Since 1994, the Municipal Securities Rulemaking Board (“MSRB”) has sought to eliminate pay-to-play practices in the municipal securities market through its Rule G-37, on political contributions and prohibitions on municipal securities business.[1]  Under the rule, certain contributions to elected officials of municipal securities issuers made by brokers, dealers and municipal securities dealers (“dealers”), municipal finance professionals (“MFPs”) associated with dealers, and political action committees (“PACs”) controlled by dealers and their MFPs (“dealer-controlled PACs”)[2] may result in prohibitions on dealers from engaging in municipal securities business with such issuers for a period of two years from the date of any triggering contributions.

Rule G-37 requires dealers to record and disclose certain contributions to issuer officials, state or local political parties, and bond ballot campaigns, as well as other information, on Form G-37 to allow public scrutiny of such contributions and the municipal securities business of a dealer. In addition, dealers and MFPs generally are prohibited from soliciting others (including affiliates of the dealer or any PACs) to make contributions to officials of issuers with which the dealer is engaging or seeking to engage in municipal securities business, or to political parties of a state or locality where the dealer is engaging or seeking to engage in municipal securities business. Dealers and MFPs also are prohibited from circumventing Rule G-37 by direct or indirect actions through any other persons or means.[3]

Due to changes in the financial markets since the adoption of Rule G-37, many dealers and MFPs have become affiliated with a broad range of other entities in increasingly diverse organizational structures.  Some of these affiliated entities (including but not limited to banks, bank holding companies, insurance companies and investment management companies) have formed or otherwise maintain relationships with PACs (“affiliated PACs”) and other political organizations, many of which may make contributions to issuer officials.  Such relationships raise questions regarding the extent to which affiliated PACs may effectively be controlled by dealers or their MFPs and thereby constitute dealer-controlled PACs whose contributions are subject to Rule G-37.  Further, such relationships raise concerns regarding whether the contributions of such affiliated PACs, even if not viewed as dealer-controlled PACs, may be used by dealers or their MFPs to circumvent Rule G-37 as indirect contributions for the purpose of obtaining or retaining municipal securities business.

The MSRB remains concerned that individuals and firms subject to Rule G-37 may seek ways around the rule through payments to and contributions by affiliated PACs that benefit issuer officials. When evaluating whether contributions made by affiliated PACs may be subject to the provisions of Rule G-37, the MSRB emphasizes that dealers should first determine whether such affiliated PAC would be viewed as a dealer-controlled PAC. If an affiliated PAC is determined to be a dealer-controlled PAC, then its contributions to issuer officials would subject the dealer to the ban on municipal securities business and its contributions to issuer officials, state or local political parties, and bond ballot campaigns would be subject to disclosure under Rule G-37. Even if the affiliated PAC is determined not to be a dealer-controlled PAC, the dealer still must consider whether payments made by the dealer or its MFPs to such affiliated PAC could ultimately be viewed as an indirect contribution under Rule G-37(d) if, for example, the affiliated PAC is being used as a conduit for making a contribution to an issuer official.

The MSRB wishes to provide guidance regarding the factors that may result in an affiliated PAC being viewed as controlled by the dealer or an MFP of the dealer and thereby being treated as a dealer-controlled PAC for purposes of Rule G-37. The MSRB also wishes to ensure that the industry is cognizant of prior MSRB guidance regarding the potential for payments to and contributions by affiliated PACs to constitute indirect contributions under the rule.

Indicators of Control by Dealers and MFPs

Soon after adoption of Rule G-37, the MSRB stated that each dealer must determine whether a PAC is dealer controlled, with any PAC of a non-bank dealer assumed to be a dealer-controlled PAC.[4]  The MSRB has also stated that the determination of whether a PAC of a bank dealer[5] is a dealer-controlled PAC would depend upon whether the bank dealer or anyone from the bank dealer department has the ability to direct or cause the direction of the management or the policies of the PAC.[6]  Such ability to direct or cause the direction of the management or the policies of a PAC also would be indicative of control of such PAC by a non-bank dealer or any of its MFPs, although it would not be the exclusive indicator of such control. While this guidance establishes basic principles with regard to making a determination of control, it does not set out an exhaustive list of circumstances under which a PAC may or may not be viewed as dealer or MFP controlled.  The specific facts and circumstances regarding the creation, management, operation and control of a particular PAC must be considered in making a determination of control with respect to such PAC.

Creation of PAC. In general, a dealer or MFP involved in the creation of a PAC would continue to be viewed as controlling such PAC unless and until such dealer or MFP becomes wholly disassociated in any direct or indirect manner with the PAC. Thus, any PAC created by a dealer, acting either in a sole capacity or together with other entities or individuals, would be presumed to be a dealer-controlled PAC.  This presumption continues at least as long as the dealer or any MFP of the dealer retains any formal or informal role in connection with such PAC, regardless of whether such dealer or MFP has the ability to direct or cause the direction of the management or policies of the PAC. This presumption also would continue for so long as any associated person of the dealer (either an individual, whether or not an MFP, or an affiliated company directly or indirectly controlling, controlled by or under common control with the dealer) has the ability to direct or cause the direction of the management or policies of the PAC. In effect, a dealer could not attempt to treat a PAC it created and then spun off to the control of an affiliated company as not being a dealer-controlled PAC. However, depending on the totality of the facts and circumstances, a PAC originally created by a dealer in which the dealer or its MFPs no longer retain any role, and with respect to which any other affiliates retain only very limited non-control roles, could be viewed as no longer controlled by the dealer.

Similarly, a PAC created by any person associated with the dealer at the time the PAC was created, acting either in a sole capacity or together with other entities or individuals, would be presumed to be controlled by such person.  Such presumption continues at least for so long as such person retains any formal or informal role in connection with such PAC, regardless of whether any such person has the ability to direct or cause the direction of the management or policies of the PAC.  This presumption also would continue for so long as any other person associated with the same dealer as the creator of the PAC has the ability to direct or cause the direction of the management or policies of the PAC. Although such PAC may not be viewed as being subject to Rule G-37 as an MFP-controlled PAC when originally created if such person was not then an MFP, if the person creating the PAC, or any other associated person with the ability to direct or cause the direction of the management or policies of such PAC, is or later becomes an MFP, such PAC would be deemed an MFP-controlled PAC.[7]

Management, Funding and Control of PAC. Beyond the role of the dealer, MFP or other person in creating a PAC and maintaining an ongoing association with such PAC, the ability to direct or cause the direction of the management or the policies of a PAC is also important. Strong indicators of management and control are not mitigated by the fact that such dealer, MFP or other person does not have exclusive, predominant or “majority” control of the PAC, its management, its policies, or its decisions with regard to making contributions.  For example, the fact that a dealer or MFP may only have a single vote on a governing board or other decision-making or advisory board or committee of a PAC, and therefore does not have sole power to cause the PAC to take any action, would not obviate the status of such dealer or MFP as having control of the PAC, so long as the dealer or MFP has the ability, alone or in conjunction with other similarly empowered entities or individuals, to direct or cause the direction of the management or the policies of the PAC.  In essence, it is possible for a single PAC to be viewed as controlled by multiple different dealers if the control of such PAC is shared among such dealers, although the presumption of control may be rebutted as described below.

The level of funding provided by dealers and their MFPs to a PAC may also be indicative of control. A PAC that receives a majority of its funding from a single dealer (including the collective contributions of its MFPs and employees) or a single MFP is conclusively presumed to be controlled by such dealer or MFP, regardless of the lack of any of the other indicia of control described in this notice.  Another important factor is the size or frequency of contributions by a dealer or MFP,[8] viewed in light of the size and frequency of contributions made by other contributors not affiliated in any way with such dealer or MFP. For example, a limited number of small contributions freely made by employees of a dealer to an affiliated PAC (i.e., not directed by the dealer and not part of an automated or otherwise dealer-organized program of contributions) would not, by itself, automatically raise a presumption of dealer control so long as the collective contributions by the dealer or its employees is not significant as compared to the total funding of the affiliated PAC, subject to consideration of the other relevant facts and circumstances. In addition, contributions made by a dealer or MFP to an affiliated PAC could raise a stronger inference of de facto dealer or MFP control than when such contributions were made to non-affiliated PACs.

However, even where a dealer or MFP is not viewed as controlling a PAC under the principles described above, dealers should remain mindful of the potential for leveraging the contribution activities of affiliated PACs in soliciting municipal securities business in a way that could raise a presumption of dealer or MFP control.  For example, an MFP’s references to the contributions made by an affiliated PAC during solicitations of municipal securities business could, depending on the facts and circumstances, serve as evidence of coordination of such PAC’s activities with the dealer or MFP that could, together with other facts, be indicative of direct or indirect control of the PAC by such dealer or MFP.  Such control could be found even in circumstances where the dealer or its MFPs have not made contributions to the affiliated PAC.[9]

Of course, the presumptions described above may be rebutted, depending upon the totality of facts and circumstances. Considerations that may serve to rebut such presumptions may include whether the dealer or person creating the PAC:  (i) participates with a broad-based group of other entities and/or individuals in creating the PAC, (ii) at no time undertakes any direct or indirect role (and, in the case of a dealer, no person associated with the dealer undertakes any direct or indirect role) in leading the creation of the PAC or in directing or causing the direction of the management or the policies of the PAC, and/or (iii) provides funding for such PAC (and, in the case of a dealer, its associated persons collectively provide funding for such PAC) that is not substantially greater than the typical funding levels of other participants in the PAC who do not undertake a direct or indirect role in leading the creation of the PAC or in directing or causing the direction of the management or the policies of the PAC.

Indirect Contributions Through Bank PACs or Other Affiliated PACs

As noted above, if an affiliated PAC is determined not to be a dealer-controlled PAC, a dealer must still consider whether payments made by the dealer or its MFPs to such affiliated PAC could be viewed as an indirect contribution that would become subject to Rule G-37 pursuant to section (d) thereof. The MSRB has provided extensive guidance on such indirect contributions, noting in 1996 that, depending on the facts and circumstances, contributions to a non-dealer associated PAC that is soliciting funds for the purpose of supporting a limited number of issuer officials might result in the same prohibition on municipal securities business as would contributions made directly to the issuer official.[10]  The MSRB also noted that dealers should make inquiries of a non-dealer associated PAC that is soliciting contributions in order to ensure that contributions to such a PAC would not be treated as an indirect contribution.[11]

The MSRB also has previously provided guidance in 2005 with regard to supervisory procedures [12] that dealers should have in place in connection with payments to a non-dealer associated PAC or a political party to avoid indirect rule violations of Rule G-37(d).  In such guidance, the MSRB stated that, in order to ensure compliance with Rule G-27(c) as it relates to payments to political parties or PACs and Rule G-37(d), each dealer must adopt, maintain and enforce written supervisory procedures reasonably designed to ensure that neither the dealer nor its MFPs are using payments to political parties or non-dealer controlled PACs to contribute indirectly to an official of an issuer.[13]  Among other things, dealers might seek to establish procedures requiring that, prior to the making of any contribution to a PAC, the dealer undertake certain due diligence inquiries regarding the intended use of such contributions, the motive for making the contribution and whether the contribution was solicited. Further, in order to ensure compliance with Rule G-37(d), dealers could consider establishing certain information barriers between any affiliated PACs and the dealer and its MFPs.[14]  Dealers that have established such information barriers should review their adequacy to ensure that the affiliated entities’ contributions, payments or PAC disbursement decisions are neither influenced by the dealer or its MFPs, nor communicated to the dealers and the MFPs.

The MSRB subsequently noted that the 2005 guidance did not establish an obligation to put in place the specific procedures and information barriers described in the guidance so long as the dealer in fact has and enforces other written supervisory procedures reasonably designed to ensure that the conduct of the dealer and its MFPs are in compliance with Rule G-37(d).[15]  Thus, for example, when information regarding past or planned contributions of an affiliated PAC is or may be available to or known by the dealer or its MFPs, the dealer might establish and enforce written supervisory procedures that prohibit the dealer or MFP from providing information to issuer personnel regarding past or anticipated affiliated PAC contributions.

_______________________________________

[1] Rule G-37 defines municipal securities business as: (i) the purchase of a primary offering of municipal securities from an issuer on other than a competitive bid basis; (ii) the offer or sale of a primary offering of municipal securities on behalf of an issuer; (iii) the provision of financial advisory or consultant services to or on behalf of an issuer with respect to a primary offering of municipal securities in which the dealer was chosen to provide such services on other than a competitive bid basis; or (iv) the provision of remarketing agent services to or on behalf of an issuer with respect to a primary offering of municipal securities in which the dealer was chosen to provide such services on other than a competitive bid basis.

[2] The MSRB has previously stated that the matter of control depends upon whether or not the dealer or the MFP has the ability to direct or cause the direction of the management or policies of the PAC (MSRB Question & Answer No. IV. 24 – Dealer Controlled PAC).

[3] Rule G-37(d) provides that no broker, dealer or municipal securities dealer or any municipal finance professional shall, directly or indirectly, through or by any other person or means, do any act which would result in a violation of sections (b) or (c) of the rule. Section (b) relates to the ban on business and Section (c) relates to the prohibition on soliciting and coordinating contributions.

[4] See Rule G-37 Question & Answer No. IV.24 (May 24, 1994).

[5] MSRB Rule D-8 defines a bank dealer as a municipal securities dealer which is a bank or a separately identifiable department or division of a bank.

[6] See Rule G-37 Question & Answer No. IV.24 (May 24, 1994).

[7] However, a PAC created by an individual acting in his or her formal capacity as an officer, employee, director or other representative of a dealer, regardless of whether such individual is an MFP, would be deemed a dealer-controlled PAC rather than a PAC controlled by the individual.

[8] A dealer or an MFP may make sufficiently large or frequent contributions to a PAC so as to obtain effective control over the PAC, depending on the totality of facts and circumstances.

[9] See Rule G-37 Question & Answer No. III.7 (September 22, 2005) for a discussion of potential indirect contributions through affiliated PACs.

[10] See Rule G-37 Question & Answer No. III.4 (August 6, 1996).

[11] See Rule G-37 Question & Answer No. III.5 (August 6, 1996).

[12] Rule G-27, on supervision, provides in section (c) that each dealer shall adopt, maintain and enforce written supervisory procedures reasonably designed to ensure that the conduct of the municipal securities activities of the dealer and its associated persons are in compliance with MSRB rules.

[13] See Rule G-37 Question & Answer No. III.7 (September 22, 2005).

[14] The potential information barriers described in the guidance include: i) a prohibition on the dealer or MFP from recommending, nominating, appointing or approving the management of affiliated PACs; ii) a prohibition on sharing the affiliated PAC’s meeting agenda, meeting schedule, or meeting minutes; iii) a prohibition on identification of prior affiliated PAC contributions, planned PAC contributions or anticipated PAC contributions; iv) a prohibition on directly providing or coordinating information about prior negotiated municipal securities businesses, solicited municipal securities business, and planned solicitations of municipal securities business; and v) other such information barriers as the firms deems appropriate to monitor conflicting interest and prevent abuses effectively.

[15] See Rule G-37 Interpretive Letter – Supervisory procedures relating to indirect contributions; conference accounts and 527 organizations (December 21, 2006).

On December 22, 1987, the MSRB published a notice[1] interpreting the fair practice principles of Rule G-17 as they apply to the priority of orders for new issue securities (the “1987 notice”). The MSRB wishes to update the guidance provided in the 1987 notice due to changes in the marketplace and subsequent amendments to Rule G-11.

Rule G-11(e) requires syndicates to establish priority provisions and, if such priority provisions may be changed, to specify the procedure for making changes. The rule also permits a syndicate to allow the syndicate manager, on a case-by-case basis, to allocate securities in a manner other than in accordance with the priority provisions if the syndicate manager determines in its discretion that it is in the best interests of the syndicate. Under Rule G-11(f), syndicate managers must furnish information, in writing, to the syndicate members about terms and conditions required by the issuer,[2] priority provisions and the ability of the syndicate manager to allocate away from the priority provisions, among other things. Syndicate members must promptly furnish this information, in writing, to others upon request. This requirement was adopted to allow prospective purchasers to frame their orders to the syndicate in a manner that would enhance their ability to obtain securities since the syndicate’s allocation procedures would be known.

In addition to traditional priority provisions found in syndicate agreements, municipal securities underwriters frequently agree to other terms and conditions specified by the issuer of the securities relating to the distribution of the issuer’s securities. Such provisions include, but are not limited to, requirements concerning retail order periods. MSRB Rule G-17 states that, in the conduct of its municipal securities business, each broker, dealer, and municipal securities dealer (“dealer”) shall deal fairly with all persons and shall not engage in any deceptive, dishonest or unfair practice. These requirements specifically apply to an underwriter’s activities conducted with a municipal securities issuer, including any commitments that the underwriter makes regarding the distribution of the issuer’s securities. An underwriter may violate the duty of fair dealing by making such commitments to the issuer and then failing to honor them. This could happen, for example, if an underwriter fails to accept, give priority to, or allocate to retail orders in conformance with the provisions agreed to in an undertaking to provide a retail order period. A dealer who wishes to allocate securities in a manner that is inconsistent with an issuer’s requirements must not do so without the issuer’s consent.

Except as otherwise provided in this notice, principles of fair dealing will require the syndicate manager to give priority to customer orders over orders for its own account, orders by other members of the syndicate for their own accounts, orders from persons controlling, controlled by, or under common control with any syndicate member (“affiliates”) for their own accounts, or orders for their respective related accounts,[3] to the extent feasible and consistent with the orderly distribution of securities in a primary offering. This principle may affect a wide range of dealers and their related accounts given changes in organizational structures due to consolidations, acquisitions, and other corporate actions that have, in many cases, resulted in increasing numbers of dealers, and their related dealer accounts, becoming affiliated with one another.

Rule G-17 does not require the syndicate manager to accord greater priority to customer orders over orders submitted by non-syndicate dealers (including selling group members). However, prioritization of customer orders over orders of non-syndicate dealers may be necessary to honor terms and conditions agreed to with issuers, such as requirements relating to retail orders.

The MSRB understands that syndicate managers must balance a number of competing interests in allocating securities in a primary offering and must be able quickly to determine when it is appropriate to allocate away from the priority provisions, to the extent consistent with the issuer’s requirements. Thus, Rule G-17 does not preclude the syndicate manager or managers from according equal or greater priority to orders by syndicate members for their own accounts, affiliates for their own accounts, or their respective related accounts if, on a case-by-case basis, the syndicate manager determines in its discretion that it is in the best interests of the syndicate. However, the syndicate manager shall have the burden of justifying that such allocation was in the best interests of the syndicate. Syndicate managers should ensure that all allocations, even those away from the priority provisions, are fair and reasonable and consistent with principles of fair dealing under Rule G-17.

It should be noted that all of the principles of fair dealing articulated in this notice extend to any underwriter of a primary offering, whether a sole underwriter, a syndicate manager, or a syndicate member.

Executive Summary

Brokers, dealers and municipal securities dealers (dealers or firms) must fully understand the bonds they sell in order to meet their disclosure, suitability and pricing obligations under the rules of the Municipal Securities Rulemaking Board (MSRB) and federal securities laws. These obligations are not limited to firms involved in primary offerings. Dealers must also obtain, analyze and disclose all material facts about secondary market transactions that are known to the dealer, or that are reasonably accessible to the market through established industry sources.

Those sources include, among other things, official statements, continuing disclosures, trade data, and other information made available through the MSRB’s Electronic Municipal Market Access system (EMMA). Firms may also have a duty to obtain and disclose information that is not available through EMMA, if it is material and available through other public sources. The public availability of material information, through EMMA or otherwise, does not relieve a firm of its duty to disclose that information. Firms must also have reasonable grounds for determining that a recommendation is suitable based on information available from the issuer of the security or otherwise. Firms must also use this information to determine the prevailing market price of a security as the basis for establishing a fair price in a transaction with a customer. To meet these requirements, firms must perform an independent analysis of the bonds they sell, and may not rely solely on a bond’s credit rating.

Continuing disclosures made by issuers to the MSRB via EMMA are part of the information that dealers must obtain, disclose and consider in meeting their regulatory obligations. The Securities and Exchange Commission (SEC) has recently approved amendments to Securities Exchange Act Rule 15c2-12, governing continuing disclosures. Firms that sell municipal securities should review and, if necessary, update their procedures to reflect the amendments, which have a compliance date of December 1, 2010.  

Background and Discussion

MSRB Disclosure, Suitability and Pricing Rules

MSRB Rule G-17 provides that, in the conduct of its municipal securities activities, each dealer must deal fairly with all persons and may not engage in any deceptive, dishonest or unfair practice. The MSRB has interpreted Rule G-17 to require a dealer, in connection with any transaction in municipal securities, to disclose to its customer, at or prior to the sale, all material facts about the transaction known by the dealer, as well as material facts about the security that are reasonably accessible to the market.[1] This includes the obligation to give customers a complete description of the security, including a description of the features that likely would be considered significant by a reasonable investor and facts that are material to assessing the potential risks of the investment.

Such disclosures must be made at the “time of trade,” which the MSRB defines as at or before the point at which the investor and the dealer agree to make the trade. Rule G-17 applies to all sales of municipal securities, whether or not a transaction was recommended by a broker-dealer.[2] This means that municipal securities dealers must disclose all information required to be disclosed by the rule even if the trade is self-directed.[3]

MSRB Rule G-19 requires that a dealer that recommends a municipal securities transaction have reasonable grounds for believing that the recommendation is suitable for the customer based upon information available from the issuer of the security or otherwise and the facts disclosed by, or otherwise known about, the customer.[4]

MSRB Rule G-30 requires that dealers trade with customers at prices that are fair and reasonable, taking into consideration all relevant factors.[5] The MSRB has stated that the concept of a “fair and reasonable” price includes the concept that the price must “bear a reasonable relationship to the prevailing market price of the security.” The impetus for the MSRB’s Real-time Transaction Reporting System (RTRS), which was implemented in January 2005, was to allow market participants to monitor market price levels on a real-time basis and thus assist them in identifying changes in market prices that may have been caused by news or market events.[6] The MSRB now makes the transaction data reported to RTRS available to the public through EMMA.

In meeting these disclosure, suitability and pricing obligations, firms must take into account all material information that is known to the firm or that is available through “established industry sources,” including official statements, continuing disclosures, and trade data, much of which is now available through EMMA. Resources outside of EMMA may include press releases, research reports and other data provided by independent sources. Established industry sources can also include material event notices and other data filed with former nationally recognized municipal securities information repositories (NRMSIRs) before July 1, 2009.[7] Therefore, firms should review their policies and procedures for obtaining material information about the bonds they sell to make sure they are reasonably designed to access all material information that is available, whether through EMMA or other established industry sources. The MSRB has also noted that the fact that material information is publicly available through EMMA does not relieve a firm of its duty to specifically disclose it to the customer at the time of trade, or to consider it in determining the suitability of a bond for a specific customer.[8] Importantly, the dealer may not simply direct the customer to EMMA to fulfill its time-of-trade disclosure obligations under Rule G-17.[9]

Amendments to Rule 15c2-12 Concerning Continuing Disclosure

Securities Exchange Act Rule 15c2-12 requires underwriters participating in municipal bond offerings that are subject to that rule[10] to receive, review, and distribute official statements of issuers of primary municipal securities offerings, and prohibits underwriters from purchasing or selling municipal securities covered by the rule unless they have first reasonably determined that the issuer or an obligated person[11] has contractually agreed to make certain continuing disclosures to the MSRB, including certain financial information and notice of certain events. The MSRB makes such disclosure public via EMMA.

Financial information to be disclosed under the rule consists of the following:

• Annual financial information updating the financial information in the official statement;
• Audited financial statements, if available and not included within the annual financial information; and
• Notices of failure to provide such financial information on a timely basis.

Currently, the rule enumerates the following as notice events, if material:

• Principal and interest payment delinquencies;
• Non-payment related defaults;
• Unscheduled draws on debt service reserves reflecting financial difficulties;
• Unscheduled draws on credit enhancements reflecting financial difficulties;
• Substitution of credit or liquidity providers or their failure to perform;
• Adverse tax opinions or events affecting the tax-exempt status of the security;
• Modifications to rights of security holders;
• Bond calls;
• Defeasances;
• Release, substitution or sale of property securing repayment of the securities; and
• Rating changes.

Rule 15c2-12(c) also prohibits any dealer from recommending the purchase or sale of a municipal security unless it has procedures in place that provide reasonable assurance that it will receive prompt notice of any event notice reported pursuant to the rule. Firms should review any applicable continuing disclosures made available through EMMA and other established industry sources and take such disclosures into account in undertaking its suitability and pricing determinations. 

On May 26, 2010, the SEC amended the rule’s disclosure obligations, with a compliance date of December 1, 2010, to: (1) apply continuing disclosure requirements to new primary offerings of certain variable rate demand obligations (VRDOs); (2) add four new notice events;[12] (3) remove the materiality standard for certain notice events;[13] and (4) require that event notices be filed in a timely manner but no later than 10 business days after their occurrence. With respect to the tax status of the security, the rule has been broadened to require disclosure of adverse tax opinions, issuance by the IRS of proposed or final determinations of taxability and other material notices, and determinations or events affecting the tax status of the bonds (including a Notice of Proposed Issue). Firms that deal in municipal securities should familiarize themselves with these amendments, and, if necessary, modify their policies and procedures to incorporate this additional disclosure accordingly. 

The Financial Industry Regulatory Authority (FINRA) noted in its Regulatory Notice 09-35 that, if a firm discovers through its Rule 15c2-12 procedures or otherwise that an issuer has failed to make filings required under its continuing disclosure agreements, the firm must take this information into consideration in meeting its disclosure obligations under MSRB Rule G-17 and in assessing the suitability of the issuer’s bonds under MSRB Rule G-19.

Credit Ratings

In order to meet their obligations under MSRB Rules G-17 and G-19, firms must analyze and disclose to customers the risks associated with the bonds they sell, including, but not limited to, the bond’s credit risk. A credit rating is a third-party opinion of the of the credit quality of a municipal security. While the MSRB generally considers credit ratings and rating changes to be material information for purposes of disclosure, suitability and pricing, they are only one factor to be considered, and dealers should not solely rely on credit ratings as a substitute for their own assessment of a bond’s credit risk. [14]  Moreover, different agencies use different quantitative and qualitative criteria and methodologies to determine their rating opinions.  Dealers should familiarize themselves with the rating systems used by rating agencies in order to understand and assess the relevance of a particular rating to the firm’s overall assessment of the bond.[15]. With respect to credit or liquidity enhanced securities, the MSRB has stated that material information includes the following, if known to the dealer or if reasonably available from established industry sources: (i) the credit rating of the issue or lack thereof; (ii) the underlying credit rating or lack thereof, (iii) the identity of any credit enhancer or liquidity provider; and (iv) the credit rating of the credit provider and liquidity provider, including potential rating actions (e.g., downgrade).[16]  Additionally, material terms of the credit facility or liquidity facility should be disclosed (e.g., any circumstances under which a standby bond purchase agreement would terminate without a mandatory tender).

Other Material Information 

In addition to a bond’s credit quality, firms must obtain, analyze and disclose other material information about a bond, including but not limited to whether the bond may be redeemed prior to maturity in-whole, in-part or in extraordinary circumstances,[17] whether the bond has non-standard features that may affect price or yield calculations,[18] whether the bond was issued with original issue discount or has other features that would affect its tax status,[19] and other key features likely to be considered significant by a reasonable investor.  For example, for VRDOs, auction rate securities or other securities for which interest payments may fluctuate, firms should explain to customers the basis on which periodic interest rate resets are determined.[20] The MSRB has stated that firms should take particular care with respect to new products that may be introduced into the municipal securities market, existing products that may have complex structures that can differ materially from issue to issue, and outstanding securities that may trade infrequently, may be issued by less well-known issuers, or may have unusual features.[21]

Supervision

Firms are reminded that MSRB Rule G-27 requires firms to supervise their municipal securities business, and to ensure that they have adequate policies and procedures in place for monitoring the effectiveness of their supervisory systems. Specifically, firms must:

• Supervise the conduct of the municipal securities activities of the firm and associated persons to ensure compliance with all MSRB rules, the Exchange Act and the rules there under;
• Have adequate written supervisory procedures; and
• Implement supervisory controls to ensure that their supervisory procedures are adequate.

Rule G-27 requires that a firm’s supervisory procedures provide for the regular and frequent review and approval by a designated principal of customer accounts introduced or carried by the dealer in which transactions in municipal securities are effected, with such review being designed to ensure that transactions are in accordance with all applicable rules and to detect and prevent irregularities and abuses. Although the rule does not establish a specific procedure for ensuring compliance with the requirement to provide disclosures to customers pursuant to Rule G-17, firms should consider including in their procedures for reviewing accounts and transactions specific processes for documenting or otherwise ascertaining that such disclosures have been made.  

Questions to Consider

Before selling any municipal bond, dealers should make sure that they fully understand the bonds they are selling in order to make adequate disclosure to customers under Rule G-17, to ensure that recommendations are suitable under Rule G-19, and to ensure that they are fairly priced under Rule G-30. Among other things, dealers should ask and be able to answer the following questions: 

• What are the bond’s key terms and features and structural characteristics, including but not limited to its issuer, source of funding (e.g., general obligation or revenue bond), repayment priority, and scheduled repayment rate? (Much of this information will be in the Official Statement, which for many municipal bonds can be obtained by entering the CUSIP number in the MuniSearch box at www.emma.msrb.org). Be aware, however, data in the Official Statement may have been superseded by the issuer’s on-going disclosures.
• Does information available through EMMA or other established industry sources indicate that an issuer is delinquent in  its material event notice and other continuing disclosure filings?  Delinquencies should be viewed as a red flag.
• What other public material information about the bond or its issuer is available through established industry sources other than EMMA?
• What is the bond’s rating? Has the issuer of the bond recently been downgraded? Has the issuer filed any recent default or other event notices, or has any other information become available through established industry sources that might call into question whether the published rating has been revised to take such event into consideration?
• Is the bond insured, or does it benefit from liquidity support, a letter of credit or is it otherwise supported by a third party? If so, check the credit rating of the bond insurer or other backing, and the bond’s underlying rating (without third party support). If supported by a third party, review the terms and conditions under which the third party support may terminate.
• How is it priced? Be aware that the price of a bond can be priced above or below its par value for many reasons, including changes in the creditworthiness of a bond's issuer and a host of other factors, including prevailing interest rates.
• How and when will interest on the bond be paid? Most municipal bonds pay semiannually, but zero coupon municipal bonds pay all interest at the time the bond matures. Variable rate bonds typically will pay interest more frequently, usually on a monthly basis in variable amounts.
• What is the bond’s tax status, under both state and federal laws? Is it subject to the Federal Alternate Minimum Tax? Is it fully taxable (e.g., Build America Bonds)?
• What are its call provisions? Call provisions allow the issuer to retire the bond before it matures. How would a call affect expected future income?

This notice addresses several questions that have arisen concerning Board rules G-12 and G-15. Board rule G-12 establishes uniform industry procedures for the processing, clearance, and settlement of transactions in municipal securities... Board rule G-15 requires municipal securities professionals to send written confirmations of transactions to customers, and specifies the information required to be set forth on the confirmation.

Settlement Dates

In order to establish uniform settlement dates for "regular way" transactions in municipal securities, rule G-12(b)(i)(B) defines the term "business day" as "a day recognized by the National Association of Securities Dealers, Inc. [the "NASD"] as a day on which securities transactions may be settled." The practice of the NASD has been to exclude from the category of "business day," any day widely designated as a legal bank holiday, and to notify the NASD membership accordingly. Such notices set forth the NASD’s trade and settlement date schedules for periods which include a legal holiday.

"Catastrophe" Call Features

Rules G-12 and G-15 require that confirmations of transactions set forth a "description of the securities, including at a minimum… if the securities are subject to redemption prior to maturity (callable)… an indication to such effect…" (paragraphs G-12(c)(v)(E) and G-15(a)(v)[*]). Both rules also require that in transactions in callable securities effected on a yield basis, dollar price must be shown and "the calculation of dollar price shall be to the lower of price to call or price to maturity" (paragraphs G-12(c)(v)(I) and G-15(a)(viii)[†]).

The references to "callable" securities and pricing to call in rules G-12 and G-15 do not refer to "catastrophe" call features, such as those relating to acts of God or eminent domain, which are beyond the control of the issuer of the securities.

[*] [Currently codified at rule G-15(a)(i)(C)(2)(a)]

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

Agency transactions: remuneration. This will acknowledge receipt of your letter dated November 1, 1977 in which you request an interpretation concerning the provision in Board rule G-15(b)(ii)[*] which requires that "the source and amount of any commission or other remuneration" received by a municipal securities dealer in a transaction in which the municipal securities dealer is acting as agent for a customer be disclosed on the confirmation to the customer.

The reference to the "amount of any commission or other remuneration" requires that an aggregate dollar amount be shown, in a purchase transaction on behalf of an equivalent of the dealer concession, and, if applicable, any additional charge to the customer above the price paid to the seller of the securities. In a sale transaction on behalf of a customer, this would normally be the difference between the net price paid by the purchaser of the securities and the proceeds to the customer. If a percentage of par value or unit profit were shown it would be difficult for many customers to relate this information to the "total dollar amount of [the] transaction" required by rule G-15(a)(xi)[†] to be shown on the confirmation.

The reference in rule G-15(b)(ii)[*] to the "source" of remuneration would not require you to differentiate between the concession and any additional charge. Standard language could be included on the confirmation to indicate that your remuneration may include dealer concessions and other charges. MSRB interpretation of November 10, 1977.

[†] [Currently codified at rule G-15(a)(i)(A)(6)(a)]

[*] [Currently codified at rule G-15(a)(i)(A)(1)(e)]

Callable securities: "catastrophe" calls. This will acknowledge receipt of your letter dated October 20, 1977 which has been referred to me for reply. In your letter you request an interpretation of the provisions in rules G-12 and G-15 requiring that the dollar price for transactions in callable securities effected on a yield basis be priced to the lower of price to call or price to maturity. (See rules G-12(c)(v)(I) and G-15(a)(viii))[*].

At its meeting held October 25-26, 1977, the Board confirmed that the requirements in rules G-12 and G-15 relating to pricing to call do not include "catastrophe" calls, that is, calls which occur as a result of events specified in the bond indenture which are beyond the control of the issuer. MSRB interpretation of November 7, 1977.

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

The Municipal Securities Rulemaking Board (the "Board") has received a number of inquiries concerning Board rules G-8 and G-9. These rules require municipal securities brokers and municipal securities dealers to make and keep current certain specified records concerning their municipal securities business and to preserve such records for specified periods of time. This interpretive notice addresses several of the more frequent inquiries received by the Board regarding these rules.

General Purposes of Recordkeeping Rules

The Board’s recordkeeping rules are designed to require organizations engaged in the municipal securities business to maintain appropriate records concerning their activities in such business. In writing the rules, the Board adopted the approach of specifying in some detail the information to be reflected in the various records. The Board believed that this approach would provide helpful guidance to municipal securities professionals as well as the regulatory agencies charged with the responsibility of examining the records of such firms. At the same time, the Board attempted to provide a degree of flexibility to firms concerning the manner in which their records are to be maintained, recognizing that various recordkeeping systems could provide a complete and accurate record of a firm’s municipal securities activities. The interpretations set forth in this notice are intended to be consistent with the foregoing purposes.

This notice is not intended to address all of the questions which have arisen, or may arise; the Board will continue its policy of responding to written requests for individual interpretations and may issue further interpretive notices on recordkeeping should additional questions of general interest arise.

The following topics are covered in this interpretive notice:General Purposes of Recordkeeping Rules

Election to Follow Board or Commission Recordkeeping Rules

Maintenance of Records on a Trade Date or Settlement Date Basis

Current Posting of Records

Unit System Method of Recordkeeping

Rule G-8(a)(ii)—Account Records

Rule G-8(a)(iii)—Securities Records

Rules G-8(a)(vi) and (vii)—Records for Agency and Principal Transactions

Rule G-8(a)(xi)—Customer Account Information

Rule G-8(c)—Non-Clearing Municipal Securities Brokers and Municipal Securities Dealers

Rule G-9(b)(viii)(C)—Preservation of Written Communications

Election to Follow Board or Commission Recordkeeping Rules

Rules G-8(f) and G-9(g) provide that municipal securities brokers and municipal securities dealers other than bank dealers, who are in compliance with the recordkeeping rules of the Securities and Exchange Commission (the "Commission"), will be deemed to be in compliance with Board rules G-8 and G-9, provided that the following additional records, not specified in the Commission’s rules, are maintained by such firms: records of uncompleted transactions involving customers (subparagraph (a)(iv)(D)); records relating to syndicate transactions (paragraph (a)(viii)); new account information (paragraph (a)(xi)); and information concerning customer complaints (paragraph (a)(xii)). Conversely, Commission rules 17a-3 and 17a-4 provide that securities firms engaged in the municipal securities business will satisfy all regulatory requirements concerning recordkeeping with respect to their municipal securities business if they are in compliance with the Board’s rules.

Securities firms must determine to comply with either the Board or Commission rules, but are not required to file with either the Board or the commission a formal written notice of election. Satisfactory compliance with either set of rules will be subject to determination in the course of periodic compliance examinations conducted by the regulatory organizations charged with enforcement of Board and Commission rules.

Maintenance of Records on a Trade Date or Settlement Date Basis

Under rule G-8, records concerning purchases and sales of municipal securities may be maintained on either a trade date or settlement date basis, provided that all records relating to purchases and sales are maintained on a consistent basis. For example, if a municipal securities broker or municipal securities dealer maintains its records of original entry concerning purchases and sales (rule G-8(a)(i)) on a settlement date basis, the municipal securities broker or municipal securities dealer must also maintain its account records (rule G-8(a)(ii)) and securities records (rule G-8(a)(iii)) on the same basis.

The above records may not be maintained on a clearance date basis, that is, the date the securities are actually delivered or received. Records maintained on a clearance date basis would not accurately reflect obligations of a municipal securities broker or municipal securities dealer to deliver or accept delivery of securities. Of course, the date of clearance should be noted in the records of original entry, account records and securities records, regardless of whether these records are kept on a trade date or settlement date basis.

Current Posting of Records

Rule G-8 provides that every municipal securities broker or municipal securities dealer must make and keep current the records specified in the rule. The Board has received inquiries as to the time within which records must be posted to satisfy the currency requirement.

Blotters or other records of original entry showing purchases and sales of municipal securities should be prepared no later than the end of the business day following the trade date. Transactions involving the purchase and sale of securities should be posted to the account records no later than settlement date and to the securities records no later than the end of the business day following the settlement date. Records relating to securities movements and cash receipts and disbursements should reflect such events on the date they occur and should be posted to the appropriate records no later than the end of the following business day.

Commission rule 17a-11 requires municipal securities dealers, other than bank dealers, to give immediate notice to the Commission and their designated examining authorities of any failure to make and keep current the required records, and to take corrective action within forty-eight hours after the transmittal of such notice.

Unit System Method of Recordkeeping

Under rule G-8, records may be maintained in a variety of ways, including a unit system of recordkeeping. In such a system, records are kept in the form of a group of documents or related groups of documents. For example, customer account records may consist of copies of confirmations and other related source documents, if necessary, arranged by customer.

A unit system of recordkeeping is an acceptable system for purposes of rule G-8 if the information required to be shown is clearly and accurately reflected and there is an adequate basis for audit. This would require in most instances that each record in a unit system be arranged in appropriate sequence, whether chronological or numerical, and fully integrated into the overall recordkeeping system for purposes of posting to general ledger accounts.

Rules G-8(a)(ii)—Account Records

Rule G-8(a)(ii) requires every municipal securities broker and municipal securities dealer to maintain account records for each customer account and the account of the municipal securities broker and municipal securities dealer, showing all purchases and sales, all receipts and deliveries of securities, all receipts and disbursements of cash, and all other debits and credits to such account.

The account records may be kept in several different formats. Ledger entries organized separately for each customer and for the municipal securities broker or municipal securities dealer, showing the requisite information, would clearly satisfy the requirements of rule G-8(a)(ii).

The requirements of rule G-8(a)(ii) can also be satisfied by a unit system of recordkeeping. See discussion above. Under such a system, a municipal securities professional might maintain files, organized by customer, containing copies of confirmations and other pertinent documents, if necessary, which reflect all the information required by rule G-8(a)(ii).

The question has also been raised whether the account records requirement of rule G-8(a)(ii) can be satisfied by an electronic data processing system which can produce account records by tracing through separate transactions. The Board is of the view that such a system is acceptable if the account records should be obtainable without delay, although the records need not be maintained by customer prior to being produced. The account records so produced must also reflect clearly and accurately all the required information, provide an adequate basis for audit and be fully integrated into the overall recordkeeping system. Under rule G-27, on supervision, a municipal securities principal is required to supervise the activities of municipal securities representatives with respect to customer accounts and other matters. In this connection, it may be appropriate to obtain printouts of customer accounts on a periodic basis.

The Board believes that it is important to maintain account records in the fashion described above in view of several of the Board’s fair practice rules, such as the rules on suitability and churning. Account records will be important both as a tool for management to detect violations of these rules and for enforcement of these rules by the regulatory agencies conducting compliance examinations or responding to complaints.

The requirement to maintain account records does not apply to a firm which effects transactions exclusively with other municipal securities professionals and has no customers, as defined in paragraph (e) of rule G-8.

Rule G-8(a)(iii)—Securities Records

Rule G-8(a)(iii) requires that records be kept showing separately for each municipal security all long and short positions carried by a municipal securities broker or municipal securities dealer for its account or for the account of a customer, the location of all such securities long and the offsetting position to all such securities short, and the name or other designation of the account in which each position is carried.

The securities records should reflect not only purchases and sales, but also any movement of securities, such as whether securities have been sent out for validation or transfer. If there is no activity with respect to a particular security, it is not necessary to make daily entries for the security in the securities records. The last entry will be deemed to be carried forward until there is further activity involving the security.

Rule G-8(a)(iii) requires that the securities records show all long security count differences and short count differences classified by the date of physical count and verification on which they were discovered. The Board currently has no rule requiring municipal securities professionals to make periodic securities counts. However, if such counts are made, all count differences must be noted as provided in this section. Commission rule 17a-13 requires municipal securities dealers, other than bank dealers and certain securities firms exempted from the rule, to examine and count securities at least once in each quarter.

The requirement to maintain securities records under rule G-8 does not apply to a firm which effects municipal securities transactions exclusively with other municipal securities professionals and has no customers, as defined in paragraph (e) of rule G-8, provided the firm does not carry positions for its own account and records or fails to deliver, fails to receive and bank loans are reflected in other records of the firm.

Rules G-8(a)(vi) and (vii)—Records for Agency and Principal Transactions

Rules G-8(a)(vi) and (vii) require municipal securities brokers and municipal securities dealers to make and keep records for each agency order and each transaction effected by the municipal securities broker or municipal securities dealer as principal. The records may be in the form of trading tickets or similar documents. In each case, the records must contain certain specified information, including "to the extent feasible, the time of execution."

The phrase "to the extent feasible" is intended to require municipal securities professionals to note the time of execution for each agency and principal transaction except in extraordinary circumstances when it is impossible to determine the exact time of execution. In such cases, the municipal securities professional should note the approximate time of execution and indicate that it is an approximation.

Rule G-8(a)(xi)—Customer Account Information

Rule G-8(a)(xi) requires a municipal securities broker or municipal securities dealer to obtain certain information for each customer. Several distinct questions have been raised with respect to this provision.

The requirement to obtain the requisite information may be satisfied in a number of ways. Some municipal securities brokers and municipal securities dealers have prepared questionnaires which they have had their customers complete and return. Others have instructed their salesmen to obtain the information from customers over the telephone at the time orders are placed. It is not necessary to obtain a written statement from a customer to be in compliance with the provision.

Except for the tax identification or social security number of a customer, the customer account information required by this provision must be obtained prior to the settlement of a transaction. The Board believes that such a requirement is reasonable since the information is basic and important.

The requirement in subparagraph (C) of rule G-8(a)(xi) to obtain the tax identification or social security number of a customer tracks the requirement in section 103.35, Part 103 of Title 31 of the Code of Federal Regulations, which was adopted by the Treasury Department and became effective in June 1972. Under this section, every broker, dealer and bank must obtain the tax identification or social security number of customers. If a broker, dealer or bank is unable to secure such information after reasonable effort, it must maintain a record identifying all such accounts. The Board interprets subparagraph (C) of rule G-8(a)(xi) in a similar fashion to require municipal securities professionals to make a reasonable effort to obtain a customer’s tax identification or social security number and, if they are unable to do so, to keep a record of that fact.

Several inquiries have focused on the scope of subparagraph (G) of rule G-8(a)(xi) which requires that a record be made and kept of the name and address of the beneficial owner or owners of such account if other than the customer and transactions are to be confirmed to such owner or owners.

This provision applies to the situation in which securities are confirmed to an account which has not directly placed the order for the securities. This frequently occurs in connection with investment advisory accounts, where the investment advisor places an order for a client and directs the executing firm to confirm the transaction directly to the investment advisor’s client.

Under rule G-8, the only information which must be obtained in such circumstances for the account to which the transaction is confirmed is the name and address of the account, information which would have to be obtained in any event in order to transmit the confirmation. Since the investment advisor itself is the customer, the other items of customer account information set forth in rule G-8(a)(xi) need not be obtained for the investment advisor’s client. The customer account information applicable to institutional accounts, however, must be obtained with respect to the investment advisor. Also, the account records required by rule G-8(a)(ii) would not be required to be maintained for the investment advisor’s client, although such records would have to be maintained with respect to the account of the investment advisor.

A municipal securities professional is not required to ascertain the name and address of the beneficial owner or owners of an account if such information is not voluntarily furnished. Subparagraph G-8(a)(xi)(G) applies only when an order is entered on behalf of another person and the transaction is to be confirmed directly to the other person.

A recent court decision, Rolf v. Blyth Eastman Dillon & Co. Inc., et al. issued on January 17, 1977, in the United States District Court, Southern District of New York, may have important implications with respect to the obligations generally of securities professionals to beneficial owners of accounts, especially to clients of investment advisors. We commend your attention to this decision, which has been appealed.

Rule G-8(c)—Non-Clearing Municipal Securities Brokers and Municipal Securities Dealers

Rule G-8(c) provides that a non-clearing municipal securities broker or municipal securities dealer is not required to make and keep the books and records prescribed by rule G-8 if they are made and kept by a clearing broker, dealer, bank or clearing agency. Accordingly, to the extent that records required by rule G-8 are maintained for a municipal securities broker or municipal securities dealer by a clearing agent, the municipal securities broker or municipal securities dealer does not have to maintain such records. A non-clearing municipal securities broker or municipal securities dealer is still responsible for the accurate maintenance and preservation of the records if they are maintained by a clearing agent other than a clearing broker or dealer, and should assure itself that the records are being maintained by the clearing agent in accordance with applicable recordkeeping requirements of the Board.

In the case of a bank dealer, clearing arrangements must be approved by the appropriate regulatory agency for the bank dealer. The bank regulatory agencies are each considering the adoption of procedures to approve clearing arrangements. It is contemplated that these procedures will require the inclusion of certain provisions in clearing agreements, such as an undertaking by the clearing agent to maintain the bank dealer’s records in compliance with rules G-8 and G-9, and will specify the mechanics for having such arrangements considered and approved. The bank regulatory agencies indicate that they will advise bank dealers subject to their respective jurisdictions on this matter in the near future.

In the case of a securities firm, Commission approval is required for all clearing arrangements with entities other than a broker, dealer or bank. The Commission has recently proposed an amendment to its rule 17a-4 which would eliminate the need to obtain Commission approval of clearing arrangements with such other entities, provided that certain specified conditions are met. If the proposed rule is adopted, the Board would make a corresponding change in rule G-8.

If an agent clears transactions, but transmits copies of all records to the municipal securities broker or municipal securities dealer, and these records are preserved by the municipal securities broker or municipal securities dealer in accordance with rule G-9, the clearing arrangement is not subject to the rule G-8(c).

Rule G-9(b)(viii)(C)—Preservation of Written Communications

Subparagraph (C) of rule G-9(b)(viii) requires municipal securities brokers and municipal securities dealers to preserve for three years all written communications received or sent, including inter-office memoranda, relating to the conduct of the activities of such municipal securities broker or municipal securities dealer with respect to municipal securities.

The communications required to be preserved by this provision relate to the conduct of a firm’s activities with respect to municipal securities. Accordingly, such documents as internal memoranda regarding offerings or bids, letters to or from customers and other municipal securities professionals regarding municipal securities, and research reports must be preserved. Documents pertaining purely to administrative matters, such as vacation policy and the like, would not have to be preserved for purposes of the rule.

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.

On December 23, 1976, the Municipal Securities Rulemaking Board (the "Board") issued an interpretive notice addressing certain questions received by the Board with respect to its professional qualifications rules (rules G-2 through G-7). Since that time, the Board has received additional questions concerning rule G-3 which are discussed in this interpretive notice.

1. Requirements for Financial and Operations Principals.

Under the rule G-3(b)(ii)[*], every municipal securities broker and municipal securities dealer other than a bank dealer is required to have at least one qualified financial and operations principal. As defined in the rule, this person is responsible for the overall supervision and preparation of financial reports to the Securities and Exchange Commission and self-regulatory organizations and for the processing, clearance, safekeeping and recordkeeping activities of the firm. If more than one person shares these overall supervisory responsibilities, each such person must be qualified as a financial and operations principal.

The question has been asked whether a financial and operations principal whose duties relate solely to financial and operational matters and not, for example, to underwriting, trading, or sales functions must qualify also as a municipal securities principal by passing the Board's municipal securities principal examination when it is prescribed. The Board does not intend to impose such a requirement on persons whose functions are limited to those set forth in the definition of a financial and operations principal.

The question has also been asked whether a person performing only the functions of a financial and operations principal on and after December 1, 1975 would be "grandfathered" as a municipal securities principal for purposes of taking the Board's municipal securities principal examination when prescribed if such person begins supervising underwriting, trading or sales functions. Activities relating to financial and operational matters are substantially different from those relating to underwriting, trading and sales or other categories of activities supervised by municipal securities principals. The Board does not intend, therefore, that financial and operations principals be "grandfathered" for purposes of the Board's examination requirements for municipal securities principals, or that a financial and operations principal would be qualified to engage in such other supervisory activities solely by reason of having met the Board's requirements for financial and operations principals.

The Board has also been asked whether senior officers or general partners of a firm, who may bear ultimate legal responsibility for the financial and operational activities of the firm, must be qualified as financial and operations principals under the Board's rules. Although the answer depends on the particular factual situation, officers or partners not directly involved in the financial and operations affairs of a firm generally would not be required to qualify as financial and operations principals.

2. Activities Requiring Qualification as a Municipal Securities Principal.

The question has been asked whether supervisory personnel in the processing and clearance areas must qualify as the municipal securities principals under rule G-3. In a securities firm, the financial and operations principal ordinarily would be the only person supervising operations-related activities who will be required to pass an examination. With respect to bank dealer supervisory personnel, to whom the financial and operations principal classification does not apply, qualification in a principal capacity in the operations area will not be required unless the person in question exercises policy-making authority. Thus, an individual may supervise a bank dealer's processing activities without qualifying as a municipal securities principal, regardless of the number of persons supervised by such individual, if policy-making functions and discretionary authority are delegated to a higher level.

Somewhat different considerations apply in determining which persons are required to be qualified as municipal securities principals in connection with underwriting, trading, sales or other activities referred to in the Board's rules as municipal securities principal activities. In these areas, the qualification requirements apply to persons having supervisory responsibility with respect to the day-to-day conduct of the activities in question, even though such persons may not have a policy-making role. The Board's conclusions in this regard are based on the fact that in these other areas the supervisory person is responsible for the activities of personnel who communicate directly with issuers, traders, and investors.

3. Activities Requiring Qualification as a Municipal Securities Representative.

In certain cases, communications from customers may be received at a time when a duly qualified municipal securities representative or municipal securities principal is unavailable. Similarly, there may be situations in which it becomes important to advise a customer promptly of transactions effected and orders confirmed, even though the individual responsible for the account may not be able to communicate with the customer at that time.

In many cases under the rules of other self-regulatory organizations, communications of this nature, which in essence reflect a mechanical function, may be received and made by properly supervised competent individuals whose clerical and ministerial functions would not otherwise subject them to qualification requirements. The Board believes the principle underlying this practice and the application of other self-regulatory organizations' qualification rules is sound.

Accordingly, the Board interprets rule G-3 to permit the recording and transmission in customary channels of orders, the reading of approved quotations, and the giving of reports of transactions by non-qualified clerical personnel when the duly qualified municipal securities representative or municipal securities principal who normally handles the account or customer is unavailable. The foregoing interpretation is applicable only to clerical personnel who are: (a) deemed capable and competent by a municipal securities principal or general securities principal to engage in such activities; (b) specifically authorized in writing to perform such functions on an occasional basis as necessary or directed to perform such functions in specific instances, in either case by a duly qualified municipal securities principal or general securities principal; (c) familiar with the normal type and size of transaction effected with or for the customer or the account; and (d) closely supervised by duly qualified municipal personnel.

All orders for municipal securities received by clerical personnel under the foregoing interpretation must be reviewed and approved by duly qualified municipal personnel familiar with the customer or account prior to being accepted or effected by the municipal securities broker or municipal securities dealer. Solicitation of orders by clerical personnel is not permitted. Confirmations of transactions may be given and quotations read by clerical personnel only when approved by duly qualified municipal personnel. Individuals subject to the 90-day apprenticeship requirements of rule G-3(i)[†] are not clerical personnel and are not authorized or permitted to engage in such activities with members of the public.

Also, the question has been raised whether a bank's branch office personnel, who are not otherwise required to be qualified under rule G-3, will be required to take and pass the qualification examination for municipal securities representatives in order to respond to a depositor's inquiry concerning possible investments in municipal securities. Insofar as the branch office personnel merely refer the depositor to qualified bank dealer personnel for discussion concerning the merits of an investment in municipal securities and execution of the depositor's order, the branch office personnel would not be required to be qualified under the Board's professional qualifications requirements. However, if branch office personnel seek to advise the depositor concerning the merits of a possible investment, or otherwise perform more than a purely ministerial function, qualification under the Board's rules would be required.

[*] [ Currently codified at rule G-3(d)(iii)]

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