Disclosure of pricing: calculating the dollar price of partially prerefunded bonds. This is in response to your March 21, 1986 letter concerning the application of Board rules to the description of municipal securities provided at or prior to the time of trade and the application of rules G-12(c) and G-15(a) on calculating the dollar price of partially prerefunded bonds with mandatory sinking fund calls.

You describe an issue, due 10/1/13. Mandatory sinking fund calls for this issue begin 10/1/05 and end 10/1/13. Recently, a partial refunding took place which prerefunds the 2011, 2012 and 2013 mandatory sinking fund requirements totalling $11,195,000 (which is 43.6% of the issue) to 10/1/94 at 102. The certificate numbers for the partial prerefunding will not be chosen until 30 days prior to the prerefunded date. Thus, a large percentage of the bonds are prerefunded and all the bonds will be redeemed by 10/1/10 because the 2011, 2012, and 2013 maturities no longer exist.

You note that the bonds should be described as partially prerefunded to 10/1/94 with a 10/1/10 maturity. Also, you state that the price of these securities should be calculated to the cheapest call, in this case, the partial prerefunded date of 10/1/94 at 102. You add that there is a 9½ point difference in price between calculating to maturity and to the partially prerefunded date.

You note that the descriptions you have seen on various brokers' wires do not accurately describe these securities and a purchaser of these bonds would not know what they bought if the purchase was based on current descriptions. You ask the Board to address the description and calculation problems posed by this issue.

Your letter was referred to a Committee of the Board which has responsibility for interpreting the Board's fair practice rules. That Committee has authorized this response.

Board rule G-17 provides that

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.

In regard to inter-dealer transactions, the items of information that professionals must exchange at or prior to the time of trade are governed by principles of contract law and essentially are those items necessary adequately to describe the security that is the subject of the contract. As a general matter, these items of information do not encompass all material facts, but should be sufficient to distinguish the security from other similar issues. The Board has interpreted rule G-17 to require dealers to treat other dealers fairly and to hold them to the prevailing ethical standards of the industry. [1] The rule also prohibits dealers from knowingly misdescribing securities to another dealer. [2]

Board rules G-12(c) and G-15(a) require that

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 ...

In addition, for customer confirmations, rule G-15(a) requires that

for transactions effected on the basis of dollar price, ... the lowest of the resulting yield to call, yield to par option, or yield to maturity shall be shown....

These provisions also require, in cases in which the resulting dollar price or yield shown on the confirmation is calculated to call or par option, that this must be stated and the call or option date and price used in the calculation must be shown. The Board has determined that, for purposes of making this computation, only "in-whole" calls should be used. [3] This requirement reflects the longstanding practice of the municipal securities industry that a price calculated to an "in-part" call, for example, a partial prerefunding date, is not adequate because, depending on the probability of the call provision being exercised and the portion of the issue subject to the call provision, the effective yield based on the price to a partial prerefunding date may not bear any relation to the likely return on the investment.

These provisions of Rules G-12(c) and G-15(a) apply, however, only when the parties have not specified that the bonds are priced to a specific call date. In some circumstances, the parties to a particular transaction may agree that the transaction is effected on the basis of a yield to a particular date, e.g., a partial prerefunding date, and that the dollar price will be computed in this fashion. If that is the case, the yield to this agreed upon date must be included on confirmations as the yield at which the transaction was effected and the resulting dollar price computed to that date, together with a statement that it is a "yield to [date]." In an August 1979 interpretive notice on pricing of callable securities, the Board stated that, under rule G-30, a dealer pricing securities sold to a customer on the basis of a yield to a specified call feature should take into account the possibility that the call feature may not be exercised. [4]

Accordingly, the price to be paid by the customer should reflect this possibility, and the resulting yield to maturity should bear a reasonable relationship to yields on securities of similar quality and maturity. Failure to price securities in such a manner may constitute a violation of rule G-30 since the price may not be "fair and reasonable" in the event the call feature is not exercised. The Board also noted that the fact that a customer in these circumstances may realize a yield in excess of the yield at which the transaction was effected does not relieve a municipal securities dealer of its responsibilities under rule G-30.

Accordingly, the calculation of the dollar price of a transaction in the securities you describe, unless the parties have agreed otherwise, should be made to the lowest of price to the first in-whole call, par option, or maturity. While the partial prerefunding effectively redeems the issue by 10/1/10, the stated maturity of the bond is 10/1/13 and, subject to the parties agreeing to price to 10/1/10, the stated maturity date should be used. MSRB interpretation of May 15, 1986.

[1] In addition, the Board has interpreted this rule to require that, in connection with the purchase from or sale of a municipal security to a customer, at or before execution of the transaction, a dealer must disclose all material facts concerning the transaction which could affect the customer's investment decision, including a complete description of the security, and not omit any material facts which would render other statements misleading.

[2] While the Board does not have any specific disclosure requirements applicable to dealers at the time of trade, a dealer is free to disclose any unique aspect of an issue. For example, in the issue described above, a dealer may decide to disclose the "effective" maturity date of 2010, as well as the stated maturity date of 2013.

[3] See [Rule G-15 Interpretation - Notice Concerning Pricing to Call], December 10, 1980 ... at ¶ 3571.

[4] See [Rule G-30 Interpretation - Interpretive Notice on Pricing of Callable Securities] August 10, 1979 ... at ¶ 3646.

Callable securities: pricing to mandatory sinking fund calls. This is in response to your February 21, 1986 letter concerning the application of rule G-15(a) regarding pricing to prerefunded bonds with mandatory sinking fund calls.

You give the following example:

Bonds, due 7/1/10, are prerefunded to 7/1/91 at 102. There are $17,605,000 of these bonds outstanding. However, there is a mandatory sinking fund which will operate to call $1,000,000 of these bonds at par every year from 7/1/86 to 7/1/91. The balance ($11,605,000) then will be redeemed 7/1/91 at 102. If this bond is priced to the 1991 prerefunded date in today's market at a 6.75 yield, the dollar price would be approximately 127.94. However, if this bond is called 7/1/86 at 100 and a customer paid the above price, his/her yield would be a minus 52 percent (-52%) on the called portion.

You state that the correct way to price the bond is to the 7/1/86 par call at a 5% level which equates to an approximate dollar price of 102.61. The subsequent yield to the 7/1/91 at 102 prerefunded date would be 12.33% if the bond survived all the mandatory calls to that date. You note that a June 8, 1978, MSRB interpretation states, "the calculation of dollar price to a premium call or par option date should be to that date at which the issuer may exercise an option to call the whole of a particular issue or, in the case of serial bonds, a particular maturity, and not to the date of a call in-part." You believe, however, that, as the rule is presently written, dealers are leaving themselves open for litigation from customers if bonds, which are trading at a premium, are not priced to the mandatory sinking fund call. You ask that the Board review this interpretation.

Your letter was referred to a Committee of the Board which has responsibility for interpreting the Board's fair practice rules. That Committee has authorized this response.

Rule G-15(a)(i)(I)[*] requires that on customer confirmations the yield and dollar price for the transaction be disclosed as the price (if the transaction is done on a yield basis) or yield (if the transaction is done on the basis of the dollar price) calculated to the lowest price or yield to call, to par option, or to maturity. The provision also requires, in cases in which the resulting dollar price or yield shown on the confirmation is calculated to call or par option, that this must be stated and the call or option date and price used in the calculation must be shown. The Board has determined that, for purposes of making this computation, only "in-whole" calls should be used.[1] This requirement reflects the longstanding practice of the municipal securities industry that a price calculated to an "in-part" call, such as a sinking fund call, is not adequate because, depending on the probability of the call provision being exercised and the portion of the issue subject to the call provision, the effective yield based on the price to a sinking fund date may not bear any relation to the likely return on the investment.

Rule G-15(a)(i)(I)[*] applies, however, only when the parties have not specified that the bonds are priced to a specific call date. In some circumstances, the parties to a particular transaction may agree that the transaction is effected on the basis of a yield to a particular date, e.g. put option date, and that the dollar price will be computed in this fashion. If that is the case, the yield to this agreed upon date must be included on confirmations as the yield at which the transaction was effected and the resulting dollar price computed to that date, together with a statement that it is a "yield to [date]." In an August 1979 interpretive notice on pricing of callable securities, the Board stated that, under rule G-30, a dealer pricing securities on the basis of a yield to a specified call feature should take into account the possibility that the call feature may not be exercised.[2] Accordingly, the price to be paid by the customer should reflect this possibility, and the resulting yield to maturity should bear a reasonable relationship to yields on securities of similar quality and maturity. Failure to price securities in such a manner may constitute a violation of rule G-30 since the price may not be "fair and reasonable" in the event the call feature is not exercised. The Board also noted that the fact that a customer in these circumstances may realize a yield in excess of the yield at which the transaction was effected does not relieve a municipal securities dealer of its responsibilities under rule G-30.

Accordingly, the calculation of the dollar price of a transaction in the securities in your example, unless the parties have agreed otherwise, should be made to the prerefunded date. Of course, under rule G-17 on fair dealing, dealers must explain to customers the existence of sinking fund calls at the time of trade. The sinking fund call, in addition, should be disclosed on the confirmation by an indication that the securities are "callable." The fact that the securities are prerefunded also should be noted on the confirmation. MSRB Interpretation of April 30, 1986.

[1] See [Rule G-15 Interpretation - Notice Concerning Pricing to Call], December 10, 1980 at ¶ 3571.

[2] See [Rule G-30 Interpretation - Interpretive Notice on Pricing of Callable Securities], August 10, 1979 ... at ¶ 3646.

[*] [Currently codified at rule G-15(a)(i)(A)(5)]

Retroactive price adjustment for early redemption.  This is in response to your letter dated January 15, 1986, regarding the application of Board rules to a plan to guarantee a minimum return to customers who purchase certain municipal securities. You note that many [state deleted] municipalities issue General Obligation Temporary Notes with maturities of approximately one year. The municipalities also reserve the right to redeem at par any or all of the notes at any time prior to maturity. Historically, few notes are actually redeemed prior to their stated maturity.

You state that, acting as a municipal securities dealer, you desire to bid on these notes with the intent of selling them to your customers. The notes would be sold at a premium to generate trading profits. Because the notes can be redeemed by the issuer at any time at par, it is conceivable that someone who pays a premium for the notes could incur an actual return on their investment that is extremely small - even negative.

You ask whether, under Board rules, a municipal securities dealer may sell notes as described above, with the provision that if the notes are redeemed by the issuer prior to maturity, the dealer will adjust the original purchase price retroactively to provide a minimum return to the purchaser for the time held. The minimum return would be negotiated with the purchaser and confirmed in writing at the time of purchase from the dealer. You cite the following example:

The XYZ Bank, a municipal securities dealer, purchases from the City of Anywhere, $100,000 par value of its 6% General Obligation Temporary Notes, dated 1-1-86, maturing 1-1-87 at par, redeemable at anytime at the option of the issuer.

The XYZ Bank sells the notes to its customer, the ABC Bank, for settlement 1-1-86 to yield 5.75%. Can the XYZ bank agree that if the notes are redeemed prior to maturity by the issuer, it will adjust the original price at which the ABC Bank purchased the notes to provide a minimum return of at least 5% for the time held?

Board rule G-25(b) generally prohibits a municipal securities dealer from guaranteeing a customer against loss. Under the rule, put options and repurchase agreements 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). The rule is anti-manipulative in purpose and was designed, in part, to prevent a dealer from artificially stimulating the market in a security by selling securities to customers who assume no market risk.  In addition, rule G-25(c) prohibits a municipal securities dealer from sharing, directly or indirectly, in the profits or losses of a transaction in municipal securities with or for a customer. Finally, rule G-30 requires municipal securities dealers to effect transactions with customers at fair and reasonable prices, taking into consideration, among other matters, the price of securities of comparable quality.

The arrangement you pose may be viewed as a guarantee against loss because the dealer would guarantee the customer a minimum return on his investment. In addition, the arrangement may be viewed as a sharing of loss arising from the customer's transaction because the dealer would participate in any loss sustained by the customer when it retroactively readjusts the price of the securities downward to grant the customer the promised return. Finally, rule G-30, on prices and commissions, requires that the price charged the customer for the securities at the time of sale, without taking into account any readjustment to the price at some future date, must be fair. MSRB interpretation of January 31, 1986.