The Municipal Securities Rulemaking Board (“MSRB”) has proposed for comment a new rule, Rule G-36, concerning the fiduciary duty of municipal advisors and proposed interpretive guidance regarding the application of MSRB Rule G-17, which concerns “fair dealing,” to municipal advisors and underwriters. These proposals give effect to Congress’ actions to increase the regulation of municipal advisors under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).1 The proposed regulations will place duties on municipal advisors, depending on the context in which they are advising clients or other parties. The MSRB has also issued draft interpretative guidance regarding the duties of underwriters of municipal securities.
Proposed Rule G-36: Fiduciary Duties of Municipal Advisors
The MSRB also has drafted interpretive guidance on the meaning of fiduciary duty for municipal advisors.
Proposed Rule G-36 states as follows: “In the conduct of its municipal activities on behalf of municipal entities, a municipal advisor shall be subject to a fiduciary duty, which shall include a duty of loyalty and a duty of care.”
The interpretive notice provides that under Rule G-36 there exists a duty of loyalty that requires a municipal advisor to deal honestly and in good faith with municipal entities and to act in the municipal entity’s best interests without regard to its financial or other interests. It requires a municipal advisor to make clear, written disclosure of all material conflicts of interest, such as those that might impair its ability to satisfy the duty of loyalty, and to receive the written, informed consent of the municipal entity. Such disclosure is to be made before the municipal advisor may provide municipal advisory services to the municipal entity or, in the case of conflicts arising after the municipal advisory relationship has commenced, before the municipal advisor may continue to provide such services. The notice provides that under Rule G-36 a municipal advisor may not undertake an engagement if certain unmanageable conflicts exist, including: (i) kickbacks and certain fee-splitting arrangements with the providers of investments or services to municipal entities; (ii) payments by municipal advisors made for the purpose of obtaining or retaining municipal advisory business other than reasonable fees paid to a municipal advisor for solicitation activities regulated by the MSRB; and (iii) acting as a principal in matters concerning the municipal advisory engagement (except when certain Internal Revenue Service competitive bidding guidelines for establishing fair market value are satisfied).isunderstandings
The notice also provides that, in certain cases, compensation received by a municipal advisor may be so disproportionate to the nature of the municipal advisory services performed that it is inconsistent with the Rule G-36 duty of loyalty and represents an unmanageable conflict. The notice further provides that the Rule G-36 duty of care requires that a municipal advisor act competently and provide advice to the municipal entity after inquiry into reasonably feasible alternatives to the financings or products proposed (unless the engagement is of a limited nature).
Conflicts of Interest. Proposed Rule G-36 would require a municipal advisor to disclose, in writing, all material conflicts of interest. According to the interpretative notice, some conflicts that must be disclosed include:
- payments by municipal advisors made for the purpose of retaining municipal advisory business;
- payments from third parties to the advisor in relation to the advisory engagement; and
- payments from third parties to enlist the advisor’s recommendation of their services to the municipal entity.
According to the proposed interpretive notice, the duty of loyalty also requires municipal advisors to make certain disclosures regarding a municipal advisor’s compensation arrangement and of the conflicts of interest that result from certain forms of compensation. For example, according to the proposed interpretative notice, a fixed fee could result in a conflict of interest since an advisor would not have an incentive to suggest more complex, time-consuming forms of financing. The MSRB has provided proposed interpretive guidance with sample disclosure of conflicts of interest associated with various forms of compensation that a municipal advisor may provide to a client in order to satisfy this obligation.
Duty of Care. A municipal advisor’s duty of care requires the advisor to exercise due care in performing its responsibilities. According to the proposed interpretive guidance, this includes:
- sufficient knowledge and expertise to provide the municipal entity with informed advice;
- consideration of alternatives to a proposed financing structure; and
- a reasonable inquiry as to the facts relevant to a municipal entity’s determination of whether to proceed with a given course of action.
Proposed Interpretative Notice of Application of MSRB Rule G-17 to Municipal Advisors
The MSRB also issued a proposed interpretive notice concerning the application of existing Rule G-17 to municipal advisors. Whereas Proposed Rule G-36’s fiduciary standard applies to municipal advisors in the context of providing advice to their municipal entity clients, the MSRB has issued a proposed interpretive notice that concerns two contexts where the standard of Rule G-17 applies. These are with respect to obligated persons, i.e., borrowers in a municipal financing, and the solicitation of municipal entities on behalf of third parties. Rule G-17 sets forth an anti-fraud prohibition similar to that which arises under Securities Exchange Act Rule 10b-5 and also establishes a general duty to deal fairly with all persons. However, Rule G-17 does not establish a fiduciary duty when advising an obligated person (unless the obligated person is a municipal entity) or when soliciting a municipal entity on behalf of others.
Duty to Obligated Persons. The MSRB proposes to establish different duties based on whether the advisor is recommending a given transaction or is reviewing a transaction recommended by another party. In the former scenario, the advisor must conclude that the transaction is appropriate for the client and must advise the client of the risks and characteristics of the given structure. When an advisor is reviewing the recommendation of another party (i.e., an underwriter), the advisor must advise of the risks and characteristics of the given structure but does not need to consider feasible alternatives. In this case, the advisor may disclaim the obligation to conclude whether the financing is appropriate. The draft interpretive guidance also requires advisors to exercise due care, disclose conflicts, obtain informed consent for such conflicts, and to advise the obligated person on the amount and forms of compensation. These duties are similar to the requirements placed on municipal advisors by Rule G-36.
Solicitation of a Municipal Entity. According to the Interpretative Notice, under Rule G-17, a solicitor must disclose all material facts about the solicitation to the municipal entity, including but not limited to the name of the solicitor’s client, the amount and source of the solicitor’s compensation, and relationships that may result in a conflict of interest. Solicitors also are bound by the antifraud prohibitions.
Application of MSRB Rule G-17 to Underwriters of Municipal Securities
The MSRB has also drafted interpretive guidance on the application of Rule G-17’s fair dealing and anti-fraud standard to underwriters of municipal securities. The MSRB highlights several examples of a non-exclusive list of obligations of municipal securities underwriters under Rule G-17. These obligations include:
- Fair Dealing – an underwriter must not misrepresent the facts, risks, or other material information.
- Representations – all representations made by underwriters must be truthful and accurate and must not omit material facts. These obligations also apply when a underwriter is assisting an issuer in making representations in the issuer’s disclosure documents.
- Required Disclosures – Underwriters must disclose the specific, material risks and characteristics of a complex municipal services financing, in writing, to officials of the issuer, prior to the execution of the financing.
- Compensation – Compensation must not be excessive. Factors to consider to determine whether compensation is proportionate to the services performed include the credit quality of the issue, the size of the issue, market conditions, time spent structuring the issue, and other relevant costs.
- Fair Pricing – The price an underwriter pays to an issuer must bear a reasonable relationship to the prevailing market price of the securities. In a competitive underwriting, an underwriter satisfies this duty by making a bona fide bid based on the best judgment of the fair market value of the securities. In a negotiated underwriting, an underwriter must negotiate with the issuer in good faith and ensure the accuracy of any representations made.
- Retail Order Periods – An underwriter must honor an agreement that has a period for orders from retail clients. Underwriters must make reasonable efforts to ensure retail clients are bona fide and that orders placed are consistent with the intent of the issuer.
- Dealer Payments to Issuer Personnel – Rule G-17 along with Rule G-20 prohibits excessive gifts (such as paying for lavish travel, meal, lodging, or entertainment) to issuer personnel during the municipal bond issuance process.
Underwriter Conflicts of Interest. The MSRB also has highlighted several circumstances in which conflicts of interest may be an issue. For example, when an underwriter receives or makes payments to third parties in connection with the underwriting, the amount of the payment, the party making or receiving such payment, and the purpose of the payment must be disclosed. Additionally, when a dealer issues credit default swaps where the dealer is also the underwriter of the reference obligations, there may be a conflict of interest that must be disclosed, as trading in such municipal credit default swaps may impact the price of the reference obligations and other securities.
Profit-sharing with investors purchasing from the underwriter and reselling the new securities may constitute a forbidden conflict of interest depending on the facts and circumstances. An important factor is whether the resale occurs reasonably close in time to the original sale by the underwriter to the investor.