Guidance on Implementation of Interpretive Notice Concerning the Application of MSRB Rule G-17 to Underwriters of Municipal Securities

The Municipal Securities Rulemaking Board (the “MSRB”) has adopted an interpretive notice on the application of MSRB Rule G-17 to underwriters of municipal securities (the “Notice”), which becomes effective on August 2, 2012.[1] The Notice describes the fair practice duties of brokers, dealers and municipal securities dealers (“dealers”) owed to issuers of municipal securities when acting as underwriters for issuers' new issues of municipal securities.

The MSRB is publishing this implementation guidance to assist dealers in revising their written supervisory procedures, as required under MSRB Rule G-27(c) as part of their overall supervisory systems, to ensure continued full compliance with their fair practice obligations under Rule G-17 on and after August 2, 2012, as well as to clarify certain aspects of the Notice concerning which the MSRB has received inquiries from industry participants. This implementation guidance summarizes the key provisions of the Notice in the context of broader dealer regulatory responsibilities, providing perspectives throughout – identified herein as “practical considerations”[2] – on the manner in which the MSRB intends for the provisions of the Notice to be operationalized by dealers, and reprints the full text of the Notice for convenience of reference.[3]

BACKGROUND

Rule G-17 provides that, in the conduct of its municipal securities activities, each dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice. The MSRB has previously observed, at least as early as 1997, that the rule applies to a dealer’s conduct toward an issuer in connection with the underwriting of its municipal securities.[4] Although many of the specific elements identified in the Notice are fully articulated by the MSRB for the first time, all of them arise from the same fundamental duty of fairness to the issuer that the MSRB has already required under Rule G-17 for some time. This is particularly true with regard to those elements of the Notice relating to representations made by dealers to issuers and to the application of the principles of Rule G-17 to certain financial aspects of underwritings, as described below. On the other hand, some elements of the Notice create for the first time specifically defined disclosure obligations, including requirements regarding the manner and timing of providing such disclosures, that can fairly be viewed as new, either in their entirety or with regard to particular actions necessary to achieve compliance with Rule G-17.

As suggested above, the Notice can be divided into three broad categories: prohibitions on misrepresentations; fairness of financial aspects of an underwriting; and required disclosures to issuers. After a brief discussion of the types of new issues to which the Notice applies, the three broad categories of guidance provided by the Notice are outlined below, including a detailed discussion of the substance, manner and timing of disclosures to issuers and of certain practical considerations in meeting these disclosure requirements as set out in the Notice.

APPLICABILITY OF THE NOTICE

No type of underwriting is wholly excluded from the applicability of the Notice. Thus, the Notice applies not only to primary offerings of municipal bonds and notes by an underwriter, but also to a dealer serving as primary distributor (but not to dealers serving solely as selling dealers) in a continuous offering of municipal fund securities such as interests in 529 college savings plans. Furthermore, the Notice applies to a primary offering that is placed with investors by a dealer serving as placement agent, although certain disclosures may be omitted as described below.

The Notice applies primarily to negotiated offerings of municipal securities, with many of the provisions – including in particular the disclosure provisions discussed below – not by their terms applicable to competitive offerings. However, the MSRB has always viewed competitive offerings narrowly to mean new issues sold by the issuer to the underwriter on the basis of the lowest price bid by potential underwriters – that is, the fact that an issuer publishes a request for proposals and potential underwriters compete to be selected based on their professional qualifications, experience, financing ideas, and other subjective factors would not be viewed as representing a competitive offering for purposes of the Notice. In light of this meaning of the term “competitive underwriting,” it should be clear that, although most of the examples relating to misrepresentations and fairness of financial aspects of an offering consist of situations that would only arise in a negotiated offering, Rule G-17 should not be viewed as allowing an underwriter in a competitive underwriting to make misrepresentations to the issuer or to act unfairly in regard to the financial aspects of the new issue.

The fair practice duties outlined in the Notice are those duties that a dealer owes to a state or local government when the dealer underwrites its new issue of municipal securities. The Notice does not purport to set out the underwriter’s fair practice duties to other parties to a municipal securities financing, including a conduit borrower. The MSRB notes, however, that Rule G-17 does require that an underwriter deal fairly with all persons, which would include such conduit borrowers. What actions are considered fair will, of necessity, be dependent on the nature of the relationship between a dealer and such other parties, the particular actions undertaken, and all other relevant facts and circumstances. Although the Notice does not address what an underwriter’s fair dealing duties may be with respect to a conduit borrower, it may serve as one of many bases for an underwriter to consider how to establish appropriate policies and procedures for ensuring that they meet such fair practice obligations to conduit borrowers and to other transaction participants, in light of their relationship with such other participants and their particular roles.

IMPLEMENTATION OF THE NOTICE

Statements and Representations

STATEMENT OF PRINCIPLE – Prohibition on Misrepresentations. An underwriter must not misrepresent or omit the facts, risks, potential benefits, or other material information about municipal securities activities undertaken with a municipal issuer.

Further guidance and examples included in the Notice. The Notice provides further guidance on this general principle and examples illustrative of the principle, as set forth below.

• Representations made by underwriters to issuers of municipal securities in connection with municipal securities underwritings, whether written or oral, must be truthful and accurate and must not misrepresent or omit material facts.


• Underwriters must have a reasonable basis for the representations and other material information contained in documents they prepare and must refrain from including representations or other information they know or should know is inaccurate or misleading.


• This principle applies to any representation, whether in writing or oral, made by the underwriter to the issuer, including but not limited to:

— representations made in certificates such as an issue price certificate;

— information provided to an issuer for use in the official statement, such as cash flows;

► Practical consideration. The need for underwriters to have a reasonable basis for representations and other material information provided to issuers extends to the reasonableness of assumptions underlying the material information being provided.

► Practical consideration. The less certain an underwriter is of the validity of underlying assumptions, the more cautious it should be in using such assumptions and the more important it will be that the underwriter disclose to the issuer the degree and nature of any uncertainties arising from the potential for such assumptions not being valid

— responses to an issuer’s request for proposals/qualifications, which:

► must fairly and accurately describe the underwriter’s capacity, resources, and knowledge to perform the proposed underwriting;

► must not contain any representations or other material information about such capacity, resources, or knowledge that the underwriter knows or should know to be inaccurate or misleading;

► if the response includes matters not within the personal knowledge of those preparing the response, such matters must be confirmed by those with knowledge of the subject matter;

► must not represent that the underwriter has the requisite knowledge or expertise with respect to a particular financing if the personnel that it intends to work on the financing do not have the requisite knowledge or expertise.

► Practical consideration. As a general matter, a response to a request for proposal should not be treated as merely a sales pitch without regulatory consequence, but instead should be treated with full seriousness that issuers have the expectation that representations made in such responses are true and accurate.

— representations made during the course of negotiations of a new issue with an issuer, including representations regarding the price negotiated, the nature of investor demand for the securities (e.g., the status of the order period and the order book), and the level of effort exerted in obtaining favorable pricing for the issuer; and

— representations made to the issuer regarding investors,[5] such as whether they meet the issuer’s definition of retail, which requires that the underwriter take reasonable measures to ensure that retail clients are bona fide.

► An underwriter that has agreed with an issuer to underwrite a transaction with a retail order period must honor such agreement, and must not allocate securities in a manner that is inconsistent with an issuer’s requirements without the issuer’s consent.

► An underwriter must not knowingly accept an order that has been framed as a retail order when it does not meet the issuer’s expectations regarding retail orders (e.g., a number of small orders placed by an institutional investor that would otherwise not qualify as a retail customer).

► A dealer must not place an order with an underwriter that is framed as a qualifying retail order but in fact represents an order that does not meet the qualification requirements to be treated as a retail order (e.g., an order by a retail dealer without “going away” orders from retail customers, when such orders are not within the issuer’s definition of “retail”).

• Practical consideration. If an underwriter is uncomfortable having an issuer rely on any statements made or information provided to such issuer, it should refrain from making the statement or providing the information, or should provide any appropriate disclosures or other information that would allow the issuer to adequately assess the reliability of the statement or information.


• Practical consideration. Underwriters should be careful to distinguish statements made to issuers that represent opinion rather than factual information and to ensure that the issuer is aware of this distinction.

STATEMENT OF PRINCIPLE – Prohibition on Discouraging the Use of a Municipal Advisor. An underwriter in a negotiated underwriting must not recommend that the issuer not retain a municipal advisor.

• Practical consideration. Thus, an underwriter may not discourage an issuer from using a municipal advisor or otherwise imply that the hiring of a municipal advisor would be redundant because the underwriter can provide the same services that a municipal advisor would.

Fairness of Financial Aspects of an Underwriting

STATEMENT OF PRINCIPLE – Excessive Compensation. An underwriter must not charge or otherwise collect, as compensation for a new issue (including both direct compensation paid by the issuer and other separate payments, values, or credits received by the underwriter from the issuer or any other party in connection with the underwriting), amounts that are, in light of the specific facts and circumstances of the offering, so disproportionate to the nature of the underwriting and related services performed as to constitute an unfair practice to the issuer.

Further guidance included in the Notice. The Notice provides further guidance on some factors that may be relevant to whether an underwriter’s compensation is disproportionate to the nature of the underwriting and related services performed, including but not limited to:

• the credit quality of the issue;


• the size of the issue;


• market conditions;


• the length of time spent structuring the issue; and


• whether the underwriter is paying the fee of the underwriter’s counsel or any other relevant costs related to the financing.

STATEMENT OF PRINCIPLE – New Issue Pricing. The price an underwriter pays to an issuer in a primary offering must be fair and reasonable, taking into consideration all relevant factors, including the best judgment of the underwriter as to the fair market value of the issue at the time it is priced.

Further guidance included in the Notice. The Notice provides further guidance on the application of this principle, depending on the type of offering:

• A dealer purchasing bonds in a competitive underwriting for which the issuer may reject any and all bids will be deemed to have satisfied its duty of fairness to the issuer with respect to the purchase price of the issue as long as the dealer’s bid is bona fide and is based on the dealer’s best judgment of the fair market value of the securities.

— A bid is considered bona fide if the dealer is prepared to purchase or sell the securities at the stated price and under any specified conditions.

• In a negotiated underwriting, the underwriter must negotiate in good faith with the issuer.

— The dealer must ensure the accuracy of representations made during the course of such negotiations, consistent with the guidance described above relating to representations made by underwriters to issuers, including representations, if any, regarding:

► the price negotiated, such as whether the dealer is providing the “best” market price available on the new issue;

► the nature of investor demand for the securities (e.g., the status of the order period and the order book); and

► the level of effort exerted in connection with the pricing of the issue, such as whether the dealer will exert its best efforts to obtain the “most favorable” pricing.

STATEMENT OF PRINCIPLE – Profit Sharing Arrangements. Arrangements between the underwriter and an investor purchasing new issue securities from the underwriter according to which profits realized from the resale by such investor of the securities are directly or indirectly split or otherwise shared with the underwriter also would, depending on the facts and circumstances (including in particular if such resale occurs reasonably close in time to the original sale by the underwriter to the investor), constitute a violation of the underwriter’s fair dealing obligation under Rule G-17.

• Any such profit sharing arrangements also are subject to the disclosure requirements relating to material conflicts of interest as described below.


• Practical consideration. Underwriters should be mindful that, depending on the facts and circumstances, such an arrangement may be inferred from a purposeful but not otherwise justified pattern of transactions or other course of action without the existence of a formal written agreement.


• Practical consideration. An underwriter should carefully consider whether any such arrangement, regardless of whether it constitutes a violation of MSRB Rule G-25(c) precluding a dealer from directly or indirectly sharing in the profits or losses of a transaction in municipal securities with or for a customer, may evidence a potential failure of the underwriter’s duty with regard to new issue pricing described above.

STATEMENT OF PRINCIPLE – Payments to Issuer Personnel. An underwriter must not characterize excessive or lavish expenses for the personal benefit of issuer personnel as an expense of the issue for which it seeks reimbursement from bond proceeds or the issuer.[6]

Further guidance included in the Notice. The Notice further notes that excessive or lavish expenses may result in violations of MSRB Rule G-20 on gifts and gratuities if the value of such excessive or lavish travel, meal, lodging and entertainment expenses in connection with an offering (such as may be incurred for rating agency trips, bond closing dinners, and other functions) that inure to the personal benefit of issuer personnel exceeds the limits set forth in the rule.

Required Disclosures to Issuers

STATEMENT OF PRINCIPLE – Disclosure of Role. In a negotiated underwriting, the underwriter must disclose to the issuer specific information regarding its role in an issuance of municipal securities.

Specific elements of role-based disclosures set out in the Notice. The required role-based disclosures consist of the following statements:[7]

• Municipal Securities Rulemaking Board Rule G-17 requires an underwriter to deal fairly at all times with both municipal issuers and investors;


• The underwriter’s primary role is to purchase securities with a view to distribution in an arm’s-length commercial transaction with the issuer and it has financial and other interests that differ from those of the issuer;

— Practical consideration. In a private placement where a dealer acting as placement agent takes on a true agency role with the issuer and does not take a principal position (including not taking a “riskless principal” position) in the securities being placed, the disclosure relating to an “arm’s length” relationship would be inapplicable and may be omitted due to the agent-principal relationship between the dealer and issuer that normally gives rise to state law obligations – whether termed as a fiduciary or other obligation of trust.[8]

• Unlike a municipal advisor, the underwriter does not have a fiduciary duty to the issuer under the federal securities laws and is, therefore, not required by federal law to act in the best interests of the issuer without regard to its own financial or other interests;

— Practical consideration. As described above, in a private placement where a dealer acts as a true placement agent, the disclosure relating to fiduciary duty would be inapplicable and may be omitted due to the existence of similar state law obligations.[9]

• The underwriter has a duty to purchase securities from the issuer at a fair and reasonable price, but must balance that duty with its duty to sell municipal securities to investors at prices that are fair and reasonable; and


• The underwriter will review the official statement for the issuer’s securities in accordance with, and as part of, its responsibilities to investors under the federal securities laws, as applied to the facts and circumstances of the transaction.

— Practical consideration. In many private placements, as well as in certain other types of new issue offerings, no official statement may be produced, so that to the extent that such an offering occurs without the production of an official statement, the dealer would not be required to disclose its role with regard to the review of an official statement.[10]

STATEMENT OF PRINCIPLE – Disclosure of Conflicts of Interest. In a negotiated underwriting, the underwriter must disclose to the issuer its actual or potential material conflicts of interest with respect to such issuance – that is, the requirement to provide such disclosure is triggered only if:

• the new issue is sold in a negotiated underwriting;


• the matter to be disclosed represents a conflict of interest, either in reality or potentially; and


• any such actual or potential conflict of interest is material.

Categories of conflicts disclosures set out in the Notice. The required disclosures regarding actual or potential material conflicts of interest include, but are not limited to, the following:

• With respect to disclosures relating to the underwriting compensation, both:

— disclosure as to whether the underwriting compensation will be contingent on the closing of the transaction, and

— disclosure that compensation contingent on the closing of a transaction or the size of a transaction presents a conflict of interest because it may cause the underwriter to recommend a transaction that it is unnecessary or to recommend that the size of the transaction be larger than is necessary.

• Disclosure of the existence of payments, values, or credits received by the underwriter in connection with its underwriting of a new issue (or relating directly or indirectly to collateral transactions integrally related to the issue being underwritten) from parties other than the issuer (but including from any affiliates of the underwriter);

— The amount of any such payment, value or credit need not be disclosed.

— Example included in the Notice. It would be a violation of Rule G-17 for an underwriter to receive undisclosed compensation from a third party in exchange for recommending that third party’s services or product to an issuer, including business related to municipal securities derivative transactions.

— Practical consideration. Even though, as noted below, the Notice specifically requires disclosure of the existence of any incentives for the underwriter to recommend a complex municipal securities financing or any other conflicts of interest associated with such recommendation, the specific requirement with respect to complex financings does not obviate the requirement to disclose the existence of payments, values, or credits received by the underwriter or of other material conflicts of interest in connection with any negotiated underwriting, whether it be complex or routine.

• Disclosure of the existence of payments, values, or credits provided by the underwriter in connection with a new issue (or relating directly or indirectly to collateral transactions integrally related to the issue being underwritten) to parties other than the issuer (but including to any affiliates of the underwriter);

— The amount of any such payment, value or credit need not be disclosed.

— Example included in the Notice. It would be a violation of Rule G-17 for an underwriter to compensate an undisclosed third party in order to secure municipal securities business.[11]

— Practical consideration. The third-party payments to which the disclosure requirement under the Notice would apply are those that give rise to actual or potential conflicts of interest and typically would not apply to third-party arrangements for products and services of the type that are routinely entered into in the normal course of business, so long as any specific routine arrangement does not give rise to an actual or potential conflict of interest.[12]

• Disclosure as to whether the underwriter has entered into any third-party arrangements for the marketing of the issuer’s securities;


• Disclosure of the existence of any arrangements between the underwriter and an investor purchasing new issue securities from the underwriter (including purchases that are contingent upon the delivery by the issuer to the underwriter of the securities) according to which profits realized from the resale by such investor of the securities are directly or indirectly split or otherwise shared with the underwriter;

— Arrangements required to be disclosed include, but are not limited to, those where the resale occurs reasonably close in time to the original sale by the underwriter to the investor.

— Any such profit sharing arrangements also may depending on the facts and circumstances, constitute a violation of the underwriter’s fair dealing obligation under Rule G-17 as described below.

• Disclosure as to whether the dealer issues or purchases credit default swaps for which the reference is the issuer for which the dealer is serving as underwriter, or an obligation of that issuer;

— Activities with regard to credit default swaps based on baskets or indexes of municipal issuers that include the issuer or its obligations need not be disclosed unless the issuer or its obligations represent more than 2% of the total notional amount of the credit default swap or the underwriter otherwise caused the issuer or its obligations to be included in the basket or index.

• Disclosure of the existence of any incentives for the underwriter to recommend a complex municipal securities financing and other conflicts of interest associated with such complex municipal securities financing.

— The underwriter must disclose any incentives for the underwriter to recommend the complex municipal securities financing and other associated conflicts of interest in all cases, regardless of the level of sophistication of issuer personnel.

— Examples included in the Notice. A conflict of interest may exist in a complex municipal securities financing when the underwriter is also the provider of a swap used by an issuer to hedge a municipal securities offering or when the underwriter receives compensation from a swap provider for recommending the swap provider to the issuer.

— Practical consideration. As noted above, even though the Notice specifically requires disclosure of the existence of any incentives for the underwriter to recommend a complex municipal securities financing or any other conflicts of interest associated with such recommendation, this specific requirement with respect to complex financings does not obviate the requirement to disclose the existence of payments, values, or credits received by the underwriter or of other material conflicts of interest in connection with any negotiated underwriting, whether it be complex or routine.

• Practical consideration. The categories of conflicts of interest described in the Notice are not mutually exclusive and in some cases a specific conflict may reasonably be viewed as falling into two or even more categories. An underwriter making disclosures of conflicts to an issuer should concentrate on making them in a complete and understandable manner and need not necessarily organize them according to the various categories described in the Notice, particularly if adhering to a strict categorization process might interfere with the clarity of disclosure.

STATEMENT OF PRINCIPLE – Disclosures in Connection with Complex Municipal Securities Financings. An underwriter in a negotiated offering that recommends a complex municipal securities financing to an issuer must disclose the material financial characteristics of the complex municipal securities financing, as well as the material financial risks of the financing that are known to the underwriter and reasonably foreseeable at the time of the disclosure – that is, the requirement to provide such disclosure is triggered if:

• the new issue is sold in a negotiated underwriting;


• the new issue is a complex municipal securities financing; and


• such financing was recommended by the underwriter.

— Practical consideration. Not all negotiated offerings involve a recommendation by the underwriter, such as where an underwriter merely executes a transaction already structured by the issuer or its financial advisor.[13]

Guidance on what constitutes a complex municipal securities financing provided in the Notice. A complex municipal securities financing is a new issue financing that is structured in a unique, atypical, or otherwise complex manner that issuer personnel responsible for the issuance of municipal securities would not be well positioned to fully understand or to assess the implications of the financing in its totality.

• A complex municipal securities financing may consist of an otherwise routine financing structure that incorporates a unique, atypical or complex element.


• Examples included in the Notice. The Notice provides certain non-exclusive illustrative examples of what constitutes a complex municipal securities financing, as set forth below:

— variable rate demand obligations (VRDOs);

— financings involving derivatives (such as swaps); and

— financings in which the interest rate is benchmarked to an index that is commonly used in the municipal marketplace (e.g., LIBOR or SIFMA), which may be complex to an issuer that does not understand the components of that index or its possible interaction with other indexes.

• Practical considerations. Underwriters must make reasonable judgments regarding whether a particular recommended financing structure or product is complex, understanding that the simple fact that a structure or product has become relatively common in the market does not automatically result in it being viewed as not complex.

— In arriving at such reasonable judgment, dealers should consider whether they have achieved a reasonable degree of alignment between what they considered to be a complex municipal securities financing for purposes of the Notice and their own internal assessments of whether particular financing structures or products merit a heightened level of expertise and/or a closer degree of oversight.

— A dealer might take into consideration a number of practical factors, including some listed as examples below, as tools for potentially flagging complex municipal securities financing, with the understanding that these examples are not obligatory, may not be helpful for a particular dealer or for particular transactions, and other factors or tools not listed below may be more effective for such dealer:

► whether its internal risk management process for approving an underwriting engagement could be helpful in potentially flagging complex municipal securities financings;

► whether a particular type of financing structure or product is handled only by the dealer’s most experienced or specialized professionals;

► whether a particular type of financing structure or product gives rise to the most significant new issue disclosure issues when assisting the issuer in preparing the official statement; or

► whether a particular feature or other characteristic of a financing results in more difficult secondary market pricing determinations as compared to the rest of the marketplace.

Examples of disclosures for a VRDO financing provided in the Notice. If an underwriter recommends a VRDO financing, material financial risks of the recommended VRDO financing that must be disclosed include, but are not limited to:

• the risk of interest rate fluctuations and


• material risks of any associated credit or liquidity facilities (e.g., the risk that the issuer might not be able to replace the facility upon its expiration and might be required to repay the facility provider over a short period of time).

Examples of disclosures for a VRDO financing involving a swap provided in the Notice. If the underwriter recommends a VRDO financing and also recommends that the issuer swap the floating rate interest payments on the VRDOs to fixed rate payments under a swap, the underwriter must disclose:

• the material financial risks of the financing, which:

— include, in addition to the risks described above with respect to a VRDO financing, the following risks associated with the recommended swap:

► market risk;

► credit risk;

► operational risk; and

► liquidity risk.

— must be accompanied by a statement by the underwriter to the issuer that there may be accounting, legal, and other risks associated with the swap and that the issuer should consult with other professionals concerning such risks;

— should be sufficient to allow the issuer to assess the magnitude of its potential exposure as a result of the complex municipal securities financing;

— if the underwriter’s affiliated swap dealer is proposed to be the executing swap dealer, may be provided to the issuer by the affiliated swap dealer or the issuer’s swap or other financial advisor that is independent of the underwriter and the swap dealer, as long as the underwriter has a reasonable basis for belief in the truthfulness and completeness of such disclosure; and

— if the issuer decides to enter into a swap with another dealer that was not recommended by the underwriter, is not required to be provided by the underwriter with regard to that swap.

• the material financial characteristics of the recommended swap, which include, but are not limited to:

— the material economic terms of the swap;

— the material terms relating to the operation of the swap; and

— the material rights and obligations of the parties during the term of the swap.

• if such dealer’s recommendation of a swap or security-based swap to the issuer also is subject to rules of the Commodity Futures Trading Commission or the Securities and Exchange Commission, any other disclosures that may be required under their respective applicable rules.

Further guidance on disclosure of material financial risks and characteristics provided in the Notice. If a complex municipal securities financing consists of an otherwise routine financing structure that incorporates a unique, atypical or complex element and the issuer personnel have knowledge or experience with respect to the routine elements of the financing, the disclosure of material risks and characteristics may be limited to those relating to such specific element and any material impact such element may have on other features that would normally be viewed as routine.

Guidance on tailoring disclosures to sophistication of issuer personnel provided in the Notice. The level of disclosure required may vary according to the issuer’s knowledge or experience with the proposed financing structure or similar structures, capability of evaluating the risks of the recommended financing, and financial ability to bear the risks of the recommended financing, in each case based on the reasonable belief of the underwriter.

• Practical consideration. The level of disclosure to be provided to a particular issuer also can vary over time.

— To the extent that an issuer gains experience with a complex financing structure or product over the course of multiple new issues utilizing that structure or product, the level of disclosure required to be provided to the issuer with respect to such complex financing structure or product would likely be reduced over time.

— If an issuer that previously employed a seasoned professional in connection with its complex financings who has been replaced by personnel with little experience, knowledge or training serving in the relevant responsible position or in undertaking such complex financings, the level of disclosure required to be provided to the issuer with respect to such complex financing structure or product would likely increase.

Guidance on specificity of disclosures required under the Notice. The disclosures concerning a complex municipal securities financing must address the specific elements of the financing, rather than being general in nature.

• Practical consideration. An underwriter cannot satisfy this requirement by providing an issuer a single document setting out general descriptions of the various complex municipal securities financing structures or products it may recommend from time to time to its various issuer clients that would effectively require issuer personnel to discover which disclosures apply to a particular recommendation and to the particular circumstances of that issuer.


• Practical consideration. An underwriter can create, in advance, individualized descriptions, with appropriate levels of detail, of the material financial characteristics and risks for each of the various complex municipal securities financing structures or products (including any typical variations) it may recommend from time to time to its various issuer clients, with such standardized descriptions serving as the base for more particularized disclosure for the specific complex financing the underwriter is recommending to a particular issuer. The underwriter could incorporate, to the extent applicable, any refinements to the base description needed to fully describe the material financial features and risks unique to that financing.

— Underwriters should be able to leverage such materials for purposes of assisting issuers to more efficiently prepare disclosures to the public included in official statements in a manner that promotes more consistent marketplace disclosure of a particular financing type from issue to issue, and also should be able to leverage the materials for internal training and risk management purposes.

STATEMENT OF PRINCIPLE – Disclosures in Connection with Routine Financings. If the underwriter reasonably believes that issuer personnel responsible for the issuance of municipal securities lack knowledge or experience with a financing structure, even if such structure is routine and well understood by the typical municipal market professional, the underwriter must provide disclosures on the material aspects of such structures that it recommends.

• Guidance on particularity of disclosure provided in the Notice. When required, the disclosures to be made in connection with a routine financing need not be as particularized as those required in connection with a complex municipal securities financing.


• Example of routine financing included in the Notice. The Notice provides that, absent unusual circumstances or features, the typical fixed rate offering may be presumed to be well understood.


• Example of complex element of routine financing included in the Notice. An otherwise routine financing structure may incorporate a unique, atypical or complex element that would result in such structure being viewed as a complex municipal securities financing.

— If issuer personnel have knowledge or experience with respect to the routine elements of the financing, then disclosure of material risks and characteristics normally required with respect to a complex municipal securities financing may be limited to those relating to such specific complex element and any material impact such element may have on other features that would normally be viewed as routine

Manner and Timing of Providing Disclosures to Issuers

Manner of providing disclosures set out in the Notice. All disclosures must be provided:

• in writing;


• to an official of the issuer that the underwriter reasonably believes has the authority to bind the issuer by contract with the underwriter;

— In the case of a disclosure of a conflict of interest, the disclosure should be provided to an official who, to the knowledge of the underwriter, is not a party to the disclosed conflict.

• in a manner designed to make clear to such official the subject matter of such disclosures and their implications for the issuer;

— In the case of a disclosure regarding a complex municipal securities financing:

► such disclosures must be made in a fair and balanced manner based on principles of fair dealing and good faith; and

► if the underwriter does not reasonably believe that the official to whom the disclosures are addressed is capable of independently evaluating the disclosures, the underwriter must make additional efforts reasonably designed to inform the official or its employees or agent.

► Practical consideration. Page after page of complex legal jargon in small print would not satisfy this requirement.[14]

► Practical consideration. In connection with a complex municipal securities financing involving a swap, Section 4s(h)(5) of the Commodity Exchange Act requires that a swap dealer with a special entity client (including states, local governments, and public pension funds) must have a reasonable basis to believe that the special entity has an independent representative that has sufficient knowledge to evaluate the transaction and its risks, as well as the pricing and appropriateness of the transaction. Section 15F(h)(5) of the Securities Exchange Act of 1934 imposes the same requirements with respect to security-based swaps.[15]

• in the case of a disclosure of a conflict of interest, by the particular underwriter subject to such conflict; and


• in the case of all other disclosures, disclosures may be made by a syndicate manager on behalf of other syndicate members.

— Practical consideration. To promote consistent and complete disclosure to issuers under this Notice while reducing the likelihood of issuers receiving multiple duplicative disclosures on the same matters in potentially inconsistent manners, it would be appropriate for the agreement among underwriters or other arrangement binding the members of the syndicate to delegate the provision of the disclosures required under the Notice, other than dealer-specific conflicts of interest disclosures, to a syndicate manager that accepts the responsibility for providing such disclosures as required under this Notice on behalf of the syndicate members to the issuer.

Issuer acknowledgement of disclosures as provided in the Notice. The underwriter must attempt to receive written acknowledgement (other than by automatic e-mail receipt) by the official of the issuer of receipt of disclosures.

• If the official of the issuer agrees to proceed with the underwriting engagement after receipt of the disclosures but will not provide written acknowledgement of receipt, the underwriter may proceed with the engagement after documenting with specificity why it was unable to obtain such written acknowledgement.

Timing for providing disclosures set out in the Notice. Disclosures must be provided in accordance with the following timeframe:

• Disclosure concerning the arm’s-length nature of the underwriter-issuer relationship must be made in the earliest stages of the underwriter’s relationship with the issuer with respect to an issue (e.g., in a response to a request for proposals or in promotional materials provided to an issuer).


• Other disclosures concerning the role of the underwriter, the underwriter’s compensation and conflicts of interest generally must be made when the underwriter is engaged to perform underwriting services (e.g., in an engagement letter), not solely in a bond purchase agreement.

— However, conflicts discovered or arising after the underwriter has been engaged, such as a conflict that arises only upon the underwriter making a recommendation of a particular financing, must be provided in sufficient time before the execution of a contract with the underwriter to allow the official to evaluate the recommendation.

• Disclosures regarding a recommended complex municipal securities financing must be provided in sufficient time before the execution of a contract with the underwriter to allow the official to evaluate the recommendation.


• Practical considerations regarding timing of disclosures. [16] Not all transactions proceed along the same timeline or pathway and on rare occasions precise compliance with some of the timeframes set out in the Notice may not be feasible.

— The timeframes set out in the Notice should be viewed in light of the overarching goals of Rule G-17 and the purposes that required disclosures are intended to serve as described in the Notice.

► That is, the issuer (i) has clarity throughout all substantive stages of a financing regarding the roles of its professionals, (ii) is aware of conflicts of interest promptly after they arise and well before it effectively becomes fully committed (either formally or due to having already expended substantial time and effort) to completing the transaction with the underwriter, and (iii) has the information required to be disclosed with sufficient time to take such information into consideration before making certain key decisions on the financing.

— Thus, the timeframes set out in the Notice are not intended to establish hair-trigger tripwires resulting in technical rule violations so long as underwriters act in substantial compliance with such timeframes and have met the key objectives for providing such disclosures under the Notice.

APPLYING THE NOTICE TO FINANCINGS IN PROCESS ON THE EFFECTIVE DATE

The Notice becomes effective by its terms on August 2, 2012. As noted above, the basic fair practice obligations of Rule G-17 have been in place for a considerable period prior to that date, and dealers should be clear that the principles prohibiting misrepresentations by underwriters to issuers and requiring that underwriters act fairly with regard to the financial aspects of an issuer’s new issue apply prior to August 2, 2012. Thus, although the Notice may specifically identify that a particular material misrepresentation is a violation of Rule G-17, underwriters must not interpret this to mean that, prior to the effective date of the Notice, an underwriter is free to make material misrepresentations to issuers without being viewed as acting unfairly under Rule G-17. Similarly, an underwriter could not charge excessive compensation, or engage in unfair new issue pricing, or undertake other types of unfair activities in connection with the financial aspects of an underwriting described in the Notice prior to August 2, 2012 and believe that, under no set of facts and circumstances, such activities could not be viewed as unfair to the issuer under existing principles of fairness arising from Rule G-17. Of course, given the more detailed articulation of the applicability of Rule G-17 to matters relating to misrepresentations and financial aspects of an underwriting provided by the Notice, the agencies charged with enforcing MSRB rules would be expected to take into account whether, in a particular set of facts and circumstances, the lack of such detailed guidance prior to the effective date would be relevant in determining whether a dealer should be viewed as having violated Rule G-17 based on actions prior such effectiveness.

However, certain other elements of the Notice create newly defined obligations, or provide insight on fair dealing obligations in a manner that may not have previously been articulated as giving rise to a potential violation of Rule G-17. In light of this, dealers should implement the portions of this Notice relating to such elements consistent with the following guidance.

Prohibition on Discouraging the Use of a Municipal Advisor. Beginning on August 2, 2012, an underwriter in a negotiated underwriting must not recommend that the issuer not retain a municipal advisor, including stating or implying that the hiring of a municipal advisor would be redundant because the underwriter can provide the same services that a municipal advisor would. While this requirement is new, depending on the totality of the facts and circumstances, actions taken prior to August 2, 2012 that constituted overt and patently unfair actions to interfere with the legitimate business relationship between an issuer and a municipal advisor could be viewed as a violation of Rule G-17.

Disclosures. The specific disclosure obligations, and the manner and timing for providing them, are largely new as of August 2, 2012, and therefore such specific disclosures would be viewed as becoming obligatory only as of such date. Dealers should be aware, however, that, depending on the specific facts and circumstances, statements made or omitted, or actions taken, by dealers prior to the effective date – while not formally covered as disclosures for purposes of the Notice – might give rise to a Rule G-17 violation if such statements, omissions or actions (when considered in light of other relevant statements or actions) constitute misrepresentations or other clearly unfair actions toward the issuer.

As noted above, the MSRB has recognized that precise compliance with some elements of the timeframe for disclosures may not be feasible in certain cases, and the occurrence of the effective date for the Notice during the course of a new issue financing may very well make it impossible for an underwriter to meet certain deadlines provided in the Notice.

New issues sold prior to August 2, 2012 – For a new issue for which a final commitment has been made prior to August 2, 2012 – that is, the bond purchase agreement has been signed in a negotiated offering – the disclosures under the Notice would not be required even if the new issue has not yet settled. However, if any material terms of a recommended financing sold before the effective date remain to be negotiated on or after August 2, 2012 that would substantially affect the overall character of an otherwise routine financing with the effect of causing the offering to become a complex municipal securities financing, then disclosures regarding such additional material terms would be required prior to the issuer’s commitment to such additional terms.

In the case of a continuous offering, such as for 529 college savings plans and other types of municipal fund securities, a primary distributor already under contract to serve in such capacity for a plan prior to August 2, 2012 would not be obligated to make the disclosures under the Notice. However, if the primary distributor recommends any new material terms with respect to the 529 college savings plan on or after August 2, 2012 that constitute complex new features of the plan or would substantially affect the overall character of such plan with the effect of causing it to become a complex municipal securities financing, then disclosures regarding such new material terms would be required prior to the issuer’s commitment to such new terms.

New issues sold on or after August 2, 2012 – In the case of a recommended negotiated offering sold – that is, the bond purchase agreement signed – on or after August 2, 2012, the disclosures under the Notice would be required to be provided.[17] For such issues expected to be sold on or about the August 2, 2012 effective date, the MSRB understands that strict compliance with the earlier deadlines for disclosures on the underwriter’s role and conflicts of interest would likely not be possible, but the underwriter would be viewed as achieving substantial compliance with such disclosure obligations so long as the issuer has been provided with the full set of disclosures, including any required disclosures with regard to a complex municipal securities financing, with sufficient opportunity to consider such disclosures before signing the bond purchase agreement. If, however, the complexity of a recommended complex municipal securities financing or the nature of potential conflicts are of a magnitude to require extended consideration by the issuer prior to making meaningful decisions regarding the financing, underwriters would be advised to consider providing disclosures in advance of the August 2, 2012 effective date to ensure that no doubt exists with regard to whether the issuer has been given a meaningful opportunity to consider such disclosures in making its decision and to avoid any need to delay the signing of a bond purchase agreement.

WRITTEN SUPERVISORY PROCEDURES

Under MSRB Rule G-27(b), each dealer is required to establish and maintain a system, including written supervisory procedures, to supervise the municipal securities activities of each registered representative, registered principal and associated person that is reasonably designed to achieve compliance with applicable MSRB rules, as well as with other securities laws and regulations applicable to the dealer’s municipal securities activities. Thus, each dealer’s written supervisory procedures must, among other things, establish procedures for monitoring compliance with all applicable rules and supervising the municipal securities representative activities of the dealer’s associated persons as required under Rule G-27(c)(i)(A). These supervisory procedures must be tested and verified by the dealer through appropriate supervisory control policies and procedures pursuant to Rule G-27(f). Dealers are reminded to update their written supervisory procedures to reflect the provisions of the Notice and to provide appropriate training to ensure compliance with such revised procedures.

* * * * *

TEXT OF NOTICE, effective August 2, 2012

INTERPRETIVE NOTICE CONCERNING THE APPLICATION OF MSRB RULE G-17 TO UNDERWRITERS OF MUNICIPAL SECURITIES

Under Rule G-17 of the Municipal Securities Rulemaking Board (the “MSRB”), brokers, dealers, and municipal securities dealers (“dealers”) must, in the conduct of their municipal securities activities, deal fairly with all persons and must not engage in any deceptive, dishonest, or unfair practice. This rule is most often cited in connection with duties owed by dealers to investors; however, it also applies to their interactions with other market participants, including municipal entities[1] such as states and their political subdivisions that are issuers of municipal securities (“issuers”).

The MSRB has previously observed that Rule G-17 requires dealers to deal fairly with issuers in connection with the underwriting of their municipal securities.[2] More recently, with the passage of the Dodd-Frank Act,[3] the MSRB was expressly directed by Congress to protect municipal entities. Accordingly, the MSRB is providing additional interpretive guidance that addresses how Rule G-17 applies to dealers acting in the capacity of underwriters in the municipal securities transactions described below. Except where a competitive underwriting is specifically mentioned, this notice applies to negotiated underwritings only. Furthermore, it does not apply to selling group members.

The examples discussed in this notice are illustrative only and are not meant to encompass all obligations of dealers to municipal entities under Rule G-17. The notice also does not address a dealer’s duties when the dealer is serving as an advisor to a municipal entity. Furthermore, when municipal entities are customers[4] of dealers they are subject to the same protections under MSRB rules, including Rule G-17, that apply to other customers.[5] The MSRB notes that an underwriter has a duty of fair dealing to investors in addition to its duty of fair dealing to issuers. An underwriter also has a duty to comply with other MSRB rules as well as other federal and state securities laws.

Basic Fair Dealing Principle

As noted above, Rule G-17 precludes a dealer, in the conduct of its municipal securities activities, from engaging in any deceptive, dishonest, or unfair practice with any person, including an issuer of municipal securities. The rule contains an anti-fraud prohibition. Thus, an underwriter must not misrepresent or omit the facts, risks, potential benefits, or other material information about municipal securities activities undertaken with a municipal issuer. However, Rule G-17 does not merely prohibit deceptive conduct on the part of the dealer. It also establishes a general duty of a dealer to deal fairly with all persons (including, but not limited to, issuers of municipal securities), even in the absence of fraud.

Role of the Underwriter/Conflicts of Interest

In a negotiated underwriting, the underwriter’s Rule G-17 duty to deal fairly with an issuer of municipal securities requires the underwriter to make certain disclosures to the issuer to clarify its role in an issuance of municipal securities and its actual or potential material conflicts of interest with respect to such issuance.

Disclosures Concerning the Underwriter’s Role. The underwriter must disclose to the issuer that:

(i) Municipal Securities Rulemaking Board Rule G-17 requires an underwriter to deal fairly at all times with both municipal issuers and investors;

(ii) the underwriter’s primary role is to purchase securities with a view to distribution in an arm’s-length commercial transaction with the issuer and it has financial and other interests that differ from those of the issuer;

(iii) unlike a municipal advisor, the underwriter does not have a fiduciary duty to the issuer under the federal securities laws and is, therefore, not required by federal law to act in the best interests of the issuer without regard to its own financial or other interests;

(iv) the underwriter has a duty to purchase securities from the issuer at a fair and reasonable price, but must balance that duty with its duty to sell municipal securities to investors at prices that are fair and reasonable; and

(v) the underwriter will review the official statement for the issuer’s securities in accordance with, and as part of, its responsibilities to investors under the federal securities laws, as applied to the facts and circumstances of the transaction.

The underwriter also must not recommend that the issuer not retain a municipal advisor.

Disclosure Concerning the Underwriter’s Compensation. The underwriter must disclose to the issuer whether its underwriting compensation will be contingent on the closing of a transaction. It must also disclose that compensation that is contingent on the closing of a transaction or the size of a transaction presents a conflict of interest, because it may cause the underwriter to recommend a transaction that it is unnecessary or to recommend that the size of the transaction be larger than is necessary.

Other Conflicts Disclosures. The underwriter must also disclose other potential or actual material conflicts of interest, including, but not limited to, the following:

(i) any payments described below under “Conflicts of Interest/ Payments to or from Third Parties”;

(ii) any arrangements described below under “Conflicts of Interest/Profit-Sharing with Investors”;

(iii) the credit default swap disclosures described below under “Conflicts of Interest/Credit Default Swaps”; and

(iv) any incentives for the underwriter to recommend a complex municipal securities financing and other associated conflicts of interest (as described below under “Required Disclosures to Issuer”).

Disclosures concerning the role of the underwriter and the underwriter’s compensation may be made by a syndicate manager on behalf of other syndicate members. Other conflicts disclosures must be made by the particular underwriters subject to such conflicts.

Timing and Manner of Disclosures. All of the foregoing disclosures must be made in writing to an official of the issuer that the underwriter reasonably believes has the authority to bind the issuer by contract with the underwriter and that, to the knowledge of the underwriter, is not a party to a disclosed conflict. Disclosures must be made in a manner designed to make clear to such official the subject matter of such disclosures and their implications for the issuer. The disclosure concerning the arm’s-length nature of the underwriter-issuer relationship must be made in the earliest stages of the underwriter’s relationship with the issuer with respect to an issue (e.g., in a response to a request for proposals or in promotional materials provided to an issuer). Other disclosures concerning the role of the underwriter and the underwriter’s compensation generally must be made when the underwriter is engaged to perform underwriting services (e.g., in an engagement letter), not solely in a bond purchase agreement. Other conflicts disclosures must be made at the same time, except with regard to conflicts discovered or arising after the underwriter has been engaged. For example, a conflict may not be present until an underwriter has recommended a particular financing. In that case, the disclosure must be provided in sufficient time before the execution of a contract with the underwriter to allow the official to evaluate the recommendation, as described below under “Required Disclosures to Issuers.”

Acknowledgement of Disclosures. The underwriter must attempt to receive written acknowledgement (other than by automatic e-mail receipt) by the official of the issuer of receipt of the foregoing disclosures. If the official of the issuer agrees to proceed with the underwriting engagement after receipt of the disclosures but will not provide written acknowledgement of receipt, the underwriter may proceed with the engagement after documenting with specificity why it was unable to obtain such written acknowledgement.

Representations to Issuers

All representations made by underwriters to issuers of municipal securities in connection with municipal securities underwritings, whether written or oral, must be truthful and accurate and must not misrepresent or omit material facts. Underwriters must have a reasonable basis for the representations and other material information contained in documents they prepare and must refrain from including representations or other information they know or should know is inaccurate or misleading. For example, in connection with a certificate signed by the underwriter that will be relied upon by the issuer or other relevant parties to an underwriting (e.g., an issue price certificate), the dealer must have a reasonable basis for the representations and other material information contained therein. In addition, an underwriter’s response to an issuer’s request for proposals or qualifications must fairly and accurately describe the underwriter’s capacity, resources, and knowledge to perform the proposed underwriting as of the time the proposal is submitted and must not contain any representations or other material information about such capacity, resources, or knowledge that the underwriter knows or should know to be inaccurate or misleading. Matters not within the personal knowledge of those preparing the response (e.g., pending litigation) must be confirmed by those with knowledge of the subject matter. An underwriter must not represent that it has the requisite knowledge or expertise with respect to a particular financing if the personnel that it intends to work on the financing do not have the requisite knowledge or expertise.

Required Disclosures to Issuers

Many municipal securities are issued using financing structures that are routine and well understood by the typical municipal market professional, including most issuer personnel that have the lead responsibilities in connection with the issuance of municipal securities. For example, absent unusual circumstances or features, the typical fixed rate offering may be presumed to be well understood. Nevertheless, in the case of issuer personnel that the underwriter reasonably believes lack knowledge or experience with such structures, the underwriter must provide disclosures on the material aspects of such structures that it recommends.

However, in some cases, issuer personnel responsible for the issuance of municipal securities would not be well positioned to fully understand or assess the implications of a financing in its totality, because the financing is structured in a unique, atypical, or otherwise complex manner (a “complex municipal securities financing”).[6] Examples of complex municipal securities financings include variable rate demand obligations (“VRDOs”) and financings involving derivatives (such as swaps). An underwriter in a negotiated offering that recommends a complex municipal securities financing to an issuer has an obligation under Rule G-17 to make more particularized disclosures than those that may be required in the case of routine financing structures. The underwriter must disclose the material financial characteristics of the complex municipal securities financing, as well as the material financial risks of the financing that are known to the underwriter and reasonably foreseeable at the time of the disclosure.[7] It must also disclose any incentives for the underwriter to recommend the financing and other associated conflicts of interest.[8] Such disclosures must be made in a fair and balanced manner based on principles of fair dealing and good faith.

The level of disclosure required may vary according to the issuer’s knowledge or experience with the proposed financing structure or similar structures, capability of evaluating the risks of the recommended financing, and financial ability to bear the risks of the recommended financing, in each case based on the reasonable belief of the underwriter.[9] In all events, the underwriter must disclose any incentives for the underwriter to recommend the complex municipal securities financing and other associated conflicts of interest.

The disclosures described in this section of this notice must be made in writing to an official of the issuer whom the underwriter reasonably believes has the authority to bind the issuer by contract with the underwriter (i) in sufficient time before the execution of a contract with the underwriter to allow the official to evaluate the recommendation and (ii) in a manner designed to make clear to such official the subject matter of such disclosures and their implications for the issuer. The disclosures concerning a complex municipal securities financing must address the specific elements of the financing, rather than being general in nature. If the underwriter does not reasonably believe that the official to whom the disclosures are addressed is capable of independently evaluating the disclosures, the underwriter must make additional efforts reasonably designed to inform the official or its employees or agent.

Underwriter Duties in Connection with Issuer Disclosure Documents

Underwriters often play an important role in assisting issuers in the preparation of disclosure documents, such as preliminary official statements and official statements.[10] These documents are critical to the municipal securities transaction, in that investors rely on the representations contained in such documents in making their investment decisions. Moreover, investment professionals, such as municipal securities analysts and ratings services, rely on the representations in forming an opinion regarding the credit. A dealer’s duty to have a reasonable basis for the representations it makes, and other material information it provides, to an issuer and to ensure that such representations and information are accurate and not misleading, as described above, extends to representations and information provided by the underwriter in connection with the preparation by the issuer of its disclosure documents (e.g., cash flows).

Underwriter Compensation and New Issue Pricing

Excessive Compensation. An underwriter’s compensation for a new issue (including both direct compensation paid by the issuer and other separate payments, values, or credits received by the underwriter from the issuer or any other party in connection with the underwriting), in certain cases and depending upon the specific facts and circumstances of the offering, may be so disproportionate to the nature of the underwriting and related services performed as to constitute an unfair practice with regard to the issuer that it is a violation of Rule G-17. Among the factors relevant to whether an underwriter’s compensation is disproportionate to the nature of the underwriting and related services performed, are the credit quality of the issue, the size of the issue, market conditions, the length of time spent structuring the issue, and whether the underwriter is paying the fee of the underwriter’s counsel or any other relevant costs related to the financing.

Fair Pricing. The duty of fair dealing under Rule G-17 includes an implied representation that the price an underwriter pays to an issuer is fair and reasonable, taking into consideration all relevant factors, including the best judgment of the underwriter as to the fair market value of the issue at the time it is priced.[11] In general, a dealer purchasing bonds in a competitive underwriting for which the issuer may reject any and all bids will be deemed to have satisfied its duty of fairness to the issuer with respect to the purchase price of the issue as long as the dealer’s bid is a bona fide bid (as defined in Rule G-13)[12] that is based on the dealer’s best judgment of the fair market value of the securities that are the subject of the bid. In a negotiated underwriting, the underwriter has a duty under Rule G-17 to negotiate in good faith with the issuer. This duty includes the obligation of the dealer to ensure the accuracy of representations made during the course of such negotiations, including representations regarding the price negotiated and the nature of investor demand for the securities (e.g., the status of the order period and the order book). If, for example, the dealer represents to the issuer that it is providing the “best” market price available on the new issue, or that it will exert its best efforts to obtain the “most favorable” pricing, the dealer may violate Rule G-17 if its actions are inconsistent with such representations.[13]

Conflicts of Interest

Payments to or from Third Parties. In certain cases, compensation received by the underwriter from third parties, such as the providers of derivatives and investments (including affiliates of the underwriter), may color the underwriter’s judgment and cause it to recommend products, structures, and pricing levels to an issuer when it would not have done so absent such payments. The MSRB views the failure of an underwriter to disclose to the issuer the existence of payments, values, or credits received by the underwriter in connection with its underwriting of the new issue from parties other than the issuer, and payments made by the underwriter in connection with such new issue to parties other than the issuer (in either case including payments, values, or credits that relate directly or indirectly to collateral transactions integrally related to the issue being underwritten), to be a violation of the underwriter’s obligation to the issuer under Rule G-17.[14] For example, it would be a violation of Rule G-17 for an underwriter to compensate an undisclosed third party in order to secure municipal securities business. Similarly, it would be a violation of Rule G-17 for an underwriter to receive undisclosed compensation from a third party in exchange for recommending that third party’s services or product to an issuer, including business related to municipal securities derivative transactions. This notice does not require that the amount of such third-party payments be disclosed. The underwriter must also disclose to the issuer whether it has entered into any third-party arrangements for the marketing of the issuer’s securities.

Profit-Sharing with Investors. Arrangements between the underwriter and an investor purchasing new issue securities from the underwriter (including purchases that are contingent upon the delivery by the issuer to the underwriter of the securities) according to which profits realized from the resale by such investor of the securities are directly or indirectly split or otherwise shared with the underwriter also would, depending on the facts and circumstances (including in particular if such resale occurs reasonably close in time to the original sale by the underwriter to the investor), constitute a violation of the underwriter’s fair dealing obligation under Rule G-17. Such arrangements could also constitute a violation of Rule G-25(c), which precludes a dealer from sharing, directly or indirectly, in the profits or losses of a transaction in municipal securities with or for a customer.

Credit Default Swaps. The issuance or purchase by a dealer of credit default swaps for which the reference is the issuer for which the dealer is serving as underwriter, or an obligation of that issuer, may pose a conflict of interest, because trading in such municipal credit default swaps has the potential to affect the pricing of the underlying reference obligations, as well as the pricing of other obligations brought to market by that issuer. Rule G-17 requires, therefore, that a dealer disclose the fact that it engages in such activities to the issuers for which it serves as underwriter. Activities with regard to credit default swaps based on baskets or indexes of municipal issuers that include the issuer or its obligation(s) need not be disclosed, unless the issuer or its obligation(s) represents more than 2% of the total notional amount of the credit default swap or the underwriter otherwise caused the issuer or its obligation(s) to be included in the basket or index.

Retail Order Periods

Rule G-17 requires an underwriter that has agreed to underwrite a transaction with a retail order period to, in fact, honor such agreement.[15] A dealer that wishes to allocate securities in a manner that is inconsistent with an issuer’s requirements must not do so without the issuer’s consent. In addition, Rule G-17 requires an underwriter that has agreed to underwrite a transaction with a retail order period to take reasonable measures to ensure that retail clients are bona fide. An underwriter that knowingly accepts an order that has been framed as a retail order when it is not (e.g., a number of small orders placed by an institutional investor that would otherwise not qualify as a retail customer) would violate Rule G-17 if its actions are inconsistent with the issuer’s expectations regarding retail orders. In addition, a dealer that places an order that is framed as a qualifying retail order but in fact represents an order that does not meet the qualification requirements to be treated as a retail order (e.g., an order by a retail dealer without “going away” orders[16] from retail customers, when such orders are not within the issuer’s definition of “retail”) violates its Rule G-17 duty of fair dealing. The MSRB will continue to review activities relating to retail order periods to ensure that they are conducted in a fair and orderly manner consistent with the intent of the issuer and the MSRB’s investor protection mandate.

Dealer Payments to Issuer Personnel

Dealers are reminded of the application of MSRB Rule G-20, on gifts, gratuities, and non-cash compensation, and Rule G-17, in connection with certain payments made to, and expenses reimbursed for, issuer personnel during the municipal bond issuance process.[17] These rules are designed to avoid conflicts of interest and to promote fair practices in the municipal securities market.

Dealers should consider carefully whether payments they make in regard to expenses of issuer personnel in the course of the bond issuance process, including in particular, but not limited to, payments for which dealers seek reimbursement from bond proceeds or issuers, comport with the requirements of Rule G-20. For example, a dealer acting as a financial advisor or underwriter may violate Rule G-20 by paying for excessive or lavish travel, meal, lodging and entertainment expenses in connection with an offering (such as may be incurred for rating agency trips, bond closing dinners, and other functions) that inure to the personal benefit of issuer personnel and that exceed the limits or otherwise violate the requirements of the rule.[18]

August 2, 2012

________________________

[1] The term “municipal entity” is defined by Section 15B(e)(8) of the Securities Exchange Act (the “Exchange Act”) to mean: “any State, political subdivision of a State, or municipal corporate instrumentality of a State, including—(A) any agency, authority, or instrumentality of the State, political subdivision, or municipal corporate instrumentality; (B) any plan, program, or pool of assets sponsored or established by the State, political subdivision, or municipal corporate instrumentality or any agency, authority, or instrumentality thereof; and (C) any other issuer of municipal securities.”

[2] See Reminder Notice on Fair Practice Duties to Issuers of Municipal Securities, MSRB Notice 2009-54 (September 29, 2009); Rule G-17 Interpretive Letter – Purchase of new issue from issuer, MSRB interpretation of December 1, 1997, reprinted in MSRB Rule Book (“1997 Interpretation”).

[3] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 § 975, 124 Stat. 1376 (2010).

[4] MSRB Rule D-9 defines the term “customer” as follows: “Except as otherwise specifically provided by rule of the Board, the term “Customer” shall mean any person other than a broker, dealer, or municipal securities dealer acting in its capacity as such or an issuer in transactions involving the sale by the issuer of a new issue of its securities.”

[5] See MSRB Reminds Firms of Their Sales Practice and Due Diligence Obligations When Selling Municipal Securities in the Secondary Market, MSRB Notice 2010-37 (September 20, 2010).

[6] If a complex municipal securities financing consists of an otherwise routine financing structure that incorporates a unique, atypical or complex element and the issuer personnel have knowledge or experience with respect to the routine elements of the financing, the disclosure of material risks and characteristics may be limited to those relating to such specific element and any material impact such element may have on other features that would normally be viewed as routine.

[7] For example, an underwriter that recommends a VRDO should inform the issuer of the risk of interest rate fluctuations and material risks of any associated credit or liquidity facilities (e.g., the risk that the issuer might not be able to replace the facility upon its expiration and might be required to repay the facility provider over a short period of time). As an additional example, if the underwriter recommends that the issuer swap the floating rate interest payments on the VRDOs to fixed rate payments under a swap, the underwriter must disclose the material financial risks (including market, credit, operational, and liquidity risks) and material financial characteristics of the recommended swap (e.g., the material economic terms of the swap, the material terms relating to the operation of the swap, and the material rights and obligations of the parties during the term of the swap), as well as the material financial risks associated with the VRDO. Such disclosure should be sufficient to allow the issuer to assess the magnitude of its potential exposure as a result of the complex municipal securities financing. The underwriter must also inform the issuer that there may be accounting, legal, and other risks associated with the swap and that the issuer should consult with other professionals concerning such risks. If the underwriter’s affiliated swap dealer is proposed to be the executing swap dealer, the underwriter may satisfy its disclosure obligation with respect to the swap if such disclosure has been provided to the issuer by the affiliated swap dealer or the issuer’s swap or other financial advisor that is independent of the underwriter and the swap dealer, as long as the underwriter has a reasonable basis for belief in the truthfulness and completeness of such disclosure. If the issuer decides to enter into a swap with another dealer, the underwriter is not required to make disclosures with regard to that swap. The MSRB notes that dealers that recommend swaps or security-based swaps to municipal entities may also be subject to rules of the Commodity Futures Trading Commission or those of the Securities and Exchange Commission (“SEC”).

[8] For example, a conflict of interest may exist when the underwriter is also the provider of a swap used by an issuer to hedge a municipal securities offering or when the underwriter receives compensation from a swap provider for recommending the swap provider to the issuer. See also “Conflicts of Interest/Payments to or from Third Parties” herein.

[9] Even a financing in which the interest rate is benchmarked to an index that is commonly used in the municipal marketplace (e.g., LIBOR or SIFMA) may be complex to an issuer that does not understand the components of that index or its possible interaction with other indexes.

[10] Underwriters that assist issuers in preparing official statements must remain cognizant of their duties under federal securities laws. With respect to primary offerings of municipal securities, the SEC has noted, “By participating in an offering, an underwriter makes an implied recommendation about the securities.” See SEC Rel. No. 34-26100 (Sept. 22, 1988) (proposing Exchange Act Rule 15c2-12) at text following note 70. The SEC has stated that “this recommendation itself implies that the underwriter has a reasonable basis for belief in the truthfulness and completeness of the key representations made in any disclosure documents used in the offerings.” Furthermore, pursuant to SEC Rule 15c2-12(b)(5), an underwriter may not purchase or sell municipal securities in most primary offerings unless the underwriter has reasonably determined that the issuer or an obligated person has entered into a written undertaking to provide certain types of secondary market disclosure and has a reasonable basis for relying on the accuracy of the issuer’s ongoing disclosure representations. SEC Rel. No. 34-34961 (Nov. 10, 1994) (adopting continuing disclosure provisions of Exchange Act Rule 15c2-12) at text following note 52.

[11] The MSRB has previously observed that whether an underwriter has dealt fairly with an issuer for purposes of Rule G-17 is dependent upon all of the facts and circumstances of an underwriting and is not dependent solely on the price of the issue. See MSRB Notice 2009-54 and the 1997 Interpretation. See also “Retail Order Periods” herein.

[12] Rule G-13(b)(iii) provides: “For purposes of subparagraph (i), a quotation shall be deemed to represent a "bona fide bid for, or offer of, municipal securities" if the broker, dealer or municipal securities dealer making the quotation is prepared to purchase or sell the security which is the subject of the quotation at the price stated in the quotation and under such conditions, if any, as are specified at the time the quotation is made.”

[13] See 1997 Interpretation.

[14] See also “Required Disclosures to Issuers” herein.

[15] See MSRB Interpretation on Priority of Orders for Securities in a Primary Offering under Rule G-17, MSRB interpretation of October 12, 2010, reprinted in MSRB Rule Book. The MSRB also reminds underwriters of previous MSRB guidance on the pricing of securities sold to retail investors. See Guidance on Disclosure and Other Sales Practice Obligations to Individual and Other Retail Investors in Municipal Securities, MSRB Notice 2009-42 (July 14, 2009).

[16] In general, a “going away” order is an order for new issue securities for which a customer is already conditionally committed. See SEC Release No. 34-62715, File No. SR-MSRB-2009-17 (August 13, 2010).

[17] See MSRB Rule G-20 Interpretation — Dealer Payments in Connection With the Municipal Securities Issuance Process, MSRB interpretation of January 29, 2007, reprinted in MSRB Rule Book.

[18] See In the Matter of RBC Capital Markets Corporation, SEC Rel. No. 34-59439 (Feb. 24, 2009) (settlement in connection with broker-dealer alleged to have violated MSRB Rules G-20 and G-17 for payment of lavish travel and entertainment expenses of city officials and their families associated with rating agency trips, which expenditures were subsequently reimbursed from bond proceeds as costs of issuance); In the Matter of Merchant Capital, L.L.C., SEC Rel. No. 34-60043 (June 4, 2009) (settlement in connection with broker-dealer alleged to have violated MSRB rules for payment of travel and entertainment expenses of family and friends of senior officials of issuer and reimbursement of the expenses from issuers and from proceeds of bond offerings).