The SEC’s startling refresher on due diligence

By Cate Long
March 20, 2012

The SEC’s Office of Compliance Inspections and Examinations, muniland’s uber-regulator, issued a “Risk Alert” yesterday directed at underwriters of municipal bond offerings. The alert basically said: If you offer new bonds for sale, you must perform due diligence on the issuer. And you better document what you did.

I have to wonder about all the sudden fuss. The SEC’s “Risk Alert” was just restating a fundamental law in securities markets that requires securities dealers to investigate and verify what they are offering to investors. In other words, dealers must know their product, because there is no immunity for selling bad stuff. It’s a little shocking that the SEC has to remind securities dealers that they are required to do due diligence, but they went further and detailed some specifics on what had to be done (Page 3, emphasis mine):

the Commission also stated that sole reliance on an issuer will not suffice in meeting an underwriter’s “reasonable basis” obligations.

What the SEC insists on, and what is stated in the law, is that securities firms go beyond the surface facts presented by issuers and verify the underlying facts. And here they point their finger at unnamed broker-dealers who are not performing to standard and scold them for not maintaining records of their due diligence (Page 4):

[The staff] has observed instances where municipal underwriters have not maintained, nor did they require the creation and maintenance of, adequate written evidence that they complied with their due diligence obligations, including those under Rule 15c2-12 and applicable Commission interpretive guidance. Indeed, some firms have asserted that it is their specific policy not to maintain any due diligence records and have stated that “it is not industry practice” or that they are following advice from outside counsel … This approach might lead to lax due diligence practices at a time when there are growing concerns over the fiscal well-being of some municipalities.

How crazy is that? You get the sense of some cocky broker-dealer telling the sheriff of Wall Street to buzz off because some attorney they hired told them that they didn’t have to keep records. Sorry unnamed broker-dealer, that is not how it works. And you should never diss the sheriff.

Of the municipal bond defaults I have written about in the last year, several jumped to mind after seeing the alert because I had wondered at the time if the underwriters had done their due diligence. The first and craziest deal was $38 million in revenue bonds issued in Missouri for Project Sugar, a substitute sugar manufacturing plant. Basically the whole deal was misrepresented (read: fraudulent), and no one — from state and local officials to the underwriter, Morgan Keegan — seemed to do any due diligence.

Then I thought of an excellent story in the Bond Buyer yesterday about a bankrupt senior housing complex in Chicago, The Clare, where bondholders might recover pennies on the dollar. The underwriter was Ziegler Capital Markets, and the exceptionally low recovery suggests a poorly structured deal. Another senior housing complex that defaulted on its bonds, one in Massachusetts called Linden Ponds, was also underwritten by Ziegler Capital Markets. Of course that could be mere coincidence, because many housing and healthcare deals have gone bad. But it would be useful to see a list of defaulted deals by underwriter. That might tell us more than league tables tell us about municipal markets.

One of the main functions of the SEC is to protect investors. The “Risk Alert” it issued yesterday goes right to the heart of investor protection by insisting that underwriters stop weak or bad issuers from coming to market.

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/