1 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 3 4 SECURITIES AND EXCHANGE COMMISSION FIELD HEARING 5 on 6 THE STATE OF THE MUNICIPAL SECURITIES MARKET 7 by 8 Elisse B. Walter, SEC Commissioner 9 10 11 Tuesday, September 21, 2010 12 13 14 Securities and Exchange Commission 15 Port of San Francisco, Pier 1, The Embarcadero 16 San Francisco, California 17 18 19 20 CONFIDENTIAL 21 22 23 24 Diversified Reporting Services, Inc. 25 (202) 467-9200 2 1 P R O C E E D I N G S 2 COMMISSIONER WALTER: Welcome to the Securities and 3 Exchange Commission's inaugural Field Hearing on the State of 4 the Municipal Securities Market. We're grateful that state 5 and local government officials, municipal securities 6 investors, and experienced municipal market professionals 7 have agreed to participate as panelists in today's meeting. 8 Thank you so much for devoting your valuable time to this 9 important effort. 10 And we are looking forward to an instructive day, 11 listening to these participants' comments, insights, and 12 recommendations on critical issues in the municipal 13 securities market, particularly in the areas of disclosure, 14 credit ratings, significant liabilities, internal controls 15 and investor experiences. We also look forward to any 16 written materials the participants here today and all other 17 interested persons submit for the record. We want to hear 18 from all of you. 19 As you know, the purpose of these hearings is to 20 explore the issues relating to the municipal securities 21 market that arise under the federal securities laws. At the 22 conclusion of all of the hearings, the Commission staff will 23 prepare a report concerning what we have learned, including 24 their recommendations for further action that we should 25 pursue, which may include legislation, rulemaking, and 3 1 changes in industry practice. 2 These hearings will be instrumental in informing 3 those recommendations. Thus, the Commission's standard 4 disclaimer, which I make for myself and all other Commission 5 participants, is particularly apt; that our remarks today 6 represent our own views, and not necessarily those of the 7 Commission, my fellow Commissioners, or members of the staff. 8 And I would like to add that the views we express today may 9 well change in light of the valuable input we receive today 10 and throughout the course of the field hearing process. 11 Before we go any further, I'd like to introduce you 12 to my colleagues and our fellow regulators who are here with 13 us today. As you may know, I'm Elisse Walter, one of the 14 SEC's Commissioners, and joining me on the state are two of 15 the Commission's senior experts in this area, Meredith Cross 16 to my left, the Director of our Division of Corporation 17 Finance, and to my right Henry Hu, the Director of our 18 Division of Risk, Strategy, and Financial Innovation, which 19 we affectionately call Risk Fin. 20 The moderators of today's panels two staff members 21 well known to you, or if they're not, they should be. Amy 22 Starr, Senior Special Counsel for Capital Markets, Office of 23 the Chief Counsel, Division of Corporation Finance, who is 24 right across from me, and Martha Haines, Chief of the Office 25 of Municipal Securities, Division of Trading and Markets, who 4 1 is down in the pink at the end of the table over here. 2 My appreciation goes as well with many, many thanks 3 to Kayla Gillan, in the pale pink, Chairman Schapiro's Deputy 4 Chief of Staff, who is leading this effort for the 5 Commission, my counsels Alicia Goldin -- Alicia is at the end 6 of the table here -- and Lesli Shepperd, who is not with us 7 today. They both have been indispensable to this effort. 8 And particularly Rachel Hurnyak from Chairman Schapiro's 9 office, who has handled the logistics for this hearing and 10 has done a phenomenal job of keeping us all organized. 11 I am also very pleased that we are joined today by 12 Mike Rofino and Julie Bower of FINRA and Alan Polsky, Steve 13 Haney, and Lynnette Hotchkiss of the Municipal Securities 14 Rulemaking Board. The MSRB and FINRA, as you well know, play 15 critical roles in regulating professionals who operate in the 16 municipal market, and their assistance has been invaluable. 17 Among those participating as panelists are several 18 knowledgeable state and local officials. The Honorable Bill 19 Lockyer, California State Treasurer, will be with us this 20 morning. The Honorable Jim McIntire, Washington State 21 Treasurer, the Honorable Michael Belsky, Mayor of Highland 22 Park, IL., David Crane with the Office of Governor 23 Schwarzenegger, Mark Blake, Deputy City Attorney of San 24 Francisco, Brian Mayhew, Chief Financial Officer for the Bay 25 Area Toll Authority, and Ed Harrington, General Manager of 5 1 the San Francisco Public Utilities Commission. Additionally, 2 in the audience with us today is California Corporations 3 Commissioner, Preston DuFauchard. Welcome. Our thanks to 4 you all. 5 Next, I'd like to provide a brief overview of the 6 current state of the municipal securities market, which will 7 be followed by a description of today's field hearing. And 8 finally, I will highlight for you the types of issues we are 9 hoping to explore during today's panel discussions. 10 Just for your information, the panels will vary in 11 our future hearings. We had more topics than we could fit in 12 any given hearing, so we somewhat arbitrarily assigned 13 different topics to different hearings across the country. 14 Over the past thirty years, the municipal 15 securities market has grown tremendously on many fronts and 16 serves as an increasingly significant part of the U.S. 17 capital markets. The current amount of municipal bonds 18 outstanding is estimated to be roughly $2.8 trillion, and 19 more than $470 billion of new bonds and notes were issued 20 last year. The Build America Bonds, or BAB program, was 21 launched in April 2009, and as of April 2010, it had enabled 22 states and localities to issue more than $90 billion of BAB 23 bonds to fund new building projects. 24 Despite the reputation of the muni market as a buy 25 and hold market, trading volume is substantial, with 6 1 approximately $3.8 trillion of long and short-term municipal 2 securities traded in 2009 in over 10 million transactions. 3 With an estimated 51,000 or more state and local 4 issuers, it is an extremely diverse market. Depending on the 5 type of financing, payments may come from general revenues of 6 the municipal issuer, specific tax receipts, revenues 7 generated from a public project or other specific revenue, 8 payments from private entities or from a combination of 9 sources. The interest paid on municipal debt securities is 10 often, but not always, exempt from federal income taxation 11 and, in some cases, also may be exempt from state income and 12 other taxes. 13 Retail investors hold approximately 36 percent of 14 outstanding municipal securities directly, and up to another 15 34 percent indirectly through mutual funds and closed-end 16 funds, and retail-sized trades account for roughly 81 percent 17 of trading volume. 18 And in spite of their well-deserved reputation for 19 safety, municipal securities can and do default. From 1999 20 to 2009, issuers defaulted on over $24 billion in municipal 21 bonds out of a total of $3.4 trillion issued. In 2009 22 alone, 194 municipal bond issues defaulted with an overall 23 dollar amount of almost $7 billion in bonds. 24 It is hard to overestimate the importance of the 25 municipal securities market to building and maintaining the 7 1 infrastructure of our nation. The billions of dollars that 2 the muni market raises each year supports projects that are 3 needed by all of us as taxpayers and residents in the towns, 4 cities, counties, and states across our country. Many of us 5 also play a dual role in the market. Not only are we 6 recipients of the benefits that our states and localities 7 provide with the funds they raise, we are also the source of 8 those funds as purchasers of municipal securities. A core 9 mission of the SEC is to protect investors, and we are here 10 today in furtherance of that mission, specifically to focus 11 on protection of those purchasers of municipal securities. 12 Despite its size and obvious importance, the 13 municipal securities market lacks many of the protections 14 customary in many other sectors of the U.S. capital markets. 15 Investors in municipal securities should have the same rights 16 as investors in other types of securities, rights to receive 17 information that is not materially misleading and does not 18 contain material omissions, which includes receiving 19 financial and other material information that is not stale. 20 These precepts are central to informed investment 21 decision-making and investor protection. As I have 22 previously bemoaned, investors in municipal securities are, 23 in certain respects, afforded second-class treatment today. 24 I, for one, believe that this needs a hard look. 25 Some have suggested looking to the corporate 8 1 disclosure scheme as a framework for municipal disclosure. I 2 believe that we can learn from the corporate world, but it is 3 also essential that we recognize the differences in the 4 municipal and corporate finance worlds and that we work 5 together to evaluate what an appropriate framework for 6 municipal finance disclosure should be in the future. 7 Chairman Schapiro shares my interest in 8 strengthening investor protection mechanisms applicable in 9 this important sector of the capital markets, which is why 10 she asked me to lead a series of field hearings across the 11 country to elicit the analyses and opinions of a broad array 12 of municipal market participants. As the Chairman has noted, 13 to grapple with the complex issues presented by the municipal 14 securities market, we need to harness the ideas of a wide 15 range of people who have experienced this market from many 16 different perspectives. 17 Over the course of the next several months, we 18 anticipate holding additional field hearings in Chicago, 19 Illinois, Washington, D.C, Birmingham, Alabama, Tallahassee, 20 Florida, and Austin, Texas. Each field hearing will include 21 participants from the local region and will examine different 22 sets of issues. The Western Region is an essential player in 23 this market, and holding our first hearing here in San 24 Francisco will provide us with an important base of 25 information going forward. 9 1 Personally, I view these field hearings as a 2 fantastic opportunity to take a fresh look at the way the 3 municipal securities market works and to effect real 4 regulatory change. I'm confident that by soliciting input 5 from market participants around the country, our staff will 6 be well equipped to develop meaningful and practical 7 recommendations to improve the state of the market. 8 We have an impressive group of panelists lined up 9 for the day, and on behalf of my colleagues and myself, I 10 would like to thank all of them for so generously agreeing to 11 participate in this field hearing. A heartfelt thank you 12 also goes to our host for today's event, the Port of San 13 Francisco, and Monique Moyer, its Executive Director, who has 14 been incredibly helpful and welcoming to us. 15 The format of today's field hearing will entail 16 five panels covering topics relating to disclosure, credit 17 ratings, significant liabilities, internal controls, and 18 investor experiences. Once I conclude my opening remarks, 19 we'll launch right into the first panel. 20 As moderators, Amy and Martha will introduce their 21 topics and panelists. Each panelist will then make brief 22 opening remarks. The moderator, Meredith Henry, and I will 23 then as the panelists some questions. We look forward to a 24 lively and fruitful discussion, and I encourage the panelists 25 to engage in a dialogue with each other in addition to 10 1 addressing our questions. 2 Our agenda for today is certainly ambitious. We 3 will be covering a number of complex and interesting topics 4 and will look to each panel to help us to understand better 5 the particular concerns of different market participants, 6 highlight key areas for improvement, and provide some 7 concrete ideas for moving forward. I want to emphasize that 8 last point. This endeavor is about the desired future state 9 of the market. 10 I'm particularly excited about this first field 11 hearing, as today's panels will be addressing two issues that 12 I care deeply about, transparency and investor experience. 13 Let me tell you a bit about what we hope to address on each 14 of the panels. 15 Our first panel of the day is entitled "Selected 16 Disclosure Practices: Transparency and Presentation," and it 17 will touch on a number of important substantive topics, 18 including disclosure of key or material events and conflicts 19 of interest, such as broker-dealer affiliate relationships 20 and issues relating to the role of insurers and credit 21 enhancers, including, for example, credit worthiness and 22 consequences of default by an insurer or credit enhancer and 23 disclosure of issuer information in the presence of insurance 24 or credit enhancement. 25 The disclosure panel will also address important 11 1 issues surrounding timing, availability, and format of 2 disclosure, including transparency of pre and post-trade 3 information, timeliness, accessibility, and clarity of 4 disclosure, and presentation or format of disclosure, 5 including disclosure principles, use of an executive summary, 6 comparability of disclosures by different issuers, possible 7 tiering of disclosure requirements, and voluntary 8 data-tagging. 9 Because it has long been my view that our principal 10 goal in this area should be to improve the quality and 11 timeliness of information available to municipal securities 12 investors, I am especially interested in hearing from this 13 first panel. 14 Our second panel, Ratings, "Impact and Practices," 15 will explore rating agency practices and protocols, for 16 example, comparing the way rating firms handle municipal 17 securities and corporate securities, the impact of bond 18 insurance on ratings, comparability of ratings from different 19 agencies, and conflicts of interest. 20 After a brief lunch break, we will jump into our 21 third panel, "Disclosure of Certain Significant Liabilities," 22 which will focus on public pensions, retiree health, and 23 derivatives. For instance, how reliable are asset and 24 liability valuations and underlying assumptions with respect 25 to pensions and retiree health? Do we have appropriate 12 1 accounting standards for reporting the economic value of 2 pension liabilities? How do issuers of variable rate debt 3 use derivatives for purposes of hedging interest rate risk? 4 What kinds of disclosure do issuers make regarding their use 5 of derivatives? How can we address better the needs of 6 investors and regulators? 7 Next, we will focus on disclosure controls and 8 internal controls, including standards for issuer officials 9 who approve offering documents and best practices for 10 disclosure controls involving securities offerings and 11 secondary market disclosure. 12 Last, but certainly not least, we will hear from 13 investors. In order to think about ways in which we can 14 combat the second-class treatment of municipal securities 15 investors, we need to listen to investors and understand 16 their needs. We want them to tell us about themselves. 17 What prompted you, as an investor, to invest in 18 municipal securities? How do you go about investing? Do you 19 use an intermediary? What kinds of information did your 20 advisor or salesperson provide to you about your investing 21 options? Do you conduct other research before investing? 22 Can you get the information you need? Have you found 23 information about the municipal securities market to be 24 accessible and clear? What kind of information would be most 25 helpful to you in making investing decisions in the municipal 13 1 market? In what form would that information be most useful? 2 Do you have specific complaints or compliments about your 3 experiences in municipal securities investor? How does your 4 experience investing in the municipal securities market 5 compare with your experience investing in other parts of the 6 capital markets? Do you think the municipal securities 7 market is fair? 8 At our future hearings, we will revisit some of 9 these topics and cover many others, such as investor 10 protection, investor education, financial reporting and 11 accounting, the Municipal Securities Rulemaking Board, 12 municipalities acting as conduit borrowers for private 13 companies or non-profit entities, market stability and 14 liquidity, offering participants professionals and market 15 intermediaries, Build America Bonds and other taxable 16 municipal securities, and 529 Plans. 17 We encourage investors and all other interested 18 people to submit comments related to the field hearing topics 19 and any other topics related to the municipal securities 20 market to assist the Commission staff in determining whether 21 to recommend changes to laws, regulations, or best practices 22 to better protect municipal securities investors. Comments 23 may be submitted by using the comment form on the SEC website 24 or sending an e-mail to munifieldhearings@sec.gov. 25 In conclusion, I'd like to remind you that the 14 1 Commission is committed to a strong and vibrant municipal 2 securities market, and I know that our talented and dedicated 3 staff is already hard at work thinking about these issues and 4 developing possible regulatory and market participant 5 responses. I hope that today's presentations and our 6 upcoming field hearings will help inform us in taking the 7 right steps to ensure the integrity of this vital market. 8 Our panelists today represent a range of 9 constituencies, including state and local government, 10 regulators, national associations, retail and institutional 11 investors, and various market participants. We are 12 privileged to have them here, and grateful for the effort 13 they have made to take part in these hearings. We look 14 forward to a spirited and substantive discussion. 15 A few housekeeping items. First, we'd like to ask 16 the panelists, moderators, and other questioners to stand 17 their nameplates vertically, like this, when you want a turn 18 to speak. Second, there will be a short lunch break from 19 12:15 to 1:00, and our last panel of the day will conclude at 20 4:30. A transcript of today's event will be made available 21 on the Commission's website, in addition to any written 22 statements provided by the panelists. 23 Thank you for attending today, and we hope you find 24 this hearing valuable. 25 MS. STARR: Thank you, Commissioner Walter. 15 1 Before we formally begin our first panel, I would 2 like to introduce the Treasurer of the State of California, 3 the Honorable Bill Lockyer. We are pleased the Mr. Lockyer 4 is able to join us for a short time this morning. 5 Mr. Lockyer was elected in November 2006 as 6 California's 32nd State Treasurer. Before that election, Mr. 7 Lockyer was California Attorney General from 1999 to 2006. 8 During his 25-year career in the Legislature that culminated 9 as a stint as the leader of the State Senate, Mr. Lockyer 10 crafted agreements to balance the state budget and reform 11 government programs to make them run more efficiently. 12 Mr. Lockyer graduated from the University of 13 California, Berkeley, earned his law degree from McGeorge 14 School of Law, and also received a teaching credential from 15 California State University, Hayward. 16 Mr. Lockyer, thank you for taking time this morning 17 to share your views with us. 18 MR. LOCKYER: Thank you very much. 19 Good morning. I was struck by the long list of 20 possible inquiries, and I'm hopeful that it won't take too 21 many decades to reach informed judgements about those 22 matters. Thanks for allowing me to be with you and to 23 address you briefly. My office and I were delighted to 24 participate and offer any possible continuing assistance that 25 we may. 16 1 The State of California is both a large investor 2 and a major issuer. My office manages about 67 billion 3 investment pool of state and local funds and, of course, in 4 addition, as the Treasurer, I serve on the Board of Directors 5 of the two largest pension funds in the nation. 6 Since the inception of the Build America Bond 7 Program, the State of California has become a very large 8 taxable issuer, as well. In a year-and-a-half, we've issued 9 slightly under $30 billion worth of issues, half of which are 10 taxable and half are tax exempt. So as both investor and 11 issuer, we're responsible for protecting the public trust and 12 adhere to the highest standards of transparency. 13 I'd like to talk about three brief things, ratings, 14 disclosure, and the need for regulation of the derivative 15 market. There's been a lot of discussion regarding ratings 16 and who should pay for them, how they should be regulated, 17 whose interest regulating agencies represent, and so on. 18 I just want to mention that whatever system is 19 developed that responds to those concerns, it's really 20 important that the rating agencies be accountable for their 21 product. There should be a system that ensures that ratings 22 can be easily understood by all segments of the market, that 23 the ratings are accurate, that they're fair to both investors 24 and issuers, and reflect the true nature of risk inherent in 25 the investment. 17 1 Recent moves by Moody's and Fitch to a global 2 ratings scale is a step in the right direction. 3 Unfortunately, there's much yet that needs to be done, and 4 Standard & Poor's is yet to discover that this is an 5 important matter. 6 Today, there's a global market. In addition to the 7 14.5 billion tax exempt bonds that I mentioned we sold since 8 the beginning of '09, we've sold 14.7 billion taxable bonds. 9 Some of that is Build American Bonds. One point seven 10 billion, or about 28 percent, of the orders for our last BABs 11 issue came from international investors. 12 The fact that international investors rely probably 13 more on agency grading than many domestic investors do who 14 are more familiar with state and local government and our 15 markets makes it important that we see that rating 16 information is fair and equitable compared to corporate 17 market ratings. And that's really the heart of my concern is 18 there's been historic discrimination in public issues 19 compared to corporate issues. 20 Municipal bonds rarely default. A study last year 21 by -- earlier this year, actually, by S&P revealed that .33 22 percent of municipal bond issues rated A minus defaulted 23 during the last 15 years, while corporate issuers rated A 24 minus had an average default of 3.16 percent. So 100 times 25 more likelihood of default, but same rating. That 18 1 discrimination costs taxpayers a lot of money because our 2 cost of issuance go up, and it's unfair to investors to not 3 be able to accurately compare the choices that they would be 4 making. 5 Retail investors are a growing percentage of the 6 municipal buyer pool. And of course, the federal legislation 7 provides for the SEC study of improved disclosure for retail 8 investors, as well as efforts to improve the financial 9 literacy of retail investors. Those folks rely heavily on 10 agency ratings, as well as advice from their brokers or 11 investment advisors, and it seems to me that ratings should 12 accurately inform them of the risk of non-payment relative to 13 other investments that they may be offered. Current ratings 14 still don't do that, though there have been these recent 15 improvements. 16 The Dodd-Frank Legislation contains provisions that 17 could move the system further down the road to fairness for 18 taxpayers and more accurate information for investors, 19 whether that opportunity and potential is realized really 20 depends greatly on what the SEC does. 21 When it comes to uniform ratings, we believe the 22 bill leaves room for interpretation of how new standards will 23 be applied and whether they actually result in ratings that 24 accurately reflect default risks. As an example, the SEC is 25 required to prescribe rules that require the agencies to use 19 1 rating procedures and methodologies that are approved by 2 their governing boards. Further, any material changes to 3 procedures in methodologies must be applied consistently and 4 adequately noticed to rating users. 5 The bill doesn't say that these procedures and 6 methodologies must ensure that ratings accurately reflect 7 default risk or any other single factor, or that default risk 8 must be based on criteria that have some demonstrated 9 relationship to the risk. I think it's within your legal 10 purview to insist on that criteria, and it would make a big 11 difference to investors. There's some written comments 12 around that include several other important, but more 13 technical, comments on ratings issue. 14 With respect disclosures, obviously we all agree 15 that government should be accountable for providing full and 16 readily accessible disclosure of all relevant and material 17 information to investors, as well as our taxpaying citizens. 18 As the largest issuer of municipal bonds -- actually, I think 19 last year we were the large issuer of any kind of bond, 20 including corporate -- in the country, we're aware of the 21 responsibility, and there has been for many, many years a 22 strong culture in California State government of full 23 disclosure. 24 Senior level officials stay involved. Training is 25 provided to all levels of staff involved in the disclosure 20 1 process, outside disclosure counsel. Experts in securities 2 laws engage specifically to advise the state on its 3 disclosure. The process for developing the document is 4 inclusive, as input from appropriate state departments as 5 well as our advisors and investment bankers. 6 The state exceeds current requirements for 7 continuing disclosure with monthly financial reports that 8 include cash reports with budget to actual comparisons, as 9 well as updated economic and data information. It's readily 10 accessible on state websites. Also, my office has an 11 investor website that we continually look for ways to provide 12 more useful information to investors. 13 There's a well-established framework for municipal 14 disclosure. By and large, the existing system has served 15 issuers and investors well. The size of the market and types 16 of debt defined broadly as municipal obviously have grown and 17 evolved. There's a need undoubtedly for regulatory 18 improvement. 19 While it's desirable to have minimum disclosure 20 standards, there may not be a single one size fits all 21 solution. So I hope you'll please consider the need for 22 disclosure standards that acknowledge the limited resources 23 of small and infrequent municipal issuers, as well as the 24 relevancy of standardized reports and uniform reporting 25 timeframes. 21 1 Disclosure standards, it seems to me, need to 2 recognize the differences between issuers, the types of 3 municipal debt issued, the relative security of the 4 investment. For example, obviously there's a difference 5 between a tax supported General Obligation Bond and the 6 disclosures with respect to that are probably very different 7 from what's needed with a utility revenue bond, which is not 8 the same that you might have for land secured financing 9 largely because of different risks associated with the 10 different issues. And finally, we think that the EMMA System 11 is needed and a significant improvement in making information 12 available to investors. 13 With respect to credit default swaps and other 14 derivatives, it's a growing concern in the wake of the 15 financial market meltdown. The municipal CDS market is not 16 yet large relative to the municipal cash bond market, but it 17 could have a potential to fairly increase muni bond prices 18 and deserves to be regulated accordingly. 19 The net notional amount of the six largest single 20 muni CDS funds together with the index total approximately 21 $6.2 billion, less than .3 percent of the almost $3 billion 22 municipal bond cash market. Even though there's been no 23 change in fundamental credit quality of our states GO bonds, 24 five year CDS prices have fluctuated between 250 and 350 25 basis points per year over the last three or four months. 22 1 These CDS spreads imply a probability of default of 2 over 50 percent, yet reasonable market participants agree 3 that the probability of this state not meeting its debt 4 service obligations on its GO debt is for all practical 5 purposes zero. While we haven't seen evidence that CDS is 6 having a discernable negative impact on our bond prices, it's 7 certainly a possibility. Market participants look to CDS 8 price signals for one way of determining appropriate prices, 9 and media frequently comment on them. So it does have some 10 potential for increasing borrowing cost to taxpayers and for 11 irrational pricing. 12 Now, I understand that CDS, for legitimate hedging 13 purposes, can benefit issuers by making investors more 14 willing to buy cash bonds, which should increase liquidity 15 and lower borrowing costs marginally over time. However, 16 it's not clear that the potential benefits will outweigh the 17 potential for severe harm if there isn't some action taken to 18 curb inappropriate speculation. 19 So I would recommend regulatory mechanisms, and 20 they're ones that you've heard numerous times before. Ensure 21 that opportunistic, non-traditional market participants, such 22 as hedge funds, are subject to regulation. Ensure that the 23 vocal rule ban on proprietary training by banks and dealers 24 is applied to muni CDS, increase margin or capital 25 requirements on default swaps to reduce leverage and ensure 23 1 equivalency with cash instruments, require that municipal CDS 2 trades be centrally cleared and executed on registered 3 trading platforms with real time disclosure, encourage the 4 relevant regulatory bodies to aggressively enforce their 5 expanded authority to prohibit market manipulation and unfair 6 trading practices in this area. 7 Finally, the Build America Bond Program, the 8 taxable bond program, has been vital to California's 9 infrastructure investment, and we hope it will continue in a 10 robust and healthy way. Unfortunately, we've recently read 11 research papers issued by investment banks that talk about 12 creating a synthetic muni market, words that we've heard with 13 some distress in the last several years, and also to discuss 14 potential financial products that would offer the means to 15 short municipal bonds. I don't yet know how that would 16 actually impact our markets, but I think it's deserving of a 17 very close, careful watch. 18 Thanks for allowing me to visit with you and also 19 for understanding that in a moment I need to run and let the 20 distinguished panelists respond to your comments and 21 questions. I don't know if there's any that I can answer 22 before I have to run out. 23 COMMISSIONER WALTER: We very much appreciate your 24 being here, and thank you for your input. We may follow up 25 later with additional questions. But thank you for your full 24 1 statement, and it was a pleasure to be able to have you here, 2 even for a little while. 3 MR. LOCKYER: Thank you very much. I appreciate 4 it. Good luck to you. 5 MS. STARR: Good morning. Now, we will start Panel 6 No. 1. 7 As Commissioner Walter had pointed out, the 8 municipal securities market is extraordinarily diverse, with 9 municipal issuers including states, cities, towns, counties, 10 and public instrumentalities, such as school districts and 11 port authorities, issuing municipal securities for a variety 12 of purposes, to finance public projects, satisfy cash flow 13 and other governmental needs, and by acting as a conduit on 14 behalf of private organizations who wish to obtain tax exempt 15 interest rates to fund non-governmental private projects. 16 Municipal securities offerings are exempt from the 17 registration and reporting requirements of the federal 18 securities laws, but remain subject to the laws anti-fraud 19 provisions. The absence of a statutory line item disclosure 20 regime for municipal securities offerings and ongoing 21 reporting has resulted in municipal securities disclosure 22 being governed by anti-fraud considerations and the demands 23 of market participants. 24 Commission rules and interpretations and 25 enforcement actions coupled with voluntary guidelines and 25 1 best practices published by municipal market participants 2 have, however, aided in developing a framework for municipal 3 securities disclosure for primary offerings on an ongoing 4 basis. Participants in the municipal securities market also 5 have worked to develop extensive guidance to improve the 6 level and quality of disclosure and primary offerings of 7 municipal securities, and since 1994 continuing disclosure in 8 the secondary market. 9 Furthermore, Rule 15c2-12 has significantly 10 improved the level of information provided in the municipal 11 securities market, both initially and through the life of the 12 municipal securities. Even with these improvements, however, 13 the practices of market participants in providing information 14 to investors is not consistent with disclosures of large 15 repeat issuers, generally being more comprehensive than those 16 of small, infrequent, or conduit issuers who may provide 17 little ongoing information to investors. 18 The first panel of our hearing, "Selected 19 Disclosure Practices: Transparency and Presentation," will 20 explore issues relating to the type and timing of 21 disclosures, including particularly disclosures about 22 material events, conflicts of interest, and the role of 23 insurers and credit enhancers, and also will examine ways in 24 which information is or could be presented and how such 25 presentations could be improved to further investor 26 1 understandings. 2 Our panelists this morning -- and I will give you 3 their bios as I walk through. Our first panelist is Brian 4 Mayhew. 5 Mr. Mayhew joined the Metropolitan Transportation 6 Commission as the Chief Financial Officer in October '99. As 7 CFO, Mr. Mayhew manages all accounting, treasury, and 8 financial functions, including debt issuance and management 9 for the Metropolitan Transportation Commission, the MTC 10 Service Authority for Freeways and Expressways, and the Bay 11 Area Toll Authority. 12 As CFO of MTC/BATA, Mr. Mayhew has overseen the 13 growth of the toll operation, transportation grant 14 administration, as well as an expanded capital program, 15 including replacement of the San Francisco/Oakland Bay 16 Bridge. Mr. Mayhew is responsible for a debt portfolio of 17 $7.5 billion, swap portfolio of $1.7 billion, with assets 18 under management of $4.5 billion. BATA has been the 19 recipient of three Bond Buyer Western Regional Deal of the 20 Year awards and one Governing Magazine deal of the year. 21 Prior to working at MTC, Mr. Mayhew spent 10 years 22 as the Finance Director for the City of Westminster, 23 California where he oversaw accounting, payroll, and 24 treasury, as well as redevelopment and economic development 25 project funding. 27 1 Mr. Mayhew holds Bachelor's and Master's degrees 2 from the University of California at Santa Barbara, along 3 with multiple certifications in accounting, payroll, 4 purchasing, cash and debt management. Mr. Mayhew is active 5 in both state and national professional associations and has 6 served on the Issuer Advisory Committee of the MSRB. 7 Our next panelist is Mary Colby. On behalf of the 8 National Federation of Municipal Analysts. Mary Colby serves 9 on the Executive Committee of the Board of Directors of the 10 NFMA and is the Chair of the Industry Practices Committee. 11 Ms. Colby is a Managing Director and the Head of 12 Municipal Fixed Income Research for Charles Schwab Investment 13 Management in San Francisco, a position she has held since 14 2004. Ms. Colby joined the research group in 1996 where she 15 and her team of analysts provide research and support for 16 four municipal bond funds seven municipal money market funds 17 whose assets total over $30 billion. 18 Prior to joining Charles Schwab, Ms. Colby spent 19 six years as a public finance analyst at Standard & Poor's 20 Corporation in New York. 21 Ms. Colby sits on several advisory committees for 22 the Investment Company Institute, including those for fixed 23 income and money market funds. She is a past president of 24 the California Society Municipal Analysts and is a member of 25 the Society of Municipal Analysts. 28 1 Ms. Colby holds a Bachelor of Arts and Master of 2 Arts in European History from Northwestern University in 3 Evanston, IL. 4 Finally, our last panelist is John McNally who is 5 representing the National Association of Bond Lawyers. Mr. 6 McNally is a partner in the Washington, D.C. office of 7 Hawkins Delafield & Wood. He is currently President-Elect of 8 the National Association of Bond Lawyers. In the 1970s, he 9 was an attorney at the Commission in the Division of Market 10 Regulation where he was a member of the Municipal Securities 11 Disclosure Task Force. 12 Mr. McNally's practice includes both a securities 13 practice and a public finance transactional practice. He is 14 a frequent speaker regarding the application of the federal 15 securities laws to public finance transactions and has served 16 as Chair and Vice-Chair of NABL's Securities Law and 17 Disclosure Committee. 18 Mr. McNally was co-editor of the Federal Securities 19 Laws of Municipal Bonds Deskbook, and he served as the 20 Project Coordinator for the Third Edition of Disclosure Roles 21 of Counsel in State and Local Government Securities 22 Offerings, a joint publication of the American Bar 23 Association and NABL. Hawkins and Mr. McNally currently 24 serves as Disclosure Counsel to the City of San Diego and the 25 District of Columbia. 29 1 Mr. McNally graduated from Georgetown University 2 Law Center in 1976 and from the University of Pennsylvania in 3 1972. 4 I now want to ask my panelists to begin with their 5 opening statements. I'd like to start with Mr. Mayhew. If 6 you could please give us your initial thoughts, and then 7 we'll ask questions after all the panels have gone. We'll 8 have Mr. Mayhew, Ms. Colby, and then Mr. McNally, and then 9 all the panelists will then start asking questions. 10 MR. MAYHEW: This is your idea of easy. How many 11 lawyers am I surrounded by here? 12 COMMISSIONER WALTER: Too many, Brian. 13 MR. MAYHEW: Way too many. 14 First, let me welcome you to the Bay Area. We're 15 always happy to have people from out of town come in, visit, 16 spend money. As a regional transportation authority, we have 17 to manage money for many, many clients around here. So the 18 more you spend, the happier my next quarter will be. 19 I didn't want to do an opening statement, but I did 20 want to give you some sort of general feel for BATA and the 21 Bay Area Toll Authority and the concept of what we do. So I 22 prepared a small, little presentation. I didn't bring copies 23 for everybody, so if you know Susan Wu, ask her. 24 I'm going to ask somebody to hand these out. I'm 25 sorry. My hand is shaking so bad. All right. I'm going to 30 1 try to get through this. 2 What I did -- let me lay out a couple things. 3 First of all, let me talk just a bit about my organization 4 and our primary organization. 5 We're a transportation agency for the nine counties 6 of the San Francisco Bay Area. People know me particularly 7 for a very large and sort of diversified debt portfolio, but 8 the other side, you see this map on page 2, is the 9 responsibility of the Metropolitan Transportation Commission, 10 which is our organization. 11 We run funding, billions of dollars worth of it, 12 through the nine counties. Our main function is what you see 13 as the Bay Area Toll Authority, and as you can see, we have 14 seven bridges spanning the San Francisco/Oakland Bay. And 15 quite frankly, if people are going to cross that water, we 16 have a pretty good enterprise. 17 We have annual revenues now of over $700 million. 18 Operating cost of only about 40 million. Quite frankly, we 19 run a billion dollar a year enterprise on less than 170 20 people. 21 Our capital program now exceeds $12 billion. Our 22 ratings are one of the highest transit rating -- highest 23 rated transit agencies in the country. We have a Schwab 24 portfolio of 2.3 billion, and we have 4.3 billion in treasury 25 assets under management. And of that, we actually have a 31 1 significant municipal bond portfolio. So we're not only the 2 people who issue the things. We actually buy them up. 3 The one thing about BATA -- somebody once said to 4 my boss, "What we like about your organization is you run it 5 like a company," and he was deeply offended. He said, "What 6 I like about this organization is we run it like a good 7 government." And quite frankly, that's what we want to be. 8 We're not looking to be as well rated or looking to be 9 General Electric. 10 And I think you said it earlier, Commissioner, 11 there are reasons we're government. There are things we do 12 that benefit people, and we do them because that's what the 13 government's agencies do. You want to be a good government 14 agency. I don't want to be an okay company, or I don't want 15 to be looked at in the same light as General Electric. We 16 have very different missions, very different focuses. 17 My focus is forty to 100 years. That ain't General 18 Electric's. And I think as you go through your hearings, I 19 do hope you keep that in mind. 20 Financial disclosure, something of a focus. I've 21 certainly heard about this. I was on -- I was over with 22 Bloomberg last week and got my head beaten off by people who 23 say we have no accounting standards, people who say we have 24 no disclosure, and quite frankly, it's kind of annoying. 25 First of all, we have very, very strict accounting 32 1 standards. GAAP is nothing to be messed with, and the GASB 2 is no bunch of sissies who couldn't get real jobs in the 3 private sector. 4 We have standards that come from the federal 5 government. We have standards that come from the state 6 government. I live in a constant world of audit. My 7 financial statements, which some people feel are inadequate, 8 the footnotes are bigger than the entire financial -- annual 9 financial statement of General Motors. So if people are 10 asking why we don't disclose, the last thing we don't do is 11 not disclose. 12 My organization sees its financial statements once 13 a year. We take them the first week in October. My 14 organization also sees a monthly budget and treasury report 15 without fail. These are all posted on a website within 16 minutes of them being transmitted to the Board. The last I 17 looked General Motors wasn't posting their Board's minutes or 18 notes or decisions on their website. 19 So I think as we go along, I'm not trying to make 20 that there's -- you know, we're better than anybody else. 21 We're government. Transparency is what we do. Are there 22 good governments? Yes. Are there bad governments? 23 Probably. 24 And I think as you go down this path, I think 25 finding that measure as to what investors need -- because we 33 1 want to give it to them. I have a very good friend who -- 2 well, used to be a good friend until he was in charge of 3 analysts -- who said, "We are going to get annual audits. We 4 are going to get a quarterly filing." 5 And I told Mark, I said, "I've known you a long 6 time. Why would we do that? Why would we take our efforts 7 and do that when we're putting the same information out on a 8 monthly basis? Besides, we're under a different accounting 9 standard. Modified accrual is not full accrual accounting. 10 Therefore, adding 12 of our statements up doesn't equal the 11 13th because the accruals come into play at BATA." 12 The other part of it, what kind of disclosures do 13 we do? Although I will say it's an interesting discussion as 14 to whether something has happened and whether it's a material 15 event or not, in reality, let's see, we got hit by AMBC being 16 downgraded and all of our short range ratings taken away. 17 Bonds snapped up like that. We had no idea it was happening 18 until somebody called and said, "There must be a mistake. 19 Your ratings are gone." 20 Well, we found out what happened. We got 21 every-thing fixed. But again, we filed the moment we knew 22 that. The idea -- nobody gets up in the morning and says, 23 "Let's not disclose something." What you do is you get up in 24 the morning and you say, "Uh-oh, this is bad." The first 25 thing you do, first act in every emergency is to get stable. 34 1 Make sure everything is okay. Everybody is okay. We can 2 account for our money. Then, tell everybody. 3 Now, that span may be minutes, may be hours, may be 4 a day. But nobody doesn't think of doing it. You're 5 thinking in a certain logical order, we hope. 6 So as you can see, we file material events. It's 7 much, much easier with EMMA. The world is a much better 8 place to live in. 9 A lot of talk about post-employment, pension 10 liabilities, and other liabilities. This isn't a balance 11 sheet discussion. So I put in here from our audits of the 12 past few years the exact schedule that's in the audit that 13 tells the level of funding, and we're not going to talk about 14 whether it should show it with a balance sheet or not. 15 What we are talking about is it's there. These 16 schedules are required schedules. They're in every GAAP 17 certified accounting, every financial statement. Do you get 18 it every month? No, you don't need it every month because 19 reality is this doesn't change but annually. 20 So -- and, you know, I don't know what level of 21 funding is the right level. But what I'm pointing out is 22 where there has been a lot of criticism of our profession, 23 the information has been staring in front of everybody. I 24 really don't know why we don't look. 25 Finally, in the debt portfolio, I guess I'm -- I 35 1 probably am a poster child for everything that went wrong. 2 Everything that could go wrong did go wrong. We were 3 diversified. In 2008, our portfolio had a net interest rate 4 of just a buck over four. We were well on our way to 5 finishing our bridge projects. That's the biggest of them. 6 And it's flowing traffic, so we're happy. 7 We had a diversified portfolio. It was synthetic 8 fixed rate debt. 90 percent of it was Triple A. And within 9 a month, it began to all fall apart. 10 And we talk about our disclosures. There were lots 11 of people not disclosing to me that they were not going to 12 meet liquidity obligations. Insurance companies had invested 13 in things and taken on practices that would ruin their 14 companies. We met with one in November of '08, had a whole 15 game plan for how this was all going to work. None of it 16 worked. 17 As you can see, we've taken -- since 2010, we 18 re-did about 2 billion-plus of the portfolio. We wrote off 19 $25 million in insurance policies. We've reduced our swap 20 portfolio. And I will say that, as we go along, we have a 21 more stable portfolio, and the Build America Bonds have been 22 a tremendous, tremendous recovery. 23 Without the Build America Bonds, I would shutter to 24 think what would have happened to public projects in 2009. I 25 mean, literally -- I'm sorry. The Treasurer is gone, but 36 1 literally the State of California got frozen out. We made a 2 loan of $200 million to keep projects from freezing up and 3 canceling contracts, and the 200 million we put in kept $500 4 million worth of projects going. Five hundred million 5 dollars is probably about $50 million payroll. 6 So you got to be -- you know, this all has a cause 7 and effect. Now, we did it. We restructured. We did a lot 8 of things. It took two years. But the other side of it is 9 we didn't really kill the portfolio, and quite frankly, the 10 rates went up because we switched more heavily to fixed 11 rates. 12 So the last thought is what does work in my 13 opinion. I've been doing this now for over 25 years from 14 local government to major government. I have seen every kind 15 of failure there is in this business. I saw the repo mess in 16 the early '80s. I was in Northern California when San Jose 17 went through its problems, and I was in Southern California 18 when Orange County went through theirs. 19 The one thing I do think works, just first off, is 20 I think the accounting standards work. I think that GASB, 21 GAAP -- I think the accounting standards we work under are a 22 good balance. 23 For years they've been trying to fit more and more 24 FASB into what we do, but there's been an overriding 25 philosophy; and that is, our role is to get our taxpayers, 37 1 our toll payers, and the people who make decisions to know 2 what their net available assets are. That's all anybody 3 wants to know. How much have I got? What's my coverage? 4 I think the accounting standards work. I think you 5 have several areas of developed accounting standards, GASB, 6 GAAP, FASB -- I mean, not FASB, but the GAGAS and the federal 7 rules, A133, all of which we're audited under every year, 8 both the financials and internal controls. So from that 9 standpoint, I think you're sort of represented pretty well. 10 Accounting standards, pretty well taken care of. 11 Disclosure. I think that you have to recognize our 12 need for individual fund accounting, which is just the end of 13 the world. It doesn't exist in FASB accounting. The fund 14 accounting is a critical component. These are not blendable 15 assets, therefore we have to stovepipe them. You have to 16 keep that in mind. 17 The fact that you've got a project over here 18 failing doesn't mean you can go over here and grab the money 19 and use it. And if we're going to be proper stewards of the 20 money, people have to recognize our legal fiduciary 21 responsibility to the people who gave us that money. I can't 22 spend tool money launching airplanes, and I can't spend grant 23 money rebuilding toll booths. And anybody in this profession 24 has got to know this stuff. 25 Board transparency. I would make a big claim that 38 1 it does actually work. You may have an issue about how 2 frequently annual financials are out. But we took a survey, 3 and most organizations update budget to actuals across their 4 funds at least quarterly, in most cases monthly, mainly 5 because managers need it and the Board wants to know, 6 especially these days. 7 So I do think that there are websites -- a lot of 8 people use websites. This could be improved. I do not have 9 an investor relations website because my investor relations 10 is sitting in the back of the room, and she takes phone 11 calls. 12 But it is something -- you know, these things can 13 be improved. But also, they are there. All of the things -- 14 I have a good friend at Vanguard who, you know, one time was 15 asked, "Is there anymore?" He says, "We'll just go on your 16 website and find it." 17 So I think those things work. I think GAAP is 18 working. I think that's a -- you know, there is a good -- 19 again, a good balance in it. 20 If you look at -- you know, in the private world, 21 you look -- you get to look at the financials. In our world, 22 they're certified through a professional organization, and 50 23 percent of those organizations -- and not nearly 50 percent 24 of them have issued debt. 50 percent of those organizations, 25 a little bit more, have actually gotten their national 39 1 certifications that come from qualified people that are very 2 nit-picky, and that's -- you know, so there is a standard, 3 and there is a review standard that gives you that 4 established piece. 5 And then finally, I think that one of the big 6 improvements in the last couple years has been the EMMA 7 System. I think it's so much -- when you're talking about 8 disclosure. Who do you send it to, what are you going to 9 with the trustees, and things like that. 10 Things that don't work. I think one of the things 11 about disclosure you might look at is why -- believe it or 12 not there are people in this profession who don't think 13 disclosure is important. I don't understand them. But they 14 think that they write all these things in an official 15 statement, they put it on the shelf, and they're done. But 16 there's no incentive to do anything about it. 17 And I think there's some inconsistency in 18 reporting. Fund accounting is relatively consistent. When 19 we get to the -- GAAP level is consistent, but internal 20 reports aren't. Obviously timeliness. If people are going 21 to issue bonds, they should be responsible for them in the 22 public market. 23 Unfunded liabilities you'll talk about a bit more. 24 That's got to be -- that's an area that even the profession 25 is going to have to address. 40 1 And then the last piece is if you don't issue debt, 2 you know, picking your accounting standard is kind of up to 3 you. If you do issue it and you issue and you still report 4 under a non-GAAP standard, which you have a potential to do, 5 I think that that's something that has to be addressed. If 6 you're going to issue in the public market and you're going 7 to be rated, we want everybody to be rated on equal footing. 8 We want GAAP financials rated against GAAP financials, 9 reporting standards rated against reporting standards. 10 Thanks for inviting me. Terrified. But thanks. 11 MS. STARR: Thank you very much. 12 Mary, can I call on you to give us your opening 13 statement? 14 Brian, if you could move that? Thank you. 15 I apologize for having to move the microphone, but 16 that way you all can hear it in the back. 17 MS. COLBY: Good morning. Commissioner Walter and 18 Commission staff, thank you very much for providing the 19 National Federation of Municipal Analysts with the 20 opportunity to participate in this hearing on the state of 21 the municipal securities market. 22 The NFMA was established in 1983 with the goals of 23 providing an informed perspective in the formulation of legal 24 and regulatory matters relating to the municipal finance 25 industry, improving primary and secondary market disclosure, 41 1 and promoting professionalism in municipal credit analysis. 2 NFMA membership includes approximately 1,000 3 members, most of whom evaluate credit and risk of municipal 4 securities. These individuals represent many of the 5 participants in the market, including mutual funds,insurance 6 companies, broker-dealers, bond insurers, and rating 7 agencies. 8 The NFMA appreciates the opportunity to offer our 9 comments on transparency and disclosure to the Commission in 10 this forum. As we have previously commented, both publicly 11 and privately, to commissioners and staff members, the NFMA 12 believes that disclosure in the muni market has made great 13 strides in the last 16 years since the adoption of the 1994 14 amendments to 15(c)212 and in the last six years since the 15 establishment of the Central Post Office. 16 We'd also like to applaud the MSRB on its 17 prestigious efforts to launch EMMA, which provides both 18 issuers and investors with a single location. Each side has 19 been seeking to deliver and retrieve disclosure documents. 20 I'll divide my comments into two broad areas, 21 primary market and secondary market disclosure. In general, 22 the NFMA believes that primary market disclosure has improved 23 a great deal over the last 20 years, with some sectors of the 24 market having made greater strides than others. 25 The NFMA began making recommendations on disclosure 42 1 in 1990 with the publication of the NFMA Disclosure Handbook 2 and have continued with almost annual publications or 3 comments on the issues, including 16 recommended best 4 practices and disclosure or white papers on various sectors 5 in the market. Issuers in many sectors have responded to our 6 suggestions with improved information and official 7 statements. However, there continues to be a misperception 8 among many in the obligor community that they must limit 9 their financial disclosure to audited information. 10 Given that most issuers only undergo audits 11 annually with a substantial lag after the end of the fiscal 12 year, this often results in fairly stale financial 13 information being included in offering documents. While this 14 situation has improved in the last few years perhaps in 15 response to the financial crisis, it is still fairly common 16 to see an official statement that only includes audited 17 financials that are six to nine months old. 18 The NFMA continues to recommend that in addition to 19 the most recent audited financials and operating information, 20 an OS should also include more timely unaudited quarterly or 21 semi-annual financial and operating information, as well as 22 up-to-date collection information for the revenues which are 23 securing the bonds in question. 24 With regard to secondary market disclosure, our 25 comments are far less glowing. Secondary market disclosure 43 1 continues to be spotty, particularly among infrequent issuers 2 and those who have historically issued only with primary 3 market bond insurance. 4 Now, I'm not speaking of the large issuers, such as 5 BATA or the State of California who are in the market very 6 frequently, update their information regularly in those 7 offering statements, as well as on their websites. However, 8 there are many smaller, less sophisticated issuers who are 9 the issue here, and there are many of them. So these 10 situations arise frequently. 11 The major challenge in secondary disclosure 12 continues to be the timeliness and completeness of filings. 13 While most issuers meet their promised deadlines for filing 14 financial updates, the deadlines are typically 270 days, or 15 nine months, after the end of the fiscal year, at which time 16 the information is significantly out of date. 17 These deadlines compare very poorly to those which 18 corporate issuers must meet and are further exacerbated by 19 issuers who do not meet their deadlines or may extend their 20 filings to a year or more. There's very large county in the 21 middle of the country, very large city there that doesn't 22 file for over 13 months. This behavior is not limited to 23 small issuers. 24 We're also aware that the Commission has made 25 recommendations to reduce the deadline for filing financial 44 1 statements to 150 days from 270 days. We're certainly in 2 support of the shorter time frame, but as the recommendations 3 are for voluntary adoption only, we're concerned that the 4 adoption would be limited to those issuers, such as Brian, 5 who already file within a shorter time frame, but not for 6 the -- not adopted by the greater municipal market. 7 In addition to more timely annual disclosure, for 8 several years the NFMA has also been calling for interim 9 financial disclosure from all issuers. Currently, more 10 frequent financial disclosure is generally limited to the 11 health care sector and to many large frequent issuers, 12 including California and BATA. 13 During the current recession, many state and local 14 governments experienced double digit declines in revenues, 15 including sales taxes, personal income taxes, property taxes, 16 and mortgage recording taxes, among others, all of which 17 separately or jointly secure tax exempt debt. Investors 18 during the period were often left relying on financial 19 information gleaned from newspaper articles because secondary 20 market disclosure lagged so substantially and was so 21 infrequent. The municipal market contrasts very poorly with 22 the corporate sector where quarterly disclosure is the norm. 23 The NFMA will continue to include recommendations 24 for interim disclosure in its recommended best practices 25 papers, but it has also begun working with the GFOA to 45 1 develop guidelines for the issuance of more frequent, 2 unaudited financial information by governmental issuers. 3 While the guidelines have not been completed, we hope to 4 arrive at agreement with the GFOA on limited quarterly 5 financial information, likely balance sheet and income 6 statement with some minimal notes. 7 As issuers are already preparing interim statements 8 for internal use, we do not anticipate that the additional 9 step of filing a limited financial update to the market will 10 present an undue burden, particularly given the user friendly 11 format provided by the EMMA System. We are pleased about the 12 GFOA's interest in working with us on this issue, and we hope 13 that issuers will rapidly adopt the recommendations once they 14 are released. However, these will be guidelines only, and 15 unless an issuer incorporates the more frequent releases in 16 their continuing disclosure agreements, they will be entirely 17 voluntary. 18 Another area of concern is the prevalence of 19 incomplete filings. Most issuers include in their continuing 20 disclosure agreements a list of items of information which 21 were included in the official statement and which they 22 promise to include in secondary market filings, and many meet 23 those promises for some period of time. But often after a 24 few years, the filings may shrink to only the audited 25 financials, and the additional items of information 46 1 disappear. These items may range from annual updates for 2 assessed valuation, property tax delinquencies and tax 3 appeals, all of which are critical for assessing a General 4 Obligation Bond, to operating information for a water and 5 sewer system or sales tax collections, all of which are vital 6 to a thorough analysis of associated bonds. 7 We don't want to suggest that this is a problem 8 with all issuers. There are certainly particular sectors of 9 the market that do provide more frequent financial 10 information, as well as Brian, and many large and frequent 11 issuers are very attuned to the needs of investors. Most, 12 although not all, of the problem lies in the medium and small 13 issuer portion of the market, which has the largest number of 14 constituents given that the market itself is over 50,000 15 issuing entities. 16 While some might argue that the filings are an 17 unnecessary burden given their low rate of default among 18 municipal general government issuers, we feel strongly that 19 the issuers have availed themselves of the benefits provided 20 by issuing debt in the public market and must be prepared to 21 follow through with the promises they have made to investors 22 to provide complete and timely information. Further, the 23 ease of filing through the EMMA System greatly reduces the 24 historic argument against more frequent financial disclosure. 25 We would also like to express concerns regarding 47 1 the poor quality of material event notices. Our concerns 2 relate to the timing and the completeness of filings, 3 specifically that many notices are filed weeks or months 4 after the event, or they are not filed at all. 5 Most recently we have learned of issuers failing to 6 report unscheduled draws on debt service reserve funds or 7 credit enhancement policies, and, of course, the failure to 8 file adverse tax opinions has been a perennial problem. 9 There are numerous issuers currently under financial stress 10 about whom newspaper articles frequently appear, but who have 11 not released any updated financial information through EMMA. 12 In many instances, issuers have cited the materiality 13 standard in Rule 15c2-12, but one could argue that 14 materiality is in the eye of the beholder and should not be 15 left up to the determination of an interested party. 16 Finally, the NFMA supports the Commission's recent 17 amendments to the rule, but are concerned that the amendments 18 will only slowly and incompletely be applicable to the $2.9 19 trillion in outstanding municipal market debt. Some portion 20 of municipal debt currently outstanding will never be covered 21 by the amendments leaving those investors at a disadvantage 22 in making decisions as to the disposition of their 23 investments. 24 We feel strongly that the Commission should take 25 the steps necessary to provide investors in all outstanding 48 1 municipal debt the comfort of knowing that after they have 2 purchased a municipal bond that they will have access to 3 timely and complete information with which to make ongoing 4 decisions regarding those investments. 5 Thank you very much for this opportunity. I look 6 forward to answering your questions. 7 MS. STARR: Thank you, Mary. If you could pass the 8 microphone down to John, that would be great. Thank you. 9 MR. MCNALLY: Thank you. And thank you, 10 Commissioner Walter, for inviting the National Association of 11 Bond Lawyers to have the opportunity to speak at these timely 12 hearings. NABL did submit a formal written submission on 13 Friday. I will draw upon that submission in making these 14 comments. However, to the extent that I have any answers 15 that are oral today, they will be my own personal because 16 they were not reviewed by the Board. 17 Amy mentioned that I recently served as Project 18 Coordinator for the Third Edition of the Disclosure Roles of 19 Counsel, and I'm happy to report that it was recently 20 described by the New York Times as the new disclosure bible 21 for municipal bond lawyers. 22 So with that aside -- 23 COMMISSIONER WALTER: John, is it on the best 24 seller list? That's what we want to know. 25 MR. MCNALLY: It is, in fact, on the ABA best 49 1 seller list. 2 NABL is comprised of approximately 2800 attorneys 3 who specialize in municipal finance. We serve as counsel to 4 issuers, as bond counsel, general counsel, disclosure 5 counsel, to underwriters, to institutional investors, to 6 trustees, to conduit borrowers, to third-party credit 7 enhancers, and to others. In short, we serve as counsel to 8 all participants in the municipal market. 9 And clearly, as you're hearing today, not all 10 participants are going to be in agreement on all of the 11 issues. However, we do have a common interest, to ensure the 12 standards of disclosure that give confidence to investors in 13 the integrity and efficiency of the municipal market as a key 14 component of our capital markets. 15 NABL recognizes the significant financial 16 challenges facing municipal and state issuers in light of 17 what has been referred to as the great recession. NABL 18 recognizes that certain issuers are responding to these 19 challenges in a manner not seen since the 1930s, with a 20 California city declaring bankruptcy and the capital of 21 Pennsylvania considering, at least until a last minute rescue 22 by the state, whether to default on a general obligation, 23 full faith, and credit issue. 24 NABL recognizes the changes that occurred in who 25 are the investors, with approximately one-third being owned 50 1 directly by retail investors and another one-third owned 2 indirectly by retail through mutual funds. 3 And finally, NABL recognizes that the municipal 4 market is experiencing extensive scrutiny in legislative and 5 regulatory change. The most significant since the Securities 6 Acts amendments of 1975. 7 The SEC has amended Rule 15c2-12 and has 8 established a municipal securities and public pension unit in 9 the Enforcement Division. The Dodd-Frank Act changed the 10 composition of the MSRB, expanded the MSRB's authority, 11 including enhanced cooperation in examinations and 12 enforcement between the SEC and FINRA, required registration 13 and oversight of any municipal financial advisors, and set 14 forth a congressional directive to establish a separate 15 Office of Municipal Securities with a director who would 16 report directly to the chairman. 17 While the Dodd-Frank Act enacted many significant 18 changes in the current regulation of the municipal securities 19 market, congress did leave in tact the current principles 20 based structure of SEC oversight of this market which relies 21 on general anti-fraud provisions of the federal securities 22 laws to police fraud and abuse in the municipal market and to 23 provide the criteria to assess the adequacy of municipal 24 disclosure. The SEC has adapted such principles based 25 structure to the municipal market through rulemakings, 51 1 interpretive guidance, enforcement actions. 2 To be sure, certain advocates have argued that SEC 3 oversight of the municipal market should be conformed to the 4 corporate bond market, and that the tower amendment, which 5 exempts municipal securities from the registration 6 requirements of the securities laws, should be repealed. 7 Congress determined to direct the GAO to study this repeal. 8 We concur that such a measured and deliberative approach is 9 wholly appropriate in light of the unique nature of the 10 municipal market. 11 The combination of exemption from registration 12 while being subject to the general anti-fraud provisions has 13 created a discipline that results in comprehensive disclosure 14 that can be tailored to reflect the unique characteristics of 15 each financing. This is a critical feature of the existing 16 disclosure framework because, unlike corporate debt, there is 17 an extraordinary diversity of municipal issuers and issues. 18 There are over 50,000 distinct issuers in municipal 19 securities ranging from multi-family housing authorities to 20 sewer authorities to stadium authorities to general 21 obligation issuers. As was mentioned, last year over 450 22 billion of municipal securities was issued. 23 In addition to the sheer number and diversity of 24 issuers, the municipal securities market also reflects the 25 unique legal status of the issuers, which are public bodies 52 1 that are subject to limits on the powers of government, 2 rather than private sector companies. Issuers are governed 3 by state constitutions, state statutes, interstate compacts, 4 city charters, municipal codes, all which limit their legal 5 powers and allocate the legal responsibility among their 6 officers, both elected and appointed. 7 Municipal issuers are also subject to laws, the 8 Freedom of Information Act requests, and public budget 9 hearings. In the instance of the 50 states, each is itself a 10 sovereign body, with its own constitution, coexisting with 11 the other states in the federal government, as well as 12 retaining powers under the U.S. Constitution. 13 As Robert Fippinger quotes in his treatis, The 14 Securities Law of Public Finance, and I'm quoting, "The 15 limitations imposed on public corporations by 19th Century 16 constitutional conventions, state legislation, and judicial 17 fiat are totally incongruent with the parietal history of 18 private corporations." The laws provided for incorporation 19 of private companies enacted by legislatures competing for 20 businesses became relatively more similar. At the same time 21 the laws creating public corporations are increasingly unique 22 to the local circumstances. 23 We thought this background was useful in light of 24 the broader audience that this presentation may reach. We 25 appreciate that the SEC and its staff have been sensitive to 53 1 the unique characteristics of the municipal market. 2 As Commissioner Walter noted in her October 2009 3 speech, I fully appreciate that deference should be shown to 4 the special questions concerning disclosure and accounting 5 that municipal securities present. Municipal securities 6 should not be treated exactly like corporate securities. 7 Moreover, there cannot be a one size fits all approach to 8 municipal disclosure given the wide range of purposes and 9 structures of the over 50,000 municipal issuers. 10 As Commissioner Walter outlined in that speech, the 11 SEC has an array of tools by which it can provide additional 12 guidance to the municipal market as it continues to evolve. 13 These tools include additional anti-fraud actions, updating 14 the 1994 interpretive release, and seeking additional 15 authority through legislation. 16 NABL has participated in that process. We 17 submitted in 2009 detailed comments on a proposed amendment 18 to Rule 15c2-12. We've responded to Commissioner Walter's 19 request in May 2010 for suggestions on additional 20 interpretive guidance that would be helpful when the 1994 21 release is updated. And with respect to the SEC's 22 enforcement actions, the disclosure roles took all the 23 significant actions and attempted to summarize, critique, 24 organize, and provide guidance to the market regarding what 25 are the lessons to be learned from those actions. 54 1 So NABL looks forward to the continuing dialogue 2 with the SEC and its staff that these field hearings 3 represent. We expect to work cooperatively regarding any 4 regulations, interpretive guidance, enforcement actions or 5 legislation that are aimed to disclosure failures and abuses 6 in the market. They're tailored to reflect the unique 7 diversity of the market, and they're intended to lead to a 8 more transparent market for the benefit of all participants. 9 Thank you. 10 COMMISSIONER WALTER: Amy, before you start the 11 questions, I want to thank you all, and I want to also thank 12 those who are standing for their patience. We're in the 13 process of getting more chairs. We didn't realize this would 14 be a standing room only function, but we're very happy that 15 it is. 16 Amy, floor back to you. 17 MS. STARR: I wanted to get started -- thank you, 18 all of you, for your opening statements. We very much 19 appreciate the time that you've spent thinking about these 20 issues. And now we're going to get started with some 21 questions. I believe this panel is going to go a little bit 22 longer than as set forth on the schedule, but not too much 23 longer. So we may be cutting short our questions just a 24 small amount. 25 I'm going to get started. My first question is, 55 1 what information -- and this is from a disclosure side. What 2 information do investors receive before they make their 3 investment decisions in the muni world, and do they receive 4 that information in a time and in a manner that allows them 5 to understand what they're investing in? 6 I'm going to put this back. John -- 7 MR. MCNALLY: Yes. 8 MS. STARR: -- you jumped in on that. 9 MR. MCNALLY: I feel like jeopardy where I have to 10 hit that button. 11 We have to distinguish I think in that question 12 between the primary market and the secondary market, and I 13 think the primary market is guided, as we mentioned, by the 14 basic standard of 10(b)5, what is all material information 15 that's important to an investor in making their decision. As 16 far as continuing disclosure, it's governed, at least 17 contractually, by the 15(c)212, Continuing Disclosure 18 Agreement. 19 So Amy, I'm not sure beyond that -- 20 MS. STARR: I think it's in reality. If I'm an 21 investor, when am I getting the information in looking at a 22 muni and in what format am I getting it in and will I 23 understand it? 24 Does anyone else want to weigh in, or we can -- 25 MR. MCNALLY: I think we're also -- 56 1 MS. STARR: Mary, I'm sorry. 2 MR. MCNALLY: I'm sorry. I think we are sensitive 3 to the Rule 159, if you will, that says from the SEC's 4 perspective you're going to govern or test the anti-fraud 5 content, if you will, of the disclosure document based on 6 what the investor has when they make the decision. So we've 7 all been very sensitized, I think, recently that the POS is 8 that document. So I think that's helped considerably. 9 We do have -- 10 MS. CROSS: For those in the audience, a POS is a 11 preliminary official statement. I think we probably need to, 12 you know, make sure that everyone -- as we're talking through 13 these things, let's try to make it so people in the audience 14 can understand. 15 MR. MCNALLY: Preliminary official statement or 16 preliminary offering statement, depending on whether it's a 17 direct government issuer or possibly a conduit. It can be 18 either one. 19 I'll let Mary speak to this a little bit. 20 MS. STARR: Mary? 21 MS. COLBY: Thank you. 22 So when do we receive a POS? I have to say that 23 with the electronic age things have improved greatly. When I 24 first started at Schwab in 1996, we used to get stacks and 25 stacks of FedEx boxes with paper official statements. Now I 57 1 get dozens of e-mails and Bloomberg messages with electronic 2 official statements. 3 I may receive them a week ahead of time. I may 4 receive them the morning of the pricing. Some of that has to 5 do with whether my portfolio manager cares about the bonds, 6 and some of it may just be for transactions that are coming 7 to the market very quickly. They may show up literally 24 8 hours ahead of time. 9 So it really depends. The timing really depends. 10 Is there enough information for me to make a decision? I'd 11 like to think so. I'm hoping that we're not buying anything 12 that we don't feel comfortable making a decision on, but I 13 have to say there are things that we pass on because we think 14 that we don't have enough information because the information 15 is not timely. 16 As I mentioned in my opening comments, there are 17 often occasions where a bond is selling in January, February, 18 March, April. The issuer's fiscal year ended in June, and 19 their updated financials are not available. And there's no 20 attempt in the official statement to write anything more 21 current than, you know, six or seven or eight, nine months 22 earlier financial statements. 23 On occasion one can call the banker or the issuer 24 directly and say, "I can't make a decision on this. I need 25 something more current. I know you have it." Sometimes you 58 1 get it, and sometimes you don't. If you think you're not 2 comfortable with that older information, then presumably 3 you're going to pass on that transaction. 4 Certainly that's not an opportunity that retail 5 investors have. That's limited, I would say, to 6 institutional investors. I'm not going to speak about when 7 retail investors receive official statements or POSs. My 8 colleague later in the day will speak to that. 9 One other comment I'd like to make I think is 10 appropriate at this time is the issue of investor road shows, 11 electronic road shows. Historically -- well, I won't say 12 historically. These have only been around for a few years. 13 Sometimes the investor road shows are broadcast 14 live as they're being completed, and you can send in -- you 15 can call in with questions, or you can send an e-mail in with 16 questions. There's some give and take with the issuer or the 17 participants in the transaction. Other times, these road 18 shows are taped ahead of time, and basically you're just 19 listening to kind of canned remarks. 20 I think the most difficult situation is that 21 there's very often information that's included in the slides 22 for these presentations which is not included in the official 23 statement and is not available to be printed in any way. 24 You're not able to print it from looking at the online 25 version, although, interestingly, obviously the information 59 1 is there for a reason. They want you to see it. They want 2 to influence your decision, but in no way can you actually 3 obtain that information to keep it for yourself. That's an 4 ongoing concern with institutional investors. 5 Perhaps I should also point out that retail 6 investors don't have access to these road shows at all. 7 COMMISSIONER WALTER: Mary, can you give an example 8 of the kind of information that you see in that context? 9 MS. COLBY: It may be some kind of financial 10 projections. It may have to do with -- that's probably the 11 most annoying situation. There's maybe other kinds of 12 supporting information that I'm not coming up with right now. 13 But the most difficult and frustrating would be some kind of 14 projections or potentially multiple scenarios of projections 15 where there's one in the official statement, and there may be 16 other ones that are presented in the road show that you don't 17 have access to. 18 MR. MCNALLY: If I could speak to that? 19 I mean, it's -- I'm not sure what particular 20 financing she's referring to. I can say that counsel should, 21 and generally does, make sure that there's nothing in the 22 electronic road show that is not in the POS. 23 The only reason there may be is there may be some 24 special request for sensitivity analyses or things of that 25 nature. And generally the reason that's not able to be 60 1 printed is we do trust the institutional investors to 2 recognize that that information should not be traded upon 3 perhaps or is sensitive projections, and they would 4 under-stand the nature of those projections and retail would 5 not. 6 So sometimes at least rating agencies, not 7 institutional investors, but rating agencies do get materials 8 that go beyond what the retail investor would get. But as 9 far as the road shows, they generally do not go beyond the 10 POS, or at least should not go beyond the POS. 11 COMMISSIONER WALTER: Can I turn the focus of your 12 attention for a second to continuing disclosure in the 13 secondary market? And I think that perhaps this is an 14 unprovable hypothesis that received less attention over the 15 years until recently because everyone conceived the municipal 16 market as buy and hold. However, we do have people who sell. 17 We have a rather active market, although not as active in any 18 single issue as is typical in other areas of the securities 19 markets. 20 There seemed to be some consensus among you that it 21 would be desirable to have financial information both 22 available more promptly for audited information but also to 23 have interim information available and had that available 24 more promptly. Do you have suggestions as to the best way to 25 make that happen? 61 1 I do think that we need to be sensitive as we move 2 forward with any recommendations that are made as a result of 3 these hearings; that the burdens that fall upon various 4 issuers, particularly the smaller issuers, may be quite 5 substantial. So do you have any particular recommendations 6 as to how to get those time periods accelerated? 7 Mary? 8 MS. COLBY: As I included in my comments, the NFMA 9 has been asking for some time for issuers to provide 10 unaudited, quarterly financial information. At this time, 11 we're working with the GFOA to develop sort of a template, 12 which would include income and balance sheet information, as 13 well as some minimal notes. 14 I think that most, if not all, issuers must have 15 internal updated at least monthly financial statements. I 16 shudder to think that some government is operating without 17 updating their financials regularly for internal use. 18 So we anticipate that quarterly disclosure, even 19 for smaller issuers, should not prove an undue burden, 20 particularly given that the medium to smaller issuers who are 21 not in the market as frequently are actually the ones that we 22 see as a greater need to provide quarterly disclosure. 23 Because they're not in the market and providing updated 24 information through an official statement or an offering 25 statement, we would look to see them to be the ones most 62 1 critically needed to provide quarterly updated financial 2 information. 3 MS. STARR: Brian? 4 MR. MAYHEW: Let me add a couple of things since I 5 actually issue these things for a living. 6 I guess I'm learning as much as anybody else. The 7 biggest argument our lawyers and bankers have is what's in 8 the OS and what's on the road show and what's being given to 9 the investors when we're on the road show. But I will say 10 the very first thing everybody asks for, everybody, is 11 updated financial information. So we have to use -- we can't 12 use audited information as information. 13 But generally speaking, again -- and I'm not -- I 14 may not be the best example. But generally speaking, because 15 we have a monthly report that goes to the Board and that 16 report in and of itself does detail the information most 17 people want to see, we have generally available information, 18 and then it's posted on the website. And that information is 19 what we use as a basis for investors. 20 The other thing is, even as we're getting ready, 21 quite frankly, it's all timed around when the financials are 22 ready. I mean, it wouldn't cross our mind to go out in a new 23 year without a new set of financials. It would just be the 24 investors we meet with, including Mary, would just hammer us 25 on stale information. 63 1 How to make it available? I honestly think Mary is 2 right. Most of us do it. Most of us. Quite frankly, if you 3 don't have some sort of internal report you're using or going 4 to your Board, that might be the flag you're looking for. 5 But most of us do put together monthly reports, you know, 6 from the enterprise side to general government side. 7 So I don't really think you're dealing with 8 something that would add an enormous burden, even to the 9 infrequent issuer. 10 COMMISSIONER WALTER: I would agree with that, but 11 the question is -- I guess what I'm looking for is, very 12 pragmatically, how do we get that implemented more generally 13 into practice? It's there. Part of it may be an educational 14 issue in terms of people understanding that it would be 15 helpful to release what they have; that we're not necessarily 16 asking for matters that go beyond and require additional 17 information. But how do we get that into practice? 18 MR. MCNALLY: I think what you have to be very 19 careful of, though, and speaking as counsel to issuers, is 20 that we're mindful of the advice you gave us in the '94 21 interpretive release to the effect that anytime the 22 information is reasonably likely, not even reasonably 23 intended, reasonably likely to reach investors in the trading 24 markets, it will be tested against 10(b)5 liability. So I 25 think the concern is the degree of comfort that the issuer 64 1 may have with the unaudited information. 2 I've had situations where because of the financial 3 reporting being sufficiently poor, and I've had to do 4 significant restatements, that we simply have not wanted to 5 go out until we had the audit. I've had other issuers where 6 they're confident that the unaudited information is 7 sufficiently accurate with the appropriate caveats that they 8 can release that. So we, as counsel, have to be mindful of 9 the fact you're going to test all of this against 10(b)5 and 10 create potential liability, so we want to be very careful and 11 make sure that we're comfortable with the unaudited. 12 I think the other distinction that Brian was making 13 when we talk about monthly and more frequent is 14 distinguishing between the budgetary information and the 15 audited financial information. In other words, what's more 16 important, I think, to the investor is where do you stand on 17 any particular month against your budget. And these budget 18 reports are produced monthly, and they're generally put up on 19 an issuer's website. 20 Mary is shaking her head, but I can tell you, at 21 least with my clients, they are. So these are produced 22 monthly. They're put up on the website. 23 What we are concerned about is, once again, the 24 potential liability. So one way we've tried to do that is to 25 distinguish between what goes on the investor information web 65 1 page, where it's been through the rigorous 10(b)5 types of 2 processes, and what otherwise is on the city's website 3 recognizing that we do want to try to insulate to some degree 4 that for which they could have the liability if it's not been 5 audited or tested. 6 MS. STARR: Meredith? 7 MS. CROSS: I wanted to ask -- we've talked a lot 8 about the various -- the wide variety of issuers in these 9 markets, if you're talking 50,000 issuers. In the corporate 10 world, there are different disclosure requirements that are 11 scaled to size, all the way down to you aren't required to 12 disclose any more if you have fewer than 300 holders and 13 you're not accessing the markets. That's the way the 14 securities laws are set up anyway. 15 So I'm trying to get a sense for what is realistic 16 here to expect of the very smallest issuers. When you say 17 they're not in the market, do they -- I'm just trying to get 18 a sense for what is this market you're looking at. Are 19 these, you know, issuers that have thousands of holders, or 20 are these issuers with very few holders who aren't accessing 21 the market but did a transaction 10 years ago? 22 I think it would be helpful to get something of a 23 sense for what are we really asking of these people, and is 24 there a cost benefit analysis to be had? I mean, I'm 25 encouraging of obviously disclosure that suits the needs of 66 1 investors. I just want to make sure we're not mixing up 2 concepts here since we don't require that if you have almost 3 no holders left to require a continuous robust reporting. 4 So can you address that? 5 MS. COLBY: It's difficult for me to respond to the 6 part of the question regarding the number of investors in a 7 particular bond because that's not information that's very 8 readily or easily available. 9 There is some information that's kept on Bloomberg 10 that shows large institutional investor positions, in 11 particular CUSIP. But beyond that, having been involved in 12 transactions where the trustee was trying to find all of the 13 investors, I know that it's very difficult for them to do so. 14 So I can't really speak to that part of the 15 question, but I think 300 holders of a municipal bond would 16 be a very high number. 17 MS. CROSS: A high number? 18 MS. COLBY: A high number, unless you're talking 19 about some of the larger issuers. But I'm thinking about 20 hundreds of small cities and counties, school districts that 21 have been in the market for jail bonds or sales tax bonds, 22 tax allocation bonds. Every four or five years they 23 historically issued with bond insurance perhaps and really 24 didn't have a relationship with the market, per se, other 25 than with their bond insurer. 67 1 Obviously, many, many investors are now looking 2 much more carefully at the issuers themselves, as several 3 bond insurers are not rated lower than the bonds that they 4 were originally insuring and have had a very difficult time 5 getting information about those particular transactions 6 because the issuers themselves have not been very good about 7 providing their continuing disclosure, despite the fact that 8 they entered into agreements to do so. 9 MS. CROSS: So the contracts, the indentures 10 require continuing disclosure, and they're just not 11 complying? 12 MS. COLBY: I mean, yes. Many issuers fail after a 13 certain number of years to provide their financial -- their 14 annual financial information or may stop providing that 15 supporting additional information that they also promise to 16 provide. 17 And often if you call up the finance director in 18 one of these places, they don't know what you're talking 19 about. They don't know who you are. They don't know why you 20 would call them. They're like, "Oh, yeah, we sent that stuff 21 in," or, "I've only been here for a year. What are you 22 talking about? We don't have to do that." 23 And so I think this has become -- it had been an 24 issue for a long time for investors who were always looking 25 through bond insurance and making sure they understood what 68 1 they owned, but it's become much more prevalent in the last 2 several years with the change in the credit enhancement 3 market. And I would say that if I own a bond that was issued 4 10 years ago by a small issuer that was insured at the time, 5 the sales tax bond, knowing what's been happening with sales 6 taxes around the country over the last two years, it's very 7 possible that I could find out that the sales taxes that are 8 backing my bond dropped 20 percent in a year. And I might 9 not find that out for nine months or more after the end of a 10 fiscal year. 11 I certainly would want to know more frequently than 12 that what the sales tax collections are, but that's not 13 something that you will find on most issuer's websites. 14 Smaller issuers don't -- very often don't put up any kind of 15 monthly information. Often, you can't even find their audit 16 on their website. 17 So I mean, I appreciate John's comments that his 18 clients do this, but there are many, many small issuers in 19 the market who don't do this. 20 MS. CROSS: Henry, you had question? 21 MR. HU: I was wondering about a longer term issue, 22 but it's kind of like an elephant in the room. In terms of 23 pension liabilities, you know, retiree health benefits and 24 the like, I was curious in terms of in the wake of San Diego 25 and the recent New Jersey action from a credit analyst's 69 1 standpoint or from the issuer's standpoint or from the bond 2 counsel's standpoint what change in actual behavior do you 3 see, if any, in light of, for instance, this recent New 4 Jersey action in terms of more focus perhaps in terms of 5 greater disclosure or any efforts in terms of greater 6 uniformity of presentation? I'm interested from all three 7 perspectives. 8 MR. MCNALLY: Thank you for asking that question. 9 I'm happy to report that the disclosure roles of counsel on 10 page 203 directly -- 11 MR. HU: I'll note that in the comments. 12 MR. MCNALLY: -- directly addresses that point. 13 No, seriously, I mean, what we did -- this was 14 written -- it was published in October 2009, so it was 15 subsequent to San Diego. I mean, granted there was the 16 recent New Jersey action against the state, but as far as 17 disclosure of pension concern, it really didn't go beyond, if 18 you will, the principles of San Diego, which are, I think, 19 that, as counsel, you have to be familiar with the GASB 20 Guidelines, 25 and 27. You're going to be setting forth -- 21 and where you set it forth, whether it's in the notes to the 22 financials or whether it's in the body of the OS or whether 23 it's in the financials itself, it will be governed by GASB. 24 But you're going to set forth what are the 25 actuarial assets, what are the actuarial liabilities, what 70 1 are the unfunded actuarial liabilities, what is the annual 2 pension cost, what is the annual required contribution, and 3 what is the NPO, referred to as the Net Pension Obligation. 4 All of these are required by GASB. They're critical elements 5 of the pension analysis. 6 But I think what we recommend in disclosure roles 7 is that simply establishes your baseline. And once you have 8 that baseline showing where you stand financially, at the end 9 of the day if I'm an investor, not an actuary, but an 10 investor, what does it mean to me, and what does it mean to 11 the issuer's budget? And to the extent the issuer is going 12 to run into a situation like Harrisburg where they say, "We 13 have obligations to our GO Bond holders. We have obligations 14 to our current employees. We have obligations to the pension 15 retirement fund. And in allocating that, where our 16 priorities are going to be if we have insufficient monies. 17 So I think there's a need for counsel to step back, 18 become familiar with how this works, set forth not only the 19 core information financially but also ask the difficult 20 questions. What is the impact on the budget? What does it 21 mean? Are these assumptions reasonable? If not, are there 22 alternative assumptions that might change those scenarios? 23 Have there been other scenarios provided to the rating 24 agencies that would be useful to the investor, et cetera? 25 So I think we certainly learned a lot from San 71 1 Diego, and I think that New Jersey action certainly once 2 again got people's attention, the fact it would go against 3 the state, as well. 4 New Jersey -- 5 MS. STARR: John, unfortunately, because of our 6 timing, what I'm going to try to do is ask our questioners if 7 they have one or two other questions for our panel, and then 8 we're going to perhaps move along. 9 We can go into more detail, Henry, on the issue 10 relating to pensions in this afternoon's panel on 11 significant -- Disclosure of Significant Liabilities. 12 But do you folks have other questions that we'd 13 like to ask the panelists at this point? 14 MR. MCNALLY: Before -- are you moving on? 15 MS. STARR: Actually, what I'd like to do is I'd 16 like to step in just with one question for you. 17 From the standpoint of disclosure of information, 18 one of the things we didn't get into discussing sort of in 19 any kind of way was should there be some kind of basic, 20 uniform disclosure principles beyond the anti-fraud that muni 21 market participants should consider to follow, whether they 22 be voluntary, best practices, mandated, something along those 23 lines. Can I have a sense sort of from an issuer, from an 24 investor, and then a lawyer's side? I think that -- 25 MR. MAYHEW: The short answer is yes. Look, we 72 1 don't want to -- you know, I listen to what information isn't 2 available to people, and then I spend my life making it 3 available. And most of the people I know in this business do 4 the same thing. 5 You're not going to mandate people going in and, 6 you know, going up and filing stuff they didn't agree to do. 7 And as I said, there are a lot of people in this business -- 8 not a lot, but there are a certain number of people who run 9 their shops and would take the position, you know, "What we 10 agreed to in that document doesn't matter now," because all 11 they care about is getting paid. And that is a view they 12 take. 13 You know, the "what" is probably pretty easy. I 14 think there should be a minimum level. I think there should 15 be an appropriate level of disclosure. If you've got a sales 16 tax bond, you should have a sales tax report, and you should 17 post it on your website. And you should post it with EMMA. 18 I mean, I think most of us want to do that. My big 19 argument with Mary all the time is, you know -- she always 20 says, "I don't have information." I say, "Tell me what you 21 want." But we do give it to her. 22 But I mean, you know -- 23 MR. MCNALLY: It will never be enough. 24 MR. MAYHEW: Well, of course not. 25 But I mean, in reality, that's kind of -- these 73 1 things -- a lot of it isn't burdensome, but you're not going 2 to go to an organization and say, "You issued a bond 15 years 3 ago that's a GO Bond, and we want to see you do this now that 4 you didn't agree to before." If they want to do it, great. 5 If you can -- you know, if we can go back and say, "Look, 6 under best practices, these are good ideas to do." But is 7 that -- 8 MS. STARR: You're looking to the future? 9 MR. MAYHEW: Yeah, it's how to go into the future. 10 MS. STARR: How do you make it better going 11 forward? 12 MR. MAYHEW: And I think you have the mechanisms to 13 do that in the future. 14 MS. STARR: Mary? 15 MS. COLBY: I think for many issuers we do feel 16 like we have enough information. Certainly from Brian we 17 have enough information in the State of California. 18 I think that, yes, there should be a mandated level 19 of disclosure. I think it should be appropriate. I think it 20 should reflect the security of the bonds that were issued. I 21 think there should be mandated timing for disclosure and 22 frequency for disclosure greater than annual. 23 I think the EMMA System is a perfect way to provide 24 all of this information to the investor, and I think it's 25 very -- it makes me very uncomfortable to think that there 74 1 are many, many bonds out there that might not ever be subject 2 to higher levels of disclosure requirements. 3 I appreciate that it's certainly a much easier task 4 to accomplish on a going forward basis. But I would urge the 5 Commission to look for ways to have a much more widely -- a 6 much wider purview on this issue and attempt to include debt 7 that's already outstanding in the market because lots of 8 people own $2.9 trillion, and they shouldn't be second class 9 citizens because they bought those bonds prior to the time of 10 a new disclosure standard. 11 MS. STARR: Thank you. 12 John, I'm going to ask you for your last statement 13 on this, and then unfortunately we're going to have to wrap 14 this panel up. But we will be very happy to get additional 15 input from all three of you and from any others who are 16 interested in this panel as to what other kinds of issues you 17 see coming up. 18 John? 19 MR. MCNALLY: Thank you, Amy. 20 I mean, let me respectfully suggest to the 21 Commissioner that in examining the information you get today 22 and what steps are next, a template, if you will, for this 23 information. In other words, distinguish as you look at this 24 what could readily be done in the market, and that is things 25 like the interpretive release, the ability of NFMA and GFOA 75 1 to work together on best practices. That could readily be 2 done. 3 There's other things -- and I think we've addressed 4 this. There's other things that could be done with 5 sufficient time and money. In other words, it's 6 theoretically possible, but may not be practical. In other 7 words, how much time, how much manpower, how much money would 8 be required to have year-end financials within the 10K 9 limits, 90 days plus quarterly financials? 10 So you have that which you can readily do. You 11 have that which is theoretically possible, but very expensive 12 and could be very time consuming. And then you have I think 13 a third category which is simply not feasible in this market, 14 and that is an attempt to establish a standardized disclosure 15 that would apply across the board by virtue of the diversity 16 of the issuers and the nature of the security. So I'd like 17 you, without giving any recommendations, to keep that 18 structure in mind about how you view these various 19 suggestions. 20 My final comment would be help us, as counsel. If 21 you want us to get out information about budgetary 22 information, unaudited financials, we need guidance along the 23 lines of the '94 interpretive release about just how an 24 issuer can insulate themselves from potential liability, 25 because the guideline now is anything they do that's 76 1 reasonably likely to reach investors could subject to them to 2 that liability. 3 So we're happy to work and to try to get better 4 disclosure, but we also need some comfort about how to 5 protect the issuer. 6 MR. MAYHEW: Amy, could I make one last comment? 7 MS. STARR: Sure. 8 MR. MAYHEW: I don't disagree with what I'm 9 hearing, but I do want to watch this slippery slope. You 10 know, an SEC company doesn't file. You have a notice that 11 they didn't file their annual financials, and they expect 12 them in blank. And this goes on. They're not in default of 13 their world. 14 In our world, you know, one of the reasons somebody 15 gives themselves 270 days is he doesn't want not filing his 16 financials to be a default. Certainly if he has variable 17 rate debt out there and liquidity facilities out there, he 18 doesn't want a technical default on his side either. 19 MS. STARR: Are those built into the terms of the 20 indenture, the timing? 21 MR. MAYHEW: Generally built. And into the 22 liquidity facilities. 23 MS. STARR: I see. 24 MR. MAYHEW: So you have to be careful about when 25 you say -- you know, as you go down and say, "Well, here's 77 1 what we want to do." But the law of unintended consequence 2 can be very bad, retroactively anyway. So if you could spend 3 all the money -- we're modified accrual accounting. You 4 could spend all the money in the world. I don't think we can 5 get our financials out in 60 days. 6 MS. CROSS: I would note that in corporate debt 7 deals the indentures generally provide it's a default not to 8 file timely information, and companies, when they get into 9 that situation, end up having to go out and negotiate with 10 the holders to avoid an acceleration notice. You know, 11 usually they end up having to pay for it. But it is a -- 12 this notion is also built in in the corporate world, and 13 companies hate being late and hate having to pay increased 14 interest rates as a result. But it isn't uncommon. 15 And Preston is nodding yes. 16 MR. MCNALLY: Meredith, on the municipal side, this 17 time limitation is normally a continuing disclosure 18 agreement, and normally the indenture would expressly say 19 that failure to meet that time limit is not an event of 20 default. 21 MS. CROSS: Yeah, they're afraid to have that be. 22 I understand. 23 MR. MCNALLY: That's how they dovetail it. 24 MS. STARR: I want to take this opportunity to 25 thank the panel very much for their participation this 78 1 morning. This has been very -- just tremendously 2 interesting, educational and enlightening for us, I believe. 3 COMMISSIONER WALTER: Absolutely. Our thanks to 4 you. 5 And I just want to note that as we switch panels, 6 which we're going to try to do very quickly, we're also going 7 to open up the partition in the back of the room so that 8 there will be more seating so everybody can be a little bit 9 more comfortable. Thanks again. 10 (Off the record.) 11 COMMISSIONER WALTER: Thank you very much. 12 Okay. Martha, take it away. Ready to go? 13 MS. HAINES: I'm ready when you are. 14 COMMISSIONER WALTER: We're all set. 15 MS. HAINES: Our second panel is -- 16 COMMISSIONER WALTER: Martha, you might want to 17 take that mic temporarily because no one will be able to hear 18 you in the back. 19 MS. HAINES: Okay. The back is farther away now. 20 Our second panel has to do with credit ratings and 21 credit rating agency practices. Credit rating agencies are 22 commonly believed to hold a position of special importance in 23 the municipal market. 24 There are a variety of reasons that are said to 25 account for this, from the relative staleness of financial 79 1 information that's available from many municipal issuers 2 compared to what's available from corporate issuers to the 3 very high proportion of individual investors in the municipal 4 market who may not have the inclination or training to 5 undertake exhaustive analyses of the credit worthiness of 6 particular bonds for themselves. 7 We've asked four panelists to come today to share 8 their thoughts with us concerning the impact of credit 9 ratings and credit rating practices. Together with 10 information to be gleaned at future hearings we believe that 11 this testimony will inform future rulemakings by the 12 Commission and other determinations concerning both the 13 municipal market and credit rating agencies. 14 Each of these panelists have notable 15 credentials and a long involvement in the municipal market, 16 which I will summarize very briefly in order to save time for 17 the questions. 18 First of all, Michael Belsky has a very broad 19 background in the municipal market. He's presently serving 20 his second term as the Mayor of Highland Park, Illinois, and 21 he's a member of the Governmental Accounting Standards Board, 22 which sets the accounting standards used by states and local 23 governments across the country. 24 He's currently employed by C.W. Henderson Research. 25 He was previously associated with Fitch Ratings for more than 80 1 15 years where he was the Group Managing Director of Public 2 Finance. Before that, he was an investment banker engaged in 3 municipal underwriting. So Mr. Belsky has seen this market 4 from many different perspectives. 5 Mark Blake is currently serving as Deputy City 6 Attorney to the City and County of San Francisco, and he 7 provides counsel to the City for all of its debt offerings. 8 Before returning to San Francisco to take this position, he 9 was the Chief Deputy City Attorney for Finance and Disclosure 10 for the City of San Diego where he assisted in the 11 establishment of policies and procedures to improve the 12 City's disclosure and financial reporting practices. And he 13 was also the Deputy General Counsel for the Metropolitan 14 Water District of Southern California. Prior to entering 15 government service, Mr. Blake was a municipal bond lawyer for 16 the firm of Brown and Wood, which is now Sidley Austin. 17 Dan Kiefer has been associated with CalPERS and a 18 number of executive capacities for 17 years. He is presently 19 the Opportunistic Portfolio Manager within the Global Fixed 20 Income Unit, and he oversees their Securities Lending 21 Program. Among his numerous other credentials, Mr. Kiefer is 22 a Chartered Financial Analyst. 23 And last, but not least, John McNally, who has very 24 kindly agreed to serve on two back-to-back panels today. As 25 Amy noted, Mr. McNally is a partner in the firm of Hawkins 81 1 Delafield & Wood and is President-Elect of the National 2 Association of Bond Lawyers. 3 I want to truly thank each of these panelists for 4 generously agreeing to share their thoughts with us today. 5 I'm going to ask each of you to provide some introductory 6 remarks, after which questions will be posed to the group as 7 a whole. If you wish to indicate that you would like to 8 speak next, please take your card and put it like that on its 9 side, and we will know who wants to speak. 10 I hope we'll enter into a broad discussion of the 11 topic, but please do not feel inhibited from raising topics 12 that you believe are important for the Commission to 13 understand or entering into a debate among yourselves. 14 Mike, would you like to start with the 15 introduction? 16 COMMISSIONER WALTER: Pass the mic down. Thanks. 17 MR. BELSKY: Thank you, Martha, and thank you, 18 Commissioner Walter. I'm pleased to be here today. I'm 19 honored to be here today. 20 I would like to give some comments based on my 21 multi-point perspective on the whole issue of disclosure and 22 ratings, but I would say I'm here representing myself, not 23 the City of Highland Park, not GASB or C.W. Henderson, which 24 is an investment advisor I'm working with now. 25 From the issuer's standpoint, the City of Highland 82 1 Park, like many other issuers, has worked very hard to be 2 transparent not only to support the sale of our securities 3 but also to give the public an idea of how their tax dollars 4 are spent. So we now have a section on our website called 5 "Know Your City's Finances" where we put our audit up, our 6 budget, any interim reports with economic data driving our 7 major revenue sources. 8 So for example, 39 percent of our general fund 9 budget comes from sales tax. We have retail sales data every 10 quarter up on our website. We also have information about 11 public meetings where people can come to speak. And we have 12 had some issues in our community with pensions and pension 13 fund padding from one of our other governments, and because 14 of that, we've talked about having a single repository site 15 for all the financial information of our sister governments, 16 as well as the state and the county, because we feel people 17 have an interest in that. 18 So all these types of things are good for the 19 public, but if anyone is looking to buy our bonds, then they 20 can come in and find this information. It would support, you 21 know, the sort of disclosure that one needs to make. 22 So I want to move to the investor's standpoint and 23 ratings. We do use research reports when we purchase bonds. 24 I happen to believe -- and I might be a little biased coming 25 from Fitch. I happen to believe that the rating agencies, 83 1 despite what happened with sub-prime, the fundamental areas, 2 corporate finance and public finance, are doing an excellent 3 job, and it's just a starting point for us. 4 We look at the research reports, then we go to the 5 audits, and then we look in the audits for any information, 6 particularly now on pensions and on any sort of risk related 7 to derivatives with termination payments. And we will make a 8 judgement on our own as to whether to purchase the bonds or 9 not. 10 What I would say is all the large issuers are doing 11 an excellent job. Being an investment advisor with 3 billion 12 in assets, we do inherit portfolios from investors that come 13 into our firm, and what I see -- where I see the problem is 14 that some investors hold securities that probably they 15 shouldn't be buying. And I would say those are things like 16 single site nursing homes and tabs, tips where there is no 17 credit worthiness to either the community or sort of 18 development, and they're getting yield. That's what they're 19 looking for. 20 But I think it's the type -- these are the types of 21 securities where you need the sophistication of a large 22 institution to really know what you're buying. So our job is 23 to maximize what sort of -- what we would get for selling 24 those bonds to preserve the assets. And I would say when I 25 try to find information on EMMA, which I think has been a 84 1 real benefit to the market from the MSRB, it's hard to find 2 it. And those same issuers, when you go to their websites 3 and try to find the agencies that are responsible for that 4 data, it's difficult. 5 Personally, I think those issuers will be 6 penalized, and those investors are penalized because of that 7 lack of disclosure. And typically, these are not rated. 8 And then finally, from the GASB perspective -- 9 again, I'm not representing GASB, but in the financial 10 statements of governments there's a lot of good information 11 about the risks that are out there now. 12 Now, GASB is looking at revising a standard, 13 Statement No. 25, Statement No. 27, on pension disclosures 14 and the talk is perhaps bringing those to the face of the 15 financial statements. But right now they're in the notes of 16 the financial statements. They're also in the required 17 statistical information. 18 So people can readily find what sort of plans there 19 are, what sort of assumptions are made, and also what the 20 funding status is. And you know, we use that information as 21 investors, if there was a financial statement that's looking 22 backwards, and we know when the next actuarial study is done. 23 You know, we can call the issuer and find out information 24 about what the status is now. 25 There's also information in the notes about 85 1 termination payments. Again, it's for the last fiscal year, 2 but it gives you the ability to go in and speak to any sort 3 of issuer about those risks. 4 And then GASB is also talking about bolstering the 5 statistical section of the audit, which might have more of a 6 forward look to it, which I think will help investors 7 because, you know, the financial statements go backwards. 8 It's the last year. But these would be forward looking. 9 Nothing has been decided there. There's just preliminary 10 discussions about what we call a fiscal sustainability 11 standard. 12 From an investor's standpoint and going back to 13 ratings, I would say that these risks, pensions and OPEB, are 14 now as large as debt outstanding. And while many issuers 15 have some ability to deal with health care costs going 16 forward or maybe eliminating or requiring higher premium 17 payments, pensions -- you know, pensions have to be paid to 18 retirees. They're constitutionally protected. And what I've 19 seen the rating agencies do, but what I'd like to see more 20 of, is really looking at these risks relative to debt 21 service. 22 For example, if you look at, you know, debt to full 23 value or debt to income and it looks low and then you add in 24 these liabilities, even though they're soft -- they don't 25 have to be paid, but ultimately they do -- you have a 86 1 different look at the credit. So I think that sort of thing 2 would help in the ratings, as well. 3 The final thing I would say is state and local 4 government are the laboratories for democracy. Oliver 5 Wendell Holmes said that. And that's a good thing and a bad 6 thing. I mean, a lot of governments are doing different 7 things to try to disclose their financial situation and their 8 risks, and I think a lot of good things are being done. 9 What I would say is, short of regulation, there 10 should be some standardization of what they must do. And I 11 know 15(c)212 attempts to do that, and I think EMMA has been 12 a big benefit. But I still don't see when you go on websites 13 and things like that that consistency, and that would help. 14 That would help with ratings. That would help the market. 15 Thank you. 16 MS. HAINES: Mark? 17 Would you pass that down? 18 MR. BLAKE: First let me just say the following 19 comments do not reflect the policies or positions of any 20 office, agency, or department of the City and County of San 21 Francisco, including the office of the City Attorney, and 22 reflect only my views. So I speak today as kind of a fellow 23 in the day-to-day grind of municipal finance. 24 So I want to thank Commissioner Walter and Martha 25 Haines of the Office of Municipal Securities, Division of 87 1 Trading and Markets for inviting me here to participate on 2 this panel. It's an honor and privilege to be here today. 3 My comments will be brief and tailored to the bread 4 and butter municipal finance issuer. My comments are not 5 directed at sophisticated issuers with complex financing 6 structures. So in commenting on the rating agencies, that's 7 the focus of my comments. 8 So I've worked in the municipal securities industry 9 as an attorney for the past 22 years. I've worked for 10 private law firms as bond counsel, disclosure and 11 underwriter's counsel, and most recently as in-house counsel 12 to issuer's, including the Metropolitan Water District of 13 Southern California during the last part of its $4 billion 14 capital program, and the cities of San Francisco and San 15 Diego. 16 Interestingly, my career in California spans work 17 touching on two significant Securities and Exchange 18 Commission actions on municipal securities, one involving my 19 work on certain notes issued by Orange County, where I was a 20 very Junior Associate, and another involving the City of San 21 Diego, where I was Chief Deputy City Attorney for Finance and 22 Disclosure during its challenging period and where I had the 23 opportunity to work with one of your panelists on the 24 establishment of one of the most rigorous sets of controls 25 and procedures in the municipal industry. For the past 88 1 two-and-a-half years I've been bringing that San Diego 2 knowledge to the City and County of San Francisco providing 3 in-house counsel and advice for the City's bond offerings. 4 Our task today is to provide comments to the SEC on 5 rating agency practices and the impact of rating agencies on 6 the municipal securities practice. As we all know, the 7 credit rating agencies play an indispensable and central role 8 in U.S. financial markets. The three primary rating 9 agencies, Fitch Ratings, Moody's Investor Service, and 10 Standard & Poor's, all carry the SEC's designation as 11 nationally recognized statistical rating organizations, which 12 has facilitated the market dominance by such firms. 13 These agencies provide opinions on the credit 14 quality of a debt or an issuer. The ratings are not in and 15 of themselves recommendations to buy, hold, or sell any 16 particular bonds, but an assessment, indeed simply one firm's 17 opinion of the likelihood that the issuer of that bond has 18 the capacity and willingness to repay the debt when due. 19 Credit ratings serve, in large measure, like the 20 securities laws, to reduce the informational asymmetry 21 between an issuer and a prospective investor. With the 22 financial meltdown beginning in the summer of 2007, the 23 practices of rating agencies, and particularly those 24 affecting municipal securities, have come under intense 25 scrutiny and criticism. 89 1 The Treasurer of the State of California, among 2 others, has been a consistent and outspoken critic asserting, 3 correctly I think, that rating agencies have adopted rating 4 methodologies that unfairly discriminate against municipal 5 issuers and in so doing have raised the cost to taxpayers of 6 financing critical infrastructure projects. In the midst of 7 today's economic challenges and constrained budget, this 8 discrimination is a real pain, costing local government 9 precious resources. 10 Important for taxpayers and rate payers, bond 11 ratings set by rating agencies raise or lower the cost of the 12 financing of capital projects. Higher ratings lead to lower 13 borrowing costs. Lower ratings lead to higher borrowing 14 costs. From the financing of police stations to firehouses 15 to critical water and sewer infrastructure, in a word, 16 everything the government does is directly affected by 17 ratings assigned to the bonds issued to finance those 18 projects. 19 It has been well established that historically 20 credit rating agencies have held municipal issuers to a 21 higher standard than their corporate bond counterparts. The 22 heart of the matter is that municipal issuers rarely default 23 in their obligations, and yet carry lower ratings. 24 Studies prepared by the rating agencies capture 25 this point. Both Moody's, Standard & Poor's, and Fitch all 90 1 have studies done in the last three or so years reflecting 2 that municipal issuers have statistically low, very low 3 probabilities. One, default, that is the miss of a payment, 4 and then secondarily the risk of loss, which is the most 5 important thing for an investor. 6 But perhaps the best evidence of this 7 discrimination by the rating agencies against municipal 8 issuers is that this industry flourished for a short time 9 insuring municipal bonds. MBIA and ABBAC Corporation, to 10 name two of the most prominent, carried the covenant Triple A 11 rating on their principal business of insuring municipal 12 bonds. The bond insurance business was a beautiful thing. 13 The bond insurers collected millions of dollars in premiums 14 to ensure against events that both the bond insurers and the 15 rating agencies from their own studies knew would rarely 16 occur, a default by one of their municipal insureds. 17 So what is to be done? More competition? Of 18 course. More transparency? Of course. Improved rating 19 methodologies? Certainly I would go for that. 20 But it's my belief that the reforms directed at the 21 municipal market, either direct or indirect, have to include 22 as a necessary component rating agency reforms. While the 23 Securities and Exchange Commission is prohibited under the 24 Credit Rating Agency Reform Act of 2006 from regulating the 25 processes or methods of ratings, surely the SEC has not lost 91 1 its central role in ensuring that investors receive accurate 2 information on which to base investment decisions. The SEC 3 should utilize its traditional tools of rulemaking, 4 interpretive releases, and as a last resort, enforcement 5 actions to bring about the change it seeks. 6 The ratings provided to municipal issuers over the 7 past 30 years or so have overstated the risk of default and 8 loss as compared to similarly rated corporate securities. 9 While moves to a single scale are intellectually appealing 10 and perhaps desirable from the investment community, I think, 11 ironically, they hit in the wrong direction. Municipal bonds 12 and corporate securities are just not comparable. 13 Government is by its very nature different from a 14 for profit private corporation. Governments have broad 15 taxing powers and revenue generating powers, police powers, 16 and captive populations. Most important, these powers are 17 exercised in public, in plain view with notice provided to 18 any and all who want it. 19 The compensation of public employees, in California 20 at least, is public. The public has the right to demand any 21 public document, contracts, agreements, resolutions, e-mail 22 maintained by the government. In short, governments do not 23 in most instances have the luxury of saying, "None of your 24 business." 25 Paradoxically, an investor, where she is so 92 1 inclined, could obtain more timely and accurate information 2 about the operations of government than they could for any 3 publicly traded corporation. Are governments divorced from 4 the economic uncertainty, financial turbulence, and long-term 5 fiscal challenges? Of course not. And yes, governments 6 rarely -- governments do rarely file for bankruptcy 7 protection. 8 But all of this argues that governments be rated on 9 a completely different scale, a rating scale based upon the 10 unique characteristics of a government. Perhaps this scale 11 would be a simple pass/fail scale, investment grade or not, 12 or perhaps a three-part scale, red, white, and blue. 13 Okay. I just threw that in. 14 In any event, the core of any such government 15 rating methodology would contain verifiable metrics 16 correlated to default risk leaving the remainder of the 17 subjective analysis or the making of finer credit 18 distinctions to investors. That may not be a sophisticated 19 rating system, but perhaps government, the government that I 20 represent, is just not that complicated. 21 Thank you. 22 MS. HAINES: Thank you, Mark. Could you pass the 23 mic down now to Dan? 24 MR. KIEFER: Thank you for the opportunity to 25 provide comments this morning on ratings in the municipal 93 1 securities market. 2 My name is Dan Kiefer, and I'm a portfolio manager 3 at CalPERS. I run our Credit Enhancement area, and I sit in 4 our Global Fixed Income Unit. 5 As you might already be aware, CalPERS is the 6 largest pension fund in the United States with over 206 7 billion in assets, and we have 1.6 million beneficiaries. 8 We're a large institutional investor with a long-term 9 investment horizon. We have a vested interest in the 10 integrity, efficiency of the capital markets. We rely on the 11 quality and integrity of market information to allocate 12 capital, and we believe the credit ratings provide a critical 13 contribution to those decisions. 14 CalPERS has a limited involvement with the 15 municipal securities market. Back in 2003 our Board approved 16 a Credit Enhancement Program, which provides credit and 17 liquidity enhancements to state and municipalities on a 18 nationwide basis. Letters and lines of credit allow 19 municipalities to access the short-term markets and lower 20 their overall borrowing costs and save taxpayer's money. 21 Our Credit Enhancement Program uses conservative underwriting 22 standards to diversify its exposure to municipalities, both 23 geographically and a sector basis, and we currently provide 24 enhancements to around 19 issues across eight states for 25 about $1.9 billion. 94 1 CalPERS has two points of interaction with the 2 rating agencies in context for the Credit Enhancement 3 Program. CalPERS Credit Enhancement Program is itself rated 4 by the rating agencies, and CalPERS -- our guidelines require 5 an investment grade rating from at least two out of three of 6 the rating agencies in order for us to enhance an underlying 7 security. We believe that the rating agencies provide a 8 valuable service in each of these regards, but there's always 9 room for improvement. 10 Additionally, CalPERS Board endorses the principle 11 that major rating agencies should rate municipal securities 12 on a scale which is uniform, fair, and consistent with other 13 rated products, i.e., a global rating scale. CalPERS 14 encourages the SEC to use its authority under Dodd-Frank to 15 require the rating agencies to develop a uniform risk based 16 rating standard that ends the differential treatment between 17 municipal and corporate issuers. 18 In relation to recent calls for financial reform, 19 CalPERS has proposed five specific reforms to the credit 20 rating agencies. Dodd-Frank takes specific action on four 21 out of five of these recommendations and has provisions for 22 further studies on alternative compensation mechanisms that 23 reduce conflict of interest and provide incentives for 24 accuracy and integrity. CalPERS has provided the SEC with 25 their suggestions on the alternative compensation mechanisms, 95 1 and Dodd-Frank addresses CalPERS' other four recommendations 2 for the credit rating agencies. 3 Specifically, the first one is Congress and the 4 Administration should bolster the SEC's position as a strong, 5 independent overseer of the credit rating agencies. The SEC 6 is the primary financial regulatory agency in Dodd-Frank. 7 SEC shall establish and Office of Credit Ratings to 8 administer rules on practices, to determine ratings to 9 protect users and the public interest, promotion of accuracy 10 in credit ratings issued, and ensure ratings are not unduly 11 influenced by conflicts of interest. 12 The second area, credit rating agencies should be 13 required to manage and disclose conflicts of interest and 14 create an executive level compliance officer position. 15 Dodd-Frank focuses on mitigating conflicts of interest. We 16 support the attestation requirement that each rating agency 17 submit an annual internal controls report. 18 Third area, the rating agencies should be held to a 19 higher standard of accountability under federal law. Credit 20 rating agencies are gatekeepers and are fundamentally 21 commercial and should be subject to the same federal 22 standards of liability that apply to others, example auditors 23 or investment bankers. 24 The fourth area, rating agencies should not rate 25 products for which they lack sufficient expertise in order to 96 1 assess. The SEC shall prescribe rules for the protection of 2 investors and public interest with respect to procedures and 3 methodologies, including both qualitative and quantitative 4 data models which require disclosure on rating assumptions 5 and methodologies. 6 Along with disclosing the methodologies employed, 7 rating agencies should comment on all factors involved in 8 making a decision to rate or not rate a security. An 9 additional transparency requirement should be considered, 10 including a ratings score card to assess the practices, 11 accuracy, and effectiveness of the ratings process via 12 historical ratings outcomes. 13 Thank you for this opportunity to share our 14 comments. 15 MS. HAINES: John, would you like to make 16 additional opening remarks? 17 MR. MCNALLY: No, thank you. 18 MS. HAINES: Okay. John was on a previous panel. 19 Historically, as you know, some credit rating 20 agencies that rate municipal bonds, as mentioned, maintain 21 separate rating scales for the municipal and corporate 22 securities. 23 WOMAN SPEAKER: We can't hear you in the back. 24 MS. HAINES: Sorry. Thank you for speaking up, so 25 I can. 97 1 Historically, as a number of our panelists 2 mentioned, some credit rating agencies that rate municipal 3 bonds maintain separate rating scales for municipal 4 securities and corporate securities. In the last year or so, 5 some of these agencies have moved or are moving to a 6 so-called global or unified rating scale in which municipal 7 and corporate debt are supposed to be rated on essentially 8 the same basis. 9 This has been criticized as somewhat diminishing 10 the granularity that was previously found with a separate 11 municipal rating scale while it has improved the ability of 12 investors to directly compare investments in municipal bonds 13 to corporate bonds, which with the establishment of the new 14 Build America Bond Program has been, I think, helpful. 15 So I wonder if you observed any impact on investors 16 or issuers from this move to a global rating scale for 17 municipal securities, and do you believe that this new global 18 scale will provide an adequate basis for an investor who is 19 not an industry professional to evaluate the relative risk of 20 different securities? If not, how might this be addressed by 21 the SEC? 22 Mike? 23 MR. BELSKY: Thank you. I've been gone from Fitch 24 I think for close to a year-and-a-half now, but I do feel 25 like I would like to address some of Mark's comments directed 98 1 at the rating agencies. But I'll start with answering your 2 question. 3 Personally, I really felt that the global rating 4 scale was a mistake. You know, I've worked on an 5 under-writing desk. I work with traders. And I can tell you 6 that, if anything, it's caused some confusion because the 7 ratings in the corporate market measure default risk and 8 recovery, and as Mark aptly put it, governments rarely 9 default. Studies have -- that's been proven and looked at in 10 several of the default studies put out by all the rating 11 agencies. 12 In order to make the market work, I think this -- 13 this industry has been around for many years, and capital has 14 been brought to market through the rating scale that allowed 15 people to make decisions based on relative value of one bond 16 to another. 17 I would say that I don't think in any way issuers 18 were penalized for, you know, having a lower rating than one 19 might have on a global scale. And I'd say now, because of 20 some of the confusion, I look at the reports, and they'll 21 say, you know, "This rating does not necessarily reflect a 22 change in credit quality. It's just simply and adjustment on 23 the global scale." 24 And you know, what are you looking at when you're 25 trying to buy bonds? You're trying to ascertain the credit 99 1 quality. You know, I always felt that that was somewhat of a 2 red herring or a political issue, and I think this market 3 worked well and would have continued to work well. I would 4 say it's early to tell whether there's going to be any sort 5 of benefit to issuers because there's not enough data to say, 6 you know, have things gravitated towards a higher rating. 7 But I do want to talk a little bit about some of 8 the remarks that were made about the rating agencies. One is 9 there are compliance studies required now internally. There 10 are compliance officers. 11 The rating agencies, you know, aren't perfect. And 12 they responded, and I think they responded with these very 13 things you're talking about with respect to regulations. All 14 the methodologies are out there and transparent. They're on 15 their websites, and they talk about how they arrive at 16 different ratings. And this is in the municipal market, mind 17 you, and I -- you know, certainly there might be some fair 18 criticism with respect to the corporate markets. 19 You know, what happened with the bond insurers is 20 that, you're right, they were collecting money because of 21 this Triple A, and as that industry grew and more people got 22 into it and it drove down premiums, they got into other 23 business lines that were riskier. And that negatively 24 impacted them from a rating standpoint. 25 But I still think that through these default 100 1 studies, ratings do instill discipline on issuers, and I 2 think what came out of the default studies is the explanation 3 for why governments have held up so well in periods of fiscal 4 stress is management. And now the rating agencies account 5 for management practices. It's part of their criteria. 6 They look at things like codified fund balance 7 policies. They look at things like long-term forecasting of 8 revenues and expenditures. All of those things are out there 9 in the criteria and accounted for, and that is now something, 10 again, that instills discipline on issuers. And I think 11 ultimately for investors it assures that they will get their 12 debt paid back on a timely basis. 13 So I'm not as disturbed. And as I said, on the 14 investor side I do use the rating reports, and I think in the 15 fundamental area they do a very good job. And I think some 16 of the criticism is deserved, but I don't believe -- and I 17 also say this single simplified scale -- I mean, saying that 18 it should be a different scale, well, they did have a 19 different scale, and it worked. And it's the simple letter. 20 It's not red, white, or blue. But I do think it was 21 adequate, and it reflected the risk within that market. 22 COMMISSIONER WALTER: We've seen in the press that 23 in light of changes brought about by Dodd-Frank some rating 24 agencies have sought indemnification, broad indemnification 25 agreements for issuers. Can you comment on what impact you 101 1 think that those indemnities might have on the ratings 2 process? 3 MR. BELSKY: As I said, I've not been at the rating 4 agency for, you know, a couple of years, but I do think the 5 idea of some sort of liability for rating agencies -- someone 6 said in their comments ratings are opinions, and they're 7 opinions based on the criteria that's applied. And I don't 8 think, you know, the government or anyone else should say 9 this is how your opinion should be. I think it should be, 10 you know, based on transparent criteria. And people can 11 disagree on opinions. 12 So I'm not aware of, you know, the indemnification 13 that you're talking about. As I said, I'm not representing 14 the rating agencies. I'm not there anymore. But you know, 15 my general feeling is that the ratings are used. They're of 16 value. And I do think that personally I like the scale where 17 it resided because I do think it's creating some confusion. 18 COMMISSIONER WALTER: Dan? 19 MR. KIEFER: I wanted to first comment on the last 20 question with the bond insurers and the underlying 21 municipalities having two separate scales. Having two 22 separate scales kind of fostered that environment where you 23 could have a corporate that was a Triple A bond insurer come 24 in and insure somebody that had a lower rating or a perceived 25 lower rating on a different scale, and whenever you have a 102 1 transition into a new scale, you're always going to have some 2 confusion because market participants are used to an old 3 scale. So I think it needs to be viewed over time. Because 4 people are trained a certain way, they're going to have to be 5 retrained. But part of the two separate scales caused the 6 confusion with the bond insurers. 7 With the second question, rating agencies are 8 insiders, and, yes, they have opinions. But whenever you 9 hold somebody accountable, usually your opinion is a lot 10 better and a lot more resources go into that opinion. So 11 that would be our comments on the second area. 12 MR. BLAKE: With respect to the indemnities that 13 were floated and then set aside by one of the rating 14 agencies, what that simply speaks to is the concentration of 15 market dominance by those three players so that the thought 16 that you would interpose as part of your rating process in 17 that contract, "Well, you will indemnify us for any lawsuit 18 that arises out of the rating or the issuance of the bonds 19 associated with the ratings," seemed to me more of an 20 indication of the amount of leverage that -- and the lack of 21 competition that are in -- that's in the rating agency 22 process. 23 With that said, I'm not sure what a rating agency 24 process would look like with 10 or so, 20 or so participants 25 in the rating process. One of the nice things about having a 103 1 few is you can kind of compare and contrast against rating 2 agencies. But nonetheless, it leads to the downside of being 3 able to impose contractual positions, basically contracts of 4 adhesion that municipal issuers have no real leverage to 5 negotiate. 6 So that would be an area of concern. Certainly it 7 didn't come to pass that we had to fight that fight. And I 8 think in San Francisco, just speaking on behalf of the City, 9 we were prepared to resist that provision. 10 COMMISSIONER WALTER: Mark, do you have an opinion, 11 too, on the public policy aspects of that which, of course, 12 might vary depending on how broad the indemnification is? 13 MR. BLAKE: You know, it's very difficult. I mean, 14 on the one hand, you know, my personal view is that if you're 15 going to -- I mean, one of the problems that I personally 16 have is that we, as a municipal issuer, pay a fee for 17 service, and the fee for service is we pay you and you rate 18 us, right? And so, the notion that we pay you and you don't 19 stand behind your work -- every other participant in our 20 marketplace stands behind their work, has to carry insurance, 21 and, in fact, we won't do business with entities that don't 22 carry insurance, that don't stand behind their work. 23 So as a policy matter, you know, that bothers me a 24 little bit that we could be forced to do business in order to 25 sell our product because their designation means that certain 104 1 funds can't buy our securities unless we have their rating. 2 But then to say, well, then they can interpose contractual 3 provisions that we would not otherwise agree to, that's 4 obviously a concern for us. 5 COMMISSIONER WALTER: Thank you. 6 Henry, go ahead. 7 MR. HU: I've been puzzled for some time about the 8 disparity, the possible inconsistency in terms of the ratings 9 assigned to municipals versus the prices of CDSs. The CDS 10 spreads for evidently California imply a pretty high 11 probability of -- a pretty material probability of default, 12 yet the credit ratings are high, relatively high. And the 13 prices of bond prices have yields that don't really seem to 14 correspond with the CDS prices. 15 So I mean, one possible explanation is that the CDS 16 markets are really thinly traded, and so they're wrong. Or 17 another possibility might be that the bond prices, in a 18 sense, may be wrong because people are chasing yield. Or, 19 you know, another possibility is in terms of the credit 20 rating; that they're somehow askew. And then, of course, 21 there are these factors beyond these kinds of probability of 22 default issues in terms of expectations in terms of income 23 tax rates and the tax exempt feature. 24 So I'm just wondering if whether you could help me 25 try to understand this kind of puzzle in terms of, you know, 105 1 perhaps inconsistency among these three different, you know, 2 markets. 3 MR. KIEFER: I'm going to throw another 4 plausibility out. The CDS is an insurance -- basically a way 5 to hedge your instrument, and if there's not a lot of hedging 6 vehicles out, it's the price of insurance. So if people want 7 to insure, that's going to cost them a little more just 8 because of the availability of the insurance. 9 MR. HU: Because it's very difficult to short these 10 things. So that this is the only game in town, so people are 11 willing to pay premium. So that the CDS spreads are not 12 necessarily reflective of the -- that the implied 13 probabilities in terms of those bid-ask spreads are really 14 not good guides? 15 MR. KIEFER: It's a good guide to demand for 16 insurance in that area, or maybe somebody has too much 17 exposure in that area and wants to hedge some of it off. 18 COMMISSIONER WALTER: Do you also -- Dan, could you 19 comment? Many individual municipal issues are sparsely 20 traded. How do you feel about the pricing mechanism in the 21 secondary market? Does it work well? Does it need help? 22 It's a little bit off topic, but -- 23 MR. KIEFER: Well, we're not a purchaser -- 24 COMMISSIONER WALTER: -- Chair's prerogative here. 25 MR. KIEFER: We're not a purchaser of municipal 106 1 securities because we don't have that tax need. So mainly 2 it's our Credit Enhancement Program. So I would be kind of 3 unduly fit to answer that question. 4 MR. BELSKY: Another thing I would say, Henry, 5 regarding what drives the pricing on the actual securities in 6 addition to rate, you know, ratings are one factor, but also 7 supply and demand. You know, if you have an issue out there 8 in a market where supply and demand are askew, you know, you 9 can get different pricing outcomes. 10 But going back to your question about the secondary 11 market, I think the MSRB has really done a great job with 12 EMMA and even pricing data that helps support securities that 13 are rated and those that are complying with 15(c)212. So 14 there is a good amount of information. 15 It's not a perfect market. It's not like an open 16 outcry exchange. It's not a perfect market. But I do think 17 that secondary market pricing works. People get a fair 18 price, and there's a lot to compare it to because there is 19 good information out there, not only through the MSRB but 20 other pricing services. 21 When you do have these issues that are thinly 22 traded, it is more difficult. As I said, people -- what 23 people basically do is they put them out for a bid and see 24 what kind of price they get. And there's kind of almost a 25 negotiation that goes back and forth. 107 1 And again, I think the penalty is a market imposed 2 penalty. If you don't have good information out there, you 3 know, when you're trying to maximize what you get for selling 4 the securities, you're going to lose value if you bought 5 something without a rating or in some area of finance that 6 you really don't understand. So the secondary market works 7 in that way, as well, to penalize you. 8 MR. HU: So putting the two pieces together in 9 terms of the larger more frequent issuers providing 10 information through EMMA or other means, the prices are more 11 reflective of the true probability than the, you know, rather 12 limited CDS market, so that the prices in the secondary 13 market, because it's relatively efficient from an 14 informational standpoint, are probably better gauges? 15 MR. BELSKY: Yeah, I would say so. 16 MS. CROSS: So we talked a lot about the fact that 17 this is a very heavily retail oriented market, and at the 18 Commission we've been spending a lot of time recently trying 19 to make sure that investors who are the target audience of a 20 particular security understand what the rating means and what 21 the limitations are. 22 I don't know about anybody else here, but certainly 23 my mom buys municipal bonds. And she thinks if it's Triple A 24 rated, that means she will be paid. She thinks it's a 25 guarantee by somebody out there who is going to make sure 108 1 she's paid. And I worry about what investor understanding is 2 of what these ratings mean, and should we do something to 3 improve investor understanding in the retail market? And if 4 so, what? 5 COMMISSIONER WALTER: Interrupt just to let people 6 know that we've been told that there's going to be a loud 7 test alarm at noon. So it may be pretty loud, but it's not 8 that anything has gone wrong. 9 MR. BLAKE: From my experience, I would say two 10 things. One, a Triple A rated bond in all likelihood is 11 going to be paid, and that the effort that we go through to 12 tell somebody that has a Triple A rated security backed by 13 the full faith, you know, or the taxing power of Government 14 X, City and County of San Francisco, chances are that that 15 bond is going to be paid absent a calamity. And even with a 16 calamity, you have, in some ways, this vertical -- I don't 17 want to call it vertical integration, but certainly vertical 18 backing by higher levels of government to ensure that the 19 municipal market doesn't collapse by having that non-payment 20 come to pass. 21 Now, does it happen? If you look back in the '30s, 22 yeah, there were higher default rates. But risk of loss in 23 this area is really a low probability event. You certainly 24 can look at communities that are under stress, that have 25 stress, and that have long-term fiscal challenges associated 109 1 with pensions, health care, and the like. But for the 2 security that you described, you know, the risk is relatively 3 low. 4 The other thing I would say is that in preparing 5 offering documents over the last 20 years they have gotten 6 better with the emergence of disclosure counsel. For most 7 issuers, the preparation of that document has gotten better. 8 And so when you look at particularly frequent issuers, you 9 will see documents that attempt to describe risk, describe 10 security, describe all manner of things, and it, quite 11 frankly, is an evolving process. 12 Certainly in the secondary market we could do 13 better. But nonetheless, as my comments -- as I included in 14 my comments, anyone that really wanted to follow an issuer 15 could. So you know, not to say that, you know, there aren't 16 unsophisticated buyers. But nonetheless, I think that the 17 process works. 18 MS. CROSS: I guess to follow up, though, at least 19 at the Commission, we've been spending a lot of time worrying 20 that investors rely too much on ratings and don't do enough 21 of their own analysis. Is that not a concern in the 22 municipal market? Is that only a concern in the corporate or 23 ABS market? And how do you -- I mean, if it is a concern, 24 should -- is there anything that should be done? 25 MR. BLAKE: I will say that in my practice working 110 1 with the issuers and working with John down in San Diego, I 2 think the business people were always concerned that we were 3 overstating the risk, pointing out every conceivable risk. 4 And so, I don't think it's a question of understating loss. 5 I mean, quite frankly, you know, there's been a 6 lot of discussion in the United States about financial 7 literacy. I mean, I think it kind of goes to that issue. I 8 mean, people have to be sophisticated about the financial 9 products that they buy. 10 MR. MCNALLY: Speaking as disclosure counsel on 11 this point, the question is how can a retail investor be 12 apprised of what it means to be rated X, Y, or Z, and what 13 we've recommended in Disclosure Roles of Counsel is we have a 14 cross-reference to the GFOA guidelines. And this is what the 15 documentation would be in the official statement, and it 16 would say, to the effect, "The rating reflects only the views 17 of the service, and the prospective purchaser should go to 18 the rating service for an explanation of what the ratings 19 mean. There's no assurance the ratings will continue for any 20 given period of time, whether they will be revised or 21 withdrawn, and that if it were to be revised or withdrawn, it 22 may have an impact on the market price of the securities." 23 That's become fairly standard disclosure in the 24 rating section. So I'm not sure what more could be done to 25 apprise the retail investor. And as far as the proposal to 111 1 simply pull it out of the regulations, I think retail does 2 probably to a greater degree -- to a great degree rely on the 3 rating in making their decision. 4 COMMISSIONER WALTER: John, let me follow up on one 5 aspect of what you said, which is to point out that withdraw 6 of a rating or change of a rating could have an impact on the 7 market price. 8 I think one of the concerns that has also been 9 raised in discussions on these issues is that the 10 relation-ship is obviously more complicated than that with 11 respect to the market price, and particularly since the 12 transparency now as related to transaction information is 13 limited to transaction, that one of the things the retail 14 public doesn't understand is that if they choose -- if 15 Meredith's mom chooses to sell one of these securities, that 16 the fact that that security is Triple A, is perhaps one of 17 the safest securities known to mankind, doesn't necessarily 18 mean that the pricing is that predictable. 19 Do you have a comment on that and whether there are 20 improvements that are needed in that area? 21 MR. MCNALLY: Well, speaking as a bond holder and 22 investor, I mean, were I Meredith's mom, I would go to 23 investinginbonds.com. 24 MS. CROSS: She doesn't use the computer. 25 MR. MCNALLY: The question is not whether she uses 112 1 it. The question is whether it's out there and available for 2 the average investor. And the fact is you can go onto 3 investinginbonds.com and see the price of all trades, and it 4 reflects whether it's a dealer to dealer trade or a dealer to 5 retail customer trade. 6 COMMISSIONER WALTER: True. But the point I'm 7 focusing on, John, is not that. 8 MR. MCNALLY: Okay. 9 COMMISSIONER WALTER: But the fact that if she 10 chooses to sell those securities given the nature of the 11 marketplace and the frequent lack of liquidity, she may not 12 get that price. It may not be a good predictor of the price 13 she can actually get. Is that an issue that we need to 14 address? 15 MR. MCNALLY: I mean, I'll turn to others, but I'm 16 not sure how you address it. I mean, the fact is there's 17 constantly bonds coming back into inventory of the 18 underwriters, and to the extent they're in small pieces or as 19 an estate where the children don't want the bonds, yes, they 20 trade differently. I mean, they're small blocks, and there's 21 differential in the pricing. But I'm not sure how one solves 22 that. 23 MR. HU: But do they really understand bid-ask 24 spread, you know? You know, if Meredith's mother has to sell 25 the bonds, do they really understand how wide the spread can 113 1 be? And is there anything we can do to -- 2 MS. CROSS: To help that understanding. 3 MR. HU: Yeah. Of course, my mom doesn't read 4 English, so nothing could be done for my mom. 5 MR. BELSKY: This is not a plug, and certainly 6 investors have to take responsibility for their money. But 7 most investors are advised. And if advisors are doing their 8 job right, you know, they're pointing out, you know, if 9 someone wants liquidity, where they should be on the yield 10 curve and the rating scale. And you know, the market is 11 going to be the market when you go to sell it. And I think 12 what's good now in the market is there are these -- this 13 information about bid ask where your mother would be advised 14 whether it's an appropriate time to sell or not. 15 So you know, I think the market works fairly well, 16 and I think interfering with, you know, pricing -- I mean, 17 transparency -- more transparency is great. I don't know if 18 an open outcry exchange would ever work for this market, but 19 I do think that, you know, retail investors, not withstanding 20 some of the -- you know, if you look at the 3 billion in 21 assets that the firm I work with is involved in, you know, 90 22 percent of it is in very liquid, highly rated securities, and 23 there is an active market. You know, it's the small portion 24 we inherit that was sold to individual investors that is not 25 liquid. 114 1 And again, I think, you know, buyer beware. They 2 have to realize that if someone is saying you're going to get 3 10 percent on a single site nursing home, they should -- you 4 know, they should think about that and ask questions. And if 5 they're ill advised, you know, I think there's -- you have 6 regulations with respect to suitability and the licensing of 7 these individuals. So you know, I would use that as kind of 8 your hammer. 9 MS. HAINES: If I could jump in with one more 10 question? How does the retail investor know that when it 11 says -- using San Francisco for no reason. It could be 12 anybody. But when it says City of San Francisco Nursing Home 13 Revenue Bonds -- 14 COMMISSIONER WALTER: Martha? 15 (Interruption to proceedings.) 16 MS. HAINES: That wasn't so bad. 17 COMMISSIONER WALTER: It's not over yet. 18 MS. HAINES: Okay. My question is that the way 19 bonds are sold and listed often it's difficult, I think, for 20 a retail investor to tell what the credit is. It might say 21 "City of San Francisco Nursing Home Revenue Bonds (XYZ)." 22 Nobody has ever heard of that little nursing home company. 23 But often that little parentheses doesn't even get into the 24 confirm or onto the listing for a bond, and so how does an 25 investor tell -- in fact, how does a broker/dealer 115 1 necessarily know what the particular credit under a bond is? 2 MR. MCNALLY: You read the official statement 3 that's been carefully written by disclosure counsel. 4 MS. HAINES: But it's a secondary market trade. 5 MR. MCNALLY: Then you go on to EMMA and get the 6 official statement. I mean, I think there's no other way. 7 You're not going to have a confirm or a description give you 8 a full characterization of the underlying credit or the 9 nature of the pledge. So I really think we cannot completely 10 insulate the investor. The investor has some work to do, and 11 the information is out there. The official statements are 12 out there, and the pricing is out there. 13 Is there a disagreement from the questioners? 14 COMMISSIONER WALTER: Well, I guess I have a couple 15 of reactions. One is -- and I'm not going to pick on Mike, 16 but I will a little bit -- that saying caveat emptor to a 17 securities regulator always makes us feel rather jumpy. 18 I wonder -- and this is really much more of a 19 long-term question, very long term, and even if one were 20 inclined to pursue it, it would be very long range -- whether 21 market structure needs to improve. I mean, rather than 22 having either a mom and pop come in with, you know, $50,000 23 worth of bonds or $25,000 worth of bonds and have their 24 broker either buy that and place it in their inventory or go 25 out and get bids, whether there needs to be a more robust 116 1 system of transparency pre-trade and whether that's -- I 2 don't know whether that's worth it. 3 I know that's a very expensive undertaking, but it 4 strikes me that the market structure really sort of has a 5 hole that forces people into a certain mode that I'm not 6 completely comfortable making that choice for them. I would 7 rather see them be in a market structure that gives them more 8 options and more readily available information. The 9 information beyond the pricing information, which is now 10 finally and so wonderfully available, is hard for people to 11 get. 12 MR. HU: Along those lines, exactly those lines, 13 like Meredith's mom is focusing on credit risk in terms of 14 Triple A and then we just talked about the liquidity risk, 15 right, in terms of bid-ask spreads, but we haven't talked 16 really about does Meredith's mom know about interest rate 17 risk, you know, in terms of there's a whole literacy -- you 18 know, again, this is a long-term issue in terms of financial 19 literacy. Do they really understand that if you're buying a 20 30-year fixed rate, even if it's Triple A, no chance of 21 default, they could lose their shirts, even if they don't 22 sell, you know, in terms of that issue, in terms of this 23 financial literacy? 24 The striking thing about this bond market, of 25 course, in contrast to the corporate bond market is the 117 1 direct retail participation and the indirect -- the huge 2 amount of direct retail participation and then the additional 3 30 percent in terms of indirect. It really concerns me. 4 COMMISSIONER WALTER: Right. Me, too. 5 One further question about investor education. I 6 am a great believer in investor education, and I've spent 7 major portions of my career being devoted to it. And I think 8 it's something that we need to continue to work very hard on 9 and be very creative about. I also think, to a certain 10 extent, we need to recognize that our aspirations for 11 investor education are different than what we are likely to 12 actually achieve, and we need to add some protections around 13 that and not count on it as being really the answer. 14 MR. BELSKY: So you're picking on me still, right? 15 COMMISSIONER WALTER: I'll be happy to pick on you 16 anytime you want. 17 MR. BELSKY: I guess what I would say is there is 18 an opportunity now for people to become more educated outside 19 of their own advisors, and that is, you know, the MSRB and 20 investing in bonds.com and has very good information about 21 interest rate risk, all the risks associated with buying 22 fixed income securities. And a lot of terminology is 23 explained on there, too. 24 But I think you're right. We're not going to -- 25 it's not going to be perfect. There are going to be many 118 1 people that, you know, don't know about -- we're all industry 2 participants, so we're very familiar with this. 3 I would say that it's evolving, you know, these 4 market structures, and I would say that the -- you know, the 5 SEC's work on 15(c)212 improved things, and I think the idea 6 of consolidating to one repository now at EMMA has really 7 improved things. And those were things maybe 20, 30 years 8 ago we didn't even think about. I mean, there was a lot of 9 mystery about pricing and credit and even interest rate 10 risk. 11 So you know, I can't think of anything right now 12 off-hand, other than a open outcry exchange, but anything 13 that moves us towards more transparency and understanding 14 about pricing and, you know, not an over-reliance on ratings. 15 Ratings are one factor in how bonds price. 16 You know, there are all sorts of, you know, other 17 factors. If you do a regression analysis at any point in 18 time, you know, it's attributable to a variety of things. 19 So you know, I do think we're much better off than 20 we were because of your work, because of the work of the 21 MSRB, and even, you know, organizations that are putting 22 information out. Of course, our bond counsel, too. And I 23 read those official statements. 24 But you know, so I think the market is all kind of 25 moving in that direction, and I believe that -- I also 119 1 believe technology is part of it. It's a big market. It's a 2 disparate market. And you know, there are 87,000 governments 3 in the United States and local governments, so it's 4 difficult. Not all of them issue debt, but, you know, if we 5 can keep thinking of ways to kind of make things more uniform 6 and understandable, you know, we'll get there. 7 So -- 8 COMMISSIONER WALTER: Mark, did you -- your card 9 went up and down and up. 10 MS. HAINES: And then he put it away. 11 MR. BLAKE: I was wondering whether or not -- you 12 know, I would -- you know, I was thinking about Meredith's 13 mom. I guess she's going to become the poster child here. 14 MS. CROSS: She's a wonderful person. 15 MR. BLAKE: You know, one, the question is, well, 16 who is responsible to her? Is it the City and County of San 17 Francisco to make sure that information gets to her? Is it 18 the rating agency? That is, once they rate a bond, there is 19 surveillance that goes on, and so is it their responsibility 20 to communicate to her in a way that's clear, understandable? 21 And then, thirdly, certainly, you know, which Dan 22 mentioned, is standards of accountability, and I do think 23 that, you know, one of the things that comes out of the 24 financial meltdown is the lack of surveillance on the 25 corporate side post rating. So on the municipal side, there 120 1 may be some discussion, you know, that needs to be had about 2 that. 3 But Triple A rated governments are not always 4 Triple A rated governments. Things change over time. And so 5 when you talk about the other piece of rating agency reform, 6 rulemaking, you may want to look at surveillance 7 post-issuance. 8 MS. CROSS: I think those are very good points. 9 I mean I think -- as I mentioned to Elise while we 10 were listening to you all -- I think a panel and subsequent 11 field hearing that focuses on sales practices and the role of 12 the people who interact with folks like my mom, is going to 13 be key. 14 Because they -- and then I think another question 15 is -- is there some kind of disclosure that could be 16 developed for the retail audience, that is short, simple, 17 plain English, summary information that says, you know, "This 18 is rated triple A, that's credit risk rating, that's today, 19 that's not interest rate risk, interest rate risk you may 20 lose if you're going to need to sell your security." 21 That's not -- the things that it's not, as well as 22 other key factors in that transaction for that kind of an 23 investor. Since it is a retail market, it does seem like -- 24 I'm not sure how this ever comes to be -- but a disclosure 25 like that would sure be wonderful. 121 1 COMMISSIONER WALTER: I guess what I would add to 2 that, is to pick up on the technology point, which is a 3 favorite theme of mine. Maybe when we get over the hurdle of 4 when the next generation of Meredith's mother's -- or I 5 always talk about my hypothetical "Aunt Milly" -- are more 6 computer literate, we will really be able to harness the 7 power that that brings to give people the appropriate 8 information at the right time. 9 We're kind of at the cusp with respect to that now. 10 I think we're about to, you know, kind of go over the edge 11 where it becomes a powerful tool. Right now there's kind of 12 a mixture. It's a great tool for some. On the other hand, 13 it really presents a challenge for others. And I think 14 looking forward a little bit into the future, we'll be able 15 to do better with that. 16 But I do think investor education is definitely an 17 area that we should look at closely. And I agree with 18 Meredith about the panel for the next hearing. 19 MR. HU: You were mentioning, Michael, in your 20 opening remarks, about, in a sense, the credit rating 21 agencies not going beyond their understanding. You know, 22 like perhaps -- I mean how big a problem is it? I mean in 23 terms of this issue? So we've been talking about the 24 investor understanding, you raised the issue in terms of 25 ratings agency understanding or sophistication. I'm kind of 122 1 curious, you know, the entire panel's views on that? 2 MR. BELSKY: I'm not sure what you're asking, so. 3 MR. HU: Oh, in your opening remarks you were 4 basically saying that there are some kinds of issues -- 5 issuances, some kinds of securities issued that perhaps the 6 ratings agencies should be cautious about rating. That -- 7 and I assumed from that, that you were referring to that 8 there may be some particular kinds of exotic municipal 9 securities that may be issued that perhaps they should not be 10 providing ratings on? 11 MR. BELSKY: Well, I can't speak for the structured 12 finance market. I would say that the rating agencies rely on 13 the information that's provided to them. And I know that, 14 you know, some of the discussion of regulation in the various 15 bills that have been passed, there's talk about, you know, 16 making that -- that part a little more rigorous. 17 What my point was is that I think the fundamental 18 rating area, such as public finance -- even with derivatives 19 and sophisticated instruments used in the municipal market -- 20 are doing a good job. And you know, from an investor 21 perspective, we rely on them, again, as a starting point, you 22 know. Just like we advise people like Meredith's mom. So 23 you know, we have to make sure that we're looking beyond just 24 the rating report and really doing a similar work that they 25 do, you know, going through documents, you know, the capital 123 1 budget, the official statement, the audit, to verify that, 2 you know, some of the things reflected in the ratings agency, 3 but also to make our own judgments about credit quality, 4 looking at things like pensions and derivative risk. 5 So my point was I think they are doing a good job. 6 And I -- I mean one thing I always thought, for Meredith's 7 mom, was that this idea of a simple understanding of a rating 8 was the letter was simple, you know. That if someone is 9 buying an A rated municipality in California, and they live 10 in Illinois, they have a sense, you know, they have a frame 11 of reference that -- well, you know, my broker is talking to 12 me about an A rated bond in California, and I've live in a, 13 you know, next to an A rated community, so I get kind of a 14 sense of, you know, what the security is. 15 But you know, if there are ways to improve upon 16 that, you know, to make sure that there are various risk -- I 17 do think the idea of talking to advisors is important, to get 18 an idea of what they do. And not -- they're not all the 19 same. Some are better than others, because I see what we 20 inherit versus what we invest, and I'm sure that's true all 21 over the country, so. 22 MS. HAINES: We're over time. Are there any last 23 questions? No? 24 COMMISSIONER WALTER: Once again, many, many 25 thanks. This has been extraordinarily helpful for us and if 124 1 you have any further thoughts, please, pick up the phone pick 2 up a pen, we'd like to hear from you. 3 Thank you so much. 4 We are breaking for a short lunch break. You're on 5 your own, everybody in the audience, but until 1:00 o'clock. 6 And we're going to try to start promptly at 1:00, because 7 we've got a full afternoon with, believe it or not, we're 8 going to try to cram in three panels this afternoon. 9 (Whereupon, at 12:15 p.m., a luncheon recess was 10 taken.) 11 A F T E R N O O N S E S S I O N 12 COMMISSIONER WALTER: If everybody can take their 13 seats, we'll get started. And I'm going to turn the floor 14 over to Amy. 15 MS. STARR: Thank you. We're now at our Panel 3, 16 which is "Disclosure of Certain Significant Liabilities." 17 And we have a relatively large panel for this program, so I'm 18 going to ask my panelists to try to keep their remarks to 19 five to 10 minutes. 20 I'm going to now introduce the panel. The topic of 21 the third panel in today's field hearing is, "Disclosure of 22 Certain Significant Liabilities." 23 Municipal issuers face important challenges in 24 assuring they provide timely and accurate disclosures to the 25 market, concerning current and future significant liabilities 125 1 that may impact their financial health and ability to repay 2 their debt obligations. These liabilities can arise from, 3 among other things, the municipal issuer's ongoing operation, 4 its liabilities relating to pension and health care for 5 municipal employees, and its exposure to financial 6 instruments such as derivatives entered into in connection 7 with funding activities, financing activities or other 8 operations. For example, the extent of under-funding of 9 pension and healthcare payment obligations of the municipal 10 issuers is highly relevant to holders of municipal 11 securities. 12 In addition, the use of complex and sophisticated 13 derivative instruments by municipal issuers has underscored 14 the need for comprehensive disclosure, to provide investors a 15 clear understanding of the terms and risks involved in the 16 use of such instruments, including market risk and credit 17 risk. When and how such significant liabilities are 18 disclosed, in connection with municipal securities offerings 19 and on an ongoing basis, must be done in a manner consistent 20 with the Federal Securities Laws. 21 Our panelists this afternoon will explore issues 22 relating to disclosures of these types of significant 23 liabilities, the interplay between financial statement 24 disclosures and supplemental narrative discussions, 25 identifying the realtime effect of potential liabilities, and 126 1 the role of other market participants in providing municipal 2 issuers information needed to make full and accurate 3 disclosures. 4 Our panelists this afternoon are the Honorable 5 James McIntire, Treasurer of the State of Washington, David 6 Crane, James Lanzarotta, Brian Mayhew and Nathaniel Singer. 7 Mr. McIntire was elected as Washington's 22nd State 8 Treasurer in 2008. Prior to this election he was a Business 9 Economist for Navigant Consulting. Mr. McIntire earned his 10 Ph.D. in Economics at the University of Washington, where he 11 founded and directed a fiscal policy center and taught 12 Economics for 25 years. He began his political career 13 working in the U.S. Senate for Hubert Humphrey, and served as 14 a policy advisor to Congressional Committee Chairmen and 15 Washington Governors. He has chaired statewide boards for 16 economic development and non-profit housing. 17 David Crane is a Special Advisor to the Governor of 18 the State of California for Jobs and Economic Growth. Before 19 joining the Schwarzenegger Administration in 2004, Mr. Crane 20 was a partner, for 25 years, with a financial services firm. 21 Mr. Crane also sits on the boards of the California Economic 22 Development Commission, the California High Speed Rail 23 Authority, and Building America's Future, the Coalition 24 established by California Governor Schwarzenegger, 25 Pennsylvania Governor Rendell and New York City Mayor 127 1 Bloomberg, to promote U.S. infrastructure investment. 2 James Lanzarotta is the leader from Moss Adams 3 Governmental Services Group, and his area of practice 4 includes government and GASB reporting, not-for-profit 5 organizations including cities, counties, port and 6 transportation authorities, university and college 7 foundations, public retirement systems, sewer and water 8 districts and numerous other organizations. He is a graduate 9 of the University of Oregon. 10 MR. CRANE: Go Ducks! 11 MS. STARR: There you go. 12 MR. CRANE: I've waited for hours to say that. 13 MS. STARR: Obtained his CPA license in 1986 and 14 became an Oregon Municipal Auditor in 1993. Jim also has the 15 AICPA Certificate of Achievement in Governmental Accounting 16 and Auditing. He is the current Chair of the AICPA State and 17 Local Government Expert Panel, responsible for reviewing 18 proposed governmental auditing and accounting standards, and 19 addressing current practice issues. 20 Brian Mayhew has willingly agreed to join us on 21 this panel again. As I noted in my introduction of Mr. 22 Mayhew this morning, he is the Chief Financial Officer of the 23 Metropolitan Transportation Commission, and in that capacity 24 manages all accounting, treasury and financial functions, 25 including debt issuance and management for MTC, MTC Service 128 1 Authority for Freeways and Expressways, and the Bay Area Toll 2 Authority. 3 Finally, we have Nathaniel Singer from Swap 4 Financial Group. Mr. Singer is a partner at Swap Financial 5 Group, an independent Swap advisor. Prior to joining Swap 6 Financial Group, Mr. Singer spent 21 years at Bear Stearns, 7 where he was the head of Bear Stearns' Municipal Derivatives 8 Products Group and Chief Operating Officer of the Municipal 9 Bond Department from 1998 to 2007. Prior to joining the 10 Municipal Derivatives Product Group, Mr. Singer managed Bear 11 Stearns' proprietary tax exempt bond position and served as 12 National Sales Manager for the Municipal Bond Department. 13 Mr. Singer received an Engineering Degree from Princeton 14 University. 15 I would now like to ask Mr. McIntire, for him to 16 start on remarks and then we are going to move our way down 17 the table. So Mr. McIntire, thank you very much. 18 MR. McINTIRE: Thank you Amy. 19 Good afternoon Commissioner Walter and colleagues. 20 My name is James McIntire and I'm the Treasurer in 21 Washington. I'd like to thank you for this opportunity to 22 share with you my comments regarding disclosure of 23 significant liabilities. 24 I'd like to divide my comments into three segments. 25 1) A brief description of our disclosure activities 129 1 in the State of Washington, which I offer in my position as 2 State Treasurer. 3 2) A brief summary of the adopted policy positions 4 for the National Association of State Treasurers, which I 5 offer as the Western Regional Vice President for NAST. 6 3) And then third, my personal suggestions about 7 moving forward on the SEC's disclosure concerns regarding 8 municipal securities. 9 The first issue. Washington State has been a 10 leader, a national leader, in municipal securities disclosure 11 practices. We have deliberately tried to distinguish 12 ourselves in the market through timely and accurate financial 13 reporting. 14 Washington is a frequent issuer in financial 15 markets. We've been in the market 16 times over the past 21 16 months, with a combined tax exempt, taxable and Build America 17 general obligation bonds, and several small issues of 18 Certificates of Participation. 19 Washington is committed to transparency in its 20 financial affairs to protect investors and to keep taxpayers 21 informed of the central infrastructure projects and the uses 22 of their tax dollars. In addition to providing timely and 23 accurate financial reporting, the state offers detailed 24 reports to investors that include quarterly economic and 25 revenue forecasts, prepared by an independent economist and 130 1 overseen by a bipartisan commission with legislative and 2 executive members. These reports are in many ways the public 3 sector equivalent of quarterly corporate financial 4 statements. We provide monthly economic and revenue updates 5 on the state's revenue collections and the state of the 6 economy. 7 The Office of the State Actuary, which is actually 8 under the supervision of the Legislature, prepares annual 9 pension reports. Recently the Actuary supplemented these 10 standard pension valuations with an alternative risk 11 assessment study, using stochastic components to quantify the 12 likelihood and magnitude of future outcomes of the pension 13 system. 14 Providing timely and comprehensive disclosure is a 15 major undertaking for my office. As a State issuer, we 16 interact with other agencies, such as the Governor's Budget 17 Office, the Department of Transportation, the State Actuary, 18 the State Auditor, and the Attorney General's Office, to 19 ensure our documents are accurately reflect the most recent 20 available financial information. This entails coordination 21 of information from agencies under five separately elected 22 executive officials, plus the Legislature. 23 Washington has over 500 separate accounts and nine 24 separately elected officials. Coordination of the audit is 25 challenging and is not really under my control. So it's a 131 1 big issue. We're working to deliver the data to the market 2 more quickly. Our goal is to release audited financials 120 3 days after the close of the fiscal year, the MSRB target, as 4 soon as we can. 5 This year we expect to meet the MSRB interim goal 6 at 150 days, and identify the measures we need to take to cut 7 that number to 120 days in the future. 8 Washington has no interest rate Swaps, and so 9 that's not part of -- we certainly disclose that. The state 10 does not mandate disclosure practices for local issuers, 11 although it does provide a statutory framework for funding, 12 purpose and approval by local government bodies and/or 13 voters. Debt levels are governed largely by revenue related 14 limitations. Some are statutory and others are 15 constitutional. 16 We believe in setting a good example for localities 17 throughout the state when it comes to producing thorough and 18 timely disclosure, and recently have worked with the State 19 Superintendent of Public Instruction to improve guidance to 20 local school districts and the use financial advisors for 21 bond sales. 22 We're committed to meeting GASB requirements. We 23 have consistently achieved a Certificate of Achievement in 24 Financial Reporting, in association with our CAFR. We 25 believe establishing standards for accounting and reporting 132 1 is to the benefit of both the issuer community and the 2 investor community. 3 Now, as my -- as a NAST Vice President, I'd like to 4 provide the following summary of the Treasurer's 5 Association's official policy positions regarding securities 6 disclosure. 7 First, NAST supported the creation and expansion of 8 EMMA. NAST encourages and promotes frequent and timely 9 disclosure of information to the municipal securities market. 10 NAST supports the regulation of all financial intermediaries 11 in the municipal securities market. They support an 12 independent and equitably funded GASB. 13 NAST opposes revision or repeal of the Tower 14 Amendment or legislation that would subject state and local 15 government issuers to federal disclosure laws and 16 registration of municipal securities with the SEC. 17 Finally, NAST encourages the rating agencies to 18 carry out their commitment to utilize a single ratings scale 19 for all debt instruments, such that a rating applied to a 20 municipal bond indicates the same credit risk as that same 21 rating applied to corporate bonds. 22 Moving forward, I believe that comprehensive -- and 23 these are my personal statements again -- I believe that 24 comprehensive and timely disclosure is of increasing 25 importance in the current environment, due to two primary 133 1 factors. 2 First, retail investors are becoming an increasing 3 percentage of municipal bond buyers and, relative to 4 institutional investors, they lack access to credit and 5 research materials. Retail investors are increasingly drawn 6 to the municipal bonds due to their historical and perceived 7 safety and will expand as the population nears retirement 8 age. 9 Second, the mixed performance of ratings agencies 10 and the homogenization of ratings offers a very muddled 11 picture for retail investors. With the recalibration and 12 homogenization of ratings, it is increasingly difficult for 13 investors to compare municipal credits relative to one 14 another. A much broader group of states now has the same 15 rating as the State of Washington. It is also difficult for 16 investors to compare corporate credits to municipal credits 17 because -- despite recalibration -- because the scales are 18 not the same with respect to measuring the ultimate risk of 19 default or recovery, municipal risk remains overstated 20 relative to corporate risk. 21 According to the Moody's Default Study, released 22 last February, from 1970 through 2009 there have been only 54 23 defaults in the municipal sector. Seventy-8 percent of those 24 occurred in healthcare and housing finance. Only three were 25 general obligation bonds. 134 1 The average five year cumulative default rate for 2 investment grade municipal debt is 0.03 percent, compared to 3 0.97 percent for investment grade corporate issuers. Taking 4 that a step further, the average 10 year cumulative default 5 rate for a triple A corporate bond is 0.5 percent, whereas 6 the cumulative default rate for an A rated municipal bond, 7 over the same time period, is 0.03 percent. On average, that 8 means that a retail buyer, buying a triple A corporate bond, 9 is taking a risk more than 15 times than if they had bought 10 an A rated municipal bond. 11 The recovery from municipal defaults is also much 12 higher than that of senior unsecured bonds of corporate 13 issuers. The average 30 day post-default price for a 14 defaulted municipal bond is 60 cents on the dollar versus 15 37.5 cents for its corporate equivalent. Even though 16 Washington is able to be in the forefront of public 17 disclosure, not all state and local governments are in the 18 position to achieve some of the more aggressive time tables 19 envisioned by the MSRB. 20 In difficult budget periods, it is even more 21 important to realize that imposing new regulatory 22 requirements on municipal issuers will come at a significant 23 monetary cost, at a time when issuers are working to contain 24 costs to protect their financial health, to the benefit of 25 both taxpayers and bond holders. 135 1 I know that it is not the focus of the hearing, but 2 I must emphasize that a repeal of the Tower Amendment and 3 imposition of a set of uniform federal regulations on the 4 issuance of municipal securities could have a devastating 5 impact on state and local budgets, at a time when we can 6 least afford it. It could also have a dramatic impact on the 7 access to market by small municipalities, and could simply 8 cause numerous infrastructure projects to grind to a halt 9 before the statutory and constitutional framework around 10 state and local accounting and debt issuance could be 11 transformed. 12 And what would the practical benefit be for all 13 this activity? How many of the precious few defaults would 14 be prevented? What marginal benefit would this produce for 15 retail investors? How would you respond to the outrage of 16 local governments across the country about changes necessary, 17 the added costs, in many cases lack of access to capital 18 markets? How do you even have the resources or do you even 19 have the resources to approve securities registrations from 20 50,000 issuers, only a few of which may have the capacity and 21 economy of scale to maintain shelf registration materials? 22 Now, these rhetorical questions point us, I think, 23 in a much more practical direction. There may be 24 significantly more value in using your new authority over the 25 rating agencies to promote higher standards in their 136 1 assessments, making them much more reflective of the actual 2 risks they face in the municipal bond market. I believe that 3 this approach would produce much greater marginal benefits. 4 At the same time, many of us in the municipal 5 issuer community will continue to strive for excellence in 6 accounting standards and reporting, and continue to focus on 7 optimizing the use of EMMA as a depository. 8 We certainly hope to work with you and to 9 reconstitute MSRB in doing so. 10 Thank you very much. 11 MS. STARR: Thank you very much. 12 Mr. Crane? 13 MR. CRANE: Thank you and good afternoon. Thank 14 you for allowing me to be here today. 15 I have to ask James how old he was when he worked 16 for Hubert Humphrey, because you must have been so young. 17 Either that or you look incredibly young. 18 MR. McINTIRE: I'm in good shape. 19 MR. CRANE: You're in good shape is right. 20 State and local governments utilize a misleading 21 method for reporting the size of public pension obligations. 22 Let me give you an example. 23 Suppose an individual wears two hats. One is a 24 just retired government employee entitled to pension payments 25 from the state government and the other as an investor in a 137 1 general obligation bond issued by that very same state 2 government. Assume the pension payments and the bond 3 payments are unconditionally owed by and fully recoursed to 4 the government. Suppose further that the pension payments 5 and the bond payments have identical profiles. For example, 6 suppose that the bond requires a payment of $30,000 per year 7 for 25 years and likewise the pension requires a payment of 8 $30,000 per year for 25 years. Also with respect to the 9 bond, assume that the interest rate at which it was issued to 10 the retiree, the government would record a present value 11 obligation of $425,000. With respect to the pension 12 payments, that very same government would record an 13 obligation of only $320,000. Now, how can that be? 14 Two identical, fully recoursed and unconditional 15 obligations owed by the same government are valued at 16 different amounts. The answer lies in the "Alice in 17 Wonderland" world of government pension accounting, that 18 allows governments to hide liabilities. In short, that world 19 permits governments to discount pension liabilities at a high 20 rate, resulting in diminished present values. 21 The logic used to justify that outcome is that 22 because the government has established a fund called a 23 "Pension Fund," in which it deposits capital in the hope that 24 capital will grow to meet the pension payments, the 25 government should be able to discount its pension liabilities 138 1 at the rate at which it hopes to earn on that capital. Now, 2 that might be a legitimate outcome if the government and its 3 taxpayers were no longer on the hook for the pension promises 4 once money is deposited in the pension plan. 5 But that's not the way it works. The government 6 and the taxpayers stay on the hook. As a result, the 7 retiree, who is due the pension payment, is not only due an 8 unconditional payment from the government and its taxpayers, 9 but also was secured by whatever assets reside in the pension 10 fund. If anything, an even lower discount rate should be 11 used to discount that senior secured obligation, when 12 compared to the unsecured bond. Yet perversely, current 13 government accounting allows governments to discount those 14 senior secured obligations at a higher rate. 15 To put this in perspective, consider this. If 16 Alice's accounting could be applied to your mortgage 17 obligation, then just setting up a trust account and 18 projecting that account to earn a high rate of return on any 19 deposits you make to that account, would allow you to reduce 20 the reported size of your mortgage. Now, wouldn't that be 21 nice? At least until you actually had to make the payments 22 on that mortgage, which of course remain the same. 23 As a result of "Alice in Wonderland accounting" 24 state and local governments are understating pension 25 liabilities by 2.5 trillion dollars, according to the Center 139 1 for Retirement Research at Boston College. And note that 2 these are not like Social Security and Medicare liabilities, 3 these are contractual liabilities. They cannot be changed, 4 even by State Legislatures or Congress. 5 It gets worse. Because of the "Alice in Wonderland 6 accounting," state and local government pension funds are 7 perversely incentivized to assume the highest rates of return 8 at those pension funds, in order to minimize reported 9 liabilities and then to swing for the fences in investing the 10 capital of those funds, in the hopes of actually achieving 11 those returns, producing even more risk to the taxpayers who 12 must make up for any pension fund shortfalls. 13 Believe it or not, recently the Chief Investment 14 Officer of a large state pension fund was quoted as saying, 15 quote: 16 "Do I think it's unrealistic to search 17 for returns in the 7.5 to 8 percent 18 range? No, I don't. It's really hard to 19 imagine, in a worldwide market system, 20 not providing a return to riskier sources 21 of capital." 22 Given that the capital in state and local pension 23 funds is there to protect governments and taxpayers from 24 having to dig further into their pockets to meet pension 25 payments, for which they are on the hook, that official is 140 1 effectively characterizing government and taxpayer capital as 2 being in search of riskier investments. 3 So what does "government pension accounting" mean 4 in the real world? As just one example, consider what Alicia 5 Munnell, former member of President Clinton's Council of 6 Economic Advisors, recently reported in that Boston College 7 report I cited before. Quote: 8 "In 1999 the California Public 9 Employees Retirement System, CalPERS, 10 reported that assets equaled 128 percent 11 of liabilities, after which the 12 California Legislature enhanced the 13 pension benefits of both current and 14 future employees. If CalPERS' 15 liabilities had been valued at their 16 riskless rate, the plan would have been 17 only 88 percent funded. An accurate 18 reporting of benefits to liabilities 19 would avoid this type of expansion." 20 In other words, in 1999, using "Alice in Wonderland 21 accounting," CalPERS reported that its assets exceeded 22 liabilities when in reality liabilities exceeded assets. 23 Encouraged by that accounting, the State Legislature enacted 24 a law that year boosting pension promises as she describes. 25 The hidden cost from that boost has already hit 15 141 1 billion dollars and will reach at least another 150 billion 2 dollars for the state budget. More generally, after having 3 reported that liabilities were a fraction of assets and 4 projecting that the state's pension costs would total five 5 billion dollars over the succeeding 10 years, the state 6 actually incurred 25 billion dollars over that period. 7 California wasn't alone in this regard. 8 Unrealistic reporting of pension promises is a systemic 9 problem. That's why the SEC must require realistic 10 accounting of public pension promises. For that to happen, 11 you must insist upon the use of a realistic discount rate 12 when reporting pension liabilities. 13 As Munnell puts it, quote: 14 "The argument is compelling that the 15 liabilities of public pension funds, 16 plans, which are guaranteed under state 17 law, should be discounted by a rate that 18 reflects their riskless nature." 19 In this sentiment she is joined by academics from 20 Stanford, Northwestern, Wharton and the University of 21 Chicago, and many other commentators. 22 In addition, the SEC cannot rely upon the 23 Governmental Accounting Standards Board, GASB, to correct its 24 ways and adopt realistic accounting. GASB is funded and 25 governed by the very governments that would be forced to 142 1 revise upwards their pension liabilities, should a realistic 2 discount rate be required. 3 I'm happy to take questions. Thank you. 4 MS. STARR: Thank you very much. 5 Mr. Lanzarotta, please? 6 MR. LANZAROTTA: Well, like my colleagues, I 7 appreciate the opportunity to be here, to attend this 8 hearing. While I am participating individually and my 9 remarks are my own, clearly they're influenced by in excess 10 of 25 years of serving governmental entities as a focus of my 11 career and, also, in the last four years serving as part of 12 the AICPA State and Local Government Expert Panel, this last 13 year as its Chair. 14 The AICPA State and Local Government Expert Panel 15 is responsible for reviewing audit standards and accounting 16 standards as they're being deliberated. And we provide 17 feedback to the standard setters. With GASB, we respond to 18 just about every invitation to comment, preliminary views and 19 exposure drafts that they issue. We're also responsible for 20 providing assistance to practitioners that provide audit 21 services to state and local governments. 22 One of the big tools that we use is an AICPA Audit 23 and Accounting Guide for State and Local Governments, that 24 provide a lot of useful information to practitioners. 25 So to address specifically the topic of this 143 1 session, I'd like to highlight some of the recent changes 2 that have occurred in governmental accounting, with respect 3 to liabilities. 4 Probably the -- and I should mention that 5 personally and as the AICPA State and Local Government Expert 6 Panel, have generally been in favor of these changes that 7 have occurred. And while you're here today, and in your 8 hearings, a number of shortcomings, you'll see that we're 9 pretty much in favor of what -- most of what GASB has done. 10 Probably one of the most significant changes was 11 GASB Statement No. 34, which changed the reporting model for 12 state and local governments. In that standard, two new 13 statements were introduced, a government-wide "Statement of 14 Net Assets," essentially equivalent to a balance sheet, for 15 those of you on the commercial -- more familiar with 16 commercial statements, and a "Statement of Activities," which 17 is the government's rendition of the income statement. 18 The interesting thing about these two new 19 statements is that they require a government to use the full 20 accrual method of accounting or the full accrual basis -- 21 bases of accounting, and contrast that with the model that 22 existed before, where you had multiple of different types of 23 governmental fund totals, side by side, that for the most 24 part used what we call the "Modified Accrual Basis of 25 Accounting." So basically, not all assets and liabilities 144 1 were reflected within those statements. 2 These statements, under GASB 34, do reflect more of 3 the assets and liabilities. And you'll see there are a few 4 shortcomings, not all assets -- or excuse me -- not all 5 liabilities are on that balance sheet just yet, but a 6 significant improvement. 7 Another element that was required is a section 8 called, "The Management Discussion and Analysis," a required 9 supplementary information. And I assume this is pretty close 10 to what a publicly traded company would present in its 11 financial statements to comply with the SEC requirements. So 12 in that is a very good discussion of events and transactions, 13 circumstances, changes in numbers presented in the financials 14 compared to prior years, changes in budget information, 15 significant capital asset and debt activity, as well as 16 economic conditions that are anticipated to have an impact on 17 the future finances of the entity. 18 The addition of these full accrual financial 19 statements actually set the stage for a number of other 20 improvements that came after that. And I'd like to just 21 highlight a few of those. 22 GASB 40 came about, which required an expanded 23 disclosure of the risks associated with deposits and 24 investments. 25 GASB 45, which requires the reporting of 145 1 liabilities on other post-employment benefits or referred to 2 as OPEB, you'll hear that acronym. 3 GASB 46, on the reporting of resources restricted 4 by enabling legislation. 5 GASB 47, on recognizing liabilities from the 6 termination of employees or employee termination benefits. 7 GASB 48, on the reporting of resources that are 8 pledged for the repayment of debt in the future. 9 GASB 49, on the reporting of liabilities from 10 pollution remediation activities. 11 GASB 50, on improved disclosures on the funded 12 status of pension plans. 13 GASB 53, on the reporting of derivatives. 14 And I would mention GASB 54 is issued and just now 15 being implemented for this coming year, which will report 16 better the level of constraints on resources within 17 governmental financial statements. 18 While these recent standards represent a 19 significant improvement in terms of reporting risks, claims 20 on resources and liabilities, there are more improvements 21 that need to be made. And as a member of the expert panel, 22 we've discussed a number of these with the GASB over the last 23 several years. I'd like to believe that, as a result of 24 those discussions, we've actually had an impact on what's on 25 GASB's agenda. So they currently have a number of projects 146 1 on their current agenda, as well as their research agenda, 2 that take into consideration some of these discussions. 3 So let me just mention a few. You know, pension 4 liabilities is the big -- seems to be one of the big topics 5 of the day. So they're currently deliberating on a 6 preliminary -- or a preliminary views document is out. 7 They're deliberating on an improvement that would put the 8 liability on the financial statements at an amount that is a 9 lot closer to the expected future payout or the discounted 10 present value of the expected obligation. And that's in 11 contrast to what's done today. Today the liability is 12 measured based on what the actuaries said their annual 13 requirement would be for funding, versus what the government 14 actually contributed. So that would be quite a change from 15 current practice. 16 There is also a project in the works to improve 17 accounting of agreements with other entities referred to as 18 "Public Private Partnerships." There's a reexamination of 19 component units and the requirements of how those get rolled 20 into financial statements. And then finally, a research 21 project on their agenda right now, to improve the reporting 22 over financial guarantees that a government might offer for 23 another entity. 24 Lastly, in recent years, at least one state 25 government attempted to create their own version of 147 1 acceptable governmental accounting standards, by creating a 2 state regulatory requirement to avoid adoption of certain 3 liabilities standard issued by the GASB. Several others 4 considered taking similar action. 5 GASB 43 and 45 addressing the reporting of OPEB is 6 an example of a recent accounting standard that some states 7 have considered avoiding implementation. The expert panel 8 and I have consistently come out in favor of one set of GAAP, 9 one set of Generally Accepted Accounting Standards, and right 10 now, as promulgated by the GASB. Currently, varying from 11 GAAP, as defined by GASB, requires auditors to modify our 12 opinion, our standard opinion on those financial statements. 13 And it would be my hope that users of governmental financial 14 statements, including municipal investors and analysts, would 15 recognize departures from GAAP as a negative factor in their 16 risk evaluation of that entity. 17 Again, thanks for the opportunity to be here today. 18 And I'll do my best to answer your questions. 19 MS. STARR: Thank you very much. 20 Mr. Mayhew? 21 MR. MAYHEW: Thank you. 22 I'll be brief, because mainly I'm stunned. I'm in 23 a position where the world has lent us seven billion dollars 24 to build a public infrastructure and I don't feel I'm in the 25 business of hiding anything from anybody. 148 1 We follow very strict rules on what our pension 2 accounting is. We do not have the ability to tell PERS what 3 their actuarial rates will be. But we follow it. 4 I will bring to your attention -- when I talked 5 earlier today -- you saw the GAAP over-funded pension of 146 6 percent, we're down to about 90 percent now, or 89 percent. 7 I caution, as we go through this, you don't want that on our 8 balance sheets. Because when you have 146 percent, somebody 9 will spend it, even though it's not really there. When 10 you're down to 89 percent, somebody will blame you, even 11 though everybody was warned that they were spending money 12 that didn't really exist. 13 What happens with GASB and their new -- the study 14 they're going through now? What happens with pension 15 accounting and what happens with -- unfunded pension 16 liabilities have not been new to government. It wasn't until 17 the 2000 range that we actually became over-funded in them. 18 So I think that part of this is that whole concept 19 that there's a pension time bomb. And maybe there is. I'm 20 not in the business to say whether there is or isn't. All I 21 know is to tell you this is an issue of disclosure and we put 22 every piece of that information, along with the methodology 23 for doing it, the actuarial assumptions and the rules 24 governing those actuarial assumptions, and the fact that we 25 make our annual pension cost and we make our arc on OPEB, and 149 1 the level of funding of each. 2 Now whether somebody agrees or disagrees with the 3 methodology PERS has used, it's not for my jurisdiction. My 4 jurisdiction, my job is to report those things as accurately 5 as the auditors tell me to report them, and we do. 6 There are other things. Not long ago derivatives 7 were not even in on the financials. And we have, since then, 8 we have GASB 53, now you have -- I knew there was a reason I 9 brought this -- the whole -- the back part of the financials, 10 there's a whole schedule on virtually every derivative 11 structure, its risk, its mark to market at the end of the 12 year, and internally all the description of virtually every 13 one of them. Not to mention internally there's a description 14 of the pension plan. 15 So whether we're right or wrong in the accounting 16 of this thing, by the great god it's here. And we put it 17 here. And all we can do is follow the rules that people tell 18 us to follow. 19 There are a couple of other things, I guess, just 20 quickly. And the one that I don't hear a lot of, and you 21 wouldn't cry about, is of course I think that with the new 22 Basel Standards, I think you're going to have to look at 23 whether variable rates and some of the liquidity agreements 24 cause some un-projected long-term risk, that we haven't 25 really taken into account yet. 150 1 And then, you know, again that probably is the only 2 thing really sitting on the horizon that isn't really being 3 too carefully examined by people, I suspect, because pension 4 bombs are blowing up. 5 And with that, I'm going to shut up. Thanks. 6 MS. STARR: Thank you. 7 Mr. Singer? 8 MR. SINGER: Thank you. 9 This goes on but, I'm the derivative guy. There 10 used to be a lot of us around. Now there's just one of us at 11 each of these things left to talk. 12 My comments are going to be a little bit different 13 and a little bit -- just to focus specifically on some 14 recommendations that I think are important, regarding -- 15 let's see if we can see this -- regarding disclosing 16 derivative liabilities. 17 MS. STARR: We may turn the lights down a little 18 bit, if we can figure out how. 19 In the meantime, go ahead and start and then we can 20 walk though, and if we're lucky enough to do that, we can. 21 MR. SINGER: The concept of disclosing specific 22 derivative liabilities isn't a new one. It's one that I've 23 addressed for years, but I've addressed it to a different 24 audience. And I've addressed it either to -- each year I go 25 to the buyer's conference and the buyers would ask me, "What 151 1 should I look for inside of an issuer's derivative portfolio? 2 What should I be concerned about?" Or I'd speak at the NMFA 3 conference and I'd go through the same analysis for them. So 4 I've listed for them what I think are the important issues 5 for them, and specifically which issues can impact capital 6 for the municipal entities. 7 So the first thing I think is very important is 8 that issuers provide what I call "plain English summary" of 9 the derivative product. And I think it's exactly what Brian 10 just talked about. That most issuers do a great job of this. 11 That you can look through their annual reports, you can look 12 through their official statements, you can look at their 13 website, and made a list of what you need to know about their 14 derivative products. And I've listed the main issues under 15 the first bullet point. 16 When did they put the trade on? Is that derivative 17 tied to specific bonds and what series of bonds are they? 18 How big is the trade? When does it end? What are the pay 19 and received legs? Who is the counter party? What's the 20 mark to market, which is important for -- not all that 21 important, and I'm going to get into a separate page of why 22 -- but most importantly, why did you do this? Give me a 23 simple description of why you put this trade on. 24 And I agree with Brian, that you look through most 25 of the issuers that use derivative products, they're going to 152 1 have that information and you can find it. You can find it 2 on their website, a description of why they did it. 3 One concern I have is that we're implementing GASB 4 53, and that's probably something I'm spending the majority 5 of my time on now, working with issuers implementing GASB 53. 6 GASB 53, from an accounting standpoint, is going to 7 give you consistent treatment of derivatives, much like we 8 see in the corporate market subject to FASB. But for the 9 user of financial information, I think it could potentially 10 be misleading, and that you need this other information to 11 supplement what GASB is requiring. 12 In terms of mark to market, I just put an example 13 here. I think every issuer should supply, either in their 14 official statement, through on their website, annual report, 15 tell me what the mark to market is of each of the derivative 16 products that I have in my portfolio, and tell me how that's 17 going to change as interest rates change in the future. And 18 this is just an example of say an issuer, hypothetically, 19 that had six interest rate Swaps on it. Show me each of the 20 Swaps. Show me, based on the current interest rates, what 21 the mark to market is on that Swap. And then tell me how 22 that's going to change as interest rates change. Because as 23 a user of financial information, I want to know what is the 24 potential that this trade either goes against me and I'd have 25 to come up with more capital, subject to there being a 153 1 termination event, or if I don't have to worry about it as 2 much, because the trade has a positive mark to market. 3 But I caveat this, and I want to come back to it, 4 mark to markets are only important if there's a significant 5 risk to the issuer of having to terminate a Swap. We never 6 look at an issuer from a bond perspective and say that they 7 issued 6 percent bonds and interest rates are now 4 percent. 8 So if I had to buy those bonds back, I'd have to pay a 9 premium and I'd be losing money. We never say that. But 10 it's the exact analogy of a Swap that has a negative mark to 11 market. And for some reason there is more concern in the 12 market about negative mark to markets, than there is about 13 bonds that were issued at higher interest rates. But 14 nonetheless, I think it's important to see that sensitivity 15 in the disclosure for municipal entities. 16 Collateral posting, again, what is -- are there 17 certain events that can cause a municipal entity to have to 18 come up with capital to have a capital call that could impact 19 their financials significantly? I'd like to know, in that 20 Swap portfolio, that if interest rates changed, does the 21 municipality have to come up with collateral to post against 22 these derivative products? 23 The majority of the municipal entities, what you're 24 going to see, is all zeros on that page. Most of what we do 25 with the municipal market is we negotiate one-way collateral 154 1 agreements. The dealers have to post collateral to the 2 municipalities, but most municipalities never have to post 3 collateral back to the dealers. That's good to know. But 4 for municipalities that do potentially have to post 5 collateral, let me know when they would have to post 6 collateral and how much? 7 If I've got a schedule like this, that shows that 8 if interest rates fall and a municipality falls into the 9 triple B category, they'd have to post millions of dollars of 10 collateral. If I'm looking at the financial statement here, 11 for a double A rated municipality, I really don't care that 12 much, because there would be no posting requirement, as long 13 as they're rated in the A or double A or triple A category. 14 But if I'm looking at the financials for an A-minus rated 15 entity, or a triple B rated entity, now this becomes 16 important to me. And I know that if interest rates falls, 17 they may have to post collateral, and that could influence 18 the financials. 19 So again, this is the kind of information that I 20 think is very important for a buyer of municipal bonds to 21 see. 22 And then finally, what I've listed as an ATE, an 23 Additional Termination Event, how low does the credit rating 24 of the municipality have to fall before the other side -- 25 before the counter-party can force them to terminate the 155 1 trade and potentially make a payment? Most of the clients 2 that we deal with, most of the municipalities, they'd have to 3 fall below investment grade. It's a relatively minor, low 4 probability occurrence. But again, I've got a double A 5 issuer that's important to me, I have a triple B-plus issuer, 6 maybe it's a little bit more important to me. So again, this 7 information, I think, is important. 8 Finally, Brian and I didn't talk about this 9 beforehand, but this is the one that's the sleeper out there, 10 that I think it's floating rate dead. It's the one that 11 caught us in 2007 and 2008, that municipalities relied upon 12 the ability to consistently rollover either auction rate 13 securities, where there was a credit -- there was a test of 14 their credit, either every seven days or every 28 days, or 15 ever 35 days, and that they didn't have permanent financing. 16 They had confident sensitive financing. They only had this 17 financing as long as the market was confident in their 18 credit. I want to know how much confident sensitive 19 financing do you have? It is comprised of auction rate 20 securities? And what's the status of those auctions? Do you 21 have variable rate demand notes outstanding? If so, who is 22 your letter of credit provider? When does that letter of 23 credit rollover or am I using self-liquidity? Because Basel 24 3 is out there, and the rumblings in the market is that it's 25 going to become very expensive for the banks to continue to 156 1 provide letters of credit to the municipal market. 2 I saw a study last week that says we've got 70 3 billion dollars of letters of credit rolling over in 2011. 4 Forty billion of that is from providers that aren't in the 5 market anymore. And the other 30 billion are going to be 6 coming from providers where it's going to becoming much more 7 expensive for them. So how much risk is there of floating 8 rate debt that's going to be rolling over? And then tell me 9 about your other variable rate debt? Tell me whether you 10 have index notes outstanding? Do you have direct purchase 11 notes that the banks own, that need to be rolled over, and 12 tell me when they need to be rolled over? Have you created a 13 floating rate debt using derivatives? But I think you kind 14 of go through the gamut here. 15 I agree with Brian that this is the sleeper out 16 there. This is the one that I think we all need to do a 17 better job with coming up. 18 MS. STARR: Thank you very much. 19 Can folks in the back hear me, if I talk without 20 the microphone? Okay, good. Good. That's good. I'm glad. 21 I'm going to start -- we're going to sort of break 22 the discussion, I think, into two, one being "pensions," one 23 being "derivatives and other types of liabilities." I'm 24 going to start with my first question, which will deal on the 25 pension side. 157 1 As Mr. Crane has point out, and others have pointed 2 out, in recent articles there's been a lot of focus on 3 under-funded pensions and pointing to actuarial assumptions. 4 And my question is, do you need disclosures in their offering 5 documents or in ongoing disclosures, disclose what the 6 effects are of the assumptions, what effects would they have 7 on the muni's payment obligations on their outstanding debt, 8 or what effects will those assumptions have on the muni 9 financial obligations relating to the pension liabilities? 10 And for those who want to talk, just hold your card 11 up and I can call on you. If anybody wants to talk? If 12 nobody wants to talk, we can move to the next question. 13 MR. HU: Who is our resident issuer here? 14 MR. MAYHEW: Am I the only one? 15 COMMISSIONER WALTER: Please, Brian. 16 MR. MAYHEW: A couple of things with regard to 17 pension obligations. 18 First of all, financial statements aren't, you 19 know, talking about financial statements are not the place 20 for prospective of projections. And so that's for, you know, 21 laying out your assets and liabilities, your balances at the 22 end of the year. 23 We don't do a lot of that discussion, as far as 24 issuing bonds is concerned. I don't think it's reached the 25 level of evaluating your potential pension obligation. Let's 158 1 say you bracketed the absolutely safe number and then you 2 used seven, and then you used eight and you gave a bracketed 3 range. Then you've analyzed that against your operating 4 expenses. Considering, you know, there are a lot of other 5 things that could impact your operating expenses, we don't do 6 that. And I think that when we are doing financials, we use 7 five year schedules and we need five year pro formas. And in 8 that we build in all operating expenses and changes in 9 various factors, in various benchmarks. We don't exclude 10 pensions, salaries and benefits, medical -- the big crisis 11 three years ago was -- "What are we going to do about medical 12 benefits?" Then it became OPEB. And how, my goodness, are 13 we going to handle those? 14 So all of those are built into different variations 15 on the model. And all of that -- that model will give you -- 16 gives the investor a clear picture of where we think our 17 coverages are, particularly in relation to those covenants. 18 So you know, if you change it, it will change your 19 covenant ratios. And clearly, if we, you know, we were to 20 change our pension assumptions, for us it wouldn't be that 21 much, but for the average, you know, for some government 22 agencies it might be fairly substantial. 23 MR. McINTIRE: Well, Washington discloses all of 24 its pension information. We disclose our pension 25 liabilities, both on a GAAP basis, or both on the GASB basis 159 1 and then also our actuarial assumptions. Are actuaries 2 actually enter the supervision of the State Legislature and 3 many of those assumptions are adopted by statute. So there's 4 a limited amount of flexibility in how often or how those 5 assumptions will change. 6 One of the things we're doing in my office is 7 actually arguing that we need a constitutional amendment for 8 the state to require at least 80 percent of funding of the 9 actuarial recommendation. And really put into the 10 constitution a pay down of the unfunded liabilities we do 11 have on two plans that were closed back in 1977. 12 But we do all the reporting, particularly around 13 OPEB, as well. Although, we do have some disagreements 14 around how GASB would like us to do that, so. 15 MS. STARR: Dave? 16 MR. CRANE: I'm not an issuer, so I'm not an expert 17 in this area. I know that New York City does a nice job of 18 disclosing an alternative pension liability measurement, 19 where they discount at a risk free rate. They published 20 their liabilities at that rate. 21 Now, OPEB is interesting, because OPEB, the way -- 22 under GASB 45 -- OPEB liabilities are reported, is the way it 23 should be reported for governments that have not yet 24 established a fund to pay for OPEB. It's only upon 25 establishing a fund that they're allowed to raise the 160 1 discount rate. 2 In the absence of that, they're required to 3 discount at a much lower rate, which is, you know, the rate 4 really reflecting the credit of the obligor. 5 MS. STARR: Not yet done. 6 MR. LANZAROTTA: I'm sorry. 7 MS. STARR: That's okay. 8 MR. LANZAROTTA: I just have a comment on -- one 9 thing to keep in mind is that GASB does not prescribe the 10 discount rate or the assumptions that are used. That's -- I 11 realize with some people who are participating in an aged 12 multi-employer plan, they may be stuck with what that plan is 13 using, or clearly a cost sharing plan, you're stuck with what 14 that plan is using. But generally speaking, a single 15 employer plan -- most governments that are in these plans, 16 they set those assumptions. So if we're setting too high of 17 a discount rate, that's because somehow between management 18 and the actuary, you know, maybe they're setting too high of 19 a rate. But that isn't prescribed by GASB. 20 GASB provides the tool, and that you need certain 21 disclosures, but they don't prescribe exactly how someone 22 picks the parameters in there. And so, you know, I just want 23 to make that a point. 24 With OPEB there is a little bit of an issue, 25 because for, you know, there wasn't a requirement that you 161 1 put the entire liability on the books on day one. And some 2 may question that, so that you can compare one to the other. 3 You really have to go into the footnotes to get that 4 information. 5 MR. CRANE: GASB doesn't pick the discount right. 6 It doesn't pick the investment return assumption. But it 7 links the two things. That's the key. GASB allows 8 governments to use their investment return assumption as the 9 discount rate against their liabilities. Unlike in FASB, 10 where they're completely two different rates. The discount 11 rate for the liabilities in FASB -- in fact, in the rest of 12 the real world, in your homes as well as in businesses -- the 13 discount rate used for reporting the present value of the 14 liabilities reflects the creditworthiness of the obligor. 15 But only in governmental accounting is the discount rate -- 16 that you get to use a discount rate which is equal to your 17 investment return assumption. 18 COMMISSIONER WALTER: I'd actually like to raise a 19 higher level and broader question about GASB. And I think 20 direct it, in the first instance, to Mr. Lanzarotta and then 21 anyone else who wants to comment. 22 Many governmental issuers do not use GASB, GAAP. 23 And I know that you said in your remarks that you favor more 24 universal -- I don't know if you would go so far as to say 25 "universal," but I don't want to put words in your mouth -- 162 1 acceptance of GASB principles. But I wonder if you have an 2 opinion, or if others have an opinion as to the application 3 of differing sets of GAAP, some of which are mandated by 4 state law, and the impact that that has on investor 5 understanding? 6 MR. LANZAROTTA: Well, I don't know that I can hit 7 the last part of your question about investor understanding, 8 but clearly you hit the nail on the head in terms of 9 different states have different requirements. The State of 10 Oregon, we have a number of clients there, has a very 11 prescriptive budgetary compliance requirements. And so 12 governments have to follow a budgetary form of reporting to 13 show compliance with state requirements. 14 But GASB has a way of addressing that. What they 15 say is that if you have state requirements, you can prepare 16 supplementary information that meets those state or whatever 17 regulatory compliance requirements. But then the financial 18 statements -- the basic financial statements that come before 19 the footnotes need to meet GASB standards. 20 I think it's difficult to tell every government 21 that they have to follow GASB. One of the things that, you 22 know, there's 87 some -- I've heard different numbers -- 23 87,000, 88,000 governments across the nation, a majority of 24 those are very small and very resource constrained. You 25 know, we think of the large ones, the states, the large 163 1 cities, the large counties, the big transit authorities, 2 ports. But a majority of these are small entities. And so 3 they have resource constraints. 4 So the question is, is it necessary for them to 5 follow GASB in order for an investor to get all the 6 information they need to rate that or to understand the 7 creditworthiness of that issuance? I don't know the answer 8 to that. But I can tell you that it's a very difficult thing 9 for smaller governments to meet all of the requirements of 10 the Generally Accepted Standards -- Government Standards 11 Board. 12 MR. MAYHEW: Could I just add, that hits it right 13 on the head. The GAAP based financials are very complex to 14 do. For some people it's probably not a logical thing for 15 them to do. But I would venture -- as I said earlier, 3600 16 people get certified under GAAP financials and GFOA, for 17 example. I would venture to bet that overwhelmingly those 18 are the people who have rated debt. People can issue debt 19 without having then rated. But if you're going to go into 20 the rated world, one of the criteria is definitely you're 21 financial statements and, you know, whether you're following 22 GAAP. 23 California has the same sort of twisted component 24 thing, where we have certain reports we have to file and we 25 have to be able to trace these back through our financials. 164 1 But our position in the public world, we have to follow GAAP 2 financials. So we do have this translation thing that goes 3 on. And we have to file our reports. 4 One time I was meeting with the State Controller, I 5 said, "You do realize your financials aren't GAAP?" And he 6 said, "Yeah, so?" And I said, "But they don't match up to 7 our financials." He said, "Look, this is what the 8 Legislature wants, give it to them." Well, it makes it 9 easier to do it when you realize that. But if you're going 10 to be, you know, out in the public world and you're going to 11 be in the rated world, you're pretty much going to be held by 12 a GAAP standard. 13 COMMISSIONER WALTER: Let me switch and take a 14 point that you're making and talk a little bit about 15 derivatives. 16 We talk about the smaller end of the vast number of 17 municipal issuers and I guess the figures -- the figure that 18 we have, the approximation, was of the 87,000 or so, about 19 over 50,000 actually are issuers in the marketplace. At the 20 sort of smaller end of the spectrum, do they understand the 21 derivatives contracts that they enter into? And if, as I 22 suspect, that that's a very difficult proposition for them, 23 how do they then disclose to their investors? How do they 24 understand whether it's appropriate for them to enter into 25 those, and then how do they explain them to their investors? 165 1 They have that responsibility. They can out-source the 2 explanation, but if they, themselves, don't understand it, 3 how does that work? 4 MR. SINGER: Yeah, it's pretty simple. If they 5 can't explain it, they probably shouldn't be in it in the 6 first place. And it's no different from my role now, working 7 as a financial advisor, as my role when I was working as a 8 principal on these transactions. And it was a standard that 9 we held ourselves to, that if our client couldn't understand 10 the transaction, they shouldn't be involved in the 11 transaction. 12 COMMISSIONER WALTER: But is that really how it's 13 operating out in the real world? I don't think so. 14 MR. SINGER: No, I think we've seen examples, 15 whether it's been in Pennsylvania or it's been in Tennessee, 16 where we've seen smaller issuers that got involved in 17 derivative transactions, that probably shouldn't have been. 18 They probably didn't understand it and they probably didn't 19 have the financial flexibility to enter into those 20 transactions, in case something went wrong. 21 A recommendation that our firm had made to both 22 Senator Dodd and Representative Frank, through negotiations 23 of the bill at the time, and now the act, was that they had 24 used a 50 million dollar standard that an issuer would get an 25 end user exemption, to the extent that they had 50 million 166 1 dollars of investable assets. And our feeling was that's the 2 wrong standard. That the standard should have been a minimum 3 of 50 million dollars in liabilities outstanding. But that 4 wasn't a magic number. It was something that should be on 5 the liabilities side. That if you're not a significantly 6 large issuer, this probably isn't the market for you. That 7 the market probably is for the larger, more sophisticated 8 issuers that can explain this. 9 And -- well, that's what we were hoping for, that 10 there would be some sort of standard like that. 11 COMMISSIONER WALTER: Do you think that the fact 12 that under the new legislation it's clear that municipal 13 advisors have a fiduciary duty, is going to have an affect on 14 how often you see this, or am I just being a Pollyanna? 15 MR. SINGER: We always felt we had a fiduciary 16 responsibility. That's the way we treated our role, that we 17 did have a fiduciary responsibility. There were other 18 issues, I think issuers that either did not use financial 19 advisors or that you had issuers where the firm that was 20 principalling the transaction was also functioning as a 21 financial advisor, you know, and those are probably the 22 issues that we should look at, where an independent financial 23 advisor with a fiduciary responsibility is important. And 24 also, the issue of registration requirements for the 25 financial advisor, make sure the financial advisor is 167 1 qualified to advise on Swaps. 2 MS. STARR: In following up on that, just very 3 quickly, in Dodd-Frank, there is a provision under the 4 Business Conduct Rules that would, in the derivatives 5 context, require that municipal entities have an independent 6 representative. Do you think that that might go far in terms 7 of making sure they have the information they need to 8 understand it, or do you think, you know, what do you think 9 about how that might work out? 10 MR. SINGER: Well, again, I think it's a critical 11 issue in terms of determining who is a qualified financial 12 advisor. You want to have the requirements strict enough 13 that you're not having a broad set of standards for a 14 financial advisor where -- I'll just use this as an example 15 -- say that if you passed a Series 7 examination, that that's 16 your requirement to become a financial advisor, that then 17 anybody that's passed a Series 7 can say, "I'm a financial 18 advisor for Swaps." So it's got to be specific enough that 19 you can prove that you have knowledge of this market, this 20 unique market, you know, without becoming overly burdensome. 21 But I guess I'm less concerned about the "overly burdensome" 22 part, than making sure that the municipalities are getting 23 good advice. 24 MS. STARR: Thank you. 25 MR. HU: I had a question -- 168 1 MR. McINTIRE: I just wanted to point out that -- 2 MR. HU: I'm sorry. 3 MR. McINTIRE: -- that in Washington, we do have a 4 requirement that no municipality can get into the interest 5 rates or the Swaps unless they've got at least 100 million 6 dollars in liabilities and have an outside financial advisor. 7 MR. MAYHEW: Can I add one thing to that -- I'm 8 sorry -- because we do hold them accountable. I mean it's 9 our line of work. And the financials we have are fully GASB 10 53 compliant, and they were last year. 11 Our feeling in doing it is that, you know, the 12 investors needed -- as we were going through the process, the 13 investors needed to know more than what the old standards 14 required, so we went 53 compliant. But from our standpoint 15 it's quite simple, and that is we have, between the bankers, 16 the lawyers and the Swap advisors, a team of people. Now, 17 the responsibility for what's in there is mine. The 18 responsibility for what we do and how we're managing the 19 portfolio is mine. But we hold people accountable for the 20 different levels of advice they give us. And it is about 21 time somebody began to put a standard on what that advice is. 22 I work at a level where pretty much you have the 23 best of the best. But quite frankly, there's a world out 24 there where they don't really exist. And people are getting 25 advice and people are taking advice from people who -- 169 1 necessarily would be the ones giving to them. And I think 2 it's about time somebody began to come in and say, "Yes, 3 these are the standards and you're going to meet these 4 standards, and you're going to have responsibility if they 5 aren't appropriate." 6 MR. HU: Your chart showing the mark to market 7 values under different interest rate assumptions remind me 8 about an issue that came up back in the late 1980s in the 9 U.K., that I want to ask you about in terms of whether it 10 might happen in the U.S. 11 As you remember, Hammersmith and Fulham, and a 12 bunch of other local counsels, basically thought they had a 13 neat alternative to raising taxes, basically by speculating 14 in interest rate Swaps, speculating on the interest rates. 15 And the interest rates went the wrong way and they basically 16 went to court and said, "Hey, those Swaps were ultra vires, 17 we didn't have the authority to run into them." So 18 basically, you know, heads I win, tails you lose, all right. 19 And so -- and the English courts actually allowed these local 20 counsels to welch on their obligations. 21 Have you heard any of these municipalities that you 22 advise or that you're aware of, you know, ever mention 23 anything about trying to repudiate any contracts that -- 24 where they have basically large termination payments? 25 MR. SINGER: There's certainly been talk in the 170 1 market. I can't say firsthand that we have. Our client base 2 tends to be the larger more sophisticated issuers, repeat 3 issues in the market, that have the sophistication to 4 understand these products. And one -- we've been throwing -- 5 there have been some stones thrown at the rating agencies 6 today, but one good point about the rating agencies is that 7 the rating agencies do review the derivative portfolio. And 8 one of the key aspects is that -- "Does the municipality have 9 a derivative policy in place?" And you'll see in the vast 10 majority, if not all, there's going to be some sort of a 11 derivative policy. And there's going to be a -- anybody that 12 puts a policy document together, there's going to be a point 13 that says, "You cannot use derivatives for speculation." 14 MR. HU: Right. 15 MR. SINGER: So I think that's important to have a 16 policy in place, it should be a requirement to have a policy 17 in place. 18 MR. HU: Right. But sometimes the line between 19 hedging and speculation is -- can be quite unclear, right? 20 And do they -- in terms of the smaller clients or the clients 21 that can't afford you, in terms of those kinds of clients, 22 those kinds are participants in the marketplace, do they 23 really understand how the mark to markets could turn very, 24 very negative on them? I mean that they even had to pay a 25 lot to get out? 171 1 MR. SINGER: Yeah, I think it's a combination of 2 looking at -- what got most of the municipalities in a small 3 market in trouble in 2007 and 2008 was not the derivative, it 4 was the floating rate debt that accompanied the derivative. 5 MR. HU: Right. 6 MR. SINGER: And what was the implication if they 7 lost their liquidity, if they lost the financing? But you 8 definitely have to tie the two together, because if you lose 9 the financing, then what's the implication on the derivative 10 product? And there should be a worst case scenario that if I 11 assume if I do lose my financing, can I afford the 12 termination on the Swap? And I think there were some 13 municipalities that didn't understand that. And there were 14 some municipalities that hadn't run the sensitivities wide 15 enough to say that. 16 We saw unprecedentedly low interest rates in 2008. 17 The majority of these Swaps were fixed pair Swaps, so as a 18 result the municipality had to pay a termination amount to 19 get out of those trades. And people didn't realize that 10 20 year Treasury could go to 2 percent. They didn't run -- they 21 ran sensitivities that were 25 or 50 basis points away from 22 the market. But let's see what happens at 300 basis points 23 and make a decision at that point how tenuous is my 24 liquidity? 25 MR. HU: So are they doing serious stress tests 172 1 now? 2 MR. SINGER: I would say most issuers do do serious 3 stress tests. I think what you're focused on, and what the 4 media has tended to focus on through the past year, has been 5 the issuer that you're talking about, the smaller issuer that 6 maybe didn't understand -- I'm saying "maybe," I don't know 7 it's a fact -- and that didn't have the financial flexibility 8 to handle the situation that came upon them. But most 9 issuers that use derivatives, and the vast majority of 10 issuers, do that type of analysis either on their own, with 11 the help of a financial advisor, or with the provider. And 12 the providers, in most cases, again do a good job of showing 13 them those worst case scenarios. 14 MR. MAYHEW: Can I add something real quick? I 15 don't want to speak for our expert, but I'm going to say GASB 16 53, this is one GASB kind of got right. But we've had it 17 online for two years now, and the testing that goes into the 18 end, and mark to markets, and their auditors and the 19 confirmations of what your market providers tell you is 20 rates -- it actually works. And so I think 53 makes a big 21 change in anybody who is GAAP based, and how they'll see it 22 and handle it. Because they have to look at it exactly the 23 way -- their disclosure is so much different now than it was 24 just a few years ago. 25 And so I think that that's really going to help 173 1 give people a level of comfort that if you still have them 2 and they're on their books, you understand why they're there. 3 They may still -- you know -- they're still valid, they're 4 still, you know, a synthetic fixed rate component. And as 5 Nat said, the issue that blew up on is in '08 was not the 6 contracts themselves, they were fine. It was the fact that 7 we were terrified that liquidity would disappear. Without 8 liquidity, the variable rate market dried up and that was the 9 big scare. 10 MR. SINGER: And just one last comment on that. I 11 think we've got to be very careful going forward that we're 12 not throwing out the baby with the bath water here. That 13 vast majority of issuers that have used derivatives, they've 14 been extremely successful and they've provided tremendous 15 amount of flexibility and a tremendous amount of savings. 16 But unfortunately in the media we see about the few cases 17 where they did not work out fully, and a lot of it was the 18 smaller issuers that probably shouldn't have been there in 19 the first place. 20 MR. HU: And you think that the kinds of provisions 21 that Commissioner Walter and Amy referred to in Dodd-Frank, 22 would help a lot in this area, in terms of dealing with those 23 few cases? 24 MR. SINGER: I think we're sorting through this, 25 through it all, to see what the fallout is going to be. I 174 1 think, you know, certainly the financial advisory -- it's 2 somewhat self-serving for us to say that -- but having -- 3 MR. HU: I'm giving you the chance. 4 MR. SINGER: Yeah. We take every chance we can. 5 But having a financial advisor as a requirement is very 6 important, and imposing that fiduciary responsibility, again, 7 is very important. 8 MS. STARR: I guess I want to raise one more thing 9 on the derivatives and then we may have some other questions. 10 But I think one of the things I had heard, in speaking with 11 some muni issuers at various panels, talking about 12 derivatives, and this was awhile ago where muni issuers said 13 to me, "Well, we don't post collateral and we don't have to 14 post margin." And the interesting question, I think, that's 15 going to come up is, "Well, do you recognize -- do you really 16 know what the cost is of that Swap to you and do you know 17 whether or not you in fact are posting collateral, because of 18 the cost your Swap?" 19 And is that something -- will you have margin 20 obligations on a going forward basis -- and is that something 21 that muni issuers are going to have to think about and 22 recognize, so that they'll know, from a disclosure side, as 23 to what their potential future obligations may be, to know 24 how that's going to play in on their financings? 25 MR. SINGER: Yeah, I guess when we talked to some 175 1 lawyers that are working at the Act, some seem to think there 2 is some question that they're going to be able to go back to 3 existing contracts and impose a collateral posting 4 requirement, which it just doesn't work. 5 MS. STARR: Right. No, I'm talking even on a going 6 forward basis. Say, you know, you have existing contracts 7 but they're, you know -- will muni STs be continuing to enter 8 into derivative contracts to hedge their interest rate risk, 9 go from floating to fixed, et cetera? And what, you know -- 10 or will there be implications for that on a going forward 11 basis? 12 MR. SINGER: Yeah, I think to the extent that there 13 is a requirement for municipalities to post collateral on 14 future agreements, will basically bring that market to a 15 standstill. Municipalities -- most municipalities can't post 16 collateral. They don't have that type of flexibility. They 17 have no place to get the collateral, because they don't sit 18 on cash. It's very different from the corporate market. 19 MS. STARR: Right. 20 MR. SINGER: So that it just doesn't appear to be 21 workable. And you take some of your larger issuers that have 22 used derivatives extremely successfully, it's going to be 23 very expensive for them, because they're not going to have 24 the ability to use synthetics and they'll have to go into, at 25 times, more inefficient traditional market. It's going to 176 1 impose a huge cost on certain issuers. 2 COMMISSIONER WALTER: I'd like to swing back to the 3 pensions area for a moment and ask a little bit about the 4 actuarial process and what happens when the actuaries come 5 in. Who they interact with? Who has input into the 6 actuarial assumptions? Whether there are third party 7 advisors to the issuers that get involved in that process? 8 And how often the underlying assumptions that lead to those 9 actuarial conclusions are reviewed? 10 So if you could answer some or all of those, that 11 would be terrific. 12 MR. McINTIRE: Our actuarial process is actually 13 overseen by the State Legislature. We have a Pension Policy 14 Committee that is both legislative and executive in terms of 15 its participation. And the actuary actually reports directly 16 to that group. They do an annual actuarial evaluation, using 17 the assumptions that are determined, in part, on a statutory 18 basis. 19 Those have changed periodically over the last 10 to 20 12 years, largely in response to economic circumstances and 21 the need to do some additional smoothing, or to respond to 22 budgetary circumstances. Those are frequently then part of 23 the discussion in the State Legislature and by some of the 24 fiscal committees' review, oftentimes proposals from the 25 Governor to alter economic assumptions. 177 1 One of the components of the constitutional 2 amendment that I was suggesting, would not allow a change in 3 economic assumptions for at least -- for at least two 4 years -- it was to lower -- the effect was to lower the 5 contribution rate. But clearly, you know, I think that the 6 interaction that we have is actually very good. We invite 7 our State Actuary into some of our rating interviews and 8 certainly interact with them in making sure that all of the 9 information that we provide in our offering statement is 10 fully compliant with the actuary. 11 MR. HU: A question relating to this precise issue, 12 in terms of actuarial assumptions and so forth. You know, 13 there's a magic to 8 percent, or whatever, that they 14 sometimes use. You know, right now the real -- the treasury 15 rate, the risk free rate is so much lower, in effect, than 16 the 8 percent as adopted. If you assume a normal equity 17 premium, you would still come up with a number much lower 18 than the 8 percent. 19 And I was kind of curious for, you know, David, if 20 you had to pick a percentage, what kinds of numbers are you 21 talking about, in terms of expected return? 22 MR. CRANE: I haven't changed. I was on CalPERS' 23 board in 2005, 2006, and I said then, during a boom period, 24 it should not exceed 6.15 percent. 25 MR. HU: Right. 178 1 MR. CRANE: And I think that -- you know, pension 2 liabilities are very long-tailed. 3 MR. HU: Right. 4 MR. CRANE: You're talking about people working 25 5 years -- 6 MR. HU: Berkshire uses what, 5.75, 5.5? 7 MR. CRANE: No. Berkshire uses 6.9 for its 8 investment return assumption and 6.1 percent for its discount 9 rate. 10 MR. HU: Right. 11 MR. CRANE: Which is why I wanted to go back to 12 this actuarial discussion for one second. 13 The actuarial analysis, the actuarial discussion 14 only applies if the discount rate is linked to the investment 15 return assumption. Because the investment return assumption 16 is one of the discount -- is one of the actuarial discussion 17 items. If you de-link those things, which is what I'm saying 18 you should do, regardless of what GASB says -- 19 MR. HU: Right. 20 MR. CRANE. If you just do what FASB does, then the 21 discount rate is not an actuarial issue, it's what discount 22 rate should apply to the credit of that issuer? And all 23 these people that issue debt know what their discount rate 24 is. 25 So if you just follow FASB's rules and separate the 179 1 two things, then you can have a discount rate, which 2 represents the creditworthiness of that borrower. And then, 3 on the investment return assumption, you can have those 4 discussions all day long. Should it be 8 percent? You know, 5 maybe I'm wrong. Maybe it should be 8 percent. But it won't 6 have the same consequence. 7 MR. LANZAROTTA: And actually, David's got that 8 right. It's interesting that over the years, for whatever 9 reason, the accounting has followed the funding of a plan. 10 So you know, James talked about smoothing a little bit, maybe 11 as necessary to meet budgetary constraints, you know. But 12 you know, the liability on the books would probably be a 13 lot more comparable number, if in fact we applied what David 14 is suggesting to change those. 15 And again, there is a project that the GASB has 16 underway right now, they're receiving feedback. I assume 17 that there will be, at some point, an exposure draft, which 18 will provide even yet another opportunity for feedback. And 19 so we have a chance right now to try to shape the accounting 20 standards. 21 COMMISSIONER WALTER: I think we also have, I 22 believe in our audience, the Chief Actuary from CalPERS, who 23 might want to add a viewpoint on that, if whoever that is 24 could come up? 25 MR. MILLIGAN: Sure. I think the original question 180 1 had to do with how we set our assumptions and how often we 2 review the assumptions. We set -- there's a couple of 3 different sets of assumptions that are relevant here. All 4 the discussion has been about the discount rate and the 5 assumed rate of return. 6 But we also have to take a look at a bunch of 7 demographic assumptions. How long people are going to live? 8 You know, not just how long are they going to live, but the 9 pattern of mortality. It's important to know not just what 10 the average length of life is, but also, how many will die at 11 each age? Otherwise we'll get our numbers wrong. A bit of a 12 morbid subject. 13 We take a look at all of those assumptions on a 14 fairly regular basis. We do it every four years. I think 15 that's probably fairly typical, but it might vary between -- 16 different actuaries use different cycles. All of our 17 assumptions are set by our board, upon the recommendation of 18 the actuary. 19 So there is not a single, you know, the actuary 20 makes the assumption and that's it, it's done. There's a 21 chance for oversight. If I want to change our actuarial 22 assumptions, I have to present that to our board and allow 23 them the opportunity, in public session, to question me about 24 those assumptions and determine whether or not they feel that 25 I've got the right backing for making the assumption change. 181 1 We also take a look at economic assumptions, things 2 like inflation. A very important assumption for us, almost 3 as important as the discount rate itself, is the rate of 4 inflation. Because many of the benefits are linked to 5 inflation. And again, we review those on a fairly regular 6 basis. In particular, we review our rate of return 7 assumption and our discount rate every time we do an asset 8 liability study, which we do -- traditionally we've done that 9 every two to three years. We are looking at increasing the 10 frequency of those, because we're finding that things seem to 11 be changing fairly rapidly. 12 COMMISSIONER WALTER: Thank you. 13 David, I'm sorry, you had something you were about 14 to say? 15 MR. CRANE: Yeah. The only thing I was going to 16 say is, with respect to this GASB plan, whatever you want to 17 call it that's out there now for commentary, and there will 18 be plenty of comment on it. Just to give you an example of 19 the sausage making that's involved there. Their plan now for 20 crafting a new discount rate, which would involve circular 21 logic and all there rest -- we had CalPERS' actuary -- he 22 probably has the answer, but I'm guessing that using their 23 new analysis, that they're proposing, they would still be 24 over-funded in 1999. That should give you an example of how 25 this whole discount rate analysis is so flawed. 182 1 The discount rate should be simple. It's the 2 creditworthiness of the obligor. California knows -- you 3 know, our state has an obligation to a state employee, come 4 hell or high water, an unconditional obligation to pay. And 5 it's no different than their obligation to me as a general 6 obligation bond holder. The state knows its discount rate 7 for that. That's the way we should report these liabilities. 8 You don't need actuaries, you don't need life spans or 9 anything like that to properly report these liabilities. 10 That's the only point that I'm making. 11 MR. McINTIRE: I'd just like to point out that 12 there's no unanimity on that position. 13 COMMISSIONER WALTER: No, I know. You know, it's 14 interesting, I don't have a lot of expertise in this area, 15 but I figured that out. 16 MR. McINTIRE: Neither within the academic world or 17 within the applied world. And I think that, you know, our 18 standard for invest -- I sit on the State Investment Board, 19 our standard for investing those funds is the highest return 20 for a proven risk. And it strikes me that the taxpayers of 21 the state recognize, when they go into the voting booth, they 22 vote for me, they vote for somebody else, or they vote for an 23 initiative. They're not -- they're not necessarily expecting 24 risk-free government and risk-free entity. 25 You know, the government is going to be around for 183 1 a long time, and there some reason for governments actually 2 to invest these funds for a long time, to give taxpayers the 3 lowest cost pension programs that they can. And I would 4 argue that in many cases the effort to do this is really an 5 effort to substitute defined benefit -- defined contribution 6 plans for defined benefit plans. It's what's driving the 7 whole tax-exempt discount rate argument. 8 And I am of the belief that those would actually 9 cost governments more and result in our pension beneficiaries 10 getting plans where they may not make all the right choices, 11 as some states have found in backing away from their defined 12 contribution plans. So part of my concern about this whole 13 defined -- the whole effort to talk about what's the right 14 discount rate here, really needs to come back to the 15 question -- "Is the state going to be there long-term as an 16 employer and as an investor and can we make these 17 investments?" 18 COMMISSIONER WALTER: We actually do need to close, 19 because we've got two more panels and two more hours, but 20 David, we will give you 30 seconds. 21 MR. CRANE: Thank you. I just think we don't 22 disagree. The issue wasn't the investment return assumption. 23 And the state is there for a long time, and they will be 24 investing appropriately and they shouldn't invest in 25 risk-free rates. 184 1 The issue is, what's the size of the liabilities? 2 That doesn't change. That's not a reflection of how you 3 invest your capital. Your liabilities are what they are. 4 That's all. 5 COMMISSIONER WALTER: Well, I want to thank you all 6 for taking what might be considered to be a dry topic and 7 making it extremely lively. And we look forward to hearing 8 more from you on this, and I'm sure the GASB does, as well. 9 And hopefully the fact that Dodd-Frank has given the GASB a 10 new source of funding, will mean that it will have the 11 resources to consider all of your comments. 12 So we need to switch panels, and I want to offer up 13 my very sincere thanks to all of you. 14 (Off the record.) 15 COMMISSIONER WALTER: Martha, I think we're ready 16 to go when you are. And the natives will stop being 17 restless. 18 MS. HAINES: Okay. We're calling the seating to 19 order, guys. 20 MS. HAINES: All accountants know the importance of 21 robust internal controls for financial reporting by states 22 and local governments. However, the establishment of 23 policies and procedures for disclosures by issuers of 24 municipal securities are a relatively recent development. 25 Both the City of San Diego and the State of New Jersey have 185 1 implemented policies and procedures for disclosure, in 2 connection with the settlement of securities fraud actions 3 with the Securities and Exchange Commission, in each case 4 related to their pension funds ultimately. 5 Whether all municipal issuers should adopt policies 6 and procedures for disclosure is a subject of an ongoing 7 debate in the issuer community. We have asked four panelists 8 to share their thoughts with us today, concerning internal 9 financial and disclosure controls. Each of these panelists 10 has notable credentials, with a long involvement in the 11 municipal market, which I will summarize, but only briefly. 12 Ed Harrington is the General Manager of the San 13 Francisco Public Utilities Commission, overseeing the 14 regional utility that provides safe drinking water and 15 hydro-power and other renewable power resources for San 16 Francisco municipal customers, and collects and treats waste 17 water and storm water for the City of San Francisco. Mr. 18 Harrington is also a member of the Board of Trustees of the 19 Financial Accounting Foundation, which oversees the 20 activities of the GASB and the FASB. He was formerly the 21 Controller of San Francisco and President of the Government 22 Finance Officers Association. 23 Stan Keller is a partner with the law firm of 24 Edwards, Angel, Palmer & Dodge, and is an acknowledged expert 25 on corporate and securities laws. He recently completed a 186 1 three year engagement as an independent consultant for the 2 City of San Diego, pursuant to that city's settlement of a 3 securities fraud action with the SEC. 4 Michael Rufino is the Chief Operating Officer of 5 Member Regulation and Sales Practices of the Financial 6 Industry Regulatory Authority, which is the result of the 7 merger of the New York Stock Exchange and the NASD. He's 8 spent 22 years with FINRA serving on both the Member 9 Regulation and Financial Operations Division. 10 And Mark Blake has agreed to stay on for a second 11 panel. He is presently serving as Deputy City Attorney to 12 the City and County of San Francisco, but he was previously 13 the Chief Deputy City Attorney for Finance and Disclosure for 14 the City of San Diego when it was establishing its disclosure 15 policies and procedures. 16 I want to thank each of these panelists for 17 generously agreeing to share their thoughts and their time 18 with us today. 19 I'm going to ask each of you to provide 20 introductory remarks for maybe 10 minutes -- 5 or 10 21 minutes -- after which questions will be posed to the group 22 as a whole. And if you wish to indicate that you would like 23 to speak next, just take your name tag and put it like that. 24 I hope that you will all enter into a broad 25 discussion of this topic, but please do not feel inhibited 187 1 from raising related topics that you believe are important 2 for the Commission to understand. 3 Now, we're going to have to pass this mic up and 4 down. And be careful to speak into it, because I understand 5 these don't -- these do not have any amplification, only 6 these are working. I understand that people in the back were 7 having difficulty, on the last panel, hearing some of this. 8 My first question would be, what do you believe are 9 the key components for an effective system of disclosure 10 policies and procedures for a government issuer, and do they 11 vary substantially, depending on the size and the nature of 12 the government? 13 MR. KELLER: Did you want us to make the remarks 14 first? 15 MS. HAINES: I'm sorry. Yes. I apologize. 16 MR. KELLER: And in doing that, maybe we'll answer 17 that question. 18 MS. HAINES: Hopefully. I apologize. 19 MR. HARRINGTON: Could I have the microphone? 20 MS. HAINES: You could. 21 MR. HARRINGTON: Good afternoon. Thank you very 22 much for asking me to testify. I am Ed Harrington. As 23 Martha said, I'm General Manager of the SF Public Utilities 24 Commission, and the next time you come we'll make sure that 25 we have other than bottled water for you, since we're 188 1 assigned to discourage bottled water. We provide water 2 services to 2.5 million customers in four counties in the Bay 3 Area. 4 I was the President of GFOA, as Martha mentioned. 5 And while I am not speaking for GFOA, I think the comments 6 I'm making today are representative of GFOA and what the 7 finance officials would indicate. 8 And I also serve on the Financial Accounting 9 Foundation Board of Trustees, but clearly, I am not speaking 10 for FASB, GASB or the FAF. 11 Let's talk about internal controls. Unlike private 12 companies, our government structure is based on internal 13 control. The separation of powers into executive, 14 legislative and judiciary branches is fundamentally about 15 segregation of duties. We have many cases of overlapping 16 checks and balances with boards, commissions, councils, not 17 to mention ever-present internal and external auditors and 18 often bond and treasury oversight committees. 19 Internal controls are ingrained into the basics of 20 how governments do business. Anyone in government, who has 21 ever tried to purchase anything or hire someone, can tell you 22 that we sometimes give up efficiency and we replace that with 23 transparency, process and control. And we carry those 24 preventive and detective internal controls into how we 25 account for transactions, roll them together into financial 189 1 reports and disclose the information about financial 2 condition. 3 Auditors of state and local government financial 4 statements audit those internal controls so that they can 5 rely on information that comes from our accounting systems. 6 Those focused reviews of internal controls have increased 7 dramatically since the issuance of AICPA Statements of 8 Auditing Standards 104 to 111 in 2006. 9 On the GFOA side, to assist our members and the 10 public, GFOA issues numerous publications and best practices 11 addressing internal controls in government finance, and I 12 will list those in my written submission. But to give you a 13 flavor of the resources we provide, we have books and 14 pamphlets titled, "An Elected Official's Guide to Internal 15 Control and Fraud Prevention," "Evaluating Internal 16 Controls, a Local Government Manager's Guide," "Disclosure 17 Guidelines for State and Local Government," and "An Elected 18 Official's Guide to Debt Management." 19 Over the years we've also adopted many best 20 practice statements, including ones governing topics such as, 21 "Documentation of Accounting Policies and Procedures," 22 "Enhancing Management Involvement with Internal Controls," 23 "Improving the Timeliness of Financial Reporting and 24 Understanding Your Continuing Disclosure Responsibilities." 25 At the local level, at the SFPUC, we have 190 1 implemented multiple layers of review to ensure the timely 2 and accurate dissemination of financial information. It 3 begins with process narratives and adopted policies and 4 procedures that both document and govern our work. Our 5 internal processes also include tracking tables with multiple 6 reviews for compliance, along with source binders and 7 reference binders for documenting all of that. 8 Certain items, like cash management, are reviewed 9 on a daily basis, while other information, like outstanding 10 debt, is reviewed on a weekly or monthly basis. Some 11 disclosure information is dictated by 15(c)2-12, while other 12 disclosures required by our various indentures, letters of 13 credit agreements, financial guarantee agreements and the 14 like. Specific information, not required to be posted to 15 EMMA, is provided to interested parties through various 16 outlets. 17 In addition to basic disclosure items, such as our 18 annual continuing disclosure documents, budget and audited 19 financial statements, we produce quarterly reports on major 20 topics where we have significant debt, such as our 4.5 21 billion dollar water system rebuild. We report to numerous 22 public boards and committees, often mandated by our voter 23 approved charter, such as our Revenue Bond Oversight 24 Committee, and our Citizen Advisory Committees. 25 This does not mean we, or any agency, is perfect. 191 1 Even with the best internal controls, people can make 2 mistakes and people have intentionally misled investors and 3 others. While rare, this has happened in the government 4 sector and the SEC correctly has authority to go after fraud, 5 should that take place. 6 On the other hand, we do not believe the SEC needs 7 to have a larger role in municipal finance. Which brings me 8 to the larger issue of why you are here and why you are 9 holding these hearings. 10 From the grossly simplified view of newspaper 11 reports and speeches, it appears the SEC is concerned about 12 the financial health of state and local governments, 13 especially when it comes to pensions. And you believe making 14 us issue quarterly and more timely annual financial reports 15 will make the world safe for investors. 16 Let me talk about why that approach is flawed. 17 First, it assumes the only way investors get 18 information is through official financial statements. Have 19 any of you seen the most recent financial statement for the 20 State of California? Probably not. Has this stopped you 21 from having an opinion about its financial strength? I don't 22 think so, because every day you hear about it in newspapers 23 and various other media. And I think tomorrow California is 24 going to be issuing 500 billion dollars in debt and investors 25 will snap it up. 192 1 Governments have public hearings, websites, 2 Sunshine Laws and requirements and lots of ways to provide 3 financial information. The financial condition of private 4 companies is information that is not readily available to the 5 public and to investors, and that is why the SEC 6 appropriately requires publishing information in the 7 corporate world. Information about the financial condition 8 of local and state governments is constantly available to the 9 public and to investors. 10 The second problem in your assumption is that the 11 most important financial publication for governments is the 12 financial statements. In most cases it is actually the 13 budget. That is the jurisdiction's largest forward looking 14 policy document. 15 There are a couple hundred press stories a year 16 about San Francisco's financial health, none of them relate 17 to our financial statements, all of them relate to our 18 budget. Open public budget hearings and documents tell an 19 investor what the projected health of the state and local 20 government is expected to be, up to a year before any 21 quarterly report you could require might be issued. Unlike 22 the corporate world, these annual budget documents are 23 important because they both publicly -- they are both 24 publicly available and legally controlling. 25 San Francisco also adopts a five-year financial 193 1 plan that includes forecasts of pension payments and other 2 obligations, and a 10-year capital plan clearly giving 3 investors and others advanced notice of our financial health. 4 The third issue seems to be a fear of a dramatic 5 unforeseen turnaround in the financial strength of a public 6 entity. It doesn't really happen that way. Most governments 7 are like aircraft carriers, it takes us a long time to turn. 8 In our case at the SFPUC, investors buy our bonds. 9 And we've sold over a billion dollars in the last three 10 months, because we are selling an essential service 11 commodity, water, to a geographically diverse area, which 12 includes relatively affluent customers and we have relatively 13 low to moderate rates. We have demonstrated the willingness 14 to raise those rates when needed. None of those things are 15 likely to change at any fast clip. And if there is a large 16 immediate change in our circumstances, you already require us 17 to make that disclosure under our obligation under 15(c)2-12. 18 The fourth issue relates to your concern about 19 investors being protected, as if that is not a primary 20 concern of us in government. When the markets, you 21 regulated -- you regulate -- failed over the last several 22 years, investors rushed to our market, a classic flight to 23 quality, because governments rarely tend to go bankrupt, 24 default or stop paying our debts. It is so rare that people 25 who can't even pronounce Vallejo, know went bankrupt last 194 1 year, and Vallejo is still paying its debt. Even though San 2 Diego's disclosure problems happened in 2002-2003, it is 3 still your poster child because so little has happened since 4 then. And I don't believe any investor in -- for San Diego 5 missed a payment. 6 There are over 87,000 government entities in the 7 United States. In California, over 800 separate government 8 entities have issued debt this year alone. And with all this 9 activity, I can count on one hand the number of investment 10 grade government bonds that have failed to pay investors. 11 We know we have to rely on capital markets to 12 continue to maintain our assets. So we prioritize debt 13 payments and we make them. It would be great if you could 14 say that about the industries you currently regulate. 15 Finally, the problem in local government right now 16 revolves around a lack of money to finance pension and other 17 costs. Clearly part of that problem stems from the decisions 18 that we in state and local government have made. The other 19 reason our pension funding status has fallen dramatically and 20 our revenues are falling short, comes right back to both 21 regulatory and market failures. Because of the failure of 22 the capital markets that you and your sister agencies already 23 regulate, most of our pension plans have lost as much as 30 24 percent of their value, causing much of our pension crunch. 25 Our general fund taxes and revenues are down because of a 195 1 failure of our market economies. 2 If you and your sister agencies could instill the 3 same confidence in the capital markets that investors 4 apparently have now under existing checks and balances in the 5 muni markets, we would all be better off. I would encourage 6 you to focus your value added abilities to the private 7 sector, which has more to benefit, and less on an already 8 efficient government market, which has an almost perfect 9 record of taking care of investors. 10 Thank you very much. 11 MR. KELLER: That's a tough act to follow. And I'm 12 not going to try to rebut it, because I wouldn't. But let me 13 try to give a perspective from at least a different -- a 14 somewhat different vantage point, which may not be as 15 relevant, but has some relevancy. 16 As some of you here know, my background is as a 17 corporate and securities lawyer with some involvement, 18 through the years, in municipal securities and most recently 19 with my role with the City of San Diego. And that causes me 20 to kind of look at things from the perspective and with base 21 of experience from the private corporate sector, but very 22 mindful of the differences in governmental agent bodies. And 23 the real challenge to translate what may make sense and may 24 work, and may be beneficial in the private and corporate 25 setting to the governmental agency setting. And indeed, I 196 1 can tell you that was one -- one of my challenges in my role 2 in San Diego. As we go, I'll tell you what my other 3 challenge was. I won't tell you about some others that Mark 4 knows well. 5 It seems to me, one of the key lessons coming out 6 of the experience with Sarbanes-Oxley and the implementation 7 of Sarbanes-Oxley, is that disclosure controls and 8 procedures, and internal controls, particularly over 9 financial reporting, along with a focus on the governmental 10 structures itself, does make a difference. I think that's 11 been demonstrated at a practical and pragmatic level. I 12 think it's been verified in the academic studies. 13 When you apply a discipline to the whole subject of 14 disclosure and financial reporting, with a focus on 15 communication and communication to investors, I agree with 16 that. Government has built within it a great deal of checks 17 and balances and controls, as well as some dysfunctionality 18 as a result. And that was my other second major challenge in 19 San Diego, which was getting it to work. You can have so 20 many checks and balances and controls put in place that 21 you're totally self-applied and can't get anything done or 22 accomplished. So it really is right-sizing it. 23 But I think the experience from Sarbanes-Oxley is 24 that having a disciplined approach to disclosure controls and 25 procedures, and looking at more broadly internal controls, 197 1 governmental structures, really does help to ensure improved 2 and timely disclosure and financial reporting. 3 I think the question -- there are several 4 questions, but one -- the threshold question is then, how do 5 you translate these lessons -- or to maybe stepping back -- 6 to what extent are the lessons that we learned as a result of 7 the Sarbanes-Oxley experience, which go back to the earlier 8 financial crisis and a different kind, Enron, WorldCom, 9 Adelphi and the like -- to what extent are those lessons 10 translatable to the municipal sector? And how do you go 11 about translating them? 12 We've seen a few SEC enforcement actions. We've 13 seen a number of speeches and other pronouncements by the 14 SEC, focusing on deficiencies that have occurred. So I think 15 there are things to be done. And I think the major benefit 16 is just beginning the process, if you will, of having people 17 focus on how they approach disclosure, how they approach 18 financial reporting, how can they improve what they're doing, 19 as the benefit of a process. And I'll come back to what are 20 ways of doing that. 21 Let me take San Diego as an example, because I 22 think what San Diego did, was forced to do, but embraced it, 23 I think in quite a zealous way, was almost to provide a menu 24 of choices and alternatives. 25 I take San Diego as an illustration, as an example, 198 1 but not as a model, because I think it is unique to San 2 Diego's situation. It doesn't necessarily translate to other 3 governmental bodies. And each municipal body, governmental 4 body, needs to focus on the issue based upon its own 5 situation and its own circumstances. 6 Just clicking off -- and I'm not going to go into 7 any detail on this -- if people want to know more, they can 8 read about it in my third and final report that I delivered 9 at the end of my tenure with the City of San Diego. But to 10 just check through a few things. 11 One, there was adoption of written disclosure 12 controls and procedures, so that there was a road map. It 13 included the formation of a "Disclosure Practices Working 14 Group," that we in the corporate world know of as the 15 "Disclosure Committee." And just a word about that. I 16 think when one thinks about a Disclosure Committee, it's not 17 so much check and balance, but rather at an operational level 18 making sure that there's a process for bringing the right 19 people into the room to focus on what the issues are, to 20 have, if you will, the breadth and to come to grips with 21 those issues. And it can serve as something of a check and 22 balance. 23 A creation of an Audit Committee at the, in this 24 case, at the legislative level, but with citizens on the 25 committee who are financial experts, in order to provide 199 1 oversight. In the private corporate setting we have 2 independent Boards of Directors and they have the Audit 3 Committee mandated by Sarbanes-Oxley. It doesn't translate 4 as readily into the municipal sector until you have to look 5 at your own structure and see what makes -- what makes sense. 6 And how do you create a body that can provide 7 effective and informed oversight over management's efforts 8 and decisions for the checks and balances? 9 A process and a written process for the review of 10 the annual financial statements and the related disclosure. 11 Certification requirements by key officials. 12 Establishment of an internal -- independent 13 internal audit function. In the case of San Diego, creation 14 of a Legislative Budget Office, so that you had checks and 15 balances at the different branches of government. 16 Initiation of internal controls over the financial 17 reporting system, with a focus on, if you will, the systems 18 in place to help support the quality of disclosure. 19 A training program, that was quite robust and 20 having qualified both internal advisors and personnel, and 21 external advisors to help in the process. 22 And finally -- and this happened to be an issue in 23 San Diego, not necessarily elsewhere, but people should think 24 about -- what's their governmental structure? How does it 25 work? And in particular, is there clear responsibility? Is 200 1 there focused accountability? And is there the requisite 2 expertise to do the job as a result of that structure? 3 As I said, this isn't the model that everybody 4 should adopt. Indeed, one has to think of layered approaches 5 and different kinds of issuers, different size issuers, the 6 differences in frequency of going to market. But to me, 7 there's no reason why -- I'll say -- "every municipal 8 issuer," shouldn't at least be thinking about what's their 9 process. And that doesn't cost a lot of money. I don't 10 think we're talking about a big expense. How robust it will 11 be, will vary depending upon size, frequency to market, 12 particular issues and problems. 13 It seems to me the objective is to get municipal 14 issuers, or at least -- and certainly at least the larger 15 ones -- to focus on what their control systems and processes 16 are, and to adapt to what really works for them. 17 Which then leads me to conclude, by asking the 18 question -- "Okay, what can or should the SEC do about it" -- 19 if that indeed is a desirable objective to build, if you 20 will, that superstructure to help ensure quality and timely 21 disclosure. 22 Let me get to the punch-line on that. While there 23 are number of possibilities, I think the key, certainly at 24 this point in the process, is to encourage, cajole, 25 facilitate, as opposed to being prescriptive. I don't think 201 1 that, certainly at a substantive level, I don't think it's as 2 easy in the governmental sector, because of the variability, 3 to be prescriptive, because one size doesn't fit all. 4 Unlike, I think, it's easier in the public sector. 5 First, there's the bully pulpit and the Commission 6 shouldn't underestimate its power using the bully pulpit. 7 People do listen. And there are lots of ways of doing it, 8 either with these hearings, there are roundtables, there are 9 speeches, there are interpretive releases, there are advisory 10 committees -- I think there are a range of alternatives to 11 get across the message and help people. 12 I see Meredith isn't there. I was going to 13 compliment her on the MD&A release that I read on the plane. 14 Here's an example of an interpretive release that really 15 helps and provides guidance. 16 Second, of course there are enforcement actions. 17 Not the best vehicle, but when justified and necessary they 18 send a message. I think the most meaningful thing about the 19 New Jersey enforcement action is the detailed level at which 20 it gets into the deficiencies, in the SEC's views, of the 21 pension disclosure. And anybody reading that will take away, 22 I think, some lessons about how they should think about that 23 disclosure. 24 Just looking at the existing regulatory regime, 25 based on 15(c)2-12, we'll call it the "back door approach" of 202 1 regulating underwriters in order to regulate the municipal 2 sector. I think as one possibility is, as the Commission did 3 with continuing disclosure, an interpretive release pointing 4 out, it seems to me, follows naturally to what reactions are. 5 That, you know, one could focus part of the responsibility of 6 underwriters, in order to be satisfied as to the key 7 representations of issuers, is to have some sense of what the 8 issuers's control environment is. To ask those questions as 9 part of the step in the process, which in turn will get the 10 issuers to focus on -- "Well, what in fact do we do?" "How 11 do we make the case for what our control environment is?" 12 And if we really can't make that case, maybe we'd better 13 think about improving it. 14 You could take the added step, if something more 15 formal is necessary, of building that into the 15(c)2-12 16 requirements, but I'm not sure if that's necessary. Also, 17 reading the recent release from the MSRB, one could also see 18 the possibility of having a voluntary commitment process on 19 the MSRB Emmet system, just like the continuous reporting of 20 commitment where I guess you get a gold star if you commit to 21 do that. And you can, there, commit somewhat more formally 22 to provide an annual report, maybe even an assessment of the 23 adequacy of your internal controls. That would be a 24 voluntary approach. 25 I mean finally, there's developing a new system, 203 1 which would be the legislative approach to direct regulation. 2 I don't see that that is necessary in order to achieve the 3 objectives, I think, of improving the quality of the 4 disclosure controls and procedures, and internal controls and 5 processes of municipal issuers. 6 So I'll stop with that. 7 MR. RUFINO: Good afternoon. I am Michael Rufino, 8 Senior Vice President in FINRA's Member Regulation 9 Department, and on behalf of FINRA, I'd like to thank Elisse 10 Walter for the opportunity to be here today and discuss 11 FINRA's role in the municipal securities market. 12 As an independent regulator, subject to SEC 13 oversight, FINRA regulates all U.S. broker-dealers that deal 14 with the public. We license firms and individuals to work in 15 the industry, and sanction those who violate the law. We 16 adopt and enforce rules to protect investors in the financial 17 markets, conduct examinations of broker-dealers and inform 18 and educate investors and maintain industry utilities. 19 When Congress established the MSRB in 1975, it 20 granted the organization broad rule-making authority. 21 Examination for compliance with MSRB rules and enforcement 22 is, however, vested with FINRA for municipal securities 23 dealers that are broker-dealers. The vast majority of 24 municipal securities dealers are FINRA regulated firms. In a 25 typical month, FINRA regulated firms effect about 99 percent 204 1 of all municipal transactions reported to the MSRB. 2 FINRA inspects broker-dealers for compliance with 3 the Federal Securities Laws, FINRA's own rules and the rules 4 of the MSRB. It has no authority over issuers of municipal 5 securities. We maintain regular contact with the MSRB, to 6 ensure that the allocation of responsibilities between the 7 two organizations is carried out efficiently and in the 8 public interest. 9 MSRB staffing -- excuse me -- MSRB staff assist in 10 training our examiners, as needed, regarding MSRB rules and 11 requirements. Our validation and enforcement programs 12 emphasize compliance with MSRB rules. FINRA uses municipal 13 bond transaction data reported to the MSRB, to create an 14 audit trail of market activity. Our market surveillance 15 systems uses data to detect potential problems. 16 Examiners review data that is available through 17 FINRA and MSRB systems and assess a firm's books and records. 18 Examiners also check whether a firm's records support the 19 regulatory filings and trade reports. 20 From January 1st, 2009 through September 8th of 21 this year, FINRA settled 115 formal disciplinary actions 22 involving violations of MSRB rules by firms and individuals. 23 In June, 2009, in light of increasing retail investment in 24 municipal securities and dislocation in the fixed income 25 markets beginning in 2008, FINRA announced an initiative to 205 1 protect muni bond investors. 2 In 2009, we undertook three sweep examinations of 3 municipal securities activities, the findings of which are 4 still being developed. We issued a regulatory notice in June 5 of 2009, that reminded firms of their obligation to disclose 6 material information to customers, including changes in the 7 financial condition of the issuing municipality as well as 8 their obligations regarding the suitability of 9 recommendations and supervision of municipal securities 10 activities. 11 In addition, FINRA and the MSRB issued an investor 12 alert called, "Municipal Bonds Staying on the Safe Side of 13 the Street in Rough Times," as well as an online muni bond 14 checklist, which provides a step by step guide to help 15 investors avoid the most common pitfalls of muni bond 16 investing. 17 In conducting our examinations, an evaluation of 18 internal controls is part of the process. SEC Rule 15(c)2-12 19 imposes disclosure obligations on municipal securities 20 dealers in both initial offerings and the secondary market. 21 We expect firms to review disclosures made available through 22 EMMA and other established industry sources, and take such 23 disclosures into account in their suitability and pricing 24 determinations. 25 The MSRB has interpreted its Rule G 17 to require a 206 1 dealer to disclose to its customers, at or prior to sale, all 2 material facts about the transaction known by the dealer, as 3 well as material facts about the securities that are 4 reasonably accessible to the market. 5 FINRA examinations review whether a dealer has 6 fulfilled its disclosure obligations. This includes whether 7 customers receive the issuer's official statement during the 8 primary offering disclosure period, and whether they were 9 informed of all material information at the time of the 10 transaction. We also review the adequacy of a dealer's 11 policies and procedures regarding disclosure. 12 Although we continue to evaluate the results of our 13 sweeps, we have identified concerns that firms may not 14 completely understand their obligations with respect to the 15 disclosure of material information to customers at the time 16 of trade. To help adjust these concerns, FINRA and the MSRB 17 yesterday issued a joint notice regarding secondary market 18 transactions in municipal securities. The notice describes 19 the SEC's recent amendments to Rule 15(c)2-12, which, among 20 other things, require a municipal securities dealer to obtain 21 a broader range of issuer continuing disclosure commitments. 22 The notice reminds firms that sell municipal securities, to 23 review and, if necessary, update their procedures to reflect 24 the amendments. The notice also reminds firms of their 25 obligations, under MSRB rules, with regard to secondary 207 1 market transactions. 2 A number of other MSRB rules provide substantive 3 investor protection, including suitability and fair pricing 4 requirements. In particular, Rule G 27 requires firms to 5 supervise their municipal securities business and to ensure 6 that they have adequate policies and procedures to monitor 7 the effectiveness of their supervisory systems. The rule 8 also requires that a firm's supervisory procedures provide 9 for regular and frequent review and approval by a designated 10 principal of customer accounts, introduced or carried by the 11 dealer, where its transactions in municipal securities are 12 effected. 13 In conclusion, FINRA comprehensively examines 14 municipal securities dealers for compliance with MSRB rules 15 and expects firms to fully understand the bonds they sell, 16 whether in a primary offering or a secondary market 17 transaction. 18 Thank you once again for the opportunity to be 19 heard today. And I'd be pleased to answer any questions that 20 you may have. 21 MS. HAINES: Mark, do you want to make -- 22 MR. BLAKE: I'll be brief. 23 MS. HAINES: Okay. 24 MR. BLAKE: I think Stan covered most of the things 25 that I want to cover. 208 1 In the establishment of the disclosure policies and 2 procedures for San Diego, I think it's beneficial in that 3 what it does -- and it really does focus on your disclosure 4 practices -- but what it does is, it really focuses you on 5 your -- on the "What." "What are your chief security 6 documents for which you have security liability?" "Who" -- 7 "Who is responsible for those documents?" It provides a set 8 of certifications that people have to execute before those 9 documents are approved by the governing board. Establishes 10 procedures for training. And finally, it establishes a 11 hotline within city government for people to report up, if 12 they think disclosure is misleading. And then it sets a 13 whole process for dealing with that. 14 So it's not one-size fits all, but I do think that 15 it's a useful practice to go through. So even after my stint 16 at San Diego, coming to the City of San Francisco, we have 17 not yet adopted a robust set of policies and procedures, 18 because there is a very rigorous process that goes on, albeit 19 unwritten process. But we have debt policies at the city. 20 We have investment policies. So these are -- this would just 21 be an adjunct to those policies. So it is a useful process 22 to go through. Certainly it's not one-size fits all. And so 23 that would be my take at the moment. 24 MS. HAINES: Well, I think Mark has just answered 25 what was my first question. 209 1 Stan, in your -- one of your reports, at any rate, 2 about San Diego, you talked about how thorough and extensive 3 their new standards were on policies and procedures. But 4 I've heard an estimate that the process of preparing, 5 reviewing and verifying a disclosure statement in San Diego 6 could take as long as nine months. And while that may be 7 appropriate for very large issuers, who essentially got a 8 shelf registration system going, can you give us suggestions 9 for how a smaller issuer could adapt to that? And it's not 10 just Mark -- any of you -- because I think this is a major 11 issue in the muni market, where so many of the issuers are 12 certainly relatively small compared to San Diego. 13 MR. BLAKE: I think that estimate was given by one 14 of your earlier panelist, John McNally, Disclosure Counsel 15 for the City -- to the City of San Diego. 16 MS. HAINES: I think it was. 17 MR. BLAKE: And one, I don't know if that in fact 18 is the case. I do think there is a challenge, as I said, to 19 right-sizing the process, so it works. So one of the 20 recommendations -- I'll call it "suggestions" -- the city had 21 to follow my recommendations, so I was careful what I 22 recommended and what I suggested. One of my suggestions was 23 that -- and I think this is true for larger issuers -- really 24 think in the shelf registration context, think about ongoing 25 disclosure. Be ready by having ongoing disclosure, by having 210 1 your robust annual process -- and that means financial 2 statements, it means MD&A, it means fulsome letter of 3 transmittals, so you're telling people about the municipality 4 through the eyes of the municipal's management. And then 5 think in terms of the periodic updates that may be necessary, 6 so that you're ready to go to market. 7 It's really a big cost benefit and efficiency to 8 the issuer having control of when they can hit the market and 9 time it, and not be told by their lawyers, accountants, 10 internal disclosure people -- "Oh, no, we can't go to market 11 for six months because we haven't done the work." So I think 12 that's part of it. 13 I think it's a focus more on the larger issuers. 14 The smaller issuers, they don't need as "robust," if you 15 will, and I hate to use that word again, but it fits. They 16 don't need as extensive and detailed a process and 17 procedures, but they can have something that works for them. 18 COMMISSIONER WALTER: Is it possible -- and here I 19 direct this to all of you -- is it necessary, in setting up 20 the proper kinds of internal controls, the ones that are 21 appropriate for the particular entity, to make sure that the 22 people at the particular body focus on items beyond credit 23 risk? I have been struck throughout the day how much time 24 all of us spend talking about the risk of default. And in a 25 lot of ways, that's not the primary risk, in many ways, that 211 1 one really needs to worry about. I think that historically, 2 since the municipal markets have tended to have been, in the 3 past, buy and hold markets, that was the focal point of 4 intention. That's not so much true anymore. If you look at 5 the data, there were over 10 million secondary sales in 2009. 6 And I don't know what your experience is. It may 7 be that changes in the marketplace have taken care of it 8 themselves, but whether in setting up internal controls 9 people have to be guided to focus on other types of risk that 10 will affect pricing, will affect how the secondary market 11 operates, rather than just credit risk. Do you have any 12 reaction to that? 13 MR. KELLER: Let me begin by saying, I do think 14 part of the disclosure process, that it has to become 15 imbedded in the DNA for regular issuers, is the stepping back 16 and thinking, "What are our risks?" And thinking about it 17 broadly. And not just the rote, "Here are the financial 18 statements and we'll explain the financial statements," but 19 moving the disclosure process further from the numbers into 20 an understanding of what are the -- both what those numbers 21 mean and what are the risks imbedded in them, which requires 22 predictive information. And you have talked a lot about 23 pension funding, that is the pension and retiree healthcare 24 benefits, the thousand pound gorilla that people need to come 25 to grips with. And that's where the biggest problem is. 212 1 But more broadly, okay, what are the challenges 2 that we face as a governmental body? You know, there was a 3 period in San Diego, for example, where it was a lousy 4 market, which affects the tax revenue base. And just 5 thinking about what your role, as a community, how does that 6 affect your perception in the marketplace and the risk? I 7 think that's difficult. When you have an enterprise, it is 8 more like the corporate enterprise risks, as you think about 9 it. What are the operating and business risks? 10 COMMISSIONER WALTER: But I guess the one thing I 11 would ask is, you mentioned a repeat issuer. But suppose it 12 was just a one time issuer. There certainly are risks, 13 interest rate risk and the like, that will affect your public 14 investors and investors in the marketplace. I'm wondering 15 how much the issuers focus on whether they need to be 16 encouraged to focus more on risks beyond basic default risk, 17 in terms of -- and even in the absence of another offering 18 coming up, I think people tend to focus more when they're 19 going into the primary market, than they do when they just 20 have securities outstanding. Okay. 21 MR. HARRINGTON: If I could comment on that? I 22 think that, again going with the "one-size does not fit all" 23 discussion that's happened a bit today, at least my estimate 24 would be that people that -- whose bonds are out there, or 25 debt is out there on the secondary market, tend to be larger 213 1 issuers. I don't think a Mosquito Abatement District is 2 going to have a robust enough -- big enough name, to have 3 somebody trading on it a lot. 4 And so yes, in fact, those people that are large, 5 repeat issuers, should have regular and open kinds of 6 information about their financial disclosure items always 7 available to people. I don't think that those that issue one 8 item of debt every once in awhile are probably people who 9 need to keep all that information going. And there is a cost 10 to it, there's been the cost benefit discussion a few times. 11 It's not so much that we can't do it, or are 12 unwilling to do it. It really is, you know -- Oakland laid 13 off police this year, San Jose laid off firefighters this 14 year. Going to our Board of Supervisors or City Councils and 15 saying -- "You need to layoff a nurse so we can hire an 16 accountant to issue a report that we don't know if anyone is 17 going to use," is really a hard -- a hard discussion to have. 18 And that's our world. 19 And so if in fact the investment community requires 20 it, we will do it. But to do it, because it feels good or 21 sounds good in the abstract, is really of little interest. 22 And I think that's the "one-size does not fit all," and that, 23 I think, goes to the "not often issuer" discussion. 24 COMMISSIONER WALTER: Right. I can understand that 25 with respect to information that is outside the issuer's 214 1 realm. You had said, when you talked before, that issuers 2 are continually putting out information, and perhaps not 3 audited financial statements. And I think you'll find our 4 focus is not just on audited financial statements but on 5 financial information. And in fact, we're very interested in 6 understanding better what the flow of information is. But 7 there are quite a number of issuers, we are told, that don't 8 put out publicly the financial information they in fact have. 9 They don't have to create anything. It's information that 10 they otherwise have available. 11 Are there steps you think we can take to encourage 12 people to do that, which was the very low cost item -- I 13 understand it has some liability aspects associated with it, 14 but how do we encourage more issuers -- for the benefit of 15 those people who are holding their securities, who may want 16 to trade them, may want to sell them -- to at least put what 17 they have out into the public? 18 MR. HARRINGTON: I think you've taken the first 19 step with EMMA. I gather when it goes fully functional, 20 later on this year, you can provide links from EMMA to your 21 regular disclosures that you have within your city and 22 county, and your regular financial reports. And so making 23 those things available through EMMA, and having people start 24 to use those -- it's not exactly the bully pulpit -- but it 25 goes a long way towards saying, "Best practice organizations 215 1 are providing this information, very easily accessible at low 2 cost through EMMA, and you should be doing that." 3 COMMISSIONER WALTER: But I'm actually talking 4 about -- and maybe my -- maybe the information we've been 5 given isn't correct -- of people who are not putting out the 6 information at all, not making it public on websites, now 7 that we have the technology available to do that, in 8 apparently an easy way? 9 MR. HARRINGTON: So the information is available to 10 them internally but not given out to the public? 11 COMMISSIONER WALTER: Correct, correct. And that's 12 what I think we're looking for, ways to incentivize people to 13 making that information available publicly. 14 MR. HARRINGTON: Yeah, they're not in California. 15 COMMISSIONER WALTER: They may not be, I don't 16 know. 17 MR. HARRINGTON: Because our Sunshine Rules are so 18 incredible that if we sign a piece of paper it is public 19 immediately. And I think that is the case in much of the 20 United States, is that Sunshine Rules require any data that's 21 given out at all to anyone, must be given to the public. It 22 may not be as obviously produced and openly put on the 23 websites, but it is publicly available. I'm not sure if 24 other folks have a different expectation. 25 MR. KELLER: No, I think that's right. If you're 216 1 thinking in the corporate context of formal disclosures -- 2 COMMISSIONER WALTER: No, I'm not. I'm precisely 3 not. 4 MR. KELLER: This is -- that -- the information on 5 governmental bodies tends to be out there, not in necessarily 6 the totally formatted way or the like. 7 COMMISSIONER WALTER: There's a lot -- there's a 8 lot of dispute about that. I mean it sounds like, from Ed's 9 perspective and perhaps that's true in California, but we are 10 told repeatedly there are a lot of municipal issuers that do 11 not make this information available. And having it available 12 simply upon request, I think is very different than having it 13 put out there publicly, because the average municipal 14 investor isn't going to know what information they're looking 15 for. 16 MR. KELLER: You also, I think, highlighted 17 something, which is the liability concern, in other words, 18 liability as an impediment. But there really is a focus on, 19 okay, what is information that is designed for investors and 20 therefore subject to, you know, potential liability. And 21 what is other information that tends to be put out in the 22 ordinary course, and may not, under Commission 23 interpretations, rise to that level of information being 24 directed at investors. Which gets you into the control 25 process and who has accountability and responsibility for 217 1 that information. 2 COMMISSIONER WALTER: Right. But it also gets you 3 into the idea -- I understand full well, and I think it is 4 quite a good point that there is a very important cost 5 benefit analysis to be raised, say for an issuer that's, you 6 know, once every three years, you know, small numbers. I 7 understand that completely. But then to say, "I'm not going 8 to put out publicly the information I have, because I'm 9 afraid of liability. Put your investors in a position where 10 they don't have information on which to formulate, you know, 11 buy, hold, sell decisions." So I think in some ways you have 12 to make a choice. I mean if it's information that is readily 13 available, making it accessible is something I think we would 14 want to encourage. 15 I'm not saying we'll go so far as to recommend 16 mandating it, but I think it's something to encourage people 17 to do. 18 MR. RUFINO: I just think from a regulator's 19 perspective, if you're going to make recommendations to 20 customers, which is under G 19, then the more information you 21 have, how you really, truly are making that recommendation to 22 a customer not having that information -- it's almost a 23 factor that you have to seriously consider before you make 24 that recommendation at all. And I think to your point is, 25 that information should be available. I think that's an 218 1 important factor that brokers should take into consideration 2 then on the ultimate sale to the customer. Because a lot of 3 these sales are recommended. I mean most customers that are 4 calling their broker are not saying, "I want XX bond." 5 They're going to say, "I'm looking for, you know, a 6 California, you know, Water Works Bond with a yield of X," or 7 you know -- and I think that's what -- and they'll kind of 8 search their database for it. 9 So I think a lot of it is a recommended market and 10 that information would be quite, you know, quite helpful. 11 MR. HARRINGTON: But again, I would not 12 underestimate the power of the press and just generally 13 available information. I really think that if you're talking 14 about the people who issue data on any regular basis, and 15 those that have their debt in the secondary market, by and 16 large these are people who are covered by a lot of different 17 aspects of getting information out. 18 Someone who invests in a school district in 19 California, and is surprised they have financial problems, 20 hasn't read a newspaper in five years in California. They 21 don't need the financial statements from that school 22 district. They know most of the money comes from the state. 23 And every school district is in financial trouble. 24 So I mean there's just generally available 25 information. Whether that individual district, small or 219 1 large, has issued something -- there's just a huge amount of 2 financial information and general information about local and 3 state governments. 4 MR. HU: Commissioner Walter has, quite correctly, 5 emphasized the pluses and minuses of the corporate metaphor, 6 in terms of, you know, how information is provided to 7 investors and things like that. 8 And Stan had mentioned Sarbanes-Oxley, on the 9 corporate side, in terms of the internal controls and the 10 like here. And I was curious, and it's kind of -- I was 11 thinking that in terms of the Sarbanes-Oxley and the concerns 12 over application of Sarbanes-Oxley to small companies, all 13 right, the controversy over that. In a sense, there may be a 14 related issue here, because throughout the day we've been 15 told that, "Hey, some of these smaller issuers may not really 16 have the sophistication, the internal controls, the training, 17 to really understand what they're doing and so forth." And 18 yet we also worry about imposing standards that -- across the 19 board -- that may be relatively really burdensome on smaller 20 issuers. And I was curious, in terms of this internal 21 controls issue, you know, how you navigate this thing, in 22 terms of dealing with internal controls in terms of small 23 issuers, and yet not in a sense of being so burdensome as to 24 perhaps driving them out of the market and making them really 25 not competitive? 220 1 MR. HARRINGTON: There is no easy answer. I mean 2 you're right to consider it. It is exactly what FAF is going 3 through now with private companies as opposed to large public 4 companies. It is exactly what GASB has dealt with before, in 5 terms of rolling out certain requirements and making them 6 rollout later for smaller governments. The ones that are the 7 most risk, in my mind, tend to be the ones who have the least 8 stability to make the kinds of extra disclosures you would 9 want, and that's just a fact of life. 10 I think the issue there is, investors need -- 11 investors need to get that and need to be aware of that. And 12 if they choose to invest in those smaller issuers, they need 13 to deal with that in some fashion. 14 COMMISSIONER WALTER: It is -- is one potential 15 answer to it as perhaps in the original offering process, in 16 terms of issuers actually making some disclosures about their 17 internal capabilities? And I'm sure some do and some don't. 18 MR. HU: Like identifying the financial literate 19 person, in effect, on the audit committees, somebody 20 corresponding to that? 21 MR. HARRINGTON: That's a thought. 22 MR. KELLER: You know, in the corporate world, the 23 Commission has scaled requirements. The Commission has also 24 stepped back and looked on a more macro basis and asked, 25 "Where is the bulk of the trading?" "How much do the largest 221 1 issuers account for?" And then made decisions that, "Okay, 2 we can't necessarily deal with each individual issue, but if 3 we look at the size of the market and deal with the largest 4 part of that market, then from at least a macro-economic 5 view, we've addressed those issues and dealt with some of the 6 cost benefit analysis." 7 Yes, the smallest issuers are the most risky, 8 because they have the least resources. But on the other 9 hand, they have the least impact, if you will, on the 10 marketplace. And so you, you know, that's something the 11 Commission has taken into account, and I think it applies 12 equally here. 13 When we're talking about internal controls, I guess 14 at least what I've suggested is -- and I know Martha once 15 asked me, "Well, where would your cut-off be?" All I can 16 tell you is that San Diego is what, the 7th, 8th, largest, 17 9th largest municipality, so anybody larger could fit into 18 that. And you can do the same with large private entities, 19 where you have this greater expectation for what they need to 20 do, because they have a bigger impact. There's more 21 involved, more at stake. And you expect them to have greater 22 resources. And then it would scale down from there. 23 But I don't think there's any reason that even the 24 smallest issuer shouldn't at least be thinking about how they 25 go about the process. And on the corporate side, we've 222 1 always said, "Yes, they're small issuers, but there is a 2 price to access the public capital markets." It doesn't 3 quite translate, because the alternatives aren't as easily 4 there for the municipal issuer, the smaller issuers, so you 5 have to make some leeway. But yes, there is some cost of 6 getting the benefit of accessing the capital markets. And 7 then the question is, "What's that cost?" And "How can we 8 minimize it?" But still have effective processes that 9 protect investors. 10 MR. RUFINO: And if I just may analogize, I mean we 11 have 4,800 firm broker-dealers at FINRA, whereby they're a 12 very diverse type of membership, meaning very small members 13 to large global, you know, investment bankers. Several years 14 ago we put out a rule requiring the testing and verification 15 of internal controls for all firms, regardless of size, which 16 requires an annual report by those firms. And we felt that 17 it was an important aspect of bringing it to the forefront of 18 the importance of internal controls and the testing and 19 verification of it. And I just think that in finality, where 20 we don't have jurisdiction over the issuers, but we do have a 21 membership similar to municipalities where they run the 22 gamut. It can be a sole proprietorship all the way up to an 23 investment banking with 25,000 employees or more. So I think 24 it's something that is doable and I think it's really a 25 decision as to a cost benefit analysis, whether it's really 223 1 worthwhile. 2 COMMISSIONER WALTER: Well, thank you all. I think 3 we've gotten to the end of our time. This has been 4 extraordinarily helpful to us. And if you have further 5 thoughts on any of these issues, please, get in touch. 6 And we want to thank you so much for spending your 7 valuable time to be with us here today. 8 (Off the record.) 9 COMMISSIONER WALTER: If everyone can take their 10 seats, we'll get going. And we promise, this is the last 11 panel, but I've been looking forward to this one all day. So 12 hopefully we will be lively and keep you awake. I think we 13 will. We've got some interesting people coming up. 14 MS. STARR: Good afternoon. Welcome to our final 15 panel of the day, as Commissioner Walter has said. 16 This panel is going to focus on "Investor 17 Experiences in the Municipal Securities Market." 18 The investor base for municipal securities, 19 particularly tax-exempt municipal securities, has experienced 20 a long-term shift from one in which large institutional 21 investors were predominant, to one where individuals play an 22 ever increasing role. In fact, individuals now account for 23 roughly 68 percent of outstanding municipal securities 24 owners, including the securities held directly as well as 25 certain mutual funds, closed-end funds and money market 224 1 funds. 2 Municipal securities trade almost completely in an 3 over-the-counter dealer market. There's no central exchange 4 for municipal securities. Individual purchasers of municipal 5 securities still tend to be "buy and hold" investors, 6 however, there are over one million different municipal 7 securities outstanding in the market in any given time, and 8 there's significant secondary market trading. 9 We're fortunate to have with us three individual 10 investors, Peter Kuhn, Jason Lehman and Irv Siminoff, who 11 will share their personal experiences investing in municipal 12 securities. 13 Also on the panel is Andy Gill from Charles Schwab 14 Investment Management, who will discuss the role of advisors 15 and brokers, and I'm sure other things, as well, in 16 representing investors and buying and selling municipal 17 securities. 18 I'm going to give a brief bio for each of my 19 panelists, and then I'm going to ask them for their brief 20 thoughts. 21 Andy Gill oversees the Fixed Income Organization at 22 Charles Schwab, responsible for all aspects of Schwab's Fixed 23 Income offerings, including trading, sales, service and 24 strategies supporting the Investor Services and Advisor 25 Services businesses. 225 1 Prior to his current position, Mr. Gill was Senior 2 Vice President of Investor Services, Client Experience and 3 Delivery. Mr. Gill began his career at Charles Schwab in 4 2001, as Vice President of Cyber Trading Marketing, known 5 today as Schwab's Active Investor Group. Prior to joining 6 Schwab, he was involved in marketing and sales for a number 7 of other companies. Mr. Gill holds a B.A. in Economics from 8 Wake Forest University in North Carolina. 9 Peter Kuhn is an entrepreneur and executive, as 10 well as a leader in the employee benefit industry. He is the 11 principal and founder of IBP Insurance Services. Mr. Kuhn is 12 a seasoned investor of real estate, venture capital and 13 private equity, as well as municipal securities. Prior to 14 his work at IBP Insurance Services, Mr. Kuhn was an Account 15 Executive at CIGNA and an Accountant at Price Waterhouse & 16 Company. He received a B.S. in Commerce and Accounting from 17 Santa Clara University. 18 Jason Lehman is the founder and CEO of Headlands 19 Technologies, a global quantitative trading company 20 headquartered in San Francisco and Chicago, and he's based in 21 San Francisco. Prior to founding Headlands, Mr. Lehman 22 worked in various roles for Citadel Investment Group in 23 Chicago. Most recently running the Global Options Market 24 Making Business for Citadel. 25 Before starting that business, he was involved in 226 1 several fixed income businesses, where he developed an 2 interest in the municipal bond market. Mr. Lehman served on 3 the Board of Directors of the International Securities 4 Exchange from 2004 to 2008. Mr. Lehman graduated from the 5 Wharton School of the University of Pennsylvania. And he has 6 been an investor in municipal bonds for ever a decade. 7 Finally, we have Mr. Irv Siminoff. Mr. Siminoff is 8 a World War II Veteran who served in the Pacific Theater with 9 the 296th Anti-Aircraft Search Light Team of the 98th 10 Division. On returning to the United States, Mr. Siminoff 11 became a Sales Manager at a high tech firm, specializing in 12 bridge cranes, hoists and materials handling, both in private 13 and public sectors. 14 After that, Mr. Siminoff became the West Coast 15 Sales Manager of the Electric Auto Light Division at Ford 16 Motor Company. In that role he introduced off-highway 17 applications of state of the art electronic and 18 electro-mechanical components. 19 In 1964 Mr. Siminoff established his own business 20 as a Design Consultant and Distributor of microwave hardware, 21 specifically co-axle cables, filters, connectors and 22 transformers to be used in space, medicine, instrumentation 23 and voice communications. He has degrees from the University 24 of California at Berkeley in Mechanical Engineering and 25 Business. At Berkeley, Mr. Siminoff began investing in Wall 227 1 Street. He phased into bonds in the early 1980s. 2 I'd like to start with Mr. Gill. If you could give 3 us your short statement, please? 4 MR. GILL: Great. Commissioner Walter and 5 Commission Staff, my name is Andy Gill, and I'm the Senior 6 Vice President of Fixed Income at Charles Schwab & Company. 7 And it is a privilege to be here to testify today and offer 8 an investor's perspective on the state of the municipal 9 securities market. Thank you for holding this series of 10 field hearings on an issue that is of critical importance to 11 investors. 12 As background, Charles Schwab is a 13 dually-registered investment advisor and broker-dealer, with 14 whom 15 our customers have entrusted more than $1.4 trillion in 16 assets. Because our business model focuses on serving retail 17 customers directly, as well as independent registered 18 investment advisors who serve them, I believe Schwab has a 19 unique perspective on the market today. Our customers have 20 an important stake in the issues relevant to the Commission's 21 inquiry regarding the municipal securities market. 22 Let me begin by addressing the question asked in 23 today's title. For our retail clients, the state is very 24 much mixed. On one hand municipal securities are an 25 important and valuable component of the fixed income 228 1 allocation in an investment portfolio, offering 2 diversification, tax advantages and the opportunity to invest 3 in the communities that they live, and the infrastructure 4 that they enjoy. 5 On the other hand, municipal security investors 6 often must accept a heightened degree of risk, as a result of 7 the uncertainty that comes with incomplete issuer reporting 8 and less-than-transparent pricing. 9 There are three topics I'd like to cover today. 10 But first, let me draw a little bit more complete picture on 11 municipal bond investors we serve at Schwab. 12 Customers maintain about 9.4 million accounts at 13 Schwab. About 84 percent of these accounts are either in our 14 Investor Services Unit, which serves retail customers 15 directly, or our Advisor Services Unit, which serves retail 16 customers through independent RIAs. 17 Our Investor Services Unit serves directly about 18 2.5 million households. Of those households, 117,000 of 19 them, representing nearly $90 billion in total assets, have 20 at least one account enrolled in a fee based advisory 21 program. These programs include a non-discretionary advice 22 program that we call "Schwab Private Client." Fixed income 23 advice, including recommendations of municipal securities, 24 plays an important role in helping our retail clients, in 25 this program, construct an overall balanced investment 229 1 portfolio. 2 At Schwab, any client, regardless of size of their 3 account, can speak to a Schwab representative and receive 4 education or advice about investing in municipal securities. 5 The reality, however, is that the vast majority of municipal 6 trades placed through Schwab are unsolicited. Our clients 7 are, by and large, self-directed. As such, they want as much 8 issuer and market transparency as possible, to help them make 9 informed decisions. 10 One Schwab client recently provided this comment in 11 research that we sponsored internally: 12 "I want to be able to go online, just 13 like you can do for stocks, and see all 14 the bonds available that meet my criteria 15 for coupon, yield, grade, CUSIP and at 16 what cost. The brokers have the ability 17 to see this, so give us the visibility." 18 Most of the self-directed trades in municipal 19 securities are placed online via Schwab.com, through Schwab 20 BondSource, an electronic inventory and trading platform that 21 allows our clients to search for fixed income securities, 22 including municipal bond offerings, that match their 23 preferences and needs. 24 Schwab clients can typically access ore than 25,000 25 bonds available through the network of alternative trading 230 1 systems, which most dealers, including Schwab, leverage to 2 shop the over-the-counter market. 3 The data available to our clients through Schwab 4 BondSource includes the bond's current offer price and yield, 5 maturity, ratings, insurer status, terms such as whether a 6 bond is callable, and information on material events. Our 7 representatives use the same system and have access to the 8 same information when assisting a customer. 9 The three topics I'd like to cover today are based 10 on the needs we hear from our clients: 11 1. Trading is principal,to obtain best price. 12 2. Issuer financial transparency. 13 3. And pricing transparency. 14 And I'll be brief. 15 In terms of the municipal bond market for new 16 issues, Schwab's participation, out of necessity, is as a 17 principal. Municipal bond investors often seek new issues, 18 motivated by the benefits of expanded availability, over what 19 is available in the secondary market, plus the 20 straightforward pricing and clear tax and accrued interest 21 status. Whether they are purchased from an underwriter, a 22 syndicate member or a selling group, new issue bonds are sold 23 in this market through a broker-dealer acting as principal. 24 By engaging in this market as principal, Schwab is 25 able to expand the selection of bonds beyond what is 231 1 available through other dealers, and to match or better the 2 best price reasonably available in the market. Although 3 trading as principal has historically been considered a 4 conflict of interest with one's client, the fact is that 5 trading solely as agent would decrease access and, in many 6 cases, increase the cost to retail investors. 7 For example, last week Schwab sought bids for one 8 of our clients to sell 25 general obligation bonds issued by 9 a municipality in Iowa. Of the three quotes we obtained from 10 other dealers, the best bid was 106.466, while Schwab quoted 11 106.766. If we had not been able to act as principal, our 12 client would have been disadvantaged by $75. 13 In a recent 45 days period, Schwab provided the 14 best price on 19 percent of our clients' muni bond purchases 15 and 54 percent of their muni bond sales. 16 The necessity and advantages of retail clients 17 buying and selling municipal bonds from their broker-dealers 18 acting as principal, should be an important consideration on 19 the Commission -- as the Commission considers the staff 20 announcement, that the staff will not recommend to the 21 Commission an extension of temporary Rule 206(3)-3T under the 22 Investment Advisors Act, and as it considers possible rule 23 making under the Dodd-Frank Wall Street Reform and Consumer 24 Protection Act of 2010, that could harmonize the standard of 25 contact for broker-dealer and investment advisors. 232 1 The temporary rule currently allows dual registrant 2 broker-dealers and investment advisors, such as Schwab, to 3 obtain client consent to principal trading in 4 non-discretionary advisory programs, in an efficient way to 5 comply with the general prohibition against principal trading 6 under Section 206(3) of the Act. 7 The basis of the temporary rule is that 8 broker-dealers, such as Schwab, acting in a dual capacity, 9 must provide best execution to the clients, and their failure 10 to do so would be a breach of duty, if not fraudulent. The 11 absence of the temporary rule, however, will encumber retail 12 investors or worse, lead to worse execution of their 13 municipal bond orders, an outcome the Commission cannot 14 intend. 15 Unless the Commission staff is willing to give 16 timely and reasonable exemptions to individual firms, this 17 will have a dramatically negative impact on retail investors 18 in our Schwab Private Client program, who will effectively be 19 precluded from the level of market access we would provide to 20 our self-directed clients. We urge the Commission to avoid 21 this anomalous and unfortunate outcome. 22 Next, the municipal securities market lacks many of 23 the basic investor protections that exist in most other 24 sectors of our capital markets. It is time for this 25 circumstance to change, beginning with an improved disclosure 233 1 regime that will boost investor confidence and improve access 2 to information about the municipal securities market. 3 Retail clients are increasingly self-reliant. They 4 use online and other research resources to evaluate their 5 current investments and consider potential purchases. They 6 access the information available before making the decision. 7 Complete and timely reporting has been required of equities 8 and other registered securities for decades. Technology has 9 provided extremely efficient dissemination of information in 10 these markets. Material events and other financial news are 11 posted quickly and uniformly. 12 But the municipal securities market remains 13 frustratingly opaque to individual investors. Financial 14 reporting by municipal issuers can take up to 270 days to 15 reach an investor. This information lag is particularly 16 worrisome, because for many investors bond assets provide 17 stability and income generation, the most critical portion of 18 an individual investor's assets. 19 Important steps have been taken. Schwab strongly 20 supports the Commission's recent changes to Rule 15(c)2-12, 21 which enhanced material event disclosures for municipal 22 securities. Schwab also applauds the Commission's recent 23 municipal enforcement initiatives that should serve to bring 24 about more complete and timely disclosure of issuers of 25 material financial information. 234 1 Clients would benefit if broker-dealers could 2 integrate a single source for material event disclosure into 3 their platforms. We believe EMMA should be that single 4 source, in order to effectively and efficiently completely 5 provide these disclosures to clients in a cost-effective way. 6 But more needs to be done. Clients need to be able 7 to count on accurate, timely and complete information in 8 making decisions on what to buy, what to hold and what to 9 sell. Clients should be able to count on the same 10 registration and disclosure standards to non-governmental 11 conduit borrowers, as if they issued their securities 12 directly, without using municipal issuers as conduits. These 13 conduit-barring arrangements should be subject to the same 14 level of disclosure as a corporate issuer directly obtaining 15 financing in the public securities market. 16 Perhaps most importantly, clients need to be able 17 to count on municipal issuers making available to investors 18 offering documents, periodic reports and other information 19 similar to the requirements of issuers in offerings of 20 corporate securities. Schwab is not advocating that the 21 disclosure programs for municipal securities and corporate 22 securities be identical, but the information gap needs to be 23 narrowed considerably. 24 At Schwab, we strike to provide simple 25 straightforward pricing for every product we sell. Municipal 235 1 trade reporting to the MSRB has been a great step forward, 2 and we support continued efforts to make market information 3 more transparent, more consistent to help investors evaluate 4 municipal securities decisions. 5 Investors are accustomed to the depth and breadth 6 of information available to them when analyzing stocks. From 7 charts of historical prices to quotes that show the depth of 8 the market, from multiple sources, to trading volumes over 9 time, the richness and variety of information available to 10 investors helps them understand the volatility and risk, and 11 assess potential liquidity issues. 12 The same should be true for investors in the more 13 fragmented bond market. As new information resources emerge, 14 more should be done to provide clearer, easily accessible and 15 comparable information in the municipal securities market. 16 Thank you very much for inviting me to participate 17 in today's hearing. I look forward to answering your 18 questions. 19 MS. STARR: Thank you, Andy. 20 Now, we're going to ask Peter Kuhn -- if you can 21 just hand him that. Great. Thank you. 22 MR. KUHN: Good afternoon everyone. Thank you for 23 having me. 24 I'm really here to talk about my experiences as an 25 individual investor in the municipal bond market. Amy was 236 1 kind enough to provide a little background, so I'm not going 2 to spend a lot of time on this slide. 3 My initial goal in investing in municipal bonds was 4 really capital preservation. I used a full service broker 5 initially, because I just didn't have any expertise or 6 knowledge on municipal bonds. And I became educated on bonds 7 as they became a more material portion of my portfolio and I 8 ventured out to look at other opportunities. 9 A little bit of my investment background. I really 10 got tired of equities in the boom and bust cycle. Over my 11 investing career we had the crash of '87, we had the 12 challenges of long-term capital in '98, we had the Dot.com 13 boom. I actually live in Silicon Valley, so we lived and 14 breathed that quite significantly. The financial crisis of 15 2008, which we may still be living with. And then I wanted 16 to get some diversification in different assets classes. 17 Municipal bonds. When you hear municipal bonds, a 18 lot of times we think of folks that are a little more 19 conservative, looking for some very stable income. I 20 certainly meet some of those criteria, but I wouldn't say I 21 meet all of those criteria. I heard "municipal bonds," and I 22 said, "What's the difference?" 23 In the beginning, I didn't understand the 24 differences between a general obligation bond versus a 25 revenue bond, versus an industrial bond, say a bond that was 237 1 issued to build a hospital, or finally a bond that was issued 2 to build a school or develop out a subdivision. 3 Over time I continued to learn and educate myself 4 about them. One of the things that I initially relied on, 5 very heavily, was the insurance protection. I would talk to 6 the broker on the other end of the phone, he would say, "Hey, 7 it's insured, it's triple A insured." Well, we know that may 8 not necessarily mean what it means at the end of the day, 9 particularly after the last couple of years. But 10 or 15 10 years ago, if you had triple A insurance on an obligation, 11 you could rest pretty comfortably. Unfortunately, the world 12 has changed a little bit. 13 So initially I really wasn't concerned about what 14 the underlying bond was, as long as it was insured, I said, 15 "This is great." The insurers now, for all intents and 16 purposes, have little or no financial worth and we're 17 concerned about their ability to potentially pay. 18 As the strength crumbled, I had some pretty 19 significant concerns. And in fact, my municipal bond 20 portfolio took material hits and reductions in value. I 21 said, "What was I going to do?" This was my safe harbor. 22 This is where I was turning for protection from some of those 23 events I had outlined previously. I needed to understand 24 what my investments were and what my exposure was. 25 I therefore, really put on my hat, dug into some of 238 1 the resources -- I'll talk about some of those tools they use 2 in a moment -- and really what I discovered is, all of a 3 sudden opportunities presented themselves. 4 In the post-meltdown environment, so really from 5 2008 going forward, bonds lost their homogenous character as 6 insurance no longer was considered credible. People really 7 ended up looking at the underlying structure of the bond, and 8 that determined the rate of return that you would get. So 9 the financial crisis changed the landscape, yields for small 10 credit soared and presented opportunities. 11 I decided to do some more research and ended up 12 really going to the Securities Industry and Financial Market 13 Association Investing in Bonds website, as well as the EMMA 14 bond site. I have to applaud whoever is responsible for 15 creating these, because 10 or 15 years ago, when I first 16 started investing in municipal bonds, I really had no 17 visibility, whatsoever, as to what was going on. Now, I 18 could log-in, I could see the volume of trades, I could see 19 what the spread was, determine if I was getting a good value, 20 determine what made the most sense. 21 I actually, believe it or not, read the offering 22 statements. I don't know if there's a lot of people that do, 23 but there's six or eight, 10 pages in those offering 24 statements that I actually read. Maybe that goes back to my 25 days as a CPA at Price Waterhouse, but I actually find them 239 1 interesting and there's some very good nuggets of information 2 in there. 3 I would like to see maybe a one or two sheet -- 4 what I'm going to call "Factor Tear Sheet," that you might 5 see for a mutual fund today, that I think would be very 6 helpful for investors, so that they could cut through the 130 7 or 200 page offering memorandum. 8 Things that I look at are the initial offering 9 statements, the SEP reports, broker-dealer information, 10 market and sector outlooks put out from people like Schwab or 11 Fidelity or PIMCO, et cetera, general interest publications 12 and specialty focused publications. One of the things that I 13 think general interest publications do a poor job at is 14 really just saying, "The sky is falling," on municipal bonds. 15 They like to focus on Jefferson County, they like 16 to focus on the incinerator in Harrisburg, they like to focus 17 on San Diego and Vallejo. Well, you know, there's a few 18 issuers that have some challenges, but if you do some 19 research and really do real research, I think you can make 20 some excellent determinations as to where you want to invest. 21 I use a company called Zion Direct, I use Fidelity, 22 I use UBS, I use Stone & Youngberg, so I actually have a 23 variety of different brokers that I use. Each one of these 24 brokers really has a specialty. One of my words of advice is 25 to find someone who is dedicated to the municipal bond 240 1 market, as you'll get a better inventory, better selection. 2 I sit -- every morning I wake up, I log-on to 3 several of my accounts. I set up a set of criteria. I 4 review the opportunities. I screen it down to maybe three or 5 four or five. I research those opportunities. I obtain the 6 CUSIP. I'll look at the offering statement. I'll go to 7 EMMA. I'll go to MSRB. I'll go to Municipalbonds.com. And 8 I'll make a determination as to whether I'm going to do a 9 transaction or not. But I feel today I have a lot more 10 information than I ever had previously. 11 However, the purchase of the bond is only the 12 beginning. And one of the things that I'm frustrated about 13 is the ability to monitor the financial conditions of the 14 bonds that I have purchased. There's changes in the 15 insurance, the financial crisis, the opportunities and the 16 exposures that these bonds have. I don't feel that I have a 17 good way, as sophisticated as an investor as I am, to monitor 18 and track ongoing real time financial information that could 19 materially impact my decision to own or sell that bond. So 20 it's certainly something that I'd like to see. 21 I don't necessarily know if the SEC is the 22 regulatory authority that should do this, and we can 23 certainly have future discussions about that, but there 24 should be some methodology put in place to help investors get 25 better information on a more timely basis. 241 1 My personal strategies, I send a bond letter out 2 from 2015 to 2045, almost exclusively general obligation 3 paper from small issuers in the State of California. My 4 investment objectives were to provide financial security, 5 work to meet those objectives, monitor my investments, change 6 strategies as appropriate, and add inventory as available. 7 I use a combination of "do-it-myself" and full 8 service brokers. In the beginning really I'd buy my new 9 issues almost exclusively from full service brokers, 10 primarily Stone Youngberg, who is actually right next door in 11 the building here, because it's just tough to get. I buy my 12 secondary offerings through a self-service channel. 13 If you're going to go on the "do-it-yourself" 14 strategy, you need to definitely educate yourself, you need 15 to learn where the resources are, and you need to be 16 persistent, have patience, monitor, update your strategy and 17 be flexible. 18 Thank you to the Securities and Exchange 19 Commission, members and representatives and the audience 20 members for having this hearing. 21 MS. STARR: Thank you very much, Mr. Kuhn. 22 Mr. Lehman? 23 MR. LEHMAN: Well, first I'd like to thank 24 Commissioner Walter, Director Hu and Director Cross. 25 COMMISSIONER WALTER: She's no longer here, but she 242 1 accepts your thanks, as well. 2 MR. LEHMAN: Okay. Good. For holding this 3 important and timely hearing on the municipal securities 4 market. 5 For the past decade, I've been an investor in the 6 municipal securities market. During that time, I've devoted 7 substantial time, like Peter, to understanding the crucial 8 differences between municipal securities prospectuses, 9 financial information, brokerage platforms and trading 10 environments. Today I'd like to focus my remarks on three 11 main areas. 12 First, I'd like to share my observations on the 13 current market structure. 14 Second, I'd like to outline the importance of more 15 rigorous financial reporting by municipal issuers. 16 And third, I'd like to discuss the critical need 17 for the creation of a mechanism for the municipal securities 18 investor to display interest in the marketplace. 19 So first, market structure observations. The 20 municipal securities marketplace has made some substantial 21 improvements over the last few years, but still lags far 22 behind other retail marketplaces in terms of transparency, 23 efficiency and investor fairness. 24 The market structure is that of a dealer market, 25 where dealer intermediaries control price discovery and 243 1 access. The dealer community is strongly incented to 2 maintain control over prices and orders, and this control 3 creates significant low risk profits. The investor does not 4 have the opportunity to see other investor's potential 5 interest, nor the ability to transact directly without dealer 6 intermediation. 7 There have been several positive steps toward 8 improving this environment in recent years. First the 9 creation of EMMA in June of 2009, allowed retail investors to 10 have better access to last sale information as well as the 11 offering memorandum. 12 The second, innovative platform enhancements by 13 online brokers like Schwab and Fidelity, have greatly 14 improved the process of sourcing and analyzing securities. 15 Third, market platform such as Bond Desk and Muni 16 Center have improved the price discovery process for retail 17 investors. 18 Despite these advancements, however, major 19 shortcomings remain. The most significant failures of market 20 structure result when a retail investor is forced to sell a 21 security. There are many reasons why an investor may decide 22 to sell a particular security, such as unexplained or 23 unexpected liquidity needs in an uncertain economy or the 24 deterioration in fundamentals for that particular security. 25 When a municipal investor tries to sell that 244 1 security, however, they will suffer a punitively expensive 2 and opaque process. The implicit execution costs of selling 3 are measured in points, not basis points. Considering the 4 average triple A rated GL bond yields something in the order 5 of 1.4 percent today, the prospect of a couple point or 2 6 percent hit on execution price is simply outrageous. 7 Now turning to financial reporting. Thanks to 8 decades of incremental regulatory improvements by the SEC, 9 the retail stock investor has access to a wealth of timely 10 financial information about corporate issuers. Corporations 11 of all sizes produce regular and detailed reports on their 12 financial state. There are severe penalties levied on 13 corporations and their managers for failure to produce these 14 reports or failure to produce accurate reports. Amazingly, 15 there are little or no such obligations for the issuers of 16 municipal debt. 17 The arguments against timely financial reporting 18 are really old and tired in my opinion. Complaints about 19 supposedly excessive burdens created by reform do not stand 20 up to the compelling benefits for the major stakeholders in 21 municipal finance. Taxpayers, investors, and regulators 22 would all benefit from access to timely and accurate 23 information. 24 Additionally, the completeness and accuracy of this 25 information should be certified by the relevant officials, as 245 1 is the case for corporate officers. Justice Lewis Brandeis 2 famously remarked in Harper's Weekly nearly 100 years ago, 3 "Sunshine is the best disinfectant." The ready availability 4 of financial information is a long overdue necessity for 5 municipal markets that will improve accountability to 6 investors and taxpayers. 7 The investor in municipal securities must also 8 confront a dizzying degree of complexity to make a sound 9 investment choice. Unlike stocks, municipal bonds do not 10 have standardized terms. To properly differentiate between 11 securities, it is necessary to read the entire prospectus of 12 each issue. Even then, one must know what key terms to look 13 for and what warning flags to be weary of. 14 I'm an experienced professional investor in complex 15 financial areas, such as credit and equity options, yet even 16 I still feel challenged by the task of picking apart a 17 municipal prospectus. It is questionable whether the average 18 retail investor is equipped to wade through these complex 19 documents. 20 The third topic I want to touch on briefly is limit 21 order display. In 1996, the SEC passed the most important 22 regulation in the history of retail stock investing, the 23 Order Handling Rules. Effective January 17, 1997, these 24 rules fundamentally realigned the balance of power in the 25 U.S. stock markets toward the retail investing public. 246 1 For the first time a retail investor could place a 2 limit order to buy or sell a security and have that order set 3 the price in the marketplace. By doing so, the investor can 4 advertise his or her interest to the entire world attracting 5 other investors to their price. This has allowed investors 6 to transact directly with each other without a dealer in the 7 middle of the trade. 8 Spreads between buyers and sellers have sharply 9 tightened, and therefore the cost of investing for the U.S. 10 public has plummeted. Unfortunately, no such mechanism 11 exists for municipal securities. There is a critical need 12 for a mechanism whereby a retail investor can place a limit 13 order that is displayed to the entire marketplace. 14 Allowing retail investors the ability to set the 15 best price will narrow spreads, improve price discovery, and 16 drastically lower execution costs. The most important 17 benefit will be measured to an investor's increased 18 confidence in the efficiency and fairness of the municipal 19 securities market. 20 I'd like to thank the Commission once again for the 21 opportunity to appear today and share my thoughts, and I look 22 forward to a productive discussion on these important topics. 23 MS. STARR: Thank you, Mr. Lehman. 24 Mr. Siminoff? 25 MR. SIMINOFF: I'm definitely -- 247 1 MS. STARR: Can you pass the -- the bigger one, 2 yeah. Thank you. 3 MR. SIMINOFF: I'm definitely your classic retail 4 investor. I've had no education or training like these 5 gentlemen have had in securities. My work has been in 6 engineering and marketing engineering products. But I want 7 to give you a two-minute overcap review of my experiences 8 over the past 25 years as a retail investor. 9 I started out investing in Wall Street right out of 10 college, and in those days things were pretty calm. One 11 could get five to 6 percent in dividends and could reasonably 12 expect maybe a five to 10 percent annual return from the 13 underlying corporation. Brokerage commissions were two to 3 14 percent of the purchase amount, and a penalty purchase on an 15 odd lot size. Sure the DOW went up and down, but that was 16 generally linked to known events. 17 In the early 1980s, I needed a stable basic income 18 source to cover my son, who had just started Stanford, with 19 grad school on the horizon. In addition to income from my 20 equity portfolio and my growing business, muni bonds seemed 21 like an ideal, good security, a given income and investment 22 return at sometime in the future at a scheduled date. Boy, 23 was I naive. 24 Over the years I have dealt with some five or six 25 brokerage houses, each have a story, not particularly good 248 1 for an industry with multi-trillion dollars at risk. My 2 first adventure was with Washington State Public Power 3 Administration, generically called Woops. Of the five 4 tranches of bonds offered, one and two was government 5 insured. Three, four, and five was not insured, but looked 6 really safe. What could be better than revenue from power? 7 I was sold Tranche Four. My greed for a slightly 8 higher yield ultimately got back about 50 percent of my 9 investment. Reaching for a high yield, I then shifted my 10 account to Drexel Burnham Lambert. I got involved with 11 several issues, which turned out to be secured by raw land 12 and an Oklahoma hospital center on the fast road to 13 bankruptcy. 14 As offered, the issue looked like a reasonable 15 business risk. Looking back, these deals were sold on 16 projections, not on established facts. End result, Drexel 17 Burnham went out of business. The CFO went to jail. 18 A few years later I got into bonds backed by Mello 19 Roos Act. Again, weak on disclosure and level of risk. 20 Again, Mello Roos Bonds were promoted on future happenings, 21 not projections in place. 22 To sum up, it's been my experience over 25 years in 23 muni bond investing that the industry has to have a uniform 24 set for all brokerages regardless of size of the firm or the 25 type of issue. Understandably, brokerage houses have various 249 1 means of motivation and self interest. Some of the 2 salespeople are on commission; some are on a sales quota or 3 pressured to close out a given month, quarter, or year. The 4 retail customer's interest does not necessarily come first. 5 I strongly believe there should be a specific 6 checklist of information every retail purchaser should have 7 given by the broker before accepting the order. Items should 8 include level of risk on a better scale than the alphabet 9 method, size of the issue, overview of where the funds are 10 going, where the income is coming from, date of last prior 11 sale, amount of that sale, lien to value ratio, and a whole 12 host of other information. The commission markup should be 13 shown as a separate item on the billing. The goal of all of 14 this is transparency and fair value to the investor. 15 Please note that many -- and the gentleman from 16 Schwab can give me some numbers. But many muni bonds are 17 bought by seniors and don't have the resources that some of 18 these gentlemen have by computer and other ways to verify the 19 quality or the risk of the bond, and that should be done by a 20 better grading system, as I've said, than the alphabet 21 system. 22 Retail brokerage overhaul and transparency has long 23 been an issue with me, and I'm more than happy to be here 24 today to share in this program. 25 MS. STARR: Thank you so much, Mr. Siminoff. I 250 1 really appreciate it. And thank you other panel members. I 2 think I'm going to kick it off. I'm going to ask one 3 question, and then Commissioner Walter and Mr. Hu will jump 4 in as their want. 5 I think I'd like to -- under 15(c)212 for 6 continuing disclosure there's an obligation for underwriters 7 to obtain and make sure that issuers have entered into a 8 Continuing Disclosure Agreement for things that you've 9 invested in. And this is for folks who are really looking at 10 this stuff. Do you have an expectation that muni issuers who 11 have come to market and have signed up Continuing Disclosure 12 Agreements that they're actually going to be providing the 13 information that they've agreed to provide, and what has your 14 experience been? Thoughts on that? 15 MR. KUHN: I'm continually amazed at the lack of 16 visibility that I have to the current financial situation for 17 the bonds that I hold. I probably hold 250, 275 individual 18 bonds, all from different entities, and I do not get any -- 19 there's no systematic, rational, easy approach, or let's call 20 it a web portal or a tool or anything, where I can get that 21 information. 22 What I'd really like to do is put my CUSIPs into a 23 tool and get a report every morning, like an RSS feed, on the 24 material disclosure. I'd also like there to be some teeth in 25 the legislation or in the regulations or the rules that 251 1 provide those disclosures to me so I can then make informed 2 decisions about whether I want to keep that bond or sell it. 3 MR. LEHMAN: I would generally share Peter's 4 thoughts. I'm very skeptical of the disclosure that we get 5 today. It seems incomplete, not particularly timely, and I 6 don't generally rely on it. I think it would be very helpful 7 if we had uniform standards and, as Peter said, real teeth to 8 obligate issuers to provide ongoing disclosure, and this 9 would be extremely helpful. 10 MS. STARR: One of the other things that one of you 11 mentioned was one or two-page tear sheet, something along the 12 lines of an executive summary. 13 Mr. Siminoff, is that something that would be 14 helpful to you, as well as to these other investors? 15 MR. SIMINOFF: Absolutely. You know, a lot of 16 people just don't have the resources, temperament, or time to 17 go through the full prospectus up front. But a tear sheet 18 with a uniformity amongst all the brokerage companies so 19 that -- you go to any McDonald's in the world, and you get 20 the same hamburger. 21 We need to get the same type of tear sheet 22 basically, only difference is a masthead with their name as 23 to what the criteria is, and that would give a lot of -- but 24 that tear sheet should be developed up front by SEC or 25 somebody who can say to you guys, "You've got to follow this. 252 1 Don't deviate." 2 COMMISSIONER WALTER: Can I ask you a question 3 about pricing? I don't know if you found any differences 4 between when you buy a municipal bond or when you sell, but 5 how do you know or develop any sort of a degree of confidence 6 that you're getting a fair price? I mean, I understand there 7 are best execution obligations that present certain 8 challenges for the professionals in this market, but what do 9 you look to to develop that kind of confidence? 10 MR. LEHMAN: I'd love to answer that question. So 11 the answer to the first part of your question, very different 12 experience when you try to buy a bond and when you sell a 13 bond. Generally, I found that when buying a bond in the 14 secondary market you have pretty good access through Schwab 15 and other brokers to general inventory in the marketplace, 16 and so you can sort through that through search queries and 17 find issues of interest. 18 You can also use EMMA to look at last sale 19 information, look at yield to maturity at different price 20 points and spread over treasuries, and that's generally how I 21 would make a determination of whether I think the price is 22 fair given the perceived credit quality of the issuer. 23 COMMISSIONER WALTER: Can I stop you there for one 24 second, Jason, and just ask a related question, which is as 25 you look at last sale information, how much reliance do you 253 1 feel comfortable placing on that? Do you discount it if it's 2 a week ago or longer? Since there are so many issues, to 3 find a relatively recent sale is probably unusual I would 4 think. 5 MR. LEHMAN: Yeah, that is true. Sometimes you 6 have very spotty price information, so you have to use what 7 is out there. And so I agree that the older the sale 8 information, the less useful it is as a data point. To the 9 extent that there is no recent price history, I would 10 generally look to spread over relevant treasuries and 11 yield-to-maturity relative to other similar credit qualities 12 or similar to perceived credit qualities. 13 The experience on the way out is very, very 14 different when you try to sell a bond. You don't have any 15 way to actually post a limit order to sell a security, so you 16 have to seek a principal bid from a dealer, which is a 17 valuable service that the dealer is providing, and it must 18 always be there. But there are many cases where you don't 19 need to sell an asset instantaneously, and I would much 20 rather leave a limit order out and try to attract interest 21 from other potential buyers. But there's no mechanism to do 22 that today. 23 COMMISSIONER WALTER: Mr. Siminoff, I think you go 24 about things in a somewhat different way. Could you 25 describe, particularly on a sale, what gives you assurance? 254 1 Was it finding the right professional to deal with, or what 2 sources of information do you look to to feel like you've 3 gotten a fair price? 4 MR. SIMINOFF: To get a fair price. To get a fair 5 price, like Jason here, I've had recent good luck with the 6 Schwab organization. They give me all of the information 7 that they have at hand, but, you know, who knows the depth of 8 it because it may not be out there in space. 9 I want to deviate for a second here. 10 COMMISSIONER WALTER: Please do. 11 MR. SIMINOFF: I don't like the alphabet method of 12 rating bonds, Triple A, Double A, A, and on down. I think 13 there should be a scale, and just to start this off, from 1 14 to 100, 100 being cash in an FDIC account or in your 15 mattress. Zero would be bankruptcy. Along the way these 16 numbers would be adjusted having four or five modules, and 17 each module would have a portion of the measurement of that 18 bond's integrity, risk, duration, yield-to-maturity. These 19 things would be built in so the average retail person would 20 get a number. 21 Maybe someone called up and wanted bonds, and they 22 were a widow. She had problems, not a lot to invest, but 23 wanted something safe. And you've said to her, "Well, I have 24 a bond package here rated 88." Pretty good. But the yield 25 is only 4.2. Term is 12 years. Okay. But I have a bond 255 1 that's rated 25, but the yield is nine. And it gives a range 2 of valuation that the computer and other people have already 3 built into it to protect the uneducated. By "uneducated," I 4 mean in finance, the investor on the street. 5 MR. HU: I was curious. This panel, all of you 6 have indicated how difficult it is, for retail investors 7 especially, to get information and to get good pricing and so 8 forth. Throughout the day we've been told institutional 9 investors sometimes have access to information from issuers 10 that retail investors don't get access to, whether in terms 11 of the electronic road shows or other means. Given all of 12 these difficulties and given the availability of no load, 13 relatively low expense mutual funds, investing in tax 14 exempts, why do you invest in individual municipal bonds as 15 opposed to relying on a bond? 16 I was going to say diversification, and then I 17 heard Peter talk about, you know, being able to invest in 18 250. We in government would be hard put to invest in two 19 municipal bonds. Leaving aside diversification, why do you 20 invest individually as opposed to -- in individual bonds as 21 opposed to going through a fund? 22 MR. KUHN: I think I've taken this up to be a 23 little bit of a hobby to the interest. My wife calls me a 24 municipal bond geek, and she's like, "Enough about the 25 municipal bonds. I'm glad you found a good one today, but 256 1 what are you going to do? Do you really need anymore?" I 2 said, "Well, yeah, I do." 3 MR. HU: So if you imply $10 an hour to your time, 4 you're actually losing money investing in municipal bonds, 5 right? 6 MR. KUHN: It's a break even proposition probably. 7 MR. HU: Okay. 8 MR. KUHN: But really, what I did was -- when you 9 have yields at four, 5 percent and you have a municipal bond 10 fund with an underlying expense of 46 to your 80 basis 11 points, that does materially eat into your returns. If 12 you've got a very small portfolio -- and Andy can probably 13 address this as to where the break even is. But if you have 14 a small portfolio or limited means or limited time or just 15 don't have the ability to do that due diligence, I think a 16 fund is a fantastic vehicle, and you get fantastic 17 diversification and professional investment management that 18 you'll never get. 19 My needs are probably a little different, a little 20 more sophisticated, and I want to get that extra yield. And 21 then due to the size of my portfolio, I'd say I get closer to 22 an institutional investor. 23 Andy? 24 MR. GILL: Yeah, I think the thing I would add, you 25 know, Henry, the mutual funds are an absolutely valid 257 1 investment for many of our clients, and Schwab, through our 2 Schwab One Source platform, Open Architectural platform, we 3 recommend lots of bond funds for clients, especially those 4 who have less than 100,000 to invest in a fixed-income 5 investment. 6 The reasons that we hear clients say they want to 7 invest in individual securities are a couple. The first is 8 many perceive that in a mutual fund they're buying someone 9 else's decisions, meaning the decision on when they buy that 10 mutual fund and the decision on when they sell that mutual 11 fund. And those decisions then have implications in terms of 12 capital gains, distributions. They have implications in 13 terms of liquidity. So that would be one reason. 14 The second reason we hear from many clients of all 15 different backgrounds is that they want to invest in the 16 communities in which they live. They may not know a mutual 17 fund manager well, but they do know most of the people on the 18 city council of the city that they live in, or they feel 19 confident that people are going to pay their power bill and 20 their water bill and the essential services that produce the 21 revenue to pay back that bond. So you know, knowledge of a 22 particular area. 23 And then third is they want that direct, calculable 24 tax benefit. 25 MR. SIMINOFF: One fine aspect of personal 258 1 investing for us, for me and my family, you can ladder it, 2 and knowing retirement, scheduling out the years, you can 3 pretty well count on what's going to happen. 4 MR. HU: But can you achieve that buying -- okay. 5 That's fine. 6 MR. SIMINOFF: I'm sorry? 7 MR. HU: No, you can go ahead. That's very 8 interesting. You have much more control in terms of tax 9 consequences and the like, and you know your neighbors. You 10 know the city council. Interesting. 11 MS. STARR: A couple questions that I was going to 12 raise. You were talking about the financial information and 13 your desire to get more current financial information. When 14 you're talking about that, are you talking about more current 15 annual financial information? Are you talking about 16 quarterly information? Are you talking about monthly? What 17 is it that you're looking for? 18 MR. LEHMAN: I would think quarterly financials 19 which would correspond to what you get from a corporate 20 issuer would seem -- seems appropriate to me, as an investor, 21 and certainly, as Peter alluded to, immediate notification in 22 terms of material events that would affect the financial 23 strength of an issuer. 24 In particular, as this would relate to the adverse 25 selection, as you said, institutional investors in the 259 1 security may have better access to information than retail 2 investors, and we're potentially trading against those 3 institutions. So they have more timely information, and 4 we're getting adversely selected. And so regular financials, 5 whether that be quarterly, and then just very timely news 6 dissemination. 7 MS. STARR: I'm just going to weigh in one more 8 thing that you can add into your answer. Does the type of 9 issuer make a difference in terms of the quality, 10 availability, timeliness of information from a GO to a 11 Revenue to a Conduit? 12 MR. KUHN: So a couple of things on that. One of 13 the things that I'd really like to see is a report on the 14 number of delinquent taxpayers in a given jurisdiction. 15 That's pretty timely information that they have that really 16 does have a material impact on whether I want to buy a bond 17 in that jurisdiction. 18 The other thing that I would like to see is for 19 revenue bonds or project bonds -- a lot of times these bonds 20 are sold with certain projections or certain revenues that 21 were supposed to be achieved. If they have a material 22 deficiency, and let's set that material deficiency at 10 or 23 15 percent, there should be a note that goes out to all bond 24 holders, "Hey we're not meeting our revenue projections." 25 So really I think the most meaningful financial 260 1 metric on any given bond is dependent on the underlying 2 security there. But those are a few examples that I can 3 give. 4 To cite an example that Jason just gave where maybe 5 we could be taken advantage of by a professional trader, I, 6 who consider myself a reasonably sophisticated investor, just 7 recently bought some Hayward School District, right across 8 the bay here, General Obligation Bonds. I got a very good 9 yield on those. However, Hayward is having some financial 10 challenges, and they're certificates of participation were 11 just downgraded to nearly junk, if not junk status. 12 I think that the bonds that I bought came from a 13 several million dollar holding position that probably an 14 institution or a fund had. They might have got wind of it, 15 off-loaded those bonds. I, as a retail investor, saw this 16 and bought it. Would I have maybe not bought them? I don't 17 know. I would have at least taken that into consideration in 18 my analysis, but I had no visibility or no way to determine 19 that in my transaction. 20 COMMISSIONER WALTER: Amy, I think we better wrap 21 up. Do you have one more burning question you want to ask? 22 MS. STARR: I did have actually one more burning 23 question to ask, which is -- and that's my last one. If you 24 buy conduit financings that are potentially insured or backed 25 by letters of credit, do you -- when you're doing your 261 1 evaluation, do you look only at the credit enhancer or the 2 letter of credit provider, or do you want to get information 3 on the underlying credit itself? 4 MR. LEHMAN: Both. 5 MR. SIMINOFF: Both. 6 MS. STARR: Both? 7 MR. SIMINOFF: I think you have to look from where 8 the revenue is coming from, that's the big thing. Parking 9 meter, water, electric -- you have to look to where the 10 revenue is coming from. Parking meters, electric, water 11 pretty safe. 12 MS. STARR: Great. Thank you very much. I really 13 want to thank you. My whole panel here, you guys were great. 14 COMMISSIONER WALTER: I'd like to thank you, as 15 well. I don't know if it will make you feel better, but 16 we've gotten some rather loud complaints from very large 17 institutional investors that they can't get information 18 either. So I don't know if that makes life better or worse. 19 Just a few closing remarks. Once again, I want to 20 thank this panel, as well as all the rest of the participants 21 on our panel. This panel certainly exceeded my expectations, 22 and it was the one I looked forward to all day long. So 23 thank you again. 24 I urge all of you or any of you who have comments 25 you'd like to share with us to do so via the e-mail box that 262 1 we've set up for these hearings, and that includes both the 2 panelists, anyone in the audience, anyone else you know. 3 We've certainly learned a lot today, a lot of food for 4 thought, and I'm not going to attempt to capture it all 5 because that will be part of our staff's job as they draft a 6 report based on all of the hearings. But I would like to 7 note just a few highlights. 8 First, it seems that there is a pervasive lack of 9 understanding about the practical and legal differences and 10 similarities between the corporate debt and municipal 11 markets. From a purely factual perspective, it would be 12 beneficial to all to clarify these differences and 13 similarities so that we can make better informed decisions 14 about whether, and if so, how, requirements for the two 15 markets should be comparable. 16 Second, there seems to be a disparity between the 17 level of information -- it was just talked about here -- that 18 institutional investors in this market are able to obtain 19 compared to what a typical retail investor can access, and 20 that's a serious concern for all of us, particularly for me. 21 And while I would not want to see a door shut on 22 institutional investors obtaining the information they need 23 to make sound decisions, we can't close our eyes to the fact 24 that retail investors are really in need of the same types of 25 information. 263 1 Third, all that the Commission is doing to enhance 2 the regulation of the security based swap market under the 3 new authority provided by the Dodd-Frank Act is particularly 4 and uniquely important to the municipal market. There really 5 is a link there. 6 Next, while there is much more that we need to 7 learn from future field hearings regarding disclosure from 8 both the muni issuer and investor perspectives and 9 considering both credit ratings and accounting issues -- and 10 we have had some talk about accounting issues today, but at 11 least one future hearing we're going to focus in laser like 12 on the accounting issues. We clearly heard today that EMMA 13 is working well, and I hope the Lynnette and her colleagues 14 on the MSRB Board certainly saw that. I saw her smile once 15 or twice today. And the MSRB should be congratulated for 16 this important tool. 17 And even more importantly, to give you an 18 incentive, congratulated on your plans to make the tool more 19 robust, more helpful, provide more functionality. I think it 20 may be the sole thing on which we could say there was a 21 consensus today. So our congratulations to you. 22 As in so many areas, improving investor education 23 and financial literacy about issues of risk, whether it's 24 credit risk, default risk, interest rate risk, always has to 25 be high priority. Also, we have focused for years on the 264 1 communications that occur between investors and their 2 advisors. That relationship is critical in the muni markets, 3 and we will probably add a panel we hadn't contemplated in a 4 future hearing to deal with those issues. 5 A couple more and I promise to get to the end. 6 Disclosure of accounting for pension and other 7 post-employment liabilities is quite complex and implicates 8 serious public policy issues. At future hearings, we'll 9 continue to explore these topics to make sure that we hear 10 all competing views. 11 And finally, we have heard, particularly in this 12 last panel, about the potential value of summary information 13 at or prior to the point at which you're purchasing or 14 selling securities and potential capital markets changes, 15 like limit order display and how important these can be to 16 retail investors. These topics really deserve further 17 exploration at a future hearing, and we'll be sure to do 18 that, as well. 19 Once again, thank you so much for your 20 participation and for taking your valuable time to be here 21 today. We hope that for the listeners in the room, and 22 perhaps for the participants, as well, we've wetted your 23 appetite for future hearings. And if you have any further 24 thoughts, once again, please let us know. 25 Thank you very much for being here. We're very 265 1 pleased to see you. 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 266 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 REPORTER'S CERTIFICATE 3 4 I Richard A. Friant reporter, hereby verify that 5 the foregoing transcript of 265 pages is a complete, true and 6 accurate transcript of the testimony indicated, held on 7 Tuesday, September 21, 2010, at Port of San Francisco, The 8 Embarcadero, Bayside Room 1, San Francisco, California, in 9 the matter of: SEC Field Hearing on the State of Municipal 10 Securities Market. I further certify that this proceeding 11 was recorded by me and that the foregoing transcript was 12 prepared by Maryann Loverro under my direction. 13 14 15 Date: October 7, 2010 16 Official Reporter: Richard Friant 17 Diversified Reporting Services, Inc. 18 19 20 21 Diversified Reporting Services, Inc. 22 Phone: (202) 467-9200 Fax: (202) 296-9220 23 24 25 267 1 PROOFREADER'S CERTIFICATE 2 3 In the Matter of: Securities and Exchange Commission 4 State of the Municipal Securities Market 5 Date: Tuesday, September 21, 2010 6 Location: Washington, D.C. 7 8 9 This is to certify that I, Donna S. Raya (the 10 undersigned), do hereby swear and affirm that the attached 11 proceedings before the U.S. Securities and Exchange 12 Commission were held according to the record and that this is 13 the original, complete, true and accurate transcript that has 14 been compared to the reporting or recording accomplished at 15 the hearing. 16 17 18 19 ___________________________ _____________________________ 20 (Proofreader's Name) (Date) 21 22 23 24 25