Yield-burning cases against investment banks will be pursued aggressively

Lazard's $9 million settlement shows industry's arguments are weak

Sept. 28, 1998-- The decision by Lazard Freres & Co. to agree to pay $9 million to settle a qui tam lawsuit involving one municipal bond refunding transaction shows that the investment banking industry has no legitimate justification for "yield-burning," said an attorney involved in the case.

"We invested enormous sums of money to develop the expertise and resources to prove this case and now intend to vigorously pursue other yield-burning cases," said John R. Phillips, whose Washington, D.C.-based firm, Phillips & Cohen, represented the Los Angeles County Metropolitan Transportation Authority (LAMTA) and another plaintiff in the Lazard case. "We are certain that other investment banks engaged in similar fraudulent practices against municipalities across the county, and we believe those banks are accountable."

The lawsuit charged that Lazard secretly and illegally overcharged the LAMTA by more than $3 million for securities it sold to the authority as part of a $560 million municipal bond refunding transaction in 1993. In addition, the LAMTA sought the return of $1.89 million it paid to Lazard for financial advisor services from 1991 to 1994.

The settlement was approved by the LAMTA board today in Los Angeles. It comes just six weeks before the case was scheduled to go to trial. A settlement agreement was worked out at a mediation session last week in San Francisco.

Robert Palmer, of the Los Angeles law firm Hennigan, Mercer & Bennett, served as co-counsel with Phillips & Cohen in the LAMTA case.

As the LAMTA's finanical advisor, Lazard recommended its client buy securities from Lazard at grossly inflated prices, the lawsuit said. Lazard secretly added huge mark-ups that were as much as 20 times the fees that should have been charged, according to the lawsuit.

"Lazard exploited its position of trust and its superior knowledge to defraud millions of dollars from a cash-strapped public agency," said attorney Erika Kelton, of Phillips & Cohen. "Lazard's settlement should send a strong signal to Wall Street banks that they have real liability to the extent they added inflated 'yield-burning' markups to the securities they sold to public issuers."

The industry leaders in negotiated advanced refundings from 1990 to 1995 were: Merrill Lynch, Goldman Sachs, First Boston, Smith Barney, Lehman Brothers, Paine Webber, Bear Stearns, Morgan Stanley and Prudential Securities. They together accounted nearly two-thirds of the market.

Phillips & Cohen's attorneys and their associated counsel have put in 25,000 hours on yield-burning issues, and the firm has spent close to $2 million to cover experts' fees and other out-of-pocket costs.

The firm's experts developed a computer model to analyze the price difference between negotiated purchases of escrow securities and competitive deals during the early 1990s. This analysis had never been done before.

By using this model, economic consultants in the LAMTA case demonstrated that investment banks engaged in widespread yield-burning abuses in municipal bond transactions in the early 1990s and cost the federal government and state and local governments hundreds of millions of dollars. The study found that negotiated escrow refunding deals should have been priced the same as competitive deals because they present identical risks. Instead, competitive deals were close to the "fair market price" while negotiated deals were on average 20 times higher.

As part of the yield-burning scheme, investment banks certified that the securities were sold for "fair market value." Most municipalities trusted that these were truthful and relied on these representations. But in Lazard's case, said the lawsuit, and in transactions involving other banks, fraudulent certifications were submitted that represented investment prices were fair when in fact they were not.

"Lazard's practices were the norm for the investment banking industry," Kelton said. "But all of its justifications for the fraud did not hold up under scrutiny, and neither will the arguments of other investment banks that engaged in yield-burning."

The case initially was brought under the California False Claims Act by Michael Lissack, a former managing director of Smith Barney, who brought nationwide attention to the problem of yield-burning. He filed the lawsuit under seal on behalf of the LAMTA in 1995 in Los Angeles.

The lawsuit was unsealed in April 1996 when the LAMTA joined the action. The authority added claims of breach of fiduciary duty and sought punitive damages.

Phillips lauded the LAMTA for joining the lawsuit and committing resources to pursue it. "The LAMTA was the only issuer in the country willing to take on Wall Street," he said. "It provided a service for basically every municipality and municipal agency in America."

According to media reports, Lissack has pending a lawsuit involving yield-burning practices against multiple unnamed defendants in federal district court in the Southern District of New York (Manhattan).

A settlement of all yield-burning cases has been urged recently by both the director of the Securities and Exchange Commission's Enforcement Division and the incoming president of the National Association of Bond Lawyers.

The Securities and Exchange Commission's enforcement director, Richard H. Walker, said in a recent interview that it was time to resolve the yield-burning controversy, either through settlements or through enforcement actions.

Floyd C. Newton, the incoming president of the National Association of Bond Lawyers, told one trade publication that the yield-burning controversy has been very damaging to the municipal market and hoped there would be settlements soon.

In the first global settlement involving the Justice Department, the Internal Revenue Service and the SEC, CoreStates in April paid the federal government $3.7 million to settle another yield-burning case brought by Lissack under the federal False Claims Act. That lawsuit said Meridian Securities, which CoreStates had acquired, defrauded the federal government through "yield-burning" in more than 100 transactions involving advance refundings totaling approximately $357 million between 1992 and 1995.

Phillips & Cohen, which also represented Lissack in the CoreStates case, specializes in bringing whistleblower lawsuits under the federal False Claims Act and similar state statutes. The federal and the California laws allow individuals to file lawsuits against companies that are defrauding the government and recover damages and penalties on the government's behalf. They are then entitled to receive 15 percent to 25 percent of whatever money the government recovers as a result of their lawsuit.

For more information about this case, see the following news stories:

  • "LAMTA's law firm says Lissack strategy will be a replay," Andrea Figler, Bond Buyer, 9/30/98.
  • "Lazard to pay $9 million in yield-burning suit," David Barboza, The New York Times, 9/29/98.
  • "Lazard pact is approved in 'yield-burning' case," The Wall Street Journal, 9/29/98.
  • "MTA, securities firm hold talks over dispute," Los Angeles Times, 9/24/98.
  • "Lazard is said to settle suit on bond sales," David Barboza, The New York Times, 9/24/98.
  • "Lazard, Los Angeles agency discuss settlement of yield-burning lawsuit," Charles Gasparino and John Connor, The Wall Street Journal, 9/22/98.