SEC to focus on conflicts in muni bond business

The SEC's announcement last week that it is launching an investigation of the municipal bond market is aimed at increasing transparency and weeding out conflicts of interest. With $2.8 trillion in muni bonds — 34% of which are held by retail investors and mutual funds — the Securities and Exchange Commission is concerned about gaps in its oversight of the market, Andrew “Buddy” Donohue, director of its Division of Investment Management, said in remarks at the Investment Company Institute's General Membership Meeting in Washington on Friday. Indeed, net flows into municipal bond funds last year hit $72.256 billion, up from just $8.861 billion in 2005. So far this year, such funds have seen $14.013 billion in net flows. And in 2008, there were 136 defaults of muni bond securities, representing $7.5 billion in assets, he said. Given those numbers, “it is surprising that there is such a low level of regulatory oversight,” said Mr. Donohue, reading a speech that SEC Chairman Mary Schapiro was scheduled to deliver. She was unable to attend, because the SEC is investigating the trading irregularities that led to a historic 1,000-point intraday market plunge Thursday, he said (See stories on this page). The SEC wants to make sure that issuers of muni securities are held to the same standards as issuers in the corporate world, Mr. Donohue said. To that end, the commission has asked SEC member Elisse Walter to hold a series of field hearings across the country to examine a broad array of muni securities providers and then issue a report on her findings. The SEC also is in discussions with the Municipal Securities Rulemaking Board about how they can work more closely together to address the potential for conflicts of interest. Currently, the SEC has no jurisdiction over municipal securities issuers, just the broker-dealers that sell the securities. The agency is seeking input from agencies and industry groups such as the ICI, Mr. Donohue said. Specifically, the agency is concerned about the lack of timely disclosure from municipal bond issuers, which can lead to massive defaults. Mr. Donohue cited Jefferson County, Alabama, which suffered a $3.8 billion default on sewer bonds. “These defaults cannot be ignored,” he said. “Individual retail investors and mutual funds have been the main source of demand and liquidity for this market.” While issuers of corporate securities have to provide financial reports within 90 days of the end of their fiscal years, municipalities often take as long as six months and are held to lower accounting standards, Mr. Donohue said. He also said there is currently a huge potential for conflicts of interest in the municipal bond world. For example, under current regulations, it's permissible for a banker to help structure a municipal bond offering, resign as an adviser to that deal and then underwrite the offering, Mr. Donohue said. “We should forbid this practice,” he said. Mr. Donohue suggested a list of reforms that could make the municipal bond market more transparent and decrease the potential for conflicts, including standardized reporting documents that would require specific disclosures of financial information, tax revenue and pension obligations so that “investors can comparison-shop.” He also called for uniform accounting standards for the market, as well as a mechanism for independent funding, such as new fees for new issuances. Finally, the agency recommended that issuers be forced to disclose changes to their financials, such as tax-based changes and lifespan changes that might affect their pension obligations. “Transparency is more than just putting dollars on a page,” Mr. Donohue said. “It is eliminating the potential for conflict of interest that can lead to poor decisions by the issuers.” Conference attendees welcomed the agency's push for more transparency of the municipal bond market. “What the agency is trying to do is avert another disaster before it happens,” said Jay G. Baris, a partner at Kramer Levin Naftalis & Frankel LLP. “Clearly, it's an important issue, and there are warning signs out there that there could be trouble in this sector.” And given that so many investors believe that fixed income is a safe place to be — particularly given the market swings last week — it makes sense that regulators are looking deeper into this part of the fixed-income market. “Not all paper is safe,” Barry Benjamin, leader of the investment management and real estate group at PricewaterhouseCoopers LLP, said in an interview at the conference. “Right now, you don't know where there are conflicts of interest.” E-mail Jessica Toonkel Marquez at jmarquez@investmentnews.com.