MSRB Seeks Comment on Application of Rule G-17 to Municipal Bondholder Consents

Introduction

On February 7, 2012, the Municipal Securities Rulemaking Board (“MSRB”) requested comment on a draft interpretative notice on the application of MSRB Rule G-17 (“Rule G-17”) to bondholder consents by underwriters of municipal securities.¹  The Notice provides that, depending upon the facts and circumstances, an underwriter could violate Rule G-17 — the duty of dealers to deal fairly with all persons in the conduct of their municipal securities business — by providing such a consent. The MSRB is concerned that in some cases underwriters provide bondholder consent to changes which may reduce the security for existing bondholders or may lower the value of their bonds without prior notice. However, the Notice provides limited examples of permissible changes for underwriters to consider when agreeing to changes to authorizing documents. The Notice, however, does state that it does not apply to amendments agreed to by underwriters that have no effect on existing bondholders.

Given the potential for broad application of Rule G-17 in the context of bondholder consents, municipal securities firms should consider filing comments with the MSRB. The Notice provides that comments should be submitted by March 6, 2012.

Application of Rule G-17 and Bondholder Consents That Reduce the Security for Bondholders

Rule G-17 imposes a general duty on a municipal securities dealer to deal fairly with all persons in the conduct of municipal securities activities, even in the absence of fraud. The Notice states that it would be a violation of Rule G-17 for an underwriter to consent to amendments to an authorizing document that would reduce the security for existing bondholders unless:

• The authorizing document expressly provided that an underwriter could provide bondholder consent and;
• The offering documents for the existing securities expressly disclosed that bondholder consents could be provided by underwriters of other securities issued under the authorizing document.²

The Notice provides a few examples of what an impermissible “reduction in security” means in the context of bondholder consents and the application of Rule G-17. Those examples include:

• Elimination of a reserve fund, a reduction in its amount or the substitution of a surety policy for a cash-funded reserve;
• A reduction in the priority of debt service on existing securities in relation to other expenditures;
• A reduction in minimum debt service coverage ratio that is a condition of the issuance of additional securities under the authorizing document; or
• The elimination or reduction in the amount of collateral for existing securities.

The Notice provides that while underwriters may technically be bondholders during the period between the time they purchase an issuer’s bonds and the time they distribute the bonds to investors, they are still underwriters subject to Rule G-17 while they hold bonds with a view to distribution. The Notice informs underwriters that in this situation they may have a monetary incentive to consent to the amendments, which would be a conflict of interest. The Notice, however, further explains that if the underwriting firm became an investor in the bonds and is no longer holding the bonds with a view to distribution, then the firm’s consent to amendments affecting their bonds would be permitted under the Notice.

The Notice does not propose a “material adverse effect” standard for analyzing amendments that affect existing bondholders under MSRB Rule G-17. In the Notice, the MSRB apparently takes the view that such a standard could result in varying interpretations by underwriters. The Notice provides that while an amendment may not “materially adversely” affect existing bondholders at the time of the amendment, its “significance” might become apparent in the future. In many cases, firms may not be able to determine the “significance” that might occur in the future, even though this could trigger a Rule G-17 violation under this Notice.

The Notice Does Not Apply to Amendments That Do Not Affect Existing Bondholders

The Notice does not address amendments agreed to by underwriters that have no effect on existing bondholders. For example, the Notice provides that if an underwriter makes amendments to variable rate demand obligations (“VRDOs”) after the existing VRDOs had been subject to a mandatory tender, then those amendments would have no effect on previous owners of the VRDOs. As such, those amendments would not be covered by the Notice. In addition, if all of the existing bonds had been defeased prior to the underwriter’s consent, then the Notice would not apply (since the amendments would not affect the defeased bondholders).

Conclusion

What the Notice informs underwriters is that, although there may be legitimate reasons for issuers and obligated persons to seek changes to the security provisions of bond authorizing documents, underwriters should be careful before providing those consents. The Notice provides examples in which the MSRB believes bondholder consents to changes in security provisions potentially could violate Rule G-17. Especially in the absence of a materiality standard, municipal securities firms will struggle to assess what “reductions in security” potentially will trigger violations of Rule G-17. Firms should consider filing comments with the MSRB.

*This alert was co-authored by Paul Tyrrell and W. Hardy Callcott.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Kroll-Amy
Boch-David
Joseph-Roger
Smith-Edwin
Burke-Timothy

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¹See Request for Comment on Draft Interpretative Notice Concerning the Application of MSRB Rule G-17 to Bondholder Consents by Underwriters of Municipal Securities, (MSRB-2012-04 (February 7, 2012).
²In the Notice the MSRB presumes that the offering document for the securities purchased by the new bondholders clearly disclose the terms of the securities as a result of any changes. If that were not the case, then the underwriter could be found to be have engaged in an unfair practice under Rule G-17 with regard to the new bondholders. See Notice at fn. 3.