WASHINGTON — The Municipal Securities Rulemaking Board has drafted an interpretive notice warning underwriters of new bonds that they may violate the fair-dealing rule if they agree to eliminate a reserve fund or take other actions for the new bonds that could hurt existing parity bondholders, without authorization from bond documents.
“The MSRB is concerned that, in some cases, underwriters have consented to trust indenture or resolution amendments that affect existing parity bondholders, even though those authorizing documents and the official statements for the existing bonds did not provide expressly that underwriters could provide such consents,” the board said in the three-page draft notice it issued Tuesday.
Issuers sometimes sell different issues of parity bonds, which have equal and ratable claims on the same underlying security and source of payment for debt service. If changes are made to the security or source of payments for a new issue of parity bonds, those changes also will affect the bondholders of the existing parity bonds.
The MSRB said in the notice that it “is aware” that some issuers or borrowers may view such underwriter consents as being more cost-effective than having to solicit existing bondholders or defease the existing securities. But it cautioned the underwriters “to consider carefully before providing such consents whether they have the potential to violate Rule G-17” on fair dealing.
The board has asked for public comments on the draft notice, setting a March 6 deadline.
The consents, which do not happen often, according to MSRB officials, occur during the period of time in which the underwriter has just purchased bonds from the issuer but has not yet distributed them to investors. During that period, the underwriter technically can be considered a bondholder that can consent to changes in the documents for new bonds.
But the MSRB warned in its notice that even though underwriters are technically considered to be bondholders during that period, “they are still underwriters while they hold bonds with a view to distribution.”
The board pointed out that underwriters are sometimes consenting to changes that will negatively affect them and that they may even have a financial incentive to make a change, which would give them a conflict of interest.
The MSRB said it is specifically concerned about bondholder consents to changes that would: reduce, eliminate or substitute a surety policy for a cash-funded reserve; reduce the minimum debt-service coverage ratio needed; reduce or eliminate the amount of collateral for the bonds; or reduce the priority of debt service in relation to other expenditures. These are examples, but they do not cover all of the changes that would raise concerns, according to the board.
The underwriter may have a legitimate reason for a change, MSRB officials said.
For example, if a credit rating agency tells the issuer or borrower that its finances have improved to the point where it no longer needs to have a large reserve fund or any reserve fund at all to maintain its credit rating, then the issuer may want to reduce or eliminate the reserve fund. But such changes could hurt existing parity bondholders.
The MSRB stressed that its draft interpretative notice does not address underwriter changes that would not have any effect on existing bondholders.
“For example, if an underwriter agreed to amendments to variable rate demand obligations after the existing VRDOs had been subject to a mandatory tender, the amendments would have no effect on previous owners of the VRDOs,” the board said.
“Similarly, if all of the existing bonds had been defeased prior to the underwriter's consent, the notice would not apply, because the amendments would not affect the defeased bondholders.”