WASHINGTON -- The SEC should more clearly define the term "derivatives" in its legal interpretation of the disclosure responsibilities of municipal bond market participants, the Public Securities Association said this week.
"There is an ongoing debate in the financial markets as to what constitutes a derivative product," the PSA said in written comments on the Securities and Exchange Commission's legal interpretation.
The interpretation was published last March to provide bond market participants with guidelines on their overall disclosure responsibilities, including those regarding derivatives.
But the PSA told the SEC in its comments on the guidelines that, "there are distinct differences between privately negotiated over-thecounter derivative contracts and structured securities.
"We believe that a consensus or definition would be helpful in this area to provide issuers with guidance on disclosure," the group said.
The PSA comments echo the concerns that R. Fenn Putman, the group's chairman and a managing director at Lehman Brothers, voiced last April at an infrastructure conference here.
Putman had said that municipal bond issuers and broker-dealers would have trouble complying with the SEC's disclosure guidelines for derivatives unless the term "derivative" was more clearly defined.
He and other PSA officials contend that the term derivatives should be applied only to interest rate swaps, caps, floors, options, and other products whose value is derived from an underlying security through a contract.
Rather than being derivatives, they say, inverse floaters and other so-called structured financings are more like variable-rate debt obligations with segregated cash flows.
The SEC disclosure guidelines, which only touch on derivatives, say that issuers and broker-dealers should disclose information about their derivatives products and activities to avoid misleading investors.
The PSA said that while it agrees with the SEC, "we believe that all participants in the municipal securities market who enter into transactions containing derivatives should understand the risks and benefits of their utilization."
The SEC's guidelines call for broker-dealers and issuers to disclose, in their offering statements, the terms and the risks of the derivative products they sell to investors.
"In particular, investors need to be informed about the nature and effects of each significant term of the debt, including credit enhancements and risk modifiers such as inverse floaters and detachable call rights," the SEC said.
"Investors in these securities should be aware of their exposure to interest rate volatility under all possible scenarios," the SEC said. "In addition, any legal risk concerning the issuer's authority to issue securities with unconventional features needs to be disclosed."
The guidelines also call for issuers who use derivatives to disclose, in offering documents and financial statements, how they are using these products and whether the resulting risks and potential exposures could affect the issuers' overall financial condition.
"Disclosure documents need to discuss the market risk to which issuers are exposed, the strategies used to alter such risk, and the exposure to both market risk and credit risk from risk alteration strategies," the SEC said in the guidelines.
The guidelines are in effect, but bond market participants were given an opportunity to comment on them along with the proposed disclosure rule the SEC had issued at the same time.
The commission's legal interpretation reminds issuers that their disclosure documents are subject to anti-fraud laws and also suggests areas of disclosure that could be improved.
The proposed disclosure rule, which would not become effective until after it is issued in final form, would bar dealers from underwriting bonds unless the issuer pledges in writing to provide ongoing disclosure to a nationally recognized information repository. Also, dealers could not recommend bonds to customers unless they review the issuer's financial statements.
