On September 9, 2010, the MSRB issued Notice 2010-35, Request for Comment on MSRB Guidance on Broker’s Brokers.1 Although the proposed guidance would apply to all types of broker’s broker activities in connection with municipal securities, MSRB’s stated focus is the conduct of bid-wanted auctions. The proposed guidance reiterates guidance issued in 2004 and provides additional guidance on the application of its rules to broker’s broker activities. The proposed guidance also addresses the establishment of information barriers and important recordkeeping requirements.
The MSRB has long held that, pursuant to Rule G-18, a broker’s broker has an obligation to its dealer client to make a reasonable effort to obtain a fair and reasonable price in relation to market conditions. Many broker’s brokers use bid-wanted auctions to satisfy this requirement. In 2004, MSRB first cautioned that a bid-wanted procedure is not always a conclusive determination of fair market value.2 MSRB advised that a broker’s broker may need to check the results of the bid-wanted process against other objective data to fulfill its fair pricing obligations. The proposed guidance sets forth the actions that a broker’s broker must take in determining fair market value as well as certain procedures for conducting bid-wanteds. The broker’s broker scenario is distinct from an inter-dealer trade, in which both parties are presumed to be acting for themselves (although there remains the obligation under Rule G-17 to deal fairly and not to act deceptively or dishonestly).
Among the proposals is a requirement that the broker’s broker must disseminate a bid-wanted widely to obtain exposure to multiple dealers with possible interest in the block of securities. The proposal does not specify the number of bids required. If securities are of limited interest (e.g., small issues with credit quality issues and/or features generally unknown in the market), the broker’s broker would be required to reach dealers with specific knowledge of the issue or known interest in securities of the type being offered.
A broker’s broker is required under Rule G-17 to conduct bid-wanteds and situations in a fair manner and to not take any action that works against the client’s interest to receive advantageous pricing. In addition, broker’s brokers may not give preferential information to bidders in bid-wanteds on where they currently stand in the bidding process. The proposal specifically prohibits practices in which broker’s brokers give “last looks” or give directions to a specific bidder that it should “review” its bid or that its bid is “sticking out.” The proposed guidance also specifies that it would be a violation of Rule G-17 for a broker’s broker to submit fake cover bids, to adjust a bid without the bidder’s knowledge, to fail to inform the selling dealer of the highest bid, to accept bids after a bid deadline, or to submit fictitious trade prices.
A broker’s broker that seeks to represent both the seller and the bidder must disclose this fact prominently and both parties must agree in writing in advance of a transaction. “In advance” means at the time the seller directs the broker’s broker to try to find bidders in the case of a seller and prior to the submission of bids in the case of a bidder.
The broker’s broker must assess the reasonableness and accuracy of the bids based on a number of factors, including the number and nature of bids received in the bid-wanted; the nature of the securities in question, including credit quality and features; and previous transaction prices for the securities in question and for similar securities. If the broker’s broker concludes after a reasonable effort that a fair and reasonable price cannot be determined within a reasonable degree of accuracy, the broker’s broker must disclose that fact to its dealer client. The broker’s broker may still effect the trade with its dealer client if it acknowledges such disclosure in writing.
Potential Conflicts of Interest
MSRB reiterated that although the special fair pricing responsibilities found in Rules G-18 and G-30 do not apply to inter-dealer transactions, a special relationship is created under Rule G-17 when a broker’s broker undertakes to act for or on behalf of another dealer. To the extent that a broker’s broker has customers, the broker’s broker must disclose that to both sellers and bidders in writing in order to address the potential conflict of interest.
A broker’s broker with customers also must establish information barriers to ensure that customers are not provided with information about securities of other clients. A broker’s broker that is part of a larger business must put information barriers in place to prevent non-public information from being transferred from the broker’s broker to the rest of the business organization. The proposed guidance states that it is a deceptive, dishonest and unfair practice for a dealer holding itself out as a broker’s broker to purchase securities for its own account, rather than for the account of the highest bidder when a seller has engaged the broker’s broker to effect a trade on its behalf.
Agent vs. Principal
The proposed guidance seeks to reconcile MSRB Interpretive Notice Regarding Application of MSRB Rules to Transactions with Sophisticated Municipal Market Professionals (April 30, 2002) with MSRB’s Interpretation on the Application of Rules G-8, G-12 and G-14 to Specific Electronic Trading Systems (March 26, 2001). In particular, MSRB clarified that the limited agency functions with respect to dealers do not include preserving the anonymity of the seller and buyer through clearance and settlement. To the extent a broker’s broker takes a position in a security sold by its dealer client into its clearing or similar account (even solely for the purposes of clearance and settlement), it would take a position in the securities and be a principal.
The proposed guidance specifies that broker’s brokers must keep records of all bids (including “quick answer” bids), together with time of receipt, for at least three years. In addition, records of bids must not be overwritten (e.g., when a new bid is entered). These requirements are consistent with general recordkeeping requirements and will assist firms in their supervisory efforts and in responding to regulatory inquiries.
The proposed MSRB guidance was prompted by the nature of rule violations in recent SEC and FINRA enforcement actions,3 and the importance of bid-wanteds to sales of municipal securities by retail investors. The proposed guidance, particularly its issuance on the heels of the April 21, 2010, proposed pricing guidance, suggests that pricing considerations for municipal securities continue to be a primary focus of the regulators. Firms have until November 15, 2010, to submit comments on the proposed guidance on broker’s brokers.
1MSRB Notice 2010-35, Request for Comment on MSRB Guidance on Broker’s Brokers (Sept. 9, 2010).
2MSRB Notice 2004-03, Review of Dealer Pricing Responsibilities (Jan. 26, 2004).
3FINRA v. Butler Muni, LLC Letter of Acceptance, Waiver and Consent No. 20060075372001 (May 28, 2010); FINRA v. Associated Bond Brokers, Inc. Letter of Acceptance, Waiver and Consent No. E052004018001 (Nov. 19, 2007); SEC v. Wolfe & Hurst Bond Brokers, Inc. et al., Exchange Act Release No. 59913 (May 13, 2009); D.M. Keck & Company, Inc. d/b/a Discount Munibrokers, et al., Exchange Act Release No. 56543 (Sept. 27, 2007); Regional Brokers, Inc. et al., Exchange Act Release No. 56542 (Sept. 27, 2007).
This article was originally published by Bingham McCutchen LLP.