WASHINGTON — Financial regulatory reform legislation that House and Senate lawmakers hope will be ready for President Obama's signature at the end of the week is expected to authorize sweeping changes to the way the municipal market is regulated.
If signed into law, the Municipal Securities Rulemaking Board would for the first time have authority to oversee non-dealer financial advisers and other unregulated market intermediaries, and the board would have to draft rules stipulating that advisers must hold their clients' interests ahead of their own.
Though finalized language was not available at press time, the bill also appeared to provide for a stable funding source for the Governmental Accounting Standards Board. But the provision was added with little fanfare to the legislation by Senate conferees and was barely mentioned during any of the conferee meetings over the past several weeks.
The legislation no longer includes language imposing a fiduciary duty on dealers that enter into swap contracts with public entities like states, local governments, and pension funds. House Financial Services Committee chairman Barney Frank, D-Mass., who was leading the negotiations, said the language change was necessary in light of concerns raised by pension funds that enter into derivative contracts.
Senate Agriculture Committee chairman Blanche Lincoln, D-Ark., had favored the fiduciary standard for firms that serve as municipal swap counterparties. However, dealers and municipal issuers had complained that it would have been legally unworkable.
In lieu of a fiduciary duty, conferees agreed on a code of conduct for dealer firms that enter into swaps with public entities.
The full House and Senate are expected to take up the bill over the next three days after House-Senate conferees early Friday morning agreed on a measure that reconciles competing versions of the legislation.
The conference committee's negotiations concluded after a bruising final 20 hours of debate and party-line votes in favor of a single bill, shortly before 6 a.m. Friday morning. House conferees approved the bill 20 to 11 while Senate conferees voted 7 to 5 in its favor.
Without final language, it was impossible to know precisely how the muni market would be altered by the legislation, but the conferees appeared to have stuck with an agreement reached earlier this month to allow the MSRB to regulate financial advisers and other market intermediaries that are not currently subject to oversight.
House conferees backtracked from their preference of giving authority over such advisers to the Securities and Exchange Commission. The group that the bill places under MSRB authority includes non-dealer FAs, swap advisers, and brokers of guaranteed investment contracts. Senate Democrats insisted that the MSRB is best suited to regulate the advisers because of the board's specialized knowledge of the muni market and because the board already has sufficient staff.
In exchange, Senate negotiators agreed to adopt House language that would impose a fiduciary duty on the advisers.
It is not clear how many advisers would fall under MSRB regulations. A report the board released last year on unregulated market participants said that of the 358 financial advisory shops that participated in at least one primary muni market transaction in 2008, only 98 were registered with the MSRB as dealers. Many of those were small FA shops, market participants said, adding that the broader universe of unregulated advisers likely surpasses 1,000 firms.
Meanwhile, it was unclear precisely how the GASB funding provision was written. It may require the SEC to study the financial viability of the board before it can direct the Financial Industry Regulatory Authority to collect assessments from muni dealers to fund GASB.
GASB is currently funded through voluntary contributions from state and local governments, as well as revenue from the sales of its publications. But it is constantly short of funds and its dependence on issuers is seen as a conflict.
Issuers groups are mixed on the provision, while dealers have warned it would be inappropriate. A GASB spokeswoman did not respond to phone calls seeking comment.
The Senate was expected to have the 60 votes necessary to overcome procedural attempts to block the compromise legislation after conferees agreed to soften some aspects of its derivatives provisions, including the so-called Volcker Rule, which restricts proprietary trading by banks with federally insured deposits.
Existing carve-outs to the provision for government securities were expanded to allow banks to continue some proprietary trading and investing, allowing banks to invest in a small portion of a hedge fund or private-equity fund. The changes also would limit the investments to no more than 3% of a bank's so-called Tier 1 capital. The provision is named after former Federal Reserve chairman Paul Volcker, who proposed it early this year.
The agreements were thought to be sufficient to sway moderate Republicans in the Senate, such as Scott Brown of Massachusetts, as well as group of centrist Democrats in the House who are on the fence over the legislation.
Obama has said he hopes to sign the legislation into law before the July 4 holiday next week.
On derivatives, the bill generally would require standardized, or routine, swaps to be centrally cleared and traded on a clearing platform. But it would permit the Commodity Futures Trading Commission to create exceptions for swaps that are nonstandardized — or highly tailored contracts that are not suited for clearing. The exceptions would apply to interest rate swaps used by states and localities.
Though some banks will be forced to spin off their derivatives businesses or lose access to emergency funds from the Fed during Friday's marathon session, conferees reached an agreement that would allow some banks to continue to trade swaps.
In addition, the conferees agreed to clarify that a "commercial end-user" exemption from central clearing of swaps would apply to municipalities and small banks. The exemption is designed to apply to entities that use swaps to hedge and not to dealers and traders that use them for speculative purposes. But industry officials had complained that the definition of a commercial end-user was too broad.
Conferees added language to the derivatives section that would allow end-users to use non-cash collateral in instances where they would be required to post collateral.
They also approved an amendment that Frank said would preserve the SEC's enforcement authority over "any" swap linked to a security, though the precise language was not immediately available. Currently the SEC has antifraud enforcement authority over securities-based swaps based on both narrow- and broad-based indexes, but no rulemaking authority.
Under the bill, however, the SEC would get rulemaking and enforcement authority over swaps based on a narrow index of securities, while it would retain antifraud enforcement over broad-based security-based swap agreements.
Among other provisions, the bill will establish the nine-member Financial Stability Oversight Council, which will have the authority to impose higher capital requirements on financial institutions or place certain non-bank firms under control by the Fed. While the Federal Deposit Insurance Corp. would have the authority to wind down large, failing banks in an orderly fashion, the conferees nixed a $150 billion pre-paid fund that would have paid for such efforts.
Separately, to boost the reliability of ratings and hold rating agencies more accountable, the bill would make it easier for investors to sue rating agencies if they "knowingly and recklessly" fail to conduct a reasonable investigation of the underlying data used in a rating. The liability standard is lower than a "grossly negligent" standard that House conferees had originally proposed.
The committee also agreed to jettison a proposal in the Senate's language that would have created an independent board to assign a rating agency to rate structured products. Instead it would have the SEC study the issue. After the study, the SEC would have to implement the independent board or propose an alternative to Congress.
Championed by Sen. Al Franken, D-Minn., the board was intended to resolve conflicts of interest in the issuer-pay business model of the top rating agencies. But conferees warned it would be impractical to make random assignments to rating agencies.
