When selling tax exempt or taxable municipal bonds through negotiated sale, in addition to negotiating the price or yield for each bond, the underwriters’ compensation, or so-called “spread,” or underwriters discount must be negotiated. There are four components of the spread; the takedown, the management fee, the underwriting risk fee, and underwriters’ expenses. Underwriters expenses included in a bond issue should represent fair reimbursement at the least public cost of expenses undertaken by the underwriters for the benefit of the transaction.
Issuers should be familiar with the types of transaction expenses that are encountered in typical bond sales and should be prepared to discuss and agree on how transaction expenses should be treated. Treatment of transaction expenses may be subject to legal constraints of bond resolutions, local ordinances, governing state statutes, or federal tax law. Certain expenses normally are considered issuer’s expenses and, if paid from the bond issue, should be characterized as “costs of issuance” rather than the underwriter’s expenses.
Issuers need to make sure that the expenses charged are appropriate for the transaction, regardless of how they ultimately are paid. Decisions about including or excluding specific expenses from being part of the underwriter’s expenses or costs of issuance require consideration of policy regarding whether certain expenses will be paid from the proceeds of the bond, either paid directly by the issuer or as part of the underwriter spreadover the life of the bond issue by inclusion, paid from available cash outside the bond issue, or paid by the underwriter outside the bond issue as a business overhead expense of the underwriting firm.
GFOA recommends that state and local government issuers establish at the beginning of the bond negotiation process what expenses will be directly paid by the issuer or as part of the underwriter spread. This should occur through discussions between the issuer (together with its financial advisor) and the underwriter. Along with establishing which expenses will be paid for by the issuer either directly or through the underwriter spread, the requirements for documenting each item, and the procedure for disbursing the expense funds at closing should be established and documented. Expense items may be categorized as follows:
Commonly accepted underwriter’s expenses:
- reasonable costs underwriter’s counsel;
- reasonable travel costs incurred as part of the transaction. Issuers may want to establish guidelines regarding travel reimbursement practices including but not limited to mode of travel, airfare, hotels and meals.
- external data service fees for transmitting information on interest rates, takedowns, and priority of orders;
- interest/day loan costs;
- charges for communication, including the rating agency presentation, mailing, printing, and telephone expenses; and,
- CUSIP fees.
Expenses commonly viewed as issuer’s expenses that normally are treated as cost of issuance and may be capitalized within a bond issue (but not within the spread) are:
- bond counsel fees,
- rating agency fees,
- financial advisor fees,
- necessary rating agency or marketing travel by the issuer,
- printing of disclosure documents,
- upfront trustee or fiduciary fees.
Expenses commonly viewed as not essential to a transaction:
- unnecessary, unreasonable or non-approved travel and meals,
- celebratory closing dinners,
- commuting costs to and from work by the underwriters’ staff, computer-or structuring charges, and undocumented clearing charges.
Issuers should be aware that inappropriately denying the underwriter fair reimbursement of necessary and reasonable expenses increases the pressure on the underwriter to compensate itself elsewhere in the bond transaction, specifically in the takedown, the management fee, the underwriting fee, or even in the bond price/yield. This may have the effect of reducing sales incentive among the members of the underwriting syndicate.
Issuers need to be certain that they do not pay for either the MSRB Underwriting and Transaction Assessment fee, which dealers are prohibited to pass along to issuers under MSRB Rule A-131, nor the SIFMA Municipal Assessment fee, which is no longer in place. Additionally, issuers should not allow the underwriter to pass through to them any fees that are assessed on the underwriter’s firm as part of a new Governmental Accounting Standards Board (GASB) fee.
- GFOA Best Practice, Issuer’s Role in Selecting Underwriter’s Counsel, 2009.
- GFOA Best Practice, Pricing Bonds in a Negotiated Sale, 2009.
- GFOA Best Practice, Selecting Underwriters for a Negotiated Bond Sale, 2008
- Debt Issuance and Management: A Guide for Smaller Governments, James C. Joseph, GFOA, 1994.
- Understanding the Underwriting “Spread,” Issue Brief No. 2, California Debt Advisory Commission, March 1993.