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Possibly Fraudulent Municipal Bond Issues Could Hurt Investors

July 10, 1987

NEW YORK (AP) _ A federal probe into billions of dollars worth of possibly fraudulent municipal bonds could lead to annulment of their tax-free status and may seriously hurt thousands of investors, credit market analysts say.

Deepening inquiries by the Securities and Exchange Commission and Internal Revenue Service are said to be focusing on up to 100 municipal bond offerings totaling as much as $12 billion to determine if they were sold in compliance with laws on bond transactions and tax-free securities.

Analysts said that if the IRS decides interest on the bonds is taxable it could have a profound impact on the largely unregulated municipal bond market, which has doubled in size over the past few years and is a fundamental vehicle for local governments to raise money for bridges, roads, schools and sewers.

″It would create a big problem for bond holders if such an IRS decision were retroactive,″ James Spiotto, a municipal bond specialist at the Chicago investment firm of Chapman and Cutler, said Thursday. ″They would have some horrendous tax problems if they had to figure out what they owed.″

The House Energy and Commerce oversight subcommittee has asked the SEC for information about its investigation, said Peter Stockton, a legislative aide to the committee in Washington.

″When you start talking about $12 billion worth of deals, it is certainly a major event,″ said Christopher Taylor, executive director of the Municipal Securities Rule-Making Board, a Washington-based self-regulator y group funded by municipal bond underwriters. ″You don’t launch a probe like this without some strong feelings that something’s wrong.″

Credit market sources who spoke with the understanding they not be identified said that in some cases under investigation, underwriters may have sold tax-free bonds on behalf of municipalities for unrealistic projects and channeled the proceeds into more lucrative investments, such as stocks or bonds with higher yields.

This would enable the bond underwriters to pay the interest to bond holders and still collect huge profits, some of which would go to the municipalities as compensation, the sources said.

In other instances under investigation, the sources said, some firms may have conducted invalid sales of tax-free bonds last year to avoid deadlines for stringent controls on such transactions contained in the new tax law.

At least one bondholder class-action lawsuit has been filed against an underwriter in connection with one bond issue under investigation, a $335 million offering to finance a trash disposal plant in Chester, Pa. that may never be built.

″We did some digging and concluded the Chester bond offering was a sham,″ said Richard D. Greenfield, a Pennsylvania attorney who represents 12 disgruntled bondholders.

″From the point of view of people who bought these bonds, it’s a fraud if they thought they were buying tax free bonds for legitimate public works projects and later discover the bonds aren’t tax free,″ he said.

Chiles Larson, an SEC spokesman in Washington, said the agency would not confirm or deny it was conducting an investigation. IRS spokesman Steven Pyrek also declined to comment.

A focus of federal scrutiny is said to be Matthews & Wright Inc., a small but aggressive Wall Street firm that underwrote the Chester bond offering.

Matthews & Wright also has underwritten issues ranging from a $474 million apartment project in East St. Louis, Ill., to a $125 million industrial park for Oklahoma’s Sac and Fox Indians. Those projects are now jeopardized because of government investigations that may determine the bonds aren’t tax exempt.

George Benoit, Matthews & Wright chairman, said in a statement issued late Thursday the firm has done nothing wrong and he repeated earlier assertions.

″Information reported in several newspapers makes it clear that the type of financing for which Matthews & Wright has been severely criticized has been broadly utilized by issuers and underwriters as a legitimate technique to cope with the deadlines imposed by changes in federal tax laws,″ he said.

Press reports have identified the firms Donaldson, Lufkin & Jenrette Securities Corp. of New York and Miller & Schroder Financial Inc. of Minneapolis as other subjects of the federal probe.

Catherine Conroy, spokeswoman for Donaldson, Lufkin & Jenrette, confirmed the SEC had requested information about several bond issues written in the fall of 1985. She said the firm complied and that ″we have no cause for concern and have no reason to believe we have any problems with any of our underwritings.″

Paul Ekholm, senior vice president for Miller & Schroeder, said the firm had not been contacted by any federal agency and that ″we feel very comfortable about our underwritings.″

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