Speech by SEC Commissioner:
Regulation of the Municipal Securities Market:
Investors Are Not Second-Class Citizens
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.1 In his many different roles in public service, including time as a Commissioner at the SEC, Vice Chairman at the NASD, and member of the Board of Directors of the American Institute of Certified Public Accountants, he set a sterling example for me, championing many of the causes that I have also advocated: enhanced corporate disclosure, the importance of good corporate governance, integrity in the accounting and auditing professions, and, most importantly, the critical need to put the protection of investors first in all that we do as securities regulators.
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.3 The title of my remarks is the “Federal Regulation of the Municipal Securities Market: Investors are not Second-Class Citizens.” 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.4 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.5
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.6 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.”7 Or, as Rahm Emanuel more recently, and more colorfully, put it, “Never let a serious crisis go to waste.”8
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.9 But, beyond recommendations in the Treasury White Paper that the Commission’s authority to promote transparency be expanded and limitations be placed on the marketing of derivatives to small municipalities, this topic has not received serious consideration in recent regulatory reform discussions.10 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.”11 I am deeply concerned that the perfect municipal storm may be brewing.12
I would like to begin by briefly providing some background on the current state of the municipal securities market; then discuss the current disclosure obligations of municipal issuers and the continuing legitimacy of the exemption for municipal securities from the Securities Act of 1933 (“Securities Act”) and the Exchange Act of 1934 (“Exchange Act”); and finally close by offering some suggestions for reforming the federal regulation of the municipal securities market. These 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.13 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. for the non-cognoscenti among us. Please bear with me if this is old news to some of you.
Municipal bonds refer broadly to securities issued by states, their political subdivisions such as cities, towns, or counties, or their instrumentalities such as school districts or port authorities.14 The two most common types of municipal securities are general obligation bonds and revenue bonds. General obligations bonds (or GO bonds) are backed by the taxing power or “full faith and credit” of the issuing governmental unit, whereas revenue bonds are backed solely by the revenue of a specific project such as a port authority, airport, or bridge.
In addition to general obligation bonds and revenue bonds, there are other types of municipal securities, such as industrial development bonds, which are also called “conduit bonds.” A conduit bond is a type of revenue bond frequently issued by a municipality on behalf of a third party, such as a college, hospital, or industrial corporation. Conduit bonds have their name because the municipality acts as a “conduit” through which investors lend money to a third party and the third party repays the debt. The credit of the third party backs the conduit bond, and the debt is generally not considered a liability of the municipality. Municipalities typically issue conduit bonds to finance the construction, purchase, or lease of dormitories, hospitals, or manufacturing and certain industrial-type facilities by the third party.
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)15 and attracted very little attention.16 The standard issue was usually a general obligation bond, with fairly standard features, and the typical participants were banks, underwriters, and bond counsel.17 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.18 Since the Build America Bonds program began in April of this year, states and localities have issued more than $35 billion of BAB bonds.19 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.20 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.21 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.22 In 2008 alone, 140 municipal issuers defaulted on almost $8 billion in bonds.23
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.”24 Rather than being a small “backwater market,” the municipal securities market is an increasingly significant part of the U.S. capital markets.25
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. 26 Investors in municipal securities are, in certain respects, afforded “second-class treatment” under current law.27 Let me briefly outline the current disclosure requirements for municipal issuers, with apologies and permission for a short nap again 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.28 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 is authorized to take enforcement actions against any person or entity, including issuers of municipal securities, who violate the antifraud provisions of the federal securities laws.29 These antifraud provisions prohibit any person, including municipal issuers and brokers, dealers, and municipal securities dealers, from making a false or misleading statement of material fact, or omitting any material facts necessary to make statements made by that person not misleading, in connection with the offer, purchase, or sale of any security, in light of the circumstances.30
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”).31 Federal regulatory authority over issuers of municipal securities, however, was specifically limited by Section 15B(d)(1) of the Exchange Act (commonly known as the Tower Amendment, after the late Republican Senator John Tower of Texas) 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.32 The MSRB is further limited in its ability to require any municipal issuer to furnish it or any purchaser or prospective purchaser with any documents.33
In 1989, in response to consistently slow dissemination of information in connection with primary offerings of municipal securities, the Commission adopted Rule 15c2-12, under the Exchange Act, which requires underwriters participating in primary offerings of municipal securities of $1,000,000 or more to obtain, review, and distribute to investors copies of the issuer's disclosure documents.34 In the same release, the Commission issued interpretive guidance concerning the due diligence obligations of underwriters of municipal securities.35
Four years later, in 1993, the then Division of Market Regulation conducted a comprehensive review of many aspects of the municipal securities market, including secondary market disclosure.36 The resulting staff report found growing participation by unsophisticated individual investors and a proliferation of complex structured products in the municipal securities market.37 The 1993 staff report also highlighted the need for improved disclosure practices in both the primary and secondary municipal securities markets.38
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 Rule 15c2-12 in 1994.39 Among other things, these amendments prohibit an underwriter from participating in a municipal offering, unless it has reasonably determined that an issuer of municipal securities or an obligated person has undertaken in a written agreement or contract for the benefit of holders of such securities to provide specified annual information and event notices to certain 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.40
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.41 The system is known as EMMA, which stands for Electronic Municipal Market Access.42 As is widely recognized, the municipal securities market has needed a single centralized repository for a long time.43 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. The MSRB deserves high praise for working so hard to get EMMA up and running so successfully, as well as for its plans to enhance the system in the future.
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.44 It would also revise an exemption from the rule for certain offerings of municipal securities with put features, such as variable rate demand obligations.45 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.46 In particular, it would permit issuers to disclose: (1) an undertaking to prepare audited financial statements pursuant to GAAP as established by the Governmental Accounting Standards Board (or “GASB”); (2) an undertaking to submit annual financial information to EMMA within 120 calendar days after the end of the fiscal year; and (3) receipt of the Certificate of Achievement for Excellence in Financial Reporting awarded by the Government Finance Officers Association (“GFOA”) in connection with the preparation of a Comprehensive Annual Financial Report (“CAFR”) of an issuer. These undertakings would be prominently displayed on EMMA, and thus act something like a “Gold Seal.” The Commission is currently reviewing the comment letters on these proposals and has not yet determined whether to approve the proposed rules.
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 under the federal securities laws: (i) the lack of perceived abuses in the municipal securities market, compared with the corporate market; (ii) the fact that the typical purchasers of municipal securities are institutional investors with financial expertise; and (iii) intergovernmental comity.47 In my view, these rationales are no longer compelling.48
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.49 These actions involved a wide range of disclosure violations by municipal issuers, such as the failure to disclose liabilities that place the municipality in serious financial jeopardy; falsely claiming a surplus for general and debt service funds; and the failure to disclose material information about the municipality’s high risk investment pool and financial condition that brought into question its ability to repay its securities.50 Very recently, for instance, the Commission sanctioned the City of San Diego for failure to disclose to municipal bond investors important information about their pension and retiree health care obligations.51 In its offering documents, San Diego failed to inform investors that the city's unfunded liability to its pension plan was projected to grow dramatically — from $284 million at the beginning of 2002 to $2 billion by 2009 — and that its liability for retiree health care was projected to grow to more than $1 billion. This is information that investors clearly need, but did not get.
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”), which in 1988 defaulted on $6 billion in bonds.52 A more recent example was Orange County, California, whose disastrous dabbling in the derivatives market in the 1990s occasioned the largest municipal bankruptcy in American history.53 We are still waiting to see what happens to Jefferson County, Alabama, which is contemplating filing for bankruptcy protection to address its debt problems. Currently Jefferson County is burdened with about $4 billion in debt from the issuance of bonds and related interest-rate swaps that soured in late 2007.54 If Jefferson County does, in fact, default on its bonds, it will be by far the biggest financial failure of a governmental body entity in U.S. history.55
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.56
The second rationale for exempting municipal securities — namely that it is a sophisticated institutional market — is clearly no longer valid today. As I mentioned earlier, there is extensive retail participation in the municipal securities market.57 With the baby boomers starting to enter retirement, this is probably only going to increase as senior investors increasingly include fixed-income and tax-free offerings in their retirement portfolios.58 The Commission is very concerned about fraud perpetrated against our nation’s seniors, who have spent much of their lives building a retirement nest egg and so the fact that municipal securities are being used as retirement vehicles raises heightened regulatory concern.59
In my view, the private gatekeepers who operate in this market — the credit rating agencies in particular — did not provide the necessary backstops for investors. The record of credit rating agencies in recent years has led both retail and institutional investors to focus more closely on the disclosure documents of municipal issuers rather than merely relying on a bond rating. And this trend is likely going to be heightened by the increased difficulty some municipal issuers are having getting credit enhancements for their bonds because of the severe financial deterioration of municipal bond insurers (or “monolines,” as they are sometimes called).60
The third rationale for exempting municipal securities — namely 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, which limits the federal government’s ability to regulate state and local governments. For over 30 years the Commission has brought enforcement actions against municipal issuers for violations of the federal securities laws.61 No one seriously questions anymore the Constitutional right of the federal government to regulate municipal issuers.62 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 in our national markets, 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. Sunlight makes the best disinfectant in politics as well as in finance!
In thinking about regulation of the municipal markets, we also have to appreciate the obligations municipalities owe to their citizens. Not only are their interests critical, there is an understandable incentive for municipal officers to placate their constituency at the expense of investors. As Warren Buffet put it, “What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a faraway bond insurer?”63 While Buffet may be stating the problem in particularly dramatic terms, we have to take this dynamic into account when considering how best to regulate the municipal securities market.
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.64 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.”65 Municipalities frequently engage in complex derivative transactions and their products are then securitized. This market is largely unregulated today.66 While this has been a problem for a long time, it only threatens to get worse as municipalities look for creative ways to manage budget shortfalls due to declining tax receipts, increasing health care costs, and mounting post-employment benefit commitments.67 The use of derivatives may, of course, provide important benefits to municipalities, such as the ability to reduce borrowing costs and hedge or manage interest rate risk. But they also pose dangers.68 If municipalities are going to use highly sophisticated and often opaque financial products, it is essential that the financial intermediaries advising them, such as independent financial advisors and swap dealers, be appropriately regulated. It is also essential that the municipalities be required to provide investors with adequate disclosure regarding the risks associated with these complex products.
Third, markets have become increasingly interconnected. Consider that many mutual funds today hold municipal securities, and now there are even exchange-traded funds (“ETFs”) that hold municipal securities.69 College savings plans established by state issuers under Section 529 of the Internal Revenue Code (so-called 529 plans) often use registered mutual funds as primary investment vehicles, but the plans are not registered with the Commission as mutual funds under the Investment Company Act of 1940 and, therefore, are not subject to the same level of regulatory oversight as registered mutual funds. Finally, perhaps the best example of how the municipal securities market is interconnected with other markets is the case of auction rate securities. As subprime mortgage defaults increased and caused many collateralized mortgage obligations (“CMOs”) to reduce dramatically in value, the ratings of a number of bond insurers dropped, which partly contributed to the liquidity crisis in municipal auction rate securities.70
I believe the extent to which municipal securities should be regulated by the federal government at bottom comes down to a policy choice. In my view, we should no longer treat muni investors as second-class citizens — hence the subtitle of my talk today. While we have to make proper allowances for the unique needs of municipal issuers, we do not have to tolerate investors in municipal securities being given “second class treatment” under the federal securities laws. 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. And, as an added benefit, I believe that improved municipal disclosure will give taxpayers a better idea of what their elected representatives are doing with their tax dollars.
V. Reforming the Municipal Securities Market
How should the municipal securities market be reformed? The goal is to improve the quality and timeliness of information available to those who buy the municipal securities that are critical to state and local funding initiatives.71 And we also want to ensure that financial intermediaries in the municipal market are properly regulated. Let me start by considering what the Commission can do under its current limited statutory authority to achieve this goal, and then discuss what legislation in this area should look like.
A. Reform Under Current Commission Authority
Under the Commission’s current authority, our options seem to be limited. As Chairman Schapiro recently noted, “[W]e are very close to exhausting our statutory authority in this area.”72 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 do under its current statutory authority.
First, I believe the Commission should further leverage its current antifraud authority over municipal issuers to try to improve quality and timeliness of disclosures. Various groups have published voluntary disclosure guidelines and industry best practices.73 In particular, I would note the important work of the GFOA, the National Federation of Municipal Analysts (“NFMA”), and the National Association of Bond Lawyers (“NABL”). 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.74 By making the obligations of municipal issuers more explicit, the Commission could provide greater clarity to the market and 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.75 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. I believe that EMMA can be an even better source for information regarding municipal issuers than it is now. 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. Currently the board of the MSRB is made up of 15 members: five representatives of investment banking firms, five representatives of commercial banks, and five representatives of the public. I have long been an advocate of majority public boards for self-regulatory organizations. For example, the board of governors of the Financial Industry Regulatory Authority (“FINRA”) is comprised of 11 public representatives, two neutral members, and 10 industry officials I can see no reason why the MSRB should be any different.
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, when those who are responsible for writing the rules are not adequately informed by those who examine and enforce compliance with the rules, or vice-versa. For this reason, I believe that Congress should seriously consider whether to combine the enforcement and regulatory authority over the municipal market into one SRO. This would be particularly important if the Commission is given greater authority over financial intermediaries and issuers in the municipal securities market.
2. Conduit Borrowers. Next, I believe that Congress should permit the Commission to apply the registration and disclosure standards to non-governmental conduit borrowers 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.76 Commercial entities responsible for debt obligations under a conduit borrowing arrangement should be subject to the same level of disclosure obligations as a corporate issuer directly obtaining financing in the public securities markets.77 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.78
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.79 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. The Commission's current statutory authority, however, limits our ability to address these concerns adequately.80 Granting regulatory authority over the activities of municipal financial advisors, including swap advisors, to the Commission would significantly benefit issuers and investors alike.81
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. 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. I fully agree with what the Commission staff wrote in its 2007 White Paper to Congress when it said that
[t]he regulatory model applicable to the securities of public companies should not . . . be duplicated and applied wholesale to municipal securities. Implementation of steps such as these must be tailored to accommodate the unique character of municipal issuers and special attributes of the municipal securities market.82
In addition, 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.83
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. I think we greatly underestimate the timeliness of information problem in the muni market today.
Of course, municipal issuers, like corporate issuers, should have an alternative to the registered public offering. With new authority, the Commission would need to engage in tailored rulemaking that would provide appropriate exemptions, for example, for small issuances and private placements, just as currently exists 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. This could help to level the playing field between the municipal and corporate markets, without obscuring the important differences between them.84
Second, legislation could give the Commission the authority to mandate that municipal issuers use “generally accepted” governmental accounting standards. In some states, deviation from GASB GAAP is required by state law, and the situation seems to be only getting worse.85 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 Sections 108 and 109 of the Sarbanes-Oxley Act for the Financial Accounting Standards Board (“FASB”). Currently, GASB is a not-for-profit organization that operates under the oversight of the Financial Accounting Foundation (“FAF”). It is funded by voluntary payments and contributions from states and local governments and the financial community, as well as sales of its publications. I do not believe that this funding mechanism is adequate to ensure that GASB is a truly independent organization that is able to develop high-quality governmental accounting standards without being unduly pressured by the issuer community.
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. We do not want to lose the level of granularity, however, that currently exists within the rating scale for municipal securities. At a minimum, I believe, if municipal issuers want to have their bonds rated on the same scale as corporate bonds, 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.”86 I hope that our experience with reform of the municipal securities market will be another instance of, what Al called, “crisis fostering constructive change.”87
1 See, e.g., Joel Seligman, “Dedication to A.A. Sommer, Jr.,” 70 Wash. Univ. L. Quarterly 399, available at http://lawreview.wustl.edu/inprint/78-2/seligman.pdf.
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.
3 See A.A. Sommer, Jr., Commissioner, U.S. Securities and Exchange Commission, “The Changing Scene for Municipal Securities,” Remarks at the Municipal Bonds Conference, New York, New York (Mar. 11, 1976), available at http://www.sec.gov/news/speech/1976/031176sommer.pdf.
4 See Ann J. Gellis, “Mandatory Disclosure for Municipal Securities: Issues in Implementation,” 13 J. Corp. L. 65, 66 (Fall 1987); see also Securities and Exchange Commission Staff Report on Transactions in Securities of the City of New York (Aug. 1977), available at http://www.sec.gov/info/municipal/staffreport0877.pdf; and “Fireside Chat: Municipal Securities” (Apr. 20, 2004) (discussing, among other things, the New York City fiscal crisis), available at http://www.connectlive.com/events/sechistorical/4-20%20Municipal%20Securities%20Transcript.htm.
5 See note 28, infra.
6 See, e.g., U.S. Department of the Treasury, “Financial Regulatory Reform: A New Foundation, Rebuilding Financial Supervision and Regulation” (June 17, 2009) (“Treasury White Paper”), available at http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.
7 See Sommer, note 3, supra; see also Theresa A. Gabaldon, “Financial Federalism and the Short, Happy Life of Municipal Securities Regulation,” 34 J. Corp. L. 739, 742 (Spring 2009) (arguing “municipal securities regulation is a tale of call and response between municipal financial fiasco and federal regulatory reaction”).
8 Quoted at, among other places, Robert C. Pozen, “A Better Blueprint for Financial Reform,” Barron’s (Sep. 28, 2009), available at http://online.barrons.com/article/SB125391751717842265.html.
9 See David S. Ruder, Chairman, U.S. Securities and Exchange Commission, “Disclosure in the Municipal Securities Markets,” Remarks Before the Public Securities Association (Oct. 23, 1987), available at http://www.sec.gov/news/speech/1987/102387ruder.pdf; Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, “Public Trust and Public Obligations in the Municipal Bond Market,” Remarks Before the National Federation of Municipal Analysts, Baltimore, Maryland (May 8, 1996), available at http://www.sec.gov/news/speech/speecharchive/1996/spch098.txt; Christopher Cox, Chairman, U.S. Securities and Exchange Commission, “Integrity in the Municipal Market,” Los Angeles, California (July 18, 2007), available at http://www.sec.gov/news/speech/2007/spch071807cc.htm; and Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission, Address before the New York Financial Writers’ Association Annual Awards Dinner, New York, New York (June 18, 2009), available at http://www.sec.gov/news/speech/2009/spch061809mls-2.htm.
10 See Treasury White Paper at 49 & 70. See Andrew Ackerman, “Obama Unveils Plan to Expand SEC Regulation,” The Bond Buyer (June 18, 2009), available at http://www.bondbuyer.com/issues/118_116/-304627-1.html.
11 Arthur Levitt Jr., “Muni Bonds Need Better Oversight,” The Wall Street Journal (May 9, 2009), available at http://online.wsj.com/article/SB124182780923802551.html.
12 See Troy L. Kilpatrick and Antonio Portuondo, The Bank of New York Trust Company, N.A., “Commentary: Is This the Last Chance for the Muni Industry to Self-Regulate?,” The Bond Buyer (Aug. 6, 2007) (warning that a “perfect storm may be brewing”).
13 See Sommer, note 3, supra; see also See John Evans, Commissioner, U.S. Securities and Exchange Commission, “SEC Approach to Municipal Securities Regulation,” Second Annual Bank Investments Conference, American Bankers Association, New Orleans, Louisiana (Feb. 18, 1974), available at http://www.sec.gov/news/speech/1974/021874evans.pdf.
14 Section 3(a)(29) of the Exchange Act defines “municipal securities” as “securities which are direct obligations of, or obligations guaranteed as to principal or interest by, a State or any political subdivision thereof, or any agency or instrumentality of a State or any political subdivision thereof, or any municipal corporate instrumentality of one or more States, or any security which is an industrial development bond (as defined in section 103(c)(2) of Title 26) the interest on which is excludable from gross income under section 103(a)(1) of Title 26 if, by reason of the application of paragraph (4) or (6) of section 103(c) of Title 26 (determined as if paragraphs (4)(A), (5), and (7) were not included in such section 103(c)), paragraph (1) of such section 103(c) does not apply to such security.”
15 See Gabaldon, note 7, supra, at 740.
16 See Ann Judith Gellis, “Municipal Securities Market: Same Problems — No Solutions,” 21 Del. J. Corp. L. 427, 428 (1996).
17 See id.
18 See Dan Seymour, “Muni Sales Show Serious 2Q Surge; Retail, Mutual Funds Fuel Quick Growth,” The Bond Buyer (Sep. 22, 2009), available at http://www.bondbuyer.com/issues/118_182/-1000363-1.html.; see also Martha Mahan Haines, Assistant Director, Office of Municipal Securities, Division of Trading and Markets, U.S. Securities and Exchange Commission, Testimony Concerning Legislative Proposals to Improve the Efficiency and Oversight of Municipal Finance Before the U.S. House of Representatives Committee on Financial Services (May 21, 2009), available at http://www.sec.gov/news/testimony/2009/ts052109mmh.htm.
19 See Kent Hoover, “Build America Bonds Become Popular Option for Localities,” Washington Business Journal (Oct. 12, 2009), available at http://www.bizjournals.com/extraedge/
20 See Schapiro, note 9, supra.
21 See Securities Industry and Financial Markets Association, Holders of U.S. Municipal Securities $ Billions (2008), available at http://www.sifma.org/research/pdf/Holders_Municipal_Securities.pdf.
22 See Joe Mysak, “Municipal Defaults Don’t Reflect Tough Times: Chart of Day,” Bloomberg (May 28, 2009), available at http://www.bloomberg.com/apps/news?pid=20601087&sid=arkJTEztA2wg; and Jack Colombo, “Muni Bond Default Parade Plays On,” Forbes (Jan. 15, 2009), available at http://www.forbes.com/2009/01/15/monorail-vegas-ethanol-pf-ii-in_jc_0115distresseddebt_inl.html.
23 See Mysak, note 23, supra (noting that “distress continues to bedevil the muni bond market, and the rest of the year looks even tougher”).
24 See Cox, note 9, supra.
25 See Erik Sirri, Director, Division of Trading and Markets, Remarks to the 2008 Bond Attorney’s Workshop of the National Association of Bond Lawyers, Chicago, Illinois (Sep. 17, 2008) (“Furthermore, the municipal bond market has changed dramatically over the last decade. While some may have considered it a quiet backwater market in the past, it is now clearly part of the mainstream — faced with many of the same problems and challenges as other markets.”), available at http://www.sec.gov/news/speech/2008/spch091708ers.htm.
26 See Ruder, note 13, supra (providing a very helpful description of the differences between the corporate disclosure system and the municipal disclosure system); see also Martha Mahan Haines, Attorney-Fellow, Office of Municipal Securities, U.S. Securities & Exchange Commission, “Disclosure in the Municipal Market: Fundamental Concepts for Issuers,” Remarks Before the Michigan Municipal Finance Officers Association Thomsonville, Michigan (Sep. 19, 2000), available at http://www.sec.gov/news/speech/spch400.htm.
27 See Cox, note 9, supra.
28 See Exchange Act Rel. No. 33741 (Interpretive Guidance on the Antifraud Provisions — Statement of the Commission Regarding Disclosure Obligations of Municipal Securities Issuers and Others) (Mar. 9, 1994) (“1994 Interpretive Guidance”) , available at http://www.nabl.org/AM/Template.cfm?Section=Archive_Disclosure_Original_Issue.
29 See, e.g., Dolphin and Bradbury, Inc. v. SEC, 512 F.3d 634, 638 (D.C. Cir. 2008) (“The antifraud provisions of the federal securities laws prohibit fraudulent or deceptive practices in the offer and sale of municipal securities”) (quoting the 1994 Interpretive Guidance).
30 See 1994 Interpretive Guidance.
31 Congress also amended the securities laws in 1975 to expand the definition of “person” in Section 3(a)(9) of the Exchange Act to include municipal securities issuers, thus clarifying that state and local government issuers were not exempt from the antifraud provisions of the federal securities law. See Gellis, “Mandatory Disclosure for Municipal Securities,” note 4, supra, at note 6.
32 Section 15B(d)(1) of the Exchange Act provides: “Neither the Commission nor the Board is authorized under this title, by rule or regulation, to require any issuer of municipal securities, directly or indirectly through a purchaser or prospective purchaser of securities from the issuer, to file with the Commission or the Board prior to the sale of such securities by the issuer any application, report, or document in connection with the issuance, sale, or distribution of such securities.”
33 Section 15B(d)(2) of the Exchange Act provides: “The Board is not authorized under this title to require any issuer of municipal securities, directly or indirectly through a municipal securities broker or municipal securities dealer or otherwise, to furnish to the Board or to a purchaser or a prospective purchaser of such securities any application, report, document, or information with respect to such issuer. . . .”
34 See Exchange Act Rel. No. 26985 (June 28, 1989), available at http://www.nabl.org/AM/Template.cfm?Section=Archive_Disclosure_Original_Issue.
35 See id.
36 See Staff Report on the Municipal Securities Market (Sep. 1993), available at http://www.sec.gov/info/municipal/mr-munimarketreport1993.pdf.
37 See id.
38 See id. (noting that information about the issuer and other obligated persons is as critical to the secondary market, where little information about municipal issuers and obligated persons was regularly disseminated, as it is in primary offerings, where, as a general matter, better disclosure practices existed).
39 See Exchange Act Rel. No. 34961 (Nov. 10, 1994), available at http://www.sec.gov/rules/final/adpt6.txt.
40 See note 28, supra.
41 See Exchange Act Rel. No. 59062 (Dec. 5, 2008), available at http://www.sec.gov/rules/final/2008/34-59062.pdf.
42 See http://emma.msrb.org/.
43 See Andrew Ackerman, “SEC OKs EMMA as NRMSIR,” The Bond Buyer (Dec. 5, 2008), available at http://www.bondbuyer.com/issues/117_232/-297217-1.html.
44 See Exchange Act Rel. No. 60332 (July 17, 2009), available at http://www.sec.gov/rules/proposed/2009/34-60332.pdf.
46 See SR-MSRB-2009-10 (“Notice of Filing of Proposed Rule Change Relating to Additional Voluntary Submissions by Issuers to the MSRB's Electronic Municipal Market Access System (EMMA)” (July 15, 2009), available at http://www.sec.gov/rules/sro/msrb/2009/34-60315.pdf.
47 See Ruder, note 9, supra (citing H.R. Rep. No. 85, 73rd Cong., 1st Sess. 7 (1933)).
48 Already in 1976, Commissioner Evans recognized: “During the intervening thirty years [since 1945], there have been significant changes in both the size and the nature of the municipal securities marketplace. Municipal securities are no longer assumed to be total riskless investments. Investors in such securities are not necessarily financial institutions or wealthy or sophisticated individuals. And there have been egregious frauds and abuses in connection with primary distributions and secondary trading of municipal securities.” John Evans, Commissioner, U.S. Securities and Exchange Commission, “SEC’s Role in ‘Municipal Fiscal Crises,’” National Institute: “Freedom From Fiscal Fiasco,” American Bar Association, Section of Local Government Law, Washington, D.C. (Dec. 3, 1976), available at http://www.sec.gov/news/speech/1976/120376evans.pdf.
49 See Municipal Securities Cases and Materials on the Commission Website, available at http://www.sec.gov/info/municipal/municase07.htm; see also Martha Mahan Haines, Assistant Director, Office of Municipal Securities, Division of Market Regulation, U.S. Securities and Exchange Commission, “Perspectives on Public Transparency,” Second Internal Control & Fraud Conference of the Association of Governmental Accountants, Atlanta, Georgia (Sep. 11, 2007), available at http://www.sec.gov/news/speech/2007/spch091107mmh.htm.
50 See U.S. Securities and Exchange Commission Staff White Paper to Congress, “Disclosure and Accounting Practices in the Municipal Securities Market” (July 26, 2007) at 1-2 (“Staff White Paper”), available at http://www.sec.gov/news/press/2007/2007-148wp.pdf.
51 See http://www.sec.gov/litigation/admin/2006/33-8751.pdf.
52 See U.S. Securities and Exchange Commission Staff Report on the Investigation in the Matter of Transactions in Washington Public Power Supply System Securities (Sept. 1988).
53 See Public Policy Institute of California, “When Government Fails: The Orange County Bankruptcy — A Policy Summary,” The Second Annual California Issues Forum, After the Fall: Learning from the Orange County Bankruptcy, Sacramento, California (Mar. 18, 1998), available at http://www.ppic.org/content/pubs/op/OP_398OP.pdf.
54 See Alabama Policy Institute, “Jefferson County on Verge of Making Bankruptcy History” (Mar. 14, 2009), available at http://www.alabamapolicy.org/gary_blog/article.php?id_art=290.
55 See id.
56 Financial advisors who limit their advisory activities to advising municipal issuers as to the structuring of their financings rather than providing advice for compensation regarding the investment of assets may not need to register as an investment adviser. See Division of Investment Management: Staff Legal Bulletin No. 11, Applicability of the Advisers Act to Financial Advisors of Municipal Securities Issuers (Sep. 19, 2000) (explaining the circumstances under which financial advisors (a) may be investment advisers, and (b) may give advice to issuers of municipal securities regarding the investment of offering proceeds without being deemed to be investment advisers), available at http://www.sec.gov/interps/legal/slbim11.htm.
57 See Schapiro, note 9, supra; see also Seymour, note 18, supra.
58 See Nicole Bullock, “Muni Bond Issuer Enjoy Record Appeal,” Financial Times Online (Sep. 20, 2009) (“Also underpinning demand is a shift that has the retiring ‘baby boomer’ generation increasingly seeking the income of investments such as munis over the total return offered by stocks. The anticipated rise in US tax rates to pay for schemes to bolster the financial system over the past year only heightens the appeal of the tax breaks of munis.”), available at http://www.ft.com/cms/s/0/799f1d90-adec-11de-87e7-00144feabdc0.html; see also Gabaldon, note 7, supra, at 759-60.
59 See the Commission’s Website at http://www.sec.gov/investor/seniors.shtml for investing information especially for seniors.
60 See Dan Seymour, “Assured/FSA: Last One Standing,” The Bond Buyer (Oct. 16, 2009), available at http://www.bondbuyer.com/issues/118_199/assured-fsa-1002586-1.html.
61 See Cases and Materials on the Commission’s Website at http://www.sec.gov/info/municipal.shtml.
62 See Gellis, “Mandatory Disclosure for Municipal Securities,” note 4, supra, at 87-88 (claiming that “little question remains” regarding the constitutionality of federal intrusion into state affairs when they issue securities “even if it involves administrative rulemaking and review of proposed disclosure”); see also Gabaldon, note 7, supra, at 753-57 (concluding that “the betting money” is still on the constitutionality of federal regulation of municipal issuers based, in part, on the “undoubtedly sweeping federal ability to regulate interstate commerce”).
63 Quoted at Mysak, note 23, supra.
64 See Sirri, note 25, supra (“The emergence of new challenges, the implications of market interconnectivity and interdependence, product complexity and globalization raise a need to reconsider further the assumptions and ground rules on which the municipal market have been based.”).
65 Fidelity Capital Markets, White Paper “The Importance of Disclosure in the Municipal Bond Market” (July 2009), available at https://www.fidelitycapitalmarkets.com/newsdocs/FCM_WHITEPAPER_EMMA.pdf.
66 See Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission, Testimony Concerning Regulation of Over-The-Counter Derivatives Before the Subcommittee on Securities, Insurance, and Investment Committee on Banking, Housing and Urban Affairs United States Senate (June 22, 2009), available at http://www.sec.gov/news/testimony/2009/ts062209mls.htm.
67 See Elizabeth McNichol and Nicholas Johnson, Center on Budget and Policy Priorities, “Recession Continues To Batter State Budgets; State Responses Could Slow Recovery” (noting that “[t]he worst recession since the 1930s has caused the steepest decline in state tax receipts on record. As a result, even after making very deep cuts, states continue to face large budget gaps.”), available at http://www.cbpp.org/cms/index.cfm?fa=view&id=711#.
68 See Don Van Natta, Jr., “Firm Acted as Tutor as It Sold Risky Deals to Towns,” New York Times (Apr. 7, 2009) (discussing the use of municipal bond derivatives), available at http://www.nytimes.com/2009/04/08/us/08bond.html?_r=1; and William Selway, “Alabama Schools to Skip Payment on JPMorgan Swap Deal (Update2),” Bloomberg (Apr. 8, 2009), available at http://www.bloomberg.com/apps/news?pid=20601015&sid=ae6tN8zCx4YU.
69 See David Hoffman, “ETF Providers Zero in on Municipal Bond Market,” Investment News (Sep. 28, 2009), available at http://www.investmentnews.com/article/20090928/FREE/909289978.
70 See Sirri, note 25, supra.
71 See Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission, Address to Transatlantic Corporate Governance Dialogue — 2009 Conference (Sep. 17, 2009), available at http://www.sec.gov/news/speech/2009/spch091709mls.htm; see also See Arthur Levitt, Jr., Statement Before the Senate Committee on Banking, Housing, and Urban Affairs (Mar. 26, 2009) (“In the same manner, the SEC should have a far greater role in regulating the municipal bond market, which consists of state and local government securities. This is the market where Wall Street and Main Street collide. Since the New York City crisis of 1975, this market has grown to a size and complexity that few anticipated.”), available at http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=9ff95df3-08a9-4fe8-81d6-6b0111977cd8.
72 Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission, Address to Conference on “The Future of Global Finance,” at Georgetown University's McDonough School of Business, Washington D.C. (Sep. 18, 2009), available at http://www.sec.gov/news/speech/2009/spch091809mls.htm.
73 See 1994 Interpretive Guidance; see also See Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securities & Exchange Commission, Remarks Before the Municipal Securities Rulemaking Board, Disclosure Forum II, Washington, D.C. (Jan. 11, 2001) (“The Commission's ability to provide specific guidance to municipal market participants is therefore much more limited than it is in the corporate securities markets, which are subject to registration and reporting. Because of this, the initiatives of the MSRB and of associations of issuers, lawyers, bankers and dealers to provide guidance to their members and to the industry are critical to ensuring that disclosure is as complete, timely, and accessible as possible.”), available at http://www.sec.gov/news/speech/spch456.htm.
74 See Municipal Securities Cases and Materials, available at http://www.sec.gov/info/municipal/municase07.htm.
75 A recent study by DPCDATA, a NRMSIR, indicated that “nondisclosure is an established practice and a growing trend among obligators. It affects an increasing amount of debt, and presents risks to investors as well as the intermediaries that serve them.” Estimating Municipal Securities Continuing Disclosure Compliance, A litmus Test Approach, DPCDATA, Peter J. Schmitt (2008).
76 See Staff White Paper at 11. The Commission does have “statutory authority, in addition to antifraud authority, over securities offerings involving conduit borrowers, whether a public reporting company or a private entity, where the exemption from the registration requirements of the federal securities laws is unavailable to the conduit borrower due to the type of securities offering involved.” Staff White Paper at note 14.
77 See Ruder, note 9 supra, at note 47 (discussing past attempts by the Commission to regulate conduit borrowing).
78 See 1994 Interpretive Guidance.
79 See Municipal Securities Rulemaking Board, “Unregulated Municipal Market Participants: A Case for Reform” (Apr. 2009), available at http://www.msrb.org/MSRB1/Press/Release/
80 See note 56, supra.
81 See Haines, note 18, supra.
82 Staff White Paper at 11-12.
83 See, e.g., Government Accounting Standards Board, White Paper, “Why Governmental Accounting and Financial Reporting is — and Should Be — Different”(2006), available at http://www.gasb.org/white_paper_full.pdf.
84 As Arthur Levitt rightfully noted, “We may not want to treat municipals like we do other securities — but we do need to level the playing field between the corporate and municipal markets and address all risks to the financial system. Municipal issuers are ill-equipped and some are reluctant to do this on their own.” Levitt, note 71, supra.
85 See Gabaldon at 752 (noting, for example, that the Texas legislature had passed a law withdrawing all Texas municipal issuers from GASB compliance).
86 Sommer, note 3, supra.