Washington - State and local finance officials Friday harshly criticized draft sales practice rules for government securities dealers and threatened to take their case to the Securities and Exchange Commission if the rules are not revised.
The warning was issued by the Government Finance Officers Association in comments submitted to the National Association of Securities Dealers, which wrote the proposed rules that were unveiled in August to carry out government securities legislation passed by Congress last year.
Charging that the rules would allow dealers to take advantage of unsophisticated state and local government investors, the GFOA also said it would seek "legislative remedies" in Congress "in the event that regulators are unable or unwilling to carry out their responsibilities."
A spokesman for the Public Securities Association said the group would unveil its officials response to the rules by the Nov. 7 deadline for comments. The deadline was originally set for Friday but was extended to give market participants more time to submit their replies.
"We're applauding the NASD for recognizing that these sales practice guidelines need to be better defined, and the market needs this kinds of guidance," said PSA spokesman Pen Pendleton.
The proposed rules set out sales practice guidelines for dealers in government securities under the Government Securities Act Amendments of 1993. The law was put on the books in response to the Salomon Brothers trading scandal in Treasury securities as well as losses by a number of state and local government offices that were cheated by rogue dealers.
The rules would set fair practice, or suitability, standards for transactions in government securities between dealers and their institutional customers. Such customers would include any corporation or entity with assets of $50 million or more.
In addition, markup rules for the prices of government securities that dealers sell to their customers would be set.
The rules are being closely watched by market participants because they are the first batch of new regulations to come out of the new government securities law. The law authorizes federal bank regulators to set similar standards for bank dealers.
The GFOA said that while the law requires dealers to take into account the sophistication of their customers, it does not draw any distinction among investor classes on the basis of portfolio size. They also said the rules do not meet the intent of Congress by classifying state and local government investors as institutional investors.
"By any traditional definition, almost all local governments, even the smallest, have assets of at least $50 million when buildings, land, sewage facilities, equipment, etc., are accounted for," the GFOA said. "Even these smallest governments are considered sophisticated investors."
The GFOA also noted that most state and local government finance officers do not trade continuously in the market but trade irregularly based on the flow of tax receipts.
The GFOA assailed a requirement for customers to indicate their reliance on the dealers' advice in sales transactions in order to be able to claim damages later. Instead, it recommended, dealers should be operating under a set of affirmative guidelines indicating their own responsibilities in making investment recommendations.
"It now appears that (the NASD) has absolved broker/dealers of virtually any obligation to recommend suitable investments to state and local governments to state and local governments," the finance officers said.
The finance officers group also assailed the markup rules as "unnecessarily complicated" and providing "no means of ascertaining whether or not a given markup is excessive. The factors used are so subjective that no investor will have access to this data."
The GFOA instead recommended a markup rule similar to the "fair and reasonable" pricing test used for municipal securities under Rule G-30 of the Municipal Securities Rulemaking Board.
The group also said it was disappointed that the proposed rules did not include anything to curb the practice of "churning" by dealers to beef up profits by excessive trading. "Does the lack of such a proposed rule indicate support for ~trading for the sake of trading'?" the group asked.
Dealers who fail to comply with NASD rules are subject to a variety of penalties ranging from fines to suspension of trading and, in severe instances, being banned altogether from doing business.