A troubling series of proposals has emerged in the U.S. Senate debate over changes to federal regulation of the financial markets.
Regulatory reform is needed, and hopefully Congress will reach agreement on a responsible, bipartisan approach to filling gaps in the current structure. But several amendments that would impose a fiduciary standard on banks and securities firms when dealing with states, municipalities, and pension funds, among others, would dramatically affect public finance for the worse, and with no relation to the need for reform.
A fiduciary duty is an appropriate standard for certain financial relationships between parties, but not all. In fact, the Securities Industry Financial Markets Association has been a leading supporter of a new, federal fiduciary standard for brokers and investment advisers that provide personalized investment advice to retail investors.
However, in the context of transactions between institutional counterparties, such as negotiated municipal bond underwriting or swap contracts, such a standard is unworkable.
The Senate is currently considering three provisions, one in the underlying bill, and two amendments that would seek to impose a new fiduciary duty on broker-dealer’s relationships with municipal issuers.
First, there is the Senate Agriculture Committee’s derivatives provision, which is included in the base text of the legislation currently being debated, would impose a fiduciary duty on broker-dealers or banks who serve as a swap counterparty with a municipality or state.
In addition, Sen. Barbara Boxer, D-Calif., has proposed an amendment that would impose a fiduciary duty on any bank or broker-dealer that provides “any individualized advice or individualized recommendation” to states or local governments.
This amendment would apply to the underwriting or sale of securities and would almost certainly encompass virtually all negotiated bond sales. The amendment also applies to securities or derivatives trades with pension funds and endowments.
Last but not least, Sen. Arlen Specter, D-Pa., has filed an amendment that would impose a fiduciary duty on any broker-dealer who “provides advice” in the context of selling or buying a security — or even just soliciting a trade — to or from any customer, including institutional investors. Specter’s amendment would go a step further by criminalizing any violations of that duty, with fines and penalties of up to 25 years in prison.
Each of these three proposals is designed to put a fiduciary standard of care on top of relationships that by their nature are arm’s length, whether that relationship is as counterparties to a swap contract, as an issuer and underwriter of bonds, or as principals in a secondary market trade.
These relationships by definition contradict the idea of being a fiduciary. Such a contradiction, if written into law, would create unmanageable legal uncertainty and risk. The implications of imposing a fiduciary duty where it does not apply could be quite severe. Broker-dealers would not be able to serve as underwriters on negotiated transactions.
The fiduciary duty in the Boxer amendment would be triggered in a negotiated sale because the variety of services performed by negotiated underwriters — providing opinions on sizing and timing an issue, structuring the cash flow, interacting with rating agencies and producing documentation, among others — would almost certainly be construed as “advice.” An underwriter would not be able to execute a bond purchase agreement while at the same time bearing a fiduciary duty to the issuer.
About 85% of the new-issue market last year was sold in negotiated sales. In Boxer’s home state of California, that figure was more than 95%. Many issuers choose a negotiated method of sale because they value the added services that underwriters provide, and because they feel they get better execution and distribution by having the underwriter involved in the deal every step of the way.
Issuers’ credits, their diverse characteristics and the unique structures of deals are hardly a commodity. In that regard, issuers and market liquidity in general are often best served by a tailored underwriting and distribution process.
For many issuers, using a negotiated method of sale is their only choice. These include issuers with weak, complex or “story” credits, first-time issuers, large issuers, Build America Bond issuers who benefit from global distribution, issuers with large deal sizes, or the many small issuers who place their bonds directly with bank investors, among others.
For deals like these, a competitive method of sale is simply not an option. These issuers would end up paying a higher cost of capital without an underwriter pre-marketing their bonds, if they could access the market at all. Boxer’s amendment would largely eliminate the option of negotiated sales and would increase illiquidity and volatility.
Those who have proposed imposing a fiduciary duty on negotiated underwriters are clearly motivated by a desire to provide a level of protection for issuers that does not exist currently. They argue that if underwriters have a duty to place issuers’ interests above their own, issuers will be less likely to execute inappropriate transactions.
Unfortunately, this perspective reflects a misunderstanding of how a fiduciary standard would affect the new-issue muni market. Imposing a fiduciary obligation on negotiated underwriters would limit choice, hamper market access and raise costs. It would not provide protection for issuers, who already employ a team of professionals that includes internal staff and outside counsel and financial advisers who have appropriate fiduciary roles.
Moreover, underwriters are already subject to a fair-dealing standard in their relationships with issuers in the Municipal Securities Rulemaking Board’s Rule G-17. The proponents of a fiduciary standard for negotiated underwriters have not cited any compelling examples of transactions where a fiduciary duty would have resulted in better outcomes for issuers.
There are circumstances where a fiduciary duty for a dealer is appropriate. A fiduciary obligation in the context of swaps, negotiated underwritings, and trades with institutional investors, however, is contradictory and unworkable. The muni community should work together to ensure the Senate understands the severe implications of a fiduciary proposal before it acts.
Michael Decker is managing director and co-head of municipal securities at SIFMA.