WASHINGTON — The Municipal Securities Rulemaking Board Tuesday said it is contemplating a rule change that would prohibit dealers from underwriting new negotiated or competitive bond issues if they served as the issuer's financial adviser on the transaction.
The MSRB is seeking public comment on the draft changes to its controversial Rule G-23 through Sept. 30. The proposal, which would completely reverse the existing rule, would eliminate what some supporters of the restrictions have described as routine business practices in certain states. Those include Colorado and Texas, in which dealer-FAs generate underwriting work by first serving as an issuer's financial adviser.
The proposal comes at the request of the Securities and Exchange Commission chairman Mary Schapiro. "Right now, a financial professional advising a municipality can guide the municipality towards securities tailored to his firm's advantage, then resign and act as underwriter," she said in a May speech. "This is a classic example of conflict of interest. … The board should change G-23 and forbid this practice."
MSRB executive director Lynnette Hotchkiss also noted that the draft changes come three weeks after financial regulatory reform legislation was enacted authorizing the board to oversee muni financial advisers and require them to adhere to a fiduciary duty rule.
"All financial advisers — dealers that act as advisers as well as independent advisers — will have a fiduciary duty to their issuer clients under the new federal financial reform law and removing any real or perceived conflicts of interest in such transactions is more important than ever," Hotchkiss said in a statement.
But dealers and industry groups yesterday were quick to express concerns about the proposal, warning that they believe the existing rule is fair and effective.
Hill Feinberg, chief executive officer of First Southwest Co., which has strongly opposed past consideration of changes to the rule, said there is no need to extend the restrictions to transactions that are competitively priced. In such deals, there is no conflict with a dealer-FA bidding on the transaction, he argued.
Feinberg said that his firm switches roles only on deals brought to market by issuers too small to attract bids from larger firms. The vast majority of such deals are priced competitively with only one or two bidders, he said, adding that he is unaware of any instances in which issuers have complained about the dealer-FA's participation in buying the securities.
Mike Nicholas, chief executive officer of the Regional Bond Dealers Association, said the proposal would make it "more cumbersome" for small municipalities to sell debt.
"The proposal would limit an issuer's options to get the lowest cost of financing and that doesn't make sense," he said. "It limits competition and options to issuers."
Michael Decker, managing director and co-head of the Securities Industry and Financial Markets Association's municipal securities group, said in a statement: "We believe Rule G-23, in its current form, strikes an appropriate balance between providing bond issuers with low-cost service and protecting them from potential conflicts of interest. The rule has been effective, and no compelling case has been made for amending the rule in such a drastic manner. We hope the MSRB will reconsider its proposal."
But issuer groups and non-dealer FAs have echoed Schapiro in warning that role-switching in general is fraught with conflicts of interest. Guidance approved by the Government Finance Officers Association in 2008 warns of an "inherent" conflict, while the National Association of Independent Public Finance Advisors has routinely called on the MSRB to tighten the rule. Since 2006, the board had twice declined to do so.
"NAIPFA believes that G-23 is inconsistent with the Dodd-Frank legislation that requires a municipal advisor's fiduciary duty to its client, the municipal issuer, and is pleased to see the MSRB's progressive step in revisiting this matter," Steve Apfelbacher, president of both NAIPFA and Ehlers & Associates in Roseville, Minn., said in a statement.
Robert Doty, president of American Governmental Financial Services in Sacramento, disputed that there is no conflict with a dealer-FA bidding in a competitive deal. He said it could structure a transaction for an issuer so that it is best suited to buy and market the bonds to its own clients, but that would not necessarily be in the issuer's best interests.
He also said that he has worked with many small, remote issuers and that if there are no bids for their bonds, it is because the FA isn't doing its job. "It's not unreasonably difficult, except when an issuer's credit is so bad that no one wants to touch it," Doty said.
Patrick Born, chief financial officer of Minneapolis, who helped write the GFOA guidance, said that the proposal reflects the expanded mission of the MSRB in overseeing a larger segment of the muni market that is much broader than just banks and broker-dealers.
"Now their point of view is much more balanced among all participants in the municipal market," he said. "I think that's progress."
It was unclear how many dealer-FAs switch roles to underwrite transactions. Kathleen McKinney, a shareholder at Haynsworth Sinkler Boyd PA in Greenville, S.C., and president of the National Association of Bond Lawyers, said there is heightened awareness among issuers about potential conflicts and a "strong desire" against role-switching. She said many issuer RFPs specify that issuers are looking for continuity throughout with the transaction with the FA.
Currently, the rule allows dealer-FAs to become underwriters in negotiated transactions if they disclose to the issuer possible conflicts of interest stemming from the role switch, disclose their expected compensation, and obtain the issuer's consent to the switch. In competitive deals, dealer-FAs must obtain the issuer's written consent before bidding on the bonds.
The rule also currently requires dealer-FAs that become underwriters or syndicate members to disclose the existence of their FA relationship with the issuer to customers who want to purchase the bonds.
But in seeking to prohibit such role-switching, the provisions regarding disclosures, terminations, and consents become "unnecessary and are eliminated," the board said in a notice Tuesday morning describing the draft proposal.
However, the draft proposal would add language to the rule that would allow dealer-FAs to switch roles in narrow circumstances, such as for certain financing transactions with governmental entities, like local government bond banks, where an FA may assist in placing an issuer's note or bond with a governmental entity. But such role-switching would only be allowed if the dealer-FA does not receive compensation other than for its financial advisory work and does not receive compensation for underwriting any contemporaneous transaction "directly or indirectly" related to the placement with the government agency.
Though no dealer-FA would be allowed to serve as a remarketing agent on a new floating-rate deal for which it has worked as financial adviser, the dealer-FA would be allowed to serve as "successor remarketing agent" on the issue at a later date as long as the FA relationship has been terminated for at least one year.
The board is seeking comment on several specific topics, including whether a dealer should be precluded for a specific timeframe from entering into an FA relationship with an issuer after underwriting one of the issuer's prior debt offerings. It also asks if there should be an exception from role-switching for dealer-FAs that participate in competitively bid transactions.
In addition, the MSRB asked: "Should a financial adviser be allowed to bid in a competitively bid transaction in which a failed bid had occurred? How would the situation be handled in which there is a failed bid and the financial adviser cannot step in to buy the bonds because of the prohibition? Is this a common occurrence?"
SEC officials declined to comment on the proposal. Asked about some of the industry's concerns about its breadth, MSRB general counsel Ernesto Lanza said in a statement that the SEC's concerns ran to both competitive and negotiated deals.
"We did recognize, however, that some market participants may have differing views on this subject, and the notice asks a series of questions on whether to include competitive offerings within the prohibition on switching roles to ensure that the pros and cons are considered before the MSRB takes final action."
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