WASHINGTON — Market participants are sharply divided on the Municipal Securities Rulemaking Board’s draft proposal to prohibit dealers from underwriting new negotiated or competitive bond issues if they served as the issuer’s financial adviser on the transaction.
The board has received some 70 comment letters in response to its August proposal to alter its Rule G-23 in response to a request by the Securities and Exchange Commission that it ban such role switching. In a May speech, SEC chairman Mary Schapiro called the practice “a classic example of conflict of interest.”
While non-dealer financial advisers and governmental borrowers are applauding the draft proposal, dealers, bond attorneys, and some small issuers are warning that it would go too far and lock small, infrequent borrowers out of the market.
However, some industry firms said they would accept a prohibition on role-switching for negotiated deals, but not for competitive ones.
“While it does limit issuer flexibility somewhat, we would not object to a rule change that prohibits a dealer who has been hired as a financial adviser on a particular issue from changing its role to an underwriter for a negotiated issue,” wrote two Piper Jaffray & Co. officials, Frank Fairman, managing director and head of public finance services, and Rebecca Lawrence, assistant general counsel and principal.
“It is in the issuer’s best interest to receive as many bids as possible for a competitive sale, particularly for smaller and more remote issuers where fewer firms are interested in serving as either a financial adviser or as an underwriter,” they added. “The vast majority of our financial adviser clients invite us to bid as an underwriter and want us to do so.”
Still, non-dealer FAs and several issuers argued for prohibiting role switching for both types of transactions. This ensures that the issuer is represented throughout the bond sale by a financial adviser “whose sole responsibility is to the issuer itself,” wrote Susan Gaffney, director of the Government Finance Officers Association’s federal liaison center here.
She noted that GFOA guidance for issuers already goes beyond Rule G-23 because of its leaders’ concerns about the ability of dealer-FAs to hold issuers’ best interests ahead of their own. Many issuers avoid this concern altogether by hiring independent, non-dealer FAs, she said.
Eric Johansen, the treasurer of Portland, Ore., said the MSRB’s proposal is “long overdue.”
“In short, it’s time to put an end to what is far too often a deceitful practice on the part of some broker-dealers to gain negotiated underwriting business by first being hired as an issuer’s financial advisor,” he wrote.
But many industry firms and groups argued that the existing system strikes an appropriate balance. Currently, a dealer-FA can underwrite a negotiated transaction only after it discloses that conflicts may exist or bid on a competitive deal and obtains the issuer’s permission.
Some industry officials questioned how seriously the MSRB should consider the SEC’s concerns. “The MSRB exists precisely because Congress never gave the SEC (either in 1975 or 2010) the ability to directly regulate the municipal securities industry,” said Robert Stracks, counsel at BMO Capital Markets, referring to legislation that established the board 35 years ago and this year’s Dodd-Frank Wall Street Reform and Consumer Protection Act.
“Therefore, the MSRB should not consider the SEC’s request or its rationale and logic with any more weight than that of any other party,” Stracks added. “The MSRB would be shirking its responsibility if it simply followed the SEC’s dictates.”
“There’s a limit to how far a regulatory body can go toward protecting an entity against itself,” he said. “Issuers employ counsel and others to review their agreements.”
Leslie Norwood, managing director and associate general counsel at the Securities Industry and Financial Markets Association, wrote: “SIFMA continues to believe that Rule G-23 represents a comprehensive and balanced approach to potential conflicts of interest, which has a long and successful history of application in the marketplace.”
Norwood said the proposal is not needed partly because the new financial regulatory reform legislation imposes a fiduciary duty on municipal advisers. She also called for an exception for corporate conduit borrowers from the role-switching ban, saying “paternalistic” restrictions regarding advisers and underwriters are not needed or appropriate for them.
Echoing Piper and others, Norwood wrote that extending the ban to competitive transactions is a mistake because “the potential for abuse in the competitive context is dramatically different and the historical basis for this distinction remains relevant.”
Awards of competitive deals, she said, are based solely on price and have nothing to do with any previous or existing relationship among issuers, advisers, and dealers. Several individual dealers said that bids on competitive transactions typically are collected through a “sealed” bid process.
While industry participants said it’s a rare occurrence for dealers to switch roles, if they were banned from doing so, small and unrated issuers would be left with a lack of viable funding sources or increased costs to access the muni market.
Michael Nicholas, chief executive officer of Bond Dealers of America, said that for most of the smaller transactions, only the local dealer is interested in marketing the securities of the issuers and the transactions are too small to attract bids from larger firms.
Nicholas and SIFMA both said that Ipreo data shows 42% of competitive bond issues of $10 million or less and competitive note sales between $1 million and $3 million received three or fewer bids between Jan. 1, 2000, and Aug. 27, 2010. Some received only one bid. This compares to bond issues of $30 million or more, where only 12% received three or fewer bids.
The point was reinforced by several Texas bond attorneys, who argued that hundreds of small municipal utility districts and similar special districts created to finance, develop, and operate public infrastructure would be harmed by the proposal. These borrowers, required by state law to sell their new-money debt competitively, typically engage a dealer as FA on a contingent-fee basis to help structure, schedule, and prepare disclosure documents for their bond issues, wrote Fredric Weber, a partner at Fulbright & Jaworski LLP in Houston.
“In doing so, the districts not only authorize the financial adviser to bid for their bonds, they also encourage it to do so,” Weber wrote. “Since the financial adviser’s compensation for services in connection with the creation, organization, and start-up of the districts is contingent, the financial adviser has an additional incentive to submit a bid to make sure that the offering will be successful. In addition, because the financial adviser watches the credit as it develops, it can more efficiently and reliably put together an underwriting syndicate than other dealers.”
Several industry participants urged the MSRB to exempt smaller transactions if it applies its ban on role switching to competitive as well as negotiated deals. SIFMA suggested that competitive transactions of less than $10 million be exempt from the ban.
Christopher Hamel, head of municipal finance at RBC Capital Markets Corp., argued the existing rule “represents a comprehensive and balanced approach to addressing the needs of municipal issuers to access capital at the lowest possible cost.” He said there should be a general exemption from the ban for both negotiated and competitive transactions of $20 million or less.
But Steve Apfelbacher, president of both the National Association of Independent Public Finance Advisors and Ehlers & Associates in Roseville, Minn., said the MSRB should go even further than its proposed restrictions.
To further ensure independence between underwriters and financial advisers, he said, underwriters should be restricted from selecting or recommending to the borrower which municipal adviser it ought to hire. In addition, an FA should be precluded from serving as underwriter for an issuer for two years from the time its financial advisory contract expires or is terminated.
The two-year cooling-off period, Apfelbacher said, would mirror the two-year ban on negotiated business under Rule G-37, which aims to prevent dealer pay-to-play activities by discouraging dealers from making contributions to issuer officials or candidates.
It also would reflect changes to Rule A-3 approved last week that make the board a majority-public self-regulator and require its public representatives not be associated with a municipal dealer or adviser for two years.
“A two-year ban will discourage underwriters from engaging in a financial advisory relationship for the purpose of later switching to an underwriter and will provide adequate time to protect an issuer from the conflicts of interest created from role change,” Apfelbacher wrote. “Given the MSRB’s two-year precedent, failure to impose a specific time ban or ban other than two years would be arbitrary and inconsistent. “
But Hill Feinberg, chairman and chief executive of First Southwest Co., said the two-year cooling off period proposed by NAIPFA is “very self-serving and restricts competition.”
“First Southwest’s position is that a dealer should not be precluded for a specific time frame from entering into a financial advisory relationship with an issuer after serving as an underwriter on one of the issuer’s prior offerings of securities,” he wrote.