Background

Representatives of brokers, dealers and municipal securities dealers (collectively, “dealers”) have increasingly inquired about the application of certain Municipal Securities Rulemaking Board (MSRB) rules to managed accounts in which a registered investment adviser (“RIA”) is exercising discretion to buy and sell municipal securities on behalf of the account holder. Specifically, dealers have asked whether, with respect to these transactions, they are expected to:
 

1) Provide the time-of-trade disclosures required by MSRB Rule G-47 to the ultimate investor, who is the account holder (i.e., the RIA’s client), particularly if the dealer does not know the identity of the investor; and

2) Obtain a customer affirmation from such an investor for purposes of qualifying the person, separately, as a sophisticated municipal market professional (“SMMP”) under MSRB Rule D-15, and owing the modified obligations under MSRB Rule G-48, on transactions with SMMPs, if the RIA is itself an SMMP.[1]
 

This notice provides background information on the relevant rules, analyzes the questions presented and provides interpretive guidance in response.

Relevant Rules

The principal rules relevant to these interpretive questions are Rules G-47, D-15, and G‑48.

MSRB Rule G-47 – Time of Trade Disclosure

Rule G-47 sets forth the general time-of-trade disclosure obligation applicable to dealers. Specifically, pursuant to Rule G-47, a dealer cannot sell municipal securities to a customer, or purchase municipal securities from a customer, without disclosing to the customer, at or prior to the time of trade, all material information known about the transaction and material information about the security that is reasonably accessible to the market. The rule applies regardless of whether the transaction is unsolicited or recommended, occurs in a primary offering or the secondary market, and is a principal or agency transaction. The disclosure can be made orally or in writing.

Information is “material” if there is a substantial likelihood that the information would be considered important or significant by a reasonable investor in making an investment decision. The rule defines “reasonably accessible to the market” as information that is made available publicly through “established industry sources.”[2] Finally, the rule defines “established industry sources” as including EMMA, rating agency reports, and other sources of information generally used by dealers that effect transactions in the type of municipal securities at issue. Under these standards, “material information” encompasses a complete description of the security, which includes a description of the features that would likely be considered significant by a reasonable investor, and facts that are material to assessing potential risks of the investment.

MSRB Rule D-15 – Sophisticated Municipal Market Professional

Rule D-15 defines the set of customers that may be SMMPs” as (1) a bank, savings and loan association, insurance company, or registered investment company; (2) an RIA; or (3) any other person or entity with total assets of at least $50 million. To qualify as an SMMP under the rule, the dealer must have a reasonable basis to believe the customer is capable of independently evaluating investment risks and market value, in general and with respect to particular transactions and investment strategies in municipal securities. In addition, the customer is required to affirm that it is exercising independent judgment in evaluating the quality of execution of the customer’s transactions by the dealer. Further, the customer is required to affirm that it is exercising independent judgment in evaluating the transaction price in non-recommended agency secondary market transactions where the dealer’s services are explicitly limited to providing anonymity, communication, order matching and/or clearance functions, and the dealer does not exercise discretion as to how or when the transactions are executed. Finally, the customer is required to affirm that it has timely access to “material information” available publicly from “established industry sources” as those terms are defined in Rule G-47. The customer affirmation may be given orally or in writing, and may be given on a transaction-by-transaction basis, a type-of-municipal security basis, an account-wide basis or a type-of-transaction basis.

Importantly, the definition of SMMP under Rule D-15 is not self-executing, nor are the contingencies for its application solely controlled by the dealer. Rather, classification as an SMMP requires the customer to make the affirmation noted above. Consequently, any customer, even if otherwise qualifying as an SMMP, could choose not to make the affirmation in order to obtain the benefits of those obligations that otherwise would be modified (e.g., best execution). Overall, the customer affirmation requirement is designed to ensure that SMMPs have affirmatively and knowingly agreed to forgo certain protections under MSRB rules.

MSRB Rule G-48 – Transactions with Sophisticated Municipal Market Professionals

Rule G-48 addresses modified obligations of dealers when dealing with SMMPs. It relieves dealers of the time-of-trade disclosure obligation under Rule G-47 for information reasonably accessible to the market, the pricing obligations under MSRB Rule G-30 under certain circumstances,[3] the customer-specific suitability obligation under MSRB Rule G-19,[4] certain obligations with respect to the dissemination of quotations under MSRB Rule G-13,[5] and the best-execution obligation under Rule G-18.[6]

Interpretive Guidance

The rules referenced above, including Rule G-48 on certain modified obligations, are, or relate to the application of, various investor/customer protections. As such, a threshold approach to the interpretive questions is to focus on who the dealer’s customer is, and, thus, to whom the dealer owes these protections when an RIA has full discretion over investor clients’ accounts.

According to past guidance, there are facts and circumstances under which the MSRB considers the RIA, and not the underlying investors, to be the dealer’s customer. When an independent investment adviser (including an RIA) purchases securities from one dealer and instructs that dealer to make delivery of the securities to other dealers where the investment adviser’s clients have accounts, and the identities of individual account holders are not given to the delivering dealer, the investment adviser is the customer of the dealer and must be treated as such for recordkeeping and other regulatory purposes.[7] Accordingly, in those scenarios, the dealer does not have any customer obligations to the underlying investors.

Even if the underlying investors are, or are considered to be, customers of the dealer, the MSRB interprets Rule G-48 to mean, under certain circumstances, that the obligations modified by that rule are modified with respect to the underlying investors, as well as the RIA that is an SMMP. Specifically, when an investor has granted an RIA full discretion to act on the investor’s behalf for all transactions in an account, the RIA has effectively become that investor for purposes of the application of Rule G-48 when engaging in transactions with the dealer. Therefore, if that RIA is an SMMP, to whom the dealers’ obligations are modified under Rule G-48, then, for purposes of complying with the rules addressed in Rule G-48, the dealer should not be required to satisfy any greater or additional obligations with respect to the ultimate investor who holds that account. When the MSRB included RIAs in the set of customers that may be SMMPs, it was, of course, aware that RIAs typically act on behalf of third-party clients. It would have been anomalous for Rule G-48 to modify the dealers’ obligations to an RIA that is an SMMP, only essentially to re-impose them on the dealer with respect to the underlying investors who have given the RIA full discretion to act on their behalf.

This interpretation, under which dealer obligations to certain investors would be modified, is supported by the existence (where the conditions of the interpretation are met) of substantially similar federal and/or state obligations. For example, RIAs registered with the SEC are subject to the Investment Advisers Act of 1940 (“Advisers Act”) and the rules thereunder, including a fiduciary duty extending to all services undertaken on behalf of clients.[8] Obligations flowing from the fiduciary duty, include, but are not limited to, the requirements to: 

• Provide full disclosure of material facts, including conflicts of interest and disciplinary events and precarious financial condition;[9]
• Give suitable advice;[10]
• Have a reasonable basis for recommendations;[11] and
• Meet best-execution obligations.[12]

These and other investor protections provided by the regulatory regime under the Advisers Act reduce the need for the similar investor protections provided by time-of-trade disclosure, customer-specific suitability, best execution and the other obligations required by MSRB rules but modified under Rule G-48.[13] Additionally, where an investor has affirmatively and in writing authorized the RIA to exercise full discretion in the investor’s account, the investor has delegated decision-making authority over what to buy and sell in the account. Finally, the MSRB notes that, where the RIA is an SMMP, the RIA has affirmed and the dealer has a reasonable basis to believe that the RIA has the sophistication to obviate the need for the protections flowing from the obligations modified under Rule G-48, which the MSRB believes is also indicative of the RIA’s ability to provide similar protections to its clients when a dealer is not required to do so. When combining the investor protections afforded by substantially similar federal or state regulatory requirements for RIAs, the full discretionary power affirmatively provided to an RIA, and the RIA’s status as an SMMP, there is sufficient protection afforded to the account holders, who are the RIA’s clients, and, therefore, for purposes of the application of the rules modified by Rule G-48, dealers do not owe these underlying account holders any greater or additional obligations than those which apply to the RIA.[14]

Overview

MSRB Rule G-47, on time of trade disclosure, requires brokers, dealers and municipal securities dealers (collectively, “dealers”) to disclose to their customers, at or prior to the time of trade, all material information known about the transaction, as well as material information about the municipal security that is reasonably accessible to the market. The MSRB has previously provided interpretive guidance, now codified in supplementary material to Rule G-47, on specific types of information that is material where specific scenarios occur and requires time of trade disclosure. Rule G-47, however, emphasizes that this list of specific disclosures is not exhaustive, and that other information may be material to a customer and required to be disclosed. The MSRB is publishing this notice to state its interpretation that the fact that a municipal security bears market discount is material information that must be disclosed to a customer under Rule G-47.

Market Discount

When a municipal security is acquired in the secondary market for less than par value, the security may have “market discount.” The amount of market discount is equal to the excess, if any, of the stated redemption price at maturity over the basis of the security immediately after its purchase by the investor. Market discount occurs when the value of a municipal security declines after its issue date—which often may occur due to a rise in interest rates. The fact that a municipal security bears market discount may significantly affect its tax treatment. Under federal tax law, for bonds purchased after April 30, 1993, the market discount is taxed at the investor’s ordinary income tax rate, rather than the capital gains rate.[1]

Original Issue Discount Bonds. Market discount is calculated differently for original issue discount (OID) bonds. An OID 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 bond’s stated redemption price at maturity exceeded its public offering price at the time of its original issuance and, for a tax-exempt municipal security, is generally treated as tax-exempt interest.[2]

Market discount exists for an OID bond when the bond is acquired in the secondary market for less than its revised or adjusted issue price. The revised or adjusted issue price for an OID bond is equal to the bond’s original issue price plus the accrued OID up to the date of purchase. The amount of market discount is equal to the excess, if any, of the revised issue price over the basis of the bond immediately after its purchase by the investor.

De Minimis Rule. Bonds with a de minimis amount of market discount are subject to more favorable tax treatment than bonds with a non-de minimis amount of market discount. Under the de minimis rule, if the amount of market discount is less than one-fourth of 1% (.0025) of the stated redemption price of the bond multiplied by the number of complete years from the date of purchase to the date of maturity, the market discount is de minimis and is generally taxed as a capital gain, rather than ordinary income.

Market Discount Disclosure at or Prior to the Time of Trade

As noted, Rule G-47 requires dealers to disclose to their customers, at or prior to the time of trade, “all material information known about the transaction, as well as material information about the security that is reasonably accessible to the market.”[3] This disclosure obligation applies whether the transaction is unsolicited or recommended, and whether it is a primary offering or secondary market transaction. Information is considered to be material under Rule G-47 if there is a substantial likelihood that the information would be considered important or significant by a reasonable investor in making an investment decision. The MSRB has previously stated, and codified as supplementary material to Rule G-47, that the fact that a municipal security bears an original issue discount is material information that dealers are obligated to disclose, because it may affect the tax treatment of the security.[4] Significantly, in explaining this interpretation of the Board’s rules, the MSRB noted that appropriate disclosure of a security’s original issue discount feature should assist customers in computing the market discount or premium on their transaction. The MSRB also noted its concern that, absent adequate disclosure of a security’s original issue discount status, an investor might not be aware that all or a portion of his or her investment return represented by accretion of the discount is tax-exempt, and might therefore, for example, sell the security at an inappropriately low price (i.e., a price not reflecting the tax-exempt portion of the discount). 

Similarly, the MSRB is concerned that, absent adequate disclosure that a security has market discount, an investor might not be aware that all or a portion of his or her investment return represented by accretion of the market discount is taxable as ordinary income, and therefore might, for example, purchase the securities at an inappropriately high price (i.e., a price not reflecting the potentially higher tax rate applicable to the discount). The existence of market discount may impact an investor’s decision to purchase or sell an affected bond or determination of what price to pay or accept for such bond. As a result, the MSRB believes that the fact that a security has market discount is material information that is required to be disclosed to a customer under Rule G-47 at or prior to the time of trade.

Q: Dealers are required to include time of trade (along with trade date) on all transaction reports. What is “time of  trade?”

A: Transaction reporting procedures define “time of trade” as the time at which a contract is formed for a sale or purchase of municipal securities at a set quantity and set price.[1] For transaction reporting purposes, this is considered to be the same as the time that a trade is “executed.” The time that the trade is executed is not necessarily the time that the trade information is entered into the dealer’s processing system. For example, if a trade is executed on a trading desk but not entered for processing until later, the time of execution (not the time of entering the record into the processing system) is required to be reported as the “time of trade.” Similarly, when a dealer executes a transaction outside of the RTRS Business Day,[2] the time the trade was executed (rather than the time that the trade report is made) is the “time of trade” required to be reported.

2. Q: What is “time of trade” for new issue securities?

A: For new issue securities, a transaction effected on a “when, as and if issued”[3] basis cannot be executed, confirmed and reported until the municipal security has been formally awarded by the issuer. For a negotiated issue, this “time of formal award” is defined as the time of the signing of the bond purchase agreement and for a competitive issue, it is the time of the official award by the issuer. While dealers may take orders for securities and make conditional trading commitments prior to the award, dealers cannot execute transactions, send confirmations or make a trade report prior to the time of formal award. Once a new issue of municipal securities has been formally awarded, trade executions can begin. The time of execution is then reported to the MSRB.[4]

3. Q: There is a non-transaction-based compensation special condition indicator (NTBC indicator) for customer transactions. Is the NTBC indicator to be used only on customer transactions executed in a wrap fee account?

A: No, while transactions that occur in a wrap fee account may be one example of a transaction that qualifies as a customer transaction with no transaction-based dealer compensation component, the NTBC indicator is intended to distinguish all customer transactions that do not include a transaction-based compensation component from those transactions that do include a mark-up, mark-down or commission. Dealers should carefully consider other transactions that may require this indicator, such as those in which the dealer receives a remarketing fee, or a transaction often referred to as an “accommodation” that does not include a transaction-based dealer compensation component.

4. Q: Is the NTBC indicator to be used only on customer trades executed on a principal basis?

A: No. The NTBC indicator applies to both principal and agency trades. It is important for dealers to affirmatively indicate the transactions where a principal transaction does not include a mark-up or mark-down and an agency trade does not include a commission.

5. Q: Is the NTBC indicator to be used only on retail customer accounts?

A: No. There is no exemption for transactions with Sophisticated Municipal Market Professionals (SMMPs). The NTBC indicator is determined on a transaction basis and is to be used on any customer transaction to which it applies.

6. Q: What is the purpose of identifying an inter-dealer trade executed with or using the services of an alternative trading system (ATS)?

A: The purpose of the indicator is to better ascertain the ex- tent to which ATSs are used in the municipal market and to indicate to market participants information that the services of an ATS were used in executing the inter-dealer transaction.

7. Q: If a counterparty does not use the ATS indicator, will the two dealers’ transaction submission still match on the NSCC Real-Time Trade Matching (RTTM)?

A: Yes. The ATS indicator is not a matching value for RTTM. As noted in the MSRB’s Specifications for Real-Time Reporting of Municipal Securities Transactions, a new error code (Q55A) will be noted when the seller’s and buyer’s trade reports differ with respect to the ATS special condition indicator. Incorrect submissions should be modified as necessary.

8. Q: Do transactions executed over the phone with an ATS (voice trades) require a special condition indicator?

A: As noted in MSRB Notice 2015-07, an inter-dealer trans- action executed with or using the services of an alternative trading system with Form ATS on file with the SEC is required to be reported with the ATS indicator regardless of the mode of the transaction. See the MSRB’s Specifications for Real-Time Reporting of Municipal Securities Transactions for more detail on the use of the ATS special condition indicator.

9. Q: As of July 18, 2016, dealers are no longer required to report yield on customer trade reports, but MSRB Rule G-15 still obligates a dealer to calculate yield for customer confirmations. If a dealer’s yield calculation used for customer confirmations to comply with Rule G-15 differs from the yield disseminated by the MSRB, how can the dealer determine the reason for the difference?

A: The EMMA website includes a column labeled “Calculation Date & Price (%)” that displays the date and price for which the yield was calculated, which provides transparency on the inputs used in MSRB yield calculations to explain any potential calculation differences.

[1] See MSRB Rule G-14 RTRS Procedures (d)(iii).

[2] Transactions effected during the RTRS Business Day (from 7:30 a.m. to 6:30 p.m. Eastern time) are required to be reported in real-time. Transactions effected outside of those hours are required to be reported within 15 minutes after the start of the next RTRS Business Day.

[3] See MSRB Glossary of Municipal Securities Terms, Third Edition, August 2013.

[4] For additional discussion of time of trade on transactions in new issue securities, see “Notice Requesting Comment on Draft Amendments to Rule G-34 to Facilitate Real-Time Transaction Reporting and Explaining Time of Trade for Reporting New Issue Trades,” MSRB Notice 2004-18 (June 18, 2004) and “Notice of Filing of Proposed Rule Changes to Extend the Expiration of the Three-Hour Exception and to Require Underwriter Participation with DTCC’s NIIDS System,” MSRB Notice 2007-36 (November 27, 2007) .

The Municipal Securities Rulemaking Board (the “Board”) has learned that sales of certain interests in accounts held by states, or agencies or instrumentalities thereof (the “state”), may be effected through brokers, dealers or municipal securities dealers (collectively, “dealers”). The Board understands that such accounts may be established by states to implement qualified ABLE programs under Section 529A of the Internal Revenue Code of 1986, as amended.[1] In response to a request of the Board, staff of the Office of Municipal Securities at the Securities and Exchange Commission (the “SEC”) has stated that “at least some interests in ABLE accounts . . . may be ‘municipal securities’ as defined in Section 3(a)(29) of the [Securities] Exchange Act [of 1934], depending on the facts and circumstances, including without limitation, the extent to which an ABLE account offered through an ABLE Program is a direct obligation of, or obligation guaranteed as to principal or interest by, a State or any agency or instrumentality thereof.”[2]

Any such interest may, in fact, constitute interests in municipal fund securities, as defined by MSRB Rule D-12. To the extent that dealers effect transactions in municipal fund securities, such transactions are subject to the jurisdiction of the Board pursuant to Section 15B of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).[3]

With respect to the applicability to municipal fund securities of Exchange Act Rule 15c2-12,[4] relating to municipal securities disclosure, staff of the Office of Municipal Securities has stated:

[W]e note that Rule 15c2-12(f)(7) under the Exchange Act defines a “primary offering” as including an offering of municipal securities directly or indirectly by or on behalf of an issuer of such securities.  Based upon your letter and communications with MSRB staff, it is our understanding that interests in ABLE Programs generally are offered only by direct purchase from the issuer.  Accordingly, we would view those interests as having been sold in a “primary offering” as that term is defined in Rule 15c2-12.  If a dealer is acting as an “underwriter” (as defined in Rule 15c2-12(f)(8)) in connection with that primary offering, the dealer may be subject to the requirements of Rule 15c2-12.[5]

Consistent with the SEC staff’s views, dealers effecting transactions in ABLE programs may be subject to all MSRB rules, unless such dealers are specifically exempted from any of those rules, because those dealers would be effecting transactions in municipal fund securities. In particular, dealers acting as underwriters with respect to the sale of interests in ABLE programs may be subject to the requirements of (i) MSRB Rule G-32, on disclosures in connection with primary offerings, and the requirement to submit official statements through the MSRB’s Electronic Municipal Market Access (EMMA®) system[6] pursuant to Rule G-32(b) and (ii) MSRB Rule G-45, on reporting of information on municipal fund securities, and the requirement to submit information on Form G-45 pursuant to Rule G-45(a).

Further, in 1999, the SEC staff provided guidance to the Board that (i) interests in higher education trusts established by states (“529 college savings plans”) may be municipal securities, depending on the facts and circumstances, under the Exchange Act and (ii) such interests appear to have been sold in a “primary offering” as defined under Rule 15c2-12 pursuant to the Exchange Act so that a dealer acting as an underwriter (defined in Rule 15c2-12(f)(8)) in connection with that primary offering may be subject to the requirements of Rule 15c2-12.[7] In addition, the SEC determined that interests offered by such 529 college savings plans are municipal securities under Section 3(a)(29) of the Exchange Act.[8] In response to the SEC staff’s guidance and the SEC’s determination, the Board published interpretive guidance relating to the sale of interests in 529 college savings plans by dealers.  All interpretive guidance under MSRB rules applicable to the sale of interests in 529 college savings plans also would apply to the sale of interests in ABLE programs, as relevant. 

The Board anticipates that it will publish guidance to address particular issues, including Rule G-45, applicable to the sale of interests in ABLE programs by dealers.

Rule G-33 generally requires that brokers, dealers, and municipal securities dealers (“dealers”) effecting transactions in municipal securities compute yields and dollar prices in accordance with the formulas prescribed.

Prior to an amendment effective February 23, 2016, Rule G-33(b)(i)(B)(2) and, by reference, (b)(ii)(B)(2), provided that, for interest-bearing municipal securities with periodic interest payments and more than six months to redemption, dealers compute the dollar price or yield using a formula that accounted for the present value of all future coupon payments and a semi-annual payment of interest. The formula in Rule G-33(b)(i)(B)(2) now provides a more precise pricing calculation when computing yields and dollar prices on securities with periodic interest payments and more than one coupon payment to redemption. Under the amended pricing formula, rather than presuming a semi-annual interest payment, the formula requires factoring in the actual interest payment frequency of the security (e.g., monthly, quarterly or annually).

The compliance date for Rule G-33, as amended, is July 18, 2016.  

Prior to July 18, 2016, a dealer will be deemed to be in compliance with Rules G-33(b)(i)(B)(2) and G-33(b)(ii)(B)(2) if calculating dollar price or yield for interest-bearing municipal securities with periodic interest payments and more than six months to redemption using the actual interest payment frequency rather than assuming a semi-annual payment. Beginning July 18, 2016, the compliance date for Rule G-33, as amended, all dealers will be required to factor in the actual interest payment frequency in calculating dollar price and yield for such securities.