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diversity of possible fact situations that may be involved as far as parties to the suit are concerned under the Eleventh Amendment, because of differences in state laws as to the extent to which sovereign immunity applies in a given state, in the case of torts or contracts or both and the extent to which it may be waived by statute, by implied consent or by other means in a given situation and because of difficult questions of the relation of federal laws versus state laws, any general statement beyond a clear indication that a serious question of whether legal liability exists, is not possible.”

A more satisfactory alternative solution that might be utilized by the Williams proposal that has been used in the municipal sections of the Federal Bankruptcy laws, would be a procedure utilizing the “carrot and stock" approach. Although the first Federal Bankruptcy Law for municipalities was held invalid because of its violation of the reserved powers of the states under the Tenth Amendment (sce Ashton v. Cameron County, 298 U.S. 513 (1935), the second municipal bankruptcy law enacted by Congress was upheld on the basis that its acceptance by the states was purely voluntary. See U.S. v. Bekins, 304 U.S. 27 (1937). In all subsequent federal legislation on the subject, the same approach has been consistently followed. The underlying practical compulsion of this approach in the bankruptcy situation is based on the fact that the states are powerless acting at the state level to effect a composition of the various creditors' claims since a state legislature cannot, because of the contract clause of the Federal Constitution, directly require a composition. On the other hand, at the federal level, utilizing the bankruptcy clause in the Federal Constitution, Congress has the power to order a composition under Federal Bankruptcy Laws that is binding on creditors of municipalities since the contract clause does not bind the Federal Government. Thus, using the carrot and stick approach, in return for a forced composition of private creditors' bonds liens, the states voluntarily permit the municipalities to invoke federal bankruptcy jurisdiction. A similar approach could be used in disclosure under which, in return for having a workable set of disclosure standards under the federal securities laws, the states would set up some form of state or local certification or approval of disclosure reports or statements, one feature of which would be placing liability on the municipal issuer for defects or provide an indemnity for the underwriter who has been held liable for the defective information furnished by the issuer.

Although the Williams proposal does not directly invite the creation of authorities or agencies that will provide sanctions to assure that the reports and distribution statements under the Williams proposal are true and complete, the Williams proposal does contain at least two provisions that offer similar or substitute sanctions. The provision in Section 13A (c) (1) which exempts the issuer from the requirement of a distribution statement where the state governmental authority (other than the issuer) is expressly authorized by law to grant approval to a statement of disclosure after appropriate hearing is a provision that has a similar approach. The difficulty with the proposed provision is the requirement that the law expressly indicate that the disclosure at the hearing has been “adequate.” Most state corporate securities laws do not provide provisions and procedures under which the state agency would be in a position to assure the adequacy of the disclosure in the given transaction. In this connection, the suggestion can be offered that perhaps an amendment should be considered that would expand the provisions in Section 11 of the 1933 Act that permit reliance upon certificates or statements of public officials. Once again, if the underwriter were relieved of liability, his place should be taken by the public official and this raises the Eleventh Amendment and sovereign immunity problem once again.

The requirement in the Williams proposal that after fiscal years commencing on or after December 31, 1978, private financial statements be furnished will in some respects eliminate the requirement that sanctions against the issuer for accurate and complete financial statements would be necessary. This represents a significant difference from the solution in the MFOA guidelines. The provisions of the MFOA guidelines requiring financial statements permits the

2 A fact situation that seems clear would be that municipal issuers are presently subject to suit by the SEC directly. However, such a suit has never been brought by the SEC.

statements to be satisfied by an alternative standard. Either these statements may be prepared by an independent certified or public accountant' or the financial statements may be those of public officials who use recognized uniform accounting standards applied to governmental bodies. To the extent the alternative requirement is eliminated and a requirement of financial statements from private accounting sources is the sole requirement, the need for sanctions on the public issuer and the public officials is significantly reduced. It has been demonstrated by the experience in private corporate securities sector under the federal securities law that private accountants can be held liable under the federal securities laws to an extent that other parties to the transaction may be relieved of liabiliy and the resulting creation of better accounting practices has resulted in removing the basis of liability."

Senator WILLIAMS. Mr. Ronald Forbes, associate professor of finance, State University of New York; and Mr. Robert W. Doty, professor of law, Creighton Law School.

STATEMENT OF RONALD W. FORBES, ASSOCIATE PROFESSOR OF

FINANCE, STATE UNIVERSITY OF NEW YORK Mr. FORBES. My name is Ronald Forbes. I'm associate professor finance, State University of New York. We have a fairly lengthy prepared statement. I won't bother to read it.

Senator WILLIAMS. I would appreciate it if you didn't. I will promise that it will be read in full before this day is over.

Mr. FORBES. Thank you.

I would like to highlight some of the research that we have been doing. I have been working under a grant from the National Science Foundation and the Municipal Finance Officers Association is the sponsoring organization, on problems of municipal credit quality and credit information. The views in this statement represent my own views and a report of some of the results of that research to date.

I think if we consider the economic and legal factors of the marketplace now it would seem that all participants have sufficient incentives to provide just the right amount of disclosure. Investors should demand it to reduce the risks. Issuers should be willing to comply to achieve lower borrowing costs and underwriters and other intermediaries have the added burden of compliance with securities laws. There have been no systematic studies of the extent of disclosure in the municipal securities markets. Therefore, we initiated a project designed to measure the extensiveness of the credit information reported in the documents, notices of sale, official statements and prospectuses that are provided by issuer or their advisors.

The first phase of this project was begun September 1975. We requested copies of the offering documents furnished in conjunction with new bond sales for all issues listed in the sealed bids invited section of the daily bond buyer. We have received 174 offering statements covering as many general obligation bond issues and we are presently in the process of analyzing the content of those statements. Each of these offering statements is being analyzed to determine whether sufficient information has been provided to enable an experienced analyst to arrive at a judgment of the relative credit strengths and weaknesses of the issue. Quite clearly, a good deal of the subjective judgment must enter this process.

3 The Disclosure Guidelines for Offerings of Securities by State and Local Governments of the Municipal Finance Officers Association, Disclosure Draft dated November 10. 1975, indicate under footnote 3 on page 7 that the recommended guidelines are those obtained in Governmental Accounting, Auditing and Financial Reporting. 1968 as presented and recommended by the National Committee on Governmental Accounting which has been reconstituted as the National Council on Governmental Accounting.

Audits of state and Local Gorernmental Unitr, 1974 prepared by the Committee on Governmental Accounting and Auditing of the American Institute of Certified Public Accounts.

6 This approach offers no panacea. See the recent case of Saunders r. John Nureen of Co., Inc., CCCH 95,347 decided October 30. 1975. where reliance on financial statements of private accountants by the underwriter was held not to prevent liability.

Without going into elaborate detail, we have focused on three broad classes of credit information, including: (1) the timely and comprehensive statement of outstanding indebtedness; (2) a detailed financial report including the revenues and expenditures and the balance sheet of the borrower; and (3) a thorough report of the economic and demographic characteristics of the population served by the governmental unit.

In our prepared statement we summarize some of the official results of this survey and we provide a lengthy list of detailed items that we evaluate on these official statements. I would only like to summarize a couple of points which are in our table 3.

We have heard a good deal of discussion-indeed, the main feature of the legislation that is proposed has been the inclusion of an independent or certified financial report by an auditing firm. As noted in our table 3, only 17 or 10 percent of the offering statements in our survey supplied copies of certified financial reports. Only 7 of these described the accounting methods used in these reports. Only 44 of the 174, or slightly more than one-quarter, provided current year operating statements of revenues and expenditures. Of these, only 25 reported in detail the sources of revenues and the purposes for expenditures, and only 5 provided detailed statements of actual cash flows.

As a specific example of the lack of detail, only four documents provided any detailed discussion of the pension arrangements covering government employees, even in light of the heightened concern over the potential liabilities of unfunded municipal pension plans.

Although our analysis of reporting practices is not yet complete, these observations drawn from a survey of 174 issues provide very strong cases that issuers of municipal securities do not generally supply the market with many of the types of information that credit analysts perceive as important disclosures. We feel that these results, even though based on a survey, are very likely representative of the practices that were followed in the past by most issuers. However, before drawing the conclusion that such evidence represents a strong case of the need for Federal rules and regulations governing municipal disclosure practices, certain other observations should be noted.

First, the offering statement may not be the sole source of credit information available to the investment market. In fact, a good deal of credit related information is available to investors through only the cost of a newspaper and governmental agencies at the state and Federal level disseminate a substantial volume of local govern

ment statistics. We cannot measure the extent to which these other sources of information are generally available nor how complete these sources are, nor even whether these sources are widely used.

In addition to this unknown quantity of free information, the investment market has always been free to purchase additional information. If municipal credit information was valued highly we could expect to observe high prices paid for analysts and we should observe active competition by firms specializing in credit analysis. Such does not appear to have been the case. While precise data is not readily available, it is common knowledge that credit analysts did not at least until 1975 command the high salaries and bonuses that were more characteristic of underwriting managers and sales personnel. Indeed, there appeared to be very few analysts around.

In a continuing study of investors' needs and uses for credit information, we have surveyed some 87 major institutions and among the questions asked of each institution was an indication of the number of employees who devoted full time to municipal credit analysis. The results are tabulated in our table 4. Perhaps the most striking result is the fact that 53 of the 87 institutions did not employ a single full-time munincipal credit analyst. The absence of credit analysts is one suggestion of the low priority that has been assigned to municipal credit evaluation in the past. Expressed most simply, indepth credit analyses costs money and these costs must be weighed against the benefits that can accrue from the production of information and analysis. For the past three decades, until 1975, municipal securities have been regarded as second in safety only to the securities of the Federal Government and its agencies. Indeed, defaults were extremely rare and generally confined to the more speculative tax-exempt revenue bonds. Since 1975, since January 1975, this trend has been completely reversed and as evidenced by trends in interest rates and other problems, the erosion of investor confidence, evidenced by the relative changes in interest rates and the renewed and heightened perceptions of credit risks have been associated with a number of developments, including the 1974 abrogation by New York and New Jersey of covenants adopted in 1962 prohibiting the application of the pledge revenues of the Port of New York Authority for rail mass transit, the recent passage of municipal bankruptcy legislation by the Senate and the House, decline and fall of the New York State Urban Development Corp., the long and tortuous still continuing situation of New York City and its cash flow problems, and the moratorium by New York City and its note applications. These recent developments have been interpreted by the market as evidence that issuers when faced with difficult choices may be willing to ignore earlier promises to bond holders.

The combined effect of these events has been a tremendous shock to the entire capital market. One fallout has been to dramatically increase the market's demand for information. Although we are just now preparing to continue our survey and cover issues sold this spring, our casual observations suggest that heightened demand for credit information is already being reflected in prospectuses accompanying new issues. If our survey supports this, then it will be clear that the market can make and may have made extremely rapid adjustments to meet these demands for added disclosure. If this view of the market is correct, then it is not at all clear that imposing Federal rules and regulations will add any net benefits. Moreover, disclosure rules address themselves to a limited body of information. These rules do not insure that public finance officials develop the management information systems that can improve the decision process in government. Indeed, it should be apparent by now that one of the symptoms of New York City's problems is that the city does not have and has not had the type of internal accounting and information systems that are necessary.

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In this context, we believe that it makes more sense to allocate the resources to the general improvement of all municipal information systems so that taxpayers as well as bond holders and underwriters can better understand the choices that are available, the funds that are needed and the resources that are to be applied.

Thank you.
Senator Williams. Thank you very much, Mr. Forbes.
[Complete statement of Mr. Forbes follows:]

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