1 E MERGING I SSUES in the M UNICIPAL S ECURITIES M ARKET Presented to International Municipal...

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EMERGING ISSUESEMERGING ISSUES

in thein the

MUNICIPAL SECURITIES MARKETMUNICIPAL SECURITIES MARKET

Presented to International Municipal Lawyers Association

2008 Annual Conference

September 15, 2008

By Robert W. Doty

AGFSSacramento

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OVERVIEWOVERVIEW

• Bond Insurer Downgrades & Impacts on IssuersBond Insurer Downgrades & Impacts on Issuers

• Dual vs. Single Rating ScalesDual vs. Single Rating Scales

• Collapse of ARS Bonds (Related Enforcement); Collapse of ARS Bonds (Related Enforcement); Underwriter ConflictsUnderwriter Conflicts

• Jefferson County Defaults; Pending BankruptcyJefferson County Defaults; Pending Bankruptcy

• SEC Action Against Former San Diego OfficialsSEC Action Against Former San Diego Officials

• MaterialityMateriality

• SEC Limitations on Reliance on Counsel/ProfessionalsSEC Limitations on Reliance on Counsel/Professionals

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BOND INSURER DOWNGRADES BOND INSURER DOWNGRADES & IMPACTS ON ISSUERS& IMPACTS ON ISSUERS

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NUMEROUS INSURER RATING DOWNGRADESNUMEROUS INSURER RATING DOWNGRADES

•All But Two Insurers Downgraded, All But Two Insurers Downgraded, Some RepeatedlySome Repeatedly

•Negatives for Remaining TwoNegatives for Remaining Two

•Some Now Below Investment GradeSome Now Below Investment Grade

•Had Declined to Certify Completeness of InformationHad Declined to Certify Completeness of Information

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ISSUER BOND DOWNGRADESISSUER BOND DOWNGRADES

Affects Outstanding Bonds, Not New IssuesAffects Outstanding Bonds, Not New Issues

Requires Material Event Notice FilingsRequires Material Event Notice Filings

Sometimes RepeatedlySometimes Repeatedly

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DUAL vs. SINGLE RATING SCALESDUAL vs. SINGLE RATING SCALES

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DIFFERENTIALS IN DIFFERENTIALS IN DEFAULT RATESDEFAULT RATES

Municipal Market Advisors, Says, e.g.—Municipal Market Advisors, Says, e.g.—

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Moody’s S&P

Muni Baa/BBB

0.13% 0.32%

Corporate Baa/BBB

4.64% 10.29

Muni Aaa/AAA

0.00% 0.00%

Corporate Aaa/AAA

0.52% 0.60%

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ISSUER CHALLENGES TO RATING SCALESISSUER CHALLENGES TO RATING SCALES

California Treasurer Bill Lockyer—California Treasurer Bill Lockyer—

““Under the current system, the agencies hold governmental issuers to a higher standard.

The result is lower bond ratings that force taxpayers to shoulder substantial,

unwarranted costs in the form of higher interest payments and insurance premiums.””

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PROPOSED FEDERAL ACTIONPROPOSED FEDERAL ACTION

Regulatory—Regulatory—Several New Requirements Several New Requirements for Rating Agency Disclosure & Conflicts Regulationfor Rating Agency Disclosure & Conflicts Regulation

Legislative (Rep. Frank)—Legislative (Rep. Frank)—Restrict Rating Focus to DefaultRestrict Rating Focus to Default

Litigation—Litigation—Connecticut AG Connecticut AG (Rating Agencies)(Rating Agencies); ; New Orleans, Los Angeles, Stockton New Orleans, Los Angeles, Stockton ( Bond Insurers)( Bond Insurers)

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STANDARD & POOR’S—STANDARD & POOR’S—

““[S&P] uses the same rating scale across the [various] sectors””

““conducting an ongoing review … with goal of further promoting the comparability of our rating opinions””

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MOODY’S—MOODY’S—

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““we are proposing to transition our public finance ratings to our global

scale””

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FITCH—FITCH—

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Indications Are a Move to Single Indications Are a Move to Single “Global” Scale“Global” Scale

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COLLAPSE OF ARS COLLAPSE OF ARS BONDS BONDS

(RELATED ENFORCEMENT);(RELATED ENFORCEMENT);UNDERWRITER CONFLICTSUNDERWRITER CONFLICTS

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AUCTION RATE SECURITIESAUCTION RATE SECURITIES

• Long-Term SecuritiesLong-Term Securities

• Rates Change Periodically Rates Change Periodically (e.g., 7, 28, 35 Days)(e.g., 7, 28, 35 Days)

• High Insured RatingsHigh Insured Ratings

• Periodic AuctionsPeriodic Auctions

• No Liquidity AgentNo Liquidity Agent

• Marketed as Highly Rated, Marketed as Highly Rated, Highly Liquid SecuritiesHighly Liquid Securities

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Actually, Auction Agents Actually, Auction Agents (Underwriters) Supported Market(Underwriters) Supported Market

Support Levels Not DisclosedSupport Levels Not Disclosed

As Bond Insurers Downgraded, ARS As Bond Insurers Downgraded, ARS Became IlliquidBecame Illiquid

Underwriters Built Enormous Underwriters Built Enormous InventoriesInventories

Damning EmailsDamning Emails

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Alleged That Certain Firms—Alleged That Certain Firms—

Discussions of Withdrawing Support Discussions of Withdrawing Support for Marketfor Market

Simultaneous Inventory Sales to Simultaneous Inventory Sales to Investor ClientsInvestor Clients

(Including Local Governments)(Including Local Governments)

Investors Found Illiquidity When Investors Found Illiquidity When Support WithdrawnSupport Withdrawn

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Alleged That Certain Firms—Alleged That Certain Firms—

Issuers Experienced Issuers Experienced High Interest High Interest RatesRates under Interest Formulae under Interest Formulae

MotivatedMotivated to Reduce Interest Costs to Reduce Interest Costs

Underwriters “Assisted Issuers” in Underwriters “Assisted Issuers” in Refinancings Refinancings to Other Structuresto Other Structures

““Dream” World for FeesDream” World for Fees

Underwriters Were Large Investors Underwriters Were Large Investors Through InventoriesThrough Inventories

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AUCTION RATE SECURITIESAUCTION RATE SECURITIESState Legal ActionsState Legal Actions

• New YorkNew York

• MassachusettsMassachusetts

• TexasTexas

• New Hampshire (for Student Loan New Hampshire (for Student Loan Issuer)Issuer)

• New Orleans (VRDOs)New Orleans (VRDOs)

• Missouri (Reported Pending)Missouri (Reported Pending)

• More Reported PendingMore Reported Pending

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AUCTION RATE SECURITIESAUCTION RATE SECURITIESState Legal ActionsState Legal Actions

• Several SettlementsSeveral Settlements

• Buyouts of Retail Customers ($20B)Buyouts of Retail Customers ($20B)

• Refunds of Restructuring Refunds of Restructuring Underwriting Fees to Underwriting Fees to

Some IssuersSome Issuers

• Significant FinesSignificant Fines

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JEFFERSON COUNTY (AL) JEFFERSON COUNTY (AL) ARS & VRDO DEFAULTS; ARS & VRDO DEFAULTS; PENDING BANKRUPTCYPENDING BANKRUPTCY

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JEFFERSON COUNTYJEFFERSON COUNTY

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Looming Enormous Municipal Looming Enormous Municipal DefaultDefault

Potential Investor LossesPotential Investor Losses

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Approximately $3B in Bond Issues in Approximately $3B in Bond Issues in 2003/20042003/2004

Also Substantial Interest Rate SwapsAlso Substantial Interest Rate Swaps

Bond Insurer Downgrades Led to Bond Insurer Downgrades Led to Auction FailuresAuction Failures

Interest Rate IncreasesInterest Rate Increases

Swap TerminationsSwap Terminations

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Interest Rates BurdensomeInterest Rates Burdensome

Swap Termination Fees HighSwap Termination Fees High

County Forbearance AgreementsCounty Forbearance Agreements

Various Restructuring ProposalsVarious Restructuring Proposals

““End Game” ApproachingEnd Game” Approaching

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SEC ACTION SEC ACTION AGAINST FORMER SAN DIEGO OFFICIALS AGAINST FORMER SAN DIEGO OFFICIALS

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SAN DIEGO ENFORCEMENT ACTIONSSAN DIEGO ENFORCEMENT ACTIONS

OPEB DISCLOSURE ISSUESOPEB DISCLOSURE ISSUES

• CityCity

• City Auditor & Individual PrincipalCity Auditor & Individual Principal

• Former City OfficialsFormer City Officials

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OPEB DISCLOSURE ISSUESOPEB DISCLOSURE ISSUES

• OS Disclosure—OS Disclosure—Both Text & Both Text & Financial Statement NotesFinancial Statement Notes

• Continuing (Annual) Disclosure—Continuing (Annual) Disclosure—Financial Statement Notes AgainFinancial Statement Notes Again

• Rating Agency Presentations—Rating Agency Presentations—Indirect Disclosure to Investors & Indirect Disclosure to Investors & MarketMarket

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CITY SETTLEDCITY SETTLED

• Cease & Desist OrderCease & Desist Order

• Agreed to Employ Independent Agreed to Employ Independent Consultant to Review & Recommend Consultant to Review & Recommend Improvements in PracticesImprovements in Practices

• Extremely Expensive Internal ReviewExtremely Expensive Internal Review

• Many Years Later, Maybe Ready to Many Years Later, Maybe Ready to Re-Enter MarketRe-Enter Market

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AUDITOR SETTLEDAUDITOR SETTLED

• Permanent InjunctionsPermanent Injunctions

• Individual Paid $15,000 Civil PenaltyIndividual Paid $15,000 Civil Penalty

• SEC Challenged Auditor’s SEC Challenged Auditor’s Qualifications, Investigation & Qualifications, Investigation & Knowledge of CityKnowledge of City

DON’T EMPLOY AUDITORS ON FEES ALONE!DON’T EMPLOY AUDITORS ON FEES ALONE!

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FORMERFORMER CITY OFFICIALS CITY OFFICIALS(Pending)(Pending)

• City ManagerCity Manager

• City Auditor-ComptrollerCity Auditor-Comptroller

• Deputy City Manager for FinanceDeputy City Manager for Finance

• Assistant City Auditor-ComptrollerAssistant City Auditor-Comptroller

• City TreasurerCity Treasurer

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SAN DIEGO ENFORCEMENT ACTIONSSAN DIEGO ENFORCEMENT ACTIONSFORMERFORMER CITY OFFICIALS CITY OFFICIALS

Penalties Sought Against IndividualsPenalties Sought Against Individuals

• Declaratory ReliefDeclaratory Relief

• Permanent InjunctionsPermanent Injunctions

• Monetary Civil PenaltiesMonetary Civil Penalties

City Recently Denied Legal FeesCity Recently Denied Legal Fees

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Changing & Stale InformationChanging & Stale Information

2002 Financial Statements Reported2002 Financial Statements Reported$39.2 MM$39.2 MM NPO NPO

But City Knew 2003 But City Knew 2003 Would Be $51.9 MMWould Be $51.9 MM

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Undisclosed EstimateUndisclosed Estimate

Estimated PV of Retiree Health Care LiabilityEstimated PV of Retiree Health Care Liability$1.1 Billion$1.1 Billion

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Predictive or Probability InformationPredictive or Probability Information

““City was aware that the CERS funded ratio would likely fall below [82.3% funded ratio] trigger level””

[Trigger in Manager’s Proposal 1 [Trigger in Manager’s Proposal 1 Required Additional City Contributions]Required Additional City Contributions]

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Expectation for Future EventExpectation for Future Event

Retiree Health Care Paid in Past from “Surplus Earnings” Retiree Health Care Paid in Past from “Surplus Earnings” in Pension Fund in Pension Fund

Would Have To Be Paid Would Have To Be Paid in Future in Future from from Direct City PaymentsDirect City Payments

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Expectation for Future EventExpectation for Future Event

City’s City’s ““LoomingLooming Financial Crisis” Financial Crisis”

Unfunded Liability Unfunded Liability ExpectedExpected To Increase To Increase DramaticallyDramaticallyfrom from $720 MM $720 MM in 2003 to in 2003 to $2B $2B in 2009in 2009

EstimatedEstimated Annual Pension Contribution Annual Pension Contribution Would GrowWould Grow from from $51 MM $51 MM in 2002 in 2002

to to $248 MM $248 MM in 2009in 2009

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NOTE—NOTE—

In Each Case, SEC Asks for In Each Case, SEC Asks for Disclosure of Disclosure of Present State of KnowledgePresent State of Knowledge

Estimates, Expectations, ProbabilitiesEstimates, Expectations, Probabilities

Uncertainties Also Should Be DisclosedUncertainties Also Should Be Disclosed

Requires Care to Frame InformationRequires Care to Frame Information

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MATERIALITYMATERIALITY

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MATERIALITYMATERIALITY

DC COURT OF APPEALSDC COURT OF APPEALS

•EachEach “reasonable” investor “reasonable” investor

•Many types of “reasonable” investorsMany types of “reasonable” investors

• Singular, idiosyncratic preference Singular, idiosyncratic preference for for balancing risk & return in unique portfoliobalancing risk & return in unique portfolio

•Different investors Different investors make very make very different different decisionsdecisions

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SEC LIMITATIONS ON SEC LIMITATIONS ON RELIANCE ON COUNSEL/PROFESSIONALSRELIANCE ON COUNSEL/PROFESSIONALS

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THE NAKED ISSUERTHE NAKED ISSUER

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RELIANCE ON PROFESSIONALSRELIANCE ON PROFESSIONALS

SEC’S FORMULASEC’S FORMULA

• Complete Disclosure to ProfessionalComplete Disclosure to Professional

• Seek Advice as to Appropriateness of Seek Advice as to Appropriateness of Challenged ActionChallenged Action

• Receive Advice Conduct Is AppropriateReceive Advice Conduct Is Appropriate

• Rely on Advice in Good FaithRely on Advice in Good Faith

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Neshannock Township School District—Neshannock Township School District—

Actually Asked & Received Informal LetterActually Asked & Received Informal Letter

Did Not Read OS or Understand Tax CertificateDid Not Read OS or Understand Tax Certificate

Dolphin & Bradbury—Dolphin & Bradbury—

Bond Counsel Fairness OpinionBond Counsel Fairness Opinion

Underwriter Counsel OpinionUnderwriter Counsel Opinion

““Must Have Known”Must Have Known” AGFS

RELIANCE ON PROFESSIONALSRELIANCE ON PROFESSIONALS(Good Faith)(Good Faith)

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RELIANCE ON PROFESSIONALSRELIANCE ON PROFESSIONALS

• Formal Written OpinionFormal Written Opinion((Not Mere Participation Not Mere Participation in Transaction)in Transaction)

• Qualified ProfessionalQualified Professional((Not Least ExpensiveNot Least Expensive))

• Make Complete DisclosureMake Complete Disclosure

• Review CarefullyReview Carefully

• Certifications of ExpertsCertifications of Experts

• Good Faith RelianceGood Faith Reliance

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RELIANCE ON RELIANCE ON PROFESSIONALSPROFESSIONALS

• Use Your OwnUse Your Own Counsel/Professional Counsel/Professional

• Not Underwriter CounselNot Underwriter Counsel(Contrast Disclosure Counsel)(Contrast Disclosure Counsel)

• NotNot Underwriter (Adverse) Underwriter (Adverse) • NotNot Developer’s Appraiser/Feasibility Developer’s Appraiser/Feasibility

ConsultantConsultant

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RELIANCE ON RELIANCE ON PROFESSIONALSPROFESSIONALS

• Bond Counsel—Bond Counsel—Limited EngagementLimited Engagement

• Fairness Opinion—Fairness Opinion—Limited in ScopeLimited in Scope

• Disclosure Counsel—Disclosure Counsel—Exceptions; Exceptions; Limited ReviewLimited Review

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GUESS WHO IS LEFTGUESS WHO IS LEFT

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IMLA’SIMLA’SFINANCING PROCEDURES CHECKLISTSFINANCING PROCEDURES CHECKLISTS

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THE ENDTHE END

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1 E MERGING I SSUES in the M UNICIPAL S ECURITIES M ARKET Presented to International Municipal...

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