Speech by SEC Staff:
Comments of Martha Mahan Haines to the Tenth Annual Conference of Women in Public Finance
Martha Mahan Haines
Chief, Office of Municipal Securities
U.S. Securities and Exchange Commission
September 29, 2006
First of all, let me say how delighted I am to be here at the 10th Annual Conference of Women in Public Finance. I am extremely flattered to have been included on a program that includes both Madeline Albright and Muriel Siebert! I am looking forward to hearing the Secretary’s luncheon speech and promise that I will not run over my allotted time today. Before I go any further, I must remind you that my comments today are my own and do not necessarily reflect the views of the Commission or of my colleagues on the Commission staff.
I attended WIPF conferences — starting with the first one — while I was a bond lawyer in private practice here in Chicago. I recall there being about 50 women there — and one loyal and hardy man, Lois Scott’s husband; the cocktail party was held in a small art gallery. It is heartening to see how this organization has thrived during the seven years that I have been in DC. The size of the audience today demonstrates the dramatic strides women have made in all sectors of public finance. When I started as a bond lawyer here in Chicago in 1978, I was typically the only woman in the room who wasn’t serving coffee. Clients often looked startled when I sat down at the conference room table. When I look around this room, it is wonderful to see how far women have come in all sectors of this industry. Good Lord, we are a persistent group! While the playing field is not yet level, each woman in this room has had a hand in leveling it through her presence, professionalism and hard work. Each of you has good reason to be proud of the contributions you have made to public finance.
I have been asked to give you a regulatory update today, but I have exercised a speaker’s prerogative to stray somewhat from the assigned topic. Rather than cover a grab bag of unrelated regulatory activities, I have selected a few topics of general interest — based largely on what I hope is their ability to keep you awake for 40 minutes. If there is time, I would be happy to take questions afterwards.
MSRB Proposal — Access Equals Delivery
Recently, the MSRB requested comment on a proposal that should interest just about everyone here — whether to change the requirement for delivery of official statements to investors during the underwriting period from delivery of a paper document to notification of a web address. The proposal is modeled in part on recent rule changes adopted by the SEC that instituted an “access equals delivery” model for prospectus dissemination in the registered securities market.1 The concept of “access equals delivery” is confusing to some people. It helps me to think of them as “push” versus “pull” systems. Under the current system, broker-dealers must actually deliver certain documents to their customers — that is, “push” them. On the other hand, posting documents at a location that investors can access for themselves and “pull” the documents for themselves. The documents don’t change, only the method of delivery does.
The “access equals delivery” standard provides that a broker selling some classes of securities in a registered offering need not deliver a final prospectus to the customer if the registration statement is effective and the final prospectus is filed with the SEC in a timely fashion. Instead, a broker selling the security must notify his customer that it was sold in a registered offering within two business days after sale, allowing them to go to EDGAR for the documents. Brokers, however, must still provide copies of the final prospectus to customers who request one.2
As you know, many aspects of the municipal market are different from the corporate markets. This is one of them. In the registered securities market, issuers are required to file registration statements and prospectuses electronically through the SEC’s EDGAR system. As you know, issuers of municipal securities are not. The EDGAR system then makes electronic versions of filings available to the public for free on the SEC’s Web site. As the MSRB noted in its request for industry comment, this immediate availability of documents through EDGAR is an underlying premise of “access equals delivery” for registered securities. However, there is no EDGAR equivalent in the municipal market.
The MSRB believes “that the adoption of a modified version of the SEC’s ’access equals delivery’ standard would greatly enhance the timeliness and efficiency of official statement deliveries in the municipal market..” and that “Electronic official statements would need to be made readily available to the investing public, at no cost, for the duration of the new issue disclosure period, at a minimum.” 3 MSRB Rule G-36 requires underwriters to submit copies of the official statements for most new issues to the MSRB by specified deadlines. The proposal would require that all submissions by underwriters under Rule G-36 be made in an electronic format. The MSRB noted in its request for comment that it currently receives only about one half of all official statement submissions under Rule G-36 in electronic format, so this concept would necessitate some operational changes in the industry if ultimately adopted by the Commission. The MSRB sought comment on whether a centralized website where all official statements for issues in their new issue disclosure period are freely available to the public would be preferable to a decentralized system in which official statements might be posted at multiple locations, with a central index providing hyperlinks to them.
Please keep in mind that “access equals delivery” is only a concept under discussion in the municipal market. The MSRB has simply described possibilities and requested comment. Under existing law, municipal dealers delivering documents electronically must continue to provide notice, access and evidence to show delivery. Electronically delivered documents must be prepared, updated, and delivered in accordance with the same laws as apply to paper documents. Municipal dealers may deliver documents electronically, but only if the customer consents in the manner specified in various Commission releases.4 In addition, dealers must provide paper copies to customers who request them.
Comments on this MSRB request were due to the MSRB by September 15, 2006. At some point, the MSRB may decide to file a version of the “access equals delivery” proposal with the Commission for approval. Once the Commission publishes such a proposal in the Federal Register, the public will have another opportunity to provide comments. I would encourage you to send the Commission your comments. They are a very important source of information for the Commission. Careful consideration is given to public comments by the Commission and staff before acting on proposals.
Some Lessons from San Diego’s Situation
I would like to say a few words about some lessons that market participants like yourselves might learn from the unfortunate situation that San Diego is in. Before doing so, I want to emphasize that my comments today about San Diego are based only on press reports and other public documents, particularly the recently released Kroll Report. I can neither confirm nor deny the existence of an SEC investigation and I am speaking for myself, not the Commission.
According to the Kroll Report, the City and multiple officials of the City and its pension system violated the securities laws in connection with disclosures it made to investors about its retirement system and its sewer rates. According to the Report and various press stories, for many years the City had apparently been settling its labor negotiations by giving relatively low pay raises, but generous pension increases to its employees. At the same time, it was seriously underfunding its pension plan, while making what the authors of the Kroll Report concluded were materially misleading statements to investors. The dramatic growth of the City’s future pension liabilities was apparently masked pretty well for some time. That ended when a member of the City’s pension board called the situation to the attention of disclosure counsel, causing him to ask the questions that brought the truth to light.6 As a result, in 2003 the City issued two voluntary disclosure statements and cancelled its pending bond issue. In addition, according to the Kroll Report, the City did not disclose that it had knowingly maintained sewer rates in violation of the Clean Water Act for many years, enabling the federal government to demand immediate repayment of hundreds of millions of dollars of grants and loans.
Since information about the alleged underfunding of the City’s pension plan and illegal sewer rates became public in 2003, San Diego has not been able to access the public market. It has not issued audited financial statements since FY 2002. Stop and think about that for a minute. A major American city has been shut out of the capital markets for three years, in part because of allegedly misleading statements and omissions in financial reports and disclosure documents! San Diego spent a huge amount of money just determining the scope of the problem and obtaining recommendations for change. It is reported to have paid approximately $26 million for reports by Vinson & Elkins and Kroll alone. It changed its form of government, reduced its workforce and curtailed services to its citizens. The City officials and employees who remained have spent an enormous amount of time dealing with the situation — time that would have been better spent on their usual duties. A number of officials of the City and the pension fund have faced investigation by various law enforcement authorities, including the U.S. Attorney’s Office. The Mayor recently announced that the City would implement all 54 of Kroll’s recommendations regarding financial reporting and disclosure — at an estimated cost of $45 million over the next 5 years. How much cheaper and easier it would have been for San Diego to have taken preventative measures and avoided the situation it finds itself in now!
So what are some of the lessons market participants might learn from San Diego’s pain? Well, some of them should have been learned long ago.
- Don’t ignore the elephant in the living room to begin with. Don’t leave it for the next guy to shovel up after. Eventually, the baby elephant will grow up and can no longer be ignored, by which point it will be substantially more difficult to tame and damaging to disclose. Human nature being what it is, we should recognize that there must be more elephants hiding out there, still under cover. In order to deal with that reality, it would be wise for issuers to have good internal controls and systems to ensure that its financial reports and disclosure documents are accurate and complete. This is pretty basic stuff. Do you ask about this when conducting due diligence on your transactions?
- Some of Kroll’s recommendations would be relatively simple and cheap for any issuer to implement. For example, it says that the City should assign the responsibilities for preparing public documents and filings to appropriate City employees. Whether or not that is appropriate under the facts and circumstances of your issuer, involving employees close to the primary sources of information deeply in the process, rather than simply relying on outside third parties, seems like common sense. Insiders already know the facts; the financing team can only ask questions and hope to find all of the material ones.
- The Report notes what the Commission has repeatedly said: that the ultimate responsibility for preparing disclosure documents cannot be assigned to the independent auditor, disclosure counsel or other professionals.5 That ultimate responsibility rests with the issuer and its officials. The Kroll Report recommends mandatory training of both City staff and elected officials every two years about their disclosure obligations under the securities laws. I’ll bet that most issuer officials would be grateful to get it. Since the buck stops with them, it seems only fair to provide training.
- As was the case in San Diego, members of governing boards may point out misstatements or omissions about which members of the financing team are unaware or too deep down in the weeds to fully comprehend. Kroll recommends a 14 day period for members of the governing body to review substantially completed drafts of preliminary official statements and CAFRs before a vote may be taken to approve their use. Since municipal issuers have an affirmative obligation to know the contents of their disclosure documents, including their financial statements, they obviously need some period of time to read them. I realize that this will seem like a pain in the neck to some issuer executives and financing team members, but I can tell you that San Diego, the Dauphin County General Authority, and Orange County, to name only a few, surely must wish that they had done so.
- I recommend that underwriters, their counsel and disclosure counsel verify that the disclosure document has actually been delivered to members of the governing body and that at least relevant potions have been read. Over 10 years after the Commission’s report regarding the conduct of the behavior of Orange County’s Board of Supervisors, I cannot imagine why, in this day and age, anyone would be comfortable with their due diligence without verification.
There are many more lessons to be learned from San Diego, but luckily for you, my time is limited. I recommend that you take a look at the Kroll Report for yourself. It is available on the City’s web site. I think you will find the story it tells to be fascinating and chilling. I suggest you review the Report’s recommendations to the City. You may find some ideas appropriate to the circumstances you face to improve your disclosure practices or those of your client...and avoid the pain and expense that San Diego did not.
Auction Rate Securities
If you read between the lines of the Commission’s recent settlements involving auction rate securities and the “Best Practices” released by TBMA, it appears that the way rates are actually set on auction rate securities often may bear little resemblance to the way the process was described in offering statements. Apparently, at least in single broker-dealer auctions, broker-dealers often directly or indirectly set or affect the rates . The market for ARS bears little resemblance to the kind of so-called Dutch auctions known to most investors: those for U.S. Treasury securities. Unlike the large, homogenous Treasury market, the ARS market, at least for municipal securities, is fragmented by a high number of dissimilar offerings, a decentralized over-the-counter market structure, and lack of transparency. Each of these features inhibit market efficiency.
As a result, I believe that a few topics about the auction rate market generally avoided before now, should be aired and discussed. First of all, we should acknowledge that, although broker-dealers involved in this market generally claim that their intervention is for the good of the market as a whole, this has not been studied. In fact, the outcome of even a completely independent study would be dependent on one’s view of what is best for the market. It is true that, due in large part to BD intervention, there have been few “failed” auctions, resulting in windfall interest rates for investors until the next auction, or “all hold” auctions, resulting in below market rates briefly benefiting issuers. Broker-dealers also intervened when the rate that would be set was not, in that broker-dealer’s opinion, an appropriate market rate. (But wasn’t a determination of the market rate the very purpose of an auction?) We are told that this is in the best interests of both issuers and investors. But is it? The true liquidity risk, volatility and fragmented nature of this market was not made clear to issuers or investors. Furthermore, broker-dealer intervention does not necessarily set the rate at the same point as would be set in a successful multi-bidder auction. This intervention supported the rapid growth of this market to over $200 billion. Was it in the best interests of issuers and investors to be so heavily dependent on broker-dealer intervention to support the expansion of that market? Perhaps the interest rate on ARS should just be set and reset by a remarketing agent? In reality, a informal process with essentially the same result seems to occur with some frequency in the ARS market.
Now that the fact of broker-dealer intervention is known, I fear that investor and issuer confidence in the legitimacy of the market may be undermined unless market participants take active steps to address these issues. First of all, the disclosure in offering documents needs to be reviewed by issuers and other financing team members. To simply say that a Broker-Dealer may submit orders in Auctions for its own account, in which case it might have an advantage over other bidders because it would have knowledge of other orders placed through it for that Auction just does not give an accurate picture of the reality of how this market functions. Disclosure should make it clear that broker-dealers commonly intervene in auctions, bid with knowledge of other bids, submit bids after the internal bidding deadline imposed on other investors, and directly or indirectly influence or set the clearing rate with considerable frequency. I am not saying that this is necessarily good or bad, but it should be disclosed in plain language. I would suggest that as part of your own due diligence investigation, you should ask for information regarding the frequency of broker-dealer bidding and its policies and procedures (which may have recently been revised as a result of the settlement) regarding the submission of bids and other activities that may affect the clearing rate. Do not dance around this issue: describe what really happens flat out. If this is the way that investors and issuers prefer for the market to function, so be it. If not, perhaps practices should change to reflect their true preferences?
Secondly, it may not be accurate to call this an auction at all. In a true Dutch auction, no bidder has knowledge of the bids submitted by others. This protects the process from manipulation and ensures that the price set is truly reflective of the market. Perhaps consideration should be given to a different name for this type of security or of the process by which rates are set? “Managed auction process” and “bidding system” have been suggested to me. I know from personal experience that traders often give nicknames to bonds. In the early days of my practice as a bond lawyer I discovered to my horror that an issue of O'Hare International Exposition Center Bonds of which I was especially proud had been nicknamed "oinks"! So I recognize that “BS Securities” is not an appealing acronym and I leave it to those more creative than me to come up with an alternative title.
You have all heard me talk about the importance of market integrity and investor confidence before. I suggest that the lack of transparency regarding the actual rates set in these auctions undermines both. Market participants should insist that the rates set in these auctions and other critical information be made public. You have all heard the remark by Justice Brandeis to the effect that sunlight is the best disinfectant. The former head of investment banking at one firm put it this way: “We believe everybody is honest, but they are more honest if you watch them like a hawk.” Giving investors, potential investors, issuers and broker-dealers a way to monitor the rates, the bidding ranges and number of bids received, would allow them to see inside the black box of this market. Disclosure of such information, which is routine in Treasury auctions, would promote market integrity, enhance investor confidence and improve pricing efficiency. Transparency would benefit everyone.
Lastly, I would like to remind everyone that adherence to industry practices does not give anyone a pass under the securities laws. Although best practices and similar releases by industry organizations may be useful, it is important to keep the overarching requirements of the securities laws and its basic themes of disclosure, fairness and integrity firmly in mind.
In conclusion, I want to thank WIPF again for inviting me to be with you today. It has been my pleasure and privilege.
1 See Securities Act Release No. 8591 (July 19, 2005), 70 FR 44722 (August 3, 2005).
2 See Section VI (Prospectus Delivery Reforms) of the SEC Release for a detailed description of the SEC rules implementing the “access equals delivery” standard.
3 MSRB Notice 2006-19 (July 27, 2006).
4 See Securities Act Release No. 7233, Release No. 7288, and Securities Exchange Act Release No. 42728.
5 See, e.g., Commission Opinion in the Matter of the City of Miami, SEC Rel. No. 34- 47552 / March 21, 2003 “Miami further asserts that the City relied on Deloitte, and other professionals who participated in the bond offerings, to advise the City on its disclosure in the Official Statements. Primary responsibility for the accuracy of information filed with the Commission and disseminated among investors rests upon the municipality. A city does not discharge this obligation by the employment of independent public accountants or other professionals. As we have repeatedly emphasized, issuers of municipal securities "are primarily responsible for the content of their disclosure documents and may be held liable under the federal securities laws for misleading disclosure." Municipal issuers have an affirmative obligation to know the contents of their securities disclosure documents, including their financial statements.” (footnotes omitted).