Securities and Exchange Commission Approves Revised MSRB Definition of Sophisticated Municipal Market Professional

On May 25, 2012, the Securities and Exchange Commission (“SEC”) approved the restatement of an interpretive notice of the Municipal Securities Rulemaking Board (“MSRB”) concerning the application of MSRB Rule G-17 (on conduct of municipal securities and municipal advisory activities) to sophisticated municipal market professionals or “SMMPs” (the “Restated SMMP Notice” and the “Existing SMMP Notice,” respectively).[1]  The Restated SMMP Notice contains a revised definition of SMMP and revises the way that MSRB Rule G-17 is applied to SMMPs.  The Restated SMMP Notice will become effective on July 9, 2012.

BACKGROUND

Under the Existing SMMP Notice, to be an SMMP a customer must be an institutional customer, which is defined as “an entity, other than a natural person (corporation, partnership, trust, or otherwise), with total assets of at least $100 million invested in municipal securities in the aggregate in its portfolio and/or under management.”   The definition of SMMP in the Existing SMMP Notice was closely modeled on an interpretation by the National Association of Securities Dealers (“NASD”) of its suitability rule.[2]  A notable difference was that the definition of SMMP also looked to whether the investor had access to material facts.  A key factor in the MSRB’s reasoning as to that difference was the lack of information available about municipal securities in 2002, when the Existing SMMP Notice was adopted.  Since the adoption of the existing definition of SMMP, there has been a vast increase in the availability of information about municipal securities reasonably accessible by institutional investors regardless of the amount of their holdings of municipal securities (e.g., on the MSRB’s Electronic Municipal Market Access (EMMA®) system, from rating agencies, and from other information vendors).  Furthermore, effective July 9, 2012, former NASD guidance on institutional suitability for securities other than municipal securities will no longer be in effect.  It will be replaced by Rule 2111 of the Financial Industry Regulatory Authority (“FINRA”), under which a FINRA member’s customer-specific suitability obligation to an institutional customer[3] will be considered satisfied if (1) the member has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities, and (2) the institutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member’s recommendations.  The MSRB generally considers it desirable from the standpoint of reducing the cost of compliance by brokers, dealers and municipal securities dealers (“dealers”) to maintain consistency with FINRA rules, absent clear reasons for treating transactions in municipal securities differently.

SUMMARY OF RESTATED SMMP NOTICE

Revised Definition of SMMP.  Under the Restated SMMP Notice, an “SMMP” is defined as an institutional customer[4] of a dealer that: (1) the dealer has a reasonable basis to believe is capable of evaluating investment risks and market value independently, both in general and with regard to particular transactions in municipal securities, and (2) affirmatively indicates that it is exercising independent judgment in evaluating the recommendations of the dealer.  As part of the reasonable basis analysis required by clause (1), the dealer should consider the amount and type of municipal securities owned or under management by the institutional customer.  The MSRB notes that, while receipt by a dealer of the FINRA Rule 2111 affirmation would satisfy clause (2) of the revised SMMP definition, a written statement from an institutional customer would not satisfy the dealer’s reasonable basis obligation under clause (1) of the revised SMMP definition.

Application of Revised SMMP Definition.  Most of the other provisions of the Existing SMMP Notice have not been changed in the Restated SMMP Notice.  The Restated SMMP Notice addresses a dealer’s obligations to an SMMP under Rule G-17 (on fair dealing), Rule G-18 (on execution of transactions), Rule G-19 (on suitability), and Rule G-13 (on quotations).  The following summarizes the way in which those rules apply to a dealer’s transactions with an SMMP, noting those provisions that have been changed substantively.

Rule G-17.  One change that was made by the Restated SMMP Notice that should be noted is that, under the Restated Notice, when a dealer effects a secondary market transaction with an SMMP, its affirmative Rule G-17 disclosure duty concerning material facts available from established industry sources[5] will be deemed satisfied, whether the transaction is recommended or non-recommended.  The Existing SMMP Notice applies this interpretation only to non-recommended transactions.  It continues to be the case under the Restated SMMP Notice that, as in the case of an inter-dealer transaction, in a transaction with an SMMP, a dealer’s intentional withholding of a material fact about a security, when the information is not accessible through established industry sources, may constitute an unfair practice that violates Rule G-17.

Rule G-18.  The Restated SMMP Notice made no significant changes to the provisions of the Existing SMMP Notice concerning Rule G-18, which requires that each dealer, when executing a transaction in municipal securities for or on behalf of a customer as agent, make a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions.  The Restated SMMP Notice continues to provide that a dealer effecting a non-recommended secondary market agency transaction to an SMMP is not required to take further actions to ensure that the transaction is effected at a fair and reasonable price, if its services have been explicitly limited to providing anonymity, communication, order matching, and/or clearance functions and the dealer does not exercise discretion as to how or when a transaction is executed.[6]

Rule G-19.  Under Rule G-19, in the case of a recommended transaction, a dealer must have a reasonable basis for recommending a particular security (“reasonable-basis suitability”), as well as reasonable grounds for believing the recommendation is suitable for the customer to whom it is made, based upon information available from the issuer of the security or otherwise and based upon the facts disclosed by the customer or otherwise known about the customer (“customer-specific suitability”).  The Restated SMMP Notice made no changes to the portion of the Existing SMMP Notice that provides that, when a dealer has reasonable grounds for concluding that an institutional customer is an SMMP, the dealer’s customer-specific suitability obligation is fulfilled.

Rule G-13.  The Restated SMMP Notice made no changes to the portion of the Existing SMMP Notice that provides that, if a dealer disseminates the quotation of an SMMP and it is labeled as such, the disseminating dealer will be held to the same standard as if it were disseminating a quotation made by another dealer.  The Restated SMMP Notice continues to provide that the following factors are relevant to the dealer’s assessment of whether dissemination of the SMMP’s quotation may be considered to be a violation of Rule G-13 by the dealer: (i) complaints received from dealers and investors seeking to execute against such quotations, (ii) a pattern of an SMMP failing to update, confirm or withdraw its outstanding quotations so as to raise an inference that such quotations may be stale or invalid, or (iii) a pattern of an SMMP effecting transactions at prices that depart materially from the prices listed in the quotations in a manner that consistently is favorable to the SMMP making the quotation.

The text of the Restated SMMP Notice is set forth below.[7]

May 29, 2012 

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RESTATED INTERPRETIVE NOTICE REGARDING THE APPLICATION OF MSRB RULES TO TRANSACTIONS WITH SOPHISTICATED MUNICIPAL MARKET PROFESSIONALS

The MSRB’s fair practice rules allow dealers[1] to recognize the different capabilities of certain institutional customers as well as the varied types of dealer-customer relationships.  This interpretive notice concerns the manner in which a dealer determines that it has met certain of its fair practice obligations to certain institutional customers; it does not alter the basic duty to deal fairly, which applies to all transactions and all customers.  For purposes of this notice, an “institutional customer” shall mean a customer with an “institutional account” as defined in Rule G-8(a)(xi).[2]

Sophisticated Municipal Market Professionals

For purposes of this notice, the term “sophisticated municipal market professional” or “SMMP” shall mean an institutional customer of a dealer that: (1) the dealer has a reasonable basis to believe is capable of evaluating investment risks and market value independently, both in general and with regard to particular transactions in municipal securities, and (2) affirmatively indicates that it is exercising independent judgment in evaluating the recommendations of the dealer.  As part of the reasonable basis analysis required by clause (1), the dealer should consider the amount and type of municipal securities owned or under management by the institutional customer.  A customer may make the affirmation required by clause (2) either orally or in writing and may provide the affirmation on a trade-by-trade basis, on a type-of-municipal-security basis (e.g., general obligation, revenue, variable rate, etc.), or for all potential transactions for the customer’s account.

While it is difficult to define in advance the scope of a dealer’s fair practice obligations with respect to a particular transaction, as will be discussed later, by making a reasonable determination that an institutional customer is an SMMP, certain of the dealer’s fair practice obligations remain applicable but are deemed fulfilled.  In addition, as discussed below, the fact that a quotation is made by an SMMP would affect how such quotation is treated under Rule G-13.

Application of SMMP Concept to Rule G-17

The MSRB has interpreted Rule G-17 to require a dealer, in connection with any sale of municipal securities, to disclose to its customer, at or prior to the time of trade, all material information about the transaction known by the dealer, as well as material information about the security that is reasonably accessible to the market from established industry sources.[3]  A dealer must provide its customer with a complete description of the security, including a description of the features that would likely be considered significant by a reasonable investor and facts that are material to assessing the potential risks of the investment.[4]

However, when the dealer has reasonable grounds for concluding that the customer is an SMMP, the dealer’s obligation to ensure disclosure of material information available from established industry sources is fulfilled.  There may be times when an SMMP is not satisfied that the information available from established industry sources is sufficient to allow it to make an informed investment decision.  In those circumstances, the MSRB believes that an SMMP can recognize that risk and take appropriate action, by declining to transact, undertaking additional investigation, or asking the dealer to undertake additional investigation.

This interpretation does nothing to alter a dealer’s duty not to engage in deceptive, dishonest, or unfair practices under Rule G-17 or under the federal securities laws.  In essence, a dealer’s disclosure obligations to SMMPs would be on a par with inter-dealer disclosure obligations.  This interpretation will be particularly relevant to dealers operating alternative trading systems, although it will also apply to other dealers.

As in the case of an inter-dealer transaction, in a transaction with an SMMP, a dealer’s intentional withholding of a material fact about a security, when the information is not accessible through established industry sources, may constitute an unfair practice that violates Rule G-17.  In addition, a dealer may not knowingly misdescribe securities to the customer.  A dealer’s duty not to mislead its customers is absolute and is not dependent upon the nature of the customer.

Application of SMMP Concept to Rule G-18

Rule G-18 provides that each dealer, when executing a transaction in municipal securities for or on behalf of a customer as agent, must make a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions.  The actions that must be taken by a dealer to make reasonable efforts to ensure that its non-recommended secondary market agency transactions with customers are effected at fair and reasonable prices may be influenced by the nature of the customer as well as by the services explicitly offered by the dealer.

If a dealer effects non-recommended secondary market agency transactions for SMMPs and its services have been explicitly limited to providing anonymity, communication, order matching, and/or clearance functions and the dealer does not exercise discretion as to how or when a transaction is executed, the MSRB believes the dealer is not required to take further actions on individual transactions to ensure that its agency transactions are effected at fair and reasonable prices.  By making the determination that the customer is an SMMP, the dealer necessarily concludes that the customer has met the requisite high thresholds regarding capability of evaluating risks and market values, and undertaking of independent investment decisions that would help ensure the institutional customer’s ability to evaluate whether a transaction’s price is fair and reasonable.

This interpretation will be particularly relevant to dealers operating alternative trading systems in which SMMPs are permitted to participate.  However, even though this interpretation eliminates a duty to evaluate each individual transaction price, a dealer operating such system, under the general duty set forth in Rule G-18, must act to investigate any alleged pricing irregularities on its system brought to its attention.  Accordingly, a dealer may be subject to Rule G-18 violations if it fails to take actions to address system or participant pricing abuses.

If a dealer effects agency transactions for customers that are not SMMPs, or has held itself out to do more than provide anonymity, communication, matching and/or clearance services, or performs such services with discretion as to how and when the transaction is executed, it will be required to establish that it exercised reasonable efforts to ensure that its agency transactions with customers are effected at fair and reasonable prices.  Further, if a dealer engages in principal transactions with an SMMP, Rule G-30(a) applies and the dealer is responsible for a transaction-by-transaction review to ensure that it is charging a fair and reasonable price.  In addition, Rule G-30(b) applies to the commission or service charges that a dealer operating an alternative trading system may charge to effect the agency transactions that take place on its system, even in connection with transactions with SMMPs for which no further action is required pursuant to this notice with respect to Rule G-18.

Application of SMMP Concept to Rule G-19

The MSRB’s suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.  Dealers’ responsibilities include having a reasonable basis for recommending a particular security or strategy, as well as having reasonable grounds for believing the recommendation is suitable for the customer to whom it is made.  Dealers are expected to meet the same high standards of competence, professionalism, and good faith regardless of the financial circumstances of the customer.  Rule G-19, on suitability of recommendations and transactions, requires that, in recommending to a customer any municipal security transaction, a dealer shall have reasonable grounds for believing that the recommendation is suitable for the customer based upon information available from the issuer of the security or otherwise and based upon the facts disclosed by the customer or otherwise known about the customer.

This guidance concerns only the manner in which a dealer determines that a recommendation is suitable for a particular institutional customer.  The manner in which a dealer fulfills this suitability obligation will vary depending on the nature of the customer and the specific transaction.  Accordingly, this interpretation deals only with guidance regarding how a dealer will fulfill such “customer-specific suitability obligations” under Rule G-19.  This interpretation does not address the obligation related to suitability that requires that a dealer have a “reasonable basis” to believe that the recommendation could be suitable for at least some customers.  In the case of a recommended transaction, a dealer may, depending upon the facts and circumstances, be obligated to undertake a more comprehensive review or investigation in order to meet its obligation under Rule G-19 to have a “reasonable basis” to believe that the recommendation could be suitable for at least some customers.[5]

The manner in which a dealer fulfills its “customer-specific suitability obligations” will vary depending on the nature of the customer and the specific transaction.  While it is difficult to define in advance the scope of a dealer’s suitability obligation with respect to a specific institutional customer transaction recommended by a dealer, the MSRB has identified the factors that define an SMMP as factors that may be relevant when considering compliance with Rule G-19.  Where the dealer has reasonable grounds for concluding that an institutional customer is an SMMP, then a dealer’s obligation to determine that a recommendation is suitable for that particular customer is fulfilled.

This interpretation does not address the facts and circumstances that go into determining whether an electronic communication does or does not constitute a “recommendation.”

Application of SMMP Concept to Rule G-13

Under Rule G-13, no dealer may distribute or publish, or cause to be distributed or published, any quotation relating to municipal securities, unless the quotation is bona fide (i.e., the dealer making the quotation is prepared to execute at the quoted price) and the price stated in the quotation is based on the best judgment of the dealer of the fair market value of the securities that are the subject of the quotation at the time the quotation is made.  In general, any quotation disseminated by a dealer (including the quotation of an investor) is presumed to be a quotation made by the dealer and the dealer is responsible for ensuring compliance with the bona fide and fair market value requirements with respect to the quotation.[6]  However, if a dealer disseminates a quotation that is actually made by another dealer and the quotation is labeled as such, then the quotation is presumed to be a quotation made by such other dealer and not by the disseminating dealer.  In such a case, the disseminating dealer is only required to have no reason to believe that either: (i) the quotation does not represent a bona fide bid for, or offer of, municipal securities by the maker of the quotation or (ii) the price stated in the quotation is not based on the best judgment of the maker of the quotation of the fair market value of the securities.

If an SMMP makes a “quotation” and it is labeled as such, then it is presumed not to be a quotation made by the disseminating dealer; rather, the dealer is held to the same standard as if it were disseminating a quotation made by another dealer.[7]  In either case, the disseminating dealer’s responsibility with respect to such quotation is reduced.  Under these circumstances, the disseminating dealer must have no reason to believe that either: (i) the quotation does not represent a bona fide bid for, or offer of, municipal securities by the maker of the quotation or (ii) the price stated in the quotation is not based on the best judgment of the maker of the quotation of the fair market value of the securities.

While Rule G-13 does not impose an affirmative duty on the dealer disseminating quotations made by other dealers or SMMPs to investigate or determine the market value or bona fide nature of each such quotation, it does require that the disseminating dealer take into account any information it receives regarding the nature of the quotations it disseminates.  Based on this information, such a dealer must have no reason to believe that these quotations fail to meet either the bona fide or the fair market value requirement and it must take action to address such problems brought to its attention.  Reasons for believing there are problems could include, among other things, (i) complaints received from dealers and investors seeking to execute against such quotations, (ii) a pattern of a dealer or SMMP failing to update, confirm, or withdraw its outstanding quotations so as to raise an inference that such quotations may be stale or invalid, or (iii) a pattern of a dealer or SMMP effecting transactions at prices that depart materially from the price listed in the quotations in a manner that consistently is favorable to the party making the quotation.[8]

In a prior MSRB interpretation stating that stale or invalid quotations published in a daily or other listing must be withdrawn or updated in the next publication, the MSRB did not consider the situation where quotations are disseminated electronically on a continuous basis.[9]  In such case, the MSRB believes that the bona fide requirement obligates a dealer to withdraw or update a stale or invalid quotation promptly enough to prevent a quotation from becoming misleading as to the dealer’s willingness to buy or sell at the stated price.  In addition, although not required under the rule, the MSRB believes that posting the time and date of the most recent update of a quotation can be a positive factor in determining whether the dealer has taken steps to ensure that a quotation it disseminates is not stale or misleading.

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[1] The term “dealer” is used in this notice as shorthand for “broker,” “dealer” or “municipal securities dealer,” as those terms are defined in the Securities Exchange Act of 1934 (the “Exchange Act”).  The use of the term in this notice does not imply that the entity is necessarily taking a principal position in a municipal security.

[2] Rule G-8(a)(xi) defines “institutional account” as the account of (i) a bank, savings and loan association, insurance company, or registered investment company; (ii) an investment adviser registered either with the Commission under Section 203 of the Investment Advisers Act of 1940 or with a state securities commission (or any agency or office performing like functions); or (iii) any other entity (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of at least $50 million.

[3] 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).

[4] The Supreme Court has stated that a fact is material when there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”  Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011); Basic Inc. v. Levinson, 485 U.S. 224 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976).

[5] See MSRB Interpretive Notice Regarding Rule G-17, on Disclosure of Material Facts (March 20, 2002); see also MSRB Notice Regarding Application of Rule G-19, on Suitability of Recommendations and Transactions, to Online Communications (September 25, 2002).

[6] A customer’s bid for, offer of, or request for bid or offer is included within the meaning of a “quotation” if it is disseminated by a dealer.

[7] The disseminating dealer need not identify by name the maker of the quotation, but only that such quotation was made by another dealer or an SMMP, as appropriate.

[8] The MSRB believes that, consistent with its view previously expressed with respect to “bait-and-switch” advertisements, a dealer that includes a price in its quotation that is designed as a mechanism to attract potential customers interested in the quoted security for the primary purpose of drawing such potential customers into a negotiation on that or another security, where the quoting dealer has no intention at the time it makes the quotation of executing a transaction in such security at that price, could be a violation of Rule G-17. See MSRB Rule G-21 Interpretive Letter – Disclosure Obligations (May 21, 1998).

[9] See MSRB Notice of Interpretation of Rule G-13 on Published Quotations (April 21, 1988).

[3] The term “institutional account” will be defined in the same manner as under MSRB Rule G-8(a)(xi).  MSRB Rule G-8(a)(xi) defines “institutional account” as:

the account of (i) a bank, savings and loan association, insurance company, or registered investment company; (ii) an investment adviser registered either with the Commission under Section 203 of the Investment Advisers Act of 1940 or with a state securities commission (or any agency or office performing like functions); or (iii) any other entity (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of at least $50 million.

[4] “Institutional customer” is defined as a customer with an institutional account (as defined under MSRB Rule G-8(a)(xi)).