July 10, 2009
More on California's Municipal Securities (IOUs): Suitability and Price Fairness
Posted by Christine Hurt

I'm so glad that Lisa educated us about the California IOUs!  I had not even thought of the securities angle, so now I'm intrigued.  I looked at Lisa's links, and the SEC investor alert reminds us that the California IOUs are exempt from registration as municipal bonds (Section 3(2) of the Securities Act), but those trading them must comply with the Municipal Securities Rulemaking Board.  The alert specifically points out that holders selling and those buying might need to register as broker-dealers and comply with suitability rules.  Wow. 

So, the first thing I was interested in was this suitability rule (Rule G-19).  Here's a 2007 MSRB release about two rules that brokers of municipal securities need to heed:  anti-fraud protections (Rule G-17) and suitability.  The more I looked, the more I think suitability might not be an issue, even thought the IOUs are being handed out to all kinds of Californians.  Although rumors of a credit downgrade have been swirling for two weeks, Moody's is still holding the State of California's general (taxable, senior) obligations at A2.  A downgrade would be to Baa or Baa2.  Most municipal bonds are rated one of those two ratings, and the default rate for municipal bonds in those ratings classes is nonzero, but only barely so.  I understand that these are special times and anything can happen (remember auction rate bonds?), but U.S. state obligations are among the safest instruments available.  So, to bring a suitability claim, someone would really have to be unsuitable for a CD. 

But another MSRB rule may be even more important:  price fairness.  In this notice dated today, the MSRB explains how the MSRB rules apply to the California IOUs:

The MSRB notes in particular its Rule G-30, which requires dealers to effect purchases and sales of municipal securities at fair and reasonable prices based on the dealer’s best judgment of their fair market value, and also requires dealers to charge fair and reasonable commissions in connection with brokered transactions. Dealers must deal fairly with customers and must not take advantage of a customer’s need for cash by offering to purchase registered warrants at deeply discounted prices that are below what could reasonably be viewed as their fair market value. More details on a dealer’s fair pricing obligations are included in a January 26, 2004 MSRB notice.[2] Published quotations regarding offers to buy or sell registered warrants must be bona fide and must be based on the dealer’s best judgment of fair market value under MSRB Rule G-13, and advertisements regarding registered warrants are subject to MSRB Rule G-21.

I would think that offering someone half of face value for an IOU doesn't reflect the fair value (value at maturity plus low default risk, etc.) but instead reflects buyers' knowledge that some recipients will have stark liquidity problems by being paid in IOUs that banks won't honor.  I'm not familiar with the MSRB, and I don't know how much teeth the rules have, or how strictly the SEC and the MSRB are going to police individual buyers and sellers of the IOUs, but on paper, Rule G-30 looks pretty important.

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» The Secondary Market In California IOUs from The Faculty Lounge ...
"I suppose it shouldn’t be surprising that a secondary market has already emerged in California IOUs. ..." [more] (Tracked on July 10, 2009 @ 16:45)
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