By Nathaniel Touboul
The financial crisis of 2008 led regulators to the realization that municipalities needed a system that protects their own interests when dealing with Wall Street. To achieve this goal, the Dodd-Frank Act, among other things, created a new class of regulated persons called “Municipal Advisors” (MAs). Under new regulations, MAs may not provide advice on behalf of, or to municipal entities without first registering with the Securities and Exchange Commission (SEC). MAs will also be held to a fiduciary standard. These new regulations are aimed at issues regarding MA misconduct such as “pay to play” practices, undisclosed conflicts of interest, advice rendered without adequate qualifications and failure to place their duty of loyalty to their clients ahead of their own interests.
Ultimately, the goal is to protect the investor and the integrity of the market. The Municipal Advisor Examination Initiative (“MA Examination Initiative”) will provide the SEC with valuable information that will allow it to discover new areas of potential MA abuse. Also, the new registration process will create a direct link between MAs and the SEC, thereby facilitating oversight.
It is often the case that when an advisor orchestrates a transaction for a municipality, the advisor will provide advice and counsel to the municipality as well. The issue with this system is that not all underwriters and brokers are fair. An example of this misconduct occurred in 2008 in Jefferson County, Alabama, where a J.P Morgan Chase banker led officials into entering a complicated interest rate swap deal. Although the banker and some county officials later pleaded guilty to corruption charges related to the deal, it eventually led Jefferson County into bankruptcy in 2011.
From the investor’s perspective, scenarios such as Jefferson County’s bankruptcy show that even investments that have traditionally been viewed as “safe” such as municipal bonds are not immune from disasters. Even when making “safe” investments, it is important for investors to understand the potential risks, including the risks of a municipality defaulting on its debt obligations. These new regulations will create more oversight and facilitate compliance with new regulations designed to prevent the kind of misconduct that led to the Jefferson County bankruptcy.
To respond to situations such as the one that occurred in Jefferson County, the SEC announced that the Office of Compliance Inspections and Examinations (“OCIE”) is launching an examination initiative directed at newly regulated MAs. The OCIE examines MAs through the National Exam Program (NEP), which is comprised of staff of the SEC’s 11 regional offices and the home office in Washington, D.C. The NEP’s mission is to “protect investors and maintain market integrity through risk-focused examinations that promote compliance, prevent fraud, monitor risk and inform policy.” Through launching the MA Examination Initiative, the NEP will be able to conduct focused, risk-based examinations of MAs that are registered with the SEC, but not registered with FINRA. The MA Examination Initiative will be conducted over the next two years and will have three primary phases described as follows:
This initial phase consists of outreach programs aimed at informing newly registered firms about their obligations under the Dodd-Frank Act and the MA Examination Initiative. This phase will also provide a forum for MA senior executives or principals to discuss issues, ask questions and communicate directly with the administrative agencies.
During this phase, the NEP staff will review the MAs selected for examination, and will determine whether they are in compliance with all applicable rules. The OCIE will focus on the following areas of identified risks:
2) Fiduciary Duty
4) Fair Dealing
6) Books and Records
Informing Policy Phase:
This final phase will consist of a final report from the NEP to the SEC containing common practices in the areas identified in the Examination phase, industry trends and other issues.