The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), among other things, authorized the Municipal Securities Rulemaking Board (“MSRB”) to establish a comprehensive body of regulation for all municipal advisors.1 On January 14, 2011, the MSRB issued a request for comment on “pay-to-play” for municipal advisors (the “Notice”). In the Notice, the MSRB seeks comment primarily on a draft proposal to establish pay-to-play and related rules pertaining to municipal advisors by way of a new MSRB Rule G-42 (“Rule G-42”), whether Rule G-38 should be eliminated or amended if G-42 becomes effective, and whether the electronic filing of Forms G-42 and G-37 should be required.2 Comments are required to be filed with the MSRB no later than February 25, 2011. In addition, the MSRB will hold an informational webinar on the draft Rule G-42 on February 3, 2010, at 2:00 p.m.
Introduction
The Dodd-Frank Act expanded the MSRB’s jurisdiction to include the regulation of municipal advisors, in addition to dealers, which the MSRB has regulated since 1975.3 As of October 1, 2010, the MSRB regulated municipal advisors. Essentially there are two types of municipal advisors: a) advisors that provide advice about municipal financial products or the issuance of municipal securities to “municipal entities,”e.g. state and local governments, 529 plans, and public pension funds; and b) advisors that solicit certain business (municipal securities or municipal financial products).4
In December 2010, the MSRB Board of Directors held a special meeting to discuss development of key rules for municipal advisors; it also approved issuing a request for comment on a pay-to-play rule for municipal advisors.5 According to the Notice, Rule G-42, among other things, would restrict municipal advisors from engaging in or soliciting business from municipal entities when an advisor has made certain political contributions to municipal officials responsible for awarding that business.6 Essentially, Rule G-42 would prohibit municipal advisors from engaging in municipal advisory business with municipal entities for compensation for two years if they make certain political contributions to state or local government officials with authority to hire such municipal advisors. They also would face a two-year ban on compensation for soliciting certain types of business engagements on behalf of others from those governments or receiving compensation for certain earlier solicitations. Under Rule G-42, individuals who are municipal advisor professionals would be entitled to contribute up to $250 per election to state and local government officials for whom they are entitled to vote.
Proposed Rule G-42
The provisions found in Rule G-42 are similar to those found in MSRB Rule G-37 (“Rule G-37”). Rule G-42 establishes when a ban on municipal advisory business and certain solidifications is mandated, and the circumstances when a municipal advisor or municipal advisor professional is prohibited from soliciting and coordinating contributions; its provisions also prohibit circumvention of the rule, require disclosures to the MSRB, and permit voluntary disclosures. Notwithstanding the similarity in the provisions of Rules G-37 and G-42, there are notable differences that pertain to municipal advisors under Rule G-42.
A. Key Terms
Rule G-42 has two key terms: “municipal advisor professional” and “official of a municipal entity.”
“Municipal advisor professional” is any associated person of a municipal advisor that:
“Official of a municipal entity” would be defined to mean any person (including any election committee for such person) who was, at the time of the contribution, an incumbent, candidate or successful candidate:
B. Rule G-42
As noted above, the concepts outlined by MSRB for draft Rule G-42 are similar in scope to those found in both Rule G-37 and the SEC’s recently established pay-to-play rules for Investment Advisers. Specifically, Rule G-42 would:
1. Look Back Provisions — Municipal Advisors Should Consider Providing Comments on This Provision
According to the Notice, no contributions made before the effective date of Rule G-42 will trigger a ban on the “look back” provisions that apply to the rule (unless the contributions were made prior to the effective date of the rule by a dealer financial advisor already subject to Rule G-37.) Certain non-de minimis contributions made within two years before an individual’s employment as a municipal advisor could trigger:
a. a ban on municipal advisory business for compensation;
b. a ban on the solicitation of third-party business from a municipal entity for compensation; and
c. a ban on receipt of compensation for the solicitation of third-party business from a municipal entity. (collectively the “look back” provisions)10
Notwithstanding the look back provisions set forth in Rule G-42, municipal advisors should consider the differences in the way in which municipal advisors are hired or “conduct their business.” Indeed, municipal advisors should provide such differences to the MSRB as they are specifically seeking comment on whether to include the look back provision in G-42 or have the look back provision in Rule G-42 differ from that found in Rule G-37.
2. No Ban on New Municipal Business — But Limitations Still Exist
Notably, unlike Rule G-37, Rule G-42 does not create a ban on new municipal business with municipal entities. Instead, Rule G-42 would ban municipal advisory business with municipal entities for compensation and solicitations of third-party business from municipal entities for compensation. To that end, under Rule G-42, the MSRB would consider compensation to “…include any economic benefit to the municipal advisor, whether in the form of an advisory fee or some other fee relating to the total services rendered, reimbursements for costs, commissions, or some combination of the foregoing.”11 As such, a municipal advisor would not be permitted to accept a new engagement to provide “non-advisory” services to the municipal entity in return for the provision of otherwise uncompensated municipal advisory services to the municipal entity. Similarly, the municipal advisor could not accept increased compensation for the provision of other services designed to replace the compensation that draft Rule G-42 prohibits it from receiving.
By way of example, in the Notice, the MSRB points out the real impact that this will have on municipal advisors. First, a dealer that was prohibited from receiving compensation for its financial advisory services as a result of the political contribution cannot receive increased underwriting compensation attributable to its financial advisory services.12 Moreover, a municipal advisor that was prohibited from being compensated for soliciting investment advisory business from a public pension fund as a result of the political contribution cannot receive increased compensation for soliciting business from another potential investor to replace the prohibited compensation.13
3. Transition Period Before Ceasing Activities for Certain Municipal Advisors
A transition period is contemplated under Rule G-42 for those municipal advisors who provide advice to or on behalf of municipal entities or obligated persons that are subject to a fiduciary duty. According to the MSRB, many municipal advisors typically have long-term contracts or engagements with municipal entities and they may not be able to immediately resign from such contract or engagement, after a non-de minimis contribution is made to an official of a municipal entity, without violating their fiduciary obligations to their municipal entity clients.14 Under Rule G-42, municipal advisors would be permitted to continue to engage in such business with a municipal entity on an uncompensated basis for a reasonable period of time. For these municipal advisors who make a political contribution triggering the Rule G-42 ban on business for compensation, the ban on municipal advisory business with that municipal entity for compensation does not end until two years after it has terminated all of its municipal advisory business with the municipal entity.
On the other hand, those municipal advisors that solicit third-party business from municipal entities do not have a municipal entity as its client and thus, it has no fiduciary duty. As a result, in those circumstances, the ban begins immediately upon making the non-de minimis political contribution that results in the ban and ends two years after such contribution is made.16
4. Supervisors Are Defined More Broadly Under G-42
Supervisors included in the definition of a municipal finance professional (“MFP”) under Rule G-37 may be different than the type of supervisors included within the definition of a municipal advisory professional (“MAP”) under Rule G-42.17 Indeed, if an individual who is an MAP engages in municipal advisory business or solicits third-party business, as well as other activities (e.g., municipal securities activities), then the individual’s supervisors for both types of activities would be considered MAPs.18 Given this difference, municipal advisors should assess who their MAPs are and the types of activities that those individuals are engaged in. Armed with that information, municipal advisors can better ascertain those individuals who may be supervisors of the MAPs.
In addition, the Notice provides that a MAP includes any associated person who is a member of the municipal advisor’s executive or management committee (or similarly situated officials), regardless of whether there are any other municipal advisor professionals in the municipal advisory firm.
5. Relationship Between Investment Advisers Pay-to-Play Rule and Draft Rule G-42
Rule 206(4)-5 under the Investment Advisers Act of 1940 imposes pay-to-play restrictions upon investment advisers. As a result of a proposal by the SEC to amend that rule, many of the solicitors covered by the SEC proposed amendment to Rule 206(4)-5 under the Investment Advisers Act of 1940 are required by Section 15B(a)(1) of the Exchange Act to register with the SEC, because they are “municipal advisors” within the meaning of Section 15B(e)(4) of the Exchange Act, which term includes persons who solicit investment advisory business from municipal entities on behalf of unrelated investment advisers.20
The Notice, however, provides that persons who solicit investment advisory business from municipal entities on behalf of their affiliates are not within the statutory definition of “municipal advisor.” As a result, the release accompanying the SEC’s proposed permanent registration rule for municipal advisors contemplates that persons who are not within the statutory definition of “municipal advisor,” but seek to be considered “regulated municipal advisors,” may voluntarily register with the SEC as municipal advisors and subject themselves to MSRB rules, including draft Rule G-42.21
According to the MSRB, it is their intent that the provisions of Rule G-42 concerning persons who solicit third-party business from municipal entities are at least as stringent as Rule 206(4)-5.22
6. Under Rule G-42, Municipal Advisors Would Have Disclosure Requirements
Rule G-42 would require municipal advisors to publicly disclose on Form G-42 all non-de minimis contributions to officials of an municipal entity, payments to political parties of states and political subdivisions, and contributions to bond ballot campaigns made by municipal advisors, MAPs, their political action committees and non-MAP executive officers, as well as information on the municipal advisory business with municipal entities and solicitations of third-party business from municipal entities.23 As such municipal advisors should ensure that they have adequate policies and procedures to ensure compliance with the proposed reporting requirements.
Conclusion
Municipal advisors should not be surprised by the MSRB’s speed in issuing a new pay-to-play rule for them. Rule G-42 closely resembles many of the provisions in both Rule G-37 and the SEC’s pay-to-play rule for investment advisers. Notwithstanding the similarities in the rules, municipal advisors should consider providing comment to MSRB about the differences in the way municipal advisors are hired or conduct their business. Although much of the existing interpretative guidance under G-37 is likely to be applicable to Rule G-42, the MSRB expects to adopt similar guidance under Rule G-42. That guidance will also be subject to review and comment.
For additional information concerning this alert, please contact the following lawyers:
Amy Natterson Kroll, Partner, Broker-Dealer
amy.kroll@bingham.com, 202.373.6118
David Boch, Partner, Broker-Dealer Group
david.boch@bingham.com, 617.951.8485
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
Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
timothy.burke@bingham.com, 617.951.8620
1See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
2It also seeks comment on draft amendments that would make conforming changes to MSRB Rules G-8, G-9 and G-37 and a draft restatement of Interpretation of Prohibition on Municipal Securities Business Pursuant to Rule G-37 (February 21 ,1997), reprinted in MSRB Rule Book (the “Rule G-37 Interpretative Notice”). In the Notice, MSRB states that the Rule G-37 Interpretative Notice would now be inconsistent with proposed Rule G-42 since it was issued before municipal advisors to municipal entities were subject to a federal fiduciary duty and includes language providing guidance on the application of the ban on municipal securities business in circumstances where a non-de minimis contribution occurs during the course of an existing financial advisory relationship. MSRB proposes restating the Rule G-37 Interpretive Notice to remove references to financial advisory services, which would instead be covered by Rule G-42.
3Although the Dodd-Frank Act also made municipal advisors subject to a federal fiduciary duty to their municipal entity clients, the MSRB has not issued guidance on the definition of fiduciary duty or the types of conduct that would violate a fiduciary duty.
4See Section 15B(e)(4) of the Securities Exchange Act of 1934, as amended by the Dodd-Frank Act (the “Exchange Act”) defines “municipal advisor” as “a person (who is not a municipal entity or an employee of a municipal entity) that (i) provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues, or (ii) undertakes a solicitation of a municipal entity. The following are not deemed advisors: municipal entities and their employees, dealers serving as underwriters, SEC-registered investment advisers, and their associated persons as long as such advisers and associated persons are providing investment advice, registered commodity trading advisers and their associated persons providing advice on swaps, attorneys offering legal advice or traditional legal services, and engineers providing engineering services.
Section 15B(e)(8) of the Exchange Act defines “municipal entity” as “any State, political subdivision of a State, or municipal corporate instrumentality of a State, including (A) any agency, authority, or instrumentality of the State, political subdivision, or municipal corporate instrumentality; (B) any plan, program, or pool of assets sponsored or established by the State, political subdivision, or municipal corporate instrumentality or any agency, authority, or instrumentality thereof; and (C) any other issuer of municipal securities.” See also MSRB Education and Outreach Event, December 6, 2010.
5See MSRB News and Events, MSRB Board of Directors Holds Special Meeting On Municipal Advisor Rules, December 6, 2010.
6 See Notice.
7This is unlike Rule G-37 which defines a Municipal Finance Professional (“MFP”) as an associated person who is primarily engaged in municipal advisory business. As a result, the proposed changes to Rule G-37 that would become effective on the effective date of Rule G-42 would remove all references to “financial advisory services” from G-37.
8Notice at 3.
9Id. at 2.
10Id.
11Id. at 4.
12Id.
13Id. at 5.
14Id.
15Id. at 4.
16Id.
17Id.
18Id.
19Id. at 3.
20Investment Advisers should pay particular attention to the resulting language that may arise out of the SEC’s proposed amendment to Rule 206(4)-5. Presently, Rule 206(4)-5 prohibit advisers from paying persons (e.g., “solicitors or “placement agents”) to solicit government entities unless such persons are“regulated persons” (i.e., registered investment advisers or broker-dealers subject to rules of a registered national securities association, such as the Financial Industry Regulatory Authority (“FINRA”), that restricts its members from engaging in pay to play activities). In the proposal, the SEC states that it would permit an adviser to pay any “regulated municipal advisor” to solicit government entities on its behalf.
Despite the proposal’s attempt to expand the scope of the category of permitted solicitors, the actual wording of the proposed rule appears to be more limiting. Proposed Rule 206(4)-5(a)(2)(i) provides: “[a]s a means reasonably designed to prevent fraudulent, deceptive or manipulative acts, practices, or courses of business within the meaning of section 206(4) of the Act (15 U.S.C. 80b-6(4)), it shall be unlawful for any investment adviser registered (or required to be registered) with the Commission, or unregistered in reliance on the exemption available under section 203(b)(3) of the Advisers Act (15 U.S.C. 80b-3(b)(3)), or that is an exempt reporting adviser, or any of the investment adviser’s covered associates; (i) To provide or agree to provide, directly or indirectly, payment to any person to solicit a government entity for investment advisory services on behalf of such investment adviser unless such person is: (A) A regulated municipal advisor; or (B) An executive officer, general partner, managing member (or, in each case, a person with a similar status or function), or employee of the investment adviser; and....” A “regulated municipal advisor” is defined in the proposal to exclude registered investment advisers (unless they are also registered as municipal advisors), who, under the current rule, are permitted to solicit government entities. As a result, there appears to be some inconsistency in the text of the rule proposing release and the proposed wording of the rule.
21Notice at 3.
22Id.
23Id. at 5.
This article was originally published by Bingham McCutchen LLP.