Investment banks pay $140 million to settle whistleblower qui tam cases and yield-burning charges

NEW YORK CITY, NY — Seventeen investment banks have agreed to pay about $140 million to the federal government to settle charges, brought by Phillips & Cohen, that they defrauded the federal government by overpricing securities sold in connection with certain municipal bond transactions.

The scheme involved what has come to be known as “yield burning” and was first brought to the public’s attention in 1995 by whistleblower Michael Lissack, who filed a “qui tam” lawsuit against more than a dozen Wall Street firms under the False Claims Act. Today’s settlement also involves a separate qui tam lawsuit brought by Joseph Mooney, a public finance banker in Florida, and separate government charges brought against three investment banks.

The settlement wraps up the government’s case against most of the major players in the municipal finance market. It covers potential False Claims Act, security law and IRS liabilities against the investment banks and was agreed to by the Justice Department, Securities and Exchange Commission, the Internal Revenue Service and NASD Regulation, the independent subsidiary of the National Association of Securities Dealers Inc. charged with regulating the securities industry.

“Today’s agreement ends a disgraceful chapter of abuse and deception in Wall Street’s history,” said John R. Phillips, a Washington, D.C., attorney whose firm, Phillips & Cohen, represents both Lissack and Mooney. “There is no doubt that without the help of our clients, investment banks would have continued to milk the U.S. Treasury for hundreds of millions of dollars.”

The settlement has two components: The securities firms will pay approximately $120.4 million to the federal government, the bulk of which will go toward settling the qui tam lawsuits. About $20 million will be returned to municipalities nationwide that were harmed by the firms’ yield-burning practices.

The firms that were named in the qui tam lawsuits and the amounts they paid to settle the lawsuits are:

  • Dain Rauscher Corp. — $11 million
  • Salomon Smith Barney Inc. — $38 million
  • William R. Hough & Co. — $3.1 million
  • U.S. Bancorp Piper Jaffray Inc. (as successor to Piper Jaffray) — approximately $1 million
  • CS First Boston Corp. — almost $1 million
  • Dillon Read Securities Inc. — $6.3 million
  • Goldman Sachs & Co. — $5.1 million
  • PaineWebber Inc. — $21.6 million
  • Prudential Securities Inc. $5.8 million
  • Raymond James & Associates Inc. — $2.6 million
  • Morgan Stanley & Co. — $2.5 million
  • Lehman Brothers Inc. — $4.5 million
  • Merrill Lynch Pierce Fenner & Smith Inc. — $4.6 million
  • First Union (as successor to Wheat First) — $6.3 million

Three banks that were not named in the qui tam lawsuits also settled government fraud charges at the same time and paid about $6.6 million for damages to the federal government and municipalities: JC Bradford, Southwest Securities and AG Edwards.

“This case has changed the way Wall Street and municipalities do business,” said attorney Erika A. Kelton of Phillips & Cohen. “Once yield-burning was publicly exposed by Michael Lissack, the industry couldn’t continue to gouge states, cities and local agencies.”

Investment banks engaged in yield-burning in the early to mid-1990s. Spurred by the qui tam lawsuits, the Justice Department, IRS and SEC have been investigating for more than five years investment broker pricing of U.S. Treasury securities sold in connection with municipal refinancing transactions, known as “advance refundings.”

At one point, the IRS considered holding municipal bond issuers liable for abuses related to yield-burning. That could have led to financial losses for investors and hurt the local governments’ ability to raise funds in the future.

“These investment firms not only stole money that belonged to the U.S. Treasury, they also clearly endangered the tax-exempt status of certain local government bond issues,” said Kelton. “The Wall Street defendants acted recklessly and against their clients’ interests.”

When interest rates decline, advance refunding transactions are a popular way for state and local governments to lower their borrowing costs by refinancing their debt at lower interest rates. They purchase Treasury securities using the proceeds of tax-exempt advance refunding bonds. By law, their investments with those proceeds cannot earn higher aggregate yields than the yield earned on the bonds. Any excess profit must be paid to the federal government. By adding large price markups to Treasury securities purchased with bond proceeds, an investment broker could artificially depress, i.e., “burn” the yield and pocket the illegal profits.

Joseph Mooney was working for a investment bank in Florida when he became aware of improper escrow pricing practices. He raised his concerns with the IRS, FBI and other government agencies in 1993, but did not get a response. The following year he quit his job, unwilling to participate in financial deals that violated the law. He filed a qui tam lawsuit in 1997 against Smith Barney, which had been involved in many advance refunding deals in Florida.

“Helping to stop a practice that has cost taxpayers many millions of dollars has given me great satisfaction, despite the personal cost of standing up to this egregious fraud,” Mooney said.

Lissack’s qui tam lawsuit was filed in 1995 in the Southern District of New York (Manhattan). Investment banks so far have paid more than $39 million to settle their liabilities under that federal lawsuit and one Lissack brought under California law.

Meridian Securities (now CoreStates Financial Corp.) paid $3.8 million to the federal government in 1998. Last year Lazard Freres & Co. paid $11 million and Deutsche Banc Alex. Brown Inc. paid $15.3 million to settle federal charges against them.

In addition, Lazard agreed in 1998 to pay the Los Angeles County Metropolitan Transportation Authority (LAMTA) $9 million to settle charges brought by Lissack under the California False Claims Act that the investment bank fraudulently overpriced securities by $3 million on a single municipal refinancing transaction. (Phillips & Cohen also served as counsel to the LAMTA in the case.)

“It has been a long road to get here,” said Lissack. “But it certainly was worth the trip given the impact that my lawsuit has had in stopping the drain on the Treasury.”

Since leaving Wall Street, Lissack has delved into academia. He is the founder and director of the Institute for the Study of Coherence and Emergence in Boston, and edits its journal. He co-authored “The Next Common Sense,” a book about complexity theory, and was co-editor of another book, “Managing Complexity in Organizations: A View in Many Directions.” Using his share of the recoveries so far from his qui tam case, he has endowed a chair in business ethics at Williams College.

Lissack’s and Mooney’s lawsuits were brought under the False Claims Act, which permits individuals with knowledge of fraud against the government to file suit on its behalf.

Companies liable under the False Claims Act can be required to pay as much as three times damages and $5,000 to $10,000 for each false claims. The “relator,” as the whistleblower is known, is entitled to a share of whatever money the government recovers as a result of the lawsuit.

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

  • “Settlement reported in bond-pricing case,” Patrick McGeehan, The New York Times, April 6, 2000.
  • “U.S., 17 securities firms reach accord on scandal-tainted municipal bonds,” Charles Gasparino and John Connor, The Wall Street Journal, April 6, 2000.
  • “Dain to pay $12.9 million to settle muni bond abuses,” Jill J. Barshay, Star Tribune, April 7, 2000.
  • “Brokers settle pricing charges,” Helen Huntley, St. Petersburg Times,” April 7, 2000.
  • “First Union to pay $7.7 million; securities fraud settlement reaches $140 million for investment banks,” Carol Hazard, Richmond Times-Dispatch, April 7, 2000.
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