WASHINGTON – For the first time in the municipal securities market, the Securities and Exchange Commission on Tuesday charged a municipal advisory firm, its chief executive officer, and two of its employees for breaching their fiduciary duty by failing to disclose a conflict of interest to a municipal client.
According to the SEC, Kansas-based Central States Capital Markets, its CEO John Stepp, former vice president Mark Detter, and current vice president David Malone served as financial advisor for an unidentified issuer in a muni transaction, then selected a broker-dealer where the three men also worked to underwrite the bonds.
Central States Capital Markets agreed to settle the SEC's charges by paying $374,828, which included the disgorgement of $289,828 of ill-gotten gains and interest, as well as an $85,000 civil penalty.
Stepp agreed to a $17,500 civil penalty and a six-month suspension from acting in a supervisory capacity with any broker-dealer, investment advisor, or municipal advisor. Detter and Malone are to pay civil penalties of $25,000 and $20,000, respectively and face a one-year minimum bar from the financial services industry.
The firm and the three individuals all agreed to the settlements without admitting or denying the SEC's findings.
"We are restricted by the SEC in what we can say, but importantly the company neither admitted nor denied the SEC's findings," said Jeffrey Jensen, the lawyer representing Central States. "We are pleased to have this behind us so we can focus on providing financial services to our many satisfied clients."
Howard Rosenburg, the lawyer for Stepp and Malone, said the two men "are ready to put this behind them and pay their penalties and eventually get back to serving their clients." He also said it is important to note the settlement does not make allegations that anybody acted intentionally, that the municipality wasn't aware of the dual relationship, or that the city suffered any harm.
The charges are the first of their kind in the muni market since the Dodd-Frank Act, which was enacted in 2010, said MAs have a fiduciary duty to put their clients' interest first above their own.
The SEC's charges stem from work that Central States did on three bond offerings in 2011 for an unnamed city. The city hired Central States as a municipal advisor in March of that year to assist with future muni bond offerings. Detter and Malone took the lead for Central States in soliciting and carrying out the advisory business.
At the same time Detter, Malone, and Stepp worked for Central States they were also registered representatives with the broker-dealer selected to underwrite the bonds, according to the SEC order, which did not identify the firm.
Between May 2011 and September 2011, the city issued two sets of temporary improvement notes and one set of general obligation refunding bonds. Detter and Malone acted as the city's municipal advisor for each of the offerings and developed both various financing structures the city could use to fund its public infrastructure projects and drafted official statements.
Both men were also responsible for obtaining underwriting services for the offerings. They, in consultation with Stepp, did not conduct a negotiated or competitive bidding process to select the underwriter but instead selected the broker-dealer where they also worked to underwrite the offerings, the SEC said.
Central States received $130,117 in municipal advisory fees in connection with the offerings and the broker-dealer received $121,530 in underwriting fees. However, the SEC found that due to an earlier agreement, the broker-dealer gave 90% of the underwriter fees to Central States, which then paid Detter and Malone commissions based on both the muni advisory fees and the underwriting fees.
The SEC said that both Detter and Malone were aware of the conflict of interest from providing both underwriter and advisory services on the same deal and used an April 2011 email between the two where Detter wrote that "out of an abundance of caution" he believed the two should resign as MAs, to prove the point. Detter went so far as to draft documents to have Central States resign as MA. The draft outlined the Municipal Securities Rulemaking Board Rule G-23 prohibition on a dealer acting as an MA on the same offering but never sent the documents to the city, the SEC found. But Central States never resigned the post.
"By failing to disclose their financial interest in the underwriting of the City's offerings, Central States -- the city's municipal advisor -- and its employees deprived the city of the opportunity to seek unbiased financial advice," said Andrew Ceresney, director of the SEC's enforcement division. "A municipal advisor's first duty should be to its municipal client, not its own bottom line."
The SEC found that the firm and three employees willfully violated the Municipal Securities Rulemaking Board's G-17 on fair dealing by failing to disclose the fact that: certain Central States employees also worked for the broker-dealer; Central States employees were performing both MA and underwriter services for the offerings; and certain Central States employees had a conflict of interest because they were receiving a direct financial benefit from the underwriting services.
Additionally, the SEC said the three employees willfully violated MSRB Rule G-23.
