Q u. s. securities and Exchange Commission~ Washington,D.C. 20549 (202)272-2650

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EMBARGOED UNTIL 7:30 p.m., EASTERN STANDARD TIME, THURSDAY,SEPTEMBER 22, 1988

Remarks ofDavid S. Ruder

ChairmanUnited States Securities and Exchange Commission

Before the 37th Annual Dinner of TheInvestment Association of New York

Waldorf Astoria, New YorkSeptember 22, 1988

UNDERWRITER RESPONSIBILITIES INMUNICIPAL BONO OFFERINGS AFTER WPPSS

The views expressed herein are those of Chairman Ruder and donot necessarily reflect those of the Commission, otherCommissioners, or the staff.

UNDERWRITER RESPONSIBILITIES INMUNICIPAL BOND OFFERINGS AFTER WPPSS

IntroductionIt is a great pleasure for me to speak before the

Investment Association of New York. Looking out at an audienceand seeing so many full heads of dark hair fills me with asense of adventure and opportunity. "Adventure" because youhave survived the black days of October 1987, and because youwill be participating in the secti~itiesmarkets of the future."Opportunity" because you will be extremely influential in ourfinancial markets for years to come.

Before launching into my primary subject for thisevening, I cannot resist offering you a few words of adviceregarding your prospective adventures and opportunities in thecoming years.

First, the chances are that the securities markets of thenext decade will be dramatically different than the markets weknow today. They will be automated, institutional,international, and complex. Those of you who succeed inmastering those markets will have immense opportunities.

Second, as members of the securities industry you havespecial responsibilities to create and operate honestsecurities markets. Although the various exchanges, theNational Association of Securities Dealers, the Securities andExchange Commission, and U.S. Attorneys may engage inregulatory and law-enforcement activity, the burden of creating

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- 2 -an honest market must fallon its participants. I urge you tofollow the highest ethical standards and to cooperate in theestablishment of industry supervisory practices that promotefair and honest markets.Today's Securities and Exchange Commission Actions

As most of you know, the Commission today released itsstaff report on the Washington Public Power Supply System(WPPSS) municipal revenue bonds and announced that it haddecided to close its WPPSS investigation without authorizingan enforcement action. The decision to refrain from anenforcement action was a difficult one, since the WPPSS StaffReport identified several areas in which disclosures regardingthe Supply System were deficient. The decision was made afterreviewing the facts in the context of legal standards andindustry practices, measuring the potential drain on Commissionresources which would result from complicated and protractedlitigation, and noting the existence of massive private damagelitigation.

Although the Commission decided not to pursue anenforcement remedy, we were very concerned about the apparentfailure of the system for underwriting municipal bonds tooperate in a way resulting in adequate disclosure. We werealso concerned over the obvious parallels of the WPPSS matterwith New York City bond problems which occurred more than adecade ago.

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This morning the Commission met in a public meeting andapproved the following actions designed to improve themunicipal bond disclosure system:

1. It published for comment proposed Rule 15c2-12, whichwould require municipal securities underwriters to obtainmunicipal issuer disclosure documents, to review them, and todistribute them to investors.

2. It published its interpretation regarding the legalobligations of municipal securities underwriters, stating thatunderwriters must have a reasonable basis for believing in theaccuracy of key representations contained in offering documentsfor municipal securities.

3. It requested comment on a recent proposal by theMunicipal Securities Rulemaking Board (MSRB) to establish acentral repository to collect information concerning municipalsecurities.

4. It announced a special project to inspect unitinvestment trusts in order to identify possible regulatorychanges.

These actions are extremely important. Let me share withyou their background and content.

Since 1933, the municipal markets have become nationwidein scope, and state and local government obligations now are amajor factor in the United States credit markets. CUrrently,over $720 billion of municipal debt is held by investors, andin 1987 new offerings accounted for $114 billion. At the same

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- 4 -time the investor base for municipal securities has become morediverse, with households accounting for slightly more than one-third of direct holdings.

As I have indicated, the Commission's actions todayreflected its concern about the current quality of disclosurein certain municipal offerings. Before taking those actions,the Commission examined the WPPSS Staff Report, the existingregulatory framework applicable to the issuance and sale ofmunicipal securities, the report 'and actions relating to the1975 New ~ork City fiscal crisis, and industry and regulatorydevelopments since then relating to the issuance and sale ofmunicipal securities.The Washington Public Power Supply System Default

Between 1977 and 1981, the Washington Public Power SupplySystem issued tax-exempt municipal revenue bonds to finance theconstruction of two nuclear power plants, Nuclear Projects Nos.4 and 5. Construction of Projects 4 and 5 was terminated inJune 1982 due to cost overr~ns, to the Supply System'sinability to continue to sell bonds to finance constructioncosts, and to gro~ing skepticism regarding the need for thepower to be provided by the Projects. Although eighty-eightpublic utilities in the Pacific Northwest had agreed to providefunds sufficient to pay the bonds whether or not the Projectswere ever completed (the so-called "take or pay" provisions),the Washington and Idaho Supreme Courts invalidated theobligations of those utilities. In 1983 WPPSS defaulted on

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$2.25 billion in principal and approximately $5 billion ininterest.

The WPPSS staff Report raises serious questions concerningwhether the official statements for WPPSS bonds adequatelydisclosed significant facts. Among other things, the StaffReport describes facts that call into question the SupplySystem's disclosure regarding the estimated cost to completethe Projects, the ability of the supply System to meet itsgrowing financing needs, the projected demand for power in thePacific Northwest, and the extent to which the participatingutilities continued to support the Projects.

The Staff Report raises questions about the role played byrepresentatives of the Supply System and others whoparticipated in the preparation of the official statements,particularly in the later Supply System offerings. Itindicates that representatives of the participating utilitiesknew some of the information that was not disclosed toinvestors.

Importantly, the Staff Report states that the underwritersconsidered themselves "as part of the audience" for disclosuresin the official statements and did not attempt to verifydisclosures.

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- 6 -The Staff Report states that sponsors of unit investment

trusts used nonspecific quality evaluation procedures thatmerely relied on ratings, and that these sponsors continued topurchase Project 4 and 5 bonds at a time when problemsassociated with the Projects may have been known.

The Staff Report also states that limitations in therating process may have contributed to the continued highratings of the WPPSS bonds.

Finally, the Staff Report indicates that bond counsel didnot take steps such as introducing legislation or bringing testcases which might have been valuable in determining thevalidity and enforceability of the participating utilities'agreements. It also indicates that bond counsel did notdisclose that legal authority issues had caused them to excludecertain participating utilities' agreements from theiropinions.The New York City Crisis and Regulatory Responses

The Commission's WPPSS investigation and the Staff Reportwere particularly disturbing to me because they raised issuesregarding the obligations of participants in the sale ofmunicipal securities that are hauntingly similar to thoseraised as a result of the Commission's investigation more thana decade ago concerning the sale of municipal securities of theCity of New York.

The New York City Staff Report revealed that from October1974 through April 1975, a period during which underwriters

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- 7 -distributed approximately $4 billion in short-term debt, NewYork City had serious, undisclosed financial problems. When adecision was made to disclose potential problems in the face ofthe worsening budget crisis, some underwriters denied that theyhad any duty to "ruaaaqe around" to determine whether, in fact,there would be revenues available to retire a contemplatedoffering of notes. The New York City staff Report concludedthat, in varying degrees, the participants in the underwritingprocess, inclUding the principal 'underwriters, bond counsel,and rating agencies, had failed to meet their responsibilitiesto the investing public.

Since the release of the New York City Staff Report,significant changes have taken place in the practicesassociated with the distribution of municipal securities.Municipal issuers have increased substantially the quality ofdisclosure contained in official statements. For instance,voluntary guidelines for disclosure were established in 1976 bythe Government Finance Officers Association (GFOA) and wereupdated in 1988. These guidelines are followed by manyissuers, permit investors to compare securities more readily,and greatly assist issuers in addressing their disclosureresponsibilities. Additionally, when an issuer voluntarilyprepares disclosure documents, the MSRB's rules now requirethat the documents be distributed to investors. Specifically,MSRB Rule G-32 requires that if an official statement isprepared by or on behalf of the issuer, it must be delivered to

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- 8 -investors even if the underwriter must produce copies at itsown expense.

Perhaps the most disturbing fact about the issues raisedby the supply System default is that these issues arose afterthe New York City problems had been thoroughly reported, afterthe subsequent voluntary improvements in municipal disclosure,and after regulatory actions such as adoption of MSRB Rule G-32. Read together, the WPPSS Staff Report and the New YorkCity staff Report demonstrate a continued potential for abusein the municipal securities area. The amounts of moneyinvolved in the 1975 default by New York City and in the 1983WPPSS default each exceeded the largest corporate default inhistory. In addition there have been additional smallerdefaults in municipal securities, as well as downgrades inmunicipal securities' ratings that have adversely affectedinvestors.

Reviewing this history and the current environment forunderwriting and sale of municipal bonds, the Commissiondecided to take action. Let me describe that action in greaterdetail.Proposed Rule 15c12-2

Proposed Rule 15c12-2 would require underwriters of issuesof municipal securities having an aggregate offering price inexcess of ten million dollars to obtain and review a nearlyfinal official statement before bidding for or purchasing thesecurities. The proposed rule would also require that

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underwriters of such municipal offerings contract with theissuer to obtain final official statements in sufficientquantities to make them available to purchasers in accordancewith rules established by the MSRB. Underwriters would also berequired to provide copies of preliminary and final officialstatements to any person upon request. This rule would assurethat official statements are available to both underwriters andinvestors, and, most notably, would require underwriters'review.Municipal Underwriter Reasonable Basis Obligations

The Commission today also published an interpretation ofthe legal standards applicable to municipal underwriters whenthey review municipal bond disclosure documents. It emphasizedthat underwriters must have a reasonable basis for believingthe truthfulness and completeness of the key representationsmade in municipal disclosure documents. This responsibilityarises from the implied recommendation about the securitiesbeing offered that an underwriter makes to its customers whenit participates in an underwriting.

As you are aware, issuers of municipal securities are notrequired to make detailed disclosures of the type mandated forcorporate issuers by the securities Act of 1933 Act (1933 Act).In the absence of specifically mandated disclosure standards,the underwriter's review of disclosure concerning the financialand operational condition of the issuer assumes addedimportance as a means of guarding the integrity of new

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- 10 -offerings. Investors in the municipal securities markets areentitled to depend on accurate disclosure in consideringwhether to bUy the offered securities, and they should be ableto rely on the reputation of the underwriters participating inan offering.

In publishing an interpretation rather than a ruleproposal regarding the responsibilities of underwriters in

•municipal securities offerings, the Commission expressed itsview regarding the law as it presently exists under the anti-fraud provisions of the federal securities laws. It should benoted that failure by underwriters to live up to theirresponsibilities under these laws may give rise to civilliability under scienter-based provisions such as section 10(b)and Rule 10b-5 of the securities Exchange Act of 1934 or maylead to Commission disciplinary action based upon thoseprovisions or upon negligence-based provisions such as Section17(a) of the 1933 Act.

While municipal underwriters generally appear to recognizea responsibility to assess the accuracy of disclosure documentsused in negotiated offerings, the Commission is not convincedthat the practice is universally followed in negotiatedofferings. The interpretation emphasizes the existence ofunderwriter obligations in negotiated offerings.

Underwriters in competitive underwritings apparentlyconsider themselves to have virtually no responsibilityregarding confirmation of the accuracy of the offering

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disclosure documents. The interpretation clearly rejects thiscontention, and emphasizes the existence of underwriterobligations even in competitive offerings.Obligations in All Municipal Offerings

The Commission's interpretation articulates basicquidelines regarding obligations of municipal securitiesunderwriters in both negotiated and competitive offerings.Under the interpretation, underwriters in all municipalofferings shOUld, at a minimum, review the issuer's disclosuredocuments in a professional manner for possible inaccuraciesand omissions. A number of factors are relevant in determiningthe reasonableness of a municipal underwriter's assessment ofthe truthfulness of the key representations contained indisclosure documents. These factors include:

1. the extent to which the underwriter relied uponmunicipal officials, employees, experts, and other personswhose duties provide them knowledge of particular facts:

2. the type of underwriting arrangement (~, firmcommitment or best efforts);

3. the role of the underwriter (manager, selling groupmember, or selected dealer);

4. the type of bonds being offered (general obligation,revenue, or private activity);

5. the past familiarity of the underwriter with theissuer;

6. the length of time to maturity of the bonds; i

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- 12 -7. the presence or absence of credit enhancements; and8. whether the bonds are competitively bid or are

distributed in a negotiated offering.Obligations in Negotiated Offerinas

In negotiated municipal offerings where the underwriter isinvolved in the preparation of the official statement, theunderwriter's efforts should involve an inquiry into keyrepresentations in the official statement, drawing upon theunderwriter's experience with the'particular issuer and withother issues, and upon knowledge of the municipal markets.Sole reliance on the representations of the issuer will notsuffice.

The role of the underwriter in assessing the accuracy ofthe issuer's key disclosures is of particular importance wherethe underwriting involves an unseasoned issuer.Obligations in Competitively B~d Offerings

With respect to competitively bid offerings of municipalsecurities, members of the municipal securities industry haveargued that the uncertainty of the bidding process and timepressures associated with these offerings make it difficult forunderwriters to conduct an investigation of the issuer or itsstatements. The Commission disagrees with this contention. Thefact that an offering is underwritten on a competitive basisdoes not negate the underwriter's responsibility to perform areasonable review. Nevertheless, the Commission recognizesthat municipal underwriters may have little initial access to

- 13 -background information concerning securities that have been bidon a competitive basis. Therefore, the fact that offerings arecompetitively bid, rather than sold through a negotiatedoffering, is an element to be considered in determining thereasonableness of the underwriters' basis for assessing thetruthfulness of key representations in final officialstatements.

It is important to note, however, that nominalclassification of an underwriting" as competitive will not berelevant to the scope of an underwriter's review where there islittle uncertainty about the choice of underwriters, or whereother factors are present that would command a closerexamination.

The Commission believes that in a normal competitively bidoffering, involving an established municipal issuer, amunicipal underwriter generally would meet its obligation tohave a reasonable basis for belief in the accuracy of the keyrepresentations in the official statement where it reviewed theofficial statement in a professional manner, and received fromthe issuer a detailed and credible explanation concerning anyaspect of the official statement that appeared on its face, oron the basis of information available to the underwriter, to beinadequate. In reviewing the issuer's disclosure documents,therefore, underwriters bidding on competitive offerings shouldstay attuned to factors that suggest inaccuracies in thedisclosure or signal that additional investigation is

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necessary. If these factors appear, the underwriter shouldinvestigate the questionable disclosure and, if a problem isuncovered, pursue the inquiry until satisfied that correctdisclosure has been made.A Proposed Central Repository

The commission is also requesting comment on a proposal bythe MSRB to establish a central repository to collectinformation concerning municipal securities. The MSRB'sproposal would call for the mandatory submission of officialstatements and certain refunding documents to a centralrepository, where information concerning new issues would bemade available, for a fee, to interested parties. In itsproposal, the MSRB expressed its belief that the repositorywould alleviate problems in offerings of municipal securitiesby allowing dealers executing transactions in new issues ofsecurities to gain access to the information contained inofficial statements by way of in-house computer screens. Therepository would also benefit the secondary market by allowingbroker-dealers to supply complete information to customerstrading in that market.The UIT Inspection Project

The Commission has also announced a Unit Investment TrustInspection Project. That project involves conducting specialinspections of approximately 20 percent of the registered UITswith regard to: the decision process for selecting portfoliosecurities; the periodic valuation of these securities; UIT

- 15 -underwriter sales practices; UIT secondary market operations;and investor experience in UIT liquidations. Followingcompletion of that Project, scheduled for mid-l989, theCommission will decide whether to take regulatory action.Conclusion

The actions I have just described represent firm andresponsible Commission policy. The actions were taken againstthe background of a mammoth default in WPPSS municipalgovernment obligations in circumstances resembling the decadeearlier New York City problem. One key fact in bothsituations _as the lack of close scrutiny of offeringdocuments necessary for the protection of investors.Particularly distressing to me was the fact that neither theunderwriters nor the rating agencies accepted responsibilityfor reviewing the offering documents.

In evaluating our actions you may note that the Commissiondid not authorize enforcement action against any of the personsor entities involved in the WPPSS default. Nor did it suggestthat a 1933 Act registration system be established formunicipal securities. It did, however, request comments andcost benefit analysis regarding proposed Rule 15c2-12,regarding its interpretation of an underwriter's reasonablebasis obligations, and regarding the suggested repository.

At the outset of these remarks I suggested that as membersof the securities industry you have special responsibilities tocreate honest securities markets. Of course I believe the

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Commission shares that responsibility. In my view, investorswill not enter a market they believe is unfair because ofdishonesty, shoddy sales practices, or informationaldisadvantages. I believe the steps regarding the disclosure.ystem for municipal securities which the Commission took todaywill help to convince investors that they may have confidencein the honesty of our municipal securities markets.