SEC Commissioner Gallagher Discusses Muni Market Issues (with Lofchie Comment)

At the MSRB Municipal Securities Regulator Summit, SEC Commissioner Daniel Gallagher delivered the keynote address, which discussed significant issues facing the municipal markets.

Commissioner Gallagher stated that, as the primary regulator for both the equity and fixed income markets, the SEC must allocate its resources properly. He explained that a good starting point for addressing major market issues would be to review the SEC 2012 Report on the Municipal Securities Market ("Muni Bond Report"), adding that the SEC should consider undertaking a similar effort with respect to the corporate bond market.

Using the Muni Bond Report as the foundation of his comments, Commissioner Gallagher focused on three secondary market issues that he views as particularly important: riskless principal markups, post-trade price transparency and best execution.

Commissioner Gallagher explained that riskless principal transactions, which take place when a dealer receives a customer order and immediately executes an identical order in the marketplace to fill while taking on the role of principal, are not very different from agency trading. This was brought to light in the Muni Bond Report, which noted additionally that, while MSRB Rule G-15 ("Confirmation, Clearance, Settlement and Other Uniform Practice Requirements with Respect to Transactions with Customers") generally requires municipal bond dealers acting as agents to disclose any remuneration to be received from the customer, there is no comparable requirement for dealers acting as principals, even in a riskless environment. Commissioner Gallagher encouraged the MSRB to consider whether it is appropriate to amend Rule G-15 to include disclosure of the markup or markdown in riskless principal transactions.

Regarding post-trade price transparency, Commissioner Gallagher commended FINRA and the MSRB for implementing TRACE and EMMA - respectively, systems designed to centralize the collection and dissemination of post-trade price information. Despite these advances, however, Commissioner Gallagher stated that retail investors are still not confident that they have received the best execution in the bond markets. He explained that the February 2014 MSRB draft proposal, which would establish a best execution for municipal securities transactions, is an important step forward.

Beyond these trading issues, Commissioner Gallagher stated, the Muni Bond Report lays out other concerns regarding municipal offerings. He stated that the failure by issuers to disclose the true extent of pension and other post-employment benefit obligations is a serious threat, explaining that the severity of unfunded pension obligations and their potential impact on investors is exemplified in Detroit's current bankruptcy proceedings. He explained that, while the Governmental Accounting Standards Board has begun to fix this problem, its standard-setting project is hugely controversial and more needs to be done, specifically with regard to discount rate issues.

Lofchie Comment: Former Commissioner Elisse Walter drove the SEC to examine the municipal bond markets more closely. Her departure slowed the momentum in this area. Commissioner Gallagher's speech may signal, however, that the Commission is refocusing on municipal bond issues and, perhaps more generally, on debt market issues.The regulation of the municipal bond market is particularly interesting because it involves not only the standard broker-dealer issues (e.g., markups and transparency), but also the quality of financial disclosures made by elected officials and by issuers that are governmental entities.

See: Commissioner Gallagher's Speech. Related news: MSRB Proposes to Establish First Best-Execution Rule for Municipal Securities Transactions (February 19, 2014) SEC Commissioner Piwowar Speaks on SEC Priorities and Issues of Regulatory Structure (with Lofchie Comment) (January 28, 2014) SEC Report on the Municipal Securities Market (July 31, 2012).