Introduction 

In view of the important role that broker’s brokers play in the provision of secondary market liquidity for municipal securities owned by retail investors, MSRB Rule G-43 sets forth particular rules to which broker’s brokers are subject.  Rule G-43(a)(i) provides:

Each dealer acting as a "broker’s broker"[1] with respect to the execution of a transaction in municipal securities for or on behalf of another dealer shall make a reasonable effort to obtain a price for the dealer that is fair and reasonable in relation to prevailing market conditions.  The broker’s broker must employ the same care and diligence in doing so as if the transaction were being done for its own account.[2]

In guidance on broker’s brokers issued in 2004,[3] the MSRB noted the role of some broker’s brokers in large intra-day price differentials of infrequently traded municipal securities with credits that were relatively unknown to most market participants, especially in the case of “retail” size blocks of $5,000 to $100,000.  In certain cases, differences between the prices received by the selling customers as a result of a broker’s broker bid-wanted and the prices paid by the ultimate purchasing customers on the same day were 10% or more.  After the securities were purchased from the broker’s broker, they were sold to other dealers in a series of transactions until they eventually were purchased by other customers.  The abnormally large intra-day price differentials were attributed in major part to the price increases found in the inter-dealer market occurring after the broker’s brokers’ trades.

Rule G-43 addresses the role of broker’s brokers, including their role in such a series of transactions.  It is the role of the broker’s broker to conduct a properly run bid-wanted or offering and thereby satisfy its duty to make a reasonable effort to obtain a price for the dealer that is fair and reasonable in relation to prevailing market conditions.  The MSRB believes that a bid-wanted or offering conducted in the manner provided in Rule G-43 will be an important element in the establishment of a fair and reasonable price for municipal securities in the secondary market.  This notice addresses the roles of other transaction participants, specifically the brokers, dealers, and municipal securities dealers (“dealers”) that sell, and bid for, municipal securities in bid-wanteds and offerings conducted by broker’s brokers.  Those selling dealers (“sellers”) and bidding dealers (“bidders”) also have pricing duties under MSRB rules and their failure to satisfy those duties could negate the reasonable efforts of a broker’s broker to achieve fair pricing.

Duties of Bidders

Rule G-13(b)(i) provides that, in general, “no broker, dealer or municipal securities dealer shall distribute or publish, or cause to be distributed or published, any quotation relating to municipal securities, unless the quotation represents a bona fide bid[4] for, or offer of, municipal securities by such broker, dealer or municipal securities dealer.”  Rule G-13(b)(ii) provides that “[n]o broker, dealer or municipal securities dealer shall distribute or publish, or cause to be distributed or published, any quotation relating to municipal securities, unless the price stated in the quotation is based on the best judgment of such broker, dealer or municipal securities dealer of the fair market value of the securities which are the subject of the quotation at the time the quotation is made.”

Dealers that submit bids to broker’s brokers that they believe are below the fair market value of the securities or that submit “throw-away” bids to broker’s brokers do so in violation of Rule G-13.  While bidders are entitled to make a profit, Rule G-13 does not permit them to do so by “picking off” other dealers at off-market prices.  Throw-away bids, by definition, violate Rule G-13, because throw-away bids are arrived at without an analysis by the bidder of the fair market value of the municipal security that is the subject of the bid.  A conclusion by the bidder that a security must be worth “at least that much,” without any knowledge of the security or comparable securities and without any effort to analyze the security’s value is not based on the best judgment of such bidder of the fair market value of the securities within the meaning of Rule G-13(b)(ii).  When the MSRB first proposed Rule G-13, it explained in a February 24, 1977 letter from Frieda Wallison, Executive Director and General Counsel, MSRB, to Lee Pickard, Director, Division of Market Regulation, Securities and Exchange Commission that, among the activities that Rule G-13 was designed to prevent was the placing of a bid that is “pulled out of the air,” which is another way to describe a throw-away bid.

Furthermore, when a dealer’s bid is accepted and a transaction in the securities is executed, that transaction price (and accordingly the bid itself) will be disseminated within the meaning of Rule G-13(a)(i) on the MSRB’s Electronic Municipal Market Access (EMMA®) platform within 15 minutes after the time of trade.  At that point, if the bid is off-market, it will create a misperception in the municipal marketplace of the true fair market value of the security.  The fact that the bid price that wins a bid-wanted or offering may well not represent the true fair market value of the security is evidenced by the trade activity observed by enforcement agencies following such auctions.  Enforcement agencies have informed the MSRB that they continue to observe the same kinds of series of transactions in municipal securities that prompted the MSRB’s 2004 pricing guidance.  They have also informed the MSRB about their observations of other trading patterns that indicate some market participants may misuse the role of the broker’s broker in the provision of secondary market liquidity and may cause retail customers who liquidate their municipal securities by means of broker’s brokers to receive unfair prices.

Duties of Sellers

Dealers that use the services of broker’s brokers to sell municipal securities for their customers also have significant fair pricing duties under Rule G-30 when they act as a principal.  As the MSRB noted in its request for comment on Draft Rule G-43,[5]

the information about the value of municipal securities provided to a selling dealer by a broker’s broker is only one factor that the dealer must take into account in determining a fair and reasonable price for its customer.  In fact, in 2004, the National Association of Securities Dealers (“NASD”) announced that it had fined eight dealers for relying solely on prices obtained in bid-wanteds conducted by broker’s brokers, which the NASD found to be significantly below fair market value.[6]  In that same year, the MSRB said that “particularly when the market value of an issue is not known, a dealer . . . may need to check the results of the bid wanted process against other objective data to fulfill its fair pricing obligations . . . .”

Under those circumstances where broker’s brokers seeks to satisfy their fair pricing obligations in bid-wanteds conducted pursuant to Rule G-43(b), Rule G-43(b)(v) provides for notice by broker’s brokers to sellers when bids in bid-wanteds are below predetermined parameters that are designed to identify possible off-market bids (e.g., those based on yield curves, pricing services, recent trades reported to the MSRB’s RTRS System, or bids received by broker’s brokers in prior bid-wanteds or offerings).  Once a seller has received such notice, it must direct the broker’s broker as to whether to execute the trade at that price.  That notice by the broker’s broker and required action on the part of the seller should put the seller on notice that it must take additional steps to ascertain whether the high bid provided to it by the broker’s broker is, in fact, a fair and reasonable price for the securities.  Rule G-30 mandates that the seller, if acting as a principal, must not buy municipal securities from its customer at a price that is not fair and reasonable (taking any mark-down into account), taking into consideration all relevant factors, including those listed in the rule.

The MSRB notes that Rule G-8(a)(xxv)(E) requires broker’s brokers to keep records when they have provided the seller with the notice described in Rule G-43(b)(v).  Among the required records are the full name of the person at the seller who received the notice, the direction given by the seller firm following the notice, and the full name of the person at the seller who provided that direction.

Rule G-43(b)(i) permits a broker’s broker to limit the audience for a bid-wanted at the selling dealer’s direction, a practice sometimes referred to as “screening” or “filtering,” because the MSRB recognizes that there may be legitimate reasons for this practice.  However, the MSRB notes that such screening may reduce the likelihood that the high bid represents a fair and reasonable price.  Selling dealers should, therefore, be able to demonstrate a reason that is not anti-competitive (e.g., credit, legal, or regulatory concerns), rather than trying to eliminate access by a competitor, for directing broker’s brokers to screen certain bidders from the receipt of bid-wanteds or offerings.  For example, a selling dealer might maintain a list of the firms it would be unwilling to accept as a counterparty and the reasons why.

The MSRB recognizes that there may be circumstances under which customers may need to liquidate their municipal securities quickly and that there are limitations on the ability of a bid-wanted or offering to achieve a price that is comparable to recent trade prices under certain circumstances, particularly in view of its timing and the presence or absence of regular buyers in the marketplace.  Nevertheless, the MSRB urges sellers not to assume that their customers need to liquidate their securities immediately without inquiring as to their customers’ particular circumstances and discussing with their customers the possible improved pricing benefit associated with taking additional time to liquidate the securities.

Rule G-17 requires dealers, in the conduct of their municipal securities activities, to deal fairly with all persons and to not engage in any deceptive, dishonest, or unfair practice.  Broker’s brokers have informed the MSRB that many dealers place bid-wanteds and offerings with broker’s brokers with no intention of selling the securities through the broker’s brokers.  Some have noted that shortly thereafter they see the same securities purchased by dealers for their own accounts at prices that exceed the high bid obtained by the broker’s brokers by only a very small amount.  Other dealers have told the MSRB that they are skeptical of many of the bid-wanteds they see, because they think the bid-wanteds are only being used for price discovery by the selling dealers and are not real.  Accordingly, in many cases, they do not bid.  This use of broker’s brokers solely for price discovery purposes harms the bid-wanted and offering process by reducing bidders, thereby reducing the likelihood that the high bid in a bid-wanted will represent the fair market value of the securities.  Additionally, it causes broker’s brokers to work without reasonable expectation of compensation.  For those reasons, depending upon the facts and circumstances, the use of bid-wanteds solely for price discovery purposes may be an unfair practice within the meaning of Rule G-17.

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.

[5] MSRB Notice 2011-18 (February 24, 2011).

[6] See https://www.finra.org/Newsroom/NewsReleases/2004/P011465.

The Board has received complaints regarding published quotations, such as those appearing in The Blue List. The complaints, which have been referred to the appropriate enforcement agency, state that municipal securities offerings published by dealers often do not reflect prices and amounts of securities that currently are being offered by the quoting dealer.

Board rule G-13, on quotations, prohibits the dissemination of a quotation relating to municipal securities unless the quotation represents a bona fide bid for, or offer of, municipal securities. The term quotation is defined to mean any bid for, or offer of, municipal securities. A quotation is deemed to be bona fide if the dealer on whose behalf the quotation is made is prepared to purchase or sell the municipal securities at the price stated and in the amount specified at the time the quotation is made.

Under rule G-13, the price stated in a quotation for municipal securities must be based on the best judgment of the dealer making the quotation as to the fair market value of such securities at the time the quotation is made. The Board has stated that the price must have a reasonable relationship to the fair market value of the securities, and may take into account relevant factors such as the dealer's current inventory position, overall and in respect to a particular security, and the dealer's anticipation of the direction of the market price for the securities.

Rule G-13 also prohibits a dealer from entering a quotation on behalf of another dealer if the dealer entering the quotation has any reason to believe that the quotation does not represent a bona fide bid for, or offer of, municipal securities. In addition, participants in a joint account are prohibited from entering quotations relating to municipal securities which are the subject of the joint account, if such quotations indicate more than one market for the same securities. Rule G-13 does not prohibit giving "nominal" bids or offers or giving indications of price solely for informational purposes as long as an indication of the price given is clearly shown to be for such purposes.

A dealer that publishes a quote in a daily or other listing must stand ready to purchase or sell the securities at the stated price and amount until the securities are sold or the dealer subsequently changes its price. If either of these events occur, the dealer must withdraw or update its published quotation in the next publication. Stale or invalid quotations violate rule G-13. Rule G-13 does permit a dealer to publish a quotation for a security it does not own if the dealer is prepared to sell the security at the price stated in the quotation. If the dealer knows that the security is not available in the market or is not prepared to sell the security at the stated price, the quotation would violate rule G-13.

It has come to the Board’s attention that insurance companies are offering to insure whole maturities of issues of municipal securities outstanding in the secondary market. The Board understands that municipal securities professionals must apply for the insurance which, once issued, will remain in effect for the life of the security. The Board further understands that other credit enhancement devices also may be developed for secondary market issues.

The Board wishes to remind the industry of the application of rule G-17, the Board’s fair dealing rule, in connection with transactions with customers in securities that are subject to secondary market insurance or other credit enhancement devices or in securities for which arrangements for such insurance or device have been initiated.[1] The Board is of the view that facts, for example, that a security has been insured or arrangements for insurance have been initiated, that will affect the market price of the security are material and must be disclosed to a customer at or before execution of a transaction in the security. In addition, the Board believes that a dealer should advise a customer if evidence of insurance or other credit enhancement feature must be attached to the security for effective transference of the insurance or device.[2]

The Board also wishes to remind the industry that under rule G-13, concerning quotations, all quotations relating to municipal securities made by a dealer must be based on the dealer’s best judgment of the fair market value of the securities at the time the quotation is made. Offers to buy securities that are insured or otherwise have a credit enhancement feature, or for which arrangements for insurance or other credit enhancement have been initiated, must comply with rule G-13. Similarly, the prices at which these securities are purchased or sold by a municipal securities dealer must be fair and reasonable to its customers under Board rule G-30 on prices and commissions.

[1] Rule G-17 provides:

In the conduct of its municipal securities business, each broker, dealer, and municipal securities dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice.

[2] The Board has adopted amendments to rule G-15 which, among other things, require that deliveries to customers of insured securities be accompanied by some evidence of the insurance.

Inclusion of IDB-related activities. This responds to your letter of June 14, 1983 concerning your request for an interpretation of Board rule G-1, which defines a "separately identifiable department or division" of a bank. In particular, you request our advice concerning whether certain activities engaged in by your Corporate Finance Division (the "Division") should be considered "municipal securities dealer activities" for purposes of the rule. Your letter and a subsequent telephone conversation set forth the following facts:

The Division acts as financial advisor to certain corporate customers of the Bank. Some of these customers wish to raise money through the issuance of IDBs. In order to assist these corporations in the placement of the IDBs, the Division contacts from one to ten institutional investors and provides them with information regarding the terms of the proposed financing and basic facts about the corporation. If the investor expresses interest in the financing, a confidential memorandum describing the financing, prepared by the corporation with the assistance of the Division, is sent.

During negotiations between the corporation and the investor, the Division may act as a liaison between the two parties in the communication of comments on the financing documents. According to the bank, the Division is not an agent of the corporation and is not authorized to act on behalf of the corporation in accepting any terms or conditions associated with the proposed financing. For its services, the Division usually receives a percentage of the total dollar amount of securities issued, with a minimum contingent on the successful completion of the deal. While the bank has established a separately identifiable division pursuant to rule G-1, the Division is not part of it.

Your inquiry was discussed by the Board at its July meeting. The Board is of the view that the activities of the Division, as described, constitute the sales of municipal securities for purposes of the definition of municipal securities dealer activities in Board rule G-1. Therefore, these activities should be conducted in the bank's registered separately identifiable department by persons qualified under the Board's professional qualifications rules. MSRB interpretation of July 26, 1983.

In a recent letter to the Office of the Comptroller of the Currency, the staff of the Securities and Exchange Commission has taken the position that private placements of industrial development bonds ("IDBs") constitute transactions in municipal securities as defined in the Securities Exchange Act of 1934, as amended. The Municipal Securities Rulemaking Board has received a number of inquiries concerning this letter. The Board is publishing this notice for the purposes of: (1) reviewing the application of its rules to private placements of municipal securities and (2) expressing its views concerning whether certain Board rules apply to financial advisory services rendered by municipal securities dealers and brokers to corporate obligors on IDBs.

A. Private Placements of IDBs

The Board’s rules apply, of course, to all transactions in municipal securities, including securities which are IDBs. The SEC letter dealt in particular with the activities of commercial banks. That letter pointed out that if a commercial bank has a registered municipal securities dealer department, under Board rule G-1, which defines the term "separately identifiable department or division of a bank," any private placement activities of the bank in securities which are IDBs must be conducted as a part of the registered dealer department. The Board urges all bank dealers which have registered as a separately identifiable department or division to review their organizations and assure that all departments or units which engage in the private placement of IDBs are designated on the bank’s Form MSD registration and other applicable bank records as part of its separately identifiable department or division. The Board also notes that such activities must be under the supervision of a person designated by the bank’s board of directors as responsible for these activities. In addition, under Board rule G-3, concerning professional qualifications, persons who are engaged in privately placing municipal securities must be qualified as municipal securities representatives and be supervised with respect to that activity by a qualified municipal securities principal.

B. Financial Advisory Services Rendered to Corporate Obligors on IDBs

Board rules G-1 and G-3 provide that rendering "financial advisory or consultant services for issuers" is an activity to which those rules are applicable (emphasis added). Similarly, Board rule G-23, on the activities of financial advisors, applies to brokers, dealers, and municipal securities dealers who agree to render "financial advisory or consultant services to or on behalf of an issuer" (emphasis added). Clearly these rules are applicable to financial advisory services rendered to state or local governments and their agencies, as well as to municipal corporations. In the Board’s view, however, rules G-1, G-3, and G-23 do not apply to financial advisory services which are provided to corporate obligors in connection with proposed IDB financings.

The Board wishes to emphasize that the scope of its definition of financial advisory services is limited to "advice with respect to the structure, timing, terms, and other similar matters" concerning a proposed issue.[1] If persons providing such advice to the corporate obligor on an IDB issue also participate in negotiations with prospective purchasers or are otherwise engaged in effecting placement of the issue, then, as indicated above, rules G-1 and G-3 would apply to their activities.

[Excerpts of the Commission letter follow:]

This is in response to your letter of December 1, 1981, requesting our views concerning certain activities by commercial banks in connection with industrial development bonds ("IDBs").[2] Specifically, you asked (1) whether the private placement activities of banks in IDBs involve transactions in municipal securities, (2) whether involvement in such activities alone would require such banks to register with the Commission under Section 15B of the Securities Exchange Act of 1934 (the "Exchange Act") as municipal securities dealers, (3) whether a bank that had registered a separately identifiable department or division with the Commission as a municipal securities dealer would be required to conduct such activities through such separately identifiable department or division, and (4) if such bank activities are required to be conducted in the separately identifiable department or division, whether the advisory services provided by those banks to the corporate obligor on an IDB should be regarded as advisory services provided to an issuer of municipal securities in connection with the issuance of municipal securities. Pursuant to your letter and subsequent telephone conversations, we understand the following facts to be typical of the activities in question.

A commercial bank offers private placement and financial advisory services to corporate entities on a regular and continuous basis. From time to time the bank recommends to the corporate entity that IDBs be used to raise capital. The bank advises the corporate entity regarding the terms and timing of the proposed IDB issuance, prepares the Direct Placement Memorandum describing the terms of the IDB, and contacts potential purchasers of the IDB. Such purchasers then make independent reviews of the corporate entity’s financial status. The bank then obtains comments from the potential buyers and relays such comments to the corporate entity. The bank might also assist the corporate entity in subsequent negotiations with the purchasers. An industrial development authority nominally issues the IDB on behalf of the corporate entity which becomes the economic obligor on the issue.

The bank engages in these activities in order to assist the corporate obligor in the sale of the IDBs. In return for its services, the bank receives from the corporate entity either a fixed fee or a percentage of the proceeds of the sale. The bank does not purchase any of the IDBs. The bank could, however, supply "bridge loans" to the corporate entity pending receipt of the proceeds of the IDB sale. In addition, the bank might provide investors with a letter of credit committing the bank to pay any interest or principal not paid by the corporate issuer. The bank might also act as trustee or paying agent for the nominal issuer of the IDB, for which the bank would receive a set fee.

IDBs AS MUNICIPAL SECURITIES

Section 3(a)(10) of the Exchange Act defines a "security" as, among other things, "any note… bond, debenture… investment contract, …or in general, any instrument commonly known as a ‘security’… " Section 3(a)(29) of the Exchange Act defines "municipal securities" to include any security which is an industrial development bond as defined in Section 103(b)(2) of the Code the interest on which is tax-exempt under Sections 103(b)(4) or 103(b)(6) of the Code. In our opinion, the private placement activities you have described involve transactions in municipal securities as defined in the Exchange Act.[3]

REGISTRATION AS MUNICIPAL SECURITIES DEALER

Section 15B(a) of the Exchange Act makes it unlawful for any municipal securities dealer to use the mails or any instrumentality of interstate commerce to "effect any transaction in, or to induce or attempt to induce the purchase or sale of, any municipal security unless such municipal securities dealer is registered" with the Commission. Section 3(a)(30) of the Exchange Act defines "municipal securities dealer" to include a bank or a separately identifiable department or division of a bank if that bank is engaged in the business of buying and selling municipal securities for its own account other than in a fiduciary capacity, through a broker or otherwise. Banks that engage solely in private placement activities in IDBs as described by you would not be required to register as municipal securities dealers since they do not appear to be engaged in the business of buying and selling municipal securities for their own accounts, but rather appear to be acting as brokers. Section 3(a)(4) of the Exchange Act defines the term broker as "any person engaged in the business of effecting transactions in securities for the account of others, but does not include a bank." Since they are excluded from the definition of broker, banks that act solely as brokers need not register under the Exchange Act.[4]

INCLUSION IN SEPARATELY IDENTIFIABLE DEPARTMENT OR DIVISION

Section 15B(b)(2)(H) of the Exchange Act authorizes the Municipal Securities Rulemaking Board (the "MSRB") to make rules defining the term "separately identifiable department or division" ("SID") of a bank as used in Section 3(a)(30) of the Exchange Act. MSRB rule G-1 defines the SID as "that unit of the bank which conducts all the activities of the bank relating to the conduct of business as a municipal securities dealer…" The rule defines municipal securities dealer activities to include "sales of municipal securities" and "financial advisory and consultant services for issuers in connection with the issuance of municipal securities." Therefore, those banks that have registered an SID with the Commission also must conduct the private placement activities within the SID in accordance with MSRB rules…

Based upon the facts and representations set forth in your letter, it would appear that the private placement activities of banks involving IDBs, as described in your example, constitute transactions in municipal securities that, if done alone, would not require a bank to register with the Commission as a municipal securities dealer. However, such activities, when conducted by a bank municipal securities dealer that had registered a separately identifiable department or division, would be treated as municipal securities dealer activities and, therefore, would be required to be conducted in the bank’s dealer department…

[1] Rule G-23(b).

[2] You have represented that the IDBs involved would be primarily those defined in Section 103(b)(2) of the Internal Revenue Code of 1954 (the "Code"), the interest on which is tax-exempt under Sections 103(b)(4) and 103(b)(6) of the Code.

[3]This determination is based on an analysis of the specific facts as described by you. Different facts and circumstances could result in a transaction involving municipal debt instruments being treated as loan participations not subject to the federal securities laws. Such determinations can only be made on a case by case basis after a thorough examination of the context of the transaction.

[4] See letter dated February 17, 1977, from Anne E. Chafer, Attorney, Securities and Exchange Commission, to Bruce F. Golden and letter dated January 11, 1982, from Thomas G. Lovett, Attorney, Securities and Exchange Commission, to Harriet E. Munrett regarding Citytrust of Bridgeport, Connecticut.

Portfolio credit analyst. This will acknowledge with thanks receipt of your letter dated May 2, 1978 concerning the status of persons occupying the position of portfolio credit analyst at your bank. Your letter, as well as our telephone conversations prior and subsequent to the letter, raise two questions concerning the status of such persons under Board rules. First, are the functions of a portfolio credit analyst subject to the requirements of rule G-1, which defines a separately identifiable dealer department or division of a bank? Second, must a portfolio credit analyst qualify as a municipal securities representative or municipal securities principal under Board rule G-3?

Although we recognize that the primary purpose of the portfolio credit analyst, as set forth in the material you furnished to me, is to review your bank's investment portfolio, a function not subject to Board regulation, to the extent that the analyst provides research advice and analysis in connection with your bank's underwriting, trading or sales activities, the analyst must be included within the municipal securities dealer department for purposes of rule G-1, and is subject to the qualification requirements of rule G-3.

Under Board rule G-1, a separately identifiable department or division of a bank is that unit of the bank which conducts all of the municipal securities dealer activities of the bank. Section (b) of the rule defines municipal securities dealer activities to include research with respect to municipal securities to the extent such research relates to underwriting, trading, sales or financial advisory and consultant services performed by the bank. Thus, we think it clear that for purposes of rule G-1, persons functioning as portfolio credit analysts who render research in connection with underwriting, trading or sales activities at your bank must be included within the separately identifiable department or division of the bank for purposes of rule G-1. This is consistent with the underlying purpose of rule G-1 to assure that all of the functions performed at the bank relating to the business of the bank as a municipal securities dealer are appropriately identified for purposes of supervision, inspection and enforcement.

Under rule G-3(a)(iii)[*] a municipal securities representative is defined as a person associated with a municipal securities broker or municipal securities dealer who performs certain functions similar to those defined as municipal securities dealer activities in rule G-1. The position of portfolio credit analyst as described in your letter and accompanying material appears to fit the definition of municipal securities representative to the extent that persons occupying such position perform research in connection with the bank's underwriting, trading or sales activities. Under rule G-3(e)[†], municipal securities representatives are required to qualify in accordance with Board rules. A similar result would obtain with respect to qualification as a municipal securities principal, if the portfolio credit analyst functions in a supervisory capacity. MSRB interpretation of June 8, 1978.

[*] [Currently codified at rule G-3(a)(i)]

[†] [Currently codified at rule G-3(a)(ii)]

Quotation of municipal securities. This will acknowledge receipt of your letter dated February 9, 1977 concerning the Board’s proposed rule G-13 on quotations relating to municipal securities. In your letter you raise certain questions concerning the intent and application of paragraph (b)(ii) of proposed rule G-13, which prohibits a municipal securities professional from distributing or publishing a municipal securities quotation, or causing such a quotation to be distributed or published, unless the quotation is based upon the professional’s best judgment as to the fair market value of the security.

While the provision in question would undoubtedly apply to situations involving outright fraud, the Board believes the rule to have appropriate application in other circumstances as well.  Thus, the Board has attempted in paragraph (b)(ii) to proscribe conduct which, in the Board’s opinion, constitutes bad business practice but may not, depending on the circumstances, constitute fraud. The Board firmly believes that as a matter of just and equitable principles of trade in the municipal securities industry and with a view to promoting free and open markets in municipal securities, certain practices should not be condoned, even though they do not necessarily rise to the level of fraud or cannot be proven to constitute fraud.

Some examples of how paragraph (b)(ii) would operate may be useful.  First, assume that a dealer submits a bid for bonds, knowing that they have been called by the issuer.  The bonds are not general market bonds and the fact that they have been called is not widely known. While called bonds ordinarily trade at a premium, the dealer’s bid is based on the value of the bonds as though they had not been called and is accepted by the dealer on the other side of the trade who is unaware of the called status of the bonds.  In these circumstances, the bid clearly would not have been based upon the best judgment of the dealer making it as to the fair market value of the bonds. While one might argue that the dealer accepting the bid should have known of the called status of the bonds, the dealer making the bid acted unethically and in a manner not conducive to free and open markets in municipal securities. In the Board’s view, the actions of the dealer making the bid should not be condoned, although a charge of fraud might be difficult to sustain in dealings between professionals and might be inappropriate. The improper nature of the dealer’s conduct would be exacerbated, of course, if the person on the other side of the transaction is a non-professional.  However, difficulties in proof that the conduct of the dealer was fraudulent suggest that the best judgment rule would provide an appropriate alternative basis for enforcement action.

Another situation that would be covered by the best judgment rule is one in which a dealer submits a bid for bonds based on valuations obtained from independent sources, which in turn are based on mistaken assumptions concerning the nature of the securities in question.  The circumstances indicate that the dealer submitting the bid knows that the securities have a substantially greater market value than the price bid, but the fact that independent valuations were obtained, albeit based on mistaken facts, clouds the dealer’s culpability.

A third situation to which the best judgment rule would apply is one in which a dealer makes a bid for or offer of a security without any knowledge as to the value of the security or the value of comparable securities. While the Board does not intend that the best judgment of a dealer as to the fair market value of a security be second-guessed for purposes of the proposed rule, the Board does intend that the dealer be required to act responsibly and to exercise some judgment in submitting a quotation.  In other words, a quotation which has been “pulled out of the air” is not based on the best judgment of the dealer and, in the interests of promoting free and open markets in municipal securities, should not be encouraged.

Given the manner in which the Board intends the “best judgment” rule to operate, the Board concluded that it would not have an anti-competitive impact on the municipal markets. The proposed rule is not intended to prohibit legitimate price discounts or mark-ups, as the case may be, based upon a dealer’s anticipation of the direction of the movement of the markets and other factors. The Board does not intend to interfere with legitimate pricing mechanisms and recognizes that there may be a variety of quotations with respect to a given security, each of which would comply with the terms of the proposed rule.

While it is not possible to anticipate all of the specific fact situations that might run afoul of the “best judgment” rule, I would like to make some general observations concerning the operation of the proposed rule. As you know, one of Congress’ principal purposes in calling for the establishment of the Board was to promote the development of a body of rules for the municipal securities industry that would furnish quidelines for good business conduct. The Senate Committee on Banking, Housing and Urban Affairs observed in its Report on the Securities Acts Amendments of 1975 that prior to the legislation, the conduct of municipal market professionals could be controlled only after the fact through enforcement by the Commission of the fraud prohibitions of the federal securities laws.  The Senate Committee expressed hope that a self-regulatory body like the Board would develop prophylactic rules for the industry which would deter unethical and fraudulent practices in the first instance. See Senate Report 94-75, 94th Cong., 1st Sess., 42-43. MSRB interpretation of February 24, 1977.

Separately identifiable department or division of a bank. This will acknowledge receipt of your letter of November 12, 1975, in which you request, on behalf of the Dealer Bank Association, an interpretative opinion with respect to the rule of the Municipal Securities Rulemaking Board (the "Board") defining the term "separately identifiable department or division of a bank," as used in section 3(a)(30) of the Securities Exchange Act of 1934, as amended (the "Act"). Such rule was originally numbered rule 4 of the Board and became effective on October 15, 1975. The rule is presently numbered rule G-1 of the Board.

In your letter you pose a series of questions concerning rule G-1, as follows: 

1. A bank has an operations department that performs processing and clearance activities, and maintains records, with respect to the bank's underwriting, trading and sales of municipal securities, as well as with respect to certain other bank activities. Can this bank have a "separately identifiable department or division" as defined in rule G-1?
2. In a bank with numerous branches, an employee or officer in a branch will on occasion accept or solicit an order from a customer for municipal securities. Does this preclude a finding that the bank has a "separately identifiable department or division"?
3. Mr. X is a senior vice president of a bank. He is not a director. Mr. X's only relationship to the bank's municipal securities dealer activities is that he is a member of a management committee within the bank that determines the amount of the bank's funds that will be made available for the bank's municipal securities dealer activities, as well as for other bank activities. The bank has a separately identifiable department or division that otherwise meets the requirements of rule G-1. Is Mr. X a person who must be designated by the board of directors of the bank under rule G-1(a)(1)?
4. A bank has a corporate trust department that, among other things, serves as paying agent for certain municipal securities and performs clearing functions in municipal securities, in addition to the processing and clearance activities performed in connection with the bank's underwriting, trading and sales of municipal securities. Are the persons in the bank's corporate trust department who engage solely in activities that do not relate to the underwriting, trading and sales of municipal securities by the bank performing municipal securities dealer activities?

With respect to question (1) above, paragraph (d) of rule G-1 contemplates that the municipal securities dealer activities of a bank, as such activities are defined in paragraph (b) of the rule, may be conducted in more than one organizational or operational unit of the bank, for example, underwriting, trading and sales activities in the bond department, and processing and clearance activities in the operations department of the bank. Under the rule, all such units can be aggregated to constitute a separately identifiable department or division within the meaning of section 3(a)(30) of the Act, provided that each such unit is identifiable and under the direct supervision of an officer designated by the board of directors of the bank as responsible for the day-to-day conduct of the bank's municipal securities dealer activities. The officer so designated need not be the same for all such units. For example, the senior officer of the bank's bond department may be designated as responsible for the municipal securities dealer activities conducted by that department, while the senior officer of the bank's operations department may be designated as responsible for the municipal securities dealer activities conducted by that department. In addition, the records of each such unit relating to municipal securities dealer activities must be separately maintained or separately extractable so as to permit independent examination of such records and enforcement of applicable provisions of the Act, the rules and regulations of the Commission thereunder and the rules of the Board. Finally, each such unit comprising the separately identifiable department or division may be engaged in activities other than those relating to municipal securities dealer activities. For example, the bond department may also engage in activities relating to United States government obligations, while the operations department may perform processing and clearance functions for departments of the bank other than the bond department.

With respect to question (2) above, paragraph (d) of rule G-1 also contemplates that the municipal securities dealer activities of a bank may be conducted at more than one geographic location. However, in order for such a bank to have a separately identifiable department or division, the branch employees who accept or solicit orders for municipal securities must, with respect to acceptance or solicitation of such orders, be affiliated with one of the identifiable units of the bank comprising such department or division and must, with respect to acceptance or solicitation of such orders, be responsible to an officer designated by the board of directors of the bank as responsible for the day-to-day conduct of the bank's municipal securities dealer activities. Further, the bank's records relating to the transactions effected by such branch employees must meet the criteria of paragraph (a) of rule G-1 with respect to separate maintenance and accessibility.

With respect to question (3) above, paragraph (c) of rule G-1 recognizes that senior officers of a bank may make determinations affecting bank policy as a whole which have an indirect effect on the municipal securities dealer activities of the bank. For example, determinations with respect to the deployment of the bank's funds may affect the size of the bank's inventory of municipal securities or volume of underwriting. Ordinarily such determinations would not directly relate to the day-to-day conduct of the bank's municipal securities dealer activities and senior officers making such determinations need not be designated by the board of directors of the bank as responsible for the conduct of such activities. However, if the determinations of senior officers have a direct and immediate impact on the day-to-day conduct of the bank's municipal securities dealer activities, whether by reason of the scope of such determinations, the frequency with which such determinations are made, or by reason of other factors, such officers may be considered to be directly engaged in the conduct of the bank's municipal securities dealer activities and required to be designated by the board of directors of the bank as responsible for the day-to-day conduct of such activities.

With respect to question (4) above, the regulatory focus of section 15B(b)(2)(H) of the Act is on the dealer activities of a bank. Accordingly, subparagraph (b)(2) of rule G-1 was intended to relate to such dealer activities, and not to describe other activities of the bank which might involve municipal securities. Employees of a bank's corporate trust department who perform clearance and other functions with respect to municipal securities, but which do not relate to the underwriting, trading and sales activities of the bank, do not perform municipal securities dealer activities within the meaning of rule G-1.

This opinion is rendered on behalf of the Board, pursuant to authority delegated by the Board. Copies of this opinion are being sent to the Securities and Exchange Commission, the bank regulatory agencies and the National Association of Securities Dealers, Inc. MSRB interpretation of November 17, 1975.