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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks at Investment Company Institute 2010 General Membership Meeting


Chairman Mary L. Schapiro

as delivered by

Andrew J. Donohue

Director, Division of Investment Management
U.S. Securities and Exchange Commission

Washington, D.C.
May 7, 2010

Good morning, it is wonderful to be here.


As you know, the SEC has a strong commitment to working with stakeholders from every facet of the financial markets, including industry groups like ICI. In fact, shortly after I returned to the SEC last year, ICI provided very constructive input into proposed rules designed to improve the resiliency of money market funds.

The money market rules that emerged were, I believe, better as a result of your input, and are already helping to bolster protections for investors without imposing undue burdens on the funds themselves.

Now, I'm sure that there are some here who may disagree with that assessment. That is to be expected. We do after all play different roles in the financial markets — we are never going to see eye-to-eye on every issue. But I'd like to believe we both have very similar goals:

  • Honest markets that efficiently allocate capital and reward investors, and

  • A financial system that gives investors and their advisors the tools they need to make rational decisions.

I am committed to working with you and with other industry representatives to achieve that goal.

Muni Market Background

So today, I want to talk about a topic on which I think we can find common ground: increasing transparency in the municipal markets.

As you know, the municipal securities market touches almost every aspect of our lives. The water we drink, the schools we send our children to and the roads we travel over — even the hospitals on which we rely, have all likely been financed by municipal securities. So, a vibrant municipal bond market is important not only to investors and to market participants, it is critical to the daily lives of all Americans, and to our nation's future.

And so, I find it surprising that such an important and omnipresent sector of the capital markets is subject to such limited regulatory oversight.

The fact is that access to public markets should come with certain obligations and responsibilities. Investors who fund municipal growth and the taxpayers who pay the dividends, deserve disclosure and transparency that produces relevant, timely and accurate information.

Perhaps it made sense when the securities laws were written to create a regime of reduced disclosure. It was, after all a small market, composed mostly of institutional investors buying traditional governmental bonds. In 1945, for example, there was less than $20 billion of state and local debt outstanding.

But today, investors hold approximately $2.8 trillion of municipal debt.

About 35% of that figure is municipal bonds directly held by individuals, with another 34% indirectly held by retail investors through the money market funds and mutual funds that many of you manage.

Despite its historic reputation as a buy and hold market, there is presently a significant amount of secondary market trading in municipal securities. Last year, nearly $4 trillion of municipal bonds were traded.

In addition, unlike the municipal market of the 1930s, more than a quarter of the municipal bond offerings today are, in reality, unregistered corporate bonds that finance private activities and yet still bear a tax-exempt interest rate. In short, this market has almost nothing in common with the municipal bond market of the 1930s.

Save for cases of securities fraud, the SEC's authority over municipal issuers is expressly constrained under existing laws.

We have regulatory authority over brokers and dealers who underwrite issuances or engage in municipal securities transactions. And we can require dealers to determine whether a particular bond is suitable for a customer — but we can't require an issuer to make information available to assist that dealer.

Similarly, we cannot require a corporate borrower accessing the public market through a municipal bond offering to make the complete disclosure that a corporate offering would require. These gaps limit the information — or at least the uniformity, timeliness and comparability of information — available to investors in the muni world.

Situation Today

Nonetheless, we can see that there are disruptions in the markets for municipal auction rate securities and variable rate demand obligations, which, combined with the recession, have impacted both investors and issuers.

As you may be aware, issuers of 70% or more of VRDOs entered into swaps in order to pay a fixed interest rate and receive a variable rate, in the belief that they were guaranteeing their cost of financing.

But the drop in short-term rates led to a decline in the market value of the swaps while, simultaneously, the cost of canceling them rose. To refinance variable rate debt, issuers often had to terminate the swaps and pay costly fees. As a result, issuers and conduit borrowers who entered into swaps to hedge their risk found that these swaps magnified, rather than decreased, their costs. Investors suffered, as well, when the value of securities decreased as a result.

Jefferson County, Alabama is a case in point. Along with other factors, the county's heavy reliance on variable rate debt offerings and interest rate swaps resulted in a default on $3.8 billion of sewer bonds — and the real possibility of the largest municipal bankruptcy in U.S. history.

It is true, as our enforcement action revealed, that Jefferson County's troubles were compounded by unethical and illegal behavior by both the underwriters and local officials.

Including Jefferson County, there were 136 defaults on municipal securities in 2008, in an aggregate amount in excess of $7.5 billion. While most of these defaults involved conduit issuers in the health care sector, rather than general obligation municipal bonds, these defaults cannot be ignored.

The Future

Regulators and investors should have the information needed to evaluate municipal securities investments.

For instance:

  • Do we have all the clarity we need about funding obligations and expected revenue?

  • Is there too much dependence on ratings, rather than independent analysis, by municipal investors?

  • Does the lack of uniformity of municipal disclosure requirements contribute to a lack of investor understanding?

These are important concerns, because individual retail investors and mutual funds have become the main source of demand and liquidity in the municipal market.

These issues underscore the need for greater market transparency.

Recent and Proposed Reforms

Investors in municipal securities need to engage in a thorough evaluation of those securities' risk, credit, and relative value — from the securities' issuance until their maturity.

More transparent, reliable and timely information about municipal securities will allow both regulators and markets to discourage excessive risk and to reward rational behavior. Unfortunately, investors in municipal securities today do not always have access to the type of information they need to evaluate their municipal investments.

We're already working to change that. In the last two years, the Commission and the Municipal Securities Rulemaking Board have each taken steps to improve transparency in the municipal securities market. These steps include:

  • Amendments and proposed amendments to Exchange Act Rule 15c2-12. These would improve the amount and availability of information, including continuing disclosures for VRDOs and notices of additional material events, such as changes of trustee, tender offers and bankruptcy.

  • Plans to update the Commission's 1994 Interpretative Release concerning disclosure obligations of municipal issuers and others regarding municipal securities initial offerings and on an ongoing basis. We are currently meeting with a variety of stakeholders, including the ICI, to get a precise feel for the state of the municipal securities market and to identify areas of disclosure that still need improvement.

  • And, very significantly, the establishment by the MSRB of an Internet site known as EMMA, from which investors may access a variety of information regarding municipal securities, and the proposed expansion of information available.

Nevertheless, there are limits on our statutory authority to provide muni investors with the type of disclosure regime that assures timely, relevant and comparable information.

For example, SEC rules require public companies to file audited annual financial statements within 60-90 days after the end of their fiscal year. But, state and local governments generally do not make their annual financial statements available for six or more months after their fiscal year ends, because there is no requirement to move more rapidly. And these financial statements are not always prepared according to generally accepted accounting standards.

As we think about designing a regulatory regime specifically for the needs of the municipal securities market, we should consider the following elements — some of which have been suggested in the past, and, of course new ideas are emerging. I think all ideas to improve municipal securities disclosure should be on the table.

These could include:

  • Requiring standardized offering documents and periodic reports, so that investors can comparison shop when purchasing municipal securities — and can stay informed of developments that could affect that security;

  • Requiring disclosure of financial information on a periodic basis. Such information could be tailored to the relevant security offered, and include tax revenues, expenditures, tax base changes or current pension obligations;

  • Mandating use of uniform accounting standards, such as those by the Government Accounting Standards Board; placing the GASB under SEC oversight; and providing an independent funding source, such as a small fee assessed on new offerings. These reforms are similar to the reforms made to FASB for corporate issuers in 2002;

  • Ensuring that private companies, such as hospitals and developers, who access the municipal market indirectly by using municipal issuers as conduits, meet appropriate disclosure standards;

  • Mandating scenario testing by municipal issuers and periodic disclosure of the impact certain key events might have on the issuer's ability to meet its public debt obligations.

    These disclosures should highlight an issuer's sensitivity to changes in its actuarial assumptions. Potentially significant variables to test include tax base changes and their impact on revenue; life span increases that might significantly increase pension obligations; and dramatic changes in interest rates or equity market returns which could affect either a municipality's portfolio returns or their obligations.

The sum of these actions would be to make the finances, strategies, risks and obligations behind municipal securities offerings far more visible to investors, broker-dealers, taxpayers and the SEC alike.

But transparency is more than putting numbers on a page. It's also limiting bad practices and incentives — like "pay to play", conflicts of interest, and guidance from unqualified advisors — that can lead to poor issuer decisions and obscure an investor's view of the real risks of a municipal security.

That's why I believe we must strengthen the standards of conduct for municipal financial advisors.

The financial reform bill passed by the House last December does this, in part by clarifying the specific duty of care that a financial advisor owes to its client and subjecting them to SEC oversight. Similarly, the Senate's version would provide the MSRB with the authority to regulate municipal financial advisors — perhaps preventing another Jefferson County.

Financial Advisers should be prohibited from resigning as financial advisor to an issuer, and then underwriting that issuer's bonds, as they are currently allowed to do under MSRB rule G-23. Right now, a financial professional advising a municipality can guide the municipality towards securities tailored to his firm's advantage, then resign and act as underwriter. This is a classic example of conflict of interest.

Whether or not legislation is passed to subject independent financial advisors to regulation by the Commission or the MSRB, the Board should change G-23, and forbid this practice.


Today, I've outlined some important questions about the state of the municipal securities market, and suggested some potential responses. But, I would be less than candid if I suggested that we have all of the answers to these questions today. These are complex issues, and we need to harness the ideas of a wide range of people who have experienced this market from many different perspectives.

That is why I've asked Commissioner Elisse Walter to lead an effort through which we will hold field hearings across the country. Through these hearings we will elicit the analyses and opinions of a broad array of municipal market participants.

At their conclusion, Commissioner Walter and her team will provide a report, to the Commission and to the public, which will recommend specific changes — to laws, to regulation, or to private sector best practices — to better protect municipal securities investors.

Every market — municipal bonds, mortgage backed securities, currency swaps or commodity futures — has characteristics that make it unique. And, these present unique challenges to regulators in search of a level playing field and fairness for investors.

But I think that there are fundamental principles that cut across markets, as well, that support those goals, that inform my remarks today, and that will be further developed at our hearings as a foundation upon which to build. Transparency is vital. Conflicts and incentives that discourage rational choices should be eliminated.

Thank you for being here this morning, I look forward to continuing to work with you towards a stable and rewarding investment environment.


Modified: 05/07/2010