UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7671 / April 21, 1999 SECURITIES EXCHANGE ACT OF 1934 Release No. 41318 / April 21, 1999 ADMINISTRATIVE PROCEEDING File No. 3-9880 : : In the Matter of : ORDER INSTITUTING ADMINISTRATIVE : PROCEEDINGS, MAKING FINDINGS LAZARD FRÈRES & CO. LLC, : OF FACT, INSTITUTING A cease- : and-desist order, AND Respondent. : IMPOSING REMEDIAL SANCTIONS : : The Commission deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 (Securities Act) and Sections 15(b)(4), 15B(c)(2) and 21C of the Securities Exchange Act of 1934 (Exchange Act) against Lazard Frères & Co. LLC (Lazard). In anticipation of the institution of these proceedings, Lazard has submitted an offer of settlement, which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, Lazard, without admitting or denying the findings con- tained herein, except that it admits to the jurisdiction of the Commission over it and over the subject matter of these proceedings, consents to the entry of the findings, the institution of the cease-and-desist order, and the imposition of the remedial sanctions set forth below. . Based on the foregoing, the Commission finds as follows: . Respondent Lazard Frères & Co. LLC is an investment banking firm with its principal place of business in New York City. It is the successor to Lazard Frères & Co., a New York limited partnership. At all relevant times, both Lazard and its predecessor were registered with the Commission as broker- dealers and municipal securities dealers pursuant to Sections 15(b) and 15B(a)(2) of the Exchange Act. B. Summary This is a municipal finance case involving the breach of Lazard’s fiduciary duty to its financial advisory client, the Passaic Valley Sewerage Commissioners ("Passaic Valley"). The breach of duty involved Lazard’s failure to make necessary disclosures in an advance refunding transaction in which it served as financial advisor and also sold Treasury securities to Passaic Valley as principal. This case also involves Lazard’s sale of Treasury securities to Passaic Valley at excessive, undisclosed markups. C. Background: Advance Refundings When interest rates fall, state and local governments often seek to reduce their borrowing costs by paying off outstanding bonds through the issuance of new bonds paying lower interest rates. When the old bonds cannot be paid off until a future call date, the municipality can still obtain a benefit from lower interest rates through an advance refunding. An advance refunding can lock in current interest rates and ensure that the municipality will realize debt service savings over the life of the new bonds. In an advance refunding, the municipality issues new "refunding" bonds and immediately invests the proceeds in a portfolio of U.S. Treasury or agency securities structured to pay the principal and interest obligations on the old bonds until the call date and then to pay off the outstanding principal and any call premium. The portfolio of government securities is normally placed in a defeasance escrow to guarantee repayment of the old bonds. Defeasance escrow portfolios are subject to Internal Revenue Code provisions and Treasury regulations that prohibit the issuer of tax-exempt refunding bonds from earning tax arbitrage (that is, a profit from the rate differential between the taxable and tax-exempt markets).[1] I.R.C. § 148; Treas. Reg. §§1.148-0 et seq. The regulations provide that the issuer cannot receive a yield on the securities held in escrow that exceeds the yield it pays on the refunding bonds. In addition, to prevent an issuer from diverting tax arbitrage to the seller of the escrow securities by paying artificially high prices, the regulations provide, in effect, that the price paid by refunding bond issuers for escrow securities purchased in the secondary market (known as "open market securities") cannot exceed the fair market value or market price of the securities as defined in those regulations.[2] When the yield on the investments in the escrow, if purchased at fair market value, would be below the yield on the refunding bonds, the transaction is said to be in "negative arbitrage." Overcharging by dealers for open market escrow securities in a negative arbitrage transaction takes money away from the municipality by reducing, dollar for dollar, the present value savings the municipality obtains through the advance refunding, but it does not involve any diversion of tax arbitrage.[3] D. Lazard Failed to Make Required Disclosures to Passaic Valley In mid-1992, Lazard proposed to Passaic Valley that it undertake an advance refunding to achieve debt service savings, with Lazard as its financial advisor. Passaic Valley accepted Lazard’s proposal. Under the parties’ written agreement, Lazard was to perform financial advisory services in connection with Passaic Valley’s refunding. In exchange for those services Lazard was to receive a fee of one dollar for every one thousand dollars of principal amount of bonds issued by Passaic Valley. The agreement listed certain services that Lazard would perform "as requested by [Passaic Valley]," including the providing of government securities to fund the escrow for the refunded bonds. As is often the case in municipal bond transactions, the sale date and closing date of Passaic Valley’s $191,535,000 refunding bond offering were several weeks apart. Both the bonds and the escrow securities were priced on the sale date, November 19, 1992, but not delivered until the closing date nearly a month later. The refunding portion of the issue required Passaic Valley to purchase a portfolio of Treasury securities costing nearly $140 million. Lazard sold the Treasury securities to Passaic Valley as principal from Lazard’s own account. Lazard priced the Treasury securities without any discussion with Passaic Valley. Passaic Valley’s personnel had no prior experience with refundings or purchasing Treasury notes or bonds. They relied on Lazard to provide financial expertise and to represent Passaic Valley’s economic interests in the refunding. Lazard explained little about the escrow securities transaction to Passaic Valley personnel. There is no evidence that Passaic Valley was aware that Lazard would make a profit on the securities.[4] Nor is there evidence that anyone at Passaic Valley was aware until several weeks after the sale date that Lazard would sell the securities to Passaic Valley from Lazard’s own account. On or about December 7, 1992, bond counsel sent Passaic Valley a copy of a draft escrow deposit agreement that noted, among other things, that the escrow securities were being purchased from Lazard. Also, on December 10, 1992, Lazard provided Passaic Valley with a memorandum stating that the Treasury securities would be purchased from Lazard. On the refunding’s closing date, December 17, 1992, Lazard provided a letter stating that it had sold the escrow securities to Passaic Valley and that "the prices at which [Lazard] sold the Escrow Securities were equal to the fair market value of such Escrow Securities obtained in an arm’s length transaction." In turn, Passaic Valley certified that it had acquired the escrow securities "at arm’s length, fair market value prices based on representations made by Lazard Frères & Co. as set forth in [Lazard’s December 17 letter]." Lazard subsequently collected $191,535 in financial advisory fees from Passaic Valley under the financial advisory agreement. E. Lazard Sold Treasury Securities to Passaic Valley at Excessive, Undisclosed Markups Lazard received an additional $685,000 from the markups charged on, and carry received from, the sale of the escrow securities to Passaic Valley.[5] Lazard did not disclose this profit to Passaic Valley. Because the Passaic Valley refunding was a negative arbitrage transaction, all profit made by Lazard on the escrow securities reduced dollar-for-dollar Passaic Valley’s debt service savings on the refunding. Under the Treasury regulations, Passaic Valley could have purchased escrow investments for approximately $727,000 less than the prices charged by Lazard and still complied with the yield restrictions. Therefore, Passaic Valley could have retained the benefit of purchasing the securities at lower prices. Lazard’s markup and carry on the transaction was approximately one half of one percent of the prevailing interdealer market prices of the Treasury securities sold to Passaic Valley. At the time, other dealers generally charged materially lower markups on escrow securities when the prices were determined through competition or bona fide arm’s length negotiation. Under the facts and circumstances, Lazard’s prices were above fair market value as defined by federal tax laws. III. Section 17(a) of the Securities Act prohibits materially false or misleading statements, or material omissions when there is a duty to speak, in the offer or sale of any security. Section 17(a)(1) requires a showing of scienter; however, Sections 17(a)(2) and 17(a)(3) do not require such a showing. Aaron v. SEC, 446 U.S. 680, 697 (1980). Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit materially false or misleading statements, or material omissions when there is a duty to speak, made with scienter, in connection with the purchase or sale of any security. Both knowing and reckless conduct satisfy the scienter element. See, e.g., Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990). A duty to speak arises, and material omissions become fraudulent, when a person or entity has information that another is entitled to know because of a fiduciary or similar relationship of trust and confidence. See Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-55 (1972); Chiarella v. United States, 445 U.S. 222, 228 (1980); In re Arleen W. Hughes, 27 S.E.C. 629 (1948), aff’d sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949). A. Material Omissions in Connection with the Sale of Securities to Passaic Valley Generally, a municipality’s financial advisor owes fiduciary obligations to it in connection with bond financings by the municipality.[6] In addition, under New Jersey state law, a fiduciary relationship arises when one person is under a duty to give advice for the benefit of another on matters within the scope of their relationship and the advisor occupies a dominant position over the other.[7] Passaic Valley had no expertise or experience in advance refundings or purchasing Treasury bonds and notes. Instead, Passaic Valley relied on Lazard, as its financial advisor, to serve its interests in all aspects of the refunding, including the purchase of escrow securities. Therefore, based on the facts and circumstances, Lazard had a fiduciary or similar relationship of trust and confidence with Passaic Valley. Courts have imposed on a fiduciary affirmative duties of utmost good faith, and full and fair disclosure of all material facts, as well as an affirmative obligation to employ reasonable care to avoid misleading its client. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963). A broker- dealer that seeks to sell securities from its own account, as principal, to a client to whom it owes fiduciary duties must follow well-established standards. Under both common law and federal securities law, the broker-dealer can only deal with its fiduciary client as a principal by making full disclosure(before entering into the transaction(of the nature and extent of any adverse interest that the broker-dealer may have with the client. See In re Arleen W. Hughes, 27 S.E.C. at 635-36; Restatement (Second) of Agency § 390 (1958). This standard requires disclosure of more than the fact that the broker-dealer will act as principal in the transaction. See, e.g., In re R.H. Johnson & Co., 36 S.E.C. 467 (1955), aff’d, 231 F.2d 523 (D.C. Cir. 1956); Norris & Hirshberg, Inc. v. SEC, 177 F.2d 228, 233 (D.C. Cir. 1949) (holding that a broker-dealer that sent a fiduciary client confirmations stating that it acted as principal in certain transactions nevertheless violated the anti-fraud provisions by failing to disclose its capacity as principal rather than agent at the time of the transaction). A broker-dealer subject to fiduciary obligations must disclose all material facts, including any current market price at which the customer could effect the transaction that is better than the price that the dealer intends to provide to the customer. See, e.g., Off Board Trading Restrictions, Exchange Act Rel. No. 13662, text accompanying notes 113-116 (June 23, 1977). Lazard violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder when it failed to obtain Passaic Valley’s fully informed consent before engaging in the escrow securities transaction as principal. Lazard failed to disclose"in a manner that its client would be sure to understand"(1) that it would sell the escrow securities to Passaic Valley from Lazard’s own account, and (2) the nature and extent of its actual and apparent conflicts of interest. Under the circumstances, Lazard had, at a minimum, an obligation to investigate whether another seller would have provided the securities to Passaic Valley at better prices, and to disclose to Passaic Valley the results of that investigation. B. Material Misrepresentations and Omissions in the Sale of Securities to Passaic Valley As to the pricing of the escrow securities sold to Passaic Valley, Lazard violated Sections 17(a)(2) and 17(a)(3) of the Securities Act by effecting that transaction at prices not reasonably related to the current wholesale market prices for the securities under the particular facts and circumstances, including the pertinent tax regulations, and by representing to Passaic Valley that Lazard had sold the securities at fair market value. See, e.g., Grandon v. Merrill Lynch & Co., 147 F.3d 184, 192 (2d Cir. 1998) (under the shingle theory, a broker-dealer has a duty to disclose excessive markups); In re Lehman Bros. Inc., 62 SEC Dkt. at 2330-31; In re Duker & Duker, 6 S.E.C. 386, 389 (1939). Lazard’s markup and carry on the transaction was approximately one half of one percent of the prevailing interdealer market prices of the Treasury securities sold to Passaic Valley. Based on all the relevant facts and circumstances, Lazard knew or should have known that the prices it charged were not reasonably related to the prevailing wholesale market prices of the securities. The excessive markups operated as a fraud or deceit because unbeknownst to Passaic Valley the excessive markups reduced the savings available to Passaic Valley from the refunding. IV. On the basis of this Order and Lazard’s offer of settlement, the Commission finds that Lazard willfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5. V. Accordingly, IT IS ORDERED, pursuant to Section 8A of the Securities Act and Sections 15(b)(4), 15B(c)(2), and 21C of the Exchange Act, that: A. Lazard is censured; B. Lazard shall cease and desist from committing or causing any violations and any future violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; C. Within ten days of the entry of the Order, Lazard shall, by a postal or bank money order, certified check or bank cashier’s check, pay disgorgement of $272,759 and prejudgment interest of $174,615 to the Passaic Valley Sewerage Commissioners in connection with a refunding that settled on December 17, 1992; D. Within ten days of the entry of the Order, Lazard shall comply with its undertaking to make the following payments related to other sales of escrow securities: $305,421 to the City of Pittsburgh in connection with the advance refunding that settled on April 1, 1993; $1,355,719 to the Municipality of Seattle in connection with the advance refundings that settled on August 27, 1992, March 23, 1993, July 1, 1993, and September 8, 1993; $1,221,995 to the City of Indianapolis Public Improvement Bond Bank in connection with the advance refunding that settled on December 3, 1992; and $218,240 to the City of Indianapolis in connection with the advance refunding that settled on March 11, 1993; E. Lazard shall comply with its undertaking to pay $7,451,251 to the United States Treasury under an agreement simultaneously entered into among Lazard, the Internal Revenue Service and the United States Attorney for the Southern District of New York; and F. Copies of payments made to the municipalities and the United States Treasury as described in sub-paragraphs C, D and E above and any cover letters accompanying them shall be sent by Lazard to Lawrence A. West, Branch Chief, Division of Enforcement, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0806. By the Commission. Jonathan G. Katz Secretary **FOOTNOTES** [1]: These provisions and regulations are designed to prevent abuse of the benefit the federal government affords municipalities by not taxing interest paid on municipal bonds. See Joint Comm. on Taxation, 91st Cong., 2d Sess., General Explanation of the Tax Reform Act of 1969, at 185-86 (Comm. Print 1970). [2]: During the relevant period, Treasury regulations provided several definitions of fair market value and market price for purposes of valuing open market government securities for advance refundings. For example, a regulation generally applicable to advance refunding transactions that settled on or before June 30, 1993 defined market price as "the mean of the bid and offered prices on an established market" on the day of pricing; if, however, the price paid by the issuer was higher than the mean of the bid and offered prices, then the higher price could be treated as the market price of the security if the issuer acquired it in an "arm’s length transaction without regard to any amount paid to reduce the yield . . . ." Treas. Reg. § 1.103- 13(c)(1)(iii)(B) (1979). Generally, after June 30, 1993, fair market value was defined as "the price at which a willing buyer would purchase the [security] from a willing seller in a bona fide, arm’s length transaction." Treas. Reg. § 1.148-5(d)(6)(i) (1993). [3]: In contrast, in a "positive arbitrage" situation"when the yield on open market securities purchased at fair market value would exceed the yield on the refunding bonds"overcharging by dealers for open market escrow securities diverts tax arbitrage to the dealers at the expense of the U.S. Treasury. This diversion, known colloquially as "yield burning," is illegal. If yield burning occurs, the IRS can declare interest paid on the refunding bonds taxable. See Harbor Bancorp & Subsidiaries v. Keith, 115 F.3d 722 (9th Cir. 1997), cert. denied, 118 S. Ct. 1035 (1998). There are several lawful methods to limit the yield of the defeasance escrow in a positive arbitrage situation. One method is to purchase from the Bureau of Public Debt at the Department of the Treasury below-market-interest Treasury securities"known as State and Local Government Series securities (SLGS)"customized to match the yield limitation. Alternatively, the municipality can purchase open market securities of shorter durations (and lower yields) than those required to satisfy the escrow requirements; when these securities mature, the cash proceeds are invested for the remaining period of the escrow in non-interest-bearing SLGS. When either of these methods is used, the Treasury obtains a benefit by issuing debt at interest rates lower than those prevailing in the taxable market. [4]: Bond counsel to Passaic Valley for the refunding knew by the sale date that Lazard would act as principal and make a profit on the sale of the escrow securities. However, bond counsel had no expertise in the pricing of escrow securities, and its representation of Passaic Valley did not extend to such financial matters as whether Passaic Valley was obtaining the best available prices. Bond counsel’s services were limited to drafting documents and rendering certain opinions related to the validity and tax-exempt status of the refunding bonds. [5]: Profit on open market escrow securities generally has two components: markup and carry. Markup is the difference between the price the dealer charges the issuer and the prevailing wholesale market price. In re Lehman Bros. Inc., Exchange Act Release No. 37673 (Sept. 12, 1996), 62 SEC Dkt. 2324, 2330. Carry is the difference between (a) the interest and accretion produced by the escrow securities between the sale date and closing date and (b) the cost of financing those securities during that period. See Board of Governors of the Federal Reserve System, Trading Activities Manual, Part 2 at 2-8 (March 1994). [6]: See, e.g., Order Approving Proposed Rule Change of MSRB Relating to Activities of Financial Advisors, Exchange Act Release No. 30258 (Jan. 16, 1992) ("The MSRB . . . believes that the existence of the conflict of interest [faced by a dealer acting as both financial advisor and placement agent on the same issue] is contrary to the fiduciary obligations of municipal securities professionals acting as financial advisors to issuers . . . ."); Notice by MSRB of Proposed Rule G-23, 42 Fed. Reg. 49856, 49859 (Sept. 28, 1977) ("As a financial advisor, the municipal securities professional acts in a fiduciary capacity as agent for the governmental unit . . . ."); cf. In re O’Brien Partners, Inc., Securities Act Release No. 7594 (October 27, 1998) (violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act for failure to make full disclosure in breach of fiduciary duty owed as municipal financial advisor). The term financial advisor is not defined in the federal securities laws. However, Rule G-23(b) of the Rules of the Municipal Securities Rulemaking Board provides that "a financial advisory relationship shall be deemed to exist when a broker, dealer, or municipal securities dealer renders or enters into an agreement to render financial advisory or consultant services to or on behalf of an issuer with respect to a new issue or issues of municipal securities, including advice with respect to the structure, timing, terms and other similar matters concerning such issue or issues, for a fee or other compensation or in expectation of such compensation for the rendering of such services." [7]: F.G. v. MacDonell, 150 N.J. 550, 696 A.2d 697 (1997) (citing In re Stroming’s Will, 12 N.J. Super. 217, 224, 79 A.2d 492, 495 (App. Div.), certif. denied, 8 N.J. 319 (1951) (stating essentials of confidential relationship "are a reposed confidence and the dominant and controlling position of the beneficiary of the transaction"), and Blake v. Brennan, 1 N.J. Super. 446, 453, 61 A.2d 916 (Ch. Div. 1948) (describing "the test [as] whether the relations between the parties were of such a character of trust and confidence as to render it reasonably certain that the one party occupied a dominant position over the other and that consequently they did not deal on terms and conditions of equality")).