On behalf of Mihalek Law posted in Securities Law on Thursday, November 20, 2014.
We have often lamented about how investment banks have been taking advantage of retail and even institutional investors by charging excessive, undisclosed markups and markdowns on principal trades of bonds and other debt securities. Well, it looks like FINRA and the MSRP are taking some action to protect most retail investors. The regulators (FINRA for corporate bonds and MSRP for municipal paper) have proposed a rule change that would require broker-dealers to disclose the markups and markdowns charged to clients on principal purchases/sales of bonds in the face amount of $100,000 or less.
The difference of an agency trade versus a principal trade is: In an agency transaction, a broker-dealer finds a bond in the market and directs the sale to a third party, the rules and regulations require the broker dealer to disclose the amount of commission it earns on the transaction. However, in a principal transaction where the broker-dealer sells a bond to its client from its own inventory – even if the bond is bought by the broker-dealer and sold to the client in just a few seconds/minutes- the rules and regulations do not require the broker dealer to disclose the markups and markdowns.
The proposed rule by FINRA and the MSRP would require such disclosure on bond purchases of $100,000 or less. While this is a good start, it is not enough. Many small businesses, including community banks, pension funds, insurance companies and the like invest millions of dollars in debt securities without similar protection. The securities industry likes to state, and frequently does, that a person or entity with a couple of million dollars to invest can “protect itself”. However, such is not always the case when buying or selling debt securities.
Unlike stock of large, publicly-traded companies where every transaction is reported and available to any investor with a computer, debt instruments often trade in the oblique, non-transparent world of the “principal”. You, or a billion dollar bank, may buy a bond from your trusted financial advisor at what appears to be a great deal, say at a two dollar discount to par, but your broker may have bought the bond a few seconds earlier for a five dollar discount – thus legally taking it into inventory, selling it in a “principal transaction” and thereby not disclosing the three dollar markup, i.e. profit to the firm.
The proposed rule changes are good, but not good enough. The $100,000 limit should be increase to say, $10 Million, to protect institutional investors who rely on their financial advisers to price bonds and other debt instruments in a fair and transparent manner. Moreover, limiting the rule to “same day” principal transactions will be easily circumvented.
The joint FINRA and MSRB press release dated November 17, 2014, is set forth below.
The Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB) today released companion proposals that would require disclosure of pricing reference information on customer confirmations for transactions in fixed income securities. The proposals are substantially similar but seek input on factors unique to the corporate and municipal bond markets.
Under the two proposals, bond dealers in retail-sized fixed income transactions would be required to disclose on the customer’s confirmation the price of certain same-day principal trades in the same security, as well as the difference between this reference price and the customer’s price. Read FINRA’s request for comment.
“Requiring additional pricing-related disclosure to investors as part of the customer confirmation promotes price transparency and will benefit customers in retail-sized trades,” said Robert Colby, FINRA’s Chief Legal Officer.
Trade prices are publicly available for corporate bonds on FINRA’s Trade Reporting and Compliance Engine® (TRACE®)and for municipal securities on the MSRB’s Electronic Municipal Market Access (EMMA®) website.
“Our approach takes information already available to the public online but provides it directly to retail investors at the time of the transaction, enabling them to more easily evaluate their transaction costs,” said MSRB Executive Director Lynnette Kelly.
The Securities and Exchange Commission (SEC) recommended that the MSRB consider requiring disclosure of pricing reference information to retail investors as part of a series of recommendations related to price transparency in the SEC’s 2012 Report on the Municipal Securities Market.
“Publishing these proposals simultaneously will allow for efficient responses to both proposals and facilitate consideration of whether any differences between the municipal securities and corporate bond markets justify differences in regulations in this area,” Kelly said.
FINRA and the MSRB are seeking input on the likely economic implications of the proposals as well as on alternative regulatory approaches, including a potential markup disclosure requirement targeting trades that could be considered riskless principal transactions.
“We invite commenters to provide data where possible to inform our analysis of the potential economic impact of the current proposals and any alternative approaches,” said FINRA’s Chief Economist Jonathan Sokobin.
Comments should be submitted to FINRA and the MSRB no later than January 20, 2015.
FINRA, the Financial Industry Regulatory Authority, is the largest independent regulator for all securities firms doing business in the United States. FINRA is dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services. FINRA touches virtually every aspect of the securities business – from registering and educating all industry participants to examining securities firms, writing rules, enforcing those rules and the federal securities laws, informing and educating the investing public, providing trade reporting and other industry utilities, and administering the largest dispute resolution forum for investors and firms. For more information, please visit www.finra.org.
The MSRB protects investors, state and local governments and other municipal entities, and the public interest by promoting a fair and efficient municipal securities market. The MSRB fulfills this mission by regulating the municipal securities firms, banks and municipal advisors that engage in municipal securities and advisory activities. To further protect market participants, the MSRB provides market transparency through its Electronic Municipal Market Access (EMMA®) website, the official repository for information on all municipal bonds. The MSRB also serves as an objective resource on the municipal market, conducts extensive education and outreach to market stakeholders, and provides market leadership on key issues. The MSRB is a Congressionally-chartered, self-regulatory organization governed by a 21-member board of directors that has a majority of public members, in addition to representatives of regulated entities. The MSRB is subject to oversight by the Securities and Exchange Commission.