SEC Proposes Consolidated Audit Trail System and New Requirements for Municipal Securities Underwriters

May 27, 2010

On May 26, 2010, the U.S. Securities and Exchange Commission (“SEC”) voted unanimously to propose a new rule (the “Proposal”) that would require self-regulatory organizations (“SROs”) to establish a centralized repository for the collection of real-time order and execution data for all secondary market transactions in National Market System (“NMS”) equity securities and listed options. The SEC also voted unanimously to adopt amendments to Rule 15c2-12 under the Securities Exchange Act of 1934 (the “Exchange Act”) concerning the obligations of Participating Underwriters of municipal bonds.

Proposed Consolidated Audit Trail (“CAT”) System

Currently, each SRO maintains and uses its own “audit trail” system for the tracking and collection of order data for the markets it oversees, with varying requirements for the types of data covered. As a result, when regulators such as the SEC or SROs seek to gather and analyze cross-market data — as with the SEC’s current investigation of the extreme intraday volatility that occurred in the U.S. markets on May 6, 2010 — they must first obtain the data from each relevant SRO and then piece together the different data sets before they can begin to review and examine the data.    

“The technology for collecting data and surveilling our markets is often as much as two decades behind the technology currently used by those we regulate,” said SEC Chairman Mary L. Schapiro. “As a result, there is an intense need for regulators to have efficient access to a far more robust and effective cross-market order and execution tracking system.”

Accordingly, the SEC has proposed new Rule 613 under Regulation NMS, which would mandate FINRA and the other SROs jointly to develop and file with the SEC a plan for a CAT system, and to propose rule changes to require each of FINRA’s and the SROs’ members to comply with the CAT system.   

Pursuant to the Proposal, the new CAT system must require each exchange and FINRA, together with their respective members, to make real-time, or near real-time, submissions of specified data for all quotes, orders and reportable events that occur with respect to secondary market transactions in NMS securities (“CAT Data”) to the CAT repository. The SEC stated in its Proposing Release1 that it ultimately intends to expand the CAT to cover not only non-NMS equity securities but also all fixed income securities. The SEC furthermore indicated in the Proposing Release that it believes Rule 613 should permit the expansion of the CAT to cover primary market transactions in NMS equity securities and other non-NMS equity securities, as well as primary market transactions in debt securities.

The CAT repository would be jointly owned and operated by FINRA and the SROs. Each FINRA and SRO member firm would be required to create a unique identifier for each order received or originated by the member. The order identifier would attach to and follow the order as it is modified, routed, executed and/or cancelled. The Proposal would further require the establishment of a uniform customer identification system, which would assign each customer a unique identifier that would be used to identify the customer across all broker-dealers.

The Proposal would require that the CAT system plans include policies and procedures to protect the confidentiality of CAT Data, access to which would be restricted to the SEC, FINRA and the SROs for the performance of their respective regulatory and oversight functions. The Proposal would require each SRO to implement changes to their surveillance systems to better utilize the CAT Data, and would further require each SRO, along with its members, to synchronize their business clocks.
Within 90 days of the adoption of Rule 613, FINRA and the SROs must submit their joint CAT system plan to the SEC. FINRA and the SROs will be required to provide CAT Data to the repository within one year after the CAT system becomes effective, and FINRA and SRO members will be required to provide CAT data to the repository within two years after the CAT system becomes effective. The SEC anticipates that if the Proposal is adopted, Rule 613 will eventually be expanded to cover transactions in securities other than NMS securities.

Adoption of Exchange Act Rule 15c2-12 Amendments

Exchange Act Rule 15c2-12 was adopted by the SEC in 1989 to improve transparency in the municipal securities market. Because the SEC is not authorized to directly require disclosure by issuing municipalities,2 Rule 15c2-12 requires the Participating Underwriters of municipal bonds to make a reasonable determination that issuing municipalities will disclose certain annual information and event notices before the Participating Underwriter purchases or sells primary offerings of covered municipal securities. The amendments adopted by the SEC on May 26 (“Amended Rule 15c2-12”)3 are intended to increase transparency in the municipal securities market by broadening the scope of securities covered and the nature of the events that issuers must agree to disclose, and more tightly defining the time period in which the disclosures must be made.

(1) Elimination of VRDO Exemption

According to the SEC Trading and Markets Staff, variable rate demand obligations (“VRDOs”) accounted for 38 percent of municipal securities trading volume in 2008. Despite the volume in this segment of the municipal securities market, Rule 15c2-12(d) previously exempted certain primary offerings of VRDOs from the requirement that a Participating Underwriter reasonably determine that the issuer will provide continuing disclosure documents to the MSRB under a continuing disclosure agreement. This exemption for VRDOs is eliminated in Amended Rule 15c2-12.

(2) Disclosure Within 10 Days

Amended Rule 15c2-12 establishes a more specific filing deadline for disclosure notices required to be filed by municipalities. Specifically, paragraphs (b)(5)(i)(C) and (d)(2)(ii)(B) have been modified to stipulate that “in a timely manner” means no more than 10 business days. Consequently, a Participating Underwriter now has to determine that a continuing disclosure agreement requires the municipality to submit notices to the MSRB within 10 business days after a particular event occurs.

(3) Determination of Materiality

Rule 15c2-12(b)(5)(i)(C) formerly required notice of certain important events only “if material.” Under Amended Rule 15c2-12, the materiality determination is largely eliminated, and now notices must be filed for a variety of events that the SEC has determined to be per se material. These events include all failures to pay principal and interest, various unscheduled payments reflecting financial difficulties or performance failures, defeasances, and rating changes. Materiality determinations would still be applicable to some other events, including bond calls.

(4) Disclosure of Tax Events

Amended Rule 15c2-12 has revised paragraph (b)(5)(i)(C)(6) to provide specifically for disclosure to the MSRB of events that could negatively affect a bond’s tax exemption. These events include adverse tax opinions, IRS issuance of taxability determinations and other material notices regarding the tax-exempt status of securities.

(5) Disclosure of Additional Events

Finally, Amended Rule 15c2-12 requires disclosure of additional events under continuing disclosure agreements. Namely, paragraph (b)(5)(i)(C) has been amended to require that the Participating Underwriter reasonably determine that a municipal issuer will provide continued disclosure of (i) tender offers; (ii) bankruptcy, insolvency, receivership or similar proceedings; (iii) material mergers, consolidations, and acquisitions; and (iv) appointment of a successor or additional trustee or change of name of trustee, if material.

The adopting release for Amended Rule 15c2-12 also reaffirms the SEC’s previous position that the federal securities laws require that underwriters review disclosure documents in a professional manner. These documents, in turn, often provide a reasonable basis for underwriters to make recommendations to clients concerning municipal securities.

For additional information concerning this alert, please contact the following lawyers:

Amy Natterson Kroll, Partner, Broker-Dealer Group, 202.373.6118

David C. Boch, Partner, Broker-Dealer Group, 617.951.8485

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area, 617.951.8615

Timothy P. Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area, 617.951.8620

1 SEC Release No. 34-62174 (May 26, 2010) (available at
2 The Tower amendment, codified as Section 15B(d) of the Exchange Act, states, “Neither the [SEC] nor the [MSRB] is authorized under this title, by rule or regulation, to require any issuer of municipal securities, directly or indirectly through a purchaser or prospective purchaser of securities from the issuer, to file with the [SEC] or the [MSRB] prior to the sale of such securities by the issuer any application, report, or document in connection with the issuance, sale, or distribution of such securities.”
3 SEC Release No. 34-62184 (May 26, 2010) (available at

This article was originally published by Bingham McCutchen LLP.