The largest institutional buyer of New York State debt balked at a $ 640 million refunding issue sold by the state's Local Government Assistance Corp., citing the transaction's designation rules, fund officials said yesterday.
Officials at the San Mateo, Calif.-based Franklin Resources Inc., which owns funds that manage about $ 40 billion of municipal assets and about $ 4 billion of tax-exempt New York bonds, said they have a company policy that does not authorize their funds to purchase bonds from offerings in which the issuer stipulates that the buyer designate commissions to specific bond dealers.
"We do business with 80% of the firms in the country," said Gregory Harrington, senior vice president and director of municipal trading and research at Franklin. "The only thing we object to is when issuers force us to designate business to firms that never even give us a call."
Franklin manages the largest New York municipal bond fund, according to Lipper Analytical Services Inc., a firm that tracks mutual fund performance. Franklin's New York fund had assets of approximately $ 4.19 billion, as of March 31, 1993.
Franklin's reaction to the LGAC deal, underwritten by a syndicate led by Goldman, Sachs & Co., continues a trend where institutional buyers of municipal debt have balked or demanded higher yields on transactions that include strict designation rules imposed by issuers.
Institutional buyers have maintained that since it is their money that is being invested, they should reward with commissions only those Wall Street firms that provide them with services. Such services include making a market in bonds the institutions purchase, or giving the buyers market information on a regular basis.
"We are the investors and would like to, within reason, be able to compensate firms which we feel offer us the best overall service," said Dave Johnson, high-yield fund manager at Van Kampen Merritt.
"At times, if you're forced to do group-designated deals, you are forced to compensate firms that, in some cases you've never heard of, never mind if they offered you any value on the deal," he said.
At the same time, issuers such as LGAC have underwriting policies that attempt to spread commissions among all members of the bond syndicate, not just those firms that buyers say they want to see compensated.
In many cases, bond issuers use such designation policies to allocate profits to securities firms owned by women or minority group members.
The LGAC underwriting group included two minority-owned firms: M.R. Beal & Co. and Samuel A. Ramirez & Co.
An official involved in public finance for one major national issuer said that forced designations are used to further the public policy goal of rewarding local or minority-owned businesses.
He said the policy is necessary because large institutional buyers are often reluctant to place orders with local or minority-owned firms, out of fear that such firms will be unable to handle the transaction.
The official said that forcing the designation allows buyers to feel confident their orders will be filled, and reduces buyers' insistence that bonds be ordered only through the senior manager.
"To get more firms involved you have to level the playing field, and investors have to know that if they put their order into a local firm or a minority firm, that they're going to get their order filled," the official said. He pointed out that the practice does not raise costs for buyers.
Gedale Horowitz, chairman of LGAC and a managing director at Salomon Brothers, said he did not believe the sale was affected by Franklin's decision.
"They didn't hurt this issue at all" but "it's conceivable they could hurt a particular issuer," he said.
Horowitz said the LGAC has used the 15% designation policy on several of the public corporation's bond offerings. The policy was implemented to ensure that "people who are willing to underwrite for us get paid."
The policy also helps to ensure that there is a liquid secondary market for LGAC securities, he added. "I think 15% is a minimal payment," Horowitz said.
He said buyers can still designate firms to receive the bulk of commissions their orders.
According to a pricing wire describing the designation rules for the LGAC deal, 15% of the takedown, or commission on the issue, that buyers must pay the deal's managers on so-called priority orders "will be retained in the account, to be distributed in accordance with the underwriting liability of each syndicate member as approved by the comptroller."
The rule essentially ensures that every firm in the 15-firm syndicate to receive a percentage of a 15% cut in the deal's takedown for priority orders -- orders made by large investor accounts that underwriters fill first. The 15% designation rule is a variation on the forced designation process that has been used by issuers across the country.
In May, for example, another state authority, the New York State Urban Development Corp., sold a $629 million refunding issue that was rebuffed by several large buyers of municipal debt because of the transaction's group-net designation rules.
This method of dividing underwriter commissions, another form of forced designation, gives buyers almost no say in the distribution of commissions.
As a result, Putnam Investments, which manages $2.3 billion in New York municipal paper, chose not to purchase the issue, said senior vice president David Eurkus.
Sources with knowledge of yesterday's LGAC deal said Eurkus also chose not to purchase the deal. He could not be reached for comment yesterday.
Despite concerns about issuers' designation procedures, few buyers have gone as far as Franklin in stating their objections.
Last year, the multiline reinsurer General Reinsurance Corp. sent a letter to some municipal firms expressing its displeasure with designation policies established by issuers. The company buys bonds for its $5.5 billion portfolio.
At that time, the reinsurance company said it would monitor new issues closely and seek to avoid offerings on which it could not designate which firms would receive commissions.
"We sent out a viewpoint and intended policy," said John Cregan, vice president and head of fixed-income investments at General Reinsurance Corp. "We are going to take into account the designation policy."
Whenever possible, General Reinsurance avoids purchasing bonds from offerings on which the company cannot designate, Cregan said. But the company does not feel it is able to totally boycott such issues and still be able to meet investment objectives, he added.
"The issuers are inappropriately injecting themselves into the sales process," said Cregan.
Underwriters and market analysts say such reactions have not severely damaged issuers efforts to both sell bonds and maintain a policy that rewards firms owned by women and minority group members.
At the moment, tax-exempt municipal bonds are in demand, given the tax policy of the Clinton Administration, and favorable market conditions, such as low inflation, that bolster all fixed-income securities.
But underwriters say a change in market conditions, such as an increase in municipal supply or higher interest rates could provide buyers with more power, and make some of these deal so unprofitable that issuers may be forced to rethink their designation policy.
"If, for example, the supply goes the other way, these reactions will have a greater impact, no doubt about it," said one underwriting source, who asked not to be quoted by name.
The Metropolitan Transportation Authority has a designation rule, similar to that on the LGAC issue, a spokesman said. The policy has been in effect since about 1989, he added. However, the book running senior manager does not receive compensation as part of that policy.
"We believe it insures compensation to all syndicate members who took a risk on a particular deal," a spokesman for the MTA said.
John Pinkham, a senior portfolio manager and vice president at Franklin, said the firm had initially considered a $35 million purchase of the LGAC deal. But after discovering the deal's designation rule, executives there decided not to purchase the deal.
"I've complained about this in the past," Pinkham said. "We decided draw the line."
Pinkham said the rule will not include the purchasing of so-called retention orders, where the fund will buy bonds from members of the selling group, despite designation rules on priority orders.
Just how much effect Franklin's absence had on the deal is difficult to determine.
Underwriting officials at Goldman Sachs said many potential investors did not purchase the issue because it was aggressively priced. "It would have been nice to have them buy some of the issue," said Richard E. Kolman, a vice president and manager of underwriting and syndication at Goldman Sachs. "But I think a lot of buyers didn't participate because of the aggressive price."
Goldman Sachs priced the LGAC deal to yield from 4.40% in 1999 to 5.63% in 20012, 5.63% in 2017, 5.70% in 2018, and 5.66% in 2021. Market sources said the offering was priced comparable to levels where outstanding LGAC bonds have been trading.
The issue is rated single-A by Moody's Investors Service and Standard & Poor's Corp., and A-plus by Fitch Investors Service.
Goldman Sachs made allotments late yesterday and market sources said the bonds were trading within the syndicate at the original price levels, less 1/4, according to market sources close to the deal.
Among large, issuers, California is one issuer that does not have such a group net designation policy, said Hal Geiogue, assistant state treasurer.
"We do not use group net. We have tried to be sensitive to some of the concerns we've heard from institutional buyers. We've had discussions with institutional buyers and a lot of them don't like it," Geiogue said.