A string of reports in recent weeks has shed light on the insular, unregulated world of so-called independent municipal financial advisers, consultants that counsel state and local governments on everything from issuing bonds and investing cash to using interest rate swaps and other derivatives.
Late last year President Obama's original choice for commerce secretary, New Mexico Gov. Bill Richardson, removed himself from consideration for the post in light of an ongoing investigation of his relationship with a financial advisory firm that received millions of dollars in compensation for work done in association with state bond issues.
The Erie, Pa., school district is suing its financial adviser, Investment Management Advisory Group Inc., known as IMAGE, which was hired in part to help assure that the district got a good deal on a derivative transaction. Erie has accused IMAGE of overlooking excessive fees paid to a derivatives provider for a swaption contract in order to continue to get business referrals from the provider.
It has also been reported that CDR Financial Products Inc., the same firm that sparked the investigation of Gov. Richardson, has been involved in a string of bond transactions that may get local governments or investors - or both - in hot water with the Internal Revenue Service.
These examples of questionable advice and conflicts of interest involving financial advisers are particularly egregious - most FAs are honest and upright and not engaged in nefarious activities.
However, these examples point to a glaring hole in the regulation of the municipal bond market. No regulator - not the Securities and Exchange Commission, the Federal Reserve, the Municipal Securities Rulemaking Board, nor any other - has any real authority over the hundreds of firms that are supposed to ensure that municipalities get good deals on their financial transactions.
And yet, the National Association of Independent Public Finance Advisors recently opposed regulation of unregulated FAs. In a statement, NAIPFA president Steve Apfelbacher said, "NAIPFA does not support regulation of independent public finance advisers."
Banks, broker-dealers, investment advisers, mutual funds, and companies that issue stocks and bonds all fall under a long-established system of regulation, oversight, and enforcement that helps ensure investors are protected and that all market participants deal with each other fairly.
Broker-dealers, especially, are the subject of strict and voluminous regulations that cover individual qualifications and testing, capital requirements, conflicts of interest, interactions with investors, transparency, books and records, and numerous other areas. These rules are backed up by a robust examination and enforcement system.
Municipal financial advisers are subject to none of this. To become a muni FA, an individual needs to do nothing more than hang a shingle. There is no system for registration or testing, let alone regulations governing business practices. And of course there is no enforcement or sanctions against financial advisers whose actions are more in line with the interest of the advisory firm than the municipal client and who often do not receive "contingent fees" for services unless deals close.
The MSRB earlier this year came out with a plan for bringing municipal financial advisers under the regulatory umbrella. The board has a long history of regulating broker-dealers active in the muni bond market, and many of its rules could easily apply to FAs. Rules governing political contributions and gifts to state and local officials, for example, could be applied to financial advisers almost unchanged.
Other MSRB rules would need to be adapted to FAs, but overall, the regulatory requirements for municipal securities dealers provide a good starting point for rules for financial advisers.
If appropriately regulated, municipal financial advisers would be required to register and file financial statements with the SEC, and employees would be subject to background checks. The MSRB or other appropriate body would then draft an appropriate set of rules for registered advisers, and the SEC or the Financial Industry Regulatory Authority would enforce those rules through examinations and sanctions.
Several times in recent years NAIPFA has asked the MSRB to ban dealers from underwriting issues after they have resigned as financial advisers. The MSRB, which is closely overseen by the SEC, has consistently rejected that approach. NAIPFA's statement this week dusted off those old, worn arguments about dealers who serve as FAs - firms that are often overseen by multiple layers of agencies and self-regulatory organizations.
While continuing to promote more stringent regulation of dealers, the group "does not support regulation of independent public finance advisers" at all. With what the credit markets have experienced in the last 18 months, there is simply no justification for exempting any group of players from regulatory oversight.
Some financial advisers have privately acknowledged the need for regulation of their businesses. Competent and honest FAs should welcome regulatory oversight. It will have the effect of ridding the market of unqualified or miscreant advisers and will enhance the market's confidence in sound advisory firms.
Federal policy-makers in Congress and the executive branch have begun the process of reforming the regulatory landscape. While their principal focus will be on addressing the holes in regulation that played a part in the current financial crisis, regulating municipal financial advisers should also be on the agenda. In light of the extreme turmoil in the credit markets of the last two years, excluding a major group of players from any federal regulatory oversight is simply not acceptable.
States and localities have suffered significantly as a result of the recession and credit crisis. They are facing extraordinary fiscal pressures. Many local governments that sell bonds - even some medium-size and larger communities - are relatively unsophisticated, which leaves them potentially less able to recognize and defend themselves against the abusive practices of rogue FAs.
Reform of our financial regulatory system gives federal policy-makers an excellent opportunity to close this glaring loophole. Now is the time for Congress to act and bring municipal financial advisers under the regulatory tent.
Michael Decker is co-chief executive officer of the Regional Bond Dealers Association.
