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SEC Eyes Regulatory Road Show

JUL 20, 2010 7:08pm ET
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WASHINGTON — The Securities and Exchange Commission is considering holding five field hearings between September and January as part of a nationwide inquiry on the municipal market that is expected to lead to recommendations for statutory and regulatory changes to better protect investors.

Elisse Walter, the commissioner leading the inquiry, said the hearings will be designed to help her and the SEC staff formulate recommendations for legislative changes, new or amended SEC and Municipal Securities Rulemaking Board rules, and how to encourage the development of market-based disclosure best-practices documents geared toward specific market sectors.

While the hearings will address a broad array of topics, establishing more timely and uniform disclosure standards is “probably at the top of my list,” Walter said in an interview from her 10th floor office Friday. “What we’re going to do is try to be broad, concentrating on some of the hot topics, particularly the concerns we’ve heard from both institutional and individual investors.”

Though Walter is also spearheading the SEC’s drafting of the first interpretive guidance since 1994 to address legal ambiguities in the commission’s Rule 15c2-12 on disclosure, she said that project, which has been underway for several months, will likely be folded into the larger muni inquiry.

Rule 15c2-12 prohibits dealers from underwriting most bond deals unless the issuers have contractually agreed to disclose annual audited financial and operating information, as well as the occurrence of key events.

“Obviously, the goal on the interpretive guidance is to bring it up to date, not in terms of the legal principles, because they haven’t changed, but it terms of what’s going on in today’s marketplace,” Walter said. “The field hearings may very well inform that.”

The SEC may release the guidance before the hearings conclude if the staff is comfortable with it, she said. If that happens, the interpretive release — which would become immediately effective upon issuance — would be the first product to come out of the inquiry.

One of the disclosure issues Walter hopes to explore during the hearings is the timeliness and quality of issuers’ secondary market filings, including annual financial statements. She declined to specify what she thinks would be the ideal timing for issuer submission of financial statements, but is concerned that many of them are so late they are stale and of little use to investors.

Investors have long complained that many issuers do not disclose annual financial information until more than six months after the close of their fiscal years — a real problem right now with the recession causing state and local finances to spiral downward.

Walter also wants to focus on the fact that financial statements are so diverse and do not adhere to uniform standards. She would like to convince more issuers to adopt generally accepted accounting principles established by the Governmental Accounting Standard Board. The SEC has long championed the GAAP standards.

Rating agency regulation also will be a key topic for the hearings. Walter is interested in both the impact of rating agency migrations to uniform or global rating scales, as well as the repercussions of rating agency provisions in financial regulatory reform legislation that President Obama is expected to sign today.

She previously said that she supports the move to a global scale, but believes that if municipal issuers are rated like corporate borrowers, they should provide the same level of timely and accurate disclosures.

The legislation would require federal agencies to strip references to rating ­agencies from their rules, including the SEC’s Rule 2a-7 on money market funds. That rule generally requires that money market funds only purchase debt rated double-A or higher, or unrated debt of similar quality.

“It’s going to have a big impact across the board,” Walter said of the legislation.

The hearings also will explore systemic issues that may take years to address, such as whether muni market rulemaking and enforcement authority should be combined into one self-regulatory organization.

Though the SEC has been “bound and determined” to push for specific legislative changes, such as the registration of corporations that borrow in the market through municipal issuers acting as their conduits, Walter said that very little, if any, of the inquiry’s results are preordained.

“You will see conduit issuers addressed in this in one way, shape or form,” she said, noting that the SEC wants feedback.

“We have certain ideas that if left to our own devices we would recommend today, but it struck us as being a much better process and more robust process to give everyone an opportunity to participate in this,” Walter said. “We really would like to make as comprehensive an effort as possible before we put forth recommendations.”

On any particular issue, the recommendations could “run the gamut,” she added, meaning that staff may recommend multiple legislative, regulatory, or practice changes for each area of concern. She also stressed that every market constituency will be asked to testify at the hearings.

Walter, along with fellow Democratic commissioner Luis Aguilar, has publicly called for a repeal of the so-called Tower Amendment that restricts the ability of the SEC and the MSRB from collecting documents prior to bond sales. But she said the commission is not designing the field hearings “to try to gin up support for a repeal of Tower.”

“The idea of having some more uniform and timely disclosure requirements is different from Tower,” Walter said. “That will be a focus of these hearings. Tower is not the big issue here.”

Asked if Congress could leave the Tower Amendment in place and allow the SEC to accomplish many of it’s goals, she said: “Absolutely.”

While she doesn’t believe the SEC should be prohibited by law from collecting bond documents prior to sales, she also said it has no interest in establishing a corporate-style regime to pre-approve the disclosure filings of 50,000 muni issuers.

Walter said she hopes the inquiry will finalize its recommendations soon after the hearings wrap up, but that they will have to be approved by the SEC.

“We think this is a very important area and we want to put it together as rapidly as possible,” she said.

However, some systemic problems may not be resolved in the inquiry, she noted, adding that she hopes the hearings will shed some light on them.

For instance, Walter is particularly concerned about the separation of muni market rulemaking from enforcement authority.

Currently, the MSRB writes rules for dealers and the Financial Industry Regulatory Authority enforces them. In an October speech on muni regulation, Walter, a former FINRA senior executive vice president, said that maintaining a separate “regulatory function” from the “enforcement and examination functions” leads to “coordination and communication problems.”

But in the interview Friday, Walter suggested that there may be no immediate answer to the issue.

“If you told me that coming out of these field hearings I could only have five recommendations, it would not be on my list,” she said. “The relationship between the FINRA and the MSRB works better than at any time I’ve been exposed to it in the past. And I particularly think that [MSRB executive director] Lynnette Hotchkiss is doing a fabulous job. But it’s an issue. To me it’s not the right model.”

“It’s an obvious issue,” she said. “I think it’s a flaw in the structure no matter who is doing it, no matter how closely they work together.”

Another systemic issue is the lack of pre-transaction price discovery, which Walter said is “a particular bugaboo” of hers. “This is important across the fixed-income markets and I think it’s a very important issue for us to address,” she said.

Her concern is that there is often no way of knowing the precise price of a municipal bond, particularly in the secondary market if the bond has not recently been traded.

Though a broker may query several other brokers to determine a price, there is no public exposure of the other brokers’ prices, she pointed out.

“You don’t have market forces working the way you do in other markets to make sure the price is a good one,” she said. “In today’s market, even if there is a near-contemporaneous trade, I don’t really trust that the contemporaneous [price is accurate]. And I’m not talking about bad motives. I’m talking about people’s lack of information. How do you know that the other trade went off at the right price? That’s a big market-structure issue.”

Though Walter stressed that she is still learning about the issue, she said one solution may involve some sort of quotation system for bids on bonds. Meanwhile, she said she is not sure exactly how the SEC would encourage more best-practices documents, saying “it could be done in a number of ways,” possibly with the SEC encouraging market groups to get together and write BPs on particular issues.

Her remarks follow an announcement by the Government Finance Officers Association, the National Association of Bond Lawyers, and the National Federation of Municipal Analysts earlier this year that they are already working together on disclosure “templates,” though it’s unlikely their work will result in a single product.

Walter said the SEC may try to highlight model processes and procedures, particularly those developed in response to muni crises in cities like San Diego.

The city was sanctioned by the SEC for material misrepresentations and omissions about its pensions and retiree health care obligations in disclosures tied to five 2002 and 2003 bond issues. It has since created a disclosure working group comprised of key city officials and outside disclosure counsel to review and ensure the accuracy of offering statements and any other document that reached investors.

The city also has detailed disclosure controls and procedures adopted by that group that lays out who must review and sign off on disclosure documents within set time periods.

“There’s a lot of power from bringing all of these people together and there are a lot of good models out there that have been made in response to disasters” like San Diego, Walter said.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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