WASHINGTON - The municipal bond industry appears to be sharply divided whether the Municipal Securities Rulemaking Board should toughen its customer protection rules for buyers of unrated bonds, according to a few comment letters that have begun to trickle in to the MSRB.

Officials with two brokerage firms, Edward D. Jones & Co. and Coastal Securities Ltd., said in letters to the board that they oppose requiring brokers to take any additional steps to protect customers when the bonds are sold. Such a move, they warned, could backfire and cut available credit to reputable small issuers.

But the Bond Investors Association, a Miami-based investor advocacy group, strongly supported additional protections. It proposed a 13-point worksheet a firm could use to estimate the risk of selling a particular bond. Firms that deal in the small percentage of bonds that carry high risk ratings should then be required to comply with tighter standards, the group said.

The groups' comments came in response to a notice published Sept. 4 by the MSRB seeking broad industry input on whether the board's three key customer protection rules need to be strengthened. Rule G-17 requires brokers to deal fairly with customers and make appropriate disclosures, Rule G-19 says brokers can sell only suitable securities to customers, and Rule G-30 requires fair and reasonable pricing. The MSRB's deadline for comments is Dec. 1.

The MSRB said in its request for comments that it has received reports that there are problems with retail transactions in speculative bonds, such as those that are unrated or conduit bonds, and said that at the conclusion of its review it will take appropriate action if it finds there are problems.

The review comes amid growing pressure from the Securities and Exchange Commission for the MSRB to tackle such tough issues as pricing and the suitability of selling conduit bonds. Securities and Exchange Commissioner Richard Roberts, who has pushed for tighter regulation of the sale of higher-risk bonds to retail investors, recommended recently that the SEC adopt a rule requiring broker-dealers to make an express written suitability determination when recommending nonrated or conduit issues to retail buyers.

If less intrusive methods of reducing risks exist, however, he has said he may support them. At a minimum, Roberts says, the MSRB should eliminate a rule that says dealers can sell bonds to customers whose backgrounds Are unknown as long as they have "no reasonable grounds" to think the bonds are unsuitable.

Lawrence R. Sobol. general counsel for Edward D. Jones, headquartered in St. Louis, warned that tough new customer protection rules "may serve to terminate the credit pipeline to many deserving small communities."

"It is our fear that regulation based upon ratings criterion would effectively curtail offerings by small communities with urgent capital needs" who are excellent credits, but do not find it cost-effective to get a rating for a relatively small offering.

"For example," Sobol said, "in early October our firm won a competitive bid offering for a $1.3 million water project for the City of Sikeston, Mo. This, in our opinion, represents a solid credit, but was nonrated. The costs of rating as bid by the major rating agencies would have represented 4.6% of the total offering amount, which was obviously prohibitively expensive.

"Our firm has underwritten 72 small municipal offerings over the past several years with an average size of approximately $1.9 million each, without any credit problem having surfaced. The underwritings were vital to the communities involved."

Richard Lehmann, president of the Bond Investors Association, proposed developing a worksheet that would be completed for any unrated bond issue being offered for sale in either the primary or secondary market. On the worksheet, each bond characteristic would be assigned a point rating. A bond issue that accumulates a given number of points would require that the broker comply with any higher suitability disclosure standard you eventually defines, he said.

The questionnaire could be prepared by either the buying or selling broker, Lehmann said, adding that the seller is in a better position to answer all the questions and assure the buying broker that he will have no compliance headaches.

Or, he said, an independent organization could prepare the questionnaire and reduce the liability risk for the brokerage community by doing the evaluations independently. Like Sobol, David J. Master, chairman and chief executive officer of Coastal Securities in Houston, opposed firms being required to make written suitability determinations at the time of sale.

"Our clients have learned to depend upon us and our judgment. The fact is we will not sell an issue which we are not willing to own ourselves. In general, we believe that customer protection is based primarily on sound underwriting and trading practices, and that while disclosure and suitability are important factors, they will not turn a bad deal into a good deal."

Coastal Securities serves as underwriters, traders, and bankers in the water district markets of the Houston area and several other Texas metropolitan areas, Master said. These evolved out of "the need for Texas' cities to meet water and sewer needs as peripheral metropolitan growth occurred," he said.

Over the past 30 years, more than 450 of these districts have been created in the Houston area alone, totaling hundreds of millions of dollars in municipal financings, he said. "Virtually all began as nonrated issues. To date we know of only two defaults among these issues equaling less than 1% of the amounts financed."

He said a major objective of the firm is to educate institutional and individual clients about nonrated water district bonds, which leads to higher levels of business. "We frequently mail or facsimile information to our clients about the nature of these districts and find this information dissemination to be effective," Master said.

He said many trades in water district bonds are in small denominations, thus, dealers will likely be unwilling to put in the time and effort to write suitability statements.

He said it is at the underwriting stage that more regulation may be needed, not at the point when bonds are sold in the secondary market. One possibility is for underwriters to be required to maintain a paper trail documenting their rationale for underwriting a risky deal.

"Our view is that underwriting and commitment standards tell the most about a broker-dealer's intentions and business principles, and if any regulatory changes are required, this is the place to look.

"Any changes should be carefully scrutinized as many nonrated issues represent ~grass roots' investment in municipal infrastructure where real economic growth is germinating."

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