MSRB NOTICE 2002-02 (JANUARY 25, 2002)

INTEPRETIVE NOTICE FILED CONCERNING THE APPLICATION OF BOARD RULES TO TRANSACTIONS WITH SOPHISTICATED MUNICIPAL MARKET PROFESSIONALS

On January 25, 2002, the Municipal Securities Rulemaking Board (the “MSRB” or “Board”) filed with the Securities and Exchange Commission (the “SEC”) an interpretive notice relating to transactions with sophisticated municipal market professionals (“SMMPs”).[1]  The interpretive notice defines an “institutional investor” for purposes of the notice[2] and provides that 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 an SMMP.  The guidance also provides that while it is difficult to define in advance the scope of a dealer’s fair practice obligations with respect to a particular transaction, as is discussed in the interpretation, by making a reasonable determination that an institutional customer is an SMMP, then certain of the dealer’s fair practice obligations  (i.e., rule G-17’s affirmative disclosure obligations, rule G-18’s duty to ensure that agency transactions are effected at fair and reasonable prices, and rule G-19’s suitability obligations) remain applicable but are deemed fulfilled.[3]  In addition, the fact that a quotation is made by an SMMP would have an impact on how such quotation is treated under rule G-13.

The MSRB published a notice on July 6, 2001 (the “2001 Notice”) requesting comments on draft interpretive guidance relating to rule G-17, disclosure of material facts and transactions with sophisticated market professionals.[4]  The draft interpretive guidance published in the 2001 Notice represented a revision of an initial draft of such guidance published on September 28, 2000 (the “2000 Notice “).[5]  The MSRB received eight comment letters on the 2001 Notice.  After reviewing these comments, the MSRB approved the draft interpretive notice, with certain modifications and additions, for filing with the SEC.

BACKGROUND

The MSRB decided to issue interpretive guidance to address the issues surrounding the development of electronic trading as an outgrowth of a May 2000 MSRB-hosted roundtable discussion about the use of electronic trading systems in the municipal securities market.  Industry discussion at the roundtable, as well as subsequent industry comments, made it apparent that the municipal securities market, like the equity market, is in the process of developing alternative models of trading relationships between dealers and customers.  In addition, technological innovation is spearheading the development of trading platforms that hope to increase liquidity, transparency and efficiency in the municipal securities market.  All of these developments essentially flow from the belief that there is a demand for trading methodologies that allow a dealer to act as an order taker when effecting transactions with customers. 

Based on the comments from the industry as well as the MSRB’s review of market developments, the MSRB concluded that in order for innovation to occur the industry needs interpretive guidance on the application of certain MSRB rules to these new trading methodologies. Alternative trading systems present the most graphic example of changing dealer/customer relationships and consequent need for regulatory change, but the changing relationships are not necessarily limited to electronic trading venues. 

The MSRB proposed the original sophisticated municipal market (“SMP”) concept in the 2000 Notice to illustrate how different fair practice rules would operate when dealers were transacting with sufficiently sophisticated market professionals.  When the 2000 Notice 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. [6]  

Ultimately, the MSRB determined that a primary purpose of its interpretive guidance should be to interpret MSRB rules to allow the development of trading relationships where the dealer acts as an order taker in secondary market non-recommended municipal securities transactions with sophisticated institutional investors.  The MSRB did not believe that disclosure and transparency in the municipal securities market are sufficiently developed at this time to permit dealers to have only order taker responsibilities when transacting with retail investors and less sophisticated institutional investors. 

The Board believes that the interpretive notice will allow for the development and growth of new trading methodologies that may lead to increased pooling of liquidity and market based transparency without diminishing essential customer protections.

COMMENTS ON THE 2001 NOTICE

Set forth below is a discussion of the comments received on the 2001 Notice and of the substantive modifications made to the draft interpretive guidance published in the 2001 Notice.  Reference is made to the 2001 Notice for a full discussion of the draft interpretive guidance language changes as of the publication of that notice and of the comments received on the initial draft of the interpretive guidance published in the 2000 Notice.

Sophisticated Municipal Market Professional—Definition

$100 Million Threshold

Three commentators on the 2001 Notice expressed the opinion that the threshold requirement that an SMMP own or control $100 million in municipal securities is unnecessarily high, and may deny access to online trading systems to large institutions that are otherwise capable of participating in electronic trading systems.  All three commentators suggested changing the threshold to $50 million and noted that this threshold would be consistent with the Board’s own definition of “institutional account” in rule G-8 (a)(xi), and with the NASD’s institutional suitability guidelines.  One commentator also stated that a $50 million threshold would benefit the markets by providing access to a number of very large institutional investors that are not SMMPs under the proposed $100 million standard.[7] 

The Board determined to add the $100 million threshold to the SMMP definition in the 2001 Notice as a way of ensuring that SMMPs are truly the most sophisticated of institutional investors.  According to the commentator’s data, lowering the threshold to $50 million will result in close to 50% of all large institutional investors being eligible to be an SMMP. 

Although the comment letters expressed concern about denying electronic trading access to smaller institutions, the SMMP definition should not operate in that fashion.  An institutional investor that does not have the level of assets in the definition of the SMMP will not be foreclosed from trading if the dealer offering the platform is providing sufficient information services, beyond transaction execution.[8]  Indeed, there is evidence that many dealers are developing electronic trading systems designed to provide extensive informational services and otherwise fulfill dealers’ fair practice obligations. Moreover, while many other “sophisticated investor” regulations have lower dollar thresholds, the threshold for qualified institutional buyers (“QIBs”) is also set at $100 million, and the Board believes that the purposes behind the QIB threshold are most analogous to the SMMP definition.[9]  Therefore, the MSRB has determined to keep the threshold at $100 million.

Presumption of Sophistication

Several commentators suggested that the SMMP definition be altered to allow investors to be presumed sophisticated if they meet the investment threshold.  The commentators pointed out that the presumption could be rebutted if the dealer knew or should have known that an investor lacked sophistication concerning a municipal securities transaction as defined in the SMMP guidance.  The commentators stated that requiring a dealer to always make individualized judgments that investors meet the definition might hinder dealers’ efforts to streamline access to online trading. 

The MSRB believes that there should not be a presumption of SMMP status for those institutions with $100 million or greater in municipal securities.  The inclusion of a presumption would make the rest of the SMMP guidance concerning who is, or is not a SMMP meaningless.  The Board believes that dealers should be required to undertake some level of investigation to determine if a customer meets the SMMP criteria and should not be allowed to presume that an institution is sophisticated just because it meets the $100 million threshold. 

Requiring Institutional Investors to Attest to SMMP Status

Two commentators also suggested a mechanism for eliminating some of the ambiguity of the “reasonable grounds” test for determining if a customer is an SMMP.  One commentator urged the MSRB to shift the responsibility from the dealer to the investor to determine and represent that it qualifies as an SMMP.[10]  The other commentator suggested that the SMMP proposal would be improved if the MSRB permits dealers to rely upon either (1) the representation of a potential user that it has the characteristics the Board has identified as indicative of a sophisticated municipal market professional; or (2) a contract pursuant to which the participant agrees to waive the disclosure, suitability and price ‘protections’ that would otherwise be afforded that same customer in the context of a recommendation.

The SMMP Interpretive Guidance is designed to help dealers understand their fair practice obligations when effecting secondary market transactions for certain customers.  As the fair practice obligations are the dealers’, the MSRB believes it would be inappropriate to shift the ultimate responsibility for determining the scope of those obligations entirely to the customer.  However, as the MSRB recognized in the 2001 Notice, the SMMP interpretation “ 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.”  Therefore, the MSRB determined that the revised interpretive notice should specifically advise dealers that they may choose to have customers attest to SMMP status as a means of streamlining the dealers’ process for determining that the customer is an SMMP and ensuring that customers are informed as to the consequences of being treated as an SMMP.  Of course, a dealer would not be able to rely upon a customer’s SMMP attestation if the dealer knew or should have known that an investor lacked sophistication concerning a municipal securities transaction as defined in the SMMP guidance.

Confirming SMMP Status

One commentator noted that the 2001 Notice is silent as to how often a dealer must confirm that a customer still qualifies as an SMMP.   They recommended that dealers be allowed to confirm SMMP status as part of their regular review of new account information.  The SMMP interpretive guidance has been revised to include a statement that would clarify that dealers are required to put a process in place for periodic review of customer’s SMMP status.

Application of SMMP Interpretation to Fair Practice Obligations

Retention of SMMP Differentiation

Two commentators again challenged the MSRB’s decision to create the SMMP differentiation.  Both expressed concerns that the  SMMP concept creates two tiers of investors and  will foster the creation and growth of electronic bond trading systems that cater solely to professional dealers and institutional investors and exclude participation by retail investors.[11]  As stated  in the 2001 Notice, the MSRB believes that there is considerable merit in differentiating between customers with different degrees of sophistication.  The MSRB believes that the SMMP Notice, as revised, is narrowly crafted so as to retain necessary customer protections for both retail and SMMP customers. 

Moreover, while the commentators posited that the MSRB guidance would foster the development of electronic trading systems that cater only to dealers and SMMPs, there is no evidentiary support for that statement.  Rather, electronic trading systems are continuing to develop for retail and non-SMMP customers and the SMMP proposal was not intended to prohibit participation by retail participants in the electronic marketplace.[12] 

Additionally, although one commentator urged the MSRB to foster the development of systems that allow retail investors to be able to trade on an equal footing with dealers and institutions, these comments do not take into account the reality of the municipal securities market.  While there may be no need to differentiate between SMMPs and non-SMMPs in certain markets such as the Nasdaq market, there are significant differences between the municipal securities market and other markets.  Municipal securities are not part of the national market system.  It would be very difficult for a retail investor to know whether a municipal security is being offered at a price that is fair and reasonable.  There is, for example, no consolidated tape reporting contemporaneous quotes and transaction prices.  Only rarely is a specific municipal security traded with sufficient frequency to allow a less sophisticated investor to obtain sufficient transaction information to assist in an analysis of the price being offered.  Moreover, there is no mandated issuer disclosure, and very little publicly available and free disclosure information.  It is very likely that retail and less sophisticated institutional investors would not even know where to go to independently assess the accuracy or timeliness of information about a municipal security.  Given these circumstances, the MSRB believes that most retail and less sophisticated institutional customers at this time continue to need dealers to be specifically obligated to fulfill their fair practice obligations by, inter alia, affirmatively disclosing any material fact concerning a municipal security transaction made publicly available through established industry sources and taking reasonable steps to ensure that agency transactions are effected at fair and reasonable prices.

Application of Board Rules to Both Traditional and Electronic Trading Systems

One commentator suggested that the SMMP concept should be limited to electronic trading platforms.  The MSRB does not believe, however, that electronic transactions should be subject to different regulation than transactions that take place over the phone or in person.  The dealers’ obligations should be the same no matter what the medium of communication.  While the SMMP interpretation will be particularly relevant to dealers operating electronic trading platforms, it could also apply to dealers who act as order takers in over the phone or in-person transactions.[13] 

While the commentator objected to applying the SMMP concept to non-electronic transactions, it has not identified a danger from applying the SMMP concept to telephonic or in-person transactions where the dealer is acting as an order taker and effecting a non-recommended secondary market transaction for an SMMP.  Moreover, the MSRB’s determination to apply the SMMP concept to both electronic and non-electronic trading is consistent with the efforts of the SEC and other self-regulatory organizations to ensure that the regulatory requirements for dealers to undertake specific investor protection responsibilities should not depend on whether a transaction takes place electronically, over the telephone, or face-to-face.  Several commentators commended the MSRB for this approach.

The SMMP Concept Should Not Apply to Securities Exempt Under Rule 15c2-12

Two commentators suggested that the SMMP concept should not apply to transactions in private placement securities and securities exempt from the disclosure requirements of Rule 15c2-12, such as variable rate demand obligations (collectively “exempt securities”) because information about these securities is not generally publicly available.  The MSRB has determined not to exempt certain types of municipal securities from the application of the SMMP proposal.  What underlies the SMMP concept is not that material information is always disclosed to the public by the issuer, but rather, that the SMMP is aware of, or capable of making itself aware, and can independently understand the significance of, the material facts available from established industry sources.  The interpretive notice recognizes that 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.” 

The MSRB understands that the commentators believe that SMMPs generally obtain information about exempt securities through dealers.[14]  However, the MSRB is concerned that the investor community may be confusing the role of a dealer effecting primary market transactions for SMMPs, with a dealer that is acting as an order taker effecting non-recommended secondary market transactions for an SMMP.  While a dealer acting on behalf of an issuer may have more information about a municipal security than an SMMP, there is no reason to assume that a dealer effecting a non-recommended secondary market transaction would have the same informational advantage.[15]  Nonetheless, the SMMP interpretation states that “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.”  Continuing to impose rule G-17’s affirmative disclosure obligations on dealers transacting with SMMPs will not necessarily create the desired additional information since disclosure information must come from the issuer, not the dealer.  In fact, it should be recognized that a dealer operating an ATS is likely to have very little information concerning the security in question if, for example, an institutional customer offers the security for sale through the ATS.  

Miscellaneous

Two commentators expressed the view that the MSRB should issue definitive guidance about online recommendations.  The MSRB will take these comments into consideration when it considers appropriate guidance concerning online recommendations. 

*            *            *            *


[1] File No. SR-MSRB-2002-02.  Comments submitted to the SEC should refer to this file number.  The interpretive notice will become effective upon approval by the SEC.

[2] For purposes of this interpretive notice, 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.

[3] However, for purposes of rules G-17 and G-18, the SMMP concept only applies when the dealer is effecting non-recommended secondary market transactions for SMMP customers.

[4]  “Notice and Draft Interpretive Guidance on Rule G-17—Disclosure of Material Facts and Interpretive Guidance Concerning Sophisticated Municipal Market Professionals,” MSRB Reports, Vol. 21, No. 2 (July 2001) at 3.

[5] “Notice and Draft Interpretive Guidance on Dealer Responsibilities in Connection with Both Electronic and Traditional Municipal Securities Transactions,” MSRB Reports, Vol. 20, No. 2 (November 2000) at 3, see also “Clarification to the Draft Interpretive Guidance” published on November 17, 2000 at the MSRB’s web site (http://www.msrb.org/msrb1/archive/etrading.htm).  The MSRB received 17 comment letters on the 2000 Notice, as a result of which a number of revisions (set forth in the 2001 Notice) were made to the initial draft of the interpretive notice.

[6] Concurrently with this filing the MSRB is filing with the SEC an interpretive notice regarding rule G-17, on disclosure of material facts.  This notice addresses some of the comments raised in response to the 2000 Notice and provides an expanded explanation of what rule G-17’s obligation to “disclose all material facts” means in today’s market.  See SEC File No. SR-MSRB-2002-01. 

[7] However, another commentator stated that the $100 million limit is too low and stated that the $100 million limit can easily be met without the concomitant demonstration of being a sophisticated investor. 

[8] Similarly, dealers that wish to allow their retail customers to view offerings on ATS type platforms may do so.  However, the dealers sponsoring retail customers are responsible for providing their customers with rule G-17 disclosures and for ensuring that the transaction prices are fair and reasonable.

[9] A QIB is an institution of a type listed in rule 144A that owns or invests on a discretionary basis at least $100 million of certain securities. See 17 CFR 230.144A(a)(1).  The QIB definition is used to identify institutions that can purchase offerings that are exempt from the registration provisions of the Securities Act and in which the securities are eligible for resale pursuant to rule 144A under the Securities Act. 

[10] While the major rationale of this commentator’s suggestion was to streamline the process by which dealers determine that a customer is an SMMP, they also raised it as a mechanism to prevent customers who do not want to be considered SMMPs from being treated as such.  However, an institution can only be treated as an SMMP, for purposes of rules G-17 and G-18, if the institution has decided that it wants to engage in a non-recommended secondary market transaction.  So, to a large extent, the institutions that can be considered SMMPs are self-selecting—they are the self-directed institutional investors that want to transact with a dealer who will act as an order taker

[11] Both commentators raised this issue in response to the 2000 Notice.  One of the commentators also stated that it could not endorse the SMMP concept before a general strengthening of the existing secondary disclosure structure occurs.

[12] To the extent that any commentators have interpreted MSRB statements to prohibit retail participation in electronic platforms, such statements have been taken out of context.  The MSRB’s intent was to recognize the need for SMMP designation because some ATS type systems are being developed as largely transaction execution systems.  Such systems may not provide sufficient information about the securities traded, and may not take reasonable steps to ensure that the transaction prices are fair and reasonable (nor do they represent that they perform these functions).  The MSRB believes that these types of systems that are limited to transaction execution services should limit access to SMMPs, or at least that the dealer-operator of such systems should be aware that they are obligated to provide affirmative disclosure under rule G-17 and reasonably ensure fair and reasonable transaction prices under rule G-18 for the non-SMMP customers who transact directly within such a system.  However, the MSRB believes and has stated that non-SMMP customers should not be foreclosed from electronic trading platforms that provide sufficient informational services. 

[13] For example, if an SMMP reviewed an offering of municipal securities on an electronic platform that limited transaction capabilities to broker-dealers and then called up a dealer and asked the dealer to place a bid on such offering at a particular price, the interpretation would apply because the dealer would be acting merely as an order taker effecting a non-recommended secondary market transaction for the SMMP.

[14] The MSRB believes that disclosure information may also be available from established industry sources since many issuers of exempt securities (e.g., VRDOs) are also issuers of 15c2-12 issues and thus have 15c2-12 disclosure obligations for those issues that are not exempt. 

[15] Moreover, investors’ comments may incorrectly assume that remarketing agents usually are effecting secondary market transactions in exempt securities (i.e. VRDOs).  A “primary offering” is defined in SEC Rule 15c2-12 to mean an offering directly or indirectly by an issuer. Many remarketings of VRDOs meet the definition of a “primary offering” under SEC Rule 15c2-12 (c).  See  Pillsbury, Madison & Sutro, SEC No-Action Letter, [1990-1991 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 79, 659 at 78, 027 (Mar. 11, 1991) (cautioning the inquirer not to read the language of SEC Rule 15c2-12 (e)(7) too restrictively and instructing that each remarketing of exempt securities should be examined as though it were a new offering to determine if an exemption applies). 

TEXT OF THE INTEPRETIVE NOTICE REGARDING SOPHISTICATED MUNICIPAL MARKET PROFESSIONALS

Introduction

Industry participants have suggested that the MSRB’s fair practice rules should allow dealers[1] to recognize the different capabilities of certain institutional customers as well as the varied types of dealer-customer relationships.  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 interpretive notice 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 interpretive notice, 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 for evaluating an institutional investor’s sophistication concerning a municipal securities transaction and these factors are discussed in detail below.  Moreover, dealers are advised that they have the option of having investors attest to SMMP status as a means of streamlining the dealers’ process for determining that the customer is an SMMP.  However, a dealer would not be able to rely upon a customer’s SMMP attestation if the dealer knows or has reason to know that an investor lacks sophistication concerning a municipal securities transaction, as discussed in detail below.

 

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 (as defined below) 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 the NRMSIR system,[2] and information generated by the MSRB’s Municipal Securities Information Library® (MSIL®) system[3] and Transaction Reporting System (“TRS”),[4] 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 sector or type of municipal security.  This is more likely to arise with relatively new types of municipal securities and 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.  As a means of ensuring that customers continue to meet the defined SMMP criteria, dealers are required to put into place a process for periodic review of a customer’s SMMP status. 

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. 

When 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.[5]  When 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.  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.  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 will be particularly relevant to dealers operating electronic trading platforms, although it will also apply to dealers who act as order takers over the phone or in-person.[6]  This interpretation recognizes that there is no need for a dealer in a non-recommended secondary market transaction to disclose material facts available from established industry sources to an SMMP customer that already has access to the established industry sources.[7] 

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.[8]  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.[9]  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. 

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 Even though this interpretation eliminates a duty to evaluate each transaction, a dealer operating such system, under the general duty set forth in rule G-18, must act to investigate any alleged pricing irregularities on its system brought to its attention.  Accordingly, 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.  Dealers’ 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.[10]

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.[11]  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.[12]  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.[13]

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.[14]  In such case, the MSRB believes that the bona fide requirement obligates a dealer to withdraw or update a stale or invalid quotation promptly enough 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.

January 25, 2002


[1]          The term “dealer” is used in this notice as shorthand for “broker,” “dealer” or “municipal securities dealer,” as those terms are defined in the Securities Exchange Act of 1934.  The use of the term in this notice does not imply that the entity is necessarily taking a principal position in a municipal security.

[2]          For purposes of this notice, the “NRMSIR system” refers to the disclosure dissemination system adopted by the SEC in Rule 15c2-12.  Under Rule 15c2-12, as adopted in 1989, participating underwriters provide a copy of the final official statement to a Nationally Recognized Municipal Securities Information Repository (“NRMSIR”) to reduce their obligation to provide a final official statement to potential customers upon request.  In the 1994 amendments to Rule 15c2-12 the Commission determined to require that annual financial information and audited financial statements submitted in accordance with issuer undertakings must be delivered to each NRMSIR and to the State Information Depository (“SID”) in the issuer’s state, if such depository has been established.  The requirement to have annual financial information and audited financial statements delivered to all NRMSIRs and the appropriate SID was included in Rule 15c2-12 to ensure that all NRMSIRs receive disclosure information directly.  Under the 1994 amendments, notices of material events, as well as notices of a failure by an issuer or other obligated person to provide annual financial information, must be delivered to each NRMSIR or the MSRB, and the appropriate SID. 

[3]           The MSIL® system collects and makes available to the marketplace official statements and advance refunding documents submitted under MSRB rule G-36, as well as certain secondary market material event disclosures provided by issuers under SEC Rule 15c2-12.  Municipal Securities Information Library® and MSIL® are registered trademarks of the MSRB.

[4]           The MSRB’s TRS collects and makes available to the marketplace information regarding inter-dealer and dealer-customer transactions in municipal securities.

[5]          The MSRB has filed a related notice regarding the disclosure of material facts under rule G-17 concurrently with this filing.  See SEC File No. SR-MSRB-2002-01.  The MSRB’s rule G-17 notice provides that a dealer would be responsible for disclosing to a customer any material fact concerning a municipal security transaction (regardless of whether such transaction had been recommended by the dealer) made publicly available through sources such as the NRMSIR system, the MSIL® system, TRS, rating agency reports and other sources of information relating to the municipal securities transaction generally used by dealers that effect transactions in municipal securities (collectively, “established industry sources”).  

[6]          For example, if an SMMP reviewed an offering of municipal securities on an electronic platform that limited transaction capabilities to broker-dealers and then called up a dealer and asked the dealer to place a bid on such offering at a particular price, the interpretation would apply because the dealer would be acting merely as an order taker effecting a non-recommended secondary market transaction for the SMMP.

[7]          In order to meet the definition of an SMMP an institutional customer must, at least, have access to established industry sources.

[8]           This guidance only applies to the actions necessary for a dealer to ensure that its agency transactions are effected at fair and reasonable prices.  If a dealer engages in principal transactions with an SMMP, rule G-30(a) applies and the dealer is responsible for a transaction-by-transaction review to ensure that it is charging a fair and reasonable price.  In addition, rule G-30(b) applies to the commission or service charges that a dealer operating an electronic trading system may charge to effect the agency transactions that take place on its system.

[9]            Similarly, the MSRB believes the same limited agency functions can be undertaken by a broker’s broker toward other dealers.  For example, if a broker’s broker effects agency transactions for other dealers 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 broker’s broker is not required to take further actions on individual transactions to ensure that its agency transactions with other dealers are effected at fair and reasonable prices.

[10]         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 (July1, 2001) at 135; In re F.J. Kaufman and Company of Virginia, 50 S.E.C. 164, 168, 1989 SEC LEXIS 2376, *10 (1989).  The SEC, in its discussion of municipal underwriters’ responsibilities in a 1988 Release, noted that “a broker-dealer recommending securities to investors implies by its recommendation that it has an adequate basis for the recommendation.”  Municipal Securities Disclosure, Securities Exchange Act Release No. 26100 (September 22, 1988) (the “1988 SEC Release”) at text accompanying note 72.

[11]         A customer’s bid for, offer of, or request for bid or offer is included within the meaning of a “quotation” if it is disseminated by a dealer.

[12]          The disseminating dealer need not identify by name the maker of the quotation, but only that such quotation was made by another dealer or an SMMP, as appropriate.

[13]              The MSRB believes that, consistent with its view previously expressed with respect to “bait-and-switch” advertisements, a dealer that includes a price in its quotation that is designed as a mechanism to attract potential customers interested in the quoted security for the primary purpose of drawing such potential customers into a negotiation on that or another security, where the quoting dealer has no intention at the time it makes the quotation of executing a transaction in such security at that price, could be a violation of rule G-17. See Rule G-21 Interpretive Letter – Disclosure obligations, MSRB interpretation of May 21, 1998, MSRB Rule Book (July 1, 2001) at p. 139.

[14]          See Rule G-13 Interpretation, Notice of Interpretation of Rule G-13 on Published Quotations, April 21, 1988, MSRB Rule Book (July 1, 2001) at 91.