On April 24, 2009, the Municipal Securities Rulemaking Board (MSRB) published a notice clarifying that “Build America Bonds” and other tax credit bonds are municipal securities and, therefore, subject to MSRB rules.[1]  The MSRB understands that many of these securities contain certain redemption provisions, such as mandatory pro rata sinking funds, and that brokers, dealers and municipal securities dealers (collectively “dealers”) frequently effect transactions on a basis of “yield to average life.”  The MSRB reminds dealers that, for transactions effected on the basis of “yield to average life,” Rule G-15(a), on customer confirmations, requires the confirmation to display that yield as well as the yield computed to the lower of an “in whole” call or maturity.

Rule G-15(a)(i)(A)(5) states requirements for dealers to calculate and display yields and dollar prices on customer confirmations.  For transactions effected on the basis of yield to maturity, call or put date, the yield at which the transaction was effected as well as a dollar price computed to the lower of an “in whole” call or maturity are required to be shown on a confirmation.  Similarly, for transactions effected on the basis of a dollar price, the dollar price at which the transaction was effected along with a yield computed to the lower of an “in whole” call or maturity are required to be shown on a confirmation. 

Sinking funds do not represent “in whole” call features.  Accordingly, MSRB confirmation requirements do not require dealers to compute yield or dollar price to a sinking fund call date or to compute a “yield to average life” using multiple sinking fund dates.  However, dealers should note that if the computed yield otherwise required by Rule G-15(a)(i)(A)(5) is different than the yield at which the transaction was effected, Rule G-15(a)(i)(A)(5)(vii) provides that both the computed yield and the yield at which the transaction was effected must be shown on the confirmation.  Therefore, when a transaction is effected on the basis of “yield to average life,” such yield must be displayed on a customer confirmation. 

Bond insurance companies recently have been subject to increased attention in the municipal securities market as a result of credit rating agency downgrades and ongoing credit agency reviews. Because of these recent events and the prominence of bond insurance in the municipal securities market, the MSRB is publishing this notice to review some of the investor protection rules applicable to brokers, dealers and municipal securities dealers (“dealers”) effecting transactions in insured municipal securities.

RULE G-17 AND TIME OF TRADE DISCLOSURE TO CUSTOMERS

One of the most important MSRB investor protection rules is Rule G-17, which requires dealers to deal fairly with all persons and prohibits deceptive, dishonest, or unfair  practices.  A long-standing interpretation of Rule G-17 is that a dealer transacting with a customer [1] must ensure that the customer is informed of all material facts concerning the  transaction, including a complete description of the security.[2]  Disclosure of material facts to a customer under Rule G-17 may be made orally or in writing, but must be made at or prior to the time of trade. In general, a fact is considered “material” if there is a substantial likelihood that its disclosure would have been considered significant by a reasonable investor.[3]  As applied to customer transactions in insured municipal securities, the disclosures required under Rule G-17 include a description of the securities and identification of any bond insurance as well as material facts that relate to the credit rating of the issue. The disclosures required under Rule G-17 also may include material facts about the credit enhancement applicable to the issue.

March 2002 Notice

In a March 2002 Interpretative Notice, the MSRB provided specific guidance on the disclosure requirements of Rule G-17.[4] The March 2002 Notice clarified that, in addition to the requirement to disclose material facts about a transaction of which the dealer is specifically aware, the dealer is responsible for disclosing any material fact that has been made available through sources such as the NRMSIR system,[5] the Municipal Securities Information Library^® (MSIL^®) system,[6] RTRS,[7] rating agency reports and other sources of information relating to the municipal securities transaction generally used by dealers that effect transactions in the type of municipal securities at issue (collectively, “established industry sources”).[8]  The inclusion of “rating agency reports” within the list of “established industry sources” of information makes clear the Board’s view that information about the rating of a bond, or information  from the rating agency about potential rating actions with respect to a bond, may be material information about the transaction. It follows that, where the issue’s credit rating is based in whole or in part on bond insurance, the credit rating of the insurance company, or information from the rating agency about potential rating actions with respect to the bond insurance company, may be material information about the transaction.

In addition to the actual credit rating of a municipal issue, “underlying” credit ratings are assigned by  rating agencies to some municipal securities issues. An underlying credit rating is assigned to reflect the credit quality of an issue independent of credit enhancements such as bond insurance. The underlying rating (or the lack of an underlying rating)[9] may be relevant to a transaction when the credit rating of the bond insurer is downgraded or is the subject of information from the rating agency about a potential rating action with respect to the insurance company. In order to ensure all required disclosures are made under Rule G-17, a dealer must take into consideration information on underlying credit ratings that is available in established industry sources (or information otherwise known to the dealer) and must incorporate such information when determining the material facts to be disclosed about the transaction.

April 2002 Notice on Sophisticated Municipal Market Professionals

In a notice dated April 30, 2002, the MSRB provided additional guidance on Rule G-17 and other customer protection rules as they apply to transactions with a special class of institutional customers known  as “Sophisticated Municipal Market Professionals” (“SMMPs”).[10] The April 2002 Notice provides a definition of SMMP, which includes critical elements such as the customer’s financial sophistication and access to established industry sources for municipal securities information. When a dealer has reasonable grounds for concluding that the institutional customer is an SMMP as defined in the April 2002 Notice, the institutional customer necessarily is already aware, or capable of making itself aware of, material facts found in the established industry sources. In addition, the customer in such cases is able to independently understand the significance of such material facts.

The April 2002 Notice provides that a dealer’s Rule G-17 obligation to affirmatively disclose material facts available from established industry sources is qualified to some extent in certain kinds of SMMP transactions. Specifically, when effecting nonrecommended, secondary market transactions, a dealer is not required to provide an SMMP with affirmative disclosure of the material facts that already exist in established industry sources. This differs from the general Rule G-17 requirement of disclosure, discussed above, and therefore may be relevant to dealers trading with SMMPs in insured municipal securities.

RULE G-19 AND SUITABILITY DETERMINATIONS

In addition to the customer disclosure obligations relating to bond insurance and credit ratings, dealers also should be aware of how suitability requirements of MSRB Rule G-19 relate to transactions in insured bonds that are recommended to customers. Rule G-19 provides that a dealer must consider the nature of the security as well as the customer’s financial status, tax status and investment objectives when making recommendations to customers.  The dealer must have reasonable grounds for believing that the recommendation is suitable, based upon information available about the security and the facts disclosed by or otherwise known about the customer.[11] Facts relating to the credit rating of a bond insurer may affect suitability determinations, particularly for customers that have conveyed to the dealer investment objectives relating to credit quality of investments. For example, if a customer has expressed the desire to purchase only “triple A” rated securities, recommendations to the customer should take into account information from rating agencies, including information about potential rating actions that may affect the future “triple A” status of the issue.[12]

RULE G-30 AND FAIR PRICING REQUIREMENTS

Another important investor protection provision within MSRB rules is Rule G-30 on prices and commissions. Rule G-30 requires that, for principal transactions with customers, the dealer must ensure that the price of each transaction is fair and reasonable, taking into account all relevant factors. Dealers should consider the effect of ratings on the value of the securities involved in customer transactions, and should specifically consider the effect of information from rating agencies, both with respect to actual or potential changes in the underlying rating of a security and with respect to actual or potential changes in the rating of any bond insurance applicable to the security.

RULE G-15(a) AND CONFIRMATION DISCLOSURE

The content of information required to be included on customer confirmations of municipal securities transactions is set forth in MSRB Rule G-15(a). For securities with additional credit backing, such as bond insurance, the rule requires the confirmation to state “the name of any company or other person in addition to the issuer obligated, directly or indirectly, with respect to debt service.”[13]  Rule G-15(a) does not generally require that credit agency ratings be included on customer confirmations. However, if credit ratings are given on the confirmation, the ratings must be correct.

CONCLUSION

Meeting the disclosure requirements of Rule G-17 requires attention to the facts and circumstances of individual transactions as well as attention to the specific securities and customers that are involved in those transactions. In light of recent events affecting credit ratings of bond insurance companies, dealers may wish to review both the March 2002 Notice on Rule G-17 disclosure requirements and the April 2002 Notice on SMMP transactions to ensure compliance with the rule in the changing environment for bond insurance companies. In addition, dealers may wish to review how transactions in insured securities are being recommended, priced and confirmed to customers to ensure compliance with other MSRB investor protection rules.

[1] The word “customer,” as used in this notice, follows the definition in MSRB Rule D-9, which states that a “customer” is any person other than a broker, dealer, or municipal securities dealer acting in its capacity as such or an issuer in transactions involving the sale by the issuer of a new issue of its securities.

[2] See, e.g., Notice Concerning Disclosure of Call Information to Customers of Municipal Securities (March 4, 1986), MSRB Manual (CCH) para. 3591.

[3]  Se e, e.g., Basic v. Levinson, 485 U.S. 224 (1988).

[4] Interpretive Notice Regarding Rule G-17, on Disclosure of Material Facts, MSRB Notice (March 20, 2002) (hereinafter “March 2002 Notice”).

[6] The MSIL^® system collects and makes available to the marketplace official statements and advance refunding documents submitted under MSRB Rule G-36, on the delivery of official statements, as well as certain secondary market material event disclosures provided by issuers under SEC Rule 15c2-12. Municipal Securities Information Library^® and MSIL^® are registered trademarks of the MSRB.

[7] The MSRB’s Real-Time Transaction Reporting System (“RTRS”) collects and makes available to the marketplace information regarding inter-dealer and dealer-customer transactions in municipal securities.

[8] See March 2002 Notice (emphasis added).

[9] The lack of a rating for a municipal issue does not necessarily imply that the credit quality of such an issue is inferior, but is information that should be taken into account when accessing material facts about a transaction in the security.

[10] Notice Regarding the Application of MSRB Rules to Transactions with Sophisticated Municipal Market Professionals (April 30, 2002) (hereinafter “April 2002 Notice”). [This notice was revised effective July 9, 2012.]

[11] As with Rule G-17, the MSRB has provided specific qualifications with respect to how a dealer fulfills its suitability duties when making recommendations to SMMPs. These are described in the April 2002 Notice on SMMPs, discussed above.

[12] To assure that a dealer effecting a recommended transaction with a non-SMMP customer has the information needed about the customer to make its suitability determination, Rule G-19 requires the dealer to make reasonable efforts to obtain information concerning the customer’s financial status, tax status and investment objectives, as well as any other information reasonable and necessary in making the recommendation. The obligations arising under Rule G-19 in connection with a recommended transaction require a meaningful analysis, taking into consideration the information obtained about the customer and the security, which establishes the reasonable grounds for believing that the recommendation is suitable. Such suitability determinations should be based on the appropriately weighted factors that are relevant in any particular set of facts and circumstances, which factors may vary from transaction to transaction.  See Reminder of Customer Protection Obligations In Connection With Sales of Municipal Securities, MSRB Notice 2007-17 (May 30, 2007).

[13] The rule provides that, if there is more than one such obligor, the statement “multiple obligors” may be shown.  If a security is unrated by a nationally recognized statistical rating organization, Rule G-15(a) requires dealers to disclose the fact that the security is unrated.

The MSRB has received inquiries regarding an interpretation of rule G-15(a) from dealers who offer automated execution of transactions and charge a small, flat "transaction fee" per transaction.  These dealers asked whether a $15.00 flat fee qualifies as a miscellaneous transaction charge. 

Rule G-15(a) sets out confirmation requirements for transactions with customers and specifies that dealers include a yield on the confirmation.  In computing yield, G-15(a)(i)(A)(5)(c)(iii) states that such "computations shall take into account ... commissions charged to the customer ... but shall not take into account incidental transaction fees or miscellaneous charges, provided, however, that ... such fees or charges [are] indicated on the confirmation."  

In a May 14, 1990 Notice Concerning Confirmation Disclosure of Miscellaneous Transaction Charges[1], the MSRB reminded dealers that clear disclosure of the nature and amount of miscellaneous fees is required.  The notice stated that these fees should not be incorporated into the stated yield because they are small and do not significantly affect a customer's return on investment, as shown in the yield.  The notice also stated that miscellaneous fees differ from commissions because they are flat amounts, and, unlike the common practice used in computing commissions for agency transactions, are not related to the par value of the transaction. 

The dealers who contacted the MSRB will charge a flat transaction fee of $15.00 for trades executed through an automated trading system.  Since this fee is relatively small and unrelated to the par value of the transaction, the MSRB believes that the transaction fee should be considered a miscellaneous transaction fee.  Therefore the fee would not have to be incorporated into the stated yield, but would need to be separately disclosed on the confirmation.

Rule G-15(a) requires that, at or before the completion of a transaction in municipal securities with or for the account of a customer, each broker, dealer or municipal securities dealer (dealers) shall give or send to the customer "a written confirmation of the transaction" containing specified information. Securities Exchange Act Rule 10b-10 states similar confirmation requirements for customer transactions in securities other than municipal securities. In December 1992, Thomson Financial Services, Inc. (Thomson) asked the Securities and Exchange Commission (Commission) to allow dealers to use Thomson's OASYS Global system for delivering confirmation under Rule 10b-10. In October 1993, the Commission staff provided Thomson with a "no-action" letter stating that, if OASYS Global system participants agree between themselves to use the system's electronic "contract confirmation messages" (CCMs) instead of hard-copy confirmations and if certain other requirements are met[1] the Commission staff would not recommend enforcement action to the Commission if broker-dealers rely on CCMs sent through the OASYS Global system to satisfy the requirements to confirm a transaction under Rule 10b-10.[2]

Thomson has asked the Board for an interpretation of rule G-15(a) that would allow dealers to use the OASYS Global system for municipal securities transactions to the same extent as dealers are allowed to use the system to comply with Rule 10b-10. The Board believes that the speed and efficiencies offered by electronic confirmation delivery are of benefit to the municipal securities industry, especially in light of the move to T+3 settlement. Therefore, the Board has interpreted the requirement in rule G-15(a) to provide customers with a written confirmation to be satisfied by a CCM sent through the OASYS Global system when the following conditions are met: (i) the customer and dealer have both agreed to use the OASYS Global system for purposes of confirmation delivery; (ii) the CCM includes all information required by rule G-15(a); and (iii) all other applicable requirements and conditions concerning the OASYS Global system expressed in the Commission's October 8, 1993 no-action letter concerning Securities Exchange Act Rule 10b-10 continue to be met.[3]

[1] The other requirements contained in the Commission's no-action letter are as follows: (i) that the CCMs can be printed or downloaded by the participants, (ii) that the recipient of a CCM must respond through the system affirming or rejecting the trade, (iii) that the CCMs will not be automatically deleted by the system, and (iv) that the use of the system by the participants ensures that both parties to the transaction have the capacity to receive the CCMs.

[2] The Commission's October 8, 1993 no-action letter is reprinted in MSRB Reports, Vol. 14, No. 3 (June 1994) at 38-39.

[3] The Board understands that Thomson's OASYS Global system is not at this time a registered securities clearing agency and is not linked with other registered securities clearing agencies for purposes of automated confirmation/acknowledgement required under rule G-15(d). Thus, under these circumstances, use of the OASYS Global system will not constitute compliance with rule G-15(d) on automated confirmation/acknowledgement.

New products are constantly being introduced into the municipal securities market. Dealers must ensure that, prior to effecting transactions with customers in municipal securities with new features, they obtain all necessary information regarding these features. The Board will attempt periodically through educational notices to describe new products or features of municipal securities and review the responsibilities of dealers to customers in these transactions. In this notice, the Board will review detachable call features.

Certain recent issues of municipal securities include a new feature called a detachable call right. This feature allows the issuer to sell its right to call the bond. Thus, upon the sale of this call right, the owner of the right has the ability, at certain times, to require the mandatory tender of the underlying municipal bond. The dates of mandatory tender of the underlying bonds generally correlate with the optional call dates. If the holder exercises such rights, the underlying bondholder tenders its bond to the issuer (just as if the issuer had called the bond) and the holder of the call right purchases the bond. In some instances, issuers already have issued municipal call rights and the underlying bonds in such cases are sometimes referred to as being subject to "detached" call rights.

Bonds subject to detachable call rights generally include a provision that permits an investor that owns both the detached call right and the underlying bond to link the two instruments together, subject to certain conditions. Such "linked" municipal securities would not be subject to being called at certain times by holders of call rights or the issuer. They may, however, be subject to other calls, such as sinking fund provisions. If a customer obtains a linked security, thereafter the customer has the option to de-link the security, again subject to certain conditions, into a municipal call right and an underlying bond subject to a right of mandatory tender.

Applicability of Board Rules

Of course, the Board’s rules apply to bonds subject to detachable call features and "linked" securities just as they apply to all other municipal securities. The Board, however, would like to remind dealers of certain Board rules that should be considered in transactions involving these municipal securities.

Rule G-15(a) on Customer Confirmations

Rule G-15(a)(i)(E)[*] requires customer confirmations to set forth "a description of the securities, including… if the securities are… subject to redemption prior to maturity…, an indication to such effect." Additionally, rule G-15(a)(iii)(F)[*] requires a legend to be placed on customer confirmations of transactions in callable securities which notes that "Call features may exist which could affect yield; complete information will be provided upon request."

Confirmations of transactions in bonds subject to detachable call rights, therefore, would have to indicate this information.[1] In addition, the details of the call provisions of such securities would have to be provided to the customer upon the customer’s request.

Confirmation disclosure, however, serves merely to support—not to satisfy—a dealer’s general disclosure obligations. More specifically, the disclosure items required on the confirmation do not encompass "all material facts" that must be disclosed to customers at the time of trade pursuant to rule G-17.

Rule G-17 on Fair Dealing

Rule G-17 of the Board’s rules of fair practice requires municipal securities dealers to deal fairly with all persons and prohibits them from engaging in any deceptive, dishonest, or unfair practice. The Board has interpreted this rule to require that a dealer must disclose, at or before the sale of municipal securities to a customer, all material facts concerning the transaction, including a complete description of the security, and must not omit any material facts which would render other statements misleading. Among other things, a dealer must disclose at the time of trade whether a security may be redeemed prior to maturity in-whole, in-part, or in extraordinary circumstances because this knowledge is essential to a customer’s investment decision.

Clearly, bonds subject to detachable calls must be described as callable at the time of the trade.[2] In addition, if a dealer is asked by a customer at the time of trade for specific information regarding call features, this information must be obtained and relayed promptly.

Although the Board requires dealers to indicate to customers at the time of trade whether municipal securities are callable, the Board has not categorized which, if any, specific call features it considers to be material and therefore also must be disclosed. Instead, the Board believes that it is the responsibility of the dealer to determine whether a particular feature is material.

With regard to detachable calls, dealers must decide whether the ability of a third party to call the bond is a material fact that should be disclosed to investors. Dealers should make this determination in the same way they determine whether other facets of a municipal securities transaction are material—is it a fact that a reasonable investor would want to know when making an investment decision? For example, would a reasonable investor who knows a bond is callable base an investment decision on whether someone other than the issuer can call the bond? Does this new feature affect the pricing of the bond?

*  *  *

The Board is continuing its review of detachable call rights and may take additional related action at a later date. The Board welcomes the views of all persons on the application of Board rules to transactions in securities subject to detachable call rights.

[1] With regard to the confirmation requirement for linked securities, if these securities are subject to other call provisions such as sinking fund calls, the customer confirmation must indicate that these securities are callable.

[2] Similarly, when considering the application of rule G-17 to transactions in "linked" securities, as with other municipal securities, dealers have the obligation to ensure that investors understand the features of the security. In particular, if a linked security to other call provisions, dealers should ensure that retail customers do not mistakenly believe the bond is "non-callable."

[*] [Currently codified at rule G-15(a)(i)(C)(2)(a)]