In MSRB Notice 2013-07 (March 11, 2013),1 the Municipal Securities Rulemaking Board is seeking comment on proposed revisions to MSRB Rule G-19 on suitability. The proposed revisions aim to harmonize MSRB Rule G-19 with FINRA’s suitability rule, Rule 2111, which underwent its own sweeping changes that took effect in July 2012.2 The proposed changes are part of the MSRB’s ongoing, comprehensive review of its rules and interpretive guidance in consideration of, among other things, aligning its rules with those of other regulators.
Proposed MSRB Rule G-19 is almost a verbatim repeat of the language of FINRA Rule 2111, although with a few substantive departures. Those departures are the focus of this Alert.
1. Proposed MSRB Rule G-19 Does Not Include FINRA Rule 2111’s Exemption for Institutional Accounts in Apparent Reliance on the MSRB’s SMMP Safe Harbor.
One critical aspect of FINRA Rule 2111 not carried over to proposed MSRB Rule G-19 is the exemption provided for certain institutional accounts.3 In particular, FINRA Rule 2111(b) provides in relevant part that a member or associated person fulfills the customer-specific suitability obligation for an institutional account if the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, and the institutional customer affirmatively indicates that it is exercising independent judgment.4 Notice 2013-07 acknowledges the departure in the proposed MSRB rule from the FINRA rule, although without commentary.5
In any case, it appears that the MSRB determined not to include an institutional account exemption in proposed MSRB Rule G-19 in reliance on the existing safe harbor for sophisticated municipal market professionals, or “SMMPs.” On July 9, 2012 (the same day that revised FINRA Rule 2111 went into effect), and per the MSRB’s stated effort to maintain consistency with FINRA Rule 2111’s suitability standard for institutional customers,6 the MSRB’s restatement of an interpretive notice on SMMPs went into effect.7 The restated SMMP notice provides (as did the prior SMMP notice) that when a dealer has reasonable grounds for concluding that an institutional customer is a SMMP, that dealer’s customer-specific suitability obligation is fulfilled.8 The restatement defines a “SMMP” as an institutional customer of a dealer that: (1) the dealer has a reasonable basis to believe is capable of evaluating investment risks and market value independently, both in general and with regard to particular transactions in municipal securities, and (2) affirmatively indicates that it is exercising independent judgment in evaluating the recommendations of the dealer.9
Here, the MSRB safe harbor for SMMPs mirrors FINRA Rule 2111’s safe harbor for institutional accounts, although with an important distinction: The FINRA Rule 2111 safe harbor is available to institutional accounts and incorporates by reference the FINRA Rule 4512(c) definition of an institutional account (i.e., the account of an entity or person with total assets of at least $50 million).10 By adopting this definitive standard for institutional accounts (for whom sophistication and independent judgment can reasonably be deemed to exist), the FINRA framework provides a measure of predictability as to whom the safe harbor may be available (if the other conditions of the safe harbor are met). In contrast, under the MSRB’s restated SMMP notice, while the definition of institutional account is substantively the same as the FINRA definition (through the SMMP notice’s incorporation by reference of the definition in MSRB Rule G-8(a)(x)),11 the safe harbor itself is available to institutional customers believed to be SMMPs only. Additionally, the restated SMMP notice eliminates the threshold requirement in the previous SMMP notice that a customer own or manage a specified amount of municipal securities in order to be considered a SMMP.12 In its March 2012 proposed rule filing with the SEC, the MSRB explained that it made this change in the restated SMMP notice due to a concern that the amount of municipal securities owned or managed by a customer does not necessarily equate to sophistication.13 In place of such a threshold, the restated SMMP notice requires that, “As part of the reasonable basis analysis . . . the dealer should consider the amount and type of municipal securities owned or under management by the institutional customer.”14 Thus, the MSRB framework leaves the issue of which institutional customers may be subject to the safe harbor open to a greater level of interpretation and uncertainty.
Another distinction is that the FINRA exemption requires in relevant part that “the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities.”15 The MSRB exemption under the restated SMMP notice contains a like requirement, although it adds market value to the matters subject to independent evaluation by the SMMP, and excludes the reference to investment strategies.16 The affirmation requirement under the two exemptions is the same, and in fact the MSRB has stated that a dealer’s receipt of the affirmation required by FINRA Rule 2111 would satisfy the affirmation requirement of the revised SMMP definition.17
2. Proposed MSRB Rule G-19 Includes a Reference to a Dealer’s Related Obligations Under a Proposed New MSRB Time of Trade Disclosure Rule (Rule G- 47).
The restated SMMP notice also provides a second safe harbor for SMMPs: when a dealer effects a secondary market transaction with an SMMP, its affirmative MSRB Rule G-17 disclosure duty concerning material facts available from established industry sources (the time of trade disclosure obligation) will be deemed satisfied for both recommended and non-recommended transactions.18 In February 2013, the MSRB proposed new MSRB Rule G-47, which addresses time of trade disclosure obligations and consolidates certain prior guidance on the topic.19 Under that proposed new rule, the time of trade disclosure obligation would require a broker, dealer or municipal securities dealer to disclose, at or prior to the time of trade, “all material information known about the transaction, as well as material information about the security that is reasonably accessible to the market.”20 Proposed MSRB Rule G-19.05(a), in turn, includes a requirement, absent from the FINRA analogue (which does not include an explicit time of trade disclosure rule), that the reasonable-basis obligation requires “an understanding of information about the municipal security or strategy, including the information described in [proposed] MSRB Rule G-47 (Time of Trade Disclosure), to the extent such information is material.”21
Proposed Rule G-47, like proposed Rule G-19, is silent on the safe harbors available under the restated SMMP notice for SMMPs. In its March 2013 comment letter, SIFMA in relevant part encourages the MSRB to affirm that its existing guidance on time of trade disclosure obligations for SMMPs in proposed MSRB Rule G-47.22 A similar revision to proposed Rule G-19 to clarify the exemption from suitability determinations for SMMPs likewise would be sensible.
3. Proposed MSRB Rule G-19.03 and FINRA Rule 2111 Specify Different Types of Communications Subject to the Exemption for Communications That Do Not Include a Recommendation of a Particular Security or Securities.
Like FINRA Rule 2111.03, proposed MSRB Rule G-19.03 provides a safe harbor for certain educational materials and asset allocation models as long as they do not include a recommendation of a particular security or securities. Both FINRA Rule 2111.03 and proposed MSRB Rule G-19.03 specify the types of communications subject to this exemption, and while there is overlap in the types of communications covered, there are also some notable differences. Specifically, FINRA Rule 2111.03 exempts communications not including a recommendation of a particular security or securities pertaining to dollar cost averaging, compounded return, and tax deferred investment; descriptive information about an employer-sponsored retirement or benefit plan, participation in the plan, the benefits of plan participation, and the investment options available under the plan; certain asset allocation models, and certain interactive investment materials.23 Proposed MSRB Rule G-19.03 does not exempt these types of communications.
Notably, proposed MSRB Rule G-19.03 adds a new category of communications subject to the exemption for communications not including a recommendation of a particular security or securities that is not present in FINRA Rule 2111.03: “general comparisons between tax-exempt and taxable bonds and the concept of tax-equivalent yield.”24 Again, MSRB Notice 2013-07 does not provide any rationale for these departures from the FINRA Rule.
4. Other Proposed Changes to MSRB Rule G-19 Would Further Harmonize the Rule With FINRA Rule 2111.
Proposed MSRB Rule G-19.05 would also incorporate the reasonable-basis, quantitative, and customer-specific suitability obligations that appear in FINRA Rule 2111.05. These concepts are covered under existing Rule G-19 using different terminology (i.e., in the case of quantitative suitability obligations, the existing rule prohibits “churning”).25
Additionally, the proposal would expand the existing list of customer information that dealers must obtain before recommending a transaction to a non-institutional account to conform it with FINRA’s list: the MSRB adds age, investment time horizon, liquidity needs, investment experience and risk tolerance.26
As part of the conforming proposed amendments, the provision on discretionary accounts in current Rule G-19 would be moved to a separate rule.27
Proposed Rule G-19 also would eliminate the requirement that brokers, dealers and municipal securities dealers obtain information pursuant to Rule G-8(a)(xi) “about the customer used . . . in making recommendations to the customer” prior to completing a transaction in municipal securities in a customer’s account.28 The MSRB has also proposed conforming amendments to eliminate the same requirement from Rule G-8(a)(xi).29
The comment period on the proposed rule change expires May 6, 2013. Although proposed MSRB Rule G-19 is similar to FINRA Rule 2111, the differences that do exist and the decision to disperse the MSRB suitability framework across multiple rules and interpretive guidance make the proposed rule difficult to navigate. Brokers, dealers and municipal securities dealers should consider submitting comments requesting full harmonization between proposed MSRB Rule G-19 and FINRA Rule 2111.
*This alert was co-authored by W. Hardy Callcott.
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:Burke-Timothy
1 Request For Comment On Revisions To Suitability Rule, MSRB Notice 2013-07 (Mar. 11, 2013, available at http://www.msrb.org/Rules-and-Interpretations/Regulatory-Notices/2013/2013-07.aspx.
2 Rule 2111, available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=9859; see also, Suitability, Regulatory Notice 12-25 (May 18, 2012), available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p126431.pdf; SEC Approves Consolidated FINRA Rules Governing Know-Your-Customer and Suitability Obligations, Regulatory Notice 11-02 (Jan. 2011), available at http://www.finra.org/web/groups/industry@ip/@reg/@notice/documents/notices/p122778.pdf. Following its adoption of revised Rule 2111, FINRA issued interpretive guidance scaling back on certain aspects of its previous interpretations of the rule. See, Suitability, Regulatory Notice 12-55 (Dec. 2012), available at http://www.finra.org/Industry/Regulation/Notices/2012/P197436
3 FINRA Rule 2111(b); FINRA Rule 2111.07.
4 FINRA Rule 2111(b).
5 MSRB Notice 2013-07, supra note 1, at 2.
6 MSRB Files Restated Interpretive Notice on Sophisticated Municipal Market Professionals, MSRB Notice 2012-16 (Mar. 26, 2012) at 2, available at http://www.msrb.org/Rules-and-Interpretations/Regulatory-Notices/2012/2012-16.aspx
7 Securities And Exchange Commission Approves Revised MSRB Definition of Sophisticated Municipal Market Professional, MSRB Notice 2012-27 (May 29, 2012), available at http://www.msrb.org/Rules-and-Interpretations/Regulatory-Notices/2012/2012-27.aspx.; Restated Interpretive Notice Regarding The Application of MSRB Rules to Transactions With Sophisticated Municipal Market Professions (July 9, 2012) (“Restated SMMP Notice”), available at http://www.msrb.org/Rules-and-Interpretations/MSRB-Rules/General/Rule-G-17.aspx?tab=2#_D37D3EF9-F642-4A63-A40D-3A6B33B5260A
10 FINRA Rule 2111(b); FINRA Rule 4512(c).
11 See Restated SMMP Notice, supra note 7 at 3; MSRB Rule G-8(a)(xi).
12 Under the prior SMMP Notice, to be an SMMP, a customer was required to be an institutional customer, which was then defined as “an entity, other than a natural person (corporation, partnership, trust or otherwise), with total assets of at least $100 million invested in municipal securities in the aggregate in its portfolio and/or under management.” See MSRB Notice 2012-27, supra note 7 at 1.
13 See Restatement of an Interpretive Notice Concerning the Application of MSRB G-17 to Sophisticated Municipal Market Professionals, SR-2012-05 at 12 (Mar. 26, 2012).
14 Restated SMMP Notice, supra note 7 at 1.
15 FINRA Rule 2111(b)(1).
16 Restated SMMP Notice, supra note 7 at 1.
17 MSRB Notice 2012-16, supra note 6 at 2.
18 Restated SMMP Notice, supra note 7 at 1. In a transaction with a SMMP, a dealer’s intentional withholding of a material fact about a security, when the information is not accessible through established industry sources, may constitute an unfair practice that violates Rule G-17. MSRB Notice 2012-27, supra note 6 at 2.
19 Request For Comment on Codifying Time of Trade Disclosure Obligation, MSRB Notice 2013-04 (Feb. 13, 2013), available at http://msrb.org/Rules-and-Interpretations/Regulatory-Nitocies/2013/2013-04.aspx .
20 Id. at 2.
21 MSRB Notice 2013-07, supra note 1 at 5.
22 Letter from David L. Cohen, Securities Industry And Financial Markets Association (Mar. 12, 2013) at 3, available at http://www.msrb.org/RFC/2013-04/sifma.pdf.
23 FINRA Rule 2111.03.
24 MSRB Notice 2013-07, supra note 1 at 5.
25 Id. at 2, 3-4.
26 Id at 2, 7 at note 5.
27 Id. at 2.
28 Id. at 1.
This article was originally published by Bingham McCutchen LLP.