Underwriting Supervision

Overview of Municipal Underwriting

Municipal securities underwriting is the process by which broker-dealers facilitate the issuance of new debt securities by state and local governments, their agencies, and authorities. As a Municipal Securities Principal, you are responsible for supervising every aspect of your firm's municipal underwriting activities, from the initial decision to participate in a syndicate to the final allocation of securities and settlement of accounts.

The municipal securities market is one of the largest debt markets in the United States, with over $4 trillion in outstanding bonds. Unlike corporate securities, municipal bonds are issued by governmental entities to fund public projects such as schools, highways, water systems, hospitals, and airports. The underwriting process for municipal securities differs significantly from corporate underwriting due to the unique regulatory framework established by the Municipal Securities Rulemaking Board (MSRB) and the nature of the issuers themselves.

A Municipal Securities Principal must understand the complete underwriting lifecycle, the roles of each participant, and the supervisory obligations that attach at every stage. Failure to properly supervise underwriting activities can result in disciplinary action by the MSRB and FINRA, including fines, suspensions, and bars from the industry.

The Role of the Municipal Securities Principal in Underwriting

Under MSRB Rule G-27, every broker-dealer engaged in municipal securities activities must designate at least one Municipal Securities Principal to supervise its municipal securities business. In the context of underwriting, the principal must:

• Review and approve the firm's participation in underwriting syndicates
• Ensure compliance with MSRB rules governing underwriting conduct
• Supervise the pricing and allocation of new issues
• Monitor communications with issuers and investors during the underwriting process
• Verify that all required disclosures are made to customers and issuers
• Ensure proper documentation and recordkeeping for all underwriting activities

Competitive vs. Negotiated Underwriting

Municipal securities are brought to market through one of two primary methods: competitive underwriting or negotiated underwriting. Understanding the distinctions between these methods is fundamental to the Series 53 exam and to effective supervision of underwriting activities.

Competitive Underwriting

In a competitive underwriting, the municipal issuer publishes a Notice of Sale (also called an Official Notice of Sale) inviting underwriting syndicates to submit sealed bids for the entire bond issue. The issuer selects the winning bid based on the lowest net interest cost (NIC) or, increasingly, the lowest true interest cost (TIC) to the issuer. This process is designed to ensure the issuer obtains the most favorable borrowing terms.

Key characteristics of competitive underwriting include:

• Notice of Sale: The issuer publishes a formal invitation that specifies the terms of the offering, including the amount, maturity schedule, call provisions, bid submission deadline, and the basis for awarding the issue (NIC or TIC).
• Sealed Bids: Competing syndicates submit sealed bids specifying the coupon rates they propose for each maturity and the price they will pay. Bids are opened simultaneously at the specified deadline.
• Lowest Cost Wins: The issuer awards the bonds to the syndicate offering the lowest borrowing cost. If using NIC, this is a simple average of the interest cost. If using TIC (also called the Canadian method), it accounts for the time value of money and is considered more accurate.
• General Obligation Bonds: Competitive underwriting is most commonly used for general obligation (GO) bonds, which are backed by the full faith, credit, and taxing power of the issuer.
• Good Faith Deposit: Bidding syndicates typically must submit a good faith deposit (usually 1-2% of the par value of the issue) with their bid to demonstrate serious intent.

Negotiated Underwriting

In a negotiated underwriting, the issuer selects an underwriter (or lead manager) through a negotiation process rather than through competitive bidding. The terms of the offering, including the coupon rates, offering price, and underwriting spread, are negotiated between the issuer and the underwriter over a period of time.

Key characteristics of negotiated underwriting include:

• Issuer Selection: The issuer selects the managing underwriter based on factors such as the firm's expertise, distribution capability, market knowledge, and past relationship with the issuer.
• Pre-Sale Marketing: The underwriter can begin marketing the bonds to potential investors before the final terms are set, gauging demand and adjusting pricing accordingly.
• Flexible Pricing: The coupon rates and offering prices are negotiated and can be adjusted based on market conditions and investor interest, potentially resulting in better execution.
• Revenue Bonds: Negotiated underwriting is more commonly used for revenue bonds, which are backed by the revenue from specific projects or sources rather than the issuer's general taxing power.
• Complex Structures: Negotiated underwriting is preferred for complex or unusual bond structures that may require extensive investor education and specialized marketing.

Net Interest Cost (NIC) vs. True Interest Cost (TIC)

The two standard methods for evaluating competitive bids are:

Net Interest Cost (NIC) is the simpler calculation. It takes the total interest payments over the life of the bond issue, subtracts any premium paid (or adds any discount), and divides by the total bond-year dollars. NIC does not account for the time value of money, meaning it treats interest payments in year one the same as payments in year thirty.

True Interest Cost (TIC), also known as the Canadian Interest Cost method, is a more sophisticated calculation that accounts for the time value of money. TIC calculates the internal rate of return (IRR) of all cash flows, discounting future payments to present value. Because TIC recognizes that money has different values at different points in time, it is considered the more accurate measure of borrowing cost and has become the preferred method for most issuers.

Syndicate Practices

When multiple broker-dealers join together to underwrite a municipal bond issue, they form an underwriting syndicate. The syndicate structure, governance, and allocation procedures are governed by MSRB rules and the syndicate agreement (also called the Agreement Among Underwriters or AAU). A Municipal Securities Principal must understand and supervise every aspect of syndicate participation.

Formation of the Syndicate

The senior manager (also called the lead manager or book-running manager) is responsible for forming and organizing the syndicate. The senior manager invites other broker-dealers to join as co-managers or syndicate members. The hierarchy within a syndicate is typically:

1. Senior Manager: Leads the syndicate, determines the offering terms (in negotiated deals), manages the order book, allocates bonds, and oversees the settlement of the syndicate account. The senior manager earns the management fee.
2. Co-Managers: Assist the senior manager in structuring and marketing the deal. They have larger underwriting commitments than regular members and share in the management fee.
3. Syndicate Members: Commit to purchasing and distributing a specified portion of the issue. They earn the total takedown on their allocated bonds.
4. Selling Group Members: Do not commit capital and are not part of the formal syndicate. They help sell bonds and earn only the selling concession.

The Syndicate Agreement (AAU)

The Agreement Among Underwriters (AAU) is the contract that governs the relationships among syndicate members. MSRB Rule G-11 requires that certain provisions be included in the syndicate agreement. Key elements include:

• Type of Account: Whether the syndicate operates as an Eastern (undivided) account or a Western (divided) account
• Participation and Liability: Each member's underwriting commitment and financial responsibility
• Order Priority: The order in which different types of orders will be filled
• Allocation Procedures: How bonds will be allocated among members
• Expenses: How syndicate expenses will be shared
• Duration: How long the syndicate will remain in effect
• Good Faith Deposit: Each member's share of the good faith deposit

Eastern (Undivided) vs. Western (Divided) Accounts

The two types of syndicate accounts determine how unsold bonds are allocated among members:

In an Eastern (undivided) account, each syndicate member is responsible for selling their allocated portion of the issue, but if any bonds remain unsold after the initial distribution period, each member is responsible for a proportional share of the unsold bonds based on their original participation percentage, regardless of whether they have already sold their own allocation. This creates shared liability for the entire issue.

In a Western (divided) account, each syndicate member is responsible only for selling their own specific allocation. If a member sells their entire allocation, they have no further obligation even if other members still have unsold bonds. Each member bears the risk only of their own portion.

Order Priority Under MSRB Rule G-11

MSRB Rule G-11 establishes the framework for order priority in municipal underwriting syndicates. Unless the syndicate agreement specifies otherwise, the standard order priority is:

1. Group Net Orders: Orders that benefit the entire syndicate. Each member receives their proportional share of the takedown. These are typically given highest priority because they benefit all members.
2. Net Designated Orders: Orders where the customer designates which syndicate member(s) should receive credit for the sale. The designated firm(s) receive the takedown.
3. Member Orders: Orders placed by syndicate members for their own accounts at the member takedown price. These are for the member's own inventory.
4. Member-Related Orders: Orders from accounts related to syndicate members, such as affiliated entities or proprietary accounts.

The senior manager must communicate the priority of orders to all syndicate members in writing before the first offer of bonds. Under Rule G-11, within two business days of the date of final allocation, the senior manager must provide each syndicate member with a summary of all orders received and filled, the designations made, and the allocation of bonds to each member.

Underwriting Spread Components

The underwriting spread (also called the gross spread) is the difference between the price the syndicate pays the issuer for the bonds (the purchase price) and the public offering price (POP) at which the bonds are sold to investors. The spread represents the total compensation earned by the underwriting syndicate and is divided among participants based on their roles.

Components of the Spread

The underwriting spread is composed of four distinct components, each compensating a different function in the distribution process:

1. Management Fee: Compensation paid to the senior manager and co-managers for organizing and managing the syndicate, structuring the deal, preparing documentation, and overseeing the entire underwriting process. This is typically the smallest component of the spread.
2. Underwriting Fee (Risk Component): Compensation to all syndicate members for assuming the financial risk of purchasing the bonds from the issuer. Each member earns this fee based on their participation percentage regardless of whether they sell the bonds. Also referred to as the underwriting allowance.
3. Selling Concession: The largest component of the spread. This compensates the firm that actually sells the bonds to the end investor. The selling concession goes to whichever firm places the bonds with investors. Selling group members earn only the selling concession.
4. Total Takedown: The combination of the underwriting fee and the selling concession. This is what a syndicate member earns when they sell bonds from their own allocation. The total takedown represents the difference between the price the member pays for the bonds and the public offering price.

Supervisory Responsibilities for Spread

The Municipal Securities Principal must review the underwriting spread to ensure it is fair and reasonable in relation to the size, type, and risk of the issue. Under MSRB Rule G-17 (fair dealing), the spread must not be excessive. Factors the principal should consider include:

• Market conditions and current spreads for similar issues
• The complexity of the offering structure
• The credit quality of the issuer
• The size of the offering and expected ease of distribution
• The services provided by the underwriter to the issuer
• Whether the issuer is sophisticated or unsophisticated (under Rule G-42, additional duties apply to municipal advisors)

Retail Order Periods

Many municipal issuers, particularly state and local governments, require or request a retail order period at the beginning of the offering. During this period, individual retail investors are given priority in purchasing bonds before institutional investors. This practice reflects the important role that individual investors play in the municipal market, as they are the largest holders of municipal securities.

The principal must supervise the retail order period to ensure that orders are genuinely from retail customers and that institutional orders are not disguised as retail orders. This is a significant compliance concern, as violations can result in sanctions from the MSRB and FINRA.

Principal Supervisory Obligations

The Municipal Securities Principal bears ultimate responsibility for ensuring that underwriting activities comply with all applicable rules and regulations. Under MSRB Rule G-27, the principal must establish, maintain, and enforce a system of supervisory procedures reasonably designed to ensure compliance with MSRB rules.

Written Supervisory Procedures (WSPs)

The firm must maintain written supervisory procedures (WSPs) that specifically address municipal underwriting activities. These procedures should cover:

• Due diligence procedures for evaluating potential underwriting opportunities
• Bid submission and review procedures for competitive underwriting
• Pricing and spread analysis procedures for negotiated underwriting
• Syndicate formation and agreement review procedures
• Order allocation and priority procedures
• Communications with issuers and investors during the underwriting process
• Post-sale reporting and settlement procedures
• Procedures for identifying and managing conflicts of interest

Due Diligence Requirements

Before participating in an underwriting, the firm must conduct reasonable due diligence to understand the terms, risks, and creditworthiness of the issue. The principal must ensure that the firm's due diligence process includes:

• Reviewing the official statement (OS) or preliminary official statement (POS) for accuracy and completeness
• Evaluating the financial condition of the issuer
• Understanding the security and source of repayment for the bonds
• Assessing any material risks associated with the issue
• Verifying that all required disclosures have been made

Conflict of Interest Management

Municipal underwriting is an area where conflicts of interest frequently arise. The principal must be vigilant in identifying and managing conflicts, including:

• Financial Advisory Relationships: If the firm also serves as a financial advisor to the issuer, there is a potential conflict between the advisory duty to the issuer and the firm's interest as an underwriter. MSRB Rule G-23 restricts a firm from switching from financial advisor to underwriter on the same issue.
• Political Contributions: Contributions to issuer officials can create the appearance of pay-to-play arrangements. Rule G-37 imposes restrictions on political contributions by municipal finance professionals.
• Affiliate Transactions: The principal must monitor for situations where the underwriting benefits the firm's affiliates at the expense of the issuer or investors.