Broker-dealers and advisory-only firms disagree over potential G-23 amendments. Writer Geraldine Lambe
What is it?
A request for comment from the US Municipal Securities Rulemaking Board (MSRB) about draft amendments to 'Rule G-23', which governs the activities of financial advisors to municipal issuers and underwriters of municipal securities.
Who dreamed it up?
The Securities and Exchange Commission (SEC) has asked the MSRB to amend the rule.
What is the problem?
SEC chairman Mary Schapiro has slammed Rule G-23 because it allows broker-dealers to switch from financial advisor to underwriter in a single bond transaction. She called this "a classic example of conflict of interest".
Rule G-23 means that for issues sold on a negotiated basis, financial advisors can switch to underwriter as long as they first terminate their advisory role, then disclose potential conflicts of interest and their expected remuneration, and get written consent to participate. For competitive bids, the rule only demands that an advisor obtain written consent to bid for the issue.
The SEC believes such disclosure does not go far enough. It wants the rule scrapped entirely and broker-dealers to be prohibited from serving as both financial advisor and underwriter in the same deal.
What's in the small print?
The draft rule provides an exception for financings in which a dealer serving as financial advisor places the entire issue with another governmental entity as part of a broader financing plan for or on behalf of the issuer. This could include the case of a state bond bank financing or other governmental financing in which an issuer may issue a bond to such a body to evidence its indebtedness under a loan programme.
The exception only stands, however, so long as the dealer does not receive compensation for the placement and is not compensated as an underwriter in connection with any related transaction undertaken by the governmental entity that takes the issue.
What does the industry say?
Not surprisingly, advisory-only firms are cock-a-hoop and broker-dealers are quietly livid.
"It's a logical step to unbundle advice from sales and trading; that's the only way to achieve unconflicted counsel," says a banker at a US advisory firm.
Broker-dealers say: if it ain't broke, don't fix it.
A response from mid-market investment bank Piper Jaffray argues that it has seen no abuses in the marketplace and asks for evidence that there is a problem so that it can "better understand the rationale behind the SEC's request for MSRB to consider changes".
Broker-dealers argue that the disclosure requirements of the current rule allow the issuer to make an informed decision by written consent. Some say the new Dodd-Frank fiduciary standards for municipal advisors eliminate the need for change. Others point out that competitive bid deals are awarded based solely on price using a sealed-bid process, so have nothing to do with any relationships among issuers, advisors and dealers.
What do issuers say?
Issuers are divided. Many big government borrowers who issue frequently applaud the proposal. The treasurer of Portland, Oregon, wrote: "It's time to put an end to what is too often a deceitful practice on the part of some broker-dealers to gain negotiated underwriting business by first being hired as an issuer's financial advisor."
Smaller issuers fear that scrapping the rule will lock such infrequent borrowers out of the market. Evidence from data provider Ipreo suggests their concerns are valid. Data show that 42% of competitive bond issues of $10m or less, and competitive note sales between $1m and $3m, received three or fewer bids between January 2000 and August 2010. Some received only one bid. For bond issues of $30m or more, only 12% received three or fewer bids.
The law of unintended consequences
The Department of Education in Alabama, for instance, says the state's complex requirements for competitive public sales already discourage bidding. Advisors in Alabama are often the same firms who submit bids, wrote the deputy state superintendent of education in his response to the MSRB. "If the firms are forced to choose either one role or another, there will be fewer participants, fewer bids, a lack of competent advice and less competition."
Could we live without it?
Yes. The SEC has not highlighted a single case in the municipal securities arena where role-switching has been abused. And if the SEC succeeds here, why stop with munis? Will banks soon be prohibited from being advisors and underwriters on the same corporate bond deal?
