WASHINGTON — The Municipal Securities Rulemaking Board issued a draft rule Monday that would spell out how muni advisers will be expected to comply with new fiduciary-duty obligations imposed on them by the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The MSRB also issued two draft interpretive notices for Rule G-17 explaining how fair-dealing requirements would be extended to municipal advisers and how the rule applies to underwriters.
Muni advisers became subject to Securities and Exchange Commission registration and board oversight on Oct. 1, under Dodd-Frank. That law delegated to the MSRB the task of delineating the scope of the fiduciary duty requirement for advisers.
The board asked market participants to comment on the draft Rule G-36 as well as both interpretive notices on Rule G-17 by April 11. Preliminary reaction from municipal market participants was muted Monday, as they analyzed the new requirements and pondered their scope.
“People always feel justifiably nervous about broad regulatory actions,” said Robert Doty, president of the independent financial advisory firm, American Governmental Financial Services Co., who had not had an opportunity to study the releases.
But several market participants were concerned about the MSRB’s decision to weigh in on these issues before the Securities and Exchange Commission has finalized whether broker-dealers must register as muni advisers. As currently written, Rule G-36 is based on the Dodd-Frank Act’s definition of muni adviser and does not extend to broker-dealers. If the SEC requires dealer-advisers to register, the board could re-release its drafts for additional comments.
“We need to settle who is a municipal adviser,” said William Daly, senior vice president of government relations for the Bond Dealers of America. “It’s a little hard to comment if you don’t know who it applies to.”
On its face, draft Rule G-36 is straightforward. “In the conduct of its municipal activities on behalf of municipal entities,” it says, “a municipal adviser shall be subject to a fiduciary duty, which shall include a duty of loyalty and a duty of care.”
In the interpretative notice accompanying the rule, however, the board outlines a series of mandatory disclosure obligations governing compensation and conflicts of interest, making clear that municipal advisers must act in the issuer’s best interests regardless of the their own.
At the beginning of engagements, muni advisers must disclose in writing any material conflicts, including payments related to obtaining municipal advisory business, third-party payments related to the engagement, and other engagements or relationships that might impair the adviser’s ability to act in the issuer’s best interests.
Advisers must obtain informed consent from the issuer. If a conflict arises after the engagement has begun, the adviser must stop providing services and obtain written informed consent before continuing. And if an adviser believes the issuer did not provide informed consent, it must take additional steps to inform officials of the nature and implications of its conflicts.
An adviser must also tell an issuer if it reasonably believes a proposed financing is not in the issuer’s best interest, even if doing so adversely affects the adviser’s compensation. Though Rule G-36 does not prohibit contingency fees, it would prod advisers to disclose them.
A draft consent form, appended to the rule, says contingent fees may create an incentive for the adviser to recommend unnecessary or disadvantageous financings.
Rule G-36 also prohibits “unmanageable” conflicts, such as kickbacks and excessive compensation, reasoning that no municipal official could provide informed consent, even if fully informed about them. The rule does not explain when compensation would veer into the realm of excess, but says fees “so disproportionate” the adviser could not act in the issuer’s best interests would violate the adviser’s duty of loyalty, even if disclosed.
In a separate section, devoted to the duty of care, Rule G-36 bars muni advisers from undertaking engagements if they lack sufficient knowledge and expertise to provide informed advice.
A muni adviser should not undertake a swap advisory engagement unless it can evaluate the transaction, as well as its risks, pricing and appropriateness. The rule would also require an FA to investigate reasonably feasible financing alternatives that would better serve the issuer’s interests, and advise the issuer about them.
Under the proposed interpretative notices for Rule G-17, which previously applied only to municipal securities dealers, muni advisers would fall within the provision’s fair-dealing requirement, prohibiting them from engaging in any deceptive, dishonest, and unfair practices. As a practical matter, the board says, any muni adviser who violates Rule 17 would also violate Rule 36.
Still, the board’s action was just the first step in a long process, likely to extend over several years.
“We’re only at the beginning stages of this,” Doty said. “It will be interesting to see how this all shakes out.”