WASHINGTON -- The municipal bond industry continued to deluge the Securities and Exchange Commission with comment letters this week opposing the agency's proposed rule that would require dealers to disclose markups on riskless principal transactions.
Regional firms blasted the rule as discriminatory against small brokerdealers, which carry much smaller inventories than large dealers and, therefore, do many more deals on a riskless principal basis.
But major firms also roundly opposed the rule, saying it would not help investors and would be very difficult to comply with.
Comments are due Friday on the SEC's rule, which was published in the Federal Register on March 17 as part of a package of rules aimed at improving disclosure in the primary and secondary municipal markets. Beside the riskless principal proposal, the SEC also asked for comment on a proposed rule that would require dealers to disclose on confirmations if a bond is unrated.
"Prudential Securities does not believe that disclosure of markups on riskless principal transactions involving debt securities would significantly benefit investors," said Robert S. Schwartz, senior vice president and associate general counsel for the firm, in a four-page comment letter.
Bond transactions are done primarily on the basis of yield, he said. "The amount of money made by the dealer on a transaction is not necessarily relevant to whether the yield at which a specific debt security is sold is fair," Schwartz said.
Chemical Banking Corp. said that dealers affiliated with banks that are not authorized to act as principal in many municipal bond deals, so-called non-Section 20 bank firms, would be at the same disadvantage as smaller firms.
"If the proposal were adopted, larger firms may avoid the disclosure requirement by increasing their inventories, thereby selling more often as principal," said William J. Jester Jr., managing director of the bank. "The smaller and non-Section 20 bank firms would be acting as riskless principal and disclosing their markups more frequently than the larger firms."
The SEC defines a riskless principal transaction as one where 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.
Customers will be confused into believing that these smaller and nonSection 20 bank firms are profiting more than the larger firms, which are not disclosing any markups when acting as principal, Jester said. As a result, these customers may give future business to the larger firms on the basis of this mistaken belief, he said.
A long list of regional firms complained bitterly that they would be gravely affected by the rule because they do not maintain large inventories.
But the Bank of New York contends that large dealers who sell heavily from inventory will be the ones at a disadvantage. The rule "fosters an image that any transaction that does not disclose profit is improper," said bank vice president James C. Gerber.
"Bonds in inventory will be considered suspicious and will be uncompetitive with riskless principal trades from other dealer offerings to customers, even at the same price," Gerber said.
Gerber, meanwhile, said he supports the SEC's proposal that dealers disclose on confirmations if a bond is unrated. But he said the Municipal Securities Rulemaking Board should issue detailed rules on the issue and should consider exempting general obligation, unlimited tax-backed securities from the rule.
Yankee Financial Group Inc. in Brightwaters, N.Y., was one of the small dealers that opposes the rule. "The days of the small independent broker-dealer are coming to an end," said Richard F. Kresge, president of the firm. "It is with unconscionable disbelief that the SEC has chosen sides" with the larger dealers, he said.
One Los Angeles dealer called the rule "un-American."
"We are deeply dismayed with the commission's consistent [issuance of rules] whose sole purpose seems to be the elimination of small firms" and "centralized government-controlled domination of the marketplace," said Richard W. McGinis Jr., director of regulatory responsibilities for Gene Moran Financial.
"The proposed changes will potentially have a devastating effect on my firm's business," said William Walsh, president of Nori, Hennion, Walsh Inc. in Parsippany, N.J. "Trying to determine whether a transaction is riskless or not will be a compliance nightmare."
Other firms said that compliance with the rule would be nearly impossible to monitor. "Firms [could] simply time stamp purchase and sale tickets with a sufficient gap between to imply 'risk,'" said William H. Coughlin, president, and Robert K. Dalton, vice chairman, of George K. Baum & Co. in Kansas City, Mo.
A.G. Edwards & Sons Inc. said that some firms may try to create the appearance of having lower markups by shifting expenses that they currently recover through markup into other charges, such as raising annual or transaction fees.
The president of Arbor Trading Group Inc. of Barrington, Ill., urged the SEC to establish a "threshold" for markups that would have to be reported. "For example, any transaction where the markup exceeds 1% could be a reportable transaction," said James R. Stevens.
The MSRB sent a comment letter to the SEC on June 15 urging the agency to scrap the rule because it will lead to confusion for bond investors seeking the best deal on a bond. But the board recommended that the SEC proceed with requiring dealers to disclose on confirmations of whether bonds are unrated.
The Public Securities Association adamantly opposed the rule in a comment letter sent to the SEC June 22. The PSA also objected to the SEC's proposal to require disclosure on confirmations of whether a bond is unrated.