FAs, MSRB Must Stop Shirking Their Responsibilities

As a nondealer financial adviser to municipal securities issuers, I support proposals to regulate all members of the financial advisory profession. Two years ago, I wrote Christopher Cox, then chairman of the Securities and Exchange Commission, proposing such regulation.

The financial advisory profession is critical to issuers. Recently, the Government Finance Officers Association recommended that "State and local governments employ financial advisers to assist ... whether through a competitive or a negotiated sale process."

In the finger-pointing for and against regulation, both sides - dealers and nondealers - omit mention of the most fundamental issue. A financial adviser's key role is performance of sound advisory services to issuers. That necessarily incorporates fiduciary duties of loyalty and due care. Through an FA's appropriate services for issuers, investors also gain important protections through sound transactions.

While both sides accuse the other of seeking unfair competitive advantages, neither side acknowledges the central element of a financial adviser's services - namely, the fiduciary relationship between advisers and issuers.

The National Association of Independent Public Finance Advisors argues against regulation in part because its members are not swap advisers. Swap advisory services, however, are financial advisory services.

Additionally, some "independent" FAs claim that they that they do not have conflicts of interest merely because they are not dealers. Such verbal gymnastics ignore some dealers' independent advisory judgments, and ignore conflicts created when "independent" advisers accept contingent fees or engage in pay-to-play practices.

The widespread use of FAs' contingent fees dependent either upon the completion or the size of a financing lie at the heart of many market difficulties. The contingent fee structure discourages asking questions. Without a closing, these professionals are likely to suffer significant adverse financial consequences. Pay-to-play practices can lead to recoupment efforts.

Surely dealers and the Municipal Securities Rulemaking Board, their self-regulatory organization, have valid concerns about unfair competitive inequities when dealers, but not nondealers, are prohibited from political pay-to-play contributions.

As a nondealer adviser, I believe the MSRB has raised valid concerns and has presented a compelling case for regulation of financial advisers. The board, however, while having undertaken a number of positive initiatives, falls short here.

The MSRB misstates standards governing advisers - standards that the board itself diminishes. It states inaccurately that "the majority of financial advisers ... operates in the public sphere without any legal standards." The advisory profession, however, is subject to strict fiduciary standards.

While the MSRB is, I believe, on the right path in urging regulation, the board, as presently constituted, is not appropriate for rulemaking.

This is true, first, because it is dominated by dealers, who earn substantial compensation as underwriters. Those firms are adversaries of advisers' issuer-clients. Such regulatory authority would be akin to China setting trade rules for the United States governing global trade by U.S. companies. It would be harmful to the market for adversaries of issuers to regulate how advisers serve issuer-clients. If the MSRB were to be given rulemaking authority over advisers, the board's composition should be a majority of public members, with a subordinate balance of dealers and nondealer advisers.

Second, there is a history of antagonism between some dealer and nondealer advisers. Apart from considerations of fairness to issuers, there can be no fair regulation of nondealer advisers by dealers or vice versa.

Third, the MSRB has failed sadly with respect to the one rule that it has promulgated relating specifically to FAs. In the process, it has provided conclusive evidence that a board dominated by dealers will not properly apply the key fiduciary concepts that govern financial advisers.

Rule G-23 allows a dealer to resign as adviser to underwrite the issuer's securities upon informing an issuer (though not required to be provided to a person in a position of authority) that there "may" be a conflict as a result of the fundamental change of roles. The resigning dealer - which after all remains in a fiduciary relationship with the issuer at least until the resignation is complete - need not identify the conflicts or how they affect issuers' interests. There is no protection against firms seeking initial employment as advisers while intending to become underwriters and deal as principals.

Interestingly, the Securities Industry and Financial Markets Association has posted on its Web site a draft of a model bond purchase agreement that makes it abundantly clear that a dealer serving as underwriter is in direct conflict with the issuer's interests, stating:

"The issuer ... agrees that (i) the purchase and sale of the securities ... is an arm's-length commercial transaction between the issuer and the underwriters, (ii) in connection with such transaction, each underwriter is acting solely as a principal and not as an agent or a fiduciary of the issuer, (iii) the underwriters have not assumed ... a fiduciary responsibility in favor of the issuer with respect to the offering of the securities or the process leading thereto ... and (iv) the issuer has consulted with its own ... advisers."

Given SIFMA's effective recognition of the adversarial and antagonistic negotiating positions of the underwriter and the issuer pursuant to such an agreement, Rule G-23 does nothing other than to suggest to resigning dealers that it is acceptable to mislead issuers materially in connection with advisory resignations by suggesting to issuers that there may not be a conflict of interest as a result of the fundamental change.

In this connection, the GFOA states in its recommended practice: "In considering the roles of the financial adviser and underwriter, it is the intent of this RP to set a higher standard than is required under MSRB Rule G-23, because disclosure and consent are not sufficient to cure the inherent conflict of interest."

I suggest the following:

1. Financial advisers, broadly defined, should register with the SEC in order to provide advisory services to issuers. Mere regulation as a broker-dealer, accounting firm, engineer, appraiser or other professional organization should not constitute a license to advise issuers.

2. I agree with the MSRB's identification of potential regulatory categories, as far as it goes: "At a minimum, the new rules for financial advisers and investment brokers should include professional qualification and fair practice standards ... prescribe examinations ... define the requirements for firm representatives and principals ... outline continuing education requirements ... [and] establish criteria for sales practices and fair dealing with issuer clients."

3. Regulation must also emphasize the fiduciary duties of advisers to issuers.

4. The regulation would not occur through the MSRB as constituted. Either it would become a board consisting primarily of public members, with dealer and nondealer firms in a subordinate balance, or given its current dealer-dominated composition, regulation would occur through the SEC.

It is time for regulation. It should be done carefully with due recognition of the importance of advisers to issuers and investors.

We financial advisers should stop running from our responsibilities, and instead should embrace and perform them. The MSRB should stop running from appropriate and full recognition of financial advisers' fiduciary duties.

Robert W. Doty is president of American Governmental Financial Services Co., a private company. This commentary summarizes a comment letter he sent to Congress and the SEC, which is available at www.agfs.com.

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