The new financial markets reform law, commonly referred to as “Dodd-Frank” in honor of the two Committee Chairmen who shepherded it through the Congress – Senate Banking Committee Chairman Christopher Dodd (D-CT) and House Financial Services Committee Chairman Barney Frank (D-MA) ---requires a number of studies to be conducted by the GAO dealing with municipal securities.
For example, one study, due within two years, is to review the disclosures made by municipal issuers, describing them and comparing their amount, frequency, and quality to those disclosures provided by corporate issuers. The GAO is also to evaluate and make recommendations regarding additional municipal disclosure requirements. Finally, the study is required to address “the advisability of the repeal or retention” of the so-called “Tower Amendment.” The Tower Amendment, named after former Senator John Tower (R-TX), prohibits the SEC and the Municipal Securities Rulemaking Board (MSRB) from requiring (directly or indirectly) municipal issuers to file municipal securities documents with the SEC or MSRB before the securities are sold.
Another study, due within 18 months, requires the GAO to provide an analysis of the mechanisms for trading, quality of trade executions, market transparency, trade reporting, price discovery, settlement clearing, and credit enhancements in the municipal bond market. The GAO is also to assess the needs of the markets and investors and the impact of recent innovations, and make recommendations on possible improvements in the transparency, efficiency, fairness, and liquidity of trading in the municipal securities markets. Finally, the study asks for information about the potential uses of derivatives in the municipal securities markets.
GAO Study of GASB
A third GAO study requires the agency to examine the role and importance of GASB in the municipal securities markets and to study the manner and the level at which GASB has been funded. This study must be completed by January 17, 2011, and the GAO must “consult with the principal organizations representing State governors, legislators, local elected officials, and State and local finance officers” in developing its report.
This GAO study of GASB should be of particular interest and concern to public pensions for a number of reasons. First, by way of background, GASB is recognized by the American Institute of Certified Public Accountants (AICPA) as the body that sets generally accepted accounting principles (GAAP) for State and local governments. Its funding currently comes “in part from sales of its own publications and in part from state and local governments and the municipal bond community,” according to GASB.
Even though compliance with GASB standards is often required by the laws of some States and through the audit process (whereby auditors render opinions on the fairness of financial statement presentations in conformity with GASB’s GAAP), there are no Federal statutory or regulatory requirements that State or local governments -- even those with public securities outstanding -- must comply with GASB standards. Finally, unlike the generally accepted accounting principles produced for private-sector entities by the Financial Accounting Standards Board (FASB), neither the SEC nor any other regulator has oversight over GASB’s standards.
This drives the SEC nuts.
The SEC and GASB
For years now, and on a bipartisan basis, the Commission has therefore been intent on gaining control of GASB. Most recently, SEC Commissioner Elisse Walter has urged that Congress should provide for an independent and more reliable funding mechanism for GASB as well as SEC oversight. Although Dodd-Frank did not authorize such oversight, it did provide that the SEC may, in consultation with the principal organizations representing State governors, legislators, local elected officials, and State and local finance officers, require the Financial Industry Regulatory Authority (FINRA) to impose “a reasonable annual accounting support fee to adequately fund the annual budget” of GASB. However, there is no requirement as to when or even whether the SEC must exercise this authority.
Nevertheless, Commissioner Walter sees this as an important move in the right direction. As she recently put it, “the first step of independent funding is crucial. It should help to ensure GASB’s independence as a standard setter that is able to develop high-quality governmental accounting standards without undue pressure.”
Is the SEC effectively suggesting that GASB lacks independence; that its current governmental accounting standards are not “high-quality;” and that these standards have been developed under undue pressure – presumably from the entities who fund GASB? Some would suggest that the recent SEC settlement with the State of New Jersey confirms just that very kind of reading of her statement.
While the SEC New Jersey settlement primarily deals with New Jersey’s failures to adequately disclose pension underfunding and its potential effects on the state’s financial health, some of the findings in the SEC’s cease and desist order suggest that certain accounting methodologies—such as the smoothing of asset values, currently permissible under existing GASB standards—are nevertheless problematic. For example, the SEC found that New Jersey’s bond offering documents did not provide asset and funded ratio information on a market value basis, although it noted they were available in the state plans’ actuarial reports. Due to the significant difference between the smoothed actuarial value and market value of plan assets, the SEC found “the actuarial value did not accurately present the current value of the pension plans.”
The SEC has nevertheless insisted that the problem in New Jersey with the use of smoothed asset valuations and other GASB-approved accounting practices was a lack of their disclosure in the bond offering documents, and not with the actual numbers themselves.
The SEC and Public Pensions: the Road Ahead
Commissioner Walter, in a speech on October 29th of this year before the 43rd Annual Securities Regulation Seminar, discussed the new SEC focus on expanding its enforcement presence in the municipal area, building a comprehensive program that will develop case law and legal precedent through “high-impact cases.”
According to her, the new Municipal Securities and Public Pensions Unit “is focusing its efforts on investigating and pursuing enforcement actions in specific categories of misconduct, including: (1) offering and disclosure fraud; (2) tax or arbitrage-driven fraud; (3) pay-to-play and public corruption violations; (4) public pension accounting and disclosure violations; and (5) valuation and pricing fraud.”
Clearly, Commissioner Walter has distinguished “offering and disclosure fraud” from “public pension accounting and disclosure violations.” This would suggest that the SEC’s interest in this area is not just about disclosures of pension information contained in the official statements accompanying bond offerings, but rather that the SEC also feels it has the authority to investigate public pension accounting practices to determine if they violate the SEC’s anti-fraud laws.
Therefore, the GAO study of GASB’s role in the municipal securities market takes on added importance, as it could serve as the basis to argue for further SEC involvement in pension accounting practices and be used to document the need for SEC oversight of GASB. Furthermore, a GAO report critical of GASB could also serve to bolster arguments of opponents of public plans who claim that the accounting practices are outdated , rarely enforced, and designed to primarily serve the interests of pension plans and not of the users of their financial information, such as muni bond investors.
In short, it would provide significant support for the ideas behind the Nunes/Ryan/Issa legislation, discussed above.
So what is the status of this GAO report? A meeting with the various required national organizations was held with the GAO in early November in Washington, DC. Participants included GASB; the SEC; NASRA; the Government Finance Officers Association (GFOA); the Association of Local Government Auditors; the Association of Government Accountants; the Securities Industry and Financial Markets Association (SIFMA); the National League of Cities (NLC); the American Institute of Certified Public Accountants; Standard & Poor's; the Maryland State Treasurer's Office; the Association of School Business Officials;, the National Association of College and University Business Officers; the Investment Company Institute; T. Rowe Price; the International City/County Management Association (ICMA); the National Association of State Budget Officers (NASBO); the Financial Accounting Foundation (FAF); the National Association of State Auditors, Comptrollers and Treasurers (NASACT); the National Governors Association (NGA); the National Federation of Municipal Analysts; Insurance Industry Investors; the American Association of Individual Investors; the Native American Finance Officers Association; Moody's Investors Service; Fitch Ratings; the National Association of Counties (NACo); the National Conference of State Legislatures (NCSL); and the Council of State Governments.
The agenda included a discussion of the following questions, which suggest the focus of the GAO’s investigation and a possible outline of its report:
1. What are your perspectives on the extent of GAAP use by municipal issuers?
2. What are the characteristics of governments that are most likely and least likely to use GAAP in preparing financial statements?
3. What are the incentives and disincentives for governments to use GAAP for financial statement reporting?
4. To what extent does GAAP-basis financial reporting meet the needs of market participants, such as securities analysts, rating agencies, and investors, in comparison with other bases of accounting?
5. Are there particular types of municipal securities or issuers for which GAAP basis financial statements provide the most benefit?
6. How does a municipal issuer's use of GAAP-basis financial statements impact its ability to issue debt or lower its borrowing costs in contrast to non-GAAP financial statements?
7. Are there current limitations in GAAP that affect the use of GAAP-basis financial statements for assessing the quality of a municipal security?
8. Are there differences in cost for municipal issuers preparing GAAP-basis financial statements compared to financial statements prepared on another basis?
9. Has market participants' perception of the usefulness of GAAP-basis financial statements changed as a result of the credit crisis or the subsequent increased demand for municipal securities?
10. How does the level of importance that recent investors in the taxable securities markets place on GAAP-basis financial statements compare to that of conventional investors in the tax-exempt securities markets?
11. How has the recent decrease in bond insurance for newly issued municipal securities affected the desirability of GAAP-basis financial statements?
12. How have recent changes made by GASB to GAAP affected the role and importance of GAAP?
13. How does GASB respond to the evolving needs of the municipal markets?
14. What is the role of municipal market participants in the development of new GASB standards?
15. Are there steps GASB could take to improve the usefulness and timeliness of financial reporting?
The SEC has also been holding field hearings to examine the municipal securities markets, with the second to be held at its Headquarters in Washington, D.C., on December 7th. Topics will include market stability and liquidity, investor impact, accounting and self-regulation; one of the scheduled witnesses will be David Bean, GASB’s Director of Research and Technical Activities. Following the hearings, the Commission will release a staff report addressing information learned, including their recommendations for further action the Commission should pursue, which may include rulemaking, recommendations for changes in industry “best practices,” or legislation.
Once again, the SEC appears concerned that there are public pension accounting and disclosure violations of the Securities anti-fraud laws and that, depending on what the GAO study finds, the SEC and Congress may need to take further action to ensure that investors in municipal bonds are being adequately protected from false and misleading actions involving pension plan funding.
And you thought we only had the IRS to worry about!
• Walter Speech Discussing SEC Municipal Securities Efforts
• SEC Field Hearing on Municipal Securities Markets Agenda
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