Passion in public finance: the debate over competitive vs. negotiated underwriting.

• Author: Juarez, Steve

In the midst of an eternal debate over competitive versus negotiated sale of debt, the California Debt Advisory Commission sought to provide public agencies with a rational framework for deciding which method of sale best serves their particular interests.

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...