In the News: Recent Developments

June 23, 2004

SEC Probes Firms in $204 Billion Auction-Rate Bond Market

By Otis Bilodeau

New York (Bloomberg) — The U.S. Securities and Exchange Commission is reviewing whether brokers who help set interest rates on $204 billion of corporate and municipal bonds misled investors and issuers.

The SEC’s enforcement staff asked several brokers of so- called auction-rate bonds to provide “a written report detailing any potentially deceptive, dishonest or unfair practices,” according to a memo that the Bond Market Association, the Securities Industry Association, and the American Bar Association sent to their members. The memo, obtained by Bloomberg News, didn’t specify what type of abuses or which firms the government is probing.

Investors in auction-rate debt buy a long-term security, such as a 30-year bond, and bid through brokers to set the coupon as frequently as weekly or monthly. The interest rate resets in a so-called Dutch auction, in which the lowest price becomes the level at which the entire offering is sold. The risk of manipulation in a Dutch auction is if bids aren’t blind or if brokers and bidders enter into undisclosed arrangements.

In practice, “there rarely are true auctions,” said Joseph Fichera, chief executive of Saber Partners LLC, a New York firm that advises bond issuers. “There’s too much risk to both the investor and the issuer for it to be a blind auction on such a frequent schedule. The broker may be eliminating the blindness to manage risk.”

Brokers submit bids to an auction agent, often the same firm that underwrites the bonds, on behalf of current and prospective investors. Typically, there is a default or index-based rate at which the security will reset if there aren’t sufficient bids.

‘Great Interest’

The SEC is investigating whether some of the deals were offered to certain customers, which would be a violation of the bond prospectuses, Institutional Investor reported yesterday.

Bond Market Association senior vice president and general counsel Marjorie Gross said the government is also looking into whether dealers had special arrangements with investors to buy the securities if the interest rate set at the auction was undesirable, Institutional Investor said, citing an unidentified person.

“The SEC staff of late has had great interest in the manner in which securities are priced in the secondary market and the way transactions in that market are executed,” said Paul Maco, a former head of the SEC’s office of municipal securities and now a partner at the Vinson & Elkins law firm in Washington. “There’s clearly a concern about whether these auctions are what they appear to be.”

IPO Settlement

The SEC separately is negotiating with Goldman Sachs Group Inc. and Morgan Stanley to settle allegations the firms improperly inflated demand for shares in initial public offerings, according to people familiar with the matter. The firms have agreed to pay $40 million each, the people said.

Goldman spokesman Lucas van Praag and Morgan Stanley spokeswoman Melissa Stonberg declined to comment. The settlement was reported yesterday by the Wall Street Journal.

Auction-rate securities were created in 1984, and by the end of June 2003, there were more than $170 billion outstanding, according to Merrill Lynch & Co.’s Web site. In the fourth quarter of last year, $204 billion in all types of auction-rate securities were outstanding, according to an industry overview prepared by Deutsche Bank AG. Issuers include municipalities, hospitals, colleges and universities.

Brokers including Goldman Sachs, Deutsche Bank’s U.S. securities unit and Lehman Brothers Holdings Inc. sell auction- rate bonds. Goldman Sachs spokesman Peter Rose, Merrill Lynch spokesman Mark Herr, Lehman spokeswoman Hannah Burns, and Deutsche Bank spokeswoman Michelle Agostinho declined to comment.

Market Abuses

The memo describes a May 26 meeting between the trade groups and SEC officials including Enforcement Director Stephen Cutler and General Counsel Giovanni Prezioso. In the meeting, SEC staff said “evidence existed of abuses in the market,” according to the memo.

Larry West, an SEC enforcement official in Washington who also attended the meeting, declined to comment on the probe.

The meeting focused on the SEC’s request for voluntary disclosure of abuses, which differs from its traditional method of seeking documents and conducting interviews to determine if violations occurred.

“This is an effort by the SEC enforcement staff to be creative,” said David Becker, a former SEC general counsel who is now a partner at Cleary, Gottlieb, Steen & Hamilton, a law firm in Washington. “They’re saying, investigate yourselves and confess all your sins and we’ll either hammer you for your sins, or hammer you for not confessing them, or both.”

Bond Market Association officials George Miller and Marjorie Gross attended the meeting with the SEC staff, along with George Kramer, a lawyer for the Securities Industry Association, and Dixie Johnson, chair of the American Bar Association’s committee on federal securities regulation.

“We don’t know what the facts or the circumstances of the investigation are,” Gross said. “The meeting was an effort was to try and ensure common understanding of the SEC’s request to ensure full and consistent cooperation,” she said.

Johnson declined to comment on the probe.

“The facts of the investigation are beyond my ken,” said the SIA’s Kramer. “The purpose of our meeting was to address procedural matters. The SEC’s approach seemed novel to us.”

With reporting by Amy Strahan Butler in Washington and Walden Siew in New York. Editors: Goldenberg, McCabe, Rooney, Wolfson, Greiff

To contact the reporter on this story: Otis Bilodeau in Washington (1) (202) 624-1988 or
To contact the editor responsible for this story: Liz Goldenberg in New York (1) (212) 893-3940 or at

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