MSRB NOTICE 2000-15 (APRIL 5, 2000)

PROPOSED RULE CHANGES RELATING TO MUNICIPAL FUND SECURITIES FILED WITH THE SECURITIES AND EXCHANGE COMMISSION

The Municipal Securities Rulemaking Board has filed with the Securities and Exchange Commission proposed rule changes relating to municipal fund securities.

On April 5, 2000, the Municipal Securities Rulemaking Board (the “MSRB” or “Board”) filed with the Securities and Exchange Commission (the “SEC”) certain proposed rule changes relating to municipal fund securities.[1] The proposed rule changes consist of (i) proposed new rule D-12, on the definition of municipal fund security; (ii) amendments to rule A-13, on underwriting and transaction assessments for brokers, dealers and municipal securities dealers, rule G-3, on classification of principals and representatives, numerical requirements, testing and continuing education requirements, rule G-8, on books and records to be made by brokers, dealers and municipal securities dealers, rule G-14, on reports of sales or purchases, rule G-15, on confirmation, clearance and settlement of transactions with customers, rule G-26, on customer account transfers, rule G-32, on disclosures in connection with new issues, and rule G-34, on CUSIP numbers and new issue requirements; and (iii) an MSRB interpretation relating to sales of municipal fund securities in the primary market.

The MSRB published a notice on August 27, 1999 (the “August Notice”) requesting comments on draft rule changes relating to transactions effected by or through brokers, dealers and municipal securities dealers (“dealers”) in municipal fund securities.[2] The draft rule changes published in the August Notice represented a revision of an initial draft of such rule changes published on March 17, 1999 (the “March Notice”).[3] The MSRB received seven comment letters on the August Notice. After reviewing these comments, the MSRB approved the draft rule changes, with certain modifications and additions, for filing with the SEC.

Background

Dealers that effect transactions in municipal securities are subject to the MSRB’s jurisdiction pursuant to Section 15B of the Securities Exchange Act of 1934 (the “Exchange Act”). In particular, Section 15B(c)(1) prohibits dealers from effecting transactions in, or inducing or attempting to induce the purchase or sale of, a municipal security in contravention of any MSRB rule. Thus, since enactment of Section 15B and the creation of the MSRB, a transaction effected by a dealer in a municipal security must be effected in conformity with MSRB rules.

In the March Notice, the MSRB reviewed two types of state or local governmental programs involving investment interests in which dealers may effect transactions: pooled investment funds under trusts established by state or local governmental entities (“local government pools”)[4] and higher education savings plan trusts established by states (“higher education trusts”).[5] These programs had been brought to the MSRB’s attention by SEC staff. In response to an MSRB inquiry as to the SEC’s position on whether interests in such programs were municipal securities, SEC staff stated that “at least some interests in local government pools and higher education trusts may be, depending on the facts and circumstances, ‘municipal securities’ for purposes of the Exchange Act.”[6]

MSRB rules do not apply to any interest in a local government pool or higher education trust that is not a municipal security. In addition, MSRB rules apply only to activities of dealers that effect municipal securities transactions. Thus, MSRB rules do not apply to an issuer of, or a non-dealer entity providing advice to issuers in regard to, municipal securities, including municipal fund securities. However, to the extent that interests in a local government pool or a higher education trust are municipal securities and dealers are effecting transactions in them, MSRB rules automatically govern such dealer transactions, without the necessity of further MSRB rulemaking.

A municipal fund security is defined in proposed rule D-12 as a municipal security issued by an issuer that, but for Section 2(b) of the Investment Company Act of 1940 (the “Investment Company Act”),[7] would constitute an investment company under the Investment Company Act. Thus, MSRB rules on municipal fund securities would apply to interests in a state or local governmental trust, such as local government pools and higher education trusts,[8] only if the following three conditions are met:

  1. A dealer is engaging in transactions in such interests;
  2. Such interests, in fact, constitute municipal securities; and
  3. Such interests are issued by an issuer that, but for the exemption under Section 2(b) of the Investment Company Act, would be considered an investment company within the meaning of that Act.

The MSRB understands that municipal fund securities may not have features typically associated with more traditional municipal securities. Instead, their features are similar to those of investment company securities.[9] In the March Notice, the MSRB stated that, although its rules generally have been drafted to accommodate the characteristics of debt securities, it believes that most current rules can appropriately be applied to municipal fund securities. Nonetheless, the MSRB felt that certain rules should be amended to recognize the unique characteristics of municipal fund securities. The draft rule changes did not seek to extend the reach of MSRB rules, since the rules already apply to municipal fund securities, but sought to tailor certain MSRB rules to the nature of municipal fund securities.

COMMENTS ON AUGUST NOTICE

Set forth below is a discussion of the comments received on the August Notice and of the modifications and additions made to the draft rule changes as published in the August Notice. Reference is made to the August Notice for a full discussion of the draft rule changes as of the publication of that notice and of the comments received on the initial draft of the rule changes published in the March Notice.

MSRB Jurisdiction and Policy Issues

Three commentators on the August Notice raise the issue of whether the MSRB can or should regulate transactions by dealers in municipal fund securities. One of these commentators, while acknowledging the MSRB’s detailed discussion in the August Notice of its statutory authority and the applicable regulatory policies, states that these issues “deserve more sensitive consideration” than what it terms the “‘in or out’ reasoning” in the August Notice. A second commentator restates the argument made by certain commentators on the March Notice that local government pool investments are not municipal securities under the Exchange Act and therefore “the Board is acting beyond its self-regulatory jurisdiction.” While not questioning the MSRB’s authority to regulate dealer transactions in municipal fund securities, a third commentator states that the MSRB “should not attempt to regulate qualified state tuition program transactions, because there is no demonstrated need for regulation to protect state and local government investors or the public interest.”[10]

The MSRB discussed its authority to undertake rulemaking in this area in the August Notice. These commentators do not raise any new issues that were not previously addressed in this discussion. In short, a security must first be a municipal security in order to be a municipal fund security. The draft rule changes would not, and existing MSRB rules do not, apply to local government pool or higher education trust interests that are not municipal securities. Thus, the MSRB does not overstep its authority by regulating dealer transactions in municipal fund securities since, by definition, regulation is limited to interests that are, in fact, municipal securities. To the extent that any such interest is a municipal security, it is already subject to MSRB rules under Section 15B(c)(1) of the Exchange Act and the proposed rule changes merely seek to make existing MSRB rules better accommodate the unique characteristics of municipal fund securities.[11]

With respect to comments regarding the lack of a demonstrated need for regulation of dealer transactions in higher education trust interests, the MSRB notes that its rules generally apply to all transactions effected by dealers in municipal securities, regardless of whether there has been a demonstration that each type of municipal security has been the subject of some kind of specific abuse or other specific threat to public investors. MSRB rules generally focus on dealers’ fair dealing duties to customers, including in particular the obligation of dealers to disclose to customers all material information regarding a municipal security transaction. The MSRB believes that some of the very arguments made by this commentator in support of its position that regulation of dealer transactions in higher education trust interests is inappropriate in fact lend greater support to the position that the MSRB is acting in accordance with its statutory mandate to protect investors and the public interest by undertaking the current rulemaking initiative. For example, the commentator states:

substantial disincentives exist to discourage contributors from using the programs for any purpose other than the prepayment of tuition. Under the federal Internal Revenue Code, if the beneficiary does not use the contributions for qualified higher education purposes, except in cases of scholarship, death, or disability, the contributor is entitled to a limited refund and [in] most states the refund amount is reduced by a penalty and other charges. Generally, no earnings attributable to the account will be refunded. Moreover, tuition payments normally do not exceed the actual cost of a beneficiary’s tuition. In addition, there is very limited opportunity to transfer program benefits.[12]

The MSRB believes that its rules, as they would be modified by the proposed rule changes, provide great benefit to potential purchasers of interests in higher education trusts by ensuring that the nature of these unique characteristics of such interests are disclosed by the selling dealers to their customers.

Specific Rule Provisions

Proposed Rule D-12, on Definition of “Municipal Fund Security” . Proposed rule D-12 defines municipal fund security as a municipal security that would be an investment company security under the Investment Company Act but for the fact that the issuer is a state or local governmental entity or instrumentality. For a security to constitute a municipal fund security, the security must first constitute a municipal security. Existing MSRB rules do not, and the proposed rule changes would not, apply to any local government pool or higher education trust interest that is not a municipal security.

One commentator urges “that the Board adopt a definition of ‘Broker’ which excludes federally registered investment advisors that do not engage in the sale or distribution of securities except in connection with services as investment advisor and administrator to the issuers of Municipal Fund Securities.” This commentator expresses concern that investment advisory firms that otherwise do not undertake broker or dealer activities will have difficulty in assessing standards applicable to dealers.

As the MSRB stated in the August Notice, its rules do not apply to activities of non-dealers. A firm wishing to determine if MSRB rules apply to services it provides to an issuer of municipal fund securities may seek advice of counsel as to whether such services constitute broker-dealer activities and may seek comfort on counsel’s opinion from SEC staff through the SEC’s no-action procedure. If a non-dealer firm’s activities do not constitute broker-dealer activities, the firm need not be a registered broker or dealer subject to MSRB rules. Thus, under these circumstances, non-dealer firms may act as investment advisers to local government pool or higher education trust programs and not become subject to MSRB rules. However, once a firm does in fact undertake broker-dealer activities with respect to municipal securities, the MSRB believes that such firm must be cognizant of and comply with all of its rules, regardless of how infrequently such dealer may transact business in municipal securities or how narrow a range of municipal securities activities in which such dealer is involved.

Rule A-13, on Underwriting Assessments . In the August Notice, the MSRB revised its draft amendment to rule A-13 toexempt sales of municipal fund securities from the underwriting assessment. The MSRB also made clear to the industry and the enforcement agencies that it does not intend to seek payment of any previously accrued underwriting assessments that may technically be due and owing on prior transactions in municipal fund securities. Two commentators support the revision to exempt such sales from the underwriting assessment. Another commentator states, however, that “there is no assurance that the assessment will not be imposed at a future time.” The MSRB believes that no further revisions to rule A-13 are warranted.

Rules G-3, on Professional Qualifications . The proposed amendment to rule G-3 permits an associated person qualified as an investment company limited representative to effect transactions in municipal fund securities (but no other municipal securities).[13] A dealer must continue to have at least one municipal securities principal as required under rule G-3(b), even if the dealer’s only municipal securities transactions are sales of municipal fund securities. One commentator states that investment company principals should be permitted to supervise sales representatives that sell municipal fund securities and to approve advertisements.[14]

The MSRB believes that the requirement that a dealer effecting transactions in municipal fund securities must have at least one municipal securities principal is appropriate since such dealer must have at least one associated person who is familiar with MSRB rules. Consistent with this view, the MSRB believes that supervision of municipal securities activities is appropriately vested in individuals who have such familiarity with MSRB rules. The MSRB has not revised this proposed amendment.[15]

Rules G-8, on Recordkeeping . One commentator suggests that rule G-8 be amended to permit a dealer to rely on a transfer agent for municipal fund securities to meet applicable books and records requirements under the rule, noting that a transfer agency system is typically used for mutual fund-type products. This commentator points to the existing provision in the rule that permits a non-clearing or introducing dealer to rely on records maintained by a clearing dealer.

The MSRB believes that it would be appropriate to permit a dealer effecting transactions in municipal fund securities to meet its books and records requirements by means of books and records maintained by a transfer agent for such municipal fund securities so long as those books and records meet the requirements of rule G-8 and such dealer remains responsible for the accurate maintenance and preservation of such books and records.[16] Therefore, the MSRB has revised rule G-8(g) to this effect.

This commentator also suggests that the definition of “institutional account” in rule G-8(a)(xi) be amended to include states and their political subdivisions and instrumentalities, noting that the additional information required under this provision for non-institutional accounts is “simply inapposite” with respect to such entities.[17] The MSRB notes, however, that this definition is also used in rule G-19, on suitability of recommendations and transactions, in connection with the requirement that dealers make reasonable efforts to obtain certain information about non-institutional accounts (but not institutional accounts as defined in rule G-8(a)(xi)) prior to recommending a municipal security transaction.[18] This information is then required to be used by the dealer when making a suitability determination under rule G-19 in connection with a recommended transaction.

The definition of institutional account under rule G-8 is identical to the definition used under rules of the National Association of Securities Dealers, Inc. (“NASD”) and the MSRB believes that it should not diverge from this common definition without substantial cause. Further, since the definition of institutional account includes any entity with total assets of at least $50 million, a substantial proportion of state or local government customers would qualify as institutional accounts under the current definition.[19] Finally, excluding state and local governments from the definition of institutional account could serve to weaken the MSRB’s suitability requirement with respect to recommended transactions with smaller state and local governments (i.e., those with assets of less than $50 million), which are the governmental entities most likely in need of investor protection.[20] Therefore, the MSRB did not make the suggested amendment.

Rule G-15, on Customer Confirmations . The draft amendment to rule G-15 permits dealers to use quarterly statements, rather than transaction-by-transaction confirmations, if customers are purchasing municipal fund securities in an agreed amount on a periodic basis (a “periodic plan”) in a group plan (e.g., an employer-sponsored salary reduction plan). In addition, the draft amendment would provide that information regarding transactions in municipal fund securities effected in connection with a program that does not provide for periodic purchases or redemptions of municipal fund securities (a “non-periodic program”), such as with many local government pool programs, may be disclosed to customers on a monthly statement in lieu of individual transaction confirmations. With respect to individuals who participate in any such non-periodic program, this monthly reporting in lieu of individual transaction confirmations would be conditioned upon receipt of the written consent of such individual or of the issuer to use of such monthly statements.[21] However, as one commentator implies, the draft amendment inadvertently imposes a more onerous condition for permitting dealers to use periodic statements for customers participating in periodic plans that are not part of a group plan, as compared to customers participating in a non-periodic program, since customer consent would be required in all cases (i.e., the issuer is not permitted under the existing language of the draft amendment to provide consent on behalf of customers in a non-group periodic plan, although it is permitted to do so in the case of a non-periodic program). As a result, the MSRB has revised draft rule G-15(a)(viii)(E) to allow issuers to provide consent for the use of periodic statements in these circumstances.

In addition, this commentator argues that certain information required to be disclosed on a periodic statement with respect to municipal fund security transactions would be unnecessarily repetitive and might best be disclosed in a separate disclosure document that is applicable to all transactions in such municipal fund securities. This information includes disclosure of deferred commissions or other charges, whether the security is redeemable,[22] the capacity of the dealer and the time of execution. The MSRB believes that dealers using a periodic statement where such information is identical for all transactions shown on such statement should be permitted to provide such information only once on the statement rather than repeatedly for each transaction. In addition, the MSRB believes that if such information is included in disclosure materials previously delivered to the customer and the periodic statement clearly indicates that such information is included in such disclosure material, such information may be omitted from the periodic statement. Of course, a dealer would not be able to rely on this provision if such disclosure materials have not in fact been delivered to the customer or if the information included in such disclosure materials is not accurate with respect to any transaction disclosed on the periodic statement (e.g., if the information has subsequently been changed). As a result, the MSRB revised rule G-15(a)(viii)(B) to this effect.

In addition, the MSRB revised rule G-15(a)(i)(E)(1) to add a cross-reference necessitated by draft rule G-15(a)(i)(D)(3).

Rule G-32, on New Issue Disclosures . The MSRB noted in the August Notice that municipal fund securities sold in a primary offering would constitute new issue municipal securities for purposes of rule G-32 so long as the securities are in the underwriting period. Since the MSRB understands that issuers of municipal fund securities are continuously issuing and delivering the securities as customers make purchases, it believes that municipal fund securities would remain in their underwriting period so long as such issuance and delivery continues. Thus, a dealer effecting a transaction in a municipal fund security would be required to deliver to the customer the official statement, if one exists, by settlement of the transaction. However, in the case of any customer making repeat purchases of a municipal security (including but not limited to a municipal fund security), no new delivery of the official statement would be required so long as the customer has previously received it in connection with a prior purchase and the official statement has not been changed from the one previously delivered to that customer.[23] In the situation where the official statement is being amended or otherwise changed, the draft amendment to rule G-32 would provide that a dealer may sell, pursuant to a periodic plan, a municipal fund security to a customer who has previously received the official statement so long as it sends to the customer a copy of any new, supplemented, amended or stickered official statement by first class mail promptly upon receipt from the issuer (i.e., actual delivery by settlement would not be required). This draft amendment was designed to address the limited circumstances where an amendment to the official statement for a municipal fund security has just been produced but, because of standing arrangements with a customer under a periodic plan, a transaction in such security will automatically be effected and the securities delivered before the dealer is able to deliver the amended official statement to the customer, as would otherwise be required under the rule.

One commentator suggests that this draft amendment to rule G-32 be made to apply equally to periodic plans and non-periodic programs. The MSRB believes that, although the problem that was intended to be addressed by the draft amendment would most likely arise under a periodic plan, such problems also may arise from time to time with respect to non-periodic programs. In addition, another commentator states that, in the case of an amendment to an official statement, dealers should be permitted to satisfy the delivery requirement under rule G-32 with respect to such amended official statement by delivering the amendment alone (including a notice that the complete official statement is available upon request). The MSRB understands that this is the typical practice in connection with amendments to mutual fund prospectuses. Although the MSRB believes that rule G-32 currently would permit delivery of the amendment alone so long as the customer already has the official statement that is being amended and the dealer ensures that the amendment makes clear what constitutes the complete official statement (as amended), the MSRB has determined that clarifying language consistent with this comment should be added to rule G-32. As a result, the Board has revised rule G-32 to effect both of these suggested changes.

Finally, one commentator implies that requiring dealers selling municipal fund securities to comply with the official statement delivery requirements of rules G-32 and G-36 may not be in conformity with Section 15B(d)(2) of the Exchange Act.[24] Except for the technical changes to rule G-32 included in the proposed rule changes, the provisions of rules G-32 and G-36 apply to dealers effecting transactions in municipal fund securities in a manner identical to dealer transactions in other forms of municipal securities. The MSRB believes that its authority to require the delivery of official statements by dealers in the manner provided in these rules has long since been settled.

Interpretation Relating to Sales of Municipal Fund Securities in the Primary Market . Interpretive guidance is provided in connection with the application of rules G-23, G-32, G-36, G-37 and G-38 to dealer transactions in municipal fund securities. The statements set forth in the interpretation have been previously published by the MSRB in the August Notice and the March Notice.

April 5, 2000

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TEXT OF REVISIONS TO DRAFT RULE CHANGES FROM AUGUST NOTICE [25]

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

(a) - (f) No additional changes.

(g) Transactions in Municipal Fund Securities.

(i) Books and Records Maintained by Transfer Agents. Books and records required to be maintained by a broker, dealer or municipal securities dealer under this rule solely with respect to transactions in municipal fund securities may be maintained by a transfer agent used by such broker, dealer or municipal securities dealer in connection with such transactions; provided that, in the case of a broker, dealer or municipal securities dealer other than a bank dealer, the arrangements with such transfer agent have been approved by the Commission or, in the case of a bank dealer, such arrangements have been approved by the appropriate regulatory agency for such bank dealer, and further provided that such broker, dealer or municipal securities dealer shall remain responsible for the accurate maintenance and preservation of such books and records.

(ii) Price Substituted for Par Value of Municipal Fund Securities. Price substituted for par value of municipal fund securities. For purposes of this rule, each reference to the term “par value,” when applied to a municipal fund security, shall be substituted with (A) (i) in the case of a purchase of a municipal fund security by a customer, the purchase price paid by the customer, exclusive of any commission, and (B) (ii) in the case of a sale or tender for redemption of a municipal fund security by a customer, the sale price or redemption amount paid to the customer, exclusive of any commission or other charge imposed upon redemption or sale.

Rule G-15. Confirmation, Clearance and Settlement of Transactions with Customers

(a) Customer Confirmations

(i) At or before the completion of a transaction in municipal securities with or for the account of a customer, each broker, dealer or municipal securities dealer shall give or send to the customer a written confirmation that complies with the requirements of this paragraph (i):

(A) - (D) No additional changes.

(E) Confirmation format. All requirements must be clearly and specifically indicated on the front of the confirmation, except that the following statements may be on the reverse side of the confirmation:

(1) The disclosure statements required in subparagraph (D)(1), (D)(2) or (D)(3) and (2) of this paragraph, provided that their specific applicability is noted on the front of the confirmation.

(2) - (3) No change.

(ii) - (vii) No additional changes.

(viii) Alternative periodic reporting for certain transactions in municipal fund securities. Notwithstanding any other provision of this section (a), a broker, dealer or municipal securities dealer may effect transactions in municipal fund securities with customers without giving or sending to such customer the written confirmation required by paragraph (i) of this section (a) at or before completion of each such transaction if:

(A) No additional changes.

(B) such broker, dealer or municipal securities dealer gives or sends to such customer within five business days after the end of each quarterly period, in the case of a customer participating in a periodic municipal fund security plan, or each monthly period, in the case of a customer participating in a non-periodic municipal fund security program, a written statement disclosing, for each purchase, sale or redemption effected for or with, and each payment of investment earnings credited to or reinvested for, the account of such customer during the reporting period, the information required to be disclosed to customers pursuant to subparagraphs (A) through (D) of paragraph (i) of this section (a), with the information regarding each transaction clearly segregated; provided that it is permissible:

(1) for the name and address of the broker, dealer or municipal securities dealer and the customer to appear once at the beginning of the periodic statement document; and

(2) for information required to be included pursuant to subparagraph (A)(1)(d), (A)(2)(a), (C)(5) or (D)(3) of paragraph (i) of this section (a) to:

(a) appear once in the periodic statement if such information is identical for all transactions disclosed in such statement; or

(b) be omitted from the periodic statement, but only if such information previously has been delivered to the customer in writing and the periodic statement includes a statement indicating that such information has been provided to the customer and identifying the document in which such information appears; and

(C) in the case of a periodic municipal fund security plan that consists of an arrangement involving a group of two or more customers and contemplating periodic purchases of municipal fund securities by each customer through a person designated by the group, such broker, dealer or municipal securities dealer:

(1) - (2) No additional changes.

(3) advises each customer in the group if a payment is not received from the designated person on behalf of the group within 10 days of a date certain specified in the arrangement for delivery of that payment by the designated person and either (a) thereafter sends to each customer the written confirmation described in paragraph (i) of this section (a) for the next three succeeding payments, or (b) includes in the quarterly statement referred to in subparagraph (B) of this paragraph (viii) each date certain specified in the arrangement for delivery of a payment by the designated person and each date on which a payment received from the designated person is applied to the purchase of municipal fund securities; and

(D) No additional changes.

(E) such customer has consented in writing to receipt of the written information referred to in subparagraph (B) of this paragraph (viii) on a periodic basis in lieu of an immediate confirmation for each transaction; provided, however, that such customer consent shall not be required if:

(1) the customer is not a natural person;

(2) the customer is a natural person who participates in a periodic municipal fund security plan described in subparagraph (C) of this paragraph (viii); (2) the customer is not a natural person and participates in a non-periodic municipal fund security program, or

(3) the customer is a natural person who that participates in a periodic municipal fund security plan (other than a plan described in subparagraph (C) of this paragraph (viii)) or a non-periodic municipal fund security program and the issuer has consented in writing to the use by the broker, dealer or municipal securities dealer of the periodic written information referred to in subparagraph (B) of this paragraph (viii) in lieu of an immediate confirmation for each transaction with each customer participating in such plan or the non-periodic municipal fund security program.

(b)-(e) No change.

Rule G-32. Disclosures in Connection with New Issues

(a) Customer Disclosure Requirements. No broker, dealer or municipal securities dealer shall sell, whether as principal or agent, any new issue municipal securities to a customer unless such broker, dealer or municipal securities dealer delivers to the customer no later than the settlement of the transaction:

(i) a copy of the official statement in final form prepared by or on behalf of the issuer or, if an official statement in final form is not being prepared by or on behalf of the issuer, a written notice to that effect together with a copy of an official statement in preliminary form, if any; provided, however, that:

(A) if a customer who participates in a periodic municipal fund security plan or a non-periodic municipal fund security program has previously received a copy of the official statement in final form in connection with the purchase of municipal fund securities under such plan or program, a broker, dealer or municipal securities dealer may sell additional shares or units of the municipal fund securities under such plan or program to the customer if such broker, dealer or municipal securities dealer sends to the customer a copy of any new, supplemented, amended or “stickered” official statement in final form amendment, by first class mail or other equally prompt means, promptly upon receipt thereof; provided that, if the broker, dealer or municipal securities dealer sends a supplement, amendment or sticker without including the remaining portions of the official statement in final form, such broker, dealer or municipal securities dealer includes a written statement describing which documents constitute the complete official statement in final form and stating that the complete official statement in final form is available upon request; or

(B) No additional changes.

(ii) No additional changes.

(b) - (d) No additional changes.

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TEXT OF INTERPRETATION RELATING TO SALES OF MUNICIPAL FUND SECURITIES IN THE PRIMARY MARKET

The Municipal Securities Rulemaking Board (the “Board”) has learned that sales of certain interests in trust funds held by state or local governmental entities may be effected by or through brokers, dealers or municipal securities dealers (“dealers”). In particular, the Board has reviewed two types of state or local governmental programs in which dealers may effect transactions in such interests: pooled investment funds under trusts established by state or local governmental entities (“local government pools”)[26] and higher education savings plan trusts established by states (“higher education trusts”).[27] In response to a request of the Board, staff of the Division of Market Regulation of the Securities and Exchange Commission (the “SEC”) has stated that “at least some interests in local government pools and higher education trusts may be, depending on the facts and circumstances, ‘municipal securities’ for purposes of the [Securities] Exchange Act [of 1934].”[28] Any such interests that may, in fact, constitute municipal securities are referred to herein as “municipal fund securities.” To the extent that dealers effect transactions in municipal fund securities, such transactions are subject to the jurisdiction of the Board pursuant to Section 15B of the Securities Exchange Act of 1934 (the “Exchange Act”).

With respect to the applicability to municipal fund securities of Exchange Act Rule 15c2-12, relating to municipal securities disclosure, staff of the SEC’s Division of Market Regulation has stated:

[W]e note that Rule 15c2-12(f)(7) under the Exchange Act defines a “primary offering” as including an offering of municipal securities directly or indirectly by or on behalf of an issuer of such securities. Based upon an analysis of programs that have been brought to our attention, it appears that interests in local government pools or higher education trusts generally are offered only by direct purchase from the issuer. Accordingly, we would view those interests as having been sold in a “primary offering” as that term is defined in Rule 15c2-12. If a dealer is acting as an “underwriter” (as defined in Rule 15c2-12(f)(8)) in connection with that primary offering, the dealer may be subject to the requirements of Rule 15c2-12.[29]

Rule 15c2-12(f)(8) defines an underwriter as “any person who has purchased from an issuer of municipal securities with a view to, or offers or sells for an issuer of municipal securities in connection with, the offering of any municipal security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking.”[30]

Consistent with SEC staff’s view regarding the sale in primary offerings of municipal fund securities, dealers acting as underwriters in primary offerings of municipal fund securities generally would be subject to the requirements of rule G-36, on delivery of official statements, advance refunding documents and Forms G-36(OS) and G-36(ARD) to Board or its designee. Thus, unless such primary offering falls within one of the stated exemptions in Rule 15c2-12, the Board expects that the dealer would receive a final official statement from the issuer or its agent under its contractual agreement entered into pursuant to Rule 15c2-12(b)(3).[31] Such final official statement should be received from the issuer in sufficient time for the dealer to send it, together with Form G-36(OS), to the Board within one business day of receipt but no later than 10 business days after any final agreement to purchase, offer, or sell the municipal fund securities, as required under rule G-36(b)(i).[32] “Final official statement,” as used in rule G-36(b)(i), has the same meaning as in Rule 15c2-12(f)(3), which states, in relevant part:

The term final official statement means a document or set of documents prepared by an issuer of municipal securities or its representatives that is complete as of the date delivered to the Participating Underwriter(s) and that sets forth information concerning the terms of the proposed issue of securities; information, including financial information or operating data, concerning such issuers of municipal securities and those other entities, enterprises, funds, accounts, and other persons material to an evaluation of the Offering; and a description of the undertakings to be provided pursuant to paragraph (b)(5)(i), paragraph (d)(2)(ii), and paragraph (d)(2)(iii) of this section, if applicable, and of any instances in the previous five years in which each person specified pursuant to paragraph (b)(5)(ii) of this section failed to comply, in all material respects, with any previous undertakings in a written contract or agreement specified in paragraph (b)(5)(i) of this section.[33]

The Board understands that issuers of municipal fund securities typically issue and deliver the securities continuously as customers make purchases, rather than issuing and delivering a single issue on a specified date. As used in Board rules, the term “underwriting period” with respect to an offering involving a single dealer (i.e., not involving an underwriting syndicate) is defined as the period (A) commencing with the first submission to the dealer of an order for the purchase of the securities or the purchase of the securities from the issuer, whichever first occurs, and (B) ending at such time as the following two conditions both are met: (1) the issuer delivers the securities to the dealer, and (2) the dealer no longer retains an unsold balance of the securities purchased from the issuer or 21 calendar days elapse after the date of the first submission of an order for the securities, whichever first occurs.[34] Since an offering consisting of securities issued and delivered on a continuous basis would not, by its very nature, ever meet the first condition for the termination of the underwriting period, such offering would continuously remain in its underwriting period.[35] Further, since rule G-36(d) requires a dealer that has previously provided an official statement to the Board to send any amendments to the official statement made by the issuer during the underwriting period, such dealer would remain obligated to send to the Board any amendments made to the official statement during such continuous underwriting period. However, in view of the increased possibility that an issuer may change the dealer that participates in the sale of its securities during such a continuous underwriting period, the Board has determined that rule G-36(d) would require that the dealer that is at the time of an amendment then serving as underwriter for securities that are still in the underwriting period send the amendment to the Board, regardless of whether that dealer or another dealer sent the original official statement to the Board.

In addition, municipal fund securities sold in a primary offering would constitute new issue municipal securities for purposes of rule G-32, on disclosures in connection with new issues, so long as the securities remain in their underwriting period. Rule G-32 generally requires that a dealer selling a new issue municipal security to a customer must deliver the official statement in final form to the customer by settlement of such transaction. Thus, a dealer effecting transactions in municipal fund securities that are sold during a continuous underwriting period would be required to deliver to the customer the official statement by settlement of each such transaction. However, in the case of a customer purchasing such securities who is a repeat purchaser, no new delivery of the official statement would be required so long as the customer has previously received it in connection with a prior purchase and the official statement has not been changed from the one previously delivered to that customer.[36]

Certain other implications arise under Board rules as a result of the status, in the view of SEC staff, of sales of municipal fund securities as primary offerings. For example, dealers are reminded that the definition of “municipal securities business” under rule G-37, on political contributions and prohibitions on municipal securities business, and rule G-38, on consultants, includes the purchase of a primary offering from the issuer on other than a competitive bid basis or the offer or sale of a primary offering on behalf of any issuer. Thus, a dealer’s transactions in municipal fund securities may impact upon such dealer’s obligations under rules G-37 and G-38. In addition, rule G-23, on activities of financial advisors, applies to a dealer’s financial advisory or consultant services to an issuer with respect to a new issue of municipal securities.


[1] File No. SR-MSRB-00-6. Comments submitted to the SEC should refer to this file number. The proposed rule change would become effective upon approval by the SEC.

[2] See “Municipal Fund Securities – Revised Draft Rule Changes,” MSRB Reports, Vol. 19, No. 3 (Sept. 1999) at 3.

[3] See “Municipal Fund Securities,” MSRB Reports, Vol. 19, No. 2 (April 1999) at 9. The MSRB received 12 comment letters on the March Notice, as a result of which a number of revisions (set forth in the August Notice) were made to the initial draft of the rule changes.

[4] The MSRB understands that local government pools are established by state or local governmental entities as trusts that serve as vehicles for the pooled investment of public moneys of participating governmental entities. Participants purchase interests in the trust and trust assets are invested in a manner consistent with the trust’s stated investment objectives. Investors generally do not have a right to control investment of trust assets. See generally National Association of State Treasurers (“NAST”), Special Report: Local Government Investment Pools (July 1995) (the “NAST Report”); Standard & Poor’s Fund Services, Local Government Investment Pools (May 1999) (the “S&P Report”).

[5] The MSRB understands that higher education trusts generally are established by states under section 529(b) of the Internal Revenue Code as “qualified state tuition programs” through which individuals make investments for the purpose of accumulating savings for qualifying higher education costs of beneficiaries. Individuals purchase interests in the trust and trust assets are invested in a manner consistent with the trust’s stated investment objectives. Investors do not have a right to control investment of trust assets. See generally College Savings Plans Network, Special Report on State and College Savings Plans (1998) (the “CSPN Report”).

[6] Letter dated February 26, 1999 from Catherine McGuire, Chief Counsel, Division of Market Regulation, SEC, to Diane G. Klinke, MSRB General Counsel, in response to letter dated June 2, 1998 from Diane G. Klinke to Catherine McGuire, published as Municipal Securities Rulemaking Board, SEC No-Action Letter, Wash. Serv. Bur. (CCH) File No. 032299033 (Feb. 26, 1999) (the “SEC Letter”).

[7] Section 2(b) provides that the Investment Company Act shall not apply to a state, or any political subdivision of a state, or any agency, authority, or instrumentality thereof.

[8] As noted in the March Notice, the definition of municipal fund security is not limited to local government pool or higher education trust interests that are municipal securities but also would apply to any municipal security of an issuer that, but for the identity of the issuer as a state or local governmental entity, would constitute an investment company under the Investment Company Act.

[9] Municipal fund securities generally provide investment return and are valued based on the investment performance of an underlying pool of assets having an aggregate value that may increase or decrease from day to day, rather than providing interest payments at a stated rate or discount, as is the case for more traditional municipal securities. In addition, unlike traditional municipal securities, these interests do not have stated par values or maturity dates and cannot be priced based on yield or dollar price. See generally NAST Report; S&P Report; CSPN Report.

[10] This commentator further states that the MSRB “has not identified any abuses or other threats to public investors or the public interest that are sought to be avoided by applying existing rules to transactions in qualified state tuition programs. Rather, the Board appears to . . . intend to apply its rules to all transactions in state and local government securities, regardless of whether such regulation is needed.” In addition, as quoted in the August Notice, this commentator has previously noted that there exist significant investor protection issues with respect to the investment by local governments in local government pools. See August Notice, footnotes 47 and 49.

[11] The MSRB believes that, based on the advice of SEC staff in the SEC Letter and a thorough review of relevant SEC no-action letters and legislative history described in great detail in the August Notice, municipal fund securities do indeed exist. Further, since publication of the August Notice, SEC staff has issued three additional no-action letters in which it has agreed not to recommend enforcement action if state entities and their employees sold higher education trust interests without registering as brokers. In each case, the applicant had opined that the interests were municipal securities under the Exchange Act, thereby exempting the issuer from registering as a broker by virtue of the exemption for issuers of municipal securities set forth in Section 3(d) of the Exchange Act. See Virginia Higher Education Tuition Trust Fund, SEC No-Action Letter, Wash. Serv. Bur. (CCH) File No. 111599009 (Nov. 16, 1999); Missouri Higher Education Savings Program, SEC No-Action Letter, Wash. Serv. Bur. (CCH) File No. 110199007 (Oct. 25, 1999); Golden State Scholarshare Trust, SEC No-Action Letter, Wash. Serv. Bur. (CCH) File No. 092099002 (Sept. 15, 1999).

[12] See also August Notice, footnote 48. Furthermore, recent press reports regarding higher education trust programs have suggested that investor protection issues may exist in this sector. See, e.g., “Saving for College – Strategies for Putting Your Plan on Course,” Consumer Reports (Feb. 2000) at 56; Julie Vore, “College Savings Plans: A Guide to How They Work,” AAII Journal, Vol. 22, No. 2 (Feb. 2000) at 11; Thomas Easton and Michael Maiello, “The College Saving Fund Scandal,” Forbes (Mar. 6, 2000) at 172; Mike McNamee, “Piling Up Those Bucks for College,” Business Week (Mar. 13, 2000) at 155.

[13] Thus, an associated person who sells both municipal fund securities and other types of municipal securities would be required to qualify as a municipal securities representative or general securities representative.

[14] Rule G-21, on advertising, requires that each advertisement be approved by a municipal securities principal or general securities principal. Rule G-27, on supervision, requires that either a municipal securities principal or municipal securities sales principal supervise municipal securities sales activities. This commentator incorrectly states that the draft amendment to rule G-3 would require that those who supervise sales representatives for local government pool investments be qualified as a municipal securities sales principal. In fact, under MSRB rules, such supervision may also be effected by a municipal securities principal.

[15] If at some future time the Investment Company and Variable Contracts Products Principal Examination (Series 26) were to include questions on relevant MSRB rules, including but not limited to those rules relating to municipal fund securities, the MSRB could reconsider the requirement that such supervisory activities be undertaken by a municipal securities principal.

[16] This provision would parallel an existing provision in rule G-8(c) permitting maintenance for a non-clearing dealer of records by clearing agencies that are not themselves dealers.

[17] Institutional account is defined as (i) a bank, savings and loan association, insurance company, or registered investment company; (ii) a registered investment adviser; or (iii) any entity with total assets of at least $50 million. The additional information that dealers are required to record under rule G-8(a)(xi) for non-institutional accounts as compared to institutional accounts consists of information about (i) the customer’s age, (ii) the customer’s occupation and employer and (iii) any beneficial owner of the account if other than the customer.

[18] The information that dealers are obligated under rule G-19 to make reasonable efforts to obtain prior to recommending a municipal security transaction to a non-institutional account (but not to an institutional account) includes information concerning (i) the customer’s financial status, (ii) the customer’s tax status, (iii) the customer’s investment objectives, and (iv) such other information used or considered to be reasonable and necessary by the dealer in making recommendations to the customer. The collection of this information can have an impact on the nature of a dealer’s suitability obligation since suitability determinations are required to be based on information disclosed by or otherwise known about the customer. Depending upon the specific facts and circumstances, rule G-19 may require that dealers make a greater effort to obtain information on which to base a suitability determination from a non-institutional account than from an institutional account.

[19] For those state or local government customers that do not qualify as an institutional account, the dealer would merely indicate in its records that such information (such as customer’s age, occupation, etc.) is inapplicable, as with any other customer that does not qualify as an institutional account and is not a natural person.

[20] Since state and local governments with assets of less than $50 million are not considered institutional accounts under NASD rules, the suggested amendment would have the effect of making the MSRB’s suitability requirements with respect to recommendations of municipal securities transactions to such entities weaker than NASD’s suitability requirements with respect to recommendations of transactions in other types of securities to these same entities.

[21] Thus, if the issuer directs that monthly statements be used in lieu of individual transaction confirmations, the draft amendment to rule G-15(a)(viii) would permit dealers effecting transactions in such municipal fund securities to use monthly statements in lieu of such confirmations without obtaining the consent of any customers.

[22] Another commentator believes that information regarding the redeemable nature of municipal fund securities need not be disclosed. The MSRB disagrees.

[23] In addition, in the case of a repeat purchaser of municipal fund securities for which no official statement in final form is being prepared, no new delivery of the written notice to that effect or of any official statement in preliminary form would be required so long as the customer has previously received it in connection with a prior purchase. However, if an official statement in final form is subsequently prepared, the customer’s next purchase would trigger the delivery requirement with respect to such official statement.

[24] This Section provides that the MSRB is not authorized to require any issuer, directly or indirectly, to furnish to the MSRB or a customer any document or information with respect to such issuer; provided that the MSRB may require dealers to furnish to the MSRB or customers such documents or information which is generally available from a source other than the issuer.

[25] Underlining indicates additions to draft rule changes from August Notice; strikethrough indicates deletions from draft rule changes from August Notice.

[26] The Board understands that local government pools are established by state or local governmental entities as trusts that serve as vehicles for the pooled investment of public moneys of participating governmental entities. Participants purchase interests in the trust and trust assets are invested in a manner consistent with the trust’s stated investment objectives. Investors generally do not have a right to control investment of trust assets. See generally National Association of State Treasurers (“NAST”), Special Report: Local Government Investment Pools (July 1995) (the “NAST Report”); Standard & Poor’s Fund Services, Local Government Investment Pools (May 1999) (the “S&P Report”).

[27] The Board understands that higher education trusts generally are established by states under section 529(b) of the Internal Revenue Code as “qualified state tuition programs” through which individuals make investments for the purpose of accumulating savings for qualifying higher education costs of beneficiaries. Individuals purchase interests in the trust and trust assets are invested in a manner consistent with the trust’s stated investment objectives. Investors do not have a right to control investment of trust assets. See generally College Savings Plans Network, Special Report on State and College Savings Plans (1998) (the “CSPN Report”).

[28] Letter dated February 26, 1999 from Catherine McGuire, Chief Counsel, Division of Market Regulation, SEC, to Diane G. Klinke, General Counsel of the Board, in response to letter dated June 2, 1998 from Diane G. Klinke to Catherine McGuire, published as Municipal Securities Rulemaking Board, SEC No-Action Letter, Wash. Serv. Bur. (CCH) File No. 032299033 (Feb. 26, 1999) (the “SEC Letter”).

[29] SEC Letter.

[30] The definition of underwriter excludes any person whose interest is limited to a commission, concession, or allowance from an underwriter or dealer not in excess of the usual and customary distributors’ or sellers’ commission, concession, or allowance.

[31] Section (b)(3) of Rule 15c2-12 requires that a dealer serving as a Participating Underwriter in connection with a primary offering subject to the Rule contract with an issuer of municipal securities or its designated agent to receive copies of a final official statement at the time and in the quantities set forth in the Rule.

[32] If a primary offering of municipal fund securities is exempt from Rule 15c2-12 (other than as a result of being a limited offering as described in section (d)(1)(i) of the Rule) and an official statement in final form has been prepared by the issuer, then the dealer would be expected to send the official statement in final form, together with Form G-36(OS), to the Board under rule G-36(c)(i).

[33] Dealers seeking guidance as to whether a particular document or set of documents constitutes a final official statement for purposes of rule G-36(b)(i) should consult with SEC staff to determine whether such document or set of documents constitutes a final official statement for purposes of Rule 15c2-12.

[34] See rule G-32(c)(ii)(B). If approved by the SEC, the proposed rule change will redesignate this section as rule G-32(d)(ii)(B).

[35] Similarly, an offering involving an underwriting syndicate and consisting of securities issued and delivered on a continuous basis also would remain in its underwriting period under the definition thereof set forth in rule G-11(a)(ix).

[36] This is equally true for other forms of municipal securities for which a customer has already received an official statement in connection with an earlier purchase and who proceeds to make a second purchase of the same securities during the underwriting period. Furthermore, in the case of a repeat purchaser of municipal securities for which no official statement in final form is being prepared, no new delivery of the written notice to that effect or of any official statement in preliminary form would be required so long as the customer has previously received it in connection with a prior purchase. However, if an official statement in final form is subsequently prepared, the customer’s next purchase would trigger the delivery requirement with respect to such official statement. Also, if an official statement which has previously been delivered is subsequently amended during the underwriting period, the customer’s next purchase would trigger the delivery requirement with respect to such amendment.