which was something they did not need to do as a governmental purpose. So I think there's still the possibility that the U.S. Supreme Court would have difficulty in, if you were talking about borrowing money, by means of bonds, assuredly an essential governmental activity. They might have difficulty enforcing this on the municipal issuer, but I think it could be done. Certainly in the State courts, as far as the 11th amendment was concerned. However, these are very tricky issues.

I think the important thing is to recognize the difficult legal problems in the area of liability and attempt to address this in some way that permits the sharing of liability in the situation.

Thank you.

Senator WILLIAMS. Thank you very much, Mr. Hodgman, and all you gentlemen. It's awfully late to begin a continuous discussion of all the things you have raised.

Just as we go into the next group of witnesses with the demands. upon the issuer for greater reporting and disclosure and the basis of intelligent investment, where this is required under law, wouldn't that move us in the direction of the underwriter being in a position to be able to rely more on the official materials that would reach him from the issuer?

Mr. HODGMAN. I think that would certainly be the desirable approach.

Senator WILLIAMS. It would seem that way, as a matter of logic. That follows from the clear disclosure demands upon the issuer.

We'll leave for the law professors now and we appreciate very much you, Mr. Hodgman, who are on the fence, and gentlemen, for all your help. Thank you.

[Complete statement of Mr. Hodgman follows:]

STATEMENT OF DONALD R. HODGMAN, OF O'MELVENY & MYERS,
LOS ANGELES, CALIF.

This statement is offered in response to an invitation from Senator Williams to testify on S. 2574 and a furnished draft of proposed legislation (the "Williams proposal"), both of which deal with the treatment of issuers of the municipal securities under the federal securities laws.

My remarks are from the standpoint of a municipal bond counsel with a firm that has a fairly long history of rendering so-called municipal bond opinions covering the validity of the issuance of municipal bonds. Such opinions are customarily a requirement of delivery for such bonds. To evaluate the customary relationship of bond counsel to the parties involved in a municipal bond transaction, I wish to point out our clients are split approximately equally between the two sides of the transaction-approximately 50% of our clients are municipal issuers and the remaining 50% are purchasers or underwriters of the municipal bonds involved. Although historically bond counsel was employed by the purchasers of municipal bonds to give an independent opinion assuring the legality of the issuance of the bonds, subsequent practice since the initial use of municipal bond opinions at the turn of the century has resulted in bond counsel being sometimes employed by the municipal issuer and sometimes by the purchaser. Because of this divided allegiance, I would not like one party or the other to have my remarks taken as favoring either one party or the other since in either case I will stand to gain the one thing that lawyers wish to avoid-a disgruntled client.

There is another position that will underlie my remarks in connection with the position of municipal issuers under the federal securities laws. This is the fact that municipal issuers are subject to the so-called anti-fraud sections of the Federal Securities Acts, namely Section 17 of the 1933 Act and Rule 10(b)

(5) as developed under the 1934 Act. There might have been some question of municipal issuers being subject to Rule 10(b) (5) of the 1934 Act prior to the Securities Reform Act of 1975 ("1975 Amendments"). This doubt should now be set at rest because of the change in the definition of "person" as a result of the 1975 Amendments so that municipal issuers are expressly covered. My position is that even if at one time there was a defensible position that exempt securities such as municipal bonds were subject to a different level of "materiality" under the anti-fraud sections than registered securities, this is now a point of view that is not felt to be defensible by experts in federal securities law. Thus, municipal issuers are fairly caught within the web of the federal securities laws under the anti-fraud sections at the present time (and I might add parenthetically that in my view this has always been the case) so that any legislative treatment of current problems of issuers of municipal securities under the federal securities laws must recognize that the sinner is already seated in the cathedral.

Although my testimony is presented on an individual basis or in some cases as a representative of my firm, I function as the chairman of a Subcommittee on Disclosure Problems of the Committee on Liaison with the Securities Industry Association, Local Government Law Section of the American Bar Association. One of our main charges over the past months has been an examination and evaluation of the guidelines proposed by the Municipal Finance Officers Association ("MFOA"). Although we have not submitted our final comment letter to the MFOA, a proposed final draft has been circulated among our membership for comment and approval. In the proposed comment letter, we had four main areas of concern in evaluating the MFOA guidelines and I would like to use the same four areas of concern as a basis for the general evaluation of the Williams proposal.

1. ISSUER COMPLIANCE VOLUNTARY

Bearing in mind the caution given above that we are excluding the presence of the anti-fraud sections of the federal securities laws, an important position of municipal issuers as indicated in the MFOA guidelines is that compliance with disclosure requirements should be on a voluntary basis. I am speaking here of "voluntary" in the sense that the method of disclosure should involve the smallest amount of federal regulation possible. The legal requirement that disclosure must take place is not in question under the federal securities laws. If a spectrum were constructed of the various stages from voluntary disclosure to required disclosure, the Eagleton Bill S2574 would be at the extreme side of the spectrum requiring mandatory disclosure. This would mandate the filing of a registration statement (which under SEC practice would include a thorough review of the statement) before solicitation of offers to purchase would be permitted. Requiring registration in compliance with the terms of the 1933 Act was a step that was clearly foreign to all of the drafts and discussion in connection with the 1975 Amendments. This is recognized by a Section 15B (d) (1) of the 1975 Amendments to the 1934 Act which clearly states that neither the Commissioner nor the Board is authorized to require any issuer of municipal securities, directly or indirectly, to file prior to the sale of such securities any document in connection with such sale. Reasons for not using the 1933 Act registration approach are in part of a historical nature and may be based upon considerations of political philosophy inherent in the federal system. The review by the one level of government of the ability of a different level to borrow money by the marketing of its securities is a significant feature in the balance of power that needs to be achieved if the federal system is to be workable. Additional reasons for not adopting registration under $2574 will be covered in the third and fourth

concerns.

On the opposite end of the spectrum, the MFOA guidelines propose a purely voluntary method of complying with disclosure. There are several intermediate possibilities and one of these is offered by the Williams proposal. The Williams proposal would require in Section 13A (f) (3) the filing of reports and distribution statements required by the Section either at a designated location as prescribed by rules and regulations of the Commission or at a central repository provided under contract by the Commission. The Williams proposal would provide no review, but the reports and distribution statements would comply with criteria as to their content as set forth in general guide

line requirements contained in the legislation. Such a filing requirement of annual reports and disclosure statements in connection with the sale and distribution of municipal issues would constitute a much milder form of federal regulation and would appear to be only a small step along the spectrum to mandatory requirements from the MFOA position of voluntary compliance as indicated.

The Williams proposal achieves another goal of both the municipal issuer and the purchaser as well as other interested persons connected with the transaction -the provision of a definite legal standard to follow in preparing the disclosure material. Although there may be quibbling about the specific disclosure requirements in the Williams proposal both as to the annual reports and the distribution statements, based upon our Subcommittee work in connection with the MFOA guidelines and bearing in mind the comments of other interested groups such as the DBA, the SIA and others, I believe it is fair to say that the Williams proposal requirements, although sufficiently comprehensive for disclosure purposes, do not appear to be onerous or unduly extensive.

At this point I would like to draw attention to what in my view is one of the most significant improvements in the current status that would be achieved by the Williams proposal. I refer to the requirement in proposed Section 13A (a) (2) (J) that requires financial statements of ne issuer for any fiscal year commencing on or after December 31, 1978 to be audited and reported on by an independent public or certified accountant ("private financial statements") in such manner as the Commission may prescribe. Although it may not be the proper function of bond counsel to comment on the desirability of requiring private financial statements, we believe that the experience of our firm in its private securities law practice would definitely permit us to make the comment that such a requirement would go a long way in redressing the differences and difficulties that separate public and private issuers of securities.

2. NO SAFE HARBOR

There is a tradition that has grown up in connection with the issuance and sale of municipal bonds that is in conflict with the practice in private securities work. Historically, municipal bond practice both from a legal and marketing standpoint, has required a degree of legal certainty that is on a different and higher level than the private securities practice. The best example would be the standard for rendering a municipal bond opinion, i.e. bond counsel must not issue an approving opinion if there is a reasonable argument to the contrary. This should be contrasted with a private securities opinion where the securities lawyer should not give his opinion if he doesn't believe it will prevail in the courts. Regardless of how this difference is categorized, whether as qualitative or quantitative, it is reflected in other areas of public law pertaining to municipal issuers. One corollary of the higher standard opinion is the search for and the desirability of safe harbors in connection with regulatory requirements. Thus, in the area of arbitrage of municipal bonds, the IRS was beseeched by issuers and their bond counsel to provide tests that would give a safe harbor from the arbitrage sanctions of the loss of income tax exemption. As a result of this demand, the IRS regulations in their various proposed formats have all evidenced an attempt to comply with the issuer's request so that upon the preparation and execution of an appropriate certificate covering the specific items required by the IRS regulations, the issuer would be able to avail itself of a safe harbor.

Alas, as our Subcommittee was to discover after a number of months of searching for satisfactory guidelines that would produce something approaching a safe harbor, such a goal seems clearly unattainable under the structure of the federal securities laws. Given the municipal issuer is subject to the anti-fraud sections as set forth above and given further the present view of the scope of "materiality" as defined by the most recent pronouncement of the United States Supreme Court in the Ute Indians case, i.e. anything that "might" be important to a reasonable investor in making his decision, the search for a safe harbor in disclosure guidelines seems unattainable. On the other hand, the presence of the Williams proposed guidelines in the 1934 Act will have definite legal and practical benefits not directly attainable by voluntary guidelines such as those of the MFOA. Although a strict compliance with the stated requirements of either the report in Section 13A (a) or the distribu

tion statement in Section 13A (b), together with any further requirements as prescribed by rules and regulations of the Commission will not constitute a safe harbor, such compliance will permit the issuer to provide specific information mandated by the governing law instead of having to determine in each case the disclosure that would be "material" based upon the broad applicable definition. In addition, since the requirements of the Williams proposal would be administered by the SEC, there would be a body of rulings and legal administrative practice that would be available for guidance. It should be pointed out that there is a loss in moving towards the voluntary approach by requiring only a neutral filing without any registration or review by the SEC. As a result of this departure, the parties lose the benefits that come from discussion and dialogue with the SEC in the preparation and registering of the appropriate statement.

3. INVESTIGATION INCENTIVES

A key area of concern in examing any solution to the treatment of municipal issuers is the question of whether the incentives to investigation by the parties to the transaction under a proposal are similar to the incentives on private issuers under the federal securities laws. It is my belief that there are some key differences in the resulting relationships and that for any amendatory legislation to be appropriate, it must take into consideration these differences. In the first place, one of the parties to the transaction is not directly under and subject to the direct enforcement powers of the SEC, namely, the municipal issuer. In the standard 1933 Act registration situation, the issuer under Section 11 has the liability of an issuer with respect to full disclosure. The liability of a municipal issuer (where even after the 1975 Securities Act Amendments the municipal issuer is still exempt) is unclear, whereas the broker or dealer following the 1975 Amendments is required to register with the SEC to be able to act as such and is subject to direct sanctions by the SEC. Thus, in a private securities transaction, the issuer has the incentive to investigation that is thrust upon him by his status as an issuer. This difference in the incentive position of the municipal issuers is felt by the underwriter to markedly increase his exposure. Often in a private underwriting, the underwriter will insist that a corporate issuer have experienced corporate securities counsel so that the issuer will be aware of his status as an insurer under the 1933 Act. This is felt to furnish protection to the underwriter even if he remains subject to exactly the same disclosure obligations he possessed before.

The so-called "due diligence" defense of the underwriter or purchaser in a pure 1933 Act transaction may not be available in the case of municipal issues. The registered offering under the 1933 Act presupposes a procedure under which the underwriter will have experienced corporate counsel, who will participate in the preparation of the registration statement and have an opportunity to question and to contemporaneously investigate the truth and adequacy of the disclosures in the registration statement for his underwriter client. Where no registration statement is required, the opportunity for investigation is not present in the same way. Even in a municipal transaction where a substantial official statement is prepared, the opportunity for investigation by the underwriter is not the same unless the underwriter is selected well in advance of the sale and he has an opportunity to participate through his own corporation securities counsel in the preparation of the official statement. Historically, this is contrary to the practice in the issuance of municipal bonds except in some negotiated sales. An added complication is the fact that a large majority of municipal bond issues (on the basis of number of transactions) are marketed through competitive bidding. Once again, in order to obtain the same opportunity for investigation by the underwriter, it would be necessary to utilize a transactional format that is presently used only for certain private utility issues which are traditionally subjected to competitive bidding. In such a case, the opportunity for investigation by the underwriter can be supplied by the appointment of an experienced private securities counsel for the underwriter by the issuer where the selected counsel has a sufficient reputation so that his participation in the transaction will be acceptable to the various prospective purchasers at competitive bidding.

This discussion points up a further essential difference in municipal transactions from those under the private sector; traditionally in municipal issues the underwriter has not engaged separate counsel to look after his interest and conduct an investigation under the federal securities laws. Recent events in the municipal bond market in early 1976 have indicated a growing awareness among underwriters that counsel who will consider their interests under the federal securities laws may be an essential ingredient of any transaction. In the case of the Williams proposal, the preparation of the disclosure statement in the traditional way by the issuer and his financial consultant with a review of the document for legality by bond counsel would not satisfy the underwriters' requirements. On the other hand, it would be possible regardless of whether the transaction were negotiated or competitively bid to provide an additional corporate securities counsel for the underwriter under the Williams proposal. For any investigation to be effective, the practice followed in private corporate securities would need to be instituted in some form so that an underwriter's counsel would participate in the preparation of the distribution statement. This would require significant changes in the procedures attendant upon the preparation of official statements offered in connection with the sale of municipal issues. It may be that in the case of firms with existing corporate practices, the role of bond counsel would be expanded or that bond counsel would increase his expertise in the federal securities area.

The objections of expense and added burdens on the municipal issuer because of the provisions of the Williams proposal if additional underwriter's counsel is utilized will not be directly met by the argument that the proposal applies only to large issuers where the size of the issue and the danger to investors merits the level of expense. It is submitted that although one may not have faith in the ability of the market to be a sufficient force so that its demands without federal law will force municipal issuers to provide private financial statements, nonetheless, if a federal statute requires only six percent of the municipal issuers to provide annual reports and distribution statements with private financial statements, the result will be to force the non-covered issuers, the remaining 94 percent, to meet the higher standards of the 6 percent or be penalized with higher interest costs of inferior securities.

4. ISSUER SANCTIONS

The other side of the coin to incentives for investigation is the question of sanctions against the municipal issuer or the possible liability of the municipal issuer for false or incomplete information in either the annual report or the distribution statement required under the Williams proposal. It is believed that one of the causes of the increased demand for disclosure by the underwriters in the January 1976 market was the spectre of the potential liability that might be visited upon underwriters as illustrated by the Abrams case, a civil suit against the City of New York, its Mayor, Controller and several of the underwriting banks filed in the Southern Federal District Court of New York August 13, 1975. The Abrams suit is a class action which uses the established theory that a purchaser may recover the loss in market value of his securities by a direct 10(b) (5) action against the issuer and others connected with the transaction. The fear of the underwriters in Abrams is that on analysis it may well turn out that the public issuer or the public officers named in the action have no real liability to the purchasers. The legal grounds for such a lack of liability are easy to suggest in general terms, i.e. depending upon the facts of the case, avoidance of liability under both the Eleventh Amendment and the sovereign immunity doctrine, would clearly be raised.1 Because of the

1 The question of the liability of a municipal issuer was discussed at a just-completed Practising Law Institute seminar at New Orleans titled "Municipal Bond Workshop 12th" held on February 18-20, 1976. At the workshop it was indicated by a bond counsel from Connecticut that the official statement for bonds of that State carried on the front cover an express indication that neither the State or State officials were liable for inadequate disclosures in connection with the official statement. In addition, a number of authorities were cited by members of the panel that would offer legal theories under which either a municipal issuer or a public officer of the issuer could be held liable in spite of the presence of the 11th amendment or sovereign immunity. The shortness of time before this appearance has not permitted an examination of these authorities but they can be made available to this committee.