On April 9, the Municipal Securities Rulemaking Board released a report entitled "Unregulated Municipal Market Participants - A Case for Reform." Its primary conclusion is that regulatory gaps in the muni securities market increasingly permit unregulated participants, including financial advisers who are not dealers, to avoid critical restraints. As a result, the MSRB is seeking authority to regulate financial advisers who are not dealers and other market participants.
After examining the report, the National Association of Public Finance Advisors asserts that the data contained in the report does not support board's conclusions.
The MSRB is a self-regulatory organization created by Congress to regulate the activities of securities firms and banks that underwrite, trade, and sell municipal securities. Rather than asking Congress to have the Securities Exchange Commission regulate all financial advisers, the MSRB is seeking to expand its powers to regulate all FAs. If regulation occurs, NAIPFA argues that the SEC, acting in the best interests of all market participants, should be the regulator due to the inherit conflict between the buy and sell side in a bond transaction.
Many bonds issued by state and local governments are revenue bonds and general obligation debt sold through competitive bidding with assistance from FAs who are not dealers. The MSRB report points out that "of the 358 financial advisory firms that participated in at least one primary market transaction in 2008, only 98 were registered with the MSRB as dealers."
According to the report, 70% of the total volume of municipal debt (by par amount) issued in 2008 was issued with the assistance of financial advisers. FAs that are not dealers were responsible for 62% of these transactions, or 43% of all debt transactions. Dealer-FAs were responsible for 38% of these transactions or 27%, of all debt transactions.
Over the past several decades the muni market has become increasing complex, in part due to complicated financing structures developed by regulated dealers. As noted in the MSRB report: "The complexity of municipal securities offerings and their related derivative transactions, and the abundance of issuers, both large and small, that may lack internal expertise, have created a need for financial advisers."
The position of NAIPFA is that state and local governments need knowledgeable market professionals to serve as the issuer's advocate, independent from the dealer involved in the transaction, in order to protect the issuer's interest. The Government Finance Officers Association shares this position and has educated issuers regarding the role FAs serve in a bond transaction.
The MSRB's recommendation for regulation raises numerous questions not addressed by the report. NAIPFA raises the following points:
1.) Who are the parties that require regulation and why? The media has recently reported pay-to-play practices among a limited number of swap advisers and losses incurred by state and local governments from derivative transactions. In contrast to swap advisers, there have been no media reports of abuses among FAs who are not dealers. The report does not provide examples of either isolated or systemic abuses. The MSRB lumps market intermediaries together by stating that unregulated parties include "unregulated financial advisers and swap advisers who should be referred to collectively as 'independent financial advisers.' " NAIPFA's view is that swap advisers should not be part of this definition. Independent means free of dealer conflict and free to provide the issuer with unbiased advice.
2.) Will further regulation protect the interests of issuers? Throughout the report, there is an emphasis on regulating FAs and providing investor protection. Except with respect to proposed swap regulation, there are no regulations mentioned for the further protection of investor or issuer interests.
3.) What are the abuses requiring regulation? As noted above, neither isolated nor systemic abuses by financial advisers are noted in the report.
4) What rules does the MSRB want to impose? The report notes that "at a minimum, the new rules for financial advisers and investment brokers should include professional qualification and fair practice standards for firms and their associated persons." It fails to note that many FAs who are not dealers are members of NAIPFA, a professional association of independent FAs in which members must adhere to the association's code of ethics, meet ongoing professional education standards as certified independent public finance advisers, and be completely independent of any underwriting of muni securities.
NAIPFA further recommends that, prior to granting additional authority to the MSRB, a further analysis is required of its existing rules and recommends it consider the following:
The report mentions that among its "fair-practice rules," dealers are required to "fairly price transactions" and "avoid conflicts of interest." Is it possible for dealers that represent both the issuers of bonds (who benefit from the lowest bond yields) and the buyers of bonds (who benefit from the highest bond yields) to avoid a conflict of interest?
The report noted that "Rule G-23 is a disclosure rule designed to minimize the actual or apparent conflict of interest that exists when a municipal securities professional acts as both financial advisor and underwriter with respect to the same issue." In spite of requests by NAIPFA to modify the rule and recent confirmation by the GFOA that a conflict does exist, the MSRB has failed to modify G-23. Consequently, the rule allows dealers to switch from serving as FA to serving as the underwriter for the same transaction.
Rule G-37 is intended to prohibit firms from engaging "pay-to-play," whereby dealers make political contributions to issuer officials in order to obtain municipal securities business. In 2005, at the Bond Market Association's 10th Legal and Compliance Conference, the SEC's Office of Municipal Securities suggested that contributions for bond referendums are a pay-to-play activity. Then, in December 2008, executives at Citi, JPMorgan and Morgan Stanley urged the MSRB to prohibit bond referenda contributions. At its meeting in April, the board failed to change the rule.
The MSRB draws the conclusion that regulatory gaps in the muni market permit unregulated participants, including FAs who are not dealers, to avoid critical restraints and play a significant increasing role in the market. They should be regulated by the board.
However, it is possible that a different conclusion could be drawn from the report. Is it possible that the large and growing number of transactions completed with FAs who are not dealers the result of muni issuers making informed decisions?
The GFOA, which represents the views of thousands of finance professionals serving as CFOs for public entities, now recognizes that a conflict does exist between the role of the FA and a dealer hired to work on the same security issue. The FA represents the issuer's interests to achieve the lowest possible cost for a deal. The dealer represents the investors' interests to achieve the highest possible return.
As an increasing number of muni issuers become more informed about this conflict, are they selecting independent FAs instead of dealer-FAs to avoid the conflict? Could the MSRB, a dealer-run organization, be seeking to protect the interests of dealers at the expense of issuers' interests?
NAIPFA believes that the board, a self-regulatory organization of dealers, cannot effectively regulate both independent financial advisers and dealers, whose interests are inherently in conflict. If regulation is deemed necessary by Congress, only the SEC will ensure that regulatory rules respect this inherent conflict as well as ensure that the market works for both the buyer and seller.
Steven Apfelbacher is president of Ehlers and Associates, a Minnesota-based independent financial advisory firm. He is also the current president of the NAPFA and a certified independent public FA.