SEC wins case against Rochester MAs over conflicts of interest disclosure

A federal judge in the Western District of New York has ruled in favor of the Securities and Exchange Commission in its case against the City of Rochester, New York’s municipal advisors, whom the SEC accused of failing to disclose conflicts of interest inherent in their contingent fee agreements with the City.

“One of the key things here is the court is not saying in any way, shape or form that contingency fee arrangements are unacceptable, illegal or anything else,” Richard Tortora said in an interview with The Bond Buyer. “But the mere existence of a contingency fee agreement in and of itself creates a material conflict of interest that must be disclosed.”

The original complaint, issued in June 2022, argued that the City of Rochester, its former finance director Rosiland Brooks-Harris, former Rochester City School District chief financial officer Everton Sewell misled investors in a $119 million bond offering by providing outdated financials on the bond offering documents and “did not indicate that the [Rochester City School District] was experiencing financial distress due to overspending on teacher salaries,” the complaint said.

Former chief financial officer for the school district Everton Sewell was allegedly aware that the district was facing a $25 million budget shortfall and misled a credit rating agency on the magnitude of that shortfall. Sewell settled charges with the Commission, agreeing to an industry bar and a $25,000 fine.

The MAs, co-principals Richard Tortora and Richard Ganci of Capital Markets Advisors were accused of failing to disclose conflicts of interest to nearly 200 municipal clients arising out of its contingent fee agreements and for violating MSRB Rule G-42 on standards of conduct.

“We misinterpreted the statute, we acknowledge that, now our intention is to make sure the clients get the disclosure that the SEC feels that they need and we move on,” Tortora said. Following the ruling this week the firm immediately sent a notice to its many hundreds of clients.

Contingent fee arrangements are widespread throughout the muni market but guidance from the MSRB on compliance with Rule G-42 on standards of conduct in addition to industry guidance state how it can create perverse incentives for MAs. Chief Judge Elizabeth Wolford leans on SIFMA’s to illustrate the matter.

“While this form of compensation is customary in the municipal securities market, this may present a conflict because it could create an incentive for Municipal Advisor to recommend unnecessary financings or financings that are disadvantageous to Client or to advise to Client to increase the size of the issue,” the SIFMA guidance said. Wolford in her ruling left it unambiguous as to what MAs should do.

“The language is susceptible to but one meaning: conflicts of interest arising from contingency fee arrangements based on the size or closing of the transaction are material conflicts of interest subject to mandatory disclosure,” the ruling said.

But to CMA the matter was not so clear. Following the unexpected death of their in-house compliance consultant in 2018, the firm brought in a compliance expert and she instructed the firm to publish a notice regarding conflicts of interest. The firm assumed that would be sufficient disclosure but after receiving notice that the SEC was looking into the Rochester deal in 2022, they hired an SEC attorney which helped them put specific language in all of their contracts.

It’s unclear whether the Commission believed that language sufficed or not. “I think it was more of a too little too late kind of thing,” Tortora said.

Rule G-42 lists occasions that would be classified as material conflicts of interest, including “any conflicts of interest arising from compensation for municipal advisory activities to be performed that is contingent on the size or closing of any transaction as to which the municipal advisor is providing advice,” the rule said. 

The Court then ruled that the plain language outlined in the rule was unambiguous and that CMA’s argument that subpart (E) of MSRB Rule G-42 does not state that all contingent fee arrangements create a material conflict of interest was unsupported.

“A fee arrangement contingent on the amount of the bond need only disclose the potential conflict arising out of that arrangement without unnecessarily suggesting that a conflict arises from any other non-contingent aspect of the fee arrangement,” the ruling said. “Likewise, a fee arrangement contingent solely on the deal closing need only disclose the potential conflict arising out of that arrangement.”

In establishing the provisions of the Rule G-42 as part of its usual request for comment process, many commenters noted the conflict of interest disclosure related to contingent fee arrangements “would serve no useful purpose and could confuse clients,” but the MSRB dug in its heels on the provision.

“While the MSRB recognizes, as some commenters pointed out, that other fee arrangements (such as hourly, fixed or otherwise non-contingent) might also give rise to conflicts, the MSRB believes that the potential harm to a client might be particularly acute if a client is not informed of a conflict of interest arising from a contingent fee arrangement,” the MSRB wrote in connection with Rule G-42, adding that MAs have the opportunity to provide additional context as to what exactly this means.

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