In the News: Recent Developments

June 24, 2004

SEC Auction Probe Raises Questions Rate-Setting Process Draws Scrutiny

By Jacob Fine

The Securities and Exchange Commission’s probe into broker-dealers to Investigate dealers passing on information to other firms that could allow them to submit winning bids for auction-rate securities raises questions about whether a broker-dealer’s bid on a deal they have underwritten could be unfairly influencing the market.

The enforcement division of the SEC sent letters to many broker-dealers last month requesting that they voluntarily investigate their activities in the auction-rate bond market and provide written reports to the regulator detailing potentially deceptive, dishonest, or unfair practices. Both J.P. Morgan Securities Inc. and Goldman, Sachs & Co. have received the letters. Calls to most of the other broker-dealers active in this market regarding the letters either were not returned or resulted in no comments.

The full scope of the SEC’s inquiries are not known, however, market participants yesterday considered some of the aspects of auction rate transactions, that could draw regulatory attention.

A source at one Wall Street broker dealer yesterday said she believed the inquiry was not so much rooted in claims that the firms are providing preferential treatment to different customers, but rather that broker-dealers have been manipulating the process to ensure the auctions do not fail.

Failed auctions -which occur when not enough bids are submitted -can result in steep penalties for issuers, forcing them to pay interest rates as high as 14% to those left holding the securities, according to Joseph Fichera, chief executive officer of Saber Partners, an investment banking advisory firm in New York. Saber has advised clients ranging from Exxon Corp. to General Electric Credit Corp. on the use of auction rate securities.

No municipality with an investment-grade credit rating has ever experienced a failed auction, according to a presentation given by Wendell Gaertner, a vice president at Banc of America Securities at a conference held by The Bond Buyer in Tampa in February.

A broker dealer “usually submits [its] own order to make sure sufficient orders are received at market rates,” according to statement in a slide from Gaertner’s presentation at that conference. A Banc of America spokesperson yesterday confirmed that Gaertner is employed by the firm, but declined further comment.

Broker-dealers collect bids and pass them along to the auction agents. By examining those bids, the dealers could be able to calculate what the winning bid would be. The SEC’s examination is looking at whether the dealers have subsequently passed that information along to other firms to prevent an auction from failing, a source said.

But the issue raises questions about whether brokers could be using the information from the initial bids in setting their own bids as well.

Broker dealers are often allowed under the terms of a contract with the auction or the obligor on the bonds to submit bids. However, the broker-dealers cannot use information from bids they collect to set their bid level, Fichera said.

By doing that, he said, broker-dealers would be interfering with what should be a “blind auction,” in which participating firms are not supposed to know the bids of current investors or other bidders until the auction is over. “It violates the rules of the auction because the broker has more information than other investors have,” Fichera said in a telephone interview with The Bond Buyer yesterday.

“As we’ve seen from past SEC enforcement actions, those bids would have the effect of either lowering the rate otherwise established through the auction and/or preventing the auction from failing, which would have resulted in the imposition of a penalty rate,” Fichera said.

“The penalty rate is set at such an extraordinary level so as to encourage the issuer to redeem the bonds if the

auctions were to continue to fail,” he added.

Broker-dealers however maintain a strong interest in ensuring that failed auctions do not occur because they could result in fewer issuers opting to sell auction rate notes, and instead turning to variable-rate demand notes.

On an overall cost basis, issuing variable rate demand notes are comparable to selling auction rate debt, according to Catherine Boone, assistant treasurer for Connecticut , which priced $97.7 million in auction-rate notes on Wednesday.

Unlike variable rate demand notes, auction rate notes do not require issuers to obtain letters of credit. But broker dealers charge much higher annual fees for auction rate notes.

Broker-dealers usually require annual payments costing issuers about 0.25% of the principal amount for auction rate deals, according to Gaertner’s February conference presentation.

The annual fees for variable-rate demand notes is closer to 0.10%, Boone said. Boone said she believed upfront fees to be just slightly higher for auction rate debt than for variable rate debt.

Because variable-rate demand notes have the additional cost of acquiring a letter of credit, their overall cost is nearly equivalent to that of auction rate notes, she added.

Boone said Connecticut had opted to sell auction-rate notes because she thought the process would be less time-consuming than it would be to try and acquire the letter of credit necessary for variable rate debt.

Boone said Bear, Stearns & Co., which served as underwriter on the Connecticut auction -rate deal, did not inform her of the SEC’s probe into auction procedures, which she only read about in newspapers yesterday. Interest rates on the notes sold by Connecticut this week were set at 1.25% for the first 28day period, which Boone said she believed to be competitive.

“I would expect issuers to call their dealers when they see this and ask whether they are doing an investigation, and if so, what that investigation will show, and then to make improvements to that process if need be,” said Patrick Born, who is a vice chairman of the Government Finance Officers Association’s committee on government debt management, and the city finance officer for Minneapolis.

“Issuers would expect integrity from their dealers in setting the interest rates, and if they have a reason to question the integrity of their dealers then they would be less likely to use auction-rate securities, and use other variable rate products,” Born said. “If the SEC is concerned about it, then it will raise some concerns with issuers, whether their auction-rate securities’ interest rates are being set at what truly is the market.”

Susanna Duff Barnett and Craig T. Ferris contributed to this story.
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