Generally speaking, large securities offerings of private companies must be registered with the Securities and Exchange Commission (“SEC”) before being offered to the public. By contrast, municipal bonds are exempt from registration with the SEC; thus they have received little attention from federal securities officers. Anti-fraud provisions, however, do apply to municipal bonds and the SEC has cracked down in the last decade on what used to be a “no harm, no foul” environment. Along with the SEC, the Internal Revenue Service (“IRS”) has also shown more interest in the municipal bond market in the last decade. Specifically, the IRS has begun auditing municipal bond issues, both randomly and after receiving tips that particular bonds may not qualify for the interest to be exempt from federal income taxes.
State and local governments sell tax-exempt municipal bonds to investment bank underwriters who then sell parts of those bonds to investors. When the state or local governments sell these bonds, they either let multiple investment banks enter bids, or privately negotiate with a chosen bank. These bonds are often highly profitable for the investment banks, and therefore employees are sometimes tempted to pressure politicians to grant them bonds. Most often, employees make political contributions to candidates for state and local office in exchange for being considered for the awarding of municipal bonds. As the former SEC chairman Arthur Levitt remarked, “There's little doubt that pay-to-play damages the integrity of the municipal bond market. It creates the impression that contracts are awarded on the basis of political influence, not professional competence… [and] breeds contempt for the political process.”
Whether it is through rigging the bidding system fraudulently, paying kickbacks to politicians, or otherwise “paying to play,” false statements made to governments to receive a municipal bond can be a violation of state FCA laws.
In addition to “pay to play” kickbacks, municipal bonds have also been the subject of fraud on Wall-Street.
Town A wants to build a new hospital. Officials go to Wall Street, which issues a bond in the town's name to raise $100 million. Investors raise the money and Wall Street moves it into a tax-exempt account. Town A uses that account to pay contractors working on the project. Town A does not spend the money all at once since it often takes years to complete a construction project, and thus years to pay the last contractor. With much of the unspent money sitting in Town A’s account, officials look for a financial company on Wall Street to invest it for them. They hire a broker to set up a public auction and invite banks to compete for the town’s business. For the $100 million Town A borrowed for its hospital, one bank might offer you five percent interest. Bank B might offer you six percent. Bank C might offer you six and a half percent and win the auction.
Wall Street recently engaged in a fraudulent scam whereby they devised phony auctions. Rather than submit competitive bids to let the highest rate win, providers like Chase, Bank of America and GE secretly divided the business of all of the cities and towns that approached Wall Street to borrow money. They bribed auctioneers to rig the auctions so that they knew each interest rate offer beforehand and paid kickbacks to other banks to ensure they would win the auction. While these big banks received relatively small fines, municipalities lost out on millions of dollars.
In 2013, the SEC charged the city of Miami and its former budget director with securities fraud relating to several municipal bond offerings and other disclosures made to investors. After a lengthy investigation, the SEC found that starting in 2008, Miami and Michael Boudreaux made fraudulent statements and omissions regarding certain interfund transfers in three 2009 bond offerings totaling $153.5 million. They also conveyed false information in the city’s financial reports for 2007 and 2008 which are disseminated to the investing public, including investors in previously issued city debt. Boudreaux used legally restricted dollars to transfer funds to specific capital projects and this enabled the city of Miami to meet or come close to meeting city requirements relating to its reserve levels. This caused credit rating agencies to favorably rate city bonds. After the fraud was uncovered by the SEC and the city reversed the transfers, bond rating agencies downgraded their ratings on the city’s debt.