The Securities and Exchange Commission's probe into broker-dealers passing oninformation to other firms that could allow them to submit winning bids for auction-ratesecurities raises questions about whether a broker-dealer's bid on a deal they haveunderwritten could be unfairly influencing the market.
The enforcement division of the SEC sent letters to many broker-dealers last monthrequesting that they voluntarily investigate their activities in the auction-rate bondmarket and provide written reports to the regulator detailing potentially deceptive,dishonest, or unfair practices. Both J.P. Morgan Securities Inc. and Goldman, Sachs &Co. have received the letters. Calls to most of the other broker-dealers active in thismarket regarding the letters either were not returned or resulted in no comments.
The full scope of the SEC's inquiries are not known, however, market participantsyesterday considered some of the aspects of auction rate transactions, that could drawregulatory attention.
A source at one Wall Street broker dealer yesterday said she believed the inquiry wasnot so much rooted in claims that the firms are providing preferential treatment todifferent customers, but rather that broker-dealers have been manipulating the processto ensure the auctions do not fail.
Failed auctions - which occur when not enough bids are submitted - can result in steeppenalties for issuers, forcing them to pay interest rates as high as 14% to those leftholding the securities, according to Joseph Fichera, chief executive officer of SaberPartners, an investment banking advisory firm in New York. Saber has advised clients ranging from Exxon Corp. toGeneral Electric Credit Corp. on the use of auction rate securities.
No municipality with an investment-grade credit rating has ever experienced a failedauction, according to a presentation given by Wendell Gaertner, a vice president at Bancof America Securities at a conference held by The Bond Buyer in Tampa in February.
A broker dealer "usually submits [its] own order to make sure sufficient orders arereceived at market rates," according to statement in a slide from Gaertner'spresentation at that conference. A Banc of America spokesperson yesterday confirmed thatGaertner is employed by the firm, but declined further comment.
Broker-dealers collect bids and pass them along to the auction agents. By examiningthose bids, the dealers could be able to calculate what the winning bid would be. TheSEC's examination is looking at whether the dealers have subsequently passed thatinformation along to other firms to prevent an auction from failing, a source said.
But the issue raises questions about whether brokers could be using the information fromthe initial bids in setting their own bids as well.
Broker dealers are often allowed under the terms of a contract with the auction or theobligor on the bonds to submit bids. However, the broker-dealers cannot use informationfrom bids they collect to set their bid level, Fichera said.
By doing that, he said, broker-dealers would be interfering with what should be a "blindauction," in which participating firms are not supposed to know the bids of currentinvestors or other bidders until the auction is over. "It violates the rules of theauction because the broker has more information than other investors have," Fichera saidin a telephone interview with The Bond Buyer yesterday.
"As we've seen from past SEC enforcement actions, those bids would have the effect ofeither lowering the rate otherwise established through the auction and/or preventing theauction from failing, which would have resulted in the imposition of a penalty rate,"Fichera said.
"The penalty rate is set at such an extraordinary level so as to encourage the issuer toredeem the bonds if the
auctions were to continue to fail," he added.
Broker-dealers however maintain a strong interest in ensuring that failed auctions donot occur because they could result in fewer issuers opting to sell auction rate notes,and instead turning to variable-rate demand notes.
On an overall cost basis, issuing variable rate demand notes are comparable to sellingauction rate debt, according to Catherine Boone, assistant treasurer for Connecticut,which priced $97.7 million in auction-rate notes on Wednesday.
Unlike variable rate demand notes, auction rate notes do not require issuers to obtainletters of credit. But broker dealers charge much higher annual fees for auction ratenotes.
Broker-dealers usually require annual payments costing issuers about 0.25% of theprincipal amount for auction rate deals, according to Gaertner's February conferencepresentation.
The annual fees for variable-rate demand notes is closer to 0.10%, Boone said. Boonesaid she believed upfront fees to be just slightly higher for auction rate debt than for variable rate debt.
Because variable-rate demand notes have the additional cost of acquiring a letter ofcredit, their overall cost is nearly equivalent to that of auction rate notes, sheadded.
Boone said Connecticut had opted to sell auction-rate notes because she thought theprocess would be less time-consuming than it would be to try and acquire the letter ofcredit necessary for variable rate debt.
Boone said Bear, Stearns & Co., which served as underwriter on the Connecticut auction -rate deal, did not inform her of the SEC's probe into auction procedures, which she onlyread about in newspapers yesterday. Interest rates on the notes sold by Connecticut thisweek were set at 1.25% for the first 28-day period, which Boone said she believed to becompetitive.
"I would expect issuers to call their dealers when they see this and ask whether theyare doing an investigation, and if so, what that investigation will show, and then tomake improvements to that process if need be," said Patrick Born, who is a vice chairmanof the Government Finance Officers Association's committee on government debtmanagement, and the city finance officer for Minneapolis.
"Issuers would expect integrity from their dealers in setting the interest rates, and ifthey have a reason to question the integrity of their dealers then they would be lesslikely to use auction-rate securities, and use other variable rate products," Born said. "If the SEC is concerned about it, then it will raise some concerns with issuers, whether theirauction-rate securities' interest rates are being set at what truly is the market."
Susanna Duff Barnett and Craig T. Ferris contributed to this story.
