Financial Adviser Private Placement Warning

WASHINGTON — The Municipal Securities Rulemaking Board warned financial advisers to state and local governments Wednesday that certain bank loans and financings may qualify as private placements of municipal securities, subjecting them to federal securities laws and MSRB rules that apply to broker-dealers.

In a one-page statement posted on the MSRB’s website, the board said financial advisers who introduce potential investors to issuers or negotiate with potential investors for “transaction-based compensation” may unknowingly become subject to federal securities laws, including the board’s broker-dealer rules.

Engaging in these activities may make FAs subject to MSRB rules on placement agents, the board said.

“Private placements of municipal securities are on the rise and it is critical that financial advisors determine whether their activities require registration with the Securities and Exchange Commission as a broker to avoid inadvertent violations of relevant securities laws,” MSRB executive director Lynnette Hotchkiss said in a release.

The board’s warning came in response to “the growing use of private placements as an alternative to traditional public municipal securities offerings,” the statement said.

A financial adviser whose activities require it to register with the SEC as a broker would also be subject to the MSRB’s rules governing broker-dealers, including Rule G-23, prohibiting role switching, the board said.

That rule, which recently underwent several rounds of public comment, revision, and final approval by the SEC, generally prohibits dealer FAs from serving as financial adviser and underwriter or placement agent on the same issue of municipal securities.

Financial advisers who act as placement agents must register with the MSRB as broker-dealers, the board said, even if they are already registered as municipal advisers.

FAs who act as placement agents would also be required to follow other MSRB rules, including Rule G-17 on fair dealing, and Rule G-37 on political contributions.

An independent financial adviser welcomed the MSRB’s warning, saying he hoped it would trigger more scrutiny of private placements and spark discussion of contingency fees in the muni market.

“I hope we don’t just stop with a notice,” said Robert Doty, president of American Government Financial Services Co. in Sacramento. “I hope there’s some serious enforcement in this area.”

Anecdotally, Doty has observed a shift among issuers away from traditional municipal securities offerings and toward private placements.

“As the cost of issuance goes up, issuers find it more and more attractive to engage in private placements,” he said.

He also warned issuers cannot receive unbiased advice from FAs who work on a contingency basis, meaning they are paid only if a transaction is finalized.

“Contingent compensation is one of the curses of the municipal market,” he said.

Another independent financial adviser said she needs additional guidance from the MSRB.

In particular, the board should clarify the difference between a bank loan and a municipal security, said Colette Irwin-Knott, a partner at H.J. Umbaugh & Associates in Indianapolis and president of the National Association of Independent Public Finance Advisors.

Irwin-Knott also said she has begun to see an increase in private placements as issuers confront challenges in the muni market.

“And I think that will only continue, particularly for the smaller transactions and the less sophisticated issuers,” she said.

A broker-dealer group applauded the MSRB’s warning as well, saying independent FAs have long enjoyed a competitive advantage over their broker-dealer counterparts.

“The [Bond Dealers of America] views this MSRB notice as another step towards increased market transparency and a leveling of the playing field for all parties active in the municipal securities market and we look forward to the MSRB clearly differentiating bank loans from municipal securities,” chief executive officer Mike Nicholas said in an e-mail.

An issuer, meanwhile, worried that small municipalities would not be able to afford FAs without contingency fees.

“We can sit here until the cows come home and talk about the perfect world in which FA work is done on a fee basis,” said Frank Hoadley, Wisconsin’s capital finance director and a member of the Government Finance Officers Association’s governmental debt-management committee. “It’s a confusing area, full of some ambiguity and many shades of grey.”

Historically, the MSRB’s statement said, the SEC permitted financial advisors to engage in certain activities related to the placement of municipal securities, such as introducing an issuer to investors and receiving “transaction-based compensation,” without registering as a broker-dealer. But in 2000, the SEC revised its stance, saying technological advances, including the rise of the Internet, had allowed more and different types of persons to provide securities-related services.

According to a guide to broker-dealer registration posted on the SEC’s website, a person may need to register as a broker if he finds investors for issuers, even as a consultant.

One factor to weigh is whether the individual’s compensation for participating in a transaction depends upon, or is related to, the outcome or size of the deal, the guide says.

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