WASHINGTON — Next year could bring some of the most significant changes in the municipal securities market in 35 years as regulators try to fulfill a vast array of mandates under the Dodd-Frank Wall Street Reform and Consumer Protection Act, and Congress weighs potentially expanded federal oversight of the market.
At the same time, market participants are waiting for the outcome of the Securities and Exchange Commission’s hearings on munis and whether they will lead to a report recommending additional regulatory and legislative changes, as well as industry best practices, to improve the timeliness and quality of municipal disclosures.
But both the SEC and the Municipal Securities Rulemaking Board will require additional funding to fulfill their Dodd-Frank mandates, and it is unclear if those funds will be forthcoming in 2011.
Republicans in the House, where appropriations bills start, have been keen to slow federal spending and even have talked about reworking some of the provisions of Dodd-Frank, while industry groups are opposing an MSRB proposal to nearly double the fees it charges dealers.
The MSRB says the fee hikes are needed to pay for the regulation of municipal advisers as well as the continued development of its Electronic Municipal Market Access, or EMMA, site.
If Congress approves fiscal 2011 appropriations for the SEC, it will be able to staff up its muni securities office. That office will gain stature under a Dodd-Frank provision that requires its chief to report directly to the chairman.
But William Daly, senior vice president of government relations for the Bond Dealers of America, noted the stopgap spending measure approved this week by Congress will only last through March 4. He said it is unclear whether the new Congress, with a Republican-led House, will fully fund federal agencies for the remainder of 2011.
Only an appropriations bill or stopgap measure for the balance of the fiscal year, which ends Sept. 30, would give the SEC authority to fulfill its new mandates.
Daly said if the regulatory issues move forward and tax-reform legislation begins to gain traction, 2011 could be “the most important year” for municipal finance since passage of the Tax Reform Act of 1986, which triggered “a period where there were really a lot of fundamental changes and a lot of regulatory guidance coming out that had to be worked through.”
Christopher “Kit” Taylor, former executive director of the MSRB, said the implementation of regulatory changes, particularly the oversight of previously unregulated market intermediaries like financial advisers and swap advisers, may be the most significant since the board was created in 1975 to regulate muni bank and securities dealers.
But he noted that the SEC and MSRB — which will jointly oversee advisers — have an existing regulatory framework to draw on and that advisers are unlikely to resist federal oversight the way some dealers did in the late 1970s.
Will firms Flee the Market?
The regulations for advisers, combined with oversight of over-the-counter derivatives for the first time, will sap industry profits and ultimately prompt additional banks and securities firms to exit the market, Taylor predicted. However, that may not begin to happen until at least 2012, after Dodd-Frank regulations are implemented, he said.
“The change will come after the industry recognizes no more will we be able to do business like we’ve always done,” he said. “But change doesn’t happen within one calendar year.”
Taylor said the exit of firms from the muni market also will depend in part on the outcome of the ongoing antitrust and securities law probes into municipal derivatives and guaranteed investment contracts by federal and state law enforcement agencies.
Early in December, Bank of America Merrill Lynch, the first bank to jump forward to cooperate with the Justice Department, agreed to pay $137 million to settle charges by securities and bank regulators, as well as 20 state attorneys general, that it rigged the bids of municipal investment and derivatives contracts. The settlement was widely seen as just the tip of the iceberg in an expected slew of other enforcement actions.
The Tower Amendment in 2011 also will undergo the most scrutiny it has faced since it was put in place 35 years ago, though market participants ultimately expect it will not be changed.
Initially, two SEC commissioners — Elisse Walter and Luis Aguilar — talked about repeal of the amendment, which was added to the Securities Exchange Act of 1934 and prevents the SEC and MSRB from collecting issuer documents prior to bond sales.
But SEC officials realized that political opposition to any change to Tower remains strong, and that state and local groups would mass together and kill any legislation to repeal or amend it.
As a result, Walter, the SEC commissioner charged with overseeing the muni hearings, has raised the possibility of making improvements to disclosure without repealing Tower. She said in an interview earlier this year that the commission could accomplish this goal even if the amendment stays in place.
The SEC is expected to ask Congress for the authority to require issuers to file specific information with it after their bond sales and to mandate a timetable for ongoing disclosures.
To achieve that, Congress would have to provide the SEC with specific authority to regulate the muni market as well as remove the registration and civil-liability exemptions in the Securities Act of 1933 and the muni carve-outs to the system of periodic reporting under the 1934 act.
The Reign of Bachus
It remains to be seen if there are enough votes in Congress to give the SEC greater authority over the market, although Alabama Rep. Spencer Bachus, incoming chairman of the House Financial Services Committee, has called for more federal oversight in the area.
Spokesmen for Bachus declined to comment, but Republican aides said members plan to hold several oversight hearings, possibly including the muni market, drawing on Bachus’ interest in beleaguered Jefferson County, Ala., which lies partly in his district.
Jefferson County threatened to file for bankruptcy while negotiating a restructuring of $3.2 billion of variable-rate and auction-rate sewer warrants and associated swaps after interest rates skyrocketed. The county has still not restructured the non-recourse debt on which it has defaulted.
Though the SEC may not immediately obtain appropriations to staff-up its municipal office or complete its four remaining muni field hearings, the agency has tentatively scheduled one for Birmingham, which is in Jefferson County. Three others are tentatively scheduled for Florida, Illinois and Texas. None is expected to be held before March.
Issuers and their representatives remain strongly opposed to additional federal oversight of the muni market. But some state and local officials said the SEC might receive support for at least one of the changes Walter has called for in speeches: subjecting non-governmental conduit borrowers to mandatory registration and disclosure, as would be the case if they issued their securities directly without using muni issuers as conduits.
Ben Watkins, director of Florida’s Division of Bond Finance, said private-activity bonds issued for housing, health care and industrial development bonds “are fundamentally different” from a credit perspective from government’s issuing debt to pay for general services.
“There might be some merit in seeing how they’re different and prescribing some enhanced disclosure” for private-activity bonds, he said.
New House Majority
Though the existing Democratic House leadership generally has been friendly to states and localities, House Republicans, who take over the chamber next month, have already demonstrated a different tack when it comes to municipal pension funds.
In early December, three key Republicans introduced a bill that would strip the ability of a state or local government to issue tax-exempt debt or receive subsidy payments from the federal government on taxable debt like Build America Bonds if they fail to file annual reports to the Treasury Department disclosing the state of their pension funds. The reports would have to adhere partly to a uniform, highly conservative set of accounting standards modeled on corporate-style pensions.
Introduced by Wisconsin Rep. Paul Ryan and Californian Reps. Darrell Issa and Devin Nunes, the Public Employee Pension Transparency Act also would preclude Washington from bailing out any state or locality overwhelmed with pension liabilities. Ryan is the incoming House Budget Committee chairman, Issa is incoming chairman of the House Oversight and Government Reform Committee, and Nunes sits on the Ways and Means Committee.
Issuer groups have been quick to pan the pension legislation, saying that state and local accounting principles should be left to the Governmental Accounting Standards Board, not Congress. GASB is in the midst of writing a new set of standards for pension accounting.
One bond attorney, who did not want to be identified, said the bill is superfluous because municipal issuers already are liable under the antifraud provisions of the securities laws for disclosure documents that contain material misstatements or omissions, including those for public pension funds and retiree health care benefits.
“The concept of the securities laws is that you have to provide full and fair disclosure and then let investors reading the offering documents make their judgment based on that disclosure,” the attorney said. “But this proposal goes much further than that and requires issuers to make certain assumptions in their analysis.”
As Congress considers these and other issues, market groups may be able to reach agreements on voluntary best-practice disclosure documents.
The National Federation of Municipal Analysts already is working with the Government Finance Officers Association on the NFMA disclosure documents for general obligation debt and dedicated-tax bonds.
When that project is complete, the two groups may work on templates outlining best practices for providing unaudited “interim” disclosures. The templates could be finalized for consideration by other market groups.
Asked about the templates, Frank Hoadley, chairman of the GFOA’s debt committee and capital finance director of Wisconsin, said his panel has been looking into how monthly financial data already compiled internally could be disseminated in a more uniform fashion without governments having to create new disclosure documents, move to new accounting standards, or accelerate the reporting timetable for audited financials.
“That information can be very valuable in an unaudited form to analysts looking to evaluate credits on a more current basis,” Hoadley said.
Much of the MSRB’s year will be dominated by rules for municipal advisers that are required under the Dodd-Frank law to register with both the SEC and MSRB and comply with MSRB rules. The board’s adviser rules would be enforced by the SEC.
By early January, the MSRB plans to propose a draft pay-to-play rule for municipal advisers that will mirror existing restrictions on political contributions imposed on dealers under Rule G-37. However, it will be subject to a round of public comments before it is ultimately sent to the SEC, where it will face another round of comments before it is approved and implemented.
The MSRB also will propose a draft “principles-based” fiduciary duty rule early next year that will state generally that advisers must put their clients’ interests ahead of their own.
The rule, which will be accompanied by interpretive guidance, will implement a provision in the Dodd-Frank law that imposes a fiduciary duty on municipal advisers but leaves it up to regulators as to what that will entail. The law gave the MSRB oversight of muni advisers beginning Oct. 1.
“We have a pretty significant charge by Congress in the Dodd-Frank Act to create a rulebook for municipal advisers,” said MSRB executive director Lynnette Hotchkiss. “The board has prioritized that process and is acting in a very methodical way dealing with the rules that are the most significant to start with.
“It’s more important to do it right than to do it quickly, so it is going to be a long process,” she added.
To help fund the Dodd-Frank mandates, the board is seeking to impose a new $1 technology fee on each interdealer transaction as well as dealer sales to customers. For the first time in 10 years, the board also is proposing to increase the transaction fee it charges on most munis to 1 cent from a 1/2 cent for every $1,000 par value of bonds.
Both fee hikes, which must be approved by the SEC, are expected to generate $17 million in additional revenue.
Though the dealer-led MSRB approved the fee proposal at its July meeting — before it was reconstituted into a majority-public self-regulator on Oct. 1 — industry groups are opposing the hikes. They contend that the board has not sufficiently explained why such a large increase in revenue is needed.
“This issue has really generated tremendous frustration and opposition among people in the industry,” said Michael Decker, the managing director and co-head of the municipal securities division of the Securities Industry and Financial Markets Association. “We’re hopeful that the MSRB will rethink its proposal.”