WASHINGTON — The Financial Industry Regulatory Authority’s top official warned Monday that FINRA will be taking enforcement action against firms for excessive entertainment of rating agencies to influence muni bond ratings and issuers. Sanctions also will be issued against firms using bond proceeds to make payments to political action committees. In addition, false reporting of issuer payments to firms or individuals who were supposed to be involved in muni transactions will be sanctioned.
“These issues raise serious noncompliance and a breach of ethics that we are continuing to investigate,” Rick Ketchum, FINRA’s chairman and chief executive officer, said at the self-regulator’s fixed income conference in New York City.
Ketchum noted that the Securities and Exchange Commission in 2009 settled cases with two firms for excessive entertainment of issuers and their family members. The entertainment extended well beyond meeting with rating agency officials and included Broadway shows, sporting events, and expensive meals.
In the first case, the SEC fined RBC Capital Markets Corp. $125,000 for using bond proceeds to reimburse itself for treating city officials from Mesquite, Tex. - along with their spouses, children, and grandchildren - to lavish meals, car services, and entertainment in trips to New York City to meet with rating agencies in 2004 and 2005.
In the second one, the SEC fined Birmingham, Ala.-based Merchant Capital LLC $55,000 for using bond proceeds to treat issuer officials, family members and friends to upscale restaurants and Broadway shows during five trips to New York from June 2003 through May 2005.
“We’ve found similar practices at other firms,” Ketchum told the group.
“We’re also investigating excessive entertainment of rating agency officials, activity that presumably represents efforts to favorably influence the rating of municipal securities issues,” he said.
In addition, he said FINRA is seeing “payments to political action committees as a line item on new bond issue expenses and false representations that issuers are directing payments to dealers or others for services that simply are not performed.”
FINRA plans to bring additional enforcement actions against firms for the failure to disclose material information, for having deficient procedures for disclosing material information, for inadequately reporting trade data, and for failing to deliver official statements during the primary offering period, Ketchum said.
The self-regulator is particularly concerned that some firms are not following the Municipal Securities Rulemaking Board’s access equals delivery standards, under which they can make official statements widely available electronically rather than sending paper statements to every investor interested in the bonds.
“If you’re underwriting municipal securities, you have an obligation to submit an official statement to [the MSRB’s] EMMA no later than the closing day of the offering,” Ketchum warned. “Otherwise you may be preventing the customers who purchased the securities during the primary offering disclosure period, including those who purchased the securities in the secondary market, from obtaining the official statement that they are entitled to receive.”
“Municipal underwriters’ should monitor the timeliness of their officials statements by reviewing their MSRB Rule G-32 report cards, which are available on the FINRA report center,” he said.
Another key area of focus for FINRA is firms’ sales practices and due diligence obligations, Ketchum said.
“Members must fully understand the municipal securities they are selling in both primary and secondary market offerings,” he said. “All material information known to the firm or available through established industry sources must be taken into account.”
Ketchum said he realizes that there are many different business models in the municipal market, from firms that are heavily involved and are major underwriters of munis, to firms whose involvement in munis is “episodic.”
“We’re not suggesting a strict liability structure that is the same for every firm in every circumstance,” he said. “What we are suggesting is both the monitoring, from the standpoint of EMMA, of material event information and the assurance that” if one part of the firm is aware of some problem or issue with a muni, that gets communicated and “particularly to the part of the firm that’s involved in providing product to retail investors.”
“We recognize the challenge. We recognize that perfection is difficult indeed not possible,” Ketchum told the group. “But we do believe that there needs to be far more focus from the industry in insuring that the communication works better and better.”
To help firms with these challenges, FINRA is developing “a municipal continuing disclosure report” that it plans to make available on its report center later this year.
“The purpose of the report is to help firms ensure that they’re taking material information into consideration in their transactions with customers in addition to making appropriate disclosures of material information at the time of trade,” Ketchum said.
