MSRB guidance warns against 'prearranged trading'
WASHINGTON — Prearranged trading in connection with primary offerings could threaten the integrity of the muni market, the Municipal Securities Rulemaking Board warned in new draft guidance.
The MSRB’s “Request for Comment on Draft Interpretive Guidance on Application of MSRB Rules to Certain Prearranged Trading in Connection with Primary Offerings,” published Thursday evening, aims to make clear the rulemaker’s views that so-called “prearranged trading” is a violation of MSRB rules. The MSRB is asking market participants to provide comments and answer certain questions posed in the draft guidance as a step toward creating a final version.
The type of prearranged trading the MSRB is focused on occurs when, prior to the completion of the distribution of a new issue, a dealer that is not a member of the underwriting syndicate arranges to purchase the bonds at or above the list offering price from either a syndicate member or an investor, typically once the bonds are free to trade. The non-syndicate dealer enters into the prearranged trade to increase the likelihood that it can purchase the bonds for its own account because an order for an investor would receive a higher priority allocation than an order placed directly by the non-syndicate dealer for its own account.
In such arrangements, the MSRB explained in the draft guidance, there is an either explicit or implicit understanding among the participants that the fact that the order is for the non-syndicate dealer’s account will not be disclosed.
This kind of arrangement can allow a dealer firm to purchase bonds it might not have been able to obtain by placing an order with the syndicate directly for its own account effectively using a syndicate member or an investor as a “proxy” the MSRB said.
Such behavior, which appears to have become increasingly common and which was the subject of a recent Securities and Exchange Commission enforcement action, has the potential to harm the muni market, the MSRB fears.
“The MSRB believes this type of prearranged trading in connection with a primary offering may have a negative impact on the fairness and efficiency of the municipal securities market,” according to the draft guidance. “Specifically, this practice could cause senior syndicate managers, who often are in communication with issuers regarding allocations, to fill orders from members of the syndicate or selling group that they might not have filled had they known that they effectively were orders for non-syndicate/selling group dealers.”
In addition, the MSRB said, prearranged trading could prevent investors from getting the priority they should receive under the issuer’s guidelines and the prices at which prearranged trades are executed could be “substantially away from the true prevailing market price of the bonds when they are free to trade,” disseminating misleading pricing information to other market participants.
Participants in such arrangements could be violating MSRB Rules G-17 on fair dealing, G-11 on primary offering practices, and G-25, on improper use of assets, the guidance warns. Non-syndicate dealers involved in these arrangements are engaging in a deceptive practice in violation of G-17, the draft guidance said, while a syndicate member could be violating both G-17 and G-11.
Rule G-11 requires, among other things, that dealers who submit orders during a retail order period to the senior syndicate manager provide information demonstrating that the order is a bona fide retail order. The potential for a G-25 violation also exists because G-25, among other things, precludes dealers from sharing, directly or indirectly, in the profits or losses of transactions in municipal securities with or for a customer or offering guarantees against loss in such transactions.
The draft guidance follows a major SEC enforcement action in August, when the commission charged two firms and 18 individuals with participating in a “flipping” scheme that included prearranged trading. In those instances, the SEC alleged, investors acting as unlicensed broker-dealers posed as local retail investors to obtain priority position to purchase bonds and then sell them to a dealer firm at a prearranged markup. The SEC announced just weeks ago that it had reached a $400,000 settlement with a former UBS Financial Services broker alleged to have participated in the scheme.
The MSRB was already at work on this draft guidance when the SEC announced those enforcement actions.
“The MSRB is seeking comment on draft guidance, which would reinforce to the market the application of the MSRB’s fair dealing and other rules to certain prearranged trading practices in connection with primary offerings of municipal securities," said Lanny Schwartz, the board's chief regulatory officer. "We believe that these practices are harmful to the market.”
Securities Industry and Financial Markets Association Managing Director and Associate General Counsel Leslie Norwood said her group appreciated the MSRB's effort to address perceived unfairness in the market.
“SIFMA is reviewing the draft interpretive guidance, and is appreciative that the MSRB is seeking industry comment. We also appreciate the MSRB’s attempt to address any real or perceived unfairness in the market, and agree that intentional misrepresentations of the character of an order would be a violation of Rule G-17. SIFMA and its members are focusing on ensuring any efforts to address such concerns are tailored so as to be effective and not unduly burdensome.”
Bond Dealers of America CEO Mike Nicholas said BDA had some concerns about the proposed guidance.
"The BDA’s members are concerned that the MSRB may be inferring too much from this type of trading activity," Nicholas said. "However, we do recognize the efforts of the MSRB to address prearranged trading where there are actual agreements to circumvent an issuer’s retail order period. The BDA will review the interpretive guidance to ensure that it narrowly targets these concerns and does not unintentionally impact market liquidity and pricing for both investors and issuers alike."
The MSRB has posed several questions along with the draft guidance, including how prevalent market participants think prearranged trading is and whether the guidance as drafted inadvertently captures conduct that market participants believe is within the rules.
The MSRB is asking that market participants provide comments no later than March 5.