On January 9, 2014, the Municipal Securities Rulemaking Board (“MSRB”) published a request for comments on a proposed new conduct rule for non-solicitor municipal advisors and amendments to existing books and records rules to include municipal advisors in Regulatory Notice 2014-01 (the “Rule Notice”).
The Dodd-Frank Act required persons engaged in the business of being municipal advisors, as defined in the Act, to register with the SEC as municipal advisors and to become members of the MSRB. In 2010 the SEC created a temporary registration program for municipal advisors which is still in effect. On September 13, 2013, the SEC adopted final rules for municipal advisors, including permanent registration forms and requirements. The final rules will become effective on July 1, 2014, and persons currently registered as municipal advisors under the temporary registration program will be required to apply for permanent registration on a rolling basis from July to October 2014. For additional detail on municipal advisor registration, see the Municipal Advisor topic on the firm’s Dodd-Frank Site.
All registered municipal advisors are required to become members of the MSRB. Municipal advisor members are subject only to those MSRB rules specifically designated as applicable to municipal advisors. In the Rule Notice, the MSRB proposes to (1) adopt a new conduct rule, Rule G-42, applicable to non-solicitor municipal advisors, (2) amend Rule G-8, requiring the making of books and records, to apply to municipal advisors and (3) amend Rule G-9, requiring the preservation of records, to apply to municipal advisors.
Municipal Advisors Subject to Proposed Rule G-42
Under the MSRB proposal, Rule G-42 would apply to all municipal advisors, as defined in Section 15B(e)(4) of the Securities Exchange Act of 1934 (the “Exchange Act”), except any person that is a municipal advisor solely because it “undertakes a solicitation of a municipal entity” pursuant to Section 15B(e)(4)(A)(ii).
Rule G-42 would, however, apply to managers of or advisers to collective pools that (i) are required to register as municipal advisors because the collective pool includes “proceeds of municipal securities” invested by municipal entities or “municipal escrow investments” invested by municipal entities or obligated persons and (ii) are not able to use the exemption available for federally registered investment advisers. Managers and advisers that fall into the non-exempt category include exempt reporting advisers, state registered investment advisers, banks (which are exempt from registration as investment advisers), and real estate advisers.
Elements of Rule G-42
Standards of Conduct. Section (a) would provide that a municipal advisor is subject to a duty of care to obligated person clients and a fiduciary duty to municipal entity clients that includes both a duty of loyalty and a duty of care.
“Obligated person” as used in proposed Rule G-42 would have the same meaning as in Section 15B(e)(10) of the Exchange Act, where it is defined generally to mean a person that is 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.
“Duty of care” is defined in supplementary material .01 and includes possessing the degree of knowledge and expertise needed to provide the municipal entity or obligated person client with informed advice, making a reasonable inquiry as to the relevant facts and having a reasonable basis for advice provided to the client and representations made in a certificate that the municipal advisor signs that will reasonably foreseeably be relied upon by the client.
“Duty of loyalty” is defined in supplementary material .02 and provides that the municipal advisor must:
- 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;
- either eliminate or provide full and fair disclosure to the client about each of its material conflicts of interest; and
- investigate or consider other reasonably feasible alternatives to any recommended municipal securities transaction or municipal financial product that might also or alternatively serve the municipal entity client’s objectives.
Disclosure of Conflicts of Interest and Other Information. The proposed rule would require the municipal advisor, at or prior to the inception of a municipal advisory relationship, to provide the client with a document making full and fair disclosure of all material conflicts of interest, including disclosure of:
- any actual or potential conflicts of interest of which it is aware after reasonable inquiry that might impair its ability either to render unbiased and competent advice to or on behalf of the client or to fulfill its fiduciary duty to the client, as applicable;
- any affiliate of the municipal advisor that provides any advice, service, or product to or on behalf of the client that is directly or indirectly related to the municipal advisory activities to be performed by the disclosing municipal advisor;
- any payments made by the municipal advisor directly or indirectly to obtain or retain the client’s municipal advisory business;
- any payments received by the municipal advisor from third parties to enlist the municipal advisor’s recommendation to the client of its services, any municipal securities transaction or any municipal financial product;
- any fee-splitting arrangements involving the municipal advisor and any provider of investments or services to the client;
- any conflicts of interest that may arise from the use of the form of compensation under consideration or selected by the client for the municipal advisory activities to be performed;
- any other engagements or relationships of the municipal advisor or any affiliate of the municipal advisor that might impair the advisor’s ability either to render unbiased and competent advice to or on behalf of the client or to fulfill its fiduciary duty to the client, as applicable;
- the amount and scope of coverage of professional liability insurance that the municipal advisor carries (e.g., coverage for errors and omissions, improper judgments, or negligence), deductible amounts, and any material limitations on such coverage, or a statement that the advisor does not carry any such coverage; and
- any legal or disciplinary event that is (a) material to the client’s evaluation of the municipal advisor or the integrity of its management or advisory personnel; (b) disclosed by the municipal advisor on the most recent Form MA filed with the Commission; or (c) disclosed by the municipal advisor on the most recent Form MA-I filed with the Commission regarding any individual actually engaging in or reasonably expected to engage in municipal advisory activities in the course of the engagement.
A municipal advisor that concluded that it had no material conflicts of interest would have to provide written documentation to the client to that effect.
Documentation of Municipal Advisory Relationship. The proposed rule would require a municipal advisor to evidence each of its municipal advisory relationships by a writing entered into prior to, upon or promptly after the inception of the municipal advisory relationship. The writing must be dated and include, at a minimum:
- the form and basis of direct or indirect compensation, if any, for the municipal advisory activities to be performed;
- the reasonably expected amount of any such compensation;
- the information regarding conflicts of interest and other matters required to be disclosed by section (b) of the rule;
- the scope of the municipal advisory activities to be performed and any limitations on the scope of the engagement;
- in the case of municipal advisory activities relating to a new issue or reoffering of municipal securities, the specific undertakings, if any, requested by the client to be performed by the municipal advisor with respect to the preparation and finalization of an official statement or similar disclosure document; and
- the date, triggering event, or means for the termination of the municipal advisory relationship, or, if none, a statement that there is none.
The rule would also require prompt amendment of the writing as necessary during the term of the municipal advisory relationship.
Recommendations. The proposed rule would provide that a municipal advisor must not recommend that its municipal entity or obligated person client enter into any municipal securities transaction or municipal financial product unless the advisor has a reasonable basis for believing, based on the information obtained through the reasonable diligence of the advisor, that the transaction or product is suitable for the client. In addition, the rule would require the municipal advisor discuss the following with its client:
- the municipal advisor’s evaluation of the material risks, potential benefits, structure, and other characteristics of the recommended municipal securities transaction or municipal financial product;
- the basis upon which the municipal advisor reasonably believes that the recommended municipal securities transaction or municipal financial product is suitable for the client; and
- whether the municipal advisor has investigated or considered other reasonably feasible alternatives to the recommended municipal securities transaction or municipal financial product that might also or alternatively serve the client’s objectives.
With respect to a client that is a municipal entity, a municipal advisor would only be permitted to recommend a municipal securities transaction or municipal financial product that was in the client’s best interest.
Review of Recommendations of Other Parties. The proposed rule would provide requirements for the review of recommendations of other parties, including factors the municipal advisor would be required to discuss with its client.
Principal Transactions. The proposed rule would prohibit a municipal advisor from engaging in any transaction, in a principal capacity, to which a municipal entity or obligated person client of the municipal advisor is a counterparty, other than activities of financial advisors expressly permitted under Rule G-23.
Specified Prohibitions. A municipal advisor would be prohibited from:
- receiving compensation that is excessive in relation to the municipal advisory activities actually performed;
- delivering an invoice for fees or expenses for municipal advisory activities that do not accurately reflect the activities actually performed or the personnel that actually performed those services;
- making any representation or the submission of any information about the capacity, resources or knowledge of the municipal advisor, in response to requests for proposals or qualifications or in oral presentations to a client or prospective client, for the purpose of obtaining or retaining municipal advisory business that the advisor knows or should know is materially false or misleading;
- making, or participating in, any fee-splitting arrangements with underwriters, and any undisclosed fee-splitting arrangements with providers of investments or services to a municipal entity or obligated person client of the municipal advisor; and
- making payments for the purpose of obtaining or retaining municipal advisory business other than reasonable fees paid to another registered municipal advisor for a solicitation of a municipal entity or obligated person.
Supplementary Material. In addition to describing the duty of care and duty of loyalty, as discussed above, the proposed supplementary material in the Rule Notice would provide guidance relating to, among other matters, limitations on the scope of engagement, suitability of recommendations and the elements of a reasonable know-your-customer inquiry.
Amendments to Rules G-8 and G-9
The MSRB proposes to amend existing Rule G-8 (Books and Records to Be Made by Brokers, Dealers, and Municipal Securities Dealers) and Rule G-9 (Preservation of Records) to apply to municipal advisors and to include records required to be maintained by municipal advisors pursuant to Section 15B of the Exchange Act and applicable SEC rules (“municipal advisor records”) within the category of records to be maintained and preserved by Rules G-8 and G-9.
Request for CommentIn addition to requesting general comment, the Rule Notice lists a number of specific aspects of the proposals, including the MSRB’s underlying economic analysis, on which public comment is sought. Comments are due not later than March 10, 2014.