Rule G-23 of the Municipal Securities Rulemaking Board

Underwriters Prohibited from Serving as Financial Advisors

An underwriter is not a financial advisor.  Underwriters have no responsibility to serve in the best interest of municipal entities and must now make this perfectly clear under new securities laws. Effective November 27, 2011, underwriters must make the following disclosure to issuers, in writing:

"The primary role of an underwriter is to purchase, or arrange for the placement of, securities in an arm’s-length commercial transaction between the issuer and the underwriter and that the underwriter has financial and other interests that differ from those of the issuer."

Rule G-23

The Municipal Securities Rulemaking Board (MSRB) is the regulatory agency that oversees firms involved in underwriting municipal bonds and providing financial advice.  The disclosure noted above is part of the requirements imposed on broker-dealers under the MSRB’s Rule G-23.  Amendments to Rule G-23 were approved by the Securities and Exchange Commission in May 2011 and became effective on November 27, 2011. The primary purpose of Rule G-23 is to prevent conflicts of interest by prohibiting an underwriter from serving as a financial advisor and subsequently serving as the underwriter of the issue.

While firms known as “independent” financial advisors never underwrite bonds and always serve in a fiduciary capacity to issuers, some broker-dealers (underwriters) periodically serve as financial advisors.  In general, Rule G-23 was amended to prohibit a broker, dealer, or municipal securities dealer (“dealer”) that serves as financial advisor to an issuer for a particular issue sold on either a negotiated or competitive bid basis from switching roles and underwriting the same issue.

History of Rule G-23

Rule G-23 was first adopted on September 20, 1977.  At the time of adoption, the MSRB filed a notice regarding Rule G-23 with the Securities and Exchange Commission. The following text, extracted from the notice, describes the different roles of a financial advisor and an underwriter.

"Proposed rule G-23 addresses certain aspects of the conduct of a municipal securities professional acting as a financial advisor or consultant to a state or local governmental unit. As a financial advisor, the municipal securities professional acts in a fiduciary capacity as agent for the governmental unit, assisting it in determining its debt structure, determining when and under what circumstances to market its securities, and preparing or assisting in the preparation of documents to be used in connection with the sale of its securities . . .

The role and interests of a securities professional acting as financial advisor to a governmental unit are significantly different from the role and interests of a securities professional acting as an underwriter or as a purchaser in a private placement. For example, as agent for the issuer, a financial advisor would normally seek to achieve the lowest possible interest cost for the issuer, while an underwriter, acting as principal for its own account, would normally want to establish yields which make the securities attractive for resale to others. Other marketing features, important from an underwriting perspective, may conflict with an independent determination of the same matters from the perspective of the issuer.  If the underwriter has customers for large amounts of the securities to be issued, the underwriter may be influenced to advocate a larger issue than might otherwise be in the best interests of the issuer; conversely, an underwriter might advocate a smaller issue if its own customers’ interest is not strong.  Maturities, redemption provisions and remedy covenants are other facets of an issue with respect to which a municipal securities professional may be influenced to give different advice, depending on whether the securities professional is acting as an underwriter or private placement purchaser of the securities, or solely as the issuer’s agent.  The size of the underwriting spread may also be affected by the arm’s-length character of the relationship between the issuer and its agents, on the one hand, and the underwriter, on the other."

In spite of the conflict of interest, Rule G-23 allowed broker-dealers to serve as a financial advisor and then switch to an underwriter as long as the firm received written consent to do so by the issuer.

Why the Rule Was Changed

"Financial Advisers should be prohibited from resigning as financial advisor to an issuer, and then underwriting that issuer’s bonds, as they are currently allowed to do under MSRB rule
G-23. Right now, a financial professional advising a municipality can guide the municipality towards securities tailored to his firm’s advantage, then resign and act as underwriter. This
is a classic example of conflict of interest.
"

 - Mary Schapiro, Chairman of the Securities and Exchange Commission, May 7, 2010

The Municipal Securities Rulemaking Board was established in 1975 as a self-regulatory organization governed by broker-dealers. Its mission was to develop rules regulating securities firms and banks involved in underwriting, trading, and selling municipal securities with the mission of protecting investors.  

With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (also known as the Dodd-Frank Act) on July 21, 2010, the MSRB’s responsibilities were expanded to include the protection of state and local government issuers as well as investors.  As a result of the passage of the Dodd-Frank Act and at the request of the Securities and Exchange Commission, on August 17, 2010, the MSRB proposed changes to Rule G-23.  Following a public comment period, on February 9, 2011 the MSRB submitted proposed amendments to the SEC and in its release stated the following:

"The proposed rule change resulted from a concern that a dealer financial advisor’s ability to underwrite the same issue of municipal securities, on which it acted as financial advisor, presented a conflict that is too significant for the existing disclosure and consent provisions of Rule G-23 to cure. Even in the case of a competitive underwriting, the perception on the part of issuers and investors that such a conflict might exist was sufficient to cause concern that permitting such role switching was not consistent with "a free and open market in municipal securities," which the Board is mandated to perfect.

The imposition by Dodd-Frank of a fiduciary duty upon municipal advisors, which includes financial advisors, made the existence of such a conflict a greater concern."

The MSRB also noted that the proposed rule change would help protect municipal entities.

Restrictions of the Rule

The long overdue amendments preclude a broker-dealer that serves as financial advisor from switching to an underwriter for that transaction regardless of whether the issue is sold through a negotiated or competitive sale.

Along with the passage of the amendments to Rule G-23, the MSRB released an interpretive notice stating that an underwriter may provide advice concerning the structure, timing, terms, and other similar matters concerning an issue of municipal securities, provided that the underwriter:

 (i)    clearly identifies itself in writing as an underwriter and not as a financial advisor from the earliest stages of its relationship with the issuer with respect to that issue (e.g., in a response to a request for proposals or in promotional materials provided to an issuer);

(ii)   the writing makes clear that the “primary role of an underwriter is to purchase securities in an arm’s-length commercial transaction between the issuer and the underwriter and that the underwriter has financial and other interests that differ from those of the issuer”; and

(iii)       the dealer does not engage in a course of conduct that is inconsistent with an arm’s-length relationship with the issuer in connection with such issue of municipal securities.

For the complete text of the rule, as amended, see Rule G-23 at the Municipal Securities Rulemaking Board's web site.  

 

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