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Market Split on MSRB's Proposed Dealer-FA Ban

WASHINGTON — Market participants remain divided over the Municipal Securities Rulemaking Board's draft proposal to prohibit dealers from underwriting new negotiated or competitive bond deals if they served as the issuer's financial adviser.

Though the MSRB is expected to submit the proposed changes to its Rule G-23 to the Securities and Exchange Commission this week, some dealer-FAs and other market participants remain wary of any blanket ban on role-switching.

They warn it would reduce competition among the handful of dealers that bid for small and often-unrated issuers' bonds and increase the issuers' borrowing costs as a result. Many dealer-FAs and other market participants are urging an exemption for such small competitive transactions.

"From our perspective, there may have been some poor practices in the past that have led to an attempt at a regulatory fix," said Jim Jones, president of Crews & Associates Inc. in Little Rock. "But if role-switching is eliminated, then you've got a real possibility of small issuers being penalized that never participated in a transaction that had a whiff of impropriety."

While non-dealer FAs and many governmental issuers have long sought a role-switching ban, the concerns about the proposal extend beyond dealer-FAs. Craig Pouncey, deputy superintendent of education for Alabama, said he is worried the role-switching ban will further limit the already limited pool of firms willing to bid on deals brought by small school districts that under state law have limited tax capacity to support their bonds.

"I am not aware of any abuse of that relationship that has occurred here in Alabama," Pouncy said. "It may have happened elsewhere, but I don't see why we need to impose something nationwide intended to correct a problem only in a small part of the United States."

Though the MSRB weighed the impact the proposal would have on small issuers, SEC officials gave the board little wiggle room. In a May speech, chairman Mary Schapiro said role-switching is a "classic conflict of interest" and essentially ordered the rule gutted.

Currently, G-23 allows dealer-FAs to become underwriters in negotiated transactions if they disclose to the issuer possible conflicts of interest stemming from the role switch, disclose their expected compensation, and obtain the issuer's consent. In competitive deals, dealer-FAs must obtain the issuer's written consent before bidding on the bonds.

The rule also currently requires dealer-FAs that become underwriters or syndicate members to disclose the existence of their financial-adviser relationship with the issuer to customers who want to purchase the bonds.

But in seeking to prohibit such role-switching, the requirements become "unnecessary and are eliminated," the board said in its August proposal, which garnered more than 70 comment letters this fall.

Though the MSRB's proposal will be subject to another round of comment and review once it is submitted to the SEC, regulators have said its implementation is all but a done deal.

Last month, Mark Zehner, the deputy head of the SEC's new municipal and public-pension fund enforcement unit, characterized the rule change as an experiment that the agency could revisit in a few years if small issuers ultimately are harmed.

Speaking with Zehner at a bond attorneys conference in San Antonio, MSRB executive director Lynnette Hotchkiss made a similar argument.

"If there are small governments that are shut out of the market, that don't get any bids, or if they get one bid but the pricing is off, we are absolutely going to continue to look at that and make adjustments as necessary," she said. "But right now it was considered that these governments are not fully able to appreciate that conflict and waive that conflict."

Regulators also have said that a fiduciary duty for muni dealers and advisers that took effect Oct. 1 makes it difficult to allow such role-switching.

The Government Finance Officers Association has maintained guidance since 2007 that strongly urges against issuers signing off on such role-switching and says many issuers avoid potential conflicts by hiring non-dealer FAs.

Robert Scott, finance director for Brookfield, Wis., and a member of the GFOA's debt committee, warned against any carve-outs in the rule, saying it would be difficult to define which issuers are small enough to be exempted from any role-switching ban.

"The rule needs to be consistent," Scott said. If borrowing costs rise for small and infrequent borrowers, he said they ought to consider bank loans or borrowing from state bond banks instead of selling debt in the public markets.

Portland, Ore., Treasurer Eric Johansen, incoming chair of the GFOA's debt committee, said that if a financial adviser is doing its job, it's going to be able to find multiple bids in most cases.

"If there's one firm that's willing to underwrite a deal, there should be another firm out there willing to bid," he said.

But some dealer-FAs worry that will not be the case if the G-23 rule changes are implemented. Bid results for all eight of the transactions brought by unrated Texas municipal utility districts during October and September show the transactions each garnered just two bids, according to data provided to The Bond Buyer by First Southwest, the largest dealer-FA firm.

The bid results suggest that if a dealer-FA were banned from bidding on such transactions, many would likely only garner a single bid, which in turn would translate into increased borrowing costs for the borrowers, according to Jack Addams, managing director and manager of public finance at the Dallas-based firm.

"The more people you have bidding a deal, the more competition you have and the better price you'll get," he said. "It's really important on these small, nonrated deals. There's just not a whole lot of people to bid on them."

Addams added that competitively priced deals often yield more affordable and better-structured transactions than bank loans.

Another wrinkle revolves around the frequency of such role-switching, for which no comprehensive data is publicly available. However, data for a five-year period submitted to the MSRB by First Southwest shows that it did not switch roles frequently.

From Aug. 1, 2005, through July 31, 2010, the firm was financial adviser on 1,898 negotiated transactions but underwrote just 21 of the issues. The average deal size was $5.54 million.

During the same period, the firm acted as FA on 2,473 competitively sold issues but only underwrote 269 of those transactions.

Of those deals, 87 were unrated and averaged $3.77 million while 182 were rated and averaged about $4.64 million.

First Southwest has long opposed changes to G-23 on the grounds that the existing rule's disclosure requirements are sufficient safeguards against conflicts. But Hill Feinberg, the firm's chief executive officer, said that if the rule has to be changed an exemption for small, competitive deals of about $5 million or less is warranted, given the data.

Feinberg said the firm's principal concerns are to small-issuer clients who could be harmed by the proposal, which in turn they believe is fueled by a false perception that role-switching occurs often.

In fact, Michael Bartolotta, First Southwest's vice chairman and current MSRB chairman — who supported the proposal when it was discussed at the board's quarterly meeting last month — suggested that appearance is a driving factor. In a conference call with reporters, he said the proposal is "the best approach for market integrity" and would "eliminate what could be perceived as a conflict of interest for dealers, and I stress the words 'could be perceived.' "

But critics warn that if a dealer-FA that has already spent money on due diligence on such small transactions is prohibited from bidding on them, any other dealer that bids will have to charge the issuer enough to cover its diligence expenses as well as the risk of whether it can sell the bonds at a profit.

"In an efficient market, you'd think that would result in higher total expenses of completing the offering," said Fredric Weber, a partner at Fulbright & Jaworski LLP in Houston.

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