Speech by SEC Commissioner:
Regulation of the Municipal Securities Market:
Investors Are Not Second-Class Citizens
[Version as Delivered]1
Commissioner Elisse B. Walter
U.S. Securities and Exchange Commission
10th Annual A. A. Sommer, Jr. Corporate, Securities, and Financial Law Lecture
New York, New York
October 28, 2009
Thank you, Ben, for that lovely introduction. And thank you also, Dean Treanor, for inviting me. I am delighted to be here at Fordham University, with the members of your Law School community, alumni, honored guests, and the many friends I see here tonight.
It is an honor to have been asked to give the Tenth Annual A. A. Sommer, Jr. Lecture on Corporate, Securities, and Financial Law, particularly since I was unable to join you for the Ninth. As you know, Al Sommer made extraordinary contributions to the federal securities laws. In his many different roles in public service, he set a sterling example for all public servants.
I had the distinct pleasure of working with Al when I was with NASD. To sum up that experience, I would simply say that the reality of Al lived up to his illustrious reputation, but with a warmth and sense of humor that the reputation could not duplicate. I like to flatter myself by thinking that, in some small way, I can walk in Al’s footsteps.
While working with Al, I also got the opportunity to get to know his wife Starr. She is an extraordinary woman, and I am extremely pleased that she and their daughter and son-in-law are with us this evening.
Before I get too much further, let me remind you that the following remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or members of the staff.2 I would also like to let you know that in the interest of time, and your continued friendship, my remarks tonight will be shorter than the version of the speech that will be posted on the SEC’s Website.
Tonight, I would like to talk about another topic that was important to Al — the municipal securities market. It is quite fitting that I address this topic here in New York because, as I am sure many of you are aware, the New York City fiscal crisis in 1975 was one of the major catalysts for change in municipal disclosure practices. And, for me, it is a return to a subject near and dear to my heart; the last major project I worked on before leaving the Commission staff in 1994 was municipal disclosure.
The recent financial crisis has revealed many gaps and weaknesses in the existing regulatory framework and has led to calls for, among other things, a systemic regulator, regulation of hedge funds, and regulation of over-the-counter derivatives. This push for regulatory reform is certainly understandable. As Al rightly noted more than 30 years ago, “Most reform in society seems to come about as the consequence of crisis or a catastrophe or a dramatic event which points up the existence of a problem.” Or, as Rahm Emanuel more recently, and more colorfully, put it, “Never let a serious crisis go to waste.”
What is far less understandable, however, is the relative lack of attention being given to the municipal securities market. SEC Chairmen ranging from David Ruder and Arthur Levitt to Christopher Cox and Mary Schapiro have advocated taking a hard look at this area. But this topic has not received serious consideration in recent regulatory reform discussions. And yet, this market is enormous and operates with increasing participation by retail investors. Municipal securities are securitized, and both large and small municipalities use complex structured products and financial derivatives whose risks even sophisticated investors sometimes have trouble understanding. As Arthur Levitt put it this past summer, “our nation’s leaders . . . risk committing a major error if they don't carefully consider the workings of the municipal-bond market. The opacity of this market is unrivaled and thus presents a significant threat to our economy.”
What follows are not necessarily new ideas. In fact, many of them have been floating around for years — you can even find some of them in a speech that Al gave way back in 1976 when he was an SEC Commissioner. But these are ideas whose time has definitely come, particularly while the window of opportunity for effecting real regulatory change is still open.
II. Background on the Municipal Securities Market
Let me start with a little background.
As recently as the early 1970s, the municipal securities market was still relatively small (with approximately $25 to 49 billion of bonds outstanding in 1975) and attracted very little attention. The standard issue was usually a general obligation bond, with fairly standard features. Interest rates were stable. Generally the only purchasers were wealthy investors, banks, and insurance companies. And disclosure was minimal or non-existent.
In stark contrast, the current amount of municipal bonds outstanding is estimated to be nearly $2.8 trillion, and more than $391 billion of new bonds and notes were issued last year. Since the Build America Bonds program began in April of this year, states and localities have issued more than $35 billion of BAB bonds. Despite its reputation as a “buy and hold” market, trading volume is also substantial, with almost $5.5 trillion of long and short-term municipal securities traded in 2008 in nearly 11 million transactions. With nearly 50,000 state and local issuers, it is an extremely diverse market. The typical municipal bond investor has changed too. Individual investors hold approximately 36 percent of outstanding municipal securities directly and up to another 36 percent indirectly through mutual funds and closed end funds. And, in spite of their reputation for safety, municipal securities can and do default. Since 1999, issuers have defaulted on over $24 billion in municipal bonds out of a total of $3.4 trillion issued. In 2008 alone, 140 municipal issuers defaulted on almost $8 billion in bonds.
In sum, the municipal securities market today bears no resemblance to, in the words of former SEC Chairman Christopher Cox, “the relatively small and sleepy municipal bond activity of days gone by.”
III. Current Disclosure Requirements
Despite its size and obvious importance, however, the municipal securities market, unfortunately, lacks many of the protections customary in many other sectors of the U.S. capital markets. Investors in municipal securities are, in certain respects, afforded “second-class treatment” under current law. Let me briefly outline the current disclosure requirements for municipal issuers, with apologies and permission for a short nap going to those of you for whom this background is unnecessary.
Congress exempted offerings of municipal securities from the registration requirements and civil liability provisions of the Securities Act and the system of periodic reporting under the Exchange Act. The Commission is thus prohibited from imposing mandatory disclosure obligations on municipal issuers or mandating that municipal issuers use “generally accepted” governmental accounting standards. Nonetheless, the Commission can bring enforcement actions against any person or entity, including issuers of municipal securities, who violate the antifraud provisions of the federal securities laws.
As part of the Securities Acts Amendments of 1975, Congress established a limited regulatory scheme for municipal securities intermediaries. This included mandatory registration of municipal securities brokers and dealers and the creation of the Municipal Securities Rulemaking Board (“MSRB”). Federal regulatory authority over issuers of municipal securities, however, was specifically limited by the provision commonly known as the Tower Amendment, which prohibits the Commission and the MSRB from requiring any issuer of municipal securities, either directly or indirectly, to make any filings with the Commission or the MSRB prior to the sale of securities.
In 1989, in response to consistently slow dissemination of information in connection with primary offerings of municipal securities, the Commission adopted Rule 15c2-12, which requires underwriters participating in offerings of municipal securities of $1,000,000 or more to obtain, review, and distribute to investors copies of the issuer's disclosure documents.
To enhance the quality, timing, and dissemination of disclosure in the secondary municipal securities market, under Chairman Levitt’s leadership, the Commission adopted amendments to that rule in 1994. Among other things, these amendments prohibit an underwriter from participating in a municipal offering, unless it has reasonably determined that the issuer of the securities or an obligated person has undertaken to provide specified annual information and event notices to information repositories. In the same year, the Commission also issued significant interpretive guidance concerning the disclosure obligations of municipal bond market participants under the antifraud provisions of the federal securities laws.
Since that time, the Commission has adopted further amendments to Rule 15c2-12 to provide for a single centralized repository, the MSRB, for the electronic collection and availability of information about outstanding municipal securities in the secondary market. The system is known as EMMA, which stands for Electronic Municipal Market Access. EMMA should help provide ready and prompt access to continuing disclosure documents to investors and help fulfill the regulatory and information needs of municipal market participants.
Finally, this past summer, the Commission proposed additional amendments to Rule 15c2-12 that would impose further requirements on broker-dealers and municipal securities dealers with respect to the disclosure of specified events by issuers or their obligated persons. In addition, the MSRB filed a rule proposal with the Commission that would permit issuers and their designated agents to make certain “voluntary” submissions to EMMA.
IV. Continuing Legitimacy of Exemption
Now I would like to turn to a consideration of the continuing legitimacy of the exemption for municipal securities under the 33 and 34 Acts. Three reasons are typically given for affording special treatment to municipal securities. In my view, these rationales are no longer compelling.
Regarding the first rationale — namely, the lack of perceived abuses in the municipal market, the Commission has brought dozens of enforcement actions in recent years that highlight the continued disclosure weaknesses in the municipal market and raised concerns about governmental accounting. These actions involved a wide range of disclosure violations by municipal issuers.
Moreover, as I mentioned earlier, municipalities can and do default on their bonds. Perhaps the most notorious example is the Washington Public Power Supply System (or WPPSS, but pronounced fittingly enough “Whoops”), followed closely by Orange County, California, the largest municipal bankruptcy in American history. We are still waiting to see what happens to Jefferson County, Alabama, which is contemplating filing for bankruptcy protection to address its debt problems.
Finally, there have been numerous bid rigging, price fixing, pay to play, and other scandals in this market. There have also been a number of instances of abusive practices by financial advisors, who are largely unregulated by the Commission.
The second rationale for exempting municipal securities — namely, that it is a sophisticated institutional market — is clearly no longer valid today. The extensive retail participation in the municipal securities market I mentioned earlier is probably only going to increase as baby boomer senior investors increasingly include fixed-income and tax-free offerings in their retirement portfolios.
The third rationale for exempting municipal securities — intergovernmental comity — is more difficult to dismiss. I should begin by noting that this is not a federalism issue under the Tenth Amendment to the U.S. Constitution. Rather intergovernmental comity is a matter of balancing the respect due to the local interests of municipalities and their citizens, on the one hand, and the federal interest in maintaining the integrity of the national market system for the benefit of investors, on the other.
This simple contrast between state and local interests and federal interests is a little misleading, however, when you consider that municipalities are populated by taxpayers who also are frequently investors, perhaps even in the bonds issued by those same municipalities. Indeed, the concerns of a citizen qua taxpayer and the same citizen qua investor have something very important in common. Just as an investor wants to understand the true financial health of an entity whose debt it purchases, a taxpayer has an interest in understanding the true fiscal health of the state or local municipality in which he or she lives. So the call for greater federal regulation of the municipal securities market could have benefits for both taxpayers and investors alike.
Now that I have addressed why the old arguments for exempting municipal securities from the 33 and 34 Acts are no longer compelling, let me provide some reasons in support of removing the exemptions.
First, the muni market has changed. Municipal securities offerings are not a local affair anymore; they are national. Investors around the country buy bonds from states like New York and California. As the municipal market becomes more diffuse, the patchwork of state regulation makes less and less sense. Without uniformity of standards, it will be difficult for investors to fully appreciate and compare the relative risks associated with different investment products. This can lead to an inefficient allocation of capital resources.
Second, in the last two decades, “the municipal market experienced the same proliferation of innovation and financial engineering as the rest of the world’s capital markets.” Municipalities frequently engage in complex derivative transactions and their products are then securitized. While the largely unregulated nature of this market has been a problem for a long time, it only threatens to get worse as municipalities look for creative ways to manage budget shortfalls.
Third, markets have become increasingly interconnected. Consider that many mutual funds today hold municipal securities, and now there are even exchange-traded funds (or “ETFs”) that hold municipal securities. But perhaps the best example of how the municipal securities market is interconnected with other markets is the liquidity crisis in auction rate securities caused by increasing subprime mortgage defaults and the resulting dramatic reduction in the value of many collateralized mortgage obligations (or “CMOs”).
The extent to which municipal securities should be regulated by the federal government comes down to a policy decision. While we have to make proper allowances for the unique characteristics of municipal issuers, we do not have to tolerate muni investors being treated like “second-class citizens.” Investors deserve the same level of high-quality disclosure and protection in the municipal market as they currently get in the corporate market and should not have to be forced to rely on good-faith voluntary disclosure.
V. Reforming the Municipal Securities Market
How should the municipal securities market be reformed?
A. Reform Under Current Commission Authority
Under the Commission’s current authority, our options seem to be limited. With the most recent proposals, we may have pushed Rule 15c2-12 about as far as we can, though I would be open to ideas how the Commission could do more with the rule. Absent legislation, however, I believe there are still some things that the Commission could and should do under its current statutory authority.
First, I believe the Commission should further leverage its existing antifraud authority over municipal issuers to try to improve the quality and timeliness of disclosures. Various groups have published voluntary disclosure guidelines and industry best practices. Voluntary disclosure has its limitations, however, and I believe that the Commission needs to send a stronger signal to the municipal issuer community regarding their obligations to provide full and fair disclosure.
After 15 years and dozens of enforcement actions, I believe it is time to update the 1994 Interpretive Guidance on the antifraud provisions. By making the obligations of municipal issuers more explicit, the Commission could help ensure that disclosure is as complete, timely, and accessible as possible. For example, recent studies have indicated that many municipal issuers are woefully tardy in issuing their annual financial statements, and yet many of these municipalities continue to issue bonds in the market. But issuing securities based on out of date financials may violate the antifraud provisions of the federal securities laws if material changes have occurred in an issuer’s financial condition since its last financial statements were issued.
Second, I would like to see the Commission continue to work closely with the MSRB to further enhance the usefulness of EMMA. The MSRB has started this initiative and I think that the Commission should support this effort strongly.
Finally, I believe that regulators and the industry should work more closely together to provide pre-trade transparency in this market. Why shouldn’t there be better information about potential buyers and sellers?
B. Legislative Reform
But, as important as these regulatory and industry steps might be, municipal securities disclosure issues can only be addressed adequately through authority that federal securities regulators do not now possess. Therefore, to fully reform the regulation of the municipal securities market, I believe Congressional action is necessary in a number of areas.
1. Changes to the MSRB. I believe that some changes need to be made to the MSRB. To begin with, it should have a majority public board.
Also, currently the MSRB does not enforce the rules it sets. Instead, FINRA, the Commission, and in some cases, other appropriate regulatory agencies enforce the MSRB’s rules. Separating the regulatory function from the enforcement and examination functions can lead to coordination and communication problems. For this reason, I believe that Congress should seriously consider whether to combine the enforcement and regulatory authority over the municipal market into one self-regulatory organization (“SRO”).
2. Conduit Borrowers. Next, I believe that Congress should permit the Commission to apply to non-governmental conduit borrowers the registration and disclosure standards that would apply if they issued their securities directly without using municipal issuers as conduits. This is something the Commission has long advocated and I fully support the recommendation. The fact that the bonds are tax-exempt does not change the fact that these are private obligations in which investors look to a private entity for repayment.
3. Regulation of Financial Intermediaries. I also believe that the Commission should have regulatory authority over all financial intermediaries involved in the municipal securities market, not just municipal brokers and dealers. The observed and reported conduct of some municipal financial advisors is alarming. Here I am thinking of "pay to play" practices, undisclosed conflicts of interest, advice rendered by financial advisors without adequate training or qualifications, and failure to place the duty of loyalty to their clients ahead of their own interests.
4. Repeal of the Tower Amendment. Further, as politically unpopular as this suggestion may be, I believe that the exemptions for municipal securities should be removed from the 33 and 34 Acts and the Tower Amendment should be repealed.
Let me say immediately that I fully appreciate that deference should be shown to the special questions concerning disclosure and accounting that municipal issuers present; municipal securities should not be treated exactly like corporate securities. Municipal disclosure serves a dual purpose. It both reports on the financial state of a municipal securities issuer and it tells citizens about how the municipality spends their hard earned tax dollars. There is nothing quite like this in the corporate space. Moreover, there cannot be a one-size-fits all approach to municipal disclosure, given the wide range of purposes and structures of the over 50,000 municipal issuers.
Nonetheless, appropriate legislative change would allow the Commission to take important steps to improve the quality and availability of municipal issuer information to investors.
First, the Commission could require that municipal issuers make available to investors offering documents and periodic reports that contain information similar, although not identical, to that required of issuers and offerings of corporate securities. Municipal issuers should not necessarily be required to receive pre-approval of offerings from the Commission. To me, what is most important is the integrity of the continuing disclosure obligations of issuers, not whether they receive pre-approval from the Commission before issuing a bond. Complete, timely, and accurate disclosure is essential for the proper functioning of the municipal securities markets, in particular for efficient pricing. Timeliness is a particular concern. With the appropriate authority, the Commission could mandate that municipal disclosures be issued in a time period that makes critical information available when investment decisions are made.
Of course, municipal issuers, like corporate issuers, should have an alternative to the registered public offering. With new authority, the Commission could engage in tailored rulemaking that would provide appropriate exemptions, for example, for small issuances and private placements, just as currently exist for corporate securities offerings. One possibility worth considering is a tranched approach to issuer obligations. The largest issuers could be required to provide disclosures similar to public companies, while smaller issuers would be subject to a less rigorous disclosure regime.
Second, legislation could give the Commission the authority to mandate that municipal issuers use “generally accepted” governmental accounting standards. In some states, deviation from accounting standards set by the Governmental Accounting Standards Board (or “GASB”) is required by state law, and the situation seems to be only getting worse. Comparability of investment opportunities is critical and today the only real way to compare municipal investments is by yield and ratings; that is not sufficient. Lack of uniform accounting standards makes financial statements hard to understand and difficult to compare, particularly for less sophisticated investors.
As part of this accounting reform, I believe that Congress should provide an independent funding mechanism for the GASB and permit Commission oversight of the GASB, as is now provided by the Sarbanes-Oxley Act for the Financial Accounting Standards Board (“FASB”). Currently, GASB is funded by voluntary payments and contributions from states and local governments and the financial community, as well as sales of its publications. This funding mechanism is not adequate to ensure that GASB is a truly independent standard setter.
Finally, I would like close with an observation on the recent discussion of mandating that credit rating agencies use a single scale for rating corporate and municipal bonds. I certainly support efforts to make the ratings of bonds more fair and accurate. In some ways, a single scale makes sense given that the corporate and municipal markets are increasingly interconnected. However, we do not want to lose the level of granularity that currently exists within the rating scale for municipal securities. At a minimum, though, if municipal issuers want to have their bonds rated on the same scale as corporate bonds, then I believe they should be prepared to provide the same level of timely and accurate disclosure as corporate issuers. It is only fair to investors.
As I end my remarks, I think it would be fitting to quote Al one last time. He said that “[o]ut of every crisis, . . . there emerges change and in most, perhaps not all cases, a change that serves the public good.” I hope that our experience with reform of the municipal securities market will be another instance of, what Al called, “crisis fostering constructive change.”
1 All citations have been deleted from this version of the speech. Please see the unabbreviated version of the speech on the Commission’s Website.
2 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission, other Commissioners, or the staff.