The Adviser Who Owes a Duty to the City Rather Than the Deal
Municipal issuers were advised on bond deals by the same firms selling them, and there was no obligation to act in the issuer interest. A statutory fiduciary duty was created after the practice produced serious losses.
The Gap That Existed
A city issuing bonds makes decisions requiring genuine expertise: whether to issue fixed or floating, whether to use derivatives, how to structure maturities, how to select underwriters, and what fees are reasonable.
Historically the parties advising on those decisions were the same firms selling the products. An underwriter has a commercial interest in the deal occurring and in its structure, and it owes no duty to advise the issuer against its own transaction.
Small municipalities, school districts, and utility authorities frequently had no internal capability to evaluate what they were being sold, and the person explaining it was paid by the outcome.
What Went Wrong
The consequences appeared most severely in structured products and derivatives sold to public issuers in the years before the financial crisis.
Issuers entered interest rate swaps intended to convert floating rate exposure to fixed, in arrangements whose termination provisions, collateral requirements, and embedded fees they did not fully understand. When rates moved and credit conditions deteriorated, several faced termination payments in the tens or hundreds of millions.
Auction rate securities were sold as low cost floating rate financing with a periodic auction resetting the rate. When those auctions failed, rates on some issues jumped to punitive maximum levels defined in documents nobody had modelled.
There was also outright misconduct. Enforcement actions established bid rigging in the market for investment agreements used to hold bond proceeds, with providers coordinating to submit losing bids so that municipalities received below market returns on their own money.
The recurring feature was not complexity, it was that everyone in the room was paid by the transaction. Nobody had an obligation to tell the issuer not to do it.
The Statutory Response
Legislation in 2010 created a regulatory category of municipal advisor and imposed a fiduciary duty to the municipal entity client.
| Underwriter | Municipal Advisor | |
|---|---|---|
| Duty to the issuer | Arm length, fair dealing | Fiduciary |
| Must recommend suitable transactions | No | Yes |
| Conflicts | Disclosed | Disclosed and managed under a duty |
| Registration | As a dealer | Separate registration required |
The duty comprises a duty of loyalty, requiring the advisor to act without regard to its own financial interest, and a duty of care, requiring it to have a reasonable basis for advice and to understand the issuer objectives and circumstances.
Regulators also required underwriters to state explicitly, in writing, that they are not acting as advisors and do not owe a fiduciary duty. That disclosure is now standard and it exists because the distinction was previously invisible to issuers.
The Independent Advisor Exemption
An important mechanism resolves a practical problem. If any communication about a potential transaction constituted advice, an underwriter could not discuss a proposed structure with an issuer without triggering advisor obligations.
The independent registered municipal advisor exemption addresses this. Where an issuer is represented by its own independent advisor, and confirms in writing that it will rely on that advisor, a dealer may present ideas without becoming an advisor itself.
The practical result is that issuers now routinely engage an advisor partly so that they can receive proposals from underwriters at all, which was not the intended purpose and is a reasonable outcome.
What an Advisor Actually Does
The role covers plan of finance development, deciding structure, size, and timing; method of sale, comparing competitive bidding against negotiated underwriting; underwriter selection and fee negotiation; rating agency strategy and presentation; document review; and pricing oversight during the sale.
That last function is where the fee is frequently justified. An advisor monitoring pricing on the day compares the levels being achieved against comparable issues and can challenge an underwriter pricing the deal generously to its own investors.
Fees are typically a fixed amount or a rate per bond, and are far smaller than underwriting spread, which is the argument for engaging one on any transaction of size.
The Limits
The framework has boundaries worth knowing.
Employees of the issuer are exempt, so an in house finance officer is not a municipal advisor.
Attorneys providing legal advice and engineers providing engineering advice are generally exempt within their disciplines.
And the duty attaches to advice on municipal financial products and bond issuance, not to every interaction a government has with a financial firm.
The Bottom Line
Municipal advisors exist because public issuers were making complex financing decisions on the advice of firms whose only obligation was fair dealing at arm length, and several of them lost very large sums as a result. The statutory fiduciary duty is the substantive change, and the requirement that underwriters state they are not advisors is the one that made the previously invisible distinction visible. For any issuer, the useful question is which parties in the room owe a duty to it, and the answer is fewer than most public officials assume.