On April 21, 2010, the Municipal Securities Rulemaking Board (MSRB) published for comment draft interpretive guidance on prevailing market prices and mark-ups for transactions in municipal securities.1 The draft guidance addresses the manner in which municipal securities dealers determine the fair market value of a municipal security in investor transactions. The draft interpretive guidance is intended to harmonize the approach for municipal securities transactions with the methodology set forth by FINRA for other debt securities. MSRB’s proposal comes more than three years after the SEC’s approval of FINRA’s mark-up policy for transactions in debt securities, which specifically excluded municipal securities, and borrows substantially from FINRA’s prior guidance.
MSRB Rule G-30(a) requires that a dealer shall not purchase or sell a municipal security for its own account to a customer except at an aggregate price (including any mark-up or mark-down) that is fair and reasonable, taking into consideration all relevant factors. MSRB’s proposed interpretive guidance provides specific examples to assist dealers in establishing the prevailing market price but, just like FINRA’s guidance for debt securities, provides no interpretive advice regarding the appropriate level of mark-ups or mark-downs from the prevailing market price. Although the proposed guidance is largely consistent with FINRA’s guidance for debt securities, MSRB acknowledged that the municipal securities market is characterized by the large number of outstanding bonds, the prevalence of “buy and hold” investors, infrequent secondary trading in most issues, the existence of multiple market sectors, differing rules for tax treatment and differing credit structures, credit enhancements, and put and call features.
The basic premise of the interpretive guidance is that the prevailing market price for a municipal security when a dealer is acting as principal is the dealer’s contemporaneous cost, with a strong preference toward using the dealer’s cost as established by inter-dealer transactions. Contemporaneous is defined as “close enough in time to the subject transaction that it would reasonably be expected to reflect the current market price for the municipal security.” We have seen instances in which regulators have considered trades that occurred days or weeks prior to the subject transaction to be “contemporaneous,” although MSRB Notice 2010-10 does not take such an extreme position.
The guidance provides that the presumption of contemporaneous cost may be rebutted only when the dealer made no contemporaneous purchases (sales) in the security or can demonstrate that under the circumstances the dealer’s contemporaneous cost (proceeds) is not indicative of the prevailing market price. In order to establish the prevailing market price as other than the dealer’s contemporaneous cost, a dealer must be able to show: (i) interest rates or yields changed after the dealer’s contemporaneous transaction to a degree that the change would reasonably cause a change in the pricing of the municipal security; (ii) the credit quality of the municipal security changed significantly after the dealer’s contemporaneous transaction; or (iii) news was issued and known to the marketplace that effected the perceived value of the municipal security. These factors are identical to those set forth by FINRA for overcoming the presumption that contemporaneous costs in a debt security transaction is indicative of the prevailing market price. To support its position, a dealer should retain contemporaneously produced records of the facts and circumstances and other evidence that warrant using something other than its contemporaneous cost as the prevailing market price.2
MSRB also set forth factors a dealer should consider, and in the following order, when not using contemporaneous cost, specifically: (1) prices of contemporaneous inter-dealer transactions in the particular municipal security; (2) prices of contemporaneous dealer purchases or sales in the particular municipal security from or to institutional accounts with which the dealer regularly effects transactions in the same security; or (3) for actively traded municipal securities, contemporaneous bids of offers for the particular security made through an inter-dealer mechanism. Provided that the preceding information is not available, dealers also may consider: (4) the prices of contemporaneous inter-dealer transactions in a similar municipal security; (5) yield calculated from prices of contemporaneous inter-dealer transactions in similar municipal securities; (6) yield calculated from prices of contemporaneous dealer purchase or sale transactions with known institutional accounts; and (7) yields calculated from validated contemporaneous inter-dealer bid or offer quotations in similar municipal securities for customer mark-ups or mark-downs. Only if none of those factors are available, then dealers are permitted to use models to value their municipal securities. In very unusual circumstances (an example given in the Notice is a forward transaction), a dealer may be able to argue that an isolated transaction is not evidence of prevailing market price and can be ignored in calculating contemporaneous cost. As in all instances, the reasonableness of the prevailing market price will depend on the facts and circumstances of the transaction and the transactions or other information to which it is compared.
Similar to FINRA’s prior guidance with respect to Qualified Institutional Buyers (“QIBs”), MSRB proposed to exclude certain investors transacting in a non-investment grade municipal security who demonstrate an awareness of the risks. In particular, MSRB proposed to exclude sophisticated municipal market professionals (“SMMPs”), as defined in Rule G-17 Interpretation — Interpretive Notice Regarding the Application of MSRB Rules to Transactions with Sophisticated Municipal Market Professionals, April 30, 2002. These investors are considered to have the capacity to evaluate independently the investment risk and exercise independent judgment in deciding to enter into a transaction. Given the level of sophistication of most municipal securities market participants, this exclusion may make regulatory enforcement more difficult.
Both firms and regulators already have been applying many of these same principles since FINRA’s guidance more than three years ago with respect to debt securities. Nevertheless, we expect that the interpretive guidance will have its detractors given the uniqueness of the municipal securities market. Firms have until June 4, 2010, to submit comments on the proposed interpretive guidance.
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This article was originally published by Bingham McCutchen LLP.