Two municipal market veterans, David Dubrow and Kent Hiteshew, delve into the history and current state of disclosure practices in the municipal bond market, highlighting the flaws in the current system. In a follow up, the authors will explore potential paths to reform and key components of a uniform standard of disclosure for municipal securities.
While consistent with applicable securities laws, the customs and practices for preparing offering statements for tax-free municipal securities are functionally and practically flawed. This reality is to the detriment of the municipal bond market and its investors.
The four trillion dollar United States municipal bond market comprises a dizzying array of governmental issuer types and credit structures. These range from simple general obligation bonds of state and local governments to revenue bonds issued by government conduits and secured by real estate projects or certain other private enterprises granted access to tax-free debt by the federal tax code. Other than the applicability of the anti-fraud provisions of federal securities laws, however, offering statements for new municipal securities are exempt from uniform disclosure standards. This is distinctly different from corporate securities which are regulated under federal law. Consequently, while disclosure is required to be materially accurate, it is too often not user friendly and negatively affected by motivations of critical market participants. Inconsistent and confusing disclosure contributes to market opacity and illiquidity and prevents investors from being able to properly evaluate the full risks of their potential purchases.
Unregulated municipal disclosure practices can be adversely influenced by a number of factors. Issuers may view their disclosure as a marketing device to promote the sale of their bonds rather than an objective description of the security and its risks. Underwriters may not be sufficiently critical of proposed disclosure for fear of losing future business opportunities with the issuer. Appraisers and market experts hired by issuers or conduit borrowers may produce overly-optimistic reports to satisfy the needs of those that hire them. And lawyers, who draft offering statements, may be overly motivated by protecting themselves from legal liability thereby quoting dense legal documents rather than summarizing such documents in plain English. Overly legalistic document drafting is reinforced by cost pressures and over-reliance on precedent.
Historically, state and local governments have strongly resisted efforts by policymakers to subject their securities to any form of federal regulation. As a result of the collapse of the stock market and widespread bond defaults during the Great Depression, Congress enacted the Securities Act of 1933 (the “1933 Act”) and the Securities and Exchange Act of 1934 (the “1934 Act”, collectively, the “Securities Acts”). State and local governments successfully lobbied Congress to exempt municipal securities from direct regulation by the newly created Securities and Exchange Commission, including the pre-issuance registration and disclosure requirements imposed on all other securities offerings by the 1933 Act. Together with 10th Amendment federalist concerns, they argued that the municipal market was too small and municipal investors, largely comprised of banks and insurance companies, too sophisticated to require federal regulatory protection. Notwithstanding defaults of 4,700 issuers on $2.85 billion of municipal bonds during the 1930s, they also argued that the inherent safety of municipal securities did not warrant federal regulation.
The 1934 Act further exempted municipal securities from its broker-dealer regulatory and enforcement regime and periodic, on-going secondary market disclosure requirements otherwise applicable to all other securities markets. Although explicitly exempted from all other provisions of the Securities Acts, municipal securities were not excluded from their broad anti-fraud provisions.
This unregulated state was in existence for forty years until two major crises during the 1970s and 1980s led federal policymakers to impose a modified form of regulation. The new regime was tailored specifically to the municipal market while not overturning the original municipal regulatory exemption from the 1930s.
First, after increasing instances of fraud and other unscrupulous practices among municipal broker-dealers and New York City’s near default in 1974, Congress created the Municipal Securities Rulemaking Board, as a new self-regulatory body. Broker-dealers were made subject to MSRB rules, but issuers remained exempt from pre-registration filing requirements and uniform disclosure standards. To make its intentions clear, the Securities Acts Amendments of 1975 (the “1975 Amendments”) included the Tower Amendment that explicitly prohibited the SEC and MSRB from imposing pre-issuance filing and disclosure requirements on municipal issuers. However, the 1975 Amendments reiterated and clarified, for purposes of removing any doubt, that municipal issuers are subject to the Section 10(b) anti-fraud provisions of the 1934 Act.
Second, after what was then the largest municipal bankruptcy in history — when the Washington Public Power Supply System defaulted on $2.2 billion of bonds in 1983 — the SEC used its anti-fraud powers to issue Rule 15c2-12 requiring underwriters to obtain from issuers and make available to purchasers in a timely manner primary offering statements that met the 1933 Act’s “no material misstatements or material omissions” standard. A year later, the MSRB issued Rule G-32 which required underwriters to deliver primary offering statements to the Board. Thus, in a sweeping change, the SEC and MSRB achieved indirect regulation of municipal issuers by using its anti-fraud powers to require underwriters to impose disclosure requirements on issuers as a condition to the purchase of newly issued securities.
Finally, in 1994 the SEC took a further step modifying Rule 15c2-12 to require underwriters to enter into continuing disclosure agreements (“CDAs”) with municipal issuers (or their conduit borrowers) mandating that such issuers provide the market with on-going, updated annual disclosure and timely material event notices. While failure to comply with such CDAs does not constitute a default under the relevant bond documents, broker-dealers are required to ensure that subsequent primary offering statements disclose to investors any such compliance failure with the presumption that such disclosure will adversely affect pricing of the issuer’s securities. Due to inefficiencies in the municipal market, however, such presumption has not always translated into actual trading penalties for non-compliant issuers.
In the absence of a formal statutory scheme for municipal securities registration and reporting, new issue and on-going disclosure in the municipal market have evolved over the past half-century as a patchwork of voluntary frameworks developed by market participants together with indirect issuer regulation by the SEC and the MSRB. Unlike the corporate securities market, the result is inconsistent reporting as to timeliness, categorical content and style.
Today, nearly a century after its original exemption from the Securities Acts, municipal market characteristics are very different. The size of the market is 15 times larger than it was in 1975 and total volume has grown to nearly half the size of the corporate securities market. Individual investors, either directly or through institutional conduits such as mutual bond funds or specially managed brokerage accounts, comprise over 75% of the total investor base. These retail investors run the gamut from the super wealthy with major holdings to small “mom and pop” investors that own small portfolios. Banks and insurance companies play a much smaller role in the market. The market comprises as many as 50,000 state and local issuers with over one million separate securities (“CUSIPs”). In its 2012 comprehensive report, the SEC described the municipal market as “fragmented, opaque and illiquid”.
The overwhelming majority of issuers sell relatively small amounts of securities on an irregular and infrequent basis. Most of the par amount of bonds outstanding today were issued by just several hundred of the largest issuers, while the overwhelming balance of issuers account for only a fraction of the remaining bonds outstanding. Importantly, there has been a proliferation of non-governmental issuance with approximately 25-30% of the current market comprised of ”private activity bonds” issued through governmental conduits on behalf of borrowers whose operations are more akin to private enterprise than essential government services. But for the regulatory and disclosure exemptions available through the municipal market, securities of these borrowers would, in most cases, be subject to the relevant regulatory provisions of the Securities Acts.
The municipal market has experienced a series of large, high-profile defaults and bankruptcies over the past 15 years, including securities issued by Puerto Rico, Detroit and Jefferson County, Alabama. These defaults have resulted in unprecedented losses by investors. While overall default rates are otherwise very low when compared to corporate securities, municipal defaults are concentrated among smaller, non-governmental conduit borrowers and non-profit health care, senior living and higher education issuers secured by a confusing array of business operations, real estate projects and non-profit activities. In many of these defaults, market observers cite shoddy and inconsistent disclosure as a contributing factor to investor losses.
While almost all primary market municipal disclosure typically adheres to the “no material misstatement/omission” standard established by the Securities Acts, new issue official statements vary widely in both categories of content (appropriate to credit type) and presentation clarity. On the other hand, notwithstanding SEC enforcement efforts, there is widespread non-compliance with respect to continuing disclosure, particularly among smaller, infrequent governmental issuers and private activity conduit borrowers. For example, Ivanov, Zimmermann, and Heinrich (2024) recently documented that municipal issuers fail to report 50-60% of private placement financings that are required by Rule 15c2-12.
The dramatic increase in the size of the municipal bond market, the proliferation of novel credits and the market’s dominance by retail investors, all suggest that it is finally time for municipal disclosure to be governed by uniform standards overseen and enforced by the SEC. In Part 2, the authors will discuss alternative paths to reform and some key components of a uniform standard of disclosure.
Author disclosure: David Dubrow advises in his capacity as a partner in ArentFox Schiff on matters related to municipal bonds and tax-exempt bond financing including work on public pensions, bond workouts and municipal bankruptcy.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
