WASHINGTON — Municipal advisors would have to determine whether transactions or products are suitable for conduit borrowers under a proposal the Municipal Securities Rulemaking Board filed with the Securities and Exchange Commission Wednesday.

The proposed interpretive notice to Rule G-17 on fair dealing modifies a draft notice the MSRB floated in February.

The draft notice would have required muni advisors to conclude, in their professional judgment, that a transaction or product was "appropriate" for the client, given its financial circumstances, objectives and market conditions.

But in the 15-page interpretive notice filed with SEC, the board said a muni advisor who recommends a transaction or product to a conduit borrower must have "reasonable grounds for believing" the transaction or product is suitable, "based on the client's financial circumstances, objectives, tax status and any other material information" known by the advisor "after reasonable inquiry."

"Today's proposal would provide obligated persons and state and local government entities that are solicited by municipal advisors many of the same safeguards provided under the MSRB's fiduciary duty initiatives," said executive director Lynnette Hotchkiss. "We believe these regulations are key in fulfilling the MSRB's mission to protect these market participants."

The SEC must publish the board's notice for public comment and take the comments into account before approving it. The notice would not take effect before the effective date of the commission's final registration rules that define "municipal advisor."

Rule G-17 applies to municipal advisors who are advising conduit borrowers or soliciting public pension funds on behalf of third parties. The board proposed this guidance because municipal advisors are not subject to a fiduciary duty when advising conduit borrowers or soliciting public pension funds on behalf of third parties.
The board's move comes after several market participants filed comment letters criticizing the draft notice, including the proposed "appropriateness" standard.

In particular, the board noted in the 142-page notice filed with the SEC that the Securities Industry and Financial Markets Association had questioned whether "appropriateness" and "suitability" meant the same thing. SIFMA also said the board's focus on "appropriateness" would create a new standard of conduct for municipal advisors.

The MSRB told the SEC that it had revised the notice's language "to align what SIFMA suggested might be potentially conflicting regulatory regimes."

In addition, the board told the SEC that the National Association of Independent Public Finance Advisors had objected to certain obligations required by the draft notice, such as a duty to investigate or make a reasonable inquiry, saying they imposed due diligence requirements on muni advisors.

SIFMA objected as well, suggesting any duty to investigate a transaction's appropriateness should be limited to facts the advisor was required to obtain under MSRB rules, or otherwise had in its possession.

But the board told the SEC that the proposed notice would require muni advisors to perform a "reasonable inquiry" into the suitability of a transaction or product.

The board said it is not trying to impose a "due diligence" requirement on municipal advisors.

Advisors who make recommendations to conduit borrowers would have to "gather and review" the information on which they base their suitability determination, the MSRB said.

Separately, the board clarified a municipal advisor's obligation to disclose any conflicts of interest under Rule G-17.

It added language in the notice that had not been included in the draft, saying muni advisors must disclose conflicts existing at the beginning of an engagement, as well as those discovered during the engagement.

The board also said muni advisors must disclose all conflicts in writing to an issuer official whom the advisor "reasonably believes" has the authority to enter into contracts on the issuer's behalf.

The draft notice would have required the advisor to disclose its conflicts in writing to an issuer official "with the authority" to bind the borrower.

But the MSRB told the SEC that it agreed with NAIPFA's comment that municipal advisors should be permitted to rely on the "apparent authority" of issuer officials to acknowledge a conflicts disclosure.

The board also clarified when an advisor's compensation might prove so "excessive" that it would violate Rule G-17.

The MSRB's draft had said that the reasonableness of a municipal advisor's compensation would vary according to its expertise and the nature of the financing.

In comments, NAIPFA had suggested criteria for deciding when compensation might be excessive, including the time and labor required, the novelty and difficulty of the issue, and the skill required to perform the services.

The MSRB said in the notice that the reasonableness of a muni advisor's compensation would vary according to its "expertise, the complexity of the financing, whether the fee is contingent upon the closing of the transaction, and the length of time spent on the engagement, among other factors."

Many factors can affect the amount of the fee, and the specific factors listed in the notice filed with the SEC are not exclusive, the MSRB said.

"In all cases, the municipal advisor should be able to support the legitimacy of its fees," the board said.

Among market participants, reaction to the proposal the MSRB filed with the SEC was mixed.

"As this regulation evolves over future years, issuers and obligated persons will receive enhanced information regarding conflicts of interest and enhanced information regarding transactions that municipal advisors recommend," Robert Doty, president of American Governmental Financial Services Co. in Sacramento, wrote in an email. "That will discourage unduly risky or unwise transactions, and by doing so, also will protect the interests of investors."

An industry group's reaction was more measured. Leslie Norwood, SIFMA's managing director and co-head of its muni securities division, said she was "pleased" the board had clarified that the G-17 standard was "suitability," not "appropriateness."

Norwood, who had not reviewed the board's proposal in its entirety, also said SIFMA would continue to study the proposal and would likely file comments with the SEC.

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