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 interpretive notice was revoked on October 12, 2010. See Interpretation on Priority of Orders for Securities in a Primary Offering under Rule G-17 (October 12, 2010)

The Board is concerned about reports that senior syndicate managers may not always be mindful of principles of fair dealing in allocations of new issue securities. In particular, the Board believes that the principles of fair dealing require that customer orders should receive priority over similar dealer or certain dealer-related account[1] orders, to the extent that this is feasible and consistent with the orderly distribution of new issue securities.

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 senior manager, on a case-by-case basis, to allocate securities in a manner other than in accordance with the priority provisions if the senior manager determines in its discretion that it is in the best interests of the syndicate. Senior managers must furnish this information, in writing, to the syndicate members. 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.

The Board understands that senior managers must balance a number of competing interests in allocating new issue securities. In addition, a senior manager must be able quickly to determine when it is appropriate to allocate away from the priority provisions and must be prepared to justify its actions to the syndicate and perhaps to the issuer. While it does not appear necessary or appropriate at this time to restrict the ability of syndicates to permit managers to allocate securities in a manner different from the priority provisions, the Board believes senior 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.[2] Thus, in the Board’s view, customer orders should have priority over similar dealer orders or certain dealer-related account orders to the extent that this is feasible and consistent with the orderly distribution of new issue securities. Moreover, the Board suggests that syndicate members alert their customers to the priority provisions adopted by the syndicate so that their customers are able to place their orders in a manner that increases the possibility of being allocated securities.

[1] A dealer-related account includes a municipal securities investment portfolio, arbitrage account or secondary trading account of a syndicate member, a municipal securities investment trust sponsored by a syndicate member, or an accumulation account established in connection with such a municipal securities investment trust.

[2] Rule G-17 provides that:

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

The Board is concerned that the market for escrowed-to-maturity securities has been disrupted by uncertainty whether these securities may be called pursuant to optional redemption provisions. Accordingly, the Board has issued the following interpretations of rule G-17, on fair dealing, and rules G-12(c) and G-15(a), on confirmation disclosure, concerning escrowed-to-maturity securities. The interpretations are effective immediately.

Background

Traditionally, the term escrowed-to-maturity has meant that such securities are not subject to optional redemption prior to maturity. Investors and market professionals have relied on this understanding in their purchases and sales of such securities. Recently, certain issuers have attempted to call escrowed-to-maturity securities. As a result, investors and market professionals considering transactions in escrowed-to-maturity securities must review the documents for the original issue, for any refunding issue, as well as the escrow agreement and state law, to determine whether any optional redemption provisions apply. In addition, the Board understands that there is uncertainly as to the fair market price of such securities which may cause harm to investors.

On March 17, 1987, the Board sent letters to the Public Securities Association, the Government Finance Officers Association and the National Association of Bond Lawyers expressing its concern. The Board stated that it is essential that issuers, when applicable, expressly note in official statements and defeasance notices relating to escrowed-to-maturity securities whether they have reserved the right to call such securities. It stated that the absence of such express disclosure would raise concerns whether the issuer’s disclosure documents adequately explain the material features of the issue and would severely damage investor confidence in the municipal securities market. Although the Board has no rulemaking authority over issuers, it advised brokers, dealers and municipal securities dealers (dealers) that assist issuers in preparing disclosure documents for escrowed-to-maturity securities to alert these issuers of the need to disclose whether they have reserved the right to call the securities since such information is material to a customer’s investment decision about the securities and to the efficient trading of such securities.

Application of Rule G-17 on Fair Dealing

In the intervening months since the Board’s letter, the Board has continued to receive inquiries from market participants concerning the callability of escrowed-to-maturity securities. Apparently, some dealers now are describing all escrowed-to-maturity securities as callable and there is confusion how to price such securities. In order to avoid confusion with respect to issues that might be escrowed-to-maturity in the future, the Board is interpreting rule G-17, on fair dealing,[1] to require that municipal securities dealers that assist in the preparation of refunding documents as underwriters or financial advisors alert issuers of the materiality of information relating to the callability of escrowed-to-maturity securities. Accordingly, such dealers must recommend that issuers clearly state when the refunded securities will be redeemed and whether the issuer reserves the option to redeem the securities prior to their maturity.

Application of Rules G-12(c) and G-15(a) on Confirmation Disclosure of Escrowed-to-Maturity Securities

Rules G-12(c)(vi)(E) and G-15(a)(iii)(E)[*] require dealers to disclose on inter-dealer and customer confirmations, respectively, whether the securities are "called" or "prerefunded," the date of maturity which has been fixed by the call notice, and the call price. The Board has stated that this paragraph would require, in the case of escrowed-to-maturity securities, a statement to that effect (which would also meet the requirement to state "the date of maturity which has been fixed") and the amount to be paid at redemption. In addition, rules G-12(c)(v)(E) and G-15(a)(i)(E)[†] require dealers to note on confirmations if securities are subject to redemption prior to maturity (callable).

The Board understands that dealers traditionally have used the term escrowed-to-maturity only for non-callable advance refunded issues the proceeds of which are escrowed to original maturity date or for escrowed-to-maturity issues with mandatory sinking fund calls. To avoid confusion in the use of the term escrowed-to-maturity, the Board has determined that dealers should use the term escrowed-to-maturity to describe on confirmations only those issues with no optional redemption provisions expressly reserved in escrow and refunding documents. Escrowed-to-maturity issues with no optional or mandatory call features must be described as "escrowed-to-maturity." Escrowed-to-maturity issues subject to mandatory sinking fund calls must be described as "escrowed-to-maturity" and "callable." If an issue is advance refunded to the original maturity date, but the issuer expressly reserves optional redemption features, the security should be described on confirmations as "escrowed (or prerefunded) to [the actual maturity date]" and "callable."[2]

The Board believes that the use of different terminology to describe advance refunded issues expressly subject to optional calls will better alert dealers and customers to this important aspect of certain escrowed issues.[3]

[1] Rule G-17 states that "[i]n the conduct of its municipal securities business, each broker, dealer, and municipal securities dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice."

[2] This terminology also would be used for any issue prerefunded to a call date, with an earlier optional call expressly reserved.

[3] The Board believes that, because of the small number of advance refunded issues that expressly reserve the right of the issuer to call the issue pursuant to an optional redemption provision, confirmation systems should be able to be programmed for use of the new terminology without delay.

[*] [Currently codified at rule G-15(a)(i)(C)(3)(a). See also current rule G-15(a)(i)(C)(3)(b).]

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

Contract sheets. This will respond to your letter of May 28, 1987, and confirm our telephone conversation of the same date concerning recordkeeping of “contract sheets.” You ask whether dealers are required by Board rules G-8 and G-9 to maintain records of “contract sheets” of municipal securities transactions.

Rule G-8(a)(ix) requires dealers to maintain records of all confirmations of purchases and sales of municipal securities, including inter-dealer transactions. Rule G-12(f), in certain instances, requires inter- dealer transactions to be compared through an automated comparison system operated by a clearing  agency registered with the Securities and Exchange Commission, rather than by physical confirmations.[1] These automated comparison systems generate “contract  sheets” to each party of a trade, which confirm the existence and the terms of the transaction.

This will confirm my advice to you that such contract sheets are deemed to be confirmations of transactions for purposes of rule G-8(a)(ix). Thus, dealers are required to include contract sheets in their records of confirmations and, under rule G-9(b)(v), are required to maintain these records for no less than three years.[2] MSRB interpretation of June 25, 1987.

[1] Rule G-12(c) governs the content of and procedures for sending physical confirmations.

[2] You also ask about the interpretation of rules 17a-3 and 17a-4 under the Securities Exchange Act. The Board is not authorized to interpret these Securities and Exchange Commission rules. You may wish to contact the SEC for guidance on this matter.

Associated person on issuer governing body. This will respond to your letter to the Municipal Securities Rulemaking Board concerning rule G-22 on disclosure of control relationships. You ask whether the rule requires a dealer to disclose to customers that an associated person of the dealer is a member of a five-person town council that issued the securities.

Rule G-22(c) states that a dealer may not effect a customer transaction in a municipal security with respect to which the dealer has a control relationship, unless the dealer discloses to the customer the nature of the control relationship prior to executing the transaction. Section (a) of rule G-22 defines a control relationship to exist with respect to a security if the dealer controls, is controlled by, or is under common control with the issuer of the security. This includes any control relationship with an associated person of the dealer.1 Whether a control relationship exists in a particular case is a factual question. The Board, however, previously has stated that:

A control relationship with respect to a municipal security does not necessarily exist if an associated person of a securities professional is a member of the governing body or acts as an officer of the issuer of the security. However, if the associated person in fact controls the issuer, rule G-22 does apply. For example, rule G-22 applies if the associated person is the chairman of an issuing authority and, in that capacity, actually makes the decision on behalf of the issuing authority to issue securities. The rule does not apply if the associated person as chairman does not make that decision and does not have the authority alone to make the decision, or if the decision is made by a governing body of which he is only one of several members.2

MSRB interpretation of June 25, 1987.

1 Rule D-11 states that references to “brokers”, “dealers”, “municipal securities dealers”, and “municipal securities brokers” also mean associated persons, unless the context indicates otherwise.

2 Notice of Approval of Fair Practice Rules, October 24, 1978, at 6.

Time of receipt and execution of orders. This is in response to your March 3, 1987 letter regarding the application of rule G-8, on recordkeeping, to [name deleted]'s (the “Bank”) procedure on time stamping of municipal securities order tickets. You note that it is the Bank's policy to indicate on order tickets the date and time of receipt of the order and the date and time of execution of the order. You note, however, that when the order and execution occur simultaneously, it is your procedure to time stamp the order ticket once. You ask for Board approval of this policy.

Rule G-8(a)(vi) provides in pertinent part for a “memorandum of each agency order . . . showing the date and time of receipt of the order . . . and the date of execution and to the extent feasible, the time of execution . . .” Rule G-8(a)(vii) includes a similar requirement for principal transactions with customers. As noted in a Board interpretive notice on recordkeeping, the phrase “to the extent feasible” is intended to require municipal securities professionals to note the time of execution of each transaction except in extraordinary circumstances when it might be impossible to determine the exact time of execution. However, even in those unusual situations, the rule requires that at least the approximate time be noted.[1] This rule parallels SEC rule 17a-3(a)(6) and (7) on recordkeeping.

Thus, rule G-8(a)(vi) and (vii) required agency and principal orders to be time stamped upon receipt and upon execution. The requirement is designed to allow the dealer and the appropriate examining authority to determine whether the dealer has complied with rule G-18, on execution of transactions, and rule G-30, on pricing. Rule G-18 states that when a dealer is “executing a transaction in municipal securities for or on behalf of a customer as an agent, it shall make a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions.”  Rule G-30(a) states that a dealer shall not effect a principal transaction with a customer except at a fair and reasonable price, taking into consideration all relevant factors including the fair market value of the securities at the time of the transaction. It is impossible to determine what the prevailing market conditions were at the time of the execution of the order if the date and time of execution are not recorded. In addition, it is important to time stamp the receipt and execution of an order so that a record can be maintained of when the order is executed.

Thus, even when the order and execution occur simultaneously, rule G-8 requires that two time stamps be included on order tickets. MSRB interpretation of April 20, 1987.

Supervisory structure.  This is in response to your letter of December 31, 1986 and our subsequent telephone conversation. You note that there has been a recent reorganization within your bank. As a consequence, you, as the head of the dealer department, now will report to the bank officer who also is in charge of the trust department and the bank's investment portfolio, rather than directly to the bank's president as had been the case. You ask whether this arrangement might constitute a conflict of interest under trust regulations or otherwise under Board rules.

Board rule G-27 places an obligation upon a dealer to supervise its municipal securities activities. It requires a dealer to accomplish this objective by designating individuals with supervisory responsibility for municipal securities activities and requires the dealer to adopt written supervisory procedures to this end. The rule does not specify how a dealer should structure its supervisory procedures, provided that the dealer adopts an organizational structure which meets the intent of the rule. You should review your dealer's written supervisory procedures to ensure that they provide for the appropriate delegation of supervisory responsibilities, given the reorganization within the bank.

You noted that the individual to whom you will be reporting is presently qualified as a municipal securities representative but not as a municipal securities principal. Board rule G-3(a)(i)^[*] defines a municipal securities principal as an associated person of a securities firm or bank dealer who is directly engaged in the management, direction or supervision of municipal securities activities. If, under the new reorganization, this individual will be designated with day-to-day responsibility for the management, direction or supervision of the municipal securities activities of the dealer, then he must be qualified as a municipal securities principal.

Finally, trust regulations are governed by the appropriate banking law and not by Board rules. Consequently, any concerns that you may have with respect to possible conflicts of interest with trust regulations should be directed to the appropriate bank regulatory agency. MSRB interpretation of March 11, 1987.

^[*] [Currently codified at rule G-3(b)(i).]

Section 2 of the Board’s Arbitration Code, rule G-35, requires all dealers to submit to arbitration at the instance of a customer or another dealer. From time to time, a dealer will refuse to submit to arbitration or will delay or even refuse to make payment of an award. Such acts constitute violations of rule G-35. The Board believes that it is a violation of rule G-17, on fair dealing, for a broker, dealer or municipal securities dealer or its associated persons to fail to submit to arbitration as required by Rule G-35, or to fail to comply with the procedures therein, including the production of documents, or to fail to honor an award of arbitrators unless a timely motion to vacate the award has been made according to applicable law.[1]

[1] A party typically has 90 days to seek judicial review of an arbitration award; after that the award cannot be challenged. Challenges to arbitration awards are heard only in limited, egregious circumstances such as fraud or collusion on the part of the arbitrators.

"Municipal Securities Principal" defined. This is in response to your letter of January 28, 1987, and subsequent telephone conversations with the Board's staff, requesting an interpretation of Board rule G-3(a)(i)[*], the definition of the term "Municipal Securities Principal". You ask whether an individual, who has day-to-day responsibility for directing the municipal underwriting activities of a firm, must be qualified as a municipal securities principal. You suggest that such activity seems to meet the definition of a municipal securities principal, namely, an individual who is "directly engaged in the management, direction or supervision of. . .underwriting . . .of municipal securities." You note that this individual has the authority to make underwriting commitments in the name of the firm, but that the firm's president is designated with supervisory responsibility for this individual's underwriting activity. Also, you indicated that this individual does not have supervisory responsibility for any other representative.

Your request for an interpretation was referred to a Committee of the Board which has responsibility for professional qualification matters. The Committee concluded that the individual you describe would not be required to qualify as a municipal securities principal, provided that her responsibilities are limited to directing the day-to-day underwriting activities of the dealer, and provided that these responsibilities are carried out within policy guidelines established by the dealer and under the direct supervision of a municipal securities principal. The Committee is also of the opinion that commitment authority alone is not indicative of principal activity, but rather is inherent in the underwriting activities of a municipal securities representative. MSRB interpretation of February 27, 1987.

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

Disqualification of municipal securities principals. In our recent telephone conversation you asked whether the Board has interpreted rule G-3(c)(iv)[*] as to the qualification status of a municipal securities principal in circumstances where the bank dealer, with which the individual is associated, fails to effect a municipal security transaction for a period of two or more years. You proposed that, if there are no municipal securities transactions for the principal to supervise, the individual would not be considered to be "acting as a municipal securities principal" and, consequently, the individual's qualification as a municipal securities principal would lapse after a two-year period of such inactivity.

The Board has considered a similar situation and given an interpretation in the matter. It reaffirmed the interpretation that an individual whose responsibilities no longer include supervision of municipal securities activities probably will not be able to remain adequately informed in the supervisory and compliance matters of concern to municipal securities principals, and that continuing association with a municipal securities dealer, in a capacity other than that of a municipal securities principal, is not sufficient to maintain qualification as a municipal securities principal. However, the Board also concluded that it did not intend this interpretation of rule G-3(c)(iv)[*] to mean that a dealer must necessarily effect transactions in municipal securities in order for its municipal securities principal to maintain such qualification. The Board noted that the definition of a municipal securities principal not only includes supervision of trading or sales, but of other municipal securities activities as well. Consequently, the Board determined that the qualification of a municipal securities principal should not automatically terminate because the individual is associated with a municipal securities broker or dealer which has not effected a municipal securities transaction in two or more years, but that to maintain such qualification the individual must demonstrate clearly that:

--the municipal securities broker or dealer was engaged in municipal securities activity during this period (e.g., determinations of suitability involving municipal securities, recommendations to customers, advertising, financial advisory activity with respect to municipal issuers); and

--the individual in question had been designated with supervisory responsibility for such municipal securities activities during this period.

MSRB interpretation of January 15, 1987

[*] [Currently codified at rule G-3(b)(ii)(C)]

Board rule G-3(a)(iii)[*] defines municipal securities representative activities to include any activity which involves communication with public investors regarding the sale of municipal securities but exempts activities that are solely clerical or ministerial. As you noted, in December 1984, the Board issued an interpretation of rule G-3 which states that individuals who solicit new account business are not engaging in clerical or ministerial activities but rather are communicating with public investors regarding the sale of municipal securities and thus are engaging in municipal securities representative activities which require such individuals to be qualified as representatives under the Board’s rules. Examples of solicitation of new account business stated in the notice included “cold calls” to individuals during which the non-qualified individual introduces the services offered by the dealers, prequalified potential customers, or suggests the purchase of specific securities currently being offered by a municipal securities dealer. An individual who introduces the name of the municipal securities dealer and inquires as to the type of securities in which a portfolio manager invests would be communicating with the public in an attempt to prequalify potential customers and thus must be qualified as a municipal securities representative. MSRB interpretation of January 5, 1987.

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