NATIONAL ASSOCIATION OF BOND LAWYERS
Voice from the Past
Chapter 6
An article on the first page of the business section of a
recent issue of The New York
Times was devoted to yield-burning and the efforts of the
Internal Revenue Service to prevent the
practice. Over 30 years ago, in those carefree days before there
were any arbitrage regulations, a
different federal agency took an interest in a similar practice
A large school district in Colorado had decided to refund
many different bonds issues that
had been delivered by it and by other districts which had merged
into it. The State's then leading
municipal bond underwriter undertook to handle the transaction
and asked Dawson, Nagle,
Sherman and Howard and Chapman and Cutler to act as bond
counsel.
By this time there had been several advance refundings in a few
of the western States, and
they were generally handled pretty responsibly by the local
underwriters, who knew better than to
attempt such very abusive deals that they would get into major
newspapers; and no one tattled to
Congress or asked stupid questions of the Internal Revenue
Service. Much of the arbitrage
profits went to the issuers in the form of reduced issue size,
lower interest rates or other non-flashy benefits. Of course an
underwriter could make the profit it thought proper without the
issuer's visibly losing any money.
To get this deal done, the underwriter had to agree to provide
the necessary government
bonds to put in the escrow so that the principal of and interest
on these investments would be
available and sufficient to pay the refunded bonds with interest
when due. This was also in the
days before an established futures market in governments. So
this underwriter agreed, as part of
the arrangements for purchasing the refunding bonds, to provide
the investments, and took the
risk that it could get them when they were needed at an
affordable price. This sort of thing had
been done several times before without mishap but there was an
appreciable risk.
There was also an appreciable risk, which underwriters always
take, that when an issue of
municipal bonds comes to market the prices on that market may not
be adequate to compensate
the underwriter enough to cover its costs and a reasonable
profit, or better. It happened that this
risk matured, and, as I recall a conversation with one of the
principals of the underwriter, the
price they got in the market yielded a net profit of fifteen
cents. But along with the fall in the
price of municipal bonds there was also a fall in the price of
government bonds, so the deal
proceeded profitably with the underwriter making its profit on
the sale of the escrow investments.
But the underwriter made the mistake of not explaining this to
the issuer, and obtaining
the issuer's informed consent to paying more than market price
for the governments before the
closing. When the issuer's lawyer found out about it, he
complained to the Securities and
Exchange Commission who conducted a long and very expensive
hearing.
I was asked by a couple of very polite young men from the Chicago
office of the
Commission a few questions that seemed to me pretty remote from
whatever was involved; they
seemed to have no idea of the significance of their questions;
they had only been asked by the
Denver office to ask them. Then I got a call from a lawyer in
the litigation department of
Dawson, Nagle, Sherman and Howard who wanted to come to talk with
me. He arrived in
Chicago a couple of days later and explained about the
investigation. I still recall my surprise at
learning how seriously the Commission took the matter, and my
comment, "But they haven't done
anything wrong!"
A few weeks later I was subpoenaed by the Commission as a
witness, and was wondering
whether the lawyer-client privilege would prevent me from
testifying when the defense lawyer
advised me that the underwriter was cooperating with the
investigation, and that, if the privilege
was applicable, they would waive it.
I spent much of my time for two or three weeks preparing to
testify, mostly being horse-shedded by a couple of Chapman and
Cutler's litigators. However the time I spent was nothing
compared to what the officers of the underwriter spent. It
seriously interfered with their ability
to keep their existing municipal bond business going. In time,
my litigation partners seemed
satisfied that I would say nothing to damage the firm very much,
but they did tell me to get a
transcript of my testimony so they could review it and perform
such corrective rites as they might
think necessary.
I flew out to Denver and testified for an hour or so. To my
relief, the SEC attorneys were
much more courteous and considerate, and even respectful, than my
litigation partners had been.
The questions they asked I was well prepared to answer, and they
were understanding when one
of my answers put me in a less flattering light than I would like
to enjoy. (I have forgotten what
question that was). There was no problem of my getting a
transcript of my testimony that I read
without regret and turned over to my litigation partners; I am
not sure that they read it at all.
After a few weeks in which the officers of the underwriter and
various other people
testified, the Commission took the matter under advisement and
eventually came down with a slap
on the wrist after the underwriter turned over to the issuer all
the profit it had made on the sale of
the government bonds.
A grimly amusing sidelight was that the officials of the issuer
were very pleased by the
result the underwriter had achieved for them, and while the
hearing was going on wanted to use
that same underwriter for their next bond issue. Their lawyer
said no.
A year or so later I got a telephone call from a small bond
dealer in Louisiana who had
just completed work on an issue of advance refunding bonds for a
municipality in that state. I
forget the reason for his call, but during the course of the
conversation I asked if he made part of
his profit from the sale of the governments for the escrow
without telling the issuer. He
hesitatingly said yes, and I told him that the SEC frowned on
that practice. I never heard from
him again.
Manly W. Mumford