I. Introduction
On August 2, 2011, as a result of the Municipal Securities Rulemaking Board’s (“MSRB”) rulemaking initiatives required under the Dodd-Frank Wall Act, the MSRB proposed a groundbreaking proposed interpretive notice (the “Notice”) concerning the application of MSRB Rule G-17 and the obligations of municipal securities underwriters to state and local government bond issuers.
Existing MSRB rules already prohibit an underwriter from engaging in any deceptive, dishonest or unfair practice with issuers of municipal securities. The proposal filed with the SEC seeks approval to establish detailed obligations for municipal securities underwriters to disclose risks and conflicts of interest to state and local government clients.1 The proposed Notice will result in new obligations for underwriters in their representations to issuers, duties in connection with issuer disclosure documents, new issue pricing and underwriter compensation, and conflicts of interests. In particular, the Notice requires an underwriter to evaluate a municipal entity’s ability to understand, evaluate and bear the risks of a financing structure, and to tailor its disclosures accordingly. Underwriters should pay particular attention to the proposal and provide comments to the SEC. The MSRB has requested that the proposed Notice be effective 90 days after approval by the SEC.
II. Representations to Issuers
The Notice provides that all representations made by underwriters to issuers of municipal securities in connection with underwritings, whether written or oral, must be truthful and accurate and not misrepresent or omit material facts. In practical terms what this means is that underwriters will need to have a reasonable basis for the representations and other material information contained in documents prepared by them and may not include information they know or should know is inaccurate or misleading. For example, in connection with a certificate signed by an underwriter that will be relied upon by the issuer or other parties to an underwriting, the dealer must have a reasonable basis for all representations and other material information.
Moreover, in an underwriter’s response to an issuer’s request for proposals or qualifications, the response must fairly and accurately describe the underwriter’s capacity, resources and knowledge to perform the proposed underwriting. The RFP response must not contain any representations or other material information about capacity, resources or knowledge that the underwriter should know to be inaccurate or misleading. Indeed, according to the Notice, matters not within the personal knowledge of those preparing the response must be confirmed by those who do have knowledge. Further, the Notice states that an underwriter must not represent that it has the requisite knowledge or expertise with respect to a particular financing if the personnel that they intend to work on the financing do not have that knowledge or expertise.
III. Required Disclosures to Issuers
The Notice proposes that underwriters make more particularized disclosures to issuers in complex municipal securities financings such as variable rate demand obligations (“VDROs”) and financings involving derivatives (i.e., swaps) than they would in more routine financing structures such as fixed rate offerings.2 The required disclosures must be made in a fair and balanced manner based on principles of fair dealing and good faith.3
Specifically, the Notice informs underwriters that they must disclose all material risks and characteristics of a complex municipal securities financing, any incentives for the underwriter to recommend the financing, and other conflicts of interest. In addition, the disclosures concerning a complex municipal securities financing must address the specific elements of the financing, rather than being general in nature.
The Notice provides that the level of disclosure by underwriters will be premised upon the underwriter’s reasonable belief of the issuer’s:
This change puts the burden on the underwriter to assess the issuer’s sophistication. If the underwriter does not reasonably believe that the official to whom the disclosures are addressed is capable of independently evaluating the disclosures, the underwriter must make additional efforts reasonably designed to inform the official or his or her employees or agents. The Notice, however, provides no meaningful guidance as to what additional efforts will be considered reasonable when addressing risks attendant to a complex municipal securities financing.
The required disclosures must be made in writing to an official of an issuer whom the underwriter reasonably believes has the authority to bind the issuer by contract with the underwriter:
The Notice states that a dealer’s duties extend to the representations and information provided by the underwriter in connection with the preparation by the issuer of its disclosure documents.
IV. Underwriter Compensation and New Issue Pricing
A. Excessive Compensation — Factors in Assessing Whether Compensation Is “Disproportionate”
According to the Notice, underwriters will need to consider certain factors in assessing whether their compensation for a new issue is “disproportionate” to the nature of the underwriting and related services performed. Those factors are:
B. Fair Pricing
The Notice reaffirms that the duty of fair dealing under Rule G-17 includes an implied representation that the price an underwriter pays to an issuer is fair and reasonable, taking into consideration all relevant factors. A dealer purchasing bonds in a competitive underwriting for which the issuer may reject any and all bids is deemed to have satisfied its duty of fairness to the issuer with respect to the purchase price of the issue as long as the dealer’s bid is a bona fide bid that is based on the dealer’s best judgment of the fair market value of the securities that are the subject of the bid.4
In a negotiated underwriting, the underwriter’s duty to negotiate in good faith with the issuer includes the obligation of the dealer to ensure the accuracy of representations made during the course of the negotiations, including representations regarding the price negotiated and the nature of the investor demand for the securities. Put another way, an underwriter may violate G-17 if its actions are inconsistent with its representations.
V. Conflicts of Interest
The Notice provides five specific categories where the MSRB views potential conflicts of interest most likely can arise between underwriters and issuers. The Notice advises underwriters to pay particular attention to conflicts of interests in these areas and provides guidance on the MSRB’s views as to what constitutes a conflict of interest and ultimately a violation of the underwriter’s obligations to the issuer.
1. Payments to Third Parties
The Notice provides that failing to disclose payments credits or other value received by the underwriter in connection with its underwriting of the new issue from parties other than the issuer, and payments made by the underwriter in connection with the new issue to parties other than the issuer, are violations of Rule G-17. The Notice alerts underwriters to particular examples which appear to be obvious conflicts of interest. It would be a violation of Rule G-17 if: (i) an underwriter compensates an undisclosed third party in order to secure municipal securities business; or (ii) an underwriter receives undisclosed compensation from a third party in exchange for recommending that third party’s services or products to an issuer, including business related to municipal securities derivative transactions.
The Notice provides that underwriters must disclose to the issuer the amount paid or received, the purpose for which such payment was made, and the name of the party making or receiving such payment. Moreover, the underwriter must disclose to the issuer the details of any third-party arrangements for the marketing of the issuer’s securities. Failure to make these disclosures would be a violation of Rule G-17.
2. Profit-Sharing With Investors
Depending upon the facts and circumstances, the Notice states that arrangements between the underwriter and an investor purchasing new issued securities from the underwriter under which profits realized from the resale by the investor of the securities are directly or indirectly split or otherwise shared with the underwriter also could constitute a violation of the fair dealing obligations of Rule G-17. These arrangements include purchases that are contingent upon the delivery by the issuer to the underwriter of the securities, and in particular if the resale occurs reasonably close in time to the original sale by the underwriter to the investor. Such arrangements could also constitute a violation of Rule G-25(c) (sharing of profits or losses of a transaction in municipal securities with or for a customer).
3. Credit Default Swaps
Trading in municipal credit default swaps (“CDS”) have the potential to affect the pricing of the underlying reference obligations, as well as the pricing of other obligations brought to market by the issuer. Therefore, the issuance or purchase by a dealer of CDS for which the reference is the issuer may pose a conflict of interest. As a result, Rule G-17 requires dealers that trade CDS on municipal issuers to disclose those activities to the issuers for which it serves as underwriter. However, trades in CDS based upon baskets or indexes of municipal issuers that include the issuer or its obligation(s) need not be disclosed, unless the issuer or its obligation(s) represents more than 2% of the total notional amount of the CDS or the underwriter otherwise caused the issuer or its obligation(s) to be included in the basket or index.
4. Retail Order Periods
Rule G-17 requires an underwriter that has agreed to underwrite a transaction with a retail order period to honor the agreement. When an underwriter agrees to underwrite a transaction with a retail order period it must take reasonable measures to ensure that retail clients are bona fide. An underwriter that knowingly accepts an order presented as a retail order when it is not violates Rule G-17 if its actions are inconsistent with the issuer’s expectations regarding retail orders. Dealers cannot allocate securities in a manner that is inconsistent with an issuer’s requirements without the issuer’s consent. In addition, the fair dealing rule is also violated if any dealer places an order that is presented as a qualifying retail order but in fact does not qualify as a retail order.
The Notice further informs dealers that the MSRB will review activities relating to retail order periods to ensure that they are conducted in a fair and orderly manner.
5. Dealer Payment to Issuer Personnel
Both Rule G-20 (the gifts and gratuities, and non-cash compensation rule) and Rule G-17 are designed to avoid conflicts of interest in connection with payments made to, and expenses reimbursed for, issuer personnel during the issuance process. The Notice reminds dealers acting as an underwriter or financial adviser that it violates the rule to pay for excessive or lavish travel, meal, lodging and entertainment expenses in connection with an offering.
VI. Conclusion
Underwriters of municipal securities transactions should pay particular attention to the proposed Notice because it creates new disclosure obligations to state and local issuers. In particular, an underwriter needs to be aware of the level of disclosure required, and its obligation to assess that disclosure based upon its reasonable belief about the issuer official’s knowledge about the type of financing that the underwriter proposes.
For additional information concerning this alert, please contact the following lawyers:
David Boch, Partner, Broker-Dealer Group
david.boch@bingham.com, 617.951.8485
Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
timothy.burke@bingham.com, 617.951.8620
Amy Natterson Kroll, Partner, Broker-Dealer
amy.kroll@bingham.com, 202.373.6118
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615
1 MSRB Rule G-17 provides that “[I]n the conduct of its municipal securities or municipal advisory activities, each broker, dealer, municipal securities dealer, and municipal advisor shall deal fairly with all persons and shall not engage in any deceptive, dishonest or unfair practice.”
2 The Notice provides that if the underwriter’s affiliated swap dealer is proposed to be the executing swap dealer, then the underwriter may satisfy its disclosure obligation with respect to the swap if the affiliated swap dealer provides the disclosure. Also, if the issuer's swap or other financial adviser is independent of the underwriter and the swap dealer, and the financial adviser makes full disclosure concerning the swap, that satisfies the underwriter's obligation, so long as the underwriter has a reasonable basis for belief in the truthfulness and completeness of such disclosure.
3 The CFTC also is in the process of drafting risk disclosure rules related to swaps. Both the MSRB and SEC are drafting rules for financial advisers, too.
4 Rule G-13(b)(iii) provides: “….a quotation shall be deemed to represent a bona fide bid for, or offer of, municipal securities” if the broker, dealer or municipal securities dealer making the quotation is prepared to purchase or sell the security which is the subject of the quotation at the price stated in the quotation and under such conditions, if any, as are specified at the time the quotation is made.”
This article was originally published by Bingham McCutchen LLP.