Municipal Fund Securities -- Notice of filing of proposed rule change relating to professional qualification of municipal fund securities limited principals

On March 21, 2002, the Municipal Securities Rulemaking Board (the “MSRB”) filed with the Securities and Exchange Commission (the “SEC”) a proposed rule change consisting of an amendment to Rule G-3, on professional qualifications.[1] The proposed rule change would establish a new permanent category of principals, known as municipal fund securities limited principals, to supervise the activities of brokers, dealers and municipal securities dealers (“dealers”) with respect to municipal fund securities.[2] The proposed rule change will become effective upon approval by the SEC.

Current Temporary Transition Period

Rule G-3 requires that a dealer have at least one municipal securities principal (and in some cases two municipal securities principals), even if the dealer’s only municipal securities transactions are sales of municipal fund securities. In order to provide small dealers seeking to enter the market for municipal fund securities relief from the requirement to immediately obtain a municipal securities principal, the MSRB amended Rule G-3 in July 2001 to provide a temporary alternative method for qualification of principals in connection with municipal fund securities.[3] Under this temporary provision, until July 31, 2002, if a dealer’s municipal securities activities are limited exclusively to municipal fund securities and the dealer has fewer than 11 associated persons engaged in such activities, it may fulfill its obligation to have a municipal securities principal by designating a general securities or investment company/variable contracts limited principal to act as a limited principal.[4] During this period, any designated limited principal has all of the powers and responsibilities of a municipal securities principal under MSRB rules with respect to transactions in municipal fund securities. Under the current transition period, on and after August 1, 2002, dealers effecting transactions in municipal fund securities are required to comply with the same municipal securities principal requirements applicable to all other dealers effecting transactions in municipal securities.

Proposed Rule Change

Permanent Municipal Fund Securities Limited Principal Category. The MSRB understands that many dealers that wish to participate in the market for municipal fund securities do not currently, and do not plan to, engage in any municipal securities activities other than with respect to municipal fund securities. Since these dealers will not participate in the market for municipal debt securities and the features of municipal fund securities differ significantly from those of debt securities, the MSRB believes that no investor protection purpose is served by requiring principals responsible for supervision of such firms’ municipal fund securities activities to demonstrate their understanding of the application of MSRB rules other than with respect to municipal fund securities.

Thus, the MSRB is proposing the creation of a new category of principals to serve permanently as municipal fund securities limited principals. Qualification as a municipal fund securities limited principal would be by an examination consisting of questions on the broad range of MSRB-specific topics that are relevant to municipal fund securities activities.[5] The examination would require that the individual taking it have previously or concurrently taken and passed the general securities principal qualification examination (Series 24) or investment company and annuity principal qualification examination (Series 26) administered by the National Association of Securities Dealers, Inc. (“NASD”). The qualification examination for municipal fund securities limited principals is scheduled to become available on October 1, 2002.[6]

An individual qualified as a municipal fund securities limited principal would be permitted to supervise only the municipal fund securities activities of the dealer and would have no authority to supervise the activities of the dealer with respect to any other type of municipal securities. However, an individual qualified as a municipal securities principal (Series 53) would continue to be qualified to supervise all municipal securities activities of the dealer, including activities relating to municipal fund securities. Thus, an individual wishing to supervise municipal fund securities activities could qualify to do so either (i) by becoming a municipal securities principal through the municipal securities principal qualification examination (Series 53) or (ii) by becoming a municipal fund securities limited principal through this new qualification examination if the individual is already or concurrently becomes a general securities or investment company/variable contracts limited principal.

Numerical Requirement. If a dealer’s municipal securities activities are limited to municipal fund securities, the proposed rule change also would count all municipal fund securities limited principals toward the numerical requirement for principals regardless of the number of associated persons engaging in such activities. Thus, any dealer that does not engage in any municipal securities activities other than with respect to municipal fund securities could fully discharge its obligation with respect to municipal securities principals with individuals qualified as municipal fund securities limited principals.

Prerequisite for Series 53 Exam. Existing rule language indirectly permits investment company/variable contracts limited representatives (Series 6) to take the Series 53 examination to become qualified as municipal securities principals.[7] Although this was appropriate when there was no other provision under Rule G-3 for qualifying a principal to supervise municipal fund securities activities, the proposed rule change discontinues this method of qualification on October 1, 2002 when the new municipal fund securities limited principal qualification examination becomes available.[8] An investment company/variable contracts limited representative would be able to qualify as a municipal fund securities limited principal by taking both the Series 26 examination and the new municipal fund securities limited principal examination.

Extension of Temporary Transition Period. In addition, the proposed rule change extends the existing temporary provision permitting general securities principals and investment company/variable contracts limited principals to supervise municipal fund securities activities from July 31, 2002 to December 31, 2002 in order to provide dealers with an adequate opportunity to prepare potential candidates for the new examination. During this extended transition period, the numerical requirement with respect to principals would be simplified so that all dealers, not just those with fewer than 11 associated persons engaged in municipal fund securities activities, could fully meet their principal requirements with principals acting in the temporary capacity permitted under the transition provisions. The proposed rule change makes clear that, beginning on January 1, 2003, all municipal fund securities limited principals (including general securities principals and investment company/variable contracts limited principals supervising municipal fund securities activities under the temporary transition period who wish to continue such supervisory activities after December 31, 2002) must be qualified by taking the new qualification examination.

Waiver of Qualification Requirements. Finally, the proposed rule change would give the NASD or any other appropriate regulatory agency the power to waive qualification requirements with respect to municipal fund securities limited principals, as with all other qualification categories. As provided in Rule G-3(g)(i), such waivers are to be granted solely in extraordinary cases.

Summary of Comments on Draft Amendment

On December 19, 2001, the MSRB published for comment a draft amendment designed to establish a permanent category of municipal fund securities limited principals and to establish permanent professional qualification requirements for dealers that limit their municipal securities activities to municipal fund securities.[9] A municipal fund securities limited principal would have the same authority as a municipal securities principal under MSRB rules, but only with respect to municipal fund securities activities. A general securities principal or an investment company/variable contracts limited principal could qualify as a municipal fund securities limited principal by passing a new qualification examination relating specifically to municipal fund securities.[10] The draft amendment would allow any dealer that limits its municipal securities activities to municipal fund securities, regardless of size, to comply with Rule G-3’s numerical requirement for principals solely with municipal fund securities limited principals that have passed the new exam. In addition, the draft amendment would make explicit an existing provision that implicitly allows an investment company/variable contracts limited representative to take the Series 53 exam without first taking the municipal securities representative qualification examination (Series 52).

The MSRB received comments from seven commentators. After reviewing these comments, the MSRB approved the draft amendment, with certain modifications, for filing with the SEC.[11] The comments and the MSRB’s responses are discussed below.

Three commentators supported the draft amendment. One commentator commended the MSRB for “continuing to tailor its regulatory requirements applicable to municipal fund securities in a manner that recognizes the differences between such securities and traditional municipal securities.” Another commentator stated that the draft amendment “appropriately tailors registration requirements to the nature of the business conducted and provides firms with needed flexibility in adapting their compliance programs as their business evolves.” The third commentator stated that “the new limited principal category is an appropriate vehicle whereby persons whose activities are limited to the supervision of municipal fund securities activities may be qualified to supervise those activities.”

However, two commentators were concerned that the draft amendment might suggest that municipal securities sales principals (Series 8 or Series 9/10) may not supervise sales activities with respect to municipal fund securities and requested clarification to the contrary. The MSRB wishes to make clear that it does not intend to limit the power of municipal securities sales principals to supervise sales activities with respect to municipal fund securities by creating the new municipal fund securities limited principal classification. However, municipal securities sales principals may undertake only certain limited types of supervisory functions relating to sales activities in satisfaction of MSRB rules. Many supervisory responsibilities under MSRB rules must be undertaken by municipal securities principals or, in the case of municipal fund securities activities, by municipal fund securities limited principals.

Four commentators opposed the draft amendment. One commentator argued that the differences between municipal fund securities and registered investment company securities that justify the need for regulation in this market should be addressed by issuer regulation rather than dealer regulation. This commentator stated that “guiding issuers toward thorough documentation of unique aspects of their municipal fund offerings would help to better educate both the selling agents and the purchasers as to differences among plans – a result that we believe would ultimately be more effective than the addition of a back-office limited principal.” It further stated that “these issues are better addressed by the selling agent or by field office series 26 or 24 registered principals who are closer to the point of sale, with more applicable knowledge to lend to the review process.” This commentator recommended that “the MSRB not create a limited municipal securities principal category to address issues that … would be better resolved at the issuer level.”

The MSRB understands this commentator’s concern that some issues relating to municipal fund securities might best be resolved through issuer regulation. However, the MSRB has no authority with respect to issuers; rather, the MSRB is charged with protecting investors through dealer regulation.[12] Since MSRB rules do apply to dealers’ municipal fund securities activities, the MSRB believes that the ultimate supervision of such activities must be conducted by someone who knows these rules. Contrary to the commentator’s characterization of the municipal fund securities limited principal as a “back-office limited principal,” the municipal fund securities limited principal would provide dealers with a second (and in many cases easier) means of fulfilling the appropriate top-level supervisory requirement established under MSRB rules which otherwise would be met by a municipal securities principal. With regard to personnel at the point of sale, dealers are permitted under Rule G-3 to use investment company/variable contracts limited representatives to sell municipal fund securities and sales principals to directly supervise such sales activities.

Three commentators believed that the draft amendment would increase their regulatory burden. One commentator mistakenly believed that its general securities principals are currently qualified to supervise municipal securities activities and should also be qualified to supervise municipal fund securities activities. This commentator stated that the “new proposal would require more testing and sure to follow CE credits. This is unjust, too time consuming and unnecessary.” Another commentator viewed the qualification provisions as an “absolutely new burden on industry & reps: entirely unnecessary” and believes that “more of these rules will force more of the smaller firms to leave the business.” The third commentator argued that dealers conducting business in municipal fund securities should not be required to become members of the MSRB, noting that dealers that are “not currently approved to conduct municipal securities business, would have to enter into a Membership Continuance Request under NASDR Membership Rule 1017. This is an arduous, time consuming and expensive process that would be especially felt by smaller Broker/Dealers.” It also argued that dealers selling securities similar to municipal fund securities, such as mutual fund IRA accounts and municipal bond mutual funds, are not required to be registered with the MSRB.

The MSRB believes that the proposed rule change would in fact decrease dealers’ regulatory burden. Without the amendment, dealers would be required to use fully qualified municipal securities principals to meet their Rule G-3 principal requirement. As stated above, the creation of the municipal fund securities limited principal category provides dealers with an alternative means of meeting this requirement. For dealers that do not otherwise engage in municipal securities activities, allowing their general securities principals or investment company principals to take a shorter, more focused examination than the Series 53 exam in order to qualify as a municipal fund securities limited principal should be less burdensome. The further reduction in regulatory burden that these commentators most likely desire – i.e., no MSRB qualification requirements – is inappropriate since activities regulated by MSRB rules require ultimate supervision by someone who knows these rules.

The fact that MSRB rules apply at all results, of course, from the Exchange Act and not because the MSRB has sought to regulate municipal fund securities. Dealers selling mutual fund IRA accounts and municipal bond mutual funds are not required to comply with MSRB rules because these securities are not municipal securities and are instead subject to regulation under other regulatory schemes. In contrast, municipal fund securities are municipal securities and therefore are subject to MSRB rules and exempt from most other provisions of federal securities laws (such as the Securities Act and the Investment Company Act).

March 21, 2002

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TEXT OF PROPOSED RULE CHANGE [13]

Rule G-3 – Classification of Principals and Representatives; Numerical Requirements; Testing; Continuing Education Requirements

(a) No change.

(b) Municipal Securities Principal; Municipal Fund Securities Limited Principal.

(i) No change.

(ii) Qualification Requirements.

(A) No change.

(B) Any person seeking to become qualified as a municipal securities principal in
accordance with subparagraph (b)(ii)(A) of this rule, must, prior to being qualified as a municipal
securities principal:

(1) have been duly qualified as either a municipal securities representative or a
general securities representative; provided, however, that any person who qualifies as a
municipal securities representative solely by reason of subparagraph (a)(ii)(C) shall not be
qualified to take the Municipal Securities Principal Qualification Examination on or after
October 1, 2002; or

(2) No change.

(C)-(D) No change.

(iii) No change.

(iv) Municipal Fund Securities Limited Principal.

(A) Definition. The term “municipal fund securities limited principal” means a natural
person (other than a municipal securities principal or municipal securities sales principal),
associated with a broker, dealer or municipal securities dealer that has filed with the Board in
compliance with rule A-12, who is directly engaged in the functions of a municipal securities
principal as set forth in paragraph (b)(i), but solely as such activities relate to transactions in
municipal fund securities.

(B) Qualification Requirements.

(1) Every municipal fund securities limited principal shall take and pass the
Municipal Fund Securities Limited Principal Qualification Examination prior to being
qualified as a municipal fund securities limited principal. The passing grade shall be
determined by the Board.

(2) Any person seeking to become qualified as a municipal fund securities limited
principal in accordance with clause (b)(iv)(B)(1) of this rule must, as a condition to being
qualified as a municipal fund securities limited principal:

(a) have been duly qualified as either a general securities principal or an
investment company/variable contracts limited principal; or

(b) have taken and passed either the General Securities Principal
Qualification Examination or the Investment Company and Annuity Principal
Qualification Examination.

(3) Any person who ceases to act as a municipal fund securities limited principal
for two or more years at any time after having qualified as such shall meet the requirements
of clauses (b)(iv)(B)(1) and (2) prior to being qualified as a municipal fund securities
limited principal.

(4) For the first 90 days after becoming a municipal fund securities limited
principal, the requirements of clauses (b)(iv)(B)(1) and (2) shall not apply to any person
who is qualified as a general securities representative, investment company/variable
contracts limited representative, general securities principal or investment
company/variable contracts limited principal, provided, however, that such person shall
meet the requirements of clauses (b)(iv)(B)(1) and (2) within that period.

(C) Actions as Municipal Securities Principal. Any municipal fund securities limited
principal may undertake all actions required or permitted under any Board rule to be taken by
municipal securities principal, but solely with respect to activities related to municipal fund
securities.

(D) Numerical Requirements. Any broker, dealer or municipal securities dealer whose
municipal securities activities are limited exclusively to municipal fund securities may count any
municipal fund securities limited principal toward the numerical requirement for municipal securities
principal set forth in paragraph (b)(iii).

(E) (iv) Temporary Provisions for Municipal Fund Securities Limited Principal.
Notwithstanding any other provision of this rule, until December 31, 2002, Until July 31, 2002, the
following provisions shall apply to any broker, dealer or municipal securities dealer whose
municipal securities activities are limited exclusively to municipal fund securities:

(A) (1) notwithstanding the provisions of paragraph (b)(ii), the broker, dealer or municipal
securities dealer may designate any person who has taken and passed the General Securities
Principal Qualification Examination or Investment Company and Annuity Principal QualificationExamination as a municipal fund securities limited principal.

(B) (2) any municipal fund securities limited principal designated as provided in clause
subparagraph (b)(iv)(A)(E)(1) may undertake all actions required or permitted under any Board rule to be taken by a municipal securities principal to the same extent as set forth in subparagraph (b)(iv)(C).

(C) (3) the broker, dealer or municipal securities dealer may count one any municipal fund
securities limited principal designated as provided in clause (b)(iv)(E)(1) toward the numerical requirement for municipal securities principal to the same extent as set forth in subparagraph (b)(iv)(D). set forth in paragraph (b)(iii); provided that, if such broker, dealer or municipal securities dealer is only required to have one municipal securities principal, such broker, dealer, or municipal securities dealer may count one municipal fund securities limited principal toward the numerical requirement only if the broker, dealer or municipal securities dealer is described in subparagraph (b)(iii)(B).

(4) On and after January 1, 2003, all municipal fund securities limited principals (including
any municipal fund securities limited principals designated as provided in clause (b)(iv)(E)(1)) must be qualified as provided in subparagraph (b)(iv)(B).

(c)-(f) No change.

(g) Waiver of Qualification Requirements.

(i) The requirements of paragraphs (a)(ii), (a)(iii), (b)(ii), (b)(iv)(B) and (c)(ii) may be waived in extraordinary cases for any associated person of a broker, dealer or municipal securities dealer who demonstrates extensive experience in a field closely related to the municipal securities activities of such broker, dealer or municipal securities dealer. Such waiver may be granted by

(A)-(B) No change.