October 28, 2024/US SEC

Dave A. Sanchez, Director, Office of Municipal Securities

Thank you, Andy, for that kind introduction. Good morning, everyone. It is great to be back here in California and to see all these formerly friendly faces. Before I say anything else, I am required to remind you that:

My comments are provided in my official capacity as the Director of the Commission’s Office of Municipal Securities but do not necessarily reflect the views of the Commission, the Commissioners, or other members of the staff.

As part of our discussion today. I would like to share with you some recent concerns observed by me that I think would be of interest to market participants. Today, time permitting, I would like to address joint powers authorities (“JPAs”), pricing issues such as retail participation in primary offerings and method of sale, and climate risk disclosures, in each case with a focus on California.

Joint Power Agencies

One area I have discussed a couple of times this last year in California has been the role of JPAs in the issuance of public debt.

Last December, in a speech at our most recent compliance conference,[1] I noted that the market had recently seen the emergence of certain deal structures including housing deals for essential workers and students that have come under scrutiny because of questionable economics or other issues.[2] I have also seen municipal entities cede authority for issuing conduit bonds to privately-run entities that are the leading issuers of defaulted bonds.[3] I questioned whether the appropriate gatekeepers, including municipal advisors (“MAs”), broker-dealers (“BDS”) and attorneys, were fulfilling their responsibilities under these deal structures and arrangements[4] and gave examples of these responsibilities.[5]

In June of this year, I noted again that defaults are comparatively high for municipal securities issued by JPAs.[6] JPAs in California are comprised of, and could not exist without, their constituent public agencies.[7] In California, JPAs are formed by agreement and must be authorized by the legislative or other governing bodies of each municipal entity.[8] JPAs were originally a means for two or more entities to work together and share resources on projects of joint interest.[9] For example, when California’s predecessor JPA law emerged initially in 1921, it helped cities and counties work together to address the Bay Area’s tuberculosis public health crisis.[10] Now, however, some of the biggest California JPAs are known, and refer to themselves, as “conduit issuers.”[11] In my opinion, these entities are not so much facilitating jointly beneficial projects as allowing private sector participants to access the lower cost tax-exempt market with little to no actual input from the individual member agencies. Although a public agency may have various reasons for entering this arrangement, when private entities are the governing body of the JPA and its public agencies are not participating meaningfully in project selection or approval, it raises the question of who exactly is accountable to the public.[12]

Once JPAs are formed, public agencies may withdraw from them. For example, in 2009, the County of Los Angeles withdrew from a JPA.[13] In the recommendation letter submitted to the Board of Supervisors, the Chief Executive Officer stated that the JPA was “a shell entity operated solely by a private contractor” and that the “relative lack of public scrutiny, transparency and regulation [was] a concern given that [the JPA then ranked] as one of the ten largest (of more than 3,000 total) issuers of tax-exempt debt nationwide.”[14]

We all know the exemption of municipal securities from registration under Section 3(a)(2) of the Securities Act[15] does not exempt those municipal securities from certain other securities regulations. For example, last November, the Commission amended Securities Act Rule 192 to prohibit an underwriter, placement agent, initial purchaser, or sponsor of an asset-backed security (including a synthetic asset-backed security), or certain affiliates or subsidiaries of any such entity, from engaging in any transaction that would involve or result in certain material conflicts of interest.[16] Some commenters requested that certain financial products and securities, including single-asset conduit bonds and municipal securities, be excluded from the definition of asset-backed security.[17] But the final rule did not provide such an exemption.[18] The Commission stated that issuers of municipal ABS are in most cases not responsible for repaying obligations they issue on behalf of conduit borrowers, including borrowers in single-asset conduit bonds, that non-governmental conduit borrowers account for the majority of municipal bond defaults, and that in particular, certain conduit issuers which are managed by private firms have elevated default risks on their bonds.[19] A JPA may be created without significant effort and may be run by a private entity that has a profit motive.

Nor is the Commission the only federal agency to take notice of the extent to which a municipal entity performs municipal functions. For example, the IRS has focused on the meaning of “political subdivision,” proposing, but ultimately abandoning, a revised definition of such term.[20] In that effort, the IRS questioned whether “an entity that is organized and operated in a manner intended to perpetuate private control, and to avoid indefinitely responsibility to a public electorate” could be a political subdivision of a State. [21] Although member entities in California JPAs are initially formed by political subdivisions of the State, again, a JPA composed of hundreds of entities and operated by what is essentially a private entity without any meaningful oversight raises similar questions about proper delegation of governmental responsibilities and avoiding indefinitely responsibility to a public electorate.[22]

Although I recognize that governance structures are different, I did note that after increasing defaults in conduit bonds issued by the Arizona Industrial Development Authority (“AZIDA”), in March of 2023, the governor of Arizona directed AZIDA to disclose details about borrowers, including past projects and experience, existing financings, past defaults, debt-to-income ratio over the past 12 months, and business plans.[23] In addition, AZIDA was asked to direct its bond issuances to certain priority areas listed by the governor that included affordable housing, broadband infrastructure, and renewable energy.[24] The governor further required that each Tax Equity and Fiscal Responsibility Act submission to the governor’s office must address how the proposed project benefits Arizonans, particularly the state’s underserved and historically excluded communities, and how it advances the governor’s project priorities.[25] The governor specified that the public benefit statement should include at least two letters of support from a current federal, state, or local elected official representing the project area.[26] Each of these requirements is designed to ensure greater oversight and input from governmental agencies, going beyond the minimal local approval required for a private activity bonds tax exemption under Section 147(f) of the Internal Revenue Code.[27] Thus, AZIDA must now provide explicit statements of benefit as well as explicit statements of support for a project from responsible public officials.

Some California JPAs have hundreds of member municipal entities. However, even these entities are not without recourse. Officers and board members of the member agencies can take action to ensure better oversight by member municipal entities over the actions of an operating private entity. For example, member agencies might, among other actions, cause the amendment of the joint powers agreement to form special committees to review disclosure documents and disclosure policies, as well as heighten standards for project selection by requiring more active oversight, participation and support by the member municipal entities.

From a disclosure standpoint, securities law questions may arise from JPAs not accurately representing the nature of what they do. JPAs may have conflicts of interest and they may need to have a process in place to identify and disclose these conflicts consistent with their obligations under the federal securities laws. For example, there may be conflicts of interest if the JPA’s fee is paid on a contingency basis or in proportion to the par amount of the bonds. The fact that JPA management may be financially interested in maximizing the par amount of bonds in order to increase JPA revenue could result in the lease or purchase agreements that serve as the security for those bonds being voided under section 1092 of the California Government Code.[28] Municipal entities might also consider whether control person liability may be applicable to member agencies for inaccurate representations by the JPA about its finances, project approval process, operating structure or conflicts of interest.[29]

Pricing

Another topic the Office of Municipal Securities has been focused on recently and more broadly is pricing. Some aspects of pricing relevant to municipal securities include retail participation in primary offerings and the predominance of negotiated deals, particularly in California.

Retail Participation in Primary Offerings

The MSRB released a study in May 2023 whose analysis showed that customers purchasing bonds in smaller trade sizes are far more likely to purchase bonds in the secondary market than the primary market compared with customers purchasing bonds in larger size trades.[30]

In fact, from 2018 to 2022, the MSRB found that only 1.2% of total par amount purchased in the primary market was by individual investors purchasing in blocks of $100,000 or less.[31] The MSRB closed its study by suggesting individual investors would benefit from more balanced participation between the primary and secondary markets, including getting access to bonds not available in the secondary market, possibly picking up more yield by buying bonds in the primary market.[32]

In August 2024, the MSRB supplemented the May 2023 study by analyzing two different but related aspects of the municipal securities market: (i) it compared customer purchases in the primary market to customer purchases during the first seven days of secondary market trading after the first execution date, defined as the “recently issued” market and (ii) it compared the competitive and negotiated new issue markets, examining the characteristics and types of issues using each market.[33]

The MSRB noted that in looking at the subset of data that covers trades in the recently issued market, the analysis indicates that from 2019 through 2023, 53% of the par amount purchased by individual investors happened in the primary market compared to 47% in the recently issued market, whereas institutional investors acquired 92% in the primary market and 8% in the recently issued market.^[34] Looking at only the “recently issued” secondary market is unlike the May 2023 report, which analyzed all customer trades regardless of how long after the first execution date the trade occurred.

The MSRB also noted that as to the prices customers paid in the recently issued vs. the primary markets, overall, from 2019 through 2023, individual investors paid an average of just over $10 per bond above the list offering price on trades in the recently issued market, which is about twice as much as what institutional investors paid.[35] If individual investors accessed the primary market more often, the MSRB noted, they likely would receive more favorable pricing than in the recently issued market.[36]

This raises some questions for me. One question is whether at least some part of the disparity due to the fact that not enough issuers are including a meaningful retail order period. Given that additional retail buyers could reduce the interest rates that municipal entities pay on their debt, even marginally, are MAs advising their municipal entity clients to include a meaningful retail order period? Are MA’s monitoring compliance with the issuer’s priority of order instructions as well as actual retail participation levels in the “primary market” and the “recently issued market”?

I think it is also relevant to remind market participants that MSRB Rule G-11 establishes basic standards applicable to the priority of orders. An issuer may set priority of order instructions for the underwriter or the syndicate. For example, an issuer may require a more robust retail order period in a primary offering designed to lower the interest that it pays on its debt or to achieve other goals. MSRB Rule G-11 imposes a number of priority of order requirements on underwriters. Issuers and their MAs should understand this in order to be aware of the choices available to issuers regarding priority of orders.

Negotiated Sales in California

Another recurring subject when it comes to pricing is method of sale. Generally, between a competitive sale and a negotiated sale, issuers receive less favorable pricing with a negotiated sale.[37] Yet negotiated pricing predominates nationally, but particularly in California. In terms of volume, for example, from 2018 through the first three quarters of 2022, approximately 87.2% of all deals (and 88.7% of total par) in California were negotiated deals, compared to the national average of 53.6% of all deals (and 73.2% of par).[38] Of all deals in Texas, approximately 57.1% (and 75.5% of par) were negotiated.[39] In New York, it was only 15.5% (and 59.8% of par).[40]

Some have suggested this disparity in California is due to misunderstandings in the market. For example, the State and one of its municipal advisors gave a presentation in February 2023 to the California Society of Municipal Finance Officers that included some interesting volume comparisons and sought to dispel certain myths about competitive sales.[41]

Among the myths the presenters sought to dispel were that:

• Only general obligation bonds price efficiently in the competitive market.
  • The presenters noted that lease revenue bonds, revenue bonds, and TRANs all price efficiently in the competitive market.
• It is difficult to price taxable bonds competitively.
  • The presentation noted that this is not true, and there have been many successful taxable competitive sales.
• There exists a lack of flexibility to change sale date, if necessary.
  • The presentation noted that the early posting of sale advertisement provides forward flexibility to change pricing date.
• There is low level of control over couponing structure.
  • The presentation noted that this not true; the notice of sale can establish minimum or maximum coupons or other pricing parameters and that there is flexibility to change structure and bid parameters up to the day prior to bid opening.
• Competitive sales cannot be used during periods of high interest rate volatility or for novel structures such as “green bonds.”
  • The presentation noted that many issuers successfully sold issues via competitive sale both during the pandemic and during a rising rate environment in 2022, including many “green bond” issues.
• Competitive sales are not effective for infrequent issuers.
  • The presentation notes that this can be mitigated by a municipal advisor’s pro-active market outreach.

It is also worth noting that several California statutes have special requirements for negotiated sales, such as a pre-approval submission of costs and reasons for a negotiated sale. For example, a local agency general obligation bonds statute (California Govt. Code Section 53508.9) requires express approval of the negotiated method of sale, a statement of the reasons for selecting the negotiated method of sale, and an estimate of the costs associated with the bond issuance. Thus, while California has a very high rate of negotiated sales relative to other states, issuers must represent to governing bodies of municipalities the costs of a negotiated sale and the reasons for selecting a negotiated sale prior to approval of the bond issue pursuant to certain state statutes. These two facts raise some questions as to whether bond/issuer counsel and/or MAs are taking these representations seriously or whether they are just rote at this point. In any case, given the demonstrated benefits a competitive sale may provide in pricing, MAs and bond/issuer counsel should think about what these issuer representations mean to the extent they are involved in advising the issuer as to these representations.

Related to this, I note that the Commission has previously taken action based on misrepresentations in certificates supporting a bond issuance. For example, the Commission brought an action against the City of South Miami based in part on misrepresentations it made in annual certifications related to its compliance with the terms of a loan agreement.[42] The misrepresentations made in the annual certifications regarding the tax-exempt status of the bonds constituted part of the conduct that the Commission found in its order to have violated Sections 17(a)(2)[43] and 17(a)(3)[44] of the Securities Act. The City’s Finance Department had experienced significant turnover and the various finance directors were unaware of the implications of the annual certification.[45] I relate this as a reminder that the Commission is not limited to looking at the four corners of the official statement, or even just the documents executed solely in connection with disclosure and that even seemingly routine certifications can be the basis for a securities law violation by a regulated entity involved in the process if the certifications turn out to be untrue.

Climate and Environmental Risks Disclosure in California

Background

Across the country, obligated persons^[46] and issuers of municipal securities are exposed to climate and environmental risks that may impact their ability to repay debt. Researchers and municipal securities analysts are signaling that climate and environmental risks are a driver of current and future material financial and operational impacts for municipal issuers on a quantitative and qualitative level.^[47]

Climate risks are impacting consumers and homeowners in California already. For example, in May 2023, the Bond Buyer reported that State Farm, the country’s largest insurance company, announced it would no longer sell homeowners policies in California.[48] The following month, Allstate also indicated that no more commercial or homeowners’ insurance would be initiated in California. “The cost to insure new home customers in California is far higher than the price they would pay for policies,” Allstate said, “due to wildfires, higher costs for repairing homes and higher reinsurance premiums.”[49] The Bond Buyer noted that these risks are already threatening livability and property values in communities around the country and that municipal finance cannot stay disconnected from those foundations of revenue for long.[50]

Antifraud Considerations

Like a public company’s financial and business disclosure, a municipal issuer’s disclosures, including any climate and environmental risk disclosures, and the omission of material information from disclosures, are subject to the antifraud provisions^[51] of the federal securities laws. These antifraud provisions prohibit fraudulent or deceptive practices in the offer or sale of municipal securities in the primary market as well as in the purchase or sale of municipal securities in the secondary market.^[52] These antifraud provisions similarly prohibit any person, including municipal issuers and brokers, dealers and municipal securities dealers, from making a false or misleading statement of material fact, or omitting any material facts necessary to make statements made not misleading, in connection with the offer, purchase or sale of any security.[53]

Observations

Over the past few decades, many municipal issuers have established primary and secondary market disclosure practices that consider what risks may be material to investors.[54]Best practices that have been articulated by market participants suggest that municipal issuers should ensure that the disclosure is reviewed with each bond offering to keep the information up to date and disclose any new events that have occurred as well as the response and impacts.^[55]

The “silo effect” occurs when a compartmentalized organizational structure causes material facts known by one group to go undisclosed because the facts were not known by or shared with individuals in other groups.^[56] This potentially leads to failures in providing material information to the market. As the most populous state in the country, California has its share of large municipal entities with specialized divisions or offices.

In addition, analysts have seen instances where municipal issuers in the same geographic region, and therefore presumably with the same climate and environmental risks, are not disclosing the same information as material environmental and climate disclosure items.^[57] It is true that materiality determinations are municipal issuer specific and depend on the facts and circumstances and there is no legal requirement to consider what other issuers are disclosing. However, it may be helpful for municipal issuers and obligated persons to consider whether items that other similarly situated and impacted municipal issuers and obligated persons are disclosing, are material and should be included in their own disclosure.[58] For example, a city in California preparing an official statement or continuing disclosure could look to their state’s, county’s, and nearby peer municipalities’ climate and environmental resiliency planning documents and official statements (or other disclosure documents) when considering the city’s own climate and environmental disclosures.^[59] At least one proprietary tool exists that allows entities to respond to climate-related questionnaires and search datasets of other entities that have responded to the questionnaires.[60] Such a tool might provide a useful insight into the kinds of climate issues neighboring jurisdictions are reporting.

Further, market participants have pointed to differences in climate and environmental risk disclosure by issuers in the same or similar geographically impacted areas when utilizing different municipal professionals (like bond counsel, disclosure counsel, underwriter, or municipal advisor).^[61] In 2023, Municipal Market Analytics (“MMA”) conducted an analysis of offering documents in Phoenix, Arizona. MMA said that issuers with what MMA considered to be arguably the same climate risks have varied in how the exposure has been articulated, if at all.[62] MMA noted that two issuers with distinctively complete climate disclosure utilized advisors and counsels that were not often providers of their services to most Phoenix area issuers.[63] MMA’s data raises questions about whether inconsistent disclosure of climate risks by Phoenix area issuers is related to their choice of counsel, advisors and other professionals.[64]

Municipal analysts and market participants have observed an absence of adherence to municipal market best practices for climate and environmental disclosure by municipal issuers.^[65] Market participants have also raised concerns about municipal issuers downplaying or omitting material facts related to climate or environmental risks due to political pressure or for fear of the market’s negative consequences.^[66] Because municipal securities are issued with longer terms, analysts and credit ratings agencies have raised concerns regarding the effects of climate and environmental risks on demographic shifts, insurability of property, livability and property value changes, and the credit risks those changes pose.^[67]

Conclusion

As the organizers of this conference have noted, the State of California and its local governments are usually the largest issuers of municipal bonds in the country and face a number of different regulatory concerns. Although my comments today were focused on very different topics, given some of the unique infrastructure and climate issues facing the Golden State, I do think the regulatory issues discussed should be of particular concern to municipal market participants in California.