Request for Comment on Draft Interpretive Notice Concerning the Application of MSRB Rule G-17 to Bondholder Consents by Underwriters of Municipal Securities

The Municipal Securities Rulemaking Board (“MSRB”) is requesting comment on a draft interpretive notice concerning the application of MSRB Rule G-17 to the provision of bondholder consents by underwriters of municipal securities.  Comments should be submitted no later than March 6, 2012, and may be submitted in electronic or paper form.  Comments may be submitted electronically by clicking here.  Comments submitted in paper form should be sent to Ronald W. Smith, Corporate Secretary, Municipal Securities Rulemaking Board, 1900 Duke Street, Suite 600, Alexandria, VA 22314.  All comments will be available for public inspection on the MSRB’s website.[1]

Questions about this notice should be directed to Karen Du Brul, Associate General Counsel, at 703-797-6600.

BACKGROUND

As described in more detail in the draft notice, the MSRB is concerned that, in some cases, underwriters have consented to trust indenture or resolution amendments that affect existing parity bondholders, even though those authorizing documents and the official statements for the existing bonds did not provide expressly that underwriters could provide such consents.  In some cases, those amendments have reduced the security for existing bondholders (e.g., by deleting debt service reserve fund requirements) or have reduced the value of existing bonds (e.g., by changing call features).  The draft notice describes circumstances under which this practice would violate MSRB Rule G-17’s requirements that brokers, dealers, and municipal securities dealers deal fairly with all persons in the conduct of their municipal securities activities.

While underwriters may technically be bondholders during the period between the time they purchase an issuer’s bonds and the time they distribute the bonds to investors, they are still underwriters while they hold bonds with a view to distribution.  As such, they will not be negatively affected by the amendments to which they consent.  In fact, they may have a monetary incentive to consent to the amendments and, accordingly, a conflict of interest.  If, on the other hand, the underwriting firm became an investor in the bonds and was no longer holding the bonds with a view to distribution, the firm’s consent to amendments affecting their bonds would not be precluded by the notice.

The MSRB notes that the notice does not address amendments agreed to by underwriters that have no effect on existing bondholders.  For example, if an underwriter agreed to amendments to variable rate demand obligations (“VRDOs”) after the existing VRDOs had been subject to a mandatory tender, the amendments would have no effect on previous owners of the VRDOs.  Similarly, if all of the existing bonds had been defeased prior to the underwriter’s consent, the notice would not apply, because the amendments would not affect the defeased bondholders.

The MSRB decided not to propose a “material adverse effect” standard for analyzing amendments that affect existing bondholders under Rule G-17.  Such a standard might be subject to varying interpretations by different underwriters.  Furthermore, while an amendment might not materially adversely affect existing bondholders at the time of the amendment (e.g., the deletion of a debt service reserve fund requirement for a strong issuer credit), its significance might become apparent in the future (e.g., if the issuer experienced financial difficulties).

SUMMARY OF INTERPRETIVE NOTICE

The draft interpretive notice provides that the provision of bondholder consents by underwriters could, depending upon the facts and circumstances, be a violation of the Rule G-17 duty of dealers to deal fairly with all persons in the conduct of their municipal securities activities.  The notice provides, as an example, that it would be a violation of Rule G-17 for an underwriter to consent to amendments to an authorizing document that would reduce the security for existing bondholders unless (i) the authorizing document expressly provided that an underwriter could provide bondholder consent and (ii) the offering documents for the existing securities expressly disclosed that bondholder consents could be provided by underwriters of other securities issued under the authorizing document.  The notice includes examples of what is meant by “reduction in security.”

REQUEST FOR COMMENT

The MSRB requests comments on the draft interpretive notice set forth below.  If the MSRB subsequently files the draft interpretive notice with the Securities and Exchange Commission, it will request that it be given prospective application.

February 7, 2012

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MSRB Notice 2012-__ (__________ __, 2012)

INTERPRETIVE NOTICE CONCERNING THE APPLICATION OF MSRB RULE G-17 TO BONDHOLDER CONSENTS BY UNDERWRITERS OF MUNICIPAL SECURITIES

It has come to the attention of the Municipal Securities Rulemaking Board (the “MSRB”) that, in some cases, an issuer of municipal securities (or an obligated person) may request that the broker, dealer, or municipal securities dealer (“dealer”) that is the underwriter of those securities provide its consent (“bondholder consent”) to certain changes to the trust indenture or resolution under which the securities are issued (“authorizing document”) at the point in time that the securities are briefly owned by the underwriter, prior to redistribution of the securities to investors (“new bondholders”).[1]  In some cases, the changes may affect investors that already own securities issued under the authorizing document (“existing bondholders”), as well as the new bondholders.  This may be the case, for example, if the authorizing document provides for the issuance of multiple series of securities and permits amendments to the authorizing document upon the receipt of the consent of more than 50% of the owners of the securities issued under the authorizing document, and the securities underwritten (and owned by the underwriter prior to distribution) represent more than the required 50%.  The MSRB is concerned that some of the changes for which such bondholder consents are provided may reduce the security for existing bondholders or the value of their bonds.

Under MSRB Rule G-17, dealers must, in the conduct of their municipal securities activities, deal fairly with all persons and must not engage in any deceptive, dishonest, or unfair practice.  This rule is most often cited in connection with duties owed by dealers to investors with which the dealers engage in municipal securities transactions.[2]  However, Rule G-17 is broader in scope, because it establishes a general duty of a dealer to deal fairly with all persons in the conduct of its municipal securities activities, even in the absence of fraud.

The provision of bondholder consents by underwriters may, depending upon the facts and circumstances, be a violation of the Rule G-17 duty of dealers to deal fairly with all persons in the conduct of their municipal securities activities.  For example, it would be a violation of Rule G-17 for an underwriter to consent to amendments to an authorizing document that would reduce the security for existing bondholders unless (i) the authorizing document expressly provided that an underwriter could provide bondholder consent and (ii) the offering documents for the existing securities[3] expressly disclosed that bondholder consents could be provided by underwriters of other securities issued under the authorizing document.  The following are examples of what is meant by a “reduction in security” but they are not exclusive: (i) elimination of a reserve fund, a reduction in its amount, or the substitution of a surety policy for a cash-funded reserve; (ii) a reduction in the priority of debt service on existing securities in relation to other expenditures; (iii) a reduction in a minimum debt service coverage ratio that is a condition of the issuance of additional securities under the authorizing document; and (iv) the elimination or reduction in the amount of collateral for existing securities.

The MSRB is aware that underwriter provision of bondholder consents may be perceived by issuers and obligated persons to be a more cost-effective way of obtaining required bondholder consents than, for example, the defeasance of existing securities or solicitation of existing bondholders, and that, in some cases, issuers and obligated persons may face economic constraints that cause them to seek changes to the security provisions of authorizing documents.  Nevertheless, the MSRB cautions dealers to consider carefully before providing such consents whether they have the potential to violate Rule G-17.
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[1] This notice would not apply to the extent a dealer purchases municipal securities for its own account without a view to distribution.

[2] See, e.g., Guidance on Disclosure and Other Sales Practice Obligations to Individual and Other Retail Investors in Municipal Securities (July 14, 2009).  See also Interpretive Notice Regarding Rule G-17, on Disclosure of Material Facts (March 20, 2002).

[3] For purposes of this notice, it is presumed that the offering document for the securities purchased by the new bondholders clearly disclosed the terms of the securities as a result of the changes.  If that were not the case, the underwriter could be found to have engaged in an unfair practice under Rule G-17 with regard to the new bondholders.