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Indirect Rule Violations: Rules G-37 and G-38
The Municipal Securities Rulemaking Board’s (“MSRB” or “Board”) statutory mandate is to protect investors and the public interest in connection with dealers’ activities in the municipal securities market. The municipal securities market is one of the world’s leading securities markets. Investors hold approximately $1.6 trillion worth of municipal securities—either through direct ownership or through investment in institutional portfolios. These investors provide much needed capital to more than 50,000 state and local governments. Maintaining municipal market integrity is an exceptionally high priority for the Board as it seeks to foster a fair and efficient municipal securities market through dealer regulation.
In 1994, the MSRB adopted Rule G-37 in an effort to remove the real or perceived conflict of interest of issuers who receive political contributions from dealers and award municipal securities business to such dealers. As noted by the Court reviewing Rule G-37, “underwriters’ campaign contributions self-evidently create a conflict of interest in state and local officials who have power over municipal securities contracts and a risk that they will award the contracts on the basis of benefit to their campaign chests rather than to the governmental entity.”[1] Pay-to play harms the integrity of the underwriter selection process.
In general, Rule G-37 prohibits brokers, dealers and municipal securities dealers (“dealers”) from engaging in municipal securities business with issuers if certain political contributions have been made to officials of such issuers; prohibits dealers and municipal finance professionals (“MFP”) from soliciting or bundling contributions to an official of an issuer with which the dealer is engaging or seeking to engage in municipal securities business; and requires dealers to record and disclose certain political contributions, as well as other information, to allow public scrutiny of political contributions and the municipal securities business of a dealer. The rule also seeks to ensure that payments made to political parties by dealers, MFPs, and political action committees (“PAC”) not controlled by the dealer or MFP do not represent attempts to make indirect contributions to issuer officials in contravention of Rule G-37 by requiring dealers to record and disclose all payments made to state and local political parties.[2] The party payment disclosure requirements were intended to assist in severing any connection between payments to political parties (even if earmarked for expenses other than political contributions) and the awarding of municipal securities business.[3]
Although Rule G-37 initially included certain limited disclosure requirements for consultants used by dealers to obtain municipal securities business, in 1996, the MSRB adopted a separate Rule G-38, on consultants, to prevent persons from circumventing Rule G-37 through the use of consultants. Rule G-38 currently requires dealers who use consultants[4] to evidence the consulting arrangement in writing, to disclose, in writing, to an issuer with which it is engaging or seeking to engage in municipal securities business information on consulting arrangements relating to such issuer, and to submit to the Board, on a quarterly basis, reports of all consultants used by the dealer, amounts paid to such consultants, and certain political contribution and payment information from the consultant.
The impact of Rules G-37 and G-38 has been very positive. The rules have altered the political contribution practices of municipal securities dealers and opened discussion about the political contribution practices of the entire municipal industry.
While the Board is pleased with the success of these rules, it also is concerned with increasing signs that individuals and firms subject to the rules may be seeking ways around Rule G-37 through payments to political parties or non-dealer controlled PACs that find their way to issuer officials, significant political contributions by dealer affiliates (e.g., bank holding companies and affiliated derivative counterparty subsidiaries) to both issuer officials and political parties, contributions by associated persons of the dealer who are not MFPs and by the spouses and family members of MFPs to issuer officials, and the use of consultants who make or bundle political contributions. In addition to dealer and dealer-related giving, the Board is also concerned about media and other reports regarding significant giving by other market participants, including independent financial advisors, swap advisors, swap counterparties, investment contract providers and public finance lawyers.
The MSRB is mindful that Rule G-37’s prohibitions involve sensitive constitutional issues and is reluctant to significantly broaden the scope of the rule. The rule was constructed and will continue to be reviewed with full regard for and consideration of an individual’s right to participate fully in our political processes. The Board, however, wishes to remind dealers that Rule G-37, as currently in effect, covers indirect as well as direct contributions to issuer officials, and to alert dealers that it has expressed its concern to the entities that enforce the Board’s rules that some of the increased political giving may indicate a rise in indirect Rule G-37 violations. While Rule G-37 was adopted to deal specifically with contributions made to officials of issuers by dealers and MFPs, and PACs controlled by dealers or MFPs, the rule also prohibits MFPs and dealers from using conduits—be they parties, PACs, consultants, lawyers, spouses or affiliates—to contribute indirectly to an issuer official if such MFP or dealer can not give directly to the issuer without triggering the ban on business. The MSRB will continue to work with the enforcement agencies to identify and halt abusive practices. If, at a later date, the Board learns of specific problematic dealer practices that it believes must be addressed more directly, the Board may proceed with additional rulemaking relating to Rules G-37 and G-38.
The Board strongly believes that pay-to-play undermines the integrity of the municipal securities industry. Such practices are regulated not only by the specific parameters of Rule G-37, but also by the fair practice principles embodied in the MSRB’s Rule G-17, on fair dealing. Similarly, the MSRB reminds issuers and dealers that the SEC has previously advised that, with respect to primary offering disclosure, increased attention needs to be directed at disclosure of potential conflicts of interest and material financial relationships among issuers, advisors and underwriters, including those arising from political contributions.[5] These issuer conflicts of interest can and do arise not only from contributions made by municipal securities dealers, but also from payments by unregulated municipal securities market participants.
The costs of political campaigns are skyrocketing across the country. The MSRB is aware of reports that elected officials, or persons acting on behalf of elected officials, are putting pressure on dealers and MFPs to find ways to contribute to the costs associated with political campaigns. The Board also recognizes that there is significant political giving that is not by, or directed by, municipal securities dealers. Thus, the MSRB wishes to encourage state and local governments to take a fresh look at these issues and see whether their policies and procedures should be revised to help maintain the integrity of the underwriting process. The Board believes that it is critical that the municipal market engender the highest degree of public confidence so that investors will continue to provide much needed capital to state and local governments.
[1] Blount v. SEC, 61 F. 3d 938 (D.C. Cir. 1995), cert. denied, 116 S. Ct. 1351 (1996).
[2] If a dealer or MFP is considering contributing funds to a non-dealer associated PAC or political party, Rule G-37 requires that the dealer or MFP “should inquire of the non-dealer associated PAC or political party how any funds received from the dealer or MFP would be used.” See Questions and Answers Notice: Rule G-37, No. 2 (August 6, 1996), reprinted in MSRB Rule Book.
[3] See Securities and Exchange Act Release No. 35446 (SEC Order Approving Proposed Rule Change by the Municipal Securities Rulemaking Board Relating to Rule G-37 on Political Contributions and Prohibitions on Municipal Securities Business, and Rule G-8, on Recordkeeping) (March 6, 1995).
[4] Rule G-38 (a)(i) defines the term “consultant” as any person used by a dealer to obtain or retain municipal securities business through direct or indirect communication by such person with an issuer on the dealer’s behalf where the communication is undertaken by such person in exchange for, or with the understanding of receiving, payment from the dealer or any other person.
[5] See SEC Release No. 33-7049; 34-33741 (Statement of the Commission Regarding Disclosure Obligations of Municipal Issuers and Others) (March 17, 1994).
The Effect of a Ban on Municipal Securities Business under Rule G-37 Arising During a Pre-Existing Engagement Relating to Municipal Fund Securities
Rule G-37, on political contributions and prohibitions on municipal securities business, prohibits any broker, dealer or municipal securities dealer (a "dealer") from engaging in municipal securities business with an issuer within two years after any contribution (other than certain de minimis contributions) to an official of such issuer made by: (i) the dealer; (ii) any municipal finance professional associated with such dealer; or (iii) any political action committee controlled by the dealer or any municipal finance professional. The Municipal Securities Rulemaking Board ("MSRB") has received inquiries regarding the effect of a ban on municipal securities business with an issuer arising from a contribution made after a dealer has entered into a long-term contract to serve as the primary distributor of the issuer's municipal fund securities.
In an interpretive notice published in 1997 (the "1997 Interpretation"), the MSRB stated that a dealer subject to a prohibition on municipal securities business with an issuer is allowed to continue to execute certain issue-specific contractual obligations in effect prior to the date of the contribution that caused the prohibition.[1] For example, dealers that had already executed a contract with the issuer to serve as underwriter or financial advisor for a new issue of debt securities prior to the contribution could continue in these capacities.
The 1997 Interpretation also addressed certain types of on-going, non-issue-specific municipal securities business that a dealer may have contracted with an issuer to perform prior to the making of a contribution that causes a prohibition on municipal securities business with the issuer. For example, the MSRB noted that a dealer may act as remarketing agent for an outstanding issue of municipal securities or may continue to underwrite a specific commercial paper program so long as the contract for such services was in effect prior to the contribution. The MSRB stated that these activities are not considered new municipal securities business and may be performed by dealers that are banned from municipal securities business with an issuer. The MSRB further stated, however, that provisions in existing contracts that allow for changes in the services provided by the dealer or compensation paid by the issuer would be viewed by the MSRB as new municipal securities business and, therefore, rule G-37 would preclude a dealer subject to a ban on municipal securities business from performing such additional functions or receiving additional compensation. The MSRB cited two examples of these types of provisions. The first involved a contract to serve as remarketing agent for a variable rate issue that might permit a fixed rate conversion, with a concomitant increase in the per bond compensation. The second example involved an agreement to underwrite a commercial paper program that might include terms for increasing the size of the program, with no increase in per bond fees but an increase in overall compensation resulting from the larger outstanding balance of commercial paper. In both cases, the MSRB viewed the exercise of these provisions as new municipal securities business that would be banned under the rule.
In the 1997 Interpretation, the MSRB recognized that there is great variety in the terms of agreements regarding municipal securities business and that its guidance in the 1997 Interpretation may not adequately deal with all such agreements. The MSRB sought input on other situations where contracts obligate dealers to perform various types of activities after the date of a contribution that triggers a ban on municipal securities business and stated that additional interpretations might be issued based upon such input.
The MSRB understands that dealers typically are selected by issuers to serve as primary distributors of municipal fund securities on terms that differ significantly from those of a dealer selected to underwrite an issue of debt securities. Issuers generally enter into long-term agreements (in many cases with terms of ten years or longer) with the primary distributor of municipal fund securities for services that include the sale in a continuous primary offering of one or more categories or classes of the securities issued within the framework of a single program of investments.[2] In addition, an issuer may often engage a particular dealer to serve as the primary distributor of its municipal fund securities as part of a team of professionals that includes the dealer's affiliated investment management firm, which is charged with managing the investment of the underlying portfolios.
The MSRB believes that the guidance provided in the 1997 Interpretation, although appropriate for the circumstances discussed therein, may not be adequate to address the unique features of municipal fund securities programs. For example, so long as a program realizes net in-flows of investor cash, the size of an offering of municipal fund securities will necessarily increase over time. Under most compensation arrangements in the market, any net in-flow of cash generally would result in an increase in total compensation, causing any new sales of municipal fund securities that exceed redemptions to be considered new municipal securities business under the 1997 Interpretation. Also, the addition by the issuer of a new category of investments (e.g., a new portfolio in an aged-based Section 529 college savings plan created for children born in the most recent year) could be considered a new offering from which such dealer might be banned, even where such new category may have been clearly contemplated at the outset of the dealer's engagement. Further, the MSRB understands that the repercussions to an issuer of municipal fund securities or investors in such securities of a sudden change in the primary distributor (and possible concurrent change in the investment manager) resulting from a ban on municipal securities business arising during the term of an existing arrangement often will be significantly greater than in the case of an underwriting or other primary market activity relating to the typical debt offering. Issuers could be faced with redesigning existing programs and investors may need to establish new relationships with different dealers in order to maintain their investments.
As a result, the MSRB believes that further interpretive guidance is necessary in this area. The MSRB is of the view that, where a dealer has become subject to a ban on municipal securities business with an issuer of municipal fund securities with which it is currently serving as primary distributor, any continued sales of existing categories of municipal fund securities for such issuer during the duration of the ban would not be considered new municipal securities business if the basis for determining compensation does not change during that period, even if total compensation increases as a result of net in-flows of cash. Further, the MSRB believes that any changes in the services to be provided by the dealer to the issuer throughout the duration of the ban that are contemplated under the pre-existing contractual arrangement (e.g., the addition of new categories of securities within the framework of the existing program) would not be considered new municipal securities business so long as such changes do not result in: (1) an increase in total compensation received by the dealer for services performed for the duration of the ban (whether paid during the ban or as a deferred payment after the ban); or (2) in an extension of the term of the dealer in its current role.
[1] See Rule G-37 Interpretation - Interpretation on Prohibition on Municipal Securities Business Pursuant to Rule G-37, February 21, 1997, MSRB Rule Book (January 2002) at 232.
[2] The various categories generally reflect interests in funds having different allocations of underlying investments. For example, a so-called Section 529 college savings plan may offer one category that represents investments primarily in equity securities and another in debt securities, or may have categories where the allocation shifts from primarily equity securities to primarily debt or money market securities as the number of years remaining until the beginning of college decreases. In the case of state and local government pools, the types of securities in the underlying portfolios may be allocated so as to create one category of short-term "money market" like investments (i.e., with net asset value maintained at approximately $1 per share) and another with a longer timeframe and fluctuating net asset value.
No comments available.
Activities by Dealers and Municipal Finance Professionals During Transition Periods for Elected Issuer Officials
The MSRB has received inquiries on the applicability of rule G-37 to certain activities by dealers and municipal finance professionals relating to the transition period during which an issuer official has won an election but has not yet taken office. The definition of “contribution” in rule G-37(g)(i) includes any gift, subscription, loan, advance, or deposit of money or anything of value made for transition or inaugural expenses incurred by the successful candidate.
The MSRB stated in a Question and Answer Notice dated May 24, 1994 (Q&A number 24) that rule G-37 is not intended to prohibit or restrict municipal finance professionals from engaging in personal volunteer work; however, if the municipal finance professional uses the dealer’s resources (e.g., a political position paper prepared by dealer personnel) or incurs expenses in the conduct of such volunteer work (e.g., hosting a reception), then the value of such resources or expenses would constitute a contribution. In addition, personal expenses incurred by the municipal finance professional in the conduct of such volunteer work, which expenses are purely incidental to such work and unreimbursed by the dealer (e.g., cab fares and personal meals), would not constitute a contribution. In a Question and Answer Notice dated August 18, 1994 (Q&A number 3), the MSRB stated that an employee of a dealer generally can donate his or her time to an issuer official’s campaign without this being viewed as a contribution by the dealer to the official, as long as the employee is volunteering his or her time during non-work hours, or is using previously accrued vacation time or the dealer is not otherwise paying the employee’s salary (e.g., an unpaid leave of absence). Thus, rule G-37 does not prohibit a municipal finance professional from serving on an issuer official’s transition team or performing other transition-related activities; however, as noted above, the use of dealer resources in connection with such activity would be considered a contribution by the dealer to the issuer official thereby resulting in the dealer being prohibited from engaging in municipal securities business with the issuer for two years.
The MSRB also recognizes that dealers and their municipal finance professionals may solicit issuer officials for municipal securities business during the transition period prior to these officials taking office. In the course of making such solicitations, dealers may sometimes prepare and present materials such as financing plans and economic development studies. The provision of these types of materials to an issuer official during the transition period would not constitute contributions under rule G-37 if performed as part of a solicitation for municipal securities business.
Finally, in a Question and Answer Notice dated September 9, 1997 (Q&A number 1), the MSRB addressed whether a municipal finance professional who is entitled to vote for an issuer official may make contributions to pay for such official’s transition or inaugural expenses without causing a prohibition on municipal securities business with the issuer. If a municipal finance professional contributed $250 to the general election of an issuer official, the municipal finance professional would not be able to make any contributions to pay for transition or inaugural expenses without causing a prohibition on municipal securities business with the issuer. If a municipal finance professional made no contributions to an issuer official prior to the election, then the municipal finance professional may, if entitled to vote for the candidate, contribute up to $250 to pay for transition or inaugural expenses and payment of debt incurred in connection with the election without causing a prohibition on municipal securities business.
