Regulators’ heightened concern for retail investors in the muni market was on display Tuesday when a top Financial Industry Regulatory Authority official posed an alarming scenario to industry representatives in New York.
What if there is a widespread crisis among governmental issuers, a number of them default on their bonds, and it is discovered that retail investors are the predominant holders of the securities?
In other words, asked Marc Menchel, FINRA’s executive vice president and general counsel for regulation, what if there is a muni crisis and it becomes clear that the safer credits in the market have been sold primarily to institutional rather than retail investors?
“The reaction would be terrible,” he said, speaking at the Securities Industry and Financial Markets Association’s Legal and Compliance Conference. Congress would be apoplectic and there would be no way to defend the industry’s actions. Lawmakers would likely impose remedial sanctions that would curtail the muni market, he said.
Though Menchel prefaced his remarks by saying he was only speaking hypothetically, he said he has heard from a buy-side firm that retail investors are routinely at a disadvantage compared to institutional investors when they buy munis.
For instance, when an institutional investor wants to buy or sell municipals, it asks dealers to show them where the market is for a particular a bond. The institutional investor has likely already performed its own in-house analysis of the bond’s price, but doesn’t reveal that, or whether it is buying or selling the bond, to keep the dealer honest, he said.
In contrast, “retail investors don’t have that power,” Menchel said.
Even if they look at a bond’s most recent trade on EMMA, retail investors have little or no traction with dealers and must either accept the prices they are offered or refuse to buy or sell the bond.
Though industry participants have widely downplayed the likelihood of an industry collapse, Menchel said the industry should nonetheless find a way to act in its own self-interest by ensuring that retail investors are not put at such disadvantages. He also suggested that existing suitability requirements may be wielded by regulators to ensure that retail investors are not somehow shut out from better credits.
Menchel’s concerns for retail investors were amplified by Mac Northam, FINRA’s director of fixed-income regulation, who opened his remarks on a later panel by saying that his focus is “retail, retail, retail.”
Northam warned that the growing role of retail investors is evident in data showing that the dollar value of 80% of the muni trades during the past year is less than $100,000 each.
He also highlighted new Municipal Securities Rulemaking Board rules meant to ensure dealers respect the priority of orders for bonds specified by issuers, since many issuers have come to rely more on retail order periods to sell their bonds.
The rules include new record-keeping requirements under which dealers must disclose whether orders are for their own or related accounts. Dealers must preserve such records for all primary offering orders — whether or not they are filled — for at least six years. They also must keep records that specify how issuers have defined their retail periods and the role they expect dealers to play.
Northam said that FINRA expects retail orders to be filled with “two-legged individuals.”
“If you are fulfilling your retail distributions by selling to large investment companies, I’m not sure that is the issuer’s understanding” of retail, he said.
Menchel and Northam’s warnings come a week after FINRA released a notice to dealers, in conjunction with the Municipal Securities Rulemaking Board, reminding them of their disclosure, pricing, suitability, and fair dealing requirements when selling municipal bonds in the secondary market.
The other big topic of discussion at the conference was provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act that will, for the first time, require nondealer municipal advisers to be regulated.
Under these provisions, which take effect Friday, municipal financial advisers, swap advisers, solicitors, and other unregulated intermediaries will have to register with the Securities and Exchange Commission and comply with MSRB regulations. They will have a fiduciary duty toward their clients that requires them to hold the clients’ interests ahead of their own.
The SEC has established a temporary registration system for advisers and plans to propose a final system by the fourth quarter. It also plans to release formal guidance to the market to clarify some of the legal ambiguities of the law in the coming months, according to Martha Mahan Haines, the SEC’s municipal securities chief who also spoke at the SIFMA conference.
Lanny Schwartz, a partner at Davis Polk & Wardwell LLP who was on a panel before Haines, said that when he and SIFMA officials met with the SEC Thursday, the staff said that about 400 dealer and non-dealer advisory firms have already registered as muni advisers. They expect as many as 1,000 non-dealer advisers and an additional unknown number of banks and broker-dealers to also register, he said.
The new registration requirements are not well known among these muni market participants and Schwartz predicted that there may be a “a lot of stragglers” who do not yet know they will be subject to federal oversight for the first time.
In addition, Schwartz said that legal ambiguities with the muni adviser section had caused many people to dub it as “the worst drafted provision” in the Dodd-Frank law.
SIFMA is seeking clarification from the SEC on several of these issues, he said.
For instance, under the law, any individual who provides advice on municipal financial products or solicits a municipality is an adviser. But, Schwartz asked, what constitutes advice? Trading ideas or proposing structural alternatives or analysis on a transaction? Must the adviser first sign an engagement letter before his advice triggers the law’s provisions?
According to the SEC staff, the definition of advice revolves around “the reasonable expectations” of the municipality, Schwartz said.
SIFMA also asked for guidance on which activities at a bank or broker-dealer are covered by the fiduciary duty rule that the MSRB must write for advisers. Is it limited to the area of the firm that has signed an advisory engagement letter or does it reach the entire organization? If employees at a large firm have entered into an advisory relationship with an issuer, does that mean that a trading desk elsewhere in the firm has to be concerned about engaging in principal trades with that issuer?
SEC staff said it depends on what a municipality would reasonably expect, Schwartz said.
Another question revolves around advisers who assist in the investment of bond proceeds. Since money is fungible, if a cash-management arm of a bank is managing funds for a municipality, does it have to register as a muni adviser if it is possible that the funds it is managing could be bond proceeds from a bond sale?
SEC staff indicated that, in their view, “there needs to be some kind of reasonable nexus between funds and proceeds of a municipal issue,” Schwartz said.
The SEC staff were reluctant to provide any informal guidance on whether, if a dealer-FA already has an advisory relationship with a client and chooses to underwrite its transactions, it can avail itself of the law’s exemption for dealers acting as underwriters.
SEC staff, he said, declined to answer that question because of expected changes to the MSRB’s Rule G-23, which would eliminate the ability of dealer-FAs to switch roles and underwrite bonds in the same competitive or negotiated transactions.