The MSRB is providing interpretive guidance to address the applicability of Rule G-42, which establishes core standards of conduct for municipal advisors [1] that engage in municipal advisory activities,[2] other than municipal advisory solicitation activities (for purposes of this guidance and Rule G-42, “municipal advisors”), in the area of conduit financing. Using various scenarios, the guidance discusses a municipal advisor’s relationship(s) with, and duties and obligations owed to, a municipal entity issuer, an obligated person that is a conduit borrower,[3] or both, in connection with the issuance of municipal securities for the conduit borrower. For purposes of this guidance, the MSRB assumes that the conduit borrower is not a municipal entity, as defined in Section 15B(e)(8) of the Exchange Act, except in the final section of the guidance entitled, “When a Conduit Borrower is also a Municipal Entity.”

 

A few broad principles should be noted. First, institutions that are often conduit borrowers, such as large universities, may choose to issue debt securities directly without the involvement of a municipal entity issuer. The exemption from registration under the Securities Act of 1933 (“Securities Act”)[4] may be based on Section 3(a)(4)[5] or Regulation D under the Securities Act,[6] rather than on Section 3(a)(2).[7] In such cases, there may be no municipal security, and Rule G-42 would not apply. In cases where there is a private placement “tail” (i.e., a non-municipal security) side-by-side with the issuance of a tax-exempt municipal security, the advice and the activities a municipal advisor engages in regarding the tax-exempt security, including any conduct or communication to fulfill the municipal advisor’s duties and obligations under Rule G-42, may have an impact or consequences for the municipal advisor with respect to its negotiations or other activities related to the non-municipal security (e.g., the disclosure to the client of a material conflict of interest as required under Rule G-42(b)).

 

Second, the scenarios described below may involve advice given to both the municipal entity issuer and the conduit borrower. Rule G-42 provides that a fiduciary duty is owed only to a municipal entity, and a duty of care is owed to both the municipal entity and the conduit borrower. If an issue arises as to an activity that involves only the duty of care, such as inquiry as to the facts that provide the basis for advice provided to the client, the duty owed may be the same to both the municipal entity and the conduit borrower. Other issues, however, may involve the duty of loyalty owed the municipal entity as part of the municipal advisor’s fiduciary duty, and thus the municipal advisor’s obligation to the issuer may be higher (or different) than the duty owed the conduit borrower.

 

Initially, the MSRB provides interpretive guidance regarding the applicability of Rule G-42 when an issuer hires a municipal advisor to provide advice directly to a conduit borrower (“First Scenario”). The MSRB then considers whether an issuer may retain a municipal advisor (either for a specific transaction, or on a long-term basis), and then provide advice that the issuer obtains from the municipal advisor, in connection with a specific issuance of municipal securities, indirectly through the issuer, to the conduit borrower in connection with the issuance (“Second Scenario”). In a third scenario, the MSRB considers whether a conduit borrower may retain a municipal advisor that, as a practical matter, will also provide advice to an issuer on which the issuer will rely, in cases where the issuer chooses not to retain a separate municipal advisor, and, in such circumstances, whether the municipal advisor must provide the issuer the disclosures set forth in Rule G-42 (“Third Scenario”). The MSRB also provides interpretive guidance regarding the application of Rule G-42 to an issuer and a conduit borrower when the issuer and the conduit borrower retain the same municipal advisor to provide advice regarding an issuance (“Fourth Scenario”). Finally, in a fifth scenario (“Fifth Scenario”), the MSRB interprets the applicability of Rule G-42 to a scenario involving two natural persons, A and B, who are employees or otherwise associated persons of a registered municipal advisor, where A is retained by the issuer to provide municipal advisory services to the issuer, and B is retained by the conduit borrower to provide municipal advisory services to the conduit borrower.

 

Section 1: First Scenario

 

In the First Scenario, the MSRB considers the applicability of Rule G-42, when, in connection with a specific issuance of municipal securities, an issuer hires a municipal advisor to provide advice directly to a conduit borrower. (For purposes of the First Scenario, the MSRB assumes that the municipal advisor does not provide municipal advisory services to the issuer. Instead, consistent with the issuer’s intent, the municipal advisor is retained for, and in fact, provides municipal advisory services solely to or on behalf of the conduit borrower.)

 

Under Rule G-42, a municipal advisor may provide municipal advisory services directly to a conduit borrower, in connection with an issuance of municipal securities by an issuer, if the municipal advisor is retained and compensated by the issuer. Whether a person (in this case, the municipal advisor retained by the issuer) is a municipal advisor to the issuer, another person (in this case, the conduit borrower), or both and therefore is subject to Rule G-42, is activity-based and turns on whether the person is providing advice or otherwise engaging in municipal advisory activities for or on behalf of the recipient. Although the First Scenario focuses on the payment of compensation by the issuer, the existence or non-existence of compensation is not a factor in determining whether the municipal advisor is a municipal advisor to the issuer or to the conduit borrower.[8] In addition, the fact that, as to the conduit borrower, the municipal advisor is paid compensation by a third party is also not a factor in determining if the municipal advisor is a municipal advisor to the conduit borrower.

 

In the First Scenario, the municipal advisor engages in municipal advisory activities solely for or on behalf of the conduit borrower, and is subject to the requirements of Rule G-42. The municipal advisor is required to comply with all the provisions of Rule G-42 as to the conduit borrower,[9] and the rule applies in all respects to the municipal advisor in its relationship with the conduit borrower, except provisions applicable solely to a municipal entity client.

 

The threshold question regarding the application of Rule G-42 to the municipal advisor in its relationship to the issuer is whether the Securities and Exchange Commission (SEC) would interpret the facts and circumstances of the First Scenario – where the issuer does not receive the municipal advisory services, and the services are in fact provided solely to and on behalf of the conduit borrower – as the municipal advisor engaging (as a legal matter) in municipal advisory activities also to or on behalf of the issuer.

 

The Exchange Act definition of municipal advisor includes a person that “[p]rovides advice[10] to or on behalf of [emphasis added] a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues.”[11] The SEC has stated that the determination of “whether a person provides advice to or on behalf of a municipal entity or an obligated person regarding municipal financial products or the issuance of municipal securities depends on all the relevant facts and circumstances.”[12] The meaning of the phrase “on behalf of” in the context of the First Scenario and more broadly, whether a person is engaged in municipal advisory activities for or on behalf of another person and is a municipal advisor to such person are interpretive issues that are solely within the jurisdiction of the SEC. Requests for interpretation regarding such issues should be directed to the SEC’s Office of Municipal Securities.

 

If, in the First Scenario, the activities of the municipal advisor with the issuer are not interpreted by the SEC to mean that the municipal advisor is also a municipal advisor to the issuer, then the municipal advisor would not be required to comply with Rule G-42 with respect to the issuer. For example, the municipal advisor would not be required by Rule G-42 to provide disclosures of conflicts of interest, if any existed, to the issuer.

 

Although compensation is not a factor in determining whether a person is a municipal advisor to a particular party (except as to a solicitor municipal advisor), the MSRB believes that, in the First Scenario, the compensation paid by the issuer to the municipal advisor for services for a conduit borrower may present a material conflict of interest, requiring the municipal advisor to make full and fair disclosure of such conflict in writing to the conduit borrower. Rule G-42 requires a municipal advisor to disclose all material conflicts of interest under Rule G-42(b)(i). (Such requirements are also incorporated in Rule G-42(c)). The requirement is not limited to actual material conflicts of interest. As provided in Rule G-42(b)(i)(F), for example, the municipal advisor must disclose potential material conflicts of interest that the municipal advisor becomes aware of after reasonable inquiry, that could reasonably be anticipated to impair the municipal advisor’s ability to provide advice to or on behalf of the client in accordance with the applicable standards of conduct under the Rule – the duty of care, and if applicable, the duty of loyalty. In this scenario, the client is the conduit borrower and the municipal advisor owes its client the duty of care as provided in Rule G‑42(a)(i) and SM .01.[13] Even if the compensation paid by the issuer to the municipal advisor is not viewed as an actual material conflict of interest by the municipal advisor, the municipal advisor must carefully consider if such payments give rise to a potential material conflict of interest. In the MSRB’s view, the payments from the issuer to the municipal advisor may create a relationship between the municipal advisor and the issuer, that even if not a municipal advisor-client relationship, generally would give rise to a potential material conflict of interest that could reasonably be anticipated to impair the municipal advisor’s ability to provide advice to or on behalf of the conduit borrower in accordance with the standards of Rule G-42(a). Before making any such disclosures to the conduit borrower, the municipal advisor should consider the guidance set forth in SM .05. Under SM .05, when a municipal advisor is required to make disclosures of material conflicts of interest, including those required under Rule G-42(b)(i)(F), the municipal advisor’s disclosures must be sufficiently detailed to inform the conduit borrower of the nature, implications and potential consequences of each conflict, and must also include an explanation of how the municipal advisor addresses or intends to manage or mitigate each conflict.

 

Finally, the relationship between the issuer and the municipal advisor, however characterized or limited, may create other compliance concerns under Rule G-42. For example, in some cases, the issuer, although not the client, may wish to provide policy direction or instructions to the municipal advisor regarding the issuance of the municipal securities. If the issuer communicates, explicitly or implicitly, an instruction or direction which the municipal advisor follows and which inhibited or limited the municipal advisor’s ability to fulfill its duties and obligations to the conduit borrower client under Rule G-42, the municipal advisor would violate the rule.

 

Section 2: Second Scenario

 

The MSRB has been asked to provide guidance regarding a scenario where a municipal advisor is engaged in municipal advisory activities as directed by an issuer and for such issuer, pursuant to an explicit arrangement or agreement, and the municipal advisor “indirectly” also provides advice to a conduit borrower, because the issuer provides to the conduit borrower the advice the issuer receives from the municipal advisor. For purposes of this Second Scenario, the MSRB assumes that the municipal advisor is aware of the flow of information from the issuer to the conduit borrower.

 

To assess whether the municipal advisor owes duties to the conduit borrower when the municipal advisor provides advice to the issuer that then flows through to the conduit borrower, again, a threshold question must be answered: Is the municipal advisor also engaged in municipal advisory activities for or on behalf of the conduit borrower because the conduit borrower is receiving, through the issuer, some or all of the advice that was provided by the municipal advisor to the issuer, establishing a municipal advisory relationship between the municipal advisor and the conduit borrower?

 

As set forth above, the SEC has stated that the determination of “whether a person provides advice to or on behalf of a municipal entity or an obligated person regarding municipal financial products or the issuance of municipal securities depends on all the relevant facts and circumstances,”[14] and whether a person is engaged in municipal advisory activities for or on behalf of another person and is a municipal advisor to such person are interpretive issues that are solely within the jurisdiction of the SEC.[15] 

 

 

If, in the Second Scenario, the transfer of advice from the issuer to the conduit borrower is interpreted by the SEC to mean that the municipal advisor is engaged in municipal advisory activities for or on behalf of the conduit borrower, the municipal advisor must comply with the requirements of Rule G-42 with respect to the issuer and the conduit borrower. This dual representation may raise several compliance issues.

 

Rule G-42 distinguishes the duties and obligations that a municipal advisor owes to an issuer client (i.e., a municipal entity) from those owed to a conduit borrower client in two provisions. First, in the conduct of all municipal advisory activities for and on behalf of an issuer client, a municipal advisor is subject to a fiduciary duty as provided in Rule G-42(a)(ii). The fiduciary duty is more specifically described as a requirement to act in accordance with a duty of loyalty[16] and a duty of care,[17] as described in, respectively, SM .02 and SM .01. In contrast and as discussed above, when the municipal advisor’s client is a conduit borrower, the municipal advisor owes a duty of care to the client as provided in Rule G-42(a)(i) and SM .01, but not a duty of loyalty. Second, in connection with a municipal advisor’s municipal advisory activities for and on behalf of an issuer client, a municipal advisor, and any affiliate of the municipal advisor, is prohibited from engaging in certain principal transactions with the issuer, as provided in Rule G-42(e)(ii).[18] This specific prohibition does not apply to a municipal advisor when its client is a conduit borrower. However, all other provisions and protections in Rule G-42 apply in the same manner to a municipal advisor whether its client is an issuer (i.e., a municipal entity) or a conduit borrower. For example, municipal advisors must provide the same timely disclosures of material conflicts of interest and material legal and disciplinary events in the earliest stages of their dealings with their conduit borrower clients as they provide to their municipal entity clients (and supplement such disclosures as necessary during the relationship). Similarly, municipal advisors have the same obligations to an issuer client and a conduit borrower to provide written documentation of the municipal advisory relationship (and supplement such documentation as necessary during the relationship). Also, if a municipal advisor makes a recommendation of a municipal securities transaction to either type of client, the municipal advisor must have a reasonable basis to believe that the recommended municipal securities transaction is suitable for the client.

 

The MSRB believes that a municipal advisor’s dual representation of an issuer and a conduit borrower with respect to the same issuance raises at least two types of compliance issues and concerns. First, the differing standards and other distinctions that Rule G-42 makes between issuer clients and conduit borrower clients will require a municipal advisor to consider whether, in every aspect of its conduct and representation, the municipal advisor acts in compliance with the more stringent standard applicable to its issuer client, and also fulfills its duties and obligations to its conduit borrower client. Moreover, under Rule G-42, compliance concerns and issues may require greater diligence to identify and address, because although certain duties and obligations are specified in Rule G-42(a)(i) and (ii) and SM. 01 and SM .02, generally, all of the specific duties or obligations that fall under the broad umbrella of the fiduciary duty cannot be specifically enumerated. Among other things, the MSRB cannot anticipate and identify all the situations that may arise in a particular offering, and, as a result, the rule cannot provide explicit instruction or guidance to a municipal advisor to an issuer, regarding what acts must be taken (or avoided) or what must be communicated (or not communicated) to an issuer to comply fully with the municipal advisor’s fiduciary duty. Similarly, all duties and obligations that a municipal advisor owes to a conduit borrower under the duty of care in a particular offering also cannot be specifically enumerated for the same reasons.

 

Further, when compliance issues or concerns arise, whether the duty owed is a fiduciary duty (a duty of loyalty and a duty of care) or a duty of care, under Rule G-42 and SM .04, the standards of conduct applicable to the municipal advisor and, except as provided in SM .04, the duties and obligations owed to the municipal advisor’s client(s), cannot be eliminated, diminished or modified by disclosure, mutual agreement or otherwise. SM .04 makes clear that nothing in the rule shall be construed to permit a municipal advisor to alter the standards of conduct or impose limitations on any of the duties prescribed in Rule G-42. For example, in various requests for guidance, the MSRB was asked, regarding dual representations, if the MSRB could confirm a municipal advisor engaged in dual representations could continue its representation of both clients if full and fair disclosures of any conflicts of interest or other issues were made to both clients. Generally, disclosure alone would not be sufficient for a municipal advisor to ensure, in all facts and circumstances, that a municipal advisor would be in compliance with all the duties and obligations owed to one or both clients, including, as to a fiduciary, the obligation of a municipal advisor not to “engage in municipal advisory activities for a municipal entity client if it cannot manage or mitigate its conflicts of interest in a manner that will permit it to act in the municipal entity’s best interests.”[19] However, certain limitations may be placed on the scope of a municipal advisory relationship with a client, and the ability to do so is not limited to dual representation scenarios. Under SM .04, if requested or expressly consented to by a client, a municipal advisor may limit the scope of the municipal advisory activities to be performed to certain specified activities or services. (The effectiveness of any such specified limitation of the scope of municipal advisory activities may be negated, however, if the municipal advisor then engages in a course of conduct that is inconsistent with the specified limitations.)

 

In the Second Scenario and any other scenario involving a dual representation, before entering into the dual representation, a municipal advisor must determine if it is possible to meet its duties and obligations to both clients under Rule G-42. The municipal advisor must determine it can comply with Rule G-42 when the duties and obligations owed to one client, the issuer, are more stringent and more difficult to fulfill, than those duties and obligations that the municipal advisor owes to the second client, the conduit borrower. Among other things, the duty of loyalty owed to the issuer requires a municipal advisor to act in the best interests of the issuer client without regard to the financial or other interests of the municipal advisor. The municipal advisor must consider whether it will be able to act consistently with this standard during the entire engagement while also providing municipal advisory services to the conduit borrower client, without putting its interests or the interests of the conduit borrower, before or above those of the issuer client, including not providing any advantages or benefits to itself or any other client to the loss or detriment of the issuer, including any financial loss or lost opportunity.

 

In addition, as discussed above, in all municipal advisory relationships, a municipal advisor must identify and disclose to its client material conflicts of interest, after reasonable inquiry, and such disclosures must be sufficiently detailed to inform the client of the nature, implications and potential consequences of each conflict. In the MSRB’s view, conflicts of interest are, in most cases, inherent in a dual representation, although they may not always be material. In a dual representation, the MSRB believes that such conflicts of interest should be identified prior to or upon engaging in municipal advisory activities with each client. Further, in the MSRB’s view, the potential for an identified, but non-material conflict to become a material conflict of interest during the dual representation is great enough that the municipal advisor will have an obligation to make an initial disclosure pursuant to Rule G-42(b)(i)(F), of the facts and circumstances of the dual representation, how such dual representation is a potential material conflict of interest and the risk that such conflict could reasonably be anticipated to impair the municipal advisor’s ability to dually represent both clients in accordance with the standards of conduct under Rule G-42(a).[20] Further, for each client, the municipal advisor must include an explanation of how the municipal advisor addresses or intends to manage or mitigate each conflict, as provided in SM .05.

 

However, because the municipal advisor owes a fiduciary duty to one client but not the other, if any material conflict of interest is identified that the municipal advisor cannot manage or mitigate in a manner that will permit the municipal advisor to act in the issuer’s best interests, the municipal advisor must not engage in, or must cease engaging in, the municipal advisory activities for the issuer. Practically, this would require the municipal advisor to terminate the relationship with the issuer, or act to eliminate the material conflict of interest. For example, if such conflicts derive from the municipal advisor’s relationship with the conduit borrower, as an alternative to terminating its relationship with the issuer, the municipal advisor may be able to eliminate such material conflicts by amending or terminating its relationship with the conduit borrower. The MSRB notes that, in either scenario, the municipal advisor’s elimination of its conflicts of interest, by terminating its relationship with the issuer, or by amending or terminating its municipal advisory relationship with the conduit borrower, may create both legal and related business issues. If termination of the municipal advisory relationship with the issuer or the conduit borrower is required, among other things, the termination may have a detrimental impact on the schedule or costs of completing the issuance, or impair the terminated client’s ability to obtain informed advice. For these reasons, municipal advisors are cautioned to determine before or upon beginning a dual representation how either municipal advisory relationship would be modified or terminated if the municipal advisor is no longer able to comply with its Rule G-42 obligations in a dual representation. Among other things, a municipal advisor may wish to consider if, prior to finalizing the initial documentation of the municipal advisory relationship as required in Rule G-42(c), the municipal advisor should negotiate the specific terms and conditions that would apply to a future termination of a municipal advisory relationship with either of the clients. As required by Rule G-42(c), if specific terms regarding termination are agreed upon, such terms must be incorporated in the writing(s) that document the municipal advisory relationship.[21]

 

An example of a difficult circumstance for the municipal advisor to resolve arises when, for example, a major university or hospital chain is engaged in multiple conduit financings in different jurisdictions around the country. The conduit borrower may have developed a certain type of financing to fit within its own broader financing plan, such as consistently structured variable rate securities. One state education authority, which is approached by the university conduit borrower, may, however, have a strong policy against the issuance of variable rate debt. The municipal advisor should bring the conflict to both parties at the earliest possible stage in the financing and make a determination whether it can advise both parties and fulfill its obligations under Rule G-42.

 

The MSRB also cautions municipal advisors that neither the facts and circumstances characterizing an issuance involving an issuer and a conduit borrower, nor the duties and obligations under Rule G-42 as applied to a relationship, are static or fixed. The requirements of Rule G-42 apply at any time during which municipal advisory activities are engaged in for or on behalf of an issuer or a conduit borrower, and with equal rigor throughout the representation. For example, although the standards of conduct do not change, as facts and circumstances change, a municipal advisor must assess if, under such changed circumstances, there are specific acts, duties or obligations that are not enumerated under Rule G-42 that must be performed or attended to arising from the broad duty of care and, if applicable, duty of loyalty.[22] Rule G-42 also incorporates protections for municipal advisory clients in certain key provisions, which are based on the recognition that key facts and circumstances may change (i.e., the continuing obligation to provide promptly to a client amended or supplemental information in writing, regarding any changes and additions in the relationship documentation, such as amendments or supplements needed regarding the material conflicts of interest disclosures, or the disclosures regarding certain legal and disciplinary events).

 

Changes in the facts and circumstances regarding the municipal securities issuance, or in the municipal advisory relationships with an issuer, a conduit borrower or both may require the municipal advisor to review if such changes may affect its ability to continue the dual representation and fully comply with Rule G-42. Even if an issuer, a conduit borrower and a municipal advisor believe at the beginning of the dual representation that the issuer and conduit borrower will be in agreement on all major issues that may arise during the course of the issuance, the interests and goals of each client may diverge later. Either the issuer, the conduit borrower, or both, may develop substantially divergent views on issues material to the issuance. Municipal advisors considering dual representation should assess initially the extent to which the interests and goals of the issuer and the conduit borrower are the same or substantially similar and make reassessments periodically thereafter.

 

Although challenging, in certain circumstances, the MSRB believes that it may be possible for a municipal advisor to provide municipal advisory services to an issuer and, in the manner described in the Second Scenario, indirectly, to engage in municipal advisory activities for or on behalf of a conduit borrower and remain in compliance with Rule G-42. Specifically, the circumstances where dual representation as described in the Second Scenario may be most feasible are those where the interests of the issuer and the conduit borrower are aligned. This may occur when the issuer is created to finance a specific project for the benefit of a metropolitan area, or in instances where the issuer applies a policy-neutral or hands-off approach to proposed projects, provided that such projects and the related financings comply with fundamental legal requirements for issuance. In such circumstances where an issuer and a conduit borrower have a complete or substantially complete convergence of interests and goals, or where the issuer’s concerns are somewhat limited and related for the most part to determining that an issuance will fully comply with the applicable legal and regulatory requirements, it may be possible for the municipal advisor to deal honestly and with the utmost good faith and act in the best interests of the issuer without regard to the financial or other interests of the municipal advisor (including the municipal advisor’s financial or other interest arising from its relationship with the conduit borrower) as required under the duty of loyalty, and also meet its obligations to both clients under the duty of care. It also may be possible for the municipal advisor, which by the very status of its dual representation creates a potential material conflict of interest that must be disclosed in the initial disclosures made pursuant to Rule G-42(b), to manage or mitigate this and any other of “its conflicts of interest in a manner that will permit it to act in the municipal entity’s best interests,” as required under SM .02.

 

Conversely, where there is not a substantially complete convergence of interests and goals of the issuer and the conduit borrower, or when the shared interests and goals of the issuer and the conduit borrower at the beginning of the issuance process diverge during the course of the issuance, it may not be possible for a municipal advisor to fulfill its duties of loyalty and care to its municipal entity client, and also provide, under the duty of care, the appropriate expert professional advice to the conduit borrower and otherwise fulfill its obligations to the conduit borrower that arise under the duty of care. Although dual representation is possible, for every action taken during an issuance, it is incumbent upon a municipal advisor to assess and determine, as to each client, if such actions comply with the standards of conduct and other requirements under Rule G-42.

 

Given the broad scope of the duty of care and the broader and more strict obligations arising in a fiduciary relationship, the MSRB concludes that it may be possible for a municipal advisor in the Second Scenario to engage in dual representations for or on behalf of both an issuer and a conduit borrower, but the municipal advisor will face a number of challenges in such situations. Moreover, the challenges to fully and completely comply with its obligations to each client will be heightened in lengthier and more complex engagements.

 

Section 3: Third, Fourth and Fifth Scenarios

 

The Third, Fourth and Fifth Scenarios raise the same compliance issues and concerns under Rule G-42 as discussed in the First and Second Scenarios. In the Third Scenario, the municipal advisor, an issuer and a conduit borrower expressly recognize that the municipal advisor is retained by and provides municipal advisory services for the conduit borrower and, also, as a practical matter, provides advice to the issuer, on which the issuer relies.[23] Although in the Third Scenario, the conduit borrower, rather than the issuer compensates the municipal advisor, all the compliance and regulatory issues arising regarding Rule G-42 are the same as those discussed above regarding the Second Scenario.

 

In relation to the Third Scenario, municipal advisors also have requested guidance regarding the municipal advisor’s responsibilities to the issuer when the municipal advisor is retained and compensated by the conduit borrower. For example, does the municipal advisor have a fiduciary responsibility to the issuer to whom advice is being provided, and is the municipal advisor required to provide disclosures of conflicts of interest to the issuer? If the provision of such advice to the issuer means, under SEC rules, that the provider is a municipal advisor to the issuer, then the municipal advisor would be a fiduciary to the issuer and subject to all the duties and obligations under Rule G-42. Thus, the municipal advisor would be required, among other things, to comply with the requirements to make disclosures of material conflicts of interest as provided in Rule G-42(b), and to provide such conflicts of interest disclosures as part of the relationship documentation as provided in Rule G-42(c).

 

The Fourth Scenario is another scenario in which a municipal advisor is engaged in a dual representation of an issuer and a conduit borrower. Rule G-42 would apply in the Fourth Scenario in the same manner as it applies in the Second Scenario.

 

The Fifth Scenario is also an example of dual representation by one municipal advisor of an issuer and a conduit borrower regarding the same issuance of municipal securities and, thus, raises the same issues regarding the municipal advisor’s compliance with Rule G-42 that are discussed for the Second Scenario. The duties and obligations of Rule G-42 run not only from a municipal advisor firm’s associated persons but also from the municipal advisor firm to the issuer and the conduit borrower. Although, in the Fifth Scenario, one employee is designated to act on behalf of the issuer and a second is designated to act on behalf of the conduit borrower, the employees are agents of their employer, a single municipal advisor firm. In the MSRB’s view, therefore, how Rule G-42 applies in the Fifth Scenario does not differ in any material respect from the Second, Third and Fourth Scenarios. In a dual representation, and, in particular, a dual representation purposefully established from the beginning of the issuance, a municipal advisor firm having the capacity to do so is likely to rely on the services of more than one of its associated persons, whether structured to work in coordination as one team, or separately.

 

Section 4: When a Conduit Borrower is also a Municipal Entity

 

In the discussion above regarding the five scenarios, the MSRB assumes that, in dual representations, the issuer client is a municipal entity, and the second client, the conduit borrower, is not. As discussed above, because under the Exchange Act and Rule G-42, a municipal advisor owes more rigorous obligations and duties to a municipal entity client – that is, a fiduciary duty – than are owed to a conduit borrower, in certain scenarios involving dual representation, a municipal advisor may find it difficult, or not possible, to fully comply with its obligations to both clients under Rule G-42.

 

The MSRB recognizes that, at times, both the issuer and the conduit borrower are municipal entities, and, in this discussion, a conduit borrower that is a municipal entity is referred to as a municipal entity conduit borrower. In such cases, a municipal advisor that provides advice to or on behalf of the issuer and the municipal entity conduit borrower would owe the more rigorous duties required of a fiduciary to both clients equally (e.g., the municipal advisor would be required, in all contexts, to deal honestly and with the utmost good faith with the issuer and the municipal entity conduit borrower, and, as to each, to act in the client’s best interests without regard to the financial or other interests of the municipal advisor).

 

Before undertaking such a dual engagement, the municipal advisor must assess its ability to comply with Rule G-42, including the proscription in Rule G-42, SM .02, which prohibits a municipal advisor from engaging in municipal advisory activities for a client if the municipal advisor could not manage or mitigate its conflicts of interest in a manner that would permit the municipal advisor to act in the best interests of the client. In addition, if the dual representation were undertaken, the municipal advisor’s assessment of its ability to fully comply with Rule G-42, including SM .02, should be carefully considered at the beginning of the dual representation and thoughtfully re-considered periodically during the course of the dual engagement. In the MSRB’s view, the facts and circumstances wherein a municipal advisor would be able to fully comply with Rule G-42, including all obligations as a fiduciary to each municipal entity, are not likely to occur frequently.

 

This interpretive guidance is intended for use only as a resource. It does not describe all provisions of Rule G-42. In addition, the MSRB has adopted other rules and interpretations that may be applicable to the conduct described in the five scenarios.

[1] This guidance is limited to persons that are municipal advisors as defined in Section 15B(e)(4) of the Securities Exchange Act of 1934 (“Exchange Act”), and the relevant rules and regulations promulgated pursuant to the Exchange Act (“Exchange Act rules”), but excludes municipal advisors engaged solely in the undertaking of a solicitation of a municipal entity or an obligated person, for compensation, on behalf of certain third parties (“solicitor municipal advisors”), because Rule G-42 does not apply to solicitor municipal advisors. See Exchange Act Release No. 70462 (September 20, 2013), 78 FR 67467 (November 12, 2013) (“Order Adopting SEC Final Rule”) (the Exchange Act rules and regulations referred to above include, but are not limited to, Exchange Act Rules 15Ba1-1 through 15Ba1-8. See also Section 15B(e)(4)(A)(ii); Exchange Act Rule 15Ba1-1(d)(1)(i) (the term “municipal advisor” includes solicitors of obligated persons); Section 15B(e)(9) of the Exchange Act (definition of “solicitation of a municipal entity or obligated person”); and Order Adopting SEC Final Rule, 78 FR 67467, at n. 138 and n. 408.

 

[2] In Exchange Act Rule 15Ba1-1(e), the term “municipal advisory activities” means “(1) [p]roviding advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues; or (2) [s]olicitation of a municipal entity or an obligated person.” Further, the Rule provides that, in the absence of an exclusion or an exemption, these activities would cause a person to be a municipal advisor.

 

[3] Although the term “conduit borrower” is not specifically defined in the Exchange Act, a conduit borrower in a municipal securities issuance, such as a private university, non-profit hospital, private corporation, or a public hospital or public university, is a type of “obligated person.” See Order Adopting SEC Final Rule, at 67483, n. 200 (the term obligated person can include entities acting as conduit borrowers, such as private universities and non-profit hospitals).

 

The term, “obligated person,” is defined in Exchange Act Section 15B(e)(10) to mean:

 

any person, including an issuer of municipal securities, who is either generally or through an enterprise, fund, or account of such person, committed by contract or other arrangement to support the payment of all or part of the obligations on the municipal securities to be sold in an offering of municipal securities.

 

Generally, for purposes of this guidance, the terms “obligated person” and “conduit borrower” have the same meaning. In addition, for this guidance, both terms exclude a municipal entity acting as an issuer of municipal securities.

 

[4] 15 U.S.C. 77a et seq.

 

[5] 15 U.S.C. 77c(a)(4).

 

[6] 17 CFR 230.500 – 508.

 

[7] 15 U.S.C. 77c(a)(2).

 

[8] See Order Adopting SEC Final Rule, at 67477 (the SEC concluded that compensation should not factor into a determination of whether a person must register (or be registered) as a municipal advisor, except in connection with solicitor municipal advisors; in such cases, the person must becompensated for such solicitation activity to be required to register (or be registered) as a municipal advisor).

 

[9] These requirements include, but are not limited to: complying with the broad obligations under the duty of care under Rule G-42(a)(i) and Supplemental Material (“SM”) .01 under the rule in all aspects of the municipal advisor’s municipal advisory relationship with the conduit borrower; making the required disclosures to the conduit borrower regarding material conflicts of interest and material legal and disciplinary events (and updating them as necessary) as set forth in Rule G-42(b) and SM .05; providing relationship documentation to the conduit borrower (and updating the documentation as necessary) as provided in Rule G-42(c) and SM .05 and SM .06; if making a recommendation to the conduit borrower, or if reviewing a recommendation from the issuer or another party to the conduit borrower, following the requirements of Rule G-42(d) and SM .09 and SM .10; and not engaging in the specifically prohibited conduct as outlined in Rule G-42(e)(i) and SM .11.

 

[10] In the Order Adopting SEC Final Rule, the SEC provided guidance to interpret “advice” as that term is used in the definition of municipal advisor and related terms. See Order Adopting SEC Final Rule, at 67471 (providing examples of communications that are excluded from the term “advice”) and 67478 - 80 (SEC guidance regarding the meaning of “advice,” statement that the SEC does not believe that the term “advice” is susceptible to a bright-line definition).

 

Jurisdiction to resolve the interpretive issue of whether “advice” has been provided, based on the facts and circumstances, lies with the SEC.

 

[11] See Exchange Act Section 15B(e)(4)(A)(i).

 

[12] See Order Adopting SEC Final Rule, at 67479.

 

[13] SM .01 of Rule G-42 sets forth core principles regarding the duty of care a municipal advisor owes to all clients, whether issuers or conduit borrowers. The duty of care includes, but is not limited to, the specific duties enumerated in the rule. For example, to fulfill its obligations under the duty of care, the municipal advisor must, among other things: possess the degree of knowledge and expertise needed to provide the client with informed advice; make a reasonable inquiry as to the facts that are relevant to a client’s determination as to whether to proceed with a course of action or that form the basis for advice provided to the client; and undertake a reasonable investigation to determine that it is not basing any recommendation on materially inaccurate or incomplete information. Also, a municipal advisor must have a reasonable basis for any advice provided to or on behalf of a client; any representations made in a certificate that it signs that will be reasonably foreseeably relied upon by the client, any other party involved in the municipal securities transaction, or investors in the issuer’s securities or municipal securities secured by payments from the conduit borrower client; and any information provided to the client or other parties involved in the municipal securities transaction in connection with the preparation of an official statement for any issue of municipal securities as to which the municipal advisor is advising. For example, to make a recommendation that complies with the duty of care, prior to making a recommendation, a municipal advisor is required to determine if the recommended municipal securities transaction is suitable, based on numerous factors, as applicable to the particular type of client. Various factors are set forth in SM .09 and include, but are not limited to: the client’s financial situation and needs, objectives, tax status, risk tolerance, liquidity needs, the client’s experience with, in this scenario, the issuance of municipal securities and related municipal securities transactions, the client’s experience with municipal securities issuance and related municipal securities transactions of the type and complexity being recommended, the client’s financial capacity to withstand changes in market conditions during the period that the municipal securities to be issued are reasonably expected to be outstanding and any other material information known by the municipal advisor about the client and the municipal securities issuance, after reasonable inquiry.

 

[14] See Order Adopting SEC Final Rule, at 67479.

 

 

[15] See supra notes 10-12, and accompanying text.

 

[16] SM .02 of Rule G-42 sets forth core principles regarding the duty of loyalty owed to the issuer. Under SM .02, the duty of loyalty includes, but is not limited to, the duties and obligations to “deal honestly and with the utmost good faith with a municipal entity client and act in the client’s best interests without regard to the financial or other interests of the municipal advisor.” In addition, “[a] municipal advisor must not engage in municipal advisory activities for a municipal entity client if it cannot manage or mitigate its conflicts of interest in a manner that will permit it to act in the municipal entity’s best interests.”

 

[17] See n. 13, supra.

 

[18] Additional information and requirements regarding the specific prohibition in Rule G‑42(e)(ii) are set forth in SM .13, SM .14 and SM .15.

 

[19] More specifically, requestors asked if the MSRB would confirm that full and fair disclosure of any conflicts of interest or other issues would address any concerns under the Rule with the result that there would be no unmanageable conflict of interest or issue that would prevent a municipal advisor from advising both an issuer and a conduit borrower (or two advisors from the same firm from representing, separately, an issuer and the related conduit borrower) as required under SM .02.

 

 

[20] The MSRB believes that a conflict of interest arises in a dual representation described in the Second Scenario as it does in the First Scenario, when a municipal advisor provides municipal advisory services to a conduit borrower and the payment for such services is provided by a third-party, such as an issuer, in that such circumstances often can create or foster divided loyalties. In both cases, the MSRB believes that the potential that such conflicts of interest, which are present at the onset of such relationship(s), may later become material conflicts of interest requires, at a minimum, that such conflict(s) be disclosed initially to the client(s) pursuant to Rule G-42(b)(i)(F).

 

 

[21] Rule G-42(c)(vi) requires that the written documentation of the municipal advisory relationship include, in writing, “the date, triggering event, or means for the termination of the municipal advisory relationship, or, if none, a statement that there is none.” Rule G‑42(c)(vii) requires that the written documentation include “any terms relating to withdrawal from the municipal advisory relationship.”

 

 

[22] As noted above, all of the municipal advisor’s obligations and duties cannot be specifically enumerated or identified at the beginning of the dual representation. Instead, the duties and obligations under either standard of conduct will unfold during the dual representation.

 

 

[23] The Third Scenario is limited to situations where an issuer chooses not to retain a separate municipal advisor. However, changing the facts and circumstances of the Third Scenario to include the retention of another municipal advisor by the issuer is not conclusive in determining if Rule G-42 would apply to the municipal advisor retained by the conduit borrower in its conduct with the issuer. If the municipal advisor retained by the conduit borrower provides municipal advisory services indirectly or, as a practical matter, to the issuer, and if the SEC interprets such conduct as engaging in municipal advisory activity for or on behalf of the issuer, the provision of such advice makes Rule G-42 applicable to the provider, except where the provider is subject to an exclusion or an exemption (from the definition of municipal advisor), such as the Independent Registered Municipal Advisor exemption provided under Exchange Act Rule 15Ba1-1(d)(3)(vi).

 

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]

 

(As updated February 7, 2019)

Background

MSRB Rule G-18, establishing the first best-execution rule for transactions in municipal securities, became effective March 21, 2016. The best-execution rule requires brokers, dealers and municipal securities dealers (dealers) to use reasonable diligence to ascertain the best market for the subject security and buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Related amendments to MSRB Rule G‑48, on transactions with sophisticated municipal market professionals (SMMPs), and to MSRB Rule D-15, on the definition of an SMMP, exempt transactions with SMMPs from the best-execution rule. This implementation guidance provides answers to frequently asked questions about the best-execution rule and the SMMP exemption.

Use of This Document

The MSRB is providing in this document general implementation guidance on certain aspects of new Rule G-18 and amended Rules G-48 and D-15 (rules) in a question-and-answer format. This guidance is designed to support compliance with the best-execution rule and the SMMP exemption.[1] The answers are not considered rules and have neither been approved nor disapproved by the Securities and Exchange Commission (SEC).

The MSRB may update these questions and answers periodically, and any updates will include appropriate references to dates of new or modified questions and answers.

Questions and Answers Concerning Best Execution and the Exemption for Transactions with Sophisticated Municipal Market Professionals:  Rules G-18, G-48 and D-15

I. Best-Execution Standard – General

I.1: Reasonable Diligence

Q: What do dealers need to do to use reasonable diligence when selling (purchasing) municipal securities out of (into) their inventory to (from) customers[2] who are not sophisticated municipal market professionals (SMMPs)?[3]

A: Overview of Best-Execution Standard. Section (a) of MSRB Rule G-18, on best execution, requires dealers, in any transaction for or with a customer or a customer of another dealer, to use reasonable diligence to ascertain the best market for the subject security and to buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. This obligation applies to transactions in which the dealer is acting as agent and transactions in which the dealer is acting as principal.[4] Section (a) includes a non-exhaustive list of factors that dealers must consider when exercising this diligence, which includes: the character of the market for the security (e.g., price, volatility, and relative liquidity), the size and type of transaction, the number of markets checked, the information reviewed to determine the current market for the subject security or similar securities, the accessibility of quotations, and the terms and conditions of the customer’s inquiry or order, including any bids or offers, that result in the transaction, as communicated to the dealer. A dealer must make every effort to execute a customer transaction promptly,[5] but the determination as to whether a firm exercised reasonable diligence necessarily involves a “facts and circumstances” analysis, and actions that in one instance may meet a dealer’s best-execution obligation may not satisfy that obligation under another set of circumstances. The rule is designed to complement existing fair and reasonable pricing standards and improve execution quality for retail investors in municipal securities, while promoting fair competition among dealers and improving market efficiency.

Policies and Procedures. As explained during the rulemaking process for the best-execution rule, dealers can use reasonable diligence in ascertaining the best market for a security by using sound policies and procedures and periodically reviewing and improving them. Indeed, paragraph .08 of the Supplementary Material requires the development of policies and procedures reasonably designed to achieve best execution. Paragraph .08 requires dealers to conduct, at a minimum, annual reviews of their policies and procedures for determining the best available market, assessing whether they are reasonably designed to achieve best execution, taking into account the quality of the executions the dealer is obtaining under its current policies and procedures, changes in market structure, new entrants, the availability of additional pre-trade and post-trade data, and the availability of new technologies, and to make promptly any necessary modifications of their policies and procedures in light of those reviews.[6] In short, a dealer can comply with the requirement to use reasonable diligence by developing, following and maintaining policies and procedures that are themselves reasonably designed.

Rule G-18 is designed to provide sufficient flexibility to accommodate the diverse population of dealers, which can adopt policies and procedures to be reasonably related to the nature of their business, including the level of sales and trading activity and the type of customer transactions at issue, and to allow dealers to evidence that they had used reasonable diligence in a manner that is different than that used by other dealers. However, in developing policies and procedures, dealers should consider reviewing and including in their policies and procedures the existing practices of their trading operations, existing best practices within the municipal securities market (particularly those used by similarly-situated dealers), existing best practices in the corporate debt securities market with respect to compliance with FINRA Rule 5310, which requires, among other things, best execution for transactions in corporate debt securities, and any other practices they believe to be relevant. By way of example, if similarly-situated dealers in the municipal securities market typically take certain steps when purchasing municipal securities from a customer, dealers should consider whether their written policies and procedures should provide for those steps to be taken on a consistent and systematic basis.

As explained during the rulemaking process for Rule G-18, the rule is generally substantively consistent with FINRA Rule 5310, with specific tailoring to the characteristics of the municipal securities market. This substantive consistency is in recognition of the efficiencies to be gained from harmonized regulation in similar areas of the fixed income markets. Significantly, the core standard of reasonable diligence in Rule G‑18(a) is stated in identical terms to the core standard in FINRA Rule 5310; however, portions of the list of factors that are considered in determining whether a firm has used reasonable diligence are different. As a result, and also in the interests of harmonized regulation, steps by a dealer that meet the reasonable diligence standard under FINRA Rule 5310 generally will be considered to meet the reasonable diligence standard under Rule G-18 in circumstances that are substantially the same. However, dealers should consider whether any additional or different steps may need to be taken to address provisions in Rule G-18 that are tailored specifically for transactions in municipal securities.

(November 20, 2015) 

I.2: Best Price

Q: Does the term “best execution” (as it relates to municipal securities) mean every trade at a particular point in time must match the best price to have occurred within a short time thereafter?

A: As stated in paragraph .01 of the Supplementary Material to MSRB Rule G-18, “[t]he principal purpose of [the] rule is to promote, for customer transactions, dealers’ use of reasonable diligence,” and a “failure to have actually obtained the most favorable price possible will not necessarily mean that the dealer failed to use reasonable diligence.” A trade occurring shortly after a transaction at a materially more favorable price with no significant change in market conditions or the credit worthiness of the security, however, could indicate a lack of reasonable diligence on the part of the dealer or the utilization of inadequate procedures. Such occurrences would suggest that dealers should consider, as part of their periodic review of their procedures, the inclusion of additional markets when handling future customer orders or inquiries.

(November 20, 2015) 

I.3: Documentation

Q: How do dealers document reasonable diligence in compliance with the best-execution standard and does documentation need to be made for each and every transaction?

A: The issue of documentation of dealers’ compliance with MSRB Rule G-18 arises in at least three areas. First, the rule requires dealers to have written policies and procedures for compliance with the rule. Second, dealers should consider documenting their periodic reviews of their written policies and procedures and the results of those reviews. Third, dealers should consider documenting their adherence to their policies and procedures generally, and paragraph .06 of the Supplementary Material specifically requires documentation of compliance with their policies and procedures with respect to securities with limited quotations or pricing information.[7] The documentation dealers should consider in the third area necessarily would depend on the content of the policies and procedures that the dealer determines to adopt. Only by way of example, recognizing this dependence on the content of the policies and procedures, a dealer could use records providing information displayed on an alternative trading system and reviewed by a trader prior to execution, records of periodic observation of traders, notations by traders and/or records of pre- and/or post-trade reviews.[8] However, these are, again, only examples of documentation methods, and Rule G-18 is designed to provide sufficient flexibility to accommodate the diverse population of dealers, which can adopt policies and procedures to be reasonably related to the nature of their business, including the level of sales and trading activity and the type of customer transactions at issue, and to allow dealers to demonstrate that they had used reasonable diligence in a manner that is different than that used by other dealers. Given this flexibility, some firms may choose to document their adherence to their policies and procedures on a transaction-by-transaction basis, but the MSRB recognizes that there may be reasonable alternative approaches that would satisfy the requirements of MSRB rules and be sufficient to demonstrate compliance.

(November 20, 2015) 

I.4: Extreme Market Conditions

Q: How do extreme market conditions affect dealers’ best-execution obligations?

A: In the potential event of extreme market conditions impacting the trading of municipal securities (e.g., a shortage of liquidity and divergent prices during periods of significant ratings changes, interest rate movements or other market-wide events) dealers should consider establishing and implementing procedures that are designed to preserve the continued execution of customers’ orders in a manner that is consistent with their best-execution obligations while also recognizing and limiting their exposure to extraordinary market risk. Dealers should consider the following guidelines when evaluating their best-execution procedures during extreme market conditions: 

• The treatment of customer orders must remain fair, consistent and reasonable.

• To the extent that a dealer’s order-handling procedures are different during extreme market conditions, it should disclose to its customers the differences in the procedures from normal market conditions and the circumstances in which it may generally activate these procedures.[9]

• Activation of procedures designed to respond to extreme market conditions may be implemented only when warranted by market conditions. Excessive activation of modified procedures on the grounds of extreme market conditions could raise best-execution concerns. Accordingly, dealers should document the basis for activation of their modified procedures. 

Ultimately, it necessarily involves a facts and circumstances analysis to determine whether actions taken by dealers during extreme market conditions are consistent with the duty of best execution, but the MSRB recognizes that market conditions are an important factor in dealers’ best-execution determinations.

(November 20, 2015)

II. Best-Execution Standard – Applicability

II.1: Applicability to Introducing Dealers

Q: Do introducing dealers that execute and clear trades through other dealers have best-execution obligations to their customers?

A: Yes. MSRB Rule G-18 applies to any transaction in a municipal security for or with a customer or a customer of another dealer, without any exception for orders that are routed to another dealer. Paragraph .08(b) of the Supplementary Material to the rule, however, provides that “[a] dealer that routes its customers’ transactions to another dealer that has agreed to handle those transactions as agent or riskless principal for the customer (e.g., a clearing firm or other executing dealer) may rely on that other dealer’s periodic reviews [of its written policies and procedures] as long as the results and rationale of the review are fully disclosed to the dealer and the dealer periodically reviews how the other dealer’s review is conducted and the results of the review.” Under this provision, introducing dealers may rely on the best-execution policies and procedures of their clearing firms or other executing dealers, all of which are subject to their own best-execution obligations under the rule. An introducing dealer, however, is not relieved of its obligations to establish written policies and procedures of its own. For example, such an introducing dealer’s policies and procedures could provide for the reliance on another dealer’s policies and procedures and periodic reviews by the introducing dealer of the other dealer’s reviews of its policies and procedures.

(November 20, 2015) 

II.2: Inter-Dealer Trades

Q: Do trades between broker-dealers have to comply with the best-execution standard?

A: No. MSRB Rule G-18 applies to any transaction for or with a customer or a customer of another dealer. Paragraph .05 of the Supplementary Material to Rule G-18 provides that “[a] dealer’s duty to provide best execution in any transaction ‘for or with’ ‘a customer of another dealer’ does not apply in instances when the other dealer is simply executing a customer transaction against the dealer’s quote,”... and “[a] dealer’s duty to provide best execution to customer orders received from other dealers arises only when an order is routed from another dealer to the dealer for handling and execution.”

(November 20, 2015)

III. Reasonable Diligence Factors – Number of Markets Checked 

III.1: General

Q: When effecting a customer transaction in municipal securities, how many dealers and/or markets does a dealer need to check, and how much diligence does a dealer need to conduct in order to have confidence that all appropriate dealers and/or markets are included? 

A: The duty of best execution requires a dealer to use reasonable diligence. It does not require a dealer to access every available market, especially given the differences in pricing information and execution functionality offered, and there is no set number of dealers making an offer or collecting bids on behalf of a customer order, or other markets, to check that categorically qualifies as reasonable diligence for compliance with the best-execution obligation. Accordingly, a dealer does not need to post a bid-wanted simultaneously on multiple fixed income alternative trading systems (ATSs) and/or with multiple broker’s brokers, though this may be warranted in some cases, or become a subscriber to every ATS. However, in general, dealers should check more than one market or expose customer orders to multiple offerings or bids, and show external offerings and bids to retail customers, which may be accomplished by the use of ATSs or broker’s brokers that expose orders to multiple dealers, each of which constitutes a “market,” as that term is broadly defined in paragraph .04 of the Supplementary Material.[10] For example, a dealer’s policies and procedures could require that, after receiving offers or bids, the dealer must evaluate the offer or bid price versus relevant market information to determine whether any additional markets, including, but not limited to, other dealers, should be checked to perform reasonable diligence. Each dealer should consider including in its written policies and procedures how and when its trading desk exposes retail customer orders to multiple offerings or bids and shows external offerings and bids to retail customers (directly or through financial advisors). Some dealers may employ “filters,” which generally refer to automated tools that allow the dealer to limit its trading, with, for example, specific parties or parties with specified attributes with which it does not want to interact. If a dealer uses filters on counterparties or filters on specific securities intended to limit accessing bids or offers in those securities, they may be used only for a legitimate purpose consistent with obtaining the most favorable executions for non-SMMP customers, and should be reviewed on a periodic basis and adjusted as needed. The dealer, accordingly, should have policies and procedures in place that govern when and how to: reasonably use filters without negatively impacting the quality of execution of non-SMMP customer transactions; periodically reevaluate their use; and determine whether to lift them upon request.[11]  

Given that the rule is designed, in part, to promote fair competition among dealers, generally, a dealer’s policies and procedures should facilitate competition for its customer order flow, including by eliminating practices that discourage other dealers from offering (bidding on) securities to (from) its clients. However, exposing customer order flow to other dealers, alone, is not sufficient to satisfy reasonable diligence, and dealers must also consider the non-exhaustive list of factors identified in Rule G‑18(a).  

(November 20, 2015)

(Updated February 7, 2019)

III.2: Use of Broker’s Brokers and ATSs

Q: Under what circumstances must a dealer use a broker’s broker or ATS to demonstrate reasonable diligence in ascertaining the best market? 

A: There is no categorical requirement in MSRB Rule G-18 for dealers to use a broker’s broker or an ATS, and the rule is designed specifically not to favor any particular type of venue over another for dealers to meet their best-execution obligations. Paragraph .04 of the Supplementary Material construes the term “market” broadly for purposes of Rule G-18, including the rule’s core provision, section (a), requiring the exercise of reasonable diligence in ascertaining the “best market” for the security. Paragraph .04 of the Supplementary Material states: “This expansive interpretation is meant both to inform dealers as to the breadth of the scope of venues that must be considered in the furtherance of their best-execution obligations and to promote fair competition among dealers (including broker’s brokers), alternative trading systems and platforms, and any other venue that may emerge, by not mandating that certain trading venues have less relevance than others in the course of determining a dealer’s best-execution obligations.” A principal purpose of this broad and even-handed language is to tailor the definition of the critical term “market” to the characteristics of the municipal securities market and provide flexibility for future developments in both market structure and applied technology. For example, the language expressly recognizes a characteristic of the municipal securities market (i.e., the role of dealer inventories in providing liquidity) by providing that the executing dealer itself, acting in a principal capacity, may be the best market for the security. Additionally, while an ATS or a broker’s broker, individually, can be considered a market, each can also be a mechanism to expose customer orders to multiple dealers and, therefore, multiple markets. 

As the availability of electronic systems that facilitate trading in municipal securities increases, dealers need to determine whether these systems might provide benefits to their customer order flow, particularly retail order flow, and help ensure they are meeting their obligations under Rule G-18(a) with respect to ascertaining the best market for their customer transactions. Similarly, pre-trade transparency, such as through electronic trading platforms, is also increasing in the municipal securities market, and dealers need to periodically analyze and determine whether incorporating pricing information available from these systems should be incorporated into their best-execution policies and procedures. 

The MSRB recognizes that different markets provide different levels of price information and execution functionality, and that a dealer’s analysis of the available pricing information offered by different systems may take these differences into account. Some systems, including auto-execution systems, both display prices and provide execution functionality, while other systems display prices but provide no execution functionality. Still other systems, such as request-for-quotation systems, may provide indications of interest but not display prices or provide execution functionality. As such, it is the dealers’ responsibility to evaluate various markets (e.g., ATSs, inter-dealer brokers, other dealers) and to establish and periodically review reasonably designed written policies and procedures addressing when and how certain markets should be checked to satisfy the requirements of the rule. Pursuant to paragraph .08(a) of the Supplementary Material, “[i]n conducting its periodic reviews, a dealer must assess whether its policies and procedures are reasonably designed to achieve best execution, taking into account the quality of the executions the dealer is obtaining under its current policies and procedures, changes in market structure, new entrants, the availability of additional pre-trade and post-trade data, and the availability of new technologies, and to make promptly any necessary modification(s) to such policies and procedures as may be appropriate in light of such reviews.” As an aspect of this periodic review, dealers should review the execution quality provided by the various markets they choose to use (including the internalization of order flow), and, to the extent information is reasonably available, the execution quality of new markets or markets they do not use to determine whether to use them.[12] This review could include, for example, reviewing EMMA^® data for previous executions in the subject security or similar securities. 

Additionally, Rule G-18(a) provides a non-exhaustive list of factors that will be considered in determining whether a dealer has used reasonable diligence, with no single factor being determinative, including: (1) the character of the market for the security (e.g., price, volatility and relative liquidity); (2) the size and type of transaction; (3) the number of markets checked; (4) the information reviewed to determine the current market for the subject security or similar securities; (5) the accessibility of quotations; and (6) the terms and conditions of the customer’s inquiry or order, including any bids or offers, that result in the transaction, as communicated to the dealer. Accordingly, a dealer’s policies and procedures for best execution should address how these factors will affect the dealer’s municipal securities transactions with customers under various conditions. 

(November 20, 2015)

(Updated February 7, 2019)

III.3: Reliance on Broker’s Brokers for Pricing

Q: Is a dealer in compliance with MSRB Rule G-18 if it uses the best bid or offer obtained by a broker’s broker as the only basis for the price at which the dealer executes a customer order? 

A: Use of the best bid or offer obtained by a broker’s broker for a particular security as the only basis for the price at which a dealer executes a customer order will not qualify categorically as reasonable diligence in compliance with Rule G-18. To the extent a dealer uses such practice alone, the dealer’s policies and procedures should establish what facts and circumstances should be considered to allow the dealer to do so (e.g., length of collection period used, number of offers/bids received, accessibility of quotations). 

(November 20, 2015) 

III.4: One ATS/Broker’s Broker

Q: Can a dealer comply with MSRB Rule G-18 by exposing customer orders to an ATS or broker’s broker that captures offers/bids from multiple markets? 

A: The market for municipal securities has evolved significantly in recent years. Some dealers have reduced their inventory positions in response to market and regulatory influences and the use of electronic trading systems, including ATSs, continues to grow. In addition, transaction prices for most municipal securities are now widely available to market participants and investors. Although the amount of pre-trade pricing information (e.g., bids and offers) available also has increased, it is still relatively limited as compared to equity securities and generally not readily accessible by the investing public. While new technology and communications in the municipal securities market have advanced, the market remains decentralized, with much trading still occurring primarily through individual dealers.  

In light of this evolution of the municipal securities market, the MSRB encourages the use of broker’s brokers, ATSs and other markets that typically provide exposure to offers/bids from multiple dealers, each of which could constitute a separate market, and it recognizes there may be facts and circumstances under which it may be sufficient for a dealer to check only one such market and satisfy the best-execution obligation. However, utilizing one ATS, one broker’s broker or other similar market will not qualify categorically as reasonable diligence in compliance with Rule G-18. To the extent a dealer checks only one ATS, broker’s broker or other similar market when executing customer orders, the dealer’s policies and procedures should establish what facts and circumstances may allow for the checking of only one such market (e.g., competitiveness of the ATS; the number of dealers, offerings or bids an order is generally exposed to through the ATS or broker’s broker; accessibility of quotations) and what steps would be required to be taken in those situations. 

(November 20, 2015) 

(Updated February 7, 2019)

III.5: Only One Market

Q: How does the best-execution obligation apply when there is only one dealer (i.e., only one market) offering or bidding on the subject security? 

A: There is no set number of dealers making an offer or collecting bids on behalf of a customer order the checking of which categorically qualifies as reasonable diligence for compliance with the best-execution obligation, and, in general, dealers’ procedures should provide for the checking of more than one market or the exposure of customer orders to multiple offers or bids (e.g., use of an ATS or broker’s broker). However, the MSRB recognizes there may be facts and circumstances under which it may be sufficient for a dealer to check only one market, including internal inventory only, and satisfy the best-execution obligation. In order to comply with the best-execution obligation, each dealer’s written policies and procedures should address such facts and circumstances and the steps required to be taken in those scenarios. At a minimum, dealers must also consider the other factors identified in MSRB Rule G-18(a), including, but not limited to, information to determine the current market for the subject security (e.g., recent trade history) and information on similar securities (e.g., offerings of similar securities). If a dealer has policies and procedures in place that are reasonably designed and otherwise comply with applicable rules and follows them, it could execute an order for which there is only one available market, as long as such handling and execution also are consistent with the terms of the customer’s order or inquiry as communicated to the dealer. 

(November 20, 2015)

IV. Reasonable Diligence Factors – Information Reviewed to Determine the Current Market for the Subject Security or Similar Securities 

IV.1: Similar Securities

Q: What constitutes a similar security? 

A: The municipal securities market differs significantly from the market for equity securities and options and also can vary significantly depending on the specific municipal security at issue. For example, some municipal securities may trade frequently, be relatively more liquid and have transparent, accessible and firm quotations available. Other municipal securities do not have public quotations or frequent pricing information available, and may trade infrequently; however, some municipal securities that are less liquid also are fungible, meaning that they trade like other, similar securities, and the pricing in these similar securities can be used as a basis for determining prices in a subject security.   

Given the wide variety of municipal securities, it is impracticable for the MSRB to provide an exhaustive list of characteristics that qualify a bond as a “similar security” for purposes of MSRB Rule G-18. By way of example, however, issuer, source of repayment, credit rating, coupon, maturity, redemption features, sector, geographical region and tax status are some factors a dealer could use to identify municipal bonds as similar. If a dealer uses a similar securities analysis, its written policies and procedures should establish how the dealer identifies similar securities, as well as how and when to consider the market for them for the purposes of complying with the best-execution rule. 

(November 20, 2015) 

IV.2: Trade Review

Q: In the absence of a market and the absence of previous trade history with other dealers in the subject security, how should dealers use reasonable diligence in compliance with their best-execution obligations? 

A: The MSRB encourages dealers to incorporate pre- and/or post-trade review(s) into their written policies and procedures for compliance with MSRB Rule G-18, but Rule G-18 does not mandate any specific trade review process and the MSRB recognizes that multiple approaches to trade reviews could satisfy a dealer’s best-execution obligations. Rule G-18 is designed to provide sufficient flexibility to accommodate the diverse population of dealers, which can adopt policies and procedures to be reasonably related to the nature of their business, including the level of sales and trading activity and the type of customer transactions at issue, and to allow dealers to evidence that they have used reasonable diligence in compliance with the rule in a manner different than that used by other dealers. Accordingly, dealers can use a variety of data, such as comparisons to similar securities, internal models for assessing the quality of execution or potential execution and/or other tools or measurements of quality of execution, as part of their policies and procedures for best execution or the evaluation thereof. To fully inform themselves when determining what procedures to use for customer transactions, dealers should consider what procedures they use or would use for executing the same or similar transactions for their own accounts, although such procedures are not absolutely required to be the same. 

(November 20, 2015) 

IV.3: Evaluated Pricing

Q: Can dealers use evaluated pricing as a component of their procedures to comply with the best-execution obligation? 

A: Yes. MSRB Rule G-18(a) requires dealers to use reasonable diligence to ascertain the best market for the subject security and to buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Section (a) includes a non-exhaustive list of factors that a dealer must consider when exercising this diligence, including the information reviewed to determine the current market for the subject security or similar securities. Accordingly, dealers can use a variety of data, which is not required to include, but can include, evaluated pricing as part of their written policies and procedures for best execution or the evaluation of their policies and procedures; however, such use would not categorically make those policies and procedures sufficient for compliance with Rule G-18. 

(November 20, 2015)

V. Maintenance of Adequate Resources 

V.1: Appropriate Level of Resources

Q: How does a firm establish that it has the appropriate level of resources? 

A: Paragraph .02 of the Supplementary Material to MSRB Rule G-18 states that “[a] dealer’s failure to maintain adequate resources (e.g., staff or technology) is not a justification for executing away from the best available market.” Additionally, paragraph .02 states that “[t]he level of resources that a dealer maintains should take into account the nature of the dealer’s municipal securities business, including its level of sales and trading activity.” This provision was designed to provide flexibility to accommodate the diverse population of dealers. Accordingly, an appropriate level of resources will depend on many factors, including, but not limited to, a firm’s amount of business, and dealers need to employ enough resources to assure that they can establish, implement, follow and periodically review and improve written policies and procedures reasonably designed to achieve best execution. 

(November 20, 2015)

VI. Securities with Limited Quotations or Pricing Information 

VI.1: Execution Timing

Q: Are there municipal bonds that require more time for a dealer to use reasonable diligence when effecting a customer transaction, and how does a dealer demonstrate such diligence? 

A: Paragraph .03 of the Supplementary Material to MSRB Rule G-18 requires dealers to make every effort to execute a customer transaction promptly, taking into account prevailing market conditions. Taking a relatively shorter time can suggest a lack of reasonable diligence to ascertain the best market, while taking a relatively longer time can suggest a failure to execute promptly. There is no specific amount of time that is too short or too long to effect a customer transaction; it necessarily will depend on the particular facts and circumstances. Paragraph .03, which is tailored for the municipal securities market and varies from the language of FINRA Rule 5310, therefore, goes on to recognize that, in certain market conditions, dealers may need more time to use reasonable diligence to ascertain the best market for the subject security. This provision clarifies that a dealer should not be considered to have failed to execute promptly in market conditions that are beyond the dealer’s control that cause reasonable diligence to be more time-consuming. This provision, at the same time, is designed to temper the promptness requirement so that it does not undermine the goal of the rule to promote reasonable diligence. By way of example, such market conditions could be illiquidity or infrequent trading of the subject security, low demand for lower-rated bonds, low demand for distressed bonds and low demand for bonds with uncommon structural characteristics.  

The absence or limitation of accessible quotations or pricing information is not uncommon for many municipal securities, but does not relieve a dealer of its best-execution obligations. Indeed, paragraph .06 of the Supplementary Material to Rule G-18 specifically requires dealers to have written policies and procedures in place that address how the dealer will make its best-execution determinations with respect to securities with limited quotations or pricing information and to document its compliance with those policies and procedures. Such policies and procedures could establish what bonds/market conditions are subject to any variance in the dealer’s other order-handling procedures, including establishing what it means to have limited quotations or pricing information, what additional procedures, if any, are required to be followed by dealer personnel, and how such steps are to be documented. For example, these securities may require dealers to take additional steps in order to satisfy the best-execution standard, including, but not limited to, seeking out other sources of pricing information and potential liquidity, including, but not limited to, directly contacting dealers with which they previously have traded the security or that are otherwise known to trade in the security.

The MSRB recognizes that, in some instances, obtaining quotations from multiple markets could adversely affect execution quality due to delays in execution or other factors.[13] Therefore, a dealer generally should analyze other data to which it reasonably has access to determine whether it has ascertained the best market for the subject security, but its policies and procedures should also establish under what facts and circumstances it would be appropriate to obtain quotations or other pricing information from multiple markets. Additionally, if pricing information related to the subject security, such as a dealer’s previous trades in the security, or other pricing information, such as a quotation from another market, is limited or unavailable, a dealer may also consider previous trades in a similar security, if that security and those previous trades constitute a reasonable basis for comparison. As with all policies and procedures related to best execution, paragraph .08 of the Supplementary Material to Rule G-18 requires dealers to periodically review these specific policies and procedures, assess whether they are reasonably designed to achieve best execution, and make promptly any necessary modifications in light of such reviews. 

(November 20, 2015)

VII. Relationship To Fair Pricing 

VII.1: MSRB Rule G-30

Q: How does MSRB Rule G-18, on best execution, relate to MSRB Rule G-30, on prices and commissions? 

A: Rule G-18 is intended to complement, support and foster compliance with the MSRB’s established substantive pricing standards, which are governed by Rule G-30, by improving execution quality for customers and promoting fair competition among dealers resulting in increased market efficiency. However, the rule makes clear that its obligations are distinct from, for example, the fairness and reasonableness of commissions, markups or markdowns.  

Rule G-30 requires dealers to trade with customers at fair and reasonable prices, and to exercise diligence in establishing the market value of municipal securities and the reasonableness of their compensation. Rule G-18, on the other hand, does not contain any substantive pricing standard; it is an order-handling and transaction-execution standard, under which the goal of the dealer’s reasonable diligence is to provide the customer the most favorable price possible under prevailing market conditions. Paragraph .01 of the Supplementary Material makes explicit that Rule G-18 is not an absolute “best-price” standard. The rule requires dealers to exercise reasonable diligence with the goal of obtaining the most favorable price possible under prevailing market conditions, which is accomplished through the use and periodic improvement of policies and procedures; it does not require the dealer to actually obtain the most favorable price possible in each transaction (although it frequently will do so through the use of reasonable diligence), and a failure to obtain the most favorable price possible in a transaction will not necessarily mean that the dealer failed to use reasonable diligence under the circumstances.  

Despite the different purposes of Rules G-18 and G-30, some of the relevant factors in determining the fairness and reasonableness of prices and commissions or service charges, such as the availability of the securities and the nature of the dealer’s business, may also be relevant to the application of the best-execution requirement. Further, although the best-execution rule does not itself contain any substantive standard by which the transaction price itself is to be or could be evaluated, the requirement to use reasonable diligence in the order-handling and transaction-execution process is expected to increase the probability that customers receive fair-and-reasonable prices.  

(November 20, 2015)

VIII. SMMP Eexemption – General 

VIII.1: Qualification

Q:  Does the best-execution obligation apply to all customer transactions? 

A: No. However, the only variance in the requirements of MSRB Rule G-18, according to the characteristics of the customer, is codified in MSRB Rules G-48 and D-15 in the form of the SMMP exemption. Section (e) of Rule G-48, which is the consolidated MSRB rule under which all modified obligations of dealers when dealing with SMMPs are addressed, provides that the best-execution obligation under Rule G-18 does not apply to transactions with customers that are SMMPs as defined in Rule D-15.  

(November 20, 2015) 

VIII.2: Applicability to Non-Recommended Transactions

Q: Will the SMMP exemption from the best-execution rule apply to non-recommended transactions? 

A: Yes. The applicability of the SMMP exemption to MSRB Rule G-18 is triggered by a customer’s status as an SMMP, not whether or not a transaction is recommended by the dealer. However, the applicability of the exemption for any particular SMMP is controlled by the scope of the customer affirmation required by MSRB Rule D-15(c) and provided to the dealer. Specifically, paragraph .02 of the Supplementary Material to Rule D-15 provides that “[t]he customer affirmation may be given either orally or in writing, and may be given on a trade-by-trade basis, a type-of-transaction basis, a type-of-municipal-security basis (e.g., general obligation, revenue, variable rate), or an account-wide basis.” As such, any transaction not covered by a customer’s affirmation would remain subject to the best-execution obligation. 

(November 20, 2015) 

VIII.3: Applicability to Transactions with Other Broker-Dealers

Q: Do dealers need to rely on the SMMP exemption to be relieved of the best-execution obligation for transactions for or with broker-dealer clients? 

A: No. MSRB Rule G-18’s best-execution obligation only applies to transactions for or with a customer or a customer of another dealer, and the MSRB’s definition of “customer” in Rule D-9 does not include broker-dealers acting in their capacity as broker-dealers.[14] Accordingly, there is no need for dealers to rely on the SMMP exemption when executing transactions for or with other broker-dealers, and, therefore, no need for customer affirmations for those broker-dealers to qualify as SMMPs. 

(November 20, 2015) 

VIII.4: Existing Customer Affirmations

Q: Can dealers rely on customer affirmations based on existing MSRB Rule D-15? 

A: No. As of the effective date of MSRB Rule G-18 and the amendments to MSRB Rules G-48 and D-15, a customer will not qualify as an SMMP unless it makes the broader affirmation required by Rule D-15, as amended, which addresses all of the modified dealer obligations provided in Rule G-48, including the exemption from the best-execution obligation. Accordingly, any customer affirmations based on existing Rule D-15 would be ineffective to qualify for the SMMP exemption. 

(November 20, 2015) 

VIII.5: Piecemeal Customer Affirmations and Waiver of Dealer Obligations

Q: Can an SMMP waive time-of-trade disclosures, but still have its trades subject to the best-execution rule? 

A: No. A customer cannot waive, and a dealer is not exempt from the time-of-trade disclosure obligation, unless the customer qualifies as an SMMP.[15] In order to qualify as an SMMP, the customer’s affirmation, according to MSRB Rule D-15, must be unified and speak to all of the modified dealer obligations provided in MSRB Rule G-48, including the modified obligations with respect to both time-of-trade disclosure and best execution. The MSRB has determined that, if a customer is not prepared to forgo all of the legal protections afforded by the dealer obligations that would be modified under Rule G-48 if they were an SMMP, then the customer likely does not have the sophistication necessary to qualify as an SMMP. However, the exemption from the best-execution obligation provided by Rules G-48 and D-15 does not preclude a dealer from following its best-execution policies and procedures when handling SMMP orders. 

(November 20, 2015) 

VIII.6: Customer Affirmation Updates

Q: If a dealer reasonably concludes a customer is an SMMP, is the initial affirmation sufficient for all future trades for that customer, or is there a periodic update requirement for customer affirmations? 

A: Although there is no explicit periodic update requirement for customer affirmations, MSRB Rule G‑48 requires that dealers “reasonably conclude” a customer is an SMMP. After a certain lapse of time, it will become unreasonable for the dealer to continue to rely on the stale affirmation, and the dealer, therefore, could no longer “reasonably conclude,” as required, that the customer is an SMMP. 

(November 20, 2015) 

VIII.7: FINRA Rule 2111

Q: Will an institutional investor’s suitability form/letter in compliance with FINRA Rule 2111 satisfy the affirmation requirement to qualify as an SMMP pursuant to MSRB Rule D-15? 

A: No. FINRA Rule 2111(b) and paragraph .07 of the Supplementary Material thereto provide that one element of the suitability obligation of member firms under that rule is fulfilled if the institution affirmatively indicates that it is exercising independent judgment in evaluating the member's or associated person's recommendations. This is similar to the existing exemption dealers have from the suitability requirement of MSRB Rule G-19 under MSRB Rule G-48(c). But neither FINRA Rule 2111 nor any other FINRA rule provides a similar exemption from best execution or any other obligations for its member firms comparable to those included in Rule G-48. Accordingly, a suitability form/letter limited in its terms to comply with FINRA Rule 2111 would not address the full scope of obligations that dealers would be relieved of fulfilling under the exemptions provided by Rules G-48 and D-15. Therefore, a customer will not qualify as an SMMP unless it makes the affirmation required by Rule D-15, which does address all of the modified dealer obligations provided in Rule G-48.

(November 20, 2015)

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