WASHINGTON -- Securities and Exchange Commisioner Richard Roberts's controversial call for written suitability determinations for risky bonds may not be as farfetched as some market participants say, several regional firms said last week.
These dealers said they already take formal precautions concerning some sales.
Officials with these firms said that while they do not necessarily record whether a bond is suitable, they do put prominent warnings on some confirmations.
These dealers agreed that firms should take formal steps to alert customers that some of the higher-yield bonds they are buying could be very risky.
Mark Ringel, vice president for compliance at New Jersey-based J.B. Hanauer & Co., a regional firm with extensive East Coast sales, said the firm has an array of warnings it places prominently on confirmations of purchase orders from investors.
Among their warnings:
* "This transaction contains certain risk factors."
* "Speculative investment. Businessman's risk."
* "This confirmation contains certain risk factors. See prospectus."
* "This trust contains certain credit risks. Bond calls or maturities will affect risk."
* "Rating currently under review by Moody's and S&P."
Mr. Ringel said the firm earmarks certain securities "in the system so that special comments will be generated on the confirmation."
"It's the only way to stay in business these days," he said. "Too many competirors fall by the wayside" because of disclosure problems.
"All of a sudden people are coming back with a series of lawsuits. You have to be aware of what you are selling, and you have to make every effort to let the client know," he added.
Several Options Offered
The debate was launched in late February when Commissioner Roberts proposed requiring written suitability determinations for unrated and conduit bonds at the Public Securities Association's annual meeting in Phoenix.
Two weeks ago, in a speech before The Bond Club of Virginia, Mr. Roberts outlined additional options for dealing with the issue.
The least intrusive, he said, would be to eliminate a loophole in Municipal Securities Rulemaking Board Rule G-19 -- the rule saying dealers must reasonably believe a security they recommend to a customer is suitable.
The loophole allows the transaction to proceed if the firm lacks relevant information about the customer's background, but has "no reasonable grounds" to believe the recommendation is unsuitable.
The most intrusive, he said, would be a rule mirroring the tough new standard recently applied by Congress and regulators to the penny stock industry. That rule not only requires firms to put in writing at the time of the sale why they think a particular bond is suitable for a customer -- Mr. Roberts's original proposal -- but also requires the customer to sign and return the statement prior to the trade.
Mr. Roberts said such a "cooling-off" period would be "regulatory overkill." He said he would be reluctant to support such a plan for municipals. "It's essentially killed the penny stock market and that would probably be the result in the municipal market as well," he said.
Or, broker-dealers could be required to inform customers of special risks regarding a bond before the trade, Mr. Roberts continued. Moreover, the SEC could require broker-dealers to provide a preliminary official statement to a customer 48 hours in advance of selling certain newly issued bonds, he said. Such a rule would "break new ground in the municipal realm," but would not curb secondary market sales abuses, he said. Finally, the SEC could propose legislation calling for registration of certain types of conduit bonds, he said.
A broker with Wheat, First Securities Inc. in Richmond said at the Bond Club meeting in Virginia that his firm assigns each bond it sells a quality rating and each new account form gets a code indicating whether the account is a growth account, a more speculative account, or other type.
"If the client were to constantly buy GOs and all of a sudden buy an unrated issue, a letter is generated that says 'you bought something that does not conform to what you [originally requested for the account]. Please contact the branch manager.'"
Frederick Stoever, president of Stoever, Glass & Co. in New York City, said the firm for more than 20 years has had a policy of putting the words "speculative elements" in capital letters prominently on the confirmation whenever applicable.
"Fortunately for us and our clients, none of these bonds have experienced difficulties, but if they did, we have proof that the extra high yields were properly represented," Mr. Stoever said.
He added that his firm would back a rule barring the sale of speculative bonds to investors with a net worth under a specific amount, such as $250,000. But he said he does not support dealers being required to make written suitability determinations at the time of sale. "It would be very, very burdensome for dealers to write a suitability report for every $5,000 or $10,000 amount.
"I don't think we would bid them, or we would bid them cheaper," he noted.
Caution on Unrated Bonds
Stephen Cartwright, president of Sweney Cartwright & Co. in Columbus, wrote in an April 30 letter to Commissioner Roberts that he agrees that unsophisticated buyers of unrated conduit bonds need written documentation concerning suitability.
But the "market will be hurt" if the solution is written suitability statements for issues that do not have ratings but are of excellent quality, the letter said. Mr. Cartwright enclosed circulars from two non-rated issues, including a recent Fairfield County, Ohio, offering, to illustrate his argument.
In an interview last week, Mr. Cartwright said, "In states like Ohio the absence of a rating has nothing to do with quality.
"In fact, I feel that all industrial development revenue bonds should be subject to the same SEC registration requirements as the underlying corporation."
In the letter to Commissioner Roberts, he wrote, "Our firm has been underwriting and dealing in Ohio issues, both rated and unrated, for more than 50 years. I can think of no instance that a general obligation or public- purpose revenue bond has ever had a problem that was other than technical in nature."
One dealer predicted the rule would be "even more confusing and burdensome" for major bond firms.
"Each individual salesman is going to have to write up a report because they are the ones who know the customer," the dealer said. "You can't have Merrill Lynch's corporate attorney write a suitability report. In smaller firms the top management is in the same area as the sales force."
But Christopher Taylor, the MSRB executive director, said using the confirmation to warn investors of bond risks may be a thing of the past.
"What if the confirm is no more?" he asked, referring to the industry task force recommendation on May 26 that stock and bond trades be settled in three days instead of the current five.
"Putting a warning on the confirmation "may not be a solution that fits the new technological age" of clearance and settlement, Mr. Taylor said. "It's too early to tell" how the rule-making board will approach the issue, he said, noting that the board is not looking at the suitability question "in isolation."
"This suitability issue is but one part of the overall question of what the dealer-customer relationship should be," he said.
"The board is not only going to look at this but a number of other issues associated with that relationship," he said, not commenting on the other issues. "We are taking the long view: Where is the board and the industry going to be in five years from now. The world has changed a great deal."
SEC Chairman Richard Breeden said recently it will probably take two to three years to shift to the faster settlement system being studied by an international panel called the Group of 30: the group had originally projected a 1993 conversion. The task force signaled it may take even longer for the municipal market to achieve the so-called "T+3" settlement goal.
"Certainly your proposal is going to restrict the marketability of unrated bonds, but that will be a good thing," Richard Lehmann, president of the Bond Investors Association in Miami Lakes, Fla., wrote Mr. Roberts in a June 10 letter outlining his support for written suitability statements. "Unrated bonds are normally not a suitable investment for individual investors.
"At some point municipalities will wake up to the fact that someone is polluting the well from which all must drink," he said. Lack of regulatory oversight in the municipal market, he said, is encouraging "unscrupulous individuals" and "harming the reputation of municipal bonds, and the price is being paid by all participants. Issuers are paying through a higher risk premium; investors are paying by resorting to buying only through a mutual fund, and both are paying for a flourishing bond insurance business."
"The securities industry has for too long taken the attitude that selling investments is much like selling cars," Mr. Lehmann said.
Mr. Lehmann called for increased regulation despite his group's report this month that municipal bond defaults in the first quarter of 1992 plunged 74% from the first quarter of 1991.
The group reported 22 defaults totaling $278 million in the 1992 period compared with 66 defaults totaling $1.08 billion in the first quarter of 1991. But Mr. Lehmann said last year's figures reflect some unusual defaults, including a series of taxable issues backed by guaranteed investment contracts from Executive Life Insurance Co., which was taken over by regulators. He said single and multifamily housing bonds as well as nursing and retirement home bonds continue to be the biggest category of bonds defaulting.