The Municipal Securities Rulemaking Board has asked the Securities and Exchange Commission to approve a new rule that would govern the activities of broker’s brokers, which typically provide secondary market liquidity for retail investors in the municipal securities market.

The board filed the proposed new Rule G-43, along with proposed amendments to its Rules G-18 on execution of transactions, G-8 on record keeping and G-9 on record retention with the SEC on Monday, urging they become effective six months after approval by the commission. The SEC must publish the rule for public comments before approving it.

“Most retail investors are unaware of what broker’s brokers are,” said MSRB executive director Lynnette Kelly. “But broker’s brokers play a critical rule in providing secondary market liquidity for retail investors by acting as intermediaries between selling and bidding dealers. Our proposed rules would ensure investors receive fair prices when buying and selling municipal securities.”

The MSRB said that while many broker’s brokers try hard to comply with its rules, it decided the new rule was needed after several enforcement actions were taken against broker’s brokers for unfairly pricing munis in trades conducted on behalf of retail investors.

The proposed Rule G-43 defines a broker’s broker as “a dealer, or a separately operated and supervised division or unit of a dealer, that principally effects transactions for other dealers or that holds itself out as a broker’s broker, whether a separate company or part of a larger company.”

In one major change from drafts, the MSRB said an electronic trading system would fall outside the definition of a “broker’s broker” if it uses only automated and electronic means to communicate with bidders and sellers in a systemic and non-discretionary fashion, with limited exceptions; has only sophisticated municipal market professionals as customers; and generally complies with provisions designed to ensure that bid-wanteds and offerings are conducted in a fair manner.

In a bid-wanted, the selling dealer asks a broker’s broker to obtain the best bid that it can find for certain munis, without specifying a desired price or yield. Many of the provisions focus on bid-wanteds because these were the subject of a lot of enforcement actions.

Under the proposed G-43, a broker’s broker would be required to make a reasonable effort to obtain a price for a dealer that was fair and reasonable in relation to prevailing market conditions. It also would have to apply the same care and diligence as if the transaction was being done for its own account. If a broker’s broker acts on behalf of another dealer in the purchase or sale of munis, it could not take any action that would work against the dealer’s interest to receive advantageous pricing.

The proposed rule would create a safe harbor under which a broker’s broker could satisfy its pricing duties if it met certain conditions. The firm would have to disseminate a bid-wanted widely and, in the case of munis with limited interest, would have to make a reasonable effort to reach dealers with knowledge of the munis or comparable securities. The broker’s broker would have to designate a deadline for the acceptance of bids.

It also would have to use certain “predetermined parameters” such as yield curves, pricing services, recent trades reported to the board’s online EMMA system, or bids submitted to a broker’s broker in previous bid-wanteds of offerings to identify off-market bids when conducting bid-wanteds. The broker’s broker would have to test the parameters periodically to see if they are achieving their designed purpose, the board said.

The proposed rule would permit a broker’s broker using the safe harbor to contact the high bidder in a bid-wanted prior to the deadline for bids without the seller’s consent, if it believed the bid might have been submitted in error. However, if the bid fell within the predetermined parameters, the seller’s consent would be required. A broker’s broker also would have to notify the seller and get its consent to proceed with a trade if the bid-wanted was below the predetermined parameters.

The proposed rule would prohibit “last looks” at bids, encouraging off-market bids, engaging in self-dealing, or failing to inform the seller of the highest bid, among other things.

The amendments to G-8 would specify the types of records that must be retained such as bids, offers, and changes bids, while the changes to G-9 would require a broker’s broker to keep the records for six years.

The MSRB filing also contains a proposed notice outlining the pricing duties of bidding and selling dealers. The board reminded selling dealers that the high bid obtained in a bid-wanted or offering is not necessarily a fair and reasonable price and that they have an independent duty under Rule G-30 on pricing to determine if the prices at which they purchase munis as a principal for customers are fair and reasonable.

The board cautioned selling dealers against getting broker’s brokers to “screen” or show bid-wanteds or offerings only to certain dealers. 

It also said that when a bid-wanted results in a bid that a selling dealer thinks is low, the selling dealer should not assume that the buyer needs to sell right away.  The dealer might make more sense to put the bonds out for the bid again to see if a higher bid would result. In addition, the board warned selling dealers against using broker’s brokers to determine prices so they can sell the munis on their own, saying this is an unfair practice that would violate G-17 on fair dealing.

The board said bidding dealers should not submit bids to broker’s brokers that they know are below fair market value or if they have made no effort to figure out what fair market value is. While bidding dealers are entitled to make a profit, they are not permitted to knowingly offer below market bids, hoping the selling dealer will not know, the board said.

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