Speech by SEC Staff:
Remarks to the 2008 Bond Attorney’s Workshop of the National Association of Bond Lawyers
Erik R. Sirri
Director, Division of Trading and Markets
U.S. Securities and Exchange Commission
September 17, 20081
Thank you for asking Erik Sirri to speak today. Erik has been detained elsewhere, but sends his best regards and regrets. As it turns out, this would have been a remarkably timely opportunity for Erik to fill you in on market conditions and the Chairman’s and Commission’s abiding interest in municipal securities. Please keep in mind that the remarks I am about to deliver are those originally prepared for Erik — not me — to present.
Global Market Changes & Recent Commission Actions
Globally, major market changes are underway right now and I don’t expect them to stop anytime soon. I can’t predict how they will all work out, but, as the events of the last few days, weeks and months have made clear, the municipal market is not immune from the forces which have influenced changes in other markets. It has become inextricably interwoven in the fabric of the financial system as a whole. Furthermore, the municipal bond market has changed dramatically over the last decade. While some may have considered it a quiet backwater market in the past, it is now clearly part of the mainstream — faced with many of the same problems and challenges as other markets. I’d like to begin by telling you about a few recent Commission actions reflective of these changes, some of which may affect or have implications for the municipal market.
- The overhaul of the credit rating agency system pursuant to the Credit Rating Agency Reform Act, for example, obviously affects how both municipal and corporate securities are rated. So far, a total of __ rating agencies — called NRSROs — have registered with the Commission. Further, in addition to the rules originally adopted by the Commission as required by the Act to implement the NRSRO regulatory scheme, the Commission has proposed rules and rule amendments intended to improve the accountability and transparency of NRSROs. Furthermore, the Commission is considering whether to remove most references to NRSROs in its regulations.
- In addition, the Commission has published a Concept Release to solicit comment about the extent and nature of the public’s interest in allowing U.S. issuers, including investment companies subject to the Investment Company Act of 1940, to prepare financial statements in accordance with International Financial Reporting Standards as published by the International Accounting Standards Board for purposes of complying with the rules and regulations of the Commission. The Commission’s issuance of the release was in response to the increasing internationalization of securities markets in general. Some press reports predict that the corporate markets will ultimately use a single set of accounting standards — internationally.
- Chairman Cox recently unveiled the successor to the agency’s 1980s-era EDGAR database. The new system, called IDEA (Interactive Data Electronic Applications), will give investors faster and easier access to key financial information about public companies and mutual funds. IDEA will at first supplement and then eventually replace the EDGAR system, which will become an archive of prior SEC filings. The decision to replace EDGAR marks the SEC’s transition from collecting government-prescribed forms and documents to making the information itself freely available to investors in a user-friendly format they can readily use. Instead of sifting through one form at a time in EDGAR and then re-keyboarding the information to analyze it, investors will be able to utilize interactive data to instantly search and collate information to generate reports and analysis from thousands of companies and forms through IDEA.
- In addition, the Commission has proposed to require U.S. companies to provide financial information using interactive data beginning as early as next year, and separately has proposed to require mutual funds to submit risk-return information from their public filings using interactive data.
- In recognition of the increased use of the Internet generally, the Commission recently published an interpretive release to provide guidance regarding the use of company web sites under the Exchange Act and the antifraud provisions of the federal securities laws. The Commission also solicited comment on issues relating to company use of technology generally in providing information to investors. Since portions of this release apply to municipal securities, I recommend it for your bedtime reading.
- Last, but not least, the Commission has proposed amending Exchange Act Rule 15c2-12 and the MSRB has proposed the addition of a continuing disclosure service to its new EMMA system that would replace the current NRMSIR structure. If the Commission were to adopt its proposed amendments and approve the MSRB proposals, EMMA would become the only location to which issuers would provide continuing disclosure documents pursuant to Rule 15c2-12. The MSRB has stated that EMMA would make all continuing disclosure documents it receives available on the Internet at no charge to the public. Among other things, EMMA should permit investors easily to distinguish issuers and other obligated persons who make information available from those who do not — permitting the market to function more efficiently. I certainly hope that you will read these releases and send the Commission your comments about both of them. The comment period ends on September 22nd. And, no, I can’t give you a date on which further consideration would occur. Like legal research, rulemaking simply takes the time it takes — and predictions are rarely accurate.
Changed Municipal Market Conditions
The extent to which the municipal market has become entwined in other markets was recently brought home when the defaults in subprime mortgages and consequent reduced value of many CMOs resulted in the lowering of ratings of a number of bond insurers — ultimately leading, along with other factors, to liquidity crisis in municipal auction rate securities. Stop and think about that for a minute. Like a row of dominoes, the negative effects of defaults on some home mortgages and related securities entirely outside the municipal market ultimately led to many of your clients paying interest rates as high as 20% on their ARS! Furthermore, the increased use of highly sophisticated and opaque products, such as derivatives, in connection with municipal offerings has increased the complexity and risk associated with this market — just ask Jefferson County. According to press reports, Jefferson County’s financial distress is related in part to the liquidity crisis in the ARS market, which disturbed the historic relationships of ARS rates with LIBOR and other reference indices used in some of its derivatives. How much more interconnected with other markets can you be?
The fall out in the municipal market from the recent Lehman bankruptcy, as elsewhere, remains to be seen. But I don’t know anyone who expects that the municipal market will be unaffected. I am particularly concerned about the possible termination of derivatives contracts that may necessitate some municipal issuers to cash out their contracts with Lehman very quickly. I pray that we will see no other issuers in Jefferson County’s shoes.
In short, the municipal market has undergone significant — sometimes dramatic — changes in the last decade and I firmly believe it will continue to experience important changes in the future. Hopefully, those will be less dramatic and negative than what it has recently experienced.
The United States securities markets are hardy and highly adaptable — but change is unavoidable. The emergence of new challenges, the implications of market interconnectivity and interdependence, product complexity and globalization raise a need to reconsider further the assumptions and ground rules on which the municipal market, have been based. Do they still hold up? Do they maximize the potential of this market? Could practices be improved? Staff frequently consider questions such as these at the Commission. I recommend that bond lawyers consider questions such as these too, accept the inevitability of change in the municipal market and keep the big picture in mind as they assist their clients to adapt to the municipal market of the future.
As you may know, the Chairman proposed some legislative changes that he believes would be beneficial for the municipal market in a letter and white paper that he sent to Congressional leadership last year. I’m not going to cover them in detail; the documents are available to you on the Commission’s web site and I am sure they will be discussed on workshop panels. In short, the Chairman believes that “it no longer makes sense to provide investor protection at the issuer level through the Rube-Goldberg device of Rule 15c2-12.” A Congressional hearing on the municipal market and the Chairman’s proposals is scheduled for next week. The Chairman has told the press that he views these hearings as a step towards the introduction of legislation implementing his proposals.
At the Chairman’s direction, SEC staff is now considering the extent to which the Chairman’s proposals may be addressed under current law and drafting potential amendments to Rule 15c2-12 for possible future consideration by the Commission. Furthermore, as suggested in the white paper, the MSRB is considering the establishment of a system to improve transparency for VRDO remarketings and ARS auctions.
The input of market participants is highly valued. Keep in mind that you don’t have to wait until a proposal is on the table to be heard. Of course, an issuer does not have to wait until the Commission takes action to adopt voluntarily some of the Chairman’s proposals. For example, issuers might undertake right now to
- prepare and release annual financial statements more quickly;
- prepare and release financial information and other continuing disclosures beyond the minimum levels of Rule 15c2-12;
- Adhere to GASB accounting standards and GAAP; and
- Establish appropriate policies and procedures for disclosure.
Why would an issuer do so, you ask? Well, in part to make the investors in its current bonds feel confidence that this issuer keeps its investors fully informed, which encourages them to buy more in the issuers next offering. Further, classic economic theory holds that a market in which full information is shared by all is more efficient than one that is opaque. Efficiency translates into increased volume and, consequently, lower rates for issuers. This has played out repeatedly in other markets.
Damage to Municipal Market from recent events
I am concerned about what damage the liquidity freeze-up in the ARS market has caused in investor confidence in general, particularly because it came contemporaneously with dropped ratings of many bond insurers. Many invest in the municipal market because of its perceived safety, not for tax-exempt interest alone. Yes, I know that the municipal ARS are technically “safe” because they rarely default — but ARS investors expected liquidity and apparently didn’t get it. Furthermore, many investors in insured bonds saw their values drop when a number of bond insurers were downgraded — further shaking confidence in the muni market. Thousands of investors contacted the SEC during this period of market disturbance. Believe me they typically did not express warm feelings about ARS in particular, or the municipal market in general. Quite the contrary — many felt burned. No one knows what will result from the Lehman bankruptcy — but the municipal market will undoubtedly be affected along with others.
Market professionals such as yourselves should do whatever they can to improve investor confidence during this difficult period. Ultimately, the benefits of improved transparency in the municipal market will benefit all investors — and issuers — and, last, but not least, bond lawyers.