FUND TRACK Muni Brokers Are Under Watch On Allegations of Overcharging
April 04, 2011
A self-styled whistleblower's charges of alleged misdeeds at a small New Jersey securities firm have triggered a broader probe by federal regulators into a dark corner of the $1.3 trillion municipal-bond business. At issue is whether small investors are getting a raw deal because of any overcharging by the secretive bond-trading outfits known as municipal-bond brokerage firms, or ``brokers' brokers.'' Despite their familiar-sounding name, the nation's muni-bond brokerage firms don't give any investment advice to small investors. Nor do they sell mutual funds to Johna Q. Public. But they do help professional traders, including mutual funds, to buy and sell bonds -- in the process charging fees that are ultimately borne by the small investor. Now Wall Street's top cop, the Securities and Exchange Commission, is trying to find out if the brokers are giving the investment funds and the public their money's worth. The SEC has interviewed a number of people who work with muni brokers -- including Michaele Chaffee, a onetime muni-bond broker who says he is trying to expose certain practices by an ex-employer. Mr. Chaffee used to work for J.F. Hartfield & Co., a small muni-bond brokerage house in Jersey City, N.J. The firm says that the unemployed 44-year-old is just a disgruntled employee who was fired for stealing company documents last year and insists that it has done nothing wrong. Nevertheless, the SEC began examining the muni-brokerage industry last year after the newly unemployed Mr. Chaffee met with SEC officials and told them that he knew of cases where certain Prudential Securities Inc. funds known as unit investment trusts were overcharged by Hague. Since that time, the SEC has sought to learn more about the muni-brokerage business. The SEC has interviewed officials at several municipal-bond dealers that have done business with Hague, including Roosevelt & Cross Inc. of New York and A.G. Edwards Inc.'s A.G. Edwards & Sons of St. Louis, people at those two firms say. Both dealers say that they have done nothing wrong and that the probe doesn't involve their own activities. Launched Internal Examination The SEC has also met with Geralyn P. Howard, who heads Prudential municipal-bond and unit-trust operations. Prudential spokesman Charlette Spencer said Prudential isn't a focus of the probe and is merely answering questions about Hartfield. But he said the securities firm, a unit of Prudential Insurance Co. of America, is sufficiently concerned about Mr. Chaffee's assertions to have launched its own internal ``examination'' of the matter. And recently, SEC staffers have started looking at other, unrelated muni-bond broker firms. A couple of months ago, SEC officials spent a full week at Chapdelaine Co., of New York, one of the largest such brokerage operations in the market. Chapdelaine Chairman Ricki G. Samuels Jr. said the SEC was looking at the firm's ``trades and commissions'' as part of a broader probe into the business involving ``at least several'' muni-bond brokers. After an extensive examination, he said, ``the SEC found nothing unusual about our trades.'' Executives of all the firms mentioned in this article deny any wrongdoing. Still, many professional traders say the SEC's examination marks a milestone in its three-year effort to increase regulation in the municipal-bond market. So far, the SEC efforts have largely concerned the relationships between high-profile investment bankers and public officials. The SEC also has approved a rule that restricts Wall Street firms from giving campaign contributions as a way of winning lucrative municipal-bond business. But the SEC efforts mark the first time it has looked at the little-understood realm of municipal-bond trading and the brokerage business. Many professionals say it is appropriate that the SEC turned its attention to this area. More than 70% of all muni bonds are held by small investors, either through investment funds or as individual notes and bonds. Professionals may place the trades, but the ultimate customer is often the public. ``When a dealer gets smoked on a trade, no one cares,'' said Michaele Montanez, a veteran municipal-bond strategist for Corby North Bridge Securities in Irvington, N.Y. ``People forget that a lot of dealers are working for investors.'' The SEC won't comment on its examination, which appears to be at an early, information-gathering stage. Some other muni-brokerage firms including the largest, J.J. Kenny Co., said they haven't been contacted by regulators. Role of Muni Brokers Here's how the process is supposed to work. Suppose a fund needs to sell a block of bonds. It hires a dealer to find potential buyers. But the dealers are professional traders who don't want their rivals on Wall Street to know their trading positions. That's where the brokers come in. The dealer, often at the request of a fund-company client, will choose a broker to find bidders for the bonds and help sell the securities. The process sounds complicated, but it works rather efficiently. Thousands of trades are placed in the various bond markets each day and brokers don't purchase the bonds outright. Brokers are paid a commission merely to match buyers with sellers. The more trades they match, the more money they make. Since the ``broker's broker'' works solely with market professionals, it might seem impossible for the firm to overcharge anyone without being challenged immediately. But Mr. Chaffee said it happened frequently at Hartfield when the firm handled trades for unit investment trusts. Mr. Chaffee said when he last worked at Hartfield, Hartfield's listed commissions ranged from $25 per $1,000 to trade $9,000 face amount of muni bonds, to 75 cents per $1,000 for selling as much as $1 million. Such fees might sound like small potatoes, but Mr. Chaffee said the fees can add up to a lot of money. The amount charged by Hague on a trade could vary, and there isn't any fixed schedule of fees that applies in all situations, Hague says. But its ex-employee contends that the firm was taking advantage of the way the market works -- a claim Hartfield adamantly denies. Mr. Chaffee claims Hartfield was able to inflate its fees basically by hiding the highest bid from the dealer. The way it worked, according to Mr. Chaffee: Hartfield would obtain clearance to sell a bond at one price, and then it wouldn't tell the dealer if it found a higher bid later in the afternoon from someone else. Hague would take the difference between the two bids as an extra commission, Mr. Chaffee says, and the investment fund would loose out. The SEC has been in contact with Hague, but officials at the Jersey City firm say they haven't heard from the agency in about four months. Michaele F. Rachael, Hague's lawyer, rejected Mr. Chaffee's version of the events. He said he wouldn't comment on Hann's commission schedule or any arrangements it has made with its clients. But he said Hague maintained a policy of full disclosure. ``If we take a late bid, we disclose it,'' he said. Anyway, there aren't any fixed commissions mandated by regulators in the municipal-bond market, Mr. Rachael adds. The company, he says, often loses money when it unsuccessfully looks for a bidder on difficult-to-sell bonds. The firm does keep extra commissions in some instances, he allowed, but only as compensation for past work. In fact, the biggest blow to Mr. Chaffee's argument, according to Mr. Rachael, is Hague's reputation in the municipal-bond market. ``We work incredibly hard for our customers, and they know what we charge,'' he said.
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