I.  INTRODUCTION

John Maynard Keynes’ theory of the “paradox of thrift” is premised on the assumption that saving cash, while advantageous to the individual, is economically detrimental. 

[1]  Hoarding money is seen as damaging because it keeps liquidity out of the market, yet the hundreds of thousands of people that graduate college every year that want to become fiscally conservative still rely on the practice.[2]  With the number of different financial instruments available, rather than putting their money into run-of-the-mill bank savings accounts and certificates of deposit (CDs), these new savers are choosing securities that are safe but still have the potential to grow in a shorter amount of time.  Enter the tax-free municipal bond.

Before discussing the contours of the instrument itself, imagine the following hypothetical situation in November 2007.[3] A recent graduate moves out of his parents’ house and into a new apartment in Manhattan.  The savings in his checking account needs to be shifted over to an instrument where the money could be stored, but also with the intention of letting it grow.  He goes to his bank, sits down with a financial advisor, and voices his intentions.  The financial advisor tells him that the young man is too young to open a CD, and that he should put his savings into tax-free New York municipal bonds.  In exchange for a couple of signatures, the graduate receives very little information about the investment he makes.  A brochure, some printouts, and that’s about it.  When Bear Stearns is sold to JPMorgan for pennies on the dollar three months later,[4]the value of the bonds fall by fifty-one percent.  The graduate has been defrauded, but because of the limited amount of mandatory disclosure for municipal securities,[5]he is left with little recourse.

While this account is one example of how the lack of municipal bond disclosure negatively affects retail investors, institutional investors have felt larger losses, mostly due to the increased number of municipal bankruptcies since 2007.[6]  The recent Chapter 9 filing by the county of Jefferson, Alabama have left citizens in shock and have enraged local institutional bondholders.  This damage may have been averted with greater disclosure by the municipality, but federal law did not impose such a requirement.

Things are about to change.  Even before Jefferson County, the Securities and Exchange Commission (SEC) began the process to amend the securities laws as they pertain to municipal bonds.  While the pressure induced by the passing of the Dodd-Frank Act is a catalyst for change, it is odd that the municipal-bond markets have largely gone unregulated for most of 20^th century.  Regulation will certainly be welcomed, but many bondholders will continue to wonder if earlier implementation could have hedged the financial damage of the last few years.

This paper discusses the potential changes in federal regulations in both the primary and secondary municipal bond market.  The discussion begins with an overview of municipal bonds’ role in capital markets.  It will then discuss the potential changes in the securities laws as they were recommended to the SEC. Next, the paper delves into the facts and circumstances surrounding the municipal bankruptcy in Jefferson County as this event had dire effects on the municipal bond market.  Finally, the Chapter 9 filing in Jefferson County will be reanalyzed as if the regulations were in place, and a discussion of the laws’ possible aggregate deterrent effect will also be touched upon.

II.  THE MUNICIPAL BOND MARKET AND THE RECENT SCRUTINY

A.  The Tax-Free Municipal Bond, its Marketplace, and its Popularity

Municipal bonds have always been a part of investing strategy throughout the United States for retail and institutional investors alike.  There are three main reasons why the instrument has gained so much popularity in American capital markets: 1) tax exemption, 2) perceived low default risk, and 3) their money-making potential.

The first alluring feature of municipal bonds is their tax exempt status.  Federal tax law dictates that all interest from state and local municipal bonds are exempt from income tax.[7]  This incentivizes institutional and retail investors to invest in government projects without tax consequences on income while giving inexpensive funding to the municipalities to implement projects.  Also, states have the advantage of taxing out-of-state municipal bonds yet allowing their own bonds to keep their tax exempt status.[8]

Another attractive characteristic of municipal bonds is their low default risk.  Indeed, municipal defaults have been incredibly rare; statistics show that the cumulative five-year default rate of investment grade municipal bonds was .03 percent from 1970 to 2009.[9]  Also, investors swallow up government-backed bonds as soon as a crisis appears.  This is due to the inherent low default risk of municipal bonds based on the presumed government guarantee.[10]

Finally, the bond market performs as well as, if not better than, the stock market and is therefore is an income-generating investment.  There exists a common misperception that stocks always outperform bonds, but economics experts have the statistics that challenge such a belief.[11]  Furthermore, considering the volume of municipal bond trading by vehicles looking for both safety and growth, e.g. trusts, one must assume that municipal bonds can create wealth as well as preserve it.[12]  At present, state and local governments have more than $3 trillion in outstanding bonds.[13]  Clearly, as governments continue to issue them, buyers will continually be easy to come by.

III.  MUNICIPAL BOND MARKET REGULATION: PAST, PRESENT, AND FUTURE

A.  Past

Municipal bonds were exempted from the registration and periodic filing requirements of the Securities Act of 1933 (“’33 Act”) and the Securities and Exchange Act of 1934 (“’34 Act”), giving deferential treatment to issuers of these instruments.[14]  At the time, Congress’ motivation to limit municipal bond market regulation stemmed from a perceived lack of abuses by its actors, the sophistication of the type of investor, and federalist policies.[15]  In terms of federalism, Congress did not want to impede on intergovernmental comity, i.e. the legislature doubted the federal government’s ability to regulate state and local governments, and therefore allowed local governments to issue debt without delay.[16]  This system went mostly unchecked until the 1970’s when New York City came close to defaulting on its own debt.[17]  It was at this point that the federal legislature knew some changes needed to be made.

In 1975 Congress added Section 15B to the ‘34 Act.[18]  Section 15B required all municipal dealers to register with the SEC.[19]  Additionally, the new act created the Municipal Securities Rulemaking Board (“MSRB”) which is designed to promulgate rules that govern the municipal securities industry, but with continuous oversight by the SEC.[20]  While the MSRB has been referred to as the “obscure regulator of municipal bonds,” the agency’s creation was a much-needed addition for this area of securities.[21]

Despite the addition of Rule 15B, municipal securities were still exempt from the substantive requirements of the federal securities laws, including the extensive disclosure requirements.[22]  The only exception to this general rule is that the anti-fraud provisions of the ’33 Act and the ‘34 Act still apply to municipal securities sold in the secondary market.[23]  Thus, even after the 1975 amendments, state and local governments were not subject to the registration and disclosure requirements of the ’33 Act and the exemptions for issuers of municipal securities still applied.[24]  At this point in time, then, governments were not held to the same standard as public companies; an obviously damaging discrepancy the continuation of which would give an unfair advantage to public sector debt issuers compared to private sector debt issuers.

B.  (Potential) Future

On August 8, 2011, the MSRB sent its official recommendations for the SEC’s update of the 1994 Interpretive Release on Municipal Securities Disclosure Obligations.[25]  The recommendations have five main areas of proposed improvements: 1) Elimination of the exemption in Rule 15c2-12 for variable rate demand obligations (VRDO); 2) SEC clarification that remarketings at the direction of the issuer be treated like primary offerings; 3) SEC support for a view that the failure to provide disclosure on circumstances under which a credit or liquidity provider may fail to pay debt service (because of insolvency or otherwise) without providing disclosure of the financial capacity of the municipality be deemed a material omission; 4) Mandatory enhanced disclosures on a) risk factors, b) conflicts of interest, and c) the projects the bond proceeds are paying for; and 5) New remedies enforceable by bondholders for noncompliance with disclosure obligations, including damages.[26]

1.  Elimination of Exemption for VRDO

The MSRB is concerned that even after the September 2010 release by the SEC, underwriters are not yet required to contract with an issuer to obtain an official statement for primary offerings of VRDOs.[27]  Because all fixed-rate municipal bond issuers must release an official statement during primary offering, this exemption gives an unfair advantage to all VRDO issuers.[28]  The MSRB cannot find “any justification to treat VRDOs differently from fixed rate municipal securities,” and therefore asks the SEC to eliminate the exception.[29]  Finally, because the SEC eliminated the old exception for VRDOs from continuing disclosure in 2010, the MSRB asks for the same rules to apply to VRDOs at their inception into the market.[30]

2.  SEC Clarification on Remarketings of VRDOs

A VRDO is unique in that its interest rate resets periodically and holders of the debt are able to liquidate their security through a “put” or tender feature.[31]  Every time the interest rate resets, the security is essentially being reissued to a new set of buyers through a Remarketing Agent.[32]  The question that arises, then, is whether VRDO remarketings should be considered a primary offering, therefore falling under the primary offering rules, or just an event that occurs in the normal course of the security.[33]

The MSRB does not have the authority to answer this question and therefore is asking the SEC for clarification on the issue.[34]  It is the agency’s position, however, that any remarketing that originates from the direction of the issuer be considered a primary offering.[35]  Most dealers and remarketing agents contacting the MSRB on this specific issue need this information so that they know where to properly post the disclosure information on the EMMA system.[36]

3.  Failure to Pay Debt Service Deemed Material Omission

Although this portion of the Letter is the shortest by length, if enacted, the effects of this recommendation will lead to the most change in the municipal bond market.  Its focus is on the relationship between a municipal issuer and a “credit enhancing” bank, i.e. one that provides the principal source of funds to pay bondholders.[37]  Since the majority of municipal assets are illiquid, many municipalities need help from the credit enhancers to provide the cash when demanded by the investor.[38]  However, there are some situations where the credit enhancer is not required to pay principal, interest, redemption price or purchase price of the bonds.[39]  In this instance, the MSRB feels that the rules should compel an underlying municipality to file disclosure on its own financial wherewithal to pay the debt.[40]  Furthermore, any failure to provide information as to whether it may not be available to pay debt service (including bankruptcy and other default) should be considered a material omission by the municipality thus subjecting them to discipline by the SEC.[41]

4.  Enhanced Disclosures for Municipalities and Issuers

In addition to the disclosures on payment of debt service by the obligor, the MSRB discussed three particular areas in which enhanced disclosure by the obligor will help investors.

First, the agency wants the terms and risks of municipalities to be clearly disclosed.  Included in these risks would be market risks, credit and liquidity risks, legal risks (including those pertaining to contractual language), risk mitigation strategies, and various risks associated with newly issued products.[42]  The MSRB also recommends that this information be clearly and readily accessible to all investors, particularly retail investors (the assumed novice purchasers of securities).[43]  As a means to this end, the agency recommends a special section entitled “Risk Factors,” needed specifically for lower-rated and non-rated securities.[44]

Secondly, the MSRB asks the SEC for more guidance on disclosures of conflicts of interest.  Of particular interest to the MSRB, and those it feels would be of interest to investors, are payments made and received by transaction participants, including swap providers.[45]  The agency believes that compelling disclosure of such transactions will act as a deterrent against the conflicts themselves, thereby increasing investor confidence.[46]

Finally, the MSRB requests that the SEC compel obligors to disclose the details of the use of bond proceeds and other sources of funds.[47]  This request comes from the fact that investors are requesting more standardization of requirements across different markets of securities to replace the current information-less state of municipal bondholders.[48]  The desired areas of disclosure include the name of issuer, name of secondary obligors, source of payment of debt service, and the object of the funds (e.g., power plant or sewer).[49]

5.  New Remedies for Bondholders

The final recommendation the MSRB proposed to the SEC is to make remedies and legal actions available if a municipality fails to comply with the continuing disclosure rules.  Almost every closing document between a municipality and an underwriter includes a Continuing Disclosure Agreement (“CDA”) whereby the parties define the type of financial information that will be provided to EMMA on an annual basis, when the disclosure will be released, and by whom.[50]  The MSRB is concerned, however, that there is no significant regulatory repercussions for non-compliance with CDAs which it believes leads to limited accountability for those parties that do not furnish the information.[51]  To counteract the possibility that municipalities will intentionally hide unfavorable information, the MSRB proposes that the SEC require CDAs to include enforceable remedial steps to ensure future disclosures including adoption of specific procedures, granting investors direct enforcement rights (damages and specific performance), and compelled hiring of professionals to assist in compliance obligations.[52]  

IV.  MUNICIPAL BANKRUPTCIES: THE DEATHBLOW TO MUNICIPAL BONDS

Municipal bonds are only as safe as the municipalities that secure them.  Considering that general obligation municipal bonds are backed by the “full faith and credit” of the municipality issuer, default on these instruments have been historically a rare occurrence.[53]  However, the recent Chapter 9 bankruptcy filing[54]of Jefferson County, Alabama challenges the status quo and muddies the waters in terms of whether these instruments are truly as conservative as investors believe.[55]  Discussing these recent filings in detail may shed light on the problems that lead to the financial chaos and whether the MSRB recommendations could have prevented them.  

A.  Jefferson County, Alabama

On November 9, 2011, the Jefferson County Commission, by a 4-to-1 vote, filed the largest Chapter 9 petition in history: about $4 billion worth of debt.[56]  This filing eclipses the second largest municipal filing, Orange County, California in 1994, by more than $2 billion dollars.[57]  The Jefferson County filing is proceeding in bankruptcy court without challenge,[58]and the circumstances leading up to the collapse are quite egregious.

The trouble started for Jefferson County when the Environmental Protection Agency ordered it to fix the county’s sewer system.[59]  To complete the project, the county issued general obligation bonds of $3.2 billion.[60]  On the advice from JP Morgan Chase, once the renovations were finished, the debt was moved from fixed-rate to VRDOs; a move that was intended to avoid paying higher yield if rates went up.[61]  The county coupled this move with the purchase of credit fault swaps that were meant to hedge the debt.[62]  As the events of 2008 unfolded, the sewer interest rates shot through the roof, the credit market froze up, and Jefferson County failed to make payments to bondholders.[63]  Soon after, Jefferson County’s general obligation bond rating fell to “junk” status, and eventual bankruptcy came only a couple of months later.[64]

From the bondholders’ perspective, there are two problem areas that should have been disclosed from the outset: the sewer system management and the debt that backed it.  First, the sewer system renovations seem to be flawed since their inception in 2002.  The system itself provides for 126,000 residents who have seen water rates increase 300% since 1997.[65]  Yet based on its revenue stream, the system is worth less than $1.5 billion.[66]  This information was available in 2002 and 2003 when the bonds were issued,[67]but due to the limited disclosure afforded municipalities, it is questionable whether this information reached investors.

Accompanying the terrible sewer system was shoddy leadership.  It is reported that Elected officials in Jefferson County were taking kickbacks in exchange of investment deals for the sewer project.[68]  In fact, Gary White, a former Commissioner, was sentenced to ten years in prison for taking bribes in July 2010,[69]while another Commissioner who directly oversaw the sewer operations between 1997 and 2001 received five years in prison for the same offense.[70]  Because these individuals are directly related to the performance of the collateral that backed the bonds (namely, the sewer system), it is arguable that this information should be provided to bond purchasers.  Instead, both the city taxpayers and bondholders are left footing the bill.

The inherent problems with the sewer system project, though, are far outmatched in severity by the financial plan to fund the project.  First, the move from fixed-rate bonds to VRDOs was used as a quick fix for interest rate payments, but ultimately was a failure.  The VRDOs (also known as auction-rate securities) have interest rates that reset periodically.[71]  J.P. Morgan (now JPMorgan Chase) pitched this idea to the county officials as a way to pay lower short-term interest rates on long-term debt.[72]  However, the short-term solution turned to disaster when the subprime crisis struck and the market for auction-rate securities all but vanished.[73]  Because VRDOs are exempt from municipal bond regulation, the investors that held the fixed-rate bonds prior to conversion and those that purchased newly issued VRDOs before the crash, probably were buying into a product they knew nothing about, thus suffering the consequences. 

Additionally, the credit default swaps (“swaps”) that J.P. Morgan coerced the county to buy as a hedge also aided in Jefferson’s financial downfall.  J.P. Morgan invented swaps as a means to make a profit while promising an effective form of risk management to the purchaser.[74]  When the 2008 crisis struck, the swaps became worthless, and Jefferson County induced an additional $200 million in debt.[75]  Once again, bondholders of Jefferson County general obligation bonds were clueless as to the county’s maneuvers when it is clear that the preceding information would be deemed “material” for any other security besides a municipal bond.[76]   

V.  APPLYING THE MSRB’S RECOMMENDATIONS TO THE PROBLEMS IN JEFFERSON COUNTY AND POTENTIAL DETERRENT EFFECT

After revisiting the events that lead to Jefferson County bankruptcy filing, one can see the potential benefits the proposed regulations would have had on the Chapter 9 filing if enacted earlier.  Such an analysis is the focal point of this section.

A.  Hypothetical Effect on Jefferson County

If the MSRB’s recommendations were enacted, their most profound effect would be on the transfer of Jefferson County’s sewer bonds from fixed rate to VRDOs.  When JP Morgan convinced the county to make this transfer, VRDOs were still exempt from Rule 15c2-12,[77]meaning that Jefferson County had no obligation to disclose the terms of the deal or the motives behind it.  An official statement of the transfer, as the MSRB proposes, would enlighten investors of the change to their debt holdings and would have given them the opportunity to sell at a time when they potentially could have received gains. 

Since the SEC could deem remarketings of VRDOs to be primary offerings as per the MSRB’s recommendation, holders of Jefferson County general obligation bonds could have received periodic information that would make them reconsider their investment.  If a remarketing agent was involved with the Jefferson County bonds, that agent would have been required to post final official statements whenever the interest rate would reset.[78]  Continuous periodic disclosure would have been more than helpful to investors as Jefferson County continued its slide into insolvency.

Jefferson County would be compelled to release a bevy of risk disclosure but most damning would be its conflicts of interest exposure.  First, Jefferson County has a history of illegal political contributions as they pertain to the sewer project.[79]  Even before the FBI discovered the bribery charges, all connections between the county politicians and credit enhancers would need to be disclosed.  Of course, once the bribery charges were levied, such information should be deemed material in terms of conflict of interest and would need to be disclosed as well.  Secondly, the second phase of the JP Morgan deal, where the county purchased derivative swaps in order to hedge their bets, would also need to be released to the general public.[80]  In fact, the recommendations specifically list relationships with “swap providers” as the type of payment that the municipality must release.[81]  If the entirety of the JP Morgan deal was disclosed to investors, institutional investors wary of the derivative situation would have pulled out and brokers for retail investors would have advised the same.  Instead, the county was not obligated to release the terms of the debt deal and so bondholders may receive pennies on the dollar for their investments.

Of course, any failure to disclose such information would result in actionable damages for the Jefferson County bondholders.  With over $4 billion worth of debt generated from the failed sewer system, there must have been some information withheld from investors during the course of the last twenty years.  If the MSRB’s recommendations were already enacted, perhaps the fear of lawsuits would have deterred Jefferson County and its crooked politicians from making the damaging decisions that lead to bankruptcy.  One can only hope that the potential enactment of the recommendations may have a more substantial effect on financial decision-making by municipalities.

B.  Aggregate Deterrent Effect

In order for these recommendations to have the impact that the MSRB seeks, they must have a deterrent effect on all potential wrongdoers.  The actors that managed the Jefferson County events do not represent all politicians, but even the smallest bit of bad press could help steer them to abide by a higher duty of care when dealing with municipal issuances.  Scholars continue to express the need for more disclosure to the public, and the MSRB recommendations should satisfy that desire in a market where accountability is lacking.[82]  Information asymmetry has burdened this country’s capital markets since their inception, starting with the Panic of 1907 and most recently during the 2008 Recession when Lehman Brothers filed for bankruptcy.[83] Hopefully, with enough support, state and local politicians will either disclose the necessary information to the public that will allow them to make an informed decision or decide to pull the plug on a project that they know will be a failure.  Increased disclosure can only help in this regard.

VI.  CONCLUSION

The municipal bond market is trending toward positive change.  As one of this country’s most popular capital markets for both security and growth, increased federal regulation can only improve investors’ confidence in such instruments.  The proposed enactments by the MSRB will build faith into the bond market even as the country witnesses the largest amount of municipal bankruptcy filings in decades.  Although in hindsight, the recommendations could have at least protected Jefferson County bondholders from the impending insolvency and at most deterred some of the flagrantly negligent financial decision-making by the municipalities’ leaders.  As this country moves closer towards recovery, retail and institutional investors need more information about the municipal bonds they buy and underwriters must be willing to receive part of the blame for default.  Four years ago recent graduates could have used such information to protect their investments; hopefully the MSRB and SEC will make the proper enactments to ensure that this story will never happen again.