MSRB Won't Amend Rule G-37

WASHINGTON - The Municipal Securities Rulemaking Board will not amend its Rule G-37 to restrict dealer contributions to bond ballot campaign initiatives because there is not enough evidence to show firms are being awarded bond business after helping to fund the initiatives. The decision left some market participants scratching their heads.

"We do not have any adequate evidence to suggest that bond ballot campaign contributions are having a deleterious effect on the municipal market," MSRB chairman Ron Stack told reporters yesterday in a conference call outlining the outcome of the board's meeting last week in New York City. The board's staff has been directed to continue to study the issue, said Stack, managing director and head of public finance at Barclays Capital.

Asked about the board's decision, MSRB executive director Lynnette Hotchkiss said that evidence of a quid pro quo is necessary to further restrict the rule.

"Any time you restrict political contributions, it's a constitutional issue," she said, referring to the First Amendment protection of free speech, which encompasses these donations. "If you're going to limit speech ... the threshold is exceptionally high. There's got to be evidence" of wrongdoing.

But market participants disagreed, saying a quid pro quo is not necessary.

The board's reluctance to make changes to the rule comes after several high-profile market participants pushed for them, including Frank Chin, a former MSRB chairman and the head of public finance at Citi, as well as Mark Melio, at JPMorgan, and Stratford Shields, managing director and head of public finance at Morgan Stanley. These firms were the three largest underwriters of negotiated transactions in 2008.

In a December letter to the MSRB, the three dealer officials said that Rule G-37's restrictions should, out of an abundance of caution, be expanded to include contributions to ballot campaigns so that dealers have the same restrictions as are imposed on contributions to issuer officials. The ballot campaign restrictions should cover banks, municipal finance professionals and associated political actions committees, as well as broker-dealers, they said.

Under G-37, dealers cannot engage in negotiated municipal securities business with an issuer for two years if they or their municipal financial professionals - known as MFPs - contribute to issuer officials who can influence the award of muni bond business. MFPs, however, can contribute up to $250 to any issuer official for whom they can vote.

One market participant who asked not to be identified said he is disappointed by the board's decision last week, noting that the problem is tied to school district financings, especially in states like California, where in 2000 a proposition was adopted lowering to 55% from 66% the amount of voter support needed to approve a bond ballot measure.

"That ushered in a period of more donations from underwriting firms because bond ballot measures were more likely to pass," said the market participant. "Is it having a deleterious effect on the market? Yes, because people unwilling to give as a rule are having a hard time competing" for bond business.

Another market participant estimated that of the underwriters of school district financings in California, 90% have contributed to ballot initiatives, suggesting that if an underwriter does not contribute, it is unlikely to be awarded business.

Missouri, the source noted, already has a law restricting underwriters, financial advisers, and bond lawyers who contribute to bond ballot initiatives from participating in such underwritings.

Meanwhile, proposed legislation in the California Legislature would restrict "investment firms" from working as a financial adviser, legal adviser, or underwriter on any new bond issue if that firm or anyone who works for it contributes to bond campaigns.

Citing the Missouri statute and proposed legislation in California, the source said it seems like the MSRB is intent on being "wholly reactive."

"It's like they're waiting for some big scandal," said another market participant. "Why not act before some big scandal?"

Meanwhile, another source said the MSRB, in insisting on evidence of a "quid pro quo," is embracing a stronger legal threshold than courts have ruled is necessary to defend G-37.

In striking down a high-profile challenge to G-37 waged by Alabama bond dealer William Blount, a federal appellate court ruled in 1995 that the rule must be narrowly tailored to further the congressionally mandated goals of the Securities and Exchange Commission and the MSRB to prevent municipal underwriters from engaging in unfair, corrupt market practices and to promote a "free and open market" and "just and equitable principles of trade."

The MSRB's decision on G-37 comes after it instructed staff in January to research all available public information on such contributions. The board declined to release a copy of that report yesterday.

Separately yesterday, the MSRB ratcheted up its case to regulate "independent" financial advisers and other market intermediaries with a new study showing that 73% of financial advisers that participated in at least one primary market transaction in 2008 were not subject to MSRB rules.

The board argued in the 12-page study, "Unregulated Municipal Market Participants: A Case for Reform," that it should have the regulatory authority to oversee market participants that are not currently subject to its professional standards and rules, particularly G-37 and G-38's ban on the hiring of independent political consultants.

Of the total $453 billion in par value of municipal bonds that were sold in 2008, roughly 70% or about $315 billion came to market with the assistance of a financial adviser, the board said, citing Thomson Reuters.

But just 38% of those FAs were dealers required to register with the MSRB. The remaining 62% comprises "independent" FAs not subject to any federal regulation.

The report comes as lawmakers and the Obama administration are in the initial stages of broad reform of the financial regulatory structure and as some market participants are arguing that the MSRB should cease to exist.

In pointed testimony before the Senate Banking Committee last month, former SEC chairman Arthur Levitt said repeatedly that the muni market is "corrupt," that self-regulation through the MSRB does not work, and that it should be folded into the SEC.

But the board argued in the report that its existing structure has worked historically and provides "a ready model" for expanded oversight of currently unregulated financial advisers and investment brokers.

The board said that these intermediaries should be subject to a form of dual oversight: registration with the SEC as well as more "prescriptive" rulemaking by the MSRB.

The need for broader regulation, the MSRB said, has been underscored by an increasing number of federal and state investigations into corruption and pay-to-play activities involving muni transactions that are not covered by the board's rules, an apparent reference to the ongoing Justice Department investigation into the anti-competitive practices tied to muni derivatives and guaranteed investment contracts.

"The limited role of the MSRB to fully oversee all market participants has caused widespread confusion over how the market is regulated," the MSRB said. "Based on the growth of the market, and the evident regulatory gaps, it is necessary for unregulated market participants to be subject to regulatory oversight that is similar to that mandated for dealers."

The 15-member board is dominated by bank and securities dealers, which hold 10 of its seats. The report does not discuss changes to the board's composition because the board believes in addressing these matters "sequentially," first getting policymakers to agree that these intermediaries need to be regulated and then convincing them to give the MSRB authority over them, Stack said. The makeup of the board would depend on new regulations lawmakers propose, he said.

Steven Apfelbacher, the president of both Ehlers & Associates Inc., in Roseville, Minn., and the National Association of Independent Public Financial Advisors, said that NAIPFA does not support regulations for independent FAs but if Congress determines that they should be regulated, they would like to work with lawmakers on such legislation.

Unregulated participants, he added, have been "unfairly lumped into one group," noting that CDR Financial Products, the firm reportedly under investigation for contributions it made to New Mexico Gov. Bill Richardson, is a swap adviser, not a financial adviser.

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