Over the last two years, the municipal market has seen an increasing amount of public scrutiny due to high-profile federal and state investigations into corruption and pay-to-play activities. On February 6, 2009, the Municipal Securities Regulatory Board (MSRB) submitted to Congress recommendations for new federal oversight of the municipal securities market and the creation of a municipal securities "czar."¹ The Recommendations Letter contains bold proposals for reform, which according to the MSRB, are necessary given recent high-profile federal and state investigations and loss of investor confidence.

This Client Alert (i) provides a brief overview of the regulation of the municipal securities market, (ii) highlights the key provisions in the Recommendations Letter, and (iii) summarizes current MSRB initiatives for greater transparency and disclosure. Given the important role that municipal bonds will play as states and localities face burgeoning budget deficits, it appears reasonably likely that this market will become subject to greater federal oversight and new regulation in the near future.

1. Regulation of the Municipal Securities Market

Current regulation of the municipal bond market has been described as "light regulation" or "patchwork regulation." This "light regulation" stems in part from the limited jurisdiction of the MSRB. The MSRB was authorized by Congress in the 1975 Securities Reform Act as a "functional" or "product-line" self-regulatory organization (SRO) to develop rules regulating securities firms and banks involved in underwriting, trading and selling municipal securities. The MSRB's jurisdiction is thus limited to writing rules for this narrowly-defined community. It does not have authority to apply these rules to other professionals and intermediaries in the municipal finance market, such as independent financial advisors and swap advisors (collectively, "financial advisors") and brokers of guaranteed investment contracts and other collateral investment products ("investment brokers").²

As an SRO, the MSRB is subject to the oversight of Securities and Exchange Commission (SEC). Responsibility for examination and enforcement of MSRB rules is delegated to the Financial Industry Regulatory Authority (FINRA) for all securities firms, and to the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Comptroller of the Currency and the Office of Thrift Supervision for banks.

2. MSRB's Proposal for Comprehensive Regulation

In its Recommendations Letter, the MSRB (i) recommended that Congress bring unregulated intermediaries in the municipal securities market under federal oversight, and (ii) outlined its support for additional changes to the overall federal financial regulatory structure, including the creation of a so-called municipal securities "czar."

With respect to (i), the MSRB recommended that:

• Financial Advisors and Investment Brokers: Congress should create a comprehensive regulatory scheme for financial advisors, investment brokers and other intermediaries in the municipal securities market. While many states and localities have prohibitions on pay-to-play activities and laws requiring disclosure of political activities, the patchwork nature of these regulations has not been effective in eliminating the appearance or practice of pay-to-play activities and a comprehensive federal approach is necessary.
• Financial Guaranty Insurance Companies: Congress should consider federal oversight for financial guaranty insurance companies, or a dual federal/state regulatory structure. Although insurance currently is regulated at the state level, the systemic risk implications of a failure in the bond insurance industry may require more comprehensive regulation.

With respect to (ii), the MSRB recommended that:

• New Regulators: Congress should create an overall regulatory framework for the financial markets that consists of a market stability regulator, a prudential financial regulator and a business conduct regulator;
• Muni Czar: Congress should establish a federal-level position charged with representing the unique needs of the municipal market or alternatively, create a senior-level, multi-agency group to coordinate municipal finance issues and create a more formal process for coordination among federal and state entities charged with enforcement of securities laws;
• Role of SROs: Congress should utilize market-funded, market-specific SROs to embody and expand on basic antifraud standards of federal securities laws; and
• Muni Derivatives: Congress should subject derivative instruments based on municipal securities to the same comprehensive regulations being considered for the overall derivatives market.

A Note on Muni Derivatives: Over the past few years, the use of derivatives in combination with municipal bonds has grown rapidly. Derivatives have been a popular tool in the municipal market, presented to states and municipalities as a means to reduce borrowing costs and hedge or manage interest rate risk. But as the recent market turmoil spread through the credit markets over the past year, some of the derivatives have collapsed, leaving local governments with unexpected costs. At the same time, the status of municipal derivatives under the securities laws and the SEC's jurisdiction over them remain largely unclear. In 2008, the SEC filed an action involving municipal swap contracts in SEC v. Langford.³ This case is noteworthy because the SEC asserted untested theories of its jurisdiction over swaps, arguing that interest rate swaps based on the SIFMA Municipal Swap Index are security-based swap agreements that are subject to the antifraud provisions of the federal securities laws. The SEC brought this case over objections by industry groups that the interest rate swaps were non-security based swap agreements and, thus, were not subject to the SEC's jurisdiction.⁴

In the Recommendations Letter, the MSRB made clear that it did not advocate a particular position on the regulation of derivatives. That said, the MSRB recommended that these instruments should be subject to a comprehensive regulatory framework (e.g., as articulated in proposals for (i) a central clearinghouse for credit default swaps, (ii) the use of a central counterparty, and (iii) disclosure requirements for CDS dealers, hedge fund managers and other investors). To that end, the MSRB volunteered to provide any required disclosures of municipal derivative contracts through its Electronic Municipal Market Access system (EMMA), described below.

3. Transparency and Disclosure in the Municipal Securities Market

A consistent criticism of the municipal securities market has been that information is not easily accessible to investors. Unlike investors in corporate securities who have direct access to free issuer information through the SEC's EDGAR system, average investors in municipal securities traditionally had no free and convenient way to access important information about municipal bonds. Because municipal securities are exempt from the registration and reporting provisions of the federal securities laws (except the anti-fraud provisions), the SEC cannot specify line-item disclosure requirements or review disclosure documents in connection with offerings of municipal securities.

To address these concerns, the MSRB launched EMMA, an EDGAR-like municipal securities market web-based disclosure portal. In December 2008, the SEC approved amendments to Rule 15c2-12 under the Securities Exchange Act of 1934, as amended (Exchange Act) that designate the MSRB as the central repository for ongoing disclosures by municipal issuers.⁵ Under a separate MSRB rule change also approved by the SEC in December 2008, EMMA will make these disclosures available to investors in the same manner that the SEC's EDGAR system does for corporate disclosures. The new MSRB rule establishes, as a component of EMMA, the continuing disclosure service for the receipt of, and for making available to the public, disclosure documents and related information to be submitted by issuers, obligated persons, and their agents under the continuing disclosure requirements of Rule 15c2-12. This new continuing disclosure component of EMMA is expected to become operational on July 1, 2009.⁶

After all components of EMMA are fully implemented in accordance with the MSRB's proposals and public statements, EMMA will provide free, real-time Internet access to all primary and secondary market disclosures, trade price data for municipal securities, interest rates on variable rate demand obligations (VRDOs), and interest rates and bidding information for auction rate securities (ARS). The MSRB began publishing information about ARS on EMMA on January 30, 2009, when it put in place a rule requiring municipal securities dealers to submit such data to the MSRB. On February 11, 2009 the MSRB announced that current interest rate information for municipal ARS will be available to investors.⁷ Beginning April 1, 2009, interest rate information about VRDOs will be available on EMMA. Subsequent phases of EMMA will provide for the collection and dissemination of bidding information for ARS and key documentation relating to ARS and VRDOs.⁸

Conclusion

The following months will likely present many changes in the regulatory landscape of the municipal securities market. All market participants are strongly encouraged to participate in the future rulemaking process. In addition, the existing members of the municipal securities dealer community should brace themselves for a heightened review of their compliance policies and procedures in the days to come.

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¹ Letter from Ronald A. Stack, Chair, MSRB, to Hon. Barney Frank, Chairman, House Financial Services Committee, et. al. (Feb. 6, 2009), available here ("Recommendations Letter"). Press Release, MSRB, MSRB Recommends Comprehensive Rules for Unregulated Intermediaries in the Municipal Market (Feb. 11, 2009), available here.

² Recommendations Letter, supra note 1.

³SEC v. Langford, et al., No. CV-08-B-0761-S (N.D. Ala. filed Aug. 7, 2008).

⁴ Brief for SIFMA as Amici Curiae Supporting Respondents, Langford, et al., No. CV-08-B-0761-S (N.D. Ala. filed Aug. 7, 2008), available here.

⁵ Amendment to Municipal Securities Disclosure, Exchange Act Release No. 34-59062 (Dec. 5, 2008), available here. Under Rule 15c2-12(b)(5), an underwriter for a primary offering of municipal securities subject to the rule is prohibited from underwriting the offering unless it has determined that the issuer or an "obligated person" for whom financial information or operating data is presented in the final official statement has undertaken in writing to provide certain information to the marketplace.

⁶ Joint Press Release, MSRB and SEC, New Measures to Provide More Transparency Than Ever Before for Municipal Bond Investors (Dec. 8, 2008), available here and here.

⁷ Press Release, MSRB, MSRB Provides Transparency for Municipal Auction Rate Securities (Feb. 11, 2009), available here. The MSRB requires dealers to submit interest rate information the day auctions take place and then immediately publishes the data on the EMMA website. All municipal auction rate transactions are displayed together on EMMA so investors can compare interest rates from program to program.

⁸Id.