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Rule G-30
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Interpretive Notice on Pricing of Callable Securities August 10, 1979 The Municipal Securities Rulemaking Board (the "Board") has recently been considering various matters relating to transactions in municipal securities which may be called prior to maturity. In this connection, the Board filed with the Securities and Exchange Commission on June 6, 1979 certain proposed amendments to rule G-15 on customer confirmations. (See Notice G-15:79:4). These proposed amendments would require that additional information be shown on customer confirmations for transactions in callable securities. The Board also has a continuing concern in this area regarding the pricing of callable securities in sale transactions with customers. As explained below, the Board believes that certain pricing practices in such transactions may violate rule G-30, which requires municipal securities professionals to effect transactions at a fair and reasonable price. The Board is concerned primarily with the situation in which a municipal securities dealer sells callable securities to customers on the basis of a stated yield to a specified call feature, whether the sale is effected on the basis of a yield price or dollar price. In such cases, the dealer affecting the transaction may do so at a yield appropriate for securities of a comparable quality with a maturity date the same as, or close to, the date of possible exercise of the call feature. The securities are sold at a price which, in effect, assumes that the specific call feature will be exercised. If the call provision is not exercised, however, the customer may realize at maturity a yield on the securities which is substantially less than the yield of non-callable securities of similar quality and maturity. In certain instances, this differential may be quite significant. The Board therefore believes that a municipal securities dealer in pricing securities on the basis of yield to a specified call feature should take into account the possibility that the call feature may not be exercised. Accordingly, the price to be paid by a customer should reflect this possibility and the resulting yield to maturity should bear a reasonable relationship to yields on securities of similar quality and maturity. Failure to price securities in such manner may constitute a violation of rule G-30, since the price may not be "fair and reasonable" in the event the call feature is not exercised. The fact that a customer in these circumstances may realize a yield in excess of the yield at which the transaction was effected does not relieve a municipal securities professional of its responsibility under rule G-30. Republication of September 1980, Report on Pricing October 3, 1984 In September 1980, the Board issued a report on the establishment of pricing guidelines under rule G-30 on prices and commissions. At that time the Board discussed the relevant factors in determining the fairness of prices and specifically declined to adopt pricing guidelines. The Board is reprinting its Report on Pricing in response to inquiries indicating confusion whether there are pricing guidelines in effect for the municipal securities industry. Report on Pricing September 26, 1980 Rule G-30 requires municipal securities professionals to effect transactions with customers at fair and reasonable prices. In a notice dated January 4, 1980, the Board indicated its concern that additional guidance under the rule might be necessary and suggested that one possible course would be to develop specific numeric guidelines. The Board solicited the views of interested parties in the Notice regarding the desirability of taking such a course. As a point of departure for discussion, a "band" of 1 point to 2˝ points was put forth as a possible guideline. In addition to soliciting written comments, the Board also held several open meetings at which prepared statements were presented, and the Board discussed the subject directly with the audiences. These open meetings were held at the Dealer Bank Association Annual Meeting in Rancho Mirage, California (January 31), New York City (March 12), Kansas City, Missouri (April 14), and Seattle, Washington (July 16). After considering the comments of the industry and other interested persons in response to the Notice, the Board is of the view that setting specific numeric guidelines would not be feasible, in view of the heterogeneous nature of municipal securities transactions and municipal securities dealers. The Board believes that its goal in rule G-30 of promoting customer protection in the pricing area can be achieved through other means. The actions which the Board intends to take are set forth below. The Board believes that the comment process has served several worthwhile purposes. First, the Notice resulted in focusing the attention of the industry on the matter of pricing practices. The Board is of the view that one salutary effect of this has been to increase the sensitivity of individual municipal securities dealers to this important issue. Second, the comments of the industry served to identify and highlight various factors which may be relevant in making pricing determinations. Third, the comments provided important insights into pricing practices of the industry which should increase the understanding of the regulatory agencies and thereby prove valuable to them in conducting examinations. Finally, the comments were important in helping the Board decide on the actions it would take in the pricing area. Comments on Pricing Proposal The Board was extremely gratified by the extent of the response to the Notice. The Board received over 100 comment letters from different types of municipal securities dealers and from all sections of the country, as well as from other regulatory bodies and industry trade organizations. The comment letters in general reflected substantial deliberation and great care in preparation. In addition, commentators at the open meetings and at other meetings provided valuable input to the Board on this subject. The Board wishes to take this opportunity to express its appreciation to all of these commentators. Most of the commentators expressed opposition to the idea of developing specific numeric guidelines. They suggested that such guidelines would be impractical, inappropriate and unworkable in light of the heterogeneous nature of the municipal markets. In this regard, the commentators emphasized the many differences in the types of municipal securities transactions, the size of transactions, the quality and maturities of municipal securities, the nature of the services provided by municipal securities dealers and the pricing practices of municipal securities dealers in different areas. Many commentators also suggested that specific numeric guidelines would either be too restrictive and thus adversely affect the market for certain types of securities (e.g., local non-rated issues), or be too liberal and thus encourage prices higher than those which would result from the operation of market forces. Although the majority of the commentators expressed opposition to the establishment of guidelines, several commentators expressed support for them. They suggested that guidelines were necessary to provide municipal securities professionals and the regulatory agencies with greater certainty as to what constitutes a "fair and reasonable" price under rule G-30. Certain commentators endorsed the concept of pricing guidelines as a means of ensuring equal regulation of all participants in the municipal markets. Several commentators expressed support for the concept of guidelines, but suggested that the Board should adopt different benchmarks or separate sets of benchmarks for different size transactions or types of securities.[1] Others suggested that the benchmarks should be limited to "riskless" transactions, contemporaneous transactions, or both. Many commentators acknowledged that there may be a need to augment rule G-30, but opposed the development of pricing guidelines. These commentators suggested a variety of alternative approaches, several of which the Board intends to pursue. As indicated above, the Board believes that the comment process was of value because, among other reasons, it provided important insights into the pricing practices of the industry which should increase the understanding of the regulatory agencies and prove valuable to them in conducting examinations. In this connection, the Board intends to provide to the regulatory agencies copies of all the written comments and the transcripts of the open meetings. The Board will also provide copies of these materials to any other interested parties, upon request. Relevant Factors in Determining the Fairness of Prices Rule G-30 requires municipal securities professionals to charge customers fair and reasonable prices, taking into account all relevant factors, including several specifically enumerated in the rule. The factors cited in the rule are "the best judgment of the [municipal securities professional] as to the fair market value of the securities at the time of the transaction…, the expense involved in effecting the transaction, the fact that the [municipal securities professional] is entitled to a profit, and the total dollar amount of the transaction." In addition, the Board has identified and discussed in notices on Rule G-30 a number of other factors which might be relevant in determining the fairness and reasonableness of prices in municipal securities transactions. These factors include the availability of the security in the market, the price or yield of the security, the maturity of the security, and the nature of the professional’s business. See Notices dated September 20, 1977 and October 28, 1978. Of the many possible relevant factors, the Board continues to be firmly of the view that the resulting yield to a customer is the most important one in determining the fairness and reasonableness of price in any given transaction. Such yield should be comparable to the yield on other securities of comparable quality, maturity, coupon rate, and block size then available in the market. This point was stressed in the Notice. In the Notice, the Board specifically requested comment from the industry on the relevance of the factors previously identified by the Board, and solicited suggestions of other possible factors to be considered in making pricing determinations. Many commentators expressed agreement with the Board’s position that yield is of paramount importance in making pricing determinations, some of them even suggesting that it should be the only test. They emphasized the importance of comparing yields in view of the fact that most municipal securities are traded on a yield basis and suggested that focusing on yield, rather than on the amount of compensation, is appropriate.[2] Other factors noted by commentators included the rating of the securities involved in a transaction, the fact that there may be an active sinking fund for the securities, and the trading history. This last factor could encompass such matters as the degree of market activity for the securities and the existence or non-existence of market-makers in the securities. The single factor which was cited most often by commentators concerned the right of municipal securities dealers to be compensated for services provided to customers. The general thrust of these comments was that municipal securities dealers often expend considerable time, effort, and money in providing services to a customer, and that this ought to be taken into account in considering the fairness and reasonableness of prices in given transactions. These services may include researching credits, maintaining markets in, and current information about issues previously sold to customers, and other similar activities. The Board believes that all of the additional factors identified by the commentators and described above may be relevant in making pricing determinations in particular cases. ENDNOTES 1 One common misunderstanding shared by several commentators was that the pricing policy of the National Association of Securities Dealers, Inc. (the "NASD") for corporate securities (the so-called 5% policy) applies to municipal securities transactions. As a general matter, the NASD’s rules of fair practices do not apply to municipal securities transactions. Accordingly, the "5% policy" does not apply to municipal securities transactions. 2 The Board notes that the amendments to rule G-15 on customer confirmations which are scheduled to become effective on December 1, 1980 will significantly expand the yield information made available to customers with respect to their municipal securities transactions. The Board believes that this will assure broad dissemination of yield information on various types of securities, enhance a customer’s ability to compare yields among securities, and promote the use of yield information for purposes of price evaluation . Interpretive Notice on Commissions and Other Charges, Advertisements and Official Statements Relating to Municipal Fund Securities December 19, 2001 The Municipal Securities Rulemaking Board (“MSRB”) has received various inquiries regarding commissions, disclosures (including delivery of disclosure materials to the MSRB) and advertisements relating to municipal fund securities, particularly in connection with sales of interests in so-called Section 529 college savings plans.[1] The nature of the commissions and other program fees that may exist with respect to municipal fund securities may differ significantly from such charges that typically may exist for traditional debt securities sold in the municipal securities market. In many cases, commissions and other fees may more closely resemble those charged in connection with investment company securities registered under the Investment Company Act of 1940 (the “Investment Company Act”). [2] Although commissions and fees charged by brokers, dealers and municipal securities dealers (“dealers”) effecting transactions in municipal fund securities are subject to MSRB rules, the nature and level of fees and charges collected by other parties in connection with such securities generally are not subject to regulation. However, under certain circumstances, a dealer selling municipal fund securities may be obligated to disclose to customers such fees and charges collected by other parties. Amount of Dealer’s Commissions or Service Charges Rule G-30(b), on prices and commissions in agency transactions, prohibits dealers from selling municipal securities to a customer for a commission or service charge in excess of a fair and reasonable amount. In assessing the fairness and reasonableness of the commission or service charge, the rule permits the dealer to take into consideration all relevant factors, including the availability of the securities involved in the transaction, the expense of executing or filling the customer’s order, the value of the services rendered by the dealer, and the amount of any other compensation received or to be received by the dealer in connection with the transaction. The MSRB has received inquiries as to whether the sales charge schedule set out in Rule 2830 of the National Association of Securities Dealers, Inc. (“NASD”) applies to or otherwise is indicative of the levels of commissions and other fees that dealers may charge in connection with sales of municipal fund securities. MSRB rules, not those of the NASD, apply to sales by dealers of municipal securities, including municipal fund securities. NASD Rule 2830 provides that no member firm may offer or sell shares in investment companies registered under the Investment Company Act if the sales charges are excessive. The NASD rule then sets forth various levels of aggregate sales charges to which member firms must conform, depending upon the nature of the investment company’s sales charges, in order to ensure that such sales charges are not deemed excessive. The MSRB notes that the NASD derives its authority for the sales charge provisions of Rule 2830 from Section 22(b)(1) of the Investment Company Act, which expressly exempts such provisions from the limitation that Section 15A(b)(6) of the Securities Exchange Act of 1934 (the “Exchange Act”) places on the NASD’s ability to adopt rules that “impose any schedule or fix rates of commissions, allowances, discounts, or other fees to be charged by its members.” In sharp contrast, no exemption exists from the limitations that Section 15B(b)(2)(C) of the Exchange Act places on the MSRB’s ability to adopt rules that “impose any schedule or fix rates of commissions, allowances, discounts, or other fees to be charged by municipal securities brokers or municipal securities dealers.” The MSRB believes that it could not, by rule or interpretation, in effect impose such a schedule for the sale of municipal fund securities. Nonetheless, the MSRB believes that the charges permitted by the NASD under its Rule 2830 in connection with the sale of registered investment company securities may, depending upon the facts and circumstances, be a significant factor in determining whether a dealer selling municipal fund securities is charging a commission or other fee that is fair and reasonable. For example, the MSRB believes that charges for municipal fund securities transactions in excess of those permitted for comparable mutual fund shares under NASD Rule 2830 may be presumed to not meet the fair and reasonable standard under MSRB rule G-30(b), although the totality of the facts and circumstances relating to a particular transaction in municipal fund securities may rebut such presumption. Further, depending upon the specific facts and circumstances, a sales charge for a transaction in a municipal fund security that would be deemed in compliance with NASD Rule 2830 if charged in connection with a transaction in a substantially identical registered investment company security often will be in compliance with rule G-30(b). However, the NASD schedule is not dispositive nor is it always the principal factor in determining compliance with rule G-30. The MSRB believes that the factors enunciated in rule G-30(b) and other relevant factors must be given due weight in determining whether a commission is fair and reasonable. These factors include, but are not limited to, the value of the services rendered by the dealer and the amount of any other compensation received or to be received by the dealer in connection with the transaction from other sources (such as the issuer). A dealer may not exclusively rely on the fact that its commissions fall within the NASD schedule, particularly where commission levels in the marketplace for similar municipal fund securities sold by other dealers providing similar levels of services are generally substantially lower than those charged by such dealer, taking into account any other compensation. Disclosure of Program Fees and Charges of Other Parties MSRB rules do not explicitly require disclosure by dealers of fees and charges received by other parties to a transaction. These can include, among other things, administrative fees of the issuer, investment adviser and other parties payable from trust assets or directly by the customer. However, depending upon the facts and circumstances, certain MSRB rules may have the practical effect of requiring some level of disclosure of such fees and charges to the extent that they are material. For example, rule G-32(a)(i) generally obligates the dealer to provide an official statement to its customer in connection with sales of municipal fund securities. Although MSRB rules do not govern the content of the disclosures included by the issuer in the official statement, the MSRB believes that an official statement prepared by an issuer of municipal fund securities that is in compliance with Exchange Act Rules 10b-5 and 15c2-12 generally would provide disclosure of any fees or other charges imposed in connection with such securities that are material to investors. The MSRB further believes that, in most respects, the disclosures provided by the issuer in the official statement would provide the dealer with the type of information it is required to disclose to customers under the MSRB’s fair dealing rule, rule G-17. Advertisements Dealer advertisements of municipal fund securities must comply with the requirements of rule G-21. [3] This rule prohibits dealers from publishing advertisements concerning municipal securities which they know or have reason to know are materially false or misleading. The MSRB has previously stated that any use of historical yields in an advertisement would be subject to this prohibition. Thus, a dealer advertisement of municipal fund securities that refers to yield typically would require a description of the nature and significance of the yield shown in the advertisement in order to assure that such advertisement is not false or misleading. Further, depending upon the facts and circumstances, a dealer may be required to disclose information regarding a fee or other charge relating to municipal fund securities that may have a material effect on such advertised yield, to the extent that such disclosure is necessary to ensure that the advertisement is not materially false or misleading with respect to such yield. The MSRB understands that advertisements and other sales material relating to registered investment company securities are, depending upon the nature of the advertisement, subject to the requirements of Securities Act Rule 156, on investment company sales literature, Securities Act Rule 482, on advertising by an investment company as satisfying requirements of section 10, and NASD Rule 2210, on communications with the public (including IM-2210-3, on use of rankings in investment companies advertisements and sales literature), among others. The MSRB notes that both Securities Act Rule 156(a) and NASD Rule 2210(d)(1)(A) include general standards for advertisements that are substantially the same as the standard set forth in MSRB rule G-21. As a result, the MSRB believes that a dealer advertisement of municipal fund securities that would be compliant with Securities Act Rules 156 and 482 if such securities were registered investment company securities also would be in compliance with MSRB rule G-21. Further, the MSRB believes that a dealer advertisement of municipal fund securities that would be compliant with NASD Rule 2210 and IM-2210-3 if such securities were registered investment company securities also would be in compliance with MSRB rule G-21. Submission of Official Statements to the MSRB Dealers selling municipal fund securities are subject to the requirement under rule G-36 that they submit copies of the official statement, together with completed Form G-36(OS), to the MSRB. In some cases, a dealer that has been engaged by an issuer of municipal fund securities to serve as its primary distributor (“primary distributor”) has in turn entered into relationships with one or more other dealers to provide further channels for distribution. These other dealers may include dealers that effect transactions directly with customers (“selling dealers”) or dealers that provide “wholesale” distribution services but do not effect transactions directly with customers (“intermediary dealers”). The MSRB believes that, regardless of whether a formal syndicate or similar account has been formed among a primary distributor, the selling dealers and any intermediary dealers in a multi-tiered distribution system for a particular offering of municipal fund securities, the primary distributor for such offering has the responsibility set forth in rule G-36(f) to undertake all actions required under the provisions of rule G-36 and the corresponding recordkeeping requirements under rule G-8(a)(xv). These obligations include, but are not limited to, the submission of official statements (including amendments and up-dates) and completed Form G-36(OS) to the MSRB on a timely basis. The MSRB further believes that any selling or intermediary dealers for such offering that might be considered underwriters of the securities may rely upon the primary distributor to undertake these actions to the same extent as if they had in fact formed an underwriting syndicate as described in rule G-36(f). ENDNOTES 1 Section 529 college savings plans are higher education savings plan trusts established by states under section 529(b) of the Internal Revenue Code as “qualified state tuition programs” through which individuals make investments for the purpose of accumulating savings for qualifying higher education costs of beneficiaries. [2] Municipal fund securities are exempt from the registration and other provisions of the Investment Company Act. 3 Rule G-21 defines advertisement as any material (other than listings of offerings) published or designed for use in the public, including electronic, media or any promotional literature designed for dissemination to the public, such as notices, circulars, reports, market letters, form letters, telemarketing scripts or reprints or excerpts of the foregoing. The term does not apply to official statements but does apply to abstracts or summaries of official statements, offering circulars and other similar documents prepared by dealers. Review of Dealer Pricing Responsibilities January 26, 2004 This notice reviews the fair pricing requirements of MSRB Rules G-18 and G-30 and discusses their application in light of the MSRB's review of certain transaction patterns that have appeared in the MSRB's Transaction Reporting System. The patterns, which show abnormally large price variance in a relatively small number of issues each day, suggest that brokers, dealers and municipal securities dealers (collectively, “dealers”) may not always be making the requisite efforts to ensure that transaction prices are reasonably related to market value. RULES G-18 AND G-30Rules G-18 and G-30 apply to customer transactions regardless of whether the dealer is buying or selling municipal securities. Rule G-18 covers agency transactions and Rule G-30 covers principal transactions, using different formulations that reflect differences between the two types of trades. As a practical matter, the investor protection function of the two rules does not differ depending on whether the dealer effected the trade on an agency or principal basis. As may be seen from the description of the rules below, the dealer in each case must exercise diligence in establishing the market value of the security and the reasonableness of the compensation received on the transaction. Agency Transactions Effected on Behalf of Customers Rule G-18 states that a dealer effecting an agency transaction on behalf of a customer must undertake “a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions.”[1] In adopting the rule, the MSRB noted that this standard means that a dealer, as a market professional, “will exercise the same level of care as the professional would if acting for its own account, including the exercise of diligence in ascertaining prevailing market conditions.”[2] In the context of effecting agency trades for a customer, the dealer either will need to know the current market value of the security, or will have to use diligence in the attempt to ascertain it. If this is not done, it is not possible to exercise the requisite level of care in finding a price for the customer that is fair and reasonable in relation to prevailing market conditions. Dealer compensation in agency transactions, which is taken in the form of a commission charged by the dealer, is not addressed in Rule G-18. Instead, commissions are addressed in Rule G-30(b). This rule states that the commission must not be in excess of a fair and reasonable amount, taking into account all relevant factors. The MSRB has noted that a variety of factors may affect the fairness and reasonableness of a commission.[3] Principal Transactions with Customers Rule G-30(a) states the pricing responsibility in principal transactions between dealers and customers. The rule states that the aggregate transaction price to the customer must be fair and reasonable, taking into consideration all relevant factors. The concept of a “fair and reasonable” price includes the concept that the price must “bear a reasonable relationship to the prevailing market price of the security.”[4] Dealer compensation on a principal transaction is considered to be a mark-up or mark-down that is computed from the inter-dealer market price prevailing at the time of the customer transaction. As part of the aggregate price to the customer, mark-up or mark-down also must be a fair and reasonable amount, taking into account all relevant factors. Rule G-30(a) and interpretative notices on the rule have identified a number of factors that may be relevant to the determination of whether the aggregate transaction price is fair and reasonable, including any commission, mark-up or mark-down. Some of these factors relate primarily to the dealer compensation component of the transaction (e.g., the nature and extent of services provided by the dealer); others relate primarily to the question of market value (e.g., existence of a sinking fund; the rating of the security).[5] The MSRB has stated that the most important factor in determining whether the aggregate price to the customer is fair and reasonable is that the yield should be comparable to the yield on other securities of comparable quality, maturity, coupon rate, and block size then available in the market.[6] Reasonable Compensation Not Same as Fair Pricing It is important to note that the fair pricing responsibilities of dealers require attention both to the market value of the security as well as to the reasonableness of compensation. Excessive commission, mark-up or mark-down obviously may cause a violation of the fair pricing standards described above. However, it is also possible for a dealer to restrict its profit on transactions to reasonable levels and still violate Rule G-18 or Rule G-30 because of inattention to market value. For example, a dealer may fail to assess the market value of a security when acquiring it from another dealer or customer and in consequence may pay a price well above market value. It would be a violation of fair pricing responsibilities for the dealer to pass on this misjudgment to another customer, as either principal or agent, even if the dealer makes little or no profit on the trade. Inter-Dealer and Broker's Brokers Transactions The fair pricing responsibilities discussed above reflect the normal relationship between a dealer, who is a market professional, and a customer, who generally is not. The rules contemplate that the customer may legitimately rely on the dealer to use its market expertise to ensure that the customer's price is reasonably related to market value. This responsibility present in dealer-customer transactions does not necessarily extend to inter-dealer transactions. Dealers are entitled to expect that other dealers will act in a professional manner in pursuit of their own interests and in compliance with their own obligations under MSRB rules and other applicable laws, rules and regulations. This includes the duty of each dealer not to act in an unfair, deceptive or dishonest manner in an inter-dealer transaction.[7] However, with the exception noted below, the special fair pricing responsibilities found in Rules G-18 and G-30 do not apply to inter-dealer transactions. Some broker's brokers' transactions present an exception to the general rule for inter-dealer transactions. When a broker's broker undertakes to act for or on behalf of another dealer – either by finding a buyer for the dealer's securities or finding securities that the dealer wishes to buy – a special relationship is created. This differs from situation normally found in other inter-dealer trading, where each party is acting in its own interest. Rule G-18 accordingly provides that, when acting for or on behalf of another dealer, the broker's broker must meet the same Rule G-18 standard as a dealer effecting an agency trade for a customer. This means that the broker's broker must use “reasonable effort” to find a price that is fair and reasonable in light of prevailing market conditions for the security and must employ the same care and diligence in doing so as if the transaction were being done for its own account. As in the case of dealer transactions with customers, the broker's broker will need to know the current market value of the security, or use requisite diligence in the attempt to ascertain it. The MSRB previously has noted that it is possible for a broker's broker explicitly to limit the extent of the services it offers so that this fair pricing duty does not exist.[8] In that case, however, the dealers using the broker's broker should be well aware that the broker's broker's role is limited and that the broker's broker has not undertaken the responsibility to find a price reasonably related to market value. LARGE INTRA-DAY PRICE DIFFERENTIALSThe advent of the MSRB's Transaction Reporting System has provided market professionals as well as investors and other interested parties with unprecedented access to comprehensive information on municipal securities transaction prices. The transaction data provided by the MSRB's Transaction Reporting System includes “net” prices of dealer-customer transactions,[9] as well as inter-dealer and broker's brokers' transaction prices. The data also has allowed the MSRB and other regulators, such as the Securities and Exchange Commission (“SEC”) and NASD, to review pricing practices in a way that previously was impossible. The transaction data shows that most municipal securities trade within reasonably narrow price ranges during each trading day. However, a relatively small number of issues each day trade with intra-day differentials (difference between high and low price of the day) that are abnormally wide. The municipal securities issues involved in these situations differ from day to day and, while they represent a very small minority of the average 10,000 issues traded each day, they are sufficiently problematic to require regulatory review. Causes of Large Intra-Day Price Differentials There appear to be several reasons for large intra-day price differentials. Data input errors made by dealers are a primary cause of large differentials in reported prices. The MSRB and NASD are working with dealers to emphasize the importance of submitting trade data in a timely and accurate manner and improving compliance with Rule G-14, on transaction reporting. The MSRB provides several services to assist dealers in monitoring the accuracy and timeliness of their trade reporting.[10] Breaking news about an issue of municipal securities, or a class of municipal securities (e.g., airport bonds or tobacco bonds), also can result in large intra-day price differentials. This can be either because the market value of an issue changes dramatically during the day, or, if there are multiple dealers trading the bonds, because of differences in how those dealers interpret the news. Price differentials in an issue also can be created when material facts relevant to the market value of an issue reach some market participants before others.[11] The Real Time Transaction Reporting System to be implemented by the MSRB in January 2005 will allow market participants to monitor market price levels on a real-time basis.[12] This should assist dealers in recognizing and reacting more quickly when news events and material events are affecting market prices. “Transaction Chains” A frequent scenario in large intra-day price differentials occurs when a single block of securities moves through a “chain” of transactions during the day. The securities involved in these scenarios often are infrequently traded issues with credits that are relatively unknown to most market participants. In a typical case, the transaction chain starts with a dealer buying securities from a customer, usually in a “retail” size block of $5,000 to $100,000. The securities are then sold through a broker's broker. Two or more inter-dealer transactions follow, with a final sale of the securities being made by a dealer to a customer. In certain cases, the difference between the price received by the selling customer and the price received by the purchasing customer is abnormally large, exceeding 10% or more. In reviewing such transaction chains, it often appears that the two dealers effecting trades with customers at each end of the chain – one dealer purchasing from a customer and the other selling to a customer – did not make excessive profits on their trades. Instead, the abnormally large intra-day price differentials can be attributed in major part to the price increases found in the inter-dealer trading occurring after the broker's broker's trade. FAIR PRICING RESPONSIBILITIES AND LARGE PRICE DIFFERENTIALSThe application of MSRB fair pricing rules to some of the situations creating large price differentials are discussed below. Application of Rules G-18 and G-30 to Transaction Chains When a transaction chain results in a large difference between the price received by one customer and the price paid by another customer for the same block of securities on the same day, and there is no news accounting for the price volatility, the question is raised whether each of these customers received a price reasonably related to the market value of the security. This question in turn raises the issue of whether the dealers effecting the customer transactions (and any broker's brokers that may have acted on behalf of such dealers) made sufficient effort to establish the market value of the security when effecting their transactions. Problematic transaction chains can begin when a customer asks a dealer to liquidate a position in a security with which the dealer is unfamiliar. The dealer in such a case may not immediately be aware of the market value of this security. The dealer may simply provide the customer with an offer that the customer can accept or reject, or the dealer may go to a broker's broker to have a bid-wanted procedure conducted, ultimately executing a riskless principal trade between the customer and the broker's broker if the customer wishes to go through with the trade. It should be noted that, in either case, the dealer retains the ultimate responsibility to its customer to ensure that the customer's price is reasonably related to market value. Hard-to-Value Securities Many municipal securities issues are small in size and infrequently traded. For some of these issues, it may be difficult to obtain timely and reliable information on the features of the issue or its credit quality. These factors may make it difficult for a dealer or a broker's broker to determine market value with precision and may require that the assessment of market value be in the form of a wider range of values than would be possible for well-known, more liquid issues. Although it is expected that the intra-day price differentials for obscure and illiquid issues might generally be larger than for more well-known and liquid issues, dealers nevertheless should be cognizant of their duty to establish market value as accurately as possible using reasonable diligence. The specific degree of accuracy to which that market value can be determined will depend on the facts and circumstances of the particular issue and transaction, including such factors as the nature of the security, available information on the issue, etc. The specific actions that a dealer may need to take to assess market value may also vary with the facts and circumstances. When a dealer is unfamiliar with a security, the efforts necessary to establish its value may be greater than if the dealer is familiar with the security. The lack of a well-defined and active market for an issue does not negate the need for diligence in determining the market value as accurately as reasonably possible when fair pricing obligations apply. A dealer or broker's broker may need to review recent transaction prices for the issue, and/or transaction prices for issues with similar credit quality and features as part of the duty to use diligence to determine the market value of municipal securities. When doing this, the dealer often will need to use its professional judgment and market expertise to identify comparable securities and to interpret the bearing of recent transaction prices on the value of the block of municipal securities in question. If the features and credit quality of the issue are not known, it also may be necessary to obtain information on these factors directly or indirectly from “an established industry source.”[13] For example, the current rating or other information on credit quality, the specific features and terms of the security, and any material information about the security such as issuer plans to call the issue, defaults, etc., all may affect the market value of securities. Use of Bid-Wanted Procedures Bid-wanted procedures are widely relied on by broker's brokers and, in turn, by the dealers that use broker's brokers, to find a buyer for securities. A widely disseminated and properly run bid-wanted procedure will offer important and valuable information on the market value of an issue. The effectiveness of this process in obtaining the true market value of a security, however, may vary depending on the nature of the security and how the procedure is conducted. A bid-wanted procedure is not always a conclusive determination of market value. Therefore, particularly when the market value of an issue is not known, a dealer (or a broker's broker subject to the requirements of Rule G-18) may need to check the results of the bid wanted process against other objective data to fulfill its fair pricing obligations, as noted above. ENDNOTES [1] If the dealer's customer is a “sophisticated municipal market professional,” special rules apply, which are not covered in this notice. See Interpretive Notice Regarding the Application of MSRB Rules to Transactions with Sophisticated Municipal Market Professional, April 30, 2002 (the “SMMP Notice.”) [2] See Notice of Approval of Fair Practice Rules, October 24, 1978, CCH Transfer Binder 1977-1987, para 10,090 (“Notice of Approval of Fair Practice Rules”). [3] Rule G-30(b) provides the following non-exclusive list of factors relevant to commissions:
Additional factors also have been noted. See footnote 5 and accompanying text, infra. [4] See Notice of Approval of Fair Practice Rules, supra note 2. [5] Other factors identified include: • The service provided and expense involved in effecting the transaction; [6] Rule G-30(a) also explicitly lists as a relevant factor “the best judgment of the [dealer] as to the fair market value at time of transaction and of any securities exchanged or traded in connection with the transaction.” [7] The MSRB previously has noted that a dealer may violate Rule G-17 on fair practice in certain trading situations. For example, the MSRB has observed that non-disclosure of information regarding an unusual material feature of a security that is not accessible to the marketplace and is intentionally withheld by a dealer selling a security to another dealer may, depending upon all the relevant facts and circumstances, constitute a violation of Rule G-17. See, e.g., SMMP Notice, footnote 1, supra. [8] See SMMP Notice, footnote 1, supra, at note 9. [9] “Net” prices include the effect of commission, mark-up, or mark-down. [10] Dealers seeking to obtain information about their error rates can find information on how to do so at the MSRB's Web site at www.msrb.org under the Transaction Reporting menu. [11] The MSRB has recognized the need for an improved disclosure system in the municipal securities industry. In 1998 and 2001, the MSRB sponsored disclosure conferences to bring together representatives of various industry sectors to discuss the state of disclosure in the market. In 2001, the MSRB invited representatives of all major market groups to participate in the “Muni Council” with the objective of improving the disclosure system. The MSRB notes that the Muni Council is making progress in planning an improved system for dissemination of secondary market disclosure documents. The MSRB is hopeful that the Muni Council's efforts will result in a more efficient and comprehensive mechanism for such disclosure documents to reach market participants. [12] See, e.g., “Real-Time Transaction Reporting: Revised Schedule and Operational Plan,” MSRB Notice 2003-44 dated December 11, 2003, on www.msrb.org. [13] For a discussion of “established industry sources” for information on municipal securities, see the SMMP Notice, footnote 1, supra. CROSS-REFERENCES
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