MSRB NOTICE 2013-07 (MARCH 11, 2013)

REQUEST FOR COMMENT ON REVISIONS TO SUITABILITY RULE

The Municipal Securities Rulemaking Board (“MSRB”) is seeking comment on proposed revisions to MSRB Rule G-19, on suitability. The proposal is part of the MSRB’s comprehensive review of its rules and related interpretive guidance and reflects an ongoing commitment to consider whether MSRB rules can be more closely aligned with rules of other regulators to promote more effective and efficient compliance. The proposed revisions would harmonize Rule G-19 with Financial Industry Regulatory Authority’s (“FINRA’s”) suitability rule.[1] Lastly, the proposal aligns with a recommendation from the Securities and Exchange Commission in its 2012 Report on the Municipal Securities Market.[2]

Comments should be submitted no later than May 6, 2013, and may be submitted in electronic or paper form. Comments may be submitted electronically by clicking here. Comments submitted in paper form should be sent to Ronald W. Smith, Corporate Secretary, Municipal Securities Rulemaking Board, 1900 Duke Street, Suite 600, Alexandria, VA 22314. All comments will be available for public inspection on the MSRB’s website.[3]

Questions about this notice should be directed to Lawrence P. Sandor, Deputy General Counsel, or Darlene Brown, Assistant General Counsel, at 703-797-6600.

BACKGROUND

The MSRB has conducted a review of Rule G-19, as well as the MSRB’s interpretive guidance addressing suitability, and is proposing the amendments described below to more closely harmonize its rule with the corresponding FINRA suitability rule. The MSRB also is proposing to incorporate elements of its current interpretive guidance on suitability into Rule G-19.  

PROPOSED REVISIONS

Account Information

MSRB Rule G-19(a), in referencing Rule G-8(a)(xi), currently requires brokers, dealers, and municipal securities dealers (“dealers”) to obtain certain customer information prior to completing a transaction in municipal securities in a customer’s account. In an effort to streamline the rule and to more closely align with the FINRA rule, the recordkeeping provisions in G-19(a) have been eliminated, and technical and conforming amendments to Rule G-8(a)(xi)(F) have been proposed.     

Suitability

The proposed amendments to Rule G-19 incorporate the application of suitability to “investment strategies.” Specifically, supplementary material .03 defines the phrase “investment strategy involving a municipal security or municipal securities” in a manner consistent with FINRA’s suitability rule. As such, the phrase “investment strategy” in the proposed MSRB suitability rule would include an explicit recommendation to hold a municipal security or securities. The proposed rule, like the FINRA rule, carves out communications of certain types of educational material so long as such communications do not recommend a particular municipal security or securities.[4]

Information Required for Suitability Determinations

The current MSRB suitability rule contains a non-exclusive list of customer information that dealers must obtain prior to recommending a transaction to a non-institutional account. The proposed rule expands this list to include additional items such as age, investment time horizon, liquidity needs, investment experience and risk tolerance.[5] The MSRB believes that these additional items are directly relevant for recommendations involving municipal securities and having such items explicitly identified will promote more consistent application of the suitability rule.[6]

The current MSRB suitability rule also requires dealers to consider information available from the issuer of the municipal security or otherwise in making suitability determinations. Similarly, the supplementary material to FINRA’s suitability rule establishes the reasonable-basis suitability obligation, which requires a broker-dealer to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. In order to perform a reasonable-basis suitability analysis, dealers must necessarily consider information from the issuer in performing reasonable due diligence on the security.[7] The proposed revisions to Rule G-19 incorporate the terminology of reasonable-basis and customer-specific suitability. 

Institutional Accounts

Provisions in guidance to Rule G-17 exempt dealers from the duty to perform a customer-specific suitability determination for recommendations to sophisticated municipal market professionals (“SMMPs”). FINRA’s suitability rule has similar provisions with respect to institutional accounts. The MSRB does not propose incorporating the SMMP exemption into Rule G-19.

Discretionary Accounts

The current MSRB suitability rule includes a provision on discretionary accounts, which the MSRB believes is more appropriately set forth in a separate rule. Similarly, FINRA’s suitability rule does not include a provision on discretionary accounts. The MSRB proposes to take a similar approach and address discretionary accounts in a separate rule.  

Churning

The proposed rule retains the substance of the existing MSRB prohibition on churning, but recasts it using the new terminology of “quantitative suitability.”

CURRENT INTERPRETIVE GUIDANCE

Over the years, the MSRB has issued guidance on suitability in connection with other issues under Rule G-17. This guidance provides that a dealer must take into account all material information that is known to the dealer or that is available through established industry sources in meeting its suitability obligations.[8] This is the same type of information that dealers are required to disclose to customers at the time of trade.[9] The Rule G-17 guidance also describes material information that dealers should consider in making suitability determinations in specific scenarios such as credit or liquidity enhanced securities,[10] auction rate securities,[11] and insured bonds.[12] Rather than listing information in the supplementary material to Rule G-19 that may be material to an investor, the proposed revisions include a general requirement for dealers to understand information about the municipal security or strategy and the supplemental material contains an explicit cross-reference to a dealer’s obligations under proposed MSRB Rule G-47 (Time of Trade Disclosure).[13] The remaining suitability obligations described in the Rule G-17 guidance[14] are incorporated into revised Rule G-19.[15] 

The MSRB also has issued interpretive guidance under Rule G-19 that addresses electronic communications, investment seminars, customers contacting a dealer in response to an advertisement, and other general suitability concepts.[16] This guidance would be superseded by revised Rule G-19 and the MSRB proposes to rescind the guidance. The MSRB also has issued interpretations under Rules G-15,[17] G-21,[18] and G-32[19] that nominally reference suitability obligations.  Since these interpretations address areas other than suitability, the MSRB proposes that these interpretations remain intact.  

REQUEST FOR COMMENT

The MSRB is requesting comment from the industry and other interested parties on the proposed revisions to Rules G-19 and G-8 set forth below. In addition to the substance of the proposed revisions, the MSRB requests that commenters address the following questions: 

  1. Is the proposal to harmonize the MSRB’s suitability rule with FINRA’s suitability rule an appropriate policy decision?
  2. Are their unique attributes of the municipal securities market that would justify differences in the MSRB’s suitability rule? If so, please identity the particular attributes and regulatory alternatives for addressing such issues. Where possible, provide supporting data or examples.
  3. Does harmonizing the MSRB’s suitability rule with FINRA’s suitability rule provide any benefits to investors or dealers? If so, please provide detail regarding the benefits and to the extent possible, provide supporting data.
  4. Does harmonizing the rules impose any particular costs or burdens on investors or dealers? If so, please provide detail regarding the costs or burdens and to the extent possible, provide supporting data.
  5. Does any of the existing interpretive guidance proposed to be retained conflict with the revisions to Rule G-19? Conversely, is any of the guidance proposed to be rescinded necessary in that it is not fairly implied from the revised Rule G-19? Please be specific in identifying any conflicts or omissions.

March 11, 2013

* * * * *

TEXT OF PROPOSED AMENDMENTS[20]

Rule G-19: Suitability of Recommendations and Transactions; Discretionary Accounts

(a) Account Information. Each broker, dealer and municipal securities dealer shall obtain at or before the completion of a transaction in municipal securities with or for the account of a customer a record of the information required by rule G-8(a)(xi).

(b) Non-institutional Accounts—Prior to recommending to a non-institutional account a municipal security transaction, a broker, dealer or municipal securities dealer shall make reasonable efforts to obtain information concerning:

(i) the customer's financial status;

(ii) the customer’s tax status;

(iii) the customer’s investment objectives; and

(iv) such other information used or considered to be reasonable and necessary by such broker, dealer or municipal securities dealer in making recommendations to the customer.

The term "institutional account" for the purposes of this section shall have the same meaning as in rule G-8(a)(xi).

(c) Suitability of Recommendations. In recommending to a customer any municipal security transaction, a broker, dealer, or municipal securities dealer shall have reasonable grounds:

(i) based upon information available from the issuer of the security or otherwise, and

(ii) based upon the facts disclosed by such customer or otherwise known about such customer for believing that the recommendation is suitable.

(d) Discretionary Accounts. No broker, dealer or municipal securities dealer shall effect a transaction in municipal securities with or for a discretionary account.

(i) except to the extent clearly permitted by the prior written authorization of the customer and accepted in writing by a municipal securities principal or municipal securities sales principal on behalf of the broker, dealer or municipal securities dealer; and

(ii) unless the broker, dealer or municipal securities dealer first determines that the transaction is suitable for the customer as set forth in section (c) of this rule or unless the transaction is specifically directed by the customer and has not been recommended by the dealer to the customer.

(e) Churning. No broker, dealer or municipal securities dealer shall recommend transactions in municipal securities to a customer, or effect such transactions or cause such transactions to be effected for a discretionary account, that are excessive in size or frequency in view of information known to such broker, dealer or municipal securities dealer concerning the customer's financial background, tax status, and investment objectives.

A broker, dealer or municipal securities dealer must have a reasonable basis to believe that a recommended transaction or investment strategy involving a municipal security or municipal securities is suitable for the customer, based on the information obtained through the reasonable diligence of the broker, dealer or municipal securities dealer to ascertain the customer's investment profile.  A customer's investment profile includes, but is not limited to, the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the broker, dealer or municipal securities dealer in connection with such recommendation.

 

---Supplementary Material:

.01 General Principles. Implicit in all broker, dealer and municipal securities dealer relationships with customers and others is the fundamental responsibility for fair dealing.  Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of the MSRB’s rules, with particular emphasis on the requirement to deal fairly with all persons.  The suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.

.02 Disclaimers. A broker, dealer or municipal securities dealer cannot disclaim any responsibilities under the suitability rule.

.03 Recommended Strategies. The phrase "investment strategy involving a municipal security or municipal securities" used in this rule is to be interpreted broadly and would include, among other things, an explicit recommendation to hold a municipal security or municipal securities.  However, the following communications are excluded from the coverage of Rule G-19 as long as they do not include (standing alone or in combination with other communications) a recommendation of a particular municipal security or municipal securities: general financial and investment information, including (i) basic investment concepts, such as risk and return and diversification, (ii) historic differences in the return of asset classes (e.g., equities, bonds, or cash) based on standard market indices, (iii) effects of inflation, (iv) estimates of future retirement income needs, (v) assessment of a customer's investment profile, and (vi) general comparisons between tax-exempt and taxable bonds and the concept of tax-equivalent yield.

.04 Customer's Investment Profile. A broker, dealer or municipal securities dealer shall make a recommendation covered by this rule only if, among other things, the broker, dealer or municipal securities dealer has sufficient information about the customer to have a reasonable basis to believe that the recommendation is suitable for that customer.  The factors delineated in Rule G-19 regarding a customer's investment profile generally are relevant to a determination regarding whether a recommendation is suitable for a particular customer, although the level of importance of each factor may vary depending on the facts and circumstances of the particular case.  A broker, dealer or municipal securities dealer shall use reasonable diligence to obtain and analyze all of the factors delineated in Rule G-19 unless the broker, dealer or municipal securities dealer has a reasonable basis to believe, documented with specificity, that one or more of the factors are not relevant components of a customer's investment profile in light of the facts and circumstances of the particular case.

.05 Components of Suitability Obligations. Rule G-19 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.

(a)  The reasonable-basis obligation requires a broker, dealer or municipal securities dealer to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.  In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the municipal security or investment strategy and the broker, dealer or municipal securities dealer’s familiarity with the municipal security or investment strategy.   A broker, dealer or municipal securities dealer’s reasonable diligence must provide the broker, dealer or municipal securities dealer with an understanding of the potential risks and rewards associated with the recommended municipal security or strategy and an understanding of information about the municipal security or strategy, including the information described in [proposed] MSRB Rule G-47 (Time of Trade Disclosure), to the extent such information is material.  The lack of such an understanding when recommending a municipal security or strategy violates the suitability rule.

(b)  The customer-specific obligation requires that a broker, dealer or municipal securities dealer have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer's investment profile, as delineated in Rule G-19.

(c)  Quantitative suitability requires a broker, dealer or municipal securities dealer who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer's investment profile, as delineated in Rule G-19.  No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer's account may provide a basis for a finding that a broker, dealer or municipal securities dealer has violated the quantitative suitability obligation.

.06 Customer's Financial Ability. Rule G-19 prohibits a broker, dealer or municipal securities dealer from recommending a transaction or investment strategy involving a municipal security or municipal securities or the continuing purchase of a municipal security or municipal securities or use of an investment strategy involving a municipal security or municipal securities unless the broker, dealer or municipal securities dealer has a reasonable basis to believe that the customer has the financial ability to meet such a commitment.  

* * * * *

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

(a) Description of Books and Records Required to be Made. Except as otherwise specifically indicated in this rule, every broker, dealer and municipal securities dealer shall make and keep current the following books and records, to the extent applicable to the business of such broker, dealer or municipal securities dealer:

(i) - (x)  No change.

(xi)  Customer Account Information. A record for each customer, other than an institutional account, setting forth the following information to the extent applicable to such customer:

(A) - (E)  No change.

(F) information about the customer used obtained pursuant to rule G-19(c)(ii) inmaking recommendations to the customer.  For non-institutional accounts, all data obtained pursuant to rule G-19(b) shall be recorded.

(G) - (M)  No change.

(xii) - (xxvi)  No change.

(b) - (g)  No change.


[1]  See FINRA Rule 2111 (Suitability). The MSRB also is seeking comment on proposed technical revisions to Rule G-8, on books and records, to conform this rule with the proposed revisions to Rule G-19.

[2]  See http://www.sec.gov/news/studies/2012/munireport073112.pdf

[3]  Comments are posted on the MSRB website without change. Personal identifying information such as name, address, telephone number, or email address, will not be edited from submissions. Therefore, commenters should submit only information that they wish to make available publicly.

[4]  Some of the educational items discussed in the supplementary material to FINRA’s rule are not applicable to the municipal securities market; therefore, the proposed revisions to Rule G-19 do not include these items. Conversely, the proposed revisions to Rule G-19 add an educational item related to tax exemption information since this is uniquely applicable to municipal securities.

[5]  The expanded list of customer information in the proposed revisions is the same as the customer information in FINRA’s suitability rule.

[6]  See also SIFMA Letter in response to MSRB Notice 2012-63 (SIFMA urged the MSRB to make the investor profile information required to be obtained under Rule G-19 consistent with that required under FINRA Rule 2111 given the effort and expense associated with updating systems and processes to comply with Rule 2111); FSI Letter in response to MSRB Notice 2012-63 (harmonization would streamline the exam process and lend greater clarity in rule interpretation and application).

[7]  FINRA’s guidance indicates that the reasonable-basis suitability obligation requires broker-dealers to perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy.

[10]  Id.

[11]  sApplication of MSRB Rules to Transactions in Auction Rate SecuritieInterpretive Notice dated February 19, 2008, .

[13]  See also FSI Letter in response to 2012-63 (asking for guidance on the scope of material information that must be taken into account to adequately complete a suitability review under G-19.)

[14]  Interpretive Notice dated March 30, 2007, Reminder of Customer Protection Obligations in Connection with Sales of Municipal Securities; Interpretive Notice Regarding Rule G-17, on Disclosure of Material FactsInterpretive Notice dated March 20, 2002,; and Notice Concerning Disclosure of Call Information to Customers of Municipal SecuritiesInterpretive Notice dated March 4, 1986, .

[15]  This does not include suitability obligations with respect to 529 plans.  The MSRB proposes including these obligations in a separate rule for 529 plans.

[16]  Notice Regarding Application of Rule G-19, on Suitability of Recommendations and Transactions, to Online CommunicationsInterpretive Notice dated September 25, 2002, ; Notice Concerning the Application of Suitability Requirements to Investment Seminars and Customer Inquiries Made in Response to a Dealer’s AdvertisementsInterpretive Notice dated May 7, 1985, ; , RecommendationsInterpretive Letter dated February 17, 1998; and , Recommendations: advertisementsInterpretive Letter dated February 24, 1994.

[20]  Underlining indicates new language; strikethrough denotes deletions.