MSRB NOTICE 2004-03 (JANUARY 26, 2004)

REVIEW OF DEALER PRICING RESPONSIBILITIES

This notice reviews the fair pricing requirements of MSRB Rules G-18 and G-30 and discusses their application in light of the MSRB’s review of certain transaction patterns that have appeared in the MSRB’s Transaction Reporting System.  The patterns, which show abnormally large price variance in a relatively small number of issues each day, suggest that brokers, dealers and municipal securities dealers (collectively, “dealers”) may not always be making the requisite efforts to ensure that transaction prices are reasonably related to market value.

RULES G-18 AND G-30

Rules G-18 and G-30 apply to customer transactions regardless of whether the dealer is buying or selling municipal securities.  Rule G-18 covers agency transactions and Rule G-30 covers principal transactions, using different formulations that reflect differences between the two types of trades.  As a practical matter, the investor protection function of the two rules does not differ depending on whether the dealer effected the trade on an agency or principal basis.  As may be seen from the description of the rules below, the dealer in each case must exercise diligence in establishing the market value of the security and the reasonableness of the compensation received on the transaction.

Agency Transactions Effected on Behalf of Customers

Rule G-18 states that a dealer effecting an agency transaction on behalf of a customer must undertake “a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions.”[1]  In adopting the rule, the MSRB noted that this standard means that a dealer, as a market professional, “will exercise the same level of care as the professional would if acting for its own account, including the exercise of diligence in ascertaining prevailing market conditions.”[2]  In the context of effecting agency trades for a customer, the dealer either will need to know the current market value of the security, or will have to use diligence in the attempt to ascertain it.  If this is not done, it is not possible to exercise the requisite level of care in finding a price for the customer that is fair and reasonable in relation to prevailing market conditions.

Dealer compensation in agency transactions, which is taken in the form of a commission charged by the dealer, is not addressed in Rule G-18.   Instead, commissions are addressed in Rule G-30(b).  This rule states that the commission must not be in excess of a fair and reasonable amount, taking into account all relevant factors.  The MSRB has noted that a variety of factors may affect the fairness and reasonableness of a commission.[3]

Principal Transactions with Customers

Rule G-30(a) states the pricing responsibility in principal transactions between dealers and customers.  The rule states that the aggregate transaction price to the customer must be fair and reasonable, taking into consideration all relevant factors. The concept of a “fair and reasonable” price includes the concept that the price must “bear a reasonable relationship to the prevailing market price of the security.”[4]  Dealer compensation on a principal transaction is considered to be a mark-up or mark-down that is computed from the inter-dealer market price prevailing at the time of the customer transaction.  As part of the aggregate price to the customer, mark-up or mark-down also must be a fair and reasonable amount, taking into account all relevant factors.

Rule G-30(a) and interpretative notices on the rule have identified a number of factors that may be relevant to the determination of whether the aggregate transaction price is fair and reasonable, including any commission, mark-up or mark-down.  Some of these factors relate primarily to the dealer compensation component of the transaction (e.g., the nature and extent of services provided by the dealer); others relate primarily to the question of market value (e.g., existence of a sinking fund; the rating of the security).[5]  The MSRB has stated that the most important factor in determining whether the aggregate price to the customer is fair and reasonable is that the yield should be comparable to the yield on other securities of comparable quality, maturity, coupon rate, and block size then available in the market.[6]

Reasonable Compensation Not Same as Fair Pricing

It is important to note that the fair pricing responsibilities of dealers require attention both to the market value of the security as well as to the reasonableness of compensation.  Excessive commission, mark-up or mark-down obviously may cause a violation of the fair pricing standards described above.  However, it is also possible for a dealer to restrict its profit on transactions to reasonable levels and still violate Rule G-18 or Rule G-30 because of inattention to market value.  For example, a dealer may fail to assess the market value of a security when acquiring it from another dealer or customer and in consequence may pay a price well above market value.  It would be a violation of fair pricing responsibilities for the dealer to pass on this misjudgment to another customer, as either principal or agent, even if the dealer makes little or no profit on the trade. 

Inter-Dealer and Broker’s Brokers Transactions

The fair pricing responsibilities discussed above reflect the normal relationship between a dealer, who is a market professional, and a customer, who generally is not.  The rules contemplate that the customer may legitimately rely on the dealer to use its market expertise to ensure that the customer’s price is reasonably related to market value. This responsibility present in dealer-customer transactions does not necessarily extend to inter-dealer transactions.  Dealers are entitled to expect that other dealers will act in a professional manner in pursuit of their own interests and in compliance with their own obligations under MSRB rules and other applicable laws, rules and regulations.  This includes the duty of each dealer not to act in an unfair, deceptive or dishonest manner in an inter-dealer transaction.[7]   However, with the exception noted below, the special fair pricing responsibilities found in Rules G-18 and G-30 do not apply to inter-dealer transactions.

Some broker’s brokers’ transactions present an exception to the general rule for inter-dealer transactions. When a broker’s broker undertakes to act for or on behalf of another dealer – either by finding a buyer for the dealer’s securities or finding securities that the dealer wishes to buy – a special relationship is created.  This differs from situation normally found in other inter-dealer trading, where each party is acting in its own interest.  Rule G-18 accordingly provides that, when acting for or on behalf of another dealer, the broker’s broker must meet the same Rule G-18 standard as a dealer effecting an agency trade for a customer.  This means that the broker’s broker must use “reasonable effort” to find a price that is fair and reasonable in light of prevailing market conditions for the security and must employ the same care and diligence in doing so as if the transaction were being done for its own account.  As in the case of dealer transactions with customers, the broker’s broker will need to know the current market value of the security, or use requisite diligence in the attempt to ascertain it.

The MSRB previously has noted that it is possible for a broker’s broker explicitly to limit the extent of the services it offers so that this fair pricing duty does not exist.[8]  In that case, however, the dealers using the broker’s broker should be well aware that the broker’s broker’s role is limited and that the broker’s broker has not undertaken the responsibility to find a price reasonably related to market value.

LARGE INTRA-DAY PRICE DIFFERENTIALS

The advent of the MSRB’s Transaction Reporting System has provided market professionals as well as investors and other interested parties with unprecedented access to comprehensive information on municipal securities transaction prices.  The transaction data provided by the MSRB’s Transaction Reporting System includes “net” prices of dealer-customer transactions,[9] as well as inter-dealer and broker’s brokers’ transaction prices.  The data also has allowed the MSRB and other regulators, such as the Securities and Exchange Commission (“SEC”) and NASD, to review pricing practices in a way that previously was impossible.

The transaction data shows that most municipal securities trade within reasonably narrow price ranges during each trading day. However, a relatively small number of issues each day trade with intra-day differentials (difference between high and low price of the day) that are abnormally wide. The municipal securities issues involved in these situations differ from day to day and, while they represent a very small minority of the average 10,000 issues traded each day, they are sufficiently problematic to require regulatory review. 

Causes of Large Intra-Day Price Differentials

There appear to be several reasons for large intra-day price differentials.  Data input errors made by dealers are a primary cause of large differentials in reported prices.  The MSRB and NASD are working with dealers to emphasize the importance of submitting trade data in a timely and accurate manner and improving compliance with Rule G-14, on transaction reporting.  The MSRB provides several services to assist dealers in monitoring the accuracy and timeliness of their trade reporting.[10]

Breaking news about an issue of municipal securities, or a class of municipal securities (e.g., airport bonds or tobacco bonds), also can result in large intra-day price differentials.  This can be either because the market value of an issue changes dramatically during the day, or, if there are multiple dealers trading the bonds, because of differences in how those dealers interpret the news.  Price differentials in an issue also can be created when material facts relevant to the market value of an issue reach some market participants before others.[11]  The Real Time Transaction Reporting System to be implemented by the MSRB in January 2005 will allow market participants to monitor market price levels on a real-time basis.[12]  This should assist dealers in recognizing and reacting more quickly when news events and material events are affecting market prices.

“Transaction Chains”

A frequent scenario in large intra-day price differentials occurs when a single block of securities moves through a “chain” of transactions during the day.  The securities involved in these scenarios often are infrequently traded issues with credits that are relatively unknown to most market participants.  In a typical case, the transaction chain starts with a dealer buying securities from a customer, usually in a “retail” size block of $5,000 to $100,000.  The securities are then sold through a broker’s broker.  Two or more inter-dealer transactions follow, with a final sale of the securities being made by a dealer to a customer.  In certain cases, the difference between the price received by the selling customer and the price received by the purchasing customer is abnormally large, exceeding 10% or more.  In reviewing such transaction chains, it often appears that the two dealers effecting trades with customers at each end of the chain – one dealer purchasing from a customer and the other selling to a customer – did not make excessive profits on their trades.  Instead, the abnormally large intra-day price differentials can be attributed in major part to the price increases found in the inter-dealer trading occurring after the broker’s broker’s trade.

FAIR PRICING RESPONSIBILITIES AND LARGE PRICE DIFFERENTIALS    

The application of MSRB fair pricing rules to some of the situations creating large price differentials are discussed below.

Application of Rules G-18 and G-30 to Transaction Chains

When a transaction chain results in a large difference between the price received by one customer and the price paid by another customer for the same block of securities on the same day, and there is no news accounting for the price volatility, the question is raised whether each of these customers received a price reasonably related to the market value of the security.  This question in turn raises the issue of whether the dealers effecting the customer transactions (and any broker’s brokers that may have acted on behalf of such dealers) made sufficient effort to establish the market value of the security when effecting their transactions.  

Problematic transaction chains can begin when a customer asks a dealer to liquidate a position in a security with which the dealer is unfamiliar.  The dealer in such a case may not immediately be aware of the market value of this security.  The dealer may simply provide the customer with an offer that the customer can accept or reject, or the dealer may go to a broker’s broker to have a bid-wanted procedure conducted, ultimately executing a riskless principal trade between the customer and the broker’s broker if the customer wishes to go through with the trade.  It should be noted that, in either case, the dealer retains the ultimate responsibility to its customer to ensure that the customer’s price is reasonably related to market value. 

Hard-to-Value Securities

Many municipal securities issues are small in size and infrequently traded.  For some of these issues, it may be difficult to obtain timely and reliable information on the features of the issue or its credit quality.  These factors may make it difficult for a dealer or a broker’s broker to determine market value with precision and may require that the assessment of market value be in the form of a wider range of values than would be possible for well-known, more liquid issues.  Although it is expected that the intra-day price differentials for obscure and illiquid issues might generally be larger than for more well-known and liquid issues, dealers nevertheless should be cognizant of their duty to establish market value as accurately as possible using reasonable diligence.  The specific degree of accuracy to which that market value can be determined will depend on the facts and circumstances of the particular issue and transaction, including such factors as the nature of the security, available information on the issue, etc.

The specific actions that a dealer may need to take to assess market value may also vary with the facts and circumstances.  When a dealer is unfamiliar with a security, the efforts necessary to establish its value may be greater than if the dealer is familiar with the security.  The lack of a well-defined and active market for an issue does not negate the need for diligence in determining the market value as accurately as reasonably possible when fair pricing obligations apply.

A dealer or broker’s broker may need to review recent transaction prices for the issue, and/or transaction prices for issues with similar credit quality and features as part of the duty to use diligence to determine the market value of municipal securities.  When doing this, the dealer often will need to use its professional judgment and market expertise to identify comparable securities and to interpret the bearing of recent transaction prices on the value of the block of municipal securities in question.  If the features and credit quality of the issue are not known, it also may be necessary to obtain information on these factors directly or indirectly from “an established industry source.”[13]   For example, the current rating or other information on credit quality, the specific features and terms of the security, and any material information about the security such as issuer plans to call the issue, defaults, etc., all may affect the market value of securities. 

Use of Bid-Wanted Procedures

Bid-wanted procedures are widely relied on by broker’s brokers and, in turn, by the dealers that use broker’s brokers, to find a buyer for securities. A widely disseminated and properly run bid-wanted procedure will offer important and valuable information on the market value of an issue.  The effectiveness of this process in obtaining the true market value of a security, however, may vary depending on the nature of the security and how the procedure is conducted.  A bid-wanted procedure is not always a conclusive determination of market value.  Therefore, particularly when the market value of an issue is not known, a dealer (or a broker’s broker subject to the requirements of Rule G-18) may need to check the results of the bid wanted process against other objective data to fulfill its fair pricing obligations, as noted above.

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Questions about this notice may be directed to Harold L. Johnson, Deputy General Counsel, at 703-797-6600.


[1] If the dealer’s customer is a “sophisticated municipal market professional,” special rules apply, which are not covered in this notice.  See Interpretive Notice Regarding the Application of MSRB Rules to Transactions with Sophisticated Municipal Market Professional, April 30, 2002 (the “SMMP Notice.”)

[2] See Notice of Approval of Fair Practice Rules, October 24, 1978, CCH Transfer Binder 1977-1987, para 10,090  (“Notice of Approval of Fair Practice Rules”).

[3] Rule G-30(b) provides the following non-exclusive list of factors relevant to commissions:

•         The availability of the securities involved in the transaction;

•         The expense of executing or filling the customer’s order;

•         The value of the services rendered by the dealer; and

•         The amount of any other compensation received or to be received by the dealer in connection with the transaction.

Additional factors also have been noted.  See footnote 5 and accompanying text, infra.

[4] See Notice of Approval of Fair Practice Rules, supra note 2.

[5] Other factors identified include:

            •        The service provided and expense involved in effecting the transaction;

            •        The availability of the securities in the market;

            •        The fact that the dealer is entitled to a profit;

            •        The total dollar amount and price of the transaction;

            •        The rating and call features of the security; and

            •        The best judgment of the dealer as to the fair market value at time of transaction and of any securities exchanged or traded in connection with the transaction.

[6] Rule G-30(a) also explicitly lists as a relevant factor “the best judgment of the [dealer] as to the fair market value at time of transaction and of any securities exchanged or traded in connection with the transaction.”

[7] The MSRB previously has noted that a dealer may violate Rule G-17 on fair practice in certain trading situations.  For example, the MSRB has observed that non-disclosure of information regarding an unusual material feature of a security that is not accessible to the marketplace and is intentionally withheld by a dealer selling a security to another dealer may, depending upon all the relevant facts and circumstances, constitute a violation of Rule G-17.  See, e.g., SMMP Notice, footnote 1, supra.

[8] See SMMP Notice, footnote 1, supra, at note 9.

[9] “Net” prices include the effect of commission, mark-up, or mark-down.

[10] Dealers seeking to obtain information about their error rates can find information on how to do so at the MSRB’s Web site at www.msrb.org under the Transaction Reporting menu.

[11] The MSRB has recognized the need for an improved disclosure system in the municipal securities industry.  In 1998 and 2001, the MSRB sponsored disclosure conferences to bring together representatives of various industry sectors to discuss the state of disclosure in the market.  In 2001, the MSRB invited representatives of all major market groups to participate in the “Muni Council” with the objective of improving the disclosure system.  The MSRB notes that the Muni Council is making progress in planning an improved system for dissemination of secondary market disclosure documents.  The MSRB is hopeful that the Muni Council’s efforts will result in a more efficient and comprehensive mechanism for such disclosure documents to reach market participants.

[12] See, e.g., “Real-Time Transaction Reporting: Revised Schedule and Operational Plan,” MSRB Notice 2003-44 dated December 11, 2003, on www.msrb.org.

[13] For a discussion of “established industry sources” for information on municipal securities, see the SMMP Notice, footnote 1, supra.