MSRB Rules and the Municipal Market

The conduct rules a representative meets daily

Rule G-17, fair dealing, is the foundation. In the conduct of municipal securities activities, a dealer must deal fairly with all persons and must not engage in any deceptive, dishonest or unfair practice. It contains two limbs: an anti-fraud prohibition modelled on SEC Rule 10b-5, and a general duty of fair dealing that applies even where there is no fraud. Its most operational requirement is time-of-trade disclosure — a dealer effecting a transaction must disclose to the customer all material information about the transaction known to the dealer, and material information about the security that is reasonably accessible to the market, at or before the sale.

Rule G-19, suitability, requires a reasonable basis to believe a recommendation is suitable based on information obtained about the customer's financial status, tax status, investment objectives and other relevant information. It is the municipal counterpart to FINRA Rule 2111, and it is why the AMT and bracket questions from the last lesson are compliance matters and not merely arithmetic.

Rule G-30, prices and commissions, requires that a dealer trading as principal deal at a price that is fair and reasonable, taking into account all relevant factors, and that commissions on agency trades not be unfair or unreasonable.

Rule G-15 governs confirmations. A municipal customer confirmation must show, among other things, the yield and dollar price, computed to the lower of call or maturity — the mechanical basis of quoting premium bonds to the call — plus the capacity in which the dealer acted, the settlement date, and any call features and material credit information.

Rule G-14 requires trade reporting to the Real-Time Transaction Reporting System, generally within fifteen minutes of the time of trade, which is what makes the price transparency on EMMA possible.

Rule G-21 governs advertising, G-27 supervision, G-8 the books and records that must be made and G-9 how long they must be preserved. Rule G-37 restricts municipal securities business after political contributions to officials who can influence the award of that business — an area with a bright-line structure and severe consequences, and one where a small personal contribution can disqualify a whole firm.

How a municipal issue comes to market

There are two routes, and the exam contrasts them constantly.

A competitive sale is advertised through a notice of sale, which states the terms of the issue, the bidding conditions, the date and time bids are due, the good faith deposit required, and the basis on which the award will be made. Underwriting syndicates submit sealed bids and the issue is awarded to the bid producing the lowest interest cost to the issuer. Two measures of that cost appear: net interest cost, which sums the interest payments and adjusts for premium or discount without regard to when payments occur, and true interest cost, which discounts the payments to present value and is therefore the more accurate measure. General obligation bonds are typically sold competitively, often because the law requires it.

A negotiated sale has the issuer select an underwriter in advance and negotiate the terms and the underwriting spread directly. It suits complex credits and revenue bonds, where the underwriter's work in structuring and marketing the issue begins long before pricing. Under G-17's interpretive guidance, an underwriter in a negotiated deal must disclose to the issuer that it is acting as an underwriter and not as the issuer's agent or fiduciary — its interests differ from the issuer's — which is a distinction the exam likes because it is counterintuitive.

A private placement sells the issue directly to a limited number of institutional buyers without a public offering.

An advance refunding, covered in lesson 4.3, is a primary market transaction as well as a credit event.

The official statement and the legal opinion

The disclosure document for a municipal issue is the official statement, and its preliminary version is the preliminary official statement, or POS. It describes the issue, the security, the sources of payment, the issuer's finances, the risk factors and the redemption provisions. It is the municipal analogue of a prospectus, but it is produced under MSRB rules and market practice rather than under a Securities Act registration.

MSRB Rule G-32 requires a dealer selling a new issue municipal security to deliver the official statement to the customer by settlement, satisfied in practice by submission to EMMA, where it becomes publicly available. Rule G-34 requires CUSIP number assignment and the submission of new issue information.

The legal opinion is written by bond counsel, printed in the official statement and historically on the bond itself. It addresses two things: that the bonds are a valid and legally binding obligation of the issuer, and that the interest is exempt from federal income tax. An unqualified opinion contains no reservations. A qualified opinion contains a reservation about some aspect of the issue, and the reason for it is something a representative must be able to explain to a customer.

Syndicate mechanics and order priority

A municipal syndicate is formed by an agreement among underwriters that sets each member's participation, the liability structure, the underwriting spread and the order priority.

Liability comes in two forms. In a Western or divided account, each member is liable only for its own allotment: sell your share and you are done. In an Eastern or undivided account, each member remains liable for its proportionate share of any unsold bonds regardless of how much it sold itself. Eastern is the more onerous, and the exam tests it by describing a member that sold its entire allotment and asking whether it retains exposure — under an Eastern account, it does.

The underwriting spread is the difference between what the syndicate pays the issuer and the reoffering price. It divides into the manager's fee, the additional takedown and the concession. A selling group member that is not a syndicate member buys at a concession from the public price; a syndicate member earns the total takedown. A reallowance is the amount granted to a dealer that is neither a syndicate nor a selling group member.

MSRB Rule G-11 governs primary offering practices, including how orders are prioritized when the issue is oversubscribed. The customary priority, which the syndicate agreement must disclose, runs presale orders first, then group net orders, then designated orders, then member orders. The logic is that orders benefiting the whole syndicate — and therefore the issuer, since they reduce the risk of unsold bonds — rank ahead of orders that benefit one member. G-11 also requires disclosure of the syndicate's terms and of any allocation that departs from the stated priority.

Continuing disclosure and EMMA

Because municipal issuers are not subject to Exchange Act periodic reporting, the SEC reached the same goal indirectly. Rule 15c2-12 prohibits an underwriter from purchasing or selling municipal securities in a primary offering unless the issuer or an obligated person has undertaken, in a written continuing disclosure agreement, to provide annual financial information and notices of specified material events to the MSRB.

The listed events include principal and interest payment delinquencies, non-payment defaults, unscheduled draws on debt service reserves or credit enhancements, substitution of credit or liquidity providers, adverse tax opinions or events affecting the tax status of the bonds, modifications to bondholder rights, bond calls and defeasances, rating changes, bankruptcy or insolvency of the obligated person, and certain financial obligations incurred by the obligor.

All of it is filed with EMMA, which is therefore where a representative goes to research a municipal bond: official statements, continuing disclosure, material event notices and actual trade prices in one place. Rule G-17's obligation to disclose material information reasonably accessible to the market is, in practice, an obligation to look at EMMA before recommending a municipal security. A representative who did not check and sells a bond whose issuer filed a material event notice last month has a real problem.