MuniLand

The SEC’s startling refresher on due diligence

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.

Wall Street’s deepest muniland fear

Wall Street’s deepest muniland fear

Although credit rating downgrades for municipal bonds are grabbing the headlines, that is not a real worry for Wall Street. Underwriters and traders are used to adjusting their models and formulas for changes in ratings and interest rates; after all, they are extremely skilled at that. However, forces are taking aim at the way they are compensated, and that is Wall Street’s deepest muniland fear. It’s all about how they are paid to underwrite municipal bonds, and the state of Maine is leading the charge.

When states or municipalities issue bonds they use Wall Street banks to underwrite them. Wall Street banks or dealers either compete against each other for these mandates in a competitive process or one bank or dealer privately negotiates the terms of the bond offering with the issuer. A privately negotiated underwriting happens in approximately 80% of municipal bond deals. This often costs municipalities and states more in fees. Bloomberg has an outstanding piece about how the state of Maine is choosing the competitive style of bond underwriting and the political struggle that happened to get there:

Banks promote negotiated sales as letting them offer the lowest cost by tailoring the debt to specific types of investors. Yet academic studies of the municipal market show such sales often raise costs by as much as $4.80 on every $1,000 borrowed, according to Mark D. Robbins and Bill Simonsen of the University of Connecticut in West Hartford.

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