When Wall Street nearly crashed five years ago, a dozen metro Atlanta governments discovered that some nifty side deals their financial advisers had coaxed them into when they issued bonds a few years earlier weren’t so nifty after all.
The side deals — involving complex packages of bonds and related securities — were supposed to lower interest costs. But as the financial crisis deepened they stopped working as expected and costs soared. The local governments, including the city of Atlanta, had to spend a total of about $400 million unwinding the deals.
Now, federal regulators have finalized long-delayed rules aimed at protecting taxpayers and communities from a repeat of such costly mistakes.
The Securities and Exchange Commission rules — required under the Dodd-Frank financial reform law enacted three years ago — set tighter standards for the financial advisers who guide cities and states borrowing money in the $3.7 trillion municipal bond market.
The Dodd-Frank act requires financial advisers to cities and counties to meet the same duties that money managers and trustees owe to investors. They’re supposed to put clients’ interests ahead of their own, avoid conflicts of interest, and get enough professional training to be able to give competent advice.
The new rules also require the advisers to register with both the SEC and the Municipal Securities Rulemaking Board, a quasi-government regulator that also oversees players in the municipal bond market.
Previously, many of these adviser firms, which help states and communities decide on the size and type of bonds that they need, haven’t been subject to federal regulation or licensing.
“It puts a whole part of the industry on notice,” said the MSRB’s executive director, Lynette Kelly. The MSRB hasn’t yet set up licensing exams or professional standards that might include prohibitions against so-called “pay to play” schemes in which advisers give gifts or political contributions to government officials to drum up business.
The rules will eventually make it easier to ensure firms’ compliance, said Kelly. “There will be a much clearer road map in place for law enforcement agencies,” she said.
About 1,100 municipal advisers — including 32 based in Georgia — have registered with the SEC under temporary rules since Dodd-Frank took effect in 2010. The companies’ registration documents, which are available online, require them to describe what type of advisory services they offer and to disclose investment fraud convictions, fines, revoked licenses and other regulatory sanctions.
Most Georgia firms didn’t report any disciplinary issues, but several did. Atlanta-based Jackson Securities, a firm founded by late Atlanta mayor Maynard Jackson in 1987, disclosed a handful of sanctions, including a $20,000 fine in 2006 for late reporting of some municipal bond trades.
Smyrna-based MWS Consulting withdrew its registration as a municipal adviser after disclosing that the SEC barred its president, Anthony C. Snell, from working with municipal securities dealers for 10 years. Snell, a former JP Morgan Securities vice president in Atlanta, pleaded guilty to felony wire fraud charges in 2005 for making illicit payments in 2003 to a Philadelphia lawyer with close ties to John Street, then mayor of that city, to steer bond work to JP Morgan.
The SEC’s new rules regulating municipal advisers are a much-needed reform, said Mike Bell, DeKalb County School District’s chief financial officer.
Wall Street firms have long used financial advisers to get their foot in the door with local governments, but then made more money underwriting the communities’ bonds and related securities, said Bell, a longtime local government official.
“That’s always been a conflict,” he said.
Firms sometimes blurred the lines, giving advice to governments that helped boost their own profits. By ensuring that municipalities have independent advisers, regulators hope to protect taxpayers from a replay of the kinds of complex and costly deals that ensnared some municipal governments and Wall Street firms in accusations of fraud and bribery.
In one scandal that helped inspire the Dodd-Frank rules, metro Birmingham’s Jefferson County, Ala., government landed in bankruptcy in 2011 after it ran up huge costs on a troubled sewer project, then agreed to risky packages of bonds and related securities that soured during the financial crisis. About two dozen county officials, contractors, financial advisers and other players were prosecuted for bribery or other alleged crimes.
By the time Jefferson County filed bankruptcy, taxpayers owed $3 billion to creditors, including more than $1 billion to JP Morgan Chase, which had helped engineer many of the complex bond deals.
“Right now, [local governments] pay for their advice through transactions” with investment banks and other firms, said University of Alabama finance professor Robert Brooks.
Brooks said he began to understand how expensive and risky such advice can be when he looked at one deal Jefferson County signed in 1997. He estimated that investment bankers had structured it to boost their own take by about $3 million at the county’s expense.
“It was so bad that I used it as a case in my 1998 class,” he said, as an example of what not to do.
Under the new rules, it should be tougher for firms to sit on both sides of the table in such deals in the future, according to the SEC and MSRB.
The agencies say the rules clarify the distinct roles of financial advisers, who are supposed to represent the local governments’ best interests, and underwriters, who make much of their profits from packaging and selling the communities’ bonds to investors. Investment banks are still allowed to own advisory firms, but they can’t both underwrite a bond issue and provide advice on the same transaction.
It’s too early to say whether the new regulations will prevent a replay of the abuses that cost taxpayers many millions of dollars, said Brooks.
“Just filling out some paperwork doesn’t change anything,” said Brooks. The key issue, he said, is how well regulators will be able to ensure that advisers avoid conflicts of interest when advising cities on when and how to raise money in new bond issues.
Brooks said he fears that not much will change unless local governments hire independent advisers for year-round advice, rather than turning to teams of investment bankers and financial advisers who get paid when new bonds are issued.
Bell agreed. “The best financial advisers are the independent advisers that do not underwrite” bonds, he said. “There aren’t many of them.”
Bell said he also worries that lawmakers didn’t go far enough when enacting the Dodd-Frank act, because they didn’t mandate regulations barring bond lawyers from making political contributions that could influence government officials’ bond financing decisions.