TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING MUNICIPAL BOND AND GOVERNMENT SECURITIES MARKETS BEFORE THE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS UNITED STATES SENATE Chairman D'Amato and Members of the Committee: I appreciate the opportunity to provide the views of the Securities and Exchange Commission regarding the municipal bond and government securities markets and the events surrounding the County of Orange, California ("Orange County"). These issues are of vital importance to Americans who invest in the municipal bond market and to the state and local governments that need access to the municipal bond market in order to provide financing for public works and services, and to state and local taxpayers who stand behind municipal bond issuers. My statement will (i) review the public record-[1]- concerning the so-called Orange County "Pools;" (ii) discuss the role of the SEC in municipal finance transactions, with particular attention to the Orange County events; and (iii) make preliminary observations on state and local governments as investors in the securities markets. In addition, as requested in the Committee's letter of invitation, my statement addresses certain issues relating to derivatives, such as dealer and end- user activities and accounting and disclosure practices for derivatives transactions. When I became Chairman of the Commission, I placed reform of the municipal securities markets at the top of my agenda. I did so in the belief that a formerly institutional market had been transformed into a primarily public one, without the protections those investors require: disclosure, transparency and the assurance, as far as possible, of integrity in the offering process. Outstanding issues in the municipal bond market now exceed $1.2 trillion.-[2]- Individual investors, including those holding through mutual funds and money market funds, held approximately 76% of municipal debt outstanding in 1993, compared with 44% in 1983.-[3]- Over the last eighteen months we have undertaken a number of initiatives to enhance the transparency and integrity of this vitally important market. In that time, the Commission has: * Issued in March of 1994 an interpretive release addressing the application of the antifraud prohibitions of existing securities law to the municipal bond markets. The release noted, among other issues, the Commission's concern about municipal issuers' disclosure practices with respect to their derivatives activities, both as issuers and end-users; and reminded municipal issuers that the antifraud provisions apply to their statements that can be reasonably foreseen to affect the secondary market for their securities; * Adopted extensive revisions to existing municipal broker-dealer rules that will facilitate better annual disclosure of financial information and timely disclosure by municipal bond issuers of material events that affect the value of municipal securities; * Taken steps to improve market transparency for the municipal bond and other debt markets; and * Encouraged industry initiatives and approved MSRB Rule G-37 eliminating "pay to play" practices from the municipal bond market. With these measures, we have created significant new tools that will allow the Commission to vigorously enforce the high standards we aspired to 18 months ago. The Committee's invitation letter also requested the Commission to address a number of issues regarding derivatives. This is an area of substantial attention at the Commission. Actions taken by the Commission to address developments in the derivatives markets include: * Undertaken targeted reviews of both 100 investment company prospectuses and 500 corporate annual reports to enhance and clarify disclosure of derivatives activities; * Clarified that money market funds may not invest in volatile, interest rate sensitive derivative instruments; * Focused mutual fund inspections on derivatives activities; * Signed a joint statement with the Commodity Futures Trading Commission ("CFTC") and the U.K. Securities and Investments Board ("SIB") that established an agenda for action and a framework for cooperation in overseeing the over-the-counter ("OTC") derivatives market; * Participated in the preparation of a document issued by the Technical Committee of the International Organization of Securities Commissions ("IOSCO") that provides guidance to regulators on a framework of management control mechanisms for firms engaged in OTC derivatives activities; * Encouraged expedited action by the Financial Accounting Standards Board ("FASB") to publish accounting standards for derivatives activities; * Encouraged an industry group to develop workable, effective standards for risk assessment reporting, capital at risk, management controls and sales practices for derivatives activities of their unregistered affiliates; and * Issued a release revisiting the securities ratings disclosure scheme for Commission registrants in light of the dramatic proliferation of highly complex, customized, structured, and derivative instruments. At the same time, the Commission issued a concept release which explores the appropriate role of the Commission with respect to "nationally recognized statistical rating organizations." I. THE ORANGE COUNTY BANKRUPTCY AND RELATED EFFECTS. On December 6, 1994, Orange County, California, and the "Orange County Investment Pools, an instrumentality of the County of Orange," filed for bankruptcy under Chapter 9 of the federal Bankruptcy Code.-[4]- These filings began the largest municipal bankruptcy in our nation's history. The full effect of these proceedings may not be known for some time. Today, however, we can safely say that the consequences are broad reaching, affecting not only the citizens of Orange County, but residents in other communities and their bond holders as well. Although additional facts come to light daily, we can provide at this time a brief description of the circumstances in which Orange County and approximately 187 local government entities invested public monies using a strategy that has resulted in an estimated loss exceeding two billion dollars.-[5]- A. The Orange County Investment Pools. Pool Participants. The Orange County Treasury managed money for 187 different and separate governmental agencies (the "Participants").-[6]- By early December 1994, the Participants had deposited approximately $7.5 billion in the Orange County Treasury.-[7]- As described by the Treasurer, the Participants included approximately 28 cities in Orange County and 6 cities outside of Orange County, 32 school districts, 5 community college districts and 53 special district accounts, of which four are outside of Orange County . . . 31 different agencies that are governed by [the Orange County Board of Supervisors] . . . also very large sums of money that are sent to [the County Treasury] by the municipal and superior court systems throughout Orange County until needed.-[8]- At least one city, Fullerton, as well as Orange County, enabled its employees to place their retirement accounts with the County Treasurer.-[9]- Districts and agencies within Orange County apparently were required to place funds on deposit in the County Treasury.-[10]- Other local agencies "that have their own treasurer and are not required by law to invest with the County Treasurer"-[11]- elected to deposit monies with the Orange County Treasurer.-[12]- As a result of judicial proceedings, approximately 400 individuals deposited funds with the Treasurer and invested in the Pools.-[13]- Some local agencies, including Orange County as well as several school districts, apparently issued one-year notes solely to invest the borrowed funds in the Pools. Orange County borrowed $600,000,000 in July 1994 to invest in the Pools and five school districts each borrowed in excess of $50,000,000 to invest in the Pools.-[14]- The Pools' Investment Strategy. Until December 5, 1994, Robert L. Citron ("Citron"), the elected Treasurer of Orange County, California, managed the Pools.-[15]- Citron had been the Treasurer of Orange County for over 20 years. Until the recent bankruptcy filings, Citron's investment strategy was to use reverse repurchase agreements-[16]- in "a strategy that utilizes leverage and . . . the use of structured or floating interest rate securities that enabled an approximate leverage figure of 2 to 1."-[17]- This strategy, as characterized in a September 1993 report to the Orange County Board of Supervisors, was "predicated on interest earning rates [continuing] to remain low for a minimum of the next three years."-[18]- Citron reported a return of 8.5% for fiscal year 1993, and 7.74% for fiscal year 1994.-[19]- A significant portion of the Pools appears to have been invested in four-year notes and structured notes issued by federal government sponsored entities ("GSEs"), such as Fannie Mae and Freddie Mac.-[20]- Some of these securities were "structured" to provide a rate of return that was equal to a fixed rate less a multiple of a floating rate index, commonly called "inverse floaters."-[21]- This rate feature makes the market value of the inverse floaters much more sensitive to interest rate fluctuations than traditional fixed or floating rate obligations. If interest rates decrease or remain stable, the inverse floaters provide a high rate of return. In the few years of declining rates prior to early 1994, this would have contributed to the high rate of return achieved by the Pools. When rates increase, however, the interest return is reduced sharply, causing a corresponding drop in the market or "liquidation" value of the note. The numerous increases in short-term rates throughout 1994 had a dramatically negative effect upon rate-sensitive structured notes.-[22]- Orange County's problems were compounded by the fact that it had entered into reverse repurchase agreements at short-term rates, to take long-term rate positions which combined with the structured notes to produce a portfolio highly sensitive to interest rate movements. By December, 1994, an estimated $7.5 billion in deposits with the county treasurer had been leveraged to over $20 billion.-[23]- As rates increased, the returns on long-term obligations no longer exceeded the cost of funds used to acquire them and their market value declined, as did the market value of the inverse floaters. Where long-term obligations were used as securities subject to reverse repurchase agreements, the decline in market value required additional commitments of securities (similar to posting additional collateral) subject to reverse repurchase agreements. Requests for withdrawal of deposited funds, combined with the negative interest return under the reverse repurchase agreements, apparently generated a cash-flow squeeze which precipitated the Orange County bankruptcy. The Assets of the Pools as of December 1, 1994. At the beginning of December 1994, the Orange County Treasurer had received approximately $7.5 billion in deposits from various government agencies within and outside the County.-[24]- Additionally, the Pools had outstanding approximately $12.5 billion in reverse repurchase agreements to which approximately $14 billion in securities were subject, boosting the total securities holdings to approximately $20 billion.-[25]- Of the estimated $14 billion, approximately $10 billion apparently were fixed rate obligations, mostly GSEs. The Pools' Losses and The County's Bankruptcy. On December 1, 1994, Orange County publicly disclosed that the Pools had suffered a "paper" loss of approximately $1.5 billion. On December 6, Orange County did not meet a substantial obligation under a reverse repurchase agreement with CS First Boston ("First Boston"), and First Boston proceeded to liquidate approximately $2.6 billion of securities it held subject to reverse repurchase agreements with Orange County. Reportedly, other firms began to sell securities subject to reverse repurchase agreements with Orange County. Later that day, Orange County and the Pools each filed a petition for bankruptcy under Chapter 9 of the Bankruptcy Code ("Chapter 9"). By Friday, December 9, a substantial part of the securities underlying Orange County's reverse repurchase agreements were reported to have been liquidated by the counterparties.-[26]- The bankruptcy of a local government with a substantial amount and diversity of outstanding municipal bonds presents a host of important issues. The Orange County bankruptcy proceedings are the largest ever commenced under Chapter 9.-[27]- The previous filings did not begin to approach the level of complexity presented by Orange County. Consequently, many of the provisions of Chapter 9 have yet to be interpreted and applied in the context of a large municipality with a substantial amount of outstanding municipal bond debt. Furthermore, the approximately 187 local agencies invested in the bankrupt Pools also are, in many instances, issuers of municipal bonds. Decisions affecting deposits in the Pools by local agencies also may have an effect on holders of their municipal bonds. Because many issues under Chapter 9 affecting certainty of payment on a wide variety of municipal securities may be addressed for the first time, decisions made in the bankruptcy proceedings will be watched very closely by the municipal bond market, and potentially will have a significant effect. These decisions will concern the community of municipal bondholders in general, as well as holders of the bonds of Orange County and the roughly 187 local agencies. The Commission, exercising its statutory right under 1109 of the Bankruptcy Code, has entered an appearance in the Orange County bankruptcy proceeding to monitor the legal proceedings related to liquidation of the securities subject to reverse repurchase agreements and other issues, and we will take action as appropriate to ensure safe, orderly markets. B. Issues Concerning Securities Subject to Reverse Repurchase Agreements. The Orange County bankruptcy petition raised several issues under the Bankruptcy Code with respect to the ability of Orange County's creditors to close out their repurchase agreements with the County. During the days immediately following the filing of the petition, rumors circulated about the County's intention to sue its repurchase agreement counterparties, and perhaps others, if the counterparties sold the securities subject to the repurchase agreements.-[28]- On December 13, 1994, Orange County sued Nomura Securities, Inc. for liquidating the $900 million of government securities it held under repurchase agreements with the County-[29]- arguing that those sales violated the automatic stay provisions of the Bankruptcy Code. In general, under Bankruptcy Code 559, parties to a standard repurchase agreement can liquidate their repurchase agreement positions with the counterparty. This Section was added in 1984 in order to prevent gridlock in the financial markets due to the bankruptcy of a major repurchase agreement participant.-[30]- While Chapter 9 of the Bankruptcy Code does not specifically incorporate 559, that Section states that it operates independently of any need for incorporation. Nonetheless, due to the rarity of large municipal bankruptcy proceedings under Chapter 9, how 559 actually will be applied to proceedings under that Chapter is not certain. Because uncertainty about the effects of bankruptcy can increase costs throughout the financial system as a whole, the Commission, as part of the President's Working Group on Financial Markets ("Working Group"),-[31]- also has been working to increase legal certainty in our financial markets.-[32]- Legal certainty in those markets is essential, because uncertainty inevitably creates disincentives to entering into transactions, potentially damaging market liquidity and causing systemic gridlock in times of market stress. C. Impact on Money Market Funds. At the time that Orange County's financial problems began to be reported in the press, many money market funds held notes issued by Orange County or municipalities that invested in the Orange County Pools ("Orange County notes").-[33]- Money market funds generally seek to maintain a stable net asset value per share, typically $1.00. Money market funds must comply with the risk-limiting conditions of Rule 2a-7 under the Investment Company Act of 1940 ("Investment Company Act"), which require, among other things, that fund investments must be limited to securities that present minimal credit risk.-[34]- As a result of the decline in prices for Orange County notes that immediately followed the bankruptcy filing, some of these funds faced the prospect that they would not be able to maintain their $1.00 share price -- that is, they would "break a dollar."-[35]- Money market fund advisers are not legally obligated to guarantee or otherwise maintain the $1.00 share price of the funds they advise, and funds must prominently disclose in their prospectuses and sales literature that there is no guarantee that this price will be maintained. Many advisers, however, when faced with the prospect of their funds breaking a dollar, have taken actions to support the funds' share price. To maintain their funds' net asset values at $1.00 in the wake of the Orange County bankruptcy, a number of fund advisers voluntarily have purchased Orange County notes from their money market funds.-[36]- Other advisers have obtained irrevocable standby letters of credit from unaffiliated banks for the benefit of money market funds to secure payment of principal and interest on the Orange County notes. Finally, many advisers have provided short-term "puts" for the Orange County notes.-[37]- Many of these actions involve affiliated transactions between a fund and its adviser or a related party that are prohibited by 17 of the Investment Company Act unless the Commission issues an order approving the transaction. The Commission's Division of Investment Management, as it has done in the past in similar instances, granted oral "no-action" relief with respect to a number of transactions involving Orange County notes.-[38]- As of December 31, 1994, 35 funds holding, in the aggregate, approximately $545 million of Orange County notes have received no-action relief from the Division of Investment Management in connection with the types of transactions described above. To our knowledge, no money market fund has been required to break a dollar as a result of the Orange County bankruptcy. If the prices of Orange County notes continue to decline, and a fund's adviser is unable or unwilling to provide support for the share price of a fund holding Orange County notes, however, the per share net asset value of the fund may fall below a dollar. The Commission is continuing to monitor closely the impact of Orange County's bankruptcy on money market funds. II. THE SEC AND MUNICIPAL FINANCE TRANSACTIONS. A. Transactions Between the Local Agencies and the Orange County "Pools." Creation Under California State Law. The ability to commingle local government funds into investment pools and the manner of and limits upon their investment are matters covered by state law. California state law sets the framework for the deposit of local agency monies with the county treasurer for investment and authorizes the types of securities in which public monies may be invested. California law appears to provide statutory authority under which some cities, towns, and other local agencies may choose to deposit their monies with the county treasurer, while others are required to deposit their monies with the county treasurer, who may be authorized to invest the monies in certain financial instruments specified by statute.-[39]- In California, counties are the largest political subdivisions of the state. They are governed by boards of supervisors, which have administrative, financial, and oversight powers. Certain financial matters, including the custody and investment of county monies, are administered by the county treasurer and reviewed by the county auditor, both of which are offices created by state statute. A board of supervisors creates districts, such as school, transportation and road districts, within the county and the board has the power to issue bonds, when approved by the electorate. California state law appears to require the deposit of certain monies with the county treasurer, such as monies of school districts,-[40]- and monies paid into or held by local courts.-[41]- California law also appears to permit probate courts to order that monies belonging to the estate of a minor or incompetent person be deposited with the county treasurer.-[42]- Local agencies that are not required by law to deposit their monies with the treasurer are permitted by California law to deposit excess monies not immediately required for investment, if their governing body authorizes the action.-[43]- The range of permissible investments also are controlled by state law. California state law expressly requires "all money belonging to, or in the custody of, a local agency, including money paid to the treasurer . . . [to] be deposited for safekeeping in state or national banks, savings associations or federal associations . . . in the state," or invested in specified types of securities.-[44]- The state periodically has expanded this list by statutory amendment, adding reverse repurchase agreements in 1979 and, subject to a percentage limit, collateralized mortgage obligations, equipment lease-back certificates, consumer receivable pass-through certificates and other structured obligations in 1992.-[45]- The investment list contains quality requirements applicable to certain types of investment. Exemption from the Investment Company Act for Government Pools. The Commission generally does not have, nor does it seek, the ability to regulate investment decisions by municipalities or other end-users of securities.-[46]- Investors seeking higher than average returns generally undertake higher than average risks. That decision generally should be made by the investor. In the case of state and local public instrumentalities, investment decisions should be made with the guidance and oversight of state and local governments. The Investment Company Act excludes from registration and regulation state and local governments and investment pools operated by one or more of these governmental entities.-[47]- The broad wording of the exclusion strongly indicates that Congress anticipated that state and local governments would establish and participate in investment pools as a means to effectuate government functions, and concluded that the federal government should not regulate those pools as investment companies. Consistent with the statutory language and purpose of S 2(b), the exclusion has been construed broadly by the Commission's staff.-[48]- The Orange County Pools are not now, and to our knowledge have never been, registered under the Investment Company Act.-[49]- Presumably, the determination not to register under the Investment Company Act was made on the basis of the S 2(b) exclusion.-[50]- The Commission believes that state and local governments should have the authority to manage their cash reserves and monies in government custody either individually or collectively. Further, the Commission believes that state and local governments or the pools created to serve this function should be able to rely on the exclusion in 2(b) of the Investment Company Act. State and local governments are in the best position to regulate the manner in which municipal funds are managed. In the Commission's view, absent special facts, requiring municipal entities to operate in compliance with the Investment Company Act would represent unnecessary federal intervention into state and local affairs. If it determines that the Commission should regulate these pools, Congress would have to amend the Investment Company Act to give the Commission the necessary authority and provide additional resources.-[51]- B. Offers and Sales of Municipal Securities. Municipal Securities Disclosure. The market for municipal securities has been largely unregulated at the federal level. Both the Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange Act") were enacted with provisions containing broad exemptions-[52]- for municipal securities from their provisions, except for the antifraud provisions. Municipal securities received special exemptions at that time due not only to considerations of federal-state comity, but also to the absence of perceived abuses in the municipal securities market as compared to the corporate market. Furthermore, the typical investors in municipal securities in the 1930s were institutional investors. In the past few decades, however, this situation has changed. In the 1970s, in response to abusive practices by dealers in municipal securities, as well as to the increasing number of retail investors in this market, Congress established a limited regulatory scheme for the municipal securities market. The Securities Acts Amendments of 1975-[53]- included provisions for the mandatory registration of municipal securities brokers and dealers and the creation of the MSRB. In 1989, acting in response to consistently slow dissemination of information in connection with municipal securities offerings, the Commission adopted Exchange Act Rule 15c2-12,-[54]- which requires dealers to obtain and review issuers' official statements prior to selling bonds, and to provide official statements to customers and potential customers. At that time, the Commission also issued an interpretation concerning the due diligence obligations of underwriters of municipal securities.-[55]- Underwriters, of course, play an integral role in the distribution of information, and they have a duty to review the disclosure documents and have a reasonable basis for believing these documents are accurate and complete.-[56]- In 1993, the Commission's Division of Market Regulation did an overall review of the municipal securities market, including secondary market disclosure. Its findings, published in the September 1993 Staff Report on the Municipal Securities Market,-[57]- underscored the need for improved disclosure practices in both the primary and secondary municipal securities markets, notwithstanding voluntary industry initiatives to improve disclosure. In March 1994, the Commission published the Statement of the Commission Regarding Disclosure Obligations of Municipal Securities Issuers and Others ("Interpretive Release"),-[58]- which outlined its views with respect to the disclosure obligations of market participants under the antifraud provisions of the federal securities laws in connection with both primary and secondary municipal market disclosure. With respect to primary offerings of municipal securities, as articulated in the Interpretive Release, the disclosure documents used by municipal issuers, such as official statements, are subject to the prohibition against false or misleading statements of material facts, including the omission of material facts necessary to make the statements made, in light of the circumstances in which they are made, not misleading.-[59]- In the Interpretive Release, the Commission stated, among other things, that municipal issuers must consider disclosure issues arising from their activities as end-users of derivative products.-[60]- Disclosure documents need to discuss the market risks to which issuers are exposed, the strategies used to alter such risks, and the exposure to both market risk and credit risk resulting from risk alteration strategies.-[61]- The Interpretive Release included these statements in its discussion of existing disclosure practices in need of improvement. With respect to accounting disclosure, the Interpretive Release pointed out that sound financial statements are critical to the integrity of the primary and secondary markets for municipal securities, just as they are for corporate securities. The Interpretive Release encouraged the use of audited financial statements and an explanation of accounting principles followed in the preparation of financial statements, unless statements were prepared in accordance with generally accepted accounting principles ("GAAP").-[62]- In order to avoid providing investors with an outdated, and therefore potentially misleading, picture of the issuer's financial condition and results of operations, the Interpretive Release indicated that audited financial statements should be available as soon as practicable.-[63]- The Release also stated that unaudited financial statements for the most recent fiscal year and other current financial information should be provided in the interim prior to completion of the audit.-[64]- In addition, the Interpretive Release pointed out that narrative explanations of data may be necessary where a numerical presentation alone is not sufficient to permit an investor to judge the financial and operating condition of the issuer or obligor.-[65]- The Interpretive Release also addressed questions of conflict of interest, and noted that information about financial and business relationships and arrangements among the parties involved in the issuance of municipal securities may be critical to an evaluation of an offering.-[66]- Failure to disclose material information concerning such relationships, arrangements, or practices may render misleading statements made in connection with the offering process, including statements in the official statement about the use of proceeds, underwriters' compensation, and other expenses of the offering.-[67]- In addition, the Interpretive Release reaffirmed the Commission's previous interpretation with respect to underwriters' responsibilities under the antifraud provisions of the federal securities laws, and emphasized the responsibilities of brokers and dealers in trading municipal securities in the secondary market. The Interpretive Release emphasized the importance of municipal issuers' establishing practices and procedures to identify and timely disclose material information, including current financial information and material events subsequent to the initial offering, as a way of minimizing the risk of misleading investors with incomplete or outdated information that is otherwise made available by the municipal issuer. The Interpretive Release makes clear that when a municipal issuer releases information to the public, through public statements and the issuance of reports, which information is reasonably expected to reach investors and the trading markets, that disclosure is subject to the antifraud provisions. Concurrent with the publication of the Interpretive Release, the Commission published a release that requested comment on proposed amendments to Rule 15c2-12,-[68]- designed to enhance the quality, timing, and dissemination of disclosure in the municipal securities market by placing certain requirements on brokers, dealers, and municipal securities dealers. The Commission recently adopted these amendments in final form.-[69]- The amendments prohibit dealers from underwriting an issuance of municipal securities without having reasonably determined that an issuer or obligated person has undertaken to provide both annual financial information and notices of specified material events to certain information repositories. The amendments also prohibit brokers, dealers, and municipal securities dealers from recommending the purchase or sale of municipal securities to which the underwriting prohibition applied unless they have in place procedures that provide reasonable assurance that they will receive promptly any notices of material events regarding these securities. The amendments are being phased in over a short period of time to allow municipal issuers and underwriters the time to put necessary procedures in place to comply with the new rules. When they become fully effective on January 1, 1996, these amendments should result in significant improvements in the existence and availability of secondary market disclosure. As indicated in the Interpretive Release, the Commission supports legislation addressing the exempt status of conduit securities under the federal securities laws. Bonds used to finance a project to be used in the trade or business of a private entity are, from an investment standpoint, equivalent to corporate debt securities issued by the underlying corporate obligor, in which the investor looks, and can look, only to a private entity for repayment. Investors need the same disclosure regarding the underlying non-municipal corporate obligor as they would receive regarding any corporate obligor under the same regulatory and liability scheme. In the Interpretive Release, the Commission renewed its legislative recommendation to amend Section 3(a)(2) of the Securities Act and Section 3(a)(29) of the Exchange Act to remove the registration exemption for the non- governmental corporate credit underlying municipal conduit securities involving private activity financings, and the Commission continues to support this recommendation. The Commission's municipal disclosure initiatives, undertaken pursuant to its antifraud and municipal securities dealer authority, provide a foundation for substantial enhancement of disclosure and offering practices in the municipal bond market. These initiatives are quite recent, and the rulemaking will be effective for offerings beginning in 1995. Congress, therefore, may wish to assess the efficacy of these initiatives before considering any legislative action to change the largely exempt status of municipal securities under the federal securities laws. Such action would have profound effects on the municipal bond market and, given the 52,000 issuers of municipal securities, could require significant resources to administer.-[70]- Improving Market Transparency. Improving disclosure practices is not our only effort in the municipal market. While enhanced transparency is needed throughout the debt markets, including the corporate debt market, the need is most acute in the municipal bond market, given the broad and diverse investor base in that market.-[71]- In a completely transparent market, all market participants have equal and immediate access to all quotations, including the size of the quotations, and to reports of prices and all volumes in all trades effected in the market. Price transparency enhances market liquidity and depth, and fosters investor confidence, while a lack of price information impairs market pricing mechanisms, weakens competition, and prevents investors from monitoring the quality of their executions. There are significant structural differences between the secondary market for municipal debt when compared to the secondary market for other debt issues. Although there exist over one million different municipal securities issues, only an average of 180 issues trade actively in the secondary market at any given time. Further, most trading activity in municipal securities issues occurs shortly after issuance. Municipal securities also are priced very differently from equity issues, based in part on the way they trade. Nevertheless, these differences should not necessarily preclude last sale reporting to public investors and market participants for a segment of actively traded municipal securities. The Commission therefore is overseeing the development and implementation by the MSRB and market participants of proposals to make pricing information available to investors.-[72]- The MSRB has a four phase program to make this information available: Phase One -- As of January 16, 1995, reports of inter- dealer transactions and daily high-low and average price figures for the most frequently traded issues will be made public. Phase Two -- Through 1995 these requirements will be expanded to include institutional customer transactions. Phase Three -- Through 1996 these requirements will be expanded to include retail transactions.-[73]- Phase Four -- In early 1997 there will be more contemporaneous reporting of transaction information. In addition to the MSRB's program, the Public Securities Association ("PSA") has a proposal to develop a generic scale and yield curve for AAA-insured revenue bonds, to be made available to daily newspapers.-[74]- The PSA also proposes to establish a "900" number, which investors could call to obtain price information regarding particular municipal securities.-[75]- If we determine, over the next four months, that these initiatives have not progressed to our satisfaction, we will consider other regulatory action to ensure that investors have access to pricing information.-[76]- The cooperation of market participants in efforts to improve price transparency may produce a market-sponsored solution. As a result of both the disclosure and price transparency initiatives, the Commission has set the framework for a radical change in how business is conducted in the municipal securities market. Improvements in Accounting and Financial Reporting. The Government Accounting Standards Board ("GASB"), created in 1984, promulgates standards of accounting and financial reporting, that are encouraged or are required to be followed in a majority of state and local governments. The goal of these standards is to provide guidance that will result in useful information for users of financial reports including, among others, investors. Through December 31, 1994, GASB has issued 27 Governmental Accounting Standards Board Statements ("Statements"). GASB Statement No. 3, Deposits with Financial Institutions, Investments (including Repurchase Agreements), and Reverse Repurchase Agreements-[77]- addresses, among other matters, the accounting and disclosures required with respect to investments by state and local government entities including repurchase and reverse repurchase agreements. While that standard requires disclosure of the market value and carrying value of each major category of investments, it does not require that any specific accounting method be followed in determining the carrying amount. The standard does require, however, that the accounting principles used to determine carrying amounts be disclosed in a footnote. Thus, there currently is no articulated standard that governs how state and local governments must measure the carrying value of these investments.-[78]- Orange County's financial statements, which were certified as prepared in accordance with generally accepted accounting principles, for the fiscal year ended June 30, 1993 indicate that investments were valued at cost, with noted exceptions. A footnote to the statements discloses information required by Statement No. 3 including the carrying value and market value of investments. As of June 30, 1993, aggregate market value of investments exceeded aggregate cost by approximately $50 million. Standards for accounting recognition and disclosure of investments recently have been addressed by GASB in Technical Bulletin No. 94-1 ("Technical Bulletin"), Disclosures about Derivatives and Similar Debt and Investment Transactions. The Technical Bulletin prescribes standards of disclosure to be followed for derivatives and similar financial instruments. The Technical Bulletin recognizes that structured notes are similar to derivatives. Among other matters, the Technical Bulletin requires disclosure of risks "to the extent that these risks are above and beyond those risks that are apparent in the financial statements or are otherwise disclosed in the notes to the financial statements." The issuance of the Technical Bulletin should improve state and local governments' accounting and disclosures for investment activities including those involving derivatives and similar instruments. Further progress by GASB in addressing these critical accounting and financial reporting issues is necessary. The Commission does not have authority with respect to the accounting principles applicable to municipal issuers and it does not oversee the standard setting process of GASB, as it does with respect to the FASB. In order for the adoption of transparent accounting and disclosure requirements to be most useful, information must be provided on a timely basis. Current financial statement practices vary widely. The GFOA Guidelines do not provide guidance on the timeliness of financial statements for offerings of municipal issuers' general obligation bonds. Antifraud proscriptions are the principal legal mandate governing the currency of financial information in municipal offering documents. Likewise reporting practices to the secondary market are equally diverse. Indeed, the provision of audited financial statements within six months following the close of the fiscal year is not widely enough practiced for the Commission to have incorporated the standard into its recent rulemaking. Instead, the new rules require that annual financial information be provided at least annually and that audited financial statements be provided when and if available to the issuer. The economic events of 1994 are an outstanding example of how rapidly and significantly markets and market values can change and the importance of disclosure of current information. C. Sales of Securities to Municipalities. Broker-dealers that recommend the purchase or sale of a security, including a derivative security, are subject both to sales practice standards arising from the antifraud provisions of the federal securities laws, and to the suitability and other fair dealing rules of the securities self-regulatory organizations ("SROs") (except that such rules of the National Association of Securities Dealers, Inc. ("NASD") currently do not apply to exempted securities).-[79]- The antifraud provisions prohibit false or misleading statements. In addition, the SRO rules provide that a broker-dealer must have a reasonable basis for believing that its securities recommendations are suitable for the customer in light of the customer's financial needs, objectives, and circumstances. The NASD rule requires broker- dealers to make a suitability determination before executing a trade in a recommended security, other than an exempted security.-[80]- While these suitability rules apply to recommendations made to all customers, the manner in which they apply depends, among other things, on the nature and circumstances of the customer. The NASD currently has solicited member comment on an interpretation of its suitability rules that seeks to delineate the obligations of a broker-dealer when making recommendations to a larger, more sophisticated institutional investor.-[81]- Working Group Investment Policies and GFOA Model Code. The range of permissible investments for state or local governmental entities is controlled by state or local law. The Commission does not believe federal legislation in this area would be appropriate. The Working Group has begun working with representatives of state and local governments to promote sound investment practices. I am hopeful that the Working Group will be successful in assisting the states and other interested parties in encouraging the use of written investment policies that will take into account not only the risks that were present in Orange County's situation, including its leveraging strategy, but other types of risks as well. As demonstrated so vividly in Orange County, leveraging investments can magnify losses as well as profits. Governmental entities should have a method for determining whether and how to use leveraging techniques. Moreover, they should have controls in place to ensure that their investments do not exceed established limits. In addition, any investment policies should address the potential risks of investing in the types of interest rate sensitive structured notes and derivatives in which Orange County invested. Orange County's experience illustrates that the market risk that comes with these and other derivative instruments may be significant. The Government Finance Officers Association's June 1994 statement recommending practices for the use of derivatives by state and local governments-[82]- could provide a starting point for developing sound written investment policies. III. STATUS OF ISSUES RELATING TO DERIVATIVES. As requested by the Committee, the remainder of this statement will briefly review the current status of the Commission's involvement in certain regulatory issues concerning derivatives. The term "derivative" encompasses a broad range of financial products, including exchange-traded options and futures, mortgage-backed securities, structured notes with embedded options or other derivatives features, and individually negotiated OTC options, swaps and forwards. These instruments are similar in that they derive their value from other products, prices or indexes. In addition, these instruments present market or interest rate risk for investors, and some, particularly those traded OTC, present credit risk for counterparties to the transactions. A. Dealer Activities. Many derivative products are already squarely within regulatory systems that provide safeguards for counterparties and for the financial system as a whole. The Commission, for example, has jurisdiction over derivatives that are securities, whether they are traded in the OTC market or on a securities exchange. In general, transactions involving derivative products that are securities must be effected by a broker-dealer that is registered with the Commission and is a member of one or more SROs. Through participation in the Working Group, the Commission has discussed with other federal regulators the appropriateness of sales practice standards for OTC derivative products that are not currently subject to sales practice requirements. In addition, the Commission's staff has met with staffs of the SROs to discuss sales practice standards for OTC derivatives. Those discussions are part of the process of implementing the agenda for oversight of the OTC derivatives market specified in the recently issued joint statement by the Commission, the CFTC, and the SIB.-[83]- Commission staff also has met with representatives of several of the largest OTC derivative dealers to discuss current industry practices and to identify best practices. Recent Initiatives. 1. Capital. The Commission has been working toward revising the capital requirements applicable to broker-dealers to better reflect modern financial theory and contemporary risk reducing techniques. In May, 1993 the Commission solicited comments on the treatment of derivative products under the net capital rule.-[84]- As a first step in revising the net capital rule in the derivatives area, the Commission, in March 1994, issued a release proposing the use of a theoretical pricing model to set capital charges for exchange-traded options and related positions, including underlying securities, futures on underlying securities, and highly correlated broad-based indexes.-[85]- This proposal would further incorporate modern portfolio theory into the net capital rule. While this proposal applies only to listed options and related positions, the Commission staff is working with the industry on an objective approach that would extend this theoretical pricing approach to OTC options, including debt options. As a second step, the Commission staff is developing an approach that would integrate interest rate swaps, futures, and forward contracts on debt instruments, government securities, and debt securities into a unified computation of market risk capital charges. This initiative relies to a large extent on the recommendations of the Basle Committee on Banking Supervision ("Basle Committee"). Finally, the Commission staff is developing a proposal that would assess capital charges on the credit risk inherent in certain OTC derivative products, including OTC options, interest rate swaps, and foreign currency forwards. In order to encourage broker-dealers to trade OTC derivative products in registered entities, the Commission staff is reviewing proposals of various industry representatives to devise a more sophisticated approach for credit risk in OTC derivatives. 2. Management Controls. Risk management controls provide end-users with the ability to monitor and control their activities and risk. Broker-dealers also benefit greatly from management controls. Thus, the Commission staff is working to provide guidance to broker-dealers on prudent management controls and risk management procedures, particularly with respect to derivatives activities. In addition, as part of its examination program, the staff is developing better methods of assessing broker-dealers' risk management systems. As part of these efforts, as noted earlier, the Commission, CFTC, and the SIB in March 1994 issued a joint statement concerning the oversight of the OTC derivatives market, which included an agreement to cooperate in developing sound management controls.-[86]- Building on the joint statement, the Commission staff took part in the preparation of a document issued by IOSCO providing guidance to regulators on a framework of management control mechanisms for securities firms conducting OTC derivatives activities. The Basle Committee simultaneously issued a similar document directed toward bank derivatives activities.-[87]- In releasing these documents jointly, the two Committees emphasized the importance that both bank and securities regulators place on sound internal risk management of derivatives activities. 3. Derivatives Policy Group. Participants in the derivatives industry are working to develop minimum standards for business conducted by derivatives dealers. Six major securities industry participants in OTC derivatives trading activities have formed a Derivatives Policy Group to examine a regulatory framework for derivatives dealers that are unregistered affiliates of broker-dealers. The Policy Group is working on four areas: risk assessment reporting, capital measurement, management controls, and sales practices. We expect the Policy Group to produce its final recommendation in the near future. B. End-User Activities. Municipal and Corporate End-Users. 1. Management Controls. Management controls are the first line of defense against the risks posed by OTC derivatives transactions, for both corporate and governmental end-users. Management controls must be understood and evaluated at all levels of management, including senior officials and boards of directors and state and local government supervisory bodies. Boards and senior executives should define the fundamental risk management policy of the entity, including clearly articulated policies governing the use of derivatives and other interest rate sensitive instruments. The board of directors of business corporations and senior management and state and local government officials and administrators also should provide effective oversight of these activities for consistency with the defined policies and should monitor the continued appropriateness of the policies in light of business and market developments. Equally vital is a system to assure that the risk management program (including the use of derivative instruments) is properly executed consistent with risk management policies and controls. Controls and management practices for the investment of public funds are set by state law and vary from state to state. Municipal government associations such as the Government Finance Officers Association and National Association of State Treasurers have adopted numerous policy statements and model legislation promoting both responsible fund management practices and the establishment of state and local investment pools to increase the rate of return on invested public monies.-[88]- 2. Accounting and Disclosure. One of the highest priorities for regulators and the securities industry is to improve accounting and disclosure for derivative transactions. In October 1994, the FASB issued a standard on disclosures concerning derivatives, Statement of Financial Accounting Standard No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments ("FAS 119").-[89]- The Commission regards this standard as a very positive step toward improving disclosure in this very important area. In addition, FASB anticipates issuing an exposure draft on hedge accounting by mid-1995. The Commission staff has been examining closely disclosures made by companies identified as having derivatives positions or significant derivatives activities. The Division of Corporation Finance has completed a targeted review of approximately 500 companies' 1993 annual reports to review disclosure of derivatives activities by such companies. This activity had two objectives: to enhance the disclosures by public companies, and to determine whether the Commission should issue guidance in this area. In connection with reviews of filings, the Commission staff has been working with public companies to expand textual and quantified disclosures that will provide a better understanding to investors of the type, extent and potential effects of companies' derivatives activities. Information sought has included: * quantification of revenues from trading activities; * a description of end-user activities including identification of risks being managed; * summarized information concerning outstanding end- user positions at the latest balance sheet date; * quantified information concerning deferred gains and losses on terminated positions; and * methods and quantified parameters used to monitor and control risk management strategies. Based on the results of this review program and in light of the recent adoption of FAS 119, the Commission anticipates providing additional disclosure guidance for its registrants in the first quarter of 1995. Mutual Fund Use of Derivatives. Since the summer of 1993, the Commission has focused on a broad range of issues concerning mutual fund use of derivative instruments, including disclosure, pricing, liquidity, leverage, risk management, and the use of derivatives by money market funds. A staff task force has examined the derivatives disclosures of 100 investment companies, representing a broad sample of complexes and fund types, and the Commission's fund disclosure review staff has given heightened scrutiny to derivatives disclosure in prospectuses. In addition, the Commission's inspection staff is examining and reporting on the derivatives activities of each fund inspected, and has conducted special examinations of certain funds holding significant positions in derivatives. The Commission believes it is critical that investors receive understandable disclosure about the manner in which a mutual fund uses derivatives and, in particular, the associated risks. Last February, the Commission staff issued a letter to all registered funds, noting that in many cases fund disclosures regarding derivative instruments are unduly lengthy and technical. The letter encouraged funds to modify their disclosure to enhance investor understanding of the risks associated with derivative instruments.-[90]- In addition, the Commission intends to issue a release early this year that will seek public comment regarding mutual fund risk disclosure, including whether funds should be required to disclose a quantitative risk measure. The Commission also is reviewing the regulatory limitations on mutual fund investments in derivatives. In general, the Investment Company Act does not contain broad prohibitions on a mutual fund's investment in any particular type of instruments, including derivatives. The Investment Company Act does, however, contain limitations on a fund's use of leverage,-[91]- which the Commission and its staff have applied to mutual fund investments in certain derivative instruments.-[92]- In addition, the Commission has published a guideline requiring that mutual funds generally limit their investments in illiquid assets to 15% of net assets (10% in the case of money market funds), and some derivatives may be illiquid under certain market conditions.-[93]- The Commission has emphasized the importance of the role of funds' managements and boards of directors in the area of derivatives. Adequate risk management systems are critical to a mutual fund's ability to monitor the risks associated with derivatives. Adequate management controls also are important to accurate pricing of derivative instruments, which may, on occasion, be a difficult task. The Commission staff has found, during inspections, that a number of funds appear to have strong risk management systems and other management controls in place, but we remain concerned that these funds may not be fully representative of the industry. We will continue to inspect funds' management controls and will consider appropriate steps to encourage better management controls. I have urged fund directors to exercise meaningful oversight of fund derivative investments, involving themselves in portfolio strategies, risk management, disclosure and pricing issues, accounting questions, and internal controls.-[94]- While the Commission's resources are sufficient to permit it to scrutinize the derivatives activities of individual mutual funds on only a periodic basis, the directors of each fund are well-positioned and obligated to protect the interests of the fund's shareholders on an ongoing basis. C. Enforcement. The Commission not only is focusing on the regulatory issues raised by derivatives but also on the enforcement issues raised by those products. Recently, for example, the Commission and the CFTC concluded a very significant enforcement case against BT Securities Corporation ("BT Securities"), a broker-dealer subsidiary of Bankers Trust New York Corporation. The Commission's order issued in this matter states that, between October 1992 and March 1994, BT Securities defrauded its customer, Gibson Greetings, Inc. ("Gibson").-[95]- BT Securities' violations stem from derivatives it sold to Gibson. During this period, BT Securities' representatives misled Gibson about the value of the company's derivatives positions by providing Gibson with values that significantly understated the magnitude of Gibson's losses. As a result, Gibson remained unaware of the actual losses from derivatives transactions and continued to purchase derivatives from BT Securities. BT Securities generated approximately $13 million in revenues from selling derivatives to Gibson over a 15-month period. The Commission further alleged that BT Securities failed reasonably to supervise its employees. BT Securities consented to the entry of orders by the Commission and the CFTC that together imposed a $10 million civil penalty. In addition, the Commission's order censured BT Securities and directed it to cease and desist from violations of the antifraud and reporting provisions of the federal securities laws. Concurrent with its order in the BT Securities matter, the Commission issued a temporary exemptive order that provides broad relief from broker-dealer registration in connection with certain transactions involving individually negotiated, cash-settled OTC options on debt securities (and groups or indexes of debt securities), to the extent such options are securities.-[96]- Specifically, the order provides a retroactive exemption from broker-dealer registration for firms that limit their activities to transactions involving individually negotiated, cash-settled OTC options on debt securities or groups or indexes of such securities, provided such transactions: (1) are documented as swap agreements and (2) satisfy the terms of the CFTC's swap exemption. The Commission issued the temporary exemption in order to avoid any short-term dislocation of existing OTC derivatives markets. The exemption, however, is scheduled to expire September 30, 1995. During the next nine months, the Commission staff intends to meet with dealers in order to assess what activities they are conducting pursuant to the exemptive order, and to continue working on revising the net capital rule. The staff also will continue to analyze how rules regarding margin, credit, and sales practices apply to activities in OTC derivative markets. It is widely recognized that derivative instruments are important financial management tools that, when used properly, provide significant benefits to corporations, financial institutions, and institutional investors in managing the risks of their business exposures or financial assets. Derivatives also permit investors to lower their funding costs and, in many instances, provide a cheaper and more liquid way of attaining desired exposure than a position in the cash market. The Commission, therefore, does not intend to take action that would disrupt this important market. It is expected that the staff's assessment prior to the expiration of the order will provide sufficient opportunity to determine whether the exemptive relief given under the order should be continued, or whether transactions involving certain categories of OTC derivative instruments can fit comfortably into the existing federal securities regulatory system.-[97]- CONCLUSION One can not understate the seriousness of the effects of the Orange County bankruptcy. It would be a grave error, however, to demonize derivatives and blame them for the loss. As I have said on prior occasions, derivatives are not inherently bad or good - - they are a bit like electricity: dangerous if mishandled; but bearing the potential to do tremendous good. Like any new innovation, the use of derivatives needs to be watched closely by end-users and by regulatory agencies. Mr. Chairman, I hope that I have made it evident how deeply committed the Commission is to reforming the municipal bond business. To us, this thriving market represents much more than money -- it represents the schools that teach our children, the water we drink, the power that drives our economy, and the roads that take us where we want to go. This market should be governed by the very highest standards. I am confident that, with your support, and with the continued cooperation of the industry, we will succeed in attaining those standards. -------------------------- END NOTES --------------------------- -[1]- The information contained in this Statement concerning the events surrounding the bankruptcy filings by Orange County is based on publicly available information. The Commission is currently conducting an investigation into a number of aspects of these events. This Statement does not discuss nonpublic matters relating to that investigation or that may become the subject of actions by the Commission or by other authorities. -[2]- Public Securities Association. In any given year there are between 6000 and 8000 new issuances. -[3]- The Bond Buyer, "Holders of Municipal Debt," July 1, 1994, 5. -[4]- 11 U.S.C. S 901 et seq. -[5]- "Valuation of County of Orange Investment Portfolio," Salomon Brothers Inc., December 13, 1994. -[6]- County of Orange, Office of the Treasurer-Tax Collector Annual 1992-93 Financial Statement, September 10, 1993 ("Treasurer's 1993 Report"). -[7]- G. Bruce Knecht "Derivatives Lead To Huge Loss in Public Fund," Wall Street Journal, December 2, 1994, A3. A report entitled "Valuation of County of Orange Investment Portfolio" released by Orange County financial advisors after the bankruptcy filing lists the "Amount Contributed by Fund Investors" as $7.42 billion as of December 12, 1994. -[8]- County of Orange, California Office of the Treasurer- Tax Collector Annual 1993-1994 Summary Financial Statement, September 26, 1994 ("Treasurer's 1994 Report"). -[9]- Jessica Crosby, "Fullerton Workers' Savings at Risk; CITIES: 78 Employees Have Deferred Savings in County Fund," Orange County Register, December 22, 1994, p. 18. -[10]- See, e.g., Cal. [Educ.] Code S 35010. -[11]- Treasurer's 1993 Report. -[12]- Cal. [Gov't] Code S 53684. -[13]- H.G. Reza, "Injured Children's Families Fear Losses in bond Fiasco," Los Angeles Times, December 18, 1994, at A1. -[14]- See United States Bankruptcy Court Central District of California, Case No. SA 94-22272-JR, Ex Parte Motion of County of Orange Pursuant to Local Bankruptcy Rule 113(1) for Emergency Order Authorizing Certain Payments of Amounts Equal to Interest on Bond Obligations of County due January 1995; Declaration of Gedale B. Horowitz in Support Thereof; see also Betsy Bates and Marilyn Kalfus "Analysis: grim view for schools," Orange County Register, December 22, 1994. -[15]- See California Government Code S 53684 (authorizing county treasurers to invest funds). On December 5, 1994, Citron resigned as county treasurer and was temporarily replaced by his deputy, Matthew R. Raabe. -[16]- A "repurchase agreement" provides for the "sale" of securities (generally government securities) by a dealer to a customer, with a simultaneous agreement by the customer to "resell" the securities back to the dealer on a date certain or on demand, not more than one year after the original transaction. "Reverse repurchase agreements" are repurchase agreements initiated by the dealer, where the dealer agrees to "buy" securities from the customer in exchange for funds and the customer simultaneously agrees to "buy back" the securities at a later date certain or on demand by the dealer. -[17]- Treasurer's 1993 Report. -[18]- Id. -[19]- See Treasurer's 1993 Report, supra, and Treasurer's 1994 Report, supra. Orange County's investment fund averaged annual returns of 10 percent annually over the past 15 years. Sallie Hofmeister, "Many Questions, but Too Late," N.Y. Times, December 6, 1994, at D1. -[20]- See Leslie Wayne, "Big County Is Facing Huge Loss," N.Y. Times, December 2, 1994, D1; Laura Jereski, "Orange County Fund Losses Put at $2.5 Billion," Wall St. J., December 12, 1994 A3. -[21]- Inverse floaters are one of a variety of structured notes. Others include instruments which return an amount of principle at maturity that may vary in accordance with other indices. -[22]- Such notes carry limited credit risk; Orange County's difficulties occurred without a single default by an issuer of the structured notes. -[23]- This "leveraged borrowing," as press accounts characterize the Orange County holdings, likely reflects the significant amount of reverse repurchase agreements. Municipal securities and government securities are exempted securities for purposes of 7 and 11 of the Exchange Act and Regulations G, T, U and X, promulgated thereunder, which govern extensions of credit to purchase or maintain ownership of securities. The requirement that a customer must deposit a certain amount of cash or eligible securities in his or her account is known as a "margin" requirement. The original justifications for controls on margin included protecting "the margin purchaser by making it impossible for him to buy securities on too thin a margin." Stock Exchange Practices, Report of Senate Comm. on Banking & Currency, S. Rep. No. 1455, 73rd Cong., 2d Sess. 11 (1934). At that time, government securities were issued predominantly in the form of traditional, interest bearing bonds. Unlike corporate and municipal issues, government debt posed no credit risk to investors, allowing the federal government to borrow at a lower cost than individuals, corporations, or municipalities. Borrowing by investors to purchase government securities therefore was not an issue of concern to the drafters of the Exchange Act. More recently, there has been a proliferation of government securities which are more complex, and riskier, than the traditional bonds on which they are based. "These instruments include mortgage-backed securities and real estate mortgage investment conduits ("REMICS") issued or guaranteed by government agencies or GSEs, zero-coupon instruments such as STRIPS [separate trading of registered interest and principal], agency mortgage-backed securities stripped into interest-only and principal-only pieces, and over-the-counter options on government securities." Department of the Treasury, Securities and Exchange Commission, Board of Governors of the Federal Reserve System, Joint Report on the Government Securities Market (January 1992). The ability of GSEs to package pools of mortgages into different REMIC tranches, for example, has permitted investors to earn rates of return which were higher than those of the mortgage securities underlying the REMIC itself, and higher than the rate at which investors can borrow. In addition, the strong demand for high yield instruments issued by well-capitalized GSEs, combined with the tremendous volume of mortgages GSEs bought and resold in the secondary mortgage markets, enabled the GSEs to reduce their borrowing costs through structured notes designed to meet the specific demands of investors. State and local governments, in particular, invest heavily in government securities, due to their reliance on such investments as "safe" obligations. H.R. Rep. No. 103-255, 103rd Cong., 1st Sess., at 32 (1993). State and local governments therefore may face a disproportionate portion of the risk posed by these investments, which although perceived generally to pose no credit risk, may actually pose other significant risks to the investor. -[24]- See note 5, supra. The Treasurer's 1993 Report refers to a "Local Agency Investment Pool" and a "Commingled Fund" through which deposits were invested. Press accounts also refer to a "Bond Pool" (collectively the "Pools"). -[25]- Press accounts describe the reverse repurchase agreements in terms of loans collateralized by pledged securities. See Jereski, supra. -[26]- N.Y. Times (December 10, 1994), at 39. According to the New York Times, all of the repurchase agreement counterparties, with the exception of Merrill Lynch, Pierce, Fenner & Smith and Donaldson, Lufkin & Jenrette had liquidated their securities subject to reverse repurchase agreements by December 10, 1994. -[27]- Of the handful of bankruptcies that have been filed under Chapter 9, most have involved small local governments. -[28]- See, e.g., "Today Orange County...," Business Week (December 19, 1994) at 28. "It still isn't clear whether those firms are prohibited from liquidating their collateral in the wake of the filing. 'People are scared to death,' says one Wall Street Executive. `No one wants to be the last to get their money.'" Id.; "Orange County is to Sue Some Firms; It Defaults on $110 Million Bond Issue," Wall Street Journal (December 9, 1994) at A3; "Orange County Defaults, Wall Street Sells," Washington Times (December 9, 1994) at B8. -[29]- In re Orange County Investment Pools, Complaint of Orange County Investment Pools, Plaintiff v. Nomura International Securities, Inc. (Bankr. C.D. Cal.) (No. SA 94-22273-JHR) (December 9, 1994). -[30]- S 559 of the Bankruptcy Code enforces contractual agreements between repurchase agreement counterparties to liquidate their positions upon the insolvency of the other party to the agreement. The 1984 amendments to the Bankruptcy Code were enacted to reverse the holding of Lombard-Wall, which held that the holder of securities subject to a repurchase agreement was subject to the automatic stay of the Code. Lombard-Wall Inc. v. Columbus Bank & Trust Co., No. 82 B 11556 (Bankr.S.D.N.Y. Sept. 16, 1982). See S. Rep. No. 65, 98th Cong. 47 (1983). -[31]- The Working Group, which was created following the October 1987 stock market break, is chaired by the Secretary of the Treasury, and includes the Board of Governors of the Federal Reserve System, the Commodity Futures Trading Commission, and the Commission. -[32]- For example, in July 1994, the Working Group submitted to Jack Brooks, then Chairman of the House Committee on the Judiciary, a proposed amendment to the Bankruptcy Code that would clarify the validity of netting of spot foreign exchange agreements under the Bankruptcy Code. The Working Group also submitted to Congress, as well as to the Commission, a report, entitled "Financial Market Coordination and Regulatory Activities of the Treasury, Federal Reserve, SEC, and CFTC in 1993-1994" (October 1994). -[33]- Orange County issued both taxable and tax exempt notes. Both taxable and tax exempt money market funds had holdings of the affected notes. Fund advisers have told the Commission staff that prior to the revelations concerning the effects that the investment pool's losses would have on the creditworthiness of Orange County, these notes appeared to satisfy the credit quality conditions of Rule 2a-7. Certain Orange County notes are subject to credit enhancements from third parties (such as banks) and we have been advised that the values of these notes were not significantly affected by the Orange County bankruptcy. -[34]- Rather than determining the market value of their portfolio securities on a daily basis, as other open- end investment companies do, most money market funds maintain a stable share price by using the amortized cost method of valuation. Under the amortized cost method, portfolio securities are valued by reference to their acquisition cost as adjusted for amortization of premium or accretion of discount. See Rule 2a-7, S (a)(1). Under Rule 2a-7, a fund must monitor the actual market prices of its portfolio securities and, if the deviation between the market value and the amortized cost of the portfolio exceeds one half of one percent, the fund's board of directors must promptly consider what actions, if any, should be initiated. See Rule 2a-7, S (d)(6). These actions may include causing the fund to sell and redeem shares at less than $1.00 - - that is, "breaking a dollar." -[35]- In September 1994, the US Government Money Market Fund, a series of Community Bankers Mutual Fund, Inc. (the "CAM Fund"), announced that it would liquidate and distribute less than $1.00 a share to its shareholders. The CAM fund incurred losses because certain adjustable and floating rate instruments in its portfolio had interest rate adjustment mechanisms which, in an environment of increasing interest rates, resulted in the market value of the instruments being less then their par value. Many press reports have cited this liquidation as the first instance in which a money market fund had broken a dollar. -[36]- Some funds took this approach even though their holdings of Orange County notes were small enough that the funds were not in danger of breaking a dollar. The advisers to these funds proposed to purchase Orange County notes from their funds to assure that the fund would be shielded from the uncertainties presented by the Orange County bankruptcy. -[37]- These puts are designed to place funds in the position of being able to continue to value the Orange County notes at or near their pre-bankruptcy prices until the puts are exercised, more permanent credit support (such as a letter of credit) can be obtained, or Orange County's ability to make payments on the notes is clarified. -[38]- This no-action process was first used in 1989, when several money market funds held defaulted commercial paper of Integrated Resources, Inc. Subsequently, the Division used this procedure to allow advisers to purchase or provide puts with respect to other securities that were in default, such as securities that were backed by Mutual Benefit Life Insurance Company, an insurance company seized by New Jersey regulators in June 1991. See generally Investment Company Act Rel. No. 19959 (Dec. 17, 1993) 58 FR 68585 (Dec. 28, 1993), at notes 12 and 28. Most recently, the Division has used this procedure in connection with the repurchase by fund advisers of certain structured notes the value of which declined substantially as a result of increases in interest rates. In December 1993, the Commission proposed a new rule under the Investment Company Act that would permit fund affiliates to purchase from a money market fund securities that are no longer eligible for money market fund investment at the higher of the securities' amortized cost value or market value, without having to seek prior Commission approval. Id. at Section IV. Funds using the exemptive rule would continue to be required to notify the Commission in the event of a default with respect to portfolio securities that account for one half of one percent or more of a fund's assets before the occurrence of the default. See Rule 2a-7, S (c)(5)(iii). -[39]- The statutes contemplate "pooled securities" in the context of securities securing deposits of local agencies in state or national banks or other authorized depositary institutions, see Cal. [Gov't] Code S 53630 et seq., not in the context of investments made by the Treasurer. -[40]- Cal. [Educ.] Code S 35010. -[41]- Cal. [Civil Proc.] Code S 573. -[42]- Cal. [Probate] Code S 3412, 3413, 3611. -[43]- Cal. [Gov't] Code S 53684. -[44]- Cal. [Gov't] Code S 53601, 53635. -[45]- Id. -[46]- The Commission does, under Rule 2a-7 under the Investment Company Act of 1940, place significant restrictions on the types and quality of securities that may be purchased by money market mutual funds. These restrictions are intended to assure that money market fund investment policies are consistent with the maintenance of a stable net asset value. In the case of other types of investment companies, the Commission seeks to assure that investment objectives and policies are fully and clearly disclosed to investors. In addition, investments by investment companies are subject to leverage restrictions and liquidity requirements. See Investment Company Act S 18, 15 U.S.C. S 80a-18 (leverage restrictions) and Investment Company Act Rel. No. 18612 (March 12, 1992), 57 FR 9828 (March 20, 1992)(limits on investments in illiquid securities). -[47]- S 2(b) of the Investment Company Act states, in relevant part, that: [n]o provision in [the Investment Company Act] shall apply to, or be deemed to include . . . a State, or any political subdivision of a State, or any agency, authority, or instrumentality of any one or more of the foregoing, or any corporation which is wholly owned directly or indirectly by any one or more of the foregoing, or any officer, agent, or employee of any of the foregoing acting as such in the course of his official duty . . . . 15 U.S.C. S 80a-2(b). S 2(b) also exempts from registration and regulation the United States and certain investment pools created by the federal government, its agencies and instrumentalities. -[48]- On a number of occasions, the staff has agreed that state and local governments can rely upon the broad 2(b) exclusion to operate or participate in pools for the collective investment of cash balances (e.g., proceeds from tax collections and bond offerings) without registering or complying with the regulatory requirements of the Investment Company Act. See Minnesota School District Liquid Asset Fund Plus (pub. avail. Feb. 27, 1985); Illinois School District Liquid Asset Fund Plus (pub. avail. June 15, 1984); Pennsylvania School District Liquid Asset Trust (pub. avail. Mar. 3, 1982); Pennsylvania Local Government Investment Trust (pub. avail. Mar. 2, 1981); State of New Jersey Cash Management Fund (pub. avail. Jan. 30, 1978); Massachusetts Municipal Depository Trust (pub. avail. May 23, 1977). In the Minnesota School District Liquid Asset Fund Plus letter, the staff noted that, having stated its views on a number of occasions, it would no longer respond to letters on this issue. In fact, the staff never formally has taken the position that a pool sponsored directly by a municipality is not eligible for the S 2(b) exclusion. The staff has informally taken the view, however, that an instrumentality of a state agency, or an instrumentality of a state instrumentality, is outside the scope of S 2(b), and thus may not rely on the section's exclusion. -[49]- In addition, Citron is not now, and to our knowledge has never been, registered under the Investment Advisers Act of 1940. S 202(b) of that Act excludes from regulation any officer of a municipality acting in the course of his official duties. As Treasurer of Orange County, Citron was an officer of the County and appears to have been acting in the course of his official duties in his management of the Orange County funds. -[50]- To meet the S 2(b) exclusion, the Pools would have to be "instrumentalities" of Orange County or other municipalities. We understand that the Pools were not specifically designated as instrumentalities of Orange County under California law. Even though the Pools may not be organized as separate legal entities, the Pools may be considered instrumentalities under Section 2(b) if they have been operated to carry out governmental functions of the participating municipalities. The Commission staff has indicated that an entity may be considered an instrumentality under the Investment Company Act even if it is not designated as a public instrumentality under municipal law. Compare Massachusetts Municipal Depository Trust (Trust specifically designated as an instrumentality of the Commonwealth of Massachusetts) with Pennsylvania Local Government Investment Trust (whether Trust is designated as a public instrumentality not specified). -[51]- If Congress were to determine that federal regulation of municipal pools is warranted, we would need to review the provisions of the Investment Company Act to determine whether all of the provisions of the Act should be applied to municipal pools and whether additional provisions would be necessary. -[52]- See Securities Act S 3(a)(2), 15 U.S.C. S 77c(a)(2) (exemption from registration requirements and civil liability provisions of the Securities Act); Exchange Act S 3(a)(12), 15 U.S.C. S 78c(a)(12) (defining exempted securities to include municipal securities). -[53]- Pub. L. No. 94-29, 89 Stat. 131 (1975). The 1975 Amendments did not create a regulatory regime for municipal issuers or impose any new requirements on municipal issuers. Indeed, S 15B of the Exchange Act expressly limited the Commission's and the MSRB's ability to establish municipal issuer disclosure requirements. S 15B(d)(1) of the Exchange Act prohibits the Commission and the MSRB from requiring municipal securities issuers, either directly or indirectly, to file any application, report, or document with the Commission or the MSRB prior to any sale by the issuer. This section does not, by its terms, preclude the Commission from promulgating disclosure standards in municipal offerings, although there is no express statutory authority contained in the Exchange Act over disclosure by municipal issuers. S 15B(d)(2) of the Exchange Act prohibits the MSRB, either directly or indirectly, from requiring issuers to furnish investors or the MSRB with any "report, document, or information" not generally available from a source other than the issuer. This section was intended to make clear that the legislation was not designed to subject states, cities, counties, or any other municipal authorities, to any disclosure requirements that might be devised by the MSRB. These sections are collectively known as the "Tower Amendment." Division of Market Regulation, Securities and Exchange Commission, Staff Report on the Municipal Securities Market (Sept. 1993) at Appendix A. -[54]- 17 CFR 240.15c2-12. See Securities Exchange Act Rel. No. 26100 (Sept. 22, 1988), 53 FR 37778 ("1988 Release"); Securities Exchange Act Rel. No. 26985 (June 28, 1989), 54 FR 28799 ("1989 Release"). Rule 15c2-12 requires an underwriter of municipal securities (1) to obtain and review an issuer's official statement that, except for certain information, is "deemed final" by an issuer, prior to making a purchase, offer, or sale of municipal securities; (2) in negotiated sales, to provide the issuer's most recent preliminary official statement (if one exists) to potential customers; (3) to deliver to customers, upon request, copies of the final official statement for a specified period of time; and (4) to contract to receive, within a specified time, sufficient copies of the issuer's final official statement to comply with the rule's delivery requirement, and the requirements of MSRB rules. Rule 15c2-12 also contains specific exemptions for three types of municipal securities offerings. -[55]- See 1988 Release at 53 FR 37787; 1989 Release at 54 FR 28811. -[56]- Id. -[57]- Division of Market Regulation, Securities and Exchange Commission, Staff Report on the Municipal Securities Market (Sept. 1993). -[58]- Securities Act Rel. No. 7049 (March 9, 1994), 59 FR 12748 ("Interpretive Release"). -[59]- The adequacy of the disclosure provided in municipal securities offering materials is tested against an objective standard. An omitted fact is material if there is a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable [investor]. Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). -[60]- Interpretive Release at 59 FR 12751-12752. -[61]- Id. -[62]- Id. at 59 FR 12752. Forty-six states currently require, or are in the process of establishing a requirement, that state government financial statements be presented in accordance with GAAP. State Comptrollers: Technical Activities and Functions (1992 Edition). -[63]- The Release noted that an appropriate period appeared to be within six months of the close of the fiscal year, based upon the Commission's understanding of prevailing practice. However, many commentators responding to the solicitation of comments on the companion rulemaking discussed below took the position that for many municipal issuers, six months was not a possible timeframe. -[64]- Interpretive Release at 59 FR 12753. -[65]- Id. -[66]- Id. at 59 FR 12751. -[67]- Id. -[68]- Securities Exchange Act Rel. No. 33742 (March 9, 1994), 59 FR 12759. -[69]- Securities Exchange Act Rel. No. 34961 (Nov. 10, 1994), 59 FR 59590. -[70]- That number includes a substantial portion of small municipal issuers. 71% of that number represents issuers with less than $10 million in bonds outstanding. By way of comparison, there are approximately 12,000 companies (other than investment companies) currently filing reports with the Commission. -[71]- Pursuant to Exchange Act 3(a)(12), municipal securities are exempt from the transaction reporting requirements of Exchange Act Section 11A. MSRB Rule G- 14 allows for the voluntary dissemination of transaction information, and establishes requirements for transaction reports voluntarily disseminated. MSRB Rule G-13 prohibits the dissemination of a quotation relating to municipal securities unless the quotation represents a bona fide bid for, or offer of, municipal securities, and the quotation is based on the dealer's best judgment of the fair market value of the securities. The MSRB's rules do not require municipal securities brokers or dealers to disseminate firm quotations or last sale reports. -[72]- See Securities Exchange Act Rel. No. 34962 (November 10, 1994), 59 FR 59611. -[73]- See Letter from Robert H. Drysdale, Chairman, MSRB, to Arthur Levitt, Chairman, SEC (Nov. 3, 1994) at pp. 3- 7. Available in Public Reference File No. S7-6-94. -[74]- See Public Securities Association, Serving Investors' Price Transparency Needs in the Municipal Bond Market: A Program to Improve Price Information to Investors (Nov. 10, 1994). -[75]- Id. -[76]- We have stated that we may consider other regulatory action, including reconsidering disclosure of mark-ups in riskless principal transactions, disclosure of mark- ups in all transactions, or direct action to require price reporting. -[77]- GASB Statement No. 3 was issued April 1986 effective for financial statements for periods ending after 12/15/86. -[78]- American Institute of Certified Public Accountants, Audit and Accounting Guide, "Audits of State and Local Government Units," at 7.15. -[79]- The Commission is the appropriate regulator, of course, of the broker-dealers through which state and local governments may invest in government securities. Prior to the Government Securities Act Amendments of 1993 ("GSA Amendments"), see Pub. L. No. 103-202, 107 Stat. 2344 (1993), Securities Exchange Act 15C(b)(3), 15 U.S.C. 78o-5(b)(3) (1993), recommendations made by a broker-dealer involving the purchase or sale of a government security were subject to the antifraud prohibitions of the federal securities laws, but were exempt from the more particularized sales practice standards of the NASD. Under the GSA Amendments, the NASD, which is the only registered securities association, was given the authority to regulate broker-dealers selling government securities. See Securities Exchange Act 19(b) and (c), 15 U.S.C. 78o(b) and (c). -[80]- See, e.g., NASD Rule of Fair Practice, Art. III, 2 ("In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs."). See also New York Stock Exchange Rule 405 (the "know your customer rule"); American Stock Exchange Rule 411. -[81]- NASD Notice to Members 94-62 (August 1994). -[82]- Government Finance Officers Association, Recommended Practice, "Use of Derivatives by State and Local Governments," adopted June 7, 1994. -[83]- Statement of the Commission, the CFTC and the SIB (March 15, 1994). -[84]- Securities Exchange Act Release No. 32256 (May 4, 1993), 58 FR 27486. -[85]- Securities Exchange Act Release No. 33761 (March 15, 1994), 59 FR 13275. At the same time these rule amendments were proposed, the Commission authorized the Division of Market Regulation to issue a no-action letter that permits broker-dealers to use until June 30, 1995 the theoretical pricing model to determine haircuts. Letter from Brandon Becker, Director, Division of Market Regulation to Mary L. Bender, The Chicago Board Options Exchange and Timothy Hinkas, The Options Clearing Corporation (March 15, 1994). At present approximately 15 firms are relying on the no- action letter in computing net capital. -[86]- In addition, in the joint statement the Commission, the CFTC, and the SIB identified six other areas in which regulators can cooperate in their respective regulatory approaches to OTC derivatives, including promoting information sharing, legally enforceable netting arrangements, risk-based capital standards, stronger customer protection standards, multilateral credit risk management arrangements, and better accounting and disclosure standards. -[87]- See Technical Committee of IOSCO, Operational and Financial Risk Management Control Mechanisms for Over- the-Counter Derivatives Activities of Regulated Securities Firms (July 1994); Basle Committee on Banking Supervision, Risk Management Guidelines for Derivatives (July 1994). -[88]- See Government Finance Officers Association Policy Statement, State Statutes Concerning Investment Practice, February 27, 1992 (with model legislation attached); National Association of State Treasurers Statement in Favor of Full Disclosure for Local Government Investment Pools, December 4, 1989. -[89]- In addition to establishing new disclosure requirements for derivatives positions and activities, FAS 119 amended existing requirements under previously issued standards, FASB Statement No. 105, Disclosure of Information about Financial Instruments with Off- Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments. Taken together these standards require significant disclosures of derivative instruments and activities. -[90]- Letter from Carolyn B. Lewis, Assistant Director, Division of Investment Management, Securities and Exchange Commission, to Investment Company Registrants (Feb. 25, 1994). -[91]- S 18 of the Investment Company Act, 15 U.S.C. 80a-18, prohibits mutual funds from issuing any "senior security" other than a borrowing from a bank. Such borrowings cannot exceed one-third of a fund's assets. -[92]- The Commission and the staff have applied 18 of the Investment Company Act to derivative investments, such as futures, forwards, and written options, that create a fund obligation or indebtedness. The Commission and the staff have required funds to "cover" the obligations these instruments create by establishing segregated accounts consisting of cash or certain other high-grade, liquid assets in an amount at least equal in value to the obligations. The Division has also permitted funds to cover certain derivatives by holding the underlying instruments or other offsetting instruments. For example, a put option obligates the writer to purchase the "underlying" on exercise. Therefore, a mutual fund may write a put option only if the fund either covers the position (e.g., sells short the "underlying" at a price no less than the option strike price) or segregates cash, U.S. government securities, or other high grade debt securities in an amount equal to the option strike price.See, e.g., Investment Company Act Release No. 10666 (Apr. 18, 1979), 44 FR 25128 (Apr. 27, 1994); Dreyfus Strategic Investing (pub. avail. June 22, 1987). -[93]- See Investment Company Act Rel. No. 5847 (Oct. 21, 1969), 35 FR 19989 (Dec. 31, 1970); Investment Company Act Rel. No. 18612 (Mar. 12, 1992), 57 FR 9828 (Mar. 20, 1992); Letter from Marianne K. Smythe, Director, Division of Investment Management, Securities and Exchange Commission, to Matthew P. Fink, President, Investment Company Institute (Dec. 9, 1992). An illiquid asset is any asset that may not be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the mutual fund has valued the investment. See Guidelines for Form N-1A, Guide 4. -[94]- Mutual Fund Directors as Investor Advocates, Remarks of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, before the Investment Company Institute's Investment Company Directors Conference (Sept. 23, 1994); Mutual Fund Directors: On the Front Line for Investors, Remarks of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, before the Mutual Funds and Investment Management Conference in Scottsdale, Arizona (Mar. 21, 1994). -[95]- In the Matter of BT Securities Corporation, Securities Act Release No. 7124, Securities Exchange Act Rel. No. 35136 (December 22, 1994). Two OTC derivative instruments that were the subject of the Commission's investigation were securities within the definition set forth in Section 3(a)(10) of the Exchange Act. These two instruments are described in notes 6 and 7 of the release and the accompanying text. -[96]- See Securities Exchange Act Rel. No. 35135 (December 22, 1994). -[97]- In another enforcement matter, the Commission filed a civil complaint in U.S. District Court on December 27, 1994 seeking a preliminary and permanent injunction against Kenneth Schulte, formerly a registered representative for various broker-dealers. The Commission's complaint alleges that from the Spring of 1990 to April 1994, Schulte fraudulently sold millions of dollars of derivatives securities to at least 14 Ohio municipalities and school districts. The complaint alleges that Schulte failed to describe the nature of the risks of the securities to the investors prior to their investing, failed to inform them of the type of securities they purchased, and misrepresented to investors that their investment principal was not at risk and that the derivatives were guaranteed by the U.S. Government. Total losses sustained by the municipalities have not yet been determined, but the Commission's complaint alleges that losses by four of the municipal investors alone exceed $3.4 million.