Automated settlement involving multidepository participants. This will respond to your letter concerning the requirements of rule G-12(f)(ii) applicable to transactions involving firms that are members of more than one registered securities depository. Your inquiry concerns situations in which a dealer that is a member of more than one depository executes a transaction with another dealer that is a member of one or more depositories. Your question is whether such dealers may specify the depository through which delivery must be made, either as a term of an individual transaction or with standing delivery instructions.

Your inquiry was referred to the Committee of the Board with the responsibility for interpreting the Board’s automated clearance and settlement rules, which has authorized my sending this response.

The rule does not specify which depository shall be used for settlement if the transaction is eligible for settlement at more than one depository.

The Board is of the view that, under rule G-12(f), parties to a transaction are free to agree, on a trade-by-trade basis or with standing delivery agreements, on the depository to be used for making book-entry deliveries. Absent such an agreement, a seller may effect good delivery under rule G-12(f) by delivering at any depository of which the receiving dealer is a member. MSRB interpretation of November 18, 1985.

NOTE: Revised to reflect subsequent amendments.

The Board has received a number of inquiries from municipal securities brokers and dealers regarding the application of the Board’s rules to transactions in put option bonds. Put option or tender option bonds on new issue securities are obligations which grant the bondholder the right to require the issuer (or a specified third party acting as agent for the issuer), after giving required notice, to purchase the bonds, usually at par (the "strike price"), at a certain time or times prior to maturity (the "expiration date(s)") or upon the occurrence of specified events or conditions. Put options on secondary market securities also are coming into prominence. These instruments are issued by financial institutions and permit the purchaser to sell, after giving required notice, a specified amount of securities from a specified issue to the financial institution on certain expiration dates at the strike price. Put options generally are backed by letters of credit. Secondary market put options often are sold as an attachment to the security, and subsequently are transferred with that security. Frequently, however, the put option may be sold separately from that security and re-attached to other securities from the same issue.

Of course, the Board’s rules apply to put option bonds just as they apply to all other municipal securities. The Board, however, has issued a number of interpretive letters on the specific application of its rules to these types of bonds. These interpretive positions are reviewed below.

Fair Practice Rules

1. Rule G-17

Board rule G-17, regarding fair dealing, imposes an obligation on persons selling put option bonds to customers to disclose adequately all material information concerning these securities and the put features at the time of trade. In an interpretive letter on this issue,[1] the Board responded to the question whether a dealer who had previously sold put option securities to a customer would be obligated to contact that customer around the time the put option comes into effect to remind the customer that the put option is available. The Board stated that no Board rule would impose such an obligation on the dealer.

In addition, the Board was asked whether a dealer who purchased from a customer securities with a put option feature at the time of the put option exercise date at a price significantly below the put exercise price would be in violation of any Board rules. The Board responded that such dealer may well be deemed to be in violation of Board rules G-17 on fair dealing and G-30 on prices and commissions.

2. Rule G-25(b)

Board rule G-25(b) prohibits brokers, dealers, and municipal securities dealers from guaranteeing or offering to guarantee a customer against loss in municipal securities transactions. Under the rule, put options are not deemed to be guarantees against loss if their terms are provided in writing to the customer with or on the confirmation of the transaction and recorded in accordance with rule G-8(a)(v).[2] Thus, when a municipal securities dealer is the issuer of a secondary market put option on a municipal security, the terms of the put option must be included with or on customer confirmations of transactions in the underlying security. Dealers that sell bonds subject to put options issued by an entity other than the dealer would not be subject to this disclosure requirement.

Confirmation Disclosure Rules

1. Description of Security

Rules G-12(c)(v)(E) and G-15(a)(i)(E)[*] require inter-dealer and customer confirmations to set forth

a description of the securities, including… if the securities are… subject to redemption prior to maturity, an indication to such effect.

Confirmations of transactions in put option securities, therefore, would have to indicate the existence of the put option (e.g., by including the designation "puttable" on the confirmation), much as confirmations concerning callable securities must indicate the existence of the call feature. The confirmation need not set forth the specific details of the put option feature.[3]

Rules G-12(c)(v)(E) and G-15(a)(i)(E)[†] also require confirmations to contain

a description of the securities including at a minimum… if necessary for a materially complete description of the securities, the name of any company or other person in addition to the issuer obligated, directly or indirectly, with respect to debt service…

The Board has stated that a bank issuing a letter of credit which secures a put option feature on an issue is "obligated… with respect to debt service" on such issue. Thus, the identity of the bank issuing the letter of credit securing the put option also must be indicated on the confirmation.[4]

Finally, rules G-12(c)(v)(E) and G-15(a)(i)(E)[‡] requires that dealer and customer confirmations contain a description of the securities including, among other things, the interest rate on the bonds. The Board has interpreted this provision as it pertains to certain tender option bonds with adjustable tender fees to require that the net interest rate (i.e., the current effective interest rate taking into account the tender fee) be disclosed in the interest rate field and that dealers include elsewhere in the description field of the confirmation the stated interest rate with the phrase "less fee for put."[5]

2. Yield Disclosure

Board rule G-12(c)(v)(I) requires that inter-dealer confirmations include the

yield at which transaction was effected and resulting dollar price, except in the case of securities which are traded on the basis of dollar price or securities sold at par, in which event only dollar price need be shown (in cases in which securities are priced to call or to par option, this must be stated and the call or option date and price used in the calculation must be shown, and where a transaction is effected on a yield basis, the dollar price shall be calculated to the lowest of price to call, price to par option, or price to maturity);

Rule G-15(a)(i)(I)[#] requires that customer confirmations include information on yield and dollar price as follows:

(1) for transactions effected on a yield basis, the yield at which transaction was effected and the resulting dollar price shall be shown. Such dollar price shall be calculated to the lowest of price to call, price to par option, or price to maturity.

(2) for transactions effected on the basis of dollar price, the dollar price at which transaction was effected, and the lowest of the resulting yield to call, yield to par option, or yield to maturity shall be shown.

(3) for transactions at par, the dollar price shall be shown.

In cases in which the resulting dollar price or yield shown on the confirmation is calculated to call or par option, this must be stated, and the call or option date and price used in the calculation must be shown.

Neither of these rules requires the presentation of a yield or a dollar price computed to the put option date as a part of the standard confirmation process. In many circumstances, however, the parties to a particular transaction may agree that the transaction is effected on the basis of a yield to the put option date, and that the dollar price will be computed in this fashion. If that is the case, the yield to the put date must be included on confirmations as the yield at which the transaction was effected and the resulting dollar price computed to the put date, together with a statement that it is a "yield to the [date] put option" and an indication of the date the option first becomes available to the holder.[6] The requirement for transactions effected on a yield basis of pricing to the lowest of price to call, price to par option or price to maturity, applies only when the parties have not specified the yield on which the transaction is based.

In addition, in regard to transactions in tender option bonds with adjustable tender fees, even if the transaction is not effected on the basis of a yield to the tender date, dealers must include the yield to the tender date since an accurate yield to maturity cannot be calculated for these securities because of the yearly adjustment in tender fees.[7]

Delivery Requirements

In a recent interpretive letter, the Board responded to an inquiry whether, in three situations, the delivery of securities subject to put options could be rejected.[8] The Board responded that, in the first situation in which securities subject to a "one time only" put option were purchased for settlement prior to the option expiration date but delivered after the option expiration date, such delivery could be rejected since the securities delivered were no longer "puttable" securities. In the second situation in which securities subject to a "one time only" put option were purchased for settlement prior to the option expiration date and delivered prior to that date, but too late to permit the recipient to satisfy the conditions under which it could exercise the option (e.g., the trustee is located too far away for the recipient to be able to present the physical securities by the expiration date), the Board stated that there might not be a basis for rejecting delivery, since the bonds delivered were "puttable" bonds, depending on the facts and circumstances of the delivery. A purchasing dealer who believed that it had incurred some loss as a result of the delivery would have to seek redress in an arbitration proceeding.

Finally, in the third situation, securities which were the subject of a put option exercisable on a stated periodic basis (e.g., annually) were purchased for settlement prior to the annual exercise date so that the recipient was unable to exercise the option at the time it anticipated being able to do so. The Board stated that this delivery could not be rejected since "puttable" bonds were delivered. A purchasing dealer who believed that it had incurred some loss as a result of the delivery would have to seek redress in an arbitration proceeding.

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[1] See [Rule G-17 Interpretive Letter - Put option bonds: safekeeping, pricing,] MSRB interpretation of February 18, 1983.

[2] Rule G-8(a)(v) requires dealers to record, among other things, oral or written put options with respect to municipal securities in which such municipal securities broker or dealer has any direct or indirect interest, showing the description and aggregate par value of the securities and the terms and conditions of the option.

[3] See [Rule G-12 Interpretive Letter - Confirmation disclosure: put option bonds,] MSRB interpretation of April 24, 1981.

[4] See [Rule G-15 Interpretive Letter - Securities description: securities backed by letters of credit,] MSRB interpretation of December 2, 1982.

[5] See [Rule G-12 Interpretive Letter - Confirmation disclosure: tender option bonds with adjustable tender fees,] MSRB interpretation of March 5, 1985.

[6] See [Rule G-12 Interpretive Letter - Confirmation disclosure: put option bonds,] MSRB interpretation of April 24, 1981.

[7] See fn. 5.

[8] See [Rule G-12 Interpretive Letter - Delivery requirements: put option bonds,] MSRB interpretation of February 27, 1985.

[*] [Currently codified at rule G-15(a)(i)(C)(2)(a). See also current rule G-15(a)(i)(C)(2)(b).]

[†] [Currently codified at rule G-15(a)(i)(C)(1)(b).]

[‡] [Currently codified at rule G-15(a)(i)(B)(4). See also current rule G-15(a)(i)(B)(4)(c).]

[#] [Currently codified at rule G-15(a)(i)(A)(5). See also current rule G-15(a)(i)(A)(5)(c)(vi)(D).]

Confirmation disclosures: tender option bonds with adjustable tender fees. This is in response to your letter requesting a one year delay in the effective date of an October 3, 1984, interpretation of Board rules G-12 and G-15 concerning confirmation disclosure of tender option bonds with adjustable tender fees. In that interpretation, the Board stated that the interest rate shown on the confirmation for these bonds should be the interest rate noted on the bond certificate (the "stated interest rate") but that the confirmation also must include the phrase "less fee for put." The Board also stated that it is the responsibility of the selling dealer to determine the current effective interest rate applicable to these bonds taking into account the tender fee (the "net interest rate") and to disclose this to purchasers at the time of trade. In addition, the Board took the position that the yield to maturity disclosure requirement does not apply to these bonds since an accurate yield to maturity cannot be calculated for these securities because of the annual adjustments to the tender fee. Dealers must, however, include the yield to the tender option date as an alternative form of yield disclosure.

While you agree with the interpretation, you state that the automated systems currently in place are not capable of complying with the interpretation and thus you request a one year delay in the effective date of this interpretation in order for the industry to effect necessary system modifications. Your request was referred to the Committee of the Board which has responsibility for interpreting the Board’s confirmation rules. The Committee has authorized this reply.

Apparently, a problem arises when dealers include the stated interest rate in the interest rate field on the confirmation. In computing the yield on the transaction, most computer systems automatically pick up the rate in that field as the interest rate. Thus, an overstated yield based on the stated interest rate, instead of a yield based on the net interest rate, is printed on confirmations. We have been informed that certain dealers have solved this problem by including the net interest rate in the interest rate field. In this way, the computer automatically picks up the correct interest rate needed to determine the accurate yield to the tender option date. In order to solve the interest rate disclosure problem, these dealers include elsewhere in the description field of the confirmation the stated interest rate with the phrase "less fee for put." The Board believes that this method of disclosure is consistent with the Board’s confirmation disclosure requirements.

Since the Board believes that most dealers will be able to comply either with the original interpretation or this clarification utilizing their present computer systems, it has decided not to approve any delay in the effective date of this interpretation for system modifications. We note, however, that any dealer that believes its system cannot comply with this interpretation might consider requesting a no-action letter from the SEC until its system modifications are in place. MSRB interpretation of March 5, 1985.

Delivery requirements: put option bonds. In a previous telephone conversation [name omitted] of your office had inquired whether any or all of the following deliveries of securities which are subject to a put option could be rejected:

(1) Certain securities are the subject of a "one time only" put option, exercisable by delivery of the securities to a designated trustee on or before a stated expiration date. An inter-dealer transaction in the securities—described as "puttable" securities—is effected for settlement prior to the expiration date. Delivery on the transaction is not made, however, until after the expiration date, and the recipient is accordingly unable to exercise the option, since it cannot deliver the securities to the trustee by the expiration date.

(2) Certain securities are the subject of a "one time only" put option, exercisable by delivery of the securities to a designated trustee on or before a stated expiration date. An inter-dealer transaction in the securities—described as "puttable" securities—is effected for settlement prior to the expiration date. Delivery on the transaction is made prior to the expiration date, but too late to permit the recipient to satisfy the conditions under which it can exercise the option (e.g., the trustee is located too far away for the recipient to be able to present the physical securities by the expiration date).

(3) Certain securities are the subject of a put option exercisable on a stated periodic basis (e.g., annually). An inter-dealer transaction in the securities—described as "puttable" securities—is effected for settlement shortly before the annual exercise date on the option. Delivery on the transaction, however, is not made until after the annual exercise date, so that the recipient is unable to exercise the option at the time it anticipated being able to do so.

I am writing to confirm my previous advice to him regarding the Board’s consideration of his inquiry.

As I informed him, his inquiry was referred to a Committee of the Board which has responsibility for interpreting the "delivery" provisions of the Board’s rules; that Committee has authorized my sending this response. In considering the inquiry, the Committee took note of the provisions of Board rule G-12(g), under which an inter-dealer delivery may be reclaimed for a period of eighteen months following the delivery date in the event that information pertaining to the description of the securities was inaccurate for either of the following reasons:

(i) information required by subparagraph (c)(v)(E) of this rule was omitted or erroneously noted on a confirmation, or

(ii) information material to the transaction but not required by subparagraph (c)(v)(E) of this rule was erroneously noted on a confirmation.

Under this provision, therefore, a delivery of securities described on the confirmation as being "puttable" securities could be reclaimed if the securities delivered are not, in fact, "puttable" securities.

The Committee is of the view that, in the first of the situations which he cited, the delivery could be rejected or reclaimed pursuant to the provisions of rule G-12(g). In this instance the securities were traded and described as being "puttable" securities; the securities delivered, however, are no longer "puttable" securities, since the put option has expired by the delivery date. Accordingly, the rule would permit rejection or reclamation of the delivery.

In the third case he put forth, however, this provision would not be applicable, since the securities delivered are as described. Accordingly, there would not be a basis under the rules to reject or reclaim this delivery, and a purchasing dealer who believed that it had incurred some loss as a result of the delivery would have to seek redress in an arbitration proceeding or in the courts. This may also be the result in the second case he cited, depending on the facts and circumstances of the delivery. MSRB interpretation of February 27, 1985.

Automated clearance: use of comparison systems. I am writing to confirm the substance of our conversations with you at our meeting on October 3 to discuss certain of the issues that have arisen since the August 1 effective date of the requirements of rule G-12(f) for the use of automated comparison services on certain inter-dealer transactions in municipal securities. In our meeting you explained certain problems that have become apparent since the implementation of these requirements, and you inquired as to our views concerning the application of Board rules to these difficulties or appropriate procedures to remedy them. The essential points of our responses are summarized below.

In particular, you indicated that the use of the "as of" (or "demand as of") feature of the automated comparison system has, in some cases, caused inappropriate rejections of deliveries of securities. This occurs, you explained, because the comparison system is currently programmed to display an alternative settlement date of two business days following the date of successful comparison of the transaction, if such comparison is accomplished through use of the "as of" or "demand as of" feature.[1] As a result, in certain cases involving transactions compared on an "as of" basis dealers have attempted to make delivery on the transaction on the contractual settlement date, and have had those deliveries rejected, since the receiving party recognizes only the later "alternative settlement date" assigned to the transaction by the comparison system. You inquire whether such rejections of deliveries are in accordance with Board rules.

I note that this "alternative settlement date" has significance for clearance purposes only, and does not result in a recomputation of the dollar price or accrued interest on the transaction.

As we advised in our conversation, the receiving dealer clearly cannot reject a good delivery of securities made on or after the contractual settlement date on the basis that the delivery is made prior to the "alternative settlement date" displayed by the comparison system. Both dealers have a contract involving the purchase of securities as of a specified settlement date, and a delivery tendered on or after that date in "good delivery" form must be accepted. A dealer rejecting such a delivery on the basis that it has been made prior to the "alternative settlement date" would be subject to the procedures for a "close-out by seller" due to the improper rejection of a delivery, as set forth in Board rule G-12(h)(ii).[2]

* * *

You also advised that some dealers who are using the automated comparison system are using their own delivery tickets, rather than the delivery tickets generated by the system, at the time they make delivery on the transaction. As a result, you indicated, there have been rejections of these deliveries, since the receiving dealer is unable to correlate these deliveries with its records of transactions compared through the system. You suggested that the inclusion of the "control numbers" generated by the comparison system on these self-generated delivery tickets would help to eliminate these unnecessary rejections and facilitate the correlation of receipts and deliveries with records of transactions compared through the system. As I indicated in our conversation, the Board concurs with your suggestion. The Board strongly encourages dealers who choose to use their own delivery tickets for transactions compared through the automated system to display on those tickets the control number or other number identifying the transaction in the system.[3] This would ensure that the receiving dealer can verify that it knows the transaction being delivered and that it was successfully compared through the system.

* * *

You also noted that many municipal securities dealers have continued the practice of sending physical confirmations of transactions, in addition to submitting such transactions for comparison through the automated system. You advised that this is causing significant problems for certain dealers, since they are required to maintain a duplicate system in order to provide for the review of these physical confirmations.

The Board is aware that certain municipal securities dealers chose to maintain parallel confirmation systems following implementation of the automated comparison requirements on August 1 in order to ensure that they maintained adequate control over their activities, and recognizes that for many such dealers this was an appropriate and prudent course of action.[4]  However, the Board wishes to emphasize that its rules do not require the sending of a physical confirmation on any transaction which has been submitted for comparison through the system. On the contrary, the continued use of unnecessary physical comparisons increases the risk of the duplication of trades and deliveries and substantially decreases the efficiencies and cost savings available from the use of the automated comparison system. The Board believes that all system participants must understand that the use of the automated comparison system is of primary importance. Accordingly, the Board strongly suggests that the mailing of unnecessary physical confirmations should be discontinued once a dealer is satisfied that it has adequate control over its comparison activities through the system.

You and others have suggested that it would be helpful if dealers which are unable to discontinue the mailing of physical confirmations would identify those transactions which have also been submitted for comparison through the system through some legend or stamp placed on the physical confirmation sent on the transaction. The Board concurs with your suggestion, and recommends that, during the short remaining interim when dealers are continuing to use duplicate physical confirmations, they include on physical confirmations of transactions submitted to the automated comparison system a stamp or legend in a prominent location which clearly indicates that the transaction has been submitted for automated comparison. MSRB interpretation of January 2, 1985.

 

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[1] For example, a transaction of trade date October 19 for settlement October 25 fails to compare through the normal comparison cycle. Due to this failure to compare, the transaction is dropped from the comparison system on October 23; however, due to a resolution of the dispute, both parties resubmit the trade on an “as of” basis on October 24, and it is successfully compared on that date. Due to the delay in the comparison of the transaction, the system will display an “alternative settlement date” on this transaction of October 26 on the system-generated delivery tickets.

[2] I understand that [Registered Clearing Agency] is taking steps to have the contractual settlement date reflected on delivery tickets produced with respect to transactions compared on an “as of” or “demand as of” basis. We believe that this will be most helpful in clarifying and receiving dealer’s contractual obligation to accept a proper delivery made on or after the date.

[3] I understand that proper utilization of the comparison system control number is a reliable method for identifying and referring to transactions.

[4] The Board is also aware that on certain transactions dealers will need to send physical confirmations to document the terms of a specific agreement concluded as the time of trade (e.g., a specification of a rating). In such circumstances the Board anticipates that physical confirmations will continue to be sent.