The Securities and Exchange Commission's first municipal enforcement case of 2018 underscored its willingness to use the Dodd Frank Act to punish some breaches of fiduciary duty that hadn't yet been spelled out by the Municipal Securities Rulemaking Board.

The lawsuit announced Friday alleges that a municipal advisor, Malachi Financial Products, Inc., overcharged the City of Rolling Fork, Mississippi, for services related to a 2015 offering. Paul Maco, a partner at Bracewell in Washington D.C., said the alleged conduct is explicitly prohibited by the MSRB's Rule-G42 governing non-solicitor municipal advisor conduct -- a rule that didn't take effect until 2016.

That indicates SEC is taking the position that the federal securities laws, as amended by the Dodd-Frank Act effective October 2010, incorporate prohibitions against such unreasonable billing, and opens the door to a number of such cases restricted only by the statute of limitations, Maco said. Typically that is five years, but it can be extended under some circumstances.

“Municipal Advisors are very much on their list of entities to take a look at,” Maco said of the SEC.

The comments came following the SEC’s Friday announcement that it has charged the Atlanta, Ga.-based municipal advisor for fraudulently billing the city and failing to disclose payments the advisor received from an employee of the underwriter.

The suit, filed in U.S. District Court for the Southern District of Mississippi, alleges that Malachi and its principal Porter Bingham violated securities laws prohibiting fraud by muni advisors, breached its fiduciary duty to the city, and violated the MSRB’s fair dealing rule when the firm billed Rolling Fork for services Malachi did not provide. The MA firm and Bingham also recommended the city hire Bonwick Capital Partners without disclosing recent cash payments Bingham received from Bonwick employee Anthony Stovall, the SEC said.

The SEC's latest enforcement action means the market could see a number of MA enforcement actions going back to before the MSRB's primary MA rule became effective, said Paul Maco of Bracewell.
The market may see municipal advisor enforcement actions dating from before the MSRB’s primary MA rule, says Paul Maco of Bracewell.

According to the SEC’s complaint, the alleged illegal conduct took place in connection with a $1.1 million offering in October 2015. The city hired Malachi to serve as its muni advisor in January 2015, and Bingham accepted two payments totaling $2,500 from Stovall in May, the SEC found. Malachi subsequently recommended that Stovall’s firm be engaged as underwriter on the transaction, the SEC said, without disclosing the payments.

The checks had been made out from the account of one of Stovall’s family members to a defunct corporation controlled by Bingham. The SEC found that Bingham and Stovall had a professional relationship dating back about 10 years and covering 15 transactions.

Malachi did not recommend or introduce any other underwriting firms for consideration, and the city’s Board of Alderman voted to hire Stovall and Bonwick based in part on Malachi’s recommendation, the SEC said.

The suit further alleges that Malachi and Bingham attempted to compensate for a lower-than-expected payday by fraudulently billing Rolling Fork. The bond offering was originally planned at $2 million, the SEC said, which would have netted Malachi $40,000 in compensation. Due to the city’s statutory offering limits, however, Rolling Fork was required to reduce the size to $1.1 million and slash Malachi’s compensation to $22,000.

The day after the offering closed, the SEC said, Bingham directed a Malachi employee to submit a legitimate invoice for $22,000 per the firm’s agreement with the city as well as a $33,000 invoice for services related to the “investment of bond proceeds.”

“This invoice was false and fraudulent and was not authorized or agreed to by the city,” the lawsuit alleges. “Although both invoices were addressed to the mayor of Rolling Fork, Malachi only transmitted them to the bond trustee and never sent them to the mayor or the city. As a result, the bond trustee paid the full $55,000 to Malachi before Rolling Fork became aware of the invoices.”

Malachi had not performed any services that could justify the second invoice and the bond proceeds had not been invested at the time the firm billed the city, the SEC said.

The SEC charged Malachi and Bingham with violating sections 15B(a)(5) and 15B(c)(1) of the Securities Exchange Act of 1934 as well as MSRB Rule G-17. Section 15B(a)(5) makes it illegal for a muni advisor to use any means of interstate commerce to “to provide advice to a municipal entity with respect to the issuance of municipal securities in connection with which such municipal advisor engages in any fraudulent, deceptive, or manipulative act or practice.” Section 15B(c)(1) imposes a fiduciary duty on municipal advisors, meaning that they must place the interests of their municipal clients above their own. Rule G-17 requires municipal advisors to deal fairly with all persons and not engage in any “deceptive, dishonest, or unfair practice.”

“The action is a classic application of the fiduciary duty of loyalty,” said Robert Doty, president and proprietor of muni bond consulting firm AGFS. “There was an alleged conflict of interest that was not disclosed to the municipal entity, and of course, the municipal entity did not consent to the conflict. Municipal advisors need to provide advice solely in the best interests of their municipal entity clients without regard to the advisors’ own financial or other interests. In this instance, as alleged, the advisor did not adhere to that principle.”

The SEC suit seeks an order that Bingham and Malachi disgorge their ill-gotten gains and asks the court to impose unspecified civil penalties on the defendants as well as a permanent injunction against further violations of the securities laws.

Bingham, reached by phone, declined to comment.

Stovall separately agreed to settle charges that he violated G-17 and the MSRB’s Rule G-20 on gifts and gratuities, which prohibits dealer representatives from giving anything of value more than $100 to a person in connection with municipal securities business of the employer of the recipient. Stovall agreed to a $20,000 penalty and a suspension six months.

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Kyle Glazier

Kyle Glazier

Kyle Glazier is the Deputy Washington Bureau Chief of The Bond Buyer. He covers securities law, regulation, and enforcement.