The Municipal Advisor Under Dodd-Frank

One of the reforms mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) is the endorsement in law and regulation of the role of Municipal Advisors in the issuance of municipal bonds and other related financial transactions. Prior to the passage of Dodd-Frank the role of Municipal Advisors had been growing steadily. Dodd-Frank set standards for Municipal Advisors and also established a regulatory regime that reinforces the advisability of issuer retention of Municipal Advisors in the absence of full time staff with robust public finance competence.

I. Background

Municipal Advisors have played an increasingly important role in public finance over the past 35 years as municipal issuers have sought out experts to sit on their side of the table as they undertake financial transactions of a size and complexity beyond their experience. Recently, Dodd-Frank has made it more difficult (albeit not impossible) for issuers to deal directly with underwriters in structuring and marketing an issue, and has imposed regulatory standards on Municipal Advisors.^[1]

For many years, Porter White & Company (“PW&Co”) acted as both underwriter and Municipal Advisor to municipal issuers (although never both with respect to the same issue). The firm also maintained an inventory of Alabama municipal bonds and engaged in the purchase and sale of municipal bonds with individuals and institutions. Since the early 1990’s, however, our municipal securities activities have been limited to municipal advisory work and we have developed long lasting relationships with a relatively small number of clients who have sought our advice over a span of years or decades rather than weeks or months. We believe that a long term municipal advisory relationship allows an advisor to bring greater value to a municipal client, because it deepens the advisor’s understanding of a municipal client and provides a sounder basis for advice on financings that inevitably have a long term impact on the client’s ability to accomplish its mission.

Just as PW&Co has evolved away from underwriting to act as a Municipal Advisor, issuers in the United States have increasingly relied upon Municipal Advisors for assistance with long range financial planning and financial transactions. The Government Finance Officers’ Association (“GFOA”) has long recommended that issuers without substantial in house debt issuance expertise engage the services of a Municipal Advisor to assist in preparing for the issuance of debt, including managing publicly bid and negotiated sale offerings.^[2] In 1980, issuers had Municipal Advisors on 21% of total par value of bonds issued. By 2014, 82% of par value of municipal bond deals had Municipal Advisors. About twelve percentage points of this increase (from 70% to 82%) has incurred since the passage of Dodd-Frank.^[3] As discussed below in Section III, recent academic studies have found that employment of a Municipal Advisor is associated with lower interest rates on issuer securities.^[4]

In Alabama, the State of Alabama has consistently used Municipal Advisors for many years. Similarly, The Board of Trustees of the University of Alabama (“Board”) permits its campuses and UAB Hospital to retain Municipal Advisors and this has been customary practice for a number of years. The Board’s record in issuing municipal securities is an example of the benefits of adopting best practices in municipal finance. Debt issued by the Board’s campuses is highly rated and well received by the market, and the Board has been successful in marketing bonds at public bid. It has also been adept at structuring issues to make them attractive to different segments of the market, with the result that banks have been successful bidders on some issues and brokerage firms on others. Greater efficiency in marketing the Board’s securities in offerings targeting specific market segments has led to lower interest rates. In appropriate cases involving revenue issues where the underlying credit is complex and requiring more extensive due diligence and marketing efforts, the Board has marketed securities in negotiated sales overseen by a Municipal Advisor in the reasonable expectation that a negotiated sale would likely result in lower interest rates.^[5]

It is our view that municipal issuers should engage a Municipal Advisor in almost all, if not all, cases where the issuance of debt or another financial transaction of similar importance is contemplated or possible.

II. What a Municipal Advisor Does

The role and function of a Municipal Advisor depends on the circumstances of an issuer and should be defined in a scope of services set forth in the Municipal Advisor’s written agreement with the issuer as amended from time to time to accommodate changed circumstances. The scope of services should be considered in light of two important principles. First, the Municipal Advisor owes a fiduciary duty to the issuer, which means that the Municipal Advisor must put the interests of the issuer ahead of its own interests and must disclose conflicts of interest in writing. Second, in connection with the issuance of municipal securities the Municipal Advisor shares responsibility with the issuer to avoid fraud. This means that the Municipal Advisor, like the issuer, must comply with Rule 10b-5 under the Securities and Exchange Act of 1934 which, in connection with the sale of securities, makes it unlawful “[t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. . . .” To carry out its responsibility under Rule 10b-5 the Municipal Advisor should perform a careful due diligence investigation of the issuer focusing on all matters with potential to have a material effect on the credit of the issuer.^[6] In summary, the Municipal Advisor is required to assist the issuer in making sure that documents describing and offering municipal securities are accurate and complete.^[7]

The following is a list of some of the important activities of Municipal Advisors in preparing to assist issuers.

• Review the legal status and authority of the issuer, taking care to identify and understand the relevant constitutional and statutory provisions.
• Review economic and demographic trends for the relevant geographic area.
• Review important statistics and historical financial information relating to the issuer, giving attention to both recent events and long term trends.
• Assist in the preparation or revision of a debt policy, including, if appropriate, sections on conditions for refundings and advance refundings, use of interest rate swaps and other derivatives, and criteria for determining debt capacity of the issuer.
• Review operating and capital budgets and long range financial plans, evaluate whether the issuer is in financial equilibrium with revenues sufficient to support essential services and capital needs.
• Review and analyze prior issues of municipal securities, track prior issues in relation to current interest rate levels to identify refunding opportunities.
• Review existing credit ratings and reports, assess potential for changes in ratings.
• Coordinate the preparation of a financing plan for new money and refunding issues, including, if appropriate, projections of revenues, expenses and debt service.
• Assist in preparation of official statement and other offering documents while performing a due diligence investigation of the issuer and the issue.
• Advise on the method of sale, i.e. private placement, negotiated underwriting or public sale.
• Coordinate the process of rating new issues or confirming or improving rating of existing issues.
• Assist in selection of members of the financing team, respond to interest from potential underwriters while collecting their ideas on deal structure and market condition.
• Advise on the advisability of refundings, taking into consideration the potential savings and potential loss of opportunity to undertake a refunding under improved market conditions or in response to changed circumstances of the issuer.
• Determine availability and advisability of credit enhancement.
• Evaluate bids in a public sale and negotiate interest rates and other terms (sinking funds, call provisions, etc.) in a negotiated sale.
• Assist in the investment of bond proceeds.
• Prepare report on results of sale to include comparisons to other issues in the market, economic conditions at time of sale, post sale trades in the securities underwritten, categories of customers purchasing securities, post sale unsold securities in accounts of underwriters.

The foregoing list should make it obvious that a substantial level of knowledge and expertise is required to do a good job as a Municipal Advisor.

III. Origins of Dodd-Frank Act

Among the many sins exposed by the Great Recession of 2007-2009 was the abuse of municipal issuers by a few household names and numerous lesser names in the financial community. These abuses led to amendments under Dodd-Frank to Section 15B of the Securities and Exchange Act of 1934 and to the elevated importance and regulation of Municipal Advisors. Dodd-Frank encourages municipal issuers to hire Municipal Advisors by making it more difficult to deal directly with underwriters, while at the same time imposing adherence to fiduciary standards and other requirements on Municipal Advisors.

The legislative history of the Dodd-Frank amendments to Section 15B is sparse. The Senate Banking Committee issued a committee report purporting to explain the bill, but the House Financial Services Committee did not issue a report. There was no joint explanation of the bill as finally adopted. The abuses sought to be remedied by the legislation are described very briefly on page 38 of the report of Senate Banking Committee, principally in the statement, “During the crisis, a number of municipalities suffered losses from complex derivatives products that were marketed by unregulated financial intermediaries.” It should be noted that while unregulated financial intermediaries did indeed market complex derivatives products, so did highly regulated banks and investment banks, fully subject to regulation by the SEC and other agencies who in retrospect appear to have been somnolent.

Looking beyond the usual sources of legislative history, one finds a report of the Municipal Securities Rule Making Board (“MSRB”) and several articles in financial and legal periodicals, some of them subsequently cited by the SEC in the release adopting rules for the registration of Municipal Advisors.^[8] In April 2009 the MSRB issued its report, “Unregulated Municipal Market Participants: A Case for Reform.”^[9] The MSRB noted the presence of unregistered Municipal Advisors and investment brokers in municipal transactions and advocated extension of regulatory authority for the SEC and the MSRB over previously unregulated municipal market participants, stating.

This expanded authority should be employed in a dual regulatory structure with registration of the firms required with the SEC, yet making the more prescriptive rules of the MSRB also applicable to these firms and their activities.^[10]

The dual regulatory structure recommended by the MSRB was adopted in Dodd-Frank. Notably, the MSRB did not explain why additional regulation was needed; it was enough that there were significant players in the municipal market who were unregulated.

The adoption of the municipal finance provisions of Dodd-Frank was not preceded by meaningful hearings before Congress, the SEC or the MSRB. However, abuses in the market place were widely covered in the financial press. In particular, participation by J.P. Morgan in a long series of improvident swaps with Jefferson County, Alabama was colorfully described in September 2005 in “The Banks that Fleeced Alabama.”^[11] A more comprehensive treatment of the Jefferson County story and the abuses visited on Jefferson County by several regulated and unregulated financial intermediaries is “Financing Plans for the Jefferson County Sewer System: Issues and Mistakes”^[12] prepared for a symposium at Cumberland Law School in January 2010 in which Congressman Spencer Bachus of Alabama’s Sixth District and then ranking Republican on the House Financial Services Committee was a participant.

At the time Dodd-Frank was under consideration in Congress, two academic articles on Municipal Advisors had recently been published or were in wide circulation in draft form. “The Role and Impact of Financial Advisors in the Market for Municipal Bonds”^[13] examined 9,493 tax-exempt municipal bond issues from the period 1990 to 1999 and found “…using a financial advisor provides statistically significant borrowing cost savings and lower reoffering yields” and “using financial advisors reduces underwriter gross spreads.”^[14] “Does the Quality of Financial Advice Affect Prices?”^[15] examined 58,562 new municipal issues from the period 1984 to 2002 and found that higher-quality financial advisors (quality being measured by experience in terms of number of deals advised) are associated with statistically significant decreases in new issue yields. The present value of financial benefits of a high quality advisor were quantified for a 20-year $16.8 million principal amount issue as $116,511, or .69% of the principal amount of the issue. Interestingly, the article goes on to comment on the practice (forbidden in recent times by MSRB Rule G-23) of having the same firm serve as underwriter and Municipal Advisor:

“Only a small percentage of issuers in our sample (2.88%) employ a financial advisor in the dual role as underwriter. Although it was not the focus of our study, our results for the effect of a financial advisor serving a dual role as advisor and underwriter confirm prior studies that issuers, on average, pay an interest cost penalty.”^[16]

This finding is relevant when considering the provision of Dodd-Frank that permits an issuer to avoid appointment of a Municipal Advisor and, instead, to appoint an underwriter before receiving any advice from the underwriter on a proposed issue and then to rely thereafter on the underwriter for both advice and marketing of the municipal securities.^[17]

Rumor has it that Representative Barney Frank, Chairman of the House Financial Services Committee at the time of passage of Dodd-Frank, was influenced in his approach to the municipal finance provisions of Dodd-Frank by representatives of issuers in his congressional district who were unhappy at being besieged by bankers touting muni finance deals. There is no doubt that Frank was also familiar with the problems in Jefferson County, Alabama because representatives of the County briefed him in the Spring of 2008. In addition, the influence of Jefferson County on the municipal finance provisions of Dodd-Frank was brought to bear by Ranking Member Bachus. Chairman Frank knew that Jefferson County was suffering greatly from the attentions of representatives of international banks with familiar names who had pushed the latest new new concepts on elected officials and finance staff ill equipped to understand them.

The Dodd-Frank amendments to Section 15B of the Securities and Exchange Act of 1934 appear to be an attempt to respond to constituent complaints by changing the way that municipal financial services are marketed and delivered. Several generations of investment bankers have been taught at the Harvard Business School and elsewhere that the way to successfully sell banking services is to call on senior officers of issuers with memoranda describing deal ideas of benefit to the issuers.^[18] Traditionally, competent issuers vet the bankers promoting the deals as well as the deal ideas and make up their minds about what they want to do. This marketing method works well for both sides in the taxable corporate world where the deal sizes are large and the issuers well staffed with experienced personnel capable of evaluating and executing transactions. In the less transparent municipal world issuer staff is usually less experienced and accomplished and may not fully understand the transactions they are asked to recommend. In the case of Jefferson County in the period 1997 to 2006 the issuer was not capable of assessing the competence of its advisors, much less the deals that were being pushed on them. It was a case of foxes guarding the hen house and joining in the theft of the eggs. Jefferson County was a prime example in establishing the need for a regulatory scheme that seeks to assure that Municipal Advisors are qualified, ethical and effectively engaged on behalf of their clients.

In the municipal world the function of the Municipal Advisor, as mandated by Dodd-Frank, is to sit on the issuer’s side of the table and protect the interests of the issuer while bringing necessary expertise to the issuer’s team. The effect of the Municipal Advisor rules is to strongly encourage the outsourcing of municipal financial services by issuers who do not maintain in house expertise in planning for and executing municipal transactions. To facilitate this outsourcing, Dodd-Frank imposes a fiduciary duty on Municipal Advisors requiring them to put the interests of their issuer clients above their own. Underwriters are not fiduciaries, making it advisable to deal with them at arm’s length and with care.

Dodd-Frank subjects Municipal Advisors to federal regulation by requiring their registration with the SEC and compliance with standards set by the MSRB. It is now illegal for a Municipal Advisor to provide advice on the issuance of municipal securities to a municipal entity without registration. The registration requirements became effective in October 2010. The SEC’s final rules for municipal advisor registration took effect July 1, 2014. The MSRB is nearing completion of a municipal advisor regulatory framework as directed by Dodd-Frank.

The elevation of the role of the Municipal Advisor in the process of issuing municipal securities is not just a means of leveling the playing field so that municipal issuers are not disadvantaged by Wall Street bankers who are intent on earning a bigger bonus. It is also an attempt by the SEC to create a structural solution to fraud in the municipal markets. For a decade or more the SEC has been advancing the role of chief compliance officers in broker dealers and registered investment advisors in an attempt to encourage financial professionals to take responsibility for lawful conduct within their own organizations. Among the shortcomings exposed by the Great Recession was the failure of the SEC to uncover fraudulent abuses before they did substantial damage, and still today the SEC arguably has insufficient competent staff to protect the municipal markets. The new Municipal Advisor regime can thus be seen as an effort to suppress fraud by institutionalizing a competent market player whose job is to look after the best interest of the issuer.

IV. Summary of Important Provisions of the Dodd-Frank Statute and Regulations

The following paragraphs address in summary form the most important provisions of the Dodd-Frank law. Rules governing municipal advisors will no doubt continue to evolve as the SEC issues additional guidance and takes enforcement actions and the MSRB issues its implementing rules. To avoid potential problems, government finance professionals should consult with their attorneys as they attempt to comply with Dodd-Frank and its related rules.

A. What is a Municipal Advisor?

Since the registration requirement is directed at Municipal Advisors, it is important to understand who is considered to be a Municipal Advisor by the SEC. Subject to certain important exclusions and exemptions, a Municipal Advisor is defined as a person who “provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities … or undertakes a solicitation of a municipal entity or an obligated person.”,^[19] A person does not have to receive compensation in order to be considered a Municipal Advisor.

To better understand the definition, though, you really need to know who is included, who is excluded, and what constitutes advice.

B. What constitutes advice?

Since a Municipal Advisor is defined as a person who provides advice, what will qualify as advice under SEC rules and therefore trigger the registration requirement if rendered to a municipal entity? Unfortunately, the SEC does not believe that the term “advice” is subject to a bright-line definition. Instead the term should be construed broadly and the determination of whether advice has been rendered will be dependent on all relevant facts and circumstances.^[20] Advice includes a “recommendation that is particularized to the specific needs, objectives, or circumstances of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities….”^[21] A “municipal financial product” means “municipal derivatives, guaranteed investment contracts, and investment strategies.”[22] A “municipal security” is defined in Section 3(a)(29) of the Securities and Exchange Act of 1934 and means generally securities issued by a state, any political subdivision of a state, or any instrumentality thereof, or that are exempt from federal taxation under Section 103 of Internal Revenue Code. “Advice” is a “call to action” (or conversely, a call to refrain from taking action) that could reasonably be expected to influence a municipal entity. Advice does not include the provision of general information that does not involve a recommendation. Information that is factual, not particularized, widely disseminated to market participants, or educational would not constitute advice.

C. Who is included in this definition of Municipal Advisor?

Specifically included in the definition are financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and swap advisors if they provide municipal advisory services.^[23]

D. Who is excluded by the Exchange Act and the SEC Rule?

Five groups of persons are explicitly excluded from the definition of Municipal Advisor. These are:

• A broker, dealer, or municipal securities dealer serving as an underwriter;^[24]
• Investment adviser registered under the Investment Advisers Act of 1940 or associated persons;
• Commodity trading advisors registered under the Commodity Exchange Act, or associated persons, who are providing swap advice;
• Attorneys offering legal advice or providing services of a traditional legal nature;
• Engineers providing engineering advice.^[25]

E. Activity-based exemptions are also offered.

SEC Rule 15B narrowed the definition of Municipal Advisor by adopting eight “activities-based” exemptions. Persons may engage in these limited activities without triggering the registration requirement:

• Accountants providing normal accounting services;
• Public officials and employees of municipal entities;
• Banks;
• Persons responding to Requests for Proposal or Qualification;
• Swap dealers registered under the Commodity Exchange Act recommending a municipal derivative or a trading strategy that involves a municipal derivative;
• Persons engaging in municipal advisory activities under circumstances where the municipal entity is represented by an Independent Registered Municipal Advisor (IRMA) (the IRMA exemption);
• Persons providing advice with respect to investment strategies that are not related to the investment of proceeds of municipal securities or the recommendation and brokerage of escrow investments;
• Persons undertaking solicitation for an entity to provide investment strategies for funds that are not the proceeds of municipal securities.^[26]

F. What are the implications of the Municipal Advisors Rule for finance staff of Municipal Entities?

First, it should be emphasized that it is the responsibility of outside professionals, not government entities, to comply with the municipal advisory rules. Nevertheless, it is important that government finance professionals understand the new operating environment that will result from implementation of the rules. Compliance failures can have serious consequences. If a prospective underwriter provides advice to an issuer prior to being designated as underwriter for an issuer, the prospective underwriter is barred by MSRB Rule G-23 from serving as underwriter on the issue in question. Because underwriters and other municipal market participants will seek to avoid such consequences, the rule will narrow the scope of information provided to governments and potentially change how information flows to issuers of municipal securities. In order to avoid providing “advice,” information is likely to be more general in nature and less tailored to the specific situation and requirements of an issuer. Information may become more compartmentalized as professionals avoid addressing issues outside their particular lane even though they may be able to bring significant expertise and insight to an issue.
Both issuers and underwriters will benefit from the issuer appointing an Independent Registered Municipal Advisor (IRMA) in order to qualify for the IRMA exemption. An IRMA is a Municipal Advisor registered with the SEC who is identified by an issuer to underwriters in a written notice that the issuer is represented by and will rely on the advice of its IRMA and that the issuer intends market participants to receive and rely on the notice for purposes of the Independent Registered Municipal Advisor exemption. This notice may be given to a potential underwriter or it may be posted on a web site available to all potential underwriters. The underwriter must in turn disclose to the issuer, with copy to the IRMA, that in relying on this representation, it is not a Municipal Advisor and is not subject to the fiduciary duty requirement.^[27] Once this is done, the prospective underwriter may provide advice to the issuer without being disqualified from acting as underwriter.

G. How can a municipal entity get the type of in-depth, specific market information necessary to properly manage its financial affairs in the new regulatory environment?

Several alternatives can be employed by government entities that will allow them access to customized financial analysis and advice. First, they can retain a Municipal Advisor and look to that advisor for analysis and market insight. Retaining a Municipal Advisor has the secondary benefit of triggering the IRMA exemption which makes available advice from the full spectrum of market participants. Under the IRMA exemption, the underwriter need not communicate with its prospective client exclusively through the Municipal Advisor nor must the Municipal Advisor be involved in meetings with the prospective client.

As a municipal entity focuses on a specific debt offering, other exclusions to the Municipal Advisor rule become available that open avenues to receiving the very specific advice that is required. Under the Request for Proposals (“RFP”) exclusion the borrower may issue an RFP for underwriters and include in the RFP a request for specific market analysis, refunding analysis or structuring proposals. The Underwriter exclusion also becomes available once a dealer has been engaged to underwrite a particular issue of municipal securities, as in the next section.

H. Underwriters

According to data published by the MSRB, a minority of issuers prefer to sell securities to underwriters without the assistance of Municipal Advisors and Dodd-Frank continues to permit such transactions, subject to certain conditions. Use of the exemption is appropriate for issuers with substantial in house expertise and probably inappropriate for issuers without such expertise.

A broker-dealer not already engaged as an underwriter can no longer market its services by providing specific advice to a municipal issuer regarding a potential municipal issue. Giving advice under these circumstances makes the broker-dealer a Municipal Advisor under Dodd-Frank and disqualifies the broker-dealer from serving as an underwriter under MSRB rules. However, an issuer that intends to use a broker-dealer as an underwriter may retain the broker-dealer for a specific issue and thereafter secure specific advice from the broker-dealer without the appointment of a Municipal Advisor; provided that in the case of negotiated underwritings the broker-dealer first complies with Rule G-17 of the MSRB.

In the MSRB rulebook, Rule G-17 is 37 words long, but requires 32 pages of interpretation. For purposes of this analysis the most important interpretation is a notice dated August 2, 2012 requiring an underwriter to make specified disclosures to an issuer at specified times and in specified ways. Some of the required disclosures relate to (i) arm’s-length nature of the underwriter-issuer relationship, (ii) role of underwriter and compensation, (iii) conflicts of interest, (iv) duty to buy and sell securities at a fair and reasonable price, (v) absence of fiduciary duty, (vi) avoidance of fraud and commitment to fair dealing. In support of the role of Municipal Advisors, the MSRB has decreed that underwriters “must not recommend that the issuer not retain a municipal advisor.”

Guidance on the underwriter exemption has been provided by the staff of the SEC in a document last updated May 19, 2014.^[28] Section 5.1 of this document indicates that engagement of an underwriter can be evidenced by an engagement letter signed by a duly authorized official of an issuer. SEC staff further states that an engagement of an underwriter by an issuer may be communicated in an email or telephone call, although staff appears to contemplate that such an email or telephone call will occur after the governing body of the issuer has voted to retain the broker-dealer as underwriter. In connection with an email or telephone call, staff repeats that the broker-dealer must provide the disclosures required under G-17 “at or before the time of engagement.”^[29]

Since G-17 requires a disclosure in writing to an official of the issuer that the underwriter reasonably believes has the authority to contract with the underwriter and to attempt to obtain written acknowledgement of receipt of the disclosure, the G-17 disclosure is not a mere pro-forma exercise. It remains to be seen how tough the Financial Industry Regulatory Authority (“FINRA”) will be in enforcing compliance with the conditions for permitting negotiated underwritings of municipal securities in the absence of a Municipal Advisor. One should anticipate the possibility of scrutiny of every issue negotiated without the benefit of a Municipal Advisor.

V. Conclusion

The Municipal Advisor regime directed by Dodd-Frank and close to being implemented by the SEC and the MSRB represents a reasonable approach to improving regulation of the issuance of municipal securities, especially given the constrained resources of the SEC. The increasing prevalence of Municipal Advisors even before the passage of Dodd-Frank indicates the acceptance of Municipal Advisors by issuers as valuable resources in connection with the issuance of municipal securities. Academic research covering a large number of municipal issues indicates that engagement of an experienced Municipal Advisor leads to lower interest costs. Negotiation theory and common sense point to the advantages of municipal issuers being armed with better market information and experience in structuring and bidding or negotiating the sale of securities. Indeed, Municipal Advisors have become so common in municipal finance that they are close to being insurance policies for public officials against the risk of poorly planned and executed municipal finance deals.
James H. White, III