IRS Tackles Mispricing In Market

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WASHINGTON — Internal Revenue Service officials are taking a two-pronged approach to address concerns there may be ongoing mispricing of investments and bonds in the muni market.

The IRS wants to work with issuers and other market participants to develop best-practice procedures to detect possible mispricing schemes and prevent them from occurring.

They also are monitoring Municipal Securities Rulemaking Board data and taking other action to uncover suspicious pricing practices, with the aim of following up on those with information requests and possible audits.

Cliff Gannett, acting director of government entities at the IRS since April, when he was head of the tax-exempt bond office, and Steve Chamberlin, manager of compliance and program management for the tax-exempt bond office, talked about these initiatives in a follow-up interview after Gannett spoke to members of the Government Finance Officers Association’s debt committee Tuesday at its winter meeting here.

“Over the last 20 years, there have been significant findings of, and concerns about, the mispricing of both investment vehicles and bonds, and then the issue becomes whether or not we have full confidence, at this point and time, that there aren’t continuing problems,” Gannett said. “Other public officials might have the same concerns.”

These do not appear to be isolated cases of mispricing, according to Gannett.

“Regretfully, I cannot state with certainty that these practices have abated,” he said.

Gannett and Chamberlin described their plans to address the concerns about mispricing during the interview. They said that working with muni bond issuers and others to develop procedures and practices to detect and prevent pricing abuses will be their primary focus.

This initiative effort will involve several avenues of outreach.

The tax-exempt bond office, in an effort that started last year, has already begun to meet and form relationships with bond financing and other officials in every state.

“We hope to use that forum to encourage a dialogue on pricing,” Gannett said.

The TEB office has reached out to members of GFOA’s debt committee for help on this issue as well.

In addition, Gannett says he would like the tax-exempt bond members of the IRS advisory committee for the tax-exempt and government entities division to explore the idea of making some recommendations in this area.

“We have a history of working together on post-issuance compliance procedures,” Gannett said. “This is just expanding it to pricing issues generally, and hopefully there will be public officials interested in joining in on this dialogue.”

Gannett and Chamberlin posed a series of questions they would like muni issuers to think about. They include:

• What information or documentation could state and local issuers require to discourage mispricing of bonds and related financial arrangements?

• Should issuers try to obtain more comprehensive information about their bond trades?

• Should issuers have procedures for refusing to engage in municipal bond business with underwriters and dealers found to have committed abusive pricing practices?

• What should the IRS and other government agencies be doing to support issuers’ development of best practices?

• What does the IRS need to do further in terms of information gathering or enforcement?

“These are not silly questions, they are serious questions that I believe should be addressed by public officials at every level of government,” Gannett said.

“It is clear to me that issuers’ engagement in identifying best practices in the area of pricing are critical to altering the historical pattern of global abuses of the past 20 years,” he said.

Gannett refused to elaborate or comment on any specific investigations and enforcement actions.

But it appeared that he was referring to the industry-wide yield-burning probes and settlements in the 1990s and the current market-wide bid-rigging investigations and enforcement actions, some of which involve transactions that date back to the 1990s.

In the yield-burning cases, firms overcharged issuers for open-market Treasuries sold for refunding escrows, and the markups reduced or “burned” the investment yields so that they were below the bond yield and would not generate illegal arbitrage profits.

Federal tax law limits what issuers can earn from refunding escrows and other investments of municipal bond proceeds. Investment yields generally must not rise above the bond yields or an issuer will earn arbitrage, violating either yield restriction requirements in the case of advance refundings, or rebate requirements if arbitrage is not rebated to the federal government for most other bond financings.

In April 2000, 17 firms agreed to pay more than $138.3 million in a global settlement to resolve federal yield-burning allegations that they overcharged muni issuers for open-market Treasuries for refunding escrows.

It was the largest of several yield-burning settlements that occurred around that time and involved some 3,603 advance refundings done for hundreds of state and local governments between 1990 and 1994.

The IRS, concerned about whether investments — particularly guaranteed investment contracts — were being purchased by issuers from firms at fair-market value, adopted a series of rules governing the bidding process.

Arbitrage rules adopted in 1993 for guaranteed investment contracts created a safe harbor under which, if there was a competitive bidding process and at least three arm’s-length bids obtained for a GIC, then the investment would be considered purchased at fair-market value.

In 1998, the rules were revised to add a provision prohibiting bidders from being provided “last looks” at other bids.

Despite those rules, the IRS became concerned about bid-rigging and took its concerns to the Justice Department in 2005, The Bond Buyer has previously reported. Gannett would not comment on that.

But in November 2006, federal marshals raided the offices of CDR Financial Products and other GIC bidding agents. The Justice Department and other federal agencies disclosed they were conducting parallel criminal and civil investigations of alleged bid-rigging involving GICs and other financial products in the muni market.

During the past few years, the Justice Department has filed criminal charges against CDR and 18 mostly former employees of banks, broker-dealers, and investment advisers.

CDR and 12 of the individuals, including three associated with that firm, have pleaded guilty.

The guilty pleas from CDR founder David Rubin, the firm’s former chief financial officer and managing director Zevi Wolmark, and former CDR vice president Evan Andrew Zarefsky came within the last two weeks just before the first trial stemming from the probes was to begin.

In addition, the Justice Department, the Securities and Exchange Commission, the IRS, bank regulators,and more than two dozen attorneys general have obtained more than $740 million in penalties and restitution in 2010 and 2011 from settlements over bid-rigging with Banc of America Securities LLC, now Bank of America Merrill Lynch, UBS Financial Services Inc., JPMorgan Chase & Co., Wachovia Bank NA, now Wells Fargo NA, and GE Funding Capital Markets Services Inc.

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