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Investor Protection

Municipal Bonds - An Over-Reliance on the 'Honor System'

April 13, 2020

by Howard Haykin



Municipal Bonds, issued by cities, states, counties and other local governments, provide investors with fixed interest payments that typically are triple-tax exempt – free of federal, state and local income taxes. Which make them a popular investment – in 2018, the muni bond market was $3.8 trillion.  - - -



However, ask an investor who just bought or sold a muni bond whether their broker-dealer gave the best price and charged a fair commission or transaction fee, and they're likely to say "they guess so, but they don't know for sure." 


That's because there's no centralized market data for municipal bonds as there is for stocks, and because broker-dealers often transact with muni bond customers on a principal basis – i.e., they buy or sell muni bonds from their own inventory, and then apply a transaction fee in the form or a mark-up or mark-down to the trade price, rather than apply an openly-stated commission.


A mark-up is added to the price a customer pays on a purchase; a mark-down is deducted from the price a customer receives on a sale.



INVESTOR PROTECTION.    Municipal bond investors are first and foremost protected by an 'honor system' that's largely based on the integrity of their broker-dealers. Absent this safeguad, it is likely that other safeguards may be irrelevant or insufficient to adequately protect investors. 


That said, each broker-dealer relies on a set of internal controls (Written Supervisory Procedures, or WSPs) to ensure that brokers, traders and other personnel act responsibly and in compliance with industry rules and regulations, as well as firm policies. For WSPs to be effective, firms are expected to keep these documents updated for new rules and business practices. 


Another safeguard is the oversight and enforcement provided by industry regulators. FINRA (Financial Industry Regulatory Authority) and MSRB (Municipal Securities Rulemaking Board) monitor their member firms (broker-dealers), largely by examining selected transactions for compliance. While those efforts are limited in scope and can only go so far, they did manage to catch one firm that didn't do best by its customers.



WHAT WENT WRONG.    FINRA found that a reputable Chicago-based broker-dealer had failed to provide some of its customers with best prices on muni bond transactions. The firm erred by relying on a computer program to determine transaction prices, while ignoring executed prices of recent trades in those particular securities. That same broker-dealer was also cited for charging excessive mark-ups or mark-downs on some transactions.


To settle these charges, the broker-dealer had to pay a $35,000 fine and reimburse $19,000 to customers who were overcharged.



[For further details, click on … FINRA Case #2017053470801.]