Indirect Rule Violations: Rules G-37 and G-38

The Municipal Securities Rulemaking Board’s (“MSRB” or “Board”) statutory mandate is to protect investors and the public interest in connection with dealers’ activities in the municipal securities market.  The municipal securities market is one of the world’s leading securities markets.  Investors hold approximately $1.6 trillion worth of municipal securities—either through direct ownership or through investment in institutional portfolios.  These investors provide much needed capital to more than 50,000 state and local governments.  Maintaining municipal market integrity is an exceptionally high priority for the Board as it seeks to foster a fair and efficient municipal securities market through dealer regulation. 

In 1994, the MSRB adopted Rule G-37 in an effort to remove the real or perceived conflict of interest of issuers who receive political contributions from dealers and award municipal securities business to such dealers.  As noted by the Court reviewing Rule G-37, “underwriters’ campaign contributions self-evidently create a conflict of interest in state and local officials who have power over municipal securities contracts and a risk that they will award the contracts on the basis of benefit to their campaign chests rather than to the governmental entity.”[1] Pay-to play harms the integrity of the underwriter selection process.

In general, Rule G-37 prohibits brokers, dealers and municipal securities dealers (“dealers”) from engaging in municipal securities business with issuers if certain political contributions have been made to officials of such issuers; prohibits dealers and municipal finance professionals (“MFP”) from soliciting or bundling contributions to an official of an issuer with which the dealer is engaging or seeking to engage in municipal securities business; and requires dealers to record and disclose certain political contributions, as well as other information, to allow public scrutiny of political contributions and the municipal securities business of a dealer.  The rule also seeks to ensure that payments made to political parties by dealers, MFPs, and political action committees (“PAC”) not controlled by the dealer or MFP do not represent attempts to make indirect contributions to issuer officials in contravention of Rule G-37 by requiring dealers to record and disclose all payments made to state and local political parties.[2]  The party payment disclosure requirements were intended to assist in severing any connection between payments to political parties (even if earmarked for expenses other than political contributions) and the awarding of municipal securities business.[3] 

Although Rule G-37 initially included certain limited disclosure requirements for consultants used by dealers to obtain municipal securities business, in 1996, the MSRB adopted a separate Rule G-38, on consultants, to prevent persons from circumventing Rule G-37 through the use of consultants.  Rule G-38 currently requires dealers who use consultants[4] to evidence the consulting arrangement in writing, to disclose, in writing, to an issuer with which it is engaging or seeking to engage in municipal securities business information on consulting arrangements relating to such issuer, and to submit to the Board, on a quarterly basis, reports of all consultants used by the dealer, amounts paid to such consultants, and certain political contribution and payment information from the consultant.

The impact of Rules G-37 and G-38 has been very positive.  The rules have altered the political contribution practices of municipal securities dealers and opened discussion about the political contribution practices of the entire municipal industry. 

While the Board is pleased with the success of these rules, it also is concerned with increasing signs that individuals and firms subject to the rules may be seeking ways around Rule G-37 through payments to political parties or non-dealer controlled PACs that find their way to issuer officials, significant political contributions by dealer affiliates (e.g., bank holding companies and affiliated derivative counterparty subsidiaries) to both issuer officials and political parties, contributions by associated persons of the dealer who are not MFPs and by the spouses and family members of MFPs to issuer officials, and the use of consultants who make or bundle political contributions.  In addition to dealer and dealer-related giving, the Board is also concerned about media and other reports regarding significant giving by other market participants, including independent financial advisors, swap advisors, swap counterparties, investment contract providers and public finance lawyers.

The MSRB is mindful that Rule G-37’s prohibitions involve sensitive constitutional issues and is reluctant to significantly broaden the scope of the rule.  The rule was constructed and will continue to be reviewed with full regard for and consideration of an individual’s right to participate fully in our political processes.  The Board, however, wishes to remind dealers that Rule G-37, as currently in effect, covers indirect as well as direct contributions to issuer officials, and to alert dealers that it has expressed its concern to the entities that enforce the Board’s rules that some of the increased political giving may indicate a rise in indirect Rule G-37 violations.  While Rule G-37 was adopted to deal specifically with contributions made to officials of issuers by dealers and MFPs, and PACs controlled by dealers or MFPs, the rule also prohibits MFPs and dealers from using conduits—be they parties, PACs, consultants, lawyers, spouses or affiliates—to contribute indirectly to an issuer official if such MFP or dealer can not give directly to the issuer without triggering the ban on business.  The MSRB will continue to work with the enforcement agencies to identify and halt abusive practices.  If, at a later date, the Board learns of specific problematic dealer practices that it believes must be addressed more directly, the Board may proceed with additional rulemaking relating to Rules G-37 and G-38. 

The Board strongly believes that pay-to-play undermines the integrity of the municipal securities industry.  Such practices are regulated not only by the specific parameters of Rule G-37, but also by the fair practice principles embodied in the MSRB’s Rule G-17, on fair dealing.  Similarly, the MSRB reminds issuers and dealers that the SEC has previously advised that, with respect to primary offering disclosure, increased attention needs to be directed at disclosure of potential conflicts of interest and material financial relationships among issuers, advisors and underwriters, including those arising from political contributions.[5]  These issuer conflicts of interest can and do arise not only from contributions made by municipal securities dealers, but also from payments by unregulated municipal securities market participants.

The costs of political campaigns are skyrocketing across the country.  The MSRB is aware of reports that elected officials, or persons acting on behalf of elected officials, are putting pressure on dealers and MFPs to find ways to contribute to the costs associated with political campaigns.  The Board also recognizes that there is significant political giving that is not by, or directed by, municipal securities dealers.  Thus, the MSRB wishes to encourage state and local governments to take a fresh look at these issues and see whether their policies and procedures should be revised to help maintain the integrity of the underwriting process.  The Board believes that it is critical that the municipal market engender the highest degree of public confidence so that investors will continue to provide much needed capital to state and local governments.