Securities Regulator Calls For Significant Improvements In The Protection Afforded To Investors Purchasing Municipal Securities

by James J. Eccleston, Esq.

ecurities and Exchange Commission (SEC) Chairman Christopher Cox recently delivered an SEC staff "white paper" to Congress that calls for significant improvements in disclosure and accounting in the municipal securities market to better protect investors.

Chairman Cox is not sugar-coating his belief that investors purchasing municipal bonds, notes and other debt securities suffer from inferior legal protection compared to that afforded to other investors purchasing corporate bonds or equities. Mr. Cox observed that the disclosure obligations and protection afforded to municipal securities investors is "not even close", despite the fact that investors (as well as analysts, investment advisers and brokerage firms) "deserve the same level" of disclosure and protection. Let's examine why Chairman Cox is so concerned, and what he has proposed to better protect municipal securities investors.

First, Chairman Cox noted that the municipal bond market was quite small, and dominated by large, institutional investors, when the federal securities laws were enacted 70 years ago. By comparison, today, individual investors own as much as two-thirds of these securities either directly or indirectly through money market funds, mutual funds and closed-end funds. Moreover, the municipal securities market today is enormous. Last year more than $430 billion of new municipal bonds and notes were issued. Currently, there are 50,000 issuers of municipal securities, with $2.4 trillion of municipal securities outstanding, and annual trading exceeding $6 trillion.

Second, Chairman Cox detailed several SEC enforcement actions that "have highlighted continued disclosure weaknesses, raised concerns about governmental accounting, and suggested the need for improvements in disclosure practices." Such cases highlighted the inadequacy of disclosure information to investors and include:

The City of San Diego, which failed to disclose in its municipal securities offering the "gravity of its enormous pension and retiree health liabilities or that those liabilities had placed the City in serious financial jeopardy";

The City of Miami, which failed to disclose in its municipal securities offering "an unprecedented cash flow shortage which it had eased, in part, by spending the proceeds of bonds issued for other purposes for operating costs";

Maricopa County, Arizona, which failed to disclose "a material decline in its financial condition and operating cash flow, the substantial deficit in its general fund, and increased deficit in another fund";

The City of Syracuse, New York, which "falsely claimed a surplus for its general and debt service funds, materially overstated its ending fund balances in those funds, and misled investors by describing certain financial information as audited"; and

Orange County, California, which "made misleading statements and failed to disclose material information about the County's high risk investment pool and financial condition that brought into question the County's ability to repay its securities - facts about which members of the Board of Supervisors [for Orange County] were aware, but failed to take appropriate steps to assure were disclosed."

Third, Chairman Cox particularly is concerned that issuers of municipal securities lack adequate policies and procedures to ensure accurate and full disclosure. For example, Chairman Cox observed that SEC enforcement actions demonstrate that municipal officials who vote to approve the use of disclosure documents often assume they are accurate based on little or no review. Likewise, representatives of the municipality often have limited involvement in the preparation of those documents. Furthermore, and unlike with corporate securities offerings, the issuers (the municipalities) often do not retain legal counsel to prepare the disclosure documents, and the underwriters often disclaim responsibility for statements made in those disclosure documents.

Fourth, and as a consequence, Chairman Cox has called upon Congress to draft legislation. His proposals include:

Requiring that offering documents and periodic reports provided to investors contain information and disclosures similar to that required in connection with all other securities offerings;

Making information on municipal securities available on a more timely basis, perhaps Internet accessible and free, similar to the SEC's interactive data systems for corporations and mutual funds;

Mandating municipal issuer use of generally accepted governmental accounting standards;

Providing for an independent funding mechanism and SEC oversight of the independent accounting standards board in this area (the Government Accounting Standards Board), just as the Sarbanes-Oxley Act provided for the Financial Accounting Standards Board;

Requiring large, complex and frequent issuers of municipal securities to have policies and procedures for disclosure; and

Clarifying the legal responsibilities of issuer officials, underwriters, bond counsels and other participants.

Chairman Cox's call for reform is admirable. Let's hope Congress is as equally persuaded that municipal securities investors should not be treated "second-class."

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James Eccleston, an attorney specializing in adviser and broker-dealer issues, is a partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston in Chicago.