Banks may be banned from working as financial advisers on state and local bond deals they underwrite, under a proposal by regulators to prevent firms from using the dual role to profit at taxpayers' expense.
The Municipal Securities Rulemaking Board, which crafts regulations for the $2.8 trillion state and local government bond market, said today it was considering closing a loophole that currently allows banks to hold both jobs, as long as they formally resign as adviser before underwriting the securities.
The proposal follows a call from Securities and Exchange Commission Chairman Mary Schapiro to ban a practice that could allow a bank to render self-serving advice to municipalities seeking to raise money. It also comes as the board is moving to craft regulations for financial advisers, as required under the financial regulatory overhaul enacted last month.
"You want to have someone who doesn't have an interest in a particular transaction because you could end up paying more," said Bart Hildreth, a professor at the Andrew Young School of Policy Studies at Georgia State University in Atlanta who specializes in municipal finance.
The proposed ban would affect companies including Piper Jaffray Cos. and Royal Bank of Canada that arrange securities sales and offer financial advice. Jennifer Olson-Goude, a spokeswoman for Piper Jaffray, and Kevin Foster, a spokesman for Royal Bank in New York, didn't immediately respond to requests for comment.
The roles of financial adviser and underwriter conflict in so-called negotiated sales, the dominant way that municipal bonds are sold. Under that arrangement, a government agrees in advance to sell the securities to an underwriter — which then negotiates the prices and interest rates on the securities — rather than awarding them to the bank offering the lowest rate at a competitive auction.
Underwriters have an incentive to raise the interest rates on the bonds to make it easier to resell them to investors, while officials want to borrow money at the lowest cost. A bank acting as a financial adviser may persuade a municipality to sell the securities in a negotiated sale or laden them with high-fee derivatives, steps that could make them more profitable but may not be in the best interest of taxpayers.
The Municipal Securities Rulemaking Board's current regulation, known as G-23, has allowed a bank to be a financial adviser and underwriter on the same transaction, provided it resigns as adviser before the securities are offered and that it discloses the conflict of interest to its client.
The rule change, if adopted, would revoke those exemptions. It would also prevent firms from underwriting bond issues they advised on even if the deal was sold competitively, when the securities are awarded to the investment bank offering the lowest cost.
It would also prevent financial advisers from serving as so-called remarketing agents on floating-rate bonds, a role that provides a steady stream of fees for periodically reselling the bonds. Such floating-rate securities were frequently paired with derivatives intended to guard against rising interest rates, a strategy that backfired and proved costly when the financial crisis erupted more than three years ago.
The ability to hold both jobs has raised concern among public officials. The Government Finance Officers Association, which issues guidelines on how to handle bond issues, said municipalities shouldn't use the same firm in both roles given the conflict of interest involved. In a speech in May, Schapiro, the SEC chairman, said the rulemaking board should ban it. The board's rules are approved and reviewed by the SEC.
The move to close those loopholes comes as the business of providing financial advice to cities, states and school districts has come under scrutiny following the crisis that cascaded through the financial markets in 2008.
That crisis hit municipalities with billions of dollars in unexpected costs because of floating-rate bond deals packaged with interest-rate derivatives, a structure once marketed as a cheap way to borrow by banks and financial advisers. When the deals went awry, municipalities were forced to choose between spiraling interest bills or paying fees, frequently in the tens of millions of dollars, to back out of the deals.
The Justice Department has also brought charges in an industry wide investigation alleging that bankers conspired with advisers to inflate their profits on investment deals sold to local governments. Three former employees of CDR Financial Products Inc., a Los Angeles advisory firm, and a former banker with UBS AG have pleaded guilty, while three other CDR executives are fighting the charges. Last month, three one-time General Electric Co. bankers were also charged.