The discovery this week that Lazard Freres & Co. had a private contract with Merrill Lynch & Co. to split fees on several swaps transactions has opened up a new avenue in the ongoing debate about inter-company relations in the municipal industry.
Officials involved in the arrangement this week confirmed the existence of the contract, which involved the sharing of about $6 million in fees on seven swaps in Massachusetts, after it was reported Monday in The Boston Globe.
Several market sources said financial advisers like Lazard who engage in private fee-splitting arrangements with underwriters reflect poorly on the industry. Such arrangements suggest the potential for unseemly backscratching and back-room deals - exactly the issues now being raised in federal and state-level investigations across the country, the sources said.
Several issuers, including Lazard's own clients, said, however, that it seemed perfectly natural that their financial adviser would have private business dealings with other companies, even companies to which Lazard could later offer lucrative underwriting positions through its position as a financial adviser on other deals.
Still, the disclosure of the contract, which has been the focus of market rumors for at least a year, has raised eyebrows among regulators and market professionals.
Richard Roberts, a commissioner at the Securities and Exchange Commission, said he believes relationships like the one between Merrill and Lazard should be the subject of more stringent disclosure requirements.
"I think a strong argument can be made for additional rules on disclosure based on some of these practices that seem to be prevalent," Roberts said. "In my last speech, I said that the rules would have to encompass more than just campaign contributions. They need to reach further."
Lazard issued a statement yesterday stressing that all relevant disclosure requirements were met, and no laws were broken or industry standards violated by the company's contract with Merrill Lynch.
The company said Mark Ferber, a former partner who was Lazard's point man on the contract, disclosed his relationship with Merrill to all the issuers involved.
In addition, "Lazard believes its former partner delivered fair value to Merrill on the transactions in which he shared fees and also provided first-rate services to the issuers for whom he worked, achieving millions of dollars in interest payment savings for them," the statement said.
A spokesman for Merrill Lynch said there was never anything surreptitious about the relationship, which he said was formed to expand the market for derivatives.
"In 1989, Merrill Lynch and Lazard did enter into a relationship for the purpose of increasing the market's understanding of derivatives, interest rate swaps, and other municipal transactions," the spokesman said. The arrangement was "proper and legal in every respect," and resulted in substantial savings for issuers. he said.
But several market sources said they had never before heard of a formal contract between an underwriter and a financial adviser on sharing swap fees. They said the contract raises questions about Lazard's ability to provide unbiased swaps advice to other clients, even if the fee-sharing arrangement did not apply to the client's specific deals.
Appearance of Conflict
Most market professionals interviewed for this article said they had never considered such a contract because it would create the appearance of a conflict of interest. "If you're entering into a business relationship with a person in a position to select underwriters, it just sort of smells bad," one municipal market professional said, explaining why his firm has never had such a relationship.
"I've never seen anything this blatant as far as an agreement from someone who's in a position as a financial adviser to steer business," another company executive said.
Other market professionals said they were disturbed by the potential for abuse inherent in private arrangements between firms, especially if issuers do not understand who is profiting from their bond sales or precisely why a financial adviser recommends one underwriter over another.
The National Association of Independent Public Finance Advisors, for example, has written by-laws that would prohibit members from splitting fees. Lazard is not a member of the financial advisers' trade group.
A spokesman for the organization said members are only allowed to accept fees from state or local government officials because taking money from companies could appear to compromise the firm's independence and objectivity.
But one market source familiar with the contract said he did not think it was fair to single out Merrill Lynch and Lazard for their private relationship, especially if it was properly disclosed to the issuers involved. The source said that several of the top ten underwriters of municipal bonds frequently act as financial advisers on other deals. That arrangement, he said, is at least as suspect as the Merrill Lynch contract with Lazard.
"These transactions and relationships' are appropriate when comprehensive disclosure is made to the clients involved and the clients have determined the responsibilities of the financial adviser will not be consequently impaired," the source said.
Boston officials whose swaps were involved in the fee-splitting arrangement said Lazard did disclose its contract with Merrill Lynch. They said they did not see it as a conflict of interest or believe it hurt Boston's deals.
In fact, Lee Jackson, Boston's treasurer, said he felt he had received the best possible terms on the city's swap with Merrill. He said Boston realized a $6.3 million savings through the swap, arranged by Boston's financial adviser, Government Finance Associates.
"We were advised by Government Finance Associates to seek the swap, and Merrill came to us with a proposal," Jackson said. "What Merrill and Lazard did after that does not affect the city."
Although Ferber, formerly of Lazard, has strong political ties to city officials in Boston, Jackson said those ties did not affect the city's bond deal. "I never had any conversation with Mark or anyone else at Lazard about using Merrill for the swap," he said.
The Boston Globe, which referred to Ferber as "the unchallenged master of the universe of municipal finance," said the former Lazard banker was approached by Merrill Lynch with the proposal for a fee-splitting contract shortly after officials at the Massachusetts Water Resources Authority picked Merrill to be an MWRA underwriter in 1989.
Ferber declined to comment.
Some of the issuers who used Lazard as a financial adviser while executing swaps through Merrill Lynch said they also did not see the contract as a conflict as long as it was managed properly.
For example, officials at the MWRA, one of Lazard's major clients during the period the contract with Merrill was in effect, said they knew about the arrangement, so they insisted Lazard not participate in the structuring of the agency's swaps deals.
Presented No Problem
Philip Shapiro, chief financial officer for the authority, said he was told of the relationship when officials at both Lazard and Merrill Lynch asked him if the authority would have a problem with the two firms working together on a Boston Water and Sewer bond sale. He said he did not see the work as a conflict with Lazard's role as financial adviser.
"When we decided to use variable-rate debt, we met with Merrill Lynch on the different kinds of swaps," Shapiro said. "But because of the relationship between Merrill and Lazard, I decided we should learn what we could on swaps apart from Lazard Freres."
Shapiro said that he, authority treasurer Kenneth Wisman, and other authority executives met with officials at Merrill Lynch. No employees of Lazard were present.
"We wanted to be experts in our own right," he said.
Shapiro said the only time he ever discussed swaps with his financial adviser was after the board decided to use Merrill Lynch for the swap transaction.
"Lazard provided us with information on how we should approach the rating agencies and confirmed that we could enter into a swap arrangement and still keep our books balanced," he said.
The fee-splitting agreement did not apply to deals on which Lazard acted as a financial adviser, because that would clearly violate the industry requirement that financial advisers provide an issuer with unbiased advice about potential business relationships, according to sources familiar with the contract.
Some of Lazard's financial advisory clients, including Washington D.C. and the MWRA, did execute swaps with Merrill Lynch during the life of the two-year contract. Officials familiar with the contract said no swap fees were split on those deals.
Merrill Lynch was also named an underwriter on numerous deals not covered by the contract for which Lazard was the financial adviser.
Massachusetts Inspector General Robert A. Cerasoli in a February letter asked MWRA officials to provide all written documentation dealing with Lazard Freres and its financial advisory services as part of a review of the authority's decision to switch its business to First Albany Corp.
This week, Cerasoli complained that no documentation detailing Lazard's relationship to Merrill Lynch was included in the authority's response. But Shapiro said that that was because there were no documents. He said Lazard officials notified him of the contract verbally.
The former executive director of the authority, Paul Levy, said that by the time the authority sat down with Lazard to assess the possibility of doing a swap, "both Phil [Shapiro] and Ken [Wisman] could have handled it without any help."
Levy said that neither Ferber nor Lazard was involved in choosing the senior, co-senior, or syndicate members for the authority.
"That was not their job," he said. "The financial adviser was there to structure the deal and help us with the timing of sales."
He said reports in The Boston Globe that he wrote a 1990 memo saying Lazard had recommended Merrill for the authority's swap are inaccurate.
A Merrill spokesman said the contract with Lazard was terminated at the end of 1992, when Ferber left Lazard for First Albany. He said Merrill now has the same kind of relationship with First Albany, but does not have a formal contract.