Request for Comment on Draft Interpretive Notice Concerning the Application of MSRB Rule G-17 to Underwriters of Municipal Securities
The Municipal Securities Rulemaking Board (“MSRB”) is requesting comment on a draft interpretive notice concerning the application of MSRB Rule G-17 to underwriters of municipal securities.
Comments should be submitted no later than April 11, 2011. Comments should be sent via e-mail to CommentLetters@msrb.org. Please indicate the notice number in the subject line of the e-mail. To submit comments via regular mail, please send them to Ronald W. Smith, Corporate Secretary, MSRB, 1900 Duke Street, Alexandria, VA 22314. Written comments will be available for public inspection on the MSRB’s web site.[1]
Questions about this notice should be directed to Peg Henry, Deputy General Counsel, or Larry Sandor, Senior Associate General Counsel, at 703-797-6600.
BACKGROUND
The MSRB has previously observed that Rule G-17 requires dealers to deal fairly with issuers in connection with the underwriting of their municipal securities.[2] More recently, in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. Law No. 111-203) (“Dodd-Frank Act”), Congress amended Section 15B of the Securities Exchange Act of 1934 (“Exchange Act”) to provide express direction to the MSRB to protect municipal entities.[3]
REQUEST FOR COMMENT
The MSRB requests comments on the interpretive guidance set forth below, which addresses how Rule G-17 applies to dealers in their interactions with municipal entities as underwriters of municipal securities, including integrally-related activities, such as interest rate swap transactions and purchases of defeasance escrow securities.
Rule G-17 provides:
In the conduct of its municipal securities or municipal advisory activities, each broker, dealer, municipal securities dealer, and municipal advisor shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice.
Under Rule G-17, all representations made by underwriters to issuers of municipal securities in connection with municipal securities underwritings, whether written or oral, must be truthful and accurate and may not misrepresent or omit material facts. Furthermore, an underwriter of a negotiated issue that recommends a complex municipal securities financing (e.g., a variable rate demand obligation with a swap) has an obligation under Rule G-17 to disclose all material risks and characteristics of the financing, as well as any incentives for the underwriter to recommend the financing and other associated conflicts of interest.
The duty of fair dealing under Rule G-17 includes an implied representation that the price an underwriter pays to an issuer bears a reasonable relationship to the prevailing market price of the securities. An underwriter’s direct and indirect compensation for a new issue must not be excessive (i.e., disproportionate to the nature of the underwriting and related services performed).
Under Rule G-17, an underwriter must disclose conflicts of interest (e.g., third-party payments, certain credit default swaps, and profit-sharing arrangements with investors) that may color its judgment and cause it to recommend products, structures, and pricing levels to an issuer that it would not have done absent such conflicts.
The notice also restates existing MSRB guidance under Rule G-17, which provides that an underwriter must honor an issuer’s directions concerning retail order periods and must not make lavish gifts to issuer personnel.[4]
TEXT OF DRAFT INTERPRETIVE NOTICE
INTERPRETIVE GUIDANCE CONCERNING THE APPLICATION OF MSRB RULE G-17 TO UNDERWRITERS OF MUNICIPAL SECURITIES
Under Rule G-17 of the Municipal Securities Rulemaking Board (the “MSRB”), brokers, dealers, and municipal securities dealers (“dealers”) must, in the conduct of their municipal securities activities, deal fairly with all persons and must not engage in any deceptive, dishonest, or unfair practice. This rule is most often cited in connection with duties owed by dealers to investors; however, it also applies to their interactions with other market participants, including municipal entities.[1]
The MSRB has previously observed that Rule G-17 requires dealers to deal fairly with issuers in connection with the underwriting of their municipal securities.[2] More recently, with the passage of the Dodd-Frank Act,[3] the MSRB was expressly directed by Congress to protect municipal entities. Accordingly, the MSRB is providing additional interpretive guidance that addresses how Rule G-17 applies to dealers in their interactions with municipal entities as underwriters of municipal securities, including integrally-related activities, such as interest rate swap transactions and purchases of defeasance escrow securities.
The examples discussed in this notice are illustrative only and are not meant to encompass all obligations of dealers to municipal entities under Rule G-17. The MSRB has issued other interpretive guidance on a dealer’s duties under Rule G-17 when the dealer is serving as an advisor to a municipal entity or obligated person.[4] Furthermore, when municipal entities are customers[5] of dealers they are subject to the same protections under MSRB rules, including Rule G-17, that apply to other customers.[6] Additionally, the MSRB notes that an underwriter must balance its duty of fair dealing to issuers with its duty of fair dealing to investors, as well as its duty to comply with other federal and state securities laws.
Basic Fair Dealing Principle
As noted above, Rule G-17 precludes a dealer, in the conduct of its municipal securities activities, from engaging in any deceptive, dishonest, or unfair practice with any person, including an issuer of municipal securities. The rule contains an anti-fraud prohibition similar to the standard set forth in Rule 10b-5 adopted by the Securities and Exchange Commission (“SEC”) under the Exchange Act. Thus, an underwriter must not misrepresent the facts, risks, or other material information about municipal securities activities undertaken with a municipal issuer. However, Rule G-17 does not merely prohibit deceptive conduct on the part of the dealer. It also establishes a general duty of a dealer to deal fairly with all persons (including but not limited to issuers of municipal securities), even in the absence of fraud.
Representations to Issuers
All representations made by underwriters to issuers of municipal securities in connection with municipal securities underwritings, whether written or oral, must be truthful and accurate and may not misrepresent or omit material facts. Underwriters must have a reasonable basis for the representations and other material information contained in documents they prepare and should refrain from including representations or other information they know or should know is inaccurate or misleading. For example, in connection with a certificate signed by the underwriter that will be relied upon by the issuer or other relevant parties to an underwriting (e.g., an issue price certificate), the dealer must have a reasonable basis for the representations and other material information contained therein. In addition, a dealer’s response to an issuer’s request for proposals must fairly and accurately describe the services, skills, background, and experience of the dealer as of the time the proposal is submitted and must not contain any representations or other material information about such services, skills, background and experience that the dealer knows or should know is inaccurate or misleading. For example, a dealer must not make representations about its underwriting capabilities that are inaccurate, and matters not within the personal knowledge of those preparing the response (e.g., pending litigation) must be confirmed with those with knowledge of the subject matter.
Required Disclosures to Issuer
An underwriter of a negotiated issue that recommends a municipal securities financing to an issuer that involves a derivative contract (such as a swap), an external index not typically used in the municipal securities market, issuer cash flows that are unusual or variable, or other atypical or complex arrangements that are integrally related (both in time and economics) to the financing (a “complex municipal securities financing”) has an obligation under Rule G-17 to disclose all material risks and characteristics of the complex municipal securities financing, as well as any incentives for the underwriter to recommend the financing and other associated conflicts of interest. For example, an underwriter that recommends a complex municipal securities financing involving variable issuer payments should inform the issuer of the risk of interest rate fluctuations and material risks of any associated credit or liquidity facilities (e.g., the risk that the issuer might not be able to replace the facility upon its expiration and might be required to repay the facility provider over a short period of time). As a additional example, if the recommended complex municipal securities financing involves an integrally-related swap, the underwriter must disclose the material risks (including market, credit, operational, and liquidity risks) and characteristics of the integrally-related swap, as well as any incentives for the underwriter to recommend the swap and any other associated conflicts of interest.[7] In general, if the underwriter is not the provider of the swap or other component of a complex municipal securities financing, it may satisfy its disclosure obligation if it reasonably believes that such disclosure has been provided to the issuer by the swap or other provider or by the issuer’s swap or other financial advisor that is independent of the underwriter and the swap or other provider.
The disclosures described in this notice must be made in writing to officials of the issuer with the authority to bind the issuer by contract with the underwriter in a manner designed to make clear to such officials the subject matter of such disclosures and their implications for the issuer. The disclosures must be provided prior to the execution of the complex municipal securities financing and must address the specific elements of the financing, rather than being general in nature.
Underwriter Duties in Connection with Issuer Disclosure Documents
Underwriters often play an important role in assisting issuers in the preparation of disclosure documents, such as preliminary official statements and official statements.[8] These documents are critical to the municipal securities transaction, in that investors rely on the representations contained in such documents in making their investment decisions. Moreover, investment professionals, such as municipal securities analysts and ratings services, rely on the representations in forming an opinion regarding the credit. A dealer’s duty to have a reasonable basis for the representations it makes, and other material information it provides, to an issuer and to ensure that such representations and information are accurate and not misleading, as described above, extends to representations and information provided by the underwriter in connection with the preparation by the issuer of its disclosure documents (e.g., cash flows).
Underwriter Compensation and New Issue Pricing
Excessive Compensation. An underwriter’s compensation for a new issue (including both direct compensation paid by the issuer and other separate payments received by the underwriter from the issuer or any other party in connection with the underwriting), in certain cases and depending upon the specific facts and circumstances of the offering, may be so disproportionate to the nature of the underwriting and related services performed as to constitute an unfair practice with regard to the issuer that is a violation of Rule G-17. Among the factors relevant to whether an underwriter’s compensation is disproportionate to the nature of the underwriting and related services performed, are the credit quality of the issue, the size of the issue, market conditions, the length of time spent structuring the issue, and whether the underwriter is paying the fee of the underwriter’s counsel or any other relevant costs related to the financing.
Fair Pricing. The duty of fair dealing under Rule G-17 includes an implied representation that the price an underwriter pays to an issuer bears a reasonable relationship to the prevailing market price of the securities.[9] In general, a dealer purchasing bonds in a competitive underwriting for which the issuer may reject any and all bids will be deemed to have satisfied its duty of fairness to the issuer with respect to the purchase price of the issue as long as the dealer’s bid is a bona fide bid (as defined in MSRB Rule G-13)[10] that is based on the dealer’s best judgment of the fair market value of the securities that are the subject of the bid. In a negotiated underwriting, the underwriter has a duty under Rule G-17 to negotiate in good faith with the issuer. This duty includes the obligation of the dealer to ensure the accuracy of representations made during the course of such negotiations, including representations regarding the price negotiated and the nature of investor demand for the securities (e.g., the status of the order period and the order book). If, for example, the dealer represents to the issuer that it is providing the “best” market price available on the new issue, or that it will exert its best efforts to obtain the “most favorable” pricing, the dealer may violate Rule G-17 if its actions are inconsistent with such representations.[11]
Conflicts of Interest
Payments to or from Third Parties. In certain cases, compensation received by the underwriter from third parties, such as the providers of derivatives and investments, may color the underwriter’s judgment and cause it to recommend products, structures, and pricing levels to an issuer when it would not have done so absent such payments. The MSRB views the failure of an underwriter to disclose to the issuer payments received by the underwriter in connection with its underwriting of the new issue from parties other than the issuer, and payments made by the underwriter in connection with such new issue to parties other than the issuer (in either case including payments with respect to collateral transactions integrally related to such underwriting), to be a violation of the underwriter’s obligation to the issuer under Rule G-17. Such disclosure obligation also would apply to payments in respect to collateral transactions integrally related to such underwriting, including but not limited to municipal securities derivative transactions and defeasance escrow securities transactions that are integrally related to the underwriting.[12] For example, it would be a violation of Rule G-17 for an underwriter to compensate an undisclosed party in order to secure municipal securities business. Similarly, it would be a violation of Rule G-17 for an underwriter to receive undisclosed compensation from a third party in exchange for recommending that third party’s services or product to an issuer, including business related to municipal securities derivative transactions. The underwriter must disclose to the issuer the amount paid or received, the purpose for which such payment was made and the name of the party making or receiving such payment. The underwriter must also disclose to the issuer the details of any third-party arrangements for the marketing of the issuer’s securities.
Profit-Sharing with Investors. Arrangements between the underwriter and an investor purchasing new issue securities from the underwriter (including purchases that are contingent upon the delivery by the issuer to the underwriter of the securities) according to which profits realized from the resale by such investor of the securities are directly or indirectly split or otherwise shared with the underwriter also would, depending on the facts and circumstances (including in particular if such resale occurs reasonably close in time to the original sale by the underwriter to the investor), constitute a violation of the underwriter’s fair dealing obligation under Rule G-17.
Credit Default Swaps. The issuance or purchase by a dealer of credit default swaps for which the reference obligations are securities of the issuers for which the dealer is serving as underwriter may pose a conflict of interest, because trading in such municipal credit default swaps, especially by those who do not own the reference obligations, has the potential to affect the pricing of the reference obligations, as well as the pricing of other securities brought to market by those issuers. Rule G-17 requires, therefore, that a dealer that engages in such activities must disclose that to the issuers for which it serves as underwriter.
Retail Order Periods
Rule G-17 requires an underwriter that has agreed to underwrite a transaction with a retail order period to, in fact, honor such agreement.[13] A dealer that wishes to allocate securities in a manner that is inconsistent with an issuer’s requirements must not do so without the issuer’s consent. In addition, Rule G-17 requires an underwriter that has agreed to underwrite a transaction with a retail order period to take reasonable measures to ensure that retail clients are bona fide. An underwriter that knowingly accepts an order that has been framed as a retail order when it is not (e.g., a number of small orders placed by an institutional investor that would otherwise not qualify as a retail customer) would violate Rule G-17 if its actions are inconsistent with the issuer’s expectations regarding retail orders. In addition, a dealer that places an order that is framed as a qualifying retail order but in fact represents an order that does not meet the qualification requirements to be treated as a retail order (e.g., an order by a retail dealer without “going away” orders[14] from retail customers, when such orders are not within the issuer’s definition of “retail”) violates its Rule G-17 duty of fair dealing. The MSRB will continue to review activities relating to retail order periods to ensure that they are conducted in a fair and orderly manner consistent with the intent of the issuer and the MSRB’s investor protection mandate.
Dealer Payments to Issuer Personnel
Dealers are reminded of the application of MSRB Rule G-20, on gifts, gratuities, and non-cash compensation, and Rule G-17, in connection with certain payments made to, and expenses reimbursed for, issuer personnel during the municipal bond issuance process.[15] These rules are designed to avoid conflicts of interest and to promote fair practices in the municipal securities market.
Dealers should consider carefully whether payments they make in regard to expenses of issuer personnel in the course of the bond issuance process, including in particular but not limited to payments for which dealers seek reimbursement from bond proceeds or issuers, comport with the requirements of Rule G-20. For example, a dealer acting as a financial advisor or underwriter may violate Rule G-20 by paying for excessive or lavish travel, meal, lodging and entertainment expenses in connection with an offering (such as may be incurred for rating agency trips, bond closing dinners, and other functions) that inure to the personal benefit of issuer personnel and that exceed the limits or otherwise violate the requirements of the rule.[16]
[1] The term “municipal entity” is defined by Section 15B(e)(8) of the Securities Exchange Act (the “Exchange Act”) to mean: “any State, political subdivision of a State, or municipal corporate instrumentality of a State, including—(A) any agency, authority, or instrumentality of the State, political subdivision, or municipal corporate instrumentality; (B) any plan, program, or pool of assets sponsored or established by the State, political subdivision, or municipal corporate instrumentality or any agency, authority, or instrumentality thereof; and (C) any other issuer of municipal securities.”
[2] See Reminder Notice on Fair Practice Duties to Issuers of Municipal Securities, MSRB Notice 2009-54 (September 29, 2009); Rule G-17 Interpretive Letter – Purchase of new issue from issuer, MSRB interpretation of December 1, 1997, reprinted in MSRB Rule Book (“1997 Interpretation”).
[3] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
[4] See Fiduciary Duty of a Municipal Advisor, MSRB Notice 2011- (_______________ __, 2011); Interpretive Guidance Concerning the Application of MSRB Rule G-17 to Municipal Advisors, MSRB Notice 2011- __ (___________ __, 2011).
[5] MSRB Rule D-9 defines the term “customer” as follows: “Except as otherwise specifically provided by rule of the Board, the term “Customer” shall mean any person other than a broker, dealer, or municipal securities dealer acting in its capacity as such or an issuer in transactions involving the sale by the issuer of a new issue of its securities.”
[6] See MSRB Reminds Firms of Their Sales Practice and Due Diligence Obligations When Selling Municipal Securities in the Secondary Market, MSRB Notice 2010-37 (September 20, 2010).
[7] For example, a conflict of interest may exist when the underwriter is also the provider of a swap used to hedge a municipal securities offering or when the underwriter receives compensation from a swap provider for recommending the swap provider to the issuer. See also “Conflicts of Interest/Payments to or from Third Parties” herein.
[8] Underwriters who assist issuers in preparing official statements must remain cognizant of their duties under federal securities laws. With respect to primary offerings of municipal securities, the SEC has noted, “By participating in an offering, an underwriter makes an implied recommendation about the securities.” See SEC Rel. No. 34-26100 (Sept. 22, 1988) (proposing Exchange Act Rule 15c2-12) at text following note 70. The SEC has stated that “this recommendation itself implies that the underwriter has a reasonable basis for belief in the truthfulness and completeness of the key representations made in any disclosure documents used in the offerings.” Furthermore, pursuant to SEC Rule 15c2-12(b)(5), an underwriter may not purchase or sell municipal securities in most primary offerings unless the underwriter has reasonably determined that the issuer or an obligated person has entered into a written undertaking to provide certain types of secondary market disclosure and has a reasonable basis for relying on the accuracy of the issuer’s ongoing disclosure representations. SEC Rel. No. 34-34961 (Nov. 10, 1994) (adopting continuing disclosure provisions of Exchange Act Rule 15c2-12) at text following note 52.
[9] The MSRB has previously observed that whether an underwriter has dealt fairly with an issuer for purposes of Rule G-17 is dependent upon all of the facts and circumstances of an underwriting and is not dependent solely on the price of the issue. See MSRB Notice 2009-54 and 1997 Interpretation, supra note 3. See also “Retail Order Periods” herein.
[10] Rule G-13(b)(iii) provides: “For purposes of subparagraph (i), a quotation shall be deemed to represent a "bona fide bid for, or offer of, municipal securities" if the broker, dealer or municipal securities dealer making the quotation is prepared to purchase or sell the security which is the subject of the quotation at the price stated in the quotation and under such conditions, if any, as are specified at the time the quotation is made.”
[11] See 1997 Interpretation.
[12] See also “Required Disclosures to Issuer” herein.
[13] See MSRB Interpretation on Priority of Orders for Securities in a Primary Offering under Rule G-17, MSRB interpretation of October 12, 2010, reprinted in MSRB Rule Book. The MSRB also reminds underwriters of previous MSRB guidance on the pricing of securities sold to retail investors. See Guidance on Disclosure and Other Sales Practice Obligations to Individual and Other Retail Investors in Municipal Securities, MSRB Notice 2009-42 (July 14, 2009).
[14] In general, a “going away” order is an order for new issue securities for which a customer is already conditionally committed.
[15] See MSRB Rule G-20 Interpretation — Dealer payments in connection with the municipal securities issuance process, MSRB interpretation of January 29, 2007, reprinted in MSRB Rule Book.
[16] See In the Matter of RBC Capital Markets, SEC Rel. No. 34-59439 (Feb. 24, 2009) (settlement in connection with broker-dealer alleged to have violated MSRB Rules G-20 and G-17 for payment of lavish travel and entertainment expenses of city officials and their families associated with rating agency trips, which expenditures were subsequently reimbursed from bond proceeds as costs of issuance); In the Matter of Merchant Capital, L.L.C., SEC Rel. No. 34-60043 (June 4, 2009) (settlement in connection with broker-dealer alleged to have violated MSRB rules for payment of travel and entertainment expenses of family and friends of senior officials of issuer and reimbursement of the expenses from issuers and from proceeds of bond offerings).
* * * * *
[1] All comments received will be made publicly available without change. Personal identifying information, such as names or e-mail addresses, will not be edited from submissions. Therefore, commenters should submit only information that they wish to make publicly available.
[2] See Reminder Notice on Fair Practice Duties to Issuers of Municipal Securities, MSRB Notice 2009-54 (September 29, 2009); Rule G-17 Interpretive Letter – Purchase of new issue from issuer, MSRB interpretation of December 1, 1997, reprinted in MSRB Rule Book.
[3] “Municipal entity” is defined in Section 15B(e)(8) of the Exchange Act as “any State, political subdivision of a State, or municipal corporate instrumentality of a State, including (A) any agency, authority, or instrumentality of the State, political subdivision, or municipal corporate instrumentality; (B) any plan, program, or pool of assets sponsored or established by the State, political subdivision, or municipal corporate instrumentality or any agency, authority, or instrumentality thereof; and (C) any other issuer of municipal securities.”
[4] See MSRB Interpretation on Priority of Orders for Securities in a Primary Offering under Rule G-17, MSRB interpretation of October 12, 2010, reprinted in MSRB Rule Book; see also MSRB Rule G-20 Interpretation — Dealer payments in connection with the municipal securities issuance process, MSRB interpretation of January 29, 2007, reprinted in MSRB Rule Book.
