REQUEST FOR COMMENTS          COMMENTS DUE BY OCTOBER 1, 2001

 

Notice and Draft Interpretive Guidance on Rule G-17—Disclosure of Material Facts and Interpretive Guidance Concerning Sophisticated Municipal Market Professionals

Route To: Manager, Muni Department  Trading Sales Compliance

Notice and Comments Requested The MSRB is seeking comment on a notice covering two related concepts. The first is draft interpretive guidance on rule G-17—disclosure of material facts; the second is draft interpretive guidance concerning the application of MSRB rules to transactions with sophisticated municipal market professionals.

 

Comments on the draft interpretive guidance notice should be submitted no later than October 1, 2001, and may be directed to Carolyn Walsh, Associate General Counsel.  Written comments will be available for public inspection.

 

 

BACKGROUND

Over the last few years, investors and dealers[1] have expressed a growing interest in the use of the Internet and new technologies for securities trading. This has brought about the rapid development of a number of electronic trading systems for equity securities. The same advances that have fueled equity systems may also change the way that municipal securities are traded. The Internet has made information a relatively inexpensive and accessible commodity. Real-time trading and communication systems may have the capability to bring greater efficiencies to municipal securities trading and enhance the quality of market information available about these securities to investors, issuers and dealers. The ease of making electronic municipal securities purchases may help lower costs and increase investor participation in the market.

 

In May 2000, the MSRB hosted a roundtable to begin a discussion about the use of electronic trading systems in municipal securities and the application of the MSRB’s rules to existing and proposed electronic trading systems. During that roundtable, as well as during subsequent conversations with industry members, it appeared that there is significant confusion about the applicability of MSRB rules to dealers who operate such systems. The MSRB then determined to seek industry comment on draft interpretive guidance relating to dealer responsibilities under MSRB rules.

 

On September 28, 2000, the MSRB published a notice seeking comment on draft interpretive guidance on dealer responsibilities in connection with both electronic and traditional municipal securities transactions (the “September Draft Guidance”).[2] The September Draft Guidance presented the MSRB’s views regarding the responsibilities of dealers under the MSRB’s fair practice, quotation, uniform practice and new issue securities rules. 

 

The MSRB reviewed the comments received on the September Draft Guidance.[3] On March 26, 2001, the MSRB published a portion of the September Draft Guidance consisting of three interpretive notices on electronic primary offering systems, on uniform practice requirements for a specific type of trading system, and on electronic recordkeeping.[4] The MSRB also has determined to publish for comment a new draft interpretive guidance notice that covers two related concepts. The first concerns rule G-17 and the disclosure of material facts (the “Rule G-17 Interpretive Guidance”). The second concerns sophisticated municipal market professionals (the “Sophisticated Municipal Market Professional Interpretive Guidance “ or “SMMP Interpretive Guidance”).

 

September Draft Guidance—Application of MSRB Rules

In the September Draft Guidance, the MSRB stated that electronic trading systems could develop for municipal securities, while maintaining the customer protection standards set forth in MSRB rules. In issuing its September Draft Guidance, the MSRB specifically reaffirmed the standards embodied in MSRB rules and reiterated that the rules apply to electronically executed transactions just as they do to transactions with customers effected over the telephone or in person. Many commentators commended the MSRB’s decision to continue to apply existing rules to the online market and not to formulate new requirements applicable only to online transactions.

 

September Draft Guidance—Sophisticated Market Professional

A major thrust of the September Draft Guidance was the proposal that the MSRB issue formal guidance that would recognize that dealers could satisfy customer protection obligations under MSRB rules in different ways, depending upon the nature of the customer. The September Draft Guidance defined a class of customers as “sophisticated market professionals” (“SMP”). The September Draft Guidance stated that, in general, the specific actions necessary for the dealer to assure that fair practice standards are met with respect to retail customers and unsophisticated institutional customers may be more comprehensive than the actions required when effecting transactions with or for customers who are SMPs.

 

DISCUSSION OF COMMENTS AND BASES FOR INTERPRETIVE GUIDANCE

 

Rule G-17 Interpretive Guidance—Disclosure Of Material Facts

When the September Draft Guidance was released for comment, several institutional investors raised concerns about the appropriateness of the guidance in light of the municipal securities disclosure regime. For example, investors asserted that the duty of a dealer to disclose all material information under rule G-17 is necessary because it cannot be presumed that an investor, however sophisticated, has access to all information that has been gathered by or is available to a dealer. Investors also noted that, like retail investors, institutional investors struggle to get the necessary disclosures in the municipal securities market and that a dealer, by virtue of its relationship with the issuer, may possess information that is material, but unavailable to the investor on a timely basis. 

 

The MSRB believes that these concerns are valid, but that they overstate the scope of a dealer’s rule G-17 obligations. In order to attempt to alleviate investors’ concerns about the SMP concept’s application to rule G-17, the new Rule G-17 Interpretive Guidance includes an expanded explanation of what rule G-17’s obligation to “disclose all material facts” means in today’s market. 

 

Investors’ comment letters suggest that they have interpreted rule G-17’s affirmative disclosure obligations too broadly by implying that a dealer always has an obligation to “acquire” all material information about a municipal security before effecting a customer transaction.  Rule G-17 requires that dealers disclose to a customer at the time of trade all material facts about a transaction known by the dealer. In addition, a dealer is required to discover and thus to disclose material facts about a security when such facts are reasonably accessible to the market. Thus, a dealer would be responsible for disclosing to a customer any material fact concerning a municipal security transaction made publicly available through sources such as the Nationally Recognized Municipal Securities Information Repositories (“NRMSIRs”), State Information Depositories (“SIDs”), the MSRB’s Municipal Securities Information Library^® (MSIL^®) system[5] and Transaction Reporting System (“TRS”),[6] rating agency reports and other sources of information relating to the municipal securities transaction generally used by dealers that effect transactions in the type of municipal securities at issue (collectively, “established industry sources”).

 

Rule G-17 was adopted many years prior to the passage of SEC Rule 15c2-12 at a time when there were few established industry sources of municipal securities information. Since 1990, official statements have been available through the MSRB’s MSIL system and NRMSIRs. While the MSRB recognizes that even today municipal securities disclosure lacks a truly centralized system for the accessing of publicly available secondary market public information, SEC Rule 15c2-12 was amended in 1994 to improve secondary market disclosure. Under the SEC rule, secondary market information must be provided to a NRMSIR and/or SID for many municipal securities. The development of NRMSIRs, SIDs, MSIL^®, TRS, rating agencies and indicative data sources in the post Rule 15c2-12 era have created much more readily available disclosure information sources for institutional investors and dealers. Recently the market has made progress and market professionals (including institutional investors) can, and do, go to established industry sources to find securities descriptive information, official statements, rating agency ratings and reports, and ongoing disclosure information.  

 

Sophisticated Municipal Market Professional Interpretive Guidance

 

A.            Revisions to SMP Concept as it Applies to All Customer Protection Rules

The MSRB received numerous comment letters about the SMP proposal. Those commentators that are opposed to the concept expressed concern that the SMP concept will create two-tiered markets where SMPs and dealers receive prices superior to retail customers and less sophisticated institutions and transactions will be driven to the less regulated market. Those that are in favor of the concept in general remain concerned that as drafted the SMP concept is too difficult to implement in practice. Certain dealers have called for the MSRB to identify classes of investors who are “otherwise qualified” market professionals (e.g., Qualified Purchasers as defined under the Investment Company Act, Qualified Institutional Buyers as defined under Securities Act Rule 144A, etc.) who will be presumed to be SMPs, or allow dealers to rely upon written representations from institutional investors that they are SMPs. On the other hand, certain institutional investors believe that the SMP criteria, as written, give broker-dealers too much flexibility to determine who is a SMP. 

 

1.                  Retention of SMP Differentiation

The MSRB determined to retain the SMP proposal with the revisions discussed below.[7] Retail customers and smaller institutions should be able to participate in the electronic marketplace. However, dealers, either those who function as system operators or those who “sponsor” a customer with access to those systems, should comply with the current panoply of customer protection rules when their customers are non-SMPs. Currently, retail and unsophisticated institutional customers may not be obtaining sufficient publicly available information about the wide variety of municipal securities outstanding, nor do they have sufficient understanding about municipal securities and the municipal securities market to allow them to access systems with limited dealer services and regulatory responsibilities. The MSRB believes, however, that certain customers (SMPs) are sufficiently familiar with the market to participate on a par with dealers when engaging in non-recommended secondary market transactions. They thus should be able to access the market, either through automated systems or otherwise, without the same level of dealer responsibility now required for less sophisticated customers. Such market access should be at a lower cost than the dealer’s current “full service.” There is support in law and regulatory precedent for differentiating between types of investors.[8]

 

2.                  Revision to Definition of SMP

The September Draft Guidance defines a sophisticated market professional as a customer who has met the following criteria:

1.      The customer has timely access to all publicly available material facts concerning a transaction;

2.      The customer is capable of independently evaluating the investment risk and market value of the securities at issue; and

3.      The customer is making independent investment decisions. 

 

After the September Draft Guidance was published, SEC staff expressed concern that individuals should not be considered to be SMPs,[9] suggested changing the SMP name to “sophisticated municipal market professional” (“SMMP”), and suggested closer adherence to the language in the NASD Institutional Suitability Release to make the application of the SMMP concept less confusing to dealers who must comply with both. The MSRB also determined to limit the application of the SMMP concept to institutions with at least $100 million invested in municipal securities in the aggregate and/or under management

 

Therefore, the MSRB has revised the SMMP definition to be more consistent with the NASD’s guidance. In addition to some specific language changes (including removing any individual or institution with less than $100 million invested in municipal securities in the aggregate and/or under management from the definition “institutional customer” for purposes of the SMMP interpretation) the new definition provides that the factors that go into determining that an institutional customer is an SMMP are merely guidelines which will be utilized to determine whether a dealer has fulfilled its fair practice obligations with respect to a specific institutional customer transaction and that the inclusion or absence of any of these factors is not dispositive of the determination. 

 

3.            Revision to Application of SMP Criteria

 

Rule G-17: Conduct of Municipal Securities Activities

In the September Draft Guidance, the MSRB stated that the actions of a dealer in complying with its affirmative disclosure obligations under rule G-17 may depend on the nature of the customer.  This concept remains in the SMMP Interpretive Guidance. However, the MSRB wishes to make clear that it believes that concept only applies when a dealer is effecting non-recommended secondary market transactions for a customer. Dealers who effect transactions in new issue securities, or who recommend a security transaction to customers may have additional pricing, disclosure, suitability and investigation obligations. Thus, the SMMP Interpretive Guidance, as modified by the changes made to the SMMP definition, informs dealers that where the dealer has reasonable grounds for concluding that the customer is an SMMP then the dealer’s affirmative disclosure obligations when effecting non-recommended secondary market transactions have been fulfilled. 

 

The MSRB believes that this interpretation is consistent with rule G-17’s goal of ensuring that dealers treat customers fairly. It affords dealers flexibility to negotiate understandings and terms with a particular customer when effecting non-recommended secondary market transactions. This approach assists dealers and customers in defining their own expectations and roles with respect to their specific relationship. 

 

The SMMP Interpretive Guidance is a mechanism to allow certain sophisticated institutional customers, who have the ability and desire to act as “self-directed” municipal securities investors, to participate directly in the development of trading platforms that are designed primarily to provide transaction execution services for dealers and other market professionals. These electronic platforms will allow dealers to be “order-takers” when effecting non-recommended secondary market transactions in all types of municipal securities. Thus, while the SMMP Interpretive Guidance by its terms applies to all non-recommended secondary market municipal securities transactions, the SMMP proposal is intended primarily to allow the development of cost efficient electronic trading platforms. 

 

The MSRB believes that investors have misunderstood the import of the September Draft Guidance by suggesting that it would allow a dealer who had actual knowledge of a material fact that was not accessible to the market to transact with an SMMP without disclosing the information. The SMMP Interpretive Guidance does nothing to alter a dealer’s duty not to engage in deceptive, dishonest, or unfair practices under rule G-17 or under the federal securities laws. Thus, if material information is not accessible to the market but known to the dealer and not disclosed, the dealer may be found to have engaged in an unfair practice. In essence, a dealer’s disclosure obligations to SMMPs would be on par with inter-dealer disclosure obligations. There would be no specific requirement for a dealer to disclose all material public facts to a customer that is presumed to know the characteristics of the securities. As in the case of an inter-dealer transaction, in a transaction with an SMMP an intentional failure to disclose an unusual feature of a security not accessible to the market (but known by the dealer) may constitute an unfair practice violative of rule G-17. In addition, a dealer may not knowingly misdescribe securities to the customer. A dealer’s duty not to mislead its customers is absolute and is not dependent upon the nature of the customer.[10] 

 

The SMMP proposal as it relates to rule G-17 should not impede the flow of municipal securities disclosure. It only will relieve a dealer when effecting non-recommended secondary market transactions of its affirmative disclosure obligation to inform the SMMP customer about the information available from established industry sources where the customer is already aware of, or capable of making itself aware, and can independently understand the significance of the material facts available from established industry sources. Unfortunately, there may be times when an SMMP is not satisfied that the information available from established industry sources is sufficient to allow it to make an informed investment decision. However, in those circumstances, the MSRB believes that an SMMP can recognize that risk and take appropriate action, be it declining to transact, undertaking additional investigation, or asking the dealer to acquire additional information. Continuing to impose rule G-17’s affirmative disclosure obligations on dealers transacting with SMMPs will not provide the desired additional information. As investor groups have realized, dealers may not be aware of new or developing material events because issuers have failed to publicly disclose them, or they are not available from established industry sources. 

 

Because electronic trading platforms currently are designed primarily to be platforms for transaction execution and are not designed either to describe the risks inherent in the municipal securities market to the platform participants, or to supply participants with extensive information about the securities being traded, the MSRB is concerned about allowing all types of customers direct access to such systems. Moreover, a dealer operating an electronic trading platform, like an alternative trading system (“ATS”), is not likely to have any unique knowledge about the securities being traded on its system. Under such circumstances, system participants must be sophisticated enough to understand the consequences of transacting with a dealer who is offering transaction execution services only and who does not have, and does not represent that it has, any unique knowledge about the security transactions being effected on its trading platform. 

 

While the MSRB wishes to encourage the development of trading platforms that strive to improve efficiency, transparency and liquidity, the MSRB is concerned that such systems must initially limit participation to dealers or SMMPs who are able to make informed investment decisions without the assistance of a “full service” dealer.[11] As noted, the fact that many electronic trading platforms currently being developed offer limited traditional dealer services does not mean that other types of electronic trading systems could not provide adequate protections for less sophisticated customers. The MSRB does not intend to inhibit the development of online trading systems, but these systems must be designed to ensure that dealers’ fair practice obligations to customers are fulfilled.The MSRB believes that to the extent that issuers improve and standardize municipal securities disclosure information, online trading platforms will be better positioned to deliver disclosure and transaction information to investors.

 

Rule G-18: Execution of Transactions

Rule G-18 requires that each dealer, when executing a transaction in municipal securities for or on behalf of a customer as agent, make a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions. The September Draft Guidance provided that the actions that must be taken by a dealer when effecting agency transactions to make reasonable efforts to ensure that its agency transactions with customers are effected at fair and reasonable prices may be influenced by the nature of the customer as well as by the services explicitly offered by the dealer. In the current draft the MSRB made changes to more precisely describe the parameters of the services offered by a dealer if the dealer wishes to avail itself of this interpretation. If a dealer effects non-recommended secondary market agency transactions for SMMPs and the services it provides are limited to providing anonymity, communication, order matching, and/or clearance functions, and the dealer does not exercise discretion as to how or when the transaction is executed, then the MSRB believes the dealer (or system operator) is not required to take further actions on individual transactions to ensure that its agency transactions with customers are effected at fair and reasonable prices.[12] 

 

Rule G-19: Suitability of Recommendations and Transactions

The MSRB’s suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct. After the September Draft Guidance was published, SEC staff made suggestions concerning conforming the rule G-19 application to the NASD’s Institutional Suitability release. The SEC suggested clarifying that the guidance concerns only the manner in which a dealer determines that a recommendation is suitable for a particular institutional customer. Therefore, the interpretation does not address the obligation related to suitability that requires that a dealer have a “reasonable basis” to believe that the recommendation could be suitable for at least some customers. 

 

The SEC staff also suggested clarifying that the manner in which a dealer fulfills its “customer-specific suitability obligations” will vary depending on the nature of the customer and the specific transaction. However, where the dealer has reasonable grounds for concluding that an institutional customer is an SMMP, then a dealer’s obligation to determine that a recommendation is suitable for a particular customer is fulfilled. The SEC also suggested reminding dealers that these factors are not intended to be requirements or the only factors to be considered but are offered merely as guidance in determining the scope of a dealer’s suitability obligation. These suggestions have been incorporated into the new SMMP Interpretive Guidance.

 

When the MSRB released its September Draft Guidance for comment many commentators raised issues with the MSRB’s statements concerning identifying when a dealer makes an online recommendation to a customer. In publishing the September Draft Guidance and the November Clarification, the MSRB intended to be consistent with existing customer suitability analysis by recognizing that historically the determination of whether a dealer is making a recommendation has been made by reference to all relevant facts and circumstances. However, several commentators noted a need for industry consensus on the definition of an online recommendation. A few commentators specifically stated that the MSRB should conform its recommendation and suitability guidance to the NASD’s soon to be released notice on its suitability rule and online communications.[13] The MSRB is reviewing the NASD’s release and plans to provide additional guidance in this area.

 

Draft Interpretive Guidance for Quotation Rule

The September Draft Guidance recognized that new electronic trading systems provide a variety of avenues for disseminating quotations among both dealers and customers. While the MSRB made changes to the definition of SMMP, the SMMP Interpretive Guidance relating to rule G-13 is substantially the same as the September Draft Guidance.

 

*            *             *            *

 

REQUEST FOR COMMENT

 

The MSRB requests comment on all aspects of the following draft interpretive guidance notice.

 

NOTICE AND DRAFT RULE G-17 INTERPRETATION—DISCLOSURE OF MATERIAL FACTS

 

Rule G-17, the MSRB’s fair dealing rule, encompasses two general principles. First, the rule imposes a duty on dealers not to engage in deceptive, dishonest, or unfair practices. This first prong of rule G-17 is essentially an antifraud prohibition. 

 

Second, the rule imposes a duty to deal fairly. Statements in the MSRB’s filing for approval of rule G-17 and the SEC’s order approving the rule reveal that rule G-17 was implemented to establish a minimum standard of fair conduct by dealers in municipal securities. In addition to the basic antifraud prohibitions in the rule, the duty to “deal fairly” is intended to “refer to the customs and practices of the municipal securities markets, which may, in many instances differ from the corporate securities markets.” See Exchange Act Release No. 13987 (Sept. 22, 1977). As part of a dealer’s obligation to deal fairly, the MSRB has interpreted the rule to create affirmative disclosure obligations for dealers. The MSRB has stated that the dealer’s affirmative disclosure obligations require that a dealer disclose, at or before the sale of municipal securities to a customer, all material facts concerning the transaction, including a complete description of the security.[14] These obligations apply even when a dealer is effecting non-recommended secondary market transactions.

 

Rule G-17 was adopted many years prior to the adoption of SEC Rule 15c2-12. The development of Nationally Recognized Municipal Securities Information Repositories (“NRMSIRs”), State Information Depositories (“SIDs”), the MSRB’s Municipal Securities Information Library^® (MSIL^®) system[15] and Transaction Reporting System (“TRS”),[16] rating agencies and indicative data sources in the post-Rule 15c2-12 era have created much more readily available information sources. Recently, the market has made progress and market professionals (including institutional investors) can, and do, go to these industry sources to find securities descriptive information, official statements, rating agency ratings and reports, and ongoing disclosure information. These developments suggest a need for further explanation of what “disclosure of all material facts” means in today’s market.

 

Rule G-17 requires that dealers disclose to a customer at the time of trade all material facts about a transaction known by the dealer. In addition, a dealer is required to discover and thus to disclose material facts about a security when such facts are reasonably accessible to the market. Thus, a dealer would be responsible for disclosing to a customer any material fact concerning a municipal security transaction made publicly available through sources such as the NRMSIRs, SIDs, MSIL^®, TRS, rating agency reports and other sources of information relating to the municipal securities transaction generally used by dealers that effect transactions in the type of municipal securities at issue (collectively, “established industry sources”).

 

The customs and practices of the industry suggest that the sources of information generally used by a dealer that effects transactions in municipal securities may vary with the type of municipal security. For example, a dealer might have to review fewer industry sources to discover all material facts about an insured “triple-A” rated general obligation bond than for a non-rated conduit issue. So too, to the extent that a security is more complex, for example because of complex structure or where credit quality is changing rapidly, a dealer might need to review a broader range of information sources prior to executing a transaction. 

 

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.”  The SEC stated, “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.”[17] In the context of a new issue underwriting this obviously may require a dealer to investigate beyond the established industry sources and thus disclose the facts known. So too, if a dealer recommends a security transaction, rule G-19 requires a dealer to “have reasonable grounds for the recommendation in light of information available from the issuer or otherwise.”[18] 

*          *            *            *

 

NOTICE AND DRAFT SOPHISTICATED MUNICIPAL MARKET PROFESSIONAL INTERPRETIVE GUIDANCE

 

Introduction

Industry participants have suggested that the MSRB’s fair practice rules should allow dealers to recognize the different capabilities of certain institutional customers as well as the varied types of dealer-customer relationships that electronic commerce allows. Prior MSRB interpretations reflect that the nature of the dealer’s counter-party should be considered when determining the specific actions a dealer must undertake to meet its duty to deal fairly. The MSRB believes that dealers may consider the nature of the institutional customer in determining what specific actions are necessary to meet the fair practice standards for a particular transaction. This draft sophisticated municipal market professional interpretive guidance (“SMMP Interpretive Guidance”) concerns only the manner in which a dealer determines that it has met certain of its fair practice obligations to certain institutional customers; it does not alter the basic duty to deal fairly, which applies to all transactions and all customers. For purposes of this interpretation, an institutional customer shall be an entity, other than a natural person, (corporation, partnership, trust, or otherwise) with total assets of at least $100 million invested in municipal securities in the aggregate in its portfolio and/or under management.

 

Sophisticated Municipal Market Professionals

Not all institutional customers are sophisticated regarding investments in municipal securities. There are three important considerations with respect to the nature of an institutional customer in determining the scope of a dealer’s fair practice obligations.  They are: 

·        Whether the institutional customer has timely access to all publicly available material facts concerning a municipal securities transaction;

·        Whether the institutional customer is capable of independently evaluating the investment risk and market value of the municipal securities at issue; and

·        Whether the institutional customer is making independent investment decisions about its investments in municipal securities.

 

When a dealer has reasonable grounds for concluding that an institutional customer (i) has timely access to the publicly available material facts concerning a municipal securities transaction; (ii) is capable of independently evaluating the investment risk and market value of the municipal securities at issue; and (iii) is making independent decisions about its investments in municipal securities, and other known facts do not contradict such a conclusion, the institutional customer can be considered a sophisticated municipal market professional (“SMMP”). While it is difficult to define in advance the scope of a dealer’s fair practice obligations with respect to a particular transaction, as will be discussed later, by making a reasonable determination that an institutional customer is an SMMP, then certain of the dealer’s fair practice obligations remain applicable but are deemed fulfilled. (In addition, as discussed below, the fact that a quotation is made by an SMMP would have an impact on how such quotation is treated under rule G-13.)

 

Considerations Regarding The Identification Of Sophisticated Municipal Market Professionals

The MSRB has identified certain factors, which may be relevant in identifying SMMPs.

 

Access to Material Facts

A determination that an institutional customer has timely access to the publicly available material facts concerning the municipal securities transaction will depend on the customer’s resources and the customer’s ready access to established industry sources for disseminating material information concerning the transaction. Although the following list is not exhaustive, the MSRB notes that relevant considerations in determining that an institutional customer has timely access to publicly available information could include:

·        the resources available to the institutional customer to investigate the transaction (e.g., research analysts);

·        the institutional customer’s independent access to Nationally Recognized Municipal Securities Information Repositories (“NRMSIRs”), State Information Depositories (“SIDs”), and information generated by the MSRB’s Municipal Securities Information Library^® (MSIL^®) system[19] and Transaction Reporting System (“TRS”),[20] either directly or through services that subscribe to such systems; and

·        the institutional customer’s access to other sources of information concerning material financial developments affecting an issuer’s securities (e.g., rating agency data and indicative data sources).

 

Independent Evaluation of Investment Risks and Market Value

Second, a determination that an institutional customer is capable of independently evaluating the investment risk and market value of the municipal securities that are the subject of the transaction will depend on an examination of the institutional customer's ability to make its own investment decisions, including the municipal securities resources available to the institutional customer to make informed decisions. In some cases, the dealer may conclude that the institutional customer is not capable of independently making the requisite risk and valuation assessments with respect to municipal securities in general. In other cases, the institutional customer may have general capability, but may not be able to independently exercise these functions with respect to a municipal market segment or type of municipal security. This is more likely to arise with relatively new types of municipal securities or those with significantly different risk or volatility characteristics than other municipal securities investments generally made by the institution. If an institution is either generally not capable of evaluating investment risk or lacks sufficient capability to evaluate the particular municipal security, the scope of a dealer’s fair practice obligations would not be diminished by the fact that the dealer was dealing with an institutional customer. On the other hand, the fact that a customer initially needed help understanding a potential investment need not necessarily imply that the customer did not ultimately develop an understanding and make an independent investment decision. 

 

While the following list is not exhaustive, the MSRB notes that relevant considerations in determining that an institutional customer is capable of independently evaluating investment risk and market value considerations could include:

·        the use of one or more consultants, investment advisers, research analysts or bank trust departments;

·        the general level of experience of the institutional customer in municipal securities markets and specific experience with the type of municipal securities under consideration;

·        the institutional customer’s ability to understand the economic features of the municipal security;

·        the institutional customer's ability to independently evaluate how market developments would affect the municipal security that is under consideration; and

·        the complexity of the municipal security or securities involved.

 

Independent Investment Decisions

Finally, a determination that an institutional customer is making independent investment decisions will depend on whether the institutional customer is making a decision based on its own thorough independent assessment of the opportunities and risks presented by the potential investment, market forces and other investment considerations. This determination will depend on the nature of the relationship that exists between the dealer and the institutional customer. While the following list is not exhaustive, the MSRB notes that relevant considerations in determining that an institutional customer is making independent investment decisions could include:

·        any written or oral understanding that exists between the dealer and the institutional customer regarding the nature of the relationship between the dealer and the institutional customer and the services to be rendered by the dealer;

·        the presence or absence of a pattern of acceptance of the dealer’s recommendations;

·        the use by the institutional customer of ideas, suggestions, market views and information relating to municipal securities obtained from sources other than the dealer; and

·        the extent to which the dealer has received from the institutional customer current comprehensive portfolio information in connection with discussing potential municipal securities transactions or has not been provided important information regarding the institutional customer’s portfolio or investment objectives.

 

Dealers are reminded that these factors are merely guidelines which will be utilized to determine whether a dealer has fulfilled its fair practice obligations with respect to a specific institutional customer transaction and that the inclusion or absence of any of these factors is not dispositive of the determination. Such a determination can only be made on a case-by-case basis taking into consideration all the facts and circumstances of a particular dealer/customer relationship, assessed in the context of a particular transaction.

 

Application of SMMP Concept to Rule G-17’s Affirmative Disclosure Obligations

The SMMP concept as it applies to rule G-17 recognizes that the actions of a dealer in complying with its affirmative disclosure obligations under rule G-17 when effecting non-recommended secondary market transactions may depend on the nature of the customer. While it is difficult to define in advance the scope of a dealer’s affirmative disclosure obligations to a particular institutional customer, the MSRB has identified the factors that define an SMMP as factors that may be relevant when considering compliance with the affirmative disclosure aspects of rule G-17. 

 

Where the dealer has reasonable grounds for concluding that the institutional customer is an SMMP, the institutional customer, by definition, is already aware, or capable of making itself aware of, material facts and is able to independently understand the significance of the material facts available from established industry sources.[21] Where the dealer has reasonable grounds for concluding that the customer is an SMMP then the dealer’s obligation when effecting non-recommended secondary market transactions to ensure disclosure of material information available from established industry sources is fulfilled. Unfortunately, there may be times when an SMMP is not satisfied that the information available from established industry sources is sufficient to allow it to make an informed investment decision.[22] However, in those circumstances, the MSRB believes that an SMMP can recognize that risk and take appropriate action, be it declining to transact, undertaking additional investigation or asking the dealer to undertake additional investigation. 

 

This interpretation does nothing to alter a dealer’s duty not to engage in deceptive, dishonest, or unfair practices under rule G-17 or under the federal securities laws. In essence, a dealer’s disclosure obligations to SMMPs when effecting non-recommended secondary market transactions would be on par with inter-dealer disclosure obligations. This interpretation allows dealers to act as “order-takers” when transacting with SMMPs. There is no need for a dealer to disclose material facts available from established industry sources to an institutional customer that already has access to the established industry sources.[23] 

 

As in the case of an inter-dealer transaction, in a transaction with an SMMP, a dealer’s intentional withholding of a material fact about a security, where the information is not accessible through established industry sources, may constitute an unfair practice violative of rule G-17.  In addition, a dealer may not knowingly misdescribe securities to the customer. A dealer’s duty not to mislead its customers is absolute and is not dependent upon the nature of the customer.

 

Application of SMMP Concept to Rule G-18 Interpretation—Duty To Ensure That Agency Transactions Are Effected At Fair And Reasonable Prices

Rule G-18 requires that each dealer, when executing a transaction in municipal securities for or on behalf of a customer as agent, make a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions.[24] The actions that must be taken by a dealer to make reasonable efforts to ensure that its non-recommended secondary market agency transactions with customers are effected at fair and reasonable prices may be influenced by the nature of the customer as well as by the services explicitly offered by the dealer. 

 

If a dealer effects non-recommended secondary market agency transactions for SMMPs and its services have been explicitly limited to providing anonymity, communication, order matching and/or clearance functions and the dealer does not exercise discretion as to how or when a transaction is executed then the MSRB believes the dealer is not required to take further actions on individual transactions to ensure that its agency transactions are effected at fair and reasonable prices.[25] By making the determination that the customer is an SMMP, the dealer necessarily concludes that the customer has met the requisite high thresholds regarding timely access to information, capability of evaluating risks and market values, and undertaking of independent investment decisions that would help ensure the institutional customer’s ability to evaluate whether a transaction’s price is fair and reasonable.[26] 

 

This interpretation will be particularly relevant to dealers operating alternative trading systems in which participation is limited to dealers and SMMPs. It clarifies that in such systems rule G-18 does not impose an obligation upon the dealer operating such a system to investigate each individual transaction price to determine its relationship to the market. The MSRB recognizes that dealers operating such systems may be merely aggregating the buy and sell interest of other dealers or SMMPs. This function may provide efficiencies to the market.  Requiring the system operator to evaluate each transaction effected on its system may reduce or eliminate the desired efficiencies. However, a dealer operating such system must act to investigate any alleged pricing irregularities on its system brought to its attention. A dealer may be subject to rule G-18 violations if it fails to take actions to address system or participant pricing abuses.

 

If a dealer effects agency transactions for customers who are not SMMPs, or has held itself out to do more than provide anonymity, communication, matching and/or clearance services, or performs such services with discretion as to how and when the transaction is executed, it will be required to establish that it exercised reasonable efforts to ensure that its agency transactions with customers are effected at fair and reasonable prices.

 

Application of SMMP Concept to Rule G-19 Interpretation--Suitability Of Recommendations And Transactions

The MSRB’s suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct. Dealer’s responsibilities include having a reasonable basis for recommending a particular security or strategy, as well as having reasonable grounds for believing the recommendation is suitable for the customer to whom it is made. Dealers are expected to meet the same high standards of competence, professionalism, and good faith regardless of the financial circumstances of the customer. Rule G-19, on suitability of recommendations and transactions, requires that, in recommending to a customer any municipal security transaction, a dealer shall have reasonable grounds for believing that the recommendation is suitable for the customer based upon information available from the issuer of the security or otherwise and based upon the facts disclosed by the customer or otherwise known about the customer. 

 

This guidance concerns only the manner in which a dealer determines that a recommendation is suitable for a particular institutional customer. The manner in which a dealer fulfills this suitability obligation will vary depending on the nature of the customer and the specific transaction. Accordingly, this interpretation deals only with guidance regarding how a dealer will fulfill such “customer-specific suitability obligations” under rule G-19. This interpretation does not address the obligation related to suitability that requires that a dealer have a “reasonable basis” to believe that the recommendation could be suitable for at least some customers. In the case of a recommended transaction, a dealer may, depending upon the facts and circumstances, be obligated to undertake a more comprehensive review or investigation in order to meet its obligation under rule G-19 to have a “reasonable basis” to believe that the recommendation could be suitable for at least some customers. See e.g., Rule G-19 Interpretation—Notice Concerning the Application of Suitability Requirements to Investment Seminars and Customer Inquiries Made in Response to a Dealer’s Advertisement, May 7, 1985, MSRB Rule Book (January 1, 2001) at 128; In re F.J. Kaufman and Company of Virginia, 50 S.E.C. 164, 168, 1989 SEC LEXIS 2376, *10 (1989).[27]

 

The manner in which a dealer fulfills its “customer-specific suitability obligations” will vary depending on the nature of the customer and the specific transaction. While it is difficult to define in advance the scope of a dealer’s suitability obligation with respect to a specific institutional customer transaction recommended by a dealer, the MSRB has identified the factors that define an SMMP as factors that may be relevant when considering compliance with rule G-19. Where the dealer has reasonable grounds for concluding that an institutional customer is an SMMP, then a dealer’s obligation to determine that a recommendation is suitable for that particular customer is fulfilled.

 

This interpretation does not address the facts and circumstances that go into determining whether an electronic communication does or does not constitute a “recommendation.” 

 

Application of SMMP Concept to Rule G-13, on Quotations

New electronic trading systems provide a variety of avenues for disseminating quotations among both dealers and customers. In general, except as described below, any quotation disseminated by a dealer is presumed to be a quotation made by such dealer. In addition, any “quotation” of a non-dealer (e.g., an investor) relating to municipal securities that is disseminated by a dealer is presumed, except as described below, to be a quotation made by such dealer.[28] The dealer is affirmatively responsible in either case for ensuring compliance with the bona fide and fair market value requirements with respect to such quotation.

 

However, if a dealer disseminates a quotation that is actually made by another dealer and the quotation is labeled as such, then the quotation is presumed to be a quotation made by such other dealer and not by the disseminating dealer. Furthermore, if an SMMP makes a “quotation” and it is labeled as such, then it is presumed not to be a quotation made by the disseminating dealer; rather, the dealer is held to the same standard as if it were disseminating a quotation made by another dealer.[29] In either case, the disseminating dealer’s responsibility with respect to such quotation is reduced. Under these circumstances, the disseminating dealer must have no reason to believe that either: (i) the quotation does not represent a bona fide bid for, or offer of, municipal securities by the maker of the quotation or (ii) the price stated in the quotation is not based on the best judgment of the maker of the quotation of the fair market value of the securities.

 

While rule G-13 does not impose an affirmative duty on the dealer disseminating quotations made by other dealers or SMMPs to investigate or determine the market value or bona fide nature of each such quotation, it does require that the disseminating dealer take into account any information it receives regarding the nature of the quotations it disseminates. Based on this information, such a dealer must have no reason to believe that these quotations fail to meet either the bona fide or the fair market value requirement and it must take action to address such problems brought to its attention. Reasons for believing there are problems could include, among other things, (i) complaints received from dealers and investors seeking to execute against such quotations, (ii) a pattern of a dealer or SMMP failing to update, confirm or withdraw its outstanding quotations so as to raise an inference that such quotations may be stale or invalid, or (iii) a pattern of a dealer or SMMP effecting transactions at prices that depart materially from the price listed in the quotations in a manner that consistently is favorable to the party making the quotation.[30]

 

In a prior MSRB interpretation stating that stale or invalid quotations published in a daily or other listing must be withdrawn or updated in the next publication, the MSRB did not consider the situation where quotations are disseminated electronically on a continuous basis.[31] In such case, the MSRB believes that the bona fide requirement obligates a dealer to withdraw or update a stale or invalid quotation by no later than the next business day, in any case, and may require such withdrawal or update to be undertaken more rapidly if necessary to prevent a quotation from becoming misleading as to the dealer’s willingness to buy or sell at the stated price. In addition, although not required under the rule, the MSRB believes that posting the time and date of the most recent update of a quotation can be a positive factor in determining whether the dealer has taken steps to ensure that a quotation it disseminates is not stale or misleading.

·July 6, 2001