for a gross negligence or recklessness standard, rather than the rules now developing in several judicial circuits. . It is not clear, then, that heavy legal responsibilities should be placed upon unsophisticated public officials. Neither is it clear that we should require of all such issuers and officials that expensive, sophisticated securities counsel and accountants be employed. Based upon the latest available information, that for the early 1970's, costs of corporate financings are in almost all instances far in excess of that for municipal issues. Particularly is this true of the small offerings. This is reflected by the following table developed by Dr. Petersen from information available from the Commission and the MFOA. TOTAL COSTS OF FLOTATION [Municipal and registered corporate securities by size of issue: cost per $1,000 of gross proceeds] It can be anticipated that these differences will be narrowed as municipal issuers continue their increasing use of the Disclosure Guidelines and as underwriters further fulfill their due diligence responsibilities. But surely it is unnecessary to go to the corporate limits, pricing small municipal issuers out of the market just as many small corporate issuers are unable to obtain funds due to the prohibitive expenses. IV. POSSIBLE LEGISLATIVE COURSES A. THE SECURITIES ACT APPROACH A Securities Act registration approach is unwarranted. As outlined in my article in The Daily Bond Buyer, there are considerable differences between the municipal and corporate securities markets which favor a less stringent disclosure policy regarding municipal issuers. Many of the differences are misunderstood. It has been assumed that some of them have disappeared. While there have been modifications, in many respects the basic differences remain. These differences are described further in the article, and are outlined here. The first is the relative absence of fraud and of opportunity for fraud in the municipal market. Municipal governments are not profit-making entities. Their affairs are open to the public and are examined continuously by the news media. Prices of municipal securities fluctuate to a significantly lesser extent than do prices of corporate equity securities, thus further reducing the opportunity for manipulative and fraudulent activities. The second difference is the degree of risk. Many persons, with a focus on New York's problems, have assumed that this factor is now irrelevant. But, the comparisons of default ratios for corporate and municipal securities are dramatic. According to Dr. Petersen, from 1929 to 1937, approximately $1.35 billion of municipal interest and principal went into default, a little over 7 percent of that outstanding. The corresponding corporate figures are $7 billion and over 30 percent. By 1944, $100 million of municipal debt remained in default, while $3 billion of corporate debt had not been paid. Since World War II, almost all defaulted debt has been held by banks in the sale locale or state as the issuer. From 1945 through 1974, about $500 million of municipal bonds went into default, or 0.24 percent of municipal debt outstanding at the end of 1974. Professor George H. Hempel estimates permanent losses of principal and interest from 1945 to 1965 to be less than $10 million, or 1/10,000th of outstanding municipal debt at the beginning of 1965. Thus, from the long-term view, it cannot be concluded that non-New York municipal investments entail the risks assumed by recent market conditions or many public pronouncements. Further, the investors themselves are of such a character as to vitiate the need for corporate style registration. While many persons are asserting that the municipal market is becoming increasingly individual, banks increased their holdings of outstanding municipal debt in the 1960-74 period from 25 percent to 49 percent, and the percentage held by households declined from 43 percent to 29 percent of the total outstanding. The municipal market, then, in this sense, actually became markedly more, not less, institutional in character. Additionally, the percentage of household wealth represented by municipal investments remained steady at 3 percent, while the percentage in corporate equities was many times that proportion. The existing exemptions, then, continue to have the same basic importance which supported them in the 1930's, and other considerations now also bear relevance. Issuers have shown that they are seriously interested in regulating themselves in an efficient and capable manner. Never in the history of the securities laws has a group of issuers acted more responsibly. These actions were commenced before the current debate. So this is no time to overreact. We should wish to foster and encourage such voluntarism, not to destroy it. B. SELF-REGULATION ALTERNATIVES AND PASSIVE REGISTRATION: The concept of self-regulation is an important and valid one if we must have a new regulatory pattern. There is no need for the Commission to become involved as a supervisor of state and local governments. Neither would regulation by the Board, as now constituted, be self-regulation. It would be quite inequitable to subject issuers to regulation by the same private parties who face them across the bargaining table. Thus, exploration of this first basic premise for any new regulatory pattern gives birth to several new proposals: (1) Regulation could be accomplished through a reconstituted Board giving issuers and dealers equality of representation. Objections to such a proposal would undoubtedly be voiced by dealers, since the Board designs dealer rules. (2) Regulation could be accomplished through a new Board or other quasigovernmental mechanism providing for issuer self-regulation, just as the existing Board is a self-regulatory body for dealers. Issuers, through their voluntary activities, warrant this trust. Such an entity may or may not be subject to Commission oversight. (3) Issuers could organize their own self-regulatory sructure outside the governmental arena. Such a structure would promulgate rules accepted as industry standards enforceable under Rule 10b-5 and, with federal funding, could operate a data bank for investor information purposes. The second premise for regulation is that it is not necessary to re-create a corporate review process for municipalities. Various forms of passive registration may then be discussed: (1) The first is annual filing, such as the present corporate 10-K's, with information accessible to those investors desiring it. Supplemental information could be filed in those unusual instances where it may become operative for a municipality. (2) Another approach involves prospectus delivery to investors with filing, but no review or comment, procedures. Whether filing is prior or subsequent to offerings would be irrelevant under the circumstances. The greatest problems here lies in designing satisfactory means for delivering the disclosures to investors at a time relevant to the making of investment judgments, while preserving the competitive bidding system. There is, then, no dearth of alternatives. It is crucial that each receive careful examination, if we are to change the basic regulatory structure, so that adverse regulatory consequences are minimized. V. CONCLUSIONS The preferable pattern for regulating municipal securities transactions is the existing pattern. There is no evidence that structural legislative changes are needed. It is desirable to fine tune the antifraud provisions to grant ex plicit private rights of action, to solve problems of informational delivery, and to override excessive judicial fervor on due diligence. There is a need to further the development of accounting standards. There is a need for the various market participants to continue to increase their recognition and fulfillment of their responsibilities. But the necessary mechanisms already exist for full enforcement of these obligations by Commission action. The imposition of a corporate regulatory scheme would add little, if any, real investor protection and would result in greatly increased expenses which must be paid by the taxpayers. This would come at a time when inflation and other factors are increasing the cost of government at an alarming rate. Interestingly, in this case, the taxpayers would pay twice: first for federal regulatory expenses and secondly for municipal compliance. If a regulatory plan is deemed necessary, it should be based upon a recognition that many arguments for corporate regulation are inapplicable to municipal issuers. The concepts of self-regulation and passive registration are particularly apt for entities reflecting such a high degree of responsibility. It is important to find ways of obtaining the desirable investor protection with the least inconvenience and expense. The beneficiaries will be the public citizens in their dual capacities of investors and taxpayers. [From the Daily Bond Buyer, Thursday, January 29, 1976] THE CASE FOR SELF REGULATION IN TAX-EXEMPT BOND FINANCING (BY ROBERT W. DOTY) Many voices have proposed of late that drastic changes be made in the regulation of municipal securities issuers. Numerous calls have been issued for the creation of comprehensive schemes granting the Federal Government unprecedented powers over state and local governments. Sen. Thomas F. Eagleton, D-Mo., and Rep. Lionel Van Deerlin, D-Calif., have gone so far as to introduce legislation imposing corporate registration upon municipalities. The haste and lack of wisdom in such approaches is underscored by the failure to realize that the bills would not work: the Securities Act of 1933 and the schedules thereto would become applicable to municipal issuers. But the information required in those schedules is corporate information or that relating to foreign governments. It is totally unrelated to domestic state and local issuers. There is, then, genuine danger that over-reaction to the New York City crisis and that a misunderstanding of the exemption for municipal issuers will result in legislative excess. Reflexive reactions to present crises which do no more than fall back upon the old concepts of increased Federal regulation of and involvement in important local affairs is inadvisable. This is particularly true since, in this case, we are concerned with one of the most important of all local matters: the power of the purse. ALREADY REGULATED It is fundamental to appreciate that we already have regulation of municipal issuers under Rule 10b-5 and the other anti-fraud provisions and that changes, if any, in this pattern should emphasize self-regulatory and passive registration concepts. On Dec. 1, 1975, in "The Money Manager," Securities and Exchange Commissioner Alfred O. Sommer, Jr., presented some of the more cogent recent thinking in emphasizing these concepts. In his article, Commissioner Sommer summarizes the distinctions between the corporate and municipal markets and suggests regulation through the Municipal Securities Rulemaking Board. Commissioner Sommer thus established a solid base upon which discussions may be grounded. Nevertheless, it is not entirely clear that detailed regulation is necessary. This article contains discussions of the strengths of the existing issuer regulatory pattern and of remedial needs in that regard. Possible legislative courses are then outlined. Of course, no one can defend fraud. But the present regulatory pattern forbids fraud. No one is opposed to increased disclosure to investor. But the present regulatory pattern requires precisely that disclosure. Municipal securities issuers have come to recognize the significance of the existing legal requirements. Long before the current proposals were heard, these issuers and numerous other market participants began moving strongly toward farreaching improvements in disclosure through preparation of the disclosure guidelines. A product of a project funded by the National Science Foundation and sponsored by the Municipal Finance Officers Association, these guidelines have gained, and are continuing to gain, wide market acceptance. It is far too simplistic to point a finger at New York City and regret that Rule 10b-5 was not sufficient protection for investors. In fact, Rule 10b-5 was not even made explicitly applicable to New York City or other municipal issuer until roughly the time New York's problems became public knowledge. Only then did the term "person" in the Rule come to include these governments through a little-noticed portion of the Securities Acts Amendments of 1975. True, Section 17 of the Securities Act of 1933, with its similar provisions was applicable. But some courts have questioned whether there is, under Section 17, the implied private right of action that is so widely accepted under Rule 10b-5. And the Commission certainly never found it necessary to act under Section 17. Indeed, in the entire history of the Federal securities laws, the SEC has never yet taken a municipal issuer to court. New York City is under investigation, and perhaps rightly so. But it is difficult to comprehend by what measure we determine that the anti-fraud provisions are insufficient if they remain untried to date by the relevant enforcement authorities and when the primary anti-fraud provision became explicitly applicable only a few months ago. ISSUER INITIATIVES Even now, across the nation, the anti-fraud provisions are having precisely the desired effects. The MFOA has distributed literally hundreds of copies of the Disclosure Guidelines. Over 1,000 have been requested, and a second printing has been necessitated. Issuers everywhere are adding to their disclosures. Underwriters are compelling more disclosure where issuers fall short. Some securities offerings have failed to attract bids, and increased costs have been imposed in others, where potential bidders disappeared after receiving what they regarded as insufficient information. I do not think it trite to note that the American spirit emphasizes voluntarism over governmental regulation. Never in the history of the securities laws has a group of issuers acted more responsibly. These actions were commenced long before the current debate. So this is no time to over-react. We should not wish to destroy entirely this attitude of self-regulation and individual responsibility. What is really needed is increased action by the SEC, by issuers, and by underwriters under the present patterns. The Commission should act under the anti-fraud powers to enforce existing laws and to bring about increased awareness of and to strengthen investor rights to sue fraudulent or non-disclosing issuers and underwriters. All market participants should bring to function the Disclosure Guidelines project, perhaps through a conference or similar mechanism. Issuers should culminate their plans for programs of further education of issuer officials as to their legal responsibilities by insisting on issuer disclosure and by performing full due diligence investigations of the adequacy and accuracy of the information disclosed. Thus, the present situation is sound, and carries with it strong responsibilities of all the relevant parties. It is important, therefore, to examine the bases for the municipal securities exemptions so that the fundamental adequacy of the present pattern may be fully comprehended. BASES OF EXEMPTIONS In adopting the Securities Act of 1933 and the Securities Exchange Act of 1934, Congress determined that the comprehensive regulatory scheme which was thereby created should not be made applicable to municipal securities transactions. Accordingly, provisions were enacted exempting municipal securities issuers from the registration requirements of the Securities Act and from the registration, reporting, and related requirements of the Exchange Act. Congress even exempted from regulation those dealers and brokers conducting business solely in municipal securities, although the policies supporting issuer exemptions did not require it. These policies are multi-based. Certainly, considerations of comity and intergovernmental relations are involved. They are reflected not only in the securities laws, but in many legislative enactments, ranging from anti-trust to labor legislation. Congress is thus generally quite reluctant to impose detailed regulatory patterns upon state and local governments under our Federal system. This reluctance has its roots in our Constitution. There are serious questions of the extent to which the Federal Government may regulate state and local governments. Further, since the securities laws give rise to private rights of action, important issues are raised under the 11th Amendment to the Constitution to the extent private litigation may be brought against states. The common law sovereign immunity doctrine poses similar considerations for litigation against both state and local governments. These issues create a context which cannot be ignored in the consideration of other matters. It is here that Rule 10b-5 and Section 17 fall short. An examination of relevant Supreme Court decisions in other legislative areas, particularly civil rights, anti-trust, and labor, discloses a strong reluctance to imply private rights of action against states and municipalities. Those of us who are accustomed to implied private rights of action under Rule 10b-5 have not been sufficiently careful in the municipal area. Certainly, my own thinking required severe adjusment. But we are faced with strong policy considerations. If Congress intends that municipalities may be sued under Rule 10b-5, it should say so explicitly in a legislative fine-tuning of the Securities Exchange Act of 1934. At present, unnecessary and undesirable doubts are permitted. ABSENCE OF FRAUD Less philosophical bases for the exemptions are found in market conditions. Some of these have changed somewhat, but the basic considerations remain. One of the most basic is the absence of fraud. Since the adoption of the securities laws, few allegations of fraud have been made against governmental issuers of securities, in contrast to the numerous allegations against corporate issuers. Those frauds occurring in the municipal securities market are found primarily in the activities of "fly-by-night" dealers. The motives of municipal officials and the absence of opportunities for personal profit from securities frauds provide a marked contrast with the corporate context. Certainly, there are those rare governmental officials who commit fraud or who otherwise benefit from personal dealings with the issuer. Yet, the incidence of such improprieties by corporate officials is much more common. Officials of corporate issuers are relatively unregulated as to their use of issuer or investor funds when compared to municipal officials. Unlike these corporate officials, municipal officials are closely regulated by state and local law in this respect. Opportunities for personal benefit are further reduced in the municipal securities markets by the relatively small fluctuations in the prices of municipal securities. Municipal securities are debt securities. Even in more unstable circumstances, prices of these securities will fluctuate at a level which is but a fraction of the fluctuations for corporate equity securities. Few dishonest persons are attracted to such a limited source of manipulative profits. And the small price fluctuations furnish additional protections: innocent investors do not unwittingly victimize themselves, for speculation based on rumor or other incomplete information is greatly discouraged. Neither do municipal officials have motivation to commit fraud on the behalf of the issuers. Transactions of doubtful honesty do not add to any "profits" for a government or to dividends which may be paid to stockholders. Governments are thereby fundamentally different entities from profit corporations, with significant consequences for securities policy. OPEN GOVERNMENT Other practical considerations limit municipal officials. The political process is open, with its frequent elections, "sunshine" laws requiring open meetings, and the consuming interest of the news media and the public in governmental affairs. Activities of corporate issuers are conducted on a much more secret |