MSRB NOTICE 2008-15 (MARCH 17, 2008)

REQUEST FOR COMMENT: PLAN FOR INCREASING INFORMATION AVAILABLE FOR MUNICIPAL AUCTION RATE SECURITIES

The MSRB continues to monitor the recent downgrades of municipal bond insurers and other short-term liquidity concerns that have created extreme volatility in the market for municipal Auction Rate Securities and an unprecedented number of “failed auctions.”  Further, the MSRB is monitoring whether there are any effects from the volatility in the market for Auction Rate Securities to the broader market for short-term municipal securities.  In a recent notice, the MSRB reminded brokers, dealers and municipal securities dealers (“dealers”) of the application of MSRB disclosure and suitability requirements that apply to all customer transactions in municipal Auction Rate Securities whether in primary offerings, at subsequent auctions, or in non-auction transactions.[1] 

The MSRB remains concerned about the lack of information available to market participants regarding municipal Auction Rate Securities.  Currently, there is no source of comprehensive same-day information about Auction Rate Securities available to non-market professionals, even information as basic as the clearing rates set through the auction process.  To increase the amount of information available to market participants, the MSRB is requesting comment on a plan to create a centralized system for the collection and dissemination of critical market information about Auction Rate Securities.  The plan would require dealers that operate auction rate programs to report auction information to a central system operated by the MSRB.  Auction results would be required to be reported by no later than 5:00 P.M. Eastern on the day that an auction occurs.  The proposed system would display this information immediately on a web site. 

Comments on the proposed plan should be submitted no later than April 21, 2008 and may be directed to Justin R. Pica, Uniform Practice Policy Advisor.  Written comments will be available for public inspection.

BACKGROUND

In recent years, there has been a growing market in municipal securities with long-term maturity dates and short-term (nine months or under) interest rate reset periods.  The number of transactions in this sector reported to the MSRB Transaction Reporting Program has increased from approximately 32,000 transactions per month in 2000, or about 6% of all transactions, to approximately 190,000 trades per month in 2007, or about 25% of all transactions.[2]  Securities commonly referred to as Auction Rate Securities[3] and Variable Rate Demand Obligations (VRDO) comprise most of the securities in this sector.  Auction Rate Securities and VRDOs are similar in that they are long-term securities with short-term interest rates.  In both types of securities, interest rates are reset periodically through programs operated by dealers on behalf of the issuers of the securities.  There are, however, several differences.

VRDOs are distinguished by the existence of a “put” or “tender” feature that allows holders to tender their securities back to an issuer-appointed representative, at par, on a periodic basis.  VRDOs normally operate with a letter of credit or stand-by bond purchase agreement designed to ensure liquidity.  Interest rates typically are reset by a dealer serving as the “remarketing agent” for the issue at a rate that allows the securities to be sold at par.  Auction Rate Securities are distinguished by the auction process that is used to reset interest rates.  Auction Rate Securities are not characterized by, and generally do not have, put features or liquidity facilities.  Although the auction process is designed to allow holders normally to sell their positions at par value during any auction, it is possible for auctions to fail, in which case holders are not able to liquidate their positions at par.

Auction Process

The auction methodology used in Auction Rate Securities is a type generally referred to as a “Dutch auction.”  An auction program employs one or more dealers (“Program Dealers”)[4] that solicit orders from investors who wish to own the securities over the next interest rate reset period.  Typical interest rate reset periods are 7, 28, and 35 days.  The programs require one “Auction Agent” – typically a bank – that receives orders from the Program Dealer(s) and conducts auctions in accordance with the method described in program documents.  The Auction Agent provides the results of the auction to the Program Dealer(s), which then inform their bidders of the auction results and the securities, if any, that have been allocated to them as a result of the auction. 

The auction method specified in program documents for Auction Rate Securities takes into consideration the total quantity of orders received in each order category specified in Auction Rate Security documents.  Typical order categories include:

• Existing holders that want to hold at any rate decided by the auction;

• Potential investors bidding for the securities by stating minimum acceptable interest rates;

• Existing holders that want to hold, but only if the auction produces a rate equal to or greater than one that the existing holder specifies; and

• Existing holders that want to sell.

Using order information that must be submitted by a Program Dealer(s) before the auction deadline, the Auction Agent employs an algorithm to determine the lowest interest rate at which all of the securities that have been offered for sale by current holders of the securities will clear the market (the “clearing rate”).  The clearing rate then becomes the interest rate for all of the securities in the issue for the next interest rate reset period.

Auction Rate Securities also have provisions that address situations that may occur if no clearing rate can be determined through the normal auction process.  For example, if all existing holders want to hold at any rate, then an “all hold rate” is used.  The all hold rate is usually a multiple of a market index and is designed to be lower than the rate that normally would be expected as a clearing rate.  Conversely, auctions also can “fail” if the auction agent does not receive enough bids to cover the aggregate amount of securities that need to be sold, or if the clearing rate is above a “maximum rate” set in the program documents.  In a failed auction, all existing holders hold their securities and the rate for the next interest rate reset period is set to the “maximum rate.”  Like the all hold rate, the maximum rate may be a multiple of a specified index.  However, it is normally designed to be a rate higher than the rate that would normally be expected in a successful auction.  

Existing Price Transparency Issues

As “short-term” securities under Rule G-14 on transaction reporting, both Auction Rate Securities and VRDOs are subject to slightly different reporting requirements than other securities.  In 2003, the MSRB proposed rules for a Real-Time Transaction Reporting System (RTRS), including a requirement to report trades no later than fifteen minutes after the time of trade execution, and, for customer transactions, a requirement that the trade report include both a dollar price and yield.[5]  In response, the MSRB received comments from dealers that, because of the special trade processing methodologies for short-term variable rate securities, it would be difficult or impossible to meet these requirements for such securities.  Based on these concerns, the MSRB included special provisions that provide dealers with an end-of-day exception from the fifteen-minute reporting deadline and allows dealers to report customer transactions in variable rate securities without yield. 

Since transactions in short-term variable rate securities are executed at a dollar price of par, the lack of yield means that RTRS provides little useful price information on these securities.  The MSRB was aware of this in 2003 when it decided to provide the special provisions, noting:

The MSRB does not currently plan to require reports of yields or reset rates on variable rate and auction rate products, but continues to be interested in price transparency in this area.  Accordingly, the MSRB will explore other ways to provide transparency for short-term rates that are being set…in variable rate and auction products. [6]  

The MSRB is not aware of any ready source of interest rate reset information available to retail investors or, in some cases, to market participants in general.  The MSRB is considering what price transparency improvements may be necessary for both Auction Rate Securities and VRDOs, but has decided to start with a plan for Auction Rate Securities in part because of the lack of liquidity guarantees for these securities and the recent volatility in the Auction Rate Securities market which has been associated with credit rating downgrades of “monoline” insurers.  In addition, the MSRB understands that Auction Rate Securities frequently are sold directly to retail investors, who may not be as sophisticated as the institutions that are the typical VRDO purchasers.[7]  While the MSRB has decided to start with a plan for Auction Rate Securities, it is also committed to improving price transparency for VRDOs and expects to propose a plan to increase the information available to market participants on VRDOs. 

PLAN TO INCREASE AUCTION RATE SECURITY TRANSPARENCY

To improve transparency of Auction Rate Securities, the MSRB plans to create a system for collection and dissemination of information about Auction Rate Securities.  Under this plan, Program Dealers would report to the MSRB results of an auction in an Auction Rate Security by no later than 5:00 P.M. Eastern on the day that auction results are provided by an Auction Agent.  In the event that auction results have not been provided by 5:00 P.M to a Program Dealer, the Program Dealer would be required to report auction results as soon as possible after they are provided by an Auction Agent.  Information received from Program Dealers would be posted to an MSRB web site immediately after receipt.  To facilitate discussion and comment on the plan, this notice separates information about Auction Rate Securities into two categories: (i) “reset rate information”; and (ii) “bidding information.” 

Reset Rate Information

Auction Rate Securities reset rate information describes auction results and would provide investors with information about the clearing rate, identity of the Program Dealer(s) and several other items of information.  This information would allow market participants to have same-day access to clearing rates and provide a mechanism to compare clearing rates of various Auction Rate Securities. 

The specific items of reset rate information about an Auction Rate Security proposed to be collected and disseminated are:

• CUSIP Number
• Name of Program Dealer(s)
• Number of days of the reset period
• Minimum denomination
• Date and time of the auction
• Interest rate for the next reset period
• Indication of whether the clearing rate is a “maximum rate,” an “all hold rate,” or “set by auction”
• Dollar amount of securities auctioned

Bidding Information

In addition to reset rate information, the MSRB requests comment on whether additional information that may be useful to price transparency should be collected and disseminated by the system (“bidding information”).  The specific bidding information may include:

• Number of bidders
• Par amount of securities for sale in the auction
• Number and aggregate dollar amount of bids made
• Number of bidders other than the Program Dealer(s), issuer or conduit borrower
• Number, interest rate(s) and amount of bids by a Program Dealer for its own account 
• Number, interest rate(s) and amount of bids by issuer or conduit borrower
• Par amount of securities allocated to bids at clearing rate
• High bid
• Low bid
• Median bid

Information Collection and Dissemination Methodology

The proposed collection of information about Auction Rate Securities would be accomplished through (i) a secure, password-protected Internet web site; and (ii) computer-to-computer data connections[8].  Because of the nature of Auction Rate Securities programs, the MSRB expects that Program Dealer(s) would form agreements with third parties, such as the Auction Agent for the issue, or designate a vendor to provide information to the MSRB on the Program Dealer(s)’s behalf and would allow for this under MSRB rules requiring submission of the data.  However, the responsibility to ensure timely and accurate reporting of information to the MSRB would remain with the Program Dealer(s). 

Each Program Dealer and submitter would be required to complete and keep current an electronic registration form.[9]  This form would provide the MSRB with contact information for purposes of sending electronic records of submissions and to allow for follow-up by MSRB staff should any submission prove to be incomplete or incorrect.  In addition, Program Dealers would identify intended methods of submitting information and identify third-party submitters that would submit information to the MSRB on their behalf.

Information about an Auction Rate Security submitted by or on behalf of a Program Dealer(s) would be displayed immediately after receipt on an MSRB web site.  In addition to the information submitted, users of the MSRB web site would be able to access any additional documents on file in the MSRB’s Municipal Securities Information Library^® (MSIL^®) associated with the Auction Rate Security, such as the Official Statement, as well as trade reports disseminated from RTRS.

REQUEST FOR COMMENT

Comment is requested on all aspects of the proposed plan for increasing transparency of Auction Rate Securities.  The MSRB acknowledges that the market for Auction Rate Securities continues to experience extreme volatility and would appreciate commentators to consider the current and future state of the Auction Rate Securities market when providing comments on this notice.  Consideration of the following questions may be helpful in providing comments:

•        The MSRB proposes that Program Dealers would be required to provide information about an Auction Rate Security to the MSRB by no later than 5:00 P.M. Eastern on the day that an auction occurs.  Would 5:00 P.M. Eastern allow for a sufficient amount of time for Program Dealers to receive auction results from Auction Agents and provide the information to the MSRB?

•        Are the items of information proposed to be collected and disseminated about Auction Rate Securities appropriate?  Are there additional items of information that should be added to this list of information?

•        The MSRB anticipates that most or all of the information listed as “reset rate information” is currently provided to Program Dealers from auction agents or is otherwise easily obtainable.  Do Program Dealers anticipate difficulty in being able to collect such reset rate information for purposes of providing it to the MSRB?

•        The MSRB understands that information listed as “bidding information” may not always be provided to Program Dealers.  Do Program Dealers currently receive or have access to this information or are there other challenges to providing this information to the MSRB?  If there are challenges associated with providing bidding information to the MSRB, should these items of information be subject to a different deadline than the 5:00 P.M. Eastern deadline for providing reset rate information?

•        The MSRB would like to be able to collect and disseminate information about Auction Rate Securities as soon as possible.  Are there standardized formats used to transmit auction information to Program Dealers from Auction Agents that the MSRB could use to minimize the number of changes needed in connection with Program Dealers submitting information to the MSRB?

•        Are there documents concerning Auction Rate Securities that are not currently required to be filed with the MSRB under Rule G-36, on delivery of official statements, advance refunding documents and Forms G-36(OS) and G-36(ARD), that should be filed with the MSRB and made publicly available?

*                      *                      *

Comments should be submitted no later than April 21, 2008, and may be directed to Justin R. Pica, Uniform Practice Policy Advisor.  Written comments will be available for public inspection at the MSRB’s public access facility and also will be posted on the MSRB web site.[10]

March 17, 2008