WASHINGTON - The Municipal Securities Rulemaking Board is urging Congress to give it the authority to regulate independent financial advisers, investment brokers, and other market participants that are currently unregulated but provide key services to state and local issuers.
The board called for the changes in a seven-page letter sent late last week to the chairman and ranking minority members of the House Financial Services and Senate Banking committees.
In the letter, the MSRB also calls for: the creation of a federal muni czar or inter-agency group that would coordinate municipal finance issues; improved federal, state, and self regulatory agency coordination of muni enforcement activities; and the consideration of federal or federal-state regulatory oversight of bond insurers.
Further, the MSRB says that while it does not have a position on the regulation of derivatives, if Congress establishes new regulatory requirements in this area, muni-related derivatives should be treated the same as other types of derivative financial products.
The letter, which was not publicly released until yesterday, was hailed by issuers and members of the broker-dealer community that have long warned about actual, or the appearance of, conflicts of interest among financial advisers and other independent market participants, as well as the lack of a level playing field between them and registered dealer-FAs.
"It would be easiest if the same entity that regulates broker-dealers engaging in financial advisory work would regulate currently unregulated financial advisers undertaking those same activities in the municipal market," said Leslie Norwood, managing director and associate general counsel at the Securities Industry and Financial Markets Association.
"The MSRB has a well-established rule book that took many years to refine and bring into its current form," said Michael Decker, co-chief executive officer of the Regional Bond Dealers Association. "If Congress is looking for a regulator for unregulated participants in the muni market, the MSRB needs to be at the top of the list."
Alan Anders, deputy director for finance in New York City's Office of Management and Budget who also serves on an MSRB issuer advisory board, said: "It's a very thoughtful, helpful letter in addressing the next areas that logically need to be thought about and considered." Anders stressed he was speaking for himself and not for New York City.
But the proposal was panned by some FAs and others who may support federal regulations for independent financial advisers but believe the MSRB is too dominated by the dealer community to be an impartial regulator of these intermediaries.
"This is the fox scratching at the hen house door," said Robert Doty, president of the financial advisory firm American Governmental Financial Services Co. in Sacramento. "For the MSRB to regulate the parties that are supposed to be independent and only have a fiduciary duty to the issuers would be a serious regulatory misconception. There is no way that the MSRB is a disinterested party in this."
Were the MSRB to regulate FAs under its current composition, its rules would be adopted by a board dominated by broker-dealers and enforced by the Financial Industry Regulatory Authority, another self-regulatory organization that is industry-controlled. Such a move would put FAs that are currently independent at a significant disadvantage, Doty said.
He suggested that the Securities and Exchange Commission, rather than the MSRB, would be impartial at adopting and enforcing standards for all financial advisers. Doty said he has urged the SEC for more than two years to take such action. Currently, the SEC only registers large investment advisers.
To emphasize that the MSRB "doesn't understand the fiduciary concept," Doty noted that the board has twice refused to modify its Rule G-23 to require that dealer-FAs contemplating a role switch on negotiated bond transactions disclose to the issuer that conflicts do exist, rather than "may" exist.
In refusing to modify G-23, "the dealers are seeking to have it both ways," Doty said, noting that model bond purchase agreement documents proposed by SIFMA explicitly state that "the underwriters and the issuer are acting on an arm's-length, commercial basis and that no underwriter is acting as a fiduciary or agent of the issuer."
"In light of these documents, it's untenable for the board to require only that there be disclosure that conflicts may result" following a role switch, he said.
But MSRB executive director Lynnette Hotchkiss said that if the board's responsibilities were to expand, it would make sense for Congress to consider changes in the composition of the 15-member board to reflect the added oversight. It is currently comprised of five representatives of banks, five from securities firms, and five members of the public, including a representative of the issuer community and a representative of the investor community.
"An SRO by definition needs to be reflective of the parties that it regulates, so there is clearly the opportunity for Congress to take a look at who is on the board and react as they see fit," Hotchkiss said.
She also said that concurrent regulation is something that Congress should consider, under which muni FAs would be required to register with the SEC and would also be subject to the more proscriptive rules of the MSRB.
Peter Shapiro, managing director of Swap Financial Group, said that his firm welcomes regulation of financial advisers, as long as the regulation is "coherent and not a hodgepodge in many places."
"If this is done coherently, it would make sense," he said. "While the MSRB has an excellent track record, I'm not sure if they would be the right organization."
In any case, most market participants believe the MSRB faces an uphill battle to get lawmakers to consider its recommendations for legislation. Munis are not at the forefront of any lawmakers' list of priorities, which are currently dominated by the stimulus and the bank stabilization plan, congressional aides said.
Several sources said that the Senate Banking Committee may be interested in addressing muni regulation in the spring, but that it first needs to devote more staff to the issue. An aide in the House said that muni regulation could potentially be a legislative nightmare in that chamber, requiring the coordination of up to five committees - Financial Services, Ways and Means, Government Oversight, Energy and Commerce, and Agriculture.
Meanwhile, some investors and market participants may be pushing lawmakers to abandon self-regulatory organizations entirely, among them Christopher "Kit" Taylor, the MSRB's former executive director.
In a brief outline of a proposal to reform municipal finance provided to some lawmakers and regulators, Taylor says he favors establishing a "national market system" for munis under which negotiated bond sales would be banned and all bond deals would be sold through a dutch-auction process, among other things.
"We cannot have a dealer-dominated market in either the primary or secondary market," Taylor said yesterday.
But in its letter, the MSRB stressed that it believes there is an important role for "market-specific, self-regulatory organizations" in any new regulatory framework, because SROs "are uniquely situated to work with the industry to develop effective rules and information systems, and can be vital links between the industry and the broader regulatory community."
Aside from calling for authority to regulate FAs and investment brokers, the MSRB also asked for the creation of a federal muni czar or inter-agency group that would coordinate muni finance issues; improved federal, state, and self regulatory agency coordination of muni enforcement activities; and consideration of federal or federal/state regulatory oversight of bond insurers.
While the issue of whether and how to regulate credit default swaps and other derivatives "remains controversial," the MSRB said that derivatives based on municipal debt should be subject to the same comprehensive regulatory framework that may be developed for swaps and other types of derivatives products. If the government chooses to require disclosures on derivatives, the muni-related disclosures should be made to the board's EMMA system, it added.
Though the MSRB urged the lawmakers to develop a regulatory structure governing certain key muni market participants, the letter makes it clear that it doesn't see the need for federal regulations of municipal issuers.
"We note the extensive improvements in municipal disclosure over the years primarily due to industry cooperation and coordination, and the influence of the buy-side community to demand additional disclosures for certain sectors and in certain markets," the board wrote in the letter, which was signed by MSRB chairman Ron Stack, managing director and head of public finance at Barclays Capital. "We believe that these ongoing industry efforts and market influences will continue to enhance the quality and timeliness of disclosures in our industry."
The letter comes after the board released a statement Jan. 9 asking that specific consideration be given to placing financial advisers, investment brokers, and other unregulated market participants in the municipal market under federal regulation.
Expanding on the points it made in the statement, the board told the lawmakers that it is making the recommendations because multiple ongoing federal investigations of investment advisers and other muni market participants - as well as "the ensuing media coverage and the resulting negative impact on investor confidence and market integrity" - have highlighted the need for broader regulation of muni market participants.
Though independent FAs and investment advisers provide "necessary investment and other services" on complex financial transactions, the MSRB said, these participants "have significant influence with issuers, earn significant fees, and many times are not constrained by any prohibitions on political contributions, either participating in pay-to-play, or giving the appearance of a quid pro quo for attaining business."
"Unfortunately, the regulatory structure over the municipal market has not kept up with the evolving marketplace and nearly all of these participants are unregulated," the letter adds. "At a minimum, financial advisers and investment brokers should be held to standards of conduct that protect municipal issuers, taxpayers and investors in this market."
While many states and localities have laws that prohibit pay-to-play activities and that require disclosures of political contributions for market professionals other than dealers - in some cases modeled on the MSRB's Rule G-37 - "the limited patchwork nature of these state and local laws has not been effective in stopping the possibility and appearance of pay-to-play activities in the unregulated portions of our market," the board said. "A comprehensive federal approach is required."
Turning to the creation of a federal muni czar or inter-agency group that would coordinate muni finance issues, the board said that such an office would be vital as part of any new "multi-layered regulatory framework."
"The lack of municipal finance expertise at the federal level became apparent during the past year and resulted in a very late and limited recognition of the impact of the credit crisis on state and local municipal finances, and the failure of federal programs intended to alleviate the economic impact of the credit crisis to address the needs of state and local governments," the board said.
Meanwhile, the MSRB said that enforcement activities have traditionally been spread across numerous federal and state governmental entities and SROs, "creating a patchwork of overlapping jurisdiction and inconsistent and uncoordinated enforcement activities."
It recommended that each of the entities that are charged with the enforcement of securities laws - regardless of the genesis of those laws - develop a more formal process to coordinate their regulatory and enforcement activities.
The MSRB noted that insurance is currently regulated at the state level, but said that because of the systemic risk implications of a failure of the bond insurance industry, Congress should consider "the potential for federal oversight for financial guaranty insurance companies or a dual federal-state regulatory structure."
The board also said it believes that the possibility of federal, or a combination of federal and state credit enhancement, and a national and-or state financial guaranty insurer, "provides an interesting opportunity worthy of further exploration."