Speech by SEC Commissioner:
Keynote Address before the 30th Bond Attorney's Workshop of the National Association of Bond Lawyers
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
September 15, 2005
Thank you, Tom (Yates) for the kind introduction. It is my pleasure to be here today at the 30th annual Bond Attorney's Workshop. On this significant anniversary, NABL should be commended for supporting high standards of practice and for year after year offering such excellent continuing education programs as this workshop. Before I start, I must issue the standard SEC disclaimer that this speech expresses my personal views, and does not necessarily reflect those of the Commission, other Commissioners, or members of the staff.
Development of Fixed Income Markets
Bond markets in the United States have had a long, illustrious, and sometimes questionable history. For example, early bond markets financed our country's westward expansion, including construction of the trans-continental railroad and the Erie Canal. They were vital to the country's development in more ways than one, but it was not always a pretty picture. Many early investors lost large sums of money as railroads and other companies went bankrupt due to fraud or mismanagement. Others lost money when municipal bonds issued for the benefit of the railroads were found to be invalid. There was no SEC at the time, so an entire private industry developed to give investors more information about these companies and the likelihood that they would repay their debts. Standard & Poor's, Moody's and the Wall Street Journal all got their start as private-sector bond market "watchdogs." As you know, purchasers of municipal securities also recognized a need for information about the validity of the bonds they purchased. Private parties again filled the need when lawyers with a recognized expertise in municipal securities and the highest reputation for integrity began to issue legal opinions for bonds. Investor demand led to the development of an entirely new kind of "watchdog" - bond counsel.
The SEC subsequently was created as a government response to financial scandals in both our bond and equity markets. Since then, our bond markets have grown enormously. Today, bond markets in the U.S. remain large and economically significant by any measure. The U.S. corporate market has over 37,000 bonds outstanding and more than 3,000 registered market participants. The municipal market has well over 1 million bonds outstanding and more than 2,000 registered dealers. The average daily trading volume in long-term corporate and municipal securities for the first five months of this year was about $37 billion U.S. dollars - compared to about $56 billion for the New York Stock Exchange (NYSE). Annual trading volume in municipal securities alone exceeds $2.6 trillion. Obviously, it's no longer simply a "buy and hold" market. Bond investors include individual retail investors with small portfolios, as well as the largest institutional investors. In fact, according to The Bond Buyer's statistics, individual investors now hold one third of outstanding municipal bonds, which is a larger proportion than is held by any other sector - and that's not counting indirect holdings through mutual funds.1 In fact, the average size trade in a fixed rate municipal security is only $25,000.1
Over the next 25 years, the number of Americans age 65 and over will nearly double: from 35 million today to 69 million by 2030. As you know, thanks in part to the availability of tax incentives from IRAs, KEOGHs and 401(k) plans, a larger proportion of personal savings are now invested in securities than ever before. Right now, they are primarily invested in equities. As the Baby Boomers near retirement, their risk tolerance can be expected to decline, which is good news for the fixed income markets of America. In preparation for this shift, the New York Stock Exchange has proposed adding certain registered and unregistered fixed income securities to its Automated Bond (trading) System.3 The municipal securities market also needs to prepare if it is to reap the full benefit of the coming demographic shift.
The establishment of rating agencies, the financial press and bond counsel demonstrate the hunger of investors for information. That need has not changed. Supplying this information is crucial to maintain investor confidence in the municipal market so that it can achieve its potential for enormous growth. Bond lawyers have an important role to play in this.
Traditional Role of Bond Lawyers
The role of bond lawyers has changed over time in response to the needs of the market. Initially, bond counsel merely reviewed documents prepared by another lawyer to determine if an unqualified legal opinion on the validity of a new issue could be delivered. As you well know, the role of bond lawyers has expanded and now includes many more tasks, such as drafting the transaction documents, rendering informal advice about the legality of varying financing structures, participating in the preparation of disclosure documents, and providing opinions on the tax-exempt status of the bonds and their exemption from registration. What hasn't changed is the importance that investors place on bond counsel serving as their "watch dog."
Traditionally, regardless of who retained or paid bond counsel, he acted as the legal advisor of the ultimate investor in the securities. He viewed the transaction exactly as though he was acting for an individual proposing to purchase the entire issue for long term investment who had requested him to act as his counsel in the transaction.4 Furthermore, most bond counsel took the view that they were concerned with more than the mere technical questions of validity and tax-exemption and also looked for matters that would reflect negatively on the transaction as a whole, such as a negative trend in judicial decisions or uncertainty about the sufficiency of revenues to pay the bonds.
Evolution of the Role
More recently, for very practical and pragmatic reasons, firms that act as bond counsel have been encouraged by their professional associations and insurance carriers to pick out someone in the transaction, preferably the issuer, as the "client," if for no other reason than to facilitate the resolution of potential conflicts. Nevertheless, bond lawyers sometimes still debate whose interests bond counsel really represents. Has the issuer hired bond counsel to represent its own interests or the interests of investors? Investors generally have not been included in these discussions. They continue to expect that bond counsel will be independent and impartial in representing their interests.
This evolution in the role of bond counsel concerns me for two reasons: First of all, investors generally are unaware that bond counsel may have loyalties to others or have undertaken additional duties and obligations inconsistent with the traditional expectations and assumptions of investors. Facts like these should be clearly disclosed in a meaningful way in order that investors will understand the extent to which bond counsel is or is not looking out for their interests. Conflicts of interest have been a focus of considerable Commission activity over the last few years. When evaluating potential conflicts of interest, we give broad consideration both to the particular facts and their implications. I would encourage you to do the same. Conflicts of interest are not found only in ethics rules, but may include matters that seem routine. For example, you might consider whether to disclose that payment of bond counsel's fee is contingent on delivery of an unqualified opinion. I don't know if you are aware that the Commission would not accept an audit from a registrant if the auditor had a contingent fee arrangement.
My second concern is the constrained view of bond lawyers generally about their role. I realize that the bond lawyers interviewed by the Division of Enforcement are not representative of the group as a whole, since they were associated with those few offerings in which there may have been a violation of the securities laws. However, one consistent thing that we hear from bond lawyers is: "That's not my job." Usually, when you consult their engagement letter, that's literally true. Nevertheless, given the dependence of issuers and investors alike on bond lawyers as experienced experts, is it unreasonable to expect that bond lawyers at least point out problems that they notice to the issuer and other transaction participants? Does it really matter that the problem does not relate to the validity or tax exempt status of the bonds? Lawyers are fiduciaries whose clients rely on them for broad advice. If you saw your client about to step off a curb in front of a speeding car, you would naturally shout a warning. You should do the same when you recognize a significant problem in a bond offering. The avoidance of fraud is everyone's job.
When advising clients and issuing opinions, it is important to keep in mind not just the technical legal question of the moment, but the long run importance to issuers and yourselves of maintaining and enhancing investor confidence so that the market may thrive. I know that municipal market participants do not desire increased regulation. The market appears to function reasonably well now. I suggest that the best way to avoid Congressional action and more regulation is to be self policing and proactive. If the municipal market repeats the mistakes of other market segments, it could bring regulation on itself.
The IRS's recent proposal to impose new standards of practice on bond lawyers is an example of regulation that better self policing might have avoided. For many years the IRS believed that there was no need to establish standards for lawyers issuing opinions on municipal bonds. Unfortunately, the IRS's audit program has demonstrated that real problems do exist which they, as regulators, are compelled to address. Many explanations have been proposed for this. Some still deny that there are any problems. What no one can deny, however, is the impact that Circular 230 will have on all bond lawyers as a result of a few overly aggressive opinions. Now bond lawyers are struggling with the potential ramifications of a new regulatory regime which might have been avoided.
We have noted certain activities in the municipal market that cause us concern, such as unquestioning reliance by some bond lawyers on certifications from laymen containing technical language, sometimes even conclusions of law, that the signer is unlikely to understand. I am not suggesting any particular standard of due diligence to you, but when a lawyer has closed his eyes to reality and ignored red flags, it may be reckless not to disclose the potential unreliability of his legal opinion.
On a different front, for some time now representatives of the IRS have publicly stated that they have fined a number of bond lawyers under section 6700 of the Internal Revenue Code for knowing participation in an abusive tax shelter. Wouldn't reasonable investors in a primary offering want to know if the bond lawyer on whose tax opinion they will rely issued a previous opinion that the IRS considered, in effect, to have been flat out wrong? Why has there been no disclosure? Why has there not even been serious debate?
Rightly or wrongly, issuers rely on bond lawyers for much that goes beyond the strict terms of their engagement letter. They expect that bond counsel will protect them from any potential trouble. Most bond lawyers try to meet this expectation. As times change, you may wish to consider suggesting new prophylactic measures, such as bidding for interest rate swaps even though the tax regulations do not require it. "Preventative lawyering" such as this may protect the issuer, yourself and investors all at once.
The strength and size of the American securities markets are envied throughout the world. Instead of relying on the government to evaluate the merits of a security, our system relies on the judgment of informed investors. Basic economic theory tells us that markets function with the greatest efficiency when all investors have full access to accurate information - as to both price and substance. Thanks to the MSRB, the municipal market has enjoyed nearly full price transparency since January. I believe that transparency of substantive information will become increasingly important for the municipal securities market to compete. A strong, liquid secondary market promotes a healthy primary market. Thus, like other municipal market participants, bond lawyers have a vested interest in maintaining and improving the secondary market. As more and better information becomes increasingly available, we fully expect that bond market liquidity will improve, transaction costs will lower, and issuers will be able to access capital at lower cost. SEC economists recently studied the decline in bond prices following increased price transparency in the corporate bond market. The magnitude of the decline found in their report suggests that $1 billion in additional savings would have been realized by investors in 2003 if all corporate bond prices had been transparent throughout the entire year. The long-run benefits from full substantive and price transparency will undoubtedly be even greater.
Municipal market organizations, including NABL, should be proud of their cooperative efforts to improve informational transparency through the creation of DisclosureUSA. Achievement of the full benefits of transparency, however, will require continued effort and a changed mind set for some issuers and bond lawyers about providing information to the secondary market. Investors should feel confident that issuers will promptly file material event notices covered by continuing disclosure agreements without quibbling about whether or not the facts "should" be material to investors in the face of insistence by investors that they are. For example, investors have made it clear that they consider the issuance of proposed adverse determination letters by the IRS to be of great significance. You undermine investor confidence by keeping them in the dark for months while negotiating with the IRS and taking appeals.
We are confident that issuers can expect to benefit from a lower cost of capital due to the improvements in liquidity from full price and informational transparency. Rather than ask "What's in it for me?" to provide continuing disclosure, issuers and bond lawyers should focus on the enormous overall benefits that come from increased investor confidence. Even if it is not possible to prove in advance that more secondary market information will improve the price of a particular bond, the benefit to the municipal market as a whole is obvious.
Issuers look to bond lawyers for guidance about many things, including releasing information into the secondary market. When giving such advice, we ask that one of the factors you keep in mind be the long term benefits that all of your clients will reap from improved information transparency in the market as a whole.
The recent devastation wrought by Hurricane Katrina on the Gulf coast should remind us all of the importance of the municipal market. Infrastructure repair and replacement alone will undoubtedly require the issuance of many billions of dollars of bonds. Furthermore, there are hospitals and other bond-financed facilities to rebuild. It is essential that the municipal market be one in which investors feel secure if they are to entrust it with sufficient funds to accomplish this monumental task. I call on the bond lawyers of NABL to take the forward looking steps needed to build investor confidence in the municipal market - for the good of the Gulf coast and all America.