BRADENTON, Fla. — The Tennessee State Funding Board late Tuesday adopted sweeping changes to the state’s guidelines governing cities and counties that want to enter into interest rate swaps and other exotic financial transactions.
The new guidelines, which take effect Nov. 1, must be followed before local governments can use derivatives and are designed to eliminate conflicts of interest by prohibiting individuals or companies from representing more than one side in derivative transactions, state officials said. Cities and counties must also employ experts and meet minimum outstanding debt requirements, among other requirements.
One issuer welcomed the new regulations while some experts said the new guidelines could make it more difficult for some Tennessee issuers to use derivatives.
Crafted over many months in response to difficulties some Tennessee issuers faced as a result of the market meltdown, the new guidelines were approved Tuesday by the funding board, which consists of Gov. Phil Bredesen, Comptroller Justin Wilson, Secretary of State Tre Hargett, Treasurer David Lillard Jr., and Dave Goetz, commissioner of the Department of Finance and Administration.
“The goal here is not to prohibit cities and counties from entering into swaps, forward purchase agreements, or similar transactions,” Wilson said. “Our goal is to make sure officials in these cities and counties really understand what they’re doing and the taxpayers who live in these cities and counties should know what risks are being undertaken and what fees are being paid on their behalf.”
The comptroller began reviewing state-mandated derivatives guidelines shortly after he took office in January and heard that a number of local governments, particularly smaller ones, had experienced difficulties with their transactions. His office is charged with issuing “compliance letters” after receiving proof that local governments complied with the state guidelines.
Until Tuesday those guidelines had not been updated since 2002 and largely required local governments to take educational courses before entering into derivatives transactions.
Firms, such as Memphis-based Morgan Keegan & Co., and the state’s own financial adviser, Public Financial Management Inc., taught Tennessee’s derivatives courses at various times. PFM is an independent adviser and does not underwrite bond financing.
However, Morgan Keegan did advise some Tennessee issuers about the use of swaps. The firm also developed a conduit issuer called the Tennessee Local Government Alternative Loan Program in 1995.
And at least some local issuers that received advice about swaps from Morgan Keegan also received loans from the firm’s conduit program.
While the firm denied there was any conflict of interest, Tennessee’s revised guidelines now prohibit individuals or companies from representing more than one side in derivative transactions.
“Morgan Keegan fully supports Comptroller Wilson and the state in their efforts to ensure that governmental issuers in Tennessee use derivative instruments in a prudent and responsible manner,” Rob Hahne, head of Morgan Keegan’s municipal derivatives and structured products group, said in a statement. “As Tennessee’s leading underwriter of fixed-rate municipal bonds, we’ll continue to comply with the state’s regulations related to derivatives in our efforts to best serve the financing and balance sheet management needs of the state’s issuers.”
The new guidelines also impose reporting requirements about derivatives transactions, including the disclosure of fees that are paid. Cities and counties must demonstrate that they employ experts in the transactions, including a chief financial officer and an accountant. They must also have an audit committee and a capital improvement plan.
Issuers that do not meet all the requirements laid out in the guidelines have the option of appearing before the comptroller to explain how they can comply with the guidelines.
The new regulations are backed by good intentions although they could make it very hard for some governments to enter derivatives, particularly small issuers, said Rick Miller, a partner at Edwards Angell Palmer & Dodge LLP, whose firm has served as bond counsel for Tennessee issuers that used derivatives.
“What Tennessee is really requiring is a level of sophistication and professional advice and monitoring,” he said. “These are not bad things.”
The guidelines adopted by the state in 2002 and those that go into effect Nov. 1 require issuers to assess swap risk, according to Miller.
“That’s pretty far-sighted,” he said.