The dramatic changes in the municipal securities market leading toward a “new normal” are daunting. When significant changes are enumerated, even when one is aware of them, they are still surprising. Because the market environment is evolving rapidly, and market re-adjustments will continue well into the future, the “new normal” does not yet exist.
Many market participants may not recognize that, for better or worse, the proverbial “new day” has dawned on the municipal market. Yet this is still at the beginning stages, as disclosure requirements will increase, enforcement actions will multiply, a newly professional “municipal adviser” sector — both dealers and nondealers — will be required to perform at much higher levels than in the past, and the newly “independent” Municipal Securities Rulemaking Board takes center stage as the market’s primary regulator.
The long-term implications of the changes will be extensive, as all market sectors will find that more is expected of them. Much of this will not occur immediately, but over time. The municipal market of 2020 will be vastly different from the market of 2010.
Among other things, the market will need either to identify ways to provide much greater assistance to tens of thousands of unsophisticated issuers in coping with the extensive changes and increasing complexity, or to see these issuers move into a growing “shadow market” of direct private placements.
Significant changes since the beginning of the financial crisis include:
Legislation
• Restructuring the MSRB’s membership to include a majority of “independent” public members.
• “Municipal advisers” (a concept much broader than financial advisers) are to be regulated by the MSRB in their business advising issuers and obligated persons.
• Codification of a free-standing fiduciary duty of municipal advisers to their issuer clients.
• Creation of a new statutory federal antifraud provision targeted specifically at municipal advisers in connection with providing advice to or soliciting municipal issuers or obligated persons.
• Changes to rating agencies’ business.
• Regulation of the sale of derivatives to local governments.
• Studies of muni disclosure, the Tower Amendment, and municipal accounting.
SEC
• Empowered to define “municipal adviser” by enforcing the registration requirement, enforce MSRB rules, enforce the fiduciary duty of muni advisers (which exists independently of MSRB rules), and enforce the new special antifraud provision, giving it significant authority over advice and communications by muni advisers to issuers or obligated persons.
• Adopted significant regulatory changes on continuing disclosure by issuers or obligated persons and associated dealer responsibilities, increasing the number of event disclosures, eliminating several materiality decisions, and fixing a 10-day period for such filings.
• Elevated importance of the Office of Municipal Securities.
• A substantial increase in staffing and funding for municipal regulation, including creation of a new muni enforcement unit.
• Announced a series of hearings on municipal disclosure.
• Took enforcement action against New Jersey, the first against a state.
• Continued its action against local officials in San Diego, seeking unprecedented monetary remedies against officials.
MSRB
• Adopted a wide variety of new rules, including the fiduciary duty of and professional standards for municipal advisers
• Implemented its Electronic Muncipal Market Access disclosure and information platform, which significantly enhanced enforcement capabilities by making information submitted to it readily accessible.
• Utilized EMMA to encourage improvements in issuer or obligated person disclosures through incentives for special recognition.
• Required that dealers submit information to EMMA regarding issuer or obligated person continuing-disclosure undertakings, including timing for submissions.
• Required greater dealer disclosure regarding auction-rate securities and variable-rate demand obligations.
Enforcement
• Extensive federal investigations into bid-rigging and price fixing regarding investment contracts, swaps and other derivatives. They included indictments, several guilty pleas, reports of dozens of “target letters,” and associated class actions brought by state and local governments that have survived motions to dismiss.
• Federal and state probes into placement agent practices, political contributions, and other payments relating to state pension funds, with several guilty pleas.
• Securities administrators in half or more states prosecuted dozens of actions relating to ARS, the first time state administrators showed broad interest in municipals.
• FINRA conducted several market-wide “sweeps” and increased enforcement with dozens of actions.
Litigation
• Significant growth in private actions occurred relating to the riskiest municipal securities under common law and often securities laws of multiple states.
• An unprecedented level of complaints was brought by state and local governments — as issuers and investors — against a variety of defendants.
• Significant judicial decisions were issued in private actions regarding governmental liability exposure, responsibilities of counsel preparing or participating in the preparation of offering documents, and responsibilities of underwriters, developers and marketers of financial products.
• Several actions were brought by state attorneys general and investment funds against rating agencies differing in terms of legal theories from less-than-successful investor actions.
• Certain investors purchasing securities in limited offerings experienced noteworthy success in overcoming rating agencies’ motions to dismiss complaints.
Tax Law
• Federal subsidy programs encouraged issuance of taxable municipal securities accompanied by widespread issuer acceptance and dramatic increases in federal power over state and local governments.
• Substantial increases in Internal Revenue Service audit personnel and number of audits.
• The IRS suspended a bond attorney from tax practice.
Market Changes
• Important new categories of muni investors — including pension funds, foreign investors, life insurance companies and hedge funds — were receptive to taxable securities.
• Retail investors demonstrated strength and loyalty at the market’s nadir when many institutional investors left.
• There was widespread loss of confidence in rating agencies.
• Rating agencies “recalibrated” municipal securities ratings to “global” scales
• The demise of five out of seven major triple-A rated bond insurers.
• Significant shrinkage occurred in bank liquidity and credit support for VRDOs
• Substantial costs to issuers associated with ARS, VRDOs and derivatives.
• Investors faced significant losses in terms of market value and delinquencies or defaults, in Florida community development districts and other risky issues that were supported by private credits or new or expanded governmental enterprise credits.
• Municipal credit default swaps and trading grew with mechanisms permitting investors to hedge, or express negative views regarding, specific issuer credits.
• Pensions, post-retirement health benefits, and other employee compensation packages threatened the financial ability of governments to serve the public.
• Harrisburg, Pa., threatened to default, ignoring a general obligation pledge and tempting a mandate to raise taxes
In summary, the pre-crisis municipal market no longer exists. The market is fundamentally different. All of us must take notice and prepare for substantial adjustments that will come in successive future stages.
Robert Doty is president of Sacramento-based AFGS Inc. and author of a recently published book, “From Turmoil to Tomorrow,” on the municipal market.
