WASHINGTON - Participants in municipal bond transactions need to clearly identify, document and disclose potential conflicts of interest in order to avoid problems such as defaults or enforcement actions, the National Federation of Municipal Analysts concluded in a white paper.
The paper, released Wednesday, is intended to address a topic oft-neglected by transaction participants, said Gilbert Southwell, vice president and senior municipal analyst at Wells Capital Management, who co-authored the paper with several other NFMA members.
"Potential and actual conflicts of interest among transaction participants are credit risks which generally do not get enough attention in municipal offering documents and due diligence," Southwell said in a release accompanying the paper.
Jennifer Johnston, NFMA chair and a vice president at Franklin Templeton, added, "While there is an understanding that conflicts of interest will be disclosed in conjunction with an offering, this paper identifies in greater detail the types of conflicts that could arise and reinforces the importance of disclosure so an analyst has the tools to make an appropriate assessment of risk."
The NFMA said in the paper that potential and actual conflicts of interest in a municipal financing are not limited to for-profit participants, but can arise from a variety of sources and remain poorly identified and undisclosed because of a number of factors.
"Those failures may occur as a result of one or more of the following: an inadequate identification of parties with interests in a transaction; a poor understanding of the roles, responsibilities, and relationships of those parties; a lack of due diligence concerning conflicts of interest; or an insufficient appreciation of the myriad potential conflicts of interest that may affect the underlying financing transactions and the sound structuring and underwriting of municipal securities," NFMA said.
Potential conflicts can arise from past, present, or anticipated business and personal relationships among issuers and issuer officials, obligors and underwriters, and experts and underwriters. Other areas of conflict can include: gifts and payments to politicians or their charities or families; contributions to bond ballot campaigns; compensation agreements that incentivize the swift completion of deals; and the economic interests of the participants in the project.
"Any such arrangement may reflect unfavorably on the integrity or competence of issuer or obligor managements," NFMA said. "The arrangements may indicate that the selection of professionals to perform bond structuring, due diligence, disclosure, municipal advisory, expert, and underwriting functions is made on a basis other than merit, with significant adverse implications for the municipal securities and their post-issuance performance."
Laws and regulations already exist to prohibit some of these types of conflicts. Bribing public officials is illegal at every level of government, NFMA pointed out, and ethics rules governing professionals such as attorneys, securities dealers, engineers, financial advisors, and others require them to disclose their potential conflicts of interest. Municipal Securities Rulemaking Board rules also may apply, prohibiting, among other behaviors, the once common practice of "role switching" between financial advisor and underwriter and pay-to-play practices.
The paper provides further detail on several areas warranting special diligence in conflict disclosure, including contingent payment agreements in which the professional involved in the transaction receives compensation contingent on the closing, or the size, of a transaction. Such payment arrangements are especially undesirable for municipal advisors or other experts who are supposed to be delivering an independent analysis of the financing, NFMA said.
"Payment arrangements that are contingent on the 'success' of a financial transaction clearly pose credit and other risks because these arrangements often entangle the opinion or advice required to complete municipal finance transactions, removing its independence," the paper said. "Historically, compensation arrangements in municipal finance transactions that hinged on transactional completion have been associated with poorly structured bond issues and overly optimistic appraisals, unrealistic fiscal and economic projections, too-confident feasibility studies, overly optimistic construction budgets and timetables, and the like, to the detriment of municipal investors, as well as issuers and obligors."
The failure to adequately identify and disclose actual and potential conflicts of interest can lead not only to bad financial outcomes, NFMA said, but also more attention from regulators, negative reaction from the public and even difficulty in qualifying for federal grants and bank loans in the future.
Southwell said potential conflicts exist in all transactions, but if they are properly disclosed analysts can make an informed judgment about how much of a credit risk the conflict or conflicts present.
The paper ends with a variety of specific examples in which conflicts of interest created problems, such as one West Virginia financing that led to a Securities and Exchange Commission enforcement action in late 2011. In that case, settled in federal court in July 2012, Charles Aiken, a conduit borrower through his company Aiken Continental, was found to have failed to disclose to other transaction participants that he had a criminal history and that he had taken a $200,000 loan from an entity partially owned by his company's attorney in order to help Aiken acquire a casket manufacturer. The undisclosed details made the official statement of the bonds misleading, the SEC said, and Aiken was ordered to disgorge ill-gotten gains and pay millions of dollars in penalties. The paper is available at NFMA's website. The group is soliciting comments on the paper through July 20, though it has already vetted the work with some underwriters and lawyers. Southwell said the group could reissue the paper to reflect market commentary.
"We're really hoping we get some good feedback on this," he said.
