«In order to assist with the implementation of Real Time Trade Matching and related functions, DTCC and TBMA staff are working together to find new ...»
IN “PLAIN ENGLISH”
In response to the bond industry’s desire for operational opportunities that promote
efficiency in the primary markets, The Bond Market Association (TBMA) and the
Depository Trust and Clearing Corporation (DTCC) developed the attached plain English
documentation that describes current business practices for submitting a corporate bond
issue to DTCC. The purpose of this documentation is to help identify opportunities for streamlining the operational underwriting process and to find ways to make the process more user friendly concerning new issue data.
In order to assist with the implementation of Real Time Trade Matching and related functions, DTCC and TBMA staff are working together to find new sources of securities descriptions that could be available as underwriters and their counsel submit underwriting data to DTCC. In the corporate new issue process, many of the operational steps occur simultaneously and over a relatively short timeframe. The immediacy of this process may place additional pressure on bond underwriting participants to modernize the method by which data is transmitted to the various parties involved.
According to the research that was conducted with industry professionals for this plain English document, there are opportunities to make new issue information publicly available in a common format via an industry utility. DTCC currently receives this information, confirms the data by comparing it with the issue’s prospectus, and then distributes it to subscribers. In moving forward, DTCC will examine the possibility of updating the current system and process, based upon the industry’s output as outlined in this document, in order to adapt to the needs of an emerging real-time environment.
Corporate Bond Operational Underwriting Process 1 Business Practices in “Plain English” December 9, 2004 Corporate Bond Operational Underwriting Process Business Practices in Plain English
Table of Contents:
II. Business Overview
DTCC Underwriting Procedures
International Depositories: Euroclear and Clearstream Procedures
Information / Service Vendors
Syndicate Information Services
Rating Agencies and Credit Enhancers
IV. Corporate Bond Underwriting Process
A. Presale Activities
Registration with the SEC
B. Closing Date (“Settlement”)
C. Syndicate Processing Activities
The Bond Market Association (TBMA) and The Depository Trust and Clearing Corporation (DTCC) recently commenced in an important cross market initiative to document the operational underwriting process in plain English. The purpose of this initiative is to help identify opportunities to make the end to end underwriting process more efficient and more congruent with enabling Straight Through Processing (STP).
This goal is compatible with the Association’s long standing effort to achieve efficiencies in the fixed income markets. The objective of documenting the underwriting process in plain English is to describe the entire current underwriting process and establish the flow of information and functionality involved in that process.
In September 2003, TBMA and DTCC jointly published the first product of this initiative, i.e. a plain English document describing the municipal operational underwriting process. This document is available on the Association’s website at www.bondmarkets.com. The second phase of the initiative describes the underwriting process for investment grade and high yield corporate bonds. The Association invited bond professionals from its member firms to participate in the Corporate Bond Underwriting Focus Group, which consisted of various types of firms, from regional to bulge bracket firms. TBMA and DTCC then held focus group sessions with these industry representatives as well as, in some cases, the advisors and counsel to these representatives. The focus group meetings were supplemented by additional individual interviews. This plain English document which is based on the output of the group’s sessions describes the corporate bond operational underwriting process and identifies the parties and their respective roles, the sequence of steps in the corporate underwriting process, the information flow and the role of DTCC.
II. Business Overview
The corporate bond market is a large and liquid market. In 2003 the average daily trading volume by primary dealers for bonds with maturities greater than one year was $18.9 billion. The new corporate bond issuance grew in the year 2003 13.9 percent from the previous year to $743.6 billion. With interest rates at historic lows and corporate bond spreads narrowing, corporations sought to take advantage of the favorable market environment. The Bond Market Association estimates that the total market value of outstanding corporate bonds in the United States as of December 31, 2003 was approximately $4.4 trillion.1 This document describes the business practices involving the operational underwriting process in connection with investment grade and high yield corporate bonds. Most corporate bonds are evaluated for credit quality by rating agencies. Bonds rated BBB- (by The Bond Market Association’s Research Quarterly 2004 Corporate Bond Operational Underwriting Process 3 Business Practices in “Plain English” December 9, 2004 S&P or Fitch) or Baa3 (by Moody’s) or higher are considered “investment grade” meaning that the bonds have a sound credit quality. Bonds with a rating of BB+ or Ba1 or below are considered “high yield” bonds, and their credit quality may be speculative.
High yield bonds pay higher interest rates to investors to compensate for the extra risk.
The issuer is the corporation that raises capital through the public offering of debt. A company may have many reasons to issue a bond, such as a desire to be less dependent on bank financing or a desire to diversify the company’s creditor base. For corporations, bonds can sometimes prove a lower cost source of capital than bank borrowing especially to finance long-term projects.
Broker-dealers may purchase the bonds from the issuer and sell the bonds to investors.
While they do so expecting to make a profit, there is also a risk of loss, particularly if the bonds are not resold quickly and the market is drifting downward. In order to spread the risk and increase the marketing opportunity, broker-dealers often invite others to join them in “underwriting” the issue.
There may be issues where a broker-dealer prefers to be the sole underwriter of the deal and purchase the entire issue without involving other broker-dealers in pricing or marketing the issue; however, it is more common for a group of broker-dealers or “syndicate” to assume responsibility for underwriting an issue. One (or more) members of the syndicate group may be appointed senior manager (or co-managers) of the deal.
The remaining members of the syndicate are committed to participate as underwriters through an Agreement Among Underwriters (AAU).
Other dealers may be asked to become part of a Selling Group; these firms do not share in the profit or liabilities of the syndicate account but do have an opportunity to resell a new issue on the same terms as the syndicate members.
Both the issuer and the underwriter are represented by a legal counsel to assist in the many legal aspects of the securities offerings. The respective counsels advise on regulatory matters and help with documentation throughout the underwriting process.
The issuer’s counsel confirms that the issuer has met all legal and regulatory requirements necessary for issuance and advises the issuer regarding the debt indenture and prospectus. The underwriter’s counsel assists the underwriter in meeting the due diligence obligations, helps to review the prospectus for accuracy and disclosure and prepares the Agreement Among Underwriters and the purchase contract.
Corporate new issue bonds are largely bought by institutional investors. Underwriters develop relationships with institutional buyers through their institutional sales force, so they are able to market large blocks of bonds to these institutions in a narrow timeframe.
Dealers often poll institutions before an issue is priced to assess their level of interest and pricing expectations. Institutional investors sometimes have rigid investment guidelines Corporate Bond Operational Underwriting Process 4 Business Practices in “Plain English” December 9, 2004 and compliance limitations that must be followed to meet specific investment objectives (i.e. purchase criteria may require minimum ratings, prohibit concentrations in a specific market sector or purpose, or have a preference for certain geographic locations). It is important that underwriters stay in contact with their buyers during the process to ensure that the deal is structured and priced appropriately to meet both the needs of the issuer and the investors.
Retail investors also have access to corporate bonds on the primary market, through a financial institution or via direct access programs that are currently being offered by underwriters and/or broker-dealers. The underwriting process of these programs is otherwise traditional, but the bonds are offered on a best-efforts basis to broker-dealers who ultimately sell them to retail investors who may purchase them in denominations starting at $1,000.
The trustee is a financial institution, usually a bank, which administers the indenture provisions of a debt issue for the benefit of the bond holders. In many cases the trustee also acts as a transfer agent or paying agent for the bonds. The transfer agent simply transfers the bonds from issuer to bond holder. The paying agent is responsible for transmitting payments of interest and principal from the issuer to the bond holders.
SEC The Securities and Exchange Commission (SEC) has set forth rules that place regulatory responsibility on the underwriters to ensure that the issuers whose securities are being underwritten have fully committed to provide current and ongoing disclosure of financial details and material events that may impact their ability to meet debt service requirements.
The SEC requires that the issuer files a registration statement 20 days prior to the public offering and that it is accompanied with the preliminary prospectus. The SEC also states what information is and is not required in the prospectus. The prospectus must include information such as use of proceeds, determination of offering price and plan of distribution. The time period between the SEC registration and the public offering, is called the cooling-off period. During this time, the SEC examines the registration statement and accompanying materials. In some cases, if the issuer has a record of compliance with earlier issues and if it is up-to-date in the on-going reporting requirements, the bond issue may be sold as soon as 48 hours after filing the registration statement.
There are some instances when registration with the SEC is not necessary. In 1990, the SEC approved Rule 144A, a reform that permits firms to raise capital from “Qualified Institutional Buyers” (QIB) without requiring registration of the securities and compliance with U.S. GAAP. Rule 144A allows for the immediate resale of private Corporate Bond Operational Underwriting Process 5 Business Practices in “Plain English” December 9, 2004 placements among QIBs. This rule was issued in order to improve the liquidity and efficiency of the private placement market and it is particularly important for foreign issuers because it allows them to gain access to institutional investors without having to meet strict disclosure standards that are typically required of U.S. public companies. The 144A market is currently the principal debt market for foreign issues in the United States.
Regulation S (Reg S) allows U.S. companies to sell securities to persons or entities located outside of the U.S. without registering them with the SEC. Many U.S. companies utilize this regulation for their offshore offerings.
Issuers may also utilize a “shelf” registration process, where bonds are registered with the SEC but the issuer may delay making an offering (or make several offerings at various times) for up to a two year period.
SEC Regulation M regulates securities offerings by providing anti-manipulation rules.
Reg M regulates the activities of the issuers, underwriting syndicate members and the securities purchasers during an offering.
NASD The National Association of Securities Dealers (NASD) is the self-regulatory arm of the securities industry that also regulates the corporate bond markets. Under the federal law, virtually every securities firm doing business with the U.S. public is an NASD registered member firm. NASD writes rules to govern their behavior, examines them for compliance and disciplines those that fail to comply with NASD rulings.
In the securities industry, there exist several entities and utilities that are critical for corporate bond underwriting operational business practices. The Bond Market Association and DTCC’s plain English on the municipal operational underwriting process outlined the role of DTCC, DTC, NSCC and the CUSIP Service Bureau. Likewise, these entities and utilities are relevant in the operational business practices of corporate bond underwriting. The aforementioned entities and utilities are required, by the rules of the SEC and/or NASD, to be implicitly involved in underwriting procedures. The details and level of involvement of industry entities and utilities are discussed further in this section.