MSRB NOTICE 2010-35 (SEPTEMBER 9, 2010)

REQUEST FOR COMMENT ON MSRB GUIDANCE ON BROKER'S BROKERS

The Municipal Securities Rulemaking Board (“MSRB”) is requesting comments on proposed guidance to broker’s brokers.  For purposes of this notice, a “broker’s broker” means a broker, dealer, or municipal securities dealer that principally effects transactions for other brokers, dealers, and municipal securities dealers (“dealers”) or that holds itself out as a broker’s broker.  A broker’s broker may be a separate business or part of a larger business.[1]  The proposed guidance is drafted in the form of a notice, but parts of it may eventually be incorporated into a proposed rule change or changes.  The MSRB is also considering rulemaking that would provide that broker’s brokers must adopt procedures incorporating this guidance, disclose them to sellers and bidders in writing at least annually, post them in a prominent position on their websites, and follow them.  Among other things, such procedures would require that a broker’s broker disclose the nature of its undertaking for the client.

BACKGROUND

The MSRB last issued guidance on broker’s brokers in 2004,[2] when it noted the role of some broker’s brokers in large intra-day price differentials of infrequently traded municipal securities with credits that were relatively unknown to most market participants, especially in the case of “retail” size blocks of $5,000 to $100,000.  In certain cases, differences between the prices received by the selling customers as a result of a broker’s broker bid-wanted auction (“bid-wanted”) and the prices paid by the ultimate purchasing customers on the same day were 10% or more.  After the securities were purchased from the broker’s broker, they were sold to other dealers in a series of transactions until they eventually were purchased by other customers.  The abnormally large intra-day price differentials were attributed in major part to the price increases found in the inter-dealer market occurring after the broker’s brokers’ trades.

Both Securities and Exchange Commission (“SEC”) and Financial Industry Regulatory Authority (“FINRA”) enforcement actions have highlighted broker’s broker activities that constitute clear violations of MSRB rules.[3]  The MSRB recognizes that some broker’s brokers make considerable efforts to comply with MSRB rules.  However, the nature of rule violations brought to light by FINRA and SEC enforcement actions suggests that it may be appropriate for the MSRB to provide reminders and additional guidance on the application of its rules to broker’s broker activities. 

Much of the following guidance relates to the conduct of bid-wanteds. Broker’s brokers also make “offerings” of municipal securities on behalf of other dealers.  In the case of a typical offering, also referred to as a “situation,” the selling dealer specifies a desired price or yield for the security and the broker’s broker negotiates between the selling dealer and potential bidders to arrive at transaction terms that can be agreed to by the seller and another party.  In contrast, a selling dealer in a typical bid-wanted asks the broker’s broker to obtain the best bid it can, without specifying a desired price or yield.  Bid-wanteds tend to involve smaller, retail size blocks of bonds and relatively infrequently traded securities.  Situations tend to involve much larger blocks of bonds and more frequently traded securities.  Most of the abuses observed by the SEC and FINRA in their publicly announced enforcement actions have occurred in bid-wanteds. However, unless otherwise specified, the proposed guidance would apply to all types of broker’s broker activities.

TEXT OF PROPOSED GUIDANCE 

Review of Broker’s Brokers Responsibilities

This notice reviews the fair pricing requirements of MSRB Rules G-18 and G-30 and the fair practice requirements of Rule G-17 as they apply to transactions effected by broker’s brokers.  It also discusses recordkeeping and record retention requirements for broker’s brokers.  While this notice discusses these particular rules in detail, all MSRB rules apply to broker’s brokers.

For purposes of this notice, a “broker’s broker” means a broker, dealer, or municipal securities dealer that principally effects transactions for other brokers, dealers, and municipal securities dealers (“dealers”) or that holds itself out as a broker’s broker.  A broker’s broker may be a separate business or part of a larger business.

Rule G-18

Under Rule G-18, a broker’s broker has an obligation to its dealer client to make a reasonable effort to obtain a fair and reasonable price in relation to market conditions -- the same duty that a dealer has to a customer in an agency transaction.  The broker’s broker must employ the same care and diligence in doing so as if the transaction were being done for its own account.[1]

Broker’s brokers frequently rely on bid-wanted auctions (“bid-wanteds”) to fulfill their Rule G-18 obligation.[2]  A widely disseminated and properly run bid-wanted will offer important and valuable information on the fair market value of a security.  The effectiveness of this process in obtaining the fair market value of a security, however, may vary depending on the nature of the security and how the procedure is conducted.  A bid-wanted is not always a conclusive determination of fair market value.  Therefore, particularly when the fair market value of a security is not known, a broker’s broker may need to check the results of the bid wanted process against other objective data to fulfill its fair pricing obligations.[3]

Given the nature of rule violations concerning bid-wanteds brought to light by Securities Exchange Commission and Financial Industry Regulatory Authority enforcement actions,[4] and the importance of bid-wanteds to sales of municipal securities by retail investors, the MSRB has determined to provide the following detailed guidance on the actions that a broker’s broker must take in determining fair market value, including guidance on the bid-wanted procedures used by broker’s brokers.   

If a bid-wanted is used to help satisfy the Rule G-18 obligation of a broker’s broker, the broker’s broker must disseminate it widely to obtain exposure to multiple dealers with possible interest in the block of securities, although no fixed number of bids is required.  If securities are of limited interest (e.g., small issues with credit quality issues and/or features generally unknown in the market), the broker’s broker must reach dealers with specific knowledge of the issue or known interest in securities of the type being offered.  It is not consistent with the Rule G-18 obligation of a broker’s broker for it to encourage off-market bids.[5] 

In a bid wanted, the client of the broker’s broker is presumed to be the seller.  It is not consistent with the Rule G-18 obligation of a broker’s broker for it to represent both the seller and the bidder unless that is disclosed prominently and both parties agree in writing in advance of a transaction.  In the case of a seller, “in advance” means at the time the seller directs the broker’s broker to try to find bidders.  In the case of bidders, “in advance” means prior to the submission of bids.

The broker’s broker may not disclaim its Rule G-18 obligation to make a reasonable effort to obtain a fair and reasonable price in relation to market conditions, except in the limited circumstance described under “Agent v. Principal.”  If, after a reasonable effort, a fair and reasonable price cannot be determined within a reasonable degree of accuracy, the broker’s broker must disclose that fact to its dealer client, in which case the broker’s broker may still effect the trade with its dealer client if it acknowledges such disclosure in writing.  Factors that might cause a broker’s broker to come to that conclusion include: the number and nature of bids received in the bid-wanted; the nature of securities in question, including credit quality and features; and previous transaction prices for the securities in question and for similar securities.

Agent v. Principal

In a typical broker’s broker operation, the broker’s broker effects principal transactions for dealer clients.  The nature of the transactions as either agency or principal is governed for purposes of the MSRB rules by whether a position is taken with respect to the security.  The MSRB has previously published guidance that, for purposes of the uniform practice rules, the MSRB considers broker’s broker transactions to be principal transactions even though the broker’s broker may be acting for one party and may have agency or fiduciary obligations toward that party under state law.[6]  Further, in any transaction in which a broker’s broker takes a position in a security sold by its dealer client, even if such position is solely in the clearing or similar account of the broker’s broker and regardless of the length of time such position is held, such transaction would be treated as a principal trade for purposes of all MSRB rules, not just the uniform practice rules.[7]

Although the MSRB has previously stated that limited agency functions may be undertaken by a broker’s broker toward other dealers,[8] the MSRB wishes to clarify that these statements were only meant to apply to circumstances in which a broker’s broker effects trades in a manner that is consistent with the March 26, 2001 Notice, including in particular where securities are never held in any account of the broker’s broker for purposes of the comparison and settlement process.  Preserving anonymity of seller and buyer through clearance and settlement is not consistent with that notice.  In order to do that, a broker’s broker would need to take the securities into one of its accounts, even if only its clearing account.  In so doing, it would take a position in the securities and be a principal.        

Transactions with Customers

The Board understands that some broker’s brokers may effect occasional transactions with customers.[9]  The Board reminds broker’s brokers that Rule G-30 applies if they effect those transactions as principal transactions.[10]  Rule G-30 provides that, for principal trades: “No broker, dealer or municipal securities dealer shall purchase municipal securities for its own account from a customer or sell municipal securities for its own account to a customer except at an aggregate price (including any mark-down or mark-up) that is fair and reasonable, taking into consideration all relevant factors, including the best judgment of the broker, dealer or municipal securities dealer as to the fair market value of the securities at the time of the transaction and of any securities exchanged or traded in connection with the transaction, the expense involved in effecting the transaction, the fact that the broker, dealer, or municipal securities dealer is entitled to a profit, and the total dollar amount of the transaction.”  In contrast, the obligation of a broker’s broker to a customer in an agency trade is subject to Rule G-18, which is the same standard applicable to broker’s brokers’ transactions with their dealer clients, as described above. 

Rule G-17

As with any dealer, Rule G-17 applies to broker’s brokers.   Rule G-17 provides: “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.”  As the MSRB has previously stated,[11] 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.  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.  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 the situation normally found in other inter-dealer trading, where each party is presumed to be acting in its own interest.

As noted above, the MSRB understands that some broker’s brokers have customers.  Because of the potential conflict of interest that this may create, Rule G-17 requires that, if broker’s brokers have customers, they must disclose that to both sellers and bidders in writing.  Furthermore, broker’s brokers with customers must put information barriers in place to ensure that customers are not provided with information about securities of other clients, including the ownership of such securities and information about bids (other than the winning bid that is reported to the MSRB).

Furthermore, broker’s brokers could violate Rule G-17 by self-dealing.  If a broker’s broker is part of a larger business, the broker’s broker must put information barriers in place to prevent non-public information (including information about bids) from being transferred from the broker’s broker to the rest of the business organization.  It is clearly a deceptive, dishonest, and unfair practice for a dealer holding itself out as broker’s broker to purchase securities for its own account, rather than for the account of the highest bidder when a seller has engaged the broker’s broker to effect a trade on its behalf.  This conduct violates Rule G-17 whether done directly or indirectly by interposing another dealer in the process.  

Broker’s brokers are required by Rule G-17 to conduct bid-wanteds and situations in a fair manner, and they must not take any action that works against the client’s interest to receive advantageous pricing, subject to the ability of both the seller and the bidder to agree in advance of a transaction that the broker’s broker may represent the interests of both the seller and the bidder.

Rule G-17 requires that broker’s brokers not give preferential information to bidders in bid-wanteds on where they currently stand in the bidding process.  This prohibition precludes “last looks,” directions to a specific bidder that it should “review” its bid or that its bid is “sticking out,” etc.  Broker’s brokers must not contact bidders in bid-wanteds about their bid prices unless there is advance disclosure to the client that this may happen and all bidders are given the opportunity to adjust their bids.  Otherwise, discussions with bidders during a bid-wanted must be limited to discussions about the characteristics and quality of the security. 

Finally, as described in prior enforcement actions,[12] it is a deceptive, dishonest, and unfair practice for a broker’s broker to submit fake cover bids, to adjust a bid without the bidder’s knowledge, to fail to inform the selling dealer of the highest bid, to accept bids after a bid deadline, or to submit fictitious trade prices. 

Recordkeeping/Record Retention  

Broker’s brokers must keep records of all bids (including “quick answer” bids), together with time of receipt, for at least three years.  Records of bids must not be overwritten (e.g., when a new bid is entered). 


[1] MSRB Notice 2004-3 (January 26, 2004).

[2] Broker’s brokers also make “offerings” of municipal securities on behalf of other dealers.  In the case of a typical offering, also referred to as a “situation,” the selling dealer specifies a desired price or yield for the security and the broker’s broker negotiates between the selling dealer and potential bidders to arrive at transaction terms that can be agreed to by the seller and another party.  In contrast, a selling dealer in a typical bid-wanted asks the broker’s broker to obtain the best bid it can, without specifying a desired price or yield.  Bid-wanteds tend to involve smaller, retail size blocks of bonds and relatively infrequently traded securities.  Situations tend to involve much larger blocks of bonds and more frequently traded securities.  Unless otherwise specified, the proposed guidance would apply to all types of broker’s broker activities.

[3] MSRB Notice 2004-3 (January 26, 2004).

[4] FINRA v. Associated Bond Brokers, Inc. Letter of Acceptance, Waiver and Consent No. E052004018001 (November 19, 2007) (broker’s broker violated Rule G-17 by lowering the highest bids to prices closer to the cover bids without informing either bidders or sellers); FINRA v. Butler Muni, LLC Letter of Acceptance, Waiver and Consent No. 2006007537201 (May 28, 2010) (broker’s broker violated Rule G-17 by failing to inform the seller of higher bids submitted by the highest bidders); D. M. Keck & Company, Inc. d/b/a Discount Munibrokers, et al., Exchange Act Release No. 56543 (September 27, 2007) (broker’s broker violated Rules G-13 and G-17 by disseminating fake cover bids to both seller and winning bidder; broker’s broker violated Rules G-14 and G-17 by paying seller more than highest bid on some trades in return for a price lower than the highest bid on other trades, in each case reporting the fictitious trade prices to the MSRB’s Real-Time Trade Reporting System); Regional Brokers, Inc. et al., Exchange Act Release No. 56542 (September 27, 2007) (broker’s broker violated Rules G-13 and G-17 by disseminating fake cover bids to both seller and winning bidder; broker’s broker violated Rule G-17 by accepting bids after bid deadline); SEC v. Wolfe & Hurst Bond Brokers, Inc. et al., Exchange Act Release No. 59913 (May 13, 2009) (broker’s broker violated Rule G-17 by disseminating fake cover bids to both seller and winning bidder and by lowering the highest bids to prices closer to the cover bids without informing either bidders or sellers).  These cases also found violations of Rules G-8, G-9, and G-28.

[5] This conduct could also be a violation of Rule G-17.

[6] MSRB Interpretation on the Application of Rules G-8, G-12 and G-14 to Specific Electronic Trading Systems (March 26, 2001) (the “March 26, 2001 Notice”).

[7] In the March 26, 2001 Notice, the MSRB contrasted the typical broker’s broker operation with the electronic trading system described in such notice, about which the notice provided: “It appears to the MSRB that the dealer operating the system is effecting agency transactions for dealer clients.”  Among the representations relevant to that conclusion were: “Participants are, or may be, anonymous during the bid/offer/negotiation process.  After a sales contract is formed, the system immediately sends an electronic communication to the buyer and seller, noting the transaction details as well as the identity of the contra-party.  The transaction is then sent by the buyer and seller to a registered securities clearing agency for comparison and is settled without involvement of the system operator.  The system operator does not take a position in the securities traded on the system, even for clearance purposes.  Dealers trading on the system are required by system rules to clear and settle transactions directly with each other even though the parties do not know each other at the time the sale contract is formed.”        

[8] MSRB Interpretive Notice Regarding the Application of MSRB Rules to Transactions with Sophisticated Municipal Market Professionals (April 30, 2002); see also MSRB Notice 2004-3.

[9] MSRB Rule D-9 provides that: “Except as otherwise specifically provided by rule of the Board, the term ‘Customer’ shall mean any person other than a broker, dealer, or municipal securities dealer acting in its capacity as such or an issuer in transactions involving the sale by the issuer of a new issue of its securities.”

[10] See also the discussion in this notice on the application of Rule G-17 to transactions with customers by broker’s brokers.

[11] MSRB Notice 2004-3.

[12] See note 4.

*  *  *  *  *

REQUEST FOR COMMENT 

The MSRB requests comments on the proposed guidance.  As noted above, it is drafted in the form of a notice, but parts of it may eventually be incorporated into a proposed rule change or changes. 

Comments should be submitted no later than November 15, 2010 and may be directed to Peg Henry, Deputy General Counsel.[4] 

September 9, 2010


[1] The MSRB considers it appropriate to define “broker’s broker” according to function, rather than to use the definition of “broker’s broker” contained in SEC Rule 15c3-1(a)(8)(ii), which was developed to determine the appropriate net capital requirement for certain broker’s brokers.

[3] FINRA v. Associated Bond Brokers, Inc. Letter of Acceptance, Waiver and Consent No. E052004018001 (November 19, 2007) (broker’s broker violated Rule G-17 by lowering the highest bids to prices closer to the cover bids without informing either bidders or sellers); FINRA v. Butler Muni, LLC Letter of Acceptance, Waiver and Consent No. 2006007537201 (May 28, 2010) (broker’s broker violated Rule G-17 by failing to inform the seller of higher bids submitted by the highest bidders); D. M. Keck & Company, Inc. d/b/a Discount Munibrokers, et al., Exchange Act Release No. 56543 (September 27, 2007) (broker’s broker violated Rules G-13 and G-17 by disseminating fake cover bids to both seller and winning bidder; broker’s broker violated Rules G-14 and G-17 by paying seller more than highest bid on some trades in return for a price lower than the highest bid on other trades, in each case reporting the fictitious trade prices to the MSRB’s Real-Time Trade Reporting System); Regional Brokers, Inc. et al., Exchange Act Release No. 56542 (September 27, 2007) (broker’s broker violated Rules G-13 and G-17 by disseminating fake cover bids to both seller and winning bidder; broker’s broker violated Rule G-17 by accepting bids after bid deadline); SEC v. Wolfe & Hurst Bond Brokers, Inc. et al., Exchange Act Release No. 59913 (May 13, 2009) (broker’s broker violated Rule G-17 by disseminating fake cover bids to both seller and winning bidder and by lowering the highest bids to prices closer to the cover bids without informing either bidders or sellers).  These cases also found violations of Rules G-8, G-9, and G-28.

[4] Written comments will be posted on the MSRB web site.  Comments are posted without change and personal identifying information, such as name or e-mail address, will not be edited from submissions.  Therefore, commentators should submit only information that they wish to make available publicly.