Widespread conversions from auction-rate securities to variable-rate demand obligations featuring liquidity facilities may result in activities that violate federal laws against bank tying as well as prohibitions against the underpricing of credit products, the Municipal Securities Rulemaking Board said in a notice to broker-dealers yesterday.
The one-page release warned that any dealer that aids and abets a violation of federal bank tying or underpricing of credit would violate the board's Rule G-17 on fair dealing.
"Given the recent activity in the market and the concurrent rise in the use of bank credit guarantees and liquidity facilities, the board felt a reminder about the prohibition of tying arrangements was warranted," said MSRB chairman Frank Chin, managing director and manager of the public finance department at Citi.
Tying, which is prohibited by Section 106 of the Bank Holding Company Act Amendments of 1970, includes conditioning the availability or terms of loans or other credit products on the purchase of certain other products or services. While it is legal for banks to tie credit and traditional banking products, such as cash management, it is not legal for banks to tie credit and debt underwriting from the bank or from the bank's investment affiliate, the board said.
For example, the board said, a bank would violate section 106 if it informs a customer seeking a liquidity facility that the bank will provide one only if the customer commits to hiring the bank's securities affiliate to underwrite an upcoming bond offering that is to be issued by the customer.
But section 106 does not prohibit a customer from deciding on its own to award some of its business to a bank or an affiliate as a reward for the bank previously providing credit or other business to the customer.
Meanwhile, the board said that if a bank provided a reduced rate on a liquidity facility because of an illegal tie-in with an underwriting, that may also constitute an underpricing of credit that could violate section 23B of the Federal Reserve Act of 1913. Section 23B generally requires that certain transactions between a bank and its affiliates occur on market terms and applies to any transaction by a bank with a third party if an affiliate has a financial interest in the third party or if an affiliate is a participant in the transaction.
MSRB executive director Lynnette Hotchkiss said in an interview yesterday that the board is acting proactively and is not aware of any illegal arrangements. But she urged market participants to contact the board and other regulators if they are aware of any.
"We encourage anyone with information about illegal bank tying arrangements to immediately notify the MSRB or appropriate bank regulatory agencies," she said.
Though the board had not heard of any specific instances of illegal tying, a research note issued by Municipal Market Advisors in April suggested that some banks were engaging in tying activities, though it was not clear if they were illegal.
"There have been examples recently of issuers buying letters of credit to put on their variable-rate demand obligations in order to get out of failing auctions rate securities," the note said. "However, before the bank gives an issuer the LOC, which are much more expensive than they were a year ago, the bank is also requiring that the issuer move its own bank account to the bank that is providing the LOC."
Market sources said yesterday that even if banks are tying their LOCs to an issuer's future underwritings, it is extremely hard to prove that the tying is illegal.
"Sometimes it's difficult to determine the line between selling an array of services and having to take the bundles as a precondition on any service," said Richard Roberts, a principal at Roberts, Raheb & Gradler LLC who called for stronger anti-tying regulations in the municipal market when he was a member of the Securities and Exchange Commission from 1990 to 1995.
Specifically, he called for bank regulators to step up the enforcement of the anti-tying laws on their books and for banks to police their industry.
The Treasury Department's Office of the Comptroller of the Currency and the Federal Reserve, which have jurisdiction over anti-tying rules, conducted several examinations in the early 1990s and brought tying charges against some banks, including National City Corp.
Roberts said that he was somewhat surprised by the MSRB notice because he has not heard any complaints recently about tying practices. The biggest complaints he has heard revolve around the general difficulty of obtaining credit, he said.
"It's just a tough time in the market and the auction-rate situation was unexpected and unusual," he said. "Folks are trying to work their way out of it as best they can."