The Municipal Securities Rulemaking Board (“MSRB”) filed a Proposed Rule Change1 (the “Proposal”) with the U.S. Securities and Exchange Commission that updates its definition of “sophisticated municipal market professionals” (“SMMPs”) under MSRB Rule G-17 and related rules. The Proposal is intended to reflect changes in the municipal securities markets and to harmonize the SMMP standard with FINRA’s new suitability rule for institutional customers. The Proposal will lower the level of assets necessary for SMMP status from $100 million solely in municipal securities to $50 million in any type of assets, but will require a municipal securities dealer to obtain an affirmation from the SMMP that it is exercising independent judgment in considering the recommendations made by the dealer.
The MSRB has requested an effective date of July 9, 2012, consistent with FINRA Rule 2111, and is requesting comment on the Proposal. Comments are due to the SEC no later than 21 days after the publication date in the Federal Register.
The Existing Notice
Under the MSRB’s existing guidance from 20022 (the “Existing Notice”), dealers have been permitted to treat institutional customers (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”) as SMMPs. Under the Existing Notice, the dealer must have reasonable grounds for concluding certain facts relating to the customer’s level of sophistication, such as whether the customer has access to publicly available material facts concerning the municipal securities transaction; the customer is capable of independently evaluating the investment risk and market value of the municipal securities at issue; and the customer is making independent decisions about its investments in municipal securities. The Existing Notice provides dealers with a list of relevant factors that would apply to each part of the definition of an SMMP. While the Existing Notice permits a dealer to have the customer attest to SMMP status as a means of “streamlining” the dealer’s SMMP determination, it provides that the dealer may not rely on this attestation if the dealer knows or has a reason to know that the investor lacks sophistication based on the enumerated list of factors.
The Proposal revises the definition of an SMMP and the application of an SMMP with respect to MSRB Rule G-17. The MSRB notes that at the time the Existing Notice was drafted, the information regarding municipal securities that was reasonably available to investors was limited. As a result, unlike other similar existing regulatory definitions of sophisticated investors, the Existing Notice’s definition of an SMMP included provisions related to the investor’s access to material facts. In light of the substantial increase in the availability of information about municipal bonds since 2002 (i.e., MSRB’s Electronic Municipal Market Access or EMMA system, the MSRB’s website, and other vendors), and in light of FINRA’s revision of its institutional suitability rule in FINRA Rule 2111, the MSRB is now proposing to align the definition of an SMMP more closely with similar regulatory carve outs for sophisticated institutional investors.
Consistent with FINRA Rule 2111, the Proposal revises the definition of an SMMP to an institutional customer of a dealer that:
(1) The dealer has a reasonable basis to believe it 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 attests that it is exercising independent judgment in evaluating the recommendations of the dealer.
Notably, under the Proposal, there will no longer be a detailed listing of factors relating to sophistication such as those found in the Existing Notice. The Proposal reduces the threshold amount for establishing whether an investor is an institutional customer from $100 million in municipal securities to $50 million in any kind of assets. However, the Proposal does not include a safe harbor contemplated in last November’s Initial Revision of the Proposal, which would have deemed the “reasonable basis” requirement of clause (1) of the SMMP definition satisfied if the $50 million threshold and the attestation requirement of clause (2) were both met.3 Rather, the dealer will have to make the “reasonable basis” determination for every SMMP. The MSRB stated that it eliminated the safe harbor “due to a concern that the amount of municipal securities owned or managed by a customer does not necessarily equate to sophistication.” However, in place of the safe harbor, the MSRB has included in the Proposal a provision that a dealer, as part of its reasonable basis analysis, “should consider the amount and type of municipal securities owned or under management by an institutional customer.” Notably, the Proposal informs dealers that they should monitor their reasonable basis determinations as frequently as they consider prudent, just as they would need to do so if they planned to treat natural persons with total assets of at least $50 million as institutional customers under either FINRA Rule 2111 or the Restated SMMP Notice. Dealers are likely to find this aspect of the proposal difficult to maneuver from a practical standpoint.
Under the Proposal, the MSRB informs dealers that in either of the attestations related to whether the client is “capable of evaluating investment risks and market value independently” and “exercising independent judgment in evaluating recommendations,” clients will be allowed to make the attestation orally or in writing. Clients also may provide the attestation on a trade-by-trade basis, on a type-of-municipal-security basis (e.g., general obligation, revenue, VRDO, etc.), or for all potential transactions for their accounts. The MSRB also provides that the attestation a dealer receives from an institutional customer under FINRA Rule 2111 may also satisfy the dealer’s obligations under MSRB Rule G-17. Dealers, however, may not rely on such an attestation if the dealer knows or has a reason to know that the investor lacks the requisite sophistication.
Application of Revised SMMP Definition to Other MSRB Rules
The Proposal would not change the application of Rules G-18, G-19 and G-13 to SMMPs. However, the Proposal would change the application of Rule G-17 to SMMPs by excluding all transactions (recommended and self-directed), rather than just self-directed transactions, from the duty to disclose all material facts to SMMPs. This change is based on the MSRB’s assessment that SMMPs now have adequate online access to material information about municipal securities.
The Proposal would eliminate endnote 9 from the Existing Notice, which in the context of Rule G-18 and agency transactions states that:
“If a broker’s broker effects agency transactions for other dealers 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, then the MSRB believes the broker’s broker is not required to take further actions on individual transactions to ensure that its agency transactions with other dealers are effected at fair and reasonable prices.”4
The MSRB notes in the Proposal that some have construed this statement to lessen the duty of a broker’s broker under Rule G-18, and thus deletes the statement in endnote 9 so that this duty will be interpreted consistently with the Board’s proposed Rule G-43.5
The harmonization of MSRB rules on SMMPs with FINRA rules on institutional suitability is a welcome development, as is the MSRB’s recognition that SMMP access to electronic information makes additional affirmative disclosure obligations to those customers unnecessary. Nevertheless, dealers should consider providing comment on the proposed rule in an effort to garner further guidance on the practical application of the Proposal in areas such as how frequently the MSRB expects dealers to monitor their reasonable basis determinations.
*This alert was co-authored by W. Hardy Callcott, Elizabeth Baird, Paul Tyrrell and former Bingham associate Timothy Foley.
. See also Bingham Alert, “Revised Definition of Sophisticated Municipal Market Professional (“SMMP”) Sought by MSRB
” (Nov. 30, 2011).
See Interpretative Notice Regarding the Application of MSRB Rules to Transactions With Sophisticated Municipal Market Professionals (April 30, 2002).
MSRB Notice 2011-63 (Nov. 8, 2011) Request for Comment on Restated Sophisticated Municipal Market Professional Notice.
See note 2, supra.
Exchange Act Release No. 34-66625 (Mar. 20, 2012), 77 FR 17548 (Mar. 26, 2012); see also MSRB Notice 2011-18 (Feb. 24, 2011) and MSRB Notice-2011-50 (Sept. 8, 2011) Request for Comment on Revised Draft Rule G-43 (On Broker’s Brokers), Associated Revised Draft Amendments to Rule G-8 (On Books and Records) and Rule G-9 (On Preservation of Records), and Draft Interpretative Notice on the Obligations of Dealers that use the Services of Broker’s Brokers.