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Brokers' Gifts That Keep Giving

JAN 13, 2012 11:11pm ET
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SAN FRANCISCO — When broker-dealers give money to California school bond campaigns, it appears to be money well spent.

A review of campaign finance records by The Bond Buyer found a nearly perfect correlation between broker-dealer contributions to California school bond efforts in 2010 and their underwriting subsequent bond sales.

The review found only one instance when a broker-dealer didn’t handle the bond sale after making a contribution to a political action committee advocating a successful school-bond measure. In that case, the business went to a firm that gave more, a review of disclosure filings with the Municipal Securities Rulemaking Board found.

Such contributions are not illegal, but they raise questions for some that regulations may need to be updated to prevent “pay-to-play” conflicts of interest.

In 2009, the MSRB elected not to restrict broker-dealer contributions to bond ballot campaigns as part of its Rule G-37, saying there was not enough evidence to show firms were being awarded underwriting business after helping to fund the measures. Instead, it required broker-dealers to disclose such contributions in filings to the MSRB beginning in February 2010. California voters approved 61 of the 83 school bond measures on the ballot in 2010, a passage rate of 74%.

According to the MSRB filings, underwriters contributed more than $700,000 to 41, or 67%, of those elections, all of which resulted in negotiated bond issues. Other successful bond elections resulted in competitive bond sales, in which the underwriter is not selected in advance.

Ten other negotiated sales by school districts also took place in 2010 without any disclosure of corresponding contributions by broker-dealers. Negotiated deals typically result in higher underwriter fees.

The California school bond measures linked to broker-dealer contributions approved in 2010 resulted in an estimated $3.85 billion of bond authorizations, resulting in around $1.2 billion of debt issued. Every time but once, the records showed, when a broker-dealer contributed to a bond referendum that passed, it ended up as lead manager or co-manager.

Piper Jaffray, De La Rosa, Stone & Youngberg, George K. Baum and RBC Capital Markets all lead negotiated school bond transactions after contributing to election campaigns, a review of MSRB records found.

Broker-dealers that commented for this story say they are hired before they give any money to a campaign. They said financial advisors and bond counsel firms generally give more and are not required to disclose campaign contributions to the MSRB. 

Other companies, such as construction firms, typically give more to the bond campaigns, but they are subject to a bid process overseen by a committee.

George K. Baum vice chairman Robert Dalton said it’s the policy of the firm to donate if asked by an independent campaign committee, not the school district, and only if the firm had already been hired as an underwriter.

“We do not make campaign contributions to influence the hiring decision,” Dalton said in a statement. “Our underwriting contracts with our school district clients are most often entered into six months to a year before the bond election is called.”

Dalton’s comments mirrored those by other broker-dealers.

The only firm not selected to underwrite a bond sale after giving money to a ballot measure committee was Stone & Youngberg, after it contributed $10,000 to West Contra Costa Unified School District’s Measure D, a $380 million bond referendum. Piper Jaffray was the lead manager on the district’s subsequent $100 million sale last November, after giving $25,000, according to disclosure documents filed by the firm to the MSRB.

A spokesperson for Piper Jaffray contacted for comment pointed to the firm’s internal policy stating it will not make any financial contribution as a condition of being retained as an underwriter. The firm didn’t comment further.

An investment banker who declined to be identified said the truth about school bond elections in California is that money is needed to pay for ballot measures.

“We want to support our clients and the unfortunate reality in California is to do a voter outreach program it takes resources,” the banker said. “This is what happens in California. In an ideal world you wouldn’t need all this stuff.”

PAY TO PLAY

Glenn Byers, assistant treasurer for Los Angeles County, along with county Treasurer Mark Saladino, has been challenging some school districts in the county over their bond issuance practices. He said pay to play is endemic.

“It is a glorified version of pay to play,” said Byers. “These people are not going to be contributing the money if they are not going to be standing in line to then work on the bond transaction. I don’t know of a single instance where someone gave money and didn’t work on the bond transaction.”

While the state government regulates campaign contributions, it cannot limit donations to referendum campaigns because of a 1982 U.S. Supreme Court ruling, according to Robert Stern, an expert of California campaign finance law. “It is not common knowledge, but it is not unusual and clearly it’s not illegal,” he said.

When the MSRB changed its Rule G-37 to require underwriters to disclose their contributions to ballot measures in 2009, it did not adopt stricter regulations advocated by Citi, Morgan Stanley and JPMorgan. Those firms argued that G-37’s restrictions on contributions to referendums should mirror existing strict limits on broker-dealer contributions to issuer officials and should cover banks, municipal finance professionals and associated political action committees, as well as broker-dealers.

Stratford Shields, a Morgan Stanley managing director, wrote in a comment letter to the MSRB that when an underwriter contributes to a bond campaign and is then selected for the resulting negotiated deal, it gives the impression of pay-to-play. Morgan Stanley has discontinued its contributions to bond campaigns.

Rule G-37 was created to restrict contributions by firms to the campaigns of politicians who could influence the selection of financial firms.

Aside from school bond campaigns, underwriters and other industry players also have contributed to parcel-tax measures for school districts.

In 2009, the rulemaking board said it was premature to extend the rule to restrict contributions to ballot campaigns because there was not enough evidence to show firms were being awarded business based on the contributions.

No action has been taken since.

MSRB executive director Lynnette Kelly said the board has no current plans to amend Rule G-37. “However, we continue to look at all issues in the market where pay-to-play activities may be occurring,” she said in an emailed statement.

Christopher Taylor, who served as executive director of the MSRB from 1978 to 2007, said the Securities and Exchange Commission has in the past pushed the board to fix the problem of choosing broker-dealers for reasons other than expertise.

“Virtually everyone who was on the board when I was executive director understood there was almost a one-to-one correlation — maybe you couldn’t prove it, but certainly there was a pretty strong connection because the issue kept arising,” Taylor said. “School districts were openly soliciting that and making it clear that contributions would play a role in their choosing the underwriter.”

Voters in the West Contra Costa School District in June 2010 approved one of the largest K-12 bond measures in California in that year, a $380 million authorization approved by 62% of the electorate. The first sale from that authorization was a $100 million deal in November of last year handled by Piper Jaffray as the lead.

The district paid the underwriters a $450,000 fee for the issuance, according to the official statement for the sale.

The underwriter also had a history working on other bond sales for the district. After its $25,000 contribution before the June 2010 election, Piper also underwrote a $27.5 million deal issued under a 2005 bond measure, and underwrote an $85 million refunding deal in August 2011.

The firm also served as lead manager on $161 million general obligation bond sale in 2009, which appears to be the first negotiated deal done by the district after it previously had done competitive sales.

Piper Jaffray’s $25,000 contribution was only a fraction of the money raised for the bond election campaign, according to county election records; the majority came from construction and architectural firms.

Sheri Gamba, associate superintendent of business at the school district, said the process for selecting underwriters and others for bond sales includes a request for proposals, interviews and a selection “matrix.”

Gamba said underwriters are chosen by the administration and the bond deals are later approved by the board. Piper was first selected by the school district in 2009 and has been the lead on each deal since.

She said the district’s financial advisor, KNN Financial, helped them with the process, including picking underwriters and negotiating the best fees. KNN also made political contributions in 2010 to the district, but only for a parcel tax measure, according to filings. The advisor is required to disclose campaign contributions because it is owned by Zions First National Bank.

While school districts normally have a committee to oversee the use of bond proceeds, they typically have no third-party oversight for selecting financial firms.

Piper, deal co-manager De La Rosa and KNN Financial also gave money, along with contractors and architects, to a summer study program for district students.

The process used to select underwriters is usually smoke and mirrors, said Joe Canciamilla, a former state Assembly member who sponsored legislation to try to bring more transparency to school bond elections. 

In 2005, Canciamilla proposed a bill that would have required school districts selling new-money general obligation bonds to use competitive bidding, in an effort to bring more transparency to the process. He described a typical negotiated bond deal.

“Basically you would have a financial firm come and say we will help with setting up the campaign, help find a consultant if you need one and then we will do the issuance when it is all said and done,” said Canciamilla, who was a member of the Pittsburg Unified School District board before winning a state Assembly seat in 2000. “Obviously, all of those upfront costs and expenses are rolled into the cost of the deal — it is not rocket science to figure it out.”

He said $50,000 to $75,000 would likely swing an election in an average-sized district, while noting that it is difficult to find people to contribute to a measure that raises costs for taxpayers.

During his research for the bills, Canciamilla said he found many instances where broker-dealers charged the school districts much higher fees for deals compared to typical bond issues. He said districts, whose officials often lacked a solid understanding of bond financing, selected underwriters they knew. 

LOBBYING AGAINST CHANGE

When the opposition “leveled both shotgun barrels” at his bill by hiring lobbyists, Canciamilla said he knew he was on the right track. One of the main opponents was the California Public Securities Association, the lobbying group for the state’s public finance industry.

Canciamilla’s bill died in committee in 2005 but returned in a heavily watered-down version the next year, and Gov. Arnold Schwarzenegger signed it. The final version only requires a school board to adopt a formal resolution before a bond sale stating the method of sale and the reason for the choice. After a bond sale, the board is required to disclose the actual cost of the sale at a public meeting.

Term limits ended Canciamilla’s Assembly tenure in 2006. Since then, a few lawmakers have taken up the cause of trying to stop financial firms from providing money or support to a bond campaign and then working on the deal, but they, too, have fallen by the wayside.

“There is a lot of money involved in this and it is just one of those things that sits on the back burner,” Canciamilla said.

School districts in California combined sell more debt than in any other state and that is reflected in the amounts contributed to bond elections there. In 1999, California passed a law to streamline the rules governing school bond elections. The law made it easier for districts to offer bonds through negotiation rather than through competitive bid.

A year later, the state’s voters approved Proposition 39, which lowered the required approval threshold for most school GO elections to a 55% majority from two-thirds. The result has been a deluge of school bond sales.

Since 1999 through the end of November, California K-12 schools have issued  2,752 of new-moneys worth nearly $62 billion, according to Thomson Reuters. That compares to $47 billion worth of new-money K-12 sales in Texas, the state with the second largest amount of new-money sales, and $25 million in New York for the third most.

In a letter last year, Saladino warned bond attorneys, underwriters and advisers to stop school bond practices that he says hurt taxpayers.

Saladino said in the letter that his office rejected some general obligation bond sales because they resembled a “cash-out” financing structure declared illegal by the state attorney general in 2009. He noted some schools were using bond proceeds to pay for cash-flow needs and employing “exotic” debt structures.

The districts have turned to such transactions as declining property values have lowered their tax revenues and limited their ability to fund debt service within tax rates set before the housing collapse.

Even though there appears to be little momentum for change, California Treasurer Bill Lockyer said the time has come.

“In our view, it is probably time to end the days when underwriters, bond counsels or financial advisors fund, manage or provide other key support for local bond campaigns, then get paid to do work on the bond sales,” Lockyer spokesman Tom Dresslar said.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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