Financial federalism and the short, happy life of municipal securities regulation.

• Author: Gabaldon, Theresa A.

1. INTRODUCTION II. BACKGROUND A. A Scandalous, if Untitillating, History: Municipal Poster Children B. Who Does What and to Whom 1. The Regulation of Dealer Practices 2. The Backdoor to Disclosure a. Transaction Information b. Deal Information c. Issuer Information i. General ii. Accounting Issues III. FINANCIAL FEDERALISM IV. GRAND THEORIES A. Law and Economics B. Public Choice V. OTHER CONSIDERATIONS VI. SECOND-BEST OR PROTOTYPE? A. The Content of Disclosure 1. Learning from Past Mistakes 2. A New Laboratory B. The Pros and Cons of Full Regulation 1. Debt vs. Equity 2. Commission Review 3. Limitations on Oral and Written Offers and Prospectus Delivery Requirements C. Civil Liability VII. CONCLUSION I. INTRODUCTION

   Not to put anyone off, but the field of municipal securities (1) regulation is the antithesis of sexy. Its powerful soporific effect may already be making itself felt on the reader; its effect on legal scholars is manifest. Academic attention to the issues presented by municipal securities regulation is extremely limited and grand theories of municipal securities regulation are glaringly absent from the pages of our country's law journals. (2) One purpose of this Article is to question why this is so, as well as to establish that it is something that might be of concern. Another is to observe that, from the perspective of the end user, functional differences between municipal and nonmunicipal securities regulation may and should be coming to an end. The third is to make the case for using municipal securities regulation as a pilot program for the overall improvement of the federal securities laws.

   The market for municipal securities is large--to the person on the street perhaps eyepoppingly so. Even in 1975, the first year in which the federal government attempted regulation of that market, $25 to $49 billion of municipal securities were outstanding. (3) There are now more than $2.4 trillion outstanding; (4) the lion's share is directly or indirectly owned by individual investors. (5) Nonetheless, according to the Securities and Exchange Commission (SEC or Commission) as recently as 2006, "the model of full registration, Commission review, and other regulation applicable to nonmunicipal issuers is not necessary or appropriate for state and local governments." (6) The explanation for this is "recognition of the fact that municipal issuers are themselves U.S. sovereigns." (7)

   In the same speech in which the SEC apparently was tugging its forelock in the vague direction of federalism, however, it recognized deficiencies in the currently applicable regime. (8) The Commission specifically called on Congress to improve municipal accounting and disclosure practices, evidently acknowledging that it has reached or is reaching the limits of its own authority. (9) This is particularly interesting in light of a languishing rule proposal made by the SEC relating to municipal point-of-sale disclosure, (10) and may have to do with the jurisdictional lumps the Commission has suffered in the last few years at the hands of the D.C. Circuit Court of Appeals. (11) A supplemental explanation is that the Commission foresaw some sort of train wreck coming, and wished to establish publicly that it would have done more if only it could.

   In any event, the academy's disinclination to comment on the regulation of municipal finance cannot be justified either by its lack of importance or by its state of perfection. More plausible reasons might include the arguable obviousness of answers to at least a few of the questions that might be raised, as well as resignation to the notion that watchful industry lobbies might defeat any meaningful change. Another potential suspect is the reluctance of at least some of academic bent to acknowledge a situation in which that free market thing--well, it just hasn't quite worked out the way it should. Each of these prospects will be examined below.

   It is true, of course, that the issuers of municipal securities are governments themselves. To be sure, this raises issues of intergovernmental comity and, perhaps, federalism. The fact that the issuers are governments, however, also means that they have no shareholders and generally are not managed to produce profits. Instead, they properly are managed for the benefit of those consenting to be governed--and, incidentally but necessarily, to pay off those who purchase their debt. As explained below, this ultimately simplifies any debate about the costs and benefits of investor protection, with the result that a new disclosure regime designed for municipal issuers could be much to the liking of those inclined to discount the value of shareholder primacy in the corporate sphere.

   Part II of this Article provides background on the condition of municipal securities regulation in 2008. This includes brief coverage of the (evidently) sexless scandals prompting the regulation that does presently exist--in other words, the story's "why." It also includes a primer on the "who," "what," and "how." (Insisting on covering the "where" seems a little over-the-top, even for the most cliche-conscious in the audience.) Part III comprises a fairly fleeting examination of the theme of federalism manifest in municipal securities regulation to date. Part IV ruminates on the possible applications of the theories of law and economics and public choice. Part V covers practical considerations to be taken into account in any proposal for regulatory redesign. Part VI synthesizes the earlier parts to make the case that divergent regulatory treatment of municipal and other securities is not merited and properly should come to an end. It also advances the proposition that the need to revise municipal securities regulation provides an opportunity for experimentation that might result in more widespread improvements in the federal securities laws.

2. BACKGROUND

   1. A Scandalous, if Untitillating, History: Municipal Poster Children

      In many regards, municipal securities regulation is a tale of call and response between municipal financial fiasco and federal regulatory reaction. (12) There is, of course, nothing unique in a governmental impulse toward securing the barn door after noticing the absence of part of the herd, (13) but the identification of the most significant developments in municipal securities regulation with particular missing ponies surely is pronounced. Moreover, since the history of those developments is relatively abbreviated, a recounting of the most important stories can be quite brief.

      First, it seems to be generally agreed that the initial significant move toward federal regulation of municipal securities was spurred by the New York City bond crisis, which peaked in 1975. (14) The Big Apple eventually was bailed out by the cooperation of its unions, the actions of New York State, and a federal guarantee, but some of the risks of municipal finance had been exposed to the public eye, and the Municipal Securities Rulemaking Board (MSRB) was born by act of Congress. (15) The MSRB adopts, but does not enforce, standards for the conduct of municipal securities dealers; (16) some of its initiatives are discussed in Part 11.13 below. The legislation creating the MSRB also required registration under the Securities Exchange Act of 1934 (the '34 Act) (17) of municipal securities dealers (18) (many of whom were already subject to registration by reason of their transactions in nonmunicipal securities (19)).

      Eight years later, the Washington Public Power Supply System (WPPSS) lived up to its acronym, going into notorious default on the bonds issued to support its Projects Four and Five. (20) Federal response was not swift, but after five years sedulously spent preparing a report and a sixth spent contemplating it, the SEC adopted a rule requiring, subject to some exceptions, that municipal securities underwriters obtain and use municipal issuers' official statements (which essentially are offering documents serving the same use as a corporate prospectus). (21) After Orange County, California, became famous for its disastrous dabbling in derivatives (that is, for losing its shirt and the camisoles of several other municipal issuers by reason of its unfortunate management of a joint investment pool), (22) the rule was amended to also require municipal securities underwriters to transact business only with issuers willing to provide annual and certain other continuing disclosure. (23)

      The SEC's 2006 call on Congress seems to have been elicited by somewhat more widespread and temporally diffuse hijinks by municipal issuers. (24) Its position paper was prefaced by reference to the disclosure defalcations of several issuers, including the City of San Diego, California, the City of Miami, Florida (there is one in Ohio, you know), and Maricopa County, Arizona. (25) Referenced later in the paper is the thus far successful attempt of Texas to secede from the Union with respect to disclosure of its accumulated obligations to fund employee benefits (further discussed in Part III below). (26) This last event may, in fact, be the straw that broke the camel's back, insofar as the Texas approach exhibits a level of brashness that might, if not patented, lead the composite municipal livestock to storm the barn doors. (27)

      Before evaluating the rhyme and reason of the SEC's entreaty to Congress, however, it is necessary to note the subsequent developments attracting attention to municipal securities. In the first quarter of 2008, tremors of the then-denominated "subprime mortgage crisis" (28) were felt when the ratings of some of the guarantors of municipal debt were downgraded and auctions setting the interest rates of municipal securities began to fail; the rates then converted to high default rates adversely affecting the financial stability of the issuers. (29) This contributed to unusual volatility in the market for municipal securities throughout mid-2008. (30)...