WASHINGTON — Now that the first shoe has dropped in the Justice Department's criminal investigation of alleged anti-competitive activities in the municipal derivatives and investment markets, what comes next in 2010?
"It's the first of many shoes to fall out of the closet," predicted Christopher "Kit" Taylor, the former executive director of the Municipal Securities Rulemaking Board, referring to Justice's nine-count indictment in late October against CDR Financial Products Inc., its founder David Rubin, as well as a current and former firm official. The indictment marked the first criminal charges stemming from the investigation, which has been ongoing since 2005.
The number of individuals and firms charged in the case is likely to widen significantly, market participants said, noting that at least 60 individuals have received so-called target letters from Justice, which also has subpoenaed dozens of firms.
Meanwhile, attorneys for the government said in court this fall that they have "a very strong case" based on multiple witnesses who agreed to plead guilty and testify against CDR, including former employees of the firm who worked with the defendants.
Last week, Justice attorneys were expected to turn over the first of several batches of evidence to attorneys representing CDR and the three individual defendants: Rubin; Stewart Wolmark, former chief financial officer and managing director; and Evan Andrew Zarefsky, currently a vice president at the firm. The documents are said to include three terabytes of information, with each terabyte consisting of the equivalent of 20,000 pages of documents. In addition, the government said it would turn over more than 500,000 recorded conversations.
Peter Shapiro, managing director at Swap Financial Group, said it would probably be difficult for the government to simultaneously pursue litigation against all of the individuals and firms that are reported to have been targeted in the bid-rigging investigation, making it hard to know exactly how the case will progress next year.
Often prosecutors seek a more visible defendant, like a big bank or public official, he added.
As a result, the case is probably going to proceed "over a protracted period," said Richard Beckler, a partner at Howrey LLP, who is representing CDR, a broker of guaranteed investment agreements and derivatives contracts.
Justice's indictment against CDR and the officials alleges that the firm, as early 1998 and at least until November 2006, rigged the bidding process for the contracts and agreements so that certain firms would submit losing bids and a specified firm would submit a winning bid in return for undisclosed kickbacks disguised as "hedge fees."
The providers of investment agreements are supposed to be chosen based on competitive bidding procedures designed to comply with tax requirements and the indictment alleges CDR falsified documents claiming the bidding process was competitive.
As a result of the rigged bids, "the intended winning provider increased its profits from the investment agreement(s) by paying interest to the municipality for the duration of the investment agreement(s) at a rate that was artificially low," Justice charged in the indictment.
The investigation became public in November 2006 when the Federal Bureau of Investigation raided the offices of Beverly Hills-based CDR, Investment Management Advisory Group Inc., known as IMAGE, in Pottstown, Pa., and Sound Capital Management in Eden Prairie, Minn. It is being conducted by the New York field office of Justice's antitrust division, the FBI, and the Internal Revenue Service's criminal investigation division, according to Justice officials. Justice is also coordinating its probe with the Securities and Exchange Commission, the Office of the Comptroller of the Currency, and the Federal Reserve Bank of New York.
The indictment against CDR refers to, but does not name, two financial institutions that were branches or agencies of foreign banks. Sources have speculated that these institutions may be UBS, which pulled out of the municipal securities market in June 2008, and Societe Generale, which the IRS alleged in the spring of 2007 was, along with CDR, fixing prices on financial products to divert arbitrage in so-called lease-to-own housing deals.
Spokesmen for both firms have declined to comment. The IRS price-fixing allegation against CDR and SocGen was revealed in April 2007 by the New Mexico Housing Authority's Region III, which filed a material event notice stating the IRS had sent it a proposed determination letter concluding $22.71 million of variable-rate lease purchase revenue pass-through bonds it issued in 2003 were not tax-exempt.
The CDR indictment also refers to Provider A, a group of related financial services companies located in Manhattan and owned or controlled by a company headquartered there, and Provider B, a group of separate financial services entities that were controlled by, or were part of, a company headquartered in Connecticut.
As previously reported in The Bond Buyer, sources said Provider B is GE Funding CMS, also known as Trinity Funding Co., a unit of General Electric Co, which is based in Connecticut. The company has disclosed in financial filings that its subsidiaries had received subpoenas and one had received a Wells Notice from the SEC, warning that staff was considering proposing the commission file civil charges against it.
Meanwhile, Provider A is believed to be Financial Security Assurance Holdings Ltd., the former subsidiary of Belgian bank Dexia SA, according to Bloomberg News LP, which linked the timing of reinvestment deals FSA did with CDR in 2002 and 2003 for the West Virginia Water Development Authority and the Port of Oakland to transactions vaguely referred to in the indictment between Provider A, CDR and an unnamed state water development authority, and an unnamed port.
In July, Dexia sold FSA, which is based in Manhattan, to Assured Guaranty Ltd. of Hamilton, Bermuda. A spokeswoman for Assured declined to comment.
As the government proceeds with its criminal case in the U.S. District Court for the Southern District of New York, several municipalities have filed class action lawsuits that have been consolidated in the same federal court. The suits present a disturbing picture of alleged widespread collusion between dozens of firms involved with municipal investment contracts and derivatives and are based in part on briefings the issuers' lawyers had with attorneys at Bank of America Merrill Lynch — the one firm that is cooperating with Justice's antitrust probe in return for indemnity from criminal charges.
Relying largely on information from a confidential witness at B of A Merrill called CW, the lawsuits provide something of a play-by-play primer on routines among certain firms in the reinvestment and derivatives business. The winner of bids for the contracts in the sector were determined in advance, traders used verbal cues to rig bids, some firms intentionally submitted losing bids, and several firms received "last looks" that allowed them to compare competing bids and alter their own to win.
These consolidated suits are pending before District Judge Victor Marrero, who is also overseeing the government's criminal suit. They are much broader than the government's case against CDR, and have been filed against more than 30 providers, or firms that were counterparties or that submitted bids or pricing information with regard to investment and derivatives contracts as well as nine firms that brokered the contracts, and 11 other firms they calls "co-conspirators."
One recent suit filed by the Sacramento Municipal Utility District added additional defendants, including the financial advisory giant PFM Group Inc., which advises municipalities on swap transactions. The SMUD suit suggests, however, that PFM, through its subsidiary PFM Asset Management LLC, was complicit in a phony bidding process for GICs. PFM officials declined to comment.
Though these cases have shed the most light so far on the alleged anti-competitive activities, it is unclear how much they are likely to progress in the coming months. Justice plans to seek a second six-month stay on discovery for the consolidated cases, to ensure that they do not interfere on its own criminal case.
Meanwhile, the individual firms have until Jan. 24 to file motions to dismiss the cases. After that date, the issuers will have a chance to respond, and a hearing may be held in the spring, said Nanci Nishimura, a principal at Cotchett, Pitre & McCarthy, the firm that has filed suits on behalf of 11 individual issuers, including SMUD, the city of Los Angeles, and Contra Costa County, Calif.
JEFFERSON COUNTY
Another high-profile muni case that is expected to move forward in early 2010 is the SEC's suit against two former JPMorgan managing directors — Charles LeCroy and Douglas MacFaddin.
The SEC brought securities fraud charges against the pair early last month, alleging they made more than $8 million in undisclosed payments to close friends of certain Jefferson County, Ala., commissioners and broker-dealers, including Goldman, Sachs & Co. and Rice Financial Products Inc., to ensure that JPMorgan would be selected as managing underwriter of the bond offerings and that its affiliated bank would be chosen as the provider of swaps.
The SEC announced the charges and that it had reached a related settlement with JPMorgan, in which the firm neither admitted nor denied the SEC's charges but agreed to pay a penalty of $25 million to the federal government and $50 million to Jefferson County.
LeCroy and MacFaddin, who have each denied wrongdoing, have until Jan. 15 to respond to the SEC's complaint, which was filed in federal court in Birmingham.
Speaking here last month, Robert Khuzami, the SEC's director of enforcement, said that the Jefferson County case, as well as other recent enforcement actions, show the SEC is not afraid to pursue complex and difficult financial crimes.
"We do every bit of sophisticated and detailed inquiries and we bring those kinds of cases on a regular basis," Khuzami said. "It may take us a little while to get there. These investigations can be challenging and difficult. But if you look at our track record, I don't think those that are inclined to engage in misconduct can take much comfort from it."
MIAMI
The SEC appears to be moving forward with a sweeping but informal inquiry into the manner in which Miami presented its financial condition in offering documents for bonds issued in 2007.
In a letter sent this month to the city, two SEC attorneys asked for Miami officials to voluntarily turn over documents from October 2006 through the present, as well as information on the transfer of money slated for capital projects to the city's general fund, according to a copy obtained by The Bond Buyer.
In particular, the SEC is looking at two transfers of about $13 million each in 2007. It is also asking for all e-mails from six financial employees of the city, as well as documents exchanged with dealer firms First Southwest Co., Merrill Lynch & Co., UBS, JPMorgan, and the accounting firm McCaldrey & Pullen LLP.
In addition, the commission is asking for the same documents that were reviewed by Miami's independent auditor general, Victor Igwe, who released a critical audit of the city's finances on Nov. 17. The audit outlined the city's failure to comply with four of 13 "financial integrity principles" that Miami officials adopted in 2000 following a fiscal emergency in the 1990s that led to state oversight for several years.
The SEC's informal investigation appears to focus on how those transfers were presented in bond documents, market participants said. Municipal issuers can be held legally liable under the federal securities laws for negligently misstating material facts or providing misleading disclosures. They also can be liable in a civil action by a third party for recklessly doing so.
Nearly a decade ago, the SEC pursued securities fraud charges against Miami, claiming that disclosure documents for three 1995 bond issues totaling $116.5 million as well as secondary market disclosures misled investors about the city's deteriorating financial condition. The case was tried in 2000 and resulted in an initial decision by an SEC administrative law judge in 2001, which was appealed by the city but upheld by the commission.
