Controversial Dealer Review Provision Scaled Back, But Material Events Would Have to Be Monitored

WASHINGTON -- The SEC staff will recommend tomorrow that commissioners adopt secondary market disclosure requirements for the municipal market that are tough but less restrictive in some cases than the ones proposed last March.

The requirements, which would not be effective immediately, are to be outlined at a Securities and Exchange Commission meeting that begins tomorrow at 10 a.m. The commissioners are expected to approve the proposed recommendations as amendments to the SEC's municipal disclosure Rule 15c2-12, but could call for some revisions.

The SEC staff is expected to recommend that the commissioners scale back a controversial proposal that would have barred broker-dealers from recommending bonds unless they had first reviewed the financial information that had been disclosed by the issuer, sources close to the SEC deliberations said.

Market participants had warned that this proposed requirement could cause liquidity problems for some investors or, in an extreme case, even bring the municipal bond market to a halt.

The staff is expected to recommend, instead, that broker-dealers be required to have in place the systems and procedures needed to monitor material events that could affect the bonds they recommend, the sources said.

A broker-dealer would then have to take into account Municipal Securities Rulemaking Board rules G-17 and G-19 and the antifraud provisions of the securities laws in deciding what information to provide the investor when making the recommendations, the sources said.

The SEC staff "is not going to recommend adding a new layer of federal regulation. There is already enough," one source said.

The MSRB's Rule G-17 says broker-dealers have a duty to inform customers of all material facts about a bond issue. The board's Rule G-19 on suitability says a broker-dealer must have a reasonable basis for recommending bonds. In addition, a broker-dealer is supposed to make recommendations that are suitable for customers under the securities laws' antifraud provisions, the sources said.

The SEC staff is expected to recommend that the commissioners keep a proposal to bar dealers from underwriting bonds unless they have "reasonably determined" that the issuer has agreed in writing to provide ongoing disclosure of annual financial information and notices of material events.

But rather than specify the form and content of the annual financial information to be disclosed, the SEC staff will propose using the primary official statement as a benchmark.

To satisfy the annual financial information requirement, issuers or other market participants would have to annually update the key financials and operating information that appears in the official statement for a primary bond offering.

"The notion is that bond market participants are free to determine what information investors need at the initial offering of the bonds and then that information, at least with respect to those who are obligated for the bonds, should be carded on on an ongoing basis," another source said.

Municipal market groups had complained about an earlier proposal that would have required financial and operating information be disclosed for "significant obligors" that were the source of 20% or more of the cashflow needs of the bonds. The groups said the concept was confusing and could be interpreted to cover taxpayers or customers.

The staff's recommendations would address this concern by making clear that it would be up to the issuer, its bond counsel, and the underwriter's counsel to specify in the primary offering's official statement whether there are significant obligors and what information should be disclosed about them. That information would then have to be updated annually.

The staff is not worried that this could result in less information being put in primary offering statements, the sources said. Some information in offering statements is extraneous and can be dropped, the sources said. However, issuers and market participants are obligated to make certain disclosures under the due diligence standards in disclosure rules adopted in 1989 and the securities laws' antifraud provisions, they said.

The SEC staff will also recommend that if an issuer prepares an audited financial statement, it should be disclosed.

The staff's recommendations are aimed at ensuring that issuers "are not going to have to provide any information beyond what they already are providing," other than to update that information on a annual basis, a third source said.

Annual financial information would have to be sent to each nationally recognized municipal securities information repository and any depository set up in the state in which the bonds were issued, under the staff's recommendations.

Three organizations are currently certified as NRMSIRs: Bloomberg Financial Markets, Kenny Information Services, and The Bond Buyer.

These organizations, however, would probably have to reapply for status as a NRMSIR if the staff's recommendations are approved because they differ from earlier proposals, the sources said.

Notices of material events would have to be sent to each of the NRMSIRs or the Municipal Securities Rulemaking Board. In either case, the notices would also have to be sent to any depository in the state where the bonds were issued.

The SEC staff will recommend that issuers with less than $10 million of outstanding municipal bonds be exempted from the requirement to provide repositories with annual financial information.

However, to qualify for the exemption, an issuer would have to agree to provide annual financial information that is publicly available to anyone requesting it or to a state depository, which would make it available upon request. The issuer would also have to agree to disclose any material events to either the NRMSIRs or the MSRB, as well as the state depository.

This exemption could apply to about 71% of the 52,000 issuers that currently have outstanding bonds in the municipal market, according to statistics made available to the SEC by Thomson Municipal Securities, a sister company to The Bond Buyer.

Issuers would also be exempt from the annual financial information disclosure requirements for short-term notes or bonds that would mature before the information is to be submitted.

The municipal securities that were exempted from the disclosure rules adopted in 1989 will continue to be exempted from the secondary market disclosure requirements, the sources said.

Those include bond issues with a total principal amount of less than $1 million. They also include bonds sold in denominations of $100,000or more that: are sold to no more than 35 investors who are relatively sophisticated and are not purchasing them for more than one account or with a view to distribute them, or; have a maturity of nine months or less, or; are variable-rate demand notes whose rates are reset at least every nine months until maturity.

The SEC moved toward mandating a secondary market disclosure program for the municipal market after discovering that few issuers were providing ongoing disclosure of information that could affect their bond issues, the sources said.

The SEC staff had been pleased with the disclosure practices that evolved for primary offerings after the commission adopted disclosure rules in 1989 and released additional guidance recommending improvements in an interpretative release issued last March. But the staff felt rules were needed to spur secondary market disclosure practices, the sources said.

SEC chairman Arthur Levitt has become increasingly concerned about the need for more disclosure and price transparency in the municipal market because more investors are investing in municipal bonds directly or through mutual funds, the sources said.

As expected, the staff will propose the SEC commissioners defer, for at least six months, a proposal to require dealers to disclose markups in confirmations of riskless principal transactions.

Instead, the SEC staff will ask the commissioners to urge the MSRB and the Public Securities Association to move forward with initiatives to improve price transparency.

The staff proposed disclosure of markups in riskless principal transactions last March, with the idea that it would give an investor information about the price of bonds as well as the broker-dealer's compensation, the sources said.

The staff thought bond prices should be readily available from such transactions, in which dealers almost simultaneously buy and sell bonds without holding them in inventory, usually to fill an order. The term "riskless principal" comes from the belief that there is little risk of loss to the broker-dealer because it holds the bonds for such a short period of time.

But securities industry officials vigorously opposed the proposal, contending that it would confuse investors and provide them with little meaningful information. Many firms, which submitted more than 300 negative comment letters, said the proposal would basically eliminate riskless principal transactions and lead broker-dealers to trade from inventory or to recommend bond funds.

The SEC staff believes that the proposal has helped spur securities industry officials and the MSRB to become more enthusiastic about developing price transparency initiatives, which the PSA and the MSRB contend will provide more useful information to investors, sources said.

The MSRB is scheduled to begin a four-part pilot program in January to make price and other transaction information available from bonds that are traded more than four times a day. The information would be made available to any subscribers of the program and to federal regulators.

In the first phase of the program, the board would make information available from trades between dealers. The next three phases would focus on dealer trades with institutional and retail investors and getting pricing information more frequently than at the end of the day of the trade.

The PSA is embarking on a program to get national and regional newspapers to print the bond prices and other information obtained from the MSRB program and from other sources.

The SEC staff, however, is expected to recommend that the commissioners reserve the right to reconsider the proposal on riskless principal transactions if the MSRB and PSA initiatives do not succeed in making bond prices and other information available to retail investors.

The SEC staff will also recommend that commissioners defer a proposal to require broker-dealers to disclose when bonds have not been rated by a nationally recognized statistical rating organization. Instead, the staff expects the MSRB to propose such a rule.

SEC Staff Recommendations to Improve Secondary Market Disclosure Would:

* Scale back a controversial proposal to bar broker-dealers from recommending bonds unless they have first reviewed the financial information that had been disclosed by the issuer.

* Instead, require that broker-dealers have in place systems and procedures needed to monitor material events that could affect the bonds they recommend.

* Remind broker-dealers that existing rules and laws make clear that they must inform customers of all material facts about an issue, must have a reasonable basis for recommending bonds, and must only make recommendations that are suitable for their customers.

* Retain a proposal to bar dealers from underwriting bonds unless they have "reasonably determined" that the issuer has agreed in writing to provide ongoing disclosure of annual financial information and notices of material events.

* Rather than specifying the form and content of annual financial information, use the official statement for an issuer's primary offering as the benchmark disclosure standard and require issuers and other participants in transactions to annually update the key financial and operating information that appeared in the official statement.

* Require issuers who prepare audited financial statements to send them to repositories.

* Require that an issuer's annual financial information be sent to each nationally recognized municipal securities information repository (NRMSIR) and to any depository set up in the state in which its bonds are issued.

* Require that disclosures of material events be sent to each of the NRMSIRs or to the Municipal Securities Rulemaking Board, and to any depository in the state where the bonds were issued.

* Would not make the new requirements effective immediately.

* Generally exempt issuers from filing annual financial information if they have less than $10 million of bonds outstanding; or have short-term note issues that mature before the annual information is required to be filed.

* Only exempt issuers with less than $10 million of bonds outstanding that agree to provide annual financial information to anyone requesting it and to disclose any material events to NRMSIRs or the MSRB, and to applicable state depositories.

* Also exempt issues of less than $1 million from disclosure requirements and keep other Exemptions listed in the disclosure Rule 15c2-12 adopted in 1989.

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