On January 9, 2014, the Municipal Securities Rulemaking Board (the “MSRB”) published draft MSRB Rule G-42, which sets forth standards of conduct and duties of municipal advisors when engaging in municipal advisory activities other than the undertaking of solicitations. As written, section (f) of the draft rule appears likely to force some banks who, directly or through an affiliate, are registered as a municipal advisor to exit the municipal advisor business. The rule does not allow municipal advisors to both give “advice” to their municipal clients and to conduct other business with those clients. Forced to choose between being a pure fiduciary /advice municipal advisor and engaging in other business with municipal entities, including more lucrative services as a depository bank, investment advisor, lender or swap provider, some banks will have no practical alternative but to exit the pure fiduciary business entirely. Forcing banks to unbundle their services appears likely to drive up overall costs, since banks will be artificially removed as competitors from the marketplace and a separate entity acting as municipal advisor (and their counsel) will now be added to municipal bond transactions in addition to the municipal entity’s (and bond issuer’s) standard platoon of legal advisors. It seems that both banks and their municipal entity customers (such as bond issuers) should lobby against this seemingly counterproductive rule.
The genesis of Rule G-42 the grant of rulemaking authority to the MSRB under the Securities Exchange Act, as amended by Dodd-Frank. Section 15B(b)(2) of the Exchange Act requires the MSRB to promulgate rules for several types of entities, including municipal advisors. Under that statute, the MSRB is required to promulgate rules designed to prevent practices inconsistent with a municipal entity’s fiduciary duty to its clients. Dodd-Frank did not expressly require that municipal advisors be limited to a pure fiduciary role but that is essentially how the MSRB has chosen to draft section (f) of Rule G-42.
The MSRB’s theory in restricting municipal advisors to a purely fiduciary role is that client consent to a dual role, even after receiving complete disclosure, cannot be valid given the “high potential for self-dealing in such situations.” In its regulatory notice accompanying proposed Rule G-42, the MSRB did not address the market reality that, just like real estate appraisers or bond rating agencies that do not “get along,” any municipal advisor acting in a purely fiduciary role will quickly find itself without clients if it gains a reputation for torpedoing bond deals negotiated by the real parties in interest. In short, a pure advice / fiduciary municipal advisor will be strongly incentivized to bless the business deal negotiated by the business people and their lawyers.
If a bond deal experiences difficulty or enters litigation, the various principals involved will now have much stronger defenses to liability due to the involvement of a statutorily unbiased advisor. As a result, liability will tend to concentrate on the advisor, which is not a bank or other deep-pocketed institution but rather a thinly-capitalized pure consulting firm. Perhaps in recognition of this likely liability concentration, the MSRB is considering requiring municipal advisors to carry professional liability insurance. However, the cost of a professional liability policy in the amounts necessary to backstop multiple large bond transaction is probably so prohibitive that the MSRB would either not specify minimum coverage or allow coverage below the actual risk. And, it can be extremely difficult to actually recover against a professional liability insurer, given the complexity of such policies, the numerous exceptions and loopholes and the common problem of policy enforcement litigation using up the coverage. In short, shifting liability to the advisors may well be less protective of municipalities and bond investors than simply allowing banks to shoulder the dual role and the attendant liability risks.