Outlook 2010: Securities Legislation and Regulation

Reg Reform, SEC Top Agenda

WASHINGTON — Next year will bring significant changes in the municipal securities market if Congress passes sweeping financial regulatory reform in what would be the biggest overhaul of financial regulation since the Great Depression.

At the very least, regulatory reform is expected to lead to federal oversight of currently unregulated financial, swap, and other advisers in the muni market as well as changes to the composition of the 15-member Municipal Securities Rulemaking Board to make it a majority-public self regulator. Currently, the MSRB is dominated by representatives from 10 dealer firms.

Last week, Senate Banking Committee chairman Christopher Dodd, D-Conn., and the panel’s ranking Republican, Richard Shelby, R-Ala., issued a joint statement suggesting they may have revised draft regulatory reform legislation ready by the time the Senate returns next month.

But aside from such legislation, which has already cleared the House, a key question that will shape munis is the extent to which the Securities and Exchange Commission plans to pursue additional legislation that would give it greater authority over munis, as called for generally this year by SEC chairman Mary Schapiro and outlined with more detail in an October speech by commissioner Elisse Walter.

In her speech, Walter said that Congress should repeal the so-called Tower Amendment and other securities law exemptions for municipal issuers so the SEC can require issuers to comply with certain disclosure requirements as well as with generally accepted governmental accounting standards.

Walter called for Congress to allow the SEC to require nongovernmental conduit borrowers to meet the same corporate-style registration and disclosure requirements that would apply if they directly sold the bonds. She also called for lawmakers to give the SEC authority over all financial intermediaries in the municipal market and to “seriously consider” combining muni market rulemaking and enforcement authority into one self-regulatory organization.

Though Walter called for the repeal of Tower — an amendment added in 1975 to the Securities Exchange Act of 1934 that prohibits the SEC and MSRB from collecting disclosures prior to bond sales — she indicated that her primary concern is the timing of secondary-market disclosures rather than those in the primary market. As with previous SEC commissioners who have called for enhanced muni authority, she said issuers should not necessarily be required to receive pre-approval for their offerings from the SEC the way corporations do.

Though the issue of whether to repeal Tower is important, some market participants believe the SEC can accomplish what it wants without repealing the amendment, which over the years has become a politically contentious subject and would be difficult to achieve legislatively.

While a majority of the five-member SEC has strongly urged for an expansion of the commission’s muni authority, only one other commissioner, Luis Aguilar, has publicly said that a repeal of Tower is needed. In an interview this month, he reiterated that position, adding that, while Tower’s repeal is not all that needs to be done, it is emblematic of the need for Congress to act to expand the SEC’s authority

“Either way you analyze it, we’re going to need congressional action to give us sufficient authority in this area,” he said, noting that he first publicly called for boosting muni disclosure standards in a speech a year ago to the North American Securities Administrators Association in which he cited recent muni-related scandals in Jefferson County, Ala., and San Diego.

Still, issuers remain strongly opposed to legislative changes that would enhance the SEC’s authority — especially the repeal of Tower — and so far appear to have the backing of key lawmakers, such as House Financial Services Committee chairman Barney Frank, D-Mass. Frank has repeatedly said he is opposed to disclosure changes that would be unduly burdensome for issuers.

Ben Watkins, director of Florida’s bond finance division and a member of the Government Finance Officers Association’s debt committee, has little confidence the SEC would “get it right” if they received greater authority over the market, owing to what he described as years of SEC bungling of continuing disclosure.

For instance, he said the SEC did not require the former national disclosure repositories — which were replaced this year by a single repository run by the MSRB — to include CUSIPs and uniform cover sheets as part of secondary market filings, making it difficult to keep track of the disclosures. In addition, he said there were no performance measures of the repositories to gauge how well they were functioning.

“It took until 2009 to create a uniform system through EMMA,” he said, referring to the MSRB’s Electronic Municipal Market Access site. “So I don’t have a high degree of confidence that they would get it right ... and I think it’s incumbent on them to spell out with specificity what their plan is, rather than saying, 'Trust me, I’m from the government, I’m here to help you. Just repeal Tower, don’t worry, we’ll get this right.’”

Watkins thinks Walter essentially got it backwards when she argued in her speech for a tiered system that would subject larger muni issuers to more corporate-like disclosure requirements. It’s more likely that smaller issuers, which do not have a lot of resources and are less frequently in the market, would provide inadequate disclosure, he said

Asked about Watkins’ remarks, ­Martha Mahan Haines, the SEC’s municipal securities chief, acknowledged that Schapiro’s calls for increased legislative authority over munis would “raise considerable debate in the industry.”

Haines said that while most people now believe the multiple repository system was a disappointment, the SEC’s original proposal for a central repository received numerous complaints that it would undermine private ­competition.

Meanwhile, in an interview with The Bond Buyer last month, Schapiro said the SEC will try to reach broad market consensus where it can, “but if we can’t then we’ll have to figure out what’s the right thing to do.”

She said the SEC will likely vote to adopt final changes to its Rule 15c2-12 on disclosure “very early” in 2010 and will then meet with lawmakers to see what can be done to expand its authority over the muni market.

The changes to 15c2-12, which regulates issuers indirectly through dealers, generally would expand the types of events issuers must disclose on a continuing basis and require the disclosures to be filed within 10 days of occurrence rather than on a “timely basis.” But once the rule is changed, Schapiro said the SEC is very close to having exhausted the limits of its authority.


Of immediate concern for many market participants is the regulatory reform legislation that passed the House earlier this month as well as separate draft legislation that the Senate Banking Committee is reworking.

The Senate legislation would be significant for the muni market in part because it 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 would have to be exchange-traded, which probably would not be feasible for state and local governments because they would be required to meet daily margining requirements.

The House bill contains a different provision. While it contains the $50 million threshold of discretionary investments, it would allow governments to be ECPs if their counterparty is a bank or broker-dealer. That would mean that virtually all municipalities could engage in derivatives transactions.

In its current form, the Senate bill would have the effect of shutting down the OTC swaps market for governmental issuers, according to Sam Gruer, managing director at Cityview Capital Solutions LLC in Millburn, N.J. Gruer contends the legislation’s definition of “discretionary investments” would exclude states and localities’ general funds, which generally are earmarked for specific projects and operations and not set aside like a university endowment that is designed to grow over time.

As a result, very few, if any, municipalities would meet the sophistication threshold, he said, adding that if Dodd’s intention is to keep states and localities out of the OTC derivatives market, the proposal works.

“But even if that’s the intent, many municipalities are already in the market and if nothing else they need a clear exit strategy so that existing trades can be unwound within existing parameters, or be restructured if and when they need or choose to do so,” he added.

One market participant who asked not to be named said Congress has a natural impulse when it encounters a situation where constituents have suffered losses to make it so that those losses become illegal in the future.

Though many municipalities have, on net, saved money with derivatives, he said some issuers, such as  Jefferson County, have lost “spectacularly,” which has led many lawmakers to try to overregulate.

But market participants said that the $50 million of “discretionary investments” threshold for determining eligible contract participants is misguided. Peter ­Shapiro, managing director at Swap Financial Group in South Orange, N.J., said it stems from a misunderstanding that derivatives are investments when in fact they are overwhelmingly hedges on debt, and have nothing to do with investing.

Meanwhile, the Securities Industry and Financial Markets Association is drafting a proposed framework for OTC derivatives used in the muni market, said Michael Decker, managing director and co-head of SIFMA’s municipal securities division here.

Other market participants note that the federal effort to address the sophistication of municipalities that engage in swaps comes amid the Justice Department and SEC’s parallel criminal and civil probes of anti-competitive practices related to municipal swaps and investment contracts. Jeffrey Blumenfeld, of counsel at Kutak Rock LLP in Philadelphia, said the probes also are likely to have a regulatory consequence at the state level, perhaps mirroring new rules in Tennessee that require issuers to have at least $50 million of outstanding debt before they can enter into interest rate swaps. Earlier this week, the Delaware River Port Authority of Pennsylvania and New Jersey agreed to ban its use of swaps and to consider terminating current agreements.

“The biggest consequence is going to be protecting public money in the future by restricting issuers, based on size or type, from participating in these kinds of trades,” Blumenfeld said. “And the pendulum may swing too far because the hardest part of any legislation of this type is knowing where to draw the line.”


Non-dealer financial advisers are concerned about a provision in the Senate’s regulatory reform bill that calls for “independent” FAs to be regulated by the MSRB. They prefer the House bill, which would give the SEC that authority.

Though the original draft of the Senate bill, along with a separate measure that passed the House this month, would require the MSRB to have a board with a majority of public 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 complain.

Specifically, the Senate legislation 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.

Robert Doty, president of the financial adviser American Governmental Financial Services Co. in Sacramento, said MSRB oversight of non-dealer 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. Though the SEC would continue to have final say over the MSRB’s regulatory proposals, the commission typically would not originate proposals, he warned. The SEC would be a better choice to regulate FAs because it understands the fiduciary role FAs play when advising their clients, he said.

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, he added.

In contrast, Doty said the MSRB’s record demonstrates it does not understand the fiduciary concept, noting that the board has repeatedly 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 transactions. For several years, non-dealer FAs have asked the MSRB to amend the rule’s language to say 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 it suggests there might not be a conflict of interest.

Asked about Doty’s and other non-dealer FA remarks, MSRB executive director Lynnette Hotchkiss said she sees the pending legislation “as a work in progress” and 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 in the market.

“The MSRB has always been extraordinarily careful and thoughtful when proposing new rules,” she said, noting there is normally a public comment process of draft rules prior to rules’ submission to the SEC for commission approval. “I would expect that the same level of thoughtfulness would be present in any future rulemaking activities.”


Hotchkiss said 2010 will be highlighted by legislative changes that are likely to make the majority of the 15-member board “public” officials. The Senate bill, if signed into law, also would allow the MSRB to create new information systems not limited to munis and to impose fees for submissions, as well as authorize the MSRB to assist the SEC and the Financial Industry Regulatory Authority in examinations and enforcement of its rules.

Among several rule proposals in the pipeline, the board is expected next month to file a proposal with the SEC on the final phase of its transparency system for short-term auction-rate securities and variable-rate demand obligations — sectors of the muni market that were the hardest hit from the broader financial crisis last year.

In conjunction with the SEC’s proposed changes to 15c2-12, the MSRB proposed specially designating issuers on EMMA that voluntarily commit to any of four proposals or undertakings, including the submission of annual financial information within 120 days of the end of their fiscal years.

Responding to issuer complaints that 120 days was not enough time, the SEC instructed the board to amend the proposal to add a temporary, 150-day filing option that will phase out at the end of the 2013.

The amended proposal will be subject to public comment through most of January and is likely to be considered by the SEC about the same time as the proposed changes to 15c2-12, probably in February or March, market participants said.

Billed by Schapiro as a creative way to encourage improved disclosure standards, Doty predicted that if the incentives are successful — if issuers are rewarded with lower borrowing costs for participating — regulators are likely to push for additional voluntary undertakings.

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