No Safe Havens: Fraud in Municipal Bonds
May 2013
IN THIS ISSUE
— Government Backed, But Still Problematic: Fraud in the Bond Market
— Checking All of the Details: Investigating Bond Sales
GREETINGS!
Welcome to the May edition of our newsletter! In this issue, we’ll examine instances of fraud in the municipal bond markets, often thought of as a safe place for investor funds, and detail methods that can help your clients avoid losses from such fraud.
GOVERNMENT BACKED, BUT STILL PROBLEMATIC: FRAUD IN THE BOND MARKET
Bond buying has been a staple of many investment portfolios for most of the last 70 years, and it’s easy to see why. After all, what could be less controversial than a municipality wanting to raise funds for water and sewer upgrades, or a professional sports stadium? (On second thought, that last example may stir up some controversy.) But the once-safe world of municipal bonds was shaken somewhat earlier this month by the U.S. Securities and Exchange Commission (“SEC.”)
In early May, the SEC sent a cease and desist letter to the city of Harrisburg, Pennsylvania — which also happens to be the seat of the state government — for making “misleading” statements not in investor materials about the bonds the city was selling, but in presentations about the securities in subsequent meetings about the city’s budget. Among the omissions cited by the SEC was Harrisburg’s outstanding debt having been downgraded by a ratings agency in 2008.
CHECKING ALL OF THE DETAILS: INVESTIGATING BOND SALES
When working for an investor who is considering a large purchase of government debt, it is essential not only to look at the quality (and accuracy) of the financial statements accompanying the offering, but also to examine the underwriters chosen by the municipality to assist in completing the sale. What ties do the underwriters have to the officials that hired them,. and could this indicate a laxity to the process that could endanger an investment at a later date? In past investigations, we’ve uncovered instances of nepotism and cronyism between underwriters and the communities they serve. Much of this information, as with the vetting of claims made in offering documents, is a matter of public record, but this can also be complemented (after that research is completed) by interviews with officials (likely former officials, in most cases) and perhaps whistle blowers who sense something is amiss.
Small purchasers of these securities are unlikely to feel compelled to hire an expert to perform this sort of research, but several not-for-profit agencies, university endowments, family trusts and other large investors routinely see municipal bonds as a safe place to grow their asset base, and as a hedge against traditionally volatile equity markets. Yet as the Harrisburg example may have shown, there are fewer safe havens today than in the past.