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Rule
G-17
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Notice of Interpretation of Rule G-17 Concerning Prompt Delivery of Securities October 13, 1983 From time to time the Board has received inquiries from purchasers of municipal securities concerning the duty of municipal securities brokers and dealers to deliver securities to customers under the Board’s rules. In particular, customers have asked what, if any, remedies are available when long delays occur between the purchase, payment and delivery of municipal securities. The Board has advised such individuals that under rule G-17, the Board’s fair dealing rule, a municipal securities broker or dealer has a duty to deliver securities sold to customers in a prompt fashion. The Board is mindful that a dealer’s failure to deliver municipal securities often is caused by its failure to receive delivery of the securities from another dealer or by other circumstances beyond its control. It nevertheless believes that a dealer’s duty to deliver securities promptly to customers is inherent in rule G-17.[1] A violation of that duty could occur, for example, if a dealer sells securities to a customer when it knows that it cannot effect delivery by the specified settlement date or within a reasonable length of time thereafter and does not disclose that fact to its customer. The Board notes that customers who fail to receive securities are not entitled to take advantage of the Board’s procedures to close out a failed transaction which are available only for inter-dealer transactions under rule G-12. However, if a customer sustains a loss or otherwise is damaged by his dealer’s failure to deliver securities, he may seek recovery through the Board’s arbitration program or through litigation. These remedies may accrue to the customer whether or not a dealer’s failure to deliver violates rule G-17. ENDNOTES 1 The duty of a securities professional to complete promptly transactions with customers also has been found to flow from the federal securities laws by the SEC and the courts. Application of Board Rules to Transactions in Municipal Securities Subject to Secondary Market Insurance or Other Credit Enhancement Features March 6, 1984 It has come to the Board’s attention that insurance companies are offering to insure whole maturities of issues of municipal securities outstanding in the secondary market. The Board understands that municipal securities professionals must apply for the insurance which, once issued, will remain in effect for the life of the security. The Board further understands that other credit enhancement devices also may be developed for secondary market issues. The Board wishes to remind the industry of the application of rule G-17, the Board’s fair dealing rule, in connection with transactions with customers in securities that are subject to secondary market insurance or other credit enhancement devices or in securities for which arrangements for such insurance or device have been initiated.[1] The Board is of the view that facts, for example, that a security has been insured or arrangements for insurance have been initiated, that will affect the market price of the security are material and must be disclosed to a customer at or before execution of a transaction in the security. In addition, the Board believes that a dealer should advise a customer if evidence of insurance or other credit enhancement feature must be attached to the security for effective transference of the insurance or device.[2] The Board also wishes to remind the industry that under rule G-13, concerning quotations, all quotations relating to municipal securities made by a dealer must be based on the dealer’s best judgment of the fair market value of the securities at the time the quotation is made. Offers to buy securities that are insured or otherwise have a credit enhancement feature, or for which arrangements for insurance or other credit enhancement have been initiated, must comply with rule G-13. Similarly, the prices at which these securities are purchased or sold by a municipal securities dealer must be fair and reasonable to its customers under Board rule G-30 on prices and commissions. ENDNOTES 1 Rule G-17 provides:
2 The Board has adopted amendments to rule G-15 which, among other things, require that deliveries to customers of insured securities be accompanied by some evidence of the insurance. Notice Concerning Application of Rule G-17 to Use of Lotteries to Allocate Partial Calls to Securities Held in Safekeeping March 6, 1984 The Board has received inquiries concerning the duty of municipal securities brokers and dealers to allocate partial calls fairly among customer securities held in safekeeping. In particular, it has come to the Board’s attention that certain municipal securities dealers use lottery systems that include only customer positions and exclude the dealer’s proprietary accounts when the call is exercised at a price below the current market value. The Board recognizes that lottery systems are a proper method of allocating the results of a partial call. Principles of fair dealing require that all such lotteries treat dealer and customer account alike. The Board is of the view that a municipal securities dealer which uses a lottery that excludes the dealer’s proprietary accounts when the call is exercised at a price below the current market value is acting in violation of rule G-17, the Board’s fair dealing rule.[1] ENDNOTES 1 Rule G-17 provides:
Syndicate Manager Selling Short for Own Account to Detriment of December 21, 1984 The Board has received an inquiry concerning a situation in which a municipal securities dealer that is acting as a syndicate manager sells bonds "short" for its own account to the detriment of the syndicate account. In particular, the Board has been made aware of allegations that certain syndicate managers, with knowledge that the syndicate account on a particular new issue of securities is not successful, have sold securities of the new issue "short" for their own accounts and then required syndicate members to take their allotments of unsold bonds. The syndicate managers allegedly have subsequently covered their short positions when the syndicate members attempt to sell their allotments at the lower market price.
Syndicate managers act in a fiduciary capacity in relation to syndicate accounts. Therefore they may not use proprietary information about the account obtained solely as a result of acting as manager to their personal advantage over the syndicate’s best interests. The Board is of the view that a syndicate manager that uses information on the status of the syndicate account which is not available to syndicate members to its own benefit and to the detriment of the syndicate account (e.g., by effecting "short sale" transactions for its own account against the interests of other syndicate members) appears to be acting in violation of the fair dealing provisions of rule G-17. Altering the Settlement Date on Transactions in "When-Issued" Securities February 26, 1985 The Board has received inquiries concerning situations in which a municipal securities dealer alters the settlement date on transactions in "when-issued" securities. In particular, the Board has been made aware of a situation in which a dealer sells a "when-issued" security but accepts the customer’s money prior to the new issue settlement date and specifies on the confirmation for the transaction a settlement date that is weeks before the actual settlement date of the issue. The dealer apparently does this in order to put the customer’s money "to work" as soon as possible. The Board is of the view that this situation is one in which a customer deposits a free credit balance with the dealer and then, using this balance, purchases securities on the actual settlement date. The dealer pays interest on the free credit balance at the same rate as the securities later purchased by the customer.
The Board believes that this practice would violate rule G-17 if the customer is not advised that the interest received on the free credit balance would probably be taxable. In addition, the Board notes that a dealer that specifies a fictitious settlement date on a confirmation would violate rule G-15(a) which requires that the settlement date be included on customer confirmations. Syndicate Managers Charging Excessive Fees for Designated Sales July 29, 1985 The Board has received inquiries concerning situations in which syndicate managers charge fees for designated sales that do not appear to be actual expenses incurred on behalf of the syndicate or may appear to be excessive in amount. For example, one commentator has described a situation in which the syndicate managers charge $.25 to $.40 per bond as expenses on designated sales and has suggested that such a charge seems to bear no relation to the actual out-of-pocket costs of handling such transactions.
The Board wishes to emphasize that syndicate managers should take care in determining the actual expenses involved in handling designated sales and may be acting in violation of rule G-17 if the expenses charged to syndicate members bear no relation to or otherwise overstate the actual expenses incurred on behalf of the syndicate. Notice Concerning the Application of Board Rules to Put Option Bonds September 30, 1985 The Board has received a number of inquiries from municipal securities brokers and dealers regarding the application of the Board’s rules to transactions in put option bonds. Put option or tender option bonds on new issue securities are obligations which grant the bondholder the right to require the issuer (or a specified third party acting as agent for the issuer), after giving required notice, to purchase the bonds, usually at par (the "strike price"), at a certain time or times prior to maturity (the "expiration date(s)") or upon the occurrence of specified events or conditions. Put options on secondary market securities also are coming into prominence. These instruments are issued by financial institutions and permit the purchaser to sell, after giving required notice, a specified amount of securities from a specified issue to the financial institution on certain expiration dates at the strike price. Put options generally are backed by letters of credit. Secondary market put options often are sold as an attachment to the security, and subsequently are transferred with that security. Frequently, however, the put option may be sold separately from that security and re-attached to other securities from the same issue. Of course, the Board’s rules apply to put option bonds just as they apply to all other municipal securities. The Board, however, has issued a number of interpretive letters on the specific application of its rules to these types of bonds. These interpretive positions are reviewed below. Fair Practice Rules 1. Rule G-17 Board rule G-17, regarding fair dealing, imposes an obligation on persons selling put option bonds to customers to disclose adequately all material information concerning these securities and the put features at the time of trade. In an interpretive letter on this issue,[1] the Board responded to the question whether a dealer who had previously sold put option securities to a customer would be obligated to contact that customer around the time the put option comes into effect to remind the customer that the put option is available. The Board stated that no Board rule would impose such an obligation on the dealer. In addition, the Board was asked whether a dealer who purchased from a customer securities with a put option feature at the time of the put option exercise date at a price significantly below the put exercise price would be in violation of any Board rules. The Board responded that such dealer may well be deemed to be in violation of Board rules G-17 on fair dealing and G-30 on prices and commissions. 2. Rule G-25(b) Board rule G-25(b) prohibits brokers, dealers, and municipal securities dealers from guaranteeing or offering to guarantee a customer against loss in municipal securities transactions. Under the rule, put options are not deemed to be guarantees against loss if their terms are provided in writing to the customer with or on the confirmation of the transaction and recorded in accordance with rule G-8(a)(v).[2] Thus, when a municipal securities dealer is the issuer of a secondary market put option on a municipal security, the terms of the put option must be included with or on customer confirmations of transactions in the underlying security. Dealers that sell bonds subject to put options issued by an entity other than the dealer would not be subject to this disclosure requirement. Confirmation Disclosure Rules
Rules G-12(c)(v)(E) and G-15(a)(i)(E)[*] require inter-dealer and customer confirmations to set forth
Confirmations of transactions in put option securities, therefore, would have to indicate the existence of the put option (e.g., by including the designation "puttable" on the confirmation), much as confirmations concerning callable securities must indicate the existence of the call feature. The confirmation need not set forth the specific details of the put option feature.[3]
The Board has stated that a bank issuing a letter of credit which secures a put option feature on an issue is "obligated… with respect to debt service" on such issue. Thus, the identity of the bank issuing the letter of credit securing the put option also must be indicated on the confirmation. [4] Finally, rules G-12(c)(v)(E) and G-15(a)(i)(E)[‡] requires that dealer and customer confirmations contain a description of the securities including, among other things, the interest rate on the bonds. The Board has interpreted this provision as it pertains to certain tender option bonds with adjustable tender fees to require that the net interest rate (i.e., the current effective interest rate taking into account the tender fee) be disclosed in the interest rate field and that dealers include elsewhere in the description field of the confirmation the stated interest rate with the phrase "less fee for put." [5]
Rule G-15(a)(i)(I)[#] requires that customer confirmations include information on yield and dollar price as follows:
In cases in which the resulting dollar price or yield shown on the confirmation is calculated to call or par option, this must be stated, and the call or option date and price used in the calculation must be shown. Neither of these rules requires the presentation of a yield or a dollar price computed to the put option date as a part of the standard confirmation process. In many circumstances, however, the parties to a particular transaction may agree that the transaction is effected on the basis of a yield to the put option date, and that the dollar price will be computed in this fashion. If that is the case, the yield to the put date must be included on confirmations as the yield at which the transaction was effected and the resulting dollar price computed to the put date, together with a statement that it is a "yield to the [date] put option" and an indication of the date the option first becomes available to the holder.[6] The requirement for transactions effected on a yield basis of pricing to the lowest of price to call, price to par option or price to maturity, applies only when the parties have not specified the yield on which the transaction is based. In addition, in regard to transactions in tender option bonds with adjustable tender fees, even if the transaction is not effected on the basis of a yield to the tender date, dealers must include the yield to the tender date since an accurate yield to maturity cannot be calculated for these securities because of the yearly adjustment in tender fees.[7] Delivery Requirements In a recent interpretive letter, the Board responded to an inquiry whether, in three situations, the delivery of securities subject to put options could be rejected.[8] The Board responded that, in the first situation in which securities subject to a "one time only" put option were purchased for settlement prior to the option expiration date but delivered after the option expiration date, such delivery could be rejected since the securities delivered were no longer "puttable" securities. In the second situation in which securities subject to a "one time only" put option were purchased for settlement prior to the option expiration date and delivered prior to that date, but too late to permit the recipient to satisfy the conditions under which it could exercise the option (e.g., the trustee is located too far away for the recipient to be able to present the physical securities by the expiration date), the Board stated that there might not be a basis for rejecting delivery, since the bonds delivered were "puttable" bonds, depending on the facts and circumstances of the delivery. A purchasing dealer who believed that it had incurred some loss as a result of the delivery would have to seek redress in an arbitration proceeding. Finally, in the third situation, securities which were the subject of a put option exercisable on a stated periodic basis (e.g., annually) were purchased for settlement prior to the annual exercise date so that the recipient was unable to exercise the option at the time it anticipated being able to do so. The Board stated that this delivery could not be rejected since "puttable" bonds were delivered. A purchasing dealer who believed that it had incurred some loss as a result of the delivery would have to seek redress in an arbitration proceeding. The Board welcomes the views of all interested persons on the application of current Board rules to transactions in put option bonds. ENDNOTES 1 See [Rule G-17 Interpretive Letter – Put option bonds: safekeeping, pricing,] MSRB interpretation of February 18, 1983. 2 Rule G-8(a)(v) requires dealers to record, among other things, oral or written put options with respect to municipal securities in which such municipal securities broker or dealer has any direct or indirect interest, showing the description and aggregate par value of the securities and the terms and conditions of the option. 3 See [Rule G-12 Interpretive Letter – Confirmation disclosure: put option bonds,] MSRB interpretation of April 24, 1981. 4 See [Rule G-15 Interpretive Letter – Securities description: securities backed by letters of credit,] MSRB interpretation of December 2, 1982. 5 See [Rule G-12 Interpretive Letter – Confirmation disclosure: tender option bonds with adjustable tender fees,] MSRB interpretation of March 5, 1985. 6 See [Rule G-12 Interpretive Letter – Confirmation disclosure: put option bonds,] MSRB interpretation of April 24, 1981. 7 See fn. 5. 8 See [Rule G-12 Interpretive Letter – Delivery requirements: put option bonds,] MSRB interpretation of February 27, 1985. [*] [Currently codified at rule G-15(a)(i)(C)(2)(a). See also current rule G-15(a)(i)(C)(2)(b).] [†] [Currently codified at rule G-15(a)(i)(C)(1)(b).] [‡] [Currently codified at rule G-15(a)(i)(B)(4). See also current rule G-15(a)(i)(B)(4)(c).] [#] [Currently codified at rule G-15(a)(i)(A)(5). See also current rule G-15(a)(i)(A)(5)(c)(vi)(D).] Notice Concerning Disclosure of Call Information to Customers of March 4, 1986 The Board has been made aware of instances in which dealers are not adequately describing securities to customers at the time of trade and may not disclose that bonds are subject to redemption, in-whole or in-part, prior to maturity. In addition, the Board understands that even when this disclosure is made, and a customer asks for further information concerning the call features, in some instances a dealer may not have this information available. Rule G-17 of the Board’s rules of fair practice requires municipal securities brokers and dealers to deal fairly with all persons and prohibits them from engaging in any deceptive, dishonest, or unfair practice. The Board has interpreted this rule to require that a dealer must disclose, at or before the sale of municipal securities to a customer, all material facts concerning the transaction, including a complete description of the security, and must not omit any material facts which would render other statements misleading. In addition, rule G-19, on suitability, prohibits a municipal securities professional from recommending transactions in municipal securities to a customer unless the professional has reasonable grounds for making the recommendation in light of information about the security available from the issuer or otherwise and believes that a transaction in the security is suitable for the particular customer. The fact that a security may be redeemed prior to maturity in-whole, in-part, or in extraordinary circumstances, is essential to a customer’s investment decision about the security and is one of the facts a dealer must disclose at the time of trade. In addition, a dealer, if asked by a customer for more specific information regarding a call feature, should obtain this information and relay it to the customer promptly. Moreover, it would be difficult for a dealer to recommend the purchase of a security to a customer without having information regarding the security’s call features. With respect to confirmations, rule G-15(a) requires dealers to note on customer confirmations if a security is subject to redemption prior to maturity (callable) and to include a legend stating that "call features may exist which could affect yield; complete information will be provided upon request." Thus, a customer, upon receipt of the confirmation, may ask for further information on call features, and dealers have a duty to obtain and disclose such information promptly. Of course, a confirmation is not received by a customer until after a transaction is effected and the Board wishes to emphasize that confirmation disclosures do not eliminate the duty of a municipal securities professional to explain the security adequately to a customer. Notice of Interpretation Requiring Dealers to Submit to Arbitration as a Matter of Fair Dealing March 6, 1987 Section 2 of the Board’s Arbitration Code, rule G-35, requires all dealers to submit to arbitration at the instance of a customer or another dealer. From time to time, a dealer will refuse to submit to arbitration or will delay or even refuse to make payment of an award. Such acts constitute violations of rule G-35. The Board believes that it is a violation of rule G-17, on fair dealing, for a broker, dealer or municipal securities dealer or its associated persons to fail to submit to arbitration as required by Rule G-35, or to fail to comply with the procedures therein, including the production of documents, or to fail to honor an award of arbitrators unless a timely motion to vacate the award has been made according to applicable law.[1] ENDNOTE 1 A party typically has 90 days to seek judicial review of an arbitration award; after that the award cannot be challenged. Challenges to arbitration awards are heard only in limited, egregious circumstances such as fraud or collusion on the part of the arbitrators. Notice of Interpretation on Escrowed-to-Maturity Securities: Rules G-17, G-12 and G-15 September 21, 1987 The Board is concerned that the market for escrowed-to-maturity securities has been disrupted by uncertainty whether these securities may be called pursuant to optional redemption provisions. Accordingly, the Board has issued the following interpretations of rule G-17, on fair dealing, and rules G-12(c) and G-15(a), on confirmation disclosure, concerning escrowed-to-maturity securities. The interpretations are effective immediately. Background Traditionally, the term escrowed-to-maturity has meant that such securities are not subject to optional redemption prior to maturity. Investors and market professionals have relied on this understanding in their purchases and sales of such securities. Recently, certain issuers have attempted to call escrowed-to-maturity securities. As a result, investors and market professionals considering transactions in escrowed-to-maturity securities must review the documents for the original issue, for any refunding issue, as well as the escrow agreement and state law, to determine whether any optional redemption provisions apply. In addition, the Board understands that there is uncertainly as to the fair market price of such securities which may cause harm to investors. On March 17, 1987, the Board sent letters to the Public Securities Association, the Government Finance Officers Association and the National Association of Bond Lawyers expressing its concern. The Board stated that it is essential that issuers, when applicable, expressly note in official statements and defeasance notices relating to escrowed-to-maturity securities whether they have reserved the right to call such securities. It stated that the absence of such express disclosure would raise concerns whether the issuer’s disclosure documents adequately explain the material features of the issue and would severely damage investor confidence in the municipal securities market. Although the Board has no rulemaking authority over issuers, it advised brokers, dealers and municipal securities dealers (dealers) that assist issuers in preparing disclosure documents for escrowed-to-maturity securities to alert these issuers of the need to disclose whether they have reserved the right to call the securities since such information is material to a customer’s investment decision about the securities and to the efficient trading of such securities. Application of Rule G-17 on Fair Dealing In the intervening months since the Board’s letter, the Board has continued to receive inquiries from market participants concerning the callability of escrowed-to-maturity securities. Apparently, some dealers now are describing all escrowed-to-maturity securities as callable and there is confusion how to price such securities. In order to avoid confusion with respect to issues that might be escrowed-to-maturity in the future, the Board is interpreting rule G-17, on fair dealing,[1] to require that municipal securities dealers that assist in the preparation of refunding documents as underwriters or financial advisors alert issuers of the materiality of information relating to the callability of escrowed-to-maturity securities. Accordingly, such dealers must recommend that issuers clearly state when the refunded securities will be redeemed and whether the issuer reserves the option to redeem the securities prior to their maturity. Application of Rules G-12(c) and G-15(a) on Confirmation Disclosure of Escrowed-to-Maturity Securities Rules G-12(c)(vi)(E) and G-15(a)(iii)(E)[*] require dealers to disclose on inter-dealer and customer confirmations, respectively, whether the securities are "called" or "prerefunded," the date of maturity which has been fixed by the call notice, and the call price. The Board has stated that this paragraph would require, in the case of escrowed-to-maturity securities, a statement to that effect (which would also meet the requirement to state "the date of maturity which has been fixed") and the amount to be paid at redemption. In addition, rules G-12(c)(v)(E) and G-15(a)(i)(E)[†] require dealers to note on confirmations if securities are subject to redemption prior to maturity (callable). The Board understands that dealers traditionally have used the term escrowed-to-maturity only for non-callable advance refunded issues the proceeds of which are escrowed to original maturity date or for escrowed-to-maturity issues with mandatory sinking fund calls. To avoid confusion in the use of the term escrowed-to-maturity, the Board has determined that dealers should use the term escrowed-to-maturity to describe on confirmations only those issues with no optional redemption provisions expressly reserved in escrow and refunding documents. Escrowed-to-maturity issues with no optional or mandatory call features must be described as "escrowed-to-maturity." Escrowed-to-maturity issues subject to mandatory sinking fund calls must be described as "escrowed-to-maturity" and "callable." If an issue is advance refunded to the original maturity date, but the issuer expressly reserves optional redemption features, the security should be described on confirmations as "escrowed (or prerefunded) to [the actual maturity date]" and "callable."[2] The Board believes that the use of different terminology to describe advance refunded issues expressly subject to optional calls will better alert dealers and customers to this important aspect of certain escrowed issues.[3] ENDNOTES 1 Rule G-17 states that "[i]n the conduct of its municipal securities business, each broker, dealer, and municipal securities dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice." 2 This terminology also would be used for any issue prerefunded to a call date, with an earlier optional call expressly reserved. 3 The Board believes that, because of the small number of advance refunded issues that expressly reserve the right of the issuer to call the issue pursuant to an optional redemption provision, confirmation systems should be able to be programmed for use of the new terminology without delay. [*] [Currently codified at rule G-15(a)(i)(C)(3)(a). See also current rule G-15(a)(i)(C)(3)(b).] [†] [Currently codified at rule G-15(a)(i)(C)(2)(a).] Notice of Interpretation Concerning Priority of Orders for New Issue Securities: Rule G-17 December 22, 1987 The Board is concerned about reports that senior syndicate managers may not always be mindful of principles of fair dealing in allocations of new issue securities. In particular, the Board believes that the principles of fair dealing require that customer orders should receive priority over similar dealer or certain dealer-related account[1] orders, to the extent that this is feasible and consistent with the orderly distribution of new issue securities. Rule G-11(e) requires syndicates to establish priority provisions and, if such priority provisions may be changed, to specify the procedure for making changes. The rule also permits a syndicate to allow the senior manager, on a case-by-case basis, to allocate securities in a manner other than in accordance with the priority provisions if the senior manager determines in its discretion that it is in the best interests of the syndicate. Senior managers must furnish this information, in writing, to the syndicate members. Syndicate members must promptly furnish this information, in writing, to others upon request. This requirement was adopted to allow prospective purchasers to frame their orders to the syndicate in a manner that would enhance their ability to obtain securities since the syndicate’s allocation procedures would be known. The Board understands that senior managers must balance a number of competing interests in allocating new issue securities. In addition, a senior manager must be able quickly to determine when it is appropriate to allocate away from the priority provisions and must be prepared to justify its actions to the syndicate and perhaps to the issuer. While it does not appear necessary or appropriate at this time to restrict the ability of syndicates to permit managers to allocate securities in a manner different from the priority provisions, the Board believes senior managers should ensure that all allocations, even those away from the priority provisions, are fair and reasonable and consistent with principles of fair dealing under rule G-17.[2] Thus, in the Board’s view, customer orders should have priority over similar dealer orders or certain dealer-related account orders to the extent that this is feasible and consistent with the orderly distribution of new issue securities. Moreover, the Board suggests that syndicate members alert their customers to the priority provisions adopted by the syndicate so that their customers are able to place their orders in a manner that increases the possibility of being allocated securities. ENDNOTES 1 A dealer-related account includes a municipal securities investment portfolio, arbitrage account or secondary trading account of a syndicate member, a municipal securities investment trust sponsored by a syndicate member, or an accumulation account established in connection with such a municipal securities investment trust. 2 Rule G-17 provides that:
Notice Concerning Securities that Prepay Principal March 19, 1991 The Board has become aware of several issues of municipal securities that prepay principal to the bondholders over the life of the issue. These securities are issued with a face value that equals the total principal amount of the securities. However, as the prepayment of principal to bondholders occurs over time, the "unpaid principal" associated with a given quantity of the securities become an increasingly lower percentage of the face amount. The Board believes that there is a possibility of confusion in transactions involving such securities, since most dealers and customers are accustomed to municipal securities in which the face amount always equals the principal amount that will be paid at maturity. Because of the somewhat unusual nature of the securities, the Board believes that dealers should be alert to their disclosure responsibilities. For customer transactions, rule G-17 requires that the dealer disclose to its customer, at or prior to the time of trade, all material facts with respect to the proposed transaction. Because the prepayment of principal is a material feature of these securities, dealers must ensure that the customer knows that securities prepay principal. The dealer also must inform the customer of the amount of unpaid principal that will be delivered on the transaction. For inter-dealer transactions, there is no specific requirement for a dealer to disclose all material facts to another dealer at time of trade. A selling dealer is not generally charged with the responsibility to ensure that the purchasing dealer knows all relevant features of the securities being offered for sale. The selling dealer may rely, at least to a reasonable extent, on the fact that the purchasing dealer is also a professional and will satisfy his need for information prior to entering into a contract for the securities. Nevertheless, it is possible that non-disclosure of an unusual feature such as principal prepayment might constitute an unfair practice and thus become a violation of rule G-17 even in an inter-dealer transaction. This would be especially true if the information about the prepayment feature is not accessible to the market and is intentionally withheld by the selling dealer. Whether or not non-disclosure constitutes an unfair practice in a specific case would depend upon the individual facts of the case. However, to avoid trade disputes and settlement delays in inter-dealer transactions, it generally is in dealers’ interest to reach specific agreement on the existence of any prepayment feature and the amount of unpaid principal that will be delivered. Educational Notice on Bonds Subject to "Detachable" Call Features May 13, 1993 New products are constantly being introduced into the municipal securities market. Dealers must ensure that, prior to effecting transactions with customers in municipal securities with new features, they obtain all necessary information regarding these features. The Board will attempt periodically through educational notices to describe new products or features of municipal securities and review the responsibilities of dealers to customers in these transactions. In this notice, the Board will review detachable call features. Certain recent issues of municipal securities include a new feature called a detachable call right. This feature allows the issuer to sell its right to call the bond. Thus, upon the sale of this call right, the owner of the right has the ability, at certain times, to require the mandatory tender of the underlying municipal bond. The dates of mandatory tender of the underlying bonds generally correlate with the optional call dates. If the holder exercises such rights, the underlying bondholder tenders its bond to the issuer (just as if the issuer had called the bond) and the holder of the call right purchases the bond. In some instances, issuers already have issued municipal call rights and the underlying bonds in such cases are sometimes referred to as being subject to "detached" call rights. Bonds subject to detachable call rights generally include a provision that permits an investor that owns both the detached call right and the underlying bond to link the two instruments together, subject to certain conditions. Such "linked" municipal securities would not be subject to being called at certain times by holders of call rights or the issuer. They may, however, be subject to other calls, such as sinking fund provisions. If a customer obtains a linked security, thereafter the customer has the option to de-link the security, again subject to certain conditions, into a municipal call right and an underlying bond subject to a right of mandatory tender.
Applicability of Board Rules Of course, the Board’s rules apply to bonds subject to detachable call features and "linked" securities just as they apply to all other municipal securities. The Board, however, would like to remind dealers of certain Board rules that should be considered in transactions involving these municipal securities. Rule G-15(a) on Customer Confirmations Rule G-15(a)(i)(E)[*] requires customer confirmations to set forth "a description of the securities, including… if the securities are… subject to redemption prior to maturity…, an indication to such effect." Additionally, rule G-15(a)(iii)(F)[*] requires a legend to be placed on customer confirmations of transactions in callable securities which notes that "Call features may exist which could affect yield; complete information will be provided upon request." Confirmations of transactions in bonds subject to detachable call rights, therefore, would have to indicate this information.[1] In addition, the details of the call provisions of such securities would have to be provided to the customer upon the customer’s request. Confirmation disclosure, however, serves merely to support—not to satisfy—a dealer’s general disclosure obligations. More specifically, the disclosure items required on the confirmation do not encompass "all material facts" that must be disclosed to customers at the time of trade pursuant to rule G-17. Rule G-17 on Fair Dealing Rule G-17 of the Board’s rules of fair practice requires municipal securities dealers to deal fairly with all persons and prohibits them from engaging in any deceptive, dishonest, or unfair practice. The Board has interpreted this rule to require that a dealer must disclose, at or before the sale of municipal securities to a customer, all material facts concerning the transaction, including a complete description of the security, and must not omit any material facts which would render other statements misleading. Among other things, a dealer must disclose at the time of trade whether a security may be redeemed prior to maturity in-whole, in-part, or in extraordinary circumstances because this knowledge is essential to a customer’s investment decision. Clearly, bonds subject to detachable calls must be described as callable at the time of the trade.[2] In addition, if a dealer is asked by a customer at the time of trade for specific information regarding call features, this information must be obtained and relayed promptly. Although the Board requires dealers to indicate to customers at the time of trade whether municipal securities are callable, the Board has not categorized which, if any, specific call features it considers to be material and therefore also must be disclosed. Instead, the Board believes that it is the responsibility of the dealer to determine whether a particular feature is material. With regard to detachable calls, dealers must decide whether the ability of a third party to call the bond is a material fact that should be disclosed to investors. Dealers should make this determination in the same way they determine whether other facets of a municipal securities transaction are material—is it a fact that a reasonable investor would want to know when making an investment decision? For example, would a reasonable investor who knows a bond is callable base an investment decision on whether someone other than the issuer can call the bond? Does this new feature affect the pricing of the bond? * * * The Board is continuing its review of detachable call rights and may take additional related action at a later date. The Board welcomes the views of all persons on the application of Board rules to transactions in securities subject to detachable call rights. ENDNOTES 1 With regard to the confirmation requirement for linked securities, if these securities are subject to other call provisions such as sinking fund calls, the customer confirmation must indicate that these securities are callable. 2 Similarly, when considering the application of rule G-17 to transactions in "linked" securities, as with other municipal securities, dealers have the obligation to ensure that investors understand the features of the security. In particular, if a linked security to other call provisions, dealers should ensure that retail customers do not mistakenly believe the bond is "non-callable." [*] [Currently codified at rule G-15(a)(i)(C)(2)(a)] Transactions in Municipal Securities with Non-Standard Features Affecting Price/Yield Calculations June 12, 1995 Rule G-15(a) generally requires that confirmations of municipal securities transactions with customers state a dollar price and yield for the transaction. Thus, for transactions executed on a dollar price basis, a yield must be calculated; for transactions executed on a yield basis, a dollar price must be calculated. Rule G-33 provides the standard formulae for making these price/yield calculations. It has come to the Board’s attention that certain municipal securities have been issued in recent years with features that do not fall within any of the standard formulae and assumptions in rule G-33, nor within the calculation formulae available through the available settings on existing bond calculators. For example, an issue may have first and last coupon periods that are longer than the standard coupon period of six months. With respect to some municipal securities issues with non-standard features, industry members have agreed to certain conventions regarding price/yield calculations. For example, one of the available bond calculator setting might be used for the issue, even though the calculator setting does not provide a formula specifically designed to account for the non–standard feature. In such cases, anomalies may result in the price/yield calculations. The anomalies may appear when the calculations are compared to those using more sophisticated actuarial techniques or when the calculations are compared to those of other securities that are similar, but that do not have the non–standard feature. The Board reminds dealers that, under rule G-17, dealers have the obligation to explain all material facts about a transaction to a customer buying or selling a municipal security. Dealers should take particular effort to ensure that customers are aware of any non-standard feature of a security. If price/yield calculations are affected by anomalies due to a non-standard feature, this may also constitute a material fact about the transaction that must be disclosed to the customer. Notice of Interpretation of Rule G-17 Concerning Minimum Denominations January 30, 2002 Municipal securities issuers sometimes set a relatively high minimum denomination, typically $100,000, for certain issues. This may be done so that the issue can qualify for one of several exemptions from Securities Exchange Act Rule 15c2-12, meaning that the issue would not be subject to certain primary market or continuing disclosure requirements. In other situations, issuers may set a high minimum denomination even though the issue is subject to Securities Exchange Act Rule 15c2-12. This may be because of the issuer’s (or the underwriter’s) belief that the securities are not an appropriate investment for those retail investors who would be likely to purchase securities in relatively small amounts. Several issuers have expressed concern to the MSRB upon discovering that their issues with high minimum denominations were trading in the secondary market in transaction amounts much lower than the stated minimum denomination.[1] Based on information obtained from the MSRB Transaction Reporting Program, it appears that there are significant numbers of these types of transactions. In the past, brokers, dealers and municipal securities dealers (collectively “dealers”) effecting such transactions likely would have had the problem brought to their attention when attempting to make delivery of a certificate to the customer. This is because the transfer agent would not have been able to honor a request for a certificate with a par value below the minimum denomination. Today, however, increased use of book-entry deliveries and safekeeping arrangements for retail customers largely preclude the need for individual certificates for customers and there is no other systemic screening to identify transactions that are in below-minimum denomination amounts. Rule G-17 states: “In the conduct of its municipal securities activities, each broker, dealer, and municipal securities dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice.” The MSRB has interpreted this rule to mean, among other things, that dealers are required to disclose, at or before a transaction in municipal securities with a customer, all material facts concerning the transaction, including a complete description of the security. The MSRB has proposed an amendment to rule G-15 that would prohibit transactions in below-minimum denomination amounts for municipal securities issued after June 1, 2002, with certain limited exceptions.[2] The MSRB anticipates that some transactions in below-minimum denomination amounts may continue to occur for issues issued prior to June 1, 2002, as well as under the limited exceptions to the proposed amendment to rule G-15.[3] In either case, the MSRB believes that any time a dealer is selling to a customer a quantity of municipal securities below the minimum denomination for the issue, the dealer should consider this to be a material fact about the transaction. The MSRB believes that a dealer’s failure to disclose such a material fact to the customer, and to explain how this could affect the liquidity of the customer’s position, generally would constitute a violation of the dealer’s duty under rule G-17 to disclose all material facts about the transaction to the customer. ENDNOTES 1 Occasionally,
bond documents may state a minimum transaction amount that applies only to
primary market transactions, but with a clear indication by the issuer that
transactions may occur at lower amounts in the secondary market. The
MSRB is not aware of non-authorized transaction amounts occurring for issues
of these types. In general, however, bond documents describing a
minimum “denomination” would appear to be intended to apply to both
primary and secondary market transactions. 2 Proposed rule change SR-MSRB-2001-07, filed with the Securities and Exchange Commission on October 16, 2001. 3 Even for municipal securities issued after June 1, 2002, below-minimum denomination transactions may need to be effected in compliance with proposed MSRB rule G-15(f) to liquidate below-minimum denomination positions created through the exercise of a will, division of a marital estate, as a result of an investor giving a portion of a position as a gift, etc. In addition, the exercise of a sinking fund or other partial redemption by an issuer can sometimes result in customers holding below-minimum denomination amounts. Interpretive Notice Regarding Rule G-17, on Disclosure of Material Facts March 20, 2002
Rule G-17, the MSRB’s
fair dealing rule, encompasses two general principles. First, the rule imposes a
duty on dealers[1]
not to engage in deceptive, dishonest, or unfair practices. This first prong of
rule G-17 is essentially an antifraud prohibition. Second, the rule imposes a duty to deal fairly. Statements
in the MSRB’s filing for approval of rule G-17 and the SEC’s order approving
the rule note that rule G-17 was implemented to establish a minimum standard of
fair conduct by dealers in municipal securities. In addition to the basic
antifraud prohibitions in the rule, the duty to “deal fairly” is intended to
“refer to the customs and practices of the municipal securities markets, which
may, in many instances differ from the corporate securities markets.”[2]
As part of a dealer’s obligation to deal fairly, the MSRB has interpreted
the rule to create affirmative disclosure obligations for dealers. The MSRB has
stated that dealer’s affirmative disclosure obligations require that a dealer
disclose, at or before the sale of municipal securities to a customer, all
material facts concerning the transaction, including a complete description of
the security. [3]
These obligations apply even when a dealer is acting as an order taker and effecting
non-recommended secondary market transactions. Rule G-17 was adopted many years prior to the adoption of
SEC Rule 15c2-12. The development of the NRMSIR system,[4]
the MSRB’s Municipal Securities Information Library® (MSIL®)
system[5]
and Transaction Reporting System (“TRS”),[6]
rating agencies and indicative data sources in the post-Rule 15c2-12 era have
created much more readily available information sources. Recently, the market
has made progress and market professionals (including institutional investors)
can, and do, go to these industry sources to find securities descriptive
information, official statements, rating agency ratings and reports, and ongoing
disclosure information. These developments suggest a need for further
explanation of what “disclosure of all material facts” means in today’s
market. Rule G-17 requires that dealers disclose to a customer at
the time of trade all material facts about a transaction known by the dealer. In
addition, a dealer is required to disclose material facts about a security when
such facts are reasonably accessible to the market. Thus, a dealer would be
responsible for disclosing to a customer any material fact concerning a
municipal security transaction 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 the type of municipal
securities at issue (collectively, “established industry sources”).
[7] The customs and practices of the industry suggest that the
sources of information generally used by a dealer that effects transactions in
municipal securities may vary with the type of municipal security. For example,
a dealer might have to draw on fewer industry sources to disclose all material
facts about an insured “triple-A” rated general obligation bond than for a
non-rated conduit issue. In addition, to the extent that a security is more
complex, for example because of complex structure or where credit quality is
changing rapidly, a dealer might need to take into account a broader range of
information sources prior to executing a transaction. With respect to primary offerings of municipal securities, the SEC has noted, “By participating in an offering, an underwriter makes an implied recommendation about the securities.” The SEC stated, “This recommendation itself implies that the underwriter has a reasonable basis for belief in the truthfulness and completeness of the key representations made in any disclosure documents used in the offerings.”[8] Similarly, if a dealer recommends a secondary market municipal security transaction, rule G-19 requires a dealer to “have reasonable grounds for the recommendation in light of information available from the issuer or otherwise.”[9] If this “reasonable basis” suitability cannot be obtained from the established industry sources, then further review may be necessary before making a recommendation. To the extent that such review elicits material information that would not have become known through a review of established industry sources, dealers recommending transactions would be obligated to disclose such information in addition to information available from established industry sources. ENDNOTES 1 The term “dealer” is used in this interpretive 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 interpretive notice does not imply that the entity is necessarily taking a principal position in a municipal security. 2 See Exchange Act Release No. 13987 (Sept. 22, 1977). 3 See e.g., Rule G-17 Interpretation—Educational Notice on Bonds Subject to “Detachable” Call Features, May 13, 1993, MSRB Rule Book (July 2001) at 129-130. The SEC described material facts as those “facts which a prudent investor should know in order to evaluate the offering before reaching an investment decision.” Municipal Securities Disclosure, Securities Exchange Act Release No. 26100 (September 22, 1988) (the “1988 SEC Release”) at note 76, quoting In re Walston & Co. Inc., and Harrington, Securities Exchange Act Release No. 8165 (September 22, 1967). Furthermore, the United States Supreme Court has stated that a fact is material if there is a substantial likelihood that its disclosure would have been considered significant by a reasonable investor. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976). 4 For purposes of this notice, the
“NRMSIR system” refers to the disclosure dissemination
system adopted by the SEC in SEC Rule 15c2-12. Under Rule
15c2-12, as adopted in 1989, participating underwriters
provide a copy of the final official statement to Nationally
Recognized Municipal Securities Information Repositories
(“NRMSIRs”) to reduce their obligation to provide a final
official statement to customers. In the 1994 amendments
to Rule 15c2-12 the SEC 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.
5 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. 6 The MSRB’s TRS collects and makes available to the marketplace information regarding inter-dealer and dealer-customer transactions in municipal securities. 7 Dealers operating electronic trading platforms have inquired whether providing electronic access to material information is consistent with the obligation to disclose information under rule G-17. The MSRB believes that the provision of electronic access to material information to customers who elect to transact in municipal securities on an electronic platform is generally consistent with a dealer’s obligation to disclose such information, but that whether such access is effective disclosure ultimately depends upon the particular facts and circumstances present. 8 1988 SEC Release at text following note 70. The SEC also stated that an underwriter must review the issuer’s disclosure documents for possible inaccuracies and omissions. In the case of a negotiated offering, the SEC expects the underwriter to make an inquiry into the key representations included in the disclosure materials. In the case of a competitive offering, the SEC acknowledges that the underwriter may have more limited opportunities to undertake such a review and investigation but nonetheless is obligated to take appropriate actions under the particular facts and circumstances of such offering. 9 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 (July 2001) at 134; In re F.J. Kaufman and Company of Virginia, 50 S.E.C. 164, 168, 1989 SEC LEXIS 2376, *10 (1989) (discussing “reasonable basis” suitability). Interpretive Notice Regarding the Application of MSRB Rules to Transactions with Sophisticated Municipal Market Professionals April 30, 2002 IntroductionIndustry 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 ProfessionalsNot 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:
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 ProfessionalsThe 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:
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:
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:
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 ObligationsThe 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. 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 TransactionsThe 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. ENDNOTES 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. Interpretive Reminder Notice Regarding Rule G-17, on Disclosure of Material Facts—Disclosure of Original Issue Discount Bonds January 5, 2005 The MSRB is publishing this notice to remind dealers of their affirmative disclosure obligations when effecting transactions with customers in original issue discount bonds. An original issue discount bond, or O.I.D. bond, is a bond that was sold at the time of issue at a price that included an original issue discount. The original issue discount is the amount by which the par value of the bond exceeded its public offering price at the time of its original issuance. The original issue discount is amortized over the life of the security and, on a municipal security, is generally treated as tax-exempt interest. When the investor sells the security before maturity, any profit realized on such sale is calculated (for tax purposes) on the adjusted book value, which is calculated for each year the security is outstanding by adding the accretion value to the original offering price. The amount of the accretion value (and the existence and total amount of original issue discount) is determined in accordance with the provisions of the Internal Revenue Code and the rules and regulations of the Internal Revenue Service. |