Muni Bond Market Faces Regulatory Upheaval

Terry Flanagan

The U.S. municipal bond market is being hit with new regulations that will require municipal advisors to disclose information about potential conflicts of interest, which some say place an unfair burden on this sector of the capital markets.

The Dodd-Frank Act’s Section 975 requires the Securities and Exchange Commission (SEC) to adopt rules mandating that municipal advisors register with the SEC, and also requires the Municipal Securities Rulemaking Board (MSRB) to adopt rules governing the behavior and activities of municipal advisors.

The intent of Congress in enacting these provisions was to impose a regulatory structure on previously unregulated companies that are active in the financial markets.

“The municipal bond market has historically been lightly regulated compared to others,” said Tom Potter, a partner at the law firm Burr & Forman. “The Dodd-Frank Act directed the SEC to implement a registration and regulatory regime for municipal advisors.”

The central roadblock is the breadth of the definition of “municipal advisor”.

“Anybody who advises a municipal or public entity on investment strategies could be termed as a municipal advisor, even a salesman who leases Caterpillar [machine] equipment to a municipal water board and discusses financing options,” said Potter.

The SEC adopted an “interim final temporary” rule in 2010, providing an avenue by which municipal advisors could comply with the registration requirement set forth in Dodd-Frank. The rule was to sunset on last December, but the SEC acted at the time to delay its sunset date again to the end of this month.

“The conflict over defining the term ‘municipal advisor’ has frozen the implementation of Section 975 of the Dodd-Frank Act,” said Potter. “Until the SEC issues a final rule defining the term, implementation of Dodd-Frank’s provisions and the development of new rules by the MSRB will remain on hold.”

The buy side has borne the brunt of regulatory actions, which will necessitate costly changes to established practices and procedures.

“To most asset managers, regulatory risk means the risk that regulations will require asset managers to spend considerable resources to implement new regulations or new regulations that would, if adopted, adversely affect one or more of their existing product or services,” said John Hunt, partner at the Nutter law firm. “Most asset managers try to accommodate new regulations within their existing compliance arrangements to avoid having to build new infrastructure, and they have largely been successful doing so.”

When there has been significant pushback from asset managers, it has come from the industry as a whole acting through trade groups, and it typically has occurred when the industry perceives that new regulations would significantly affect a product or service, said Hunt.

“Money market fund sponsors, for example, recently were very aggressive in their largely successful efforts to discourage new SEC rule making, and they are likely that to continue to be aggressive if the other regulators look to take up the regulatory sword from the SEC,” he said.

The U.S. House Committee on Financial Services this week passed a bill that would clarify the language of Dodd-Frank Section 975.

The bill excludes from the regulations routine activities or activities that are already regulated, such as acting as a broker or principal on a securities trade, providing a list of price quotations or valuations, acting as a custodian, or providing generalized investment information not tailored to a particular municipal entity.

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