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FINRA Eyes Action Against Firms Selling Munis to Retail Without Disclosure

WASHINGTON — The Financial Industry Regulatory Authority is preparing to take enforcement action against certain firms for selling municipal bonds to retail customers without disclosing material information, including that the bonds’ credit ratings had been spiraling downward, a FINRA official said Thursday.

Speaking on a municipal securities panel at the Securities Industry and Financial Markets Association’s Compliance and Legal Seminar, Malcolm Northam, FINRA’s director of fixed income, said the agency also will take a series of enforcement actions this year against firms for excessive markups and markdowns of municipal securities.

In other action, FINRA is conducting inquiries of muni bond underwriters’ relationships with swap providers and investment advisers tapped to serve state and local municipal bond issuers and investment pools or pension funds, he said.

But generally a big area of focus in the municipal market for FINRA during 2010 will be dealer interactions with retail customers, Northam said.

“The key words for 2010 are retail, retail, retail,” he told those attending the seminar.

One area that FINRA plans to focus on is retail order periods, which increasingly are being included in sales of new muni bond issues, he said. It plans to look at issuers’ requests for retail order periods, how the underwriters are complying with those requests, as well as how issuers and underwriters are defining retail, he said.

If issuers are asking underwriters to set aside a certain amount of bonds for retail customers, “I should darn well be able to see retail trades going on,” Northam said, adding that he typically views retail trades as being smaller trades. Some underwriters, however, define retail to include mutual funds and broker-dealers with large retail businesses, he said.

FINRA will look at how the retail order period was conducted, whether underwriters complied with rules, and whether flipping occurred, he said. Flipping occurs when an underwriter sells bonds to another dealer or institutional investor that immediately resells them to retail investors at a higher price.

The retail sales-related enforcement actions stem from a FINRA sweep of a total of about 20 firms that began last year, Northam said. The agency initially started looking at how firms sold bonds used to finance a $709 million prepaid gas contract under the authority of Main Street Natural Gas Inc. The bonds appeared headed for default after Lehman Brothers filed for bankruptcy and Lehman Brothers Commodities Services Inc. failed to deliver the gas or make payments as required under contract.  FINRA then expanded the inquiry to include broker-dealers with the largest retail businesses in the muni market.

“This is just about done and it’s now at the enforcement stage,” Northam told those attending the seminar.

The Municipal Securities Rulemaking Board’s Rule G-17 on fair dealing requires dealers to disclose to customers, at or before the sale of muni securities, all material information regarding those securities.  But FINRA found that about one-third of the 20 firms did not make any disclosures when selling the Lehman-related prepaid gas or other bonds. Another third “gave it the college try” and made disclosures in some cases, but and not others, he said. A final third complied fully with the rule. FINRA plans to take enforcement action against the third that did not disclose material information.

FINRA also may issue guidance in this area as well, he said. Some firms think they are complying with G-17 by telling their sales representatives to check for material information before they sell bonds. “That’s not good enough,” said Northam. “You’ve got to have procedures in place” that outline how the sales rep should check for the information.

Turning to pricing, he told the group, “I think there’s a fair number of price markup cases in the hopper than will hit the press.” 

FINRA and MSRB rules require dealers to sell bonds at fair and reasonable prices.

Northam said that qualified institutional buyers are exempted from FINRA’s pricing rules if they are sophisticated and are buying junk bonds. But the exemption does not give dealers free reign to take advantage of such customers, he said.

FINRA’s inquiry into the relationships between large underwriters and swap providers began last year. It is looking at whether underwriters routinely recommend certain swap providers to municipal issuers and whether they share fees. The authority also is looking at whether underwriters and swap providers routinely work together, switching roles in various transactions. For example, Northam said, a firm will be underwriter on one deal with a swap provider, and then the firm will be swap provider on the next deal with the swap provider becoming the underwriter.

FINRA earlier this year began looking at whether broker-dealers are serving as placement agents by recommending certain favored investment advisory firms for business from state and local government investment pools or pension funds. The authority is examining whether there is any fee-sharing or if the advisers put all of their sales and purchases from the business they obtained through the broker-dealer that helped them get the business, he said.

Northam also urged FINRA members to look at the transaction-based fees they are paying to the authority, warning that he has found some firms are not paying the full amount of fees due.

In the disclosure area, Rebecca Lawrence, assistant general counsel of Piper Jaffray & Co., who was also on the municipal securities panel, said broker-dealers would like to see some sort of standard developed so that an issuer that has failed to file its annual disclosure notices in violation of its continuing disclosure contract with bondholders can remedy the situation and avoid having firms refuse to underwrite its bonds.

Under the SEC’s Rule 15c2-12, underwriters must reasonably determine that an issuer has agreed in writing to disclose annual financial information and material events as they occur. A number of issuers, particularly small ones, have failed to file their annual financial information, either on a timely basis or at all.

But there are few, if any, cases of broker-dealers refusing to underwrite their bonds. Lawrence said the onus should be on the issuer to remedy the situation and that there should be steps it can take to correct the situation. The underwriters should not be held responsible for issuers’ disclosure failures, she said.

Kenneth Gross, a partner at Skadden Arps Slate Meagher & Flom LLP who also was on the panel, cautioned firms underwriting Build America Bonds about the dangers of running afoul of the MSRB’s Rule G-37 on polticial contributions.

“It raises some very delicate issues,” he said.

Under G-37, a broker-dealer must ban itself from engaging in negotiated municipal securities business with an issuer if if or its municipal finance professionals make political contributions to issuer officials who can influence the award of underwriting business. MFPs are allowed, however, to contribute up to $250 for anyone for whom they can vote.

Gross said that BABs are taxable bonds that often involve a firm’s taxable bond desk. However, BABs must adhere to the tax and securities rules for tax-exempt bonds, including Rule G-37.  As a result, underwriters must make sure that the dealers in their taxable group who may have become MFPs by virtue of working on BAB deals, do not contribute to issuer officials.

In fact, under a so-called look back provision of G-37, the firm must check to make sure individuals in their taxable BAB group have not contributed to issuer officials during the two years before they became MFPs, he said.

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