Recent months in the US has seen the Securities and Exchange Commission (SEC), the financial markets regulatory authority, explore the role of stock bond brokers in serving their customers' interests better. The municipal bond scam in New Jersey has brought the role of brokers into focus.

This article looks at the two issues. First is SEC new guidelines to broker-dealers on information disclosures in the bond market explored in context of the municipal bond fraud case against New Jersey. Second is the question of brokers giving a priority to their customer's interests or having fiduciary-like responsibility for their investment advice.

Stock Bond Brokers and Municipal Bonds

Local government bodies issue municipal bonds in order to raise money for various projects such as building road infrastructure, reforming hospitals, or funding local schools in a particular region. Also called muni bonds, these are quite popular among the general public as they are thought to be a safe investment as the government issues them. These bonds also have tax exemptions.

Muni bonds can be purchased from specific municipal bond brokers or from general stock bond brokers.

According to the SEC, the State of New Jersey issued municipal bonds valued at US$ 26 billion between August 2001 and April 2007.

In September 2010, the SEC charged the State of New Jersey, with withholding information regarding its financial state from its bond investors. New Jersey government had not disclosed to its muni bond investors that two of its pension plans, the Teachers' Pension and Annuity Fund and the Public Employees Retirement System, were not getting enough funding. This reflected negatively on the State's financial health.

Muni bond issuers do not have the same level of regulation as corporate bond issuers. Stock bond brokers and investors in the corporate sector can expect regular financial reports and performance statements. Corporate bond brokers make recommendations to their clients on the basis of the regular availability of such information regarding the company. However, municipal bond investors do not get the regular information that is required in appropriate investment decisions relating to muni bonds.

Role of Municipal Bond Brokers under New Guidelines

In May 2010, the SEC brought in some amendments to improve financial information disclosure from municipal bond issuers. These amendments will come into effect from Dec 1, 2010 and highlight the role required to be played by municipal bond brokers.

Some amended guidelines regarding the municipal bond market are:

• More disclosure - Under the current law, a stock bond broker dealing with municipal bonds must have a "reasonable belief" that the local government issuing the bonds will provide regular annual financial statements and notices for events impacting the financial status of the bond issuer, if material. The new amendments remove the materiality condition for many events such as payment defaults and change in ratings.
• Timely notice of events - Information regarding financial events such as defaults, bankruptcy or mergers should be given within 10 business days to the stock bond brokers dealing in muni bonds and the general investor.
• Evaluation by brokers selling muni bonds - Municipal bond brokers should have a "reasonable basis" to recommend a particular muni bond to a potential investor. This means that the broker believes that the issuer will make financial disclosures according to the new rules. If a bond issuer has a history of withholding information, then the bond broker should take that into consideration.

Thus we see that the SEC has entrusted the stock bond brokers who recommend various muni bonds with the task of looking after their clients' interests. After the New Jersey municpal bond scam, the SEC wants to bring in more regulations to govern the municipal bond market, according to Elisse Walter, SEC commissioner, in an interview given to the Wall Street Journal.

Should Stock & Bond Brokers have Fiduciary-like Responsibility?

Continuing with exploring the role of stock & bond brokers, the SEC is debating on how much responsibility a broker should have towards his or her clients.

For example, corporate bond brokers may think that the bonds issued by a particular company may be "suitable" or appropriate for their clients. They may recommend particular corporate bonds according to their judgement.

However, is the "suitability" standard enough? Should the corporate bond brokers explore alternative bonds of other companies, compare prices, analyse results and present their clients with much more well-researched bond choices? To put it in a nutshell, should the corporate bond brokers act in the "best interests" of the clients instead of just preserving standards of "suitability"?

The US Securities and Exchange Commission (SEC) lists the personal financial information that each investor must provide to stock & bond brokers such as annual income, net worth and financial objectives for investment. According to the SEC, the stock bond brokers can assess such financial information before making "suitable" investment recommendations. Visit the SEC website for information on the suitability rules.

Now, the SEC is debating whether brokers should go beyond the "suitability" guidelines when advising on stock or bond investments. Brokers do not have fiduciary duty, meaning that they are not required to explore the best choice for their client, which is act in their "best interest".

The North American Securities Administrators Association (NASAA) is advocating fiduciary-like standards for brokers where they must ensure that the best possible investment choice is recommended for their clients.

Some stock bond brokers are opposing this idea as this goes beyond the current "suitability" standards and if implemented, will lay the brokers open to more risk of legal action if it is proved that they have not acted in the best interest of their customers. Also since many brokers sell proprietary funds, an obligation to search for alternatives will undermine their own profits.

The SEC is reviewing the issue and is likely to come up with a solution within six months.