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