Why SEC adviser rules are desperately needed

By Cate Long
May 31, 2013

Stockton, California is in the early stages of their bankruptcy and a local grand jury polled current city council members about their understanding of public finance. Does the latest round of public servants have any knowledge municipal finance? No, sadly the San Joaquin County Grand Jury discovered that there was little understanding of the city finances that the council oversees and that they could easily repeat prior mistakes. Local ABC affiliate, News10, reports (emphasis mine):

It has been widely reported how Stockton mismanaged its finances into bankruptcy court.  The grand jury also questions the current council and council members’ ability to manage important financial issues.

“The Grand Jury’s concern is the limited grasp of municipal finances.  While a few [council members]) indicated they had taken college-level courses in finance, or attended workshops, none indicated they were proficient in the matter,” read the report.

Here are city officials who have been seriously burned by financial problems and they have basically no more knowledge than their predecessors. Depressingly this lack of knowledge is true of many American municipalities and a critical reason that the SEC’s new rule for municipal advisers must have very strong fiduciary requirements for professionals who advise communities on bond offerings and other debt projects. Municipal advisers are the only outside professionals who will have a legal duty to protect the interests of their client, a municipality.

Here’s a little background on municipal advisers, since the issue has floated off the radar:

In July, 2010 Dodd-Frank legislation created a new category of regulated municipal professional, a municipal adviser, a person who gives advice to municipal entities that are structuring bond, or swap deals or other investment contracts. The SEC went through a preliminary round of rule-writing and scooped up anyone remotely connected with structuring bond deals as needing to register as muni adviser.

The SEC’s original proposed rule in December, 2010 identified accountants and engineers and others who play minimal supporting roles in bond offerings as needing to register as muni advisers. The market immediately went into an uproar about the wide net the SEC had cast and the regulatory burden for professionals not involved directly in a bond or swap deals. The SEC withdrew that Proposed Rule and has been working to review the over 1,000 comment letters it received.

Meanwhile the latest fight over municipal advisers is how underwriters will be regulated. Banks and dealers currently have no fiduciary responsibility to their clients through the underwriting process, only a requirement for “fair dealing” and a prohibition against fraud. The original SEC rule would have barred underwriters from acting as advisers on a deal and then switching hats to become an underwriter. This hat switching is very conflicted as the adviser should be giving independent advice.

Banks and dealers have taken their fight over being barred from “hat switching” to Congress and got three House members to sponsor legislation to blur the fiduciary duty of underwriters who act in a municipal adviser role. The Senate previously refused to sponsor equivalent legislation. Jeanine Rodgers Caruso, president of the National Association of Independent Public Finance Advisors (those not affiliated with banks or dealers), wrote in the Bond Buyer:

NAIPFA believes that the Dodd-Frank Act got it right by clearly delineating the roles of certain municipal market participants, particularly the roles of municipal advisers and underwriters.

These roles had been blurred for too long as a result of underwriters having provided advice to issuers within the scope of their underwriting engagement that was identical to that which was provided by financial advisers (i.e. municipal advisers), with the only distinction being that underwriters lacked corresponding fiduciary duties for such services.

As a result, muni issuers began to rely on their underwriters to provide advice that was perceived to have been given with the issuer’s best interests in mind.

There are numerous examples across the country where communities took on debt and swaps arrangements that were not in their best interest and their underwriters earned hefty fees. Given that most public officials have little to no financial understanding someone with expert knowledge must look out for the public’s interest. Stockton’s bankruptcy had many causes but one of the primary reasons is that they assumed too much debt to build a ballpark, arena and marina. A municipal adviser, with a fiduciary responsibility to protect the city’s interest, would likely have discouraged issuing so much debt.

An unconflicted municipal adviser is the best party to help communities navigate through the municipal underwriting process. Hopefully the SEC will craft the new rule to exclude underwriters from playing the role of adviser then switching hats and underwriting the debt they advised upon. The nation can only take so many bankrupt, debt laden cities like Stockton.

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