Q&A with Dave Sanchez, Director of the SEC Office of Municipal Securities

The State of California and its local governments are usually the largest issuers of municipal bonds in the country.   That coupled with some of the unique or heightened infrastructure and climate issues facing California means that matters of concern to the SEC are often concentrated in the Golden State. 


Transcription:

Andy Nakahata (00:10):

Really interesting session. If any of you are not feeling especially warm. I think I learned from the last session that now that there are studies that show that our performance will improve given the temperature in the room this morning. So not only that, but you'll also stay awake. It's my honor and pleasure to introduce Dave Sanchez. It's really, I feel like I'm introducing one of our own who really needs no introduction, but Dave became director of the SEC's Office of Municipal Securities in April, 2022. Dave has had really a number of jobs. I think IMERS met first Dave, when I first met Dave, when you were an associate at Orrick, Herrington, Dave worked at Orrick, Herrington, he also worked at City Austin. He had stops in between as a Deputy city attorney, I believe your associate general counsel at FSA as well, in addition to then also serving as attorney fellow previously at the Office of Municipal Securities. So with that, I'd like to turn it over to Dave and say, welcome.

Dave Sanchez (01:15):

Thank you, Andy. Good morning everyone. It's nice to be here and to see so many formerly friendly faces. But before I say anything else, I'm required to remind you that my comments are provided in my official capacity as the Director of the Office of Municipal Securities and do not necessarily reflect the views of the commission, any of the commissioners or any of the other staff members. So as part of our discussion today, I'd like to share with you some recent concerns observed by me and that I think would be of interest to market participants, particularly in California. So time permitting, I'm going to talk about joint powers authorities, some additional pricing issues I didn't talk about yesterday at the CDIAC pre-conference, as well as climate risk disclosures, but also because this was advertised as a Q&A session. And we do have the two mics at the front of the room.

(02:04):

Please feel free to step up to the mics and ask any questions, and I'll be happy to answer them. So I'm going to start with JPAs. And this is an area that I've discussed a couple of times this last year, the role of JPAs in the issuance of public debt. And I've noted that the market has recently seen the emergence of certain types of deal structures, including housing deals for essential workers and students that have come under scrutiny because of questionable economics or other issues. I've also seen municipal entities seed authority for issuing conduit bonds to these privately run entities that are the leading issuers of defaulted bonds. So in June of this year, I noted again that defaults are comparatively high for municipal securities issued by JPA, including several California JPAs. And this is important because JPAs in California are comprised of and could not exist without their constituent public agencies.

(02:59):

So I think everyone remembers that JPA were originally a means for two or more entities to work together and share resources on projects of joint interest. JPA actually just celebrated their hundredth birthday. The predecessor of JPA law that emerged in 1921 was originally helped cities and counties work together to address tuberculosis crisis in the Bay Area. But now some of the biggest California JPA are known and refer to themselves as conduit issuers. And so 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. It also raises the question of who exactly is accountable to the public. And this has consequences. For example, last November, the commission SEC amended securities rule 192 to prohibited various entities from engaging in any transaction that would involve or result in certain material conflicts of interest.

(04:00):

The ABS conflict rule and some commenters in the comment process requested that municipal securities be excluded from the definition of asset-backed security, but the final rule did not provide that exemption amongst other things. The commission stated that non-governmental conduit borrowers account for the majority of municipal bond defaults and then particular certain conduit issuers, which are managed by private firms, have elevated default risks on their bonds. So because the JPA can create it can be created without significant effort and may be run by a private entity that has a profit motive, it was difficult to say that the types of conflicts addressed by the rule would not be potential problems specifically for that type of issuer, nor is the commission the only federal agency that has taken a look and the extent of which a municipal entity performs municipal functions. I think folks recall the IRS had focused on the meaning of public subdivision, political subdivision a few years ago proposing but ultimately abandoning a revised definition of such term. But in that process, the IRS had questioned whether an entity that is organized and operated in a manner intended to perpetuate private control and to avoid responsibility to a public electorate could really be a political subdivision of a state.

(05:14):

Again, to me, a JPA composed of hundreds of entities and operated by what is essentially a private entity without any meaningful oversight, raises similar questions about the proper delegation of governmental responsibilities. And in that proposal, the IRS had also talked about the privilege of the tax exemption and the need to ensure that it was being used appropriately. And so given some of the more recent concerns about the tax exemption in general, questions of the abuse of its use may even be of continued importance. I also want to note that although I recognize the governance structures are different after increasing defaults and conduit bonds issued by the Arizona Industrial Development Authority AZIDA in March of 2023, the governor of Arizona directed a AZIDA to disclose details about borrowers including past projects and experience existing financing past defaults, debt to income ratios and business plans. The governor of Arizona also required that public benefit statement should include at least two letters of support from each of the elected officials in the project area.

(06:18):

Each of these requirements was designed to ensure greater oversight and input from governmental agencies going beyond the very minimal approval required by a TEFRA hearing. So I know that some California JPA have hundreds of member cities and municipalities and that can make oversight more complicated. However, even these municipal entities are not without recourse officers and board members of the member agencies can take action to ensure better oversight by the member of municipal entities over the actions of the 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 policies as well as heightened standards for project selection by requiring more active participation support and oversight by the member of municipal entities. From a disclosure standpoint, securities law questions may arise from JPA not accurately representing the nature of what they do.

(07:14):

JPA may have conflicts of interest and need to disclose those conflicts consistent with their obligations under the federal securities laws. For example, there may be conflicts of interest if the JPA 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 P amount of bonds that are issued, including by issuing more bonds than necessary, may also raise questions about the lease or purchase agreements that serve as the security for those bonds being voided under California Government Code Section 10 92. And whether that risk is properly disclosed, municipal entities might also consider whether control person liability may be applicable to member agencies for inaccurate representations made by the JPA about its finances, about its project approval process about its operating structure or its conflicts of interest.

(08:12):

As I said, I've talked about this issue before. We've seen some movement by other states to address some of the worst abuses by JPA, and this is something that remains of continued interest to our office. So now I'm going to move on to another topic that we've been talking about a lot and that is pricing and specifically new issue pricing and talked about this a lot during yesterday's really great CDIAC pre-conference. I just want to touch on a few more items and highlight a few more items that I didn't necessarily talk about as much yesterday. One is that notably with respect to retail participation in a primary issuance, the MSRB released a study in May, 2023 that found that only 1.2% of total paramount purchased in the primary market was by individual investors, by retail investors, but yet somehow they end up with over 40% of the bonds at the end of the day.

(09:10):

So the MSRB study, not surprisingly closed by suggesting that individual investors would benefit from getting access to bonds not available in the secondary market, possibly picking up more yield by buying bonds in the primary market. And a corollary of that is that you would also expect that the interest cost to issuers would also go down if the bonds more quickly found their way into the hands of individual investors rather than 1.2% being given to individual investors in the primary market. And then somehow in the week to two weeks after over 40% ending up in their hands in August of this year, the MSRB supplemented that May, 2023 study and noted also that the prices customers paid in the recently issued market, which they identified as the seven days after primary issuance. Overall from 2019 to 2023, individual investors paid an average of just over $10 per bond above the list offering prices, which is about twice is what institutional investors paid.

(10:09):

So again, if institutional, if individual investors or retail investors access to primary market more often the MSRB noted they would likely receive more favorable pricing. So that raises some questions for me. Is this disparity due to the fact that not mean, one of the questions is the disparity due to the fact that not enough issuers are including a meaningful retail order? And what does that say about what their financial professionals are doing to advise them of that both their municipal advisors and their broker dealers, given that additional retail buyers could help reduce the interest rates that municipalities pay on their debt, even marginably are MAs advising municipality declines to include a meaningful retail order? Are they designing a meaningful retail order? Are MAs monitoring compliance with the issuer's priority of order instructions as well as actual retail participation levels in the primary market? As part of this, I would like to remind market participants that B Rule G 11 establishes basic standards applicable to the priority of orders and issuers, and their MA should understand this rule and the other MRB rules applicable to priority of orders in order to be available of their full range of choices during a primary offering.

(11:21):

All this affects pricing the quality of pricing that municipal issuers are receiving.

(11:30):

I'm just checking my time. Another recurring subject when it comes to pricing is method of sale generally between a competitive sale and negotiated sale. Most academic studies have noted that issuers receive less favorable pricing with a negotiated sale. And this is really interesting in California especially negotiated pricing predominates in California in terms of volume from 2018 to 2022, approximately 87% of all deals and almost 89% of all par in California were negotiated deals. This compares to a national average of 53% of all deals and 73% of par and really noticeable compared to places like Texas where 57% of deals and 75% of par and New York were only 15% of deals and just over half of par are done in negotiated sales. So some folks have suggested that this disparity in California is amongst other things due to misunderstandings about the value of competitive sales in the market and situations when they can be used effectively.

(12:34):

For example, the state and one of its municipal advisors gave a presentation in February, 2023 that amongst other things sought to dispel certain myths about competitive sales. And I'm not going to go through all those myths here and the arguments that were made, but I highly encourage folks to review that 2023 February, 2023 presentation at the CMFA. I think it was CMFA, but I also thought that that was a very important process because the process of revisiting conventional wisdom and it is always an important exercise, particularly in public finance. And as I've stated in a number of recent speeches, this is not only an important exercise, but in some cases, especially with respect to municipal advisors, to some extent with broker dealers, actually part of your regulatory responsibility and part of the service that you're supposed to be providing to your municipal entity clients and for municipal entities to understand that these are the responsibilities of the people you're hiring to address conventional wisdom to kick the tires on statements that are be made or decisions that have been made and making sure that you're getting the lowest cost of borrowing.

(13:52):

I also think it's worth noting that several California statutes have special requirements for negotiated sales, such as pre-approval submission of costs and reasons for the negotiated sale. And so thus, while California has a very high rate of negotiated sales relative to other states, issuers, their counsel, their MAs must represent to governing bodies of municipalities the cost of negotiated sale prior to approval of the bonds by the legislative body in a number of circumstances. And so I think MAs and issuers, and again, their counsel should think about what these required representations mean and whether all the costs of negotiated sale, including the heightened risk of underpricing bonds, is appropriately being communicated. It's worth noting that the commission has taken actions based on misrepresentations and certificates supporting a bond issuance before, for example, the commission brought an action against the city of South Miami based in part on misrepresentations that made in annual certifications related to its compliance with the terms of a loan agreement.

(14:59):

And I relate this just as a reminder that the commission is not limited to looking at the four corners of official statement or just documents executed solely in connection with disclosure. And that even seemingly routine certifications or representations can be the basis for a securities law violation if the certifications turn out to be untrue. And here I'm just being clear, we don't regulate issuers, we don't regulate counsel, but we do regulate MAs. We do regulate broker dealers. And so when I'm talking about the basis for these certifications that are being made and that are being represented to a legislative body, I'm talking about what went into that representation, what went into the advice with respect to that representation, representation that was provided by regulated entities. And so no questions so far, so I'll just keep going. But happy to continue to welcome questions. Andy, feel free to jump in if you want. So,

Andy Nakahata (16:03):

Feel better when you were my counsel.

Dave Sanchez (16:05):

I said formerly friendly faces. And then last big topic I want to talk about is just climate and environmental and risk disclosure and building a little bit off what was said in the prior session. But as we all know right across the country, obligated persons issuers of municipal securities are exposed to various climate and environmental risks that may impact their ability to repay debt. And I think was brought up in the last session and been reported frequently that climate risks are impacting not just homeowners and consumers, but also state and local governments, if you just look at insurance costs and insurance availability. And that's one of the areas where analysts have really highlighted where you can start to see looming problems with just these questions of insurance costs and insurance availability. These risks are already threatening livability and property values and communities around the country.

(17:05):

And folks, analysts have argued that municipal finance cannot stay disconnected from these foundations of revenue for too long if it becomes too expensive of a place to live if it becomes impossible to live because of climate impacts, obviously those have revenue and credit impacts. So definitely note that 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. And in those disclosure practices have highlighted the dangers of the silo effect. And the silo effect is 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. And this potentially leads to failures in providing material information to the market. And I note here again, when we talk about anti-fraud, I used to say this when I was in private practice all the time, issuers would say, well, I'm not really worried.

(18:06):

I'm not, I'm not defrauding anybody. And I would remind them that under the anti-fraud statutes, negligence is fraud, right? So it's not that you're willfully trying to cheat people if you just are not being observant about what the material risks are to your community, that can constitute fraud under the securities laws. So as the most populous state in the country and with various overlapping state and local governments, California has its share of large municipal entities with specialized divisions or offices, many of which are looking at climate risk. And those may not always be the same people that are doing a deal that are in the finance division. But just in addition to this silo effect, particularly within organizations, 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 climate and disclosure items. So it is very true that materiality determinations are municipal issuer and credit 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 to consider what other items that similarly situated and impacted municipal issuers are disclosing and whether those are material and should be included in the disclosure of your own entity.

(19:36):

For example, a city in California that is preparing an official statement or continued disclosure could look to the state to county nearby pure municipalities, climate and environmental resiliency planning documents and official statements when considering what the effects might be on their own credit and their own city. And I know there was a mention in the prior section about some tools to do this. We're also aware of at least one proprietary tool that exists that allows entities to respond to climate related questionnaires and then search data sets of other entities that have responded to the same questionnaire. So there are some tools out there for folks to be aware of when developing your own climate disclosure.

(20:25):

I've said this before in other context, but I think it's important enough to repeat here. Market participants have pointed to differences in climate and environ risk disclosure by issuers in the same geographically impacted area when utilizing different municipal market professionals, right? So depending on who your bond council is, who your underwriter is, who your disclosure council is, who your municipal advisor is in 2023, municipal market analytics, MMA, conducted an analysis of offering documents with one example being in Phoenix, Arizona and MMA said the issuers with what MMA considered to be arguably the same climate risks have varied in how the exposure has been articulated, if at all, and that that difference was pretty clearly tied to the council or financial professionals that were utilized. So to me, this MMA data raises questions about whether inconsistent disclosure of climate risks is related to choice of counsel and advisors and other professionals. And again, what this shows me is that the climate risk is not being particularized to the municipal issuer. It's being driven by forces other than municipal issuer rather than deriving organically from the municipal issuer's actual risks.

(21:44):

So market analysts, market participants have observed also an absence of adherence to municipal market best practices for climate and environmental disclosure. I see Emily Brock here. I think I get a dollar every time I mention the gfo a's best practices. So thank you. But really to me, if you go through those best practices and take the time to do that, they really do highlight all the best practices that most of the time everybody would underscore. And really the issue that folks have noticed is that practice is not being done. And so again, also because municipal securities are issue with longer terms, we're just increasingly hearing analysts and credit rating agencies raising concerns about the effect of climate, environmental risks on demographic shifts, on the insurability of property, on the livability, property value changes, and of course all the related credit risks that those changes pose. So I did not expect to get through this without questions, but I'm fine. That is what I want to talk about. Those are the three main things that I wanted to highlight in this particular session. And so again, I think we have a couple minutes.

Andy Nakahata (22:57):

Plenty of time.

Dave Sanchez (22:58):

Yeah, couple of minutes. If folks have any questions about those topics or any other topic, happy to answer them. We can turn this into a firing line type situation. But speak now or forever hold your peace.

Andy Nakahata (23:12):

Questions.

Dave Sanchez (23:16):

See someone walking from the back, but it might just be no. Okay. Yeah, coming to get some coffee or something.

Audience Member 1 (23:23):

I use the restroom.

Dave Sanchez (23:24):

There you go.

Andy Nakahata (23:27):

Great. Well, thank you, Dave.

Dave Sanchez (23:28):

Yep, absolutely. Thanks.