In a recent release (the Release),1 the Securities and Exchange Commission (the SEC) proposed final rules relating to the registration of municipal advisors as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). On their face one might assume that these rules would be of little application beyond the narrow market of unregistered financial advisors to municipalities. Indeed, that appears to have been Congress’ intent. Unfortunately, however, because of the broad language of the statute and the apparent unwillingness of the SEC to construe this language more narrowly, these requirements are of concern to a broad group of financial markets participants.
The primary reason for this concern stems from the fact that if a person is found to be a municipal advisor that person will owe a fiduciary duty to the advised entity. In combination with the broad language of the statute, this may cause market participants to rethink certain business activities that were previously understood to be executed in a strictly arms length context. In fact, application of this fiduciary standard in certain instances could dramatically change the way financial services providers interact with municipal entities. In addition, a person found to be a municipal advisor will be subject to the filing and regulatory regime of the SEC and the Municipal Securities Rulemaking Board (the MSRB), including the MSRB’s proposed pay-to-play rules.
The Statute and Rules
Section 15B(e)(4) of the Securities Exchange Act of 1934, as amended (the Exchange Act), defines a municipal advisor as a person who "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," or who "undertakes the solicitation of a municipal entity." Again, on its face this definition appears narrowly drawn; however, there are a number of defined terms imbedded in this provision that substantially broaden its scope. The relevant imbedded definitions are as follows:
First, "municipal entity" is defined to include not only municipal securities issuers, and other state and local subdivisions and agencies, but also "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."2 The SEC has further clarified that this "includes, but is not limited to, public pension funds, local government investment pools and other state and local governmental entities or funds, as well as participant-directed investment programs or plans such as 529, 403(b), and 457 plans."3
Second, the SEC has conformed the definition of "obligated person" to that found in Rule 15c2-12 under the Exchange Act, which broadly includes all persons who are committed to support the payment obligations of municipal securities (e.g., conduit borrowers), except for providers of liquidity facilities, such as bond insurers and banks that provide letters of credit.
Third, the term "municipal financial product" means "municipal derivatives, guaranteed investment contracts, and investment strategies." Within this seemingly narrow litany of products, however, lies a deceptively broad term with a somewhat circular meaning. The SEC has stated that the term "investment strategies" includes advice with respect to "plans, programs, or pools of assets that invest funds held by or on behalf of a municipal entity."4
Finally, broker-dealers serving as underwriters are exempt from the definition of municipal advisor, but not with respect to other non-underwriting activities they may undertake in connection with a municipal entity or obligated person. Registered investment advisors are also exempt from the definition of municipal advisor but only with respect to the provision of investment advice. That is, to the extent a registered investment advisor were to provide advice outside the scope of the Investment Advisors Act of 1940, as amended, (such as advice on the structuring of municipal bonds) that activity would not be covered by the exemption.
Connecting the Dots
Among the many issues that arise from this regulation, we note the following as significant to general financial markets participants:
- The SEC has made clear that any person who provides advice to municipal entities and conduit borrowers with respect to municipal financial products — such as, derivatives, guaranteed investment contracts, plans, programs or pools of assets (including pension funds and money held by municipalities for temporary investment) — must register as a municipal advisor and be subject to the statutory fiduciary duties. Thus, financial services providers who are otherwise not exempt and who wish to remain outside this regulatory regime must be wary in their contacts with municipal entities and understand the context in which any such contact is made.
- As noted above, since conduit borrowers are included as "obligated persons" under the definition of "municipal advisor," contacts by financial services providers with conduit borrowers could subject the providers to registration as a municipal advisor.
- The SEC notes in the Release that a municipal entity’s investment in a private fund would not necessarily require registration by the fund manager. That is, to the extent a municipal entity invests in a pooled investment vehicle along side other non-municipal entities, such investment would not cause the advisor to such investment vehicle to register as a municipal advisor.
- A solicitation of a municipal entity, including a direct or indirect communication may require registration as a municipal advisor. Because broker-dealers are exempt only if they are acting as underwriters in connection with a particular offering, providing separate investment advice or soliciting an advisory relationship could require registration as a municipal advisor. For example, third party marketers who solicit state pension funds would be subject to registration. In addition, because of conflicting statements in the Release and ambiguity in the statute, it appears that investment managers who are not registered investment advisors and who solicit pension funds would be subject to registration.
- Typical secondary market trading practices appear to be implicated as well. The Release implies that the mere provision of quotes or trading ideas (including desk research) may require registration. The SEC has asked, however, for comment as to whether such activities should be specifically exempted.
Room for Advocacy
Because of the far-reaching impact of these new requirements, there are a number of constituencies that are planning to submit comment letters to the SEC on the proposed rules and financial services industry advocates are urging participants to submit their own comment letters. Accordingly, there is some hope that material changes will be made in the final rule proposals. Among those who commented previously on the temporary rules are SIFMA and the ABA, and we expect that they will each submit comment letters on this proposal as well. The comment period expires February 22, 2011.