The Financial Industry Regulatory Authority has issued guidance warning broker-dealers to be fair when allocating partial redemptions of auction-rate securities among customers who hold them.
"When allocating redemptions in the context of a partial redemption of ARS, firms must follow procedures that are reasonably designed to treat customers fairly and impartially, and that put their customers' interests ahead of their own," FINRA said in a
FINRA's notice comes as many investors have been left holding auction-rate securities in recent weeks in the wake of the credit crunch. The self-regulator appears to be concerned that firms may redeem ARS they are holding before their customers' securities or that they may treat some of their customers more favorably than others, sources said.
Auction-rate securities are long-term or perpetual variable-rate securities with interest rates that reset every seven, 14, 28, or 35 days through a "Dutch auction" process. These securities are typically insured and have been affected by the rating downgrades of insurers that had exposure to the subprime mortgage market.
Neither investors nor broker-dealers have been willing to participate in the auctions of these securities, thereby causing the auctions to fail and leaving the holders holding the securities, even if the ARS interest rates reset at higher default rates. Higher rates may not matter to investors who saw ARS as a place to park their money on a short-term basis. Until recently, ARS were marketed as cash-like, liquid investments.
Some issuers of ARS have announced plans to partially redeem their ARS, generally at par value. In the case of such partial redemptions, the Depository Trust Company allocates the redemptions among the broker-dealer firms, which in turn, allocate them to their customers holding ARS.
The self-regulator, previously called NASD, said in the guidance that NASD Rule 2110 requires firms to observe high standards of commercial honor and just and equitable principles of trade when conducting business with their customers. It requires firms to adopt procedures to ensure that customers are treated fairly.
In addition, firms that are members of the New York Stock Exchange are subject to a rule that specifies the use of "an impartial lottery system" for securities of an issue that is partially callable, FINRA said.
Muni bond firms may also be subject to an MSRB rule, the self-regulator added.
"We also note that the Municipal Securities Rulemaking Board's interpretive notice concerning application of Rule G-17 to Use of Lotteries to Allocate Partial Calls to Securities Held in Safekeeping states that a municipal securities dealer that uses a lottery that excludes the dealer's proprietary accounts when the call is exercised at a price below the current market value is acting in violation of the fair-dealing rule," FINRA said. Rule G-17 is the MSRB's fair dealing rule.
