Failures in Investor Protection in Muni Market Identified in New DPC DATA Research Report (pdf version)
Hundreds of questionable transactions in 2008 linked to lack of oversight and enforcement of disclosure regulations
Roseland NJ (USA) – February 23, 2009 – DPC DATA, leading provider of municipal bond disclosure data, has released the second of a series of groundbreaking research reports into disclosure issues in the municipal bond market. The study uncovered hundreds of trades in bonds in 2008 that are questionable in terms of meeting regulatory standards for investor protection. These standards are promulgated by the US Securities and Exchange Commission and the Municipal Securities Rulemaking Board (MSRB), the self-regulatory organization overseeing underwriters and dealers of municipal bonds.
To identify these suspect trades, the DPC DATA study matched trade data with officially filed disclosures, focusing on material event notices that typically indicate distressed bonds. These notices were Payment Delinquencies, Non-Payment Related Defaults, Unscheduled Draws on Debt Service Reserves, and Unscheduled Draws on Credit Enhancements.
The research report, entitled The Consequences of Poor Disclosure Enforcement in the Municipal Securities Market and available for download at www.DPCDATA.com, includes the following key findings:
· In 2008, 667 dealer-to-customer sales were executed at par or higher after a default or other stress notice was filed by the issuer or obligor in the official disclosure system, suggesting possible failure by dealers to ensure suitability or fair pricing in the trades
· The majority of these trades occurred during the tumultuous months of September through November when credit markets were imploding.
· In half of these sales, there was no way for investors to protect themselves with independent research because no financial statements had been made publicly available in the official disclosure system during the 2007 or 2008 calendar years.
· More than 40 percent of the trades were in par amounts of $50,000 or less, suggesting they were sales to retail (rather than institutional) buyers.
· Both default-related notices and sales of apparently distressed bonds to investors jumped dramatically in 2008 over previous years.
The study reviewed four years of trade data from MSRB’s Real-time Transaction Reporting System (RTRS) and corresponding disclosure data from the Nationally Recognized Municipal Securities Information Repository (NRMSIR) operated by DPC DATA. In order for their bonds to trade publicly, issuers and obligors of municipal bonds that are subject to the continuing disclosure requirements of SEC Rule 15c2-12 must commit to filing operating and financial statements at least annually with the NRMSIRs and the relevant State Information Depositories.
Implications for Investors
“The implications of this study are twofold, and both bode ill for the municipal investor unless significant improvements are made in regulatory oversight and enforcement,” says Peter J. Schmitt, CEO of DPC and author of the study. “First, the traditional low default rates of municipal bonds as investments can no longer be assumed. The rise in distress notices indicate that issuers and obligors are suffering from the same financial stresses as the rest of the market. Until the economy recovers, this increase in distressed issues is likely to be a continuing trend.
“A second implication arising from this study,” continues Schmitt, “is that the failure of the SEC and the MSRB to address the massive rate of non-disclosure by issuers and obligors, identified in our last study, is now quite possibly contributing to the growth of apparently predatory trades. If DPC DATA had not identified these trades as suspect, there is no known initiative by the SEC or MSRB to identify them. Likewise there is no evidence of any investigative effort to identify non- compliant bonds or dealer sales of these bonds to customers. It’s not surprising, given the lack of enforcement, that non-disclosure persists and that questionable trades like these can occur without fear of regulatory repercussions.”
In the municipal market, the disclosure-related requirements on the dealers to ensure fair dealing are the only point of enforcement for investor protection regarding bond obligor and issuer disclosures. The Tower Amendment to the Securities Exchange Act of 1934 exempted municipal issuers from SEC oversight except in cases involving fraud. The MSRB was created by Act of Congress in 1975 to regulate municipal dealer and bank dealer activities, and it is controlled by the SEC through SEC’s rule making authority. SEC Rule 15c2-12 requires dealers to maintain access to the official SEC-designated repositories of disclosure information. The practical implementation of Rule 15c2-12 occurs through MSRB rules pertaining to fair dealing, suitability and fair pricing by dealers. Dealers face the risk of enforcement action if they fail to do so.
Increasing Risks to Investors
In 2008, the SEC under the direction of then-Chairman Christopher Cox determined to abolish the multi-NRMSIR archive system and consolidate the market information clearinghouse function under the MSRB. As of July 1 of this year, the MSRB will control the only official disclosure archive of the municipal market going forward. The primary reason given for this
change is to provide disclosure documents free to investors who, like dealers and other market participants, currently must purchase them from the privately held NRMSIRs.
“At this point, we have natural concerns about the future of this part of our business,” notes Schmitt, “but we have more immediate concerns about the increasing risk presented to investors. Unfortunately the current plan to shift ownership of the archives to the MSRB is a meaningless and possibly counterproductive move in investor protection. Governed by the dealers and investment banks it regulates, the MSRB has no incentive to mine the archive to present cautionary information, such as this study, about disclosure or trading risks to FINRA, to lawmakers or to the investing public. Likewise, the MSRB has shown no previous inclination to use or promote the NRMSIR archives as an enforcement resource. Even if it finally chooses to use the archive for enforcement purposes, the MSRB’s status as an entity created and overseen by the federal government, as well as law precluding direct federal regulation of municipal issuers, may restrict its legal capability to do that.
“This study is DPC DATA’s first effort to clarify the real meaning to investors of the regulatory failure to enforce continuing disclosure infractions at the dealer level. It raises the overriding question of the safety of leaving the only mechanism of disclosure-related investor protections in the hands of a self-regulating industry body. Support for MSRB control of the official archive has largely come from the dealer and issuer communities who face the potential cost of increased oversight and enforcement. However we are not alone in our concerns about investor protection, and we hope the implications of this study are considered carefully by lawmakers and regulators.”
Both this study and the previous DPC DATA study, Estimating Municipal Securities Continuing Disclosure Compliance: A Litmus Test Approach, which identified mounting failures of issuers and obligors to file annual financial statements in the official archives, may be downloaded at no cost at www.DPCDATA.com.
About DPC DATA
DPC DATA Inc., founded in 1992, is the leading provider of disclosure-related data products and specialized data services to the municipal industry. Its customers include more than 600 financial institutions and information intermediaries. DPC DATA is a privately held firm, headquartered in Roseland, NJ. For more information please visit www.DPCDATA.com.
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