Dealer groups say MSRB's prearranged trading guidance goes too far

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WASHINGTON — Dealer groups believe the Municipal Securities Rulemaking Board has cast too wide a net with its draft January guidance on prearranged trading, and want clarification on what conduct constitutes a violation of its fair dealing rule under that proposed guidance..

Bond Dealers of America and the Securities Industry and Financial Markets Association expressed those ideas in comment letters sent to the MSRB last week. The letters came in response to the board’s January request for comment on draft guidance,which warned that arrangements in which a dealer firm uses an intermediary to allow the firm to purchase bonds it might not have been able to obtain itself are against the rules and a threat to market integrity.

The type of prearranged trading the MSRB is focused on occurs when, prior to the completion of the distribution of a new issue, a dealer that is not a member of the underwriting syndicate arranges to purchase the bonds at or above the list offering price from either a syndicate member or an investor, typically once the bonds are free to trade. The non-syndicate dealer enters into the prearranged trade to increase the likelihood that it can purchase the bonds for its own account because an order for an investor would receive a higher priority allocation than an order placed directly by the non-syndicate dealer for its own account.

Participants in such arrangements could be violating MSRB Rules G-17 on fair dealing, G-11 on primary offering practices, and G-25, on improper use of assets, the guidance warns. Non-syndicate dealers involved in these arrangements are engaging in a deceptive practice in violation of G-17, the draft guidance said, while a syndicate member could be violating both G-17 and G-11.

But the guidance goes too far in roping in dealers who are not part of an underwriting syndicate, BDA told the MSRB.

“The BDA believes that the guidance will have the unintended consequence of imposing a burden on dealers to monitor how they trade municipal securities that have been recently distributed when they are not syndicate members,” wrote Mike Nicholas, BDA chief executive officer. “The BDA believes that the guidance should cover only syndicate members and regulate their relationship with issuers.”

BDA opposes extending issuer restrictions to non-syndicate dealers, wrote Nicholas, stating that the guidance inappropriately uses Rule G-17 to impose a duty on non-syndicate dealers to be aware of and comply with issuer restrictions. That could impose a burden on dealers to monitor how they trade municipal securities, he told the board.

The only violation of Rule G-17 under the facts contemplated in the guidance, Nicholas wrote, is if a syndicate member submits an order which it knows constitutes a misrepresentation of compliance with issuer restrictions.

Wording in the guidance needs to be changed as well, according to the BDA, such as substituting the word "agree" for the word "arrange," which Nicholas said is a broader term.

The draft guidance follows a major SEC enforcement action in August, when the commission charged two firms and 18 individuals with participating in a “flipping” scheme that included prearranged trading. In those instances, the SEC alleged, investors acting as unlicensed broker-dealers posed as local retail investors to obtain priority position to purchase bonds and then sell them to a dealer firm at a prearranged markup.

The Securities Industry and Financial Markets Association submitted a comment recommending the MSRB defer action on the guidance and future rulemaking until the SEC enforcement proceedings are finished.

“When the MSRB says it’s making new guidance, then the assumption is that that’s the way the rules should have always been, which could potentially impact ongoing cases,” said Leslie Norwood, SIFMA managing director and associate general counsel.

SIFMA also asked for clarifications to the guidance, writing that prearranged trading was not defined, and could easily be confused with permitted activities.

Norwood also addressed investors’ ability to sell bonds they own at any time, key to market liquidity, and not restrict their trading activity. Whether the prearranged trade involves a dealer firm or an investor, Norwood wrote, the key determination for whether a rule violation occurred should be the intent to misrepresent the order. Misrepresentation is a key word when deciding if an event is in violation of Rule G-17 and should be reflected in the guidance, Norwood said.

“We feel that a critical point in this is if they’re talking about some agreement to misrepresent the bonds into the syndicate, that that misrepresentation is critical there,” Norwood said.

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MSRB rules Primary bond market SEC enforcement Securities law BDA MSRB SIFMA Washington DC