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Federal regulation of the municipal bond market.

Over the past several years, municipal market participants, federal regulators, Congress and representatives of self-regulatory organizations have been giving thought to the adequacy of the current system of regulation in the municipal market and whether additional regulatory measures are needed to provide full investor protection. Among the concerns that have arisen have been the changing composition of purchasers of municipal securities, the adequacy of disclosure in the primary and secondary markets, the appropriateness of suitability rules as they pertain to brokers and dealers of municipal securities, the need for restrictions on political contributions, and on the distribution and review of disclosure documents.

Recently, a few reports have appeared in the press of individual cases of alleged abusive practices involving the selection of underwriters in connection with state and local government bond sales. In response to the alleged abuses, market observers and some members of Congress have called for a review of the municipal bond market's regulatory structure, and others have proposed changes in that structure.

Oversight hearings on the adequacy of the current regulatory structure are expected later this year in the U.S. House of Representatives. In addition, a bill, H.R. 2464, has been introduced that would repeal the so-called "Tower Amendment" and require certain municipal market participants to disclose to the Securities and Exchange Commission (SEC) their political contributions to elected officials. The Tower Amendment is a provision in the securities laws that prohibits the SEC and the Municipal Securities Rulemaking Board (MSRB) from requiring issuers of municipal securities, either directly or indirectly through their underwriters, to file any document prior to the sale of securities by the issuers. It also prohibits the MSRB from directly or indirectly requiring any document or information to be furnished by an issuer to prospective purchasers after the securities have been sold.

Current Regulatory Structure

While issuers of municipal securities are exempt from federal disclosure requirements, the market is not an unregulated one. It is a highly regulated and secure market that is characterized by a low level of defaults. According to J.J. Kenny, less than one-tenth of one percent of rated municipal bonds issued between 1980 and 1991 defaulted, representing 0.27 percent of total dollar volume. For nonrated bonds, 2.12 percent of the issues sold during the same time period defaulted, representing 1.93 percent of the volume.

Principal authority for federal regulation of all securities markets rests with the SEC. Unlike the corporate securities market, however, the municipal market has traditionally been self-regulating. The MSRB, an industry self-regulatory body, was established in 1975 to provide rules for underwriters, brokers and dealers dealing in municipal securities. MSRB rules must be approved by the SEC, and their enforcement is carried out by the SEC, the bank regulatory authorities and the National Association of Securities Dealers (NASD). State and local governments, while exempt from SEC and MSRB disclosure requirements, do provide information to purchasers of their securities on a voluntary basis. In addition, they are subject, as are all securities market participants, to the general anti-fraud provisions of the federal securities laws. The municipal market also is subject to state constitutional limitations and laws governing the issuance of debt.

Several changes in the regulatory structure of the municipal market have been recommended to respond to concerns about recent alleged abuses. An analysis is provided of the following general areas:

* regulation of state and local government issuers under the federal securities laws through the repeal of the Tower Amendment,

* limitations on negotiated bond sales and

* controls on political contributions.

Repeal of the Tower Amendment

There have been proposals to repeal outright or on a limited basis the Tower Amendment. The purpose of the Tower Amendment was to preserve both the long-established right of states to govern their own affairs and the voluntary and self-regulatory structure of the market.

Repeal of the Tower Amendment would potentially subject state and local governments to an array of new federal mandates that would impose new compliance costs. For example, under a modified regulatory scheme, the SEC or the MSRB could 1) require annual financial reports prepared in a federally prescribed format and filed with a federal entity by a certain date, 2) specify the form and content of an official statement, 3) review and approve bond issues prior to their sale, 4) establish or strongly influence state and local government accounting standards and practices, and 5) preempt state oversight of the debt issuance process.

A modification in current law of this proportion would have several direct negative impacts on state and local governments and would present the federal government with regulatory challenges. It is doubtful that the benefits of new federal regulations will justify compliance burdens that will inevitably impose legal costs, require significant educational efforts, cause delays in going to market, and conflict with state regulatory and oversight systems that are already in place. In addition, because of the large number of state and local government issues and issuers, there will be an overwhelming new requirement on the SEC or the MSRB staff to perform their oversight and monitoring functions. While the express attempt of enhanced federal involvement may be laudable, in practice it could seriously harm the efficiency of the market. The implementation of the federal arbitrage restrictions is an example of a worthy federal policy objective gone awry through the regulatory process.

To date, the major proponents of repeal of the Tower Amendment have endorsed this policy option in response to concerns about the use of campaign contributions for the purpose of influencing the selection of underwriters by state and local issuers. However, the Tower Amendment relates to the disclosure of financial and other relevant information about the issuer and the securities being offered and is not related to the problem of the abusive use of political contributions.

Repealing the Tower Amendment and granting new powers to the federal government to regulate the state and local government debt issuance process also would raise serious concerns about the disruption of our federal system of government and the delicate balance between the legitimate national interest in investor protection and the rights of states under our system of federalism to govern their own affairs.

Limitations on Negotiated Bond Sales

Since the potential for abuse in the use of political contributions to influence the selection of municipal bond underwriters is relevant only to negotiated bond sales, there have been suggestions that negotiated bond sales should be prohibited or limited. In fact, in response to recent press reports of a political influence scandal in connection with refunding bonds of the New Jersey Turnpike Authority, the governor of New Jersey issued an executive order requiring that all bond offerings of the state and its agencies and authorities, even refundings, be competitively bid.

There are, of course, advantages and disadvantages to each method of selecting underwriters. Principal advantages of negotiated bond sales are the assistance provided by the underwriter in preparing for the bond sale and the flexibility issuers have to respond to changes in market conditions. One great disadvantage of a negotiated sale, however, is the potential for charges of favoritism toward particular firms.

In competitive sales, taxpayers have some assurance that bonds are sold at the lowest interest cost given market conditions and that the bonds have not been awarded to underwriters on the basis of political favoritism. Historically, too, competitive sales have resulted in lower gross underwriting spreads relative to negotiated sales, although that difference has narrowed in recent years. Disadvantages, however, are that the issuer loses flexibility to respond to changes in market conditions, the underwriter may have written a "risk premium" into the bid since bidding underwriters have no assurance they will be awarded the bonds, and the issuer has the responsibility of all the preliminary work in preparing the issue for market, although a financial advisor may be employed to assist in these tasks.

In 1992, there were many more negotiated offerings--80.9 percent of dollar volume--than there were in previous years, which reflects that the pendulum may have swung too far. The extent to which the role of political influence contributed to the large increase in negotiated sales is not known. One contributing factor that is known is the recent decline in interest rates, which has led to a flood of bond refundings. Refundings are almost always carried out as negotiated deals because market timing is critical to meeting the target level of savings to be realized from a refunding. Refunding issuance totaled $119.5 billion in 1992, up from 1991 by 124.4 percent.

The implication that most bonds now are sold on a negotiated basis should not be drawn from the current high of 80.9 percent of dollar volume, however. If data are compiled on the basis of percentage of issues rather than percentage of volume, the results are significantly different, as noted below, and particularly for general obligation (GO) issues.
Percent of Issues

1992 Competitive Negotiated

All issues 33.7 66.3
GOs 51.1 48.9

There have been suggestions for action by the federal government, ranging from a general ban on negotiated sales to a requirement that issuers disclose in writing why they chose a negotiated over a competitive sale so voters can determine whether a negotiated sale is justified and cast their votes for elected officials accordingly. Other observers believe that curbs on negotiated sales are best carried out at the state and local levels of government.

Any effort to limit or circumscribe negotiated bond sales needs to reflect the fact that a number of factors, described above, contribute to the choice between competitive and negotiated sales. Small issuers, in particular, may not have sufficient access to the market to draw appropriate bids for their securities.

Controls on Campaign Contributions

A discussion of controls on political contributions is controversial and a difficult topic to deal with because of the issues surrounding our system of campaign finance and the ethical issues raised. Concerns about the linkage between political contributions and municipal finance have spawned proposals for regulating campaign contributions.

It is important to note that there is already a well-developed body of law governing state and local elections. All states and the District of Columbia have laws requiring campaign finance reports from either candidates for elected office or from political parties and political action committees, or both. A review of these laws, compiled by the Council on Governmental Ethics Laws, reveals that

* 25 states require statewide, county and municipal candidates to report to a state agency, with the remainder requiring reports from candidates for some offices;

* 37 states require state and local political parties to report to a state agency;

* 48 states and the District of Columbia require political action committees to report to a state agency;

* 44 states require both pre-election and post-election reporting;

* 20 states require a listing of all contributors;

* 26 states require a listing of contributors' funds in excess of certain amounts ranging from $25 in Washington to $500 in Nevada;

* 25 states place limits on campaign contributions in some form; and

* 25 states aggregate and publish campaign finance data.

Individual cities also have their own campaign finance laws.

Two states have specifically dealt with concerns about political contributions and the influence those contributions might have on the underwriting process. Florida's governor banned political contributions to officials involved in the debt issuance process. The executive order of the governor of New Jersey is discussed above. Bills have been introduced in both houses of the New Jersey state legislature to codify the governor's action.

While there has been no clear demonstration that this is not an area best regulated at the state and local levels, several suggestions have been made for new controls on campaign financing as it relates to municipal finance. These are to

* ban contributions to officials involved in the debt issuance process,

* require certain market participants to file information with the SEC or with the appropriate federal bank regulatory agencies,

* require underwriters and brokers and dealers to report contributions to the MSRB, and

* require reporting of political contributions in an official statement

Each of these suggestions raises numerous questions about the design and implementation of the requirement. For example, there have been suggestions that banning contributions would be in violation of the U.S. Constitution's First Amendment guarantee of free speech. Another issue related to this suggestion is to whom the requirement should apply. Some have suggested that the ban should apply to all private market participants, not just underwriters, brokers and dealers. Another problem is defining which elected officials should be subject to the ban. For example, in a city financing, should the ban apply to the mayor, elected treasurer, elected comptroller and all members of the city council? At the state level the issue is even more complicated. Would the ban apply to the governor, treasurer, other elected officials and all members of the state legislature?

The filing of information at the MSRB, SEC or federal bank regulatory agencies is fairly straightforward, but it will impose costs on those who file the information and the agency that will have to collect, store and disseminate the information. It is difficult to discern how this function is related to investor protection; and with limited federal resources, there is doubt that this is the most effective use of investor-protection federal resources. Furthermore, why should information most likely collected and accessible at the state level be duplicated at the federal level? The duplication of effort will result in another cost that is passed on to state and local government issuers.

Requiring the reporting of campaign contributions in the official statement presents the same problem as banning contributions does with respect to defining the appropriate elected officials. A more troubling aspect of this proposal is the justification for such a requirement. The purpose of municipal bond disclosure is to provide information to the market in connection with the sale of securities. While certain non-financial information is important to investors, it is hard to justify the inclusion of campaign contribution data. It may be relevant to the local press and to taxpayers of the jurisdiction, but its relevance to investors is dubious. If the press and taxpayers are the relevant audience, then the official statement is not an appropriate vehicle for reporting information about campaign contributions. Furthermore, assembling the information and including it in the official statement would complicate an already complex process and impose significant new costs on the issuer.

Concluding Comments

There is no easy solution to the issues raised in the market recently. If it is determined that some national-level action is called for, a measured and targeted response should be identified. Major factors to consider are

* the cost of new regulation compared with the expected benefits,

* identification of the problem and an assessment of its importance and severity,

* the relationship of the problem to the federal government's responsibilities for investor protection and

* the need for federal action in an area that is widely regulated by the states.

This article was prepared by CATHY SPAIN, director of GFOA's Federal Liaison Center (FLC), and RUTH WALLICK, consultant to the FLC.
COPYRIGHT 1993 Government Finance Officers Association
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Spain, Cathy; Wallick, Ruth
Publication:Government Finance Review
Date:Aug 1, 1993
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