Public Finance Client Alert July 22, 2010 Regulation for the Short- and Long-Term: How Dodd-Frank Will Affect Municipal Securities The Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank or the Act ) was signed into law by the president on July 21, 2010. The Act is frequently and accurately described as sweeping because of the fundamental changes it makes to the banking system, the federal securities laws and the operation of markets in general. The provisions of Dodd-Frank directly affecting the municipal securities market are more modest, at least in the short run. These include bringing municipal financial advisors under federal regulation and creating a new Office of Municipal Securities within the SEC. More significantly for the long run, the Act requires two major studies of municipal securities markets and disclosure practices, with a view to possible future legislation. The outcome of these studies, and future legislation in response to them, would seem to have much greater potential to change the municipal securities business in fundamental ways over a period of years. The Act has a general effective date of one day after enactment, but it is written in a manner which delegates substantial amounts of rulemaking authority to regulatory agencies, with the result that the exact meaning of a number of its provisions will not be known until the conclusion of rulemaking by the agencies. The provisions of the Act expressly pertaining to municipal securities appear as Subtitle H (Sections 975 through 979) of a much larger Title IX, which concerns securities markets in general. Title IX is in turn one of a total of 16 Titles making up the 2319-page Act. It should be noted that, in Title IX and elsewhere, Dodd-Frank includes a number of general provisions, not specifically enacted for the municipal securities market, which appear to grant new rights to aggrieved investors, including municipal securities investors, create a bounty system for securities market whistleblowers who notify the SEC of violations, change the regulation of derivatives and asset-backed securities, impose new requirements for rating agencies and make other changes which are likely to affect all markets, including the municipal securities market. A detailed description of these general provisions is outside the scope of this E-alert, which is primarily intended to notify our municipal finance clients of the more immediate and direct effects of the Act on municipal securities.
Registration of Municipal Financial Advisors For the first time, in Section 975, Dodd-Frank requires registration of municipal advisors. A municipal advisor is defined as follows: (4) the term municipal advisor (A) means a person (who is not a municipal entity or an employee of a municipal entity) that (i) provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues; or (ii) undertakes a solicitation of a municipal entity; (B) includes financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and swap advisors, if such persons are described in any of clauses (i) through (iii) [sic] of subparagraph (A); and (C) does not include a broker, dealer, or municipal securities dealer serving as an underwriter (as defined in section 2(a)(11) of the Securities Act of 1933) (15 U.S.C. 77b(a)(11)), any investment advisor registered under the Investment Advisers Act of 1940, or persons associated with such investment advisers who are providing investment advice, any commodity trading advisor registered under the Commodity Exchange Act or persons associated with a commodity trading advisor who are providing advice related to swaps, attorneys offering legal advice or providing services that are of a traditional legal nature, or engineers providing engineering advice; * * * * * Municipal advisors, unless expressly exempted, will be required to register with the MSRB, meet continuing education requirements and professional standards and be subject to discipline pursuant to Section 15 of the Securities Exchange Act of 1934. A somewhat ambiguous exemption provision in Section 975(b)(2)(J)(iv) of the Act requires that the Board s rules not impose a regulatory burden on small municipal advisors that is not necessary or appropriate in the public interest and for the protection of investors, municipal entities, and obligated persons, provided that there is robust protection of investors against fraud. It is not known at this time how the Board will define a small municipal advisor or what kinds of exemption provisions will be included in its regulations. 2
Municipal Securities Rulemaking Board Changes Section 975(b) of Dodd-Frank expands and changes the makeup of the MSRB. Under the new rules, the MSRB is required to include (a) the public representatives, consisting of eight individuals who are independent of any municipal securities broker, municipal securities dealer, or municipal advisor, at least one of whom shall be representative of institutional or retail investors in municipal securities, at least one of whom shall be representative of municipal entities, and at least one of whom shall be a member of the public with knowledge of or experience in the municipal industry; and (b) seven individuals who are associated with a broker, dealer, municipal securities dealer or municipal advisor, including at least one individual who is associated with and representative of brokers, dealers or municipal securities dealers that are not banks or subsidiaries or departments or divisions of banks (the broker-dealer representatives ), at least one individual who is associated with and representative of municipal securities dealers which are banks or subsidiaries or departments or divisions of banks (the bank representatives ) and at least one individual who is associated with a municipal advisor (the advisor representatives and, together with the broker-dealer representatives and the bank representatives, the regulated representatives ). SEC Office of Municipal Securities Section 979 of the Dodd-Frank legislation directs the creation of an Office of Municipal Securities within the SEC for the purpose of administering the municipal securities rules of the Commission and coordinating rulemaking and enforcement actions with the MSRB. This would appear to be consistent with the Commission s recent statements concerning the need for additional rulemaking and enforcement activity in the municipal securities market. Treatment of Asset-Backed Municipal Securities Dodd-Frank makes significant changes to the regulatory treatment of asset-backed securities in general, possibly affecting some common types of municipal asset-backed-securities. The asset-backed securities provisions of Article IX of Dodd-Frank do not contain an exemption for municipal securities. The bank regulatory agencies and the SEC are directed to issue regulations further defining asset-backed securities and granting a total or partial exemption for state and local government asset-backed securities as may be appropriate in the public interest. Dodd-Frank s definition of an asset backed security would seem clearly to cover single-family mortgage revenue bonds, student loan bonds, bank bonds and other pooled financings and could even be read to cover any conduit financing. Therefore, to the extent the regulatory agencies exemption rules do not exclude municipal asset-backed securities, the securities not exempted would be subject to a greatly expanded regulatory scheme. For example, Title IX requires securitizers to retain an interest in the securitized assets (except qualified i.e., not subprime mortgage loans), requires the SEC to set disclosure standards (this requirement is imposed by amending Section 7 of the Securities Act of 1933, so it may apply only to registered offerings, but this is not clear) and requires the SEC to adopt regulations requiring any securitizer to disclose fulfilled and unfulfilled repurchase requests (for breaches of representations and 3
warranties). The issuer or underwriter of any issue of asset-backed securities that obtains a third-party due diligence report must make the findings and conclusions of the report publicly available. Also, Section 939F of the rating agency provisions of Dodd-Frank requires the SEC to study whether a system should be implemented in which issuers and underwriters will not be permitted to select which rating agency gives the initial rating on their asset-backed securities issues, and that the SEC is to prescribe such a system unless it finds that another system would be more effective. None of these provisions will take effect until the SEC and the bank regulatory agencies have issued regulations, which they are to do within 270 days of enactment. Treatment of Swaps Under Dodd-Frank, substantial new regulation of swaps will be instituted, although it is uncertain how much of this new regulation will affect typical municipal swap transactions, in which an issuer of municipal securities enters into a swap to hedge against interest rate risk in connection with bonds issued by it. There will be several new requirements for swap dealers dealing with state and local governments. The Commodities Futures Trading Commission (the CFTC ) (or the SEC in the case of Security-Based Swaps ) will be required to issue codes of conduct (applicable to all counterparties) that, among other things, require swap dealers to disclose material risks and characteristics of the swap, communicate in a fair and balanced manner and provide daily marks. In addition, a swap dealer entering into, or offering to enter into, a swap with a state or local government will be subject to a duty, to be established by CFTC and SEC regulation, to have a reasonable basis to believe that the government entity has an independent representative that (a) has sufficient knowledge to evaluate the transaction and risks, (b) is not subject to a statutory disqualification, (c) is independent of the swap dealer, (d) undertakes a duty to act in the best interests of the governmental entity, (e) makes appropriate disclosures and (f) will provide written representations to the governmental entity regarding fair pricing and the appropriateness of the transaction. Swap dealers acting as advisors will have additional duties. There will be new requirements that swaps be cleared by a clearing agency (and thus subject to margin requirements) and traded on a board of trade or other swap execution facility, but this is not required if no clearing agency or execution facility will accept the swap (i.e., only standardized swaps which municipal swaps generally are not would be required to be cleared). In addition, there is an exemption from clearing and board of trade or other swap execution facility execution for certain end-users that are using them for hedging in the conduct of a commercial enterprise, but it is unclear whether this exemption can be used by governmental entities. Nonetheless, since most government entity swaps are customized, it is unlikely that they will be subject to the clearing and swap execution facility requirements. The banking and securities regulators are to formulate increased capital requirements and also margin requirements for uncleared swaps. Such margin and capital requirements, if made applicable to state and local government swaps, could be the swap provision that most affect governments wanting to enter into swaps in the future. 4
The swap provisions will become effective once regulations are issued, which is required within 360 days of enactment. Reports to Congress Sections 976, 977 and 978 of Dodd-Frank contain requirements that the Government Accountability Office ( GAO ) complete and submit to Congress three significant studies, at least two of which we believe are likely to result in material legislative changes affecting the municipal securities business, as follows: Study GAO Study of Increased Disclosure to Investors GAO Study of Municipal Securities Markets Recommended funding for Governmental Accounting Standards Board ( GASB ) Deadline for Written Report 24 months after enactment 18 months after enactment 180 days after enactment Possible Legislation A major study comparing the municipal and corporate securities markets, specifically including recommendations concerning repeal or retention of the Tower Amendment Analysis of various operational aspects of the municipal securities market with a view to changes to improve transparency, efficiency, fairness and liquidity of market A study by the Comptroller General of the United States of the method and need for funding of the GASB In our view, the most significant impact of the required studies will be the GAO s recommendations pursuant to Section 978 with reference to the possible repeal of the Tower Amendment. The Tower Amendment (Section 15B(d)(1) and (2) of the Securities Exchange Act of 1934) was enacted in 1975 and prohibits the SEC or the MSRB from requiring registration of municipal securities. Additional regulation of municipal securities, including the possible repeal of the Tower Amendment, is a subject which members and representatives of the Commission have often discussed, but Congress has not previously given such a clear indication that it might consider repeal. A repeal of the Tower Amendment could subject a large part of the new-issue municipal securities market to some form of registration, which would have significant cost implications to issuers and would probably greatly increase the lead times necessary for most financings. 5
Conclusion While the regulation of municipal financial advisors and the creation of an office of municipal securities are entirely new, and the broader asset-backed securities and swap provisions of the Act will impact certain municipal securities transactions, the studies mandated by Dodd-Frank appear to have the greatest potential in the long run to change the way the municipal securities business is actually conducted. 6