WASHINGTON — The Securities and Exchange Commission's recent enforcement action against 13 dealer firms represents a broad effort to correct behavior that was probably due to mistakes by individual traders dealing with an unusual bond issuance, attorneys and market participants said on Tuesday.

The SEC fined the dealers from $54,000 to $130,000 after identifying 66 instances in which they improperly sold Puerto Rico bonds in denominations below a $100,000 minimum set forth in the official statement of the financially distressed island's $3.5 billion general obligation offering earlier this year. The minimum amount, which is to remain in place until the bonds receive an investment grade rating, is designed to protect retail investors.

The enforcement case is the SEC's first under the Municipal Securities Rulemaking Board's Rule G-15 on uniform practice requirements, which prohibits broker-dealers from executing trades in sizes below the minimum denomination set by the issuer, except in very limited circumstances.

Elaine Greenberg, a partner at Orrick, Herrington & Sutcliffe in Washington who formerly headed the SEC enforcement division's municipal securities and public pensions unit, said the action is an example of the SEC taking a "sweep" approach to target multiple market participants for conduct the commission has not taken action on before.

"The SEC is clearly looking at certain industry behaviors in the municipal market that have not been scrutinized before," Greenberg said. "I'm sure they think that will have a greater market impact."

Greenberg said the SEC likely chose not to pursue fraud charges against the dealers because the presence of a clearly applicable MSRB rule makes a much easier and swifter analysis for enforcement lawyers. Instead of needing to prove materiality or who knew what and when, the commission only needs to show that the conduct occurred.

"It's probably an easier enforcement action for them when there is a specific MSRB rule on point," she said.

Market participants said the misconduct almost certainly was the result of missteps by individual traders who were not familiar with the unusual terms of the Puerto Rico bonds. Most municipal issuances have much smaller minimum denominations, commonly $5,000, in an effort to encourage participation by retail investors. This deal was structured specifically to discourage less sophisticated investors from buying the junk-rated bonds.

Many of the deals were cancelled and disappeared from EMMA shortly after they were reported in The Bond Buyer.

"I think this whole situation really underscores the lack of information in the marketplace," said Matt Posner, a managing director at Municipal Market Advisors. "I find it hard to believe that brokers selling these bonds below the threshold to retail investors knew they were not allowed to, as it was such a high profile transaction with a very large syndication. And because it matured in a single maturity, it was extremely easy to track the secondary activity of the deal."

"I recall hearing from traders at the time that thought the $100,000 denomination was only in the primary and did not apply to the secondary" market, Posner continued, adding that Puerto Rico has issued and traded in $5,000 increments in the past.

An industry source who asked not to be identified said the enforcement action is not a surprise because the improper trades were reported by The Bond Buyer and other media. The action will hopefully highlight the importance for dealers to fully understand the terms of the securities they buy and sell, the source said.

"It is absolutely imperative that firms be aware of the minimum denomination size," the source said.

Most of the firms fined declined to comment. A Charles Schwab spokesperson said the firm is taking steps to prevent recurrences of the problem.

"We can confirm that Schwab was included in yesterday's settlement related to four unsolicited trades that were made under the $100,000 regulatory threshold," the firm said in a statement. "When we were alerted to those trades, they were cancelled. We are reviewing all related procedures to ensure it doesn't happen in the future."

Kyle Glazier is a reporter at The Bond Buyer.

Read more:

Register or login for access to this item and much more

All Financial Planning content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access