Request for Comments on the Underwriting Activities of Financial Advisors

Financial advisors assist municipal issuers in accessing the market by providing advice on selecting underwriters and the structure, timing and terms of the underwriting.    Financial advisors may be brokers, dealers or municipal securities dealers (“dealers”) that are registered with the Securities and Exchange Commission and subject to the rules of the Municipal Securities Rulemaking Board (“MSRB”), or non-dealers that are not so subject.  The National Association of Independent Public Finance Advisors recently raised issues regarding certain practices of dealer financial advisors and provisions of Rule G-23, on activities of financial advisors.  These issues concern the conflict of interest that arises when a dealer acting as financial advisor on an issue of municipal securities resigns from that position in order to underwrite the issue.

The MSRB is seeking comment from all interested persons on the practices of dealer financial advisors.  This notice summarizes the current requirements of Rule G-23 concerning underwriting activities, provides a short history of the adoption of Rule G-23 and presents a series of questions on areas in which the MSRB is seeking comment from industry participants.

REQUIREMENTS OF RULE G-23 REGARDING FINANCIAL ADVISORS AND UNDERWRITING ACTIVITIES

Current Rule

Rule G-23 establishes disclosure and other requirements for dealers that act as financial advisors to issuers of municipal securities.  Rule G-23 also requires a financial advisor to alert the issuer to the conflict of interest when changing roles from financial advisor to underwriter on an issue that might lead the dealer to act in its own best interest as underwriter rather than in the issuer’s best interest.

The rule states that a dealer acting as financial advisor may not acquire the issue as principal, either alone or in a syndicate, or act as agent for the issuer in the placement of such issue, unless certain requirements are met.  If a financial advisor for an issue wishes to be an underwriter for the issue to be sold on a negotiated basis, Rule G-23(d)(i) requires that: (i) the dealer terminate the financial advisory relationship with regard to the issue and at or after such termination the issuer expressly consent in writing to such acquisition or participation; (ii) at or before such termination, the dealer disclose in writing to the issuer that there may be a conflict of interest in changing from the capacity of financial advisor to that of purchaser of or placement agent for the securities and the issuer expressly acknowledge in writing to the dealer receipt of such disclosure; and (iii) the dealer disclose in writing to the issuer at or before such termination the source and anticipated amount of all remuneration to the dealer with respect to such issue and the issuer expressly acknowledge in writing to the dealer receipt of such disclosure.

With respect to issues sold by competitive bids, Rule G-23(d)(ii) provides that a financial advisor must obtain the issuer’s written consent prior to making a bid for the issue.[1]

In general, the requirements of Rule G-23 are applied “issue by issue.”  Thus, it is permissible for a firm to be a financial advisor to an issuer on one issue and then function as underwriter on the next issue, even if the two issues are in the market concurrently.

Rule G-23(d) also states that a dealer that has a financial advisory relationship with respect to a new issue is not precluded from purchasing such securities from an underwriter, either for its own trading account or for the account of customers, except to the extent that such purchase is made to contravene the purpose and intent of the rule.  Finally, Rule G-23(h) states that, if a dealer acquires new issue municipal securities or participates in a syndicate or other account that acquires new issue municipal securities in accordance with Rule G-23(d), such dealer must disclose the existence of the financial advisory relationship in writing to each customer who purchases such securities from such dealer, at or before the completion of the transaction with the customer.[2]

Adoption of Rule G-23

The MSRB has long viewed the role and interests of a financial advisor as significantly different from those of an underwriter.  In general, the financial advisor is an agent of the issuer while the underwriter is not.[3]  The original draft of Rule G-23, in 1977, would have prohibited a dealer from underwriting a negotiated sale of an issue on which it acted as a financial advisor.  The MSRB’s rationale was that, in a negotiated sale situation, the element of competition among prospective underwriters typically is absent.  It concluded that, if a financial advisor also acts as underwriter on the issue, it may have an opportunity to act in a manner contrary to the advisor’s fiduciary obligations to the issuer.  The draft rule did allow financial advisors to bid competitively on the issue with the issuer’s consent.  The MSRB determined that the prima facie conflict was mitigated in competitive bid situations in which the existence of competition among underwriters for award of the securities tends to introduce an arm’s-length element into the establishment of the terms of the issue and underwriting.

The 1977 draft rule was controversial.  Some issuers questioned whether the draft rule was overly paternalistic in its attempt to “protect” issuers.  Commentators, including a number of issuers, stated that regulation of financial advisors more appropriately should be left to the respective states and that the draftrule would unduly restrict the flexibility of issuers.  It was pointed out that in certain circumstances, such as in connection with interim financings or small issues, the negotiated sale of securities by an issuer to its financial advisor may be the most effective, and sometimes the only way, for an issuer to place its debt.  Commentators urged that issuers are capable of protecting themselves and noted that an issuer is in the best position to determine whether, in any given situation, it is appropriate to permit a financial advisor to participate in the underwriting of its securities.  It was also noted that the draft rule would disrupt certain regional industry practices. 

There were some comments in support of the draft rule.  One commentator noted that issuer costs may be higher if a municipal securities dealer acts as both financial advisor and underwriter in a negotiated sale.  These commentators also referred to the inherent conflict of interest when a financial advisor acts in a dual capacity.

The MSRB later revised draft Rule G-23 and embodied the current disclosure provisions regarding underwriting.  The MSRB stated that it continued to be concerned about the prima facie conflict of interest that exists when a dealer acts as financial advisor to an issuer of municipal securities and then purchases the securities in a negotiated sale.  Nevertheless, the MSRB concluded that the purpose and intent of draft Rule G-23 could be achieved without restricting the flexibility of issuers through a disclosure approach.  The MSRB noted that the disclosures would promote informed decisions by issuers whether to permit a financial advisor to purchase its securities in a negotiated sale.  In addition, Rule G-23 has always required that a dealer disclose in writing its role as financial advisor of an issue of which it is an underwriter to customers who purchase such securities from the dealer.  This disclosure must be made at or before the completion of the transaction with the customer.

REQUEST FOR COMMENTS

The MSRB is seeking comments from industry participants on the practices of dealer financial advisors.  The MSRB welcomes comment on all aspects of Rule G-23, and in particular seeks comments regarding dealer financial advisor participation in the underwriting process.  To help formulate areas of discussion, commentators may wish to provide their views on the questions posed below.

1.  Would issuers be better served if greater restrictions were placed on dealer financial advisors stepping into the role as underwriter for either negotiated or competitive underwritings?  Would restrictions on dealer financial advisors serving as underwriters prove detrimental to issuers by reducing the universe of dealers able and interested in underwriting their issues?  Would certain categories of issuers or issues be more adversely affected by greater restrictions on dealer financial advisors underwriting issues on which they advised?

2.  Are current disclosure requirements to issuers adequate?  How and when do dealers provide such disclosures?  Who receives such disclosures?  What is the wording of the typical disclosure provided to issuers?  Is the disclosure effective in alerting issuers to the potential conflict of interest?  If the disclosure requirements are inadequate or dealers are not providing such disclosures in an effective manner, how could such disclosures be improved?

3.  At what point in the process does a dealer typically resign its role as financial advisor in order to underwrite an issue?  Is such timing appropriate?

4.  What, if any, potential conflicts do you believe exist when a financial advisor resigns from a single offering while continuing to advise on other issues?

5.  Should a financial advisor that resigns such position on an issue in order to underwrite that issue be precluded for a specific period of time from being able to act again as financial advisor for this issuer?  Similarly, should a dealer be precluded for a period of time from entering into a financial advisory relationship with an issuer after serving as an underwriter on one of this issuer’s offerings of securities?

6.  Are investors made aware of situations where dealers serving as financial advisors terminate the financial advisory relationship in order to underwrite an issue?  How do investors learn of such situations?  Is such information material to their investment decisions?  What disclosures about such situations would investors consider material in connection with their investment decisions?  How could the content or method of such disclosures be improved?

7.  Would investors be better served with greater restrictions on dealer financial advisors stepping into the role as underwriter, or would such restrictions prove detrimental to investors?

*     *     *     *     *

The MSRB welcomes comments from all interested parties; in particular, the MSRB would like to receive comments from issuers on this topic.  Comments should be submitted no later than January 17, 2006, and may be directed to Ronald W. Smith, Senior Legal Associate.  Written comments will be available for public inspection.

November 18, 2005