MSRB Files Rule Proposal on Regulation of Broker’s Brokers

On March 5, 2012, the Municipal Securities Rulemaking Board (“Board” or “MSRB”) filed with the Securities and Exchange Commission (“Commission” or “SEC”) a proposed rule change consisting of: (i) proposed MSRB Rule G-43 governing the municipal securities activities of broker’s brokers and certain alternative trading systems (“Proposed Rule G-43”); (ii) proposed amendments to MSRB Rule G-8 (on recordkeeping by broker’s brokers and certain alternative trading systems), MSRB Rule G-9 (on record retention), and MSRB Rule G-18 (on agency trades and trades by broker’s brokers) (collectively, the “Proposed Amendments”); and (iii) a proposed interpretive notice on the duties of brokers, dealers, and municipal securities dealers (“dealers”) that use the services of broker’s brokers (the “Proposed Notice”).[1]  The MSRB requested that the proposed rule change be made effective six months after approval by the Commission.

BACKGROUND

The MSRB decided to consider additional rulemaking concerning broker’s brokers and the dealers that use their services due to the important role that broker’s brokers play in the provision of secondary market liquidity for retail investors in municipal securities.  In 2004,[2] the MSRB issued a notice that, among other things, addressed the role of broker’s brokers in large intra-day price differentials in the sale of retail size blocks of securities.

"Transaction Chains"

A frequent scenario in large intra-day price differentials occurs when a single block of securities moves through a "chain" of transactions during the day.  The securities involved in these scenarios often are infrequently traded issues with credits that are relatively unknown to most market participants.  In a typical case, the transaction chain starts with a dealer buying securities from a customer, usually in a "retail" size block of $5,000 to $100,000.  The securities are then sold through a broker's broker.  Two or more inter-dealer transactions follow, with a final sale of the securities being made by a dealer to a customer.  In certain cases, the difference between the price received by the selling customer and the price received by the purchasing customer is abnormally large, exceeding 10% or more.  In reviewing such transaction chains, it often appears that the two dealers effecting trades with customers at each end of the chain - one dealer purchasing from a customer and the other selling to a customer - did not make excessive profits on their trades.  Instead, the abnormally large intra-day price differentials can be attributed in major part to the price increases found in the inter-dealer trading occurring after the broker's broker's trade.

The MSRB deferred its rulemaking on the subject of broker’s brokers until the completion of Commission and Financial Industry Regulatory Authority (“FINRA”) enforcement actions, which subsequently highlighted broker’s broker activities that constitute clear violations of MSRB rules.[3]

The MSRB recognizes that some broker’s brokers make considerable efforts to comply with MSRB rules.  However, given the nature of the rule violations brought to light by Commission and FINRA enforcement actions and the important role of broker’s brokers in the provision of secondary market liquidity for retail investors, the MSRB determined that additional guidance and/or rulemaking concerning the activities of broker’s brokers was warranted.

On September 8, 2011, the MSRB requested comment on a draft of the proposed rule change.[4]  Comments were received from Bond Dealers of America; Tom Dolan; Hartfield, Titus & Donnelly, LLC; Knight BondPoint; Regional Brokers, Inc.; Securities Industry and Financial Markets Association; TMC Bonds L.L.C.; Vista Securities, Inc.; and Wolfe & Hurst Bond Brokers, Inc.  Summaries of those comments and the MSRB’s responses are contained in File No. SR-MSRB-2012-04.

The MSRB issued two other requests for comment on the regulation of broker’s brokers prior to MSRB Notice 2011-50.  On September 9, 2010, the MSRB published “Request for Comment on MSRB Guidance on Broker’s Brokers” (“MSRB Notice 2010-35”).  In MSRB Notice 2010-35, the MSRB requested comment on an interpretive notice reviewing the fair pricing requirements of MSRB Rules G-18 and G-30 and the fair practice requirements of MSRB Rule G-17 as they applied to transactions effected by broker’s brokers.  It also proposed to discuss the recordkeeping and record retention requirements for broker’s brokers.  On February 24, 2011, the MSRB published “Request for Comment on Draft Broker’s Brokers Rule (Rule G-43) and Associated Recordkeeping and Transaction Amendments” (“MSRB Notice 2011-18”).  In MSRB Notice 2011-18, the MSRB requested comment on the original version of Draft Rule G-43 (on broker’s brokers), as well as associated draft amendments to Rule G-8 (on books and records), G-9 (on records preservation), and G-18 (on execution of transactions).  Each subsequent request for comment has included a summary of the comments received on the previous request for comment, as well as the MSRB’s responses to those comments.

SUMMARY OF PROPOSED RULE CHANGE

PROPOSED RULE G-43

The role of the broker’s broker is that of intermediary between selling dealers and bidding dealers.  Proposed Rule G-43(a) would set forth the basic duties of a broker’s broker to such dealers.[5]  Proposed Rule G-43(a)(i) would incorporate the same basic duty currently found in Rule G-18.  That is, a broker’s broker would be required to make a reasonable effort to obtain a price for the dealer that was fair and reasonable in relation to prevailing market conditions.  The broker’s broker would be required to employ the same care and diligence in doing so as if the transaction were being done for its own account.

Proposed Rule G-43(a)(ii) would provide that a broker's broker that undertook to act for or on behalf of another dealer in connection with a transaction or potential transaction in municipal securities could not take any action that would work against that dealer’s interest to receive advantageous pricing.  Under Proposed Rule G-43(a)(iii), a broker’s broker would be presumed to act for or on behalf of the seller[6] in a bid-wanted, unless both the seller and bidders agreed otherwise in writing in advance of the bid-wanted.

Proposed Rule G-43(b) would create a safe harbor.  The safe harbor would provide that a broker’s broker that conducted bid-wanteds in the manner described in Proposed Rule G-43(b) would satisfy its pricing duty under Proposed Rule G-43(a)(i).[7]  The provisions of the safe harbor are designed to increase the likelihood that the highest bid in the bid-wanted is fair and reasonable.

Proposed Rule G-43(b)(i) and (ii) would require a broker’s broker to disseminate a bid-wanted widely and, in the case of securities of limited interest, to make a reasonable effort to reach dealers with specific knowledge of the issue or known interest in comparable securities.

Proposed Rule G-43(b)(iii) would require that each bid-wanted have a deadline for the acceptance of bids to assist in measuring compliance with the safe harbor.

Proposed Rule G-43(c)(i)(F) would require broker’s brokers that availed themselves of the safe harbor to use predetermined parameters designed to identify possible off-market bids in the conduct of bid-wanteds. For example, the predetermined parameters could be based on yield curves, pricing services, recent trades reported to the MSRB’s Real-Time Trade Reporting System (RTRS), or bids submitted to a broker’s broker in previous bid-wanteds or offerings.  Broker’s brokers would be required to test the predetermined parameters periodically to see whether they were achieving their designed purpose.

Proposed Rule G-43(b)(iv) would permit a broker’s broker that availed itself of the safe harbor to contact the high bidder in a bid-wanted about its bid price prior to the deadline for bids without the seller’s consent, if the bid was outside of the predetermined parameters described above and the broker’s broker believed that the bid might have been submitted in error.  If the high bid was within the predetermined parameters, yet the broker’s broker believed it might have been submitted in error (e.g., because it significantly exceeded the cover bid), the broker’s broker would be required to obtain the seller’s consent before contacting the bidder.  In all events, under Proposed Rule G-43(c)(i)(D), the broker’s broker would be required to notify the seller if the high bidder’s bid or the cover bid had been changed prior to execution and provide the seller with the original and changed bids.

Under Proposed Rule G-43(b)(v), a broker’s broker would be required to notify the seller if the highest bid received in a bid-wanted was below the predetermined parameters and receive the seller’s oral or written consent before proceeding with the trade.  This required notice would have the effect of notifying the selling dealer that the high bid in a bid-wanted might be off-market.  The selling dealer would then need to satisfy itself that the high bid was, in fact, fair and reasonable, if it wished to purchase the securities from its customer at that price as a principal.

Proposed Rule G-43(c) is designed to ensure that bid-wanteds and offerings are conducted in a fair manner.  Many of the requirements of Proposed Rule G-43(c) would address behavior that would also be a violation of Rule G-17 (e.g., the prohibitions on providing bidders with “last looks,” encouraging off-market bids, engaging in self-dealing, changing bid or cover prices without permission, and failing to inform the seller of the highest bid), although the requirements of Proposed Rule G-43(c) would not supplant those of Rule G-17.  Other requirements of Proposed Rule G-43(c) are designed to notify sellers and bidders of the manner in which bid-wanteds and offerings will be conducted and disclosing potential conflicts of interest on the part of broker’s brokers (e.g., when a broker’s broker has its own customers or when it allows an affiliate to enter bids).   Proposed Rule G-43(c) would apply to the conduct of all bid-wanteds and offerings by broker’s brokers, regardless of whether the broker’s broker had elected to satisfy its Proposed Rule G-43(a)(i) pricing duty for bid-wanteds by means of the Proposed Rule G-43(b) safe harbor.  A broker’s broker would be required by Proposed Rule G-43(c)(i)(G) to describe the manner in which it would satisfy its Proposed Rule G-43(a)(i) pricing obligation in the case of offerings and in the case of bid-wanteds not subject to the Proposed Rule G-43(b) safe harbor.

Proposed Rule G-43(d) would contain the definitions of terms used in Proposed Rule G-43.  Under Proposed Rule G-43(d)(iii), the term “broker’s broker” would mean a dealer, or a separately operated and supervised division or unit of a dealer, that principally effects transactions for other dealers or that holds itself out as a broker’s broker, whether a separate company or part of a larger company.  Certain alternative trading systems would be excepted from the definition of “broker’s broker.”  To be excepted, the alternative trading system would be required, with respect to its municipal securities activities, to utilize only automated and electronic means to communicate with bidders and sellers in a systematic and non-discretionary fashion (with certain limited exceptions), limit any customers to sophisticated municipal market professionals, and operate in accordance with most of the provisions of Proposed Rule G-43(c).  In essence, an alternative trading system qualifying for the exception from the definition of “broker’s broker” would be subject to most[8] of the requirements of Proposed Rule G-43 except the Proposed Rule G-43(a)(i) pricing obligation.

PROPOSED AMENDMENTS

The proposed amendments to Rule G-8 would require recordkeeping designed to assist in the enforcement of Proposed Rule G-43.  Records would be required to be kept of bids, offers, changed bids and offers, the time of notification to the seller of the high bid, the policies and procedures of the broker’s broker concerning bid-wanteds and offerings, and any agreements by which bidders and sellers agreed to joint representation by the broker’s broker.

Proposed Rule G-8(a)(xxv)(D) would require broker’s brokers to keep the following records of communications with bidders and sellers regarding possibly erroneous bids: the date and time of the communication; whether the bid deviated from the predetermined parameters and, if so, the amount of the deviation; the full name of the person contacted at the bidder; the full name of the person contacted at the seller, if applicable; the direction provided by the bidder to the broker’s broker following the communication; the direction provided by the seller to the broker’s broker following the communication, if applicable; and the full name of the person at the bidder, or seller, if applicable, who provided that direction.

Under Proposed Rule G-8(a)(xxv)(E), the broker’s broker would be required to keep records of the date and time it notified the seller that the high bid was below the predetermined parameters; the amount by which the bid deviated from the predetermined parameters; the full name of the person contacted at the seller; the direction provided by the seller to the broker’s broker following the communication; and the full name of the person at the seller who provided that direction.

Proposed Rule G-8(a)(xxv)(J) would require that each broker’s broker keep a record of its predetermined parameters, its analysis of why those predetermined parameters were reasonably designed to identify most bids that might not represent the fair market value of municipal securities that were the subject of bid-wanteds to which the parameters were applied, and the results of the periodic tests of such predetermined parameters required by Proposed Rule G-43(c)(i)(F).

Proposed Rule G-8(a)(xxvi) would impose comparable recordkeeping requirements on alternative trading systems.

In the case of broker’s brokers or alternative trading systems that are separately operated and supervised divisions of other dealers, separately maintained or separately extractable records of the municipal securities activities of the broker’s broker or alternative trading system would be required to be maintained to assist in enforcement of Proposed Rule G-43.

The proposed amendments to Rule G-9 would provide for the retention of the records described above for six years.

The proposed amendment to Rule G-18 would eliminate duplication, as the deleted text would be moved to Proposed Rule G-43(a)(i).

PROPOSED NOTICE

The Proposed Notice would discuss the duties of dealers that use the services of broker’s brokers.

Under the Proposed Notice, selling dealers would be reminded that the high bid obtained in a bid-wanted or offering is not necessarily a fair and reasonable price and that such dealers have an independent duty under Rule G-30 to determine that the prices at which they purchase municipal securities as a principal from their customers are fair and reasonable.  Selling dealers would be cautioned that any direction they provided to broker’s brokers to “screen” other dealers from their bid-wanteds or offerings could affect whether the high bid represented a fair and reasonable price and should be limited to valid business reasons, not anti-competitive behavior.  Selling dealers would be urged not to assume that their customers needed to liquidate their securities immediately without inquiring as to their customers’ particular circumstances and discussing with their customers the possible improved pricing benefit associated with taking additional time to liquidate their securities. The Proposed Notice also would provide that, depending upon the facts and circumstances, the use of bid-wanteds by selling dealers solely for price discovery purposes, without any intention of selling the securities through the broker’s brokers might be an unfair practice within the meaning of Rule G-17.

Under the Proposed Notice, bidding dealers that submitted bids to broker’s brokers that they believed were below the fair market value of the securities or that submitted “throw-away” bids to broker’s brokers would violate MSRB Rule G-13.  The Proposed Notice would provide that, while bidders are entitled to make a profit, Rule G-13 does not permit them to do so by “picking off” other dealers at off-market prices.

* * * * *

Questions about this notice should be directed to Peg Henry, General Counsel, Market Regulation, at 703-797-6600.

March 5, 2012

* * * * *

TEXT OF PROPOSED RULE CHANGE [9]

Rule G-43:  Broker’s Brokers

(a) Duty of Broker’s Broker.

(i) Each dealer acting as a "broker’s broker" with respect to the execution of a transaction in municipal securities for or on behalf of another dealer shall make a reasonable effort to obtain a price for the dealer that is fair and reasonable in relation to prevailing market conditions.  The broker’s broker must employ the same care and diligence in doing so as if the transaction were being done for its own account.

(ii) A broker's broker that undertakes to act for or on behalf of another dealer in connection with a transaction or potential transaction in municipal securities must not take any action that works against that dealer’s interest to receive advantageous pricing.

(iii) A broker’s broker will be presumed to act for or on behalf of the seller in a bid-wanted for municipal securities, unless both the seller and bidders agree otherwise in writing in advance of the bid-wanted.

(b) Conduct of Bid-Wanteds.  A broker’s broker will satisfy its obligation under subsection (a)(i) of this rule with respect to a bid-wanted if it conducts that bid-wanted as follows: 

(i) Unless otherwise directed by the seller, a broker’s broker must make a reasonable effort to disseminate a bid-wanted widely (including, but not limited to, the underwriter of the issue and prior known bidders on the issue) to obtain exposure to multiple dealers with possible interest in the block of securities, although no fixed number of bids is required.

(ii) If securities are of limited interest (e.g., small issues with credit quality issues and/or features generally unknown in the market), the broker’s broker must make a reasonable effort to reach dealers with specific knowledge of the issue or known interest in securities of the type being offered.

(iii) Notwithstanding subsection (a)(ii) of this rule, each bid-wanted must have a deadline for the acceptance of bids, after which the broker’s broker must not accept bids or changes to bids.  That deadline may be either (A) a precise (or “sharp”) deadline or (B) an “around time” deadline that ends upon the earliest of: (1) the time the seller directs the broker’s broker to sell the securities to the current high bidder, (2) the time the seller informs the broker’s broker that the bonds will not be sold in that bid-wanted, or (3) the end of the trading day as publicly posted by the broker’s broker prior to the bid-wanted.

(iv) If the high bid received in a bid-wanted is above or below the predetermined parameters of the broker’s broker and the broker’s broker believes that the bid may have been submitted in error, the broker’s broker may contact the bidder prior to the deadline for bids to determine whether its bid was submitted in error, without having to obtain the consent of the seller.  If the high bid is within the predetermined parameters but the broker’s broker believes that the bid may have been submitted in error, the broker’s broker must receive the oral or written permission of the seller before it may contact the bidder to determine whether its bid was submitted in error.

(v) If the high bid received in a bid-wanted is below the predetermined parameters of the broker’s broker, the broker’s broker must disclose that fact to the seller, in which case the broker’s broker may still effect the trade, if the seller acknowledges such disclosure either orally or in writing.

(c) Policies and Procedures.

(i) A broker’s broker must adopt and comply with policies and procedures pertaining to the operation of bid-wanteds and offerings for municipal securities, which at a minimum:

(A) require the broker’s broker to disclose the nature of its undertaking for the seller and bidders in bid-wanteds and offerings;

(B) require the broker’s broker to disclose the manner in which the broker’s broker will conduct bid-wanteds and offerings;

(C) require the broker’s broker to be compensated on the basis of commissions or other economically similar basis and to provide the seller and bidders with a copy of its commission or other economically similar schedules for transactions, with such schedules reflecting at a minimum the maximum charge that the broker’s broker could impose on a given transaction;

(D) if the winning high bidder’s bid or the cover bid in a bid-wanted has been changed, require the broker’s broker to disclose the change to the seller prior to execution and provide the seller with the original and changed bids;

(E) if a broker’s broker allows customers (as defined in Rule D-9) or affiliates (as defined in Rule G-11(a)(x)) to place bids, require the disclosure of that fact to both sellers and bidders in writing and require disclosure to the seller if the high bid in a bid-wanted or offering is from a customer or an affiliate of the broker’s broker; provided, however, that the broker’s broker is not required to disclose the name of the customer or affiliate; 

(F) if the broker’s broker wishes to conduct a bid-wanted in accordance with section (b) of this rule, require the broker’s broker to adopt predetermined parameters for such bid-wanted, disclose such predetermined parameters prominently on its website in advance of the bid-wanted in which they are used, and periodically test such predetermined parameters to determine whether they have identified most bids that did not represent the fair market value of municipal securities that were the subject of bid-wanteds to which the predetermined parameters were applied;

(G) describe in detail the manner in which it will satisfy its obligation under subsection (a)(i) of this rule in the case of offerings and bid-wanteds not conducted in accordance with section (b) of this rule;

(H) prohibit the broker’s broker from maintaining municipal securities in any proprietary or other accounts, other than for clearance and settlement purposes;

(I) prohibit self-dealing by the broker’s broker; 

(J) prohibit a broker’s broker from encouraging bids that do not represent the fair market value of municipal securities that are the subject of a bid-wanted or offering; 

(K) prohibit a broker’s broker from giving preferential information to bidders in bid-wanteds , including but not limited to, “last looks,” directions to a specific bidder that it should “review” its bid or that its bid is “sticking out”; 

(L) prohibit a broker’s broker from changing a bid price or offer price without the bidder’s or seller’s respective permission;

(M) prohibit a broker’s broker from failing to inform the seller of the highest bid in a bid-wanted or offering; 

(N) prohibit a broker’s broker from accepting a changed bid or a new bid in the same bid-wanted after the broker’s broker has selectively informed a bidder whether its bid is the high bid (“being used”) in the bid-wanted; and 

(O) subject to the provisions of sections (b), if applicable, and paragraph (c)(i)(N) of this rule, prohibit the broker’s broker from providing any person other than the seller (which may receive all bid prices) and the winning bidder (which may only receive notice that its bid is the winning bid) with information about bid prices, until the bid-wanted has been completed, unless the broker’s broker makes such information available to all market participants on an equal basis at no cost, together with disclosure that any bids may not represent the fair market value of the securities, and discloses publicly that it will make such information public.

(ii) The broker’s broker must disclose the policies and procedures adopted pursuant to subsection (c)(i) of this rule to sellers of, and bidders for, municipal securities in writing at least annually and post such policies and procedures in a prominent position on its website.

(d) Definitions.

(i) “Bidder” means a potential buyer in a bid-wanted or offering.

(ii) “Bid-wanted” means an auction for the sale of municipal securities in which:

(A) the seller does not specify a minimum or desired price for the securities that are the subject of the auction at the commencement of the auction;

(B) the identities of the bidders and the seller are not disclosed prior to the conclusion of the auction, other than to the broker’s broker;

(C) bidders must submit bids for the auctioned securities to the broker’s broker; and

(D) the seller decides whether to accept the winning bid.

(iii) “Broker’s broker” means a dealer, or a separately operated and supervised division or unit of a dealer, that principally effects transactions for other dealers or that holds itself out as a broker’s broker.  A broker’s broker may be a separate company or part of a larger company.

An alternative trading system, registered as such with the Commission, is not a broker's broker for purposes of this rule if, with respect to its municipal securities activities:

(A) it utilizes only automated and electronic means to communicate with bidders and sellers in a systematic and non-discretionary fashion (with the exception of communications that are solely clerical or ministerial in nature and communications that occur after a trade has been executed); 

(B) all of the customers (as defined in Rule D-9) of the alternative trading system, if any, are sophisticated municipal market professionals; and 

(C) the alternative trading system adopts, and complies with, policies and procedures that, at a minimum, 

(1) require the alternative trading system to disclose the nature of its undertaking for the seller and bidders in bid-wanteds and offerings; 

(2) require the alternative trading system to disclose the manner in which it will conduct bid-wanteds and offerings; and 

(3) prohibit the alternative trading system from engaging in the conduct described in paragraphs (H)-(O) of subsection (c)(i) of this rule. 

(iv) For purposes of paragraph (c)(i)(O) of this rule, a bid-wanted for a municipal security will be considered “completed” when either of the following occurs: (A) the security is traded, whether through the broker’s broker or otherwise or (B) the broker’s broker is notified by the seller that the security will not trade; 

(v) “Cover bid” means the next best bid after the winning bid.

(vi) “Dealer” means broker, dealer, or municipal securities dealer.

(vii) For purposes of this rule, “offering” means a process for the sale of municipal securities in which:

(A) the seller specifies a minimum or desired price for the securities as part of the offering, at the offering’s commencement; 

(B) the identities of the seller and the bidders are not disclosed prior to the conclusion of the offering; and

(C) a broker’s broker negotiates between the seller and the bidders to arrive at a price acceptable to the parties.

(viii) “Predetermined parameters” means formulaic parameters based on objective pricing criteria that are: (A) reasonably designed to identify most bids that may not represent the fair market value of municipal securities that are the subject of bid-wanteds to which they are applied, (B) determined by the broker’s broker in advance of the acceptance of bids in such bid-wanteds, and (C) systematically applied to all bids in such bid-wanteds.   Predetermined parameters may not be based on bids submitted in the bid-wanted to which they are applied (e.g., cover bids).  A broker’s broker may establish different predetermined parameters for different types of municipal securities.

(ix) For purposes of this rule, “seller” means the selling dealer, or potentially selling dealer, in a bid-wanted or offering and does not include the customer of a selling dealer.

* * * * *

Rule G-8:  Books and Records to be Made by Brokers, Dealers and Municipal Securities Dealers

(a) Description of Books and Records Required to be Made. Except as otherwise specifically indicated in this rule, every broker, dealer and municipal securities dealer shall make and keep current the following books and records, to the extent applicable to the business of such broker, dealer or municipal securities dealer:

(i) - (xxiv)  No change.

(xxv) Broker’s Brokers.  A broker’s broker (as defined in Rule G-43(d)(iii)) shall maintain the following records with respect to its municipal securities activities:

(A) all bids to purchase municipal securities, together with the time of receipt;

(B) all offers to sell municipal securities, together with the time the broker’s broker first receives the offering and the time the offering is updated for display or distribution;

(C) the time that the high bid is provided to the seller;  the time that the seller notifies the broker’s broker that it will sell the securities at the high bid; and the time of execution of the trade; 

(D) for each communication with a seller or bidder pursuant to Rule G-43(b)(iv), the date and time of the communication; whether the bid deviated from the predetermined parameters and, if so, the amount of the deviation; the full name of the person contacted at the bidder; the full name of the person contacted at the seller, if applicable; the direction provided by the bidder to the broker’s broker following the communication; the direction provided by the seller to the broker’s broker following the communication, if applicable; and the full name of the person at the bidder, or seller if applicable, who provided that direction;

(E) for each communication with a seller pursuant to Rule G-43(b)(v), the date and time of the communication; the amount by which the bid deviated from the predetermined parameters; the full name of the person contacted at the seller; the direction provided by the seller to the broker’s broker following the communication; and the full name of the person at the seller who provided that direction;

(F) for all changed bids, the full name of the person at the bidder that authorized the change and the full name of the person at the broker’s broker at whose direction the change was made;

(G) for all changes in offering prices, the full name of the person at the seller that authorized the change and the full name of the person at the broker’s broker at whose direction the change was made;

(H) a copy of any writings by which the seller and bidders agreed that the broker’s broker represents either the bidders or both seller and bidders, rather than the seller alone, which writings shall include the dates and times such writings were executed; and the full names of the signatories to such writings; 

(I) a copy of the policies and procedures required by Rule G-43(c);

(J) a copy of its predetermined parameters (as defined in Rule G-43(d)(viii)), its analysis of why those predetermined parameters were reasonably designed to identify most bids that might not represent the fair market value of municipal securities that were the subject of bid-wanteds to which the parameters were applied, and the results of the periodic tests of such predetermined parameters required by Rule G-43(c)(i)(F); and

(K) if a broker’s broker trading system is a separately operated and supervised division or unit of a broker, dealer or municipal securities dealer, there must be separately maintained in or separately extractable from such division’s or unit’s own facilities or the facilities of the broker, dealer or municipal securities dealer, all of the records relating to the activities of the broker’s broker or alternative trading system, and such records shall be so maintained or otherwise accessible as to permit independent examination thereof and enforcement of applicable provisions of the Act, the rules and regulations thereunder, and the rules of the Board.

(xxvi) Alternative Trading Systems.  An alternative trading system registered as such with the Commission shall maintain the following records with respect to its municipal securities activities:

(A) for all changed bids, the full name of the person at the bidder firm that authorized the change and the full name of the person at the alternative trading system at whose direction the change was made;

(B) for all changes in offering prices, the full name of the person at the seller firm that authorized the change and the full name of the person at the alternative trading system at whose direction the change was made;

(C) a copy of the policies and procedures required by Rule G-43(d)(iii)(C); and

(D) if the alternative trading system is a separately operated and supervised division or unit of a broker, dealer or municipal securities dealer, there must be separately maintained in or separately extractable from such division’s or unit’s own facilities or the facilities of the broker, dealer or municipal securities dealer, all of the records relating to the municipal securities activities of the alternative trading system, and such records shall be so maintained or otherwise accessible as to permit independent examination thereof and enforcement of applicable provisions of the Act, the rules and regulations thereunder, and the rules of the Board.

(b) - (e) No change.

(f) Compliance with Rule 17a-3.  Brokers, dealers and municipal securities dealers other than bank dealers which are in compliance with rule 17a-3 of the Commission will be deemed to be in compliance with the requirements of this rule, provided that the information required by subparagraph (a)(iv)(D) of this rule as it relates to uncompleted transactions involving customers; subsection paragraph (a)(viii); and subsections paragraphs (a)(xi) through (a) [(xxiv)] (xxvi) shall in any event be maintained.

(g) No change.

* * * * *

Rule G-9:  Preservation of Records

(a) Records to be Preserved for Six Years.  Every broker, dealer and municipal securities dealer shall preserve the following records for a period of not less than six years:

(i) - (ix) No change.

(x) the records required to be maintained pursuant to rule G-8(a)(xviii); [and]

(xi) the records concerning secondary market trading account transactions described in rule G-8(a)(xxiv), provided, however, that such records need not be preserved for a secondary market trading account which is not successful in purchasing municipal securities[.];

(xii) the records required to be maintained pursuant to rule G-8(a)(xxv); and

(xiii) the records required to be maintained pursuant to rule G-8(a)(xxvi).

(b) - (g)  No change.

* * * * *

Rule G-18:  Execution of Transactions

Each broker, dealer and municipal securities dealer, when executing a transaction in municipal securities for or on behalf of a customer as agent, shall make a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions.  [A broker, dealer or municipal securities dealer acting as a "broker’s broker" shall be under the same obligation with respect to the execution of a transaction in municipal securities for or on behalf of a broker, dealer, or municipal securities dealer.]

* * * * *

MSRB Notice 2012-__

Notice to Dealers That Use the Services of Broker’s Brokers 

Introduction 

In view of the important role that broker’s brokers play in the provision of secondary market liquidity for municipal securities owned by retail investors, MSRB Rule G-43 sets forth particular rules to which broker’s brokers are subject.  Rule G-43(a)(i) provides:

Each dealer acting as a "broker’s broker"[1] with respect to the execution of a transaction in municipal securities for or on behalf of another dealer shall make a reasonable effort to obtain a price for the dealer that is fair and reasonable in relation to prevailing market conditions.  The broker’s broker must employ the same care and diligence in doing so as if the transaction were being done for its own account.[2]

In guidance on broker’s brokers issued in 2004,[3] the MSRB noted the role of some broker’s brokers in large intra-day price differentials of infrequently traded municipal securities with credits that were relatively unknown to most market participants, especially in the case of “retail” size blocks of $5,000 to $100,000.  In certain cases, differences between the prices received by the selling customers as a result of a broker’s broker bid-wanted and the prices paid by the ultimate purchasing customers on the same day were 10% or more.  After the securities were purchased from the broker’s broker, they were sold to other dealers in a series of transactions until they eventually were purchased by other customers.  The abnormally large intra-day price differentials were attributed in major part to the price increases found in the inter-dealer market occurring after the broker’s brokers’ trades.

Rule G-43 addresses the role of broker’s brokers, including their role in such a series of transactions.  It is the role of the broker’s broker to conduct a properly run bid-wanted or offering and thereby satisfy its duty to make a reasonable effort to obtain a price for the dealer that is fair and reasonable in relation to prevailing market conditions.  The MSRB believes that a bid-wanted or offering conducted in the manner provided in Rule G-43 will be an important element in the establishment of a fair and reasonable price for municipal securities in the secondary market.  This notice addresses the roles of other transaction participants, specifically the brokers, dealers, and municipal securities dealers (“dealers”) that sell, and bid for, municipal securities in bid-wanteds and offerings conducted by broker’s brokers.  Those selling dealers (“sellers”) and bidding dealers (“bidders”) also have pricing duties under MSRB rules and their failure to satisfy those duties could negate the reasonable efforts of a broker’s broker to achieve fair pricing.

Duties of Bidders

Rule G-13(b)(i) provides that, in general, “no broker, dealer or municipal securities dealer shall distribute or publish, or cause to be distributed or published, any quotation relating to municipal securities, unless the quotation represents a bona fide bid[4] for, or offer of, municipal securities by such broker, dealer or municipal securities dealer.”  Rule G-13(b)(ii) provides that “[n]o broker, dealer or municipal securities dealer shall distribute or publish, or cause to be distributed or published, any quotation relating to municipal securities, unless the price stated in the quotation is based on the best judgment of such broker, dealer or municipal securities dealer of the fair market value of the securities which are the subject of the quotation at the time the quotation is made.”

Dealers that submit bids to broker’s brokers that they believe are below the fair market value of the securities or that submit “throw-away” bids to broker’s brokers do so in violation of Rule G-13.  While bidders are entitled to make a profit, Rule G-13 does not permit them to do so by “picking off” other dealers at off-market prices.  Throw-away bids, by definition, violate Rule G-13, because throw-away bids are arrived at without an analysis by the bidder of the fair market value of the municipal security that is the subject of the bid.  A conclusion by the bidder that a security must be worth “at least that much,” without any knowledge of the security or comparable securities and without any effort to analyze the security’s value is not based on the best judgment of such bidder of the fair market value of the securities within the meaning of Rule G-13(b)(ii).  When the MSRB first proposed Rule G-13, it explained in a February 24, 1977 letter from Frieda Wallison, Executive Director and General Counsel, MSRB, to Lee Pickard, Director, Division of Market Regulation, Securities and Exchange Commission that, among the activities that Rule G-13 was designed to prevent was the placing of a bid that is “pulled out of the air,” which is another way to describe a throw-away bid.

Furthermore, when a dealer’s bid is accepted and a transaction in the securities is executed, that transaction price (and accordingly the bid itself) will be disseminated within the meaning of Rule G-13(a)(i) on the MSRB’s Electronic Municipal Market Access (EMMA ®) platform within 15 minutes after the time of trade.  At that point, if the bid is off-market, it will create a misperception in the municipal marketplace of the true fair market value of the security.  The fact that the bid price that wins a bid-wanted or offering may well not represent the true fair market value of the security is evidenced by the trade activity observed by enforcement agencies following such auctions.  Enforcement agencies have informed the MSRB that they continue to observe the same kinds of series of transactions in municipal securities that prompted the MSRB’s 2004 pricing guidance.  They have also informed the MSRB about their observations of other trading patterns that indicate some market participants may misuse the role of the broker’s broker in the provision of secondary market liquidity and may cause retail customers who liquidate their municipal securities by means of broker’s brokers to receive unfair prices.

Duties of Sellers

Dealers that use the services of broker’s brokers to sell municipal securities for their customers also have significant fair pricing duties under Rule G-30 when they act as a principal.  As the MSRB noted in its request for comment on Draft Rule G-43,[5]

the information about the value of municipal securities provided to a selling dealer by a broker’s broker is only one factor that the dealer must take into account in determining a fair and reasonable price for its customer.  In fact, in 2004, the National Association of Securities Dealers (“NASD”) announced that it had fined eight dealers for relying solely on prices obtained in bid-wanteds conducted by broker’s brokers, which the NASD found to be significantly below fair market value.[6]  In that same year, the MSRB said that “particularly when the market value of an issue is not known, a dealer . . . may need to check the results of the bid wanted process against other objective data to fulfill its fair pricing obligations . . . .”

Under those circumstances where broker’s brokers seeks to satisfy their fair pricing obligations in bid-wanteds conducted pursuant to Rule G-43(b), Rule G-43(b)(v) provides for notice by broker’s brokers to sellers when bids in bid-wanteds are below predetermined parameters that are designed to identify possible off-market bids (e.g., those based on yield curves, pricing services, recent trades reported to the MSRB’s RTRS System, or bids received by broker’s brokers in prior bid-wanteds or offerings).  Once a seller has received such notice, it must direct the broker’s broker as to whether to execute the trade at that price.  That notice by the broker’s broker and required action on the part of the seller should put the seller on notice that it must take additional steps to ascertain whether the high bid provided to it by the broker’s broker is, in fact, a fair and reasonable price for the securities.  Rule G-30 mandates that the seller, if acting as a principal, must not buy municipal securities from its customer at a price that is not fair and reasonable (taking any mark-down into account), taking into consideration all relevant factors, including those listed in the rule.

The MSRB notes that Rule G-8(a)(xxv)(E) requires broker’s brokers to keep records when they have provided the seller with the notice described in Rule G-43(b)(v).  Among the required records are the full name of the person at the seller who received the notice, the direction given by the seller firm following the notice, and the full name of the person at the seller who provided that direction.

Rule G-43(b)(i) permits a broker’s broker to limit the audience for a bid-wanted at the selling dealer’s direction, a practice sometimes referred to as “screening” or “filtering,” because the MSRB recognizes that there may be legitimate reasons for this practice.  However, the MSRB notes that such screening may reduce the likelihood that the high bid represents a fair and reasonable price.  Selling dealers should, therefore, be able to demonstrate a reason that is not anti-competitive (e.g., credit, legal, or regulatory concerns), rather than trying to eliminate access by a competitor, for directing broker’s brokers to screen certain bidders from the receipt of bid-wanteds or offerings.  For example, a selling dealer might maintain a list of the firms it would be unwilling to accept as a counterparty and the reasons why.

The MSRB recognizes that there may be circumstances under which customers may need to liquidate their municipal securities quickly and that there are limitations on the ability of a bid-wanted or offering to achieve a price that is comparable to recent trade prices under certain circumstances, particularly in view of its timing and the presence or absence of regular buyers in the marketplace.  Nevertheless, the MSRB urges sellers not to assume that their customers need to liquidate their securities immediately without inquiring as to their customers’ particular circumstances and discussing with their customers the possible improved pricing benefit associated with taking additional time to liquidate the securities.

Rule G-17 requires dealers, in the conduct of their municipal securities activities, to deal fairly with all persons and to not engage in any deceptive, dishonest, or unfair practice.  Broker’s brokers have informed the MSRB that many dealers place bid-wanteds and offerings with broker’s brokers with no intention of selling the securities through the broker’s brokers.  Some have noted that shortly thereafter they see the same securities purchased by dealers for their own accounts at prices that exceed the high bid obtained by the broker’s brokers by only a very small amount.  Other dealers have told the MSRB that they are skeptical of many of the bid-wanteds they see, because they think the bid-wanteds are only being used for price discovery by the selling dealers and are not real.  Accordingly, in many cases, they do not bid.  This use of broker’s brokers solely for price discovery purposes harms the bid-wanted and offering process by reducing bidders, thereby reducing the likelihood that the high bid in a bid-wanted will represent the fair market value of the securities.  Additionally, it causes broker’s brokers to work without reasonable expectation of compensation.  For those reasons, depending upon the facts and circumstances, the use of bid-wanteds solely for price discovery purposes may be an unfair practice within the meaning of Rule G-17.

________________________

[1] Rule G-43(d)(iii) defines a “broker’s broker” as “a dealer, or a separately operated and supervised division or unit of a dealer, that principally effects transactions for other dealers or that holds itself out as a broker’s broker.” Certain alternative trading systems are excepted from the definition of “broker’s broker.”

[2] A bid-wanted conducted in accordance with Rule G-43(b) will satisfy the pricing obligation of a broker’s broker.

[3] MSRB Notice 2004-3 (January 26, 2004).

[4] Rule G-13(b)(iii) provides that:

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.

[5] MSRB Notice 2011-18 (February 24, 2011).

[6] See http://www.finra.org/Newsroom/NewsReleases/2004/P011465.