THOUGHT LEADERSHIP/ALERTS

On May 4, 2012, the SEC approved an interpretative notice (Notice) by the Municipal Securities Rulemaking Board (MSRB) relating to MSRB Rule G-17. The primary regulatory change represented by the Notice is the new requirement that underwriters of municipal securities must provide additional disclosures to issuers of municipal securities as a part of the dealers’ fair dealing duties under MSRB Rule G-17. The Notice will become effective on August 2, 2012.

General description of MSRB Rule G-17

MSRB Rule G-17 precludes a dealer, in the conduct of its municipal securities activities, from engaging in any deceptive, dishonest, or unfair practice with any person, including an issuer of municipal securities. MSRB Rule G-17 contains an anti-fraud prohibition. Thus, an underwriter must not misrepresent or omit the facts, risks, potential benefits, or other material information about municipal securities activities undertaken with a municipal issuer. However, MSRB Rule G-17 does not merely prohibit deceptive conduct on the part of the dealer. It also establishes a general duty of a dealer to deal fairly with all persons (including, but not limited to, issuers of municipal securities), even in the absence of fraud.

Additional disclosures by underwriters

As a part of a dealer’s duties under MSRB Rule G-17, the Notice requires an underwriter of municipal securities to make four kinds of disclosures to issuers of municipal securities: (1) disclosures concerning the underwriter’s role, (2) disclosures concerning the underwriter’s compensation, (3) disclosures concerning material conflicts of interests, and (4) disclosures concerning complex municipal securities financings. The Notice also provides guidance about when the underwriter is required to provide these disclosures and the person at the issuer to whom the underwriter must send them.

Content of disclosures

Disclosures Regarding Underwriter’s Role. The Notice requires the underwriter to disclose to the issuer that:

1. MSRB Rule G-17 requires an underwriter to deal fairly at all times with both municipal issuers and investors;
2. The underwriter’s primary role is to purchase securities with a view to distribute in an arms’ length commercial transaction with the issuer, and it has financial and other interests that differ from those of the issuer;
3. 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;
4. 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
5. 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 Notice requires the underwriter to 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 Notice requires the underwriter to also disclose other potential or actual material conflicts of interest. The Notice includes the following as a non-exhaustive list of such conflicts:

1. Compensation received by the underwriter from third parties, such as the providers of derivatives and investments, in connection with the underwriting of the new issue;
2. Any arrangements an underwriter has with investors purchasing bonds from the underwriter to share in the profits realized by such investor;
3. The issuance or purchase by the underwriter of any credit default swaps related to the issuer or its bonds; and
4. Any incentives for the underwriter to recommend a complex municipal securities financing and other associated conflicts of interest.

Disclosures Concerning Complex Municipal Securities Financings. The Notice requires an underwriter to provide the following additional written disclosures for “complex municipal securities financings”:

1. Material financial characteristics and risks of the financing, disclosed in a manner that is appropriate for the issuer’s knowledge, experience and capabilities, and that is specific to the financing being proposed; and
2. Incentives for the underwriter to recommend the financing and related conflicts of interest.

The Notice defines a complex municipal securities financing as any financing in which the issuer personnel responsible for the issuance of municipal securities would not be well positioned to fully understand or assess the implications of a financing in its totality, because the financing is structured in a unique, atypical, or otherwise complex manner. The Notice explains that an underwriter, in a negotiated offering that recommends a complex municipal securities financing to an issuer, has an obligation under MSRB Rule G-17 to make more particularized disclosures than those that may be required in the case of routine financing structures. The underwriter must disclose the material financial characteristics of the complex municipal securities financing, as well as the material financial risks of the financing that are known to the underwriter and reasonably foreseeable at the time of the disclosure. It must also disclose any incentives for the underwriter to recommend the financing and other associated conflicts of interest.

Timing of disclosures

The disclosure concerning the arms’ length nature of the underwriter-issuer relationship must be made in the earliest stages of the underwriter’s relationship with the issuer with respect to an issue (e.g., in a response to a request for proposals or in promotional materials provided to an issuer). Other disclosures concerning the role of the underwriter and the underwriter’s compensation generally must be made when the underwriter is engaged to perform underwriting services (e.g., in an engagement letter), not solely in a bond purchase agreement. Other conflicts disclosures must be made at the same time, except with regard to conflicts discovered or arising after the underwriter has been engaged. The underwriter must make the disclosures concerning complex municipal securities financings in sufficient time before the execution of a contract with the underwriter to allow the official to evaluate the recommendation.

Manner of delivery of the disclosures

All of these 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. Disclosures must be made in a manner designed to make clear to such official the subject matter of such disclosures and their implications for the issuer.

Other interpretative guidance in notice

The Notice also includes additional interpretative guidance in addition to the requirement that underwriters deliver disclosures to issuers of municipal securities. This guidance largely reminds underwriters of their existing duties under the MSRB rules and the federal securities laws. The additional guidance includes the following:

1. An underwriter must have a reasonable basis for the representations and other material information contained in documents it prepares and must refrain from including representations or other information it knows or should know is inaccurate or misleading;
2. 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 MSRB Rule G-17;
3. The duty of fair dealing under MSRB Rule G-17 includes an implied representation that the price an underwriter pays to an issuer is fair and reasonable, taking into consideration all relevant factors, including the best judgment of the underwriter as to the fair market value of the issue at the time it is priced; and
4. MSRB Rule G-17 requires an underwriter that has agreed to underwrite a transaction with a retail order period to, in fact, honor such agreement.

Some considerations concerning the Notice

On the surface, the Notice does not appear to fundamentally change the process of municipal securities transactions. Most issuers understand the role of an underwriter, and that an underwriter acts for its own account and in its own interests. Accordingly, these disclosures could become a part of the routine flow of documents in typical municipal securities transactions. However, the Notice will still need to be worked out in practice and, depending on the circumstances, the content and timing of some of the disclosures could become complicated. We believe that some of the areas that will need to be worked out are as follows:

1. How boilerplate will the disclosures become?
   
   Some of the disclosures, particularly concerning the role of the underwriter and the typical compensation structure of an underwriter, appear destined to become boilerplate. Underwriters will need to make these disclosures in every transaction and, if only for efficiency sake, will probably deliver these disclosures in the same form every time. But other disclosures will be much more difficult to become boilerplate. The disclosures about conflicts of interest will vary from transaction to transaction. But, as we discuss below, underwriters may face challenges in developing disclosures about complex municipal securities financings because underwriters will need to craft them from the issuer’s perspective, which will vary, in order for them to be meaningful.
2. What is a “complex municipal securities financing”?
   
   The Notice defines a “complex municipal securities financing” in a subjective manner. The underwriter is responsible for determining the implications of any financing from the perspective of the “issuer personnel responsible for the issuance….”  That is, a complex municipal securities financing may not be that complex at all. If it is complex to the issuer, then it is complex for purposes of the Notice. Depending on the issuer, this may even extend to traditional fixed rate bonds. The Notice itself states that if an underwriter reasonably believes that the issuer personnel lacks knowledge or experience with traditional fixed rate offerings, then the underwriter must provide disclosures on the material aspects of that structure. Thus, aspects of offerings that are intuitive to municipal market professionals, such as the risks of acceleration of principal on a covenant default, may constitute a complex aspect of a financing in the case of unsophisticated issuers. This will become a major area in which the practice of these disclosures will need to develop. Will an underwriter fold standard risk disclosures covering routine transactions (such as the risk of acceleration) into a larger boilerplate disclosure? How much will an underwriter need to customize these disclosures for individual issuers?
3. Will underwriters need to monitor transactions to determine whether additional disclosures are necessary?
   
   While underwriters will probably be able to deliver many of these disclosures at the outset of an offering, underwriters will need to continue to monitor the transaction structure, the evolving understanding of issuers and potential conflicts of interests so that the underwriters are able to comply with the requirements of the Notice. As we discuss above, many of the disclosures, such as most of the disclosures relating to the role and compensation of underwriters, will likely be boilerplate, and underwriters will be able to deliver these disclosures early in the financing process. But underwriters will need to monitor potential conflicts of interest, transaction structure changes, and market conditions to evaluate from time to time whether the Notice requires them to deliver additional disclosures. Perhaps most importantly, an underwriter will need to stay focused on the issuer itself and continue to monitor whether there are aspects of the transaction structure (even aspects that appear intuitive to the underwriters) that are confusing or ambiguous to the issuer and properly disclose those aspects to the issuer. It is unlikely that underwriters will be able to comply with the Notice by just “checking the box” and moving on with a transaction.