Municipal issuers: Know your friends

September 19, 2012

Having spent almost a year on Capitol Hill when the Dodd-Frank financial reform bill was being debated and drafted, my antenna goes up when an industry trade group praises something done by Congress. It’s usually a sign that the trade group was successful at getting their points of view adopted into law. I’m much happier when trade groups are screaming and kicking about provisions of the law, such as the new rules for derivatives trading and reporting.

This week the Bond Buyer ran an op-ed from Michael Decker, managing director of the securities industry and financial markets association (SIFMA),that praises recent legislation by the House Financial Services Committee. The new legislation amends the Dodd-Frank definition of “municipal advisors” by narrowing who the law would cover and specifically removes securities dealers from that designation. Municipal advisors are professionals paid to advise cities and other municipal issuers on the best ways to structure new bond offerings and manage the debt they have outstanding.

Thankfully the legislation leaves in place a “fiduciary” responsibility for municipal advisors, which requires that they act in the best interests of their clients, the municipal bond issuers (ie cities, states, sewer and water authorities). A “fiduciary” obligation is the strictest form of relationship between two parties.

This threshold of care makes sense for a party acting as a “municipal advisor” to public officials who are directing or investing taxpayer funds. The problem with the recent legislation is that it exempts the following parties who might be doing large transactions with the municipal entity:

[B]rokers, dealers, municipal securities dealers, any investment adviser registered under the Investment Advisers Act of 1940, commodity trading advisor, swap dealer…

In the past, some of these market professionals have acted in the role of muni-advisors, and then switched hats when it was time to do a transaction, throwing away their fiduciary responsibility.

The exemption basically covers all securities professionals who are not registered municipal advisors. This means these parties only have the regulatory threshold of “fair dealing” with municipal issuers, which is a much weaker standard of care. The danger of exempting securities dealers, especially those who act as underwriters to municipal issuers, was perfectly illustrated in a comment letter to the MSRB on proposed changes to Rule G-23 from Nathan R. Howard, a municipal advisor at WM Financial Strategies:

Because, historically, underwriters were permitted to provide recommendations and guidance to municipal entities, municipal entities often considered their underwriter to be a trusted advisor. Consequently, even if underwriters only provide “information”, it is very likely that municipal entities will believe that underwriters are acting in their best interest.

For example, if historically an individual has obtained recommendations and guidance from an attorney regarding legal matters, and now that attorney is no longer licensed, but provides information without disclosing it in writing…the individual will likely believe that the attorney is still his trusted advisor, and will perceive this information to be advice.

The legislation passed by the House Financial Services Committee has yet to be taken up by the full House, and it doesn’t seem to even be on the radar of the Senate Banking Committee. It seems that its purpose was to send a signal to the SEC, which has been revising its proposal for the definition of a municipal advisor to significantly narrow who is one. And more particularly to signal to the SEC that a municipal advisor must have a written contract for compensation to be deemed “engaged” to give advice, which triggers a fiduciary responsibility. This will likely shield bond underwriters from being held to higher standards of care as they guide small municipal issuers in structuring new bond deals.

It is unclear how this will turn out, but the most important thing for municipal issuers, especially small ones, to understand is that their underwriter has no duty to give unconflicted advice with their best interests in mind. Their underwriter is bound only by a requirement of fair dealing, which is a much weaker threshold. There are hundreds of bond issues that were clearly not structured to benefit the issuer. See the recent reporting on capital appreciation bond deals in California for a case where no one was watching out for the issuer’s interests.

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