I had the pleasure of co-presenting on February 19 with senior attorney Elaine Greenberg as part of an educational briefing for the Practising Law Institute. A partner with Orrick, Herrington & Sutcliffe LLP and the former chief of the Municipal Securities and Public Pensions Enforcement Unit, part of the U.S. Securities and Exchange Commission (“SEC”), Attorney Greenberg talked about a spate of recent SEC actions against both issuers and underwriters, penalties, non-monetary corrective actions and the focus on timely and complete disclosures. In addition, she talked at length about the relatively new municipal advisor registration rules as part iof mplementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. Click here to access the program slides and recording.
I talked about hedge funds as relatively new entrants as investors in municipal bonds and conjectured the extent to which liquidity, volatility and price efficiencies will be impacted as a result. Some suggest that the presence of hedge fund investors will change the tone of any restructuring discussions, in the event of a municipal bond issuer default.
The conversation then transitioned to a discussion about the extent to which municipal transactions fall within the allowable debt limit and/or are authorized under state law. The point is that a claimant could realize a loss if a judge rules that a transaction(s) is illegal because it was not authorized. I continued to explain that the monitoring of collateral amounts, credit risk and the valuation of pledged assets is critical as is the assessment of how derivatives are used and whether effective hedges are in place. Following the implementation of Government Accounting Standards Board (“GASB”) Statement No. 53, governments are permitted to verify hedge effectiveness (if it exists) via quantitative testing or showing that what is being hedged has similar terms as that of the hedging instrument.
Attorney Greenberg gave the audience a quick overview of GASB Statements No. 67 and No. 68 since they address pension plan financial reporting. Inasmuch as pension plan obligation numbers pop up increasingly in discussions about particular municipal bond issuers’ disclosure deficiencies (and related credit risk), these new accounting rules cannot be ignored. Recognition of liabilities, doing away with smoothing and using more conservative rates are a few of the “must know” items. Notably, the point was made that the SEC does not require a municipality to report according to GASB rules. However, if a government issuer makes the claim of being GASB-compliant, the SEC is within its rights to investigate whether this is true.
We both contributed to the discussion about pieces of information that investors need, at a minimum, to make an informed decision about whether to allocate or remain exposed to a particular municipal bond issuer. These include, but are not limited to, the following:
- Cash flow requirements of a municipal bond issuer;
- Contractual status of employee benefit plan obligations;
- Degree of unionization of public labor force;
- Risk-taking in cash management and/or investment portfolio;
- Credit capacity;
- History of ratings, particularly if downgrades have followed in succession;
- Quality of tax base;
- Changing demographics;
- Evidence that quality due diligence has been completed (and continues) on the part of underwriters, asset managers, advisors and issuer; and
- Plans as to how a municipal issue intends to generate local economic growth.
We discussed economic and legal consequences of providing misleading disclosures and/or rendering incomplete due diligence. Bankruptcy, inability to borrow further, regulatory enforcement, higher insurance premiums, cost of restating financials, loss of tax-exempt status and private litigation are a few of the many “bads” that accompany poor process.
Ending on an upbeat note, we spent time on what prescriptive steps can be taken to mitigate risks. These include, but are not limited to, the following items:
- Create and implement a compliance-focused training program;
- Engage outside counsel and forensic economists and compliance experts to carry out a mock regulatory and governance audit of policies and procedures as well as operational controls;
- Stay abreast of new rules, requirements and reporting mandates; and
- Review regulatory enforcement actions and private litigation filings to understand areas of possible vulnerability for an issuer, advisor, underwriter and/or portfolio manager.
Elaine Greenberg and Susan Mangiero’s comments are highlighted in a February 21, 2014 article by Yin Wilczek. It is entitled “Municipal Securities – Regulatory Developments Heighten. Risk Exposures for Muni Market Participants” and is published in Bloomberg BNA’s Securities Regulation & Law Report.