FINRA issued its late-July Regulatory Notice 15-27 warning brokerage firms that inadvertent short positions or fail-to-delivers in municipal securities trading can create situations where the member-firm pays a customer substitute interest that is not tax-deductible. Firms need to ensure their supervisory and compliance systems, and just as importantly their customer communications, address those situations.

Short sales of municipal securities (selling a borrowed position, and buying it in lower, later) are rare. But the IRS has held that the lender’s receipt of interest (from the firm or the borrower) after title passes, isn’t tax-deductible because it wasn’t paid the municipal issuer. See IRS Rev. Rul. 80-135 (1980-1 C.B. 18). A municipal short can arise inadvertently, where (for example) a firm sells John 100 tax-exempt City bonds, then mistakenly sells Sally the same 100 bonds – creating a short. Until it’s corrected, the firm will have to cover interest for John or Sally, but it won’t be tax-exempt. A similar situation arises when a seller fails to deliver by settlement date and the firm is required to pay substitute interest until it covers its short position.

The Reg. Notice is part of continuing Regulatory focus on municipal markets and can be found here.