WASHINGTON -- A controversial recommendation by a commissioner of the Securities and Exchange Commission that broker dealers put in writing their reasons for recommending more speculative bonds to retail investors has the backing of investor groups, but is not going over big with regional firms.
Investors are being "misled, lied to, and vitimized by unscrupulous and ill-prepared brokers," said James W. Fennell, president of the Municipal Bondholders Association of Colorado, in a letter to SEC Commissioner Richard Roberts, who called for written "suitability" determinations for unrated and conduit bonds in a speech before the Public Securities Association in late February.
Mr. Fennell also says, "There is a crying need to severely tighten up regulation of municipal bond transactions."
But regional dealers contacted across the country almost unanimously opposed a written suitability standard. They warned that such a rule would impose an impossible paperwork burden on firms and expose them to extensive litigation from disgruntled investors despite firms' best efforts to evaluate their clients' needs.
George Pugh Jr., senior vice president of Craigie Inc., said that such a rule "will really restrict the marketability of unrated bonds. I've talked to a lot of retail operations. [They] will instruct their branch managers not to sell unrated bonds."
"A awful lot of junk has been issued and a lot is coming back to roost," said John deGraffenried, a former vice president of Merrill Lynch & Co., who also wrote Mr. Roberts in support of the commissioner's proposal. "Over the last two decades you've seen municipals used to finance everything," he said. "A lot of marginal revenue bonds" were issued and a "lot are deep in red ink already."
He also said that with yields coming down dramatically, this is a time that smaller "predatory firms set people up by showing them something with a big, fat coupon."
Michael Shalley, a Red Bank, N.J., attorney who represents retired buyers of defaulted First Humanics Corp. bonds, told Mr. Roberts he has been "absolutely stonewalled" in his efforts to get information from New York-based Advest Inc., about why brokers sold the unrated nursing home bonds to his clients. He said not only should regulators enact a suitability standard for unrated tax-exempts, but they should go one step further and limit sales to retail buyers with a minimum net worth, such as $200,000 excluding their home.
Only a few markets are currently covered by a written suitability standard. Penny stock brokers, for instance, and those selling certain more exotic options must record their reasons for selling some of the securities to customers. But the equities, futures, and corporate bond markets generally are free from such standards.
Representatives of those markets contend that existing requirements enforced by regulators like the National Association of Securities Dealers adequately protect investors, such as the Municipal Securities Rulemaking Board's Rule G17, requiring fair dealing with customers, and Rule G-19, requiring brokers to recommend to investors only those bonds they consider suitable.
William Heyman, director of the SEC's market regulation division, wrote the MSRB early last month urging it to study Mr. Roberts's proposal or variations on the plan. Current board rules require dealers to record certain information when they open an account with a customer, including the customer's background and investment goals. But brokers do not have to record their reasons for recommending a particular bond at the time of sale.
The dealer simply must reasonably believe the recommendation is suitable, or, when the customer's background is unknown, have "no reasonable ground" to believe it is unsuitable, the MSRB rules say.
Mr. Heyman said short of requiring written suitability findings, the board may want to reconsider that part of G-19 that allows a transaction to proceed if the firm lacks relevant information but has "no reasonable grounds" to believe the recommendation is unsuitable.
"We'll take our first cut at it in July," said MSRB Executive Director Christopher Taylor, referring to the board's next meeting. "This raises too many serious questions to instantly react. We want to be very careful of what we say is operating policy. You're talking about the relationship between the customer and dealer. Suitability is often at the root of customer dealer disputes.
"There are possible extreme versions of this that I don't think anybody is going to contemplate," he added, referring to the idea posed by Mr. Shalley that sales be barred to individuals who have below a certain net worth. "Mr. Roberts has raised a legitimate issue. No one disagrees that this stuff should not be foisted on [certain] individuals. But the problem is drawing a line.
"It will make selling a lot more difficult," said James Frein, of Hutchinson, Shockey, Erley & Co. "This paper trail is plaguing industries to death."
Michael D. Vick, president of M.B. Vick & Co. in Chicago, said, "I think a dealer should be able to justify whatever he sells to any client. But to make a written report is burdensome. What may be right for one phase of a client's investment life certainly may not be correct for another phase. To have to put constant changes into the system is ridiculous. What good is an old file if it's not updated?
"One of the things we live with is 'know our customer.' Those rules are critical. So we stay in touch. Every time a purchase is made, we reacquaint the customer with what's needed and what's available. I'd have a great deal of additional layer of reports if this thing went through," said Mr. Vick, a member of the MSRB from 1981 to 1984 and of the NASD District 8 Business Conduct Committee. Such committees oversee the rules that the MSRB has put into place.
Robert Beck, principal and manager of Edward D. Jones in St. Louis, said additional regulation of the offering or sale of more speculative types of bonds may be in order. But he urged regulators to move with care. "If you paint with too broad a brush," there could be problems, he said.
"We may be better off if we do have controls in place that may discourage the sale of speculative issues," Mr. Beck said. "But if you paint with too broad a brush," there could be problems, he said.
Gregory Menne of St. Louis-based A.G. Edwards, which has extensive retail sales, said he would not comment on Mr. Roberts's proposal. Mr. Menne, a vice president for fixed-income with the firm, is one of three Public Securities Association representatives who were scheduled to meet with Commissioner Roberts recently on his suitability recommendation. The meeting was postponed, but will be rescheduled.
"It would be a no-win situation," said David Thompson, of Griffin, Kubik, Stephens & Thompson Inc. in Chicago. "If nothing ever goes wrong with the securities, then the rationale provided in writing holds up. But if the first thing goes wrong, then the Monday morning quarter-back syndrome sets in and [your] rationale is minutely dissected by hordes of plaintiffs's attorneys and undoubtedly will be found deficient."
