SEC Probes Brokers' Ties to Bond-Auction Investors, People Say

U.S. investigators probing the $204 billion auction-rate bond market are focusing on whether brokers tipped favored customers such as investment-banking clients to other investors' bids in supposedly blind auctions, people familiar with the matter said.

The Securities and Exchange Commission has asked 25 firms including Charlotte, North Carolina-based Bank of America Corp. to report any instances in which they helped clients alter their bids in order to get the best possible yield, said the people, who asked not to be identified. The request is part of a previously reported broader investigation of the market.

In the auction-rate market, a bond's interest rate is reset in auctions run by brokers. Potential buyers submit bids for bonds they're willing to buy at specific rates. The bid with the lowest rate that sellers will accept wins, and sets the rate the issuer has to pay until the next auction. SEC investigators suspect brokers have given some customers an unfair advantage by alerting them to competing bids, the people familiar said.

``In this environment, any potential conflicts and perceived special treatment of certain classes of investors are going to get extremely aggressive scrutiny by the SEC's enforcement division,'' said Michael Missal, a former SEC enforcement lawyer now at the Kirkpatrick & Lockhart law firm in Washington.

E-Mails Sought

Bank of America, the third-biggest U.S. bank, said Wednesday it was cooperating with the SEC. A.G. Edwards Inc., a St. Louis-based brokerage, said on Monday it had suspended one employee in connection with the probe. Bank of America spokeswoman Shirley Norton and A. G. Edwards spokeswoman Margaret Welch declined to comment further on Thursday.

John Heine, an SEC spokesman, also declined to comment.

The interest rates on auction-rate bonds are reset in so- called Dutch auctions as frequently as weekly or monthly. An investor who knows the right price to bid can avoid placing a bid that's lower than necessary and get a better yield. Issuers wind up paying a higher rate than a truly blind auction might have produced.

The agency's enforcement staff has asked brokers to provide reports ``detailing any potentially deceptive, dishonest or unfair practices,'' according to a memo the Bond Market Association, the Securities Industry Association and the American Bar Association sent to their members in May. The memo didn't name the brokers under scrutiny.

The SEC now has asked the brokers to produce e-mails relating to all aspects of their auction-rate operations, the people familiar with the probe said.

Top Underwriters

Neither Bank of America nor A.G. Edwards ranks among the largest underwriters of auction-rate bonds. According to Thomson Financial, the top five underwriters of such bonds since Jan. 1, 2000, are Citigroup Inc., UBS AG, Goldman Sachs Group Inc., RBC Dain Rauscher Inc., and Morgan Stanley.

Auction-rate securities were created in 1984, and by the end of June 2003, there were more than $170 billion outstanding, according to Merrill Lynch & Co.'s Web site. In last year's fourth quarter, $204 billion in all types of auction-rate securities were outstanding, according to an industry overview prepared by Deutsche Bank AG. Issuers include municipalities, hospitals, colleges and universities.

Eight of the top 10 auction-rate debt issuers since January 2000 are student-loan corporations, according to Thomson Financial, including the Brazos Higher Education Authority and the Brazos Student Finance Corp., affiliated companies that are the No. 1 and No. 3 issuers respectively with a total of $6.7 billion sold in the past four years. The New York State Dormitory Authority, with $3.3 billion sold, is the second-biggest issuer.

Broker Bids

The SEC is also likely to examine whether brokers improperly traded for their own accounts in the auctions they run for issuers and other investors, the people familiar with the probe said.

Broker-dealers who underwrite auction-rate offerings routinely step in and place bids for themselves, knowing other investors' bids, said Mark Lindgren, general counsel for NorthStar Education Finance Inc., a St. Paul, Minnesota-based student loan reseller with about $1.8 billion in outstanding auction-rate notes.

When unexpectedly high bids from other investors threaten the issuer with a sudden change in interest-rate payments, a broker can help ``stabilize'' the auction, Lindgren said in an interview Wednesday.

``Is that maybe not in the best interest of one investor at a particular time? Sure,'' Lindgren said. ``But if the goal is to stabilize the market for everybody, you have to allow that.''