WASHINGTON — Independent financial advisers are warning the Securities and Exchange Commission that the Municipal Securities Rulemaking Board’s proposed changes to Rule G-23 contain loopholes that would allow dealer-financial advisers to switch roles and become underwriters in the same muni transactions.
Broker-dealer groups, however, are questioning the need for the rule changes and worry they go too far. They are urging the SEC and MSRB to exempt small issuers and competitive transactions from the proposed changes, which generally would prohibit dealer-FAs from becoming underwriters in the same muni transactions.
In comments filed with the SEC, the independent FAs complained the MSRB proposal was too lax and the dealer groups said it was too restrictive.
The non-dealer FAs focused on guidance the MSRB issued in February along with its most recent proposed rule changes, which followed an earlier proposal it issued in August.
The more recent proposal, like the existing rule, says an FA relationship would not exist when, “in the course of acting as an underwriter,” a broker-dealer advises an issuer about the structure, timing, terms, and other similar matters concerning a muni issue.
In the guidance, the MSRB said the proposal would presume an FA relationship exists when a broker-dealer advises an issuer about a muni issuance. But the broker-dealer can rebut that presumption by clearly identifying itself as an underwriter from “the earliest stages” of the relationship.
However, the board said that even if a broker-dealer clearly identifies itself early on as an underwriter in a transaction, it can still make statements or engage in certain activities that cause it to become an FA under the rule, triggering a ban on underwriting.
By way of example, the MSRB said a broker-dealer who claimed it was acting “only in the issuer’s best interests, rather than as an arm’s length counterparty,” could be considered an FA, precluding it from underwriting the bond issue.
Under the existing Rule G-23, dealer-FAs can become underwriters in negotiated muni transactions if they terminate their FA role, 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.
But last year, SEC chairman Mary Schapiro prodded the board to revamp the rule, saying such role switching was “a classic example of conflict of interest.”
When it proposed rule changes in February, the MSRB said a dealer-FA’s ability to serve as underwriter and adviser on the same issue presents a conflict “too significant” for the existing disclosure and consent provisions to cure.
Even in a competitive underwriting, the board said, some investors and issuers still perceive a conflict, contrary to the board’s mandate to protect a free and open muni marketplace.
Role-switching generated even greater concern beginning last year, after the Dodd-Frank Wall Street Reform and Consumer Protection Act imposed a fiduciary duty on municipal advisers, including financial advisers, the board noted.
Still, some non-dealer FAs — concerned that role-switching is riddled with conflicts of interest — told the SEC that the MSRB’s proposed rule and guidance fall short.
In a comment letter dated Feb. 25, John White, chief executive officer of Public Financial Management Inc. in Philadelphia, urged the SEC to reject both Rule G-23’s carveout for broker-dealers acting as underwriters as well as the MSRB’s guidance in its entirety.
Referring to the board’s composition, which became majority-public last year as a result of Dodd-Frank, White said: “The fact that the board surreptitiously has proposed the guidance at the last hour is powerful evidence that despite superficial additions to the board’s membership, the underwriting community still holds the board firmly by the neck.”
Specifically, White said underwriters pose “significant competition” to financial advisory firms.
“And in many cases,” he wrote, “the municipal issuer decides to forego the independent advice which potentially would conflict with the underwriter’s convenience and profit.”
In a comment letter filed earlier this month, Robert Doty, the president of American Governmental Financial Services Co. in Sacramento, said he supports the board’s proposed rules and guidance overall, calling them “a very good effort.”
But he said the MSRB should look at whether a dealer does or says anything during the transaction that would cause it to become an FA, even at the outset of its relationship with the issuer.
Doty told the SEC that if an underwriter makes statements or takes actions that suggest it is placing the issuer’s interest first or is acting in the issuer’s best interest, then many issuers would understand the firm is serving as their FA, regardless of whether it has identified itself as an underwriter.
As for permitting underwriters to rebut the FA presumption by clearly identifying themselves up front as underwriters, Doty said he remains skeptical. It would be better, he noted, if the broker-dealer told the issuer it was not acting in a fiduciary capacity, and explained what that meant.
Doty also said the SEC should encourage issuers to seek advice from municipal advisers, who are subject to the commission’s proposed registration scheme and Dodd-Frank-mandated fiduciary duty.
Finally, he said, any contract between issuers and underwriters should say underwriters are acting at arm’s length, not as a fiduciary, and broker-dealers should have an explicit discussion with issuers at the outset of the relationship to clarify that the underwriter is not a fiduciary.
Some dealer-FAs and market participants, on the other hand, urged the SEC to narrow the scope of the proposed rules, warning they would reduce competition and drive up costs for small issuers.
In a comment letter dated March 16, Hill Feinberg, chairman and CEO of First Southwest Co. in Dallas and a former MSRB chairman, urged the SEC to exempt offerings of less than $5 million, saying such deals typically attract few potential underwriters.
“Current times of economic stress, coupled with regulations that limit bidders for small-issue deals, will cripple the market for small-issue deals with a resulting effect of economic devastation to small issuers,” Feinberg said.
In an interview, Feinberg said his firm performed a five-year internal review of its own role-switching last year.
Between Aug, 1, 2005, and July 31, 2010, First Southwest served as FA on 1,898 negotiated issues, including 21 — or roughly 1% — that it underwrote after resigning and switching roles.
The average size of those deals was $5.54 million, according to First Southwest.
The internal review also found that First Southwest acted as FA in 2,473 competitive deals during the same five-year period, including 269 — or roughly 11% — that it underwrote.
Eighty-seven of these issues were nonrated, with an average size of $3.76 million, and 182 were rated, with an average size of $4.64 million.
Meanwhile, in an SEC comment letter dated March 21, the Bond Dealers of America said the existing disclosure provisions in Rule G-23 provide issuers the information they need to evaluate potential conflicts, and echoed the plea for a small issuer exemption.
Citing Ipreo data, the BDA said that during the 10-year period between Jan. 1, 2000, and Aug. 27, 2010, 42% of competitive bond issues of $10 million or less received three or fewer bids. Only 12% of bond issues of $30 million or more received three bids or fewer, the BDA said.
“If even fewer firms are able to bid as a result of the proposed amendments to Rule G-23,” said Mike Nicholas, the group’s CEO, “the cost of accessing the capital markets for these smaller issuers is likely to increase, or, in the worst case, these issuers may be prevented from accessing the markets at all.”
The BDA also urged the commission to carve out an exemption for competitive deals, saying the bidding process in such transactions minimizes potential conflicts of interest and introduces an arm’s-length basis for establishing the terms of the underwriting and issue.
The group also criticized the MSRB’s guidance, saying it creates a lack of clarity about when an underwriter could be considered an FA.
Rather than employ presumptions, rebuttable and otherwise, the BDA said there should be a simple rule: a party engaged by an issuer as an FA is an FA and a party engaged by an issuer as an underwriter is an underwriter.
“If the commission believes that issuers entering the credit markets do not understand the difference between those roles, it can prescribe disclosures that make the difference clear,” the group said.
Similarly, in its March 21 comment letter, the Securities Industry and Financial Markets Association asked the SEC to exempt small municipal issues — those under $10 million. SIFMA also said the SEC should create an exemption for competitively bid, unrated, non-credit enhanced, fixed-rate issuances in which the issuer used an electronic bidding platform, saying it is unaware of abuse in this arena.
In addition, SIFMA urged the SEC to eliminate the FA presumption from the MSRB’s guidance, saying broker-dealers who intend to act solely as underwriters should be required to make their intentions “clear and unambiguous” during initial communications with issuers.
SIFMA said the board’s guidance should provide that a written agreement between the underwriter and issuer reflecting such an understanding would establish a presumption that the underwriter will continue to act in that role throughout the offering.
“The subsequent course of conduct of the parties should then only be relevant to the extent the underwriter acts outside the scope of the established relationship,” said Leslie Norwood, SIFMA’s managing director and associate general counsel, who signed the letter.
Finally, SIFMA said the existing rule represents a “balanced approach” to managing potential conflicts of interest. SIFMA also said it remains concerned about “considerable uncertainty” surrounding the muni-adviser fiduciary duty standard, given recent and ongoing rulemaking in this area.
Specifically, SIFMA pointed to the SEC’s proposed municipal adviser-registration scheme, the draft Rule G-36, which details how muni advisers will be expected to comply with fiduciary duty obligations imposed by Dodd-Frank.
The group also cited the MSRB’s draft interpretive notices for Rule G-17, which explains how fair-dealing requirements would be extended to muni advisers and how the rule would apply to underwriters.
“Until the fiduciary standard proposals and related definitions and interpretations of the commission and the MSRB have been finalized, we strongly believe that any actions to revise Rule G-23 would be premature,” Norwood said. “Accordingly, we respectfully request that the commission’s consideration of the proposed amendments be tabled until final rules implementing and harmonizing the standards promulgated by the commission and the MSRB are firmly in place.”
The SEC’s comment period on its proposed muni adviser registration rules ended last month. The MSRB is seeking comments on draft Rule G-36 and the Rule G-17 interpretive notices through April 11.