On July 31, 2012, the SEC published its long-awaited Report on the Municipal Securities Market (“Report”). The 150-page Report is the culmination of two years of field hearings and review of comment letters, academic studies, and statistics on the municipal securities market. The Report addresses both issuer disclosure and municipal market structure. As to issuer disclosure, the Report finds a need for issuers to improve and make more uniform their financial reporting, and makes both legislative and regulatory recommendations. With respect to market structure, the Report calls for regulatory changes to improve pricing disclosure by municipal securities dealers. Some of the regulatory recommendations would require SEC rule changes but most are addressed to the MSRB, the self-regulatory organization for municipal securities dealers. Among the most significant recommendations are:
The Report calls for improved financial reporting by issuers in both form and frequency. The Report cites an increased focus on issuer credit quality following the 2008 financial crisis and notes that investors and other market participants previously relied upon the credit quality of municipal bond insurers and relied on the insurers to perform diligence on issuers. Combined with decreased confidence in rating agencies, the Report finds that the diminished role of bond insurers supports increased direct scrutiny of issuers. The Report concedes that default rates among municipal securities issuers are low, particularly in comparison to corporate issuances. But the Report cites the recent defaults of Jefferson County, Alabama; the city of Stockton, Calif.; and the town of Mammoth Lakes, Calif., as evidence that defaults do occur. The Report also cites increased concerns over the unfunded pension obligations and Other Post-Employment Benefits (“OPEBs”) of government issuers.
With respect to market structure, the Report concludes that the municipal securities market is uniquely opaque, illiquid, and lacking in pricing transparency. In advocating for increased pricing disclosure, the Report cites the heavy participation of retail investors in the market. It concludes that retail investors lack access to adequate pricing information and are limited in their knowledge of available trade execution options. The Report also notes that lack of pricing transparency inhibits dealers in meeting their obligations to trade at a fair price, to exercise diligence in establishing market value, and to establish reasonable compensation.
Disclosure: Concerns Over the Timeliness and Substance of Issuers’ Financial Reporting
The Report addresses the timeliness and frequency of municipal issuer disclosures, and the comprehensiveness, consistency, and reliability of the financial information in those disclosures. The Report notes that the SEC’s authority over municipal issuers with respect to their disclosures historically has been limited to enforcement of the antifraud provisions of the federal securities laws. The SEC has greater regulatory authority over the conduct of municipal securities dealers with respect to municipal securities disclosures, as well as dealers’ obligations regarding fair dealing, suitability and disclosure of trading and issuance information. Exchange Act Rule 15c2-12 also imposes obligations on municipal securities underwriters concerning issuers’ initial and continuing disclosures.
The Report notes that the disclosure obligations of municipal issuers historically have been governed by voluntary initiatives and industry disclosure guidelines. Municipal issuers routinely make information available to the public pursuant to open government laws and other public accountability measures, but the Report notes that the voluntary practices of market participants are not consistent in their comprehensiveness or frequency.
The Report finds that market participants believe sufficient financial information is available at the time of an offering, but continuing disclosure is often unavailable or not available in a timely manner. Investors express frustration that current credit ratings are not always readily available and that institutional investors have access to more information than retail investors. For instance, institutional investors may be able to contact issuers directly to request information, and have access to electronic road shows.
The Report cites wide discrepancies in the length of time issuers take to publish annual financial reports, and notes concerns over stale financial data. The Report notes a lack of consistency in the frequency and detail in disclosures made by issuers during the life of an issuance. Some issuers voluntarily provide interim financial information, such as monthly budget or cash flow reports, but other issuers do not provide it or do not provide it in a manner accessible to all market participants. The Report finds that some issuers are hesitant to provide interim financial information due to liability concerns.
With respect to the substance of financial disclosures, the Report’s primary concern is the lack of uniform accounting standards. The Report notes the SECs lack of authority to prescribe accounting standards for municipal issuers. Many, but not all, state and local governments use generally accepted accounting principles established by the Governmental Accounting Standards Board (“GASB”). The Report identifies “[d]isclosure regarding pension funding obligations of states and other municipal entities [as] at the forefront of discussions regarding the municipal securities market.” Pension and OPEB concerns center on the appropriate accounting treatment and disclosure of pension and healthcare funding obligations. The Report points to the increase in the underfunded portion of state and local liabilities following the market collapse in 2008 and notes that the appropriate accounting treatment by which to assess funding levels has been subject to intense debate. Disclosure practices with respect to potential pension and OPEB liability also vary widely.
Another substantive disclosure concern cited by the Report is issuer exposure to derivatives. The report acknowledges the potential of derivatives to lower borrowing costs or manage interest rate risk. But the Report views derivatives as posing unique risks to municipal issuers and cites the specific risks posed by fixed-for-floating swaps, the potential for swap counterparties to have conflicts of interest, and the risk that issuers may not understand some complex derivative transactions.
The Report expresses concern about the less-robust information provided to the market by third-party conduit borrowers such as nonprofit and for-profit hospitals, colleges and universities, utilities, real estate projects, and sports facilities. The Report observes that the majority of municipal securities defaults have been in conduit revenue bonds issued for non-governmental purposes.
More generally, the Report notes that “[t]he diversity and complexity of the municipal securities market appears to provide challenges for investors” as some retail investors may have difficulty understanding lengthy disclosure documents and complex offerings. The Report also states that information concerning “financial and business relationships or practices, such as undisclosed payments, political contributions and bid rigging, among offering participants or decision makers may be critical to investors.” The Report cites specific concerns about pay-to-play issues and contributions in support of ballot initiatives.
Market Structure: Concerns Over Pricing Transparency
The Report observes that municipal securities “trade in a decentralized over-the-counter dealer market.” According to the Report, virtually all transactions are executed in a principal capacity by municipal bond dealers, with some effected on a “riskless principal” basis. The Report notes the heavy concentration of municipal bond trading, “with the top ten municipal bond dealers accounting for approximately 75 percent of customer trades by par amount in 2011.” It characterizes the market as having relatively low liquidity and infrequent trading following the initial distribution period, and notes that it is largely a “buy-and-hold” market.
The Report finds that “[t]he secondary market for municipal securities is relatively opaque.” Pre-trade bid and ask quotes are not readily available. Market participants have sought greater insight into the value of municipal securities as they rely less on rating agencies or on bond insurance and other credit enhancements. The Report finds that lack of price transparency inhibits retail customers in assessing the fairness of prices offered by dealers. Further, the lack of price transparency undermines the ability of dealers to meet fair pricing obligations.
The Report observes that availability of post-trade transaction information has increased in recent years, but access to pre-trade price information has remained limited. Initiatives such as the MSRB’s RTRS and EMMA systems have improved post-trade transaction information. But as to pre-trade information, the Report finds a lack of firm bid-and-ask quotations. Pre-trade price information is generally available only through indicative prices provided by dealers, submission of a request for quote (“RFQ”) through a broker’s broker electronic network or obtained through an ATS. The Report notes that electronic trading platforms account for a large percentage of municipal securities transactions and do provide pre-trade price transparency to municipal bond dealers. These systems, however, account for only a small percentage of the dollar volume of municipal securities transactions, which suggests that they are used primarily for smaller, retail-size orders. The Report finds that retail investors themselves have little access to pre-trade pricing information.
The Report observes that municipal securities are more expensive to trade than corporate bonds or equities and links those higher transaction costs to the lack of liquidity and price transparency. The Report also finds that transaction costs are generally higher for retail investors than institutional investors. The Report suggests that retail investors cannot bargain with dealers for a better price because they lack pricing information.
As highlighted above, the Report contains many recommendations, including the following:
The Report recommends a variety of legislative, regulatory, and market-based reforms to address disclosure issues, including the following:
The Report cites a need for increased price transparency to assure fair and efficient markets and to enforce fair pricing obligations. The Report recommends a variety of reforms, including:
The Report notes that any action on its recommendations will require further study, including cost benefit analysis, and consideration of public comment. While the legislative reforms in particular are not likely to be imminent, the Report demonstrates that the SEC is committed to better oversight of municipal issuer disclosures. And the SEC and the MSRB have the ability, without legislative action, to require additional trading and pricing disclosures by municipal securities dealers. All municipal market participants should watch closely as the SEC and the MSRB consider how to implement the Report’s regulatory recommendations concerning disclosure and market structure.
*This alert was co-authored by W. Hardy Callcott, Elizabeth Baird, David Boch, Paul Tyrrell and Michael Moran.
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This article was originally published by Bingham McCutchen LLP.