A Municipal Securities Rulemaking Board proposal concerning an MSRB rule that defines the term sophisticated municipal market professional could, if adopted, end up harming retail investors who rely on smaller Securities and Exchange Commission-registered investment advisers to buy municipal bonds on their behalf.
That's according to Mark Conner, principal at Second Chair LLC, and Michael Bixby, president of the Public Investors Advocate Bar Association, who each responded to a Nov. 3 request for comment the MSRB published to seek comment on draft amendments to MSRB Rule D-15, which defines the term sophisticated municipal market professional.
Referred to as SMMP for short, the term is defined by three essential requirements: The nature of the customer, dealer determination of customer sophistication and customer affirmation. The draft amendments include a proposal that, according to the RFC, would exempt SEC-registered investment advisers "from having to make certain affirmations in order to qualify for status as an SMMP."
Exempting SEC-registered investment advisers from the rule's affirmation requirement could expose retail customers of small or midsize investment advisers registered with the commission to "unsuitable recommendations and possible losses," Conner, who serves as an expert witness and case consultant at Financial Industry Regulatory Authority arbitration and in court matters, said in an interview this week.
In responding to the RFC, both Conner and Bixby cited language in it that said that the MSRB had stated in an earlier RFC that it understood that SEC-registered investment advisers "are typically very sophisticated and, as a result, some market participants have questioned whether the burdens associated with obtaining an attestation from these professionals is sufficiently outweighed by the protections afforded to them."
In PIABA's Jan. 30 comment letter to the MSRB, Bixby called that assumption "fundamentally flawed," and said it "overlooks the substantial variability in RIA expertise, particularly with respect to municipal securities."
Barriers to becoming a registered investment adviser "are relatively modest," he said, adding that they entail one exam, incorporating a company, registering with the SEC or state depending on assets under management, filing a Form ADV and setting up a custodian for a client's securities.
"Notably, none of these requirements mandate any knowledge or experience specific to municipal securities: their unique risks, complex structures, tax considerations, or credit analysis methodologies," Bixby said in PIABA's letter.
Smaller RIAs, which make up a substantial portion of the industry, "often lack dedicated research staff, credit analysis capabilities, or the infrastructure necessary to independently evaluate complex municipal securities transactions," PIABA's comment letter said.
"The attestation requirement currently serves a critical gatekeeping function: it forces RIAs to affirmatively confirm that they possess the specific capabilities required for SMMP status— timely access to material facts, independent evaluation capacity, and independent decision-making," Bixby said in the letter. "Eliminating this requirement would allow automatic SMMP classification of RIAs regardless of their actual municipal securities expertise, resources, or track record in this asset class."
Like Bixby, Conner disagrees with any notion that the affirmation requirement is unduly burdensome and that all RIAs are presumptively SMMPs. Conner responded to the MSRB's Nov. 3 RFC via both an email sent that day and a subsequent letter.
"In the last decade, there has been a proliferation of smaller registered investment advisers (RIAs), both SEC and state registered, that employ client-facing RIA agents that are woefully unsophisticated, untrained, and uninformed about municipal bonds," Conner said in his email.
Those RIAs and their agents "lack requisite sophisticated resources for conducting both market and municipal credit research, and generally do not understand the salient yet peculiar aspects of how the municipal bond market operates," Conner's email said.
"As an expert witness at FINRA arbitration, I am receiving more and more inquiries from claimant attorneys related to losses and/or unsuitable municipal bond recommendations..," he said in the email.
Should an RIA become exempted from the affirmation requirement, "it exposes their customers to the risks arising from the condition that the agent is, in fact, not an SMMP," Conner said in his Nov. 3 comment.
In the interview, Conner identified a "further problem" relating to the relatively small size of many RIAs that could result from exempting SEC-registered investment advisers from the rule's affirmation requirement.
If an RIA customer is awarded damages after filing an arbitration claim against an RIA and the RIA lacks sufficient capital to pay the award – a growing problem – that RIA, because it would be presumed to be an SMMP under the MSRB's proposal, "would have limited if any claim against the dealer that might have made an unsuitable recommendation," he said.
Michael Decker, senior vice president for research and public policy at the Bond Dealers of America, said that retail investors who rely on RIAs, whether those investment advisers are registered with the SEC or state regulators, "expect their IAs to understand their own decisions."
"That is a very basic function and service of IAs," Decker said, adding that if an IA doesn't fully understand municipal securities, it shouldn't be advising customers on their municipal portfolios. "It is an IA's job to determine whether a recommendation is suitable for their customer."
The MSRB provided a statement in response to a request to address comments made by Conner and Bixby.
"MSRB's Request for Comment on Rule D-15 was issued to solicit targeted input on defining the term Sophisticated Municipal Market Professional within its rulebook," the statement said. "MSRB appreciates all comments received from market participants and will review feedback and consider whether further amendments are warranted based on the comments received."
