WASHINGTON — At the request of the Securities and Exchange Commission, the Municipal Securities Rulemaking Board is moving forward with rule changes for priority of orders in primary offerings. The changes are more in line with the original proposal the MSRB floated late last year rather than a pared-down version it agreed to in April.
Market participants said the rule changes show that the SEC — which signs off on all MSRB proposals — will continue to play a key role in setting the board’s agenda, even though the MSRB gained significant new regulatory authority under the Wall Street reform bill signed into law this week.
“I expect that to continue going forward,” said Christopher “Kit” Taylor, the former executive director of the board who is now a financial consultant.
Noting the hotter-than-usual summer temperatures at the board’s quarterly meeting this week on Cape Cod, where it is reconsidering the priority of orders proposal, Taylor quipped: “Now they’re going to feel the heat not only from the weather but from the commission, too.”
The MSRB is also expected to consider scrapping its Rule G-23 at the request of the SEC. In May, commission chairman Mary Schapiro asked the 15-member board to abandon the rule, which allows dealers acting as financial advisers to switch roles and underwrite the same negotiated transactions as long as they disclose that there may be a conflict of interests and their expected compensation.
Schapiro characterized such role switching as “a classic example of conflict of interest,” and called on the board to prohibit broker-dealers from serving in both roles in the same muni deals.
Despite having decided on two separate occasions in as many years that there is no systemic problem requiring G-23 to be changed, the board is reconsidering the rule at its meeting this week, chairman Peter Clarke, managing director and vice chairman of tax-exempt capital markets at JPMorgan, said in an interview Wednesday.
Though Clarke declined to provide any details of the SEC staff’s concerns about the priority of orders proposal, market participants said they are worried the board’s April vote to back off its proposal in the face of criticism from the industry effectively gutted key provisions. The SEC staff does not want the board to delay implementing a comprehensive proposal.
As drafted in August and filed with the commission in November, the proposal generally would have altered Rule G-11 on new-issue syndicate practices. It would require a managing underwriter in a primary offering to give priority to customer orders over orders for its own account, affiliated accounts, or the accounts of other members of the syndicate, unless it reached some other agreement with the issuer.
In addition, the proposal would have altered Rule G-8 on records and G-9 on preservation of records to require the managing underwriter to retain records for all primary offering orders for at least six years, regardless of whether the orders were filled. It also would have included an interpretive notice to provide guidance on the application of Rule G-17 on fair dealing to promote a fair distribution of new issues to customers.
But in the face of industry opposition and an apparent lack of board consensus, the MSRB voted in April to significantly scale back the proposal, saying they needed more time to review public comments before proceeding.
In the meantime, the it said it would file an amended proposal with the SEC highlighting guidance from 1987 that generally states customer orders should receive priority over syndicate orders or orders for their affiliated accounts. The board also committed to strengthening dealers’ obligations to document compliance with such guidance.
But market participants said SEC staff, in conference calls with MSRB staff after their April board meeting, saw the pared-down proposal as insufficient and thought the 1987 guidance too dated to be relied upon. They also said the industry concerns about the proposal — that it was confusing, duplicative and would lead to higher borrowing costs — revolved around issues not directly related to the heart of the proposal.
SEC and MSRB officials declined to comment Thursday.
The basis for the proposal that the board drafted was institutional investor complaints that their orders for muni bonds were not being filled during primary offerings, even though the bonds became available at higher prices soon after in the secondary market.
The institutional investors claimed there were two possible causes. One is that dealers are, in essence, placing so-called phantom orders during retail periods without having any actual retail investors lined up to buy the bonds and then flipping them at higher prices in sales to investors. The other is that syndicate members or their affiliates are front-running the bonds, buying them for their own or affiliated accounts before filling orders from investors.
Flipping generally occurs when dealers or institutional investors purchase bonds and then immediately resell them to retail investors at higher prices. Industry groups have cautioned that there can be perfectly legitimate reasons for flipping and that phantom sales and front-running violate Rule G-17 on fair dealing.
A number of market participants are convinced the proposed rule changes were an attempt to curtail flipping, but board officials said they were meant to clarify that dealers must respect the priority of orders for bonds specified by issuers, as many issuers have come to rely more on retail order periods to sell their bonds.
Separately, as it prepares to transition to the regulatory reform law’s requirement that it become a majority-public board beginning Oct. 1, the MSRB Thursday formally reopened the nomination process for adviser board candidates.
The board said in its notice: “Generally, a municipal adviser’ is a person who is not a municipal entity or an employee of a municipal entity that (i) provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues; or (ii) undertakes a solicitation of a municipal entity. Municipal advisers include certain financial advisers, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and swap advisers.”
The board plans to accept nominations over the next two weeks and to add them to the ones it already received from its regular nomination process earlier this year
Under the new law, the board may increase in size beyond 15 members, as long as a majority of its members are “public” officials. Dealers and advisers are to comprise a minority portion of the board, and the new law requires the board to hire at least one adviser.
Clarke said Wednesday that the board will likely temporarily expand to 17 or so members so that it can comply with the public majority membership requirement without having to force existing members off the board. As the terms of existing members expire, the board will revert to 15 members, he said.
