Brokers probed for entertaining rating firms

By Joseph A. Giannone

NEW YORK (Reuters) - Municipal bond underwriters are under investigation by the Financial Industry Regulatory Authority to see if firms are funding lavish entertainment for rating agency executives as well as public officials from towns and cities, FINRA Chief Executive Richard Ketchum said Monday.

"We have seen examples of excessive expenses for the entertainment of issuer officials and rating agency officials, which are then charged to the municipalities' cost of issuance, thereby reimbursing the firm out of bond proceeds," he said at FINRA's annual fixed-income conference in New York.

The Securities and Exchange Commission in 2009 settled two cases, he noted, against firms that flew issuer officials to New York for a holiday of Broadway shows, sporting events and expensive meals.

FINRA's investigation has extended to other firms, he said. It is part of a broader effort by Wall Street's self-policing force to ensure new issue pricing practices and fees in the $2.8 trillion muni market are fair.

Entertaining rating agency officials -- Ketchum did not identify the underwriters or the agencies -- appears to represent efforts to influence the rating of the securities, he said.

The investigation has also turned up payments to political action committees as a line-item in new bond underwriting expense, as well as false representations of payments made municipalities to dealers and others for services never performed, he said.

"These issues raise serious noncompliance issues and a breach of ethics that we are continuing to investigate," he said.

Officials from the two largest credit rating agencies, Standard & Poor's and Moody's Investors Service, were not immediately available for comment.

FINRA's focus on underwriting expenses follows a move by California's treasurer on February 1 to bar underwriters from using bond proceeds to pay fees to their lobbying group, the Securities Industry and Financial Markets Association.

In December, the Municipal Securities Rulemaking Board (MSRB) said it was considering extending "pay to play" rules to municipal advisers. The MSRB also asked to SEC to approve new rules that would force Wall Street firms to disclose their membership and contributions to PACs.

Regulators for years have worked to bring to fixed income markets more of the openness and price visibility found in the stock market.

FINRA, Ketchum said on Monday, is looking to apply to fixed-income research analysts the same kinds of conflict-of-interest rules in place among equity analysts. Brokerages and their advisers, he continued, need to be sure that customers understand the risks of their debt investments.

Ketchum said surging high-yield bond markets are also an area of greater focus. With issuance and fund flows soaring to new highs, Ketchum said some investors may not fully understand the credit and interest-rate risks they face.

Munis are another top priority, as regulators look to ensure Wall Street firms are meeting sales practice and due diligence obligations.

FINRA announced on Monday it had fined SWS Group Inc's Southwest Securities unit $500,000 for paying former Texas municipal officials and others to solicit underwriting assignments.

The Dallas-based brokerage from October 2006 through April 2009 paid five individuals, including three former Texas municipal officials, to solicit underwriting business on its behalf. Southwest paid the consultants more than $200,000 for the services, FINRA said.

These payments violated MSRB prohibitions against such activity "and threatened to compromise the integrity of the municipal securities market," Brad Bennett, FINRA's enforcement chief, said in a statement.

Southwest neither admitted nor denied the charges.

(Reporting by Joseph A. Giannone, editing by Maureen Bavdek and Matthew Lewis)