WASHINGTON - The Municipal Securities Rulemaking Board urged the Securities and Exchange Commission yesterday to scrap its recent proposal that would require dealers to disclose markups or markdowns on riskless principal transactions.
But the board recommended that the SEC proceed with a second proposal that would require dealers to disclose on confirmations whether bonds are unrated.
The recommendations were included in a five-page letter signed by David C. Clapp, chairman of the MSRB, that was sent to the commission yesterday in response to a package of rules proposed by the SEC March 9.
So far the SEC has received dozens of letters, particularly from regional bond firms, arguing that the disclosure proposal for riskless principal transactions would be unnecessary, dangerous to investors, and discriminatory to smaller dealers.
In a riskless principal transaction, a dealer receives an order from an investor, locates a seller, buys the bonds for its own account, and then quickly sells them to the investor.
Comments on the proposals originally were due yesterday. But Douglas Preston, associate general counsel of the Securities Industry Association, said in a telephone interview yesterday that the agency granted a recent request by his group for a 30-day extension of the comment period to July 15. The association argued that additional time is needed because the proposals are so complex and "potentially damaging" to the debt markets.
"The board is concerned that requiring markups and markdowns could have some unintended negative consequences," the MSRB's Clapp said. "The proposed amendment may distract customers from focusing on yield."
For example, if a customer reviews the confirmations of riskless principal transactions handled by different dealers, the buyer may decide to do future transactions with the dealer showing the lower percentage markup regardless of whether he may receive a higher yield from the dealer, said Clapp, who is a partner with Goldman, Sachs & Co.
If the proposal is adopted, some dealers might begin to advertise that they are willing to execute riskless principal transactions at low markup levels. Investors could believe that they would always benefit from such arrangements, when, in fact, they may get a lower yield from such dealers than they could get otherwise, Clapp said.
If the commission proceeds with the rule, the board may issue an interpretation of Rule G-21, which deals with advertising, that would bar dealers from advertising low markup levels unless they also spell out the importance of yield of a municipal bond.
The MSRB also warned that dealers may tend to sell more bonds from inventory to avoid the disclosure requirement and the necessity of proving to regulators which transactions are done on a riskless principal basis, the board said.
"Customers of small dealers, who generally carry less inventory than large dealers, may find that their purchase options are limited." the board said. Some issues may face greater illiquidity, it added.
In other comments, the MSRB voiced agreement with the commission's proposal that dealers disclose on customer confirmations if a bond is not rated by a nationally recognized statistical rating organization.
"An unrated bond may not necessarily be unsound or speculative," the board said. "But disclosure of the fact that a bond is unrated will [alert investors] that they may want to make further inquiry of the dealer."
Meanwhile, market participants solidly opposed the commission's markup proposal for riskless principal transactions.
"I have been in the business since 1965 and have always played by the rules," wrote James W. Bryan, chairman of Ahart & Bryan Inc. in Little Rock. "Now I will have to take a risk on every transaction or disclose my profit. This will turn small dealers into gamblers while large dealers can sell from inventory."
"We believe this to be a compliance and regulatory nightmare," said Robert J. O'Brien, senior vice president of Rickel & Associates Inc. in Milburn, N.J. "It would cause a tremendous amount of confusion with public customers.
"Our organization is deeply concerned with proposed new Rule 15c2-13," wrote George C. Reichle, president of the Independent Broker Dealer Association.
Disclosure usually helps consumers make more intelligent buying decisions, Reichle said. "Unfortunately," he continued, "the markup disclosure as proposed will have exactly the opposite effect."
He said consumers will be led to believe that they will be paying a markup when buying fixed-income securities from a dealer that got them risk free. But if those same securities were bought from a dealer out of inventory, no markup would be disclosed, Reichle said. "The consumer would be led to believe he or she would be getting a better deal buying bonds out of inventory."
This "misleading disclosure" would substantially harm smaller firms who ordinarily do not sell bonds from inventory, while giving an unfair advantage to larger dealers who do, even though buying from a smaller dealer may cost less, Reichle said.
Reichle said his group recently passed a resolution stating that if the SEC proceeds with a rule, the measure should cover markups across the board regardless of whether they are riskless trades or trades from inventory.
"We believe the proposed rules are unnecessary in most cases, will be extremely difficult to enforce, and will place our firm, as well as many other firms like [ours], at a tremendous competitive disadvantage in dealing with large institutional customers," said Allen Mead Ferguson, president of Craigie Inc. in Richmond.
"The proposed regulation would be very detrimental to smaller firms that do not have the capital to risk carrying large inventories," said Lawrence. T. Lewis 3d, managing director of Clark Melvin Securities Corp. in Annapolis, Md. "We would lose clients very quickly."
"Dealers will execute more trades from securities held in inventory," warned William W. Deupree Jr., president of Morgan Keegan & Co. in Memphis. "The small firms and regional firms that cannot commit capital to this process will exit this type of business and/or reduce its participation, which in turn will affect the liquidity in the market place."
"The disclosure of a markup in riskless principal transactions is at best irrelevant and at worst misleading to customers," said William B. Sims, president of Herbert J. Sims & Co. in Westport, Conn.
"In a market with thousands of thinly traded issues, it is no small task to match up buyers and sellers," wrote Donald R. Lipkin, associate director for municipal research, at Bear, Stearns & Co. "The climactic moment when the trade is done in a so-called riskless principal transaction is the end of a process that has real and significant costs. A part of the ~markup' in these cases is compensation for these services."
Lipkin wrote that if the SEC proceeds with a rule the commission should define riskless principal transactions in the narrowest way possible. in the narrowest way possible. "A riskless principal transaction should only be one in which the dealer, upon taking a security into his inventory, already has an order to sell that security," he said.
