SCOPE

There are many municipalities which do not enter the capital markets frequently or to a heavy degree, and thus present lesser concerns to the investing public or to the proper functioning of our Nation's capital markets. There are many municipal issues which have a relatively limited market. So that mandatory disclosure does not result in overkill, we favor the setting of threshold limits below which disclosure would not be required.

Once the issuers which should be subject to disclosure standards have been identified, the information required of them should be carefully specified and relatively comprehensive. Some flexibility, of course, is advisable, but in general State and local governments are entitled to clear and explicit guidance from the Congress on the kind of information they are required to disclose.

COMMENTS ON PENDING DISCLOSURE BILLS

Based on the above principles, we oppose H.R. 11044. By eliminating the 1933 and 1934 Act exemptions for municipal securities, this bill would require that municipal securities undergo the same disclosure, filing and clearance and registration procedures as corporate securities. Such an approach would impose burdens and costs which outweigh the benefits derived.

As I indicated at the outset, I concur with the essential substance of H.R. 15205. The bill provides for the preparation of annual reports, including audited financial statements, by issuers of municipal securities with more than $50 million outstanding. It provides also that distribution statements be prepared prior to public offer or sale of $5 million or more of securities. And it requires that such reports and statements be reliable and comparable, as well as readily available to underwriters, dealers and investors. Finally, it encourages State oversight by providing for exemptions from the distribution statement requirement where a State authority has approved the offer and sale of the issue.

From our standpoint, perhaps the most important feature of the legislation is the requirement of an annual independent audit. Not only does this requirement itself satisfy two of the three fundamental criteria of disclosure legislation-insuring the accuracy and the comparability of the financial information provided-but it also provides the issuer with an important management tool. As we in the Treasury have become involved with the activities and the structure of particular local governments, we have come to recognize the relationship between sound supervisory mechanisms and the care with which employees handle the government's finances. If the public employee knows that every action related to the fiscal affairs of his employer will be subject to review on an annual basis by an independent party, he is far more likely to act in a manner consistent with the employer's best financial interests. Thus, in addition to meeting the fundamental need for insuring the accuracy and comparability of reported financial information, the independent audit can aid the issuer in its internal financial management as well.

In short, we believe the Chairman's bill strikes an appropriate balance: requiring disclosure of as much information as is necessary to allow the market to function properly, without burdening our states and cities with requirements that impose unnecessary costs.

However, we would recommend several changes in the bill. First, I am concerned about the authority conferred upon the Commission by subsection (d) of Section 13A. To the extent this provision reflects the view that, in light of inflation, it may be appropriate at some future date to allow the Commission to adjust upward the minimum filing requirements, such intent could be more clearly expressed by substituting the word "increase" for the word "change" on line 5.

If, on the other hand, the provision contemplates a possible downward adjustment of the minimum limits, I believe the provision constitutes an inappropriate delegation of authority to the Commission. It is important to keep in mind that this legislation contemplates a degree of Federal involvement in the affairs of sovereign political units. Accordingly, it is our strong belief that any change which materially increases the scope of the legislation, or the burden on entities initially subject to the legislation, must receive the review and approval of the Congress in the form of new legislation.

This leads directly to a second area of concern. While we recognize the necessity for some rulemaking authority in the Commission to implement the statu

tory directives, we think the legislation, as currently drafted, goes much too far. As I indicated earlier, while the protection of investors is, and must be, a consideration, it is not in my view a consideration of such paramount importance as might be the case on the corporate side. The grant of discretion to the Commission to expand the type of information required must be carefully circumscribed and should recognize expressly the different competing considerations which exist in the municipal securities area.

Finally, there is the complex and troublesome question of liability. While the clamor over this issue has subsided somewhat in the wake of the Hochfelder decision and the return of relative calm to our municipal markets, I believe there remains a risk that the benefits of disclosure legislation-healthier markets and net reduction in borrowing costs—may be impaired by a failure to address the liability issue.

It is tempting to suggest deferring this question until a more general reappraisal of the private action under the securities laws is made. But given the emotional and financial interests inherent in any such general reappraisal, I believe it more desirable to take the opportunity presented by our consideration of comprehensive new legislation in the municipal field to develop principles applicable to this market alone.

In assessing the question of liability, it seems to me we are again placed in the posture of imposing a balancing test: do the benefits to the marketplace outweigh the costs incurred by imposing full liability on dealers and underwriters? Costs, it again must be stressed, which will be directly paid by the taxpayers of the issuing juridiction. To put it more bluntly, is requiring underwriters and dealers to be financially responsible for the accuracy and the completeness of an issuer's disclosures worth the price taxpayers will pay for imposing such a responsibility?

It is important to note that it is only this narrow question that we are considering. While the Committe may want to confirm my judgment with representatives of the dealer, and the underwriter community, I assume that no one is suggesting that an underwriter or a dealer should not be liable for its own misconduct for example, for concealing actual knowledge of false disclosures or material nondisclosures or for providing information to investors, other than that provided by the issuer, which is false or misleading.

What we must ask is whether an underwriter should be responsible for conducting an independent inquiry into the fiscal and financial affairs of an issuer to confirm that the issuer's disclosures are accurate.

My own judgment is in the negative. I believe the costs of such an independent inquiry far outweigh whatever benefits, if any, can be derived. And while there may be some superficial appeal to issuers in the prospect of sharing their exposure with other parties, in the final analysis no real sharing takes place. The issuers pay, and pay dearly, for conferring upon investors the right to seek recourse against the financial intermediaries they have retained.

Mr. Chairman, let me briefly summarize the principles-many of which are already embodied in legislation before us--which I believe must guide us as we move toward enactment:

First, the legislation itself must set forth with detail and clarity the specific items and methods of disclosure required. As little as possible must be left to subsequent regulatory interpretation.

Second, causes of action against an issuer must be strictly based on violations of the above requirements and an issuer's exposure limited to actual, out-ofpocket losses.

Third, the legislation should recognize the principle that potential underwriters' liability will be directly reflected in the issuer's borrowing costs. I personally believe that an underwriter should be relieved by statute of any liability with respect to disclosures by an issuer unless (1) the underwriter conceals actual knowledge of false disclosures or material non-disclosures or (2) it provides information to investors other than that provided by the issuer which is false or materially misleading.

I am sure I need not emphasize for the Committee that a decision to support legislation involving a greater Federal role in the activities of a market is not one that is taken lightly by a representative of this Department and this Administration. But as strong advocates of free markets, we recognize that markets function best when the best information is available. And in our view, achieving that objective requires prompt enactment of the legislation before us today.

Mr. MURPHY. Mr. Gerard, when you say the taxpayer will pay dearly, would you outline for us the type of cost involved and just what you mean by "pay dearly"?

Mr. GERARD. All right.

The legislation would require an issuer, prior to selling securities in the market, to provide a broad range of financial information which would be made publicly available, which would involve audited financial statements, which in short, would provide all of the information any potential buyer might need to make a decision whether to invest in the securities.

If liability standards comparable to the standards currently in place in the corporate arena existed in this market as well, after the issuer disclosure process had taken place, the underwriter would have to come in with his own set of lawyers, his own set of accountants, and basically do the work over again. That is what we call due diligence, as a practical matter, today. The rule of thumb in the courts, when an underwriter is sued seems to be that the more lawyers and more accountants you have hired, the less likely you are to be liable. Therefore you pile more and more on in an attempt to protect yourself. Well, lawyers and accountants have got to eat, and they get fees, and those fees are reflected in the price the underwriter is willing to pay the issuer for securities. It is a lower price. It is the difference between the price the underwriter actually pays and the price he would have been willing to pay had he not been required to incur these costs, and it is paid for by the taxpayers.

Mr. MURPHY. Do you have any percentage in mind?

Mr. GERARD. Well, it would vary depending on the size of the issue and how things developed. But as a practical matter, in the corporate arena, and I am not sure it is the perfect analogy, an underwriter might incur costs of anywhere from $50,000 to $500,000 with respect to meeting his due diligence obligations for a new issue. A roughly similar range in the municipal area can be a fairly substantial roadblock. Mr. MURPHY. Mr. McCollister?

Mr. MCCOLLISTER. Your testimony is excellent, Mr. Gerard, very helpful to me.

Where in the bill does the liability issue come other than on page 8, line 20, where it says "(g) In no event shall any underwriter of an issue of municipal securities" and then skipping that in parentheses, "be liable in, or as a consequence of, any suit for damages"

Mr. GERARD. I don't think it is anywhere else.

Mr. MCCOLLISTER. It is implied because of due diligence?

Is that your idea?

Mr. GERARD. I would assume that if, irrespective of whether this legislation is enacted or not, the courts would come to the position based on the analogies to corporate law. Irrespective of whether the basis for jurisdiction was antifraud or this legislation itself, that the works would find that the underwriter did have obligations comparable to the obligations of an underwriter of corporate securities. Mr. MCCOLLISTER. Does he not have those obligations now? Mr. GERARD. He probably does. If I were practicing law and advising an underwriter, I would recommend that he make an inquiry roughly comparable, perhaps not quite so extensive, as the due diligence effort in the corporate deal. You do have a basic and threshold

problem which changes the whole process, in a sense, which is that nobody has audited financials, and it is hard to make a very serious financial inquiry when you are using unaudited numbers.

Mr. MCCOLLISTER. All right. Isn't an underwriter or a dealer in some jeopardy now as he distributes municipal securities lacking, in the case of the District of Columbia, lacking everything as far as knowledge of the District financial affairs?

Mr. GERARD. I think he is.

Mr. MCCOLLISTER. Well, why do dealers expose themselves to that risk?

Mr. GERARD. Well, I guess they take the position that the risk in some broad sense can be quantified in terms of a finite amount of financial exposure, and the opportunities for profit conceivably may exceed that financial exposure. That is one thing.

But perhaps a more important factor here, and one that gets back to the need for this legislation is the-I don't want to call it political pressure, but

Mr. MCCOLLISTER. We understand what that phrase means.

Mr. GERARD. You are a securities firm or you are a bank in business in a particular town and as I think we learned in the New York experience, there is a certain amount of pressure on you to make markets in, to underwrite, and to generally foster the sale of the securities of the city or State in which you do business. I think many institutions which perhaps would just as soon reduce their level of activity in municipal securities keep it up because they are afraid of the headlines and the attacks they would get for freezing out their towns and States. Mr. MCCOLLISTER. Well, wouldn't one way out of it for a municipal securities underwriter or dealer in his underwriting agreement, to pass the liability back to the issuer?

Mr. GERARD. I recommend that you ask that question to people closer to the law than I am. My initial reaction is to ask whether such an agreement under current law would be void as it is public policy.

I suspect that there is law in the corporate area on this subject, but I am not personally familiar with the law.

Mr. MCCOLLISTER. Anyway, your point on liability was that the bill should define more precisely the nature of the underwriter's liability. Mr. GERARD. My basic point is the purpose of this bill is to provide more and more reliable, more comparable information to the market. And I think that is all we as the Federal Government ought to be asking for when we are dealing with other levels of the Government in this country. I believe the bill, with the modifications we have suggested meets that objective. Then the question becomes; do you want to deal at the Federal level with the question of whether to put window dressing on the information by having somebody else go through the information and check it again and again? My answer, given the cost involved, is no.

Mr. MCCOLLISTER. Finally. I am thankful to you for your recommendation that we severely limit the rulemaking power of the SEC insofar as the informational requirements are required. I agree, both specifically here and generally, that we cede to the regulatory agencies a great deal of our legislative powers, and I am grateful for your suggestion.

Thank you, Mr. Chairman.

Mr. MURPHY. Mr. Gerard, we are certainly thankful that you have taken such a deep and abiding interest in the New York problem and your testimony before the New York delegation on various occasions reflects that. To get to a point that Mr. McCollister raised, a point from your testimony, you are suggesting that because of the sensitive nature of municipal disclosure, little rulemaking authority ought to be left up to the Commission.

However, if we adopt the suggestion as reflected on page 23 of your statement, that the legislation itself should set forth with detail and clarity the specific items and methods of disclosure, won't we run into the familiar problem of statutory inflexibility?

Mr. GERARD. Well, there is that risk, but my views are premised on the fact that although we can have years of debate as to specifically what State or local governments should disclose, as a practical matter, I think you are talking about an audited set of financial statements prepared in accordance with generally accepted accounting principles and little else. If the statute said that, and in effect left it to the private accountancy profession, which has served us so well in this area over the years, to establish the specific standards with input from the SEC, with input from State and local government, I think we get an adequate amount of flexibility.

But what concerns me is that you may run into a situation where there are some complex regulations requiring an issuer to disclose the intricacies of a particular piece of legislation that it may have passed the previous year, and in effect explain and attempt to justify past governmental conduct. That troubles me quite a bit, No. 1.

No. 2, I think we have to be practical here. You will hear from the issuers, but what I hear is that they are not head over heels in love with this legislation. Therefore, to the extent we can, consistent with the objectives of the legislation, we ought it in a form that is most. palatable to State and local government, and I think that to the extent you limit the possibility of further, after the fact Federal intrusion, you make it more palatable. You set the rules at the outset, and you play by them, and to the extent they do prove inadequate, we could enact subsequent legislation.

Mr. MURPHY. Thank you, Mr. Gerard. We certainly appreciate your testimony.

Mr. GERARD. Thank you, Mr. Chairman.

Mr. MURPHY. Our next witness is Mr. Richard F. Kezer, Dealer Bank Association.

Mr. Kezer, would you identify the two gentlemen with you?

STATEMENT OF RICHARD F. KEZER, PRESIDENT, DEALER BANK ASSOCIATION; ACCOMPANIED BY PETER HARKINS, EXECUTIVE DIRECTOR; AND HENRY RATHBUN, COUNSEL

Mr. KEZER. Yes, sir. I have with me Mr. Henry Rathbun of the law firm of Wilmer, Cutler & Pickering, counsel to the association, and Mr. Peter Harkins, our newly appointed executive director.

I am Richard Kezer, president of the Dealer Bank Association and senior vice president of Citibank in New York City. I am pleased to appear before you today on behalf of the Dealer Bank Association, a