Expectations of the Financing Team to Provide Equitable Pricing Outcomes

Issuers rely heavily on their financing team to help them achieve the lowest cost of borrowing. The MSRB and the SEC have established rules and regulations regarding the responsibilities of municipal advisors and underwriters with respect duties of care and fair dealing. Presenters will discuss the laws that govern the relationship issuers have with their financing team members and how these legal protections are designed bring more fairness and transparency to new issuance pricing.

Transcription:

Dave Sanchez (00:10):

Robert, is this thing on? Yeah. Okay, great. Thank you Robert, and thanks for indulging me and letting me sit down. It's just much more comfortable for me. I'm not a podium guy. First, I want to thank CDIAC for organizing this particular pre-conference. I think one, it's very timely and it's extremely important. It's something at the commission we've been focused on, especially the last couple of years. As I start, I want to remind everybody that the comments I make today are my own. They do not reflect the views of the commission, any of the commissioners or any of my fellow staff members of the commission, but they are informed by my role as the Director of the Office of Municipal Securities. This is a little bit of a continuing conversation. I've been talking about pricing issues, method of sale issues, responsibilities of regulated entities to issuers for a little while now.

(01:02):

And so part of what I'm going to say today is a little bit in response to feedback we've received on the things we've said in the past, but also really to underscore this purpose of CDIAC and to be speaking to issuers as well as the regulated entities and say, look, these are the rules that are in place, and these rules can help you achieve more fair and efficient pricing and basically lower your cost of borrowing. And that's kind of ultimately our focus. I want to start by talking really big picture about both the mission of the SEC and the mission of the MSRB. My friends from the MSB, were supposed to be here today, but we're not able to make it. But one of the core components of the SEC's mission is to maintain fair, orderly and efficient markets. So we have those words fair and efficient in there.

(01:54):

And even when Dr. Marlowe was speaking about underpricing and one of the big focuses that we've had and talking about a 35 basis point underpricing on average, we see numbers that vary from that to up from that. But if you're talking about a 400 billion a year issue, even at 35 basis points, that's 1.5 billion of under issuance. The numbers can be pretty big. And then the MSRB as a result of Dodd-Frank has to write rules for the regulation of dealers and municipal advisors that protect issuers. And so this whole notion of issuer protection is very important in the regulation. I think in some of the conversations I've had about this recently, people think this is just me or just a very recent thing that has happened, and it's not true. Regulator interest in pricing is definitely not new, and particularly just even in new issue pricing, the SEC has brought several cases related to new issue pricing in the last decade, including with respect to a municipal advisor's fiduciary duty in evaluating pricing in misrepresentations by a broker dealer about its customer base and how that resulted in higher issuance costs for municipal entities as well as a series of flipping cases which affect the pricing right at the time of primary issuance.

(03:21):

So even in October, 2021 when I was still in private practice, and I remember this very fondly because I commented on a private practice, the SEC, I'm sorry, the MSRB put out a request for comment on pricing compliance for both dealers and municipal advisors. So I want to be clear that this is obviously something that's not new. It's something that's going to always be of concern to regulators. It was concern to regulators before I had this position. It'll be of concern to regulators after I have this position. And one of the things though that's important to me is to talk about this because I know that when I was in the private sector, I didn't. And some of the criticisms about regulation by enforcement is because people think this is coming out of nowhere. And one of the reasons we've made a conscious decision to speak to municipal advisors, to speak to dealers, to speak to issuers about pricing is that these rules are not new.

(04:17):

Almost all of these rules have been in place for a while. Obviously the municipal advisor rules are more recent, but just in the same way, it's nice if, for example, a guest is coming over and they tell you you're coming over and you have a chance to clean up. I mean, we're letting you know that we're going to be looking at this stuff. And if you look at the exam priorities that were put out this week, a story about it in the bomb buyer, definitely part of the exam priorities for this year will continue to be pricing and method of sale. So two things I just want to talk about. And by the way, I also want to say please feel free to step up at any moment to ask questions. I'm fine to answer questions as we go. But two things I kind of want to talk out about just in particular to help frame the issue.

(05:03):

One is the SEC's case against first mid-state, which was brought in December, 2020. And that particular case, that particular underwriting firm had made representations in its marketing materials that they had a big investor base, right? They had a big customer base of investors. This is how they pitch themselves to issuers. And I think people are very familiar with those kinds of comments when you read RFPs, right? This is something that underwriters talk about to distinguish themselves about their customer base, about how they're able to reach a broad range of customers with the idea that you're going to get a lower cost of borrowing. Well, in this particular case, that's what first mid-state said. However, in reality, most of the time or not most of the time, a little over 30% of the time, they were selling their bonds exclusively to another broker dealer. And then that other broker dealer was almost immediately turning around and selling bonds to other investors in some cases in less than 30 minutes after they'd received the bonds.

(06:02):

So there was this very obvious, very immediate cost to the issuer. If first mid-state had reached out to these investors directly, the prices would've been higher for the issuer, the lower yield. But I also think that particular case, because in some ways it was a little egregious. I mean this underwriter was selling directly to other broker dealers. It makes people think that only that type of activity is potentially relative of the rules. Only that type of activity results in the kind of efficiencies or lack of efficiency that raises regulatory concern even when Dr. Marlowe was speaking, there's this point of have we seen improvement? Yes, we have seen improvement. I think even in secondary market trading, we've seen improvement in primary trading, we've seen improvement. The question of is it enough? I think the answer is no, it's not quite enough. And that's why we continue to have this interest.

(07:02):

But also when the SEC is speaking, it's not always, I think I can understand that when I talk about these things, people think, oh my God, there's a new rule or there's a whole bunch of enforcement cases coming. But really not everything is an enforcement case. And a big part of the regulatory process is one, reminding people of these rules so that people can look at their own practices and improve their own practices and help that efficiency be achieved to some level just by issuers focusing more on the issue by municipal advisors, focusing more on the issue by dealers focusing more on the issue. Also, we will be examining for this, and that's a little more serious, but it doesn't always result in an enforcement action. But so you can expect that when examiners come in, they're going to be looking at these issues and they're going to be looking at these issues because of the kind of price evolutions that we're seeing in the seven days, 14 days right after primary issuance because of those level of underpricing that it's still raising concern.

(08:06):

But I acknowledge that we're looking at this in an aggregate sense, and it may not be equally applicable to all of you. So some people may be in a better position, some people may be in a worse position. But part of the reason for doing this type of communication is to remind people, look at your practices. There are things that you can do probably to improve. And also part of that messaging, again to issuers is understand the protections that are in place for you as part of the regulatory process. So I think when you look at these two MSRB pricing compliance sections, they go through the rules that are applicable, and I don't need to go through them in great detail here, but they go through the rules, rules that are applicable to broker dealers and say, as part of your fair pricing duties, it's very under MSRB rule G 17, which is fair dealing.

(09:05):

It is very analogous to what happened in that first mid-state case. Are you making promises about the types of investors that you're going to reach during the pricing process? Are you actually reaching those type of investors when you are having conversations with the issuer and the MA about the order book and how soft it may be? Like for example, if we move basis, move the price up one or two basis points, everyone's going to drop, are those accurate? And kind of methodically going through the things that are identified in that MSRB compliance resource about your responsibilities under G 17, this is what people will be examining for. And I think this gives people an opportunity to look at their process, but it also gives MAs an issuers an opportunity to say, Hey, look, this is what a broker dealer is supposed to be doing for you, and are they doing it?

(09:57):

And I think that's something that can help improve the discipline in the market by knowing that those are the broker dealer responsibilities. Similar with a municipal advisor. Municipal advisor has responsibilities under G 42. They have similar advertising type responsibilities where they're not supposed to be making promises that they didn't make. And again, an issuer should know that if a municipal advisor has agreed to evaluate pricing for you to evaluate method of sale for you, that they are held to this responsibility, they're held to this responsibility that they're supposed to put the needs of you ahead of their own. That includes if they have discomfort with having a conversation with the broker dealer or with the pricing group, they feel like it might make them look like the squeaky wheel. That's the problem. That's still the responsibility to have those tough conversations. Also, I think importantly, we want to remind municipal issuers that a lot of the cases that have been brought by the SEC are about priority provisions, right?

(11:07):

So retail order periods, identification of retail investors, and consistent with MCB rule G 11, the issuer is not required to provide those, but the issuer can provide those. And so I think that's one place again, where issuers may not be aware that they have this ability to create the priority of order provisions to identify retail orders. Particularly, it's important for municipal advisors to know that issuers can do that similarly, that if those priority provisions are created by the broker dealer, that you have the broker dealer supposed to send them to you and you have the ability to review them. So knowing those particular regulations and knowing your ability to actually affect where your bonds end up, I think is important and something that we will continue to message.

(12:02):

One other important point I want to make about municipal advisors is that a lot under the rule and under MSRB rule, G 42 municipal advisors can essentially describe the services that they're going to provide. So one big question we've had is pricing considered to be generally municipal advisor services? And I think the answer would be yes. I think in most cases it would. But then is a municipal advisor allowed to exclude pricing from their services? And then the answer again is yes, they can, but they have to expressly disclose that to their client and it has to be expressly consented to by the client. And that's something that I don't know happens in practice, particularly when an MA is trying to exclude pricing from their services. And then on a similar vein, and this is one of the cases that the SEC brought comer capital is you hear a lot of times from municipal advisors and issuers may hear this in retrospect when something goes wrong, but you hear this a lot where people say, the deal was already packaged by the time we got here and we were just there to execute.

(13:15):

And I think what SEC said in Coer capital is like, look, that's not sufficient. Just because you walk into a bad deal doesn't mean that you don't have the responsibility to raise the issue that, hey, this is a bad deal. And so I really want to underscore that point as well, that you can't just walk in eyes closed. And for issuers to also understand that, I mean a split advisor does have this responsibility. If they see something wrong with the deal, they are supposed to raise it. And there may be many reasons why an issuer may make a choice to proceed with the deal that have nothing to do with economics that have to do with other goals of the issuer. But don't be surprised when MAs are raising this more frequently because it is their regulatory responsibility.

(14:07):

And so again, just broadly speaking, raising the awareness of these rules that apply to broker dealers that apply to municipal advisors in the pricing context is something that we're going to continue to do. And we're going to continue to message to broker dealers and municipal advisors that these are the things we're going to be examining for. So you should know your responsibilities and make sure you're fulfilling your responsibilities. But also just that we have continued to see these issues on a big picture basis with respect to the types of underpricing with respect to lack of retail participation in the primary sales. So the MSRB has put out two separate studies in the last two years, retail participation in the primary issuance was in some estimates was less than 1% of bonds were immediately going to retail, but somehow they're ending up with 42% after the fact.

(15:02):

So those type of issues, when they're being identified in the market, we are going to always be paying attention to them because they do have a cost, ongoing cost to issuers. And that's part of our job to watch for that. I think in particular with the slow distribution of bonds to retail, I don't think it's should be a big surprise to folks that if it's taking five trades to get bonds into the hands of the ultimate holder versus one, that's something that's always going to be of interest. But also just the fact that that happens doesn't mean that there's a violation. Right? And this is the other thing that I want to emphasize in this conversation is when we see things happening on a big picture basis, it's been very interesting to me the type of feedback I've received when I've been providing this kind of message in the past.

(15:59):

Because I think folks come back and say, well, are you considering this? Are you considering this? And the answer is sometimes yes, sometimes no. But it's important to have that conversation. And the way this is going to roll out and the way this is going to continue to roll out is not in an aggregate basis, right? We are seeing things on an aggregate basis. Our examination staff is going to go in and ask questions, but there might be very good answers for why something happened the way it did in some circumstances there may not be in other circumstances, but just be prepared for the conversation and to also know that just because we are asking the question doesn't mean at the end of the day that there's absolutely a problem. So that's actually it. That's what I wanted to say today. If folks have questions, I'm happy to answer questions.

Audience Member Jim Gibbs (16:54):

Jim Gibbs, again is an SMA order a retail order?

Dave Sanchez (17:03):

So basically you can choose whether it is or not, and I think there's been some interesting concerns regarding SMAs and to how they're treated, not necessarily for this purpose, but ultimately from a regulatory perspective. What we care about is how is this defined by the issuer or by the syndicate, and do people follow the rules? And then two, is this helping improve pricing as an overall matter. That's the two things that we would actually care about, not whether we're defining something one way or another because the rule allows each individual transaction to define it for themselves. Hey,

Audience Member Diana Hamilton (17:50):

David Diana Hamilton, Financial Advisor, this matter of disclosure, David was my former lawyer. He fired me. He said he was taking another job and could not represent me in that position. That is correct. Anyway, so I have a couple concerns. One of which is I saw the academic study. I kind of think if you're looking at 2008 and there's a big gray bar there, there's a reason there was no liquidity. And if you were there the day Lehman went down, there was no liquidity in the market. So that data just needs to be tossed. And I was there the day Lehman went down, so it was quite a day.

(18:38):

I'm sure Dave remembers it. Well, anyway, my concern has to do, you talked about G 17 and fair dealing and then the question of making promissory statements about your investor base and things like that. And obviously I write RFP, so I'm kind of familiar with, we ask a question about marketing strategies. That's a fairly typical type of question normally. And then there's some sort of evaluation of the existing investor base and people or investors who buy types of credits. One of my concerns is as you're going into the pricing itself, and some people only act as pricing advisors on certain transactions, others have a broader portfolio as an MA, but I'm just concerned about the lack of or the not that from a regulatory standpoint, anything that the SEC would be doing that would further inhibit the flow of information from the broker dealer to the issuer.

(19:43):

Because a lot of times when you're looking at over subscription, which I understand you are, you can say, oh, it's 10 times oversubscribed and therefore we should adjust nine to 11 basis points. That used to be a rule of thumb. I would suggest to you that's not true, that it's absolutely critical that you look at the order book and the quality of that order book, and there's certain names that you go, oh, ARB account, hedge account. And then you have to kind of say, okay, what have I got here? But I am concerned that, and this isn't a question, it's really more a statement, which is I am concerned that your exploration and their wanting to avoid anything that looks promissory will limit the information that we receive on the date of pricing because something that's critical to us going into pricing and where are we setting coupons or what kind of options are we looking at and are we going with a nine year call or a 10 year call, those sorts of things. We need feedback from investors. And if they feel that any statement they've made is promissory in any way, that's going to cut the conversation off.

Dave Sanchez (20:58):

Are you talking about the investors making promissory statements?

Audience Member Diana Hamilton (21:01):

No, the underwriter, as we're sitting at the table the morning of pricing, we're about to go out with a wire, what are we going out with? I always ask for investor reads. Sometimes I get it in writing, sometimes I get it verbally, but I'm concerned that your kind of line of questioning could potentially have a chilling effect, shall we say, on me as the MA represent and the issuer getting feedback on who wants a 4% coupon. I mean, that's my concern.

Dave Sanchez (21:35):

No, and that's a very good comment and very good point, and I think I can adjust it pretty clearly. So obviously not meant to inhibit that type of flow of conversation. I think really the issue where that would come up is if people are making statements that are more absolute, my memory of those type of conversations is that they're not as absolute. But again, if you look back to the analogy of the case that was brought, the question is are you misrepresenting the amount or the quality of the demand? And I guess it would have to be the types of statements that would have to be made would seem to be a little more concrete than I'm used to them be made for them to be incorrect. Does that make sense? I don't know if I'm explaining myself correctly.

Audience Member Diana Hamilton (22:28):

No, I understand that, but I think I'm concerned about where the line in the sand gets drawn and,

Dave Sanchez (22:36):

Well, and that's a good, so the point is there is no line in the sand because every situation is different. And I think that's something that can be very hard for folks to deal with when we discuss these type of issues. But the natural process through examination, and the way most rules are written is that we are looking at a reasonableness level. So there's not hard lines in the sand. You can't say this word, this is a magic word. This is not a magic word. You're going to be looking for either much more sustained, incorrect statements, like much more sustained false statements or the type of statements that, for example, are just clearly fraudulent, but not okay, I would estimate that 20% of people are going to walk if we do this and it turns out to be 25. That is not the type of thing.

(23:29):

And I think people's experience, it would be that that is not the kind of thing that really turns out to be a problem. Again, one of the issues that I think happens when we bring enforcement cases, for example, first mid-state like comer capital, where the pricing was over a hundred basis points off, is that people think that is the only thing that we're concerned about and not lesser things. And the point is really more that lesser things get discussed in examination. Lesser things get discussed in the type of form that I'm discussing them now, and only the most egregious things turn into enforcement action. But collectively, all those three things together help to improve the efficiency of the market because first, when you pass a rule, you hope that people start abiding by the rule, and that alone improves the fairness and efficiency of the market.

(24:18):

Second step is, hey, we're going to examine you for it. And even by asking you these questions, hopefully we're approving improving the fairness and efficiency. Third, we're going to give you a deficiency letter, still not an enforcement action. And that also will help improve the fairness and efficiency. And then finally, in the worst case scenario, we will do a enforcement action, but I just don't, I think when folks start to think that there's some bright line thing that we're going to step over, step not over, and that's not the way things work. So that should address the chilling aspect, because in all these cases, really the issue is have you thought about this? Have you had a back and forth about it? Those types of things always survive regulatory scrutiny. What doesn't survive regulatory scrutiny is a total lack of thought, a total lie. You know what I mean? A total fraudulent statement. Does that help?

Audience Member Diana Hamilton (25:14):

Yeah and I can understand the egregious, but I also just want to offer a cautionary statement that you don't want to have a chilling effect so that the issuer has less information than they might've otherwise.

Dave Sanchez (25:29):

Yeah, I think if an issuer is, I mean to flip it the other way, I think if an issuer MA is asking for information, a broker dealer should respond with the best information they have, which may not be perfect information, which may be based on their expertise, which may be some of a guess, but to not provide the information when you actually have it, I think would be a worst case scenario.

Audience Member Diana Hamilton (25:51):

Okay, thank you.

Audience Member Dave Anderson (25:54):

Morning, Dave. I was going to do this on the next panel that I'll be sitting on, but since you're sitting there, and by the way, this is Dave Anderson from Bank of America Underwriting, and the first speaker as well as yourself have alluded to over 400 billion of issuance this year and potentially a 25 to 35 base point differential from where they've then trade after their pricing. I dunno whether this is a question or a comment or to see what your stance is from being the regulator. If I was going to sell five to 10 million, if even everybody agrees the best trading bond in the municipal market, I'm going to get a better price than if I sell 300 million at a point in time. And if I have to sell two and a half billion for the state of California, for example, we did recently the notion that it's going to trade where they're trading in the secondary, you're not going to clear the market. So I'm just curious. So if that bond trades up or if it was oversubscribed four or five times, which is what it would need to be in order to clear that kind of size, especially when they're going to sell a competitive deal within two weeks, another 600 million supply, the investors aren't stupid. They understand the float and they're not going to participate unless there's some concession. So I'm just curious if you have a comment or anything on that topic.

Dave Sanchez (27:22):

Yeah, I think kind of goes to the main point I was making, which is all of these individual circumstances are going to matter, and really what we're looking at is the aggregate and it raises questions. And so the questions are going to be asked, and I'll tell you from the experience I've had already, you ask these questions and in many cases you get back a great answer that sort of explain, here's the subtleties of the situation, here's the way it worked. Great. Sometimes you get back, we never thought about it. There's no evidence that anyone ever even considered it. And so the process of asking as I acknowledge it can be uncomfortable for the folks that are regulated. You know what I mean? But it's a necessary part of the regulatory process. You're going to get asked these questions and you may very well have good answers.

(28:11):

And I can tell you for certain that just the fact that we might say collectively underpricing, we might consider to be a problem, does not mean that we think there's underpricing on every single deal. And we're going to go in with a mindset that this is violative underpricing on every single deal versus pricing. You say that makes sense within the context of that particular deal, that particular day, that particular market. So the mind is always open to those kind of responses. But the point of having the conversation again is to me, it is another part of the function of the regulatory process, which is to say the first best thing to happen is for market participants to have this discipline on their own and to take a look at their practices. One of the other things that Dr. Marlowe said, which has been of continued interest, and certainly having been in the market for as long as I have, I saw this all the time where we do fall into patterns.

(29:09):

That's what human beings do. You fall into these patterns and they may not be the most efficient thing. Just simple things that you see on your newsfeed every day on your phone, which is you have five Netflix subscriptions that you don't need and you just go through and clean 'em out. It's those kinds of things. But to me, that's a very important part of the regulatory process is to remind people of the rules, to remind people that we're going to be examining for the rules so that you can take a look at your own processes. And again, you may find no problem, you may find some problem, but I'd rather have you guys find those problems before we come in and find the problems. Hey Nicolette.

Audience Member Nicolette (29:50):

Thanks again for joining us today. In many ways, this whole dialogue is a continuation of a conversation you've been having with the marketplace now for a number of months. In particular, I would point our audience to your published comments from the last CDIAC conference at the Debt Essentials. We have a number of folks in the room, and you've talked a little bit about examinations and enforcement, but I wonder if we could focus specifically on the issuers here in the room and what you hope they take away from this, in particular, whether you're signaling, whether you're going to second guess decisions that they're making?

Dave Sanchez (30:36):

So most definitely, right? We don't regulate the issuers in this area, and our job is not to second guess decisions that issuers make. Really what the message is is to remind issuers that, look, these folks that you hire have these responsibilities to you, and we are concerned about the type of pricing the issuers get. We want issuers to have the lowest cost of borrowing in various enforcement actions where it's come up. Issuers have continually reiterated that yes, they hired people because they wanted the lowest cost of borrowing. That was reasonably possible. I mean, that's basically what they're going for and that's why they're hiring people to help them achieve that. So our messaging is just to say, look, there are rules in place to do that, and you should be aware, for example, that it probably makes sense for your MA to look at price movement after a deal that probably would be a good MA service.

(31:33):

Hey, how did we actually perform? And then if we've been, in some instances, people using the same underwriter over and over again, are they actually doing a good job or not? Again, kind of goes to one of the points that Dr. Marlowe made, so just building in that extra discipline. But on the issuer side, our main message is to say, look, these rules are here to protect you. We're here to protect you. We are definitely not here to second guess your decisions. I worked at City of County of San Francisco for a while. I understand that. And anybody who's worked in government knows that you're going to have other priorities as well that are going to be important to you. And so the job of the SEC is just not to second guess your economic decisions. The job of the SEC is to make sure that the financial professionals that you hire give you the information you need to make the best decisions that you need to make for yourself. That is our message.

Speaker 5 (32:35):

Good morning, director. Just a quick question. From what I've taken in this morning from different comments is as far as Onfi issue is concerned and for a rate concerned, some of the most important things that you feel are the most important would be a stable network of your underwriting group. Retailers are priority order flow and stuff like that makes for ease of issuing bonds and can control some of the different spread. But my question, I guess is from a negotiated standpoint, you're able to pretty much achieve all of those things because it's much more transparent. But when you get to a competitive thing, you really lose all that front end perspective. Correct. And basically the bonds are bought by whoever the group is and they're on their way. So when you're looking at defining is it better to go competitive or how much of the spread from being able to negotiate? How much emphasis do you put into really wanting those things that you feel is important for the control and the orderly management of issuing bonds as opposed to they're sold? You got two basis points better than you would've got, but we don't know what's going to happen from there

Dave Sanchez (33:47):

I mean. So again, fair comments to consider. I think one of the reasons we've focused on method of sale is one, this is one fundamental aspect of being a municipal advisor in many cases. This is something that people are promised to look at. Two, to me, to my mind, the most studied thing in municipal bonds is this question of do people get better pricing in competitive sales or negotiated sales? My view of the academic literature is people say consistently competitive sales. There are some that say it's unclear or some say negotiated sales. Other people have said it's 50 50.

(34:25):

Sure, sure, I'll get that. But the point is, so my point of raising the point of the issue is it's clearly an issue, and at least a decent amount of the literature out there says that a competitive sale is generally a better idea. So why is this not being considered more often? And then we get to your point, each individual person is going to have a reason for making the decision they make. But my concern from a regulatory perspective is more why is this not being raised more often? Why are people not thinking about this more often? That's the concern where you end up, why you end up. That's going to get a lot of different variables that generally speaking are not a regulatory concern. But I am concerned when I'm saying, I don't know why this is not being questioned. And I think under the MA rule, that's pretty clearly something that is part of an MA's responsibility. So that's it. Did you have any more? We're good for the break. Yep. All right. Thanks everybody.