Underwriters Should Walk Away from Deals with Bad Disclosure

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PHILADELPHIA – Underwriters should walk away from municipal securities transactions when they discover the issuer has failed to disclose key information, dealer officials said here, citing their own experiences as examples.

Ron Bernardi, president and chief executive officer of Chicago-based Bernardi Securities, Inc., and Stephen Heaney, director of public finance for Stifel, Nicolaus & Co., made their comments during a panel at the Bond Dealers of America's National Fixed Income Conference.

They both said that the Securities and Exchange Commission or the legal and muni advisor communities need to provide more information about what information must be disclosed.

Their comments responded to questions the about impacts on disclosure in the market from the Securities and Exchange Commission's Municipalities Continuing Disclosure Cooperation initiative.

The initiative promised underwriters and issuers would receive lenient settlement terms if they self-reported instances over the last five years where issuers falsely said in offering documents that they were in compliance with their continuing disclosure agreements. MCDC has led to settlements with 72 underwriters and 71 issuers to date.

Bernardi, who said it was "traumatic" for his firm to go through the process of reporting under MCDC, added that he and other firm officials still struggle at times when they cannot directly interact with issuers on disclosure matters.

"We find that issuers want to do the right thing if they are told what needs to be disclosed," he said, adding the same is true with most municipal advisors. However, he said, there are still situations that are problematic when there is a difference of opinion, between underwriters and other parties such as MAs or bond counsel, about what needs to be disclosed.

"On a couple of occasions, we've threatened to step away from a transaction," Bernardi said. "You've got to be prepared to do that."

He later added, "It pains me to say that because I know there will be one or more competitors that will step in," but reaffirmed the need to be ready for that reality.

Bernardi gave several examples of instances where his firm has been faced with such situations. In one, his firm discovered that the issuer's largest employer was leaving and the issuer had not disclosed that in its official statement. When his firm pointed it out, it was told the fact was not material. Eventually, because the firm had direct contact with the issuer, it was able to talk with the mayor of the municipality and make sure the disclosure was included.

In another transaction, the firm discovered there was an undisclosed lawsuit pending against a municipality with damages that would have amounted to 30% of its general fund. In that case, the firm had no contact with the issuer and had to make the threat that it would step away from the transaction late in the process before "calmer heads prevailed" and there was language included, according to Bernardi.

Just last week, Bernardi said his firm was set to be part of an issue in New York until it found that the official statement falsely claimed that the issuer hadn't been late with its filings over the last five years. He said his firm tried to call the senior manager and municipal advisor on the deal but got no response. It eventually dropped out of the deal.

We made the decision at the firm level in the aftermath of MCDC [that] our due diligence is the same whether we are senior, sole, or co-manager," Bernardi said.

Heaney said Stifel has run into similar problems with differences of opinion about what an issuer should be disclosing in official statements.

He and Bernardi agreed that a good solution to the problem would involve getting more clarity from regulators about reasonable disclosure and diligence, including different parties' roles in the process. Heaney said he doesn't hold a lot of hope that the SEC will clarify materiality, but pointed to MAs and bond counsel as possible areas for clarity and emphasis in the disclosure process.

There will be a challenge with disclosure in the market "until we see the MAs held accountable and until we see some change on the part of counsel," Heaney said. "I don't see [issuers] being educated [about disclosure] en masse without bond counsel helping them and without advisors helping them."

Heaney said that while issuers have had a better understanding of their obligations when they have entered into continuing disclosure undertakings post-MCDC, they "are not well-served oftentimes by their counsel or advisors who are mistakenly trying to protect [them] by having them disclose less under the theory" that less disclosure means less liability.

Gregg Bienstock, chief executive officer and co-founder of Lumesis, Inc., also pushed for more clarity, saying the market needs a consistent message when it comes to materiality. Lumesis is a technology company in the muni industry that provides business efficiency and compliance solutions.

"Something that we see by virtue of what we do is that there is a fair level of inconsistency when it comes to the requirement of due diligence that needs to be done," Bienstock said. He attributed the problem to the variety of independent consultants that firms who settled under MCDC were required to hire as part of the settlement terms. The consultants have reached different conclusions with regard to the scope of required due diligence, Bienstock said.

Lumesis has seen some firms require a full, comprehensive review before they bid on a competitive deal and others that "take a very light touch," Bienstock said. He suggested that regulators could start with "some pretty basic stuff" such as how late is considered material and what is a reasonable level of diligence for competitive and negotiated deals, as well as whether the required diligence changes when a firm is part of a syndicate.

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