SEC Kicks Off Muni Inquiry

WASHINGTON — The Securities and Exchange Commission is launching a nationwide inquiry into the municipal market that will lead to recommendations for specific statutory and regulatory changes to better protect investors, an SEC official said at the Investment Company Institute general membership meeting here Friday.

SEC chairman Mary Schapiro has tapped commissioner Elisse Walter to hold a series of public hearings across the country to solicit ideas from a wide range of individuals who have experienced the market from many different perspectives, Andrew “Buddy” Donohue, director of the investment management division, said in a speech he ­delivered for ­Schapiro, who did not appear at the meeting because she was tied up with Thursday’s steep stock market drop.

In her written keynote speech, which focused entirely on municipal securities, Schapiro made clear that the SEC wants public input on “designing a regulatory regime specifically for the needs of the municipal securities market” in an effort to go beyond its current disclosure and other proposals for the market.

She also called for the Municipal Securities Rulemaking Board to scrap its controversial Rule G-23 and prohibit broker-dealers from serving as both financial adviser and underwriter in the same municipal bond deal. The rule allows a dealer to switch from the FA to the underwriter role in a bond transaction as long as they disclose possible conflicts of interest and their expected compensation to the issuer. But Schapiro’s speech said: “This is a classic example of conflict of interest… The board should change G-23 and forbid this practice.”

Keith Curry, a managing director at Public Financial Management Inc. and former head of the National Association of Independent Public Finance Advisors, said: “We are pleased that the SEC has joined us in calling for the prohibition of this inherently conflicted practice. The practice of flipping from adviser to underwriter is already illegal in California and it should be illegal nationally.”

But Michael Decker, managing director and co-head of the municipal securities division at the Securities Industry and Financial Markets Association, said the MSRB has considered the rule at least twice and concluded it provides investor protections.

Mike Nicholas, chief executive officer of the Regional Bond Dealers Association, said the group “strongly disagrees that highly regulated financial advisers affiliated with highly regulated broker-dealers should be prohibited from serving as lead underwriter after providing financial advice to the municipal bond issuer. MSRB Rule G-23 as currently written is well accepted and functioning in the marketplace with no reasons for change.”

But former MSRB executive director Christopher Taylor said, “It’s pretty clear to me that the SEC will be determining the MSRB’s agenda in detail.”

Current executive director Lynnette Hotchkiss said that “protection of investors in the municipal market is the single most important goal of the MSRB” and the board “has worked together with the Securities and Exchange Commission for 35 years to create a robust and expansive set of industry regulations that have provided for a fair and efficient market. MSRB pay-to-play rules are the most rigorous in the financial industry. We continually review all our rules to ensure they reflect current market practices and issues.”

SEC officials said any timetable and details of how the commission plans to proceed with the hearings are currently unavailable.

Schapiro’s speech comes after Walter, in a speech last October, called for repeal of the Tower Amendment, which was added in 1975 to the Securities Exchange Act of 1934 and prohibits the SEC from requiring municipal issuers to file disclosure documents with it before the sale of securities. Walter’s speech upset issuers, some of whom complained the SEC does not understand the muni market. The SEC appears to be responding to those complaints with its inquiry.

Schapiro’s speech stated: “I find it surprising that such an important and omnipresent sector of the capital markets is subject to such limited regulatory oversight. The fact is that access to public markets should come with certain obligations and responsibilities.”

The muni market today — in which retail investors, directly or indirectly through mutual funds, hold 69% of $2.8 trillion of muni debt outstanding — is dramatically larger and more complex than the market in 1945 when there was less than $20 billion of state and local debt outstanding.

Yet the SEC’s authority over the market is limited. The commission has regulatory authority over broker-dealers who underwrite or otherwise participate in muni transactions and can require dealers to determine whether a particular bond is suitable for a customer. But the SEC cannot require an issuer to make information available to assist the dealer.

Schapiro is especially vexed that the SEC cannot require corporate borrowers in tax-exempt conduit deals to disclose the same kind of information they would have to disclose if they borrowed in the corporate market. The SEC requires public companies to file audited annual financial statements within 60 to 90 days of the end of their fiscal years. But state and local governments often do not make their audited financials available for six or more months after their fiscal years end, and, in addition, may not follow generally accepted accounting standards, according to her speech.

While issuers contend the muni market is safe because there are so few defaults, Schapiro noted that the recent disruptions in the auction-rate securities and variable-rate demand obligation markets adversely affected both issuers and investors.

She also pointed out that while issuers of more than 70% or more of VRDO’s entered into swaps to pay a fixed rate while receiving a variable one, the drop in short-term rates led to a decline in the market value of the swaps and an increase in the cost of cancelling them. As a result, conduit borrowers that entered into swaps to hedge their risks found the swaps “magnified rather than decreased their costs,” her speech said.

Schapiro singled out Jefferson County, Ala., whose heavy reliance on VRDOs and interest rate swaps, she said, resulted in a default of $3.8 billion of sewer bonds and “the real possibility of the largest municipal bankruptcy in U.S. history.” Including the county, there were 136 defaults in municipal securities totaling more than $7.5 billion in 2008, “which cannot be ignored,” she said.

In the SEC’s look at the muni market, “All ideas to improve municipal securities disclosure should be on the table,” Schapiro said. They included: requiring standardized offering documents and periodic reports so that investors can comparison shop when buying munis; requiring periodic disclosures of financial information specially tailored to securities, such as tax revenues; and increasing the disclosure standards for private borrowers in conduit deals. In addition, issuers should be required to use uniform accounting standards such as those issued by the Government Accounting Standards Board, and GASB should be placed under SEC oversight and provided with an independent funding source, she said.

Schapiro’s speech also suggested mandating “scenario testing” by municipal issuers and periodic disclosure of the impact that certain events should have on an issuer’s ability to meet its muni debt obligations. An example of this could be testing for, or disclosing, how interest rate changes would impact an issuer’s swaps contracts, one source said.

Former SEC chairman Arthur ­Levitt said the SEC’s inquiry into the muni market “is a great idea. I applaud it with enthusiasm.”

Decker said SIFMA “welcomes an examination by the SEC of the regulation of the municipal market and what changes may be warranted.”

Mark Stockwell, chairman of the National Federation of Municipal Analysts and director of research at PNC Capital Advisors in Philadelphia, said the NFMA believes it is “absolutely necessary” to have quarterly disclosure in all municipal sectors, and “that is why I’m encouraged by chairman Schapiro’s comments.”

Stockwell said the NFMA is discussing how to develop standards for quarterly disclosure with other municipal groups.

Kathleen McKinney, president of the National Association of Bond Lawyers and a shareholder at Haynesworth Sinkler Boyd PA in Greenville, S.C., said: “We do hope that the SEC will continue to reach out to NABL as a valued resource to explore any new initiatives in this area. We all have the same goal: a vibrant and transparent market where state and local government and other beneficiaries of tax-exempt bonds can efficiently access capital.”

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