Broker-dealers face increasing scrutiny and may be required in some cases to put the interests of municipal issuers ahead of their own, regulatory officials said Wednesday.
“Clearly the municipal market is not a sleepy, little, safe market any more,” said Lynnette Hotchkiss, executive director of the Municipal Securities Rulemaking Board. “And we don’t necessarily expect that level of attention will wane any time soon.”
The remarks came on the last day of a three-day conference held here by the Financial Industry Regulatory Authority. Hotchkiss spoke on a panel devoted to the regulator’s perspective on the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is approaching its one-year anniversary in July.
Throughout the morning, regulators from the MSRB, the Securities and Exchange Commission and FINRA grappled to explain key elements of rulemaking proposed in Dodd-Frank’s wake.
One provision in particular surfaced across the discussions: the MSRB’s proposed amendments to Rule G-23, currently under consideration by the SEC, that would prohibit dealer-financial advisers from switching roles and becoming underwriters in the same municipal securities transactions.
“The reality of doing a public finance offering is that you’ve got all your professionals around the table,” Hotchkiss said.
And whether the issuer is large and sophisticated, such as New York City, or a small and infrequent local issuer, she said, regulators need to encourage as much discussion as possible.
Still, Hotchkiss suggested, in certain circumstances, underwriters who switch roles and serve as FAs in the same bond issuance may be required to put their muni client’s interests ahead of their own.
“You want to make sure that when people cross the line, when they start giving financial advice, and certainly when the issuer thinks that that advice is being given as a fiduciary, you want to make sure that the fiduciary standard attaches,” she said. “And it’s going to be a challenge.”
Under the existing Rule G-23, dealer financial advisers can become underwriters in negotiated muni transactions if they terminate their FA role, disclose to the issuer possible conflicts of interest stemming from the role switch as well as their expected compensation, and obtain the issuer’s consent.
The MSRB’s proposed G-23 amendments, filed with the SEC in February, contained interpretive guidance that said a dealer would not be considered an FA for purposes of the role-switching ban if it clearly identified itself as an underwriter from “the earliest stages of its relationship with the issuer.”
In comment letters filed with the SEC, though, groups representing issuers and independent FAs urged the commission to tighten the proposed G-23 amendments, saying it failed to recognize the distinct roles played by FAs and underwriters and their differing obligations to issuers.
Specifically, under Dodd-Frank, FAs are treated as muni advisers who are subject to the SEC’s proposed registration scheme and have an obligation to put their clients’ interests ahead of their own. But Dodd-Frank exempts broker-dealers serving as underwriters from the muni-adviser definition and registration requirements, and thus from the fiduciary standard.
Elsewhere at the conference, another MSRB official echoed Hotchkiss’ concerns.
In the near future, said Ernesto Lanza, the MSRB’s general counsel and deputy executive director, “you will no longer be allowed to switch roles, on either negotiated or competitive transactions.”
Lanza also said that where an underwriter and an FA were providing the same kind of financial advice, regulators could conceivably require the underwriter to put the issuer’s interests ahead of its own.
Additional rulemaking would be required, Lanza added.
An SEC official on Lanza’s panel weighed in on G-23 as well.
When the rule is finalized, it will provide guidance on the roles of an underwriter and a muni adviser, said Dave Sanchez, an attorney fellow in the SEC’s office of municipal securities. And they may be held to different standards, depending on the advice they are providing, he added.
“It’s not your professional title that makes you a municipal adviser, it’s what you do or don’t do,” Sanchez said.
Other Dodd-Frank muni regulatory issues surfaced for discussion as well, both during panel sessions and in questions from audience members.
SEC officials at the conference touched on the commission’s proposed muni-adviser definition, stemming from a rule proposal floated late last year. The SEC has fielded more than 1,000 comment letters on the proposal.
“At the end of the day, there will be a rational definition of municipal adviser,” said John Ramsay, the deputy director of the SEC’s division of trading and markets.
In response to a question from an audience member, Hotchkiss also said she expects the MSRB to create an exam for muni advisers, as part of an overall effort to establish a regulatory framework for the advisers’ professional qualifications.
Some muni advisers may have already obtained licenses pursuant to their activity at broker-dealers or as investment advisers, Hotchkiss noted.
However, the MSRB, which hopes to have the muni adviser test ready by the fall of 2012, is working with a psychometrician.
In an interview, she said a psychometrician assesses a test’s validity, including whether questions can be gamed in any way.
“We are working very diligently to get there,” Hotchkiss said.
In addition, Mac Northam, FINRA’s director of fixed income, member regulation and sales practice policy, said the self-regulator is continuing an ongoing review, launched after the 2008 financial crisis, to ensure that broker-dealers are disclosing material information to investors in the primary and secondary markets at the time of the transaction.
FINRA has settled several actions against broker-dealers and is pursuing others, according to Northam.
He also said FINRA is making inquiries about potential payments to issuer officials stemming from trips to rating agencies. The payments could include reimbursement of travel and entertainment expenses for officials’ family members.
The trip expenses are then “reimbursed” to the issuer as a cost of the issuance, Northam said.
“The key,” he said, “is what is being disclosed and who is making the payments?”
