SEC Launches Probe of Municipal Bond Market

The Securities and Exchange Commission has launched a major investigation of the U.S. municipal bond market, one that could ultimately involve $12 billion in bond issues, credit market sources said Thursday.

Deepening inquiries by the SEC and Internal Revenue Service into the largely unregulated municipal bond business could seriously affect the money-raising abilities of many municipalities.

The inquiries also could lead the IRS to invalidate the tax-free status of bonds held by thousands of investors and put pressure on Congress to tighten the rules covering the issuance of municipal bonds, market analysts said.

The federal agencies were said to be investigating up to 100 tax-exempt municipal bond offerings totaling as much as $12 billion to determine if they were sold in compliance with laws on bond transactions and tax-free securities.

“When you start talking about $12 billion worth of deals, it is certainly a major event,” said Christopher Taylor, executive director of the Municipal Securities Rule-Making Board, a Washington-based self-regulatory group funded by municipal bond underwriters. “You don’t launch a probe like this without some strong feelings that something’s wrong.”

Credit market sources, who spoke with the understanding they would not be identified, said that in some cases under investigation, underwriters sold tax-free bonds on behalf of municipalities for unrealistic projects and channeled the proceeds into more lucrative investments such as stocks or bonds with higher yields.

This would enable the bond underwriters to pay the interest to bondholders and still collect huge profits, some of which would go to the municipalities as compensation, the sources said.

In other instances under investigation, the sources said, some firms may have conducted invalid sales of tax-free bonds last year to avoid deadlines for stringent controls on such transactions contained in the new tax law.

At least one bondholder class-action lawsuit has been filed against an underwriter in connection with one bond issue under investigation: a $335-million offering to finance a trash disposal plant in Chester, Pa., that may never be built.

“We did some digging and concluded that the Chester bond offering was a sham,” said Richard D. Greenfield, a Pennsylvania attorney who represents 12 disgruntled bondholders.

Chiles Larson, an SEC spokesman in Washington, said the agency would not confirm or deny it was conducting an investigation. IRS spokesman Steven Pyrek said: “We can’t comment on any kind of investigation that’s going on until it’s a matter of public record.”

A focus of federal scrutiny is said to be Matthews & Wright Inc., a small but aggressive Wall Street firm that underwrote the Chester bond offering.

Matthews & Wright also has underwritten issues ranging from a $474-million apartment project in East St. Louis, Ill., to a $125-million industrial park for Oklahoma Indians. Those projects are now in danger because of government investigations that may determine the bonds don’t qualify as tax exempt.