Statement on Making the Municipal Securities Market More Transparent, Liquid, and Fair

Introduction

It is difficult to overstate the importance of the municipal securities market. There is perhaps no other market that so profoundly influences the quality of our daily lives. Municipal securities provide financing to build and maintain schools, hospitals, and utilities, as well as the roads and other basic infrastructure that enable our economy to flourish. Municipal bonds’ tax-free status also makes them an important investment vehicle for individual investors, particularly retirees.[1] Ensuring the existence of a vibrant and efficient municipal bond market is essential, particularly at a time when state and local government budgets remain stretched.

Unfortunately, despite its size and importance, the municipal securities market has been subjected to a far lesser degree of regulation and transparency than other segments of the U.S. capital markets.[2] In fact, investors in municipal securities are afforded “second-class treatment” under current law in many ways. This has allowed market participants to cling to outdated notions about how the municipal securities market should operate. The result is a market that, in the view of many, is excessively opaque, illiquid, and decentralized.

The municipal securities market also places individual investors at a distinct disadvantage.[3] This is vividly illustrated by the fact that individual investors in this market receive less favorable prices and pay higher mark-ups than do institutional investors.[4] In fact, one study estimates that, between 2005 and 2013, the total amount of excessive markups and markdowns that investors paid on municipal securities “likely substantially exceed[ed] $10 billion.”[5] Individual investors are not the only ones who lack a level playing field in the municipal securities market. It has been reported that issuers of municipal securities pay billions of dollars each year in unnecessary fees, transaction costs, and interest expense.[6] Such a situation would be troubling in any market, but it is especially so in the municipal securities market, which is dedicated to the provision of vital public resources, and which is heavily invested in by individual investors, either directly or indirectly.[7]

In light of this, I am pleased that this past year witnessed a number of initiatives that will help to make our municipal securities market fairer and more transparent. Among other things, the Commission’s municipal advisor rule took effect, and the Municipal Securities Rulemaking Board (“MSRB”) proposed several final rules, including ones that clarify the fiduciary duties of municipal advisors, require disclosure of reference price information for same-day principal trades, and impose a best execution requirement for trades involving retail investors. The Financial Industry Regulatory Authority (“FINRA”) also proposed rules concerning best execution and the disclosure of reference price information. These are important advances that should yield tangible benefits, but even if the proposed rules are finalized, more can and should be done.

The following discussion describes: (1) the current state of the municipal securities market and the recent developments that have begun to reshape it; (2) some key issues that merit close consideration; (3) recent regulatory initiatives; and (4) several proposals that could be undertaken in a careful, thoughtful, and measured way to improve the functioning of the municipal securities market.

The Current State of the Municipal Securities Market

The Structure of the Municipal Securities Market

The municipal securities market’s breadth and diversity resist broad generalizations, but certain characteristics differentiate this market from all others. The first is the remarkable number and variety of issuances. Although it is less than half the size of the corporate bond market in terms of total principal outstanding,[8] the municipal securities market is estimated to have more than 1.5 million different types of bonds, which is 20 times the number of corporate bond types.[9] The wide variety of municipal securities stems from a number of factors, including the fact that municipal securities are often issued in series, frequently have nonstandard features—such as sinking funds—and include embedded derivatives much of the time.[10] The existence of so many unique bonds atomizes the municipal bond marketplace and impedes trading in the secondary market, as it is far more difficult for investors to locate willing counterparties for the bespoke bonds they hold or wish to acquire.[11]

An equally important characteristic of the municipal securities market is that trades occur in a decentralized, over-the-counter dealer market, rather than on exchanges.[12] Investors looking to trade in the secondary market must buy or sell exclusively through dealers, which execute nearly all transactions in a principal capacity.[13] This greatly inhibits pre-trade price transparency, as individual investors find it prohibitively difficult to shop for bids in the absence of a centralized exchange.[14] To solicit competitive quotes from multiple dealers, for example, an individual investor would have to contact different brokers, which is difficult to do unless the investor has accounts with multiple brokerages. Dealers, by contrast, have access to inter-dealer brokers and electronic platforms, such as alternative trading systems (ATSs), which gives them a tremendous informational advantage over their customers.[15] The value of this advantage is revealed by the lengths to which some dealers have gone to protect it. For example, there is evidence that certain dealers have refused to disclose to their clients the quotations to which the dealers have access through ATSs or their contacts with other dealers.[16] It is difficult to conceive of a legitimate basis for withholding this information.

These factors have conspired to create a market that is more illiquid, opaque, costly, and unfair than it should be. Some figures will help to frame the scope and urgency of this problem. For example, a primary gauge of liquidity is the frequency with which securities trade. While municipal bonds trade actively in the first 90 days after issuance as they move from dealer inventories to investors, trading drops off dramatically thereafter. In fact, one study found that one-third of all municipal bonds trade only once after the initial distribution period, with the bulk of the remaining bonds trading only two or three times throughout their lifetimes.[17] Another study found that 5% of all municipal bonds trade only once every twelve years.[18] As a result, average daily trade volumes for municipal bonds are less than 2% of daily trade volumes for U.S. Treasury bonds, and are less than 50% of daily trade volumes for corporate bonds.[19] This lack of liquidity means not only that it can be difficult for investors to trade municipal bonds,[20] but also that issuers face significantly higher costs, since they must compensate investors for the risks associated with holding such an illiquid investment. In fact, by one estimate, issuers of municipal bonds must pay a premium of approximately 1.12 percentage points to compensate investors for this liquidity risk.[21] It has been asserted that issuers would save in excess of $6 billion annually if this premium could be reduced by just 20%.[22]

The municipal securities market’s lack of transparency has also led to excessive trading costs for individual investors, a situation that is deeply incongruous with dealers’ longstanding obligation to provide fair pricing.[23] According to one study, between 2009 and 2013, individual investors traded approximately $915 billion in municipal bonds.[24] During that period, they paid brokers an average spread of 1.73%, approximately double the spread paid on corporate bond transactions during that period, and about 15 times the spread paid on equity trades.[25] Equally troubling is the fact that individual investors appear to pay higher prices for municipal securities than do institutional investors and dealers. For example, whereas institutional investors and dealers typically buy new offerings at or very near the reoffering price,[26] individual investors routinely pay more—sometimes as much as much as 5% more.[27] This problem extends to the secondary market, as well. One study found that the average spread paid by retail investors in the secondary market is 2% of the bond’s yield, more than double the spread paid by institutional investors.[28] Other studies have confirmed this, and have shown that the advantage enjoyed by institutional investors and dealers can increase by as much as 200% as trade sizes grow larger.[29] It is particularly dismaying to realize that it is currently twice as expensive to trade New York municipal bonds as it was in the 1920s.[30]

It has been recognized that advances in recent years in the availability of post-trade transaction information have enhanced transparency and narrowed somewhat the information gap between dealers and individual investors.[31] Specifically, the MSRB now requires dealers to report all trades within 15 minutes, and this information is available to the public for free via the MSRB’s Electronic Municipal Market Access (“EMMA”) website.[32] In addition, the MSRB has improved its EMMA website to allow investors to compare trade histories of bonds with comparable features, which helps investors determine fair prices for bonds that lack recent trade activity.[33]

Nonetheless, because pre-trade quotation information still is not widely available, dealers and institutional investors retain a substantial information advantage through their exclusive access to electronic trading platforms and dealer networks.[34] This advantage is a serious concern, one that has taken on an added urgency since the financial crisis. Prior to the crisis, the availability of credit enhancements such as municipal bond insurance allowed investors, in many instances, to discount liquidity and default risks in pricing municipal bonds.[35] But recent figures indicate that, as of the end of 2014, only 6% of newly issued municipal securities were insured.[36] The bond insurers’ retreat from the market in the wake of the financial crisis requires individual investors to assess risks more carefully, and to be far more precise in their ultimate pricing decisions.[37] This is a difficult task, because the current structure of the municipal securities market does not provide individual investors the information they need.

It has been reported that ongoing concerns about individual investors’ lack of access to reliable quotations—and the potentially unfair mark-ups that may result—led Commission staff recently to request price information from electronic trading platforms handling municipal securities.[38] Such information would be an important step in the Commission’s efforts to understand how the lack of transparency in the municipal securities market affects individual investors.

Disclosures by Issuers of Municipal Securities

The municipal securities market is characterized by stark disparities in the availability of timely, accurate, and complete financial information about issuers. There are several reasons for this, but one principal driver is that municipal securities are exempted from the Securities Act’s registration requirements, as well as from the Exchange Act’s periodic reporting regime.[39] The Commission, thus, cannot establish mandatory disclosure requirements for municipal offerings, or require them to follow a uniform accounting standard. The Tower Amendment, named after the late Senator John Tower of Texas, also plays a critical role in denying investors accurate and timely disclosures, by limiting federal regulatory authority over issuers of municipal securities. Specifically, the Tower Amendment prohibits the Commission and the MSRB from requiring municipal securities issuers to submit information to them prior to the sale of securities.[40] The Tower Amendment further prohibits the MSRB from requiring any municipal issuer to furnish it, or any purchasers or prospective purchasers, with any information either before or after the sale of securities.[41] Instead, the Commission indirectly regulates municipal securities offerings through its Rule 15c2-12,[42] which requires underwriters of municipal securities offerings to obtain issuers’ disclosures for the securities they intend to sell and provide them to purchasers.

In addition, varying approaches to disclosure have developed over the years. This stems from a combination of a diverse mix of municipal issuers, and the absence of uniform regulatory oversight of disclosures.[43] By one estimate, there are more than 78,000 potential issuers of municipal securities, which range from small school districts and water authorities to states.[44] Disclosure practices have also evolved in such a way that they vary across different types of municipal bonds, such as general obligation bonds, revenue bonds, and conduit bonds. Disclosure practices also vary across the different subgroups within these broader categories of municipal securities.[45] The absence of uniform disclosure protocols vastly complicates investors’ efforts to assess the risks they face when purchasing these securities.

Investors and other market participants have long criticized the quality, consistency, and timeliness of the disclosures provided by municipal issuers.[46] With respect to the initial disclosures that are made when bonds are first issued, there are concerns over the absence of detailed information about issuers’ outstanding debt, such as liens and collateral pledges.[47] There is also widespread concern that issuers are not disclosing bank loans, which issuers have been pursuing in greater numbers in recent years.[48] Municipal issuers also have a contractual obligation to provide continuing disclosure for the vast majority of the securities they issue.[49] But here, too, there are pervasive problems. Industry participants have long complained that many issuers struggle to meet their obligation to provide complete and timely disclosures to the secondary market.[50]

Industry efforts to improve the quality and consistency of disclosures have yielded improvements in recent years,[51] and the availability of disclosures has advanced considerably since 2009, when the MSRB’s EMMA system began serving as a central repository for municipal issuers’ disclosures.[52] Nevertheless, serious problems still remain. This is evidenced not only by criticisms levied by industry participants,[53] but also by the numerous enforcement actions the Commission has brought in recent years against municipal issuers for failing to make disclosures, or for making misleading disclosures that ran afoul of the antifraud provisions of the federal securities laws. These actions have not been limited to smaller issuers, but have included state governments that are frequent participants in the municipal securities markets, as well.[54] Additionally, pervasive shortcomings in issuers’ and underwriters’ compliance with their obligation to provide continuing disclosures led the Division of Enforcement to launch the Municipalities Continuing Disclosure Cooperation Initiative (“MCDC”) in March of last year.[55] The MCDC seeks to encourage issuers and underwriters to police themselves by self-reporting materially inaccurate statements in continuing disclosures regarding an issuer’s prior compliance with its continuing disclosure obligations. Members of the industry have informed my office that the MCDC initiative has instilled “shock and awe” in issuers and underwriters alike. This is deeply troubling, as it signals not only a widespread failure to satisfy the Commission’s limited disclosure requirements, but also an entrenched culture of non-compliance.

New Challenges Facing the Municipal Securities Market

Liquidity is the lifeblood of any properly functioning market. It is what allows investors to execute trades with ease and—perhaps more importantly—to do so without significantly moving prices. Dealers have traditionally served as the principal source of liquidity in the municipal securities market, but that is now changing. According to Federal Reserve data, dealer inventories of municipal bonds have fallen by 65% since the end of 2007.[56] The causes of this apparent retreat from the municipal securities market are complex and not well understood at this point. It may reflect a reduced appetite for risk in the wake of the financial crisis, the diminished profits available from holding bonds during a period of historically low interest rates, or the effects of post-financial crisis banking regulations, to which most of the larger dealers are subject, through their affiliations with banks.[57] Whatever the cause, larger dealers may be curtailing their traditional role as the buyers of last resort.[58]

Institutional investors have partly stepped in to fill the void left by bank-affiliated dealers. For example, asset managers have increased their holdings of municipal securities by 57% since 2007, and now hold 20% of all outstanding municipal bonds.[59] While this has helped buoy liquidity somewhat, asset managers and other institutional investors generally are not designed to function as liquidity providers.[60] Moreover, asset managers tend to be more acutely focused on short term returns than dealers, and may be forced to quickly liquidate their holdings in the event of a market disruption. In fact, this is precisely what happened in 2013, when the so-called “taper tantrum” caused interest rates to spike.[61] This led to a vicious cycle: the sharp rise in rates caused mutual funds specializing in municipal securities to incur substantial losses, which precipitated a wave of investor redemptions.[62] Then, fund managers were forced to sell municipal securities to satisfy these redemption requests, which pushed fund valuations still lower. This, in turn, prompted new redemption requests, which triggered still more sales of municipal securities.[63] As I said, a vicious cycle.

The cumulative effect of these structural changes in the municipal securities market remains to be seen. One consequence may be that the growing role of asset managers will portend heightened volatility and reduced liquidity in the municipal securities markets, particularly during times of market stress, when bank-affiliated dealers historically served as liquidity stabilizers.[64] Another consequence could be that dealers will execute more transactions on a riskless principal basis—in which dealers buy and sell securities within a short period of time, so they face little risk of loss due to market changes—rather than from their inventories. A rise in riskless principal transactions could lead to several outcomes, including an increase in trading costs due to declining trade sizes, the development of price gaps in the market, and a decline in overall trade volumes.[65] Still another consequence of the market’s structural changes could be that investors will turn in greater numbers to exchange traded funds that specialize in municipal securities, in hopes that these funds will offer better liquidity than individual securities.[66] Finally, issuers may find it more difficult to access the market. In the past, the large inventories of both liquid and illiquid securities maintained by dealers allowed issuers to make offerings with little regard for liquidity considerations.[67] Strong investor demand for municipal securities has allowed this to continue in recent years,[68] but the shifting dynamics of the municipal securities market could limit issuers’ ability to access the markets at will in the future.[69]

It is unclear how, and to what extent, the changes described above will shape the municipal securities market in the future. I believe, however, that the Commission needs to monitor carefully this secular shift in market dynamics. In fact, the uncertainties presented by the municipal securities market’s shifting landscape take on an added urgency in light of recent developments, particularly the impending change in U.S. monetary policy. Interest rates are widely expected to rise this year, and this has led many industry participants to warn that investors who have built up sizeable positions in municipal securities may find the exit crowded when the 30-year bull market in bonds finally comes to an end. Without dealers to absorb the heavy selling pressure that could result from a sharp rate hike, investors could be forced to take steep losses on their positions. This potential risk makes it all the more important that long-standing problems in the municipal securities market be addressed without delay.

Recent Regulatory Initiatives

In the past year, a number of initiatives have begun to enhance fairness and transparency in the municipal securities market. Among the most significant developments are the new registration and fiduciary duty requirements for municipal advisors, which took effect on July 1, 2014.[70] Furthermore, in July 2014, the MSRB proposed rules to further articulate municipal advisors’ fiduciary obligations, which rules specify the duties of care and loyalty to which municipal advisors are subject.[71] These rules are vitally important, as they will help to address the myriad abuses observed in the municipal securities markets in recent years, including undisclosed conflicts of interest, and advisors’ failure to place their clients’ interests ahead of their own.[72] It is important for issuers to have the benefit of the protections embodied in the MSRB’s fiduciary duty rules as soon as possible. Accordingly, the MSRB should finalize these rules without undue delay. The MSRB should also promptly seek Commission approval of its proposals to extend to municipal advisors its rules governing pay-to-play practices.[73] Such rules are an important complement to the fiduciary rule that the MSRB is currently pursuing.[74]

More recently, in December 2014, the Commission approved an MSRB rule creating a best execution standard for municipal securities dealers.[75] This standard enhances pricing protections under existing MSRB rules by creating an explicit obligation for dealers to use “reasonable diligence” to obtain a price that is “as favorable as possible under prevailing market conditions” when executing municipal security trades for retail investors.[76] This reasonable measure was long overdue, and it should help diminish the informational advantage dealers hold over individual investors. Many in the industry complained that a best execution requirement, like the ones for equities and corporate bonds, would be wholly unworkable in the highly fragmented municipal securities market.[77] But the MSRB’s final rule recognizes that, even in markets that lack centralized trading platforms, broker-dealers still have an obligation to obtain the best possible price for their clients. Moreover, while the time and expense required to comply with the best execution rule will likely be greater in the municipal securities market, some industry members have noted that tools already exist to make compliance with the rule quite feasible.[78] I support this rule, and urge the MSRB to provide dealers with practical guidance on its application.

In addition, the MSRB and FINRA both proposed rules in late 2014 that would help improve price transparency for individual investors.[79] Under these proposed rules, a dealer would be required to disclose on a retail customer’s trade confirmation price information about the dealer’s same-day principal trades in the security that the customer bought or sold. This is a commonsense change that is long overdue—in fact, the Commission has been pursuing it in the face of industry opposition since the 1970s.[80] These proposed rules will help individual investors to make more informed choices about which dealers to use for future transactions, and will help foster more competitive pricing among dealers.[81] These changes will also help enhance price transparency in the municipal securities market by providing individual investors better insight into the market for the security they have bought or sold.

While I fully support these proposals to make prices more transparent, I urge both FINRA and the MSRB to give serious consideration to additional ways to enhance the quality and extent of the disclosure that investors receive. First, both FINRA and the MSRB should consider implementing a true markup disclosure requirement. Investors are entitled to know how much dealers are charging them for their services. Second, FINRA and the MSRB should consider requiring dealers to disclose their proposed markups before a trade is executed. For example, dealers could be required to send customers an email disclosing the price differential on a proposed trade prior to execution. This simple expedient would empower individual investors to make truly informed investment decisions. Third, FINRA and the MSRB should consider developing a disclosure standard that would not limit the time period for reference transactions to the same day as the transaction being executed for the customer.[82] This would, among other things, require dealers to disclose the price for the most recent trade in the relevant security when there are no same-day reference transactions to report. Fourth, I encourage both regulators to consider requiring dealers to disclose reference price information to institutional investors, as well.[83] Less sophisticated institutional investors, like charitable institutions, could also benefit from this information. Finally, I urge FINRA and the MSRB to consider requiring dealers to disclose other market information on trade confirmations that could inform investors’ decisions. For example, dealers could be required to furnish benchmark or market-price forecast information prepared by external services. If this information could be made available on a commercially feasible basis, it would be helpful to investors.[84]

The MSRB has pursued other rules that will make investor protections more robust. For example, last year the MSRB implemented municipal advisor supervision and compliance requirements.[85] The MSRB has also sought Commission approval to set baseline professional qualification requirements for municipal advisors.[86] The MSRB has also solicited input on its revised draft rule to create core standards of conduct for non-solicitor municipal advisors.[87] Finally, the MSRB has sought comment on amending its existing gifts rule for dealers, MSRB Rule G-20, to establish limitations on gifts given by municipal advisors in their professional capacity.[88]

The last year has also seen improvements in accounting standards. The Government Accounting Standards Board (“GASB”) adopted improved disclosure standards regarding pension liabilities that issuers began implementing in their audited financial statements in late 2014 and early 2015.[89] The key changes include requiring state and local government to disclose pension liabilities, use a lower discount rate, disclose key assumptions, standardize the calculation of pension expense, and value pension assets at market rather than smoothed values.[90] These changes will afford investors greater ability to assess and compare pension liabilities across municipal issuers. Nonetheless, further improvements may be warranted. For example, the new discount rate standards do not fully solve the chase-for-yield and cash-burning problems identified by critics.[91]

Furthermore, there is another major draw-back to the GASB standards: they are entirely voluntary. In fact, by one estimate, only 38 states require local governmental entities to comply with GAAP in preparing financial reports.[92] Certain states, including New Jersey, Kansas, and Washington, set their own standards for local governmental entities, and some entities within those states issue statements that comply with both GAAP and state-compliance statements.[93] This lack of uniformity creates its own set of issues that the Commission is currently powerless to address.

How to Make the Municipal Securities Market Fairer, More Transparent, More Liquid, and More Efficient

Although the regulatory regime for municipal securities markets has witnessed some improvements in recent years, more work needs to be done. There are several key areas where additional reforms are needed, if the municipal securities market is to become as transparent, liquid, efficient, and fair as possible.

1. Repeal of the Tower Amendment and the Exemption for Municipal Securities from the Registration and Disclosure Provisions of the Securities Act and the Exchange Act

Repealing the Tower Amendment would allow the Commission and the MSRB to require issuers of municipal securities to file disclosure materials for review before offering securities to investors. But even without the Tower Amendment, the Commission and the MSRB would still lack the authority to determine what information municipal issuers need to disclose, and when they need to disclose it.[94] Along with the Tower Amendment’s repeal, therefore, Congress should repeal municipal securities’ exemption from the Securities Act’s registration provisions, and from the Exchange Act’s ongoing reporting requirements, as well. Alternatively, Congress could leave these exemptions in place, but give the Commission broad authority to establish improved disclosure practices in the municipal securities market.

With the appropriate statutory authority, the Commission could take a number of steps to enhance disclosure in the municipal securities markets. The Commission’s 2012 Report on the Municipal Securities Market[95] identified a number of such changes, including the following:

• Prescribe minimum requirements for disclosures, such as financial statements and other financial and operating information;
• Establish the form and content of the financial statements used in municipal securities offerings;
• Designate GASB as the standard setter for municipal issuers, and mandate adherence to GASB’s accounting principles;
• Require municipal issuers to have their financial statements audited;
• Directly require issuers to provide continuing disclosures, rather than doing so indirectly through Rule 15c2-12;
• Establish mandatory deadlines for disclosures, including annual reports;
• Prescribe the frequency of continuing disclosures; and
• Establish an enforcement mechanism for these new disclosure obligations.

In addition, I urge the staff to consider the National Federation of Municipal Analysts’ (“NFMA”) recent recommendations to improve disclosures for newly issued municipal securities.[96] The NFMA has identified numerous ways in which municipal issuers can make their initial offering statements for general obligation bonds clearer, more informative, and more comprehensible to investors. For example, the NFMA recommends changes to ensure that bond names are not misleading, that issuers include all material information in their initial statements, and that issuers be required to define the term “general obligation” in their offering statements to avoid confusion that has arisen on this point.[97]

Any new disclosure regime should be calibrated to the unique characteristics of the municipal securities markets—municipal issuers need not necessarily be subject to the same registration framework that applies to public companies. Thus, while more oversight is clearly necessary, any new rules could take into consideration the size and nature of the municipal issuer, the frequency of the issuer’s offerings, and the type of security offered, among other things.[98]

2. Revise Rule 15c2-12 to Improve Municipal Issuers’ Disclosures

I recognize that the statutory changes described above are unlikely to occur in the current political climate. Accordingly, the Commission must explore other ways to address the pressing issues surrounding disclosure by municipal issuers. One way the Commission could have an immediate and significant impact would be to revisit Rule 15c2-12. The Commission’s 2012 report, which was unanimously approved by the Commission, identified a number of revisions to that rule that would help improve disclosure practices for municipal securities. To date, the Commission has not implemented these changes, which include the following:

• Amend the definition of final official statement to include required disclosure about the terms of the offering, including the plan of distribution, any retail order period, and the price to be paid for the municipal securities in the initial issuance;
• Mandate more specific types of disclosures in official statements and continuing disclosures, including event disclosures, primary offering disclosures relating to risks, and disclosures about underlying obligors;
• Establish an enforcement mechanism to address noncompliance with continuing disclosure undertakings;
• Consider modifications regarding the rule’s application to demand securities and underwritten municipal fund securities offerings; and
• Make disclosures more comprehensible and available—especially to individual investors—by requiring issuers to use plain English, to prepare summaries of official statements, and to make all disclosures available on their websites.

The need to revisit Rule 15c2-12 has been clear for some time, and this is evidenced by the MSRB’s repeated calls for the Commission to do so. Just a few weeks ago, the MSRB urged the Commission to engage in a comprehensive review of the rule, particularly to consider revising it to require disclosure of bank loans, swap transactions, guarantees, and lease financing.[99] The trend among municipal issuers to rely on bank loans and other debt obligations in lieu of public offerings is especially troubling, because these debt obligations are not currently subject to Rule 15c2-12. As a result, purchasers of municipal securities may not learn of these debts, if at all, until the municipal issuer releases its financial statements at the end of its fiscal year. Timely notice of such debt obligations is important, because they can impair the rights of municipal securities holders in several ways, including by increasing the municipal issuer’s total debt burden, thereby straining the issuer’s ability to repay the municipal security, and by allowing the bank to assert remedies before municipal securities holders.[100] Similarly, in 2011, the MSRB urged the Commission to revise Rule 15c2-12 to require official statements for all variable rate demand obligations.[101]

The Commission should move quickly to reexamine and revise Rule 15c2-12, particularly to require timely disclosure of bank loans and similar debts that could impair the rights of holders of municipal securities. In this regard, the Commission could look to Form 8-K for examples of the types of events that municipal issuers should have to report immediately.[102] The Commission should also consider amending the rule to require issuers to sign up for automatic email notifications from the MSRB’s EMMA website regarding upcoming deadlines for continuing disclosures. Finally, the Commission could consider extending Rule 15c2-12 to all municipal offerings, including those in denominations of $100,000 or less.[103]

In making these revisions, it is important for the Commission to seek public comment so the rulemaking process will be fully informed, and will have the benefit of thoughtful commentary of investors, market participants, the MSRB, and others.

3. Update The Commission’s Interpretive Guidance

While working to amend Rule15c2-12 is important, the Commission also should promptly update its interpretive guidance regarding disclosure obligations under Rule 15c2-12. This guidance has not been updated since 1994. The developments in the municipal securities markets outlined above make clear how urgently such an update is needed. The 1994 guidance should be revised to address a number of topics, including the 2008 and 2010 amendments to Rule 15c2-12. It should also discuss the issues surfaced by the numerous enforcement actions the Commission has brought against municipal issuers since 1994. In particular, the guidance should provide further information on issues identified through the MCDC initiative, where the Commission’s first settled action apparently occasioned some confusion regarding the precise scope of municipal issuers’ disclosure obligations.[104]

The updated guidance should also provide the staff’s views on areas in which disclosure practices could generally be improved. For example, the staff could provide guidance on: (i) when the re-marketing of variable rate demand obligation securities constitutes an initial offering; (ii) the need for robust disclosure about the underlying obligor, even in offerings that are bolstered by credit enhancement; and (iii) the abiding importance of key disclosures, such as those relating to risks and conflicts of interest.[105] Finally, the updated guidance should encourage issuers to voluntarily provide disclosures beyond what is required by Rule 15c2-12 when appropriate, such as for bank loans and other debt obligations. In this regard, the guidance should remind municipal issuers that bank loans, if they amount to private offerings, may be subject to the anti-fraud provisions of the federal securities laws.

4. Improve Pre-Trade Price Transparency

The lack of pre-trade price transparency lies at the root of many of the problems in the secondary market for municipal securities. It perpetuates the high level of markups and other transaction costs that individual investors incur, and it prevents individual investors from assessing the fairness of the prices they are quoted by their dealers. It also complicates broker-dealers’ efforts to comply with their fair pricing and best execution obligations. The Commission can and must do better for individual investors, particularly in light of the impending rise in interest rates, which might lead to massive waves of selling. Such panic selling typically benefits dealers and institutional investors at the expense of less informed retail investors.

The Commission’s 2012 report identified concrete and achievable steps the Commission could take to level the playing field for individual investors and give them the data they need in order to make informed decisions about their investments. Specifically, the report recommended amending Regulation ATS to require alternative trading systems with material transaction volume in municipal securities to publicly disseminate their best bid and offer prices, along with responses to “bids wanted” auctions, albeit on a delayed and non-attributable basis.[106] The report also recommended that the MSRB issue a rule that would require brokers’ brokers that operate electronic trade platforms to publicly disseminate this same information, provided they also process a significant volume of transactions. These recommendations would do much to make the secondary market for municipal securities more efficient and transparent.

Accordingly, Commission staff and the MSRB should move quickly to seek public comment on these recommendations and develop proposed rules for the Commission’s consideration. These recommendations no doubt pose difficult questions and potential trade-offs. For example, these recommendations could lead dealers to refrain from using ATSs, which could potentially impair liquidity. I have high hopes that the Commission staff will be able to seek solutions to such problems, perhaps by also requiring brokers’ brokers that meet certain volume thresholds to report bid information on their voice brokered transactions. I also believe the Commission staff can devise ways to ensure that unrealistic bids are not published as the best bid when there is little demand for a particular security.

Other members of the Commission have gone further, and have called for the development of electronic exchanges for municipal securities, much like the exchanges that currently exist for equities.[107] This notion has much to commend it, but I recognize that it faces considerable challenges. In fact, recent industry efforts to develop electronic trading platforms for corporate bonds appear to have faltered.[108] The municipal securities market could pose even greater challenges, since merely placing a large number of highly bespoke bonds on an exchange in a market that has traditionally been dominated by buy-and-hold investors may do little to foster liquidity.

For exchanges to thrive in the municipal securities market, municipal securities would likely have to become much more standardized. Other members of the Commission have advocated this,[109] and it is an approach that merits serious consideration. While municipal securities implicate complex and unique legal and tax issues, there is research—including by one of my fellow Commissioners—suggesting that issuers would benefit meaningfully from simpler offerings, both through reduced issuance costs and higher yields.[110] The staff should study what steps the Commission can take to help simplify municipal offerings, as well as other steps that would help foster the development of exchange-like structures for the municipal securities market. In doing so, the staff should consider how the quote-driven municipal securities market differs from the order-driven equities market, as well as the increased role asset managers currently play in the municipal securities market. In addition, the MSRB should continue studying ways of making pre-trade price information available to investors, including through its planned central transparency platform.[111]

Given the significant hurdles that face any proposed transition to an exchange-based market structure, however, the Commission should consider ways to enhance the efficiency of the existing market structure. One possibility would be to examine whether existing electronic trading platforms could be made more open. This could be achieved, for example, by encouraging electronic platforms to transition from the existing request-for-quotation approach, in which dealers select the counterparties from which they solicit quotes, to a so-called “all-to-all” system, in which quotes are solicited from all members of the trading platform simultaneously. Another option would be to determine whether buy-side participants should be allowed to participate directly in electronic trading platforms. The combination of all-to-all functionality and participation by both buy- and sell-side participants could result in more efficient pricing, and also unlock additional liquidity.[112] Another possibility would be to encourage the development of crossing systems, which bring buy-side market participants together. Such systems, if required to publish their best bids and offers, could also help improve price transparency and liquidity. Each of these proposals presents hard questions, but given the significant challenges facing the municipal securities market, the Commission cannot stand idly by.

5. Continue to Improve Post-Trade Price Transparency

In recent years, the MSRB has leveraged its EMMA system to vastly improve post-trade price transparency for municipal securities. For example, last year, the MSRB introduced a “price discovery tool” on EMMA to allow investors to more easily find and compare prices of municipal securities with similar characteristics. This heightened transparency has reduced price disparity, and has enhanced individual investors’ ability to negotiate with dealers for a good price.[113] It is, therefore, vitally important for the MSRB to continue its efforts in this area. Among other things, the MSRB should continue to enhance the functionality of its EMMA website, such as by providing easier-to-read daily trade summaries and graphs that allow users to visualize how their trade prices compare to others for the same security.[114] The MSRB should also follow through on its proposal to require disclosure of pricing reference information on customer confirmations for transactions, and explore the various improvements I discussed above,[115] including a requirement that dealers disclose their proposed markups prior to executing a trade.[116]

6. Enhance Information Sharing Among Regulators

Under current law, the IRS cannot share with the Commission tax return information—which includes a taxpayer’s identity—in connection with the Commission’s enforcement actions.[117] In the past, this has hindered the Commission’s efforts to prosecute violations of federal securities laws involving municipal securities.[118] Congress should revise the tax code to allow the IRS to share with the Commission information the IRS obtains from returns, audits, and examinations when that information concerns potential fraud in the offer or sale of municipal securities. This information could allow the Commission to identify and stop instances of fraud earlier, thereby minimizing potential investor losses.

Conclusion

The municipal securities market is unique in many ways, but an important and compelling feature is the amount of money invested by retail investors, especially retirees. The Commission has a responsibility to ensure that investors in this market are not taken advantage of, but instead have the information and protections they need. There appears to be agreement among the Commission that the municipal securities market is not as liquid, transparent, and fair to retail investors as it could be.[119]

Given this consensus, the Commission should move swiftly to evaluate and, where appropriate, begin the process to adopt the proposals outlined in the Commission’s 2012 report, as well as other initiatives, including those set forth in this statement. Individual investors in the municipal securities market deserve a fair shake. It is well past time the Commission gave them one.