Securities Regulator Takes Sweeping Action to Protect Municipal Bond Investors

By James Eccleston

INRA (the Financial Industry Regulatory Authority) has launched a "comprehensive initiative" to protect municipal bond investors. Among other things, FINRA is conducting "sweeps" of financial services firms and has published investor alerts and on-line tools in an effort to inform investors and better protect their interests. Let's examine FINRA's efforts.

First, in terms of sweeps, FINRA is conducting a "broad sweep" of industry practices with respect to municipal bond sales to retail customers. FINRA has requested information from firms, including "sales data, marketing data, pricing data and procedures, disclosure practices, customer complaints and supervisory procedures and practices." Another sweep, described as a "more targeted sweep", is examining "potential conflicts, disclosure practices and marketing by firms underwriting municipal securities involving swaps and derivatives for small municipalities." Alongside the sweeps, FINRA published for firms Regulatory Notice 09-35. In that notice FINRA "urges" financial services firms to "reassess the adequacy of their current policies and procedures" with respect to disclosure of material information, suitability of recommendations to customers, and supervision.

Second, in terms of investor alerts, Municipal Bonds - Staying on the Safe Side of the Street in Rough Times, is worthwhile reading. There are numerous points to highlight from the publication. For example, FINRA cautions investors that they must be aware that: municipal bonds do default (albeit rarely); information regarding an issuer's financial problems has not always been readily available; infrequent trading may make it difficult to determine a bond's current market value; a change in interest rates can affect a bond's market value; and the credit rating of a bond with insurance (or some other protection feature) may have more to do with the insurance than with the financial condition of the issuer of the bond.

Likewise, FINRA's discussion of "Muni Bond Basics" is excellent. For example, FINRA discusses bond defaults. Investors must be aware that there are two types of municipal bonds, "general obligation bonds" ("GO bonds") and "revenue bonds." While municipal bonds rarely default, one should know that, "Defaults tend to be higher for revenue bonds than for GO bonds - especially those that back private-use projects such as nursing homes, hospitals or toll roads." Assessing the issuer's financial condition is a must. New bonds for sale issue what is called an "Official Statement" (analogous to a prospectus for corporate securities offerings) which details the offering and the financial condition of the issuer. Importantly, this information typically is updated each year, as well as more often through "material events notices." To make this and other information easy to obtain, FINRA takes the opportunity to announce that beginning July 1, 2009, investors will be able to obtain information for free on the web from EMMA (Electronic Municipal Market Access).

Another helpful discussion relates to bond insurance and credit ratings. FINRA cautions investors that credit ratings just are "estimates only and should be only one of many factors in evaluating a municipal bond investment." Not only that, FINRA warns that ratings can change at any time and that investors need to ascertain the current rating of a bond before purchasing it. Investors should note that a high credit rating "is not a seal of approval and neither reflects nor guarantees stability of market value or liquidity". Likewise, a low credit rating "may very well be a sign of a bond's increased risk of default or an indicator of greater liquidity risk and price level risk." So-called "high yield" municipal bonds often have low credit ratings.

Finally, investors must be very cautious regarding bond insurance (an arrangement whereby the bond issuer purchases a bond repayment guarantee from an insurance company). As FINRA makes clear, "any guarantees are only as sound as the protection agent/insurance company that makes them." Significantly, FINRA warns, "Following recent economic turmoil, the credit ratings of most bond insurers have been downgraded - and, in many cases, the current credit profile of the municipal bond issuer itself may now be higher than the current credit rating of the bond insurer."

Third, in terms of on-line tools, FINRA's Muni Bond Checklist is a gem. 11 tasks are listed "to avoid some of the most common pitfalls of municipal bond investing." The tasks are:

• Verify whether the bond is general obligation or revenue and understand the terms and risk factors;
• Study the bond's Official Statement;
• Review all disclosure filings and be wary of an issuer who is not current in its filings;
• Monitor the bond's credit rating and the issuer's creditworthiness;
• If the bond is insured or otherwise backed by a third-party, verify that party's credit rating;
• For secondary market bond purchases, determine the reasons why the bond is priced the way it is;
• Understand how and when the bond will pay interest;
• Understand the bond's tax implications;
• Know a bond's call provisions (detailed in the Official Statement).
• Know what you are paying for a bond in commission or mark-up; and
• Review your purchase confirmation statement to ensure accuracy.

As one can see, FINRA truly has launched a comprehensive initiative to protect municipal bond investors. Let's hope that financial services firms get the message!

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.