Regulatory Reform Bill Faces Dissent

WASHINGTON — Market participants are increasingly concerned about provisions in Senate and House regulatory reform bills that are designed to address the level of sophistication of states and localities that want to engage in over-the-counter derivatives transactions.

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The worries have come to the forefront as the Senate Banking Committee is expected to begin marking up its proposed 1,139-page bill sponsored by chairman Christopher Dodd, D-Conn, sometime next month. Meanwhile, the full House is expected to vote on several measures pushed by Financial Services Committee chairman Barney Frank, D-Mass., in mid-December that may be combined into a single omnibus bill, congressional sources said.

At a Banking Committee hearing last week, several senators said they were unhappy with various provisions in their draft bill, but its muni provisions did not appear to be the subject of their concerns.

Specifically, the Senate bill would prohibit states and localities that have discretionary investments of less than $50 million, excluding bond proceeds, from being considered “eligible contract participants” in derivatives transactions. Derivatives deals with non-ECPs must be exchange-traded, which may not be feasible for state and local governments because they would be required to meet daily margining requirements.

The House bill contains a similar provision that states and localities would not be ECPs unless they have $50 million of discretionary investments. But under that bill, they could be ECPs if their counterparty is a bank or broker-dealer, which would mean that virtually all municipalities could engage in derivatives transactions.

Peter Shapiro, managing director at Swap Financial Group in South Orange, N.J., said the $50 million threshold “seems like a strange standard” to gauge sophistication. Instead, the threshold should be based on the size of an issuer’s debt portfolio, perhaps $50 million of outstanding debt.

“How much they have to invest on the asset side of their portfolio has very little to do with how sophisticated they would be at managing derivatives on the debt side, which is where governmental agencies use derivatives overwhelmingly,” Shapiro said. “There are very sophisticated agencies that don’t manage assets.”

One such agency, the New Jersey Educational Facilities Authority, has about $5 billion of outstanding debt and about $1 billion invested in bond funds, but only about $10 million of what might be considered “discretionary assets,” said Roger Anderson, the NJEFA’s executive director.

“We think we’re very sophisticated, but we’re small,” said Anderson. He added that basing the $50 million threshold on the amount of bonds outstanding would speak to some sophistication, though he believes a better metric would be to simply impose a suitability requirement on muni issuers’ counterparties.

Sam Gruer, managing director at Cityview Capital Solutions LLC in Millburn, N.J., said the legislation should focus less on a numerical threshold and instead base an issuer’s eligibility on whether it has a full-time chief financial officer, the background and education of its staff, and the number of times it enters the market in a year.

“An issuer that’s frequently accessing the market is probably more in touch with what’s going on in the market than someone who issues bonds once every two years,” Gruer said.

Market participants also are concerned about a separate provision in the Senate bill that would require an issuer to hire an independent swap adviser and for its dealer counterparty to have “a reasonable basis” to believe that the adviser has expertise and will make disclosures to the issuer about fair pricing and the appropriateness of the transaction.

While requiring issuers to hire swap advisers would essentially mandate existing practice, Anderson said he resents the idea of requiring swap dealers to essentially sign off on the competency of the swap advisers that issuer hires, because it presumes municipal governments are never sophisticated.

Scott DeFife, senior managing director for government affairs at the Securities Industry and Financial Markets Association, was more pointed. He said the provision “doesn’t make any sense,” largely because both the House and Senate bills would require all FAs to be registered with the Securities and Exchange Commission and to follow either Municipal Securities Rulemaking Board or SEC rules.

As a result, DeFife said that it seems “onerous and duplicative and paternalistic” to “propose that a municipal government can’t make its own well-reasoned determination of the type of swap adviser to hire ... as a competent, independent custodian of its swap management.”

DeFife added SIFMA believes there is a range of provisions on OTC derivatives that it finds problematic, and “this would be one of them.”


Non-dealer financial advisers and others say they are worried about a provision in the massive Senate bill that calls for “independent” FAs to be regulated by the MSRB, the self-regulator that was created in 1975 to write rules for municipal dealers.

Though the bill in the Senate, along with the separate legislation in the House, would require the MSRB to have a board with a majority of public sector, not industry, members beginning next fall, the proposed changes do not go far enough to eliminate significant conflicts with the MSRB’s rulemaking decisions, several independent FAs and an academic warned last week.

Specifically, the Senate bill would require that at least eight of the MSRB’s 15 members be public representatives, including one institutional or retail investor, one issuer, and one muni expert. The House bill would require that the board’s public members only include one representative of an issuer and one of an investor. Currently the board is comprised of five securities dealers, five bank dealers, and five public members, including one issuer and one investor representative.

But market participants note that neither bill would require that any of the public members be free of financial relationships with the dealers they would regulate, an omission that makes the switch to a majority public board “an empty change,” said Tamar Frankel, a professor at the Boston University School of Law.

The definition of public members should be broadened, Frankel said, to include more than at least one issuer and to require that none of the public members have close business ties with dealers.

Thomas Johnsen, a principal at financial advisory firm Fieldman Rolapp & Associates in Irvine, Calif., said that legislation giving the MSRB authority over non-dealer FAs is akin to Congress telling sports agents that the National Football League owners are going to write rules governing the agents’ conduct.

Even if the board’s composition is changed, “there’s still the possibility that the composition would be weighted more towards the broker-dealers,” he warned, adding that his preference is for the SEC to regulate FAs, as is called for by the House bill.

Robert Doty, president of financial adviser American Governmental Financial Services Co. in Sacramento, said that even with a majority of the board as public members, dealers would likely maintain a “very strong” influence over the regulation of non-dealer firms under the current draft of the Senate bill.

While Doty believes that the MSRB has done an “impressive” job over the past couple of years, especially with the establishment of its Electronic Municipal Market Access system, he nonetheless said that MSRB oversight of non-dealers FAs would be “an intolerable situation” unless there is parity on the board between the number of dealers and non-dealer FAs.

“This would have people that I’m negotiating with regulating me,” he said. “I can’t live with it. It’s just not something that I’m willing to accept.”

Though the SEC would continue to have final say on the MSRB’s regulatory proposals, the commission typically would not originate proposals, some of which independent FAs worry could be so onerous that they would drive out many small FA firms from the business.

Doty said the SEC would be a better choice to regulate FAs because it understands the fiduciary role they play when advising their clients. Though muni FAs are not currently subject to federal fiduciary standards, the SEC has repeatedly enforced the fiduciary concept in more than a dozen common-law fraud cases based on state law it filed against dealers and non-dealers in situations where conflicts of interest were not disclosed.

In contrast, he said, the MSRB’s record demonstrates that it does not understand the fiduciary concept because the board has twice refused to alter its Rule G-23 on dealer FAs, which currently only states that there “may” be a conflict of interest if a dealer FA switches roles to become the underwriter on a negotiated transaction.

For several years, the National Association of Independent Public Financial Advisers has pushed the MSRB to amend the rule’s language to say that a conflict “does” exist, but the board has repeatedly declined.

Doty said that since the issuer wants the best possible price for their securities, and the underwriter wants to pay the lowest price possible, merely requiring dealers to say there may be a conflict is extremely misleading because its suggests there might not be a conflict of interest. 

“It doesn’t get more straightforward than that,” he added.

Finally, Doty said he is skeptical about the intent of the Senate bill because it is silent on a federal fiduciary standard for FAs, which the House bill calls on the SEC to effectuate. “I don’t think that was an accident,” he said.

Asked about Doty’s and other non-dealer FA remarks, MSRB executive director Lynnette Hotchkiss said that she sees the pending legislation “as a work in progress at this point,” and that if Congress changes the board’s jurisdiction, its composition would have to change as well. She also said that all of the MSRB’s rules would have to be carefully reviewed in light of changes to the market.

“The MSRB has always been extraordinarily careful and thoughtful when proposing new rules,” she said, noting that there’s always a public comment process followed by required SEC approval. “I would expect that the same level of thoughtfulness would be present in any future rulemaking activities.”


The Senate bill sidesteps some of the more controversial calls for reform in the municipal market, such as the repeal of the so-called Tower Amendment, which was added to the Securities and Exchange Act of 1934 and restricts the MSRB and SEC from collecting offering documents prior to bond sales.

Instead, it would commission the Government Accountability Office to submit a report within one year of enactment that compares muni and corporate disclosure requirements and evaluates the costs and benefits to issuers of requiring them to improve disclosure. The report must also recommend whether Tower should be repealed.

Separately, the SEC would be required to study the role and importance of the Governmental Accounting Standards Boards, its funding, and whether legislative or other changes are needed.

Jeff Esser, executive director of the Government Financial Officers Association, said that both studies ought to be performed by the GAO and that state and local government officials and their national organizations should be consulted on them.

Esser also suggested that certain additional topics be added to the studies, such as the effect that federal funding would have on the independence of GASB and that issues of federalism and state sovereignty be examined as part of the disclosure study. He said the study should also examine what state and local governments disclose with regard to financial information that is “above and beyond what corporations disclose,” such as financial reporting that is available through open meetings laws, government Web sites, and in the statistical section of comprehensive annual financial reports, or CAFRs.

“These are all disclosures widely available in the governmental sector but not generally in the corporate sector,” Esser said.

Mark Stockwell, the vice chairman of the National Federation of Municipal Analysts and director of municipal research at PNC Capital Advisors in Philadelphia, said the NFMA stands ready to provide information and insight to federal regulators and agencies regarding disclosure requirements and practice.

But Stockwell noted the Senate bill also would authorize the MSRB to establish new information systems, even though “concerns over the quality of disclosure information would still linger.”

The NFMA, he said, remains concerned about the timeliness and quality of information in both primary and secondary markets.

“The largest disclosure gap is in the area of municipal swaps and other derivative contracts, a problem that has yet to be adequately addressed in recent regulatory and legislative initiatives,” he said.

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