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What if the Advice Is Suspect? Municipal Securities Advisor Registration and Dereliction

As discussed in a prior blog, “SEC Focus on Municipal Securities: Disclosure and Enforcement – The Peculiar Structure of the Municipal Securities Disclosure Regime,” things in the world of municipal securities differ from those in the rest of the capital markets. As noted in the earlier blog, this results from both policy and political considerations, and either way, it produces anomalies. Persons involved with assessing and recommending investments in non-municipal securities, or in effecting transactions (purchases and/or sales) in them, are required to be registered with the Securities and Exchange Commission (“SEC”), either as Registered Investment Advisers under the Investment Advisers Act of 1940, as amended, OR as broker/dealers under the Securities Exchange Act of 1934, as amended (the “34 Act”). But in the “land of municipal securities,” the “advisors” to municipal issuers were not until 2013 subject to any registration requirement (unless they happened, otherwise, to be a registered broker/dealer or registered investment adviser). As part of the material restructuring of the financial markets in the U.S. in the Wall Street Reform and Consumer Protection Act of 2010 (better known as “Dodd-Frank”) in response to the so-called Great Recession of 2007-2009, Congress dictated that municipal securities advisors should be registered with the SEC. Dodd-Frank amended Section 15B of the 34 Act to require registration of anyone who was a “municipal advisor,” which is a person who provides advice to or on behalf of a municipal entity (or an obligated person, i.e., an entity that is ultimately financially responsible in the case of conduit issuers), with respect to the issuance of municipal securities; or who undertakes a solicitation of a municipal entity or an obligated person.

Municipal Advisor

Exempt from the registration requirement under this definition is a panoply of persons and entities: a registered broker/dealer; a registered investment adviser; a registered commodity trading advisor (registered under the Commodity Exchange Act) or an associated person; an attorney; an engineer; AND, if the following engage in only permitted activities under SEC Rule 15Ba1-1(d)(3): an accountant; an official or employee of a municipal entity or obligated person; a bank; a person responding to a request for proposal from a municipal entity or an obligated person in connection with municipal securities; a swap dealer registered under the Commodity Exchange Act or associated persons; a person engaging in municipal advisory activities, so long as a registered municipal advisor represents the entity or obligated person; a person providing advice with respect to investment strategies, so long as there are not plans for the investment of the proceeds of municipal securities or recommendation/investments of municipal escrow investments; certain solicitations of municipal entities or obligated persons where the person proposes investment strategies that are not plans for the investment of proceeds or recommendations as to the investment of municipal escrow funds.

A reason Congress was so concerned about municipal advisors in connection with the deterioration of the financial markets in 2007-2009 was that municipal securities, long a back “eddy” of relative security, had become a place where opaque and complex securities were sold, particularly to elder Americans looking for yield in a time of reduced interest rates. Accordingly, Congress added as part of Section 975 (a) (5) of Dodd-Frank:

No municipal advisor shall … provide advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products, the issuance of municipal securities, or …To undertake a solicitation of a municipal entity or obligated person …[where] the municipal advisor engages in any fraudulent, deceptive, or manipulative act or practice.

This provision reflects a Congressional finding that municipal advisors HAD engaged in fraudulent, deceptive, and/or manipulative practices. Requiring municipal advisors to register also subjects them to the possibility of administrative and/or judicial disciplinary proceedings. Clearly, municipal advisors have been found by Congress (at least in the aftermath of the Great Recession) to be a suspect class.

Registration and Dereliction

Nonetheless, municipal advisors have significant roles relating to the structure AND sale of securities, and ultimately assist issuers in obtaining the lowest financing costs. Unfortunately, neither the world nor the municipal advisors (or at least not all of them) are perfect. Underwriters of municipal securities (and of most non-municipal securities) primarily represent the buyers of the securities. In contrast, the municipal advisor, in most cases, acts as a fiduciary, as an agent for the issuer (or obligated entity). Municipal advisors are registered with the SEC and are primarily regulated by the Municipal Securities Rulemaking Board (“MSRB”), a body (as noted in my prior blog) that has primary jurisdiction over municipal advisors AND is subject to the oversight of the SEC. Generally, municipal advisors help issuers obtain better financial terms in connection with the sale of municipal securities, recognizing that financing costs are typically lower when securities are sold either in a private placement or a public sale, as opposed to paying interest on a bank loan. As one market participant, Joy A. Howard of WM Financial Strategies, pointed out in “The Role of a Municipal Advisor” (a presentation as part of “Roles and Responsibilities of Professionals in a Negotiated Bond Transaction,” June 13, 2018):

… if you don’t have a municipal advisor there is no party to your transaction working solely in your interest to establish favorable financing terms and to reduce your financing costs.

How has the imposition of this regulatory regime worked in practice? On June 13, 2016, the SEC announced settlements with two municipal advisory firms AND their respective executives where the advisory firms used deceptive practices when soliciting business from five California school districts. One of the firms was supposedly advising the districts on hiring financial professionals. At the same time, this firm was retained by another municipal advisory firm to help it get the municipal advisory business of the same school districts. As part of being on both sides, the first firm disclosed to the second firm confidential information about those districts. The SEC noted that this was the first enforcement action under the new regulatory regime and enforcement authority created by Dodd-Frank. The first firm paid a $30,000 penalty, and its president was ordered to pay a $20,000 penalty. The second firm paid a $100,000 penalty, and its two principals agreed to penalties of $30,000 and $20,000 respectively. On May 9, 2018, the SEC charged a registered municipal advisor and its owner with fraud in connection with multiple municipal bond offerings by a South Texas school district. The SEC’s enforcement action claimed that the advisory firm and its sole member had provided material misstatements concerning the advisory firm and its experience, and failed to disclose material conflicts of interest in connection with three bond offerings between January 2013 and December 2014. The firm and its sole member, whom the SEC notes was a paralegal when he registered as a municipal advisor and drafted the firm’s brochure, earned hundreds of thousands of dollars that they would not have received but for their fraud. The firm and its sole member consented to a cease and desist order, were held jointly and severally liable to disgorge $362,606 plus $19,514 in prejudgment interest, were assessed civil penalties of $160,000 and $20,000 respectively, and the sole member was barred from working in the securities industry, including as a municipal advisor.

On September 20, 2018, the SEC settled proceedings against an unregistered municipal advisor and its principal for failing to register, and for failing to disclose material facts about their status to another California school district. In 2015 the firm led the school district to believe that it was properly registered and eligible to serve as the district’s municipal advisor. Even after being contacted by SEC staff about its failure to register, the firm continued to act in connection with the district’s bond offering. The firm and its principal consented to the entry of a cease and desist order, $35,520 in disgorgement plus $4,241.38 in prejudgment interest, and a $15,000 civil penalty; and the principal agreed to be barred from working in the securities industry, including as a municipal advisor. The SEC notes that the enforcement action arose from the investigation of the firm by the SEC’s Office of Compliance Inspections and Examinations, a clear warning for those who might seek to “fly under the radar.” On July 16, 2019, the SEC announced a settlement of charges against both a San Francisco-based registered municipal advisor and a firm and its principal who were UNREGISTERED solicitor municipal advisors. A solicitor municipal advisor is essentially an independent salesperson for a municipal advisor; the Dodd-Frank-created regulatory regime requires that these salespersons also be registered. Here, that was not the case. For a multi-year period (2011-2016), the registered municipal advisor used the firm and its principal to solicit bond offering business from school districts around California. The firm and its principal were paid either a monthly retainer or a percentage of the bond offering fees. The firm and its principal each agreed to pay penalties of $10,000. The registered municipal advisor paid a penalty of $25,000.

On September 25, 2020, the SEC issued an order instituting cease and desist proceedings against a Scottsdale, Arizona, entity, Funding The Gap, LLC (“FTG”), and its principal with respect to serving as a municipal advisor to twelve charter schools located throughout the U.S., including Florida, Colorado, Texas, and South Carolina, from July 2014 to September 2019, concerning twelve municipal bond offerings (in each case using a conduit issuer) that raised $222 million. Neither FTG nor its principal was registered as a municipal advisor, although the SEC asserts that the principal was aware of the registration requirement since at least 2011. Curiously, the principal also owns another entity that did register as a municipal advisor that did register effective September 2019. The SEC’s Order takes pains to note that charter schools are “generally considered municipal entities because they are public schools” and are chartered by a political subdivision of a state. Both FTG and its principal agreed to the imposition of a cease and desist order and to joint and several liabilities to pay a $30,000 civil penalty.

The SEC, some two weeks ago (on September 14, 2020), cited all but the most recent of the municipal advisor cases noted here, in a release concerning a separate enforcement proceeding against a charter school and its chief executive, for providing falsified financial information in connection with a bond offering. One may fairly infer from this unusual bit of SEC “publicity” that it remains concerned about the possibilities of abuse by those purporting to provide advice in connection with the offering of municipal securities and that further scrutiny and enforcement are likely.

©2020 Norris McLaughlin P.A., All Rights ReservedNational Law Review, Volume X, Number 273
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About this Author

Peter D. Hutcheon Corporate Governance Lawyer Norris
Of Counsel

Peter D. Hutcheon practices primarily in the areas of business governance, commercial transactions, securities, banking, and finance.

Peter counsels management of public and private companies and banking institutions on governance matters.  He also has particular expertise with respect to indemnification and insurance issues affecting directors and officers.  Peter has represented parties in major public-private partnership financings.  He also represents clients seeking investment capital from private placements, venture capital, and private...

(908) 252-4216
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