UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 41224 / March 30, 1998 ADMINISTRATIVE PROCEEDING File No. 3-9857 ----------------------------------------------------------------- ORDER INSTITUTING PUBLIC In the Matter of: PROCEEDING, MAKING FINDINGS AND IMPOSING A CEASE-AND- KIDDER, PEABODY & CO. DESIST ORDER AND DISGORGEMENT INCORPORATED Respondent. ----------------------------------------------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate that a public cease-and-desist proceeding be, and hereby is, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Kidder, Peabody & Co. Incorporated ("Kidder") violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. II. In anticipation of the institution of this proceeding, Kidder has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein, except that Respondent admits the jurisdiction of the Commission over it and over the subject matter of this proceeding, Kidder consents to the issuance of this Order Instituting Public Proceeding, Making Findings and Imposing a Cease-and-Desist Order and Disgorgerment ("Order") and to the entry of the findings and the imposition of the relief set forth below. III. On the basis of this Order and Respondent's Offer, the Commission finds the following:[1]/ A. Respondent Kidder, Peabody & Co. Incorporated was, at all relevant times, a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act. Kidder withdrew its registration by filing a Form BDW, which was effective January 1996. B Other Relevant Entity Tampa, Florida ("Tampa" or "City") is the largest municipality in the State of Florida. At all relevant times, the City was empowered to issue bonds and invest the bond proceeds in accordance with applicable laws and regulations. C. Facts This matter involves material misrepresentations by Kidder in connection with the purchase of an Escrow Reinvestment Agreement ("Agreement"), whereby Kidder was able to purchase the Agreement at less than fair market value. Kidder’s purchase of the Agreement at less than fair market value had the effect of reducing--or "burning"--the yield on that Agreement, a form of "yield burning." In December 1993, Kidder was the winning bidder for the right to enter into an Agreement awarded by the City. Kidder also had been responsible, along with another broker-dealer (referred to here as "BD-1"), for soliciting bids on the Agreement from others. During the bidding, an individual affiliated with BD-1 ("Registered Person") engaged in misconduct that caused two bidders (one of which was affiliated with the Registered Person), to submit artificially low bids. Kidder won the Agreement with a bid of $1.319 million, more than $3.0 million below what Kidder then believed the Agreement was worth. In connection with the award of the Agreement, Kidder and BD-1 made certain representations to the City regarding the bidding process and the value of the Agreement. Kidder either knew or recklessly disregarded that these representations were false. In subsequent purchases and sales of securities under the Agreement, Kidder and BD-1 realized profits of nearly $3.5 million. 1. The City’s Series 1991 Advance Refunding Bonds In April 1991, the City issued its tax-exempt $138,610,000 Utilities Tax and Special Revenue Refunding Bonds, Series 1991 (the "Series 1991 Bonds"). The Series 1991 Bonds were advance refunding bonds, meaning that the City intended to use the proceeds to repay previously-issued bonds when those bonds became due and payable. Because the previously-issued bonds were not then due and payable, the City set up an escrow account to hold the proceeds from the Series 1991 Bonds. The proceeds from the Series 1991 Bonds were invested in various federal government securities, which were chosen in amounts and for durations such that they matured as near as possible to the time the City would actually need the proceeds to repay the previously-issued bonds. However, in several instances, the federal government securities matured prior to the time the City actually needed the funds. These gaps, referred to as "float periods", ranged from 45 to 228 days. Pursuant to certain provisions of the Internal Revenue Code ("IRC"), a municipal issuer of tax-exempt advance refunding bonds may invest the bond proceeds so long as the issuer does not earn an overall return on the proceeds materially higher than the yield on the underlying tax-exempt bonds. See 26 U.S.C. §148. These provisions are generally referred to as the "IRC arbitrage provisions." An issuer must either structure the escrow in compliance with these provisions or run the risk that the Internal Revenue Service will declare interest on the advance refunding bonds taxable. Id. As originally structured, the overall yield to the City was below the maximum it could earn. Thus, an opportunity existed for the City to earn additional investment income if the City could find a proper vehicle through which to invest proceeds from the Series 1991 Bonds during some or all of the float periods in the escrow, so long as that additional income did not cause the overall yield on the escrow to exceed the maximum, which was 6.892697%. 2. The Proposal by Kidder and BD-1 to Restructure the Escrow for the Series 1991 Bonds In late 1992, Kidder and BD-1 proposed that the City restructure the escrow for the Series 1991 Bonds. Kidder’s primary representative in this matter was a then Senior Vice President in Kidder’s Tampa office (the "Former Senior Vice President"). In his dealings with the City, the Registered Person presented himself as a representative of BD-1. Neither Kidder nor the Registered Person ever disclosed to the City that the Registered Person was also affiliated with a second broker- dealer (referred to here as "BD-2").[2] The proposal Kidder and BD-1 eventually presented to the City focused on seven float periods in the escrow. Under the proposal, Kidder would make an initial cash payment to the City, and Kidder would obtain the right, at the outset of each float period, to sell to the escrow a federal government security that matured on or before the end of the float period, in an amount at least equal to the amount the City needed to meet its underlying repayment obligation. Kidder would then take the proceeds from the escrow that the City paid in exchange for the federal government security, reinvest those proceeds for the duration of the float period and retain for itself any reinvestment earnings. At the end of the float period, Kidder would retain both the principal amount of the proceeds and any reinvestment earnings, and the City would retain the initial cash payment and the government security provided by Kidder, which would mature as needed to meet the City’s underlying repayment obligation. The increase in the City’s overall yield on the escrow from such a transaction is determined by the amount of the initial payment: the higher the payment, the higher the City’s overall yield. Thus, the size of the initial payment the City could receive was limited by the requirement that the City’s overall yield on the escrow not exceed the yield on the City’s underlying tax-exempt bonds. In a proposal dated January 11, 1993, Kidder and BD-1 proposed a transaction which would result in a payment to the City of $1,367,928.33. In this proposal, Kidder and BD-1 calculated that the effect of such a payment would be to increase the City’s yield on the escrow to 6.892591%, just below the yield restriction of 6.892697%. In late 1993, the City agreed to enter into an Escrow Reinvestment Agreement. However, IRC arbitrage provisions required that any payment to the City under the Agreement represent "fair market value" for the reinvestment rights transferred under the Agreement. 26 CFR §1.148-5(d)(6)(iii). One of the purposes of the fair market value requirement is to ensure that investment banks and others that enter into such agreements with yield-restricted escrow accounts do not artificially depress the yield to the municipality (and thus allow the municipality to appear to be in compliance with the IRC arbitrage provisions). Id. Such practices are commonly referred to as "yield burning." Regulations under the IRC provided a safe harbor for determining the fair market value of an investment contract such as the Agreement. Among other things, the IRC regulations required that an issuer obtain bids for any such investment contract from at least three qualified bidders (i.e., bidders with no other financial interest in the transaction) and that the contract be awarded to the highest bidder. Id. As a result, in December 1993 the City required that Kidder and BD-1 solicit bids on the Agreement from at least three bidders not otherwise involved in the escrow restructuring, to ensure that the initial payment the City received for the Agreement represented fair market value. 3. The Rigged Bidding on the Escrow Reinvestment Agreement As noted above, in their January 11, 1993 proposal Kidder and BD-1 determined that the maximum initial payment the City could receive for an escrow restructuring without violating IRC yield restrictions was approximately $1.37 million. However, internal Kidder documents prepared by the Former Senior Vice President prior to bidding on the Agreement in late 1993 show that Kidder believed that the present value of the Agreement was between $4.34 million and $4.8 million, far above the maximum amount the City could receive. Kidder never disclosed its present value calculations to the City. Kidder agreed to be jointly responsible, along with BD-1, for soliciting bids on the Agreement. The bidding produced bids from three entities, in addition to a bid from Kidder itself. At least two of the non-Kidder bids, which ranged from $1,205,000 to $1,301,550, were rigged. In one instance, the Registered Person provided false information to a bidder as to the amounts available for reinvestment and the duration of the float periods under the Agreement, which caused that bidder to submit an artificially low bid. In a second instance, the Registered Person (known to the City only as a representative of BD-1) solicited an artificially low bid from BD-2, without disclosing the fact that he was affiliated with BD-2 or that BD-2 had a written agreement to share with Kidder in any profits either party realized on an escrow restructuring transaction with the City. [3] As a result, Kidder was the high bidder for the Agreement at $1.319 million, more than $3.0 million below what Kidder then believed the Agreement was worth. 4. Misrepresentations by Kidder and BD-1 in the Representation Letter With the bidding complete, the City awarded the Agreement to Kidder and held a closing on December 28, 1993. As part of the closing, Kidder and BD-1 each signed a letter (the "Representation Letter") which contained the following three representations, each of which was false. The first representation was that the yield to the City on the Agreement (i.e., the initial payment to the City) was at least equal to the yields offered on similar obligations under similar agreements. This representation was false because, as internal Kidder documents show, Kidder believed the actual present value of the Agreement was at least $4.34 million, or $3.0 million more than Kidder’s winning bid. The second representation was that in soliciting the bids Kidder and BD-1 had not acted with an intent to reduce the resulting yield to the City. This representation was false because the Registered Person had obtained an artificially low bid from one bidder by providing that bidder with false information and had obtained a second artificially low bid from his affiliated company, BD-2. The third representation was that Kidder and BD-1 had taken reasonable steps to obtain bids for the Agreement from at least three bidders not otherwise involved in the escrow restructuring. This representation was false because one of the bids the Registered Person obtained was from BD-2. Because it already had a profit-sharing agreement with Kidder concerning the transaction with the City, BD-2 was not a disinterested bidder. The City’s Special Tax Counsel drafted the Representation Letter and relied on each of these representations in rendering his opinion that entering into the Escrow Reinvestment Agreement would not jeopardize the tax-exempt status of the Series 1991 Bonds. **FOOTNOTES** [1]: The findings herein are made pursuant to Respondent's Offer and are not binding on anyone other than Respondent Kidder. [2]: Kidder’s relationship with the Registered Person was memorialized in a four-page agreement dated February 23, 1993. The agreement lists a number of pending escrow restructuring proposals (including the transaction with the City) and details the manner inv which the parties would share any profits arising from the transactions. The Registered Person signed the agreement on behalf of BD-2. [3]: Notwithstanding the fact that it agreed to be jointly responsible with BD-1 for the bidding process, Kidder took no part in preparing or distributing the bid solicitation forms, contacting potential bidders or reviewing the bids received. 5. Profits to Kidder and BD-1 Resulting from the Fraudulent Escrow Reinvestment Agreement The Agreement contemplated that Kidder would realize its profits over time; at the outset of each float period, Kidder would sell a security to the City in exchange for escrow proceeds, which Kidder would then reinvest for its own benefit. However, the Agreement included a second option which allowed Kidder to substitute securities for those in the escrow, and thus realize its profits sooner. In February 1994, Kidder exercised this second option, which required the City to liquidate certain federal government securities then held in the escrow. The securities at issue were those which, had the City held them to maturity in the escrow, would have produced the proceeds scheduled to be available for reinvestment during each of the seven float periods covered by the Agreement. The market value of the securities the City liquidated was $142,089,275.40. Pursuant to the terms of the Agreement, Kidder then required the City to use those proceeds to purchase from Kidder a group of securities sufficient to meet the City’s repayment obligations on its underlying tax-exempt bonds at the end of each of the seven float periods. The market value of the securities Kidder sold to the City was $137,494,667.37. The difference, approximately $4.6 million, was wired to Kidder by the City’s escrow agent pursuant to the Agreement. Kidder also realized commissions of nearly $400,000 for the trades. Thus, the gross profits on the transaction were $4,992,072.72. After deducting Kidder’s initial payment to the City and other expenses, net profits on the transaction were $3,461,724.66. Of this amount, Kidder retained $1,676,673.08 and transferred the balance, or $1,785,051.58, to BD-1. 6. Kidder’s Violations of Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder In signing the Representation Letter, Kidder made material misrepresentations of fact in connection with the sale of securities to the City, in violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The first representation was that the yield (i.e., the initial payment) to the City under the Agreement was at least equal to the yield on similar obligations under similar agreements. At the time it made this representation, Kidder knew that the present value of the Agreement was in excess of $4.34 million. Thus, Kidder knew that, absent the IRC-imposed restriction on the amount of the initial payment the City could receive, a willing buyer would have paid much more than Kidder’s winning amount of $1.319 million for the right to enter into the Agreement. Because Kidder was aware of the significant disparity between the present value of the Agreement and the amount of its winning bid, Kidder either knew or recklessly disregarded the fact that this first representation was false. The second representation was that the bids for the Agreement were not solicited with an intent to reduce the yield to the City. Kidder was reckless in making this representation because Kidder knew that its own winning bid was more than $3.0 million below what Kidder believed the Agreement was worth, and that the only reason Kidder had limited the size of its bid was to limit the yield to the City on the Agreement. The fact that Kidder relied on the Registered Person to solicit bids from other parties does not change this analysis, since any such bids were lower than Kidder’s winning bid. Similarly, Kidder was reckless in disregarding the falsity of the third representation--that Kidder and BD-1 had taken reasonable steps to obtain bids from at least three bidders not otherwise involved in the escrow restructuring. Had Kidder conducted even a minimal inquiry, it would have learned that one of the bids was from BD-2, with which Kidder already had an agreement to share profits from any escrow restructuring agreement with the City. Under these circumstances, Kidder was reckless in falsely representing that it had obtained bids from at least three bidders not otherwise involved in the escrow restructuring. IV. On the basis of this Order and the Offer submitted by Respondent, the Commission finds that Kidder violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. V. Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that Kidder: (1) cease and desist from committing or causing any violation and any future violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; (2) disgorge, within 30 days after the date of issuance of the Commission’s Order, an amount equal to Kidder’s wrongful profits of $1,676,673.08 plus prejudgment interest, computed and payable as follows: (a) if paid by Kidder on or before March 31, 1999, a total amount of $2,466,657.34; (b) if paid by Kidder after March 31, 1999, the amount of $2,466,657.34 plus interest to be accrued at an annual rate of 7.62%, compounded daily beginning April 1, 1999; and (3) make the monetary payment called for in the Order by United States postal money order, certified check, bank cashier’s check, or bank money order payable to the United States Treasury. Such payment shall be sent by certified mail to: Mr. Charles Anderson, Group Manager- Tax Exempt Bond Group, Southeast Key District Office (EP/EO), Department of the Treasury, Internal Revenue Service, 31 Hopkins Plaza, Room 1420, Baltimore, MD 21201, with a cover letter that identifies the payment as relating to the City of Tampa, Florida Utilities Tax and Special Revenue Refunding Bonds, Series 1991, and also identifies Kidder as the Respondent in the public proceeding instituted by the Order. A copy of the cover letter and the payment instrument shall simultaneously be sent to David B. Bayless, District Administrator, San Francisco District Office, Street, Suite 1100, San Francisco, California 94104. By the Commission. Jonathan G. Katz Secretary