Nov. 2 (Bloomberg) -- At the end of a March 6, 2000, conference call with the financial adviser David Rubin, city of Atlanta officials disqualified the winning bid for a $453.3 million investment-management contract.

The decision shaved $58,000 off what Atlanta taxpayers would have earned from the $13.5 million high bid and awarded the account to runner-up Bank of America Corp., according to a copy of city documents obtained under the Georgia Records Act.

Only after the Internal Revenue Service investigated five years later did local officials learn that Rubin’s firm, CDR Financial Products Inc., had entered into a secret side agreement with the Charlotte, North Carolina-based bank. CDR’s share would be worth as much as $340,000, based on city and federal records.

“IRS believes that CDR, Bank of America and possibly others may have colluded to fix pricing,” an unidentified Atlanta employee wrote in an undated internal memorandum after city authorities met with IRS investigators in September 2005.

Rubin, two co-workers and CDR were charged on Oct. 29 in a nine-count indictment that alleges conspiracy, wire fraud and obstructing federal tax authorities. The indictment in U.S. District Court in the Southern District of New York, which doesn’t cite the Atlanta transaction or any others by name, accuses Rubin and CDR of conducting sham auctions and reaping kickbacks from 1998 to 2006.

Rubin, 47, grew up working in his parents’ Los Angeles dress shop and built a nationwide business profiting from allegedly illegal transactions with schools, towns and utilities. His story shows the costs of financing in the dark.

Diverting Millions

CDR-sponsored transactions from California to Florida diverted millions of dollars from local governments and the U.S. Treasury to banks and advisers, including more than $3 million in Fargo, North Dakota, alone, government records show. The firm is also alleged to have taken “kickbacks” of as much as $475,000 for brokering investment-management contracts, according to the criminal indictment. Bloomberg News obtained documents related to state and federal investigations in response to 30 public records requests and conducted more than 100 interviews.

In a $2.8 trillion municipal bond market that more than doubled in just over a decade, public corruption, officials’ mistakes and lack of disclosure cost taxpayers as much as $6 billion a year, according to data compiled by Bloomberg.

Need for Transparency

The kinds of fraudulent practices that Rubin and his Los Angeles-based firm are accused of by federal prosecutors and the IRS help transfer to private hands some of the $36 billion-a- year tax benefit the U.S. Treasury confers on state and local governments and non-profit agencies when they borrow. That money could be used for roads, school books and fire trucks during the worst recession since the Great Depression.

“We need a worldview change about transparency and that includes municipal finance,” said Elizabeth Warren, chairwoman of the Congressional Oversight Panel for the Troubled Asset Relief Program, in an interview with Bloomberg last month.

The indictment alleges that Rubin and two of his employees orchestrated artificially low winning bids and “intentionally losing bids.” They face five to 20 years in prison if convicted, and CDR could be fined more than $100 million.

The criminal charges against CDR’s founder and co- defendants Zevi “Stewart” Wolmark, a former managing director and chief financial officer of the firm, and Evan Zarefsky, a vice president, are the first filed in the federal government’s three-year investigation of the municipal bond market.

Rubin’s Defense

“This represents another in a long line of recent examples in which taxpayers end up the losers. It also reiterates the need for greater due diligence in investments and more vigorous oversight,” said Eleanor Bloxham, founder of the Value Alliance, a governance advisory firm in Columbus, Ohio.

Rubin had no comment when reached by phone last week.

“We believe the indictment has no merit,” said Donald Etra, Rubin’s defense attorney and a former assistant U.S. attorney in Los Angeles. “We will vigorously defend the charges. David is a brilliant businessman and a well-known philanthropist. The bottom line is that David Rubin did nothing wrong.” Wolmark and Zarefsky also are contesting the charges.

Bank of America, which is not named in the indictment, entered a Justice Department amnesty program in January 2007 that grants it leniency in exchange for aiding prosecutors. Bank spokeswoman Shirley Norton said the financial institution helped federal investigators in their probe of the Atlanta contract and other transactions and terminated several employees involved.

“We cooperated fully and continue to cooperate with the industrywide derivatives investigations,” Norton said. The IRS and Justice Department declined to comment.

Municipal Derivatives

Since CDR’s founding almost a quarter-century ago, Rubin has specialized in municipal derivatives, an umbrella term that covers a variety of tax-exempt instruments that governments use to invest their bond proceeds while they wait to spend the money for its intended purpose. Derivatives include options tied to government securities prices and swaps on interest rates.

Public officials turn to unregulated financial middlemen such as Rubin to obtain the best returns on their investments while staying within limits set by federal law. Sometimes CDR brokered local governments’ investment-management contracts. At other times, the firm worked with banks and insurers to structure the investments.

Rubin’s firm helped municipal authorities borrow, hedge and invest more than $60 billion on 4,000 transactions, according to CDR’s Web site. The complex derivatives often outstripped local officials’ ability to control, or even see, where public money went.

‘High-Powered Magnification’

“You have to pull out some pretty high-powered magnification equipment, and then you have to spend a couple of nights stewing over it, before you realize the whole thing,” said Frank Hoadley, capital finance director in Wisconsin’s Department of Administration. After CDR brokered an investment- management contract for the state in 1993, Hoadley investigated the transaction and insisted that it be unwound.

Five municipal governments led by Fairfax County, Virginia, are pursuing a civil conspiracy lawsuit parallel to the federal investigation. The complaint names CDR and Bank of America among 36 banks, insurers and advisers as defendants.

The alleged collusion “makes a three-ring circus look small,” Michael Hausfeld, the lead plaintiff’s attorney, said in an interview. Hausfeld, who specializes in antitrust cases, said it is “one of the most complex webs that I’ve ever seen.”

Jefferson County Swaps

Another federal criminal probe of Rubin and CDR in Albuquerque, New Mexico, ended in August without indictments. Investigators there were examining whether Rubin’s financial contributions from 2003 to 2005 to the state’s governor, Bill Richardson, a Democrat, played any role in the firm’s being awarded $1.5 million of state work.

CDR also advised Jefferson County, Alabama, on interest- rate swaps that pushed the county close to bankruptcy and were at the center of Birmingham Mayor Larry Langford’s bribery conviction Oct. 28. CDR, which wasn’t a defendant in the case, arranged nine interest-rate swaps with a notional value of $4.3 billion for Jefferson County between March 28, 2003, and June 10, 2004, when Langford was president of a five-member governing board. Rather than save money, the county paid $748 million to terminate them in March, according to county records.

The state and federal regulatory net leaves gaps in the municipal marketplace. While the IRS seeks to ensure that tax- exempt issuers spend their borrowings for the public’s benefit, its power is largely limited by federal law to enforcing compliance of federal code by bond issuers and taxing investors.

Cease and Desist

The Municipal Securities Rulemaking Board, a self- regulatory organization based in Alexandria, Virginia, establishes professional standards for the banks and securities dealers that capitalize the municipal bond market, with no enforcement power or oversight of independent advisers.

While the Securities and Exchange Commission has civil authority to enforce federal fraud statutes, derivatives contracts are “largely excluded from the securities regulatory framework,” SEC Chairman Mary L. Schapiro told Congress in July.

CDR never updated its SEC disclosure information to reflect a 2007 cease-and-desist order from the agency though the firm is subject to commission enforcement as a registered investment adviser. The order prohibits CDR from making material misrepresentations, as the SEC alleged it did on $650 million of tax-exempt bonds issued in Florida in 1999 and 2000. CDR helped structure the investments while receiving undisclosed fees, according to the agency finding. CDR agreed to the order without admitting wrongdoing.

Paychecks, Brassieres

Rubin grew up in L.A.’s Fairfax district and worked in his parents’ clothing store, Bella’s Fashions, he told Bloomberg News in 2006. He moved from helping women pick apparel to leading financial seminars for them, he said.

“I said, ‘You know, you’re giving me your paychecks and you’re having me close up your brassieres. Let’s do something with your money,” he said in the interview.

At 23, Rubin was named president of Allrich, Alexander & Co., a Los Angeles insurance brokerage, he said. There, he popularized a financial instrument known as the guaranteed investment contract. GICs are fixed-rate, fixed-maturity contracts. They help municipal authorities stay within earnings limits established by Congress to keep them from leveraging their federal tax exemption to profit on their debt.

“It was a way for the municipalities to earn a yield safely,” said Bob Affronti, the president of FSD Financial Services in Tarzana, California, in an interview. Affronti said he met Rubin in 1985 and helped him underwrite some of the first GICs.

Chambers, Dunhill, Rubin

Rubin quit Allrich, Alexander in January 1986 to form his own firm, Chambers, Dunhill, Rubin & Co., known now as CDR. There was no Chambers or Dunhill, he just liked the sound of the names, he said in the 2006 interview.

Just as the business was getting under way, Allrich Alexander accused him of writing 20 unauthorized checks on a company account and using its funds to pay “kickbacks” on a sales commission he said was owed to him, according to four interrelated lawsuits filed in Los Angeles Superior court against Rubin in 1987. The allegation stemmed from $84,000 Rubin paid by company check and wire transfer to two firms that were the source of the $105,429 commission, according to the lawsuits.

Allrich Alexander also accused Rubin of taking fraudulent reimbursement for credit-card charges, a tuxedo and a $1,738 car phone. Rubin argued in court declaration that as the insurer’s chief executive he was authorized to make the expenditures, which he described as standard expenses and compensation. The litigation settled privately.

A Young Success

As he built CDR, Rubin amassed a personal fortune and moved into a $5 million house in the Hancock Park neighborhood of Los Angeles with his wife and seven children. He became a steady contributor to Democratic politics and served 2 ½ years as a commissioner on a city housing authority, public records show.

“You very rarely find the person who will say ‘I don’t like him, he’s a bad guy,’” said Marc Gelman, a friend and former business partner. “You might find people who are jealous of his success because he was successful at a very young age.”

Gelman told the Oceanside, California, Housing Commission in February 2008 the two men’s combined net worth was “well in excess of $100 million,” according to a city recording of the meeting obtained under the state public records act request.

One of CDR’s first controversies arose in Wisconsin. In November 1993, Rubin’s firm auctioned a $136.6 million state investment-management contract that Lehman Brothers Holdings Inc. won by offering Wisconsin $741,500, according to a copy of the bid sheets.

Financial Detective Work

Lehman awarded CDR $150,000 for brokering the agreement. It was standard practice for the winning bidder to pay the cost of the auction. Rubin’s firm then negotiated an 84 percent reduction in the bank’s payment to Wisconsin without telling state officials, according to deal records and correspondence obtained under the public records act in that state. As a result, CDR’s compensation exceeded the $119,000 Wisconsin earned on the investment, deal records show.

Officials might never have known if not for the detective work of another financial analyst. Jamie Dlugosch was going over a printout of the state’s account in late March 1995 when he said he found that someone had changed the date when $22.2 million of government bonds were scheduled to roll into lower- yielding securities. The investments had to be scaled back to stay within federal earnings limits, state records show.

Changed Date

At the time, Dlugosch was trying to help his father, James Dlugosch, then a principal at Minneapolis-based bank Miller & Schroeder Financial Inc., win Wisconsin’s business.

The date switch to March 26, 2009, from May 15, 2007, was worth as much as $2 million to Lehman, about six times more than the IRS allowed, state officials discovered.

“We felt there was an opportunity for the state to recoup those excess fees,” Jamie Dlugosch said in an interview.

Excessive markups on investments that are purchased with tax-exempt bond proceeds are illegal and known as “yield burning.” That’s because the practice may give the appearance that a local government’s returns comply with federal limits.

“We had a hot potato,” said Hoadley, the state official.

He wrote to his supervisor on Sept. 6, 1995, that he suspected “fraud or deception on the part of Lehman and/or Chambers, Dunhill & Rubin and/or” Dain Bosworth Inc., a brokerage based in Minneapolis that had hired CDR to solicit the bids. Hoadley never said who he suspected changed the date.

After investigating, he asked Lehman to unwind the deal. The bank asked for $873,000 before accepting the $119,000 it originally paid, state records show. New York-based Lehman declared bankruptcy in September 2008 and is being liquidated.

Settling the Investigation

Dain Bosworth contributed $40,000 toward the cost of the state’s investigation, according to an April 1996 letter to Hoadley from Michael Kavanagh, then a senior vice president and director of public finance at the regional brokerage. Kavanagh, who still works for the firm, now known as RBC Dain Rauscher, referred questions to its owner, Royal Bank of Canada in Toronto. Spokeswoman Stephanie Lu declined to comment.

Nothing in the records released by Wisconsin indicates that the state asked CDR to contribute to its costs. Hoadley refused to respond when asked why not.

Two years after Wisconsin’s internal probe, CDR designed an investment contract for Fargo that led to an IRS penalty over a $3 million option the federal tax agency characterized as unnecessary, according to city records.

Transaction’s Architect

While Dain Bosworth ran the September 1997 auction, Rubin’s firm was the transaction’s architect, City Attorney Erik Johnson said in a written statement to Bloomberg. The only documentation of CDR’s participation was inserted in deal documents “in the final hours leading up to the closing,” Johnson wrote.

The $56.3 million investment included an option for the city to return securities to the provider, Bear Stearns Cos., at par, according to an IRS letter to the city in November 2005. JPMorgan Chase & Co. acquired Bear Stearns last year. The IRS, estimating the option’s cost to the city at $3,049,616, said the derivative held little or no value because the securities alone were sufficient to service the debt.

The tax agency ruled that Fargo’s financial advisers had “burned” the yield, according to its letter. When confronted with an IRS threat to tax investors on their earnings, city officials settled by pledging to pay $1.7 million. Dain Bosworth contributed $400,000 and the law firm of Hunton & Williams LLP paid $845,000, according to the agreement. Darrell Smelcer, a former senior attorney in the law firm’s public finance group in Atlanta, who worked on the transaction, didn’t respond to several requests for comment.

IRS Concerns

“Bear Stearns and Chambers were pursued by the city for contribution to the settlement but declined to respond,” Johnson, the city attorney, said in a written statement.

During the IRS investigation in Atlanta, city officials discovered CDR employed another opaque investment to recoup a brokerage fee local authorities had cut by more than one-third, according to city records. As winning bidder, Bank of America paid CDR $330,000. Yet city leaders were concerned that the IRS might consider that fee excessive, John MacMaster, a public finance attorney for Atlanta, said in an interview. As a result, the officials negotiated for three months to reduce the payment to $205,084, city records show.

The IRS later found that Bank of America restored CDR’s compensation via an undisclosed “side trade.” After accepting the city’s payment, Rubin’s firm gave the bank $200,000 for an investment equal to 7.5 basis points of the escrow securities under management, the IRS told the city in a June 2005 letter. That would make CDR’s investment worth about $340,000.

Antagonizing the City

Atlanta officials discovered something else during the IRS investigation. The city owed the U.S. Treasury $5.7 million plus interest because of unspecified errors in how it accounted for the investment, according to city records. It paid to settle. City spokeswoman Beverly Isom declined to comment.

Douglas Lee Campbell, a former Bank of America Securities LLC investment broker who worked with Rubin’s firm on the contract, wrote that the experience antagonized city officials.

“CDR got themselves tossed out of the Atlanta market,” Campbell e-mailed a Bank of America colleague in October 2001, according to a copy of the communication released by the city.

There was still more to the relationship between Rubin’s firm and the bank. In June 2002, Campbell e-mailed his boss that Bank of America had made four payments to CDR totaling $57,393 for transactions Rubin’s firm hadn’t worked on in 2001 and 2002. He described the payments as “part of the ongoing attempt to develop a better relationship with our major brokers.”

Philadelphia Scandal

The bank fired Campbell in August 2002 after an internal review, according to the former broker’s licensing history with the Financial Industry Regulatory Authority in Washington. He couldn’t be reached for comment.

In 2003, CDR’s work became part of a federal criminal probe in Philadelphia, where Rubin hired local lawyer Ronald White as a lobbyist to help the firm win city contracts.

White achieved that objective in part by bribing City Treasurer Corey Kemp, federal officials charged. Rubin paid White $230,000 from January 2001 through September 2003, according to monthly checks he signed and that were included as exhibits in the government’s criminal case. Rubin also spent $10,500 on three Super Bowl tickets used by White, Kemp and a friend in January 2003, according to a copy of the receipt billed to Rubin, trial exhibits show.

Contracts Won

While CDR wasn’t implicated, it won city contracts as a result of the lawyer’s work, prosecutors said. CDR received $565,000 for financial advisory work in Philadelphia from April 2002 through June 2004, according to a spreadsheet prepared by the city’s finance director, Rob Dubow.

White died of cancer in November 2004, five months after a 56-count criminal indictment against him, Kemp, now 40, and others was unsealed. The federal government dropped the lawyer as a defendant. Rubin and his firm weren’t charged.

“It’s not a federal offense to pay somebody to be a lobbyist,” said Assistant U.S. Attorney Robert Zauzmer.

Kemp was convicted of 27 corruption-related counts in May 2005. Now midway through a 10-year prison term he’s serving in Devens, Massachusetts, 39 miles west of Boston, Kemp said in an interview that he reads his Bible and prays three times a day.

“I let myself down because I allowed myself to be played,” he says. “But I can’t push that blame on CDR.”

In late 2005, Charles Anderson, then a Baltimore-based manager in the IRS’s tax-exempt bond group, said he made a criminal referral to the Justice Department’s antitrust division based on evidence of bid-rigging and price-fixing he uncovered. Anderson said the alleged conspiracy reached far beyond CDR.

Lightly Supervised

“In some cases, when we summonsed the bidding documents, we could see the fax header showing that the bids weren’t received at the same time,” said Anderson, who retired in 2007. “Often we found certain types of swaps and put options, and things like this were payments for something everyone knew wasn’t going to happen.”

Lightly supervised middlemen such as Rubin and CDR “are at the core of it,” Anderson said in an interview “That’s where the rubber meets the road.”

Rubin himself was a public official from 2002 to 2004, serving as a commissioner at Housing Authority of the City of Los Angeles, Southern California’s largest residential landlord.

During a public meeting in March 2003, when the commission was finalizing plans for a $17.2 million bond issue, Rubin announced he had a “disclosure comment to make.” RBC Dain Rauscher was vying for the agency’s business. A law firm that practiced alongside CDR and RBC Dain Rauscher on several deals would serve as counsel to the commission.

‘Worked With Both’

“I have worked with both in the past,” Rubin said, according to a tape recording of the event. “And none of these firms are a source of income to me at my firm at this time.”

He didn’t mention that CDR was paid $50,000 out of a bond issue RBC Dain Rauscher had underwritten for the Region III Housing Authority New Mexico Inc. six weeks earlier, according to the Los Angeles commission’s tape recording of the meeting. RBC Dain Rauscher and the law firm were selected on a unanimous voice vote, with no abstentions recorded.

Housing authority officials were unaware of the New Mexico transaction, said Craig Takenaka, a Los Angeles assistant city attorney and the agency’s chief legal counsel.

“If he is receiving any income, even indirect, he is violating that statement right there,” Takenaka said in an interview. He said he negotiated Rubin’s “involuntary” departure from the agency in 2004 because CDR had surfaced in the Philadelphia public corruption probe.

Waiting Period

Rudy Montiel, now the housing authority’s executive director, said he met Rubin after his departure:

“He came in a few months after I’d been there. He said, ‘I want to do this affordable housing deal. I’d like to partner with you.’ I said, ‘Mr. Rubin, you’re aware you have a one-year waiting period aren’t you, before you can approach the housing authority?’ Never heard from him again.”

To contact the reporter on this story: Elliot Smith in Washington at esmith29@bloomberg.net.

Last Updated: November 2, 2009 00:01 EST