The Securities and Exchange Commission issued a risk alert Monday warning that some underwriters do not have adequate written evidence to show they properly assess the financial condition of state and local governments before selling bonds to investors.
The eight-page alert, which follows an SEC examination of broker-dealers’ compliance with due-diligence obligations, reminded underwriters of their responsibilities under securities laws and included examples of practices they can adopt to show they used due diligence and followed proper supervisory reviews.
“The commission’s examination staff has observed that some broker-dealers have not maintained adequate written evidence that they complied with their responsibilities regarding due diligence and supervision,” Carlo di Florio, director of the SEC’s office of compliance inspections and examinations, said in a release. “To protect investors, it is important that broker-dealers perform adequate due-diligence to assess the financial and operational condition of states and municipalities before selling their securities to the public.”
The SEC also issued a bulletin to educate individual investors about municipal bonds, investment risks and other factors.
The alert said awareness of municipalities’ financial vulnerabilities has increased since the 2008 financial crisis, and that the SEC is currently focused on addressing risks faced by muni investors.
It reminded broker-dealers that Rule 15c2-12 of the Securities and Exchange Act requires they obtain official statements before bidding on, or purchasing, munis. They must also review issuers’ disclosures for completeness and accuracy.
Underwriters that participate in an offering make “an implied recommendation about the securities” and a “representation that it has a reasonable belief in the truthfulness and completeness” of disclosure documents, the SEC said.
“If a broker-dealer fails to undertake efforts to form such a reasonable belief, it may violate the antifraud provisions of the securities laws,” the agency said.
Broker-dealers are also required, under the Municipal Securities Rulemaking Board’s Rule G-27, to have written policies and procedures to ensure they comply with the Securities and Exchange Act.
The alert said the SEC is “concerned” about underwriters’ due-diligence practices and has been conducting examinations to access broker-dealers’ compliance.
Those examinations found that some underwriters lacked adequate written evidence showing they met due-diligence obligations. Some firms had specific policies against keeping due-diligence records.
The alert provided examples of practices firms can use to ensure compliance, including writing policies and procedures, creating diligence checklists, establishing “commitment committees” to ensure due-diligence is performed, and holding on-site meetings with issuers.
The SEC noted that though Rule 15c2-12 does not have record-keeping requirements, “a firm may not be able to demonstrate compliance with that rule, and its supervisory responsibilities, without having evidence of its due diligence process and supervisory review.”
Leslie Norwood, co-head of the municipal securities division at the Securities Industry and Financial Markets Association, said she appreciates the SEC’s alert because the guidance can help broker-dealers ensure they comply with securities laws.
She noted that alerts generally address issues that regulators uncover during periodic examinations of broker-dealers.
“When the examiners, from the SEC or FINRA, see trends or patterns, they release notices … to try to help the industry focus on particular areas of the law [where] they could use further guidance,” Norwood said. “They are trying to help the industry.”
Michael Nicholas, chief executive of Bond Dealers of America, said his group has been active in ensuring dealers and underwriters understand their disclosure requirements. He said a BDA panel, working with the Financial Industry Regulatory Authority, produced a report in 2011 that recommended disclosure policies and procedures for dealers, as well as an overview of their obligations under MSRB rules.