MSRB NOTICE 2001-39 (OCTOBER 16, 2001)

PROPOSED RULE CHANGE CONCERNING MINIMUM DENOMINATIONS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION

On October 16, 2001, the Municipal Securities Rulemaking Board (the "MSRB") filed with the Securities and Exchange Commission a proposed rule change concerning minimum denominations. [1]   The proposed rule change includes an amendment to rule G-15, on confirmation, clearance and settlement of transactions with customers, that, for securities issued after June 1, 2002, would prohibit transactions in below-minimum denomination amounts, with two limited exceptions.  First, a broker, dealer or municipal securities dealer (collectively “dealers”) may purchase a below-minimum denomination position from a customer provided that the customer liquidates his/her entire position.  Second, a dealer may sell such a liquidated position to another customer but would be required to provide written disclosure, either on the confirmation or separately, to the effect that the security position is below the minimum denomination and that liquidity may be adversely affected by this fact.  The proposed rule change also includes an amendment to the MSRB’s recordkeeping rule as well as an interpretation of rule G-17 on fair practice.

On March 14, 2001, the MSRB published a notice seeking comment on an exposure draft of the proposed rule change (“March 2001 draft amendment”) the terms of which substantially were the same as the rule G-15 amendment.  The March 2001 draft amendment differed from the one in the proposed rule change in that it would have restricted transactions in all municipal securities, while the one in the proposed rule change applies only to municipal securities issued after June 1, 2002.  In addition, the proposed rule change includes an interpretation of rule G-17 and a rule G-8 recordkeeping requirement, while the March 2001 draft amendment did not. 

The MSRB received fifteen comment letters in response to the March 2001 draft amendment.  In response to these comments, several suggestions were incorporated in drafting the rule G-15 amendment.  The March 2001 draft amendment would have restricted transactions in below-minimum denomination amounts for all municipal securities but the rule G-15 amendment applies, on a prospective basis, only to those municipal securities issued after June 1, 2002.  Under the second exception to the rule G-15 amendment, dealers may sell to customers below-minimum denomination positions that are a result of a customer liquidating his/her entire position under the first exception.  However, the selling dealer must provide written disclosure to the customer. [2]  The March 2001 draft amendment would have required such written disclosure to be provided on a separate document.  The revised rule G-15 amendment gives dealers the option of providing such written disclosure either on the trade confirmation or separately.  The proposed rule change also includes an amendment to rule G-8, on books and records to be made by brokers, dealers and municipal securities dealers, and requires dealers to retain such disclosure provided on a separate document for a period of at least three years, which is the same amount of time dealers are required to retain customer confirmations.

The proposed rule change also includes an interpretation of rule G-17, on conduct of municipal securities activities.  Rule G-17 states: “In the conduct of its municipal securities activities, each broker, dealer, and municipal securities dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice.” The MSRB has interpreted this rule to mean, among other things, that dealers are required to disclose, at or before a transaction in municipal securities with a customer, all material facts concerning the transaction, including a complete description of the security.  The interpretation of rule G-17 being issued as part of the proposed rule change states that any time a dealer is selling to a customer a quantity of municipal securities below the minimum denomination for the issue, the dealer should consider this to be a material fact about the transaction.  The MSRB believes that a dealer’s failure to disclose such a material fact to the customer, and to explain how this could affect the liquidity of the customer’s position, generally would constitute a violation of the dealer’s duty under rule G-17 to disclose all material facts about the transaction to the customer.

The proposed rule change will not become effective until approval by the Securities and Exchange Commission.  Persons wishing to comment to the Securities and Exchange Commission should refer to file number SR-MSRB-2001-07.

October 16, 2001

 

G-15 Confirmation, Clearance, and Settlement of and Other Uniform Practice Requirements with Respect to Transactions with Customers

(a)    through (e) No change.

(f)     Minimum Denominations.

                            (i)            Except as provided in this section (f), a broker, dealer or municipal securities dealer shall not effect a customer transaction in municipal securities issued after June 1, 2002 in an amount lower than the minimum denomination of the issue.

                            (ii)            The prohibition in subsection (f)(i) of this rule shall not apply to the purchase of securities from a customer in an amount below the minimum denomination if the broker, dealer or municipal securities dealer determines that the customer’s position in the issue already is below the minimum denomination and that the entire position would be liquidated by the transaction.  In determining whether this is the case, a broker, dealer or municipal securities dealer may rely either upon customer account information in its possession or upon a written statement by the customer as to its position in an issue.

                            (iii)            The prohibition in subsection (f)(i) of this rule shall not apply to the sale of securities to a customer in an amount below the minimum denomination if the broker, dealer or municipal securities dealer determines that the securities position being sold is the result of a customer liquidating a position below the minimum denomination, as described in subsection (f)(ii) of this rule.  In determining whether this is the case, a broker, dealer or municipal securities dealer may rely upon customer account records in its possession or upon a written statement provided by the party from which the securities are purchased. A broker, dealer or municipal securities dealer effecting a sale to a customer under this subsection (iii) shall at or before the completion of the transaction, give or send to the customer a written statement informing the customer that the quantity of securities being sold is below the minimum denomination for the issue and that this may adversely affect the liquidity of the position unless the customer has other securities from the issue that can be combined to reach the minimum denomination.  Such written statement may be included on the customer’s confirmation or may be provided on a document separate from the confirmation.


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

     (a)  Description of Books and Required to be Made

            (i) through (viii) No change.

(ix)       Copies of Confirmations, Periodic Statements and Certain Other Notices to Customers.  A copy of all confirmations of purchase or sale of municipal securities, of all periodic written statements disclosing purchases, sales or redemptions of municipal fund securities pursuant to rule G-15(a)(viii), of written disclosures to customers, if any, as required under rule G-15(f)(iii) and, in the case of a broker, dealer or municipal securities dealer other than a bank dealer, of all other notices sent to customers concerning debits and credits to customer accounts or, in the case of a bank dealer, notices of debits and credits for municipal securities, cash and other items with respect to transactions in municipal securities.

Rule G-17. Conduct of Municipal Securities Activities

Notice of Interpretation of Rule G-17 Concerning Minimum Denominations

Municipal securities issuers sometimes set a relatively high minimum denomination, typically $100,000, for certain issues.  This may be done so that the issue can qualify for one of several exemptions from Securities Exchange Act Rule 15c2-12, meaning that the issue would not be subject to certain primary market or continuing disclosure requirements.  In other situations, issuers may set a high minimum denomination even though the issue is subject to Securities Exchange Act Rule 15c2-12.  This may be because of the issuer’s (or the underwriter’s) belief that the securities are not an appropriate investment for those retail investors who would be likely to purchase securities in relatively small amounts.

Several issuers have expressed concern to the MSRB upon discovering that their issues with high minimum denominations were trading in the secondary market in transaction amounts much lower than the stated minimum denomination.1 Based on information obtained from the MSRB Transaction Reporting Program, it appears that there are significant numbers of these types of transactions.  In the past, brokers, dealers and municipal securities dealers (collectively “dealers”) effecting such transactions likely would have had the problem brought to their attention when attempting to make delivery of a certificate to the customer.  This is because the transfer agent would not have been able to honor a request for a certificate with a par value below the minimum denomination.  Today, however, increased use of book-entry deliveries and safekeeping arrangements for retail customers largely preclude the need for individual certificates for customers and there is no other systemic screening to identify transactions that are in below-minimum denomination amounts.

Rule G-17 states:  “In the conduct of its municipal securities activities, each broker, dealer, and municipal securities dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice.” The MSRB has interpreted this rule to mean, among other things, that dealers are required to disclose, at or before a transaction in municipal securities with a customer, all material facts concerning the transaction, including a complete description of the security.  The MSRB has proposed an amendment to rule G-15 that would prohibit transactions in below-minimum denomination amounts for municipal securities issued after June 1, 2002, with certain limited exceptions.2 The MSRB anticipates that some transactions in below-minimum denomination amounts may continue to occur for issues issued prior to June 1, 2002, as well as under the limited exceptions to the proposed amendment to rule G-15.3  In either case, the MSRB believes that any time a dealer is selling to a customer a quantity of municipal securities below the minimum denomination for the issue, the dealer should consider this to be a material fact about the transaction.  The MSRB believes that a dealer’s failure to disclose such a material fact to the customer, and to explain how this could affect the liquidity of the customer’s position, generally would constitute a violation of the dealer’s duty under rule G-17 to disclose all material facts about the transaction to the customer.

1             Occasionally, bond documents may state a minimum transaction amount that applies only to primary market transactions, but with a clear indication by the issuer that transactions may occur at lower amounts in the secondary market.  The MSRB is not aware of non-authorized transaction amounts occurring for issues of these types.  In general, however, bond documents describing a minimum “denomination” would appear to be intended to apply to both primary and secondary market transactions .

2              Proposed rule change SR-MSRB-2001-07, filed with the Securities and Exchange Commission on October 16, 2001.

3              Even for municipal securities issued after June 1, 2002, below-minimum denomination transactions may need to be effected in compliance with proposed MSRB rule G-15(f) to liquidate below-minimum denomination positions created through the exercise of a will, division of a marital estate, as a result of an investor giving a portion of a position as a gift, etc.  In addition, the exercise of a sinking fund or other partial redemption by an issuer can sometimes result in customers holding below-minimum denomination amounts.


[1] SR-MSRB-2001-07, October 16, 2001 .

[2] Inter-dealer transactions are not subject to the proposed rule change .