Over the past several months, both dealers and nondealer advisors have made inflammatory public statements accusing the other of shoddy and questionable practices. Neither side, however, has a monopoly on competence or integrity.
The market needs both skillful underwriters and sound advisors. They perform separate functions. There are plenty of both in the market. Nothing is to be gained by finger pointing. In the end, the goal should be to serve the interests of the principals who have the most at stake in the market—issuers and investors. If issuers are well-advised so as to avoid or re-structure unwise securities transactions, and to investigate transactions appropriately, investors will benefit from enhanced securities quality. This offers an opportunity for some of the most significant improvements that could be achieved in the municipal market.
The regulation of “municipal advisors” therefore offers the prospect for substantial improvements in practices by parties providing advice to “municipal entities” and obligated parties. The protection is to be provided in connection with the issuance of municipal securities and certain derivative and investment transactions. Before regulation of advisors by the MSRB can begin in earnest (Rule G-17, the “fair dealing” rule already applies), the SEC must complete its long-awaited refinement of the municipal advisor concept. Nevertheless, Congress adopted a broad definition in the Dodd-Frank Act encompassing many varied firms. Financial advisors are core municipal advisors.
Municipal advisors have a statutory fiduciary to municipal entities, that protects governmental issuers, but not private obligated persons. That duty, like MSRB Rule G-17, already is in effect. It is widely accepted that the duty requires advisors to place the interests of municipal entity clients first, ahead of their own interests. The fiduciary duty requires advisors to avoid conflicts of interest with municipal entities the advisors advise. Sometimes disclosure of conflicts to clients may be sufficient. Sometimes, more serious conflicts may be prohibited even if disclosure is made. The fiduciary duty requires advisors not only to speak truthfully to issuers, but also to be forthcoming with information relevant to the advisors’ engagements by issuers. Further, the fiduciary duty requires competence in the performance of advisory services.
The expanded MSRB, which also has a new mission to protect issuers, as well as investors, has a mandate to promulgate rules for advisors with several goals in mind. Those important goals include, among others, implementation of the fiduciary duty, adoption of professional standards, prevention of fraud, requiring qualifications testing, and requiring continuing education. Enforcement of MSRB rules and the statutory fiduciary duty, in combination with continuing education about enforcement activities and applicable rules, will underscore for municipal advisors the importance of their roles and responsibilities.
Both dealer advisors and nondealer advisors will be subject equally to the new regulatory regime. Dealers already are regulated as dealers, but in their advisory capacities, they are not regulated in the manner or to the extent contemplated in the Dodd-Frank Act. Although there will be necessary adjustments, and full realization of the anticipated improvements will require time, market participants can expect that, over a period of years, there will be substantial changes in practices by advisors.
How will issuers and obligated persons benefit from the regulation? First, the issue of advisor competency is important. Large numbers of firms calling themselves “financial advisors” have been subject to no qualification requirements. Until recently, anyone simply could hang out a shingle claiming to be a financial advisor. The work product of some of these advisors shows that they are sadly lacking in competency. This has been especially prevalent among nondealer advisors, but some dealer advisors have their own issues in this area at times.
Another potential area of improvement is a change in the mindset of advisors from one of completing “deals” to one of providing sound advice. Too many advisors place a primary value on the number of notches in their belts, not on how well they serve their clients’ interests. This mindset is evident in the riskier municipal financings for private parties or start-up revenue producing facilities, when the goal is to reach a closing, rather than to consider carefully how the risks should affect bond structures, due diligence activities, or issuer interests. Putting aside recent convictions of a few municipal advisors for outright fraud against their clients, the powerful desire to close transactions in order to be paid after months of work sometimes may override an advisor’s sense of duty to provide clear advice to clients regarding risks, assumptions and alternatives.
This mindset is evident also in some of the most secure municipal securities transactions, such as capital appreciation bond issues in school general obligation financings in which schools are locked irreparably into seriously disadvantageous noncallable bond structures that may impact adversely the schools’ ability to provide adequate facilities and services for future generations of children. It can be evident when the pricing and terms of bonds are not the best that may be available to issuers in the market. It also is evident in some of the private “bank loan” placements locking issuers into securities structures in which interest rates are subject to unconstrained change at distant future dates and under unpredictable economic or market conditions.
Too many advisors have conflicts of interest with their clients. This arises, for example, when advisors accept contingent fees without informing their clients that other fee alternatives are available and that contingent fees represent a very serious conflict of interest, especially when transactions entail significant risks. Advisors misrepresent the nature and quality of their advice when they hold themselves out as “independent,” while they are sadly subject to such conflicts that the advisors themselves create, promote and disregard.
Historically, although nondealer advisors are fond of pointing their fingers, with justification, at some dealers for overly-complex transactions sold to unsophisticated issuers, many of those same transactions included nondealer advisors as participants. Even today, nondealer advisors are accepting payments from underwriters funneled through bond election campaigns, when the advisors already have assisted, or will assist, the underwriters in gaining employment by issuers without informing the issuers of the conflicts and potential consequences. Meanwhile, those advisors are to negotiate on behalf of issuer clients with the very underwriters who pay, or have paid the advisors, perhaps without knowledge of key issuer officials.
Nondealer advisors need to recognize that the MSRB’s recent action requiring underwriters to make meaningful explicit disclosure to issuers regarding the dealers’ roles and associated conflicts goes a long way toward mitigating prior issuer misunderstandings of underwriters’ roles. Dealers, for their part, need to recognize that there are many experienced and skillful nondealer advisors who seek to, and do, provide sound advice to issuer clients.
Going forward, both dealer advisors and nondealer advisors are to be on a level regulatory playing field. Incompetent advisors, as well as advisors engaging in deceptive practices, either will change their operations or will be weeded out. There no longer is a reason for one group or the other to pretend that it is the sole repository of truth or competence. There are excellent reasons for them to work together for the advancement of the advisory profession and for the ultimate benefit of issuer and obligated party clients and, through conducting sound transactions properly investigated and disclosed, for the benefit of investors.
In summary, there are faults among some in both the dealer and nondealer advisor communities. Having said that, most dealers and nondealer advisors are honest and capable. Nothing is to be gained by pouring gasoline on the flames of historical mistrust. It is better to work cooperatively and constructively for professional improvement.