Passion in public finance: the debate over competitive vs. negotiated underwriting.
Editor's note: Each year the Government Finance Officers Association awards its prestigious Award for Excellence to recognize outstanding contributions in the field of government finance. This article describes the 1994 winning entry in the capital finance and debt administration category.
Competitive or negotiated sale--which method of sale of public debt best serves the issuer? This has been a fundamental question that has confronted municipal debt issuers for many years. Underwriters, financial advisors, market regulators, finance officers, elected officials, academicians and the media--everyone, it seems, has his or her own opinion as to which method of sale is best suited to meet the needs of public agencies. At stake are hundreds of millions of dollars in borrowing costs paid by public debt issuers every year. Given these high stakes, it should be little wonder that studies, reviews and commentaries on this issue often inflame the passion of those who stand to gain or lose according the type of sale chosen.
Yet, when the California Debt Advisory Commission (CDAC) decided to take a closer look at the competitive versus negotiated underwriting debate in late 1991, the commission and its staff were not fully aware of the pitched battle it would encounter between proponents of each method of sale. Consequently, a study that was expected to last three months, ended up taking more than 11 months to complete. The product of this effort was Issue Brief #1: Competitive Versus Negotiated Sale of Debt, released by the commission in September 1992.
This article describes the evolution of the commission's involvement in this study, the rocky road followed by CDAC in completing its work and ensuing events that have added to the controversy surrounding the debate over competitive versus negotiated underwriting.
The Debt Advisory Commission
The CDAC was established in 1981 to serve as a central repository of public debt information and to assist public agencies in achieving the best financing terms on their bond issuances. At that time, state policymakers were concerned about the financial difficulties facing local agencies, which were not only adjusting to the impacts of the landmark tax limitation measure, Proposition 13, but also coping with historically high interest rates in the municipal marketplace. Moreover, the defaults of New York City on its municipal debt obligations in the mid-1970s served as a warning of the consequences of ignoring growing fiscal pressures. It became clear that California public agencies could benefit from the collection of better information on municipal debt issuance and profit from technical assistance that could be provided by a centralized state entity. Thus, CDAC was created.
The commission consists of nine members, including the state treasurer, the governor or the director of finance, the state controller, two local government finance officials and four members of the state legislature. The state treasurer serves as the chairperson and appoints the two local government officials. Assisting the commission in carrying out its mission is the Technical Advisory Committee (TAC), consisting of 30 individuals representing various parts of the municipal finance industry in California, including bond counsel, underwriters, financial advisors, investors, credit rating agencies and local bond issuers. The TAC serves as a forum for the discussion of issues, problems and opportunities related to public agency debt transactions and provides technical review of the commission's work products.
Dominance of Negotiated Sales
In late 1991, one of the issues that attracted the California Debt Advisory Commission to the topic of competitive versus negotiated underwriting was the preponderance of negotiated sales in the California municipal market. According to CDAC data available at the time, 83 percent of the public debt volume issued in the state between 1985 and 1990 was sold through negotiation. This left only 17 percent of the state volume available for competitive bidding. The commission noted that this corresponded with the competitive-negotiated ratio at the national level.
By itself, this heavy reliance on negotiated sales might be viewed as an innocuous statistic, assuming that ethical and legal standards were being followed in the selection of underwriters and that the costs of issuance under the negotiated process were not significantly higher than costs associated with similarly structured competitive transactions (or at least where higher negotiated costs could be reasonably explained). As the commission looked more closely at the issue, however, it discovered that questions of ethics were swirling around some negotiated transactions, including the process of underwriter selection, and that national statistics suggested that negotiated deals were more costly to issuers.
While the press reports in 1991 surrounding certain controversial transactions done in California (including bonds sold by Stanislaus County and smaller deals done elsewhere under the Marks-Roos Local Bond Pooling Act) did not establish a clear link between the method-of-sale selection and the alleged shenanigans that followed, the commission's interest was peaked by the notion that all the "problem" areas cited in press reports were, indeed, negotiated transactions. Even if a direct connection did not exist, the commission believed that the perception was nevertheless troubling.
Moreover, national statistics showed that the average gross underwriting spread--that is, the underwriter's compensation for purchasing bonds--of bonds offered through negotiated sale was higher than the average gross underwriting spread of bonds offered using the competitive sale method. According to statistics published in The Bond Buyer, the daily newspaper reporting on the municipal bond market, the average annual gross spread for all competitive sales (across all types of debt) between 1985 and 1991 was $10.10 per $1,000 bond. For negotiated sales, however, the average annual gross spread over the same time period was $13 for every $1,000 bond. While these types of comparisons sometimes fail to take into account nuances such as the complexity of bonds being sold and the level of service being provided, the commission remained concerned that California issuers might not be taking full advantage of competitive sales. This concern, along with the controversies that were brewing, prompted the commission to ask CDAC staff to take a closer look at why negotiated sales had become so predominant in California.
Although the commission did not begin collecting data on method of sale until 1985, available literature and interviews with municipal market participants suggested that the trend in favor of negotiated sales began in earnest in the mid-1970s. Up until that time, the competitive sale method was used much more often. CDAC's research indicated that the shift toward the negotiated sales during the 1970s appeared to be attributable to three main factors.
First, the increasing use of revenue bonds over general obligation (GO) bonds (a rise which began in the mid-1970s and accelerated after the passage of Proposition 13 with its restrictions on local GO bonds) increased the share of bonds being negotiated. Inasmuch as revenue bonds had traditionally been sold on a negotiated basis, the changing composition of debt in favor of revenue bonds affected the proportion of total debt being negotiated. The second factor was the volatile interest rate environment of the late 1970s and early 1980s. During unstable market conditions, issuers generally prefer the negotiated sale because of the timing flexibility it offers. The third factor was the emergence of innovative financing options and products. New financing options and products require a longer education process to generate investor interest and, thus, tend to rely on the more intensive marketing offered by the negotiated sale. This last factor was especially relevant in California, where restrictions imposed by Proposition 13 in 1978 led to the development of several new financing techniques.
While CDAC staff believed that the rise in negotiated financings could be explained by these events, the continued hegemony of negotiated underwriting vis-a-vis its public sale counterpart could not. In view of stabilized interest rates, the rise of general obligation bond issuance in California and the increased acquaintance of the investor community with earlier innovations, it seemed reasonable to assume that California debt issuance would begin tilting back in the direction of competitive sales. The fact that the expected tilt had not occured prompted the commission 1) to undertake a review of the conditions and factors that support each type of sale and 2) to offer recommendations to assist issuers in selecting the appropriate method of sale and reducing the costs of debt issuance.
As staff began to assemble a technical reference piece on competitive versus negotiated underwriting, the issue brief format was selected as a means of providing issuers with user-friendly information in a fairly short document (six to eight pages) Given the limitations on length, the most arduous task CDAC staff faced was to provide comprehensive coverage of a complex subject in a condensed form.
Framework for Decision Making
The method-of-sale decision is one of the important and difficult decisions a public debt issuer has to make in the bond issuance process. Unless the method of sale is stipulated in statute or administrative policy, an issuer planning to take a debt offering to the market must make the method-of-sale decision early in the process. The decision over which way to turn is crucial to underwriters, who may find themselves at an relative advantage or disadvantage depending on their relationship to the issuer and their competitive skills, as well as to financial advisors (FAs), whose services may or may not be sought depending on the type of sale.
An issuer often will turn to an underwriter or FA for help in making critical financing or structuring decisions. Yet the need to establish the method of sale early on can create a dilemma for many issuers: in view of conventional wisdom that suggests that underwriters prefer negotiated sales while FAs lean toward competitive transactions, how can an issuer request advice and assistance, be it from an underwriter or FA, without tipping the scales in a particular direction?
Helping issuers solve this dilemma was at the heart of the commission's rationale for studying competitive versus negotiated underwriting. It was hoping to create a framework that public officials could use not only for evaluating the type of sale that is appropriate for their transaction but also for evaluating the advice they receive from finance professionals on this topic. In the end, the commission hoped to provide public debt issuers with a more rational basis for deciding on the method of sale.
Why should the issuer care which method of sale is selected? As public debt managers, one of the most critical concerns facing officials is how to lower costs associated with their debt issuance. While both methods of sale offer advantages and disadvantages, each bond issue carries with it a set of characteristics that invariably argue for one method of sale over the other. Using a method of sale ill-suited for the bond offering may result in higher borrowing costs to the issuer, thereby reducing funds available for a project or other public purposes.
Reducing costs, therefore, became the driving force behind the commission's efforts to provide issuers with a systematic way of evaluating their method-of-sale decisions. While the commission recognized that issuers may have other goals and concerns, including the need to conduct an open process, maintain maximum flexibility or achieve certain policy goals, the commission never lost sight of the primary purpose of its effort: helping public agencies save money.
The commission released Issue Brief #1: Competitive Versus Negotiated Sale of Debt in September 1992. The document, whose contents are outlined in Exhibit 1, includes discussions on the strengths and weaknesses of competitive and negotiated underwriting, the factors to consider when making a method-of-sale decision and alternative approaches that certain issuers may want to consider. It concludes with a set of recommendations to help issuers choose the method of sale and save issuance costs.
Facing Up to Controversy
Issue Brief #1 was the end-product of a fascinating and challenging process. At the outset, the commission committed itself to seeking a wide range of input from finance professionals and public-sector participants on the contents of the document. Thus, even though the document itself is only six pages long, an untold number of words, phrases, sentences and whole pages were the subject of edits by more than 20 municipal finance practitioners who reviewed and helped rewrite the document.
If the commission harbored any illusions about there being general agreement on the issue of competitive versus negotiated underwriting, such notions were quickly dispelled when staff submitted its initial draft of the issue brief to CDAC's Technical Advisory Committee (TAC). There were points of agreement, and naturally there were points of contention, and many times staff found itself attempting to reconcile contradictory points of view.
The points of agreement tended to revolve around general and descriptive aspects of the document. Practically everyone conceded that each method of sale has its own place in the world of municipal finance, that each has its own set of pluses and minuses and neither is perfect for all bond issues at all times, and that it is difficult to develop a "cookbook recipe" approach to deciding which method of sale to use. While in certain respects the issue brief does convey this type of "it depends" philosophy, commission staff did seek to provide concrete statements whenever it was appropriate and possible.
The more controversial aspects of the issue brief centered primarily on 1) how issuers should make the method-of-sale decision and 2) whether the document was too heavily biased in favor or one method versus the other or that it did not do justice to certain arguments for or against a particular method of sale.
Disagreements involved topics like "issuer sophistication." Some members of the TAC strongly believed that the sophistication level of the issuer should be a key consideration in the method-of-sale decision. If the issuer is not experienced enough to handle the pricing discussions involved in a negotiated sale, this group argued, it should be advised to stay away from this type of sale. Other TAC members expressed the belief that if such advice were heeded, it merely would lead to more competitive transactions by default, rather than on the basis of truly relevant issuer or financing characteristics. Those opposed to the use of "issuer sophistication" as one criterion for decision making suggested that if the issuer does not have the necessary expertise to carry out the negotiations on its own behalf, then it should hire a financial advisor to assist it in the negotiations. This was the direction eventually adopted in the issue brief.
The elaborate review and redrafting process that the commission went through to develop the issue brief was well worth the effort. Members of the TAC and the other municipal market participants who reviewed the document were a tremendous help in making the final product meaningful for CDAC's primary audience--public agency officials--as well as for the wide range of private finance professionals.
The Debate Rages On
More than 750 copies of Issue Brief #1: Competitive Versus Negotiated Sale of Debt have been requested, making it one of the most popular publications ever issued by the commission. The large demand for Issue Brief #1 has been fueled, in part, by ongoing turmoil that has surrounded the method-of-sale subject since the document's release. By early 1993, reports of influence-peddling investigations in the selection of bond underwriters in the City of New York and the State of New Jersey became prominent features in the mainstream, as well as the financial press. Similar controversies in other states, including California, also surfaced later that year. By 1994, Securities and Exchange Commission (SEC) Chairman Arthur Levitt was vowing that the issue of competitive versus negotiated sale would be one of the five critical areas of the municipal bond market that the SEC was planning to examine.
One rather extreme response to the controversies, in CDAC's view, has been the movement by some jurisdictions to consider, and even implement, policies that ban the use of negotiated sales. While CDAC's research efforts sought to raise questions about the preponderance of negotiated underwriting in California, and while some commission members have wanted to encourage greater use of competitive sales, CDAC has maintained the position that both methods of sale have their place in keeping public debt issuance costs to a minimum. CDAC believes that blind adherence to a single method can have negative consequences for the issuer.
CDAC's stance on this issue closely resembles the position adopted by the Government Finance Officers Association at its annual meeting in June 1994. The GFOA's recommended practice, titled "Selecting and Managing the Method of Sale of State and Local Government Bonds," urges state and local government issuers to 1) adopt policies governing the method-of-sale decision that ensure that the appropriate method of sale is selected in light of financial and issuer-related factors; 2) use the competitive method of sale when conditions exist that generally favor that method of sale; and 3) follow specified practices that ensure a competitive and accountable process should a negotiated sale be necessary.
Any thought, however, that the adoption of this recommended practice would take place without the differing opinions and intense debate that accompanied CDAC's deliberations was quickly dismissed. GFOA's Committee on Governmental Debt and Fiscal Policy, along with its subcommittee on financial policies, spent long hours seeking language that would satisfy state and local officials who serve on the committee, as well as the GFOA Executive Board and the association's general membership. The divided committee vote of 13-5 in favor of the recommended practice is a testament to the fact that competitive versus negotiated underwriting remains a provocative issue. In view of the SEC's proclaimed interest in this issue, CDAC expects that this debate will continue full throttle for the foreseeable future.
CALIFORNIA DEBT ADVISORY COMMISSION ISSUE BRIEF #1: COMPETITIVE VERSUS NEGOTIATED SALE OF DEBT
The debate on which method of sale of public debt--competitive or negotiated--best serves the issuer's interest is one of the most enduring in the municipal finance arena. Most municipal finance professionals agree that neither competitive sale nor the negotiated method of sale is ideal for all bond issues. Each method has its strengths and weaknesses, making one method of sale more conducive to a particular bond issue than the other. Among these characteristics are:
* Competition motivates underwriters to keep the effective interest cost as low as possible
* Historically lower spreads on general obligation and revenue bond issues
* Process is open and fair; eschews favoritism or the appearance thereof
* Potential for risk premium in underwriter's bid to compensate for uncertainty about market demand
* Limited ability to make last-minute timing and structural changes
* Minimal control over underwriter selection and bond distribution
* Underwriter assists the issuer in preparing the issue for the sale
* More extensive pre-sale marketing to more accurately gauge the market demand for the bonds
* Ability to make last-minute timing and structural changes
* Issuer can have influence over underwriter selection and bond distribution
* Pricing is less subject to rigors of competition; issuers need to be vigilant during the pricing
* Open to wide fluctuations in spread between comparable deals as some issuers are more versed at negotiating than others
* Vulnerable to allegations of favoritism or impropriety in the underwriter selection
In order to determine the most appropriate method of sale for a specific offering, the issuer must conduct a systematic evaluation of the following factors:
* Market familiarity. The less familiar is the credit, the more important is pre-sale marketing.
* Credit strength. Everything else being equal, the higher the credit quality, the less need for negotiation.
* Policy goals. The negotiated sale allows the issuer to have control over underwriter selection and bond distribution.
* Type of debt instrument. New and unfamiliar instruments may require the more effective marketing offered by the negotiated sale.
* Issue size. If the issue is either too small or too large, the issuer should consider negotiating the sale.
* Complexity of the issue. "Plain vanilla" issues lend themselves to the competitive sale process.
* Market conditions. During periods of interest rate stability, timing flexibility is not critical.
* Story bonds. Issues associated with unusual events or conditions can benefit from the more effective pre-sale marketing of a negotiated sale.
If neither of the straight competitive or negotiated sale fits the issuer's needs, it may consider one of the following alternative approaches.
* Utilizing the legal framework of a negotiated sale but pricing the issue through solicitation of bids from all interested underwriters. Combines the flexibility offered by negotiated sale and competition in the pricing offered by competitive sale.
* Infusing competition in the negotiated sale process by using the request for qualifications (RFQ) process or request for proposals (RFP) process in the selection of underwriters. Eschews allegations of favoritism in underwriter selection.
* "Unbundling" financial services--hiring a financial advisor or investment banker only for certain portions of the sale. Minimizes cost of engaging outside expertise.
Other actions the issuer can take in choosing an appropriate method of sale and reducing issuance costs include:
* Take responsibility for the issuance. Do not rely on financing team members to protect the public's interest.
* Assess the level of demand for the issue to determine if there is sufficient competition to merit a competitive sale.
* Focus on the total cost of the financing. Take both the spread and interest costs into account.
* If in-house resources are inadequate to handle the sale, hire a financial advisor.
* Evaluate the method of sale for every issue. Choice of method of sale should be dictated by issuer and financing characteristics, not by blind faith in one method of sale.
GOVERNMENT FINANCE OFFICERS ASSOCIATION RECOMMENDED PRACTICE: SELECTING AND MANAGING THE METHOD OF SALE OF STATE AND LOCAL GOVERNMENT BONDS
The members of the Government Finance Officers Association (GFOA) of the United States and Canada adopted a recommended practice for Selecting and Managing the Method of Sale of State and Local Government Bonds at its annual meeting in June 1994. In it, the GFOA encourages government finance officers to:
1. Adopt policies governing the method of sale decision, if the issuer has the ability to make the choice. These policies should ensure that:
* the method-of-sale decision is based on an analysis of financial, market, transaction-specific and issuer-related factors;
* an evaluation of the most appropriate method of sale is conducted for each issue;
* the jurisdiction can defend its decision, irrespective of which method of sale it chooses.
2. Use the competitive method of sale when conditions generally favoring that method of sale exist. In order to protect the public's interest and avoid concerns or allegations of impropriety in the selection or compensation of finance professionals, jurisdictions should use the competitive method of sale when the following conditions exist:
* the issuer is familiar to the market;
* the issuer is a stable and regular borrower;
* there is an active secondary market for the issuer's bonds;
* the issue has a nonenhanced credit rating of A or above or can obtain a credit enhancement prior to the competitive sale;
* the debt is backed by a strong and stable revenue source (i.e., full faith and credit or well-known and stable revenue stream);
* the issue is neither too large nor too small;
* the issue or debt instrument is not viewed as complex, innovative or requiring explanation;
* interest rates are stable, market demand is strong and the market is not saturated with comparable credits; and
* policy considerations such as disadvantaged business enterprise (DBE) participation and regional firm participation can be reasonably addressed through the Notice of Sale.
3. Follow specified practices that ensure that negotiated sales are subject to a competitive and accountable process. In the event that a competitive sale is not feasible or practical based on an analysis of the above-mentioned factors, a negotiated sale may be appropriate. When negotiating a sale, however, issuers should:
* ensure fairness in the selection of underwriter by considering multiple proposals;
* remain actively involved in each step of the negotiation and sale process;
* ensure that adequate municipal finance expertise is available, either from in-house staff or independent finance professionals;
* avoid conflicts of interest which may occur when an issue's financial advisor also acts as its underwriter;
* request financing professionals to disclose firms and personnel engaged to promote their interests;
* request financing professionals to disclose joint proposals, joint accounts and fee-splitting arrangements, plans, parties and changes thereto; and
* require submission of, review and monitor compliance with "Agreement Among Underwriters."
Adopted June 4, 1994
STEVE JUAREZ is the executive director of California Debt Advisory Commission. He is vice-chair of GFOA's Committee on Governmental Debt and Fiscal Policy and served on the faculty of GFOA's Advanced Government Finance Institute. He is currently membership chair of the State Debt Management Network and on the editorial board of the Municipal Finance Journal. CHARMETTE BONPUA is an associate program specialist with CDAC and was the primary author of Issue Brief #1: Competitive Versus Negotiated Sale of Debt. Copies of the issue brief may be obtained by calling CDAC at 916/653-3269.
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|Author:||Juarez, Steve; Bonpua, Charmette|
|Publication:||Government Finance Review|
|Date:||Dec 1, 1994|
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