“The pay to play rules came in at the end of my career in Chicago…The investment bankers fought it tooth and nail. And then it was passed and they discovered they loved it, because it saved them tens of millions of dollars of political contributions, because they could just look at the politicians and say, ‘I’m sorry, but I’m not allowed to give you any money. If I do, I can’t do any work with your government for two years. So I‘m sorry, I can’t do that.’”
The 1986 Tax Reform Act did nothing to stabilize the municipal market. Instead, it created years of uncertainty, heightened when the Supreme Court’s 1988 South Carolina v. Baker decision held that the Constitution did not forbid federal taxation of municipal debt. The Act transformed a “once placid environment for municipal securities into a frenetic and arcane market.” 17
In this new environment, an old and secretive practice found spectacular new life. Elected officials had long expected political contributions from aspiring underwriters. This practice, now dubbed “pay to play,” became ubiquitous in the era of narrower spreads, when broker-dealers had to participate in negotiated bids in order to stay in business, and elected officials invited only friends to the table. By the early 1990s, about 80 percent of municipal offerings were negotiated.
Pay to play hit the headlines in April 1993 when the New York Times revealed that Fleet Bank, a contributor to Elizabeth Holtzman’s successful campaign for New York City comptroller, had subsequently been retained as one of the city’s municipal underwriters. In May, Merrill Lynch suspended its four top municipal securities broker-dealers after an investigation into pay to play and kickbacks related to New Jersey Turnpike funding. U.S. Representative John Dingell asked the SEC, the NASD and the MSRB to take on the problem. Congressional hearings followed later that year, although with little result at the time.
Since political contributions could be equated with free speech, it was difficult to legislate them out of municipal finance, so moral suasion filled the void. The chief persuader was Frank Zarb, who had worked on Wall Street and served in the Nixon and Ford Administrations. Now Chairman of Smith Barney, Zarb had decided by 1992 to convince fellow financial executives to stop pay to play. He found an ally in Arthur Levitt, who became SEC Chairman in 1993. Levitt’s father had been long-time comptroller of New York City, so he was all too familiar with pay to play. Concerned about a constitutional challenge, Levitt welcomed Zarb’s voluntary approach. That fall, the two persuaded officials from 17 investment banks, which together handled about 70 percent of municipal business, to renounce pay to play.
The MSRB had decided to weigh in against the practice. “To the Board’s credit, they said, ‘We’re going to ban them, and we’ll take the hit and see what happens with it.’” 18 Rule G-37, approved by the SEC in 1994, prohibited broker-dealers from negotiating business within two years of making a political contribution. It was a curious construction, but unavoidable since only the business, and not the contribution, could be prohibited.
William Blount, a registered broker-dealer and chair of the Alabama Democratic Party, had solicited underwriting business from state officers for whom he raised funds. Blount filed suit, claiming that his actions were protected as free speech under the 1st Amendment and shielded from federal regulation under the 10th Amendment. The MSRB held that G-37 was the result of industry self-regulation rather than government action. In 1995, the D.C. Circuit Court ruled against Blount, and the Supreme Court refused his appeal.
By 1996, the inevitable work-arounds had emerged, with broker-dealers channeling contributions through consultants, lawyers and family members. In response, the MSRB adopted Rule G-38 to cover consultants. 19 SEC Chairman Levitt put pressure on the American Bar Association to pass its own pay to play restrictions, but it took until 2000 for the ABA to act. By then, a series of high-profile enforcement cases involving Paine Webber, Merrill Lynch, and Morgan Stanley had made G-37 stick. On pay to play, the MSRB had definitely taken the hit. 20 But in the end, the regulators had done the industry a favor by relieving participants of the obligation to participate in political fundraising.
Up to the 1990s, the SEC was more attuned to the equities market than to municipal debt. But in 1994, convinced that “a formerly institutional market had been transformed into a primarily public one,” Chairman Levitt brought bond lawyer and former SEC enforcement staffer Paul Maco back to the SEC to help establish the legal responsibilities of participants in the municipal market and put constructive pressure on the MSRB. 21 Maco understood that, despite the hearings in 1993, the SEC could not expect help from Congress. “Because of the nature of administrative proceedings, the Commission has the ability to write a narrative of what it considered to be wrong with the conduct underlying the administrative proceeding. So here’s a way for you to create a mosaic of administrative proceedings within a broader outlying of regulation.” 22
The first three tiles were laid in March 1994, in the form of SEC releases detailing new anti-fraud provisions, a requirement that broker-dealers disclose markups on secondary trading, and related proposed amendments to Rule 15c2-12. 23 The releases regarding 15c2-12 and secondary trading were intended to send the strong message that the SEC expected bold new action on the part of the MSRB to promote transparency in the still-murky municipal market. That message was underscored with the establishment of the SEC Office of Municipal Securities in 1995, signaling the Commission’s long-term commitment to improving the quality of the municipal market.
(17) W. Bartley Hildreth and C. Kurt Zorn, “The Evolution of the State and Local Government Municipal Debt Market Over the Past Quarter Century,” Public Budgeting & Finance (Silver Anniversary Edition, 2005), 127-153, see 128.
(20) Lynn Hume, June 4, 2015 The Remaking of the Municipal Market.
(21) Seligman, The Transformation of Wall Street, 640.
(23) Securities Act Release No. 7049 (March 9, 1994), 59 FR 12748. Securities Exchange Act Release No. 33742 (March 9, 1994), 59 FR 12759. Securities Exchange Act Release No. 33743 (March 9, 1994).
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