By Karen Brettell
NEW YORK (Reuters) - A lobbying campaign by the securities industry threatens to water down a U.S. financial reform measure that was supposed to protect American states, towns and cities from being taken for a ride by financial advisors.
One of the main ideas of the 2010 Dodd-Frank law was to defend the finances of U.S. local issuers, which have often been hit by fraud and bid-rigging or simply hurt by bad advice. The solution was to impose a fiduciary duty on financial advisers to make sure they protect the interests of town halls and state capitols around the nation.
But the Republican-controlled House of Representatives passed a bill in September that would exempt so many people from the definition that it could create large loopholes.
While the measure, which is backed by the Securities Industry and Financial Markets Association, may not get approval in the Senate, it could put pressure on the U.S. Securities and Exchange Commission, which is still finalizing its definition of a municipal adviser.
The SEC is still mulling its definition. "Staff are analyzing the public comments and no final decisions have been made," SEC spokesman John Nester said.
Local governments often engage in highly sophisticated derivatives transactions to reduce the cost of borrowing or hedge their budgets against changes in interest rates.
The largest municipal bankruptcy in U.S. history, by Jefferson County, Alabama, in 2011, was in large part caused by expensive interest rate swaps that the county entered in a deal led by JPMorgan Chase which was originally attached to a bond sale.
If the SEC adopts a more narrow definition, a similar situation could emerge again because this type of advice could fall outside of the fiduciary responsibility.
Other bills have already succeeded in scaling back rules relating to derivatives. Partly due to pressure from legislative activity, the Commodity Futures Trading Commission raised the bar for which firms qualify for its tougher swap dealer requirements.
The issue of regulating advice is tricky, as banks that help communities sell debt often develop close relationships with local issuers, and the line between ideas and advice can be very fine. Some market participants also say they don't want to stem the exchange of ideas between communities and banks.
Banks that underwrite debt deals are currently exempt from a fiduciary duty when it relates purely to the debt underwriting. But the House bill seeks to broaden the fiduciary exemption to any advice given by brokers, dealers or banks that is "related to or connected" with underwriting debt, sales of derivatives, and a host of other financial products.
"The legislation would create significant new exemptions and loopholes," said Marcus Stanley, a policy director at Americans for Financial Reform, a coalition of more than 250 consumer, community, labor, small business and other groups.
The legislation would leave communities less protected against being talked into deals that are not in their interest, Stanley said.
BAD ADVICE, CONFLICTS OF INTEREST
In the case of Jefferson County, JPMorgan was accused by regulators of bribing local officials to enter the swap deal.
JPMorgan made a $722 million settlement in November 2009 with the SEC over allegations JPMorgan officials paid more than $8 million in undisclosed fees tied to the swaps.
But bad advice given to municipalities also extends far beyond fraud, with recommendations often being muddied by conflicts of interest relating to compensation structures, in addition to a lack of standards and market savvy.
Andrew Kalotay, founder of debt advisory firm Andrew Kalotay Associates, which works with companies and municipalities, says that a key problem is that swaps advisors are only paid if a swap is executed, creating an incentive to push the contracts.
"Debt advisors that municipalities hire are supposed to negotiate with the banks, but they are just pushovers. Swap advisors are conflicted, because they get paid only if the deal is consummated," he said.
Local governments pay higher charges for the swaps than other issuers, often without their knowledge as the markets are opaque.
Kalotay says that municipalities often pay almost 2 percent more than fair market value to enter a swap, in addition to other transaction fees, citing a controversial deal entered into by the Denver Public Schools in 2008 as an example.
He estimates that mispricing of swaps sold to municipalities has cost U.S. taxpayers around $20 billion in extra costs for the $1 trillion in swaps sold over the past five years.
Joseph Fichera, chief executive at New York-based advisory firm Saber Partners, says the opacity of the swap market hurts issuers, as communities trust prices that bankers quote to them, instead of verifying them through other platforms.
Advisors are not required to pass any standards test to qualify. "Advisors are usually chosen by the lowest hourly fee and do not yet have minimum professional standards," Fichera said.
"When they perform poorly, what's the enforcement mechanism? You fire them, then sue? You can't get their license revoked because there is no license, and this is all after the fact," he said.
Professional standards requirements will be enforced as part of the Dodd Frank reform after the advisor definition is completed, but existing advisors may be confirmed.
Peter Shapiro, a managing director at New Jersey-based advisory firm Swap Financial Group, disagrees that municipalities are routinely overcharged relative to other issuers such as companies.
Mispricing of swaps happens for various reasons across markets but there is no real pattern and it is no worse for municipal issuers than for corporate borrowers, he said. Shapiro also said it was unfair to allow recent scandals to tarnish the reputation of all municipal officials.
"I think it's a disservice to people in municipalities to stereotype them as dumb, lazy and corrupt," he said.
Meanwhile, others see risks in the new rules if they give towns, cities and states a false sense of confidence.
Pennsylvania's auditor general is proposing to ban municipalities from entering into swaps, after its schools have suffered large losses from the contracts.
"New regulation won't remove all risks of the contracts, as can be seen from the Pennsylvania experience. There could be more deference, then more litigation," said Fichera.
That's no reason, however, not to try to rein in the banks, said Americans for Financial Reform's Stanley.
"If you asked most Americans should a big bank dealing with taxpayer money put taxpayer interests first, most would say obviously ‘yes'. Some people believe this problem cannot be controlled because we can never stop predatory behavior by the big banks, but you have to try to protect taxpayers," he said.
(Reporting by Karen Brettell; Editing by Tiziana Barghini, Tim Dobbyn and Chizu Nomiyama)