Municipal Fund Securities - Request for Comment on Draft Amendment Creating Municipal Fund Securities Limited Principal Category; Interpretive Notice on Commissions and Other Charges, Advertisements and Official Statements

In July 2001, the Municipal Securities Rulemaking Board (“MSRB”) published a notice seeking comment on the application of MSRB rules to fees, disclosure and other market practices relating to municipal fund securities (the “July Notice”).[1] The July Notice also described an amendment to rule G-3 designed to provide a temporary alternative method for qualification of municipal securities principals in connection with municipal fund securities. This amendment, which expires on July 31, 2002, allows general securities and investment company/variable contracts limited principals to serve in a limited principal capacity in connection with transactions in municipal fund securities without qualifying as a municipal securities principal.

After reviewing the comments received on the July Notice, the MSRB has determined to publish for comment a draft amendment to rule G-3, on professional qualifications, creating a permanent municipal fund securities limited principal category. Comments on the draft amendment are due on January 25, 2002. In addition, the MSRB is publishing an interpretive notice providing guidance on the application of its rules to commissions and other charges, advertisements and official statements relating to municipal fund securities.

QUALIFICATION OF MUNICIPAL SECURITIES PRINCIPALS

Rule G-3, on professional qualification, currently requires that a broker, dealer or municipal securities dealer (“dealer”) have at least one municipal securities principal (and in some cases two municipal securities principals), even if the dealer’s only municipal securities transactions are sales of municipal fund securities. In order to provide small dealers seeking to enter the market for municipal fund securities relief from the requirement to immediately obtain a municipal securities principal, the MSRB amended rule G-3 in July 2001 to provide a temporary alternative method for qualification of principals in connection with municipal fund securities. Under this temporary provision, until July 31, 2002, if a dealer’s municipal securities activities are limited exclusively to municipal fund securities and the dealer has fewer than 11 associated persons engaged in such activities, it may fulfill its obligation to have a municipal securities principal by designating a general securities or investment company/variable contracts limited principal to act as a limited principal.[2] During this period, any designated limited principal will have all of the powers and responsibilities of a municipal securities principal under MSRB rules with respect to transactions in municipal fund securities. On and after August 1, 2002, dealers effecting transactions in municipal fund securities would be required to comply with the same municipal securities principal requirements applicable to all other dealers effecting transactions in municipal securities.

All commentators supported the amendment. However, one commentator suggested that this transitional provision be made permanent and that it be broadened to apply to all dealers whose municipal securities activities are limited exclusively to municipal fund securities, regardless of the number of associated persons engaged in such activities. Another commentator suggested that the MSRB exempt dealers and their personnel from the licensing requirements if their sole purpose for becoming licensed is to make available municipal fund securities.

The MSRB believes that it would not be appropriate to make permanent or to broaden the temporary provision allowing general securities or investment company/variable contracts limited principals to serve as principals with respect to municipal fund securities transactions. Although the securities themselves are, in many respects, quite similar to traditional mutual fund or money market fund shares, there is a fundamental difference in the two markets in that there are few legal obligations for issuers of municipal fund securities to maintain this similarity over time. Thus, the nature of issuer disclosures, fee structures, fund governance and other matters as they relate to municipal fund securities can potentially differ significantly from what is permissible with respect to registered investment company securities. This type of difference has always existed with respect to traditional municipal debt securities and, as a result, a number of unique MSRB rules have evolved over the years to provide investor protections through dealer regulation in an environment where issuers have very limited legal obligations with respect to such protections. These MSRB rules also provide important protection to investors in municipal fund securities and it is vital that principals who supervise the municipal fund securities activities of dealers be fully versed in those rules.[3]

Thus, the MSRB is proposing the creation of a new category of principals to serve permanently as municipal fund securities limited principals. Qualification as a municipal fund securities limited principal would be by an examination made up of questions on the broad range of MSRB-specific topics that are relevant to municipal fund securities activities. The examination would not be as extensive as the typical existing principal examination (e.g., Series 24, 26 or 53)[4] and would require that the individual taking it have previously or concurrently taken and passed the Series 24 or Series 26 examination. Thus, an individual wishing to supervise municipal fund securities activities could qualify to do so either (i) by becoming a municipal securities principal through the Series 53 examination or (ii) by becoming a municipal fund securities limited principal through this new qualification examination if the individual is already or concurrently becomes a general securities or investment company/variable contracts limited principal. If a dealer’s municipal securities activities are limited to municipal fund securities, the draft amendment also would count all municipal fund securities limited principals toward the numerical requirement for principals regardless of the number of associated persons engaging in such activities. Finally, the draft amendment would make clear that an investment company/variable contracts limited representative that engages in municipal fund securities activities is qualified to take the Series 53 examination to become a municipal securities principal.

COMMISSIONS AND OTHER CHARGES, ADVERTISEMENTS AND OFFICIAL STATEMENTS

Amount of Dealer’s Commissions or Service Charges

Rule G-30(b), on prices and commissions in agency transactions, prohibits dealers from selling municipal securities to a customer for a commission or service charge in excess of a fair and reasonable amount. The MSRB noted in the July Notice that the rule permits dealers to consider a number of factors in assessing the fairness and reasonableness of commissions and stated that the sales charge schedule set out in NASD Rule 2830 in connection with the sale of registered investment company securities may, depending upon the facts and circumstances, provide some relevant information. The MSRB stated, however, that the NASD schedule is by no means dispositive or the principal factor in determining compliance with rule G-30.

One commentator suggested that the MSRB incorporate the standards of NASD Rule 2830 for purposes of limiting sales charges for municipal fund securities or interpret rule G-30 to deem “fair and reasonable commission or service charges” to mean sales charges that would be in compliance with the amounts set forth in Rule 2830.[5] As stated in the July Notice, the MSRB believes that it does not have the authority to establish a sales charge schedule. However, the MSRB provides further elaboration in the Interpretive Notice on Commissions, Disclosures and Advertisements Relating to Municipal Fund Securities set forth at the end of this notice (the “Interpretive Notice”) on the applicability of NASD Rule 2830 and other relevant factors in determining a fair and reasonable commission under MSRB rule G-30.

Disclosure of Commissions

In the July Notice, the MSRB stated that rules G-15 and G-32 set forth certain obligations to disclose fees and other charges received by the dealer in connection with municipal fund securities transactions. Among other things, rule G-15 requires that a dealer disclose on the confirmation the amount of any transaction-based remuneration received or to be received by the dealer from the customer and the nature and amount of any miscellaneous fees charged.

Two commentators stated that, to the extent that the official statement for municipal fund securities provide disclosure concerning the dealer’s commissions and fees, the MSRB should permit dealers to omit such information from the confirmation. One commentator noted that Exchange Act Rule 10b-10, on confirmations of non-exempted securities transactions, has a disclosure requirement regarding the amount and source of remuneration to dealers that is similar to the requirement under MSRB rule G-15. This commentator stated that the SEC has taken a no-action position to the effect that a confirmation of a transaction in a mutual fund share is not required to include information relating to transaction-based sales load or other charges if the customer has received, at or before settlement, a prospectus that discloses the precise amount of the sales load or other charges or a formula that would enable the customer to calculate these charges.[6] However, if a dealer receives remuneration that is not disclosed in the prospectus, that remuneration must be separately disclosed on a confirmation. The commentators argued that not permitting disclosure to occur in the official statement rather than on the confirmation would require an expensive redesign of existing confirmation formats and that, given the size of the confirmation, a comprehensive and more meaningful disclosure of such information can be given in the official statement. The MSRB has taken these comments under advisement but is taking no action at this time.

Disclosure of Program Fees and Charges of Other Parties; Advertisements

The July Notice reviewed existing disclosure rules, including MSRB rules G-17 and G-32 and Exchange Act Rules 10b-5 and 15c2-12, and concluded that these rules may have the practical effect of requiring some level of disclosure of fees and charges received by parties (other than the dealer) to a transaction in municipal fund securities. In addition, the July Notice described the applicability of MSRB rule G-21, on advertising, to advertisements of municipal fund securities that refer to the historical yield of such securities. The MSRB noted that, depending upon the facts and circumstances, such an advertisement may be required to include information regarding a fee or other charge relating to the municipal fund securities that may have a material effect on an advertised yield, to the extent that such disclosure is necessary to ensure that the advertisement is not materially false or misleading.

Two commentators concurred with the MSRB’s conclusions regarding disclosure of program fees and charges. One commentator recommended that the MSRB state that an advertisement for municipal fund securities that complies with Securities Act Rule 482, on investment company advertisements, and NASD Rule 2210, on communications with the public, will not be deemed materially false or misleading for purposes of MSRB rule G-21. In the Interpretive Notice, the MSRB reiterates its guidance on disclosure of program fees and charges of parties other than the dealer under MSRB rules G-17 and G-32. The MSRB also provides interpretive guidance in the Interpretive Notice to the effect that compliance with certain SEC and NASD advertising rules applicable to registered investment company securities generally would satisfy the advertisement requirements relating to municipal fund securities under MSRB rule G-21.

Submission of Official Statements to the MSRB

In the July Notice, the MSRB provided guidance under rule G-36 to the effect that the primary distributor of municipal fund securities in a multi-tiered distribution system has the responsibility to take all actions required in connection with submission of the official statement to the MSRB as if it were the managing underwriter of an underwriting syndicate. The MSRB did not receive any comments on this portion of the July Notice. In the Interpretive Notice, the MSRB extends its guidance regarding compliance with rule G-36 for selling dealers in multi-tiered distribution systems to include wholesalers as well.

MISCELLANEOUS ISSUES

Rule G-37. In the July Notice, the MSRB reminded dealers that rule G-37 applies to their municipal securities activities even if those activities are limited to municipal fund securities. The MSRB stated that, absent unusual circumstances, the primary distributor of municipal fund securities should be considered to be engaged in municipal securities business for purposes of rule G-37. The July Notice sought comment on whether selling dealers in multi-tiered distribution systems also should be considered to be engaged in municipal securities business.

The MSRB received comments from several commentators on the application of rule G-37 to the municipal fund securities activities of dealers. These comments are being reviewed by the MSRB in conjunction with a broader examination of various provisions of rule G-37.

Capacity of Dealer. The July Notice sought comment on a number of factors relating to the capacity of dealers in connection with transactions in municipal fund securities. The MSRB sought comment on whether transactions in municipal fund securities are ever undertaken in a principal capacity. In addition, in cases where such securities are sold in a multi-tiered distribution system, the MSRB sought information regarding which dealer in this system was effecting the transaction and therefore which dealer has the customer protection obligations imposed under various MSRB rules, including but not limited to rule G-19, on suitability of recommendations and transactions. Furthermore, the MSRB asked whether inter-dealer trades in municipal fund securities exist.

One commentator stated that, to its knowledge, all transactions effected between the issuer of such securities and the investor are conducted on an agency basis. It further stated that, based upon the structure of many municipal fund securities programs (particularly Section 529 plans), these securities likely could not be traded on a principal basis because of restrictions in the program regarding eligibility of investors and transferability of interests in the plan resulting from federal tax law requirements. Another commentator stated that, in connection with the plan for which it serves as program manager, neither it nor any selling dealer purchases municipal fund securities for its own account or maintains an inventory in municipal fund securities.

Three commentators stated that the selling dealer in a multi-tiered distribution system should have the customer protection obligations under MSRB rules. They noted that it is the selling dealer that has the relationship with the customer and that the primary distributor generally does not have information regarding the customer. One of these commentators stated that if any recommendation is made to a customer, it is made by the selling dealer. Another of these commentators stated that the selling dealer has knowledge of the prospective purchaser’s financial circumstances, risk tolerance and other relevant factors. All three commentators also stated that they are unaware of any inter-dealer trades occurring in municipal fund securities.

The MSRB has concluded that no further action is called for in these areas at this time. The MSRB reminds dealers that effect transactions in municipal fund securities with customers that they must be cognizant of their customer protection duties under MSRB rules. The MSRB urges dealers serving as primary distributors in multi-tiered distribution systems to help educate selling dealers as to their front-line responsibilities under the MSRB’s customer protection rules.

* * * * *

Comments on the draft amendment to rule G-3 are due by January 25, 2002 and may be directed to Ernesto A. Lanza, Senior Associate General Counsel, or Jill C. Finder, Assistant General Counsel. Written comments will be available for public inspection.

December 19, 2001

* * * * *

Text of Draft Amendment to Rule G-3 [7]

Rule G-3 – Classification of Principals and Representatives; Numerical Requirements; Testing; Continuing Education Requirements

(a) No change.

(b) Municipal Securities Principal; Municipal Fund Securities Limited Principal.

(i) No change.

(ii) Qualification Requirements.

(A) No change.

(B) Any person seeking to become qualified as a municipal securities principal in accordance with subparagraph (b)(ii)(A) of this rule, must, prior to being qualified as a municipal securities principal:

(1) have been duly qualified as either a municipal securities representative, or a general securities representative or limited representative – investment company and variable contracts products; or

(2) have taken and passed either the Municipal Securities Representative Qualification Examination, or the General Securities Registered Representative Examination or Limited Representative – Investment Company and Variable Contracts Products Examination.

(C) No change.

(D) For the first 90 days after becoming a municipal securities principal, the requirements of subparagraph (b)(ii)(A) shall not apply to any person who is qualified as a municipal securities representative, general securities representative, limited representative – investment company and variable contracts products, or general securities principal or investment company/variable contracts limited principal, provided, however, that such person shall take and pass the Municipal Securities Principal Qualification Examination within that period.

(iii) No change.

(iv) Temporary Provisions for Municipal Fund Securities Limited Principal. Until July 31, 2002, the following provisions shall apply to any broker, dealer or municipal securities dealer whose municipal securities activities are limited exclusively to municipal fund securities:

(A) notwithstanding the provisions of paragraph (b)(ii), the broker, dealer or municipal securities dealer may designate any person who has taken and passed the General Securities Principal Qualification Examination or Investment Company and Annuity Principal Qualification Examination as a municipal fund securities limited principal. Definition. The term “municipal fund securities limited principal” means a natural person (other than a municipal securities principal or municipal securities sales principal), associated with a broker, dealer or municipal securities dealer that has filed with the Board in compliance with rule A-12, who is directly engaged in the functions of a municipal securities principal as set forth in paragraph (b)(i), but solely as such activities relate to transactions in municipal fund securities.

(B) Qualification Requirements.

(1) Every municipal fund securities limited principal shall take and pass the Municipal Fund Securities Limited Principal Qualification Examination prior to being qualified as a municipal fund securities limited principal. The passing grade shall be determined by the Board.

(2) Any person seeking to become qualified as a municipal fund securities limited principal in accordance with clause (b)(iv)(B)(1) of this rule, must, as a condition to being qualified as a municipal fund securities limited principal:

(a) have been duly qualified as either a general securities principal or an investment company/variable contracts limited principal; or

(b) have taken and passed either the General Securities Principal Qualification Examination or the Investment Company and Annuity Principal Qualification Examination.

(3) Any person who ceases to act as a municipal fund securities limited principal for two or more years at any time after having qualified as such shall meet the requirements of clauses (b)(iv)(B)(1) and (2) prior to being qualified as a municipal fund securities limited principal.

(4) For the first 90 days after becoming a municipal fund securities limited principal, the requirements of subparagraph (b)(iv)(B)(1) and (2) shall not apply to any person who is qualified as a municipal securities representative, general securities representative, investment company/variable contracts limited representative, general securities principal or investment company/variable contracts limited principal, provided, however, that such person shall take and pass the Municipal Fund Securities Limited Principal Qualification Examination and shall meet the requirements of subparagraph (b)(iv)(B)(2) within that period.

(C) Actions as Municipal Securities Principal. Any (B) any municipal fund securities limited principal designated as provided in subparagraph (b)(iv)(A) may undertake all actions required or permitted under any Board rule to be taken by a municipal securities principal, but solely with respect to activities related to municipal fund securities.

(D) Numerical Requirements. Any (C) the broker, dealer or municipal securities dealer whose municipal securities activities are limited exclusively to municipal fund securities may count any one municipal fund securities limited principal toward the numerical requirement for municipal securities principal set forth in paragraph (b)(iii); provided that, if such broker, dealer or municipal securities dealer is only required to have one municipal securities principal, such broker, dealer, or municipal securities dealer may count one municipal fund securities limited principal toward the numerical requirement only if the broker, dealer or municipal securities dealer is described in subparagraph (b)(iii)(B).

(c)-(h) No change.

* * * * *

INTERPRETIVE NOTICE ON COMMISSIONS AND OTHER CHARGES, ADVERTISEMENTS AND OFFICIAL STATEMENTS RELATING TO MUNICIPAL FUND SECURITIES

The Municipal Securities Rulemaking Board (“MSRB”) has received various inquiries regarding commissions, disclosures (including delivery of disclosure materials to the MSRB) and advertisements relating to municipal fund securities, particularly in connection with sales of interests in so-called Section 529 college savings plans.[8] The nature of the commissions and other program fees that may exist with respect to municipal fund securities may differ significantly from such charges that typically may exist for traditional debt securities sold in the municipal securities market. In many cases, commissions and other fees may more closely resemble those charged in connection with investment company securities registered under the Investment Company Act of 1940 (the “Investment Company Act”). [9] Although commissions and fees charged by brokers, dealers and municipal securities dealers (“dealers”) effecting transactions in municipal fund securities are subject to MSRB rules, the nature and level of fees and charges collected by other parties in connection with such securities generally are not subject to regulation. However, under certain circumstances, a dealer selling municipal fund securities may be obligated to disclose to customers such fees and charges collected by other parties.

Amount of Dealer’s Commissions or Service Charges

Rule G-30(b), on prices and commissions in agency transactions, prohibits dealers from selling municipal securities to a customer for a commission or service charge in excess of a fair and reasonable amount. In assessing the fairness and reasonableness of the commission or service charge, the rule permits the dealer to take into consideration all relevant factors, including the availability of the securities involved in the transaction, the expense of executing or filling the customer’s order, the value of the services rendered by the dealer, and the amount of any other compensation received or to be received by the dealer in connection with the transaction. The MSRB has received inquiries as to whether the sales charge schedule set out in Rule 2830 of the National Association of Securities Dealers, Inc. (“NASD”) applies to or otherwise is indicative of the levels of commissions and other fees that dealers may charge in connection with sales of municipal fund securities.

MSRB rules, not those of the NASD, apply to sales by dealers of municipal securities, including municipal fund securities. NASD Rule 2830 provides that no member firm may offer or sell shares in investment companies registered under the Investment Company Act if the sales charges are excessive. The NASD rule then sets forth various levels of aggregate sales charges to which member firms must conform, depending upon the nature of the investment company’s sales charges, in order to ensure that such sales charges are not deemed excessive. The MSRB notes that the NASD derives its authority for the sales charge provisions of Rule 2830 from Section 22(b)(1) of the Investment Company Act, which expressly exempts such provisions from the limitation that Section 15A(b)(6) of the Securities Exchange Act of 1934 (the “Exchange Act”) places on the NASD’s ability to adopt rules that “impose any schedule or fix rates of commissions, allowances, discounts, or other fees to be charged by its members.” In sharp contrast, no exemption exists from the limitations that Section 15B(b)(2)(C) of the Exchange Act places on the MSRB’s ability to adopt rules that “impose any schedule or fix rates of commissions, allowances, discounts, or other fees to be charged by municipal securities brokers or municipal securities dealers.” The MSRB believes that it could not, by rule or interpretation, in effect impose such a schedule for the sale of municipal fund securities.

Nonetheless, the MSRB believes that the charges permitted by the NASD under its Rule 2830 in connection with the sale of registered investment company securities may, depending upon the facts and circumstances, be a significant factor in determining whether a dealer selling municipal fund securities is charging a commission or other fee that is fair and reasonable. For example, the MSRB believes that charges for municipal fund securities transactions in excess of those permitted for comparable mutual fund shares under NASD Rule 2830 may be presumed to not meet the fair and reasonable standard under MSRB rule G-30(b), although the totality of the facts and circumstances relating to a particular transaction in municipal fund securities may rebut such presumption. Further, depending upon the specific facts and circumstances, a sales charge for a transaction in a municipal fund security that would be deemed in compliance with NASD Rule 2830 if charged in connection with a transaction in a substantially identical registered investment company security often will be in compliance with rule G-30(b).

However, the NASD schedule is not dispositive nor is it always the principal factor in determining compliance with rule G-30. The MSRB believes that the factors enunciated in rule G-30(b) and other relevant factors must be given due weight in determining whether a commission is fair and reasonable. These factors include, but are not limited to, the value of the services rendered by the dealer and the amount of any other compensation received or to be received by the dealer in connection with the transaction from other sources (such as the issuer). A dealer may not exclusively rely on the fact that its commissions fall within the NASD schedule, particularly where commission levels in the marketplace for similar municipal fund securities sold by other dealers providing similar levels of services are generally substantially lower than those charged by such dealer, taking into account any other compensation.

Disclosure of Program Fees and Charges of Other Parties

MSRB rules do not explicitly require disclosure by dealers of fees and charges received by other parties to a transaction. These can include, among other things, administrative fees of the issuer, investment adviser and other parties payable from trust assets or directly by the customer. However, depending upon the facts and circumstances, certain MSRB rules may have the practical effect of requiring some level of disclosure of such fees and charges to the extent that they are material. For example, rule G-32(a)(i) generally obligates the dealer to provide an official statement to its customer in connection with sales of municipal fund securities. Although MSRB rules do not govern the content of the disclosures included by the issuer in the official statement, the MSRB believes that an official statement prepared by an issuer of municipal fund securities that is in compliance with Exchange Act Rules 10b-5 and 15c2-12 generally would provide disclosure of any fees or other charges imposed in connection with such securities that are material to investors. The MSRB further believes that, in most respects, the disclosures provided by the issuer in the official statement would provide the dealer with the type of information it is required to disclose to customers under the MSRB’s fair dealing rule, rule G-17.

Advertisements

Dealer advertisements of municipal fund securities must comply with the requirements of rule G-21.[10] This rule prohibits dealers from publishing advertisements concerning municipal securities which they know or have reason to know are materially false or misleading. The MSRB has previously stated that any use of historical yields in an advertisement would be subject to this prohibition. Thus, a dealer advertisement of municipal fund securities that refers to yield typically would require a description of the nature and significance of the yield shown in the advertisement in order to assure that such advertisement is not false or misleading. Further, depending upon the facts and circumstances, a dealer may be required to disclose information regarding a fee or other charge relating to municipal fund securities that may have a material effect on such advertised yield, to the extent that such disclosure is necessary to ensure that the advertisement is not materially false or misleading with respect to such yield.

The MSRB understands that advertisements and other sales material relating to registered investment company securities are, depending upon the nature of the advertisement, subject to the requirements of Securities Act Rule 156, on investment company sales literature, Securities Act Rule 482, on advertising by an investment company as satisfying requirements of section 10, and NASD Rule 2210, on communications with the public (including IM-2210-3, on use of rankings in investment companies advertisements and sales literature), among others. The MSRB notes that both Securities Act Rule 156(a) and NASD Rule 2210(d)(1)(A) include general standards for advertisements that are substantially the same as the standard set forth in MSRB rule G-21. As a result, the MSRB believes that a dealer advertisement of municipal fund securities that would be compliant with Securities Act Rules 156 and 482 if such securities were registered investment company securities also would be in compliance with MSRB rule G-21. Further, the MSRB believes that a dealer advertisement of municipal fund securities that would be compliant with NASD Rule 2210 and IM-2210-3 if such securities were registered investment company securities also would be in compliance with MSRB rule G-21.

Submission of Official Statements to the MSRB

Dealers selling municipal fund securities are subject to the requirement under rule G-36 that they submit copies of the official statement, together with completed Form G-36(OS), to the MSRB. In some cases, a dealer that has been engaged by an issuer of municipal fund securities to serve as its primary distributor (“primary distributor”) has in turn entered into relationships with one or more other dealers to provide further channels for distribution. These other dealers may include dealers that effect transactions directly with customers (“selling dealers”) or dealers that provide “wholesale” distribution services but do not effect transactions directly with customers (“intermediary dealers”).

The MSRB believes that, regardless of whether a formal syndicate or similar account has been formed among a primary distributor, the selling dealers and any intermediary dealers in a multi-tiered distribution system for a particular offering of municipal fund securities, the primary distributor for such offering has the responsibility set forth in rule G-36(f) to undertake all actions required under the provisions of rule G-36 and the corresponding recordkeeping requirements under rule G-8(a)(xv). These obligations include, but are not limited to, the submission of official statements (including amendments and up-dates) and completed Form G-36(OS) to the MSRB on a timely basis. The MSRB further believes that any selling or intermediary dealers for such offering that might be considered underwriters of the securities may rely upon the primary distributor to undertake these actions to the same extent as if they had in fact formed an underwriting syndicate as described in rule G-36(f).