In November 1998, the MSRB published an interpretation about the use of electronic media to deliver and receive information by brokers, dealers and municipal securities dealers under Board rules (the “1998 interpretation”).  Since that time, the MSRB has been granted rulemaking authority over municipal advisors, and in the exercise of that authority, the MSRB has been developing a comprehensive regulatory framework for municipal advisors.

 

The Board believes that the use of electronic media to deliver and receive information under Board rules also is important for municipal advisors, and extends the guidance provided in the 1998 interpretation, as relevant, to municipal advisors.  See Rule G-32 Interpretation – Notice Regarding Electronic Delivery and Receipt of Information by Brokers, Dealers and Municipal Securities Dealers (November 20, 1998).

 

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).

 

The MSRB amended Rule G-17, regarding fair dealing, to require that, in the conduct of their municipal advisory activities, municipal advisors, including solicitor municipal advisors, and their associated persons must deal fairly with all persons and not engage in any deceptive, dishonest, or unfair practice. (Previously, the rule applied only to dealers and their associated persons.) Rule G-17 became applicable to all municipal advisors, including solicitor municipal advisors, and their associated persons, on December 22, 2010.

Rule G-17 contains an anti-fraud prohibition similar to the standard set forth in Rule 10b-5 adopted by the SEC under the Exchange Act. Thus, all municipal advisors must refrain from engaging in certain conduct and must not misrepresent or omit the facts, risks, or other material information about municipal advisory activities undertaken. However, Rule G-17 does not merely prohibit deceptive conduct on the part of a municipal advisor. The rule also establishes a general duty of a municipal advisor to deal fairly with all persons, even in the absence of fraud.

Rule G-17 imposes a duty of fair dealing on solicitor municipal advisors when they are soliciting business from municipal entities and obligated persons on behalf of third parties. Again, municipal advisors are reminded that the term “municipal entity” also includes certain entities that do not issue municipal securities. Thus, in addition to owing the specific obligations discussed below to issuers of municipal securities, solicitor municipal advisors also owe such obligations to, for example, state and local government sponsored public pension plans and local government investment pools.

The duty of fair dealing includes, but is not limited to, a duty to disclose to the municipal entity or obligated person being solicited material facts about the solicitation, such as the name of the solicitor’s client; the type of business being solicited; the amount and source of all of the solicitor’s compensation; payments (including in-kind) made by the solicitor to another solicitor municipal advisor (including an affiliate, but not an employee) to facilitate the solicitation regardless of characterization; and any relationships of the solicitor with any employees or board members of the municipal entity or obligated person being solicited or any other persons affiliated with the municipal entity or obligated person or its officials who may have influence over the selection of the solicitor’s client.

Additionally, if a solicitor municipal advisor is engaged by its client to present information about a product or service offered by the third-party client to the municipal entity or obligated person, the solicitor municipal advisor must disclose all material risks and characteristics of the product or service. The solicitor municipal advisor must also advise the municipal entity or obligated person of any incentives received by the solicitor (that are not already disclosed as part of the solicitor municipal advisor’s compensation from its client) to recommend the product or service, as well as any other conflicts of interest regarding the product or service, and must not make material misstatements or omissions when discussing the product or service.

Under the Exchange Act, municipal advisors and their associated persons are deemed to owe a fiduciary duty to their municipal entity clients.[*] Similarly, Rule G-42 (which applies only to non-solicitor municipal advisors) follows the Exchange Act in deeming municipal advisors to owe a fiduciary duty, for purposes of Rule G-42, to such municipal entity clients. However, because a solicitor municipal advisor’s clients are not the municipal entities that they solicit, but rather the third parties that retain or engage the solicitor municipal advisor to solicit such municipal entities, solicitor municipal advisors do not owe a fiduciary duty under the Exchange Act or MSRB rules to their clients (or the municipal entity) in connection with such activity. Nonetheless, as noted above, solicitor municipal advisors are subject to the fair dealing standards under Rule G-17 (including with respect to their clients and the entities that they solicit).

From time to time the Board has received inquiries from purchasers of municipal securities concerning the duty of municipal securities brokers and dealers to deliver securities to customers under the Board’s rules. In particular, customers have asked what, if any, remedies are available when long delays occur between the purchase, payment and delivery of municipal securities. The Board has advised such individuals that under rule G-17, the Board’s fair dealing rule, a municipal securities broker or dealer has a duty to deliver securities sold to customers in a prompt fashion.

The Board is mindful that a dealer’s failure to deliver municipal securities often is caused by its failure to receive delivery of the securities from another dealer or by other circumstances beyond its control. It nevertheless believes that a dealer’s duty to deliver securities promptly to customers is inherent in rule G-17.[1] A violation of that duty could occur, for example, if a dealer sells securities to a customer when it knows that it cannot effect delivery by the specified settlement date or within a reasonable length of time thereafter and does not disclose that fact to its customer.

The Board notes that customers who fail to receive securities are not entitled to take advantage of the Board’s procedures to close out a failed transaction which are available only for inter-dealer transactions under rule G-12. However, if a customer sustains a loss or otherwise is damaged by his dealer’s failure to deliver securities, he may seek recovery through the Board’s arbitration program or through litigation. These remedies may accrue to the customer whether or not a dealer’s failure to deliver violates rule G-17.

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[1] The duty of a securities professional to complete promptly transactions with customers also has been found to flow from the federal securities laws by the SEC and the courts.

Automated clearance: "internal" transactions. As you are aware, the Board has been considering for the past year the adoption of amendments to the Board rules to mandate the use of automated confirmation/comparison and book-entry settlement systems in connection with the clearance of certain inter-dealer and customer transactions in municipal securities. In connection with its consideration of this matter, the Board released, in July 1982, an exposure draft of a proposal to apply such requirements to customer transactions, and, in March 1983, two exposure drafts of comparable proposals with respect to customer transactions and inter-dealer transactions. The Board has recently taken action on these proposals, and adopted amendments to its rules, substantially along the lines of the March 1983 proposals, for filing with the Securities and Exchange Commission; a copy of the notice of filing of these amendments is enclosed for your information.

[The bank] commented to the Board on both the July 1982 exposure draft, by letter dated October 15, 1982 from [name omitted] of the bank's Operations Department, and on the March 1983 exposure drafts, by letter dated June 1, 1983 from yourself. In these letters, among other comments, the bank suggested that the proposed requirement for the use of automated confirmation and book-entry settlement systems on certain customer transactions should not apply in circumstances where the transaction is between the bank's dealer department and a customer who clears or safekeeps securities through the dealer department or through the bank's custodian or safekeeping department. Your June 1983 letter, for example, commented as follows:

Internal trades [with] customers of a dealer bank are not exempt from the amendment. This seems inconsistent with operating efficiency and the objectives of the amendment. Technically, a bank dealer would have to submit to [an automated confirmation and book-entry settlement system] trades made with customers who clear or safekeep through another department in the bank. If adopted, the amendment should allow for such an exemption.

I am writing to advise you that, in reviewing the comments on the July 1982 and March 1983 proposals, the Board concurred with this suggestion. The Board is of the view that the proposed requirement for the automated confirmation and book-entry settlement of certain customer transactions does not apply to a purchase or sale of municipal securities effected by a broker, dealer, or municipal securities dealer for the account of a customer in circumstances where the securities are to be delivered to or received from a clearance or safekeeping account maintained by the customer with the broker, dealer, or municipal securities dealer itself, or with a clearance or safekeeping department of an organization of which the broker, dealer, or municipal securities dealer is a division or department. MSRB interpretation of September 21, 1983.

Financial advisory relationship: potential underwriter. This responds to your letter of July 20, 1983, requesting our view on the applicability of Board rule G-23 to the following situation:

Your firm, a registered municipal securities dealer, along with an architectural firm and a construction firm, plans to present to a municipality a proposal to design, build and finance a criminal justice facility. If the municipality shows interest, the team members will suggest that the municipality engage them to put together a specific, customized proposal for review. If the municipality accepts this proposal, the team will ask the municipality to execute a contract covering the additional services. This contract will provide for compensation to be paid to the firm in connection with the creation of a financing proposal. This proposal could encompass such issues as those set forth in Rule G-23(b). Further, it is the intent of the team members that a project may ultimately be brought to fruition by all or any one of the team members. Therefore, the firm may make the final financing proposal but fail to be retained by the municipality to actually finance the construction. In this event, the other two team members will proceed and the municipality will obtain another underwriter. However, it will be the firm's intent throughout the negotiation phase to ultimately be retained as the municipality's underwriter.

You express concern whether the above facts create a financial advisory relationship under rule G-23(b). Board rule G-23(b), concerning activities of financial advisors, provides that a financial advisory relationship shall be deemed to exist:

"when a broker, dealer, or municipal securities dealer renders or enters into an agreement to render financial advisory or consultant services to or on behalf of an issuer with respect to a new issue or issues of municipal securities,..."

The rule provides, however, that a financial advisory relationship shall not be deemed to exist

"when, in the course of acting as an underwriter , a municipal securities dealer renders advice to an issuer, including advice with respect to the structure, timing, terms and other similar matters concerning a new issue of municipal securities." [Emphasis added]

It does not appear that your firm would be rendering advice to the municipality "in the course of acting as an underwriter." In the beginning of the firm's relationship with the municipality, it is acting as a financial advisor, and being compensated as such. No underwriting agreement has been executed with the municipality. Therefore, based upon the representations in your letter, it appears that the firm's activities would be subject to the requirements of rule G-23. MSRB interpretation of September 7, 1983.

Inclusion of IDB-related activities. This responds to your letter of June 14, 1983 concerning your request for an interpretation of Board rule G-1, which defines a "separately identifiable department or division" of a bank. In particular, you request our advice concerning whether certain activities engaged in by your Corporate Finance Division (the "Division") should be considered "municipal securities dealer activities" for purposes of the rule. Your letter and a subsequent telephone conversation set forth the following facts:

The Division acts as financial advisor to certain corporate customers of the Bank. Some of these customers wish to raise money through the issuance of IDBs. In order to assist these corporations in the placement of the IDBs, the Division contacts from one to ten institutional investors and provides them with information regarding the terms of the proposed financing and basic facts about the corporation. If the investor expresses interest in the financing, a confidential memorandum describing the financing, prepared by the corporation with the assistance of the Division, is sent.

During negotiations between the corporation and the investor, the Division may act as a liaison between the two parties in the communication of comments on the financing documents. According to the bank, the Division is not an agent of the corporation and is not authorized to act on behalf of the corporation in accepting any terms or conditions associated with the proposed financing. For its services, the Division usually receives a percentage of the total dollar amount of securities issued, with a minimum contingent on the successful completion of the deal. While the bank has established a separately identifiable division pursuant to rule G-1, the Division is not part of it.

Your inquiry was discussed by the Board at its July meeting. The Board is of the view that the activities of the Division, as described, constitute the sales of municipal securities for purposes of the definition of municipal securities dealer activities in Board rule G-1. Therefore, these activities should be conducted in the bank's registered separately identifiable department by persons qualified under the Board's professional qualifications rules. MSRB interpretation of July 26, 1983.

Use of formulas: annual interest securities. I am writing in response to your letter of June 1, 1983 regarding the appropriate method of calculating yield and dollar price on periodic-interest municipal securities which pay interest on an annual, rather than the more customary semi-annual, basis. You note in your letter that Board rule G-33 requires the use for purposes of computations of yield and dollar price on such securities of a formula which presumes semi-annual payment of interest (i.e., that formula set forth in subparagraph (b)(i)(B)(2) of the rule). You suggest that the rule should be amended to require the use of a formula that recognizes the annual interest payment cycle on the securities.

As I indicated to you in our previous telephone conversation on this subject, the industry has traditionally disregarded the unusual nature of the interest payment cycle on these securities when computing yields and dollar prices on them, and has followed the practice of using the standard formula for computing yield and dollar price on a security paying interest on a semi-annual basis for these purposes. As a result of this traditional practice, all of the calculators presently available for use by industry members when computing yields and dollar prices have been designed in accordance with the assumption that all periodic-interest municipal securities pay interest on a semi-annual basis; these calculator models cannot be used to compute yields and dollar prices on such securities on any other basis. Therefore, the adoption of a requirement that yields and dollar prices on securities which pay interest on an annual basis be computed by means of a formula which recognizes the annual nature of the interest payment cycle, such as you suggest, would render all of the existing calculator models obsolete, and require that all industry members incur the cost of purchasing new calculator equipment capable of performing such computations (equipment which does not, to my knowledge, exist as of yet).

It is because of the substantial compliance expense that would have been imposed on the industry that the Board declined to adopt a requirement such as you suggest at the time rule G-33 was promulgated, even though it recognized that the requirement that was adopted mandated the use of a formula that would produce slightly less accurate results. MSRB interpretation of June 6, 1983.

Microfilming of records. I am writing in response to your letter of May 20, 1983 regarding our previous conversations about the requirements of Board rules G-1 and G-9 as they would apply to the bank's retention of dealer department records on microfilm. In your letter and our previous conversations you indicated that the bank wishes to retain all of the records required to be maintained by its municipal securities dealer department on microfilm, with the hard copy of each record destroyed immediately after it has been microfilmed. You inquired as to the circumstances under which this method of record retention could be used. You also inquired about the extent to which municipal securities dealer department records could be commingled with records of other departments on the same strips of microfilm.

As you are aware, Board rule G-9(e) provides that

a record...required to be preserved by this rule...may be retained...on microfilm, electronic or magnetic tape, or by the other similar medium of record retention, provided that [the] municipal securities broker or municipal securities dealer shall have available adequate facilities for ready retrieval and inspection of any such record and for production of easily readable facsimile copies thereof and, in the case of records retained on microfilm, electronic or magnetic tape, or other similar medium of record retention, duplicates of such records shall be stored separately from each other for the periods of time required by this rule.

Therefore, the following three conditions must be met, if records are to be retained on microfilm: 

(1) facilities for ready retrieval and inspection of the records (such as a microfilm reader or other similar piece of equipment) must be available;

(2) facilities for the reproduction of a hard copy facsimile of a particular record must also be available; and

(3) duplicate copies of the microfilm must be made and stored separately for the necessary time periods.

If these conditions are met, the retention of records by means of microfilm is satisfactory for purposes of the Board's rules, and hard copy records need not be retained after the microfilming is completed.

With respect to the establishment of a separately identifiable municipal securities dealer department of a bank, Board rule G-1 provides that all of the records relating to the municipal securities activities of such department must be

separately maintained in or separately extractable from such [department's] own facilities or the facilities of the bank...[and must be] so maintained or otherwise accessible as to permit independent examination thereof and enforcement of applicable provisions of the Act, the rules and regulations thereunder and the rules of the Board.

These requirements would not preclude you from maintaining the required records on microfilm which also contained other bank records, as long as the required records were "separately extractable." The course of action you propose, maintaining all municipal securities dealer department records together as the first items on a roll of microfilm, would seem to be an appropriate way of complying with these requirements. MSRB interpretation of June 6, 1983.

In a recent letter to the Office of the Comptroller of the Currency, the staff of the Securities and Exchange Commission has taken the position that private placements of industrial development bonds ("IDBs") constitute transactions in municipal securities as defined in the Securities Exchange Act of 1934, as amended. The Municipal Securities Rulemaking Board has received a number of inquiries concerning this letter. The Board is publishing this notice for the purposes of: (1) reviewing the application of its rules to private placements of municipal securities and (2) expressing its views concerning whether certain Board rules apply to financial advisory services rendered by municipal securities dealers and brokers to corporate obligors on IDBs.

A. Private Placements of IDBs

The Board’s rules apply, of course, to all transactions in municipal securities, including securities which are IDBs. The SEC letter dealt in particular with the activities of commercial banks. That letter pointed out that if a commercial bank has a registered municipal securities dealer department, under Board rule G-1, which defines the term "separately identifiable department or division of a bank," any private placement activities of the bank in securities which are IDBs must be conducted as a part of the registered dealer department. The Board urges all bank dealers which have registered as a separately identifiable department or division to review their organizations and assure that all departments or units which engage in the private placement of IDBs are designated on the bank’s Form MSD registration and other applicable bank records as part of its separately identifiable department or division. The Board also notes that such activities must be under the supervision of a person designated by the bank’s board of directors as responsible for these activities. In addition, under Board rule G-3, concerning professional qualifications, persons who are engaged in privately placing municipal securities must be qualified as municipal securities representatives and be supervised with respect to that activity by a qualified municipal securities principal.

B. Financial Advisory Services Rendered to Corporate Obligors on IDBs

Board rules G-1 and G-3 provide that rendering "financial advisory or consultant services for issuers" is an activity to which those rules are applicable (emphasis added). Similarly, Board rule G-23, on the activities of financial advisors, applies to brokers, dealers, and municipal securities dealers who agree to render "financial advisory or consultant services to or on behalf of an issuer" (emphasis added). Clearly these rules are applicable to financial advisory services rendered to state or local governments and their agencies, as well as to municipal corporations. In the Board’s view, however, rules G-1, G-3, and G-23 do not apply to financial advisory services which are provided to corporate obligors in connection with proposed IDB financings.

The Board wishes to emphasize that the scope of its definition of financial advisory services is limited to "advice with respect to the structure, timing, terms, and other similar matters" concerning a proposed issue.[1] If persons providing such advice to the corporate obligor on an IDB issue also participate in negotiations with prospective purchasers or are otherwise engaged in effecting placement of the issue, then, as indicated above, rules G-1 and G-3 would apply to their activities.

[Excerpts of the Commission letter follow:]

This is in response to your letter of December 1, 1981, requesting our views concerning certain activities by commercial banks in connection with industrial development bonds ("IDBs").[2] Specifically, you asked (1) whether the private placement activities of banks in IDBs involve transactions in municipal securities, (2) whether involvement in such activities alone would require such banks to register with the Commission under Section 15B of the Securities Exchange Act of 1934 (the "Exchange Act") as municipal securities dealers, (3) whether a bank that had registered a separately identifiable department or division with the Commission as a municipal securities dealer would be required to conduct such activities through such separately identifiable department or division, and (4) if such bank activities are required to be conducted in the separately identifiable department or division, whether the advisory services provided by those banks to the corporate obligor on an IDB should be regarded as advisory services provided to an issuer of municipal securities in connection with the issuance of municipal securities. Pursuant to your letter and subsequent telephone conversations, we understand the following facts to be typical of the activities in question.

A commercial bank offers private placement and financial advisory services to corporate entities on a regular and continuous basis. From time to time the bank recommends to the corporate entity that IDBs be used to raise capital. The bank advises the corporate entity regarding the terms and timing of the proposed IDB issuance, prepares the Direct Placement Memorandum describing the terms of the IDB, and contacts potential purchasers of the IDB. Such purchasers then make independent reviews of the corporate entity’s financial status. The bank then obtains comments from the potential buyers and relays such comments to the corporate entity. The bank might also assist the corporate entity in subsequent negotiations with the purchasers. An industrial development authority nominally issues the IDB on behalf of the corporate entity which becomes the economic obligor on the issue.

The bank engages in these activities in order to assist the corporate obligor in the sale of the IDBs. In return for its services, the bank receives from the corporate entity either a fixed fee or a percentage of the proceeds of the sale. The bank does not purchase any of the IDBs. The bank could, however, supply "bridge loans" to the corporate entity pending receipt of the proceeds of the IDB sale. In addition, the bank might provide investors with a letter of credit committing the bank to pay any interest or principal not paid by the corporate issuer. The bank might also act as trustee or paying agent for the nominal issuer of the IDB, for which the bank would receive a set fee.

IDBs AS MUNICIPAL SECURITIES

Section 3(a)(10) of the Exchange Act defines a "security" as, among other things, "any note… bond, debenture… investment contract, …or in general, any instrument commonly known as a ‘security’… " Section 3(a)(29) of the Exchange Act defines "municipal securities" to include any security which is an industrial development bond as defined in Section 103(b)(2) of the Code the interest on which is tax-exempt under Sections 103(b)(4) or 103(b)(6) of the Code. In our opinion, the private placement activities you have described involve transactions in municipal securities as defined in the Exchange Act.[3]

REGISTRATION AS MUNICIPAL SECURITIES DEALER

Section 15B(a) of the Exchange Act makes it unlawful for any municipal securities dealer to use the mails or any instrumentality of interstate commerce to "effect any transaction in, or to induce or attempt to induce the purchase or sale of, any municipal security unless such municipal securities dealer is registered" with the Commission. Section 3(a)(30) of the Exchange Act defines "municipal securities dealer" to include a bank or a separately identifiable department or division of a bank if that bank is engaged in the business of buying and selling municipal securities for its own account other than in a fiduciary capacity, through a broker or otherwise. Banks that engage solely in private placement activities in IDBs as described by you would not be required to register as municipal securities dealers since they do not appear to be engaged in the business of buying and selling municipal securities for their own accounts, but rather appear to be acting as brokers. Section 3(a)(4) of the Exchange Act defines the term broker as "any person engaged in the business of effecting transactions in securities for the account of others, but does not include a bank." Since they are excluded from the definition of broker, banks that act solely as brokers need not register under the Exchange Act.[4]

INCLUSION IN SEPARATELY IDENTIFIABLE DEPARTMENT OR DIVISION

Section 15B(b)(2)(H) of the Exchange Act authorizes the Municipal Securities Rulemaking Board (the "MSRB") to make rules defining the term "separately identifiable department or division" ("SID") of a bank as used in Section 3(a)(30) of the Exchange Act. MSRB rule G-1 defines the SID as "that unit of the bank which conducts all the activities of the bank relating to the conduct of business as a municipal securities dealer…" The rule defines municipal securities dealer activities to include "sales of municipal securities" and "financial advisory and consultant services for issuers in connection with the issuance of municipal securities." Therefore, those banks that have registered an SID with the Commission also must conduct the private placement activities within the SID in accordance with MSRB rules…

Based upon the facts and representations set forth in your letter, it would appear that the private placement activities of banks involving IDBs, as described in your example, constitute transactions in municipal securities that, if done alone, would not require a bank to register with the Commission as a municipal securities dealer. However, such activities, when conducted by a bank municipal securities dealer that had registered a separately identifiable department or division, would be treated as municipal securities dealer activities and, therefore, would be required to be conducted in the bank’s dealer department…

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[1] Rule G-23(b).

[2] You have represented that the IDBs involved would be primarily those defined in Section 103(b)(2) of the Internal Revenue Code of 1954 (the "Code"), the interest on which is tax-exempt under Sections 103(b)(4) and 103(b)(6) of the Code.

[3]This determination is based on an analysis of the specific facts as described by you. Different facts and circumstances could result in a transaction involving municipal debt instruments being treated as loan participations not subject to the federal securities laws. Such determinations can only be made on a case by case basis after a thorough examination of the context of the transaction.

[4] See letter dated February 17, 1977, from Anne E. Chafer, Attorney, Securities and Exchange Commission, to Bruce F. Golden and letter dated January 11, 1982, from Thomas G. Lovett, Attorney, Securities and Exchange Commission, to Harriet E. Munrett regarding Citytrust of Bridgeport, Connecticut.

Municipal securities principal: bank operations. I am writing in response to your letter of April 26, 1983 concerning the results of a recent examination of your bank's municipal securities dealer department by examiners from the Office of the Comptroller of the Currency. In your letter you indicate that the examiners expressed the view that the bank's present organizational structure did not comport with the definition of a "separately identifiable department or division of a bank" set forth in Board rule G-1. You note that the examiners' basis for this conclusion was their belief that the municipal securities processing functions of the bank were not under the supervision of a qualified municipal securities principal. You state that you disagree with the examiners' conclusions, and you request that the Board indicate whether, in its view, the organizational structure through which the bank presently carries on its municipal securities activities is satisfactory for purposes of compliance with Board rules.

As a general matter we would hesitate to disagree with the opinion expressed by on-site examiners in a matter of this sort. The examiners are, of course, in direct contact with the matter in question, and have access to the full details of the situation, rather than an abstraction or summary of the particulars. Accordingly, we are unable to express a view that the examiners' conclusions are incorrect in the circumstances you describe.

With respect to the specific issues which you raise, it is not impossible for a bank to establish a "separately identifiable department or division" for purposes of rule G-1 which includes areas in the bank which, for other purposes (e.g., for general bank organizational and reporting purposes), would be considered separate. To the extent that such areas are engaged in municipal securities dealer activities (as enumerated in rule G-1), however, they must be under the supervision of the person or persons designated by the bank's board of directors, in accordance with rule G-1(a)(1), as responsible for the conduct of such activities.

As you are aware, the person or persons who are responsible for the management and supervision of the day-to-day activities of the municipal securities processing area need not be qualified as municipal securities principals if they do not have policy-making authority with respect to such activities. However, such activities must be subject to the supervision of a municipal securities principal. Therefore, if those directly involved in the day-to-day supervision of the municipal securities processing activities do not have policy-making authority over such activities and, as a consequence, are not qualified as municipal securities principals, a person who is qualified as a municipal securities principal (whether that person designated by the bank's board of directors pursuant to rule G-1(a)(1) or some other person who is subordinate to that person) must be designated as having responsibility for the supervision of the processing activities. The bank's supervisory procedures should appropriately reflect such designation and set forth the manner in which the designated person will carry out these responsibilities. MSRB interpretation of May 13, 1983.

The Board has received several inquiries from banks concerning the activities which may be performed in connection with the marketing of municipal securities through branch, affiliate, and correspondent banks. Rule G-2 of the Board provides that no municipal securities dealer may effect transactions in, or induce or attempt to induce the purchase or sale of any municipal security, unless the dealer in question and every individual associated with it is qualified in accordance with the rules of the Board. Board rule G-3 establishes qualification requirements for municipal securities representatives and other municipal securities professionals. Board rule G-27 requires supervision of municipal securities activities by qualified municipal securities principals.

Activities of Branch, Affiliate and Correspondent Bank Personnel

Bank employees who are not qualified municipal securities representatives may perform certain limited functions in connection with the marketing of municipal securities. Namely, such persons may:

• advise customers that municipal securities investment services are available in the bank;

• make available to customers material concerning municipal securities investments, such as market letters and listings of issues handled by the bank's dealer department, which has been approved for distribution by the dealer department's municipal securities principal; and,

• establish contact between the customer and the dealer department.

Further sales-related activity would be construed as inducing or attempting to induce the purchase or sales of a municipal security, and may only be engaged in by duly-qualified municipal securities representatives.

The Board wishes to emphasize that each bank dealer should take steps to assure that its branch, correspondent, and affiliate bank personnel understand and observe the restrictions outlined above concerning referrals of municipal securities customers to the bank's dealer department.

Placement and Supervision of Municipal Securities Representatives

Bank dealers have also directed inquiries to the federal bank regulators and to the Board concerning whether qualified municipal securities representatives in affiliates or branches of a bank dealer may respond to customer inquiries concerning municipal securities and take customer orders for municipal securities if no municipal securities principal is located in such affiliates or branches. Board rule G-27 places on each broker, dealer, and municipal securities dealer the obligation to supervise the municipal securities activities of its associated persons and the conduct of its municipal securities business. The rule requires that municipal securities dealers designate a municipal securities principal as responsible for the supervision and review of municipal securities transactions and other activities. There is no requirement that a municipal securities principal be located in each office or branch of a municipal securities dealer, provided that adequate supervision of all municipal securities activities can be assured. For purposes of the Board rules, each employee of a branch or affiliate of a bank dealer who communicates with public customers on investment opportunities in municipal securities and who takes customers' orders for such securities would be considered an "associated person" to whom the Board's qualification and supervision requirements would apply.

Callable securities: extraordinary mandatory redemption features. I am writing in response to your letter of February 15, 1983 regarding the confirmation disclosure requirements applicable to municipal securities which are subject to extraordinary mandatory redemption features. In your letter you inquire whether such securities need be identified as "callable" securities on the confirmation. You also inquire as to the relationship between an extraordinary mandatory redemption feature and a "catastrophe call" feature, and the disclosure requirements applicable to the latter type of provision.

An extraordinary mandatory redemption feature, in my understanding, is a call provision under which an issuer of securities would be obliged to call all or a part of an issue if certain stated unexpected events occur. For example, many of the recent mortgage revenue issues have extraordinary mandatory redemption provisions under which securities would be called if a portion of the proceeds of the issue has not been used to acquire mortgages by a certain stated date, or if moneys received from principal prepayments have not been used to acquire new mortgages by a certain period following receipt of the prepayment. In general, securities which are subject to extraordinary mandatory redemption provisions must be identified as "callable" securities on any confirmation. Extraordinary redemption provisions would not, however, be used for purposes of computing a yield or dollar price.

One specific type of extraordinary mandatory redemption provision is what has been colloquially termed a "catastrophe" or "calamity" call provision. Under this type of provision the issuer of securities would be obliged to call all or part of an issue if the financed project is destroyed or damaged by some catastrophe (e.g., by fire, flood, lightning or other act of God) or if the tax exempt status of the issue is negated. The Board has previously expressed the view that securities which are callable solely under this type of "catastrophe" call provision, and are not otherwise callable, need not be designated as "callable" securities on a confirmation.

In summary, therefore, securities which are subject to extraordinary mandatory redemption provisions other than "catastrophe" call provisions must be identified as "callable" securities on confirmations. MSRB interpretation of February 18, 1983.

Put option bonds: safekeeping, pricing. I am writing in response to your recent letter regarding issues of municipal securities with put option or tender option features, under which a holder of the securities may put the securities back to the issuer or an agent of the issuer at par on certain stated dates. In your letter you inquire generally as to the confirmation disclosure requirements applicable to such securities. You also raise several questions regarding a dealer’s obligation to advise customers of the existence of the put option provision at times other than the time of sale of the securities to the customer.

Your letter was referred to a committee of the Board which has responsibility for interpreting the  Board’s confirmation rules, among other matters. That committee has authorized my sending you the following response.

Both rules G-12(c) and G-15, applicable to inter-dealer and customer confirmations respectively, require that confirmations of transactions in securities which are subject to put option or tender option features must indicate that fact (e.g., through inclusion of the designation “puttable” on the confirmation). the date on which the put option feature first comes into effect need be stated on the confirmation only if the transaction is effected on a yield basis and the parties to the transaction specifically agree that the transaction dollar price should be computed to that date. In the absence of such an agreement, the put date need not be stated on the confirmation, and any yield disclosed should be a yield to maturity.

Of course, municipal securities brokers and dealers selling to customers securities with put option or tender option features are obligated to disclose adequately the special characteristics of these securities at the time of trade.  The customer therefore should be advised of information about the put option or tender option feature at this time.

In your letter you inquire whether a dealer who had previously sold securities with a put option or tender option feature to a customer would be obliged to contact that customer around the time the put option comes into effect to remind the customer that the put option is available. You also ask whether such an obligation would exist if the dealer held the securities in safekeeping for the customer. The committee can respond, of course, only in terms of the requirements of Board rules; the committee noted that no Board rule would impose such an obligation on the dealer.