The Municipal Securities Rulemaking Board has issued an interpretive notice (the "Notice") concerning the application of MSRB Rule G-17 to underwriters of municipal securities. The Notice takes effect August 2, 2012. As a result, issuers can expect to receive new communications and disclosures from underwriters. The MSRB offers the full text and a webinar on the Notice online.
MSRB Rule G-17 is commonly referred to as the fair dealing rule. The full text of Rule G-17 is as follows:
In the conduct of its municipal securities or municipal advisory activities, each broker, dealer, municipal securities dealer, and municipal advisor shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice.
Rule G-17 not only applies to the relationship of brokers, dealers, or municipal securities dealers ("dealers") with investors, but also to the relationship of dealers to issuers of municipal securities. Rule G-17 has been in effect for some time, but the Notice expands the interpretation of Rule G-17 and adds specific new requirements to comply with the Rule.
The Notice applies when a dealer is underwriting municipal securities and does not apply when a dealer is acting as a municipal advisor. The Notice applies to negotiated sales of municipal securities and only applies to competitive sales where expressly mentioned. The Notice is summarized as follows:
Disclosure of Role of the Underwriter/Conflicts of Interest.
In a negotiated underwriting, the underwriter must make certain disclosures to the issuer to clarify its role in an issuance of municipal securities and its actual or potential material conflicts of interest with respect to such issuance.
Disclosures Concerning the Underwriter's Role.
The underwriter must disclose to the issuer that:
- Rule G-17 requires an underwriter to deal fairly at all times with both municipal issuers and investors;
- the underwriter's primary role is to purchase securities with a view to distribution in an arm's-length commercial transaction with the issuer and it has financial and other interests that differ from those of the issuer;
- unlike a municipal advisor, the underwriter does not have a fiduciary duty to the issuer under the federal securities laws and is, therefore, not required by federal law to act in the best interests of the issuer without regard to its own financial or other interests;
- the underwriter has a duty to purchase securities from the issuer at a fair and reasonable price, but must balance that duty with its duty to sell municipal securities to investors at prices that are fair and reasonable; and
- the underwriter will review the official statement for the issuer's securities in accordance with, and as part of, its responsibilities to investors under the federal securities laws, as applied to the facts and circumstances of the transaction.
The underwriter also must not recommend that the issuer not retain a municipal advisor.
Disclosure Concerning the Underwriter's Compensation.
The underwriter must disclose to the issuer whether its underwriting compensation will be contingent on the closing of a transaction. It must also disclose that compensation that is contingent on the closing of a transaction or the size of a transaction presents a conflict of interest, because it may cause the underwriter to recommend a transaction that it is unnecessary or to recommend that the size of the transaction be larger than is necessary.
Other Conflicts Disclosures.
The underwriter must also disclose other potential or actual material conflicts of interest, including, but not limited to, the following:
- any payments received by the underwriter in connection with its underwriting of the new issue from parties other than the issuer, and payments made by the underwriter in connection with such new issue to parties other than the issuer;
- any arrangements between the underwriter and an investor purchasing new issue securities from the underwriter according to which profits realized from the resale by such investor of the securities are directly or indirectly split or otherwise shared;
- The issuance or purchase by a dealer of credit default swaps for which the reference is the issuer for which the dealer is serving as underwriter; and
- any incentives for the underwriter to recommend a complex municipal securities financing and other associated conflicts of interest (as described below under "Required Disclosures to Issuer").
Timing and Manner of Disclosures.
All of the foregoing disclosures must be made in writing to an official of the issuer that the underwriter reasonably believes has the authority to bind the issuer by contract with the underwriter and that, to the knowledge of the underwriter, is not a party to a disclosed conflict. The Notice sets forth the times at which these disclosures must be made.
Acknowledgement of Disclosures.
The underwriter must attempt to receive written acknowledgement (other than by automatic e-mail receipt) by the official of the issuer of receipt of the foregoing disclosures.
Other Required Disclosures to Issuers.
Many municipal securities are issued using financing structures that are routine and well understood by most issuer personnel. In the case of issuer personnel that the underwriter reasonably believes lack knowledge or experience with such structures, the underwriter must provide disclosures on the material aspects of such structures that it recommends.
An underwriter in a negotiated offering that recommends a complex municipal securities financing to an issuer has an obligation under Rule G-17 to make more particularized disclosures than those that may be required in the case of routine financing structures. Examples of complex municipal securities financings include variable rate demand obligations ("VRDOs") and financings involving derivatives (such as swaps). An underwriter must also disclose any incentives for the underwriter to recommend the financing and other associated conflicts of interest.
Representations to Issuers.
All representations made by underwriters to issuers in connection with municipal securities underwritings, whether written or oral, must be truthful and accurate and must not misrepresent or omit material facts. In addition, an underwriter's response to an issuer's request for proposals or qualifications must fairly and accurately describe the underwriter's capacity, resources, and knowledge to perform the proposed underwriting as of the time the proposal is submitted and must not contain any representations or other material information about such capacity, resources, or knowledge that the underwriter knows or should know to be inaccurate or misleading. An underwriter must not represent that it has the requisite knowledge or expertise with respect to a particular financing if the personnel that it intends to work on the financing do not have the requisite knowledge or expertise.
Underwriter Duties in Connection with Issuer Disclosure Documents.
Underwriters often assist issuers in the preparation of disclosure documents, such as preliminary official statements and official statements. A dealer's duty to have a reasonable basis for the representations it makes, and other material information it provides, to an issuer and to ensure that such representations and information are accurate and not misleading, as described above, extends to representations and information provided by the underwriter in connection with the preparation by the issuer of its disclosure documents (e.g., cash flows).
Compensation and Pricing
An underwriter's compensation for a new issue, in certain cases and depending upon the specific facts and circumstances of the offering, may be so disproportionate to the nature of the underwriting and related services performed as to constitute an unfair practice with regard to the issuer that it is a violation of Rule G-17.
In general, a dealer purchasing bonds in a competitive underwriting for which the issuer may reject any and all bids will be deemed to have satisfied its duty of fairness to the issuer with respect to the purchase price of the issue as long as the dealer's bid is a bona fide bid that is based on the dealer's best judgment of the fair market value of the securities that are the subject of the bid. In a negotiated underwriting, the underwriter has a duty under Rule G-17 to negotiate in good faith with the issuer.
Conflicts of Interest
Payments to or from Third Parties.
The Notice provides that the failure of an underwriter to disclose to the issuer the existence of payments received by the underwriter in connection with its underwriting of the new issue from parties other than the issuer, and payments made by the underwriter in connection with such new issue to parties other than the issuer is a violation of the underwriter's obligation to the issuer under Rule G-17.
Profit-Sharing with Investors.
Arrangements between the underwriter and an investor purchasing new issue securities from the underwriter according to which profits realized from the resale by such investor of the securities are directly or indirectly split or otherwise shared with the underwriter also may, depending on the facts and circumstances, constitute a violation of the underwriter's fair dealing obligation under Rule G-17.
Credit Default Swaps.
The issuance or purchase by a dealer of credit default swaps for which the reference is the issuer for which the dealer is serving as underwriter, or an obligation of that issuer, may pose a conflict of interest, because trading in such municipal credit default swaps has the potential to affect the pricing of the underlying reference obligations, as well as the pricing of other obligations brought to market by that issuer.
Retail Order Periods.
Rule G-17 requires an underwriter that has agreed to underwrite a transaction with a retail order period to, in fact, honor such agreement. A dealer that wishes to allocate securities in a manner that is inconsistent with an issuer's requirements must not do so without the issuer's consent.
Dealer Payments to Issuer Personnel.
Dealers should consider carefully whether payments they make in regard to expenses of issuer personnel in the course of the bond issuance process, including in particular, but not limited to, payments for which dealers seek reimbursement from bond proceeds or issuers, comport with the requirements of Rule G-20. For example, a dealer acting as a financial advisor or underwriter may violate Rule G-20 by paying for excessive or lavish travel, meal, lodging and entertainment expenses in connection with an offering (such as may be incurred for rating agency trips, bond closing dinners, and other functions) that inure to the personal benefit of issuer personnel and that exceed the limits or otherwise violate the requirements of the rule.
 This supplements our Client Advisory dated May 14, 2012.
If you have any questions, regarding this advisory or its possible impact on your activies and operations, please contact one of the attorneys
in our Public Finance Group
Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and this does not create an attorney-client relationship between any reader and the Firm.
© 2012 Sherman & Howard L.L.C. July 13, 2012