Selling Municipal Securities via the Internet

The Municipal Securities Rulemaking Board

While the Municipal Securities Rulemaking Board (MSRB; www.msrb.org) writes investor protection rules and other rules regulating broker-dealers and banks in the U.S. municipal securities market, its jurisdiction does not cover municipalities. The MSRB sets standards for broker-dealers, banks and municipal advisors. These rules do not apply to issuers of municipal securities or other municipal entities, which Congress generally exempted from most provisions of the federal securities laws (such as the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940).

The MSRB was established in 1975 by Congress to develop rules regulating security firms and banks involved in underwriting, trading and selling municipal securities. Like other self-regulatory organizations, it is subject to oversight by the Securities and Exchange Commission (SEC), and its rules are enforced by various other federal regulatory organizations, including the SEC, the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC).

Selling bonds directly to the public is increasingly important to municipalities, now that the SEC is trying to limit bond market risk. Although the SEC has no direct authority to oversee municipalities, it does have authority to regulate banks and other financial institutions, which buy municipal bonds. In particular, the SEC has the authority to examine banks and other financial institutions' procedures for participating in traditional bond auctions. In exercising its authority, the SEC has increasingly limited banks' and other financial institutions' purchases of municipal bonds via both Internet and through traditional channels. Thus, municipalities' direct Internet sales to the public should become more significant.

Direct Bond Selling

Traditionally, municipal bonds are purchased through an investment broker, and the transaction fees are typically between 0.5% and 3% of the purchase price. Selling directly to the public can eliminate the cost of using a broker, and thus one of the costs of the bond debt. Alternatively, a municipality selling its bonds without a broker can increase its revenue by either earning the fees directly or by making the bond more profitable to the municipality by changing the bond interest rate or the amount of bonds issued.

Selling municipal bonds directly to the public was pioneered more than a decade ago. In 1999, Pittsburgh won a $100,000 award from the Ford Foundation for a program that enhances the sale of municipal bonds over the Internet. Using the Internet, the city of Pittsburgh saved more than $2 million as compared to its previous seven bond offerings.

The bids for the Pittsburgh bonds offering individual maturities were accepted through the city's private Internet site, www.PGHauction.com, using software from MuniAuction Inc., and was open to both the public and the broker-dealer community. Unlike previous Internet sales, all bidders would remain anonymous during and after the auction, to allow institutional investors to bypass the underwriter without jeopardizing relationships and secondary market liquidity.

Crowdsourcing and Auctions

During the past 15 years, Internet technology changes and acceptable methods allow more robust channels for municipalities to sell bonds, such as crowdsourcing income. Crowdsourcing is the practice of obtaining needed contributions from a large group of people, and especially from an online community, rather than from traditional employees or suppliers.

In the past, Internet municipal bond sales required electronic methods for conducting “original issuer auctions” of financial instruments. Rather than simply offering a variety of bonds to the public at a fixed price, municipal bond auctions were conducted over an electronic network.

In addition to crowdsourcing to the public, Internet municipal bond sales could be limited to underwriters who buy an entire bond offering (“all-or-none bidding”). Underwriters would then have their own Internet auction to resell the individual bonds in the offering to the public.

Software to support prior Internet municipal bond sales required bidders to install software before participating in an auction. Some systems were designed to be used together with fax and other bid submission methods. Other software systems used a single server to allow issuers to run the auction and bidders to submit bids using a Web browser.

Today, no separate bond-selling software is needed to allow Internet users to simply buy intangible assets such as municipal bonds directly from a municipality. If a bond auction is still desirable, no separate software is needed for an Internet user to monitor the progress of the auction and for bidders to monitor their bids.

SEC Compliance

Municipalities' statements to potential bond investors without an attorney opinion letter are more likely to be found misleading and punish offenders accordingly. Even though the SEC may not directly regulate municipal bond issuers, it can charge a municipality with securities fraud for misleading investors about the status of the municipality's finances, and then take action against the municipality.

A municipality that uses the Internet to sell bonds potentially has an advantage over a non-Internet seller for avoiding SEC legal difficulties. Internet transactions are more susceptible to documentation than non-Internet transactions. A bond-issuing municipality using the Internet to sell its bonds can force the buyer to acknowledge and document the scope of due diligence the buyer has undertaken prior to executing the bond sale, thus ameliorating the SEC's major concern, which is lack of timely and effective notice.

Prior to issuing municipal bonds for Internet sale, just as in the case of traditional municipal bond sales, the bond issuer should have an attorney render a legal opinion that includes:

• The basis for allowing an authority to borrow, which demonstrates that it is legal for this entity to borrow money via municipal bonds under state and federal laws;
• Reference to the 1933 Act exemption, which states that municipal issuers are exempt from filing registration statements with the SEC; and
• A statement of the tax exemption, which states that the interest from municipal bonds is normally exempt from federal taxation.

The legal opinion should cite the appropriate laws as a basis for each finding.

The opinion letter may be either an unqualified or qualified opinion. An unqualified opinion is used when the opinion writer has no reservations about the issuer's authority to borrow, the nature of the bond and the tax exemption. A qualified opinion indicates that the bond counsel has concerns about some aspects of the bond. An Internet municipality bond issuer need not have either, but failure to provide either will likely increase the municipality bond issuer's liability and decrease the pool of interested buyers.

Jonathan Bick is Of Counsel at Brach Eichler LLC in Roseland, NJ. A member of this newsletter's Board of Editors, he is also an adjunct professor at Pace and Rutgers law schools, and the author of 101 Things You Need to Know about Internet Law (Random House 2000) (available from Amazon at http://amzn.to/TUbFM2). He can be reached at [email protected].

Traditionally, municipalities depend upon property taxes to constitute the largest source of local governments' own revenue. Charges, sales and gross-receipt taxes, individual income taxes and other revenues make up the remaining local general revenues. Due to the mismatch of revenue and expense timing, a municipality usually uses bond debt borrowing to facilitate local funding. Normally, municipal bonds can be purchased through an investment broker. However, municipalities may lawfully sell municipal bonds directly to the public via the Internet and potentially save money.

One of the primary purposes for municipal bonds is to allow governments to borrow money to finance capital projects without causing burdensome changes in tax rates, fees or other charges.

Municipalities that sell directly to the public via the Internet benefit three ways: 1) increase the competition for their bond offerings; 2) lower borrowing costs by eliminating brokers; and 3) improve transparency by allowing municipalities to know who holds their debt. Internet municipal bond buyers also benefit by allowing investors to exercise more control over the pricing and distribution of bonds, discretion that normally resides exclusively with bidding broker-dealers.

The Municipal Securities Rulemaking Board

While the Municipal Securities Rulemaking Board (MSRB; www.msrb.org) writes investor protection rules and other rules regulating broker-dealers and banks in the U.S. municipal securities market, its jurisdiction does not cover municipalities. The MSRB sets standards for broker-dealers, banks and municipal advisors. These rules do not apply to issuers of municipal securities or other municipal entities, which Congress generally exempted from most provisions of the federal securities laws (such as the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940).

The MSRB was established in 1975 by Congress to develop rules regulating security firms and banks involved in underwriting, trading and selling municipal securities. Like other self-regulatory organizations, it is subject to oversight by the Securities and Exchange Commission (SEC), and its rules are enforced by various other federal regulatory organizations, including the SEC, the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC).

Selling bonds directly to the public is increasingly important to municipalities, now that the SEC is trying to limit bond market risk. Although the SEC has no direct authority to oversee municipalities, it does have authority to regulate banks and other financial institutions, which buy municipal bonds. In particular, the SEC has the authority to examine banks and other financial institutions' procedures for participating in traditional bond auctions. In exercising its authority, the SEC has increasingly limited banks' and other financial institutions' purchases of municipal bonds via both Internet and through traditional channels. Thus, municipalities' direct Internet sales to the public should become more significant.

Direct Bond Selling

Traditionally, municipal bonds are purchased through an investment broker, and the transaction fees are typically between 0.5% and 3% of the purchase price. Selling directly to the public can eliminate the cost of using a broker, and thus one of the costs of the bond debt. Alternatively, a municipality selling its bonds without a broker can increase its revenue by either earning the fees directly or by making the bond more profitable to the municipality by changing the bond interest rate or the amount of bonds issued.

Selling municipal bonds directly to the public was pioneered more than a decade ago. In 1999, Pittsburgh won a $100,000 award from the Ford Foundation for a program that enhances the sale of municipal bonds over the Internet. Using the Internet, the city of Pittsburgh saved more than $2 million as compared to its previous seven bond offerings.

The bids for the Pittsburgh bonds offering individual maturities were accepted through the city's private Internet site, www.PGHauction.com, using software from MuniAuction Inc., and was open to both the public and the broker-dealer community. Unlike previous Internet sales, all bidders would remain anonymous during and after the auction, to allow institutional investors to bypass the underwriter without jeopardizing relationships and secondary market liquidity.

Crowdsourcing and Auctions

During the past 15 years, Internet technology changes and acceptable methods allow more robust channels for municipalities to sell bonds, such as crowdsourcing income. Crowdsourcing is the practice of obtaining needed contributions from a large group of people, and especially from an online community, rather than from traditional employees or suppliers.

In the past, Internet municipal bond sales required electronic methods for conducting “original issuer auctions” of financial instruments. Rather than simply offering a variety of bonds to the public at a fixed price, municipal bond auctions were conducted over an electronic network.

In addition to crowdsourcing to the public, Internet municipal bond sales could be limited to underwriters who buy an entire bond offering (“all-or-none bidding”). Underwriters would then have their own Internet auction to resell the individual bonds in the offering to the public.

Software to support prior Internet municipal bond sales required bidders to install software before participating in an auction. Some systems were designed to be used together with fax and other bid submission methods. Other software systems used a single server to allow issuers to run the auction and bidders to submit bids using a Web browser.

Today, no separate bond-selling software is needed to allow Internet users to simply buy intangible assets such as municipal bonds directly from a municipality. If a bond auction is still desirable, no separate software is needed for an Internet user to monitor the progress of the auction and for bidders to monitor their bids.

SEC Compliance

Municipalities' statements to potential bond investors without an attorney opinion letter are more likely to be found misleading and punish offenders accordingly. Even though the SEC may not directly regulate municipal bond issuers, it can charge a municipality with securities fraud for misleading investors about the status of the municipality's finances, and then take action against the municipality.

A municipality that uses the Internet to sell bonds potentially has an advantage over a non-Internet seller for avoiding SEC legal difficulties. Internet transactions are more susceptible to documentation than non-Internet transactions. A bond-issuing municipality using the Internet to sell its bonds can force the buyer to acknowledge and document the scope of due diligence the buyer has undertaken prior to executing the bond sale, thus ameliorating the SEC's major concern, which is lack of timely and effective notice.

Prior to issuing municipal bonds for Internet sale, just as in the case of traditional municipal bond sales, the bond issuer should have an attorney render a legal opinion that includes:

• The basis for allowing an authority to borrow, which demonstrates that it is legal for this entity to borrow money via municipal bonds under state and federal laws;
• Reference to the 1933 Act exemption, which states that municipal issuers are exempt from filing registration statements with the SEC; and
• A statement of the tax exemption, which states that the interest from municipal bonds is normally exempt from federal taxation.

The legal opinion should cite the appropriate laws as a basis for each finding.

The opinion letter may be either an unqualified or qualified opinion. An unqualified opinion is used when the opinion writer has no reservations about the issuer's authority to borrow, the nature of the bond and the tax exemption. A qualified opinion indicates that the bond counsel has concerns about some aspects of the bond. An Internet municipality bond issuer need not have either, but failure to provide either will likely increase the municipality bond issuer's liability and decrease the pool of interested buyers.

Jonathan Bick is Of Counsel at Brach Eichler LLC in Roseland, NJ. A member of this newsletter's Board of Editors, he is also an adjunct professor at Pace and Rutgers law schools, and the author of 101 Things You Need to Know about Internet Law (Random House 2000) (available from Amazon at http://amzn.to/TUbFM2). He can be reached at [email protected].