Remarks Of Richard Y. Roberts Commissioner* U.S. Securities and Exchange Commission Washington, D.C. "Present and Future Reform of the Municipal Securities Market" Bond Investors Association Municipal Bondholder Rights Conference Anaheim, CA February 7, 1995 ______________ * The views expressed herein are those of Commissioner Roberts and do not necessarily represent those of the Commission, other Commissioners or the staff. I. Introduction I appreciate the opportunity to participate in this conference, although I wish that the circumstances surrounding the need for it were more pleasant. I suspect that it is a very painful time for Orange County bondholders, and I do sympathize with you. Of course, the Securities and Exchange Commission ("Commission" or "SEC") is currently conducting an investigation into a number of aspects of the events surrounding the bankruptcy filings by Orange County, and obviously, I will not discuss nonpublic matters relating to that investigation. I have spent a great deal of time while a member of the Commission advocating a number of municipal securities reforms that I believe were necessary to respond to certain problems existing in this marketplace. For quite a while, I was pretty lonely since save for a few organizations such as the Bond Investors Association, there was very little support for my suggested reforms. Fortunately, that dynamic changed upon Chairman Levitt's arrival at the Commission. As a result of Chairman Levitt's interest in the municipal securities market, many of the muni market reforms which I had recommended in the past, or variations thereof, became the subject of Commission action in 1994. I find this turn of events to be particularly gratifying at this point in my Commission career and so should municipal bond investors around the country. If nothing else, I hope to convey to you today the message that the Commission has been very active for some time now in attempting to improve the quantity, quality, and timeliness of information to municipal bondholders. The Commission cares about the municipal securities market and about the plight of municipal bondholders and will continue to be active in the muni area for the foreseeable future. Due in large part to the financial misfortunes of Orange County, the municipal securities market has experienced extraordinary scrutiny of late. Much of this attention has been focused on two areas: the disclosure deficiencies which exist in the municipal market, particularly in the secondary market, and on the need for increased price transparency in this market, again especially in the secondary or trading market. It is my intention today to discuss, among other things, the Commission's actions that are designed to respond to those two problem areas. I also intend to speculate on what future reforms may be deserving of consideration in the disclosure area if the Commission's actions are subsequently determined to be insufficient. II. Orange County Events As the members of this audience know all to well, on December 6 of last year, Orange County, California, and the Orange County investment pools filed for bankruptcy under Chapter 9 of the federal Bankruptcy Code. These filings initiated the largest municipal bankruptcy in our nation's history, and the full effect of these proceedings may not be known for some time. Additional facts appear to come to light almost daily. I believe that I can safely say that the consequences of Orange County's bankruptcy filings are far reaching - affecting the citizens and bondholders of Orange County as well as many residents in surrounding communities and their bondholders, and even rippling through the municipal market and mutual fund industry on a national scale. In fact, the events in Orange County and their impact on the mutual fund community have already led me to believe that a diversification requirement for single state tax exempt money market funds may make sense. Of course, because of the importance of the bankruptcy of Orange County, the Commission has authorized our General Counsel to enter an appearance in the bankruptcy case pursuant to our express authority under the federal Bankruptcy Code to do so. I wish to assure you that the Commission will be monitoring these bankruptcy proceedings very carefully with the interests of municipal bondholders and the municipal securities market foremost in mind. I believe that the Bond Investors Association will be an integral figure in these bankruptcy proceedings, and I hope that some mechanism could be put in place so that individual as well as institutional bondholders will have a voice in the proceedings. I remain concerned that Orange County may attempt to place on the shoulders of bondholders a disproportionate share of the burden of the financial hardships now facing the County. The bankruptcy filings by Orange County did temporarily rattle municipal securities investors around the country and left the muni market with the jitters. The municipal securities market has undergone periods of great stress in the past when liquidity was absent from the market. On each occasion, in time, the muni market rebounded to be stronger and even larger than before, and most expect this to be the result from the Orange County adversity as well. Certainly, as the level of information improved about the extent of Orange County's troubles and about Orange County's reaction thereto, the muni market became less nervous and more stable. The usual reaction to any financial market disaster is to cry for an increase in the federal oversight of the areas involved. Much of the reaction to the Orange County tragedy has followed this traditional pattern, and there have already been a number of calls for additional federal legislation to reform, among other areas, the muni bond market. More specifically, some have suggested the enactment of legislation to impose on the municipal securities market the initial registration and continuing disclosure requirements applicable in the corporate securities area. Upon reflection, any such response should be resisted, at least for the immediate future. Notwithstanding the Orange County problems, historically, defaults in the municipal area have lagged considerably behind those in the corporate area, so right off the bat serious cost- benefit concerns arise about the necessity for corporate style registration in the municipal area. Further, while the municipal securities market does need more information about bond issuers, especially on an ongoing basis, and more information about bond prices, again particularly in the secondary or trading market as I indicated at the outset of my discussion, the Commission already has in place an ambitious program to eliminate those information deficiencies. The SEC's muni effort, which was well underway prior to Orange County's misfortunes, may preclude the necessity for any additional federal intervention in the marketplace for the near future. I am inclined to be of the view that the Commission's municipal securities projects either recently completed or in substantial progress should be more fully implemented before any new initiatives are pursued seriously. III. SEC Muni Program At this juncture, it may be helpful to review the SEC muni actions either completed or currently underway. First, almost one year ago last March, the SEC approved and published an interpretive release emphasizing to municipal securities issuers and underwriters their disclosure responsibilities under the federal securities antifraud laws, both at the offering stage and on an ongoing basis. The release noted, among other things, the Commission's views about the disclosure practices of municipal issuers with respect to their derivatives activities, both as issuers and as end users. It also reminded municipal issuers that the antifraud provisions apply to their statements that can be reasonably foreseen to affect the secondary market for their securities. As this release merely clarified existing law, it was effective immediately. Next, in November, the SEC adopted extensive revisions to existing rules applicable to municipal securities brokers and dealers that should facilitate better annual disclosure of financial information and timely disclosure by municipal securities issuers of material events that affect the value of municipal bonds. These rules were developed with the assistance of a wide array of muni market participants, and they will be phased in over the course of 1995. Finally, the SEC is developing, again with the assistance of the municipal securities industry, a pricing information system which should result in vastly improved price transparency for municipal securities investors interested in trading muni bonds. Unfortunately, this latter project will take several years to complete. Once fully effective and implemented, these SEC initiatives may result in an adequate cure for the information deficiencies now present in the municipal securities market and exposed by the recent events in Orange County. Of course, muni market participants can elect to ignore whatever rules are in place, but by doing so, they run the risk of being subjected either to an SEC enforcement action or to a private suit from a disgruntled investor (assuming that Congress does not severely limit investors' litigation rights). Chairman Levitt has made it clear that the municipal securities market is now, and will remain so for the next several years, a focus of the SEC's enforcement resources. IV. Possible Future Reforms Since the Commission's muni disclosure rules will be completely phased in by the beginning of next year, the impact of these rules should be measurable by the beginning of 1997. If this impact is subsequently determined to be insufficient to cure the present municipal market disclosure deficiencies, there exist a number of additional viable reforms possible. For example, while there are jurisdictional questions as to just how far the Commission can go with its current rulemaking authority, the Commission arguably could strengthen the new disclosure rules by further amending Exchange Act Rule 15c2-12 and require municipal issuers to provide audited financial statements to the marketplace. Moreover, the Commission could require that these financial statements be made available as early as three months after the end of the fiscal year, rather than annually as allowed currently. This additional reform should not require legislation. For another example, presently the Commission has no authority to set government accounting standards, although it does have such authority in the corporate area. Of course, the Commission defers to the Financial Accounting Standards Board ("FASB") to set accounting standards for corporations. Interestingly enough, it is now up to a state to decide if the government units that fall within its boundaries will follow the standards of the Government Accounting Standards Board ("GASB"). While most states have elected to follow GASB's standards, Congress could pass legislation providing the Commission with the express authority to set the accounting standards for issuers of municipal securities. The Commission could then defer to the GASB to establish those standards and make them mandatory. Moreover, this action would enable the Commission to work with the GASB as it presently does with the FASB to strengthen or otherwise modify the government accounting standards when necessary. There does appear to be some support in Congress for this approach, and I suspect that I would be inclined to support such an approach at the appropriate time. Another possibility is that Congress could go further than the road laid out by the prior approach and not just stop with accounting standards. Congress could provide the Commission with the direct statutory authority to set mandatory disclosure requirements and authorize specifically the Commission to require continuing financial disclosure by municipal issuers. Of course, this approach would be controversial. For another example, Congress could amend Section 12 of the Securities Act and effectively delete the exemption for municipal securities from coverage of that section. This would impose liability for rescission or damages upon anyone who offers or sells any municipal security by means of a material misrepresentation and fails to meet the due diligence defense. While this action may not necessarily result in more disclosure, at the least, it would encourage those providing or preparing the disclosure to be more careful. However, at the moment, Congress does not appear to be inclined to extend any additional cause of action in the security area due to a fear of exacerbating what some now view as a securities litigation crisis. Finally, Congress could go all the way and pass legislation that would rescind the exempt status of municipal bonds under the Securities Act and Exchange Act, thereby subjecting them to the registration and continuous reporting obligations applicable to corporate bond issuers. Obviously, the system for corporate bond issuer reporting could not be adopted wholesale, but would need to be adjusted to take into account the unique characteristics of the municipal securities market. This approach would be very controversial, but it has already been suggested by a number of members of Congress. Possibilities of future reform notwithstanding, other than with respect to nongovernmental conduit bonds, it is my view that Congress should assess the efficacy of the Commission's disclosure initiatives before seriously considering any legislative action to change the largely exempt status of municipal securities issuers under the federal securities disclosure laws. Such an action would have a profound effect on the municipal bond market and would require significant additional resources at the Commission. The Commission's municipal disclosure initiatives, undertaken pursuant to its antifraud and municipal securities dealer authority, provide a foundation for substantial enhancement of disclosure and offering practices in the municipal securities market. These initiatives are quite recent and should be given an opportunity to work before new initiatives are seriously pursued. Again, the impact of these disclosure initiatives should be measurable in early 1997. V. Municipal Investment Pool Reform I wish to change gears briefly at this time and spend a few minutes discussing municipal investment pools as well as some possible reforms that should be considered for those pools. I know that this is an area of interest to the members of this audience, and there are a number of groups working on recommendations in this area including the President's Working Group on Financial Markets, various state and local government associations, and even a California task force headed by Treasurer Matt Fong. I suspect that the Bond Investors Association also could play an active and constructive role in the development of appropriate recommendations in this area. The investment policies of state and local governments clearly are a state matter and not a federal one. The Commission generally does not have, nor should it have, the ability to regulate investment decisions by municipalities and other end users of securities. However, it is my view that all local government entities should have written investment policies that address the various risks such as credit risk, market risk, interest rate risk, or currency risk which may be inherent in different types of investments. Moreover, once policies are established, there should be controls in place to ensure that any investments made actually fall within the guidelines. While guidelines may vary between entities, at a minimum, I believe that they should address a few key issues. For example, if liquidity is necessary, municipal investment pools should be required to mark all investments to market on a frequent basis, probably monthly, regardless of the term or maturity of the investment. Marking investments to market, rather than using their historical value, facilitates early problem recognition. In addition, I encourage government entities to adopt guidelines on the use of leverage, including standards for determining whether and how to use leveraging techniques, as part of their investment policies. Moreover, I believe these investment policies should address the risks of investing in potentially volatile instruments, including derivatives, and should take definitive steps toward ensuring the proper understanding and effective management of these risks. I am of the view that these policies should also include leverage limits. The implementation of risk management policies by state and local governments was endorsed by a June 1994 statement of the Government Finance Officers Association. It also is consistent with the July 1993 report of the Global Derivatives Study Group of 30, which recommended that end-users have risk management systems that are commensurate with the nature, size and complexity of their derivatives activities. I suspect that as a result of the tragedy which occurred in Orange County, state and local governments will be paying closer attention to these recommendations. Possibly the Bond Investors Association could utilize an appropriate mechanism to convey encouragement and support to state and local governments that have developed suitable investment policies. However, state and local governments do need more than just good investment policies; they need a way of ensuring that their investments are being made and that their trading is being done in accordance with these investment policies. One such mechanism of assurance could be more vigilant oversight by officeholders, taxpayers and bondholders. Certainly, the Bond Investors Association could be a positive factor in this area, and I hope that you will be. VI. Conclusion In conclusion, I wish to stress that for the last year or so, the SEC has aggressively pursued a program designed to eliminate the disclosure and pricing information deficiencies which exist in the municipal securities market, and this program is well on its way to completion. More may need to be done from a regulatory or legislative perspective as a result of the unfortunate events which unfolded in Orange County, especially at the state level. However, the participants in the municipal securities market should be allowed a reasonable length of time to digest the massive regulatory changes either already initiated by, or forthcoming soon from, the SEC before any new federal initiatives are pursued seriously. I believe the Commission's recent actions in the muni area will benefit all the participants in the municipal securities market, but especially muni investors. While municipal bondholders should substantially benefit from the Commission's actions to achieve better disclosure and to achieve the transmission of accurate, current price information, you can also help yourself by becoming more militant in protecting bondholder rights. Thus, I wish to close my presentation today by challenging municipal securities investors to become more active and to utilize a stronger voice as an additional means of improving the municipal securities market.