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Brokers Violate Puerto Rico OS, MSRB Rules with Retail Trades

WASHINGTON — It didn't take long for several broker-dealers to start selling small denominations of Puerto Rico $3.5 billion of general obligation bonds to retail investors in violation of a requirement in the official statement and municipal securities rules.

The official statement for the bonds states that the bonds cannot be sold in denominations of less than $100,000 unless one of the three major rating agencies — Standard & Poor's, Moody's Investors Service, or Fitch Ratings — upgrades them to an investment grade rating.

All three rating agencies gave the bonds speculative grade ratings when they were issued on March 11. S&P rated them BB+, Moody's Ba2, and Fitch BB. The bonds would need to be upgraded to an investment grade rating — BBB or higher — in order for the minimum denomination to drop to $5,000.

The idea behind the minimum denomination requirement was to ensure the bonds would not sold to retail investors, who might not fully appreciate the risk they entail.

The OS specifically states: "The bond resolution provides that the bonds shall be issued in the minimum denomination of $100,000 and any integral multiple of $5,000 in excess thereof; provided, however, that upon receipt by the Registrar from the Secretary of the Treasury of written evidence from any of Fitch, Moody's or S&P that the bonds have been rated 'BBB-,' 'Baa3,' or 'BBB-,' or higher, respectively, then the minimum denomination for the bonds shall be $5,000 (the 'authorized denominations').

Sources familiar with that provision says it covers the bonds over the life of the bond issue and not just initial issuance.

However, a review of the trades reported to the Municipal Securities Rulemaking Board's EMMA system shows that from 9:16 AM on Tuesday, March 11 through 4:30 on Tuesday, March 18 there were 94 trades of bonds in denominations of less than $100,000.

Seventy of those trades were sales to customers and 24 were interdealer trades. Two of the sales to customers occurred on March 11. One was a $95,000 bond and the other was a $50,000 bond. The number of smaller-than-minimum denomination sales to customers ramped up on March 12 and March 13. Four were in denominations of $5,000 and others were $10,000, $12,500, $25,000, $30,000 and $50,000. All but eight of the trades were listed with a "W" for a "When issued trade," meaning the trade was executed on or before final issuance and settlement.

"I think it's pretty outrageous that those bonds are immediately going to retail," said one market professional who did not want to be identified. "It's a clear violation."

"This was the most scrutinized bond deal of the year, maybe the next couple of years. Everyone was focused on how it would trade and multiple organizations were reporting on how it was trading," said another market participant who did not want to be named. "The regulatory agencies are supposed to be protecting retail investors. They had to be seeing this. Why didn't they say something?"

"MSRB rules prohibit trades below the legally authorized minimum denomination prescribed in the official statement," said MSRB executive director Lynnette Kelly. "The MSRB regularly makes referrals to the appropriate enforcement agencies when it becomes aware of possible rule violations."

The MSRB's Rule G-15, on uniform practice requirements with respect to transactions with customers, states that a broker-dealer "shall not effect a customer transaction in municipal securities issued after June 1, 2002, in an amount lower than the minimum denomination of the issue," with very limited exceptions. One exception, for example, is when the broker-dealer determines the below-minimum denomination resulted from a customer liquidating a position.

In addition, an interpretative notice to Rule G-17 on fair dealing dated Jan. 30, 2002, the MSRB referred to the G-15 prohibition and said, "the MSRB believes that any time a dealer is selling to a customer a quantity of municipal securities below the minimum denomination of the issue, the dealer should consider this to be a material fact about the transaction."

The board added that, "A dealer's failure to disclose such a material fact to a customer, and to explain how this could affect the liquidity of the customer's position, generally would constitute a violation of the dealer's duty under Rule G-17 to disclose all material facts about the transaction to the customer."

Securities and Exchange Commission officials would not comment.

The trade data reported on EMMA do not show the specific firms or investors involved, but regulators get trade reports that include that information so that they have a complete audit trail.

"Brokers are supposed to abide by the restrictions in the bond documents," said another source who did not want to be named. Historically, trustees could monitor trades to make sure they were in compliance with requirements, the source said. But today, everything goes through the Depository Trust and Clearing Corp.

"The issuer and the trustee have no idea what's going on," he said.

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