The Securities Litigation Expert Blog

The DOL Fiduciary Rule - Reasonable Compensation and Index Funds

Posted by Jack Duval

Aug 9, 2017 9:23:09 AM

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This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My previous blog posts can be found here.

A large part of the motivation for the DOL FR is summarized in the Federal Register as follows:[1]

This final rule and exemptions aim to ensure that advice is in consumers’ best interest, thereby rooting out excessive fees and substandard performance otherwise attributable to advisers’ conflicts, producing gains for retirement investors.  (Emphasis added)

Reasonable Compensation

One of the ways that “excessive fees and substandard performance” will be rooted out is the requirement, under the BICE, that no more than reasonable compensation be charged.  For instance, the BICE states:[2]

In particular, under this standards-based approach, the Adviser and Financial Institution must give prudent advice that is in the customer’s best interest, avoid misleading statements, and receive no more than reasonable compensation.  (Emphasis added)

Perhaps the most impactful part of the reasonable compensation standard is that it is not based on what is customary.  The DOL could not be more clear on this, writing:[3]

The Department is unwilling to condone all “customary” compensation arrangements and declines to adopt a standard that turns on whether the agreement is “customary.”  For example, it may in some instances be “customary” to charge customers fees that are not transparent or that bear little relationship to the value of the services actually rendered, but that does not make the charges reasonable…

An imprudent recommendation for an investor to overpay for an investment transaction would violate that standard, regardless of whether the overpayment was attributable to compensation for services, a charge for benefits or guarantees, or something else.  (Emphasis added)

From “Everyone is doing it” to the Prudent Expert Standard

Industry custom and practice is frequently a topic of expert testimony in securities litigations.  However, under the DOL FR, this will no longer be relevant when it comes to justifying compensation.

The mere fact that “everyone is doing it” will fail to meet the fiduciary standard.  As discussed in a previous blog post, what will be required is diligence that meets the Prudent Expert Standard and all the attendant fiduciary obligations.

This will require substantial, documented, due diligence into the recommended investment and alternatives.  Each investment will have to stand on its own against comparable investments in the same category.

As an example, before a large cap growth mutual fund can be recommended, it will have to be judged against other large cap growth investment options, including: both active and passive mutual funds and ETFs.

Are Index Funds the Only Prudent Investment?

There has been some speculation that the DOL FR would require the use of index funds.  The DOL has spoken to this indirectly, writing:[4]

… the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees without regard to other relevant factors.

However, advisors will be hard pressed to justify not using index funds.[5]  Contrary to popular belief, index funds don’t give average returns, most index funds perform in the 75-80th percentile range compared to other funds in their category, over five- and 10-year periods.

Furthermore, the longer the time horizon of the investor, the more compelling are index funds due to the simple math of compounding returns on the fees avoided.  Since, most IRA and pension fund assets are managed for the long term, this is highly salient.

Over the years, Morningstar has conducted research into what is the most predictive factor of mutual fund performance.  The answer every time is: fees.  Morningstar Director of Manager Research, Russel Kinnnel, writes:[6]

The expense ratio is the most proven predictor of future fund returns…

Using expense ratios to choose funds helped in every asset class and in every quintile from 2010 to 2015.  For example, in U.S. equity funds, the cheapest quintile had a total-return success rate of 62% compared with 48% for the second-cheapest quintile, then 39% for the middle quintile, 30% for the second-priciest quintile, and 20% for the priciest quintile.  So the cheaper the quintile, the better your chances.  All told, the cheapest-quintile funds were 3 times as likely to succeed as the priciest quintile.[7]  (Emphasis added)

Chart 1: Performance Success by Fee Quintile[8]

 Accelerant - DOL Fiduciary Rule - Mutual Fund Fees.png

The dominance of fees in predicting future performance addresses another point raised by the DOL:[9]

No single factor is dispositive in determining whether compensation is reasonable; the essential question is whether the charges are reasonable in relation to what the investor receives.  (Emphasis added)

In my example, the investor is receiving large cap growth stocks.  Is it reasonable to charge more and deliver what is likely to be worse performance?  That is very difficult to justify.

Another factor making active management hard to justify is that many active funds have a significant overlap with their benchmark index.  This “closet indexing” means that the fund manager is buying the same stocks that are in the benchmark.  This would be harmless except for the fact that many benchmark indexes are almost costless while active funds frequently charge one percent or more for their services.[10]

Where closet indexing occurs, the client is paying an active fee for passive management, which is not reasonable and fails the fiduciary standard.  Closet indexing can be measured using the active share and other metrics, which I will discuss in more detail in later posts.

Because of their extremely low fees and generally superior long-term performance, index funds can help advisors accomplish the DOL’s goals of "rooting out excessive fees and substandard performance".



[1]       Federal Register; Vol. 81. No. 68; April 8, 2016; Definition of the Term Fiduciary; 20951.  This language also appears, verbatim, in the DOL Regulatory Impact Analysis; April 14, 2015; 7.

[2]       Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21003.

[3]       Id. at 21031.

[4]       Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21030.

[5]       I am including here capitalization-weighted and non-capitalization weighted indexes (aka “smart beta” indexes), many of which have proven to outperform the relevant capitalization-weighted index on an after-fee basis.

[6]       Russel Kinnel, Predictive Power of Fees: Why Mutual Fund Fees Are So Important; Morningstar; May 2016; 1-2.  Available at:;  Accessed May 23, 2017.

[7]       Id. Success is defined as a fund surviving the entire time period and outperforming the relevant category group; 1.

[8]       Id. at 3. The lowest fee funds are in the first Expense Ratio Quintile and the highest fee funds are in the fifth Expense Ratio Quintile, etc.

[9]       Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21030.

[10]     For instance, the Vanguard S&P 500 Index ETF has an expense ratio of four basis points, (4/100) of one percent.  Bloomberg; August 9, 2017.  Morningstar reports that the average third quintile expense ratios for U.S. Equity mutual funds was 1.26 percent as of December 31, 2010.  See supra Note 6; at 4.

Click to view useful links on our DOL Fiduciary Rule - Securities Litigation Resources page.

To learn more about ERISA fiduciary expert Jack Duval, click here.


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Topics: litigation, Due Diligence, securities litigation, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule, prudent expert standard, index funds, reasonable compensation, active share

The DOL Fiduciary Rule - Risk Tolerance Questionnaires

Posted by Jack Duval

Aug 2, 2017 7:31:02 AM

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This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My previous blog posts can be found here.

In my last blog post, I discussed how the traditional three-choice Investment Objective and Risk Tolerance options would no longer be sufficient under the DOL FR.  In this post, I will expand on topic of Investment Policy Statements (“IPS”) and an often-missed aspect of their drafting – determining both the client’s ability and willingness to take risk.

The Difference Between the Ability and Willingness to Take Risk

Most financial plans focus on the client’s ability to take risk.  This is usually accomplished mathematically, by predicting cash flows and evaluating those against known liabilities.  Generally, the thinking is if the client can sustain losses and still meet her needs, then she has the ability to take risk.  (For instance, if the client needs $20,000 per month to sustain her lifestyle, but her portfolio can generate $40,000 per month, after fees and taxes, then she has a high ability to take risk.) 

The client’s willingness to take risk is a softer metric that requires getting to know the client and their history, going through questionnaires, and scenario planning.  Many of the questionnaires and scenario plans revolve around a series of questions, hypothetical situations, and attempt to determine the client’s probable responses to market events.  For instance: what would you do it your portfolio declined by 10, 20, or 30 percent?

Problems with Risk Tolerance Questionnaires

In my experience, most risk tolerance questionnaires lead to inflated risk tolerances.  The reason is that unless the most conservative answer is given to every question, the client will be scored with a moderate or moderate-aggressive risk tolerance.  Furthermore, if even one question is answered with the most aggressive option, the client will typically end up with a moderate-aggressive or aggressive risk tolerance.

Another flaw in risk tolerance questionnaire design is that they are generic and rely on percentage gains and declines in their examples.  Percentage losses don’t live for clients, but dollar losses do.  For instance, many clients can be philosophical about a 30 percent decline in their portfolio, but most would not be as sanguine about a $3 million decline on a $10 million portfolio.

These flaws can have far-reaching implications.  The skewing towards aggressive Risk Tolerances can lead to misaligned asset allocations, unsuitable investments, and higher than expected volatility.  This frequently leads to clients changing their Risk Tolerance (to what it should have been originally) after a market decline.

Ironically, if litigation should ensue from misaligned asset allocations originating from skewed Risk Tolerances, the questionnaires underlying the improper allocations will be presented as proof of the client’s willingness to take risk, and used to justify aggressive and/or speculative investments.

The Prudent Expert and Risk Tolerance

For background on the Prudent Expert Standard required under the Best Interest Contract Exemption, see my previous posts here and here.

Simplistic, one-dimensional Risk Tolerance Questionnaires will not meet the Prudent Expert Standard.  Instead, the due diligence required to "know the client" is at least a two-dimensional approach to risk tolerance that encompasses both the ability and willingness to take risk.

If only one type of Risk Tolerance is identified, the advisor cannot make a Prudent Expert determination of the client’s true Risk Tolerance.  This will not meet the fiduciary standard, nor even the suitability standard.

One of the few financial writers to address the two dimensions of Risk Tolerance is Michael Kitces.  Some of his writings on risk tolerance can be found here, here, and here.  Kitces has created some very useful charts comparing Risk Tolerances that arise from the one- and two-dimensional Risk Tolerance methodologies.

Chart 1:  One- and Two-Dimensional Risk Tolerance Methodologies[1] 

Accelerant - Risk Tolerance - The Ability and Willingness to Take Risk.png

The central idea illustrated in these charts is that in the one-dimensional methodology (left pane), both the ability and willingness to take risk act as a floor to the resulting Risk Tolerance.  Conversely, in the two-dimensional Risk Tolerance methodology (right pane), both the ability and willingness to take risk act as a ceiling to the resulting Risk Tolerance. 

Unpacking One- and Two-Dimensional Risk Tolerance

In the one-dimensional Risk Tolerance methodology, both the ability and willingness to take risk increase Risk Tolerance.  Thus, if the client has either a high ability or high willingness to take risk, she will end up with an aggressive Risk Tolerance.  However, this is the perverse Risk Tolerance outcome discussed above.

Under the one-dimensional Risk Tolerance methodology, a low ability to take risk is overridden by a high willingness to take risk, at the same time a low willingness to take risk is overridden by a high ability to take risk. 

However, under the two-dimensional Risk Tolerance methodology, this cannot happen because both the ability and willingness to take risk decrease Risk Tolerance.  Thus, if the client has either a low ability or low willingness to take risk, she will end up with a conservative Risk Tolerance.

Under the two-dimensional Risk Tolerance methodology, a high ability to take risk is overridden by a low willingness to take risk, at the same time a high willingness to take risk is overridden by a low ability to take risk.

The two-dimensional Risk Tolerance methodology results in much more accurate Risk Tolerances and helps implement a financial advisor’s version of the Hippocratic Oath: help clients achieve their goals with the least amount of risk possible.



[1]       Michael Kitces; Nerd’s Eye View; Adopting a Two-Dimensional Risk Tolerance Assessment Process; January 25, 2017.  Available at:; Accessed August 1, 2017.


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Topics: risk tolerance, litigation, suitability, Due Diligence, securities litigation, Investment Policy Statement, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule, prudent expert standard

The DOL Fiduciary Rule - Investment Policy Statements

Posted by Jack Duval

Jul 26, 2017 9:07:10 AM

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This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My previous blog posts can be found here.

One of the implications of a fiduciary standard is that investment recommendations will be judged on an ex ante basis.  Ex ante is a Latin phrase common to law and economics that loosely translates to “before the event”.

This means that fiduciary recommendations must meet the Prudent Expert Standard before the recommendation is made.  While this may seem logical and obvious, it carries important implications should litigation arise from the fiduciary advice.

As discussed in my previous post, there are specific duties of due diligence that arise from the DOL Fiduciary Rule (“DOL FR”) for both the firm and the advisor.  In this post, I will focus on one aspect of diligence that should be made and documented, ex ante, in order for a fiduciary recommendation to be made: the Investment Policy Statement (“IPS”).

Investment Objective and Risk Tolerance

Industry standard broker-dealer (“BD”) new account forms have three choices of Investment Objective:[1] 

  • Income;
  • Total Return, and;
  • Growth;

and three choices of Risk Tolerance: 

  • Conservative;
  • Moderate, and;
  • Aggressive.

These traditional Investment Objective and Risk Tolerance choices are vague and generic.  They are also subject to abuse.  In my experience, most clients end up with a Total Return/Moderate or Growth/Moderate Investment Objective/Risk Tolerance.  If litigation arises, these combinations are used to justify virtually any asset allocation or investment strategy.

Furthermore, I have frequently encountered new account forms where multiple Investment Objectives and/or multiple Risk Tolerances will be selected.  This practice renders the new account form useless and the account non-supervisable.  For instance, if the Risk Tolerances: Conservative, Moderate, and Aggressive are all selected, then any type of investment will comport with them, including all cash and all equities.

Under the DOL FR, these short-hand categories will no longer be sufficient.  While they could still be used to provide a supervisor an at-a-glance summary when doing a first-level review, they are too vague and generic for the advisor to demonstrate knowledge of their client at a fiduciary level or to manage the investments appropriately.  They are insufficient for supervision as well.

The industry standard for fiduciaries is to have an Investment Policy Statement.

Investment Policy Statement

An investment policy statement is described by the CFA Institute as:[2]

A strategic guide to the planning and implementation of an investment program… 

The IPS is a highly customized document that is uniquely tailored to the preferences, attitudes, and situation of each investor.  Templates that purport to offer convenience and ease in development of an IPS almost inevitably sacrifice consideration of factors that are highly relevant to the investor.  The investment professional must thoroughly understand the investor’s objectives, restrictions, tolerances, and preferences to be able to develop a truly useful policy guide.  (Emphasis added)

An IPS is important for the successful planning, implementation, and ongoing management of investments over time.  The CFA Institute’s description of the benefits of an IPS includes:[3]

When implemented successfully, the IPS anticipates issues related to governance of the investment program, planning for appropriate asset allocation, implementing an investment program with internal and/or external managers, monitoring the results, risk management, and appropriate reporting.  The IPS also establishes accountability for the various entities that may work on behalf of an investor.  Perhaps most importantly, the IPS serves as a policy guide that can offer an objective course of action to be followed during periods of market disruption when emotional or instinctive responses might otherwise motivate less prudent actions.  (Emphasis added)

As a “highly customized document”, the IPS goes well beyond the check-the-box Investment Objective/Risk Tolerance that is frequently used today.  As an example, instead of a check-box that would allow “Speculative” investments, an IPS would define the exposure as a percentage of the portfolio, i.e. 3 percent, etc.  This policy could then be used to guide implementation, and if litigation were to arise, the investments could be evaluated for comportment with the IPS.

Although not required by the DOL, an IPS is contemplated under the DOL FR. 

The Department of Labor is well aware of the benefits of IPS’ and speaks directly to their requirement under ERISA:[4]

This interpretive bulletin sets forth the Deportment of Labor’s interpretation of sections 402, 403, and 404 of the Employee Retirement Income Security Act of 1974 (ERISA) as those sections apply to voting of proxies on securities held in employee benefit plan investment portfolios and the maintenance of and compliance with statements of investment policy

The maintenance by an employee benefit plan of a statement of investment policy designed to further the purposes of the plan and its funding policy is consistent with the fiduciary obligations set forth in ERISA § 404(a)(1)(A) and (B)...

For purposes of this document, the term “statement of investment policy” means a written statement that provides the fiduciaries who are responsible for plan investments with guidelines or general instructions concerning various types or categories of investment management decisions…

Statements of investment policy issued by a named fiduciary authorized to appoint investment managers would be part of the “documents and instruments governing the plan” within the meaning of ERISA § 404(a)(1)(D). (Emphasis added)

Without an IPS the client’s investments are untethered from predetermined guidelines, unaccountable for performance, and more subject to emotional management and behavioral biases.

It is very difficult to see how an ERISA fiduciary could meet the prudent expert standard without having an IPS.

No Safe Harbor

Importantly, a fiduciary advisor cannot craft an IPS that is inappropriate for the investor and then use that as a safe harbor from the fiduciary standard.  The DOL writes:[5]

… ERISA § 404(a)(1)(D) does not shield the investment manager from liability for imprudent actions taken in compliance with a statement of investment policy.

As I’ve discussed in previous blog posts, the Prudent Expert Standard is extremely rigorous and applies to the crafting of an IPS as well as investment recommendations and implementation.

If an IPS is defective, abusive, or inconsistent with the client’s particular facts and circumstances, goals and objectives, it will violate the fiduciary standard.



[1]       Through my securities litigation consulting work, I have seen new account forms from well over 75 different firms, including small, regional, and global BDs.  Some new account forms will also have a check box to select if “Speculative” investments are allowed.

[2]       Elements of an Investment Policy Statement for Individual Investors; CFA Institute; May 2010; 1.  Available at:; Accessed July 25, 2017.

[3]       Id.

[4]       29 CFR Ch. XXV (7.1.07 Edition); § 2509.94-2; Interpretive bulletin relating to written statement of investment policy, including proxy voting policy or guidelines; 364-6.

[5]       Id. at 366.

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Topics: litigation, Due Diligence, securities litigation, Investment Policy Statement, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule, prudent expert standard

The DOL Fiduciary Rule - Shifting the Burden of Proof

Posted by Jack Duval

Jul 7, 2017 9:13:05 AM

DOL - Accelerant Fiduciary Rule Expert.jpeg

This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My previous blog posts can be found here.

The DOL’s Regulatory Impact Analysis, states:[1]

… traditional compensation sources – such as brokerage commissions, revenue shared by mutual funds and funds’ asset managers, and mark-ups on bonds sold from their own inventory – can introduce acute conflicts of interest.

… the Department found that conflicted advice is widespread, causing serious harm to plan and IRA investors, and that disclosing conflicts alone would fail to adequately mitigate the conflicts or remedy the harm.

In order to address these conflicts and the resulting harm to investors, the DOL has introduced the DOL Fiduciary Rule (“DOL FR”) and the Best Interest Contract Exemptions (“BICE”), which I have discussed in my previous posts.

Shifting the Burden of Proof

One remarkable facet of the DOL FR is that under the BICE, if violations are alleged, the burden of proof is on the defendants.  The DOL writes:[2]

Moreover, inclusion of the standards in the exemption’s conditions adds an important additional safeguard for ERISA and IRA investors alike because the party engaging in a prohibited transaction has the burden of showing compliance with an applicable exemption, when violations are alleged.  In the Department’s view, this burden-shifting is appropriate because of the dangers posed by conflicts of interest, as reflected in the Department’s Regulatory Impact Analysis and because of the difficulties Retirement Investors have in effectively policing such violations.  (Emphasis added)

This language is reiterated by the DOL elsewhere in the BICE:[3]

Advisers and Financial Institutions bear the burden of showing compliance with the exemption and face liability for engaging in a non-exempt prohibited transaction if they fail to provide advice that is prudent or otherwise in violation of the standards.  The Department does not view this as a flaw in the exemption, as commenters suggested, but rather as a significant deterrent to violations of important conditions under an exemption that accommodates a wide variety of potentially dangerous compensation practices.  (Emphasis added)

Meeting the Burden of Proof

Shifting the burden of proof from plaintiffs to defendants will introduce a new dynamic in securities litigation and arbitrations.  In my experience, brokerage firms and their registered representatives are not prepared to meet this burden.

I have been involved in many cases where brokers will testify that it is their “business practice” to not take notes during client meetings and calls.  Furthermore, this paucity will frequently extend to their research habits.  For instance, despite making hundreds of recommendations to a client over a multi-year period, a registered representative will not produce one document that evidences any research or due diligence for any recommendation.

These practices will immediately fail under a fiduciary standard.[4]  As discussed in a previous post, under the BICE, there is an explicit requirement to undertake rigorous due diligence, document that due diligence, share the results of the due diligence with the client, and to supervise the process.

With the burden of proof residing with defendants, the documentation and supervision of the due diligence process will have high salience in any litigation.

Due Diligence and the Firm

A number of news articles have highlighted a surge in business for compliance software in the wake of the DOL FR passage.  While technological solutions can be helpful, broker-dealers and their registered representatives should not confuse them with actual due diligence.

For instance, having registered representatives cycle through a check-the-box screen before making a recommendation will be a failure if the actual due diligence has not been done.  Firm supervisors will need to insure that:

  • Rigorous and professional due diligence has been undertaken that meets the Prudent Expert Standard;
  • A fiduciary-quality conclusion has been reached, and;
  • Evidence of the entire process has been archived.

Failure to undertake any of these steps will likely result in liability, should a violation be alleged.

Due Diligence and the Registered Representative

Under the fiduciary standard, the client has reposed trust and confidence in their registered representative to look after their interests.  This means the registered representative is charged with carrying out the fiduciary obligations to the client.  These obligations cannot be outsourced.

One of the primary obligations is that of due diligence into investments before a recommendation is made.  Independent due diligence by registered representatives is required to meet the fiduciary standard.  This does not mean that third party resources cannot be used, however, they cannot be the primary means of due diligence.

Conflicted sources of research should be discounted heavily, if not ignored.  Traditionally, one of the most conflicted sources of research has been the brokerage firms at which registered representatives work.  If a brokerage firm is offering a product and will earn a commission from its sale, then the firm is conflicted and its research should be viewed with great skepticism.

Indeed, the offering itself should be viewed with great skepticism by the firm’s own registered representatives.[5]

As will be discussed in greater detail in subsequent blog posts, independent research requires a great deal of work, including: close reading of offering documents, talking with issuers, modeling assumptions, and comparing offering risk, reward, and pricing, to other similar options.



[1]       Department of Labor; Fiduciary Investment Advice: Regulatory Impact Analysis; April 14, 2015; 9.

[2]       Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21033.  Also see: Fish v. GreatBanc Trust Company; No. 12-3330; (7th Cir. 2014); at 27.  Under ERISA, the burden of proof is on a defendant to show that a transaction that is otherwise prohibited under § 1106 qualifies for an exemption under § 1108.

[3]       Id. at 21060.

[4]       Indeed, they frequently fail under a suitability standard.

[5]       All offerings that involve commissions should be viewed with great skepticism by both firms and their registered representatives.

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Topics: litigation, Due Diligence, securities litigation, fiduciary obligations, erisa fiduciary expert, dol fiduciary rule, prudent expert standard, burden of proof

Litigation Costs May Sink Deutsche Bank Contingent Convertible Bonds

Posted by Jack Duval

Feb 9, 2016 7:48:07 AM

Guest Post by Len Santoro

Last year, European banks issued a record amount of a new type of high-risk bond meant to bolster each respective bank's Tier I capital in times of stress.  This year Deutsche Bank, which has been suffering through a lengthy restructuring and extreme litigation and settlement costs, may have to tap these bonds - wiping investors out.[1]

Deutsche Bank 6% Perpetual Contingent Convertible Bond Price Chart (Bloomberg)


These new bonds are called Contingent Convertible’s (“CoCo’s”).  They are a pre-funded source of capital meant to insure that the issuing bank maintains its Tier 1 Capital ratio if its other assets decline in value.

If a bank's assets suffer a catastrophic decline in value, the CoCo's are triggered and the capital gets transferred to the bank's balance sheet when it needs it the most, without having to go through a protracted and costly capital raise.

CoCo's can be considered a form of insurance-linked securities ("ILS") that insure against financial catastrophies (see our previous posts on ILS here and here).  CoCo's offer high yields, are highly complex, and can turn into equity or be written down to zero by the issuing banks at their discretion.

The creation and issuance of CoCo bonds goes back to the financial crisis of 2008-2009 which saw bank balance sheets destroyed by bad bets on sub-prime mortgages.  The international banking community, working through the Basel accords has been required to bolster its Tier 1 Capital.  CoCo bonds provide a buffer to an issuing bank's Tier 1 Capital.  Just like a catastrophe bond, if the issuing bank takes large losses to it's capital base, the CoCo bond gets written down for its owners and the assets are transfered to the issuer's balance sheet.

In this way, it can be thought of as insurance for the banks Tier 1 Capital ratio.

Tier 1 Capital

Tier 1 capital is comprised of common stock, retained earnings, some types of preferred stock, and certain hybrid securities such as trust preferred securities and now, CoCo’s.  It is used in the computation of a banks leverage ratio.  This ratio is calculated by dividing Tier 1 capital by total assets.

Since the global financial crisis, regulators have been working with banks to raise their Tier I capital (and thus lower their leverage).

Contingent Convertible as Tier I Capital

To qualify as Tier 1 capital, CoCo’s must meet a number of criteria, some of which include them being:

  • Unsecured;
  • Subordinated;
  • Not convertible at the holders option;
  • Having interest deferability where the profitability of the bank would not support payment.

Essentially, a CoCo is constructed to absorb losses when the bank's capital drops below certain regulatory levels.  Exactly how losses are absorbed varies by security and structure.

At issuance, CoCo’s are non-dilutive, debt servicing is subsidized by tax deductions, and, unlike traditional convertible securities, the issue is converted at the issuers discretion.  CoCo’s frequently do not have a maturity date and are typically callable every five years.  The other two key characteristics are the "trigger point" and the "lost absorption mechanism".

The Trigger Point

The trigger is the event that changes these securities from being contingent to certain.  Like ILS, CoCo triggers are very specific and are defined in the prospectus.  In practice, the trigger point is where the CoCo is partially or totally written down, or converted to stock.

Triggers can be formula- or regulatory-based and there are unique risks associated with each.  Formula-based triggers can be based on book or market value.  Book value triggers are less transparent and less timely.

Market value formula triggers have the advantage of being timely and transparent, however, they are subject to market pressures.

It's hard to imagine a situation where a trigger executed based on a regulator's decision would be preferred by the bondholder.

The Loss Absorption Mechanism

Loss absorption is simply the method through which management takes the bondholders investment.

There are two main methodologies for implementing this transfer of wealth.  One is through equity conversion and the other is through an outright principal write down of the bondholder's  investment.  Historically the loss absorption method has been evenly split between the two methods.

Equity Conversion

On the surface, equity conversion appears to be a preferential method for bondholders.  Having equity gives the bondholder some upside potential.  In addition, since equity conversion is dilutive, one can assume that management will be less motivated to implement the trigger.

However, the second part of the equity conversion method is the conversion price.  Depending on the issue, the conversion could be the market price at the time the trigger is breached or some other predetermined price.  Since a market price conversion would be dilutive, that is the most favorable to the CoCo investor.  A predetermined price conversion is less dilutive, and thus less attractive for bond investors.


Some CoCo's give the issuer the ability to write-down the bonds to zero if certain triggers are met.  In this way, they are similar to Catastrophe Bonds that have been issued by reinsurers to protect issuers against severe weather events. 

The principal write-down security is most attractive to the issuer since it is not dilutive to current shareholders.  As with most bonds, what is favored by the issuer should be avoided by the bond investor.  The danger of buying a principal write down CoCo with a "high " trigger is that the company can obtain cheap capital when the bank is still well above insolvency, all at the bondholder’s expense.

As a general rule, market price equity conversion with low triggers is most attractive while principal write-down with high triggers are the least.  As with all fixed income investments, the bondholder must recognize that they and management are adversaries.

If a Coco bond write down is executed at a relatively high trigger point, it could be a windfall for the stockholders.  In such a case, there would be a transfer of wealth from the bondholders to the stock holders when the bank is still far from insolvency.


CoCo’s have high complexity risk and are suitable only for the most sophisticated investors who are capable of understanding and evaluating their risks.  To fully evaluate the risks of a CoCo bond, an investor (or advisor) would need to understand at least the following factors:

  • Bank capital requirements and potential changes to those requirements;
  • The effect of the investment on an overall portfolio
  • Currency risks
  • The terms and provisions of the security
  • How economic and interest changes might affect the security

In the Deutsche Bank deal mentioned above, the prospectus states:[4]

The Notes may not be a suitable investment for all investors.  Potential investors must determine the suitability (either alone or with the help of a financial adviser) of an investment in the Notes in light of their own circumstances.  In particular, each potential investor should:
  • have sufficient knowledge and experience to make a meaningful evaluation of the Notes, the merits and risks of investing in the Notes...
  • have access to, and knowledge of, appropriate analytic tools to evaluate, in the context of his/her particular financial situation, an investment in the notes...
  • have sufficient financial resources and liquidity to bear all of the risks of an investment in the Notes, including the risk not to receive any return on investment or repayment of the invested amount...
  • understand thoroughly the terms of the Notes and be familiar with the behavior of the financial markets; and
  • be able to evaluate possible scenarios for econmic, interest rate and other factors that may affect his/her investment and his/her ability to bear the applicable risks.

Clearly, CoCo's are only appropriace for the most sophisticated market participants.  Furthermore, Deutsche Bank also attached a minimum lot size of the issue of $200,000, which demonstrates that it was not targeted for retail investors.[5]  (Most corporate bonds have $1,000 minimum lot sizes.)

In the current low interest rate environment, the mid-single digit percent yield on most CoCo’s is attractive[6].  However, chasing yield in CoCo bonds could end badly, especially for investors who did not understand what they were sold.

CoCo’s are only appropriate for investors who are comfortable speculating with their investments and who are prepared to see their CoCo investment wiped out if the bank issuers comes under stress.  As with all ILS, CoCo bonds should only be purchased in diversified pools and only represent a small portion of an investor’s diversified bond portfolio.



[1]      John Glover, "Deutsche Bank's Woes Threaten CoCo Coupons, CreditSights Says", Bloomberg.  Available at:; Accessed Tuesday, February 9, 2016.  For general background on CoCos, see:  John Glover, “Riskiest Bank Bond Sales Swell to Record in Europe”, Bloomberg, (October 1, 2014)

[2]           FDIC, “Optional Regulatory Capital Worksheet”,

[3]           Deutsche Bank Research, “Contingent Convertibles: Bank Bonds Take on a New Look”, May 23,2011,

[4]           Deutsche Bank 6% Perpetual Contingent Convertible prospectus, 8.

[5]        . at 5.

[6]           These yields are approximately three to four full percentage points over senior bank note bonds.

 For information about insurance-linked securities expert Jack Duval, click here.


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Topics: litigation, suitability, Deutsche Bank, Complexity Risk, Contingent Convertible Bond, ILS, insurance-linked securities, CoCo

Market Efficiency and Its Role in Securities Litigation

Posted by Jack Duval

Sep 30, 2014 4:47:00 PM


Establishing whether or not the market for a security is efficient is critical in securities class action lawsuits. If a security trades in an efficient market, then its market price factors in all material information,  the price will rise with good news and fall with bad news.  In this way, news is transferred through price.

When investors evaluate a security, the current price is central to their analysis.  (If they believe the security is undervalued at the current price, they will purchase it, or if they own it and believe it is overvalued, they will sell it.) If the market for the security is efficient, its price reflects all the existing information about the company, and thus investors who are evaluating the security are implicitly incorporating all the existing information about the company into their decisions.

Therefore, if there is an omission or misstatement of material information, there is a clear link between it and any consequent damages because the omission or misstatement would have been incorporated into the security price through the efficient market.

Consequently, if a security trades in an efficient market, then plaintiffs can use a fraud-on-the-market theory to file a class action that includes the pool of all investors who traded in the security. In short, an efficiently traded security allows each stockholder to show reliance on a material misstatement or omission without having to show that he or she actually read or heard the material misstatement or omission first hand.

Obviously, this standard greatly increases class pool eligibility.

Defendants, at both the class certification and merits stages, often attempt to show that an investment trades in an inefficient market. If a security price doesn’t react to new material information in the first place, then how can an omission or misstatement of material information be a cause of damages to investors who relied on the price?

Eugene Fama - Market efficency and efficient markets

Photo: Eugene Fama, grandfather of efficient markets

Defining Market Efficiency

The efficient market hypothesis (“EMH”) was developed by Professor Eugene Fama during his Ph.D. thesis in the early 1960s at the University of Chicago Booth School of Business. This work, which Fama continued to develop over his career, led to his sharing the Nobel Prize in Economics in 2013. The Nobel Committee cited Fama’s seminal work in their award, noting:

Fama demonstrated that stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately, which means that the market is efficient.[1]

As with all great theories, the idea that markets adjust to new information now seems self-evident.  Indeed, it is a cliché  that the markets are a “discounting mechanism”. 

Fama argued that markets can be efficient at three levels:[2]

  1. Weak-form efficiency – Implies that current prices reflect all market information inherent in past prices and assumes that past rates of return have no effect on future rates;
  2. Semi-strong form efficiency – Implies current prices reflect all information in past prices and all “publicly” available information (including financial statements and news reports);
  3. Strong form efficiency – The current price reflects all information, public and private.

Although economists make distinctions of different forms of market efficiency, the courts have not seemed to focus on them. Instead, they have appeared to generally accept the idea of market efficiency and have been interested in whether or not a particular security can be said to have an efficient market. Establishing the extent of information efficiency, as we will explore below, is critical in making fraud-on-the-market class action claims. 

Legal Precedence – Basic v. Levinson (1988)

In 1988 the Supreme Court ruled on Basic v. Levinson which give life to the fraud-on-the-market theory.[3]

The fact pattern of Basic was simple: the President of Basic, Inc. denied publicly that his company was involved in any merger discussions, and then the next day approved a tender offer from another company. Plaintiff Max L. Levinson, a Basic shareholder, brought a class action suit against Basic alleging that he and other shareholders were damaged by selling Basic shares at artificially depressed prices.

The case went to the Supreme Court, where the Court ruled in favor of the plaintiff, and also adopted a rebuttable presumption of reliance based on the fraud-on-the-market theory.  Specifically, the plurality noted that:[4]

The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business... Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.

From Basic to Present Day

The interpretation of Basic has been tested many times since 1988, with the economic underpinnings of efficient market theory driving most of the debate. Almost a year after Basic a lower court developed a list of factors that could be checked to determine whether the market for a security demonstrated some elements of being efficient.  This case was known as Cammer v. Bloom and in their decision the Court identified five elements of market efficiency:[5]

  1. Eligibility to file an SEC Form S-3;[6]
  2. Average weekly trading volume;
  3. Analyst coverage;
  4. Existence of market makers and arbitrageurs;
  5. Price reaction to company-specific information;

The Court in Unger v. Amedisys expanded upon Cammer and listed eight factors that determine market efficiency. The first five were identical, but the Court added the following three: [7]

  1. Market capitalization;
  2. Bid-ask spread for stock sales, and;
  3. Float.

The fifth factor in Cammer, whether or not the price of a security responds to company-specific news, has emerged by consensus to be the most important.  The extent to which a security price moves when material news is released can be statistically measured.  This exercise is known as an “event study”. Typically, event studies are prepared by experts on both sides of a class action.

Halliburton v. Erica P. John Fund 

Basic recently faced one of its strongest attacks in the Supreme Court’s Halliburton v. Erica P. John Fund decision. Originally brought to lower courts back in 2002, Halliburton shareholders led by Erica P. John Fund sued the company over understating its asbestos liabilities while overstating revenues in its engineering and construction business and the benefits of its merger with Dresser Industries. Halliburton sought Supreme Court review after losing in lower courts.

While declining to overturn Basic, the Court’s 9-0 decision issued on June 23, 2014 did give defendants another tool to work with in their efforts to push back during the class certification stage of a trial. Defendants can now rebut plaintiff presumption of reliance by showing direct evidence “that the alleged misrepresentation did not actually affect the stock’s price and, consequently, that the Basic presumption does not apply.”[8]

This new ruling should serve to increase the importance of event studies and price impact studies during the earlier stages of litigation.  

Get Updates on Market Efficiency  and Event Studies



[1]                 Eugene F. Fama – Facts. Nobel Media AB 2014. Available at; Accessed September 26, 2014.

[2]                 Wikipedia, s.v. “Efficient-market hypothesis”; Available at; Accessed September 24, 2104.

[3]                 Basic Inc. v. Levinson, 485 U.S. 224 (1988)

[4]                 Basic Inc. v. Lensions, 485 U.S. 224 (1988).

[5]                 Rose Cammer, et al., Plaintiffs v. Bruce M. BLOOM, et al., Defendants (1989).

[6]                 S-3 Filing is an indicator of efficiency because the original intention of this filing by the SEC was to be an abbreviated filing for companies that met certain criteria. SEC Securities Act Release No. 6331, 46 Fed. Reg. 41,902 (Aug. 13, 1981) establishes the criteria for a Form S-3 filing in conjunction with an equity offering.  They include the following: a company must have been filing reports under the Exchange Act for the last 3 years; and, either have outstanding $150 million of voting stock held by non-affiliates or $100 million of stock outstanding with an annual trading volume of three million shares per year.

Companies eligible for filing an S-3 were eligible because they were deemed to trade in an efficient market by the SEC, so Courts still use this as a factor. 

[7]                 On Petition for a Writ of Certiorari to the United States Court of Appeals for the Fifth Circuit, Halliburton v. Erica P. John Fund.



The Accelerant market efficiency and event study expert is Steve Pomerantz.

You can find our complete roster of securities experts here.




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Topics: litigation, class action, Event Study, Market Efficiency

Accelerant Publishes Puerto Rico Municipal Bond Crisis White Paper

Posted by Jack Duval

Feb 7, 2014 7:20:30 AM

This post continues our expert coverage of the Puerto Rico municipal bond crisis.

Accelerant is pleased to announce the publishing of a new white paper entitled:  "The Puerto Rico Municipal Bond Crisis:  What took you so long?"  The paper is co-authored by analyst Jay Dulski, fixed income expert Gerry Guild, and CEO Jack Duval, and can be accessed here.

Paper sections include:

  • The Puerto Rico Economy from 2006 to 2013
  • Understinding Puerto Rico Municipal Bonds
  • Municipal Bond Funds
  • The Effect of Combining Internal Fund and Account Leverage: 1 + 1  = 4
  • Appendicies of Tax Tables, Historical Bond Ratings, and Credit Ratings Scales
  • Links to News Articles and Data Sources



For information about Accelerant municipal bond and closed-end fund experts, click here.

 Get Updates on the Puerto Rico Municipal Bond Crisis


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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, litigation, white paper, investments, securities litigation

S & P Puerto Rico Credit Ratings Downgrade Call Notes

Posted by Jack Duval

Feb 5, 2014 1:19:04 PM

This post continues our expert coverage of the Puerto Rico municipal bond crisis.

Accelerant analyst Jay Dulski has summarized the Standard and Poor's conference call announcing the downgrade of Puerto Rico debt ratings.

On February 4, 2014 Standard and Poor’s made the following downgrades:

  • GOs downgraded to BB+ from BBB-
  • Commonwealth appropriation secured debt downgraded to BB
  • Employee Retirement System (“ERS”) debt downgraded to BB
  • Highways and Transportation Authority (“HTA”) bonds downgraded to BB+
  • GDB long-term issuer rating downgraded to BB from BBB-
  • GDB short-term issuer rating downgraded to B from A-3

Ratings of Puerto Rico Sales Tax Finance Corporation (“COFINA”) bonds remain unchanged.  All ratings except COFINA are on a negative CreditWatch, however COFINA has a negative outlook.

See the February 4, 2014 S&P releases below:

Puerto Rico GO Rating Lowered to 'BB+'; Remains on Watch Negative

Research Update: Government Development Bank for Puerto Rico Downgraded to 'BB/B' from 'BBB-/A-3'; Ratings Remain on CreditWatch Negative

On January 28, 2014, in hindsight quite a coincidence, S&P Dow Jones Indices announced their February 2014 rebalancing of the S&P National AMT-Free Municipal Bond Index.  Citing a methodology change, all U.S. territories were removed from the index, which had contained extensive Puerto Rico holdings.  The change took effect after the close of business on Friday, January 31, 2014.  The full index announcement may be found below.

February Rebalancing Results for S&P National AMT-Free Municipal Bond Index Announced by S&P Dow Jones Indices

 At 4:00pm EST on February 4, 2014, S&P hosted a webcast regarding the downgrades.  The following notes are highlights, and a link to the full webcast may be found below.           

Rating Actions on the Commonwealth of Puerto Rico and the Government Development Bank

Webcast: Ratings Actions on the Commonwealth of Puerto Rico and the Government Development Bank

February 4, 2014

Speakers included but were not limited to:

  • Horacio Aldrete-Sanchez, Managing Director, Finance Ratings Standard & Poor’s Ratings Services
  • David Hitchcock, Senior Director, Public Finance Ratings Standard & Poor’s Ratings Services
  • Sunsierre Newsome, Associate Director, Financial Institutions Ratings Standard & Poor’s Ratings Services


-The downgrade reflects the GDB’s ability to provide near term liquidity to the Commonwealth

-The GDB is also on CreditWatch, which S&P expects to be addressed after the downgrade

-S&P expects the downgrade to cost Puerto Rico $940 million in debt accelerations and swap collateral postings

-In any future decisions, S&P will examine the recapitalization of the GDB, which may include a bond sale

-The GDB downgrades reflect S&P’s opinion that the liquidity position has weakened and the deterioration of the Commonwealth’s creditworthiness has hurt GDB’s business position and heightened the risk of their heavy loan portfolio concentration

-Since the GDB may not borrow from the central bank, the ratings reflect S&P’s opinion that the GDB cannot fund the Commonwealth’s liquidity without accessing the markets

-S&P expects that the GDB or the Commonwealth will seek to access the market in the near future

-A $1 billion debt placement by the GDB or the Commonwealth would be viewed as a stabilizing factor by S&P

-The funding and liquidity of the GDB “is not in line with an investment grade rating”

-The ratings also reflect that the GDB operates within a single market and is exposed to significant concentration risk

-S&P views the health of the Commonwealth as important to the GDB and recognizes that the two are closely tied

-The deterioration in the health of the Commonwealth’s financial situation may negatively affect payments for the GDB due to asset concentration in government affiliated entities

-The GDB’s deposits are down while loans up, posting a very high 160% loan to deposit ratio

-Asset quality at the GDB has deteriorated with a significant rise in non-performing assets (“NPAs”)

Question and Answer Session

If Puerto Rico cannot fix their cash flows, how far down would the rating go?

-The credit rating does assume that they will be able to raise additional funding by the end of February

-The CreditWatch reflects the risks that they may not raise significant additional capital

-S&P will continue to evaluate the situation

-For now, at BB+ S&P believes they have adequate liquidity, but they will need to raise additional capital between now and the end of the fiscal year

Regarding the status of rum bonds

-Rum bonds (based on excise taxes) and HTA bonds were taken down to the same rating as GOs because of Article 6 of the Puerto Rican Constitution, which grants priority payment to the GOs 

-This diversion to GOs makes the ratings equal, even though their natural ratings may be higher than the GOs

Regarding the impact on COFINAs

-No rating action was taken on COFINAs

-The outlook was changed to a negative outlook a few months ago to reflect economic weakness

-S&P has legal opinions that the GO diversion does not affect COFINA, as it is simply a gross revenue pledge, so no rating action has been taken on COFINA

-COFINA is not currently under review unless there is new information, but nothing is currently pending

Would a yield above 10% represent a lack of market access?

-Market access is an important component of liquidity evaluations

-The question is whether Puerto Rico will be able to bridge the period to budget balance

-Puerto Rico recently announced a balanced budget for FY 2015, which would be the first time in many years

-Such a development could represent some credit improvement

-For now S&P believes that in the near term there are significant liquidity and implementation risks

Regarding the effect on bond insurers

-The rating action does not affect either Assured or National Public Finance (“NPF”) with respect to capital adequacy or financial strength ratings

-S&P believes their capital and liquidity are strong and can absorb higher theoretical losses

-Assured and NPF Each have $5 billion of exposure to various Puerto Rico outstanding obligations

What impact will the Commonwealth’s liquidity issues have on the island’s local banks?

-Depending on legislation, there may be a transfer of public deposits from local banks to the GDB

-S&P does not expect any material effect on banks, since they will still have private deposits and broker deposits

Since a bond offering is expected, why downgrade ahead of GDB?

-S&P will keep the BB+ rating even in the event of a sizeable bond issue in the near term

-S&P had the information and wanted to share it with market

-Again, the bond issue could resolve the CreditWatch, but also could demonstrate some market access risks

-Again, without market access, the rating could be below BB+

-The bond issue will not change the rating, but may resolve CreditWatch

-S&P had expected an issuance in the fall which did not happen, and thus believes that access has been constrained

What is the next step, what can the government do, how long will it take?

-S&P is not prescriptive, only an observer, and has made no suggestions as to what to do

-S&P is rigidly bound by their published criteria
-Short term resolution of liquidity issues could take Puerto Rico off CreditWatch, and if the attempt to balance the budget overcomes implementation risks, that could improve the credit rating

-There have been very significant budget and pension reforms by the Padilla administration, but there other credit factors outside of executive management, such as macroeconomic and market access headwinds

What extent does the coupon level or size of the deal affect CreditWatch status?  What’s affordable for the Commonwealth?

-S&P will have to look at the impact on the general fund

-There have been significant deficit cutting efforts and there are prospects for more, which represent long term positive credit factors

Any additional details about the GDB’s asset quality?

-High concentration to the Commonwealth

-NPAs have more than doubled over last few years

-Entities that are non-performing are government related entities that have been struggling

-NPAs ~3% in 2011, FY 2012 at more than 6%

Will the GDB have enough liquidity?

-S&P believes that the GDB will have a limited ability to fund liquidity needs for the government in coming quarters

-But again, failure to access markets in coming quarters would be “very difficult”

-The first concern is concentration in the Commonwealth and government entities

-To be clear, S&P views the GDB as well capitalized, but very concentrated

-S&P is not saying the GDB has problems of big losses, but rather is noting the GDB’s concentration in incrementally deteriorating entities

Comment on the 1-notch difference between GOs and the GDB

-S&P applies government related entity criteria in addition to the stand alone profile of the GDB

-S&P does not feel that Puerto Rico has significant liquidity except through the GDB at this point

Does  the current rating assume the teachers’ pension reform will stick?

-The current rating does assume that the teachers’ pension reform, currently in court, will stick

-S&P believes that the issues are very similar to the ERS reforms which the court upheld

-Also, reforms do not go into effect until the beginning of 2015, but a court decision is expected within a few weeks

-If it is ruled invalid S&P expects legislative tinkering, but the rating incorporates an expectation that it will be upheld

What would have to happen to be concerned about bond insurers?

-Last week S&P published a commentary with a stress scenario if Puerto Rico obligations go to single B, and in that scenario both Assured and NPF maintained capital adequacy cushions well above the requirements for their current ratings

-Since we did not get there today, S&P is very comfortable with their ratings and their liquidity positions.

Bond Insurers’ Capital Adequacy is Sufficient to Handle Potential Credit Deterioration in Puerto Rico

What impact will this have on Puerto Rico local banks? [second time this was asked]

-OFG Bancorp (Oriental Bank and Trust) is on CreditWatch with a negative outlook

-Have not stated a resolution timeframe, but did say that S&P could lower the rating on OFG if:

they expect loan performance to weaken materially;

capital is no longer viewed as strong;

the rating on the Commonwealth is lowered;

-No more than a 1-notch downgrade at the bank and a 2-notch downgrade at the holding company are expected

-Other banks’ outlooks include:

Firstbank of Puerto Rico (negative outlook)

Banco Santander Puerto Rico (negative outlook)

Doral Bank (negative outlook)

Banco Popular (stable outlook)

What economic growth forecast are we expecting in the rating?

-S&P does not make an independent forecast but does look at others

-The outlook is for economic weakness, and forecasts are not anticipating any major growth

-The Puerto Rico planning board will issue a new forecast for next fiscal year shortly

-S&P expects to see more of the same

-S&P does feel that the government is taking steps to grow business, including finding native substitutes for agricultural imports

-Problems remain, really since 2006 and the Section 936 phase out, and the economic environment is “very difficult”

 Are any resources available from the U.S. federal government for liquidity?

-S&P does not expect support from the federal government

-The current rating does not include any expectation of a federal bailout


For information about Accelerant municipal bond experts, click here.

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, litigation, investments, securities litigation

Puerto Rico Debt Crisis Conference Notes

Posted by Jack Duval

Jan 24, 2014 10:20:50 AM

This post continues our expert coverage of the Puerto Rico municipal bond crisis.

On January 15, 2014, Jay Dulski (Analyst) and Gerry Guild (Senior Consultant), co-authors of our forthcoming Puerto Rico whitepaper, attended a conference on Puerto Rico municipal debt organized by the Global Interdependence Center and hosted at the New York Athletic Club in New York City.  Below are some of the highlights.  The conference was very informative and included many esteemed speakers from within the municipal bond industry, and covered many topics including economic, market, and political trends.

For complete video of the conference and viewable presentations of the speakers, please visit the GIC’s website:


Tom Tzitzouris, Vice President and Fixed Income Strategist, Strategas Research Partners

  •        Puerto Rico burst onto everyone’s radar largely due to the Detroit bankruptcy and the Chicago downgrade
  •        The US Federal Reserve’s actions are causing the spreads to diverge between US and PR bonds
  •        Puerto Rico is large enough to be disruptive to the US and global recoveries
  •        Since the danger of 3Q2013 has passed, Puerto Rico still matters but the risk of a catastrophe has decreased
  •        Just as the EU benefitted from quarantining and delaying the Greek default scenario, so may the US benefit from delaying and quarantining Puerto Rico’s problems

o   Notably the resulting austerity has been very painful for the Greeks themselves and their bondholders, but isolated from the rest of the EU


Donald Rissmiller, Founding Partner of Strategas Research Partners

  •        As we discuss in our forthcoming paper, Puerto Rico is suffering from a dismal Labor Force Participation Rate of near 40%
  •        The problem with the LFPR is that it is very sticky, meaning it takes a long time to go down and a long time to go up, and there are relatively few policy tools which are able to influence it

o   A low LFPR means fewer workers paying taxes and more dependents

  •        PR revenue collections are up so far for FY 2014, and the emergency climate has calmed since 3Q2013
  •        Other demographic issues confronting Puerto Rico include population loss and high crime.  High public debt and high crime rates tend to be correlated, and represent a terrible combination for a country.

o   “Puerto Ricans Flock North Away from Battered Economy,” Campo-Flores, Arian, WSJ 1/6/14

o   “Plagued by Violence, Bad Economy, Puerto Rico Rings in 2014 with a Bang; 13 murders in 5 days,” O’Reilly, Andrew, FoxNEWS Latino, 1/8/14


Natalie Cohen, Managing Director and Head of Municipal Research, Wells Fargo

  •        Puerto Rican pension reform is continuing, and meeting strong resistance

o   The reforms regarding the PRGERS pension fund (government employees) were upheld in a 5-4 split decision by the PR Supreme Court

o   Reforms passed in December 2013 regarding the PRTRS pension fund (teachers) are currently in court, halted temporarily by a January 15, 2014 decision amidst a two day strike organized by the teachers union.  Governor Padilla called the decision “dangerous.”  Reuters.

o   A separate legal challenge has been filed regarding the PRJRS pension fund (Judiciary

  •        A complicating factor is that PRGERS members contribute to US Social Security, whereas the other systems do not
  •        Ms. Cohen discussed that the pension funds count member loans and balance sheet receivables, and they are not true earning assets.  This potentially overstates the strength of the balance sheets.

o   PRGERS outstanding member loans: $760 mil (June 2013)

o   PRTRS outstanding member loans: $411 mil (June 2013)


Jospeh Engelhard, Senior Vice President, Capital Alpha Partners

  •        US can help PR by reforming rum tax, and granting tax credits to US companies for PR excise taxes
  •        In 2012, US provided approximately 21% of PR economy



  •        Rissmiller: Underground economy in PR is significant, maybe $14 billion
  •        Engelhard: “Section 936 is never coming back.”
  •        Engelhard regarding the Jones Act (following a question asked by Jay Dulski)
    • Always on PR’s wish list, but absent a crisis change is highly unlikely at this point


Joseph Mysak, Editor of "Municipal Market"

  •        70% of mutual funds own PR debt due to the triple tax exemption
  •        of 565 open end funds tracked by Morningstar, 395 are exposed to PR
  •        Noted the change in the investor profile in the last decade or so due to dilution
  •        No longer is it “mom and pop” losing their retirement, but rather large institutional investors with huge pools of cash
  •        According to Morningstar, most prospectuses limit the purchase of junk bonds, but not holdings of junk bonds if they are downgraded later.  Accordingly, market reaction to a downgrade may be muted
    • 7 and 8 rate handles are probably accurately reflecting market risk


John Mousseau, Executive Vice President and the Director of Fixed Income at Cumberland Advisors

  •        Refer to John’s presentation for some very informative market charts
  •        We may see see some kind of taxable PR debt deal floated to expand buyer universe
  •        Headline risk is likely contributing to overreaction


Robert Kurtter, Managing Director for U.S. State and Regional Ratings, Moody's Investors Service

  •        Green shoots in PR economy, but still negative trends, especially weaking manufacturing and population loss/brain drain
  •        Noted the potential problem of “Scoop and Toss,” using new issues to pay old ones and throw them deeper into the capital structure
  •        Noted that the PRGERS is a closed system now, but still has to get through a very difficult 20 years under significant operating pressures
  •        Referred to Puerto Rico as a “much more third world kind of economy” than is usually associated with a US territory
  •        An interesting note regarding the constitutional protections on interest payments in Puerto Rico:
    • COFINA (revenue) bonds have not been tested in court as to whether they are exempt from the constitutional 1st lien obligation
  •        Unlike EU countries, PR is not subject to huge rollover risks, however its finances are much narrower and more constrained


David Hitchcock, Senior Director in Standard and Poor’s State Group

  •        Manufacturing in PR is about 40% GDP but only 9% of employment
  •        Stated that real progress is being made in PR, but obviously they are not out of the woods yet, thus the BBB- rating as of March 2013
  •        Liquidity concerns are not immediate due to actions by GDB (PR Development Bank)
  •        Water authority is now self-supporting through rate increases
  •        General Obligation claw back provisions do not apply to PREPA or PRASA (utility bonds)

For information about Accelerant municipal bond experts, click here.

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Topics: municipal bond crisis, closed-end funds, Puerto Rico, UBS, litigation, investments, securities litigation

Puerto Rico Municipal Bond Crisis - Adverse Tax and Trade Policies

Posted by Jack Duval

Nov 19, 2013 4:17:06 AM

Our expert analysis of the Puerto Rico municipal bond crisis continues with an examination of tax and trade policies that have negatively affected the island economy.  In particular, the timing of the expiration of Section 936 coincided with the start of the 2006 recession.

The Puerto Rico economy has been adversely affected by a number of changes in tax and trade policy.  Repealed by President Clinton in 1996 with a ten year phase out, Section 936 of the Federal Tax Code expired in 2006, helping to thrust the island economy into its long-run recession.  Section 936 was a tax incentive for U.S. companies to manufacture in Puerto Rico, allowing the repatriation of profits to the mainland U.S. without paying federal tax.  The pharmaceutical industry was a large beneficiary of this tax break and was a major driver of employment on the island.  According to a 2002 article published by the Pharmaceutical Industry Association of Puerto Rico, the pharmaceutical sector was responsible for 56% of total manufacturing jobs and 20% of total industrial jobs on the island.  The article states that although the pharmaceutical industry was able to largely maintain its tax advantages as an existing industry on the island, the expiry of the exemption was a significant disincentive for new industries to move to Puerto Rico.  27,373 industrial jobs were lost from October 1996 to September 2002.[1]  Additionally, included below is a reference table of historical Puerto Rican tax rates.

[1]                 Maldonado, A. W., “The Loss of 936: Good or Bad for Puerto Rico?” The Pharmaceutical Industry Association of Puerto Rico, November 17, 2002


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Topics: fixed income experts, Puerto Rico Municipal Bond Crisis, UBS, closed-end bond funds, litigation, investments, fixed income

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