of the dealers’ ability to set rates. She suggested calling the bids a “managed auction process” or “bidding system.” She said issuers and investors need to know not just that dealers may intervene to set rates but that dealers “commonly” intervene to control rates “with considerable frequency.”

Investors don’t know how many legitimate bids there were at an auction or what the range of offers was, so they can’t know how much real demand there was for the securities, said Joseph Fichera, chief executive officer of Saber Partners LLC, a New York-based financial advisory firm.

“There are still serious disclosure issues out there,” said Fichera. “If they’re going to call it an auction, you need a level playing field.”

Auction Fees

The other firms that settled charges brought by the SEC are Bear Stearns Cos., JPMorgan Chase & Co., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and two units of Morgan Stanley, all based in New York; Toronto-based Royal Bank of Canada; Wachovia Corp., based in Charlotte, North Carolina; A.G. Edwards Inc. of St. Louis; Morgan Keegan Inc., based in Memphis, Tennessee; Piper Jaffray Cos. of Minneapolis; and Suntrust Banks Inc. of Atlanta.

The SEC settlement estimated that brokerages charge 0.25 of a percentage point on average to manage the auctions. Based on Thomson’s estimate that there are $260 billion of such securities outstanding, the firms generate fees of $650 million a year. The $13 million fine the group paid amounts to 2 percent of the fees.

“We are basically helpless,” said Sarah J. Hussey, principal of Weston Financial Group in Bridgewater, New Jersey, who sometimes buys the securities and sells them when rates are reset too low. “We have to take whatever rate is set.”

Money-Market Alternative

Auction-rate securities, which also include some preferred stock, accounted for 8.6 percent of the municipal bond market in 2006, or about $32.6 billion of bond sales, according to Thomson. Sellers are attracted to the market because it offers an alternative to variable-rate debt, while buyers purchase them instead of a money-market account.

States and local governments sell auction-rate debt, as do corporations. Borrowers include Washington, D.C., New Jersey’s Economic Development Authority, and the Brazos Higher Education Authority, a student loan provider in Texas.

The Bond Market Association, a New York-based trade group for bond underwriters, proposed guidelines last May that would allow banks to use information on bids before putting in their own offers. The so-called best practices for auction-rate securities “are being worked on,” said Katrina Keller, spokeswoman for the group, now known as the Securities Industry and Financial Markets Association.

‘Fair and Reasonable’

Dealers don’t have an advantage in auctions because their bids must be at the so-called estimated market rate, judged by a broker-dealer to be “fair and reasonable,” according to the proposed practices, said Mary Kuan, vice president and assistant general counsel at the Securities Industry and Financial Markets Association, in a written statement.

The SEC appears most interested in preventing failed auctions and ensuring there are adequate buyers, said James D. Cox, the Brainerd Currie Professor of Law at Duke University in Durham, North Carolina, and a securities law specialist.

“The SEC got a victory and the other side got off with limited sanctions, so both sides think they’re better off,” said Cox, who isn’t related to the SEC chairman.

Brian Steel, a spokesman for New York-based Citigroup, said the bank has adhered to the settlement agreement.

“We’ve complied with the order,” he said.

Typical Buyers

Goldman spokesman Michael DuVally in New York; Merrill spokesman Mark Herr; Lehman spokeswoman Kerrie Cohen; JPMorgan spokeswoman Brooke Harlow; and Wachovia spokeswoman Christy Phillips declined to comment. Shirley Norton, a spokeswoman for Charlotte-based Bank of America, also declined to comment. Spokesmen for Bear Stearns, Morgan Stanley, RBC, A.G. Edwards, Morgan Keegan, Piper Jaffray and SunTrust didn’t respond to phone calls seeking comment.

“The lack of transparency is a little off-putting,” said Dominick Vetrano, who manages $125 million at Clune & Associates in Chicago. “You have to get a better yield to make up for the opaqueness.”

Vetrano said typical buyers of auction-rate securities are wealthy individuals living in states with high income taxes such as California or New York. They buy the securities for periods such as three months rather than certificates of deposit or individual municipal bonds, which can be difficult to find.

For example, Vetrano said a current New York City auction- rate bond pays 3.15 percent, compared with 2.90 percent on a standard New York municipal money market fund. “Therefore, I am getting the client more yield on a very similar product,” he said.

More Transparency

The guidelines being worked on by the bond industry group don’t specify the fiduciary duties of dealers hired by underwriters to handle auctions and don’t give issuers any way to review the bids to see how the price is determined, according to Frank Hoadley, bond finance chief for Wisconsin.

“While there must be a level playing field for all investors to assure investors fair treatment, the duty of the broker-dealer is to the issuer to achieve the lowest cost of funds,” Hoadley, a member of the Chicago-based Government Finance Officers Association, wrote in a letter last July to the industry group.

Investors also said the proposals don’t go far enough in requiring securities dealers to separate their dual roles as overseers of auctions and buyers of the debt.

“We would like to have more transparency,” said Lance Pan, whose Capital Advisors Group in Newton, Massachusetts, manages $7.5 billion in cash and follows the auction-rate market. “There are not enough hard and fast rules.”

—With reporting by Michael Quint in Albany and David Scheer and Jay Newton-Small in Washington.

Editor: Pickering (bew)

Story illustration: To see an industry trade-group memo about the SEC probe, click {NXTW NSN HZTP5G1A1I4H }.

—For a link to the Securities Industry and Financial Markets Association’s draft go to:

—To contact the reporter on this story: Darrell Preston at +1-214-954-9454 or

—To contact the editor responsible for this story: Beth Williams at +1-212-617-2307 or

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