Timothy J. Horstmann ()
On July 23, the Municipal Securities Rulemaking Board issued Regulatory Notice 2014-12, requesting comment on its proposed revisions to Draft Rule G-42, concerning the standards of conduct and duties of municipal advisers. The MSRB’s changes to the rule incorporate many of the comments previously received from the public, the effect of which would be to substantially relax the duties owed by municipal advisers to their municipal entity clients.
The MSRB expects that the changes to the rule will reduce the compliance burden for those firms required to register as municipal advisers. Municipal entities, however, will generally have to take affirmative steps to obtain certain information from their advisers, which previously would have been automatically provided to them under the rule as originally proposed.
The MSRB published the original version of Rule G-42 on Jan. 9. The proposed rule sets forth standards of conduct and duties of municipal advisers to their municipal entity clients. The proposed rule does not address the duties of municipal advisers when soliciting municipal entities; the MSRB intends to address solicitation activities in a separate rule.
The rule as originally written establishes that municipal advisers owe a fiduciary duty to their municipal entity clients, and this duty includes both a duty of loyalty and a duty of care. While the MSRB did not change this portion of the rule, it did tinker at the edges of it by making changes to the supplementary material that interprets the rule.
In particular, the MSRB removed from the supplementary material the requirements that the municipal adviser review any official statement issued by the municipal entity, as well as investigate or consider other reasonably feasible alternative arrangements to the recommended transaction that might also serve the client’s objectives. The MSRB explained that these changes were made because “the client should be empowered to determine the scope of services and control the engagement with the municipal adviser.” Thus, municipal entities may still require that their advisers perform such services for them, but the rule does not mandate it.
Additionally, the revised rule changes the municipal adviser’s duty to the municipal entity client when recommending a particular transaction. As originally written, the rule required that the municipal adviser exercise due diligence in determining whether a particular transaction was suitable for the client, and further provided that “a municipal adviser may only recommend a municipal securities transaction or municipal financial product that is in the client’s best interest.”
The revised rule deletes this latter requirement, and while the municipal adviser is still required to act generally in the client’s best interest, the deletion of this specific reference to a “best interest” standard suggests that a municipal adviser may recommend any number of transactions that are suitable to the client, rather than only the transaction that is in the client’s best interest.
The original draft of Rule G-42 also would have required that municipal advisers disclose certain information (including conflicts of interest) to their municipal entity clients either before or upon the commencement of the engagement. The MSRB has proposed a number of changes in the information required to be disclosed pursuant to the rule.
First, the MSRB substantially rewrote the disclosure requirement for conflicts arising from compensation arrangements. As originally written, municipal advisers would have been required to disclose any conflict of interest that may arise from the use of the form of compensation under consideration or selected by the client. As revised, municipal advisers now only have to disclose conflicts arising from compensation that is contingent on the size or closing of the transaction.
The MSRB has also deleted the rule’s requirement that municipal advisers disclose to their municipal entity clients the amount and scope of coverage of professional liability insurance that the adviser carries. The MSRB made the decision to scrap this disclosure requirement after receiving comments that the requirement would have made it more difficult for smaller municipal advisers to obtain and retain clients, likely leading to the exit of such smaller municipal advisers from the industry. Municipal entities therefore should specifically request documentation of professional liability insurance when considering engaging a municipal adviser.
The revised draft of the rule also limits the requirement for disclosure of legal or disciplinary actions taken against the municipal adviser. As originally written, the rule would have required that the municipal adviser affirmatively disclose the existence of any legal or disciplinary event that was material to the client’s evaluation of the municipal adviser or the integrity of the adviser’s management or advisory personnel, as well as any legal or disciplinary event that was otherwise disclosed by the adviser on certain required filings with the U.S. Securities and Exchange Commission. The MSRB has scrapped the latter part of this disclosure requirement, and thus only material events are required to be affirmatively disclosed by the municipal adviser.
However, the MSRB also amended a provision in the original draft rule that requires that the terms of the adviser’s engagement be reduced to writing, to require that this writing also include a description of the types of disciplinary actions that must be disclosed to the SEC on required filings, as well as instructions on how to electronically access these filings.
In addition, the writing must now also include the date of the last material change to a legal or disciplinary event disclosure on any such filing. Thus, while municipal entities would no longer be directly informed of such events, it appears that they will be provided with sufficient information to undertake an independent investigation of such issues, if so willing.
The MSRB made other changes to the writing requirement in the rule. For instance, the MSRB eliminated the requirement that the municipal adviser document each specific undertaking to be performed in connection with a new issue or reoffering of municipal securities; in its place remains the requirement that the writing document the general scope of the activities to be performed, and any limitations on the engagement’s scope. The MSRB also added a new requirement, that the writing document any terms relating to the withdrawal by the municipal adviser from the engagement.
The revised rule also would relax the prohibition on municipal advisers engaging in so-called “principal transactions” with their clients. As originally written, the rule provided that municipal advisers were generally prohibited from engaging in “any transaction, in a principal capacity, to which a municipal entity client of the municipal adviser is a counterparty.”
After receiving several comments that the prohibition was vague and overbroad, the MSRB narrowed the prohibition to only cover those transactions “directly related to the same municipal transaction or financial product as to which the municipal adviser is providing advice.” In addition, the MSRB added a definition for the term “engaging in a principal transaction,” defining it to mean, “when acting as a principal for one’s own account, selling to or purchasing from the municipal entity client any security or entering into any derivative, guaranteed investment contract, or other similar financial product with the municipal entity client.” The result of these changes is that many transactions, which previously would have been prohibited under the original rule, are still permissible.
A final point about the rule changes is worth noting: The revised rule adds an “oops” exception to the disclosure and documentation requirements for firms that inadvertently engage in municipal advisory activities but do not intend to continue such activities or enter into an engagement with the municipal entity. Firms wishing to take advantage of the exception must provide a disclaimer to the recipient of the activities, and take steps to ensure there aren’t any additional such moments in the future.
Timothy J. Horstmann is an associate at McNees Wallace & Nurick in Harrisburg and practices in the firm’s public finance and municipal recovery groups. The firm represents state and local governments and agencies as issuers of revenue bonds and general obligation bonds. The firm also routinely serves as underwriter’s counsel and counsel to conduit borrowers, banks and trustees.