DALLAS — Bond dealers who claim the role of market maker in the pricing of municipal securities can run afoul of regulators unless they qualify with the Securities and Exchange Commission, warned Malcolm Northam, director of fixed-income securities at the Financial Industry Regulatory Authority.
Northam joined Elaine Greenberg, chief of the SEC’s municipal securities unit, and Steven Chamberlin, manager for tax-exempt bonds at the Internal Revenue Service, in a discussion about the current regulatory environment for municipal bond dealers last week at the Bond Dealers of America’s National Fixed Income Conference & Technology Summit in the Dallas suburb of Irving.
The BDA, formerly the Regional Bond Dealers Association, is in its third year representing middle-market dealers. One of the regulations the BDA is challenging is the definition of a market maker, which its officials say limits muni market liquidity.
“The SEC has one definition for market makers, and it’s an equity definition,” said BDA chief executive Mike Nicholas. “The only ones that meet the definition are the large dealers.”
The BDA believes its members should be allowed to act as market makers on taxable securities such as Build America Bonds.
In a Sept. 15 letter to James L. Eastman, chief counsel and associate director in the SEC’s division of trading and markets, Nicholas urged a return to a 1998 definition from the National Association of Securities Dealers, that would “provide welcome certainty for dealers striving to comply with the mark-up policy and would be more consistent” with Section 3(a)(38) of the Securities Exchange Act of 1934.
Under the 1998 definition, “in the debt securities markets, a market maker is a dealer who, with respect to a particular security, furnishes bona fide competitive bid and offer quotations on request and is ready, willing, and able to effect transactions in reasonable quantities at his or her quoted prices with other brokers or dealers.”
However, Northam said that there are no market makers in municipal debt, even among the large firms. Market makers in equities and corporate debt must register with the SEC.
Under the definition of market maker in a 2007 SEC release, “a dealer must hold itself out as being willing to buy and sell a security for its own account on a regular or continuous basis.”
So, a dealer with a bid-ask spread of 42-44 who marks the bond up to 45 because he is playing the role of a market maker could face questions on pricing, Northam said.
“The reason why is because you’re not the market maker,” Northam said. “How do I know? Because you didn’t register with the SEC as a market maker. I don’t see your offering bid and ask quotes in that market and executing orders on those quotes, so therefore you’re not a market maker.”
Instead of marking up the bond from the “ask” figure, the dealer’s markup should come from the price he or she paid. In the above example, the price would be 42 rather than 44.
One dealer pointed out that municipal securities were expressly exempt from provisions of Section 3(a)(38) of the 1934 act.
“I agree with you,” Northam said. “Municipals are exempt securities, as are governments, as are agencies, as are tribal bonds, and as are church bonds. However, the SEC has said the only way you can be a market maker in those particular securities is to meet the standards of the act.”
In a follow-up call, Northam said he does not know if market makers would even be allowed in munis. But under current regulations, they would have to meet the requirements imposed on dealers of equities and corporate debt.
The market maker issue is just one of several facing dealers and other industry executives as the SEC and IRS team up for a national inquiry of muni market trading practices.
Greenberg identified five areas where dealers could face scrutiny: offering and disclosure; public pension liabilities disclosure; pay to play; tax arbitrage fraud; and valuation pricing fraud.
“We’re also proactively seeking to identify market activity that may pose the greatest risk of fraud to investors,” she said. “So, this list may expand in the future.”
In citing examples of SEC enforcement action in the past year, Greenberg noted the commission’s Aug. 18 settlement with New Jersey on fraud charges for failing to disclose its full pension liabilities in its official statements.
“New Jersey was the first state ever charged by the SEC for violations of the federal securities law,” she said. “According to our order, New Jersey offered and sold more than $26 billion of municipal bonds in 79 offerings over a six-year period. And these securities documents for these offerings created the false impression that its two largest pension plans were being adequately funded.”
On the pay-to-play front, Northam cautioned dealers about possible interpretations of contributions to the favorite charity of a mayor or other elected official.
“Is that a political contribution?” he asked. “Well, maybe not certainly yet, but there’s room there for negotiation and discussion about what it actually is if it’s not a political contribution.”
For the IRS, Build America Bonds remain a major focus of attention.
“The U.S. Treasury reported in August that the Build America Bond market has grown to over 1,600 transactions placed in over $128 billion in volume and comprised about 21% of the municipal market,” Chamberlin noted. “From our perspective at the IRS, we’ve actually processed over $1.6 billion in direct payments to state and local governments.”
The IRS has sent out forms to every BAB issuer seeking information such as whether they track their bonds in the secondary market. Chamberlin estimated that the agency has received 75% to 85% response on its forms.
IRS inquiries into the initial pricing of BABs have caused concern in the market, with some issuers fearing complications from audits. The IRS has backed away from a statement that it plans to audit as many as half the BAB deals in the nation and says it currently has about 10 audits in the works.
Chamberlin emphasized the importance of due diligence in the issuing of BABs, some of which have longer maturities than typical tax-exempts.
“An issuer still remains with ongoing compliance responsibilities as long as the bonds are outstanding,” he said.
