WASHINGTON — Retail order periods are often gamed so that retail investors do not get many bonds and dealers or institutional investors sometimes “flip” bonds, purchasing them and then immediately reselling them to retail investors at higher prices, market participants told the Municipal Securities Rulemaking Board last week.
But the Securities Industry and Financial Markets Association contends these practices, when abusive, are violations of existing MSRB rules and said the board should enforce those rules rather than propose regulating dealer allocations of bonds.
Meanwhile, First Southwest Co. urged the board to undertake a thorough study of flipping, which it said is “a controversial and complex issue.”
The individuals, groups, and firms made their comments in letters sent to the MSRB in response to rule changes it proposed on Aug. 11 on the priority of orders in primary offerings.
Under the proposed rule changes, new-issue underwriting managers or syndicates, “unless otherwise agreed to with the issuer,” would be required to give priority to customer orders over orders for their own accounts or orders for affiliates or related accounts. In addition, the board issued a draft interpretation of its Rule G-17 on fair-dealing saying that an underwriter’s failure to give priority to, or allocate, retail orders in conformance with its commitments under a retail order period could be a violation of the rule.
The MSRB said it issued the proposals after institutional investors complained that their orders for muni bonds were not filled during primary offerings, but the bonds became available soon after in the secondary market at higher prices.
The institutional investors posed two possible causes for this: that dealers were, in essence, placing so-called phantom orders during retail periods without having any actual retail investors lined up to buy the bonds and then flipping them at higher prices in sales to investors; or that syndicate members or their affiliates were front-running the bonds, buying them for their own or affiliated accounts before filling orders from investors.
A number of market participants were convinced the proposed rule changes were an attempt to curtail flipping, but board officials said they were meant to clarify that dealers must respect the priority of orders for bonds outlined by issuers, as many issuers have come to rely more on retail order periods to sell their bonds.
In a two-page letter to the MSRB, Napoleon Brandford 3rd, chairman of Siebert Brandford Shank & Co., told the MRSB that there has been a “sporadic breakdown” of syndicate procedures for filling bona fide retail orders.
“Prior to the financial crisis faced by many Wall Street firms, issuers and their financial advisers were quite diligent in demanding verification on true retail orders submitted during the retail order period,” he said. “This verification process was abandoned in early 2008 as issuers became more concerned with getting their deal completed quickly than maintaining the integrity of the order-taking process they had put in place to ensure fair dealing by the underwriters.”
Without the verification process, underwriting syndicates “soon abandoned any pretense of 'retail,’ ” Brandford said. In some deals, syndicate members have been allowed to submit large orders for retail in primary offerings, claiming these were for many small retail orders that had been bundled, he said.
In other deals, the managing underwriter will allocate a large amount of “retail” bonds away from syndicate members to a non-syndicate firm. In transactions with high demand, institutional investors and syndicate members know they only way to bonds is to “get ahead of the line like everyone else,” Brandford said.
“While the MSRB may try in earnest to correct this breakdown in compliance with well-established syndicate rules, underwriting firms are already developing other methods to circumvent the syndicate rules with respect to fair-dealing,” he said.
In an interview, Brandford said that during a recent bond offering from an issuer in Florida, two major broker-dealers announced they had formed a retail-brokerage joint venture and wanted to place retail orders on behalf of the new joint-venture firm. Brandford said the firm should have been added as a selling group member for the retail order period.
Lynn Hampton, vice president for finance and chief financial officer of the Metropolitan Washington Airports Authority, told the board in a two-page letter that she once discovered a retail sales firm buying bonds in the institutional sales market and then marking them up for their retail clients. She discussed the situation with the underwriters and asked that the firm begin participating in the retail order period.
Hampton said that, following a bond sale, the MWAA always analyzes the transaction data to confirm that its request for retail priority has been met and to determine if “flipping” has occurred.
But SIFMA and the Regional Bond Dealers Association maintained that Rule G-17 already covers abusive practices.
Leon Bijou, managing director and associate general counsel of SIFMA, said, “We cannot support the proposed rules [because they would] tell dealers how to allocate securities.”
The rules would run counter to the MSRB’s Rule G-11 on syndicates, which he said allows dealers to set up priorities and deviate from them on a case-by-case basis if it is in the best interest of the syndicate. The rules also run counter to a notice issued recently by the Financial Industry Regulatory Authority that would permit syndicate members to sell corporate bonds to affiliates if prices are not discounted, he said.
Bijou said that phantom sales and front-running violate the current Rule G-17. “These are violations, but the proposed amendments are not going to curtail them. Better enforcement [of G-17] will,” he said.
Michael Decker and Mike Nicholas, co-chief executive officers of the Regional Bond Dealers Association, agreed in their letter to the MSRB that G-17 already covers abuses. They said that while they support the intent of the board’s proposals, they are not sure the measures would address the perceived abuses.
First Southwest Co. capital markets managing director Carl Giles said that while his firm supports the MSRB’s proposed changes to the syndicate rules, the board should “undertake a thorough study of flipping and, if warranted, make appropriate recommendations for the regulation of this practice.”
