The False Claims Act and Wall Street: How a qui tam case reformed the municipal bond market

By Erika A. Kelton, Phillips & Cohen LLP
(Reprinted from False Claims Act and Qui Tam Quarterly Review, July 2000)

In December 1993, Michael R. Lissack was on vacation in Florida and read a brief article in the financial press that aggravated him. The article reported that documents produced by a public agency in California had failed to turn up evidence that Merrill Lynch and Lazard Freres & Co. were engaging in illegal fee- and market-splitting arrangements. At that time, both banks were under active investigation for violations of securities laws in public finance transactions undertaken in Massachusetts and the District of Columbia.[1]

Lissack, an investment banker, knew that federal investigators were missing a much larger scandal by focusing on the fee-splitting allegations. He went to a pay phone near the beach and made an anonymous call to the U.S. Attorney's office mentioned in the article to let the government in on Wall Street's dirty - but very profitable - little secret. For several years, he told them, investment banks had engaged in systematic, industry-wide overpricing of securities sold in connection with certain municipal bond transactions. Hundreds of millions of dollars in illegal profits had been pocketed by Wall Street. Lissack stressed that these overpricing practices - known as "yield burning" - were the true scandal on Wall Street, for they infected thousands of transactions across the country and touched nearly every public issuer of municipal debt. Yield burning was hurting the Treasury, the bond markets and the taxpayers far more than any market-splitting arrangement.

With that phone call, Lissack became determined to educate the government about one of the largest illegal schemes to have ever affected the municipal bond market.

Michael Lissack had enjoyed a stellar career as an investment banker at Smith Barney. He joined the firm's public finance department in 1981. Six years later he was the second youngest person to have been made a managing director in Smith Barney's history. With one phone call, he placed it all at risk.

In his first conversation with the U.S. attorney's office, and in four or five later telephone conversations, Lissack laid out the pricing fraud to the U.S. attorney's office and FBI agents. He explained how Wall Street's yield-burning practices were diverting hundreds of millions of dollars from the Treasury into the pockets of Wall Street bankers. Michael Lissack was convinced that yield burning was hurting the Treasury, the bond markets and the taxpayers far more than any individual market-splitting arrangement.

In the course of his anonymous conversations, Lissack gave the FBI the names of ten people, including himself, to interview about his overpricing allegations. His anonymity was important for he knew his job was at risk. Lissack was among the highest level Wall Street "defectors" to come willingly to the Government. Ten months later, the FBI asked Smith Barney's permission to interview him at their offices in connection with a public finance investigation. Lissack thought that the FBI was making its way down his list and had finally gotten to his name. He was dumbfounded when they did not ask him a single question about yield burning.

Lissack knew then that the government would not act, unless he first acted himself. In February 1995, Smith Barney terminated Lissack in major part because of his objections to the firm's business practices. A month later, Lissack filed a qui tam lawsuit under seal against numerous Wall Street and regional investment banks. Several days later, he accused the industry of improper yield burning in a front-page story of The New York Times. It was only then, due to the action-forcing mechanism of the False Claims Act, that the government began to investigate his allegations.

Lissack's resolve, and the qui tam lawsuits he filed against numerous Wall Street and regional investment banks, resulted in a major multi-agency federal investigation and the payment, to date, of about $180 million by 20 investment banks to settle "yield-burning" charges. It also has brought Securities and Exchange Commission (SEC) sanctions against individual bankers, and an Internal Revenue Service (IRS) review of tax exempt status of hundreds of tax free municipal bonds. Perhaps most importantly, Lissack's allegations have caused a fundamental change in the way state and local entities purchase investments from Wall Street.

I. Wall Street's Yield-burning Fraud

"Yield burning" refers simply to the artificial lowering of a security's yield by pricing it in excess of its fair market value. Yield and price have an inverse relationship: As the price of a security goes up, its yield goes down.

Yield burning came to have a more specialized significance for the securities industry in the early 1990s, however, for yield was "burned" in connection with transactions that are strictly regulated by federal law. As explained in detail below, securities purchased with the proceeds of tax-exempt municipal bonds must (1) be priced no higher than "fair market value," and (2) earn an aggregate yield that does not exceed that earned on the tax-exempt municipal bond. These regulatory restrictions and others grew out of a long history of abuse by Wall Street's public finance bankers.

Public finance concerns the financing of public projects - highways, subways, schools, bridges - through the underwriting and issuance of tax-exempt municipal bonds and the investment of those bond proceeds. Securities and tax laws intersect in the public finance area and make it a field dense with regulations. Even so, the esoteric nature of public finance historically has created opportunities for investment banks to obtain extraordinary and illegal profits at the Government's and taxpayers' expense.

The "arbitrage" of public, tax-exempt bond proceeds is at the heart of the yield-burning fraud that Lissack exposed. Bond arbitrage occurs when any portion of the proceeds from a tax-exempt bond is used - either directly or indirectly - to acquire higher-yielding investments. State and municipal bonds receive the benefit of federal tax exemption (which effectively lowers the interest rates paid to bondholders and thereby lowers the municipalities' costs), and for that reason their bond proceeds may only be used in a manner that furthers the intended public purpose of the bond.

The investment of tax-exempt bond proceeds for profit is not regarded as a valid public purpose and is strictly prohibited as a result. Issuers of tax-exempt bonds are barred from earning a higher yield on their investment of the bond proceeds than they pay in interest to bondholders. This prohibition is termed "yield restriction." Federal law requires that the Treasury be reimbursed for any "positive arbitrage" - or profit - that is obtained from the investment of bond proceeds at yields above the yield-restricted rate.

Arbitrage schemes have a long history on Wall Street. The proliferation of "invested sinking funds" in the 1970s, "blind pool" funds in the early 1980s and "hedge bonds" in the late 1980s gave federal lawmakers great concern, for they all were created by Wall Street bankers to earn arbitrage profits. Progressively over this period, the Government tightened arbitrage regulations so that by 1989 it was impermissible to acquire arbitrage profits by investing bond proceeds at yields above the yield-restricted rate.

II. Yield Burning On Municipal Refinancings

The prohibition on investing bond proceeds for profit applies to initial bond issues as well as any subsequent refinancing. At times when interest rates fall, refinancing municipal bonds may make economic sense. Refinancing allows a public agency to capture interest rate savings by refinancing higher rate, outstanding municipal bonds with lower rate "advance refunding bonds."

As a general matter, falling interest rates in the period between 1990 and 1994 made advance refunding transactions an attractive means for municipal issuers to realize present value savings on bonds with "call" provisions that prevented their immediate redemption. Bond refinancing was a sensible alternative for municipal governments that had issued earlier bonds at much higher interest rates. From 1990 to 1995, nearly 8,100 tax-exempt advance refunding bonds were issued by municipal agencies in every state, as well as the District of Columbia, Puerto Rico and the Virgin Islands. The aggregate value of advance refunding bonds issued during this five-year period was more than $261 billion.

Advance refunding transactions have two chief components, both of which are critical to achieving the maximum savings: (1) Low-rate advance refunding bonds are issued; and (2) the refunding bond proceeds are invested in an escrowed 'defeasance' portfolio of U.S. Treasury securities that is used to make interest and principal payments on the prior, higher rate "refunded" bonds. Federal law requires that escrow investment yields that create "positive arbitrage" - i.e., yields above the restricted rate - must be rebated to the Treasury lest the entire tax exempt bond issue be deemed taxable. Yield restrictions on escrow investments, thus, are the means by which the government regulates profit-taking and speculation through bond arbitrage.

Issuers have two alternative means of achieving the yield-restricted rate and rebating positive arbitrage to the federal Treasury. They may invest all of the refunding escrow in "State and Local Government Series" bonds (SLGS), which pay varying interest rates - including no interest - and are sold by the federal government's Bureau of Public Debt. Issuers may subscribe to the Bureau to purchase SLGS bonds that will earn the exact yield-restricted rate. Thus, issuers that choose to invest all of the defeasance escrow in SLGS have no risk of violating the prohibition on bond arbitrage.

Alternatively, issuers may invest the escrow in higher-yield open market Government bonds and then "blend" the investments down to the yield-restricted rate by purchasing no-interest SLGS in the final period of the escrow. An escrow invested in this manner makes "profit" from the open market bonds in the early maturity years, which is recaptured by the Government in the form of no-interest SLGS in the escrow's final maturity years. No interest SLGS allow yield-restricted investments to be blended with precision and thus assure that the federal government will not pay higher interest on escrow investments than a municipal government pays on its tax-exempt bonds. The "blended" escrow yield requirement was designed to ensure that the Government would recover any positive arbitrage that it paid on open market bonds in a defeasance escrow's early years, by paying no interest on SLGS in the escrow's final years.

In contrast, escrow yields that are below the refunding bonds "restricted rate" create "negative arbitrage," which causes the issuer to suffer a dollar-for-dollar loss in present value savings. Because inflated security prices will artificially depress investment yields, federal law also mandates that refunding escrow investments be priced at their "fair market value." These regulations are intended to prevent positive arbitrage profits from being diverted from the federal Treasury by dealers inflating escrow investment prices and "burning yield" down to, or below, the refunding bonds' restricted rate. Fair market pricing of refunding escrow investments is essential to maintaining the tax-exempt status of advance refunding bonds.

In short, maximum savings are achieved when the escrowed Treasury securities earn the highest yield allowed by federal law, and federal law is satisfied when escrow securities are priced fairly and positive arbitrage is rebated to the U.S. Treasury.

III. A Federal Investigation Of Systematic Yield Burning Practices Is Launched

Lissack's allegations were sweeping and direct. He asserted that across the securities industry and investment bankers across the U.S. systematically stole positive arbitrage owed to the federal government on refunding escrows by selling overpriced securities to unsuspecting issuers who relied on their representations of fair pricing. Never before had the workings of Wall Street's public finance banking been subject to such scrutiny on an industry-wide basis.

We anticipated that the investment banks would try to defend their high security prices by contending that refunding transactions were "risky" and justified high markups. We understood that it was important for us to move swiftly and to establish empirically that Wall Street opportunistically and unfairly inflated security prices in a manner unrelated to risks. The relator's team saw a potential chink in the Street's likely "transaction risk" defense: About 15 percent of advance refunding escrows were purchased on a competitive bid, rather than a sole-source, basis. It was Lissack's experience that, in most cases, competitively purchased escrow securities were priced with very little markup over cost, while sole-source purchases were loaded with undisclosed price markups. Because competitive and sole source transactions held identical transaction risks, a demonstrable differential in price markups would establish that high prices were not related to transaction risks, but only to the method of sole source purchase.

Surprisingly, no empirical or academic study had previously examined the valuation and pricing of U.S. Treasury securities. Starting from scratch, the qui tam team requested beginning in March 1995 public bond transaction documents from issuers across the country. By the end of 1995, requests had been made to more than 500 issuers. Materials were received for several hundred transactions. With our expert economists, the sole-source and competitive transactions were closely analyzed and priced using daily published high/low/close prices. More than 1,900 individual Treasury securities were priced and analyzed, each using three different sets of pricing assumptions. The validity of our analysis was rigorously tested with multiple regression analyses.

This pricing analysis resulted in several simple but compelling conclusions:

  • In the period between 1990 and 1995, Wall Street investment banks consistently overpriced Treasury securities purchased for municipal advance refunding escrows on a sole-source, noncompetitive basis.
  • The most conservative economic analysis showed that sole-source refunding escrow transactions were burdened with average price markups of over $4 for every $1,000 of a par bond.
  • Treasury securities purchased for advance refunding escrows on a competitive basis were, in contrast, priced with an average markup of just 3 cents over published market prices.

The transactions analyzed by the qui tam team were similar in all essential respects and risks. Only the method of security purchase was consistently different.

The pricing analysis not only established the "fair market pricing" of Treasury securities for the first time, but most importantly for the litigation it left Wall Street without a tenable "risk" defense.

IV. Opening A Second Front

In August 1995, the qui tam team opened a second front in the yield-burning litigation by filing a California False Claims Act case on behalf of the Los Angeles County Metropolitan Transportation Authority (LAMTA) against Lazard Freres & Co. The action arose out of Lazard's fraudulent sale of overpriced U.S. Treasury securities to the LAMTA in connection with an advance refunding in April 1993.

Unbeknownst to LAMTA, Lazard's prices on this single transaction were close to $4 million over fair market value. In fact, Lazard's prices were so excessive that not only did they "burn" all the "positive arbitrage" owed to the federal government, but they also caused about $3 million in "negative arbitrage" damages to be suffered directly by the LAMTA.

Lissack again initiated the action. LAMTA joined in 1996 and hired Lissack's legal team[2] to represent the agency as well. The case presented a unique opportunity, both because qui tam counsel was in control of prosecuting the entire action and because a success in California would certainly influence events in the federal action.

VI. Parallel Federal Investigations Increase the Pressure

Since advance refunding transactions also are governed by federal securities and tax laws, the SEC and IRS had their own interests in taking enforcement action against yield-burning investment banks. The involvement of multiple agencies each with its own perspective on the fraudulent conduct was unique. While DOJ was interested in recovering the Treasury's losses through a False Claims Act remedy, the SEC was charged with protecting the integrity of the securities markets and investor interests. The IRS was concerned about the validity of public issuers' tax-exempt status. While there was inter-agency cooperation and collaboration throughout the litigation, the agencies' unique perspectives also were manifested in separate enforcement and regulatory actions.

The IRS first acted in the summer of 1996 by issuing a Revenue Procedure that would have placed the financial liability on public issuers - rather than on Wall Street - even though the municipal agencies in nearly all instances did not profit from yield-burning practices. Revenue Procedure 96-41 specifically provided that issuers that did not repay yield-burning profits on their transactions within a year would be subject to investigation and audit, and potentially the revocation of tax-exempt status.

The loss of tax exemption would be catastrophic for an issuer, for it would generate potentially huge tax liabilities for bondholders and cause tremendous instability in the bond market. Not surprisingly, municipal governments were outraged that they were going to be forced to foot the bill for a yield-burning fraud that they neither participated in or knew about. They protested that holding state and local agencies accountable while Wall Street's yield-burning profits went unchallenged was fundamentally unfair.

Although the IRS deferred implementation of the Revenue Procedure, it continued investigating many dozens of individual refunding transactions. This scrutiny, coupled with the looming threat of losing tax-exempt status, created significant - albeit indirect - pressure on the Wall Street defendants. After all, it was the investment banks' own issuer-clients who were being squeezed to pay back profits enjoyed by the bankers. It was an uncomfortable position for bankers who wanted to maintain an ongoing business relationship.

Meanwhile, the SEC initiated multiple investigations of individual banks' yield-burning practices and filed its own action against an individual regional investment bank in January 1998. Securities and Exchange Commission v. Rauscher Pierce Refsnes and James Feltham, (D. Ariz. 1998). The complaint alleged that Rauscher Pierce's yield-burning overcharges on an Arizona refunding transaction violated various securities laws, including (1) Section 10(b) and Rule 10b-5 for Rauscher's failure to disclose material information and making false representations in connection with escrow price markups; (2) Section 17(a) for engaging in a scheme to defraud in the sale of escrow securities; and (3) Section 206(1), (2) and (3) of the Advisers Act for engaging in conduct that deceived and defrauded an investment advisory client.

The threat of individual SEC litigations, sanctions and censures and IRS revocation of issuer tax-exempt status, along with the federal and state qui tam actions, all helped push the Wall Street defendants toward settlement.

In April 1998, CoreStates Financial Corp. became the first investment bank to settle multi-agency yield-burning charges. It paid $3.7 million to settle yield-burning allegations against Meridian Capital Markets, which CoreStates acquired in 1996 acquisition.

The CoreStates settlement established a framework for settling similar yield-burning charges pending against other banks, for it covered potential False Claims Act, security law and IRS liabilities. As part of the settlement, the IRS agreed not to challenge the tax-exempt status of bonds issued by Meridian clients.

V. Resolution Of the State Qui Tam Case Set the Stage for Federal Settlements

The California qui tam action against Lazard created great momentum in settling the federal case against the Wall Street banks. After vigorous motion practice and intense discovery by both parties, Lazard settled in September 1998, just a few weeks before trial. Lazard agreed to pay the LAMTA $9 million to settle False Claims Act and other charges relating to one refunding transaction in which the single damages to LAMTA were roughly $3 million.

The settlement of the California qui tam action for three times the value of single damages sent a strong message to Wall Street: Yield-burning liability is a serious exposure.

Other settlements followed. In April 1999, Lazard paid $11 million to resolve the federal yield burning charges. Seven months later, BT Alex. Brown Inc. agreed to pay $15.3 million to settle its yield burning liabilities.

In April of this year, the majority of the yield burning cases were settled. Seventeen regional and national securities firms agreed to pay a total of $140 million to resolve the charges - bringing the total damages to date to nearly $180 million. The most recent defendants to settle are: Salomon Smith Barney, PaineWebber Inc.; Dain Rauscher Inc.; Warburg Dillon Read LLC; First Union Securities Inc.; Prudential Securities Inc.; Edwards & Sons Inc.; Goldman, Sachs & Co.; Merrill Lynch, Pierce, Fenner & Smith Inc.; Lehman Brothers Inc.; William R. Hough & Co.; Raymond James & Associates Inc., Morgan Stanley Co. Inc.; U.S. Bancorp Piper Jaffray Inc.; Credit Suisse First Boston Corp.; J.C. Bradford & Co.; and Southwest Securities Inc.

VII. The False Claims Act's Application to Yield-burning Frauds

(1) The Federal Case

Michael Lissack's yield-burning allegations brought the False Claims Act to Wall Street for the first time that we are aware of. In this unusual case, the defendants' securities' pricing fraud set in motion a series of events that resulted in enormous financial loss to the Government. Although the mechanism through which the fraud was accomplished is somewhat complicated, the fraud itself was very simple and not materially different from other, more garden variety frauds in which overcharges were passed on to the federal Treasury through an unwitting third party.

The defendants charged municipal issuers exor­bi­tant prices on the open-market Treasury securities purchased to fund the re­finan­cings. Since the municipalities were not lawfully allowed to earn an arbitrage profit, they had no economic incentive to question the advice given to them by their investment profes­sion­als that the bonds were priced at their fair market value. By using higher prices to reduce the yield on the Treasury bonds, rather than lowering the Government's interest obligations to ob­tain the same reduced yield, the defendants were able to take for themselves money that otherwise would have gone to the Govern­ment in the form of lower interest payments.

To obtain their yield-burning price markups, the defendants made and caused to be made a series of false statements designed to assure all concerned (including the issuers and the federal Government), that the advance refunding bonds were not used for impermissible arbitrage. The net re­sult of their false statements and fraudulent conduct was payment ­by the Government of claims for interest due on Treasury securities that substantially exceeded the payments the municipalities were lawfully entitled to receive and the Government was obli­gated to pay. To the extent there were any "arbitrage" profits from municipal bond refinancings, those profits were by law sup­posed to go to the Treasury in the form of lower interest pay­ments - not to investment banks in the form of illegal mark-ups of the Treasury security prices.

­The positive arbitrage profit that was paid to the banks in the form of high-escrow price markups deprived the federal Treasury of lower interest rates. As a result, Wall Street's yield-burning scheme caused two companion harms to the federal Government - both actionable under the False Claims Act. First, a yield-burning escrow causes the federal Treasury to pay more interest than it otherwise would if the escrow complied with federal regulation. Second, a yield-burning escrow also deprives the federal Treasury of recouping that excess interest (yield) through no-interest borrowing via the zero-interest SLGS program.

Accordingly, in the federal case, causes of action under Sections 3729(a)(1), (2), (3) and (7) of the Act alleged that the defendants caused false claims for interest payments to be presented and made and caused to be made false records to get these false claims paid; conspired with other defendants to get false claims for interest paid; and made and caused to be made false records to avoid or decrease an obligation to pay positive arbitrage to the federal Treasury.

(2) Liability Under The California False Claims Act

As stated above, the California qui tam action against Lazard Freres alleged that LAMTA was caused direct financial harm because of Lazard's undisclosed and excessive markups. That case alleged that Lazard's escrow pricing caused approximately $3 million of negative arbitrage harm directly to the LAMTA, (and an additional approximately $1 million of positive arbitrage to be diverted from the federal Treasury.)

Lazard's California False Claims Act liability was based primarily on the numerous, allegedly false representations to LAMTA concerning the sale of escrow securities at fair market value. In this case, Lazard's alleged misrepresentations were the direct cause of the public agency's financial harm. Unlike the federal case, there were no intervening entities or transactions that occurred between the alleged fraudulent statement and the ultimate financial harm. There was no "pass through" of the fraud, but rather direct claims for payment that harmed a public agency that relied on the representations and advice of its financial advisor. It was alleged under California Government Code Sections 12651(a)(1) and (2) that Lazard presented false claims for payment to LAMTA for overpriced U.S. Treasury securities, and that it also made false records and statements in support of those false claims.

VIII. Remedial Impact Of The Yield Burning Litigation

Lissack's False Claims Act litigations substantially helped eradicate yield-burning pricing practices in municipal finance today. By forcing attention to be paid to this nationwide overpricing practice, the action contributed both to the industry-wide shift from noncompetitive to competitive purchases of open-market escrow securities, and to regulatory changes that encourage bona fide competitive bid practices.

In this case, the insights from a False Claims Act case not only exposed a fraud scheme, but also dramatically increased federal, state and local awareness of Wall Street's yield-burning practices. As a result, Wall Street has had to change the way it does business with tax-exempt public agencies. Making the sale of open-market securities to public entities a transparent and fair process is a lasting and healthy change for the public finance community. It is one we believe would not have been made but for the action-forcing qui tam provisions of the False Claims Act.